The relationship b/w TC, ATC and MC

Let's say that if we don't produce anything, a firm still has to pay $100 in rent. The firms total costs are the sum of its fixed costs ($100) plus its variable costs ($0) (Q0). So total costs are $100.

Now let's say the firm wants produce one unit. The cost of this unit will be $10. With 1 unit(Q), the costs will be the sum of its fixed costs ($100) plus its variable costs ($10). So the total costs are $110 (100+10).

Now let's say you are asked to find out how much "extra" this one unit costs. If you get this question, you are being asked to calculate the Marginal Cost of the unit. Thus the "extra" cost is simply the total cost at one unit (Q1) minus the total costs with 0 unit(Q0). So the marginal cost is 110-100 = 10. 10 is your marginal cost of the first unit produced.

Now lets say that I want the average total cost if you produce one unit. This is even easier because all you have to do is take the total cost and divide it by the number of units you produce. For Q1, it is simply $110/1 = $110.

Now do this same calculation for the second unit produced(Q2). The variable costs for 2 units is $15. Calculate both the total cost, marginal cost and the Average total cost at this level.

I have the answer's below (shade it to see).

Total Cost = $115. Marginal Cost = $5. Average Total Cost = $57.5

E-mail me if you still have questions.

How do we correct for a Monopoly?

Another question some students had problems with is in how to correct for monopolies. First, the problem with monopoly is that we are both allocatively inefficient (P>MC ) and productively inefficient (ATC is not minimized). There are two ways we can correct for this

1) We can make the monopolist "behave" like a firm in perfect competition. That is, we can force the monopolist to set P = MC. Notice that if P=MC then we are now allocatively efficient. However, there are two problems that arise with this

a) It is often hard to estimate a firm’s Marginal Cost Curve

b) Sometimes by forcing it to behave like a perfect Competitor (P=MC), you are actually causing the firm to lose money. In the graph above, setting P=MC means that the firm loses money because P
2) To correct for this, we can adopt an alternative solution. We simply set P=ATC. If P=ATC, there is still some allocative inefficiency (on the graph above, P is still > than MC). But it is a step in the right direction.

Perfect Competition Review

I noticed that some people were confused as to why Q is the optimal level of output. Essentially any other output level (Q) is sub optimal. Why?

Well if the firm produces below Q (to the left) than you have a situation where MR>MC. That is, producing more units produces more marginal revenue than it does marginal costs. Hence the firm can increase its profits simply by producing more at the product price (P). If you look at the graph and draw a line up you will notice that the MR curve (the red line) is greater than the MC point (where the line cross the Nike Swoosh).

On the other hand, if you produce more units than the Q shown then MC>MR. Each extra unit produced costs more than the marginal revenue it is bringing in. Thus profits are decreasing if the firm starts producing more.

So in conclusion, there is no better point than Q (where MR=MC). That is where the firm is maximizing profits.

Note, however, that in perfect competition there is only normal profits. There are no economic profits because P=ATC. If you want permanent economic profits than P>ATC, you will most likely have to look at a monopoly model.

Free Trade discussion

Again, this is for after Test 2 but a number of economics blogs have been discussing free trade theory. Greg Mankiw has two posts on Free trade theory here and here.

Greg mentions The Ricardian Trade Model and the H-O model. The latter model is beyond the scope of this class, but since both are based on the principle of comparative advantage you can get the basic idea behind all free trade models by studying this counter-intuitive principle.

In economics, the theory of comparative advantage explains why it can be beneficial for two parties (countries, regions, individuals and so on) to trade if one has a lower relative cost of producing some good. What matters is not the absolute cost of production but the opportunity cost, which measures how much production of one good is reduced to produce one more unit of the other good

Essentially what comparative advantage allows countries to do is eliminate production inefficiences, increasing the total amount of output. The posts above discuss the distributions of benefits of free trade. Essentially there will always be winners and losers, but the winners gains will outweigh the losers losses.

