PRINCIPLES OF MACROECONOMICS
Ranjit Dighe
WEEK 3 (LECTURES 6 - 8)
Feb. 7 - 11, 2000

[In this week we finished up the review of microeconomics, spent some time on critical thinking in economics, and started on economic systems and institutions.  These lectures draw on material from Chapters 1, 2, 4 and 5.]

WEEK 3, LECTURE 6
Mon., Feb. 7, 2000

* Today: Micro review
   I.   Supply
   II.  Industry demand and supply curves

I.  SUPPLY

SUPPLY CURVE: a graph showing how much of a product will be produced and supplied at different prices
-- "Law" of Supply: As the price of a good goes up, the quantity supplied of that good goes up, too
----> supply curves slope upward
------ Note: A firm's supply curve is the upward-sloping portion of its marginal cost (MC) curve, as we shall soon see.

[In class we saw an overhead of a wheat farmer's supply curve. The diagram was roughly similar to Case & Fair's Figure 4.6 (page 81).]

What the supply curve is: a schedule of the quantity of a product that will be supplied at different prices.
-- Assumption: The industry is competitive. (In a monopolistic or otherwise non-competitive industry, there is no supply curve.) A competitive industry is one with a very large number of firms producing an identical product, and free entry and exit from the industry. Firms in such an industry are "price takers," in that they must sell their output at the market price.
-- Where the supply curve comes from: The supply curve is the upward-sloping portion of the marginal cost (MC) curve.
---- Why: A profit-maximizing firm equates marginal revenue (MR) and marginal cost (MC). In a competitive industry, where an individual firm's demand curve is flat at the market equilibrium price P*, the price of the good is equal to the marginal revenue from selling an extra unit of that good. So the supply curve just shows what the profit-maximizing outputs for the firm will be at different prices.
---- [In class we saw an overhead of a firm's MC curve, which is U-shaped (first falling, then bottoming out, then rising as diminishing returns set in. The upward-sloping part of that curve was colored in and labeled "S" for supply curve. Unfortunately Case & Fair's textbook has no graph that corresponds to the one I drew in class, so I'll have to add a link to a self-drawn diagram at some point.]

Why supply curves slope upward: Two reasons:
(1) PROFIT MAXIMIZATION
---- At a higher price, a firm can earn higher profits by producing more. A purely competitive firm maximizes profit by producing at the level where P = MC.
(2) DIMINISHING RETURNS
---- Each additional unit of output is more costly (has a higher "marginal cost") than the previous unit.

Q: What causes the supply curve to shift outward (what causes supply to increase)?
A: Lower (marginal) costs of production, or increased production. (Keep in mind that the supply curve is the upward-sloping part of the marginal cost curve.) Namely:
(1) Lower input prices -- e.g., if labor or physical capital (or raw materials used in production, like mozzarella cheese at Pavone's) becomes more expensive, then the cost of production goes up and the supply curve shifts up (or in).
(2) Better technology - Better technology makes production cheaper --> the marginal cost curve shifts down, so the supply curve shifts down (or out), too
(3) Entry of firms (more firms means a larger quantity will be supplied at each price)
(4) Other factors: higher prices of complements in production; lower prices of substitutes in production; increased capacity or decreased inventories of firms
 

II. INDUSTRY DEMAND AND SUPPLY CURVES

These are obtained by "horizontally summing" the individual demand curves of consumers or the individual supply curves of firms.

Ex. The demand for ketchup in a two-household economy
-- [This was shown on an overhead in class. The diagrams in Case & Fair's Figure 4.5 (page 79) tell a similar story.]

Ex. The supply of ketchup in a two-firm economy.
-- [This was shown on an overhead in class. The diagrams in Case & Fair's Figure 4.8 (page 85) tell a similar story.]

***

PRINCIPLES OF MACROECONOMICS
WEEK 3, LECTURE 7
Wed., Feb. 9, 2000

Today: Micro review (finish)
I.    Equilibrium
II.   Disequilibrium
III.  Perfect competition and the "law of one price"
IV.  Elasticity

I. EQUILIBRIUM

The point where the industry supply and demand curves intersect is the market's EQUILIBRIUM.

EQUILIBRIUM: occurs when there is no force acting to change prices, i.e. when quantity supplied equals quantity
demanded.
-- [The diagram shown in class is similar to Case & Fair's Figure 4.9 (p. 86), ignoring the part about excess demand, which is coming later in this lecture.]

THE "DIAMOND-WATER PARADOX": Why are diamonds (a luxury) so expensive while water (a necessity) is
so cheap?
-- The answer comes down to the relative SCARCITY of diamonds as compared with water:  diamonds are very scarce (they are in short supply), whereas water is plentiful (it is in abundant supply).  Even though the demand for water is much greater than the demand for diamonds, since water is necessary for our survival and diamonds are not, the supply of water is so much greater than the supply of diamonds that diamonds sell for a much higher price.
-- [The two diagrams shown in class are the same as the ones at the bottom of the first page of "Solutions to Problem Set 1," handed out in class on Friday.]

