EEP100 - Lecture 12

Uploaded by calcommunitycontent on 09.10.2009

We're back againÉthis is lecture 12. Blogging! If you haveÉyou might have
noticedÉsome of you might have had your posts put up (I recognize your face). I'm
putting up little pictures of peoples' faces. Ew! Sorry people are going to see you in
life. Go complain to the university about your profile
photos. For people that are like "photo not available"ÉI'm going to put interesting
stuff. I'm looking forward to that. So there's been some very good feedback from
other readers on the blog. I encourage you guys to give feedback on each
other, because most of my readers don't talk about opportunity cost and marginal
cost everyday. You guys should know more about that.
There's 10 of them posted so far; I'm going to do two every day until I run out. So
that's some cool stuff. Office hours. Normal hours today. Not on Thursday at all.
I'm going to be out for a medical thing, and hopefully I will not die, and I will see you
guys next Tuesday. And on next Tuesday, I'll have double time office hours probably
fromÉI usually start at 12:30. Does anybody have any idea besides 12:30 till 2:30?
Does anybody have any preference for a different hour?
No? The midterm will be next week on Thursday. After four?
After four? Anybody else for after four? Hold on let's do a vote.
Let's do 1:30-2:30 versus 4:30 This is Tuesday, and Tuesday only. These are
my office hours. The GSIs do their own office hours.
4:30 to 5:30? Is this the nomination for the afternoon? Okay. Afternoon? Wow.
Maybe I should just cut this first hour and put it all in the afternoon?
No, okay. This one here? This extra hour here? Nobody cares. Okay, I'll do one at
12:30, and I'll have another office hour at 4:30, yeah?
Okay great. In terms of
a review session, I don't have any problem with that.
Okay so your homework is due on Thursday (your homework 2). I looked up in case
there was likeÉjoy or rapture on anyone's face.
Any questions on homework 2? Three?
Three? What's 3c say? You have to do the marginalÉ
You have to do marginal stuff? EwwÉis that using the labels for the areas of both
graphs? Where am I looking? Oh, this one here. Oh that's awesome. That's so easy
I'm not going to even help you with that. Help each other.
Okay, any other questions about other stuff that's not related to the homework?
Are you going to give us a study guide for the midterm?
No. What we talked about. I have thought of some very devious ways of making
sure I ask you questions about everything you are supposed to have read. The
Hayek, those guest lecturers. And those of you who are asking about YouTube
lectures being posted? I don't have very much control in terms of when they show
up on YouTube. I have done my job, my side of things, in terms of getting them
to ETS. So the video lectures are up toÉI think last week is not posted. Does anybody
know? Does anybody care? The audio is always posted, as far as I'm
concerned. Because I post those. Any other stuff?
Will we go over the readings in class or [inaudible] Most of the readings are on your own. If I
ask you something, it should be a pretty bloody huge theme.
I didn't mean in terms of the midterm, I mean as a general interest discussion.
Hayek is obviously coming up (off and on) the information paper. And when we
doÉI don't even know if IÉwhat did I assign? CoaseÉ
Coase, Hardin, and GordonÑwe will talk about those. I will talk about those in
lecture. And if the GSIs decide to do it in their discussions that will be fine. The
GordonÉin fact all three of those pieces (Gordon, Coase, and Hardin) are pieces that
address the issue that you guys learned about when you did the experiment with the
fishery. With the candy? Remember thatÉwiping out the fishery example? All
these three guys talk about the theory of overcoming those kinds of tragedies of the
commons. And of course The Logic of Collective Action
(the book that you will be finishing after the midterm, as in starting after the midtermÉby
mid-November, by Thanksgiving), that book addresses the same topic. So we're
going to have a lot of time on group dynamics and things like that and that kind
of game theory. Is that a good answer? Other question? Yeah?
So we need to know the paperÉwhat about the novels? Are they going to be on the
test? Yup. In a sense ofÉyou should've read them.
And the question that I ask will be so big that if you read it, you won't have a
problem. If you didn't read it you'll be like woahÉwhat's this economics stuff?
Is the midterm going to be more like homework, or more like lecture?
They'll be more likeÉwell like the lecture is chaos. NoÉthere will be some problems
that will look a lot like the homework, and there'll be some problems that don't.
But it will not be essays, because it's impossible to grade essays very quickly. I'm
justÉindifference to my GSIs life expectancy. I'm not going to do that.
How many questions do you think it will be? I'd takeÉmaybe an hour and 20 minutes worth
of questions. Any other questions? No? Okay. You can neverÉyou just show up,
you take it, it's done, right? It's just like everything else.
Right, so I listened to Claire's talk in order to create devious questions for you, and
what are the two things that she said are necessary for markets? What'd she say?
Property rights? Okay, that's a good one. Somebody had a question
in the audience that was likeÉyou have to have a legal system, which
isÉyou have to protect the property rights. But definitely property rights. And?
Difference in value? Difference in value, okay great. And then
what's the thing that can inhibit or destroy a market from showing up?
Transaction costs? Transaction costs, right? Yeah. It's too hard.
I was actually moving this weekend. If I stumble a lot it's because I haven't been
sleeping very much. But the guy that was helping me moveÉI said, "Oh I have these
three extra cardboard boxes." "Oh, put them on Craigslist, for free."
I was like noÉI'll just put them on the curb. I mean the transaction cost of me
putting it on Craigslist to get a phone call from somebody who's going to come up to
my place and get three empty cardboard boxesÉit's unbelievable, right?
Forget my time. Oh, it's a photo of a cardboard box you can get for free. So I just put
them on the curb. So that is where I didn't have a market transaction. Or even
worseÉI could've tried to sell them for a dollar, and then someone's trying to find
me to spend a dollar, right? So transaction costsÉin kind of a vague senseÉthere's
a big categoryÉlike utility. You can put a whole bunch of stuff into transaction
costs. But that can inhibit the formation of a market. Now she mentioned something
about market failure or government failure.
Did she mention government failure or did she mention market failure?
Does anybody remember what she mentioned? If you don't rememberÉwhat is
market failure. Somebody tell me what market failure is. It's very popular in the
political classes to talk about market failure. What does it mean when a market
fails? You know? You don't know? The market never
fails for you? What does it mean when a market fails?