Kinked Demand Curve

This is for after Test 2. But when we pick up our discussion of Oligopoly we will be looking at the Kinked Demand Curve. The empirical fact that the kinked demand curve is trying to explain is why do prices in Oligopolies tend to remain constant?

Basically we are assuming that there are two elasticities. At higher prices (low quantity) the curve is relatively elastic. This means that an increase in P will lower TR (because other firms will not follow suit with a price hike). Thus prices do not tend to rise. However, at lower prices we have a relatively inelastic demand curve. This means that if prices fall below a certain point TR does not increase.

Yet firms do tend to match price decreases because they do not want to lose market share to the competition. Thus, if prices do start to fall, they tend to fall very quickly. We call this a "price war" in economics and there have been examples in the past. This article, on the price war between Burger King and McDonald's, is an excellent example of this. I have also heard about price wars between Cereal Brands and, of course, the current price war among HDTV's, which have come down substantially in price. The price war between McDonald's and Burger is interesting in that the prices came down on a day by day basis.

Sports Economics Continued

My old Economics professor has a post on when baseball players "peak."

Let’s start with a pop quiz: At what age does the average big-league ballplayer reach his peak?
If you said 27, you are an unusually conscientious student of sports and, quite likely, a devotee of the great Bill James, one of the founding fathers of sabermetrics and a consultant to the Red Sox.
You’re also wrong.

Wizard Economics

This paper discusses the economy that exists in the Harry Potter Books. The most interesting conclusion (which would make a good extra credit assignment) was this.


This implies that the factors of production (physical capital, human capital and
labor force) and the technology which could potentially drive economic growth remain
unchanged in the Potterian economy. As a consequence, the wizards’ economy remains
in a steady state without growth.

In the real world the economy grows and has been for hundreds of years. But in our fiction we keep things stagnant...interesting.

Marginal Revolution has a post on JK Rowlings earnings, tying it into inequality.

May be 10 minutes late to class today

I may be 10 minutes late to class today, although I should be able to make it on time. However, I am providing a fair heads up so don't leave class if I am a few minutes late.

Quiz Reminder

The links for the two quizzes due on Wed are Quiz 6 and Quiz 7 on production theory and perfect competition, respectively.

We will also be having a 10 question multiple choice quiz as preparation for the text, which will be the following Wed.

Sports Economics Post

There are a couple of interesting articles on sports economics up.

The first is an article interview with JC Bradbury, a sports economist who wrote the book The Baseball Economist. The free link is here. His Baseball blog is here.

This is the aspect I find most intriguing.

Are the final standings a product of pure financial determinism, or do small cities have a fighting chance?

JCB: While it is true that the big-market Yankees have been one of the most successful franchises and the small-market Brewers one of the worst in recent baseball history, these teams differ in more than just the sizes of their fan bases. Over a 10-year span from 1995–2004, I calculate that every 1.6 million residents of a city translates into one additional win for the team in that market. Given the disparity in market sizes between New York and Milwaukee, the Yankees were expected to win about 11 more games a season than the Brewers. That is not chump change; however, the actual disparity between these franchises was a whopping 26 games. Market size explained a minority of the difference (about 40 percent) between these organizations, which means that a majority of the blame must be placed somewhere else: the ineptitude and skill displayed by the front offices of these teams.

In itself this is an interesting point. But I wonder, just how good is league parity to begin. Football, America's most popular sport, has league parity. But has league parity done the NBA any good? ESPN.com argues no.

On the flip side, when the Lakers, Celtics, Sixers and Pistons were battling for control of the 1980s, did anyone care that the Clips, Cavaliers, Warriors and Kings were dreadful? Was it a coincidence that the NBA peaked from 1987 to 1993, with a lopsided league of quality teams and crummy teams? Call it the 600/400 Rule: More teams finishing above .600 (50 wins or more) and under .400 (50 losses or more) makes for a more entertaining league.