Changes in the equilibrium price and quantity are caused by shifts in demand and supply.

Examples

Ex. 1:  The technology for making ketchup takes a great leap forward
           --> supply of ketchup increases (supply curve shifts out)

    Result:
     P decreases
     Q increases (namely, quantity demanded increases)

Ex. 2:  Health-conscious consumers start shunning ketchup as too salty
           --> demand for ketchup falls (demand curve shifts in)

     Result:
      P falls
      Q falls (namely, quantity supplied decreases)

Ex. 3:  A bad tomato harvest raises the (marginal) cost of production
           --> supply of ketchup decreases (supply curve shifts in, or up and to the left)

      Result:
       P increases
       Q falls (namely, quantity demanded decreases)

Ex. 4:  An increase in the population
           --> demand for ketchup increases (demand curve shifts out)

      Result:
       P increases
       Q increases (namely, quantity supplied increases)

A summing up:

Cause Effect
P* Q*
demand increases increases increases
demand decreases decreases decreases
supply increases decreases increases
supply decreases increases decreases

II. DISEQUILIBRIUM

When P is not equal to P*, then the market is in DISEQUILIBRIUM -- there will either be a shortage (too little) or a surplus (too much) of the good, because quantity supplied is not equal to quantity demanded.

If a PRICE CEILING is set below the equilibrium price P*, preventing the price from rising above a certain level, as in the New York City rental apartments market, then:
                                                                                      quantity demanded > quantity supplied (excess demand);
                                                                                      SHORTAGE, long lines
-- [In class we saw a diagram of a shortage caused by a price ceiling.  See Case & Fair's Figure 4.9 (p. 86) for a similar diagram.]

If a PRICE FLOOR is set above the equilibrium price P*, preventing the price from falling below a certain level, as in government milk-price support programs, then:
                                                                                      quantity supplied > quantity demanded (excess supply);
                                                                                      SURPLUS, vast unsold quantities
-- [In class we saw a diagram of a surplus caused by a price floor.  See Case & Fair's Figure 4.10 (p. 89) for a similar diagram.]
 

III. PERFECT COMPETITION AND THE "LAW OF ONE PRICE"

The intersection of the industry supply and demand curves determines the equilibrium price and quantity for the whole industry.  The total quantity produced will be divided up among the many firms in the industry, with each one producing up to the point where marginal cost equals price. The firms will all have to charge the same price, the industry equilibrium price P*.
-- Since the good they're producing is identical, and since there are many firms for consumers to choose from, if a firm tried to
sell at a price higher than P*, nobody would buy any of its output.
-- A firm could sell its output for less than P* if it wanted to, but what's the point? It can already sell all of its output at P*.

Each firm in the industry, therefore, faces a flat demand curve -- the firm's demand curve is flat at the industry (or market) equilibrium price.

[The "Law of One Price" was illustrated by a pair of diagrams, the first of which showed the industry supply and demand curves and equilibrium price P* and the second of which showing the demand curve facing an individual firm, which was perfectly horizontal at the price P*.  The key insight is that the equilibrium price P* is determined by the market demand and supply curves, and this same price is taken as a given by individual firms in the market.
-- Unfortunately these diagrams do not appear in your textbook.  The picture of the demand curve of the soybean producer on Problem Set 1 and on page 2 of "Solutions to Problem Set 1" includes the second of those demand curves, however.]
 

IV. ELASTICITY

Not all demand curves are the same. Some are very flat (quantity demanded is very responsive to price), others are very steep
(quantity demanded is not very responsive to price). The same goes for supply curves. Since we often want to know just how
responsive demand (or supply) is to price in a particular market, we need some way of measuring that responsiveness. Slope is
one possible way of measuring that responsiveness, but it's overly sensitive to one's choice of units to measure the quantity
demanded or supplied.

--> Economists have a better measure of the responsiveness of quantity demanded (or supplied) to price, called...
ELASTICITY:  the degree to which one variable (say, quantity demanded, QD, or quantity supplied, QS) responds to changes in another (usually price, P).  Specifically, it is the percent change in one variable associated with a given percent change in the other variable.

  Elasticity of demand = (percent change in QD) / (percent change in P)

  Elasticity of supply = (percent change in QS) / (percent change in P)

If the demand for a good is very elastic with respect to price, its demand curve will be relatively flat.
(Perfectly elastic demand means a perfectly flat demand curve.)

If the demand for a good is very inelastic with respect to price, its demand curve will be relatively steep.
(Perfectly inelastic demand means a perfectly vertical demand curve.)

If the supply for a good is very elastic with respect to price, its supply curve will be relatively flat.
(Perfectly elastic supply means a perfectly flat supply curve.)

