New Economics - HS Pforzheimblog.hs-pforzheim.de/beck/files/2013/02/Introduction... · 2013. 9....

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Economics

Session #1:

Getting started

Prof. Dr. Hanno Beck

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Getting started

About this lecture

How to study

Why should you study?

Germanys next Top-Model

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• 14 chapters • every chapter has

– one topic: basic ideas, examples, case studies, political implications, discussion

– reading assingments: see syllabus for details

• you are supposed to – do the reading assigments before the lecture – repeat what you have learned in the lecture;

answer questions and discuss them with your fellow students

• Questions, comments: Office-Hours; E-Mail; after (or during) the lecture

About this lecture

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• How many days do you need to finish your term paper / thesis? (Bühler, Griffin Ross 1994)

– Expectations: on average 34 days; optimistic students: 27 days

– real time needed to finish paper: 55 days

• Huh, you are not supposed to do such mistakes? Here`s a simple question: – how do you pronounce the capital of Kentucky:

Loo-ee-ville or Loo-iss-ville? – how many Euros are you willing to bet that you know the

right answer?

• Empirical findings: We suffer from overconfidence, illusion of control, and self serving bias

How to study

Cortical (left) versus limbic system (right)

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• Neuroeconomics: your brain has two different areas – limbic system: affective system; basic survival; immediate satisfaction

– cognitive system (präfrontal Cortex): self-control; willpower

• As long as the limbic systems rules our behavior (as it in fact does), we

– smoke, drink, eat too much

– Don‘t learn enough, start learning to late

• Solution: self-committment – tight schedule; learning routinely, regulary

– learning with fellow students

– Êmpirical findings: learning with good students improves your own grades (Sacerdote 2002)

– compare your learning goals with your real learning efforts by means of a diary

– promise yourself a reward (after you finished)

How to study

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• The economics of education: – going to university is like an investment

– a economics student costs 40.000 Euro

– this is how an investment works: sacrifying consumption today for more consumption tomorrow

• Tuitition fees: – an investor has to pay for his investment (class rooms, teaching

staff, etc.).

– investments are usually financed by credit (bonds) or equity. This does not work for an investment in human capital because there is no collateral

– Tuitition fees: if your investment (your visit at the university) pays off, you are able to pay back your fees. As long as the return of the investment is > than the costs of your investment it makes you better off

– A matter of fairness: who really pays if your studies are for free?

Why should you study?

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Germanys next Top-Model

Brazilian top-model Gisele Bündchen is – according to the Forbes-

list – the best-paid model of the world. She earns 33 million Dollar

(23,9 million euro) per year. Born in 1980, she is paid up to 40 000

Euro per show.

Top-model Kate Moss is ranked as the second-best paid model.

Aged 33, she earns 9 million Dollar (6,5 millionen euro) per year.

After leaving her friend, babyshambles-singer Pete Doherty, and

loosing her contracts with Burberry and Agent Provocateur she

made a comeback: she is the new Chanel-girl.

Heidi Klum earns 8 million Dollar (5,8 million euro) per year.

Born in Bergisch-Gladbach, she still is on the catwalk, doing

promotion for several companies and is hosting TV-shows

(„Germany´s Next Topmodel“, „Runway“).

source: Gala

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Ökonomisches Denken: Germanys next Top-Model

A few questions

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• Why are there so many women dreaming of a job as

a top-model?

- money, fame

- But: how are chances that you make it on top?

- The decision for a job is a decision between risk and

reward

- The higher the risk, the higher the reward – if not, this is no

good job

• What do we learn from this?

- People respond to incentives – big incentive, great efforts

- Each risk, each effort has to be rewarded

- Economics is to find a good balance between efforts and

rewards

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• Why do models earn that much money?

- special skills?

- unique look?

- reward for the risky decision to start a career as a model?

- Soccernomics: a model has only a small window of

opportunity to make money

- model as a brand


- work has no intrinsic value (K. Marx)

- as long as somebody is willing to pay for your work, it is

worth that

- there is no obligation for anybody to hire somebody for a

given wage

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• Should there be a limit on model‘s wages?

- too much money for too less work?

- undeserved income? You are born with your look; you did

not have to work for it


- cut wages by law and find out that a lot of models will

quit their job and that there will be no new recruits

- the value of a job is determined by what the employer is

willing to pay

- if you think you know the value of a job better than the

employer, you should also be responsible for the

consequences

- what is the difference between Heidi Klum and Josef

Ackermann?

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• Should there be a minimum wage for models?

- some models cannot make their living from their job

- Some models have a high income, some earn almost

nothing – is this a matter of fairness?

What do we learn from this?

- a minimum wages for models will lead to a excess supply of

models

- without a guarantee for a job, a minimum wage will not help

the models to earn their living; only some lucky models who

got a job benefit from the minimum wage

- What about a minimum wage for rock musicians, poets,

artists and and and?

- spot the difference to minimum wages as discussed in

Germany

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Homework: reading assignments

Reading assignments:

A letter from London

At LSE, we don‘t have one single book for one course.

The amount of literature is huge: 900 pages for three courses, that is 120 pages

per day. For example, the capital markets session requires the reading of nine

research Papers, seven articles from newspapers, selected readings from seven

books plus the slides from the lecture. Source: F.A.Z.

Please get all the slides and the literature you are supposed to read for this

lecture. From now on, you ought to read all the reading assigments before the

lecture. You have to read them anyway, so why not before the lecture?

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Economics

Session #2:

First ideas


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First ideas

What is economics?

Economic thinking

Economics and freedom

Economics and markets

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What is economics?

• „Economics is making best out of life“

The problem with life: so many wishes, but so little

means to fulfill these wishes. Economics means to

organize an economy in order to reduce scarcity in the

most efficient way

• „People respond to incentives“

Economists think of people as selfish beings – rewards

make them work; punishment makes them behave

properly

• „Economists as policy advisers“

Economics is not an selfish art: reducing scarcity is one

common political goal.

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What is economics?

• Why do we need models? They are like a map to solve economic problems

• Methods: – ceteris paribus-analysis (holding other things constant )

– make your assumptions transparent (people maximize utility)

– make explanations (how do people maximize utility)

– make predictions (if prices increase, consumption will decrease)

• Three ways to craft a model: – verbal description

– graphical representation

– mathematical representation (exact)

• Statistics: testing theories and models with empirical observation

• Positive vs. normative theory (“Mr. Beck should accept other positions”)

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Economic thinking

• Scarcity: the cookie-experiment

- test person is asked to try a cookie and to tell her willingness to

pay for that cookie

- Two groups: cookie-jar #1 ist full; cookie-jar #2 is almost empty

- variation I: show a full jar, replace it with an almost empty jar

- another experiment: the toys-partitionwall-experiment

- Empirical findings: humans are focussed on scarce

ressources

- explanations:

- if other people value something as valuable, then it must be

valuable

- scarcity means a loss of options; people don‘t like the idea of

loosing options (i.e. freedom)

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Under discussion: scarcity

• Scarcity: Consequences and political implications – why is coffee at Frankfurt Main station so expensive?

And who earns the money from the expensive coffe?

– in 15. Century, the black death killed almost one-third of the population. Afterwards, wages increased; the system of serfdom and lords of the manor disappeared. Why?

– What justifies huge salaries and profits?

• The power of scarcity: If there is a deal to be done and one of the contractors is in possesion of a scarce, unique ressource, then the profits (the rent) will go to the owner of the scarce ressource. Always ask yourself: who owns the scarce ressource?

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Economic thinking

• Incentives: the cobra-effect – In the 19th Century, the English government in India tried to fight

a cobra-plague in India by paying money for every cobra caught.

What happened?

– 1965: “Unsafe at Any Speed” by Ralph Nader forced a wide

array of automobile safety legislation – cars became much safer.

Consequence: the number of accidents increased. Two effects:

More accidents, fewer drivers killed (side effect: more

pedestrians killed)

• Pepole respond to incentives – selfishness: people tend to maximise their own utility

– politics: if you want people to do something, watch out for the

incentives they are exposed

– banning certain behavior: costs of controlling and prosecution;

people will always try to evade a ban

– wrong incentives lead to a disaster: theory of oilspots

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Economic thinking

• Incentives: oilspot-theory

• E.g. agricultural policy in the E.U.: – goal: a minimum income for farmers

– policy: guaranteed prices

– consequence: excess suply

– next step: destroying excess suply; paying farmers for not growing agricultural products

– Next step: fraud

– consequence: more and closer monitoring of farmers

– result: you are paying people for not to work and spending a whole lot of money for controlling if they really do not work

• Oilspot-theory (W. Eucken): once you start with a wrong policy, your mistakes start to spread over your economy like oil over water

• Homework: taking a cab

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Homework: Taking a cab

Taking a cab in Prague

Journalists from the daily newspaper

Mlada fronta Dnes claimed to be foreign tourists

while taking a cab in Prague. In six out of ten cases,

they were charged extremely high prices. In one case,

they had to pay a price eight times as high as the price

allowed. The city council of Prague said that it controlled 755

cab-drivers; 1.5 percent of them charged a price too high.

How would you like to pay a cab-driver assuring that he will not

cheat you? How do you think a physician should be paid?

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Economic thinking

• Property rights: pay the piper, call the tune – why are there so many expensive restaurants in

Frankfurt City and who is willing to pay for the expensive food?

• Who pays the bill? – you: maybe you’ll choose McDonalds instead – your company: you may order champagne instead of table water

• If you have to pay your bill by yourself, you will take care of your expenses and your property

• Property rights ensure an efficient allocation of ressources; if your boss pays the restaurant, you make a decision about his property, not yours

• Private property is necessary for a market-economy • For a world without property rights see former eastern-

european socialist economies

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Case study: Tokio Hotel serving for the army?

Tokio Hotel:

Your‘re in the army now?

Instead of staging concerts, Tom and Bill Kaulitz from Germany‘s most sucessfull pop group Tokio Hotel may soon be serving for the german army. They got their call-up-order recently, as „Bild“ wrote. „We do not make any exeptions for prominent people, actors or musicians“ says Uwe Ullrich from the draft comission Stendal. „If they don‘t show up at the recruiting station they may be forced by the police to do so.“ (Source: Bild-Zeitung)

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Economic thinking

• Opportunity costs: should the german army draft Tokio

Hotel? (from an economic point of view)

– should Tiger Woods mow his own lawn?

– should you bake your own bread?

– the costs of some action might not be as obvious as it

seems – what about your time?

– opportunity costs of an item is what you give up to get

that item. There is no free lunch – whatever you choose

to do, you do it at expense of the next best alternative

• So what is more expensive: compulsory military services or

volunteers?

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Homework: Too busy for university?

Too busy for university?

What do Bill Gates, David Beckham an Kylie

Minougue have in common? None of them has a

university degree. In fact many extremely sucessfull

people – especially those in careers like acting or athletics,

where starting early in life is especially crucial – do not attend

university. On the other hand, Queen-guitarist Brain May just

recently finished his Ph.D. in astrophysics – more than 30 years

after he left university to rock the world.

Do you think Mr Beckham or Mrs. Minougue should have finished

their studies before making a fortune? Should you leave university

for a career as singer/manager? And do you think that it was

clever from Mr. May to finish his Ph.D.?

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• Specialisation: should Tiger Woods mow his own

lawn?

– the principle of specialisation: everybody should

specialise in the activities he is best at

– the division of labor (i.e. specialisation) constitutes

modern market economies: journalists, lawyers, car

makers, baker etc.

– idea: everybody does what he is best at and trades the

fruits of his work on the market

– division of labor is ALWAYS welfare-increasing

– division of labor on an international level: globalisation

– Ricardo: the principle of comparative advantage

Economic thinking

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Case study: Thinking at the margin

• Thinking at the margin: more security on the road – requirements on the driver: speed limit, obligation to use

seat belts and not to phone / drink

– requirements on a car: brakes, lights, tires

– benefits: less people are hurt / killed

– costs: requirements on the driver: freedom; requirements

on a car: money

• How far should we go to reduce the amount of

people hurt in traffic?

– speed limit at 20 km/h? 50 km/h? 100 km/h?

– obligation not to hear music while you drive?

– more airbags?

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Economic thinking

• Gossen‘s law

– the additional utility of a good (action) changes with increasing

consumption

– additional utility of the next unit consumed decreases with increasing

consumption (decreasing marginal utility)

• the additional costs of your action are increasing (increasing

marginal costs)

– reaching a certain level of security, every additional measure to make

traffic more secure is getting more expensive (in terms of money or

loosing liberties)

– e.g. enviromental policy: marginal costs of abating emissions are low

(high) for a old (new, efficient) machine

• economic thinking: marginal costs should always equal

marginal utility

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• examples:

– (compulsory) preventive medical checkup for

children

– protection for workers

– protection for tenants / lodgers

– consumer potection („Überraschungs-Ei“)

– registered master

– licensing financial advisers

Marginal utility: protection of the citizens

Marginal costs: loss of freedom

Economic thinking

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• freedom – as a value; people want to enjoy the benefits of liberty

– efficiency needs freedom: voluntary contracts between rational, equally entiteled parties are welfare-maximising (pareto-improving)

• Problems – equally entiteled partners? One needs to protect weaker parties and

minorities

– rational parties: unintended, unforeseen consequences of our actions

– contracts bothering third parties: enviromental policy; speed limit to

protect other drivers

– here, policy has to step in and restrict personal freedom in order to

protect consumers, weak parties, third parties. Therefore, markets

need additional policy.