Inefficiency? Inefficiency, but what kind of inefficiency?
In supply and demand. Okay, keep going, is it like a monopoly kind
of inefficiency? Not necessarilyÉit could be that there's
no demand for your marketÉ Ah, that's called a business failure. I'm
not going to go with that one. Or a missing demandÉ
Not exactly. This is kind of like missing markets and stuff like that. Let me try andÉ
The thing to keep in mind is this difference between private and social costs. So
private and social costsÉwhat does it mean when we have a market failure. And
people who had their hands upÉkeep your hands up if you want to.
Externalities exist that result in people not paying the full cost of their actions?
Perfect. Externalities exist. Now what does that mean? "Externalities exist"
essentially means that if we have our aggregate demand curve here, and we haveÉ
Let's just say we have this supply functionÉlet's just call this the marginal cost of
gasoline. Externalities exist because we say that the
consumption of gasoline produces some byproduct that is not reflected in the cost.
So the pollutionÉso gas equalsÉlet's just call it "go". You get to go. But it also
produces pollution. So the consumer who's buying gas will say, "Oh look the price of
gas is $3 a gallon." And I'm going to buy as many gallons as I want "Go". So this is
actually Q star. Now there's a cost of pollutionÉdoes that mean that the supply
curve should be lower or higher in terms of the additional cost of pollution from
using gasoline? Higher
Higher. There's this additional cost that's on top here; let's just make it like this.
I mentioned last week that someone said that
the cost of a barrel of oil should be $300 if you reflect military spending and
the cost of geopolitical risk. Not geopolitical risk, sorry. Military spending.
Right? $300 versus 100 and (what's the cost of oil right now?)É80? Or 70?
So a much bigger number than the current price of 180. So if we have this additional
cost, that means every unit of gasoline out there that's consumed creates some
pollution. Now if there is nothing going on (there's
no regulation, there's no intervention) then the quantity produced is going to be Q star,
and there's going to be this much pollution produced. And this is going to be
an inefficient quantity of consumption. Because if we did want toÉif we reflect the
entire cost of consumption, we would want to have a gas price that was higher.
I'm just putting in $4; this is not actually the quantitative measurement of how high it
should be. But more importantly, the quantityÉI'm just going to put a little E
here for efficientÉwould be lower. So the idea is that if you consume Q star, you're
producing pollution. If we take this pollution into account by setting an efficient
price, then the quantity consumed would be lower. And that would fix the so-called
market failure. That's just kind a straightforward explanation
of about what market failure means. Does that make sense to you guys?
What does the word failure refer to? A failure to achieve the efficient outcome.
So in fact, although this might be a perfect equilibrium here, it is the inefficient equilibrium,
right? And that's because it is the inefficient equilibrium. And that is because
of (essentially) this social cost of consuming fuel.
Now you can have market failure in different ways. One of them is, for example, a
pollution that produces a public bad, and the other one might be thatÉ
So the public bad is an externality. And when it comes down to the externality
falling on a particular individual or identify a group of individualsÉthe cost is being
born by those individuals. So it's not necessarily a public bad.
I have to talk about property rights so that we can draw this diagram.
But say it's a private bad that occurs to one individual, then there's actually the
possibility of not having a market failure, but having a, in a sense, market failure in
a bilateral way in a sense thatÉ
So say thatÉthis is an overview concept that I'm giving you. We're going to be going
over that that concept a million times. Let me give you two examples. So one exampleÉyou've
got your donut shop. And they're producing pollution. And this is a
public bad. So we want to tax their consumption of frying
oil, or something like that,
right? This requires some form of governance, or
some form of social intervention. Coordinated intervention by a government body.
Because a public bad is accruing to every member of the public. It's to everybody.
And this scaleÉwe're talking about this scale that is essentially a transactions cost
respective toÉit's too hard to find every person that's being harmed. Too
expensive. So you could have a public bad in Berkeley, and there's tens of thousands
of residents there that are all suffering from this donut pollution. Or it could be
on scale of California. Scale of the United States.
Scale worldwide. What is the biggest public bad going on right now?
Greenhouses gasses. Greenhouse gasses. Thank you. So greenhouse
gasses, and as a result of thatÉclimate change. Everybody's pointing
a finger at everybody else. This is a market failure, and now we're trying to solve
it with a government intervention. Maybe we're experiencing a government failure,
but that's what this debate is all about.
Could you have a consumer driven market failureÉlikeÉbottled waters and carbon
oxides. So that could be likeÉ[inaudible] Yes, that's essentially a voluntary tax that
the bottled water company is engaging in to offset the harm of buying their product.
Which is kind of like the bullet manufacturer giving you an insurance policy
for when you shoot your friend. Fiji water does that. In fact, I think Fiji
water is so green that they double offset their
carbon footprint. Which is of course water that's coming across the Pacific Ocean.
I call that marketing. If it actually works as advertised, it might be a way of
overcoming that externality. I kind of hesitate becauseÉremember this thing is
about cutting consumption down, right? So if your demand functionÉif you have aÉlet's
call it a varied inelastic demand. And you raise the price by this much. Then
you're not reducing the quantity by very much. And oh, I can actually just go like
this. A totally inelastic demand, right? And a totally inelastic demand is called "I
don't care about that price." If you don't care about that price differential,
then you actually don't consume any less. So that's accomplishing nothing in terms
of producing consumption. It is, however, generating this block of money, which
is theoretically going to do something good, which is opposed to the block
of money is actually supposed to offset this amount of harm.
And if the harm is greater or less, that's not the issue. That's what they're shooting
for. But I'm not a fan of what I call indulgencesÉthe idea ofÉyou buy your water
and you pay a dollar extra so you can not feel guilty about throwing your bottle of
water away. Your empty bottle or whatever. Good example. Okay so this is
aÉpublic bad from an externality. But what happens if the donut store just starts
dumping oil on the neighbor's lawn? Is that a market failure? No.
Is that an externality? Yes. Do we need a government intervention to fix this? What
kind of government intervention? We've got property rights. We've got that legal
system. Here's our Berkeley farmer who's upset about the donut oil that's spilled on
his garden. And the government shows up and says, "We want to intervene and help
you." What kind of government intervention is going
to happen? How does this get fixed? This problem? Or maybe it doesn't. Maybe you
just get oil on the lawn. Anyone else? Who hasn't talked yet?
