Vijaya Raj Sharma, Ph.D.

These notes are not edited. They also do not necessarily cover every material that will be discussed in the class. Students are responsible for additional materials discussed in the class. These notes broadly follow the chapters of the textbook - Macroeconomics: Private and Public Choice, by James D. Gwartney, Richard L. Stroup, and Russel S. Sobel, Ninth Edition, Dryden Press, 2000

I. INTRODUCTION

(Chapters 1 and 2)

1. Microeconomics and macroeconomics

Microeconomics is a study of the behavior of individual households and firms, whereas macroeconomics is a study of the aggregate behavior of all households and firms in an economy.

2. Scarcity, choice, and economics

Many of you may have wished you had more income and more time. Unfortunately, income and time are not plenty, they are scarce. But, the number of wants that you seek to satisfy from your limited income or time are numerous or unlimited. The scarcity of resources, therefore, forces you to make choices from your long list of wants.

Economics is the study of choices people make to satisfy unlimited wants from limited resources. Scarcity of resources is the fundamental reason we study economics. Since you make choices from your long list of wants, you give up pursuit of some wants. In other words, you sacrifice some wants to satisfy other wants from the limited resources in your command.

3. Opportunity cost

Opportunity cost is defined as the value of the best alternative foregone. Consider an example.

You are attending this class right now, using your scarce time which you could have for other alternative purposes. What is the next best thing you could have done during this time? The value of that next best alternative you sacrificed to attend this class is the opportunity cost of this use of time. Since resources are scarce, there is always an opportunity cost involved with every use of a resource.

No matter who pays, scarce resources have a cost. High school education is free to parents in the U.S. However, resources (teachers, equipment, property, etc.) that are devoted to high school education have opportunity costs; they could be used elsewhere. Parents do not pay for these resources, taxpayers do.

4. Economic Way of Thinking or Economizing Behavior

Since resources are scarce, they must be used efficiently. The objective would be to obtain maximum possible net benefits (benefits minus costs) from resources. Acting in a manner to fulfill this objective is called "economizing" or "rational" behavior. While choosing from a number of alternative uses of a resource, an economic agent compares expected net benefits from each alternative use of the resource and chooses that alternative associated with the largest net benefits.

5. Marginal analysis

The economizing behavior is characterized by "marginal" analysis. Marginal means additional. Economic agents consider their current situation, or status quo, as given and evaluate what marginal, or additional, benefits and additional costs are associated with each alternative use of a resource. Marginal benefit from a can of pop in hot weather would definitely be higher than the marginal benefit during cold weather. Do you see the importance of current situation (in this example, the kind of weather)? Consider another example.

Suppose you are currently employed in a job that yields you $30,000 a year. You receive a new job offer from another company that would pay you $40,0000 a year, but the job requires additional 8 hours of work every week. Should you accept the offer?

You are already earning $30,000 (the current status); therefore, the decision is whether you should switch job for additional benefits of $10,000 of wage, associated with additional costs of 8 hours of work every week and any additional tax burden. This kind of analysis is marginal analysis. If your marginal benefits ($10,000) exceed marginal costs (extra hours and more taxes), you would accept the new job offer.

6. Three Economic Questions and Economic Organization

Every society has to answer three economic questions. What (which goods) will be produced? This is a consumption decision. How will goods be produced? This is a production decision asking for which resources should be used in which proportions in the production of goods. For whom will goods be produced? This is a distribution decision as to who shares how much in the outputs produced.

There are three alternative types of economic organizations which attempt to answer these questions differently.

Market mechanism, or capitalism:

This organization allows a decentralized process of decision making. That is, each individual household and firm decides independently what to consume or produce and how to do produce. Market coordinates these independent decisions through prices. Consumers look at market prices and decide what to consume in what quantities. Producers also look at market prices and decide what to produce in what quantities and what kinds of resources to use in production processes. Although decisions are independently made, producers produce goods which consumers want and generally there are no shortages or surpluses. Adam Smith, the father of economics, called this the invisible hand of market. Government is a neutral referee in this mechanism.

In a market system, those who are able and willing to pay get most of the goods. Dollar votes decide the distribution of goods in the market. Therefore, some consider market allocations "unfair" to poor people. Most Western economies are close to this type of economic organization. Hongkong is considered the most free market economy in the world.