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• Policy

– to protect weaker parties (labor market, information

asymmetries, subsistence level)

– to protect consumers from their selves (obligation to

save for retirement, compulsory health insurance, drug

policy, education)

– to protect third parties (enviromental policy, speed limit)

• How should this policy be designed?

– marginal utility should equal marginal costs

– efficient and effective

– use the power of incentives instead of coercion


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• markets are

– specialisation: you can only specialise in what you are good at if

you can exchange the friuts of your work on an market

– therefore you need the right to exchange what you want with

whom you want and the right to choose the job you want to do

– the distribution of the gains from specialisation is done by the

market according to the scarcity of the goods exchanged

(remember: always ask for the scarce ressource)

– incentives: I will only exchange goods if it makes me better off

and if I am sure that I can reap the benefits form this exchange.

Therefore you need property rights (Art. 14 GG)

• A exchange of goods via markets makes both parties

better of is always welfare-increasing (pareto-

improving)

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• what makes markets work

– competition; no power resulting from scarcity or

monopolies

– protection from sweating

– rational consumers and voters

– no externalities

• Policy to make markets work

– competition policy (GWB)

– Social protection against hardships of life (Art. 20 GG)

– consumer protection; (alcohol, drugs etc.)

– protection of third parties from externalities (enviromental

policies)

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Economics

Session #3:

How markets work


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Homework: Taking a cab

• passenger: wants to get to his destination fast and cheap

• cab driver: wants to maximise his income

– pay per hour: driving lot of roundabout ways or traveling at speed

of light

– pay per kilometer: no good idea

– fixed price: fear for your life

– bonus for reaching destination as fast as possible: see fixed price

– Fixed price plus bonus if the passenger reaches destination

without suffering from the roman disease

• Other examples: profit sharing schemes in companies;

payment of physicains; managers salaries

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Homework: Too busy for university?

• Opportunity costs: opportunity costs of an item is what you give up to get that item

• What about Bill, Kylie and David? – the costs of their studies are the foregone profits from their career – David and Kylie: they are making their fortune in young years –

maybe they should go to university after they finished their active career

• Brian: – leaving university for Queen was a good decision – now, the Brians opportunity costs are decreasing due to the

decreasing marginal utility of money (why?)

• Should you leave university? – it depends on your opportunity costs – it depends on the changes of making it to the charts / Bayern

München; the higher the risk of failing, the closer you should stick to your studies

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How markets work

How markets work

The path to equilibrium

Supply and demand

Markets in action

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How markets work

You are in a supermarket. At which cash desk do you line up?

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How markets work

• That’s how markets work: Incentives (save time) trigger behavior (search for the shortest queue); that will bring markets into equilibrium (all queues do have the same expected time to wait)

• Thats how markets work – scarcity as a sign of demand for a product / service

– scarcity leads to higher prices

– higher prices as an incentive for producers to increase production – as long as he can reap the profits from his increased production (property rights!)

– as prices rise, supply rises, which helps to reduce scarcity

– this happens only as long as prices are allowed to change and producers are allowed to profit from their increased efforts

• Result of free markets: equilibrium

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The path to equilibrium

• Incetives, property rights and freedom make disequilibria dissapear – supplier: seeks for profit

– consumer: seeks for cheapest contract

• markets channel egoims of supplier and consumer to a social efficient result

• Adam Smith: „invisible Hand“

• What happens if you try to administer prices?

• How would you run a command economy?

• Do you know some examples where markets do not work?

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The hog cycle

The year of the golden pig

„Economists are remebered of the so-called hog-cycle taught in economics-courses in the first year at university. It explains why prices are volatile – because productions responds not immideately to changes in demand. In 2004, the price for pigs was not higher than today. Then, high prices made farmers to raise more pigs. In consequence, prices dropped dramatically, what in turn made farmers stop raising pigs. As an inevitable result, the price for pork increased to todays high level – this may lead to lower prices in the next years. (Economist, June 9th 2007; p. 59)

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• A markets consists of consumers (demand) and

producers (supply)

• the price is the crucial variable that coordinates

supply with demand

• requirements for well-functioning markets:

– free prices; no obstacles to changes in prices

– property rights, incentives

– freedom to choose job, supplier, contract partner

– competitive marktes: no single supplier; no exploitation

• Graphical representation: Supply-demand-

diagramm

Supply and demand

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Supply and demand

5

4

3

2

1

1 5 10 20 30

price

quantity demanded

price quantity

5 1

4 5

3 10

2 20

1 30

• Law of demand: as p decreases, D increases

• substitution

• Income-effect

• but: ceteris-paribus-assumption

D

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Supply and demand

5

4

3

2

1

1 5 10 20 30

price quantity

1 1

2 5

3 10

4 20

5 30

• Law of supply: as p increases, S increases, too

• Selling more promises more profits

• but: ceteris-paribus-assumption

price

quantity supplied

S

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Supply and demand

5

4

3

2

1

1 5 10 20 30

price D S

1 30 1

2 20 5

3 10 10

4 5 20

5 1 30

• equilibrium: supply = demand

• Excess supply: S > D

• Excess demand: D > S

price

quantity

S D

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• Supply-curve:

– xS = -c + dp

– at p = 0, there is no supply

– d = slope of the supply-curve. Shows how supply reacts

to a change in prices

• Demand-curve:

– xD = a – bp

– at xD = 0, there is no demand; i.e.: 0 = a – bp; i.e.,

p = a / b so-called reservation price

– p = 0 saturation point; xD = a

– b = slope of demand-curve, shows how demand reacts

to a change in prices

Supply and demand

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Supply and demand

• equilibrium:

– xS = xD; i.e.,

– -c + dp = a – bp

– Equilibrium price P*= (a+c) / (b+d)

• example:

– XD = 100 – 0.5 p

– XS = -20 + p

– Find price and quantities traded in equilibrium

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Markets in action

5

4

3

2

1

1 5 10 20 30

p

q

p old new

5 1 0

4 5 1

3 10 5

2 20 10

1 30 20

• Change of a exogenous variable: demand-curve shifts; loosening the ceteris-paribus-assumption

• This is not a movement along the curve (endogenous variable)

D

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Markets in action

• The government decides to increase the tax on income

• The demand for Playstations: a new version enters the market

• The interest rate is rising

• The government introduces a new minimum wage legislation

• The price of your playstation is increasing

• Discuss the demand-curve for

– hard drugs

– silicone

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• with the 1996 BSE-crisis, consumers switched from beef to pork

• farmers switched from rearing cows to pigs

• what happened to the price of beef?

• what happened to the price of pork?

p

q

S

D

D‘

Case study: the BSE-crisis

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• For the last years, demand for natural ressources was steadily increasing

• Prices for natural ressources were steadily decreasing

p

q

S D

S‘

D‘

Case study: natural ressources

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• What can politics do against drug-consumption?

• More punishment, more prosecution

• more educational work

• What if government decides to give heroin to addicted people for free?

p

q

S D

Case study: drug policy

D S‘

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Case study: cheap food no more

• findings:

– Food-prices are rising

– Inventories are decreasing

– record crops worldwide

• Why are prices rising?

– China and India are getting richer; demand for meat is

increasing; meat needs more grain as input

– Demand for (state-sponsored) biofuels increases

– bad harvest in Australia

• measurements

– politics: price controls; export restrictions

– farmers: producing gen-food; re-activate fallow lands

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• Demand curve shifts due to

- increasing incomes

- increasing demand for meat

• Supply curve shifts due to

- bad harvest in australia

- Increasing supply of biofuels

- but: supply-curve may shift back due to reactivated fallow land

p

q

S

D S‘ D‘


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• Before price controls and export restrictions:

- Domestic suppliers produce S1; exports: S1-D1 sold at price P1

- Price controls; export restrictions

- price decreases to p2

- demand increases

- total supply decreases; but: domestic consumption increases

- income of farmers decreases

- consequences: more fallow land; smuggling; black markets

p

q

S D


S1 D1

p1

p2

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Homework: Beating the traffic

Beating the traffic

All big cities have traffic problems, and many

cities try to discourage people from driving into

the crowded city centre. If we think of a car journey

into the city as a good that people consume, one can

use the economics of demand and supply as a tool to analyze anti-

traffic policies. Here are a few strategies: One could reduce the

prices of substitutes (making bus or rail-tickets cheaper) or raise

the price of complements (high taxes on commercial car parks;

shorter times on the parking meters). The city of London imposed

a congestion charge on cars entering the city during the business

hours. Some cities restrict the number of cars allowed to enter the

city during the rush-hours.

Show graphically what happens to the market for car journeys to

the city if you implement the policies described above .

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Economics

Session #4:

Elasticities and welfare analysis


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• Reducing demand by taxes on carparks; higher costs of parking in the city shifts demand curve to the left

• Reducing demand by lowering prices for public transport

• What happens if the government decides to restrict the number of cars allowed to enter the city?

p

q

Homework: Beating the traffic

D‘ D S S‘

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Elasticities and welfare-analysis

Elasticity of demand

Elastic and inelastic demand

Other elasticities

Consumer- and Producer-Surplus

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• Who needs protection in social and economic

life – and why?

– tenants / lodgers

– employees

• What is the problem with drugs?

• Should we sell life-saving medicine via

markets – and if not, why?

• What is exploitation and what is the root of it?

Elasticitiy of demand

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• Basic idea of marktes: supply and demand react to changes in prices

• How can we measure the reaction of supply / demand to changes in prices? („sensity of demand to price changes“)

• We may use

– the absolute decline of demand (supply) per Euro

– decline of demand (supply) in percent per Euro

– elasticities

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• Elasticity: percent change in demand divided by the corresponding percent change in its price

• p decreases by 20 % = -(5 – 4) / 5

• demand increases by 11,11 % = (100 – 90) / 90

• elasticity: 11,11 / (-20) = -0,55

• If the price decreases by 1 %, demand increases by 0,55 %

• unit-free number enables comparisons between different goods; PE is independent from price level

p

q


D

5

90

4

100

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• One Problem with this idea: What if the price increases (last slide: price increases)?

• p increases by 25 % = (5 – 4) / 4

• q decreases by 10 % = -(100 – 90) / 100

• elasticity: -10 / 25 = -0,4

• The value of PE depends on whether the price increases or decreases

• solution: averaging

p

q


D

5

90

4

100

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elasizität • Price on average: 4.5

• (5 – 4) / 4,5 yields: p changes by 22 %

• average quantity: 95

• (100 – 90) / 95 yields: q changes by 10,5 %

• elasticity: 10,5 / 22 = -0,47

• bow elasticity

• Elasticity is NOT the slope of a curve (ΔQ/Δp); but it is an important part of it:

• PE = (ΔQ/Δp) (p/q)

p

q


D

5

90

4

100

4,5

95

change in price mean price

change in quantity mean quantity

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Homework: some elasticities

Oscar Angela p demand p demand

2 20 2 19

4 15 4 18

6 12 6 18

8 11 8 12

10 5 10 4

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• elasticity: if the price decreases by one %, demand increases by Є %

• inelastic demand: absolute value of Є < 1. (0,19)

• elastic demand: absolute value of Є > 1 (1,6)

• Isoelastic demand: absolute value of Є = 1. (113 – 90) / 101,5 (5 – 4) / 4,5

p

q


D

5

90

4

130

D

94

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• Complete inelastic demand: demand does not react to a change in price; Є = 0. E.g. drugs.

• Totally elastic demand: if p increases only slightly, demand goes to zero;if p decreases only slightly, people every quantity

offered. Є = . Perfect substitutes; demand in the case of polypol (see session #8)

p

q


D

D

75

• Hard drugs (heroin): completely inelastic demand

• Soft drugs: elastic demand (pot; alcohol, cigarettes)

• consequence: drug policy has to distingiush between hard and soft drugs

• prosecution: shift of the supply-curve. Helps with soft drugs; not with hard drugs

• education: shift of demand-curve; does not work that well with soft drugs because as p decreases; demand increases again. Helps with hard drugs.

p

q

S D

Case study: hard and soft drugs

D D*

S‘

26

76

• What determines elasticity of demand

• Essentials or luxury goods?

– travelling, restaurants

– gasoline, basic foods

• Availability of substitutes – are there good

substitutes? (I-Phone and telecom)

• Supply; i.e. competition prevents consumers from

being exploited (GWB)

• Time

– gasoline: in the long rund demand is more elastic

– Cars (durables): in the long run demand is more inelastic


77

• revenue: price times quantity

• revenue at p = 5: 90 * 5 = 450

• revenue at P = 4: 100 * 4 = 400

• revenue has decreased altthough demand has increased. Reason: the decrease of the price. Inelastic demand

p

q


D

5

90

4

100

78

• revenue: price times quantity

• revenue at p = 5: 90 * 5 = 450

• revenue at P = 4: 120 * 4 = 480

• if demand is elastic; a decrease of price increases revenues

• Elasticity of demand depends also on the actual price

• as p declines, PE declines, too

p

q


D

5

90

4

120

27

79

Other elasticities

• Elasticity of supply – %-change of quantity supplied divided by %-change of price

– shows how supply reacts on changes of market data (how long does it take to close a gap between demand and supply?)