You pay a fine. A fine. Where does the money go from the fine?
Does it go to this guy? It goes to Sacramento and gets wasted.
Can you sue? Can you sue? Who's suing?
This guy, right? He can sue. This is what the Coase paper is
about. This is the problem of social cost. Coase basically saysÉin the absence of transaction
costsÉan amazing significant caveatÉpeople involved in pollution can make
agreements (side agreements) based on property rights to mitigate the cost of
an externality, all right? If you read the paper, he says it probably a lot better.
But the idea basically isÉwho has the property rights here? What's natural? Who's
stolen the property rights? The donut polluter or the farmer pollutee? The farmer.
The right not to be polluted on. Or someone not to dump crap on your roadÉor
your land. So the rights belong to the farmer, here comes
this oil, the farmer has the right to say what (about the oil)?
So the oil guyÉdoes he have the right not to be polluted, or does the donut guy have
the right to pollute him? Not be polluted right? It's fairly common
sense, and there's lot's of different ways to
structure this. But it's fairly common sense that you have
the right to not be polluted. Right? You bought your landÉit did not involve an easement
for donut, oil, clothes. So if this guys got the rights then he can basically
say, "You shut down." Now this guyÉhe's going to do what? What's
he going to do? Is he going to shut down his business? No. What are his options?
What can he do? Go open a store somewhere else?
Right. Put it right here. What else? Raise prices and figure out a way to get rid
of the oilÉ Right, no dumping. Change technology. That's
a delta for cange. And change of technology implies there's a higher cost method,
right? Because if there was a lower cost method that
did not involve pollution, they would've done it already, right? So costs
will go up. Pay the farmer to cover the costs of the oil.
Essentially a side payment, right? That's what Coase said.
Other hands? Pay somebody else to clean it up.
Pay to pollute. That's actually the word that shows up in the newspapers all the
time. Or I'm going to put cleanup as aÉthat's the same idea. Cleanup as in change
technology. That actually is going to raise costs. Other hands? That's pretty much
it. This is the one that Coase talked about. This
happens a lot. Developed so-called no- pollution havens. Pollution dumping.
This is what ends up happening if this is too expensive, right? If three costs more
than two, usually, in a law-abiding society, this isn't going to happen. But two or
three ends up being the kind of result. Somebody wakes up in the morning and says,
"Oh my god there's all this oil here." Or "Oh my god there's all this carbon in the
atmosphere. Oh my god there's smog" Let's fix this problem. And either you go
to paying people to pollute or paying people to do that kind of activity or changing
the technology. And there's a business tradeoff between which
one you decide to do. We're getting into this a lot because it's a big topic in
environmental economics. But I wanted to bring it up in terms of what got tingled on
in Claire's talk. So is it the truth that that is all [inaudible]Éeverything
will be inefficient after they pay for the farmer's land to get cleaned up.
Everything will be inefficient if these two go into a negotiation to sufficiently lower
transaction costs. That's what Coase said. But then in that case, let's say he agrees
onÉwe'll only pay 300 dollars. The costs don't
have to go up. Then people are happier because now they get cheap donuts. And it's
not just with donuts, it's for example with cars. So then can't you say that it's also
inefficient becauseÉ No, it has nothing to do with inefficient.
The price is the price. The price affects cost. So some of the costs before were not
reflected in the price of those donuts. Isn't there a social cost of unhappiness of
people who now can't go from place A to place B?
Yes, but everybody can complain about that. I'm unhappy I don't have a one-dollar
Mercedes. I'm very unhappy. So that wouldn't count then?
No. So what we do when we do supply and demand is we say, "Hey, this is the
surplus here." But we want to make sure that supply and demand are accurate ways
of representing what's going on. So this is the sense that the supply curve should've
been shifted up again. Other questions?
I have a related question after theÉ[inaudible]..what is the goal of the group that the
government wants to impose the tax on? Do they look at the elasticity and think, okay
do we want to impose a tax so the quantity goes downÉand tax collected is equal to
the amount of damage doneÉwhat is the goal? Well that's the theory. Let me just take an
aside. I'm going to talk about this later, but now's the time. Let me talk about taxes
versus regulations. Okay so you've got yourÉlet's call it a benevolent
citizen group. And they're interested in endingÉsuch and such source
of pollution. So let's just take our demand curve and here's the supply curve,
and here's supply efficient and here's supply market failure. Let's just call it
that. So here's the theory. The theory is that
they want to impose a tax that will be identical to the cost so that the market
transactions are efficient. That's the goal. So this amount here is a tax. So this is all
tax revenue and the tax revenueÉyou could either take it as the area under the
sloping curve or out of the whole box here, right?
Either way. But the revenue was meant to offset the cost of the pollution. So in the
example of climate change, we will tax carbon, and we will use the tax revenue to
reforest areas or do carbon sequestration or whatever.
So that's a very important thingÉwhat happens to the money after it goes. There's
an interesting controversy in US politics about taxing the cap and trade regime. And
this is different cap and trade by the way. But the idea is that if there's some
revenue it should be used to fund green programs to increase energy efficiency.
What they call a double play, right? You tax to reduce the activity, then you
subsidize the actual virtuous activity. So then don't you have to place a value on
the virtuous activity? Oh, absolutely. That's determined by the tax.
Calculating that is the alchemy right? It is very hard to calculate those things.
Isn't that a flawed idea? It's a flawed ideaÉwell the idea, the theory
is sound. You should make it cost more. How much more? What if this isÉokay let me
just throw out this idea again. If this is the market supply curve and our price hereÉand
one our geniuses calculates this number hereÉand that's the taxÉbut really
it should be bigger, right? If it really should be bigger you have an inefficiently
high level of pollution. If it should be smaller, than you have an
inefficiently high level of taxes. So pinpointing that exact tax is actually impossible.
But that doesn't mean they're not going to try. And more importantly, I think
the idea is that you want toÉI mean I'm a big believer in terms of feedback loops
on taxes, so if you have a targeted level of
emissions or pollutions or water quality, air quality, or whatever, if the activity
is still producing too much of that bad, you
just raise the tax. So your tax will go up and down depending on how much bad is going
on. And then you don't have to be so precise about your calculations on the
first go. That's called Basian updating for the statistical geeks in the room.