Centralized planning, or socialism:

In this organization, there is a central authority that plans, commands, and coordinates what, how, and for whom to produce. The authority pursues some social objectives, like equitable distribution of wealth. All productive assets are owned by the government; there is no private ownership of productive assets. The previous Soviet Union, Cuba, and China are the best examples of this type of economic organization; however, China is now experimenting with market mechanism.

Mixed economy:

This is a combination of the above two types of organizations. Some sectors of the economy are centralized, whereas others are left to the market. Most of the economies in the world fall in this category.

II. VOLUNTARY EXCHANGE AND CREATION OF WEALTH

(Chapter 2)

1. Production Possibilities Curve (PPC)

PPC is a curve that outlines all possible combinations of total output that can be produced by an economic entity, with its given fixed amounts of resources available, given specific state of technical knowledge, and assuming that all of its resources are utilized fully and efficiently.

2. A concave PPC: Nonhomogeneous Resources

Consider an example of PPC of a hypothetical country.

Above the PPC is presented as a schedule, it can also be presented graphically. Generally, PPC is a concave or bowed-out curve. Draw a figure to show the shape.

A PPC demonstrates that there is no such thing as a free lunch. If you want more of something, you must give up something else. There is opportunity cost involved in the use of scarce resources. In the above example, if you want to produce more food, you need to give up increasingly larger quantity of clothing to produce one unit of food (see the third column in the above schedule). This is a case of increasing opportunity cost which happens when resources are nonhomogeneous, or specialized, in the production of one or the other goods. To maximize production, you begin producing foods with resources that are highly skilled in food production and you begin producing clothing with resources that are highly skilled in clothing production. But when you start increasing production of food, you have to progressively withdraw additional resources away from clothing. In the beginning, you will withdraw resources that are relatively less specialized in clothing production so that clothing production suffers least. However, if you keep on increasing food production, you will be forced progressively to withdraw resources that are more and more productive in clothing, thus sacrificing more and more of clothing production.

This example also emphasizes the importance of marginal analysis. Note that the cost associated with production of one more unit of food depends on the current status, or your current position on the PPC.

3. A straight line PPC: Homogeneous Resources

Consider an example of PPC of a hypothetical shoes firm.

If you draw the above PPC, it will be a straight line PPC. Show in a figure. Note that in this example, the opportunity cost of producing one pair of black shoes is the same, irrespective of where you are currently located in the PPC. This is a case of constant opportunity cost, which happens when resources are homogeneous, or equally adaptable to production of all goods. The opportunity cost in the above example happens to be 1, but this is not a norm. It can be different from 1.

4. A few things about PPC

Although we will mostly use straight line PPCs in the class for the sake of simplicity; concave PPCs are more realistic. Resources in the world tend to be nonhomogeneous.

The slope of the PPC, whether concave or straight line, shows the opportunity cost.

A PPC can be drawn for any economic entity (individual, household, country), showing what it can produce with resources in its command.

5. Regions inside and outside PPC

An output combination inside the PPC indicates inefficient use of resources. An output combination outside the PPC is unattainable by the definition of PPC. An output combination on the PPC (actually every point on the curve) is productively efficient. Show these points in the curve.

Every society has to strive to be on the curve for efficient use of resources. But, there are innumerable points on the curve that are efficient. Where should a society be on the curve. The choice depends on preferences of its people (their relative likings of food and clothing in our example).

6. Factors Shifting PPC

A change in resource endowment shifts PPC. For example, separation of Quebec from Canada would shrink the Canadian PPC: a shift to left. Show a shift in the figure. New findings of resources in an economy expand the PPC of the economy to the right. Show this shift too. The most general method of expanding amount of resources is investment. Countries invest today to increase capital to work with tomorrow. Thus, there would be more resources available tomorrow. Today's investment shifts tomorrow's PPC (a shift to right).

A change in technical knowledge also shifts PPC. Firms invest on research in the hope of increasing productivity, or capability of the firm to produce more. Improved technology shifts PPC to right.

A change in work habits also can shift PPC. People may change outputs by changing work habits. The more the number of hours people work every week, the more the output from the same number of labor resources. The number of hours people devote on work every week is closely related to their valuation of leisure. Public policies can affect work habits. For example, a very high income tax rate can suppress people's willingness to work more.