– ES is determined by availability of inputs, time, profits

• income elasticity – %-change of demand divided by %-change of income

– inferior goods: food (IE<1); superior goods: travelling (IE>1)

• cross-price-elasticity – %-change of demand for good 1 supplied divided by %-change

of price for good 2

– important for competition policy

– close substitutes: CPE is small and < 0; complements: CPE > 0

80

PE

tomatoes 4,6

legal gambling 1,9

marijuana 1,5

cigarettes 0,51

cinema 0,87

IE

cars 2,5

restaurant 1,4

clothes 1,0

margarine -0,2

source: Samuelson 1998

Empirical estimates

81

Home work: the boll weevil

Boll Weevil Monument, Enterprise, Alabama

From 1910 – 1915, the boll weevil, a bug from

mexico, destroyed almost the entire harvest of

the local cotton farmers, exspecially in Enterprise,

Alabama. In december 1919, a monument was built

in the heart of the city to remind of the bug. It was

manufactured in Italy, the city payed 1800 dollars for it.

It is the only monument worldwide built in honor of a parasite.

Why should the city build a monument in honor of the boll weevil?

28

82

Consumer- and producer surplus

5

4

3

2

1

1 2 3 4 5

p

q

p q

5 1

4 2

3 3

2 4

1 5

• Demand curve represents the willingness to pay of every single consumer; i.e the utility they derive from consuming the product

• What if the price is below the willingness to pay?

D

83

• If p = 4 Euro, consumer #1 buys one unit; consumer #2 buys one unit, too;

• consumer #1 pays 4 Euro for something he is willing to pay 5 Euro this increases his total welfare by 1 Euro

• Is p = 2 Euro, so the increase in welfare for #1 = 3 Euro #2 = 2 Euro #3 = 1 Euro


5

4

3

2

1

1 2 3 4 5

p

q

D

84

• Consumer surplus: welfare increases if p is below the willingness of the consumer to pay

• If p decreases, total welfare increases

• graphically: area between market price and demand curve


5

4

3

2

1

1 2 3 4 5

p

q

D

29

85


5

4

3

2

1

1 2 3 4 5

p q

1 1

2 2

3 3

4 4

5 5

p

q

S

• Supply curve represents the willingness to offer a good for a given price; i.e. his total costs

• what if p is above costs?

86


5

4

3

2

1

1 2 3 4 5

p

q

S • with p = 2 euro, supplier

#1 gains 1 € on top; #2 just breaks even

• with p = 4 Euro, the additional gains are: #1 three Euro #2 two Euro #3 one Euro #4 breaks even

87


5

4

3

2

1

1 2 3 4 5

p

q

S • Producer surplus:

increase in producers welfare, if market price is above total costs of production

• if p is increasing, total welfare increases, too

• graphically: area between supply curve and price

30

88


5

4

3

2

1

1 5 10 20 30

p

q

S D

• CS and PS represent consumers‘ and producers‘welfare from market transactions

• Overall welfare (OW): CS plus PS

• CS = total utility consumers receive from the good – payments to producer

• PS = consumers‘ payments – costs

89

Markets revisited

• markets are efficient: – if p is above equilibrium price, total utility consumers derive from

consuming the good is larger than costs of production

– if p is below equilibrium price, total utility consumers derive from consuming the good is smaller than costs of production

– on markets, goods are allocated to the customers with the highest willingness to pay

– on markets, customers buy at the companies with the lowest costs (price)

– remember: markets need freedom of coalition; freedom to buy where ever and what ever you want; freedom to sell what ever you want a which price you want

• on markets, goods are only distributed by ability to pay, not by needs

• Markets reward for achievements

• markets do not provide equality

90

• Before price controls and export restrictions:

- domestic suppliers produce S1; exports: S1-D1 sold at price P1

- PS: 0p1B

- CS: p1CDE

- Price controls; export restrictions

- PS: 0p2A; producers lose p2p1CBA

- CS: p2ADE; consumers gain p2p1CA

- Net loss of welfare: CBA

p

q

S D

Case study: cheap food no more (revisited)

S1 D1

p1

p2 A

0

B C

E D

31

p

q1

p1

p2

A

B C

E

D S

q2

PS with free trade : ABC CS with free trade: E PS with export restrictions : A CS with export restrictions: EB Loss of welfare: C

Case study: cheap food no more (revisited)

92

• Should one pay organ donors?

• Some people would spent even

without pay (S‘); in this case: no

producer surplus, consumer

surplus: E+D+A

• If we allow a professional market

for organs:

PS: A+C; CS: D+B+E

• Deadweigh loss if we do not allow

a market: Those who receive an

organ gain A, those who do not

get one, loose B

• but:

- who shall receive organs?

- does a professional market

for organs undermine the

willingness to spent without

pay?

p

q

Case study: organ donations

p

S

D

q1 q0

A

B

C

D

S‘ E

93

• Subsidy shifts demand curve

to D‘

• Consumers pay net price pn,

producers receive gross price

pG.

• difference pG – pn = z =

subsidy

• Consumers gain A

• producers gain B

• Costs to the government:

B+A+C; divided between

consumers (A) and producers

(B)

• C = excess burden;

deadweigh loss of a subsidy

p

p

S D

pn

q1 q0

Case study: cash for clunckers

z A

B

pG

q

D‘

C

32

94

Economics

Session #5:

Analysis of competitive markets


95

Homework elasticities: Oscar

q p dq dP Mold +Mnew

2

Pold +Pnew

2

(3) / (5) (4) / (6) PE:

(7) / (8)

5 10 - 2

11 8 6 - 2 8 9 0,75 - 0,22 - 3,3

12 6 1 - 2 11,5 7 0,08 - 0,28 - 0,3

15 4 3 - 2 13,5 5 0,22 - 0,4 - 0,55

20 2 5 - 2 17,5 3 0,28 - 0,66 - 0,4

q = quantity; p=price; dM=change of quantity; dP = change of price; Mold = quantity before change of price;

Mnew = quantity after change of price; Pold = old price; Pnew = new price

96

Homework elasticities: Angela

q p dq dP Mold +Mnew

2

Pold +Pnew

2

(3) / (5) (4) / (6) PE:

(7) / (8)

4 10 - 2

12 8 8 - 2 8 9 1 - 0,22 - 4,5

18 6 6 - 2 15 7 0,4 - 0,28 -1,4

18 4 0 - 2 18 5 0 - 0,4 0

19 2 1 - 2 18,5 3 0,05 - 0,66 - 0,08

q = quantity; p=price; dM=change of quantity; dP = change of price; Mold = quantity before change of price;

Mnew = quantity after change of price; Pold = old price; Pnew = new price

33

97

• why should one built a monument for a parasite?

• the destruction of the harvest shifts the supply curve to the left. consequence: revenues are increasing

• With inelastic demand, revenues are increasing

• Second reason: weevil made farmers switch to other products (peanuts)

p

q

Homework: the boll weevil

D S S

98

Analysis of competitive markets

Price strategy and consumer surplus

Price ceilings

Minimum wages

Taxes and social security contributions

99

• Basic idea: capturing consumer surplus by charging customers according to their willingness to pay

• Two prices: expensive pe and cheap Pc

• Old CS: A+B+C

• New CS: A+C

• Old PS: D+E

• New PS: D+E+ B

p

q

D

Price strategy and consumer surplus

pe

qe

S

pc

A

B C

D E

qc

34

100

• Do you prefer expensive brands?

– Müller Milchreis or „Elite“-Milchreis (40 %)

– Nestlé-Eis or Classic Choco Vanilla from Lidl?

– Hochland-Feta or Mitakos-Feta?

• Separate customers by their income (lawyers, consultants,

„families (pensioners) pay half the price“)

• Different discounts to different customers (car sales)

• „Slighty imperfect“ products with discount

• out-of-fashion products

• „professional“ vs. „homeworker“ edition

• hardcover vs. paperback edition

• Premium vs. non-premium brands

• Perfect price discrimination: E-Bay

Case study: hardcover or paperback?

101

P

S

D

q1 q0 q2

A

B

C

q

Rent ceiling

D

E

Price ceilings: rent control

Are rent controls a good

idea to protect tenants

from exploitation?

102

Price ceilings: rent control

• Rent controls make the economy as a whole worser off – supply decreases; shortage of cheap appartments

increases (C)

– some tenants don‘t get an appartment anymore (B)

– If you get an appartment, you win (A), but on the expense of the landlord

• consequences:

– Under-the-table-payments; subcontracting

– in the long run: supply decreases even more (S shifts to the left)

– who gets the cheap appartment? The needy?

35

w

w

S D wmin

L1 L0 L2

A B

C

D

E

• Demand for labour (for hours

worked) = L1, supply of labour

(hours worked) = L2

• unemployment L2 –L1

• L1 hours are actually employed

CS (rent of those who demand

labour; i.e. employers)

decreases by A (higher wages

for those who still have a job)

and B (those who loose their

job due to higher wages)

• PS increases by A (higher

wages for those who still have

a job); decreases by C (those

who loose their job )

• Deadweigh loss: B+C

Minimum wages

104

• Minimum wages hurt some

workers; but do they help all

workers as a group?

• Loss of PS for workers: A – C

• If the demand curve is flat

(elastic demand for labour) B

> A, i.e. workers as a group

loose

• Empirical findings: demand for

low-skilled labour is more or

less elastic, because one can

replace it with machines

w

Minimum wages

w

S D

wmin

L1 L0 L2

A B

C

105

Minimum wages

• You don‘t need minimum wages for high-skilled workers but for low-skilled workers. Consequences: – total loss of welfare to workers as a group (B > A)

– wage sum: Lmin * workers payed decreases if demand is elastic; wage increases, but the number of persons receiving this higher wage dereases (see session #4)

• A few questions concerning minimum wages: – in Germay, we are talking about different minimum wages for

different industries – why, if the MW shall provide workers with a minimum income to make their living?

– minimum wages for self-employed persons?

– minimum wages lead to more unemployment; but: what, if employers are able to pass the increased wages to their customers? If the demand for their product is inelastic, minimum wages don‘t lead to unemployment; but the higher wages are paid by the customers

36

106

Minimum wages and social market economy

• Social market economy: use efficient markets and provide social protection by additional social policy

• say: free wages, no minimum wages plus additional govermental payments on the wage. Consequences: – no unemployment

– social protection is now payed by the tax-payer, not by companies who employ employees for minimum wages or their customers

– minimum wages in germany: Hartz IV

• Concepts: so-called Kombilohnmodelle (Mainzer Model), negative income tax (USA)

107

• Taxes / SSC make supply

curve shift to S‘

• Consumers pay gross price

pG, producers receive net

price pn.

• difference pb – pn = t

• Consumers loose B+C

• producers loose A+D

• tax revenues: B+A; shared by

consumers (B) and producers

(A)

• C+D = excess burden;

deadweigh loss of a tax


p

S D

q1 q0

B

A

S‘

t

C

D

q

E

F

pG

pN

108

• Now: demand inelastic; supply

elastic

• Tax burden (A+B) is now

being shouldered mainly by

the consumer (B) because of

their inelastic demand

• the more inelastic part of the

market bears the main burden

of a tax

• Inelastic demand yields a

larger tax revenue

• Inelastic demand: cigarettes,

alcohol, gasoline – so why are

taxes on these goods so

popular?

p

p

S

D

pn

q1 q0

B

A


S‘

C

D

pG

q

37

109


• Idea #1: inelastic demand yields higher tax

revenues

– tax revenues in Germany: tobacco 14,4 bn.; VAT

147 bn.; gasoline 40 bn.

– taxes on work vs. taxes on machines?

• Idea #2: employer and employees share the

burden of social security contributions?

• Idea #3: more tax revenues with taxes on

luxury goods?

110

• Social security contributions shift

demand curve to the left; the

price for labour increases for

producers

• employees: if SSC are

considered as a perfect

equivalent for cash, supply curve

shifts downwards

• But: if employees consider social

security contributions as a tax

without adequate benefits, supply

curve does not shift;

consequence: unemployment due

to high social security

contributions

wage

w = wG

S D

wn

q0

Case study: social security contributions

b

hours worked

b

111

Homework: EU-agricultural policy

A sea of milk

Since 1957, the European Union has a common

agricultural policy. The goal of this policy was to

provide an income for farmers. Brussels promised

to buy the entire production of certain crops.

Cheap imports from abroad were heavily taxed via tariffs.

With the Uruguay-round, the EU was forced to change its system

of agricultural subsidies and price controls. Since 1993, farmers were

payed direct transfers.

What happens if the EU promises to buy any production? Show the

consequences for consumer- and producer-surplus.

38

112

Homework: How the „Spiegel“ got it wrong

Nonsense-o-nomics

In his 44/2010 edition, the german weekly magazine

complained that german house-buyers have to pay the

fee for the real estate agent although he is commisioned by

the vendor of the house and therefore acting not in interest

of the buyer. Moreover, the writer of the article wondered that

in some german districts the vendor pays the commision. The writer claims that the

comission for the agent should be shared in equal parts between the vendor and the

buyer.

Who bears the burden of the commission for the real estate agent?

Why are there some districts where the vendor pays the commission?

Why did the „Spiegel“ get it wrong? Explain your reasoning by

means of a graph and by means of producer surplus and consumer

surplus.

113

Economics

Session #6:

Production


114

p

Homework: EU-agricultural policy

p

S D

pmin

q1 q0 q2

A B C

q

• Government promises to buy

the whole production for

minimum price pmin

• CS: loss of A, which is

redistributed to producers;

loss of B for those who stop

consuming

• PS: gain A+B+C

• Government: buys surplus

production q2-q1; i.e. totals

costs are pmin(q2-q1)

(speckled rectangle)

• Guess who pays this policy?