I have no idea how to use it, but I just know it's called that. So now the alternative is
that there's a regulation. The regulation looks at the same example and says, "Well,
forget that tax stuff, let's just make these people use less." We'll have a limited
number of permits or rights to use that item. We can call this anything. It could be
called tax, it could be called carbon, it could be called housing developments,
parking licensesÉany of those things. This is the worst diagram ever. I hope you're
not just copying it down. Make good notes though, about this diagram. The idea
is that you regulate what? Quantity. You regulate on quantity, and over here you're
regulating on price. That's actually the big difference between these two ideas.
Now there's this other type of regulation calledÉyou're not allowed to sell leaded
gas, you have to sell unleaded gas. But you have toÉthe idea is essentially similar.
If you regulate the quantity, then do you still have to sell it for the old price?
You regulate the quantity, and then you watch whatever happens to the price.
Because in market equilibrium, you can set price, and quantity will be an outcome.
Or you can set quantity, and price will be an outcome. But you can't set both.
This is actually extremely important because very few people, besides economists,
and by that I mean you guys, understand that you can't set price and quantity at the
exact same time. I did my dissertation on the Metropolitan
Water District. And they try to set price and quantity a year ahead of the market. And
then they hope that this happens. They hope. They don't actually know what supply
or demand look like, but they try and set price and quantity. So that's kind
ofÉyou knowÉit's good employment for economists; they're doing assessments for
them, but they're wrong almost all the time by definition. So in regulation, you're
either messing with Q or messing with P. Taxes.
Is there a deadweight loss associated with regulation? Because taxes is actually a
revenue that goes with the government. Whereas regulation just doesn't happen.
Right, regulation isÉThat's a very important and correct observation. The taxes
produce revenue. This box hereÉokay, so this taxÉthere's P and there's tax. This
taxÉdoes this have any impact on social welfare? That tax?
Who thinks yes? Who thinks no? Well all
the "yes" people are wrong. This has no impact on social welfare. The
deadweight loss triangleÉyes, that has impact. This is merely a transfer. It's a
transfer of surplus from producers (it's from their surplus triangle) and consumers (their
surplus triangle) to the government, which will then do something very wise with
that money. And it may not go back to these producers
or consumers. It's meant to go back to those who are harmed by pollution. If it goes
into the congressional junk it to Bermuda fund, then it may not all be wasted,
but some of it will be wasted in terms of social outcomes.
Sometimes isn't a tax better than regulations because [inaudible]
In one sense taxes are better than regulations because the money is quantified. The
deadweight loss is the same in both circumstances. But in this circumstance, you're
just inhibiting activity. But more interesting is that taxes are more transparent.
When you see the tax, you see the tax. With regulations, you're not quite sure what's
the extra cost. That, ironically, is why cap-and-trade is
much more popular with politicians, because they don't want taxes to be visible
and regulationsÉthe cost of regulationsÉthere was an assemblyman of California
who I quoted in my blog. And he said, "California" (they have a cap and
trade rule in California called AB42) "yes, we know it's going to cost a hundred times
more than the carbon tax, but at least people won't see any of these costs."
That was a quote from a politician. Now that's evenÉthe benevolent side of the
politician. Because if you're doing a tax, you realize that every unit is going to have
a revenue associated with it.
When you do a regulation, you can write those regulations lots of different ways.
Exempting ranches that are greater than a hundred thousand miles located in
Montana (Ted Turner, campaign donor). So regulations have a lot more area for
negotiation among politically active groups that do not include you (citizens) right?
That's for special interest groups, the lobbyists. The 60 thousand DC lobbyists.
The carbon tax is not an effect on social welfare because the valueÉyou wouldn't get
the deadweight lossÉ Oh, they absolutely do have an effect on social
welfare. I was going with this triangle here. That was a trick question. This is the
deadweight loss. That's true. This is nominally not a deadweight loss if it is spent
efficiently to offset the actual cost. It goes into the black hole of corruption, and
it's also deadweight loss in a sense. That's why some people say, "Don't even have
taxes, I'll still have government." Right?
So regulations, producers just lose the moneyÉ It just increases the cost. And in that senseÉthey
willÉthey're producing a higher supply function andÉso there's the deadweight
loss, and they're havingÉ So their surplus was...let's do this bigger,
because I do want to figure out what the producers are losing. So there's our original
cost curve, there's demand function. we essentiallyÉlet's just do the tax this
wayÉ But for regulations, don't youÉwouldn't the
priceÉI mean for regulations why would the cost go up? Would they just say that you
can only sell that much? They don't tax it, so the cost stays the same. It's just that
now everybody who is in that market actually likes it because it's a monopoly. They make
the same stuff but they can sell it for higher prices because there's less supply,
and they're not allowed to make more. Right, but there's different ways of doing
it. So the scenario you're talking aboutÉyou've got demand and supply, and the
government just says you can't sell more than that. Okay. So now we have this
supply function; it kind of goes like this. And you could have the price jump up just
like you said. And they lose A, they gain B. Consumers lose C and B in terms of their
surplus. That's if you just cut it off. The problem is at that price, you've got all these
guys who want to be producing for the market. So you have, somehowÉnot just to
choke it down from Q, you have to choke down supply. Not just from Q star to Qe. You've
got to choke out all these guys too in some wise and benevolent wayÉdecide who
gets to produce for that market. That's what comes into what I was mentioning
about cap and trade. that's where you get the lobbyists showing up saying, "Oh,
give me the production license because we print stuff on recycled paper.
So we need the million dollars worth of subsidy."
Well it's not a subsidy; it's market access. So this is very much a dynamic for
market regulation. What I was doing here is just kind of benevolently assuming this
was going to happen. And there was no lobbying going on. So treating the
regulation essentially like a cost. But this isÉuse this for the deadweight loss of the
regulation. And the taxes are what I have left.
So the deadweight loss is B and A right? This is a CÉbut yesÉC and A.
And what does it look like when consumer surplus decreased?
Consumer surplus decreased. In this example? Yeah. Consumer surplus used to be
C plus B plus D. [student comment]
No, above the price. Consumer surplus. Is that the question you're asking?
Oh, so producer is on the bottom. Producer is on the bottom.
So why does it say producer surplus? Why doesn't it increase?
