Economics in context

1. Managerial EconomicsLecture #2: Economics in context (part 1/2)25 October 2016Dr John Humphreysjohn@humancapitalproject.com.au

2. Economics in context • Lecture #2: Economics in context (part 1/2) (25-Oct-2016) • Background = Definition, economic language & history of economic thought • Micro: trade & markets = gains from trade, S&D graph, equilibrium, price fixing, elasticity, and market structures • Micro: underlying theory = consumer theory, producer theory, and behavioural economics • Lecture #3: Economics in context (part 2/2) (8-Nov-2016) • Political economics = Pareto, market failure, state failure, and public policy • Dynamic economics = time, risk, financial assets, and strategic decisions • Institutional economics = types, impact on markets, society & government • Macroeconomics = GDP, business cycle, economic growth, and money

3. 1. Background: What is economics? • What economics is NOT • NOT the study of money • NOT learning how to invest and get rich (though it can help) • NOT learning how to run a business (though it can help) • Economics is the study of happiness& choice • Goal = economists try to maximise utility (happiness), not money • Definition = the study of human action when faced with trade offs • There aint no such thing as a free lunch (TANSTAAFL) • Scarcity exists = there is limited matter, energy, space & time • Desires are effectively unlimited, so choices must be made • Economics = how to allocate scarce resources when there are different options • If there is no scarcity or no disagreement, then (nearly) no need for economics

4. Language of economics • Cost • Economists use the term “cost” differently from most people • Does not mean the dollar price you pay for something • Econ meaning: it is what you had to give up in order to get that thing • Referred to as the “opportunity cost” • Different meaning for “cost” also means different meaning for “profit” • Rationality • Economists use the term “rational” differently from most people • Does not mean that people make sensible decisions • Econ meaning: complete & transitive preferences (if A>B & B>C, then A>C) • Institution • Economists use the term “institution” different from most people • Does not mean organisations, such as banks, firms, or the government • Econ meaning: the formal or informal rules that exist and are enforced

5. Basic concepts • Marginal analysis • In economics we are often interested in the “marginal change”, which means most recent incremental change • E.g. production changes from 025916… last marginal change = 7 • Factors of production • Land & resources = from nature • Labour = people willing & able to do productive work • Capital = combination of resources & knowledge • Knowledge = technology, information, and systems to run a business • Entrepreneurship = willingness to combine factors in an uncertain world • Facts or opinions? • Positive economics = study of reality (what “is”) • Normative economics = suggestions for actions (what “ought to be”)

6. The role of money • Economics is not the study of money, but money is part of the economy • Money is a means to an end, not an end in itself • It is a type of technology that reduces transaction costs • What is money? • Store of value (doesn’t depreciate quickly) • Unit of account (can use it to compare different options) • Medium of exchange (people are willing to accept money in trade) • Does everything have a price? • https://www.youtube.com/watch?v=9W9Hy64LeBM&feature=em-share_video_user%20%00 • A price does not have to be money; money is just way to describe price, but in economics the real price of something is the “opportunity cost” • Everything has a price… except one thing. What is it?

7. History of economic thought (HET) • Pre-history of economics • Pre-modern economic commentary from Greek, Roman, Indian & Islamic philosophers • Mercantilism (18th century) = exports good, imports bad, wealth measured in gold • Political economy of the 19th century • Adam Smith (1776) “The Wealth of Nations” showed that trade is win-win • David Ricardo (trade), Thomas Malthus (famine), JS Mill (utility), Karl Marx (communism) • Marginal revolution & neoclassical economics • Menger, Jevons & Walras separately proposed subjective marginal value in the 1870s • Marshall (1890): Classical econ + marginal revolution = neoclassical econ (S&D graph) • Mainstream schools of thought • Neoclassical (1890s), Chicago (1960s) & New Classical (1970s) = prices adjust quickly • Keynesian (1930s), neo-Keynesian (1950s) & New Keynesian (1980s) = prices adjust slowly • Alternative schools of thought • Austrian (Menger,Mises, Hayek) = innovation, entrepreneurship & dynamic competition • Evolutionary (Veblen, Schumpeter, Potts) = the economy is constantly changing • Marxist (Marx, Engels) = critique of capitalism; used labour theory of value (debunked)