If the supply for a good is very inelastic with respect to price, its supply curve will be relatively steep.
(Perfectly inelastic supply means a perfectly vertical supply curve.)

[All four of these cases were illustrated with supply or demand diagrams drawn in class.  Unfortunately they do not appear in your textbook, though you could surely find them in any microeconomics textbook.]

***

PRINCIPLES OF MACROECONOMICS
WEEK 3, LECTURE 8
Fri., Feb. 11, 2000

0. IMPEDIMENTA

* Pick up: Solutions to Problem Set 1; Problem Set 2

Today: Critical thinking in economics; Economic institutions (begin)
I.     Pitfalls to objective reasoning
II.    Economic systems and institutions
III.  U.S. economic institutions: the distribution of income and production

* QUIZ
 

I. PITFALLS TO OBJECTIVE THINKING

Some "red flags" to look for that may be associated with flawed reasoning:
* bias (consider the source, context, other statements that may indicate bias)
* loaded terminology ("myths," "obscene profit rates," "our socialist president," "NATO's genocidal policy in Yugoslavia")
* (imprecision or misunderstanding of) definitions ("money," "investment").

COMMON FALLACIES IN ECONOMICS / SOCIAL REASONING

* fallacy of composition: assuming that what's true for the individual (part) is also true for the group (whole)
-- (important in micro, and also when going from micro to macro)
-- Classic ex.: Watching a parade (or a band): If you stand up on tiptoes, you get a better view. But if everyone stands up on
tiptoes, no one gets a better view.
-- Micro ex.: If Farmer Bob has a bumper crop, his income will rise. If all farmers have a bumper crop, prices (of crops) will
plummet, and total farm income will probably fall.
-- Micro-to-macro ex.: If the price of a particular good goes up by 10%, producers of that good will be better off; but if the
price of everything bought and sold goes up by 10%, no one will be better off.
-- Micro-to-macro ex.: If a family regularly spends more than it takes in, it's headed for financial ruin. Yet the government
spends more than it takes in, year after year; and as long as its deficits aren't too large, it could go on doing that ~indefinitely.

* the post hoc (ergo propter hoc) fallacy
-- "after this, therefore because of this"
-- Ex.: "The rooster crowed at 6:15 and the sun rose at 6:30. Therefore, the rooster caused the sunrise."
-- Ex.: blaming President Bush's tax increase of 1990 for the 1990-91 recession
-- Ex.: crediting Bill Clinton for the big reduction in unemployment (from 7.3% in January 1993 to 4.0% in January 2000) since
he took office

* assuming your conclusion; confusing assumptions and theory with facts.
-- Does your conclusion rest on a particular premise, and how strong is that premise?
-- Remember:  "It's just a model."  The economic models you learn (e.g., supply & demand), however compelling they may be, are still just models.  Appealing to a model is not enough to validate one's argument.  Models need to be tested with real-world data.
-- Exs.:
---- Effect of minimum wage on fast-food employment:  An empirical study of the effect of higher minimum wages on fast-food employment, by two Princeton economists named Card and Krueger, concluded that, contrary to the "law" of demand, higher minimum wages did not cause a reduction in employment in fast-food restaurants.  Many economists and observers reacted angrily to their findings, saying that Card and Krueger needed to go back to Econ 101, because of course a minimum wage lowers employment.  But those critics did not address the fact that the supply-and-demand model only applies to markets that are purely competitive, which the fast-food labor market almost surely is not.
---- What is the best place to live in America?  A recent study by an economist at the St. Louis Federal Reserve Bank attempted to answer this question by appealing to the Theory of Revealed Preferences, which basically states that the best way to learn what people want is to watch what they actually do.  The economist, whose name was Wall, therefore studied moving patterns, and found that the U.S. city that had had the largest number of people moving there was Las Vegas.  Thus, Las Vegas is the best place to live in America.
------ Convinced?  You probably shouldn't be.  Dr. Wall's conclusion rested on the assumption that people move to the places that they find most desirable to live in, as if they were completely free to choose where to work or where to be near their families.  Since that assumption seems highly invalid, so does Dr. Wall's conclusion.
 

II. ECONOMIC SYSTEMS AND INSTITUTIONS

Defns.

ECONOMIC INSTITUTION: a physical or mental structure that significantly influences economic decisions
-- Exs.: markets, corporations, banks, governments, families, cultural norms

THE ECONOMIZING PROBLEM: How does a society reconcile its limited, or scarce, resources with people's
unlimited wants?

ECONOMIC SYSTEM: the set of institutions and mechanisms that a society uses to try to coordinate people's
wants and needs and society's available resources (i.e., the way a society goes about trying to solve the economizing problem); the system that decides What, How, and For Whom to produce.

[We left off with the different types of economic systems, without getting all of the way through them.  That part of the lecture will be reproduced on Mon., Feb. 14, and will appear in the Week 4 Lecture Notes instead of here.]