It did increase. Because essentially the governmentÉI mean this is a different way
of doing regulations. In this case we're just cutting back on quantity. Just like a
monopolist would want to. This is why a lot of industries ask for regulations. Please
regulate us. Remember the please don't throw us in the brier patch?
Anybody seen that? What's that movie? Please don't throw me in theÉplease don't
regulate me! Oh don't regulate me! And thenÉoh those regulations are wonderful
because usually it'll keep out an entry. It'll keep out competition. Okay so the
producer surplus increases by the quantity B and falls by the quantity A. And B, let's
assume, is greater than A. So why doesn't it fall by C as well?
This is consumer surplus, just lost by the production and quantity.
NowÉtheÉthis segues perfectly into what I want to talk about with profits. Because
in the short runÉshort run profits. Are the greater than zero, equal to zero, or less
than zero. Who thinks they're greater than zero? Equal to zero? Less than zero?
Less than zero. Yay. In some ways they can be any of these. But
the one that we talk about most often is that short run profits are positive. They
can be equal to zero just because. Because we're adjusting, right? If you're a firm and
you're adjusting your enterprise, and you're like, "Oh my god, we're selling below
costs; we better raise our prices." That's just a fact of running a business. And they
might be less than zero because you, again, miscalibrate. But in economics, we
almost always assume this. Right? We assume that short run profits are greater
than zero. Because of what phenomenon? Typically?
Come on business people. Why would short run profits be greater than zero? What
happens in the long run? Well if you have your firm just starting out,
and if you're very popular then a lot people willÉbutÉa lot of people will
want to enter your market as wellÉ Entry, right? For entry. So long run profits
equal zero. We assume in economics they equal zero because of entry. If there
is not entry, the long run profit of the post office, the 200 plus year monopoly, is greater
than zero although they continue to lose money. Now how they're usingÉso their
financial profits might be negative but their rentÉtheir happinessÉthey're sitting
around drinking coffee, losing your mail. Those are greater than zero, okay? Because
there is no entry against the postal service in some segments. Obviously we've
seenÉthey've lost packages, they've lost most first class mail (in terms of e-mail)
and a lot of business posts, right? But for a
competitive business, long-run profits are equal to zero because of entry. Because
firms come into the market and will innovate to take away that profit from Apple or
theÉCinnabuns or whatever. TheseÉ "Oh my god, I can't I'm eating a cube of
butter." That kind of stuff. So until somebody come in and copies their
business model, then that will be positive, right? And it's important to keep
in mind that there's two typesÉ There are a lot of things that are affecting
short run profits that like being positive. Let me get to this one first, and then I'll
go to the other things on the list. One reason is that there's some form of regulation, in
terms of law, protecting your market share. You have got a temporary monopoly for
a taxi driver in Berkeley. There's only whateverÉ120 Medallions in Berkeley?
And you can't startÉthere's no startups for taxi drivers.
So you could have a form of a regulation that's protecting your short run
profitability, being greater than zero. It doesn't mean that...there could be competition
among the taxi drivers, but that still will stop after awhile. And it will
keep profits positive. The other one is essentially an out of equilibrium path. No
one knows what's really going on, so profits are being made, technology is hard
to catch up withÉa local monopoly is quite important.
A local monopoly is going to be when you have one donut shop here and one donut
shop here, and essentially the marketÉ If you're standing here and you're thinking,
gee I want a donut. Maybe the transaction costs are going over here. Well,
let's just say it's greater than zero, right? If the transaction cost is greater than zero,
can this guy charge you a higher price? Yeah, right? The profit is greater than zero.
And likewise, over here, when people are crossing this way. This is essentially
a form of a local monopoly. Now if the transaction costs fall, so that you can instantly
go from donut shop to donut shop, and there's price comparison, then that monopoly
profit will fall. I'm going to the airport today, and I'm going
to experience the Starbucks coffee monopoly, right? You go there, you go through
security, and it's not like you're walking out to get coffee for a dollar less;
you've got to deal with their prices. And I
routinely know prices of Starbucks coffee cost a dollar more a cup after security, or
when there is not another concession near inside there.
In fact my first and only successful business in high school was selling candy. And
there was a monopoly on campus selling candy bars for 50 cents. And the Dean of
Students and IÉwe conspired to defeat the monopoly. And I had my only candy
machine that wasn't supposed to exist. Guess what my price was?
49? 49Éexcept that we don't do pennies, right?
45 cents. And I didn't exist. It was perfect because they didn't knowÉthey were
setting prices at a higher level in order to reap in the monopoly profits. They didn't
realize that they had actually set a floor below which I could go and take advantage
of all the student demand. I bought a car with that candy machine. Great deal.
Wouldn't it be easier though for the people that have two quarters and theÉ
I had change though in the machine. Except it was shocking people. There was a
little bit of a problem with that machineÉbut it was 45 cents and maybe a shock.
Okay so profitsÉI hadÉthis is not exactly how I had my profits protected, but I
wasÉthere was kind of like we were a duopoly, right? It was me and this other guy.
The other guy didn't even know I was there, so I was cutting his prices and taking
some share of market potential. But students would still buyÉI was selling Twix
barsÉthey would still buy the 50 cent Twix bar when? When would they buy it?
More convenient. Convenient, right? It was more convenient
because, you know, I only had one machine. This guy had about 12 of them. Candy,
candy everywhere. So, if I don't want to walk more than 20 feet to get my candy
bar then they wouldn't get the nickel.
It was on the student union. Any other questions? You were talking about how the short run is
affected when you're out of equilibrium path? What does that mean?
Out of equilibrium path means thatÉin an economic sense it would that you
obviously haven't gotten to equilibrium. And why haven't you gotten to
equilibrium? Potentially because not all the firms have entered the market yet.
Potentially because the consumers haven't found the best bargain, for example. So
there's a lot of reasons you'll be out of equilibrium, and, as I mentioned a lecture
or two ago, the world is out of equilibrium,
right? Economists are the only people that really assume equilibrium because it makes
the math easier. So that's a statement you should walk out of here with in general.
[inaudible] I don't know, you should go ask him? Accounting
profits versus economic profits. Have any yogurt shops gone out of business
in the last year? Yes or no? Well they've all had to convert to Yogurtland
style. There's no moreÉlike the Pinkberry? They don't sell it byÉ
Yogurt used to be sold by cups, like a cup for $3, now it's 30 cents an ounce.