8. 2. Micro: trade & markets • Trade leads to prosperity • Without trade, people could only consume what they produce (autarky), and everybody would live in absolute poverty – for example, it took $1500 and six months to make a sandwich: https://www.youtube.com/watch?v=URvWSsAgtJE • By specialising in a job & then trading, billions of people escaped poverty & drastically increased their standard of living; trade is like advanced technology that converts your labour into things you want = https://www.youtube.com/watch?v=uXMnAPGY1uE • Explained by “theory of comparative advantage”; can show with math, graphs& data • Trade is a positive sum game • Trading also benefits your trading partners. Even if you are purely selfish, the “invisible hand” pushes you towards social good, because people will only trade with you if you give them something they want = forced reciprocal benevolence • Positive-sum game means there is win-win cooperation, not a win-lose contest • Trade benefits everybody as long as (1) it is voluntary, and (2) there is sufficient information – if there is no mutual benefit, people would refuse to trade • Trade occurs within markets • A markets exists whenever people voluntarily trade with each other • A free market does not have a controller or manager; millions of independent actions come together to form a “spontaneous order”, determined by supply & demand

9. Adam Smith on specialization “The greatest improvement in the productive powers of labor… seem to have been the effects of the division of labor. "[A]n example...the trade of the pin-maker; a workman not educated to this business (which the division of labor has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labor has probably given occasion), could scarce... make one pin in a day, and certainly could not make twenty. “But in the way in which this business is now carried on... one man draws out the wire, another straights it, a third cuts it...; and the...business of making a pin is...divided into about 18 distinct operations... I have seen a small manufactory of this kind where 10 men only were employed... But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could...make upwards of 48,000 pins in a day.” • Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776)

10. Supply & demand

11. Partial equilibrium • Supply & demand graph • Simple model of the economy that looks at the two key variables of “quantity” (x-axis) and “price” (y-axis) for a given market • Called “partial equilibrium” because don’t consider impact on other markets • Demand curve represents consumers; as the price increases, then consumers want to consume less = downward sloping demand curve • Supply curve represents producers; as the price increases, then producers are willing to produce more = upward sloping supply curve • Consumer & producer theory can get very detailed (advanced economics) • Equilibrium • A situation is in equilibrium if nobody has an incentive to change • The only stable equilibrium is where demand & supply intersect, so markets will tend to adjust towards the equilibrium price (p*) and quantity (q*) • If price too high = over-supply • If price too low = shortage

12. Coffee equilibrium

13. Price fixing examples • Price floor: setting a minimum price for labour • Minimum wage = $153/month for factory workers (2016) • If the price floor is above the market rate, there will be a surplus of labour= unemployment (more people looking for jobs and not enough jobs) • If the price floor is below the market rate, then it is irrelevant • Price ceiling: setting a maximum price for rent • Rent control on accommodation has been tried several times • If the price ceiling is below the market rate, then there will be a shortage of accommodation (few people offering accommodation and many people wanting the cheap accommodation) • If the price ceiling is above the market rate, then it is irrelevant • How large is the effect? • That depends on the elasticities

14. Elasticity • Price elasticity of demand • Measures how much the consumer changes their consumption (%ΔQD: percentage change in quantity demanded) in response to a change in the price (%ΔP: percentage change in price) • eD = %ΔQD/ %ΔP • High elasticity = consumer is very responsive to changes in prices • Low elasticity = consumer doesn’t respond much to change in prices • Price elasticity of supply • Measures how much the producer changes their production (%ΔQS: percentage change in quantity supplied)in response to a change in the price (%ΔP: percentage change in price) • eS = %ΔQS/ %ΔP • High elasticity = producer is very responsive to changes in prices • Low elasticity = producer doesn’t respond much to change in prices

15. Market structure • Perfect competition • Often used as the “base case” for how the economy should work; has been shown to be Pareto optimal (best possible outcome) • Many firms, no barrier to entry, complete information, rational decisions • Each firm is a “price-taker” (price determined by market); price = marginal cost • No economic profit (accounting profit only) due to new firms entering • Monopoly • One supplier, which has market power to set the price or quantity • Price higher & quantity lower than perfect competition; therefore not optimal • Earns “monopoly profit” (more than accounting profit) • Oligopoly • Small number of large firms; called a “duopoly” if there are two firms • If the firms colludethen same as monopoly; otherwise, more firms = more efficient • Involves strategic behaviour; need to factor in the expected decisions of other firms • Monopolistic competition • Similar to competition, except product differentiation between firms (e.g. coke, pepsi) • No economic profit (accounting profit only) due to new firms entering • Produce below capacity at a price above marginal cost; therefore not optimal