• Net welfare loss: depends on

what happens to the product-

ion the government buys

D

39

115

Production

Production function

Costs

Cost function

Shareholder and Stakeholder

116

• Why learning about production? – Goal: efficent production; avoiding waste of time

and inputs

– companies need profits to survive

– employees need companies

– companies play a crucial role for employment and welfare of a country

• What do you need to know?

– production function

– costs

– owner, shareholder

Production function

117

• The jelly baby-experiment – your product: delivery of jelly-babys from chair A to B

– time: 15 seconds

– amount of workers variies

– we may use more capital

• Please write down the results of the

experiment – total output

– average output (output per worker)

– marginal product (additional output produced as input is

increased by one unit )

Production function

40

118

Production function

#W TO AP MP

1

2

3

4

5

6

7

8

9

• W = worker; MP =

marginal product; AP =

average product; TO =

total output

119

Production function

• w = worker; TO = total

output; AP = average

product; MP = marginal

product

• Law of diminishing returns:

the more workers we use,

the lower is the additional

output

• most times: starting with

increasing MP, later on

decreasing MP

• Sources: Synergies;

division of labour; learning

w TO AP MP

1 3 3 3

2 5 2,5 2

3 8 2,66 3

4 12 3 4

5 17 3,4 5

6 23 3,83 6

7 26 3,71 3

8 28 3,5 2

9 29 3,2 1

10 29,5 2,95 0,5

120

Production function

TO

w

41

121

Costs

• Costs: – opportunity costs

– explicit and implicit costs (do not require a cash outlay)

– cost of capital: loans (interest) and equity (opportunity

costs)

• measures of costs – total costs

– fixed costs (do not vary with output)

– variable costs (depend on output)

– average costs (total costs divided by quantity of output)

– marginal costs (increase of total costs that arises from

an extra unit of production)

Fixed costs = 100;

wage: 10 € per worker

TO = total output

TC = total costs

VC = variable costs

AC = average costs

MC = marginal costs

(change of total costs / additional

output),

i.e.: 5 = (120-110) / (5-3)

122

w TO TC VC AC MC

1 3 110 10 36,6 10

2 5 120 20 24 5

3 8 130 30 16,25 3,33

4 12 140 40 11,6 2,5

5 17 150 50 8,8 2

6 23 160 60 6,95 1,67

7 26 170 70 6,54 3,34

8 28 180 80 6,43 5

9 29 190 90 6,55 10

10 29,5 200 100 6,78 20

Costs

123

Costs

TC

TO

• Most times:

total cost curve

is S-shaped

• i.e.: MC are

decreasing at

the beginning;

they tend to

increase with

increased

output

• Reason: first

increasing MP;

decreasing MP

as output

increases

42

124

• AC: decreasing at

the beginning;

increasing with

increased output

• Reason for

decreasing AC: fixed

costs

• application: natural

monopolies

Cost function

AC

TO

125

Case study: The Bundesnetzagentur

The federal agency for postal services and

telecommunication is responsible for for postal services,

energy services and the telecommunications industry.

Since January 2006 it is responsible for the railway-infrastructure,

too. It is obliged to assure that every competitor has access to the

infrastructure of its industry. Natural monopolies arise when there are

huge fixed costs. They lead to a market where one company is able to

satisfy the whole market demand. The most visible natural

monopolies are utilities (water, gas), electricity, and phone services.

126

Cost function

• MC: decreasing

with small output;

increasing with

increasing output

• Reason for

decreasing and

(later) increasing

MC: law of

diminishing returns

MC

TO

43

127

0

20

40

60

80

100

120

0 2 4 6 8 10 12

AFC

FC

AC

- FC: fixed costs

- AC: average costs

- MC: marginal costs

- AFC: average fixed costs

- Minimum of average costs:

where AC = MC (why?)

output

Cost function

MC

128

Homework: Jelly-Babies, Baby

The Gummi Bear

The Gummi Bear originates from Germany where it

is hugely popular under the name Gummibär

(rubber bear) or Gummibärchen (little rubber bear).

Hans Riegel of Bonn invented bear-shaped sweets

and started the Haribo company in 1922, which first produced and

introduced its Gold-Bear product in the 1960s. In the United States,

Haribo gummi bears usually come in raspberry (red), orange,

strawberry (green), pineapple (clear), and lemon (yellow), however,

many offshoot companies (typically the health-related gummi bears)

may use more exotic flavors and colors.

Please complete the table for the jelly-baby-experiment. Calculate

different costs (one worker is 5 €; fixed costs are 100 €)

129

Shareholder Value and Stakeholder Value

• Shareholder value – the more profit a company earns, the more valuable it is

– a sucessfull company is valuable

– idea: high market capitalisation means a valuable company; i.e. a

sucessfull company

– goal: increase market value of the company (market capitalisation =

shareprice * number of shares

– problems: short-term-thinking of shareholders (?); what about stakeholder‘s interets

• Stakeholder Value: interest of companies‘ business

partners (workers, customers, government,

creditors)

44

130

Case study: 12 million euros

• Why is Josef Ackermann earning 12 million Euro per year? – scarcity? – international competition for excellent management-

talents? – negligent shareholders? („devil may care“)

• Why do shareholders not care about the income of the CEO – one share, one vote – small amount of shares, small influence on decicions

concerning the company – why should you care about voting if your influence is that

small – similiar problem with democracies

131

Shareholder Value and Stakeholder Value

• Should there be a legal limit on CEO‘s salaries?

– „unearned“ income? Remember the super-models

– lack of control by owner (shareholder) and supervisory board

– high salaries of CEO‘s lead to mistrust in market economies

– consequences: lack of supply of good CEO‘s; under-the-table-payments

• Other policy measures – shareholders: compulsory voting

– legal framework for salary schemes

– shareholder activism; especially asset management firms

– education

132

Economics

Session #7:

supply


45

133

Supply

Revenue and profit

Maximising profits

Supply-curve and competition

Taxes, Social security contributions and supply

134

Revenue and profit

q R AR MR

1 12 12 12

2 24 12 12

3 36 12 12

4 48 12 12

5 60 12 12

6 72 12 12

7 84 12 12

8 96 12 12

9 118 12 12

10 120 12 12

• q = quantity supplied; R=

revenue; AR = average

revenue; MR = marginal

revenue

• price is always the same

and is 12 €

• average revenue =

revenue divided by quantity

sold (€ per unit sold)

• marginal revenue =

revenue added by the last

unit sold

135

• the additional revenue from one more unit sold must at least

equal the additional costs caused by the production of this

unit

• i.e:

– if marginal revenue exceeds the marginal costs one should produce

one more unit

– if marginal revenue is below the marginal costs one should decrease

production

– i.e.: profit-maximum when marginal revenue equals marginal costs

– marginal revenue if the price remains unchanged: p (one unit

produced times its price)

– P = MC applies as long as an increase (decrease) in supply does not

lead to an decrease (increase) of the price

Maximising profits

46

136

Maximising profits

q P TC R MC MR Pr MR-MC

0 - 10 0 0 -10

1 12 25 12 15 12 -13 -3

2 12 36 24 11 12 -12 1

3 12 44 36 8 12 -8 4

4 12 51 48 7 12 -3 5

5 12 59 60 8 12 1 4

6 12 69 72 10 12 3 2

7 12 81 84 12 12 3 0

8 12 95 96 14 12 1 -2

9 12 111 108 16 12 -3 -4

10 12 129 120 18 12 -9 -6

137

P; MC; AC

q

B

Maximising profits

AC

MC

P

C D

E

O qG

• Profit-maximisation where p = MC

(B)

• Revenue = quantities sold qG * p;

i.e. OEBqG

• Total costs: costs per unit

(=average costs) * q; i.e.

ODCqG

• profit: revenue minus costs,

i.e. DEBC

• in the long run costs must at

least equal revenues; i.e. D =

minimum price producer must

charge in the long run

• if p < AC (D), the company

should exit the market

138

P; MC; AC

q

B

Maximising profits

AC

MC

P A

O qG

• Profit-maximisation where p = MC

(B)

• Revenue = quantities sold qG * p;

i.e. OABqG

• Total costs: costs per unit

(=average costs) * q; i.e.

OABqG

• profit: revenue minus cost,

here: zero

• p = minimum of AC is the least

price the company must

charge

• If p < minimum of AC, company

must exit the market in the

long run

47

139

P, MC;

ATC;

AVC

q

A

B

Maximising profits

ATC

AVC

MC

P

C D

E

F

O qG

• If p < minimum of AC, company

must exit the market in the

long run

• In the short run?

• As long as p > AVC the

company should continue to

produce (contribution margin)

• Total costs: ODCqG

• Revenue: OEBqG

• Loss: EDCB

• Variable Costs: OFAqG

• Contribution margin: FEBA;

part of fixed costs that are

covered by revenues

140

Homework: Is it Dumping?

Cheaper flights In November 2001, the german airline Germania Charged 99 € for flights between Berlin and Frankfurt. Deutsche Lufthansa, which held the largest market share for flights between Berlin and Frankfurt, reacted quick: it reduced the price for its tickets by 60 percent to 100 respectively 105 €. Additional services (Catering, Miles & More, more connections) made Lufthansa‘s offer more attractive than Germanias. Assume that Lufthansa is selling its tickets below total costs. Do you think that Germania can accuse Lufthansa for dumping? Is Lufthansa right to sell tickets below total costs?

141

• In p = 1 supply is q1




• ABCD: as p increases, supply

increases, too

• ABCD = supply curve

• Supply in the long run: starts

from minimum of TAC

• Supply in the short run: starts

with minimum of VAC

p

q

Supply-curve and profit maximisation

1

2

3

4

A

B

C

D

MC

q1

AC

q2 q4 q3

48

142

• Supply curve: marginal-cost-curve; starting from minimum of

TAC

• Total market supply: sum of all MC-curves of all firms

• Total market supply in the long run:

– if firms in the market are already profitable, new firms will have the

incentive to enter the market

– new entrants will increase the number of firms in the market; supply

increases; price decreases

– at the end of this process, economic profit in the market will be zero; if there

would be a profit higher than in any other sector, more supply would shift to

this sector

– economic profit is zero - i.e. p will equal minimum of average costs

– but: economic profit = accounting profit; economic costs include

opportunity costs of the owner (time, work etc.)

– result: competition drives prices down to minimum average costs

Supply-curve and profit maximisation

143

• competition – makes firms produce as cost-efficient as possible (in minimum of

TAC); this makes products as cheap as possible

– makes firms adapt to changes in market data (otherwise you loose

profit and revenue)

– gives incentives for innovation; innovation leads to lower costs /

higher demand; gives you a leading edge on your competitors

– firms are producing according to the wishes of the customers

• Competition needs: – free entry to the market

– property rights (Art. 14 GG)

– many suppliers

– market transparency

Supply-curve and competition

144

Taxes and supply curve

• What happens to supply if we introduce taxes or

social security contributions?

– tax on fixed costs: total costs increase; marginal costs

remain unchanged; average costs increase. AVC-curve

shifts upwards

– taxes on inputs: MC and AC increase; AC-curve and MC-

curve shift upwards

– taxes on profits: cost-curves remain unchanged; marginal

supplier leaves the market

• As we introduce taxes (or social security

contributions), supply decreases and thereby

employment

49

145


W TR TC VC AC MC

1 5 110 10 22 22

2 11 120 20 10,9 1,6

3 18 130 30 7,2 1,4

4 27 140 40 5,18 1,1

5 37 150 50 4,05 1

6 45 160 60 3,5 1,25

7 50 170 70 3,4 2

8 54 180 80 3,3 2,5

9 57 190 90 3,3 3,3

10 58 200 100 3,4 10

FC= 100;


TR= total revenue

TC = total costs

VC = variable costs

AC = average costs

MC = marginal costs

Now: 20 % tax on

TC (social security

contributions)

146


W TR TC VC AC MC

1 5 132 22 26 26

2 11 144 44 13 2

3 18 156 56 8 1,7

4 27 168 68 6 1,3

5 37 180 80 4,8 1,2

6 45 192 92 4,2 1,5

7 50 204 104 4 2,4

8 54 216 116 4 3

9 57 228 128 4 4

10 58 240 140 4,2 12

FC= 100;


TR= total revenue

TC = total costs

VC = variable costs

AC = average costs

MC = marginal costs

Now: 20 % tax on

TC (social security

contributions)

147

0

5

10

15

20

25

30

0 10 20 30 40 50 60 70


AC-curve before and after taxes

total revenue

AC

50

148

0

1

2

3

4

5

6

0 10 20 30 40 50 60


MC-curve before and after taxes

total revenue

MC

149


• Previous analysis: minimizing cost; maximising profits by choosing the adaequate level of output

• Now: minimizing costs by choosing the right combination of production factors

• Basic idea:

- use cheap inputs whenever you can; avoid using expensive inputs

- use inputs which are more productive than others

- balancing costs and productivity of an input: if it is expensive, avoid using; if it is productive, use it

- So: balancing marginal productivity of an input (output per unit input) and its marginal costs

150


Labour

wage in € 10

output per unit labour 10

capital

Interest in € 5

Output per unit capital 4

Labour

wage in € 10

output per unit labour 8

capital

Interest in € 5

Output per unit capital 4

• Spending one € for work yields one

more unit output

• Spending one € for Capital, yields

0,8 more units of output

• i.e.: employ more workers

• With increasing amount of labour

employed; marginal productivity of

work decreases (from 10 to 8)

• as prices remain unchanged, capital

as an input is becoming more

attractive

51

151


• the marginal productivity per Euro

- how do I spent the next Euro if I want a maximum of additional productivity?