So it's all by weight. Yeah, so now it's a lot cheaper across Berkeley.
But not all of them do that. Except for Yogurt Park.
The city of Berkeley has a yogurt price cap? Or is it nowÉit's competition because
it's transparent what you're paying? Competition.
AhhÉokay. So that's a good example of adjusting to equilibrium. So someone
switched over toÉthey probably had pennies per whateverÉper ounce. And they
said, oh look at our competitorsÑthey cut the cost 3 bucks, and all the people were
like: "Holy cow look at that!" Free yogurt coupons. Any yogurt firms entering the
market? Yeah? Okay so short run profits are still greater than zero, apparently.
Someone still thinks it's worth starting a shop. And there's some shop in San
FranciscoÉthe cereal? Has anyone seen the cereal shop?
We have it here too Yeah, we had it, right? Who would go eat cereal
at a store? You watch TV and eat cereal. I don't get that. But anyway, yogurt's
still a profitable business. Okay so the good sideÉif profits are still
greater than zero, it could be a sign of something good or a sign of something bad.
It could be a sign of something good because you're witnessing creative destruction;
you're witnessing competition. And that essentially is benefitting who?
Consumers? Consumers. In the long run. In the short run,
it benefits who? Producers?
Which producers? The ones whoÉno, forget toxicology. Which producers are
benefitting from creative destruction in the short run?
The one's that have the awesome products, right? I meanÉApple is making a killing
on the iPhone. Who's losing in the short run for creative destruction?
All other phone companies. The other ones. The other competition to Apple.
Remember the RAZR used to be the shit, and now who cares about that. So creative
destruction benefits some groups and harmful to others. So you know who's going
to oppose it and who's going to favor it.
So Motorola might oppose it by saying, "We have to put a regulation saying that you
can't produce a phone if your company is named after a fruit." And then they'll send
some money to their congressperson right? But on the other hand, some firms will fail
to deal with creative destruction because they'd rather just not do anything. That's
being the ever hopefully ostrich sticking your head in the sand, or whatever, okay?
And that's also something calledÉwhat's it calledÉproduct line cannibalism or something
like that? The firm doesn't want to innovate to destroy it's own product lines.
This is a known problem. IBM had an issue withÉIBM came out with theÉApple
came out with a PCÉbut IBM came out with the PC, right? Around 1981.
Back in the day. So the PC came out, and IBM used to sell mainframe computers. And
the mainframe people did not wantÉor many computer people did not want personal
computers because that would've done what?
Taken away market share. Taken away their market share, making their
life harder, right? So the people that actually created the PC created it in a secret
lab in Florida. IBM's from New York. And the rest of the company didn't know about
it because if they had known about it, they would've squashed them in terms of
internal politics. But for the company as a whole, the PC was an amazingly good product,
right? So the executive said yes, take several million dollars and go for it
and make the product. So there's opposition inside a firm to innovation. I'll
get back to the opposition inside a firm in a second. Oh, I just skipped ahead of this
stupid thing. Alright. I'll go back to it. I had a question about monopolies. If you
should have a product that defeats everyone else'sÉhow is thatÉbecause you're kind of
on the way to becoming a monopoly because you're beating everyone elseÉhow
is that some firms are able to do that and other firms are notÉthey're not likeÉhow
is that some markets are competitive and some areÉ
Give me an example. Well like with Apple, because they have an
iPod, everyone wants to buy it. And the less otherÉlike Zune is just a lot less popularÉso
it's likeÉI feel like Apple is on the path to
becoming a monopoly, sort of? But if you have anotherÉyou have a lot of companies
that can sell more or less the same goodÉor the same purpose then.
So it's a question of commoditization then, is what you're getting at. The idea that a
product line will become a commodity out of it after awhile. The profits will
disappear. What's an example of a product that became a commodity? Okay so
bottled water in a sense. Back in the 70s or whatever, the only bottled water was
Callistoga and Perrier. And they had a reasonable marketshare. And it's like $2 for a
bottle of water and no one cared about drinking bottled water.
And then bottled water became a healthy thing and the doctors are likeÉdrink 8
glasses of water a day. And a couple of companies got in the bottled water business,
and they're selling EvianÉa big brand of distilled water. And people are likeÉOh
Evian, $2 a bottle. And the water companies are like Holy Cow. I just read likeÉthe
other dayÉNestle is opening a bottling plant in Sacramento. They're going to pay
about like a dollar per thousand gallons of water. They're going to put in bottles and
sell it for about a dollar, or two dollars a gallon. So talk about profit margin, right?
And the profits get eaten up in shipping the water around in plastic bottles and
things like that. But basically, bottled water started to get
like this lucrative monopoly area. Or not monopoly, but lucrative in terms of profits.
And more and more firms in and said, if we just take water out of the tap and sell
it to someone and make a fat profit, why don't we do that? And they did. They started
bottling water everywhere. This guy in New York, actually bottles New York tap
water, and sells New York tap water in a bottle for a dollar. Even though they cost
likeÉa penny. So commodification of bottled water that followedÉpeople go into
Walmart and sayÉI'll pick up a couple cases of water. They don't care about Evian
or CallistogaÉor any of that shit. It's a commodity now.
So the profits in that business have sunk so far that the Walmart water profit per
bottle is I think one penny. And we're talking about the cost per bottle might be
whateverÉit might be 2 cents. So the profits have been really squeezed out to
almost nothing. And that's what happens in competition, right? In competition,
there will be short run profits. There will be rents. But the good kind of rents.
Rents that are returns on innovation. What's another way of getting those rents?
Monopoly rents? How else do you do that besides competition and innovation?
Using market or political powerÉ Yes, I'm going to say not market power, but
political power. So let's talk about the difference between short run profit greater
than zero because of market power or government power. Okay?
Market power is going to be because you make a better widget. Your widget sells
for more. Government power is because your government bans all your
competitors. It doesn't matter if you sell crapÑyou're the only business in town.
Do you put patents under government power? Patents are a form of government powerÉthat's
using government power. They're often explained as a way of protecting short
run profits to benefit society. There's a question about whether or not that's true.