It seems that a few questions need to be asked

1) Has the NFL benefited from league parity? Was the league less popular in the early 90's when Dallas and San Fran dominated?
2) Are different sports different? That is, does league parity work for some leagues (NFL), but not for others (NBA).
3) Would increasing parity in baseball improve the sports popularity given that you would have to weaken teams in areas where baseball is extremely popular (New York, Boston)?

These would be good topics for an extra credit assignment.

Prediction Markets and American Idol

In a followup post on American Idol, if you are interested in forecasing who will be knocked off from week to week, trade sports has an interesting betting market here . They were right last week with Gina and this week they are predicting Lakisha by a large margin.

Prediction markets have tended to be more right than either polls or expert opinions. Why? Because they are functioning like an efficient market, where price reflects all known information. There are other markets (such as for US President, weather, economic data and sports) that are worth taking a look at.

Supply Side Economics Continued

Economist Brad Delong has a good follow up post on Supply Economics Here

This debate is a relatively good summary of the debates on different macroeconomic outlooks.

Are we all Supply Siders?

Bruce Bartlett has an interesting op-ed in the NY Times today here

His main argument is that we should lay rest to the label "supply-side economics" because a) all the good stuff about supply-side economics has been incorporated into mainstream economic thinking and b) the term is being mis used to support dubious tax cuts that are not economically efficient. Here is the main point of the article

"It’s important to remember that at the time supply-side economics came into being, Keynesian economics dominated macroeconomic thinking and economic policy in Washington. Among the beliefs held by the Keynesians of that era were these: budget deficits stimulate economic growth; the means by which the government raises revenue is essentially irrelevant economically; government spending and tax cuts affect the economy in exactly the same way through their impact on aggregate spending; personal savings is bad for economic growth; monetary policy is impotent; and inflation is caused by low unemployment, among other things"

"The original supply-siders suggested that some tax cuts, under very special circumstances, might actually raise federal revenues. For example, cutting the capital gains tax rate might induce an unlocking effect that would cause more gains to be realized, thus causing more taxes to be paid on such gains even at a lower rate.
But today it is common to hear tax cutters claim, implausibly, that all tax cuts raise revenue."

Since the main tenets of supply side are now mainstream economic thought, there is no need to use the term anymore since using it is often invoked to support "Child Tax Credits" and "Tax rebates," taxes that are not very economically efficient.

Mark Thoma, a Keynesian Economist, defends keynesianism here

His main point is that a new form of Keynesianism can explain many of the faults of the 1970's (high inflation, low growth) quite well. Additionally, whether new Keynesian economics is usable is still an open question (Pres Bush employed quazi-Keynesian policies during the last recession). It depends on whether the "shock" to growth is a supply shock (where Keynesian theories cannot help much) or a demand shock (where he believes they can).

Personally, I believe Bruce Bartlett's rejoinder answers this criticism.

Interesting discussion. However, I think Mark misses the historical context of my analysis. In the 1970s, we were unaware of real business cycle theory or New Keynesian theory. We were confronting Old Keynesian theory. What Mark has basically done is take a current theoretical debate and superimposed it on the 1970s.

I wasn't around during this time period, but I have read a bit about it. While there may have been a good explanation offered from theoretical economists who knew about these complications, I don't think the public or the politicians were aware of it. Hence, a more old school simplistic Keynesian theory was what was usually debated. The old supply siders were countering this doctrine with a bout of tight monetary policy and cuts in the marginal tax rates.

It is still an open question whether these cuts in marginal tax rates stimulate long term growth. (discussion about to get technical). Personally, if you are looking at a simple labor supply elasticity, probably not. But if you are looking at career formation choices, I think there has likely been a greater response to lower marginal taxes (see Martin Feldstein's research for empirical evidence).