- it is not only the price of an input or its marginal productivity, but the marginal productivity per Euro spent for this input

- as the price increases, MP per Euro decreases. The same productivity is now more expensive

- as MP increases, MP per Euro increases; one should increase the use of this input

• Implications for the labour market?

MP labour MP capital

price for labour Price for capital =

152

Case study: productivity-oriented wage policy

„In the conception of the council of economic

advisors, room for higher wages depends on the

marginal productivity of labour. If wages remain

below the increase of the marginal productivity of

labour, one can say that wage policy may help to

boost employment.“

(SVR, 2007)

153

Economics

Session #8:

Monopoly and imperfect competition


52

154

Homework: is it Dumping?

• Why should Lufthansa sell below cost price?

– contribution margin: temporarily selling below cost price because of

fixed costs

– seasonal/closing-out sales; persihable goods

– marketing strategy to lure in new customers

• But: what about cut throat pricing?

– German competition authority (Kartellamt): Lufthansa is selling tickets

below cost price

– this strategy makes only sense if it is supposed to help to squeeze

Germania out of the market and to raise prices afterwards

– the Kartellamt restrained Lufthansa form charging low prices, because

Lufthansa dominates the market; has enough money to bridge

temporarily losses and the barriers to (re-)enter the market are very

high

155

Monopoly and imperfect competition

Monpoly

Monopolistic competition

Competition policy

German competition law

156

Monopoly

• Monopoly: only one supplier

• Sources of monopoly power?

- control of inputs (patents; know-how, copy-rights)

- Branding, elasticity of demand

- production function (natural monopolies)

• consequences - consumer: loss of freedom

- Monopolist may gain political power

- loss of efficiency and welfare

- Pricing in monopoly: marginal revenue equals marginal costs

53

157

Monopoly

q P TR AR MR

1 10 10 10

2 9 18 9 8

3 8 24 8 6

4 7 28 7 4

5 6 30 6 2

6 5 30 5 0

7 4 28 4 -2

8 3 24 5 -4

9 2 18 2 -6

10 1 10 1 -8

• q = quantity supplied; TR=

total revenue; AR = average

revenue; MR = marginal

revenue

• As quantity supplied

increases, price decreases,

because the monopolist is the

sole supplier in the market

• average revenues represent

demand curve

• revenue = q * p

• As q increases, there are two

effects on revenues:

q increases

p decreases

158

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

0 2 4 6 8 10 12

Monopoly

Average revenues and marginal revenues

total revenue

AR

MR

p

159

• In monopoly, demand curve

equals average revenue (see

table) because the monopolist

is the only supplier

• MR is always below demand-

curve (AR) (see table)

• Profit maximisation in

monopoly: marginal costs =

marginal revenues (Cournots

Point)

p

q

MR

Monopoly

demand = AR

54

160

• Profit-maximisation in

monpoly: first, find point where

MC = MR (where MC-curve

intersects MR-curve)

• Find the quantity qM, where

MC = MR

• Find price corresponding to qM

p

q

pM

demand = AR

MR

MC

C

qM qC

pC

Monopoly

161

• Monopolist‘s profit: revenue –

total costs

• revenue: quantities sold *

price (PM • qM)

• Total costs: average costs *

quantity supplied (ACM • qM)

• Profit: ACMpMDC

p

q

pM

demand = AR

MR

MC

C

qM

Monopoly

AC

ACM

D

162

• Compared to perfect

competition (PP):

• Consumer surplus in

monopoly: consumers loose A

plus C

• Producer surplus in monopoly:

monopolist gains A (from the

consumers) and looses B

• Deadweight loss: BC

• Monopolies always lead to a

loss in total welfare

p

q

pM

MC

qM qP

pP

Monopoly

A

B

C

MR

demand = AR

55

163

• Sources of monpoly power

• Elasticity of demand

– the higher elasticity of demand, the lower the monopolist‘s power

– determinants of the elasticity of the firms demand: product differentation,

marketing, substitutes, branding

• Number of competitors

– the monopoly power of a firms increases as the number of competitors is

decreasing

– the monopoly power of a firms increases as the barriers of entry increase

• Interaction among firms (collusion vs. competition)

• there are (almost) no perfect monopolies and no perfect

competition. More realistic: Oligopolies and monopolistic

competition

Monopoly

164

• Rule of thumb for pricing in a monopoly:

(p – MC) / p = - 1 / ED

• Left side of equation: markup on MC in percent

– perfect competition: ED approaches infinity, so 1/ED

approaches zero. So p = MC; no mark-up on MC possible

due to completely elastic demand

– the smaller ED, the higher is the right-hand side of the

equation,i.e. the higher is the mark-up on MC. Inelastic

demand means high market power

• Re-arrange as a simple price-formula:

p = MC / (1+(1/ED))

Monopoly

165


• Monopoly: demand curve is demand of the whole market

• Oligopoly: few suppliers; strategic interaction between suppliers – Oligopoly I: very few suppliers; acting in concert, maybe even without

explicit communication

– Oligopol II: more suppliers; fierce competition as a result

• Monopolistic competition: demand curve is the demand curve for the product of each supplier – heterogeneous products

– limited market power of every supplier in a narrow range

– branding

– price differentitation

– supplier has a limited degree of market power

• perfect competition: demand curve for the single supplier ist the price, because he has no market power

56

166

p

q

pM

demand = AR

MR

MC

C

qM


AC

ACM

• More realistic: a firm faces a

individual demand curve which is

more elastic than market demand,

but not perfectly elastic

• In the latter case, the firm has

some limited monopolistic power

• Here, MC = MR applies, too

• In the short run the company

makes profit (A)

• In the long run, new competitors

may enter the market, thereby

shifting the firms individual

demand curve to the left

A

167

p

q

pL

demand = AR

MR

MC

C

qL


AC

• In the long run, new competitors

will enter the market, thereby

shifting the firms individual

demand curve to the left

• How much may the demand

curve shift to the left? Untill the

company makes no more

economic profit, i.e. where

revenues = costs, i.e. where

p = AC

• At pL,qL, MR = MC, and p = AC,

so profit = zero

• But: price ist still > as MC

168

p

q

monopolistic competition

MR

MC

qL

pL


AC

p

D =MR = p

MC

AC

perfect competition

qp

D

57

169


• Monopolistic competition: – q is smaller than in perfect competition

– production where MR = MC and p = AC; so P is > MC

– because p is > MC, there is a deadweight loss which would vanish if

one would decrease p to D = MC

– because demand curve is downward sloping, so zero-profit production

occurs not at minimum of AC; by increasing production one could

reduce AC

• Has the government to step in? – suppliers don‘t make monopolistic profit

– in most cases, its marketing and branding that creates limited monopolistic power – does this mean we need to intervene?

– the debate over advertising

170

• Competition needs additional policy to ensure that there is a sufficient degree of competition

• questions: – what is „a sufficient degree of competition“?

– how shall we estimate the market power of a company?

– how shall we define a market (time / product / place)

– how shall we idetify anti-competitive, unfair behaviour?

• Problems of competition policy – Collusion: prohibiting agreements or practices that restrict free trading and

competition between business entities. (e.g. cartells)

– abusive behaviour and anti-competitive practices: banning abusive behaviour by a firm dominating a market, or anti-competitive practices that tend to lead to such a dominant position. Practices controlled in this way may include predatory pricing, tying, refusal to deal and others.

– concentration of market power (takeovers; merger)

Competition policy

171

• collusion: negogiations between suppliers aimed to reduce the pressure of competition – horizontal: between competitors

– vertical agreements: between firms at different levels of the supply chain

– acting in concert

• problems: – finding evidence of collusion

– distinguish between collusion and behaviour resulting from the pressure of competition

• Germany‘s competition law (GWB) – horizontal cartells and collusion aimed to restrict competition are forbidden

– vertical contracts are forbidden if they restrict one of the parties of the contract in closing other contracts with third parties

– this applies to an acting in concert even if there is no contract

– exemption permits for some cartells and cooperation of small companies

Competition policy: Collusion

58

172

Competition policy: Collusion

The great vitamin conspriracy In 1999 some of the worlds largest drug companies agreed to pay billions of dollars in damages to customers after being convicted of a huge conspiracy to rig the world vitamin market. The conspriacy began in 1989 when Roche and BASF began secret talks about raising prices for vitamins; soon Rhone-Poulenc and other japanese companies joined. The members of the group met regularly in hotels or private homes to set prices and divide up markets for bulk vitamins mainly sold to other companies (e.g. animal feed makers). The animal feed companies grew suspicious about the prices they were charged, which led to a series of investigations. The case broke down when Rhone-Poulenc made a deal with competition officials in the US to provide evidence about the conspiracy.

173

• abusive behaviour and anti-competitive practices – Germany: the abusive exploitation of a dominant position by one or several

undertakings is prohibited

– abusive behavior against competitors and other firms in the supply chain

• examples: – price discrimination: dominant firm demands payment or other business

terms which differ from those which would very likely arise if effective competition existed;

– predatory pricing: a company offers goods or commercial services not merely occasionally below its cost price, unless there is an objective justification for this

– boycott: small firms depend on one single supplier / buyer (Uhren-Krämer / Seiko; adidas)

– exclusive commitments and contracts: (Meto-Handpreisauszeichner; i.e. price gun)

• Problems: definition of dominant position and abusive behaviour versus regularly business policy

Competition policy: abusive behavior

174

Competition policy: abusive behavior

Uhren-Krämer versus Seiko

Seiko, a manufacturer of watches, refused to

deliver his watches to Uhren-Krämer (Berlin). Krämer

went to courts and accused Seiko of unfair hindrance:

Seiko refused deliverey because Krämer did not commit to the

price recommended by Seiko – if he would stick to this price, Seiko

would deliver the watches. Seiko had a market share of 75 percent in

Berlin.

Adidas versus SB-Kauf

Adidas refused to deliver his products to SB-Kauf (who intended to sell

the shoes with a large discount) and claimed that it intended to have its

shoes only sold by specialty stores. The cartell authorities recognised

adidas as market-dominant company.

59

175

Homework: The I-Phone

No I-Phone in Australia? Queensland University of Technology (QUT) law

researcher Dale Clapperton has questioned whether

Apple could release the I-Phone in Australia under the

same conditions that has seen it locked to a single carrier

in the US, UK, Germany and France. That said, an appeal

was placed in Germany by Vodafone to force Deutsche Telekom to offer an

unlocked version, but this was successfully challenged in court. Customers

will now only be able to buy the phone for a 399-euro offer with a binding

two-year contract. After two years, users can have the iPhone unlocked so

they can switch to other providers, T-Mobile said. The French I-Phone can

be purchased in an unlocked configuration, but can reportedly only be used

with SIM cards from other French companies – not any SIM from any

carrier worldwide.

Is it abusive behaviour if Apple refuses to deliver the I-Phone

to other telecoms? What about the french solution?

176

• Better than preventing dominant companies from abusing their power: preventing the rise of a dominant market position

• Internal and external growth may lead to a dominant market position

• concentration

– Horizontal,

– vertical or conglomeral

• policy:

– control of concentrations (supervising mergers and acquisitions)

– breaking up market-dominant firms

– supervising market-dominant firms

Competition policy: Concentration

177


• Act against restraints of competition (GWB) is made of three parts – Prohibition of agreements restricting competition (cartels)

– market dominance, restrictive practices

– control of concentrations

• Enforcement: cartell authority (Bundeskartellamt)

• European competition law (Art. 81, 82 EG-treaty) – restrictions of competition are forbidden if they affect the trade between

member states of the European community

– national law applies as long as the trade between community members is not affected

– primary competence for applying EU competition law rests with European Commission and its Directorate General for Competition

– public procurement: state aid, control of direct and indirect aid given by EU Member States to companies (Article 87 EC)

60

178


• control for market dominance and abusive behaviour: abusive behaviour is forbidden

• market-dominant companies: – if 1 (3 / 5) companies share 33 (>50 / 66) percent of revenues in

the relevant geographic market

– relevant geographic market: elasticities of demand and supply

• abusive behaviour – predatory pricing: prices differ from what you expect them to be

with competition (rebates, price discrimination)

– restrictive practices: market-dominant companies restrict possibilities / opportunities of customers or stakeholders

179


• Control of concentrations to keep markets competitive;

acting before a market-dominant company rises

• Principles – the provisions on the control of concentrations shall apply if in the

last business year preceding the concentration: 1. the combined

aggregate worldwide turnover of all the undertakings concerned

was more than EUR 500 million, and 2. the domestic turnover of

at least one undertaking concerned was more than EUR 25

million.

– a concentration which is expected to create or strengthen a

dominant position shall be prohibited unless the companies

concerned prove that the concentration will also lead to

improvements of the conditions of competition and that these

improvements will outweigh the disadvantages of dominance

180


Hertie und Karstadt

In 1993, the largest department store Hertie

took over the third-largest department store,

Karstadt. The cartell authority approved the

merger; although the number of department store-chains

in Germany was being reduced to two. The authority found

evidence for market-dominance only in some local areas;

but it said that department stores compete also with local

specialised stores. Competition would be only reduced in

some special areas. So Hertie had to sell only some lines of

business (for examples the sale of records in Kiel)

61

181

Economics

Session #9:

Game theory


182

Hausaufgabe: No I-Phone in Australia?