16. 3. Micro: underlying theory • Consumer theory • Try to maximise utility (u), given their budget constraint (w) & price vector (p) • Utility function: u=f(x), with consumption bundle x=(x1, ..., xn)∈Rn, for “n” products • Max u=f(x), subject to Σ(p*x) ≤ w for each (p,w); need p>>0 & w>0 • Max u(x), s.t. (px) ≤ w • Producer theory • Try to maximiseprofit (π), given the available technology (Y) & price vector (p) • The production plan (y) includes both inputs (yk<0) and outputs (yk>0) • Profit function is π=Σ(p*y) = py, with production plan y=(y1, ..., yn)∈Y, where Y⊂Rn is the technologically feasible production set regarding “n” products • Max π=py, s.t. y∈Y and p>>0 • Behavioural economics • Behaviouraleconomics looks at how people behave to learn more about the nature and dynamics of utility functions

17. Consumer theory • Hicksian demand • Hicksian (or compensated) demand is given by x=h(p,u), which represents the consumption bundle “x” that minimises spending to achieve a utility of “u” with prices p>>0, where the expenditure function e(p,u) = ph(p,u). • Note, Hicksian demand measures the substitution effect (caused by change in relative price) but not the wealth effect (caused by wealth shock). • Law of Demand • Suppose p, p’ ≥ 0 and let x∈h(p,u) and x’∈h(p’,u). Then, (p’−p).(x’−x) ≤ 0. • Proof = By definition u(x) ≥ u and u(x’) ≥ u. So, by optimization, p’·x’ ≤ p’·x and p·x ≤ p·x’ . We may rewrite these two inequalities as p’·(x’−x) ≤ 0 and 0 ≥ −p·(x’−x), and the result follows immediately. Q.E.D. • Consider a single good. Suppose the only difference between p’ and p is that, for some k, (p’k > pk), while (p’i= pi) for all i ≠ k. Then, with single-valued demand, (p’k − pk).[hk(p’, u) − hk(p, u)] ≤ 0. Therefore hk(p, u) is decreasing in pk. • In other words, when the price of a product (pk) rises, then consumer demand for that product (hk) decreases, giving a downward sloping demand curve.

18. Producer theory • Production function • The production plan (y) concealed the production function due to the convention of using “y” for both inputs (yk<0) and outputs (yk>0) • Split products into inputs (z) & outputs (y); then production function y=f(z) Re-stating the profit-maximising problem… • Max[pf(z) − wz], where vector p = output prices & vector w>>0 = input prices • Law of Supply • For any p, p’, y ∈ y(p) and y’ ∈ y(p’), (p’ − p) (y’ − y) ≥ 0. • Proof = Given any p, p’, y∈y(p) and y’∈y(p’), profit-max with price vectors p and p’ imply that (py ≥ py’) and (p’y’ ≥ p’y) respectively. Therefore, p(y−y’) ≥ 0 ≥ p’(y−y’), from which conclusion follows. Q.E.D. • Consider a single good. Suppose the only difference between p’ and p is that, for some k, (p’k > pk), while (p’i = pi) for all i ≠ k. Then, with single-valued supply, (p’ k− pk) (y’k− yk) ≥ 0. Therefore yk is increasing in pk. • In other words, when the price of a product (pk) rises, then production of that product (yk) increases, giving a upward sloping supply curve.

19. Summary Lecture #2: Economics in context (Part 1/2)✓ 25 October 2016 • Background: definition, language & history ✓ • Micro: trade & markets (equilibrium & elasticity) ✓ • Micro: underlying theory (consumers & producers) ✓ Lecture #3: Economics in context (Part 2/2)8November 2016 • Political Economics (market failure & public policy) • Dynamic Economics (time, risk, strategic behaviour) • Institutional Economics • Macroeconomics: GDP & money