Samuelson on the Fed

Economic Journal Robert Samuelson says the Fed should focus more on inflation, even at the risk of a recession here

His argument is as follows:

Electronic banking has largely erased the difference between checking and savings accounts. The interest rates that matter most to the economy -- on mortgages, auto loans and business borrowing -- are increasingly set in the market. Investors decide what they'll accept on bonds and "securitized" mortgages and other loans. The banking sector represents only 23 percent of lending. The impact of the fed funds rate has weakened. Rates on conventional 30-year mortgages (6.2 percent) are now what they were in mid-2004, despite a huge jump in the fed funds rate.

None of this renders the Fed powerless. It can still alter the economy's available credit. But the channels of its influence are more murky, indirect and unpredictable. It cannot steer the economy single-handedly, and many other forces (technology, business and consumer confidence, global money flows) matter as much or more. There is, however, one area where the Fed's power is unquestioned: inflation.

The greater economic stability of the past 25 years stems fundamentally from the fall of inflation -- 13 percent in 1980. The Fed engineered that decline, beginning with the deep 1981-82 recession (peak monthly unemployment: 10.8 percent). Since then the Fed has refused to supply the extra money and credit that would feed ever-worsening inflation.
The result: calmer business cycles

Keep in mind that support for this type of proposition relies on a long run argument. That is, short run deviations in (read recessions) do not alter the trend growth rate, which is determined by long run factors (some of which we will discuss on Micro.) Thus the Fed should give a greater weight towards inflation, since high and variable inflation will cause uncertainty and dampen growth, and underweight growth, since it is a short term problem.

This type of analysis depends heavily on how "long" you think the long run takes to occur. A more Keynesian type of economist believes that this long run can be rather "long" in coming. Some economists believe in hysterosis, which means that a recession can actually lower the long run growth path. Think of it this way. Say you are a computer programmer that loses his job due to recession. The recession may mean that you have to accept a lower paying job. Your pride will not allow you to do this, so you remove yourself from the labor force or take a lower paying job that maybe fun (school bus driver) rather than what your optimal production would be (computer programmer).

This probably holds for people in their 50's rather than 20's, however.

As a general reply, I will say that better monetary policy has been at least partly behind the smoother growth path, but better inventory management and technology has also played a role. It is an open debate whether Keynesian style management of short run fluctuations help in this regard. Personally, I think the monetary side of the equation is more promising than the fiscal side.

Fed paper on Milton Friedman

This is a really good paper on the contributions and thought of Milton Friedman.

Money quote:


At the beginning of his career, Friedman adopted two hypotheses that isolated him from the prevailing intellectual mainstream. First, central banks are responsible for inflation and deflation. Second, markets work efficiently to allocate resources and to maintain macroeconomic equilibrium. Because of his success in advancing these ideas in a way that shaped the understanding of the major economic events of this century and influenced public policy, Friedman stands out as one of the great intellectuals of the 20th century.

An Economic explanation for Sanjaya.

Why is Sanjaya Malakar, widely considered the worst American idol finalist in history, continue to get voted through? How can the worst singer continue to be loved by Americans?. I can think of a few economic explanations.

1) Rational Ignorance - This is actually an extension of rational ignorance. It's not exactly voters are rationally ignorant (they don't know), its more that the aggregate of voters don't care one way or the other who wins. Most of the viewers either watch the show without voting or vote once or twice for a good contestant. But Sanjaya has a whole army of people dedicated to voting for him 100's of times each.

I give you this summary from Howard Stern:

Howard started by saying he stayed up last night to vote for Sanjaya after “American Idol,” while Robin noted she called in for him as well, while Artie admitted he went to bed to take a nap, just to be ready to vote, but ended up sleeping until 4:30 a.m. and therefore wasn’t able to help the cause. Artie did point out, though, how angry he thought Beth was about Howard’s Sanjaya campaign when she spoke about it as a co-host on “The View” yesterday. Howard went on to say he started voting for Sanjaya at 9:05 p.m. and that he got through only twice. However, Robin added she was able to vote “30 or 40 times” when she called. Robin also commented she felt like Simon Cowell was speaking directly to Howard and his fans last night when he told Sanjaya that nothing he said about his performance mattered if “they” wanted him to win.