• To find out wheter Apple is involved in abusive behaviour one must ask for a dominant market position and restrictive practices

• Dominant market share:

– not, if the relevant market ist the market for mobile communication. There are enough substitutes

– Apple has market power: its brand. Do we need to protect brand-addicted customers by law?

– but: may Apples brand lead to a reduction in competition on the market for mobile communication?

• restrictive practices

– if Apple has market-dominance, the fact that Apple is selling its I-Phone only locked to a singel carrier points towards the direction of abusive behaviour

– is the tariff for the I-Phone above other prices?

– the user is locked to the carrier for two years – does this reduce competition in the long run?

183

Game theory

Oligopoly

Prisoners Dilemma

Sequential games

Repeated games

62

184

Oligopoly

• Oligopoly: a market where only a few firms compete with each other and entry by new firms is impeded due to barriers of entry

– scale economies

– patents, technology, branding

– Entry deterence

– Airlines, cigarettes, aluminium, automobile industries

• Because only a few firms are competing, all decisions involve important strategic considerations – each firm must take in account how competitors may react to a move (compete, collude)

• An example: the OPEC-Cartel

185

• The market for gasoline – homogenous Produkt; one can only differentiate through the price

– only a few suppliers; every move of every suppliers is visible to his competitors

• First idea: Cartel. Producers decide to collude and to maximize joint profits by charging to monopoly-price (total MR of all firms = Total MC); e.G. OPEC. Problem: every member of the cartel has an incentive to charge a lower price („cheating“)

• Second idea: price war; this may lead to parallel moves of the price each competitor charges

• evidence: prices for gasoline tend to be cointegrated; i.e. they move together – does this mean that there is tacit collusion or fierce competition?

Oligopoly

186

- Iran and Iraq agree on a cartel

- If both of them co-operate, each of them receives 50

- In case of a price war, each of them receives 40

- if one co-operates while the other one cheats, the pay-off is 60 for the cheater and 30 for the other contract party

- result: both countries will cheat

- (collude, collude) would make both countries better off

Oligopoly

cooperate Cheat

cooperate 50, 50 30, 60

cheat 60, 30 40, 40

Iraq Iran

pay-off Iraq pay-off Iran

63

187

Oligopoly

• A game is a situation in which the participants (players) make

strategic decisions

• strategic decisions: decisions that take into account the actions

and responses of the other players

• strategic decisions result in payoffs to the players; i.e. the

outcomes of the decisions

• strategy: a rule or plan of action for playing the game

• optimal strategy: maximise the expected payoff

• If I assume that my competitors (the other players) try to maximise

their payoffs, how shall I take their behavior in account when

making my decisions

• OPEC-example: both players have a dominant strategy

• most famous example: prisoners dilemma

188

- after a raid, A and B are caught by the police

- Police may arrest them for one year for a minor offence (illegal posession of weapons); not for the robbery

- Police offers a separate deal to A and B: if one confesses while the other one denies; his charge will be dropped. The other one who remains silent gets 20 years

- if A and B confess, each of then gets 8 years

- result: both of them will confess

Prisoners Dilemma

deny confess

deny 1, 1 20, 0

confess 0, 20 8, 8

B. A.

189

Prisoners Dilemma

• In this game, „confess“ is a dominant strategy: no matter what the other players does, it is the best strategy. I‘m doing the best I can no matter what player #2 does

• Examples of prisoners dilemma: - collusion; price wars; advertising wars

- Military spending

- Sports owners and players

• Not every game has dominant strategies

• Dominant strategies: I‘m (you) doing the best I can no matter what you (I) do

• Nash equilibrium: I‘m (you) doing the best I can given what you (I) are doing

• Domimant strategies are special cases of Nash equilibria

64

190

Prisoners Dilemma

crunchy sweet

crunchy -5, -5 10, 10

sweet 10, 10 -5, -5

B. A.

- Two new variations of a breakfast cereal can be introduced

- but market volume is only enough for one company

- each company can only introduce only one new product

- each firm is indifferent which procuct to introduce – as long as it is not the same product as its competitor

- what if the companies must behave noncooperatively?

- two Nash-equilibria

191

Prisoners Dilemma

• Further applications

– Competition between suppliers: price wars, advertising,

investment decisions

– sports: Americas Cup – if you are in the lead, you should

behave like the boat which is right behind you

– hostages and hijacker: one person must start the attack

– coordination between parties (battle of sexes)

– threats (Dr. Strangelove)

– Tying ones hands

• Not every game is a zero-sum-Game (like in sports)

• Competition is not a zero-sum-game as soon as you

think about the consumers

192

Prisoners Dilemma: Commitments

• Strategic move: an action that influences the behavior of the other player in a manner favorable to oneself

• commitment: you commit yourself for the future in order to change the behaviour of your counterparty; threats or commitments; constraining the partners choice by constraining own behavior

• Types of commitments and threats: – public commitment – Give power to a third party („Dr. Strangelove“) – Probabilistic threat (Kuba-crisis) – building up reputation (central banks; newspapers)

• examples: – Xenophon and the conquistadoras: burn your bridges behind you – most favorite nation-principle: each customer gets the same price

what makes it impossible to re-negogiate

65

193

Homework: threads and commitments

Ice cream wars

You are the owner of the only ice-cream-parlor in

town, but now a new competitor plans to enter the

market. If he enters, you could lower prices, thereby

lowering your profits from 200 to 70. Instead of lowering prices,

you could still charge a higher price a loow your competitor to enter the

market – this would make your profits drop from 200 to 100. If your

competitor enters the market, there are two possible scenarios: you

lower your prices – this will make him loose 10. If you don‘t start this

price war and charge high prices, his profits will be 20. If you lower your

prices and he keeps out of the market, your profits drop to 130.

Will your competitor enter the market? If yes, why?

194

Prisoners Dilemma: mixed strategies

right

corner

left

corner

right

corner -, + +, -

left corner +, - -, +

you

Kahn

- Which strategy should a football player choose to shoot a penalty?

- as soon as the player applies a certain pattern (RRLLRR) he will loose in the long run, as soon as the goalkeeper finds out about this pattern

- better strategy: flipping a coin, i.e. equilibrium in mixed strategies

- mixed strategy: strategies in which players make a random choice among possible actions based on a set of chosen probabilities

195

- Two new variations of a breakfast cereal can be introduced; but one cereal yields a higher revenue than the other

- without coordination this game has no single solution – as long as both players must act at the same time

- both companies would like to produce „sweet“ – as long as the other party does not produce it

- solution: sequential game; extensive form of a game

Sequential games

crunchy sweet

crunchy -5, -5 10, 20

sweet 20, 10 -5, -5

B. A.

66

196

- now: solving the game from the end

- if firm B reacts first, it has a first-mover-advantage

- what can A do to get the first-mover-advantage?

- but sometimes there may be first-mover-disadvantages: if you are in the lead in a game-show, you should always mimic the strategy of your competitor

- Here: buying machinery, launching an expensive advertising campaign – self commitment

Sequential games

sweet crunchy sweet crunchy -5, -5 20, 10 10, 20 -5, -5

A A

sweet crunchy

B

197

produce no

productio

n

produce -10, -10 100, 0

no

production

0, 100 0, 0

Boeing

Airb.

#1 produce no

productio

n

produce -10, 10 100, 0

no

production 0, 120 0, 0

Boeing

Airb.

#2

Sequential games

- Commercial aircraft market has large economies of scale

- It is only economical for one firm (Airbus or Boeing) to produce a new aircraft

- In game #1 there is a clear first-mover-advantage

- Now: EU commits itself to a subsidy of 20 to airbus if it produces the plane regardless what Boeing does (#2)

- Now Boeing surrenders

- EU has shifted profit from the US to Europe

- But: what about retaliation measures by the US-Government?

198

Repeated games

• Repeated games: playing the same game several times

• Repeated games help you to learn about your competitor and his strategy; they help you to built up a reputation

• How can you built up a reputation as a trustworthy rival?

• Best solution: tit for tat. • collude as laong as the other player colludes; defect as soon as he defects.

TfT: eye for an eye

– as long as the game is infinitely repeated, it does not pay out for your competitor to cheat; cumulative loss will outweigh short-term gain

• Finite number of repetitions: equilibrium is defect right from the start (Eddy Murphy)

• In these games, reputation is everything

– as a competitor

– as government / central bank

– as boy/girlfriend

67

199

Economics

Session #10:

Why we need governments


200

- The threat of a price war is not realistic, because charging a high price is a dominant strategy

- but you may change your strategy if you believe that there are more competitors to come – repeated game

- in this case, it may pay off to built up a reputation as a loggerhead who is willing to sacrify profits just in order to keep other competitors away from your market

- but: do you have the financial strengh to built up this reputation?

Homework: Ice cream wars

enter Stay

away

high price 100, 20 200, 0

Low price 70, -10 130, 0

you comp.

201

Why we need governments

Market failure

Public goods

Quasi-private goods

Network externalities

68

202

Market failure

• Two types of market failure

– Price mechanism does not work (economic market failure)

– the outcome of the market is not accepted by politics or society (political market failure)

• Market failure is caused by – Public goods

– externalities

– Network externalities

– social security and redistribution

– Merit goods (quasi-private goods)

– politics

203

- Nonrival goods: for any level of production, the MC of providing it to an additional customer are zero (lighthouse)

• Nonexclusive goods: people

cannot be excluded from

consuming it. As a consequence,

one cannot charge them for using

it. This gives a free rider problem

(lighthouse, defense)

• How many public goods shall the

government privide? How do you

estimate the willingness to pay for

public goods?

Public goods

exclusive non-exclusive

rival clothes,

food

private

goods

environment

highway

Non-

rival

environment

TV

street;

highway

army;

lighthouse

public goods

NR

NE

204

Quasi-private goods

• Idea: one has to protect people from themselves (alcohol, cigaretts) or support „good“ things (arts, public broadcasting)

• This is not a economic issue; government intervenes because it does not accept the result of the market mechanism; the price mechanism is not disturbed

• goods like alcohol and cigarettes are taxed to reduce consumption; goods like arts or broadcasting are subsidized

• questions: - who decides what is „good“ or „bad“

- paternalism: what if you want to drink / smoke; what if you don‘t like public broadcasting?

- quasi-private goods are a good playground for bad politics

69

205

Merit wants : Public broadcasting

• Public broadcasting: wrong arguments

– Public broadcasting is not a public good

– Public broadcasting is not natural monopoly anymore

– Political education by public brodcasting = externality

– information is an experience good; but this problem is solved by

reputation

• What about the quality of private broadcasting?

- bribemoney; masked advertising: ARD

- competition and reputation prevent private broadcasters from doing a

bad job; do public broadcasters have to face competition, too?

- Lower-class-TV: spot the difference (GZSZ or „Marienhof“?)

206

Homework: public broadcasting and the Internet

Do we need a public broadcaster in the Internet?

The ARD (Consortium of public-law broadcasting

institutions of the Federal Republic of Germany),

is a joint organization of Germany's regional public-service

broadcasters. Together with ZDF, the secod large public

broadcaster, almost 8 bn. Euro per year are spent for public

broadcasting in Germany. The fact that ARD (and also ZDF)

uses license fees to subsidize their World Wide Web sites,

and also the non-transparency of their license fee

expenditure, is the topic of an ongoing controversy with the

European Union. Public broadcasters im Germany are

spending 52,5 mn. Euro per year on the internet.

Do you think we need public broadcasting in the internet?

207


• Example of an network externality: telephone

• Network externality: the more people use a good, the higher the utility derived from this good for all users

• This is a so-called externality: as A buys a telephone, the utility of the telephone increases for B (who has a telephone, too) – but B has not to pay and A does not care

• Network externalities work like an epidemic; you need a critical mass to start with

• Further examples

– E-bay; parship

– standards: VHS; TCP/IP; qwerty

– software (Microsoft)

– broadcasting

• network externalities may cause problems

70

208


• First-Mover-advantage („gorilla“): in case of a standard, the

winner takes it all. Winner will be the first mover, not

necessarily the best technology (see VHS vs. Video 2000)

• Problem #1: lock-in of an inferiorer technology (qwerty-

problem)

• Problem #2: the winner may exploit the market after

• Problem #3: the winner may extend his market power to other

markets (Explorer; Media Player)

• solutions:

– more competition

– license agreements

– nationalization

209

Economics

Session #11:

Externalities and environmental

policy


210

Hausaufgabe: Öffentlich-rechtliches Internet

• The case for public broadcasting in the internet: – public broadcasting on TV and radio is threatened by the increased use

of the internet – who will be watching TV in 20 years?

– Information-chaos at the internet; public broadcasting as a torch of information in the night

– better quality of public broadcasting-information on the internet

• The case against public broadcasting in the internet – does the internet need one more broadcaster?

– enough information on the internet

– private broadcasters are threatened by a public subsidized competitor

– is the internet-user that stupid – or is he able to distinguish between „good“ and „bad“ information“?

• One question remains: why is there no subsidized newspaper?