A change in economic organization is another factor that affects PPC. Experience has shown that some economic organizations (which are characterized by excessive government interventions in economic activities) are inherently inefficient, because government interventions often discourage people from giving their best or provide perverse incentives. Increased reliance on market mechanism and system of private property rights are likely to improve efficiency. This is the reason behind China, Russia, and many developing countries moving toward privatization and free market.

7. Savings and Economic Growth

Investment improves future PPC by making more capital available to work with. This was pointed out above. But setting aside resources for investment entails a sacrifice of current consumption. Fewer resources would be available for producing consumption goods. Thus, there is a tradeoff between investment and current consumption.

Draw a PPC for consumption goods and capital goods. Compare two similar countries with identical PPCs initially. The countries make different choices and end up with different levels of economic growth over time, thus different PPCs in future. This is an explanation of how Japan with its savings rate of about 20% could catch up with the U.S. which has a savings rate of less than 7% of GDP.

8. Gains from Voluntary Exchange

The possibility of voluntary exchange allows people to specialize in what they do best (instead of trying to do everything) and then exchange goods according to their needs. Thus, voluntary exchange expands the size of the pie. Voluntary exchange also allows goods to flow from low value uses to higher value uses. Suppose you want to sell your car at $1000 or more (you do not have to reveal your price), which implies that the car is not worth more than $1000 to you. If someone offers $1200 for the car, it means that the same car is worth more to this person than to you. You would of course be happy to sell at $1200. Thereby, the car moves from a lower value use to a higher value use. Both you and the buyer gain from the exchange, because only mutual benefit can be the basis of a voluntary exchange.

Voluntary exchange makes meaning only in the presence of clear and enforceable private property rights system. No one should be able to forcibly snatch or take away your car. If someone could forcibly take away your car without paying, why would the person be willing to buy? The whole basis of voluntary exchange is destroyed without private property rights system. This is also true if the government has the authority to seize your property without due compensation or without your consent.

III. MARKET AND SOCIAL WELFARE

(Chapters 3 and 4)

1. Law of demand

The higher the price of a commodity, the lower the quantity demanded (everything else the same). Consider a hypothetical demand schedule (P=10-0.5Q).

The graphical representation of the above schedule is a demand curve. Draw a demand curve. Price here refers to the opportunity cost borne by the consumer. Price includes money cost, time cost, and any other cost associated with the purchase of the commodity. Generally we consider only the market price (money cost), implicitly assuming that other costs are negligible.

The clause "everything else" in the law of demand refers to factors that influence demand, such as income level, preferences, prices of substitutes, prices of complements, and expectations about future prices of the commodity. In a demand curve these factors are considered fixed; thus, demand curve shows only the negative relationship between price of a commodity and its quantity demanded.

Why is there a negative relationship between price and quantity? That can be explained by the "law of decreasing marginal returns." Marginal benefits from a commodity decreases as you consume more of the commodity. The more apples you eat, the less tastier would be the next apple. Therefore, you would be willing to buy larger quantities only at a lower price (be it apples or any other commodity).

You need to distinguish relative price changes from inflation. There are two kinds of price changes: inflation (a general price change) and relative price change (price of a particular commodity changes with other prices remaining the same). Inflation means increase in price of every commodity. Suppose the prices of all commodities double. Such a price change does not change the relative price of commodities. If you could buy a can of beer by giving up two cans of pop before the general price change, the tradeoff would remain the same even after inflation. On the other hand, a relative price change changes the tradeoff. Suppose beer becomes more expensive requiring three cans of pops to buy one beer. Since price refers to opportunity cost of buying a commodity, we are talking about relative price changes and not inflation.

2. Distinguish between demand and quantity demanded.

Demand refers to the whole demand curve, or the whole demand schedule. On the other hand, quantity demanded refers to a particular point in the curve. Change in demand refers to a change in the whole schedule (a shift of the entire demand curve), whereas change in quantity demanded refers to a movement along the demand curve.

Note that own price changes only quantity demanded, not demand. All other factors change demand; see below for such factors.

3. Factors affecting demand

Income:

When income of an individual increases, his or her demand for most of the goods increases (shifts to right). Such goods are called "normal" goods. Graphical representation. Demand for certain goods, however, may decrease with an increase in income. Such goods are called "inferior" goods. Possible examples: potato, macaroni cheese, spam, etc. Graphical representation of shifts in case of inferior goods.