There are even computer programs set up to dial his number 100's, even 1000's of times a night.

2) Marginal Benefit/Marginal Cost - Some of the less crazy people may nevertheless be phoning up to vote for Sanjaya because the marginal benefit of seeing him look like below outweighs the cost of losing one of the better singers in the competition (who are, let's admit, not exactly the best this year). In other words, watching Sanjaya is fun and makes for interesting water cooler talk.

Credit and Consumption Theory

Related to the worries over the subprime sector is some criticism over whether subprime loans (credit) should be extended in the first place. One way to defend credit lending is to extend the theory of consumption that we learned last night. Think of consumers as rational maximizer's of their utility. Since they are rational they will want to maximize their consumption over their entire life. That is, it is unlikely that they will consume all their income in one period but rather attempt to spread it out over their lifetime. One way to do this is to save. If you earn $100 dollars you spend $80 and then save $20 a paycheck. You then use your savings for future consumption.

Another way to smooth your consumption out is to purchase large items on credit. That is, instead of saving you purchase on credit and pay it off slowly but surely. Perhaps some people have done this for the Flat Panel TV purchases (via a credit card or a 0% credit offer. I know I have with my latest laptop). But I would venture to guess that any of you who own a house have a mortgage. You purchased the home on credit and then pay off a portion of it each month, with interest.

Sub prime lending is an extension of this type of theory, except that it targets low income borrowers. So while there may be some people complaining that supporters of sub prime lending are voo-doo economists, we can answer them by showing how these type of financial innovations actually allow consumers to smooth out their consumption or use their lifetime income to make a purchase now. Granted, their are problems with this type of development, but in the end it will work out.

Update: The New York Times has a good article on subprime lending here.

The money quote (which I was trying to explain above):

These economists followed thousands of people over their lives and examined the evidence for whether mortgage markets have become more efficient over time. Lost in the current discussion about borrowers’ income levels in the subprime market is the fact that someone with a low income now but who stands to earn much more in the future would, in a perfect market, be able to borrow from a bank to buy a house. That is how economists view the efficiency of a capital market: people’s decisions unrestricted by the amount of money they have right now.

And this study shows that measured this way, the mortgage market has become more perfect, not more irresponsible. People tend to make good decisions about their own economic prospects. As Professor Rosen said in an interview, “Our findings suggest that people make sensible housing decisions in that the size of house they buy today relates to their future income, not just their current income and that the innovations in mortgages over 30 years gave many people the opportunity to own a home that they would not have otherwise had, just because they didn’t have enough assets in the bank at the moment they needed the house.”

How to think about shifts in Supply

Some of you made a mistake on the quiz because you assumed that an increase in supply would shift the Supply curve "up." Don't use the word "up" if it confuses you. Think about it in terms of right or left. If a new production technology comes out and it makes producing an item more efficient, this is an increase in supply, otherwise called a "rightwards" shift in the curve, like below.

Key terms

Key terms to know for the exam on Wed are the following (we went over this in class, so this should just be a refresher)

Scarcity
Opportunity Cost
Demand - how it slopes and the reasons
a) substitution effect
b) income effect
c) marginal benefit
Supply - how it slopes and the reasons
a) marginal cost per additional unit
Externalities
a) negative
b) positive
Public Good
elasticity
a) Price
b)Cross Price
c) Income
d) Supply
Asymmetical information
Moral Hazard
Rational Ignorance.

In class Quiz 4

You can view a copy of last Nights Quiz here

The answers are

A
C
C
A
A
D
A
B
D
D

After I grade I will probably put an explanation to questions that the class as a whole did not get. I already went over 9 and 10 in class.