71

211

Externalities

Externalities

Public policies

International policy

Property rights

212

• Some daily problems: – your room-mate is heavy smoker

– your neighbour is addicted to black-metal-records

– you are living near a chemical factory

• what have these problems in common? – person A is harmed by B

– A is not compensated by B

– the costs of A are not included in the calculation of B

– B gets all the benefits from his doing; he does not care about the costs imposed to A

• Externality: the uncompensated impact of one person‘s (company‘s) action on the well-being of a bystander

Exernalities

213

• What is the problem? Society‘s interest extends beyond the well-being of

buyers and sellers; it also includes the well-being of bystanders being

harmed by the actions of buyers and sellers. The person causing the

externality does not take it into his private calculation; therefore he

consumes (produces) too much (or too less)

• negative externalities: pollution

– companies don‘t care about the costs imposed to the environment

– consequence: to much production (consumption) of a good

• positive externalities: a shot aginst the flu

– if you are considering to take a shot against the flu, you don‘t care about the

positive effects on your neighbour

– More people should take a shot against the flu

• To reach a social optimum, the person causing the damage must include

the damage done to the bystanders into his private calculation

Exernalities

72

214

• Supply does not take include social costs of pollution into his calculation

• Social costs of production are private plus social costs; for society as a whole, SS is the supply-curve that represents total costs of production

• producing at pp,qp: the marginal social

costs of production are higher then the

marginal benefit, represented by the

demand curve

• Each unit produced above qp brings more

social costs than benefits to consumers;

ABC – loss of welfare

• Source of inefficieny: price p reflects only

the private cost of production, not the

social costs (i.e. the cost of pollution)

p

q

Exernalities

D S SS

qP qS

PP

PS

A

B

C

215

• To reach a social optimum, one has to reduce (increase)

consumption (production) of goods with negative (positive)

externalities

• Private solutions to externalities

– social pressure, moral codes, sanctions

– Acting up, charities (e.g. Greenpeace)

– private contracts (Coase Theorem)

• Public policies

– regulation

– taxes and subsidies

– Tradable pollution permits (Kyoto)

Exernalities

216

• Pigou-taxes: taxing activities that have negative externalities; changing the price; shifting supply-curve upwards

• Emissions standard: a legal limit on how much a firm can

emit (changing q)

• a standard offers more certainty about the level of emission

• tax: leaves it up to each company how much to abate – it takes in account the different marginal costs of abating that every company has

p

q

Public policies

D

S SP

qP qS

PP

PS

S

73

217

• When marginal social costs of pollution are high and marginal costs of abating are low, the costs of reducing emissions is not high – but the cost of not avoiding emissions may be high

• Standard: ensures that a certain amount of emissions will be reduced (but to which costs?)

• Tax: offers certainty about the level of abatement costs; but leaves the level of redcution uncertain

• Taxes are more efficient, standards are effective

• Can we combine both instruments to ensure the level of reduction with more effiency?

Public policies:taxes vs. standards

218

• Springfield has two factories:

Simpson Corp. und Burns Inc.

• Both of them emit 5 tons

carbon dioxide per day

• Companies have different

production functions and cost

functions

• The local council estimates the

social costs of pollution in € (s.

table)

Public policies: tradable pollution permits

tons dioxide damage in €

2 30

4 40

6 60

8 106

10 155

Marginal external costs of pollution in

Europe: one ton SO2 causes in a city with

100,000 inhabitants 6000 Euro costs

(Europäische commission DG

environment, Benefits table database:

Estimates of the marginal external costs of

air pollution in Europe)

219


Simpson Inc. Burns Corp. total

t costs MC costs MC t social

costs

total

costs

1 240 50 130 35 2 30 400

2 190 40 95 20 4 40 325

3 150 30 75 15 6 60 285

4 120 20 60 10 8 106 286

5 100 50 10 155 305

74

220

• Council declares that emissions have to be reduced by 4 t

• Standard: both companies have to abate 2 t; total costs of

abatement: 75 (50 Simpson; 25 Burns)

• tradable permits: each company is allowed to emit 3 t

- Burns is willing to emit 2 t instead of 3 t, as long as Simpson pays at

least 20 €. Simpson is willing to pay max. 30 €

- Burns is willing to emit 1 t instead of 2 t, as long as Simpson pays at

least 35 €. Simpson is willing to pay max. 20 €

- Burns abates 1 t and sells it to Simpson for 20 - 30 €

• Total emission: Simpson 4 t, Burns 2 t = 6 t

• Total costs of abating: 20 € Simpson, 45 € Burns

• Tradable emission permits


221

• Government decides how much pollution is allowed

• Each permit specifies a number of emissions that a firm is allowed to put out

• Permits are allocated among firms; the total number of permits represents the total amount of emissions allowed to put out

• Permits are marketable: they can be bought and sold

• Marginal costs of abating for 1 t > price for 1 t Emission buy emission permits

• Marginal costs of abating for 1 t < price for 1t Emission sell emission permits

• This leads to one conclusion: the price of a tradable emission permit will equal the marginal costs of abating


222


• How many rights shall be granted to the economy? E.G.: Reclaim (Regional clean air incentives market) in california failed because too many rights were granted

• How shall the rights be granted? – auctions: additional revenues / costs

– grandfathering: early action advantage

• How shall new entrants be treated?

• Period of validity?

– short: flexibility

– long: longe-range planning

• Area of validity: avoidance of „hot spots“

75

223


• USA: – 1974: emission trading program to reduce lead in fuels. 1987: fuels

are completely lead-free

– Acid rain program: trading in nitrogen-emissions (SO2); amount of

certificates granted to companies reduced every year

reduction of SO2 40 % above target

– Reclaim (Regional clean air incentives market) in California failed.

Reason: to much emission rights were granted; no incentives to

reduce emission of GHG

• World: Kyoto protocoll – Emission trading between indutrialized countries from 2008 on

– Industrialized countries agreed to reduce emission of green house

gas (GHG) from 2008 until 2012

– next step: Bali-Conference

224

• The Kyoto Protocol is protocol to the international Framework Convention on Climate Change with the objective of reducing greenhouse gases in an effort to prevent anthropogenic climate change

• As of May 2008, 182 parties have ratified the protocol. 137 developing countries have ratified the protocol, including Brazil, China and India, but have no obligation beyond monitoring and reporting emissions. Kyoto mechanisms: – emissions trading (carbon market) – the Clean Development Mechanism (CDM) allows a country with an

emission-reduction or emission-limitation commitment under the Kyoto Protocol to implement an emission-reduction project in developing countries. Such projects can earn saleable certified emission reduction (CER) credits

– joint implemetation: similiar mechanism for eastern-european countries


225

Property rights

factory fisher total

nF; nT 500 100 600

F; nT 300 500 800

nF; T 500 200 700

F; T 300 300 600

• a firm dumps its effluent in a

river, which reduces the catch

of fish

• Two options: filter system or

treatment plan

• Factory has to pay the filter,

treatment plan must be paid by

the fishermen

• Depending on the combination

of filter and treatement plan,

the factory and fishermen yield

different profits

• what happens if we allocate

property rights?

nF: no filter

F: filter

T: treatment plan

nT: no treatment plan

76

226

Property rights


nF; nT 500 100 600

F; nT 300 500 800

nF; T 500 200 700

F; T 300 300 600

• #1: the factory owns the river; it

has the right to polute

• T gives the fishermen only

additional profit of 100

• Fishermen are willing to pay 300

to the factory if it uses a filter

• if the fishermen have to pay more

than 300 for the filter, nF;T

becomes more attractive (500

profit – 300 costs of filter)

• the company demands at least 200

for using a filter

• Result: fishermen pay at least 200

to the factory which uses a filter

nF: no filter

F: filter

T: treatment plan


227

Property rights

• #2: fishermen own the river;

they have the right to demand

from the factory to use a filter

• Factory is willing to pay 200 to

the fishermen if they install a

treatment plan

• fishermen demand at least 300

for installing a treatment plan;

F; nT yields 500; nF;T yields

only 200

• result: factory installs a filter


nF; nT 500 100 600

F; nT 300 500 800

nF; T 500 200 700

F; T 300 300 600

nF: no filter

F: filter

T: treatment plan


228

Property rights

• Other possibility: suing for damages

• Fishermen are given the right for clean water

– if the firm does not install a filter, it harms the fishermen (damage =

400$); therefore fishermen can sue for 400$. Profit to firm: 500$ -

400$ (fine)

– firm installs a filter; profit: 300$

– firm will install a filter

• Factory is given the right to emit effluent

– fishermen have the right to ask firm to installing a filter, but they

have to compensate the firm

– treatment plan makes a profit of 200

– ask firm to install a filter (and pay for damage) makes a profit of

300 = 500 – 200 (compensation)

– no treatment, no filter makes a profit of 100

– fishermen will pay a filter to firm

77

229

Property rights

• Coase-Theorem: if private parties can bargain without costs over the allocation of ressources, then the private market will always solve the problem of externalities and allocate ressources efficiently

• The initial distribution of rights does not matter for the ability of the market to reach an efficent outcome

• but: the distribution determines the allocation of economic well-being

• Externalities rise due to a lack of property rights • problems

- transaction costs - what about the coordination of the parties involved? - Distribution of economic well-being is affected by the

distribution of the property rights

230

Homework: don‘t marry, be happy

Trouble in Disneyland

Donald and Daisy are married; Micky and

Minnie are married, too. The ladies want to get rid

of their men and file in for diverce. Donald (Micky)

is willing to pay 20 (10) bucks to avoid a divorce.

Daisy (Minnie) is willing to pay 5 (15) Taler for getting divorced.

Assume that Minnie / Daisy may pay compensation to Micky /

Donald – what will happen if both of them partners have to

agree to get divorced? What, if one partner can file for divorce

and his counterpart may payahim for stepping back from the

divorce?

231

Economics

Session #12:

Social Market Economy


78

232

Ducks Mouse

She pays for

divorce

5 15

He pays for not

divorce

20 10

No matter who owns the

right to file divorce, the

results are always the

same: the Ducks get not

divorced; the Mouses get

divorced

• Family Duck:

- if one partner can file for divorce,

Donald is willing to pay up to 20

for not getting divorced; Daisy

accepts

- if both partners are to agree, Daisy

is willing to pay up to 5 for getting

divorced, Donald will not accept

• Family Mouse:

- if one partner can file for divorce,

Mickey is willing to pay up to 10

for not getting divorced, Minnie

disagrees

- if both partners are to agree, Minnie

is willing to pay up to 15 for getting

divorced, Mickey will accept

Homework: don‘t marry, be happy

233



Health insurance

Pension System

Poverty and inequality

234


• German „Ordoliberalismus“ (W. Eucken, A. Müller-Armack, L.

Erhard et al.) during the 1940’s and 50’s.

• Basic idea: combine the efficiency of free markets with social

justice – enforced by government policies.

• “Design” of an economic system which is efficient and humane at

the same time.

• Key elements: Free and open markets, private property, antitrust

policy, income redistribution

• Principle of subsidiarity: individuals and families should try to

solve their problems themselves - only where they are unable to

cope with their problems shall government help.

• Principle of non-distorted prices: if the government intervenes, it

should not change prices

79

235

• Basic idea: free markets first, but additional policy to correct for market failures – welfare policy

– externalities; public goods

– redistribution; quasi-private goods

• Basic framework – Property rights, freedom

– competition policy against monopolies and collusion

– tight money; open economy

• How to intervene if the results of the market mechanism are not accepted by policy / society? – Regulatory framework (Ordnungspolitik): setting a framework with

proper incentives

– intervention: principle of non-disorted prices


236

• The problem with cheap housing: people need an

affordable home

– bad ideas: rent ceilings; subsidies for appartments

– SME: direct transfer to needy people, financed by taxes

• Minimum wages: what if you can‘t make a living from your

job?

– bad idea: minimum wage distorts price mechanism

– SME: let the markets determine the wages; if your income is too low

to make a living, you may get a transfer (negative income tax)

• Basic idea: direct payments to the needy; financed by taxes

(i.e. by everyone) instead changing the price mechanism

Social Market Economy: applications

237

Homework: planned economies

Lets give communism another chance?

A planned economy or directed economy is an economic system in

which the state or government manages the economy. Its most

extensive form is referred to as a command economy, centrally

planned economy, or command and control economy. In such

economies, the government controls all major sectors of the economy and

formulates all decisions about their use and about the distribution of income. The

planners decide what should be produced and direct enterprises to produce those

goods. Important planned economies that existed in the past include the economy

of the Soviet Union, China and India, prior to its economic reforms in 1991.

Beginning in the 1980s and 1990s, many governments presiding over planned

economies began deregulating (or as in the Soviet Union, the system collapsed)

and moving toward market-based economies by allowing the private sector to make

the pricing, production, and distribution decisions. Today, planned economies exist

in some countries such as Cuba, North Korea, and Burma.

How would you plan an entire economy? What are the problems of a planned

economy?

80

238

Health insurance

• Why do we need health insurance? – some therapies are way far to expensive to pay them from your

income

– When you are 20, do you think about the cures you may need when you are 60?

– weakness of will

– Hoping on a bail-out by the government

• problems of a health insurance – moral hazard: you may change your behaviour as soon as you are

insured (own participation necessary)

– Lack of information of the insured

– the doctor may maximize his income in expense of his patients (see cab driver-problem)

– adverse selection: only those who are in need of an insurance buy one; this makes the insurance expensive

239

Health insurance

• increase contribution rates

• increase wages

• Increase number of insured persons: abolish private insurance schemes

• Less services

• reduce price of services

- price prescriptions

- more competition

- managed care

revenues = expenditures

contribution*wage* insured persons = services*price

240

Pension System

• Why do we need a pension system?

– when you are 20, do you think about your pension you‘d

like to have when you are 60?