There's a lot debate among economists and legal scholars about whether patents are
a good idea or not. They do protect profits though.
[inaudible question] So the question is are profitsÉcan you raise
prices and get more demand, in a sense? Did anybody hear about that iPhone app called
"I am Rich"? It was all fixed costsÉsome dude sat in his living room and
made a little gem, I guess, I didn't buy it. And it was sold on the Apple store for I thinkÉ$1000
or $999 dollars. And the marginal cost of production was zero, right?
And the entire point of having this thing (in terms of psychology) wasÉI have
so much money I can waste it to buy a picture of a gem (I think it was). And there
was demand for this product. And the Apple store (in one of their worst moves)
removed it because of a customer complaining that he didn't mean to be an asshole
when he hit "buy". Or an idiotÉor whatever you want to call it. But that's an
exampleÉI mean if you sold the "I am Rich" thing for $10, probably no one would
buy it. But if you're obviously so wastefully wealthy that you can pay $1000
dollars then there's demand. But that's not necessarily irrational because in my mindÉI
look at this stuff as it fits into the evolutionary psychology literature, which
is that we have evolved to buy these so- called positional goodsÉthese goods that
put you in a higher position relative to somebody else because of it's direct connection
with reproductive success. So I wonder if any girls bought that.
It's like the guys who rev their engines going by, the guys who buy the penthouse
apartment (not the floor below)Éthose are positional goods to show how big and
bad you are. Donald Trump buys billboards for his ex-girlfriend.
Do you think art are an example for that? In a sense, art is an example for that. But
art also has an extremely limited market almost by definition. Every piece is unique.
And also art is in the eye of the beholder. If somebody buys art just to show
people how much money they have to waste, then that's exactly what's going on.
If they buy art because they love 16 million dollar paintings of sunflowers, then
it's aesthetics, potentially. Would you say that every product that's sold
by the sameÉlike people who spend $200 on a pair of designer jeans that are made
at the same shop with the same people as the Walmart pantsÉjust for status?
Right. It's not just status, but that's also branding and membership in the
community. Pepsi and Coke are just like that. "Drink Coke. You'll be cool like all of
us in the Coke commercial." Or Pepsi, which is more coolÉfor whatever reason,
right? So people who are buying those colasÉif you
sold a cola in a plain can that didn't actually say coke, or you had to drink it
on your own in a room, it would lose it's kind of potency. In a sense of that price
differential between Coke and a Safeway Coke. Because as far as I'm concerned, they're
very similar. So is that something where the demand goes
up? Or demand curve is upward sloping? ItÉno it's not demand is sloping up. What's
going on? Demand is a relationship between price and quantity. Right? What we're
doing hereÉare we affectingÉare we moving up and down a demand curve? Or shifting
it in and out? What's shifting it in and out?
Tastes and preferences. Tastes and preferencesÉso we're actually
creating a preference for this bling Cola. There's actually bling water. They have little
gems and stuff attached to it. right? So it's shifting the demand curve out.
What if the firm entering is prevented by the government. For example in the
healthcareÉthey get a lot of competitors orÉwho are opposed to public doctors orÉ
So this question is what if the firm is enteringÉthis is a little bit off topic but on
topic, so it's good. But it's likeÉif a firm entering the market
is actually the government, right? And the government is already in the healthcare market
through the Veteran's AdministrationÉor Medicare and Medicaid in
some way. But the complaint is that in a public option, then that will drive out
private providers of either private insurance or medical care. That complaint
holds some water. It is valid. The number one reason that it is valid is
because of the possibility of cross subsidy using tax dollars to subsidize medical service.
Whereas the private business can't do that. Well it's pretty well-known right now
that for every private dollar in medical know the government Éwhatever.
Let's just say _. The costs of public health provision might be _ of the private
cost of health provision. Let's just do it. Just saying. That's the argument.
Or drugs in the USAÉUS versus drugs (legal drugs) in Canada. Oh, lets just go buy
drugs in Canada and bring it back to the United States. Now they can't do that. Well
that's kind of stupid; they both come from the same factory, right?
The difference in those prices is because of the system that those drugs are in. If
you start bringing back these cheaper drugs in
the U.S. then you break down this system. And in this circumstance of the public and
the private, what's going on is that the public provision of medical care is either
implicitly subsidized through property taxes or financing discounts (you know the
government borrows more cheaply that a private firm), or they explicitly subsidize
in a sense that these guysÉthe private companiesÉif you have a hospital, a private
patient will pay $100 for the procedure. The public patient will pay $50 for the procedure,
and the cost is 80. There is a cross subsidy between public and private.
So that is the main complaint of those folks if it's legitimate. If it's illegitimate,
then we'll say, "Hey, just go." But there's a
legitimate economic complaint about that. Okay that was a little side note. Where
was I? So the government power can support monopoly
power that is greater than zero, and if that's so, we know that there's going
to be business out there that are lobbying the government for protection. And
the businesses don't always need the government to protect their profits. There's
such a thing as an oligopoly or a cartel, and we'll get into that more as the course
progresses, but I wanted to quote Adam Smith, the uber capitalist.
I might have said thisÉI'm just going to read it. It saysÉpeople of the same trade
seldom meet together for merriment and for diversion, but the conversation ends in
a conspiracy against the public or on some conspiracy to raise prices. Adam Smith is
sayingÉthe individual hand is awesome, but don't let those guys in the same room
with each other because they will conspire against you. I mentioned this last week
in terms of cartels. But that's the gospel from Adam.
So that's some stuff on profits. Now I was actually on this thingÉI was trying to
respond to something on Claire's talk. So she was talking about market failure
versus government failure. What's government failure? That's what I was trying to
get to. What does government failure mean? Is it like you can't trust the currency because
it doesn't stay the same? No. That is an actual economic failure, but
that's not what I'm looking for. Would it be incorrectly pricing the externality
in that case? Yes. In a direct price senseÉthe tax sense.
Is it something like a price floor whereÉ Right, a price floor and ceiling is a little
more accurate in terms of regulation, okay? You can haveÉremember market failure is officiallyÉit's
the inefficient quantity of a good. We're at the wrong price. Either way,
you get the supply and demand crossing. So if you've got this situation
going on, you could have a market failure and the price should be higher. You could
have a government failure anywhere you want. You could just sayÉthis is the price
here, and the government decidesÉwe'll we're going to put a price ceiling on there.