– weakness of will

– Hoping on bail-out by the government

– lack of information, complex topic (finance)

• Pension system in Germany

– public pension system: pay-as-you-go system

– private pension schemes: Riester; Rürup

– corporate pension systems

– Versorgungswerke (lawyers; medicians)

81

241

generation 1 generation 2 generation 3

generation 0 generation 1 generation 2

contribution

pension pension pension

claims claims

Pension System: Pay-as-you-go

contribution

242


• Pay-as-you-go can be started immidiately (war)

• implicit governmental debt

• Bad demographics and unemployment are threatening

this system

• redistribution on the expense of later generations

• winner: generation #1; old people

• looser: generation #x; last generation (at least one

generation has to pay the debt of the first generation )

• it is extremely dificult to shut this system down

• Pay-as-you-go is not a contract; not a so-called

generation-contract („Generationenvertrag“)

243


• Increasing contribution rates leads to more unemployment

• increase wages: one must create more employment

• Increase # of insured persons: e.g. self-employed persons; problem: this policy

also increases the number of pensioners

• pay smaller pensions: smaller pension; later payments („pension at 67“)

• Federal subsidies, payed from taxes

• switch from pay-as-you-go to capital-based pension system

• more kids: no solution, because this will increase the number of pensioners

revenues = expenditures

contribution*wage*#insured persons = #pensioners*pension

82

244


• Social policy: markets only provide eficiency and income according

to achievement;

– extreme poverty: hunger and homeless persons

– relative poverty: poor compared to average living standards

– poverty as equality of chances

• redistribution

– as normative policy

– social inequality may cause political and social problems

• Redistribution of: income; wealth; chances

• problems:

– time dimension: students are poor, too

– definition of poverty

– Poverty trap: marginal tax rates of 100 %

– incentives and fairness

245


• Definition of poverty in the EU: 60 % of the average income

– shows only the amount of inequality, not poverty

– if all incomes increase, „poverty“ remains the same

– Why 60 %?

• Gini-coefficient: shows distribution of income

– Lorenzcurve: how many people in % have how many % of total income?

– Gini-coefficient: 1 = one person has 100 % of the income; 0 = every personhas exactly the same share from total income

• source: federal report on poverty and inequality

246


0

0,05

0,1

0,15

0,2

0,25

0,3

0,35

0,4

0,45

0,5

1991 1994 1997 2000 2002 2004Gini-Coefficient market income and net income in Germany

1991 – 2004

Quelle: Sachverständigenrat 2007

83

247


• What makes poor people poor – divorce; children with only one parent

– Long-term unemployment

– no education

– parents

• What determines the distributon of incomes? – Economic cycle; labour market

– self-employment

– „Agenda 2004“: the reduction of unemployment among low-skilled workers led to a reduction of average wages

• What determines the distributon of wealth? – interest rates; if you are wealthy you have more possibilities to

manage your portfolio

– real estate prices

– pension system

– parents

248

Economics

Session #13:

Consumer choice


249

Homework: planned economy

• planned economy: – state-owned companies

– central planning of needs

– central planning of production: who produces what for whom

– central distribution of goods produced

• problems of planned economies

– detect consumer preferences, shortages, and surpluses with sufficient accuracy

– how to co-ordinate production (in a market economy, a the price is intended to serve this purpose)

– strategy information during the planning process

– production network: if one particular input is scarce (due to wrong planning), the entire line of production is endangered

– lack of incentive for innovation (inventors cannot reap benefits from inventing a new technology

– any incentives for working harder? For taking some risk?

84

250

Consumer choice

Budget restriction

Indifference curves

Optimal choice

Changes in prices and income

251

• Consumer choice: how do consumers make decisions about

what to buy?

– how do people react to a change in prices, wages, wealth etc.?

– three steps: budget constraint (how much can I spent?), indifference

curve (what do I like?), optimal choice (what do I buy?)

– Simple model to find out about how people make decisions

– basic tool for the entire microeconomics branch (with applications

e.g. in finance, taxes, international trade etc.)

• Budget constraint

– Is the limit on the consumption bundles that a consumer can afford

with a given income

– two goods, two prices, one income

Budget restriction

252

• Income I:

I = pB•B + pS • S

• The whole income is spent

either on books or stuff

• e.g.: I = 100; pB=10; pS=5

• choice #1: 5 books (= 50 Euro)

and 10 stuff (=50 Euro)

• choice #2: 4 books (= 40 Euro)

and 12 stuff (= 60 Euro)

• budget constraint: all

combinatons B and S a

consumer can afford; given

income I

books

stuff 10

4

5

12

C1

C2

Budget restriction

85

253

• I = pB•B + pS • S

• Buy only books: S= 0; this

yields B = I / pB; i.e.: 100 / 100

= 10 books

• Buy only stuff: B = 0 yields: 100

/ 5 = 20 stuff

• Slope of the budget constraint: exchange rate

between B and S =

(price S / price B), i.e.

–(5/10)=- ½

(you may exchange 2 stuff for

one book or ½ book for one

stuff)

books

stuff 10

4

5

12

C1

C2

Budget restriction

254

• I = pB•B + pS • S

• I increases from 100

to 200; budget

constraint is being

shifted outwards

• Slope remains

unchanged, because

prices did not change

B

S 20

I = 200

I = 100

Budget restriction

10

20

40

255

• I = pB•B + pS • S

• I remains 100

• Price for stuff

decreases from 5 to

4

• budget constraint

rotates around

vertical axis

B

S 20

I = 100

Budget restriction

10

20

25

86

256

5 B 30 75 90 105 115 120

4 B 25 65 85 100 110 115

3 B 20 55 75 90 100 105

2 B 15 40 60 75 85 90

1 B 10 20 40 55 65 75

0 B 0 10 15 20 25 30

1 S 2 S 3 S 4 S 5 S

Indifference curves

257

B

S

I1 1

3

2 5

75

75

• Indifference curves = a curve

that shows consumption bundles

that give the consumer the same

level of satisfaction

• Points on a higher indifference

curve are preferred to points on a

lower indifference curve

• Every point on the indifference

curve represents the same utility;

only the composition of the

consumption bundle changes

• Slope of IDC: exchange rate

between the goods

3

I2

Indifference curves

90

258

B

S

B

I1=75 1

-1

1

-2

A

D

• Slope of the IDC from A to B: if I

give up two books, I need to be

compensated by 1 stuff – that

leaves my total level of satisfaction

unchanged

• Slope of IDC from C to D: if I give

up one book, I need to be

compensated by 1 stuff – that

leaves my total level of satisfaction

unchanged

• Marginal rate of substitution:

exchange rate between B and S,

that leaves total level of

satisfaction unchanged

• MRS from A to B: -2

• MRS from C to D: -1

C

Indifference curves

87

259

B

S

B

I1=75 1

-1

1

-2

A

D

• Marginal rate of substitution:

decreases from the upper left to the

lower right

• Why? Gossens law; marginal utility

of consumption decreases with

increasing level of consumption

• MRS from A to B: -2. Little amount

consumption of S means a high

marginal utility of S; i.e. you are

willing to exchange much B for one S

• MRS from C to D: -1. More S (lesser

B) reduces (increases) MU of S (B);

you exchange only a small amount of

B for S

C

Indifference curves

260

• Lets put together budget

constraint and indifference curve

• consumption bundle K1 is not

welfare-maximising: if one

exchanges 1 B for 1 S, one can

increase the level of satisfaction

form 75 to 90 without spending

more money – you stay on the

budget constraint

• welfare-maximising consumption

bundle: one maximises welfare

by reaching the highest IDC; i.e.

the IDC that touches budget

constraint (K2)

books

stuff 1

4

5

2

K1

K2

Optimal choice

I1=90

I0=75

261

• welfare-maximising consumption

bundle: where budget constraint

touches IDC, i.e. slope of IDC =

slope of budget constraint; i.e.

PS/PB = exchange rate (exchange

rate of the market = consumers

exchange rate)

• PB = 2; PS = 1

• In A you are willing to exchange one

B for one S; MRS = -1. So: sacrify

one B; buy two S with the money

saved thereby

• Stop at the point where you are

willing to exchange ½ B for one S

(2 S for one B)

books

stuff 2

4

5

4

A

K2

Optimal choice

I1=90

I0=75

88

262

• Income I increases: budget

constraint shifts outwards

• You are able to consume more

of both goods

• but:

- inferior goods: consumption

may decrease with an

increase of income (income

elasticity < 0)

- the consequences of an

increase in income on the

consumption of a good

depends on the shape and

on the position of the IDC

Optimal choice

S

books

A

A B

C

263

• P for S decreases: budget constraint

rotates around A

• Consume more S, lesser B

• As the price for S continues to fall;

BC rotates further; consumption of

S (= demand!) increases further

• result: demand curve

• Two effects:

- income effect: as P for S

decreases, one can buy more S

and more B

- substitution effect: compared to

B, S becomes cheaper; you

buy more S

Optimal choice

B

S

A

264

B

S

A

PS

A B C A B C

Ps decreases

demand curve

Optimal choice

S

89

265 265

• What happens if prices and income change?

• Supply of labour

– an increase in wages gives you a higher income. So, one can work less for the same income; this may decrease the supply of labour, i.e. as wages increase, supply of labour decreases

– an increase in wages makes work more attractive compared to leisure time; this may increase the supply of labour; i.e. as wages increase, supply of labour increases

– the net effect of an increase in wages depends on the workers preferences concerning leisure time

– wage-elasticity of the supply of labour depends on the level of income, gender, industry

Changes in price and income

266

income = consumption

leisure time

wage

Supply of labour

Changes in price an income

hours worked

income = consumption wage

Supply of labour

hours worked leisure time

267

wage

hours worked

w1

• labour supply:

- for high wages supply

increases as wage increases

- for low wages there may be

an anormal response of the

supply of labour: as w

decreases, S increases

(marxism)

• consequence: two equilibria on

the labour market

• below W1: marxist theory;

impoverishment of the workers

class

• Political remedy: for example

Hartz IV


supply of labour

demand for labour

90

268


leisure time

A

B

C

• Trade-off between income (=work) and

leisure time

• Budget constraint: C p = w (24 – L);

i.e.: consumption* price = hours worked

times wage

• What if the government introduces a

minimum income for every person (CB)?

• Instead of working and earning A one

prefers now B: no work, but still minimum

income; working would reduce level of

satisfaction

• CB = poverty trap

• Solution to this problem:

- increase wages: BC rotates around C

upwards

- reduce transfer

- making work pay

Changes in price and income

269

leisure time

• Making work pay: the working

families tax credit in UK pays a

certain sum of money to parents

who work a minimum amount of

hours per week

• new budget constraints: BCDEG

• Now work pays off; this eliminates

the poverty trap


A

B

C

D

E

G


270

Homework: save more tomorrow

Save more tomorrow

With the decline of the U.S. savings rate to near zero last year,

household asset accumulation warrants greater attention as a

national priority. Until recently, low household savings has

received limited attention from government officials, the press, and nonprofit

organizations, much less than that of continuing campaigns to reduce smoking,

curtail drunk driving, use safety belts, practice safe sex, „say no“ to drugs, and even,

despite low oil and gas prices, conserve home energy. This neglect of household

savings is especially troubling because most low- and moderate-income households

have accumulated few assets that will allow them to survive financial crises and

sustain levels of living into retirement. With no or low assets, these families have

difficulty investing in a home, car, education, or a business that can help them

improve their economic condition. In the absence of such improvement, the larger

society may pay a high price ranging from larger income transfers to greater crime-

related costs.

Show graphically the decision between consumption and saving. What happens if

the interest rate increases? Why is ist so difficult to save?

91

271

consumption today

consumption

tomorrow supply of capital

Homework: save more tomorrow

savings

savings

consumption

tomorrow

Consumption today

interest

interest

supply of capital

272

homework: save more tomorrow

• Budget constraint:

– if the interest rate increases, budget constraint rotates; it increases our consumption possibilities tomorrow

– upper graph: consumption today decreases; supply of savings increases (substitution effect)

– Lower graph: consumption today increases, too (income effect)

– Net effect undetermined

• Political consequences

– can politics make people save more?

– tax breaks for saving more may decrease saving

– Germany: subsidies for saving for retirement (Riester-Rente)

273 273

Case study: time inconsistency

• What do you choose:

– a) €1000 in 12 months or b) €1010 in 13

months?

– a) €1000 now or b) €1010 in a month?

– empirical evidence: people choose b) in the

first case but a) in the second case

• This is not time-consistent: whatever you

choose, one should choose a) or b) in

both cases

92

274 274


• Empirical evidence:

– people act time-inconsistent

– people are impatient in the short run („$ 1000 now“),

patient in the long run ($ 1010 in 13 months“)

– in the short run, we demand a high compensation for

postponing ($ 10 is not enough to compensate me for

waiting one more month)

– in the long run, we‘re much more patient (what is another

month compared to the 12 months I already have to wait?)

– Result: we do not save for retirement; do not quit smoking;

stay overweight (sorry: undertall)

275 275


• Solutions:

– self-commitment: „I bet that I‘ll quit smoking within three

months

– christmas clubs; fitness clubs

– saving in illiquid assets

– put yourself to the hall of shame: „Hello everybody on the

www, my name is Hanno and I failed to stick to my diet“

(www.poorerthanyou.com; www.makelovenotdebt.com)

– Save more tomorrowTM: workers agree to save a part of the

future increase of their salary

• But: for all theses solutions to work, you first need to

relize that you have a problem

New Economics - HS Pforzheimblog.hs-pforzheim.de/beck/files/2013/02/Introduction... · 2013. 9....

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