P upper bar. On that price ceiling you have this much supply and this much demand.
So that'sÉessentiallyÉ the government has intervened on that kind of
market, and intervention is producing a higher priceÑPÉokay so this is actually
a good point. So if that intervention is restring the quantity available in the market
because the government set's it at P1 upper bar. What's Pt upper bar? What is that?
Why is that price there? Why is that the actual price? What does it mean? What
does that price mean? Restricted quantity?
It did restrict quantity. But why is Pt equalÉ What is P2?
Is it what people are willing to pay at that price?
Not what they're willing to payÉit's what they do pay. In order to have a balance
between supply and demand you've got to be able to choke demand all the way up
the demand curve, right? And you choke it. You know the price is set. What's P2
composed of? Anybody ever boughtÉrememberÉevery once in a while they'd have
a rush for some kind of fad toy at Christmas? Like Beanie Babies or whatever? And
the Cabbage Patch dolls? And the kids are like, "If you don't give me this, I'm going
to kill you." And then the parents are likeÉI mean they
have a movieÉArnold Schwarzenegger was trying to find some toy or something right?
What's this P bar 2 equal to? The government has restricted quantity demanded
(quantity). They've restricted quantity by setting this price cap. It is available at
Pt, but what is Pt equal to? It's equal to cash
plus transaction costs. What are those transaction costs? You're trying to buy a
Beanie Baby, you go down to Toys R Us and what happens? Sold out. You go to Toys
R Us in El Cerrito. Sold out. You get on the planeÉgo to ChinaÉ
So what's going to happen isÉyou're going to spend P2 in terms of waiting around,
searching around, asking aroundÉthey're all transactions costs, okay? Information
problems, timing problems, and usually we just say it's time spend queuing.
Standing in line. The idea is that, yeah it's only $10 a ticket, but you have to wait in
line for 4 hours. So is it how like the football games tickets
are? Yes. Student rush? Free ticket! If you get
in lineÉ Can't government failure also be likeÉyou
thought they were regulating something, but they weren't actually regulating it?
You, the demander, thought they were regulating it?
I guess soÉI mean.. Example? LikeÉI buy gasÉI think the government
is fixing the problem with pollution. Like that kind of thing?
Yeah, or likeÉI think it was AIG that you were talking about where you said they were
like insuredÉ I think that's a complication of regulation.
I wouldn't necessarily call it government failure right off the batÉlet's just not
call it government failure. That's an important example of how a regulation can really go
sideways. Would it be something in terms of football
tickets. It's sold out and it's whateverÉ 400É so would P2 be the difference?
Well, so you'll have two markets. You might have a secondary market for the tickets.
That would be a pure price market. When you're dealing with a scalper, there's no
waiting in line. They're there. They want your money. It's nice and simple. But
they're queuing up. Or they're buying tickets with these super computers on the 2nd
day of sales. Or they know somebody that Billy Graham presents or in tickets or
whateverÉthey buy tickets from the back door? There's a number of reasonsÉ
But then the scalper market is a relatively efficient stub hub and all that stuff.
I'm thinking about rent control. I'm going to say the transaction costs cost something
like 3 months. But once they're in, they'reÉ Yes. So once you're inÉso this representsÉso
this is the deadweight lossÉthis is the producer surplus. This is the consumer surplus.
And this is a transactions cost. This transactions cost represents the capitalized
value or the capitalized cost of buying that thing. So for those three months
of waiting, you'll get access to this price. But over the relative time period,
you're paying this price. Now if you stay in
the department for 20 years, then maybe you're going to make out, right? But then
there's other kinds of opportunity costs. But in a sense, what we assume is that
consumers are going to pay a good chunk of surplus against that profit.
And whether or not the breakeven for search costs is one month or three years or
whateverÉthat's a good observation. Yeah? Other questions?
Sorry, what were the boxes again? This is producer surplus, this is consumer
surplus, and this is essentiallyÉI'm going to call it transactions costs.
So in that picture right here, where's the government cost? Is that Pb?
The government is setting the price ceiling at P1. The total price the consumers end
up paying is P2. It's P1 plus P2. And those are transaction costs?
Right. So at Pt, there is no shortage?
At Pt there is no longer shortage because the cost has been high enough to reduce
that demand. I'll say one more thing. The theory of the
firmÉso what we talked about last weekÉwe talked about the donut entrepreneur,
and the coffee entrepreneur. Mr. Donut and Mr. Coffee, okay? And the question
was: should they merge into one firm? Now that's fine and simple and interesting,
but this theory (this is not an extension, but this is another angle of looking
at firms) this question about the boundaries of the firm, assumes that the firm
is a monolith. It assumes that the firm acts as an individual.
Now who's worked for anybody for a wage? Okay. Did you notice that inside of that firm, loosely
construed, was everybody on the same team, with the same program, we're all
there together, we're all profit maximizingÉwe all have one objective function?
Is that true? Or were there some kinds of disputes inside the company about
who's doing their job or who's working hard enough or who's the good manager, and
this manager's not producing much for the firm. Does anybody notice those kinds
of dynamics inside of the firm? So that's what I kind of want to point out
to you as an existing situation. So here, we
blow this circle up, and we've got a bunch of individuals, and they all haveÉso this
is a profit-maximizing firm. We assume that.
But inside that, you've got a whole bunch of profit max equals a function of U1,
U2, U3, and so on for all the utility functions for people in that firm.
The profits of the firm are the result of a negotiated outcome among all of the
individuals working inside that firm. All of those people have their own objective
functions. Yes I want to get paid, no I don't really want to work. Yes, I want to sell
that product, no I hate selling that product. Yes, I'll show up on Tuesday, but I'll
never work on Wednesday. I don't like you, I like that person. And so on. All of
those utility functions are interacting inside the firm. And there's this kind of mish
mash. The idea essentially is that we pay you. We want you to be a good employee
so you have extrinsic motivation and intrinsic motivation. And that will produce a
profit. But sometimes those utility functions are in conflict. And the firm profit may
not be as high as a result of that. I want to point to that, and we'll get very heavy
duty into principal agent stuff, and I'll see you on Thursday. Homework due at the
start of class on Thursday. I've got office hours now.