Preferences

Preferences, or tastes, of individuals are likely to change over time with experience and information. A more favorable taste toward a commodity increases demand for the commodity, and a less favorable taste decreases demand (graphical representation).

Prices of substitutes

A change in the price of substitute has a positive relationship with demand. A decrease in price of Pepsi is likely to decrease demand for Coke (graphical representation).

Prices of complements

A change in the price of complement has a negative relationship with demand. A decrease in price of peanut butter is likely to increase demand for jelly (graphical representation).

Expectations about future prices

If a consumer expects prices of a commodity to go up tomorrow, the consumer is likely to buy it today before prices go up. A higher price expectation increases demand (graphical representation). Note that the price has not gone up today, so it is not a movement along the d-curve but a shift of d-curve.

Note. a convenient rule of demand shifts: MoRe to the Right and Less to the Left.

4. Market demand

Market demand is the horizontal summation of individual demand curves. For each price, add quantities demanded of all consumers in the market. Show graphically.

5. Demand is a measure of MB / MWTP.

It should be evident that demand curve is a marginal willingness to pay (MWTP) curve or a marginal benefit (MB) curve. Demand curve shows prices consumers are willing to pay for given quantities of a commodity.

6. Consumer Surplus

The area below the demand curve is total willingness to pay (TWP) for a given quantity. However, market does not require consumers to pay their MWTP for each additional quantity. Goods are available at a fixed price, irrespective of quantity purchased. Actual cost paid by consumers (price * quantity purchased) is lower than the total willingness to pay. The difference between the TWP and the actual cost paid is called "consumer surplus." Consumer surplus is a measure of welfare (net gain) to consumers from purchase of a commodity. Show graphically TWP, actual cost, and consumer surplus.

7. Law of supply

The higher the price of a commodity, the larger the quantity supplied (everything else the same). Let us consider a hypothetical supply schedule (P=1+0.5Q).

The graphical representation of supply is an upward-sloping curve. The implicit assumption behind the supply curve is the assumption of increasing opportunity cost (marginal cost of producing goods). According to this assumption, marginal cost of production increases as more and more of the same good is produced. For this reason, higher prices must be offered to sellers to enable them to cover higher marginal costs of producing larger quantities and, thus, to be willing to supply larger quantities.

It is possible that marginal cost decreases initially up to a point due to economy of scale, but it increases later with production. For some products such as aircrafts, shipbuilding, etc., the economy of scale may be applicable even for production of large quantities, reducing MC of production progressively with increasing production. We, however, would take the most general case of increasing MC; therefore, supply curve is also a marginal cost curve.

8. Supply and quantity supplied

Supply refers to the whole supply schedule or the curve, whereas quantity supplied refers to a particular point on the curve. Price of a commodity changes its quantity supplied, but all other factors change supply (the whole curve).

9. Factors affecting supply

Cost of production has a negative relationship with supply. An increase in cost of production reduces supply. Show graphically.

Technology of production has a positive relationship with supply. An improvement in technology increases supply. Show graphically.

Supply shock (natural disasters, weather phenomenon, war, etc.). A bad weather reduces supply of agricultural crops, but a good weather increases supply.

10. Market supply curve

Market supply curve is the horizontal summation of supply curves of individual firms (as in case of market demand).

11. Producer Surplus

The area below the supply curve is total cost of production. Suppliers receive a fixed price for their product, irrespective of the quantity sold. Suppliers' sales revenue is price times the quantity sold. The difference between sales revenue and total cost of production is producer surplus. Show graphically.

Profit is generally less than producer surplus. Producer surplus does not account for fixed costs (those costs that are independent of quantity supplied), whereas profit accounts for fixed costs.

12. Market and Transaction Costs

Market brings together buyers and sellers. Whether a transaction takes place depends on buyers' willingness to pay (the demand curve), suppliers' opportunity cost of producing (the supply curve), and transaction costs.

Transaction costs are the costs of arranging contracts or transaction agreements between demanders and suppliers. Middlemen and retailers reduce transaction costs and, thus, serve the market. If there were no grocery stores, imagine how difficult it would be for each buyer to identify farmers willing to sell grocery. Transaction costs use up real resources which may have alternative uses.

A well functioning market provides necessary information to both buyers and sellers to facilitate transactions. When complete information is not available, transaction cost goes up. Consider sales of used books. When students sell their used books to book stores, students get only about 25% of the original price of the book. On the other hand, when students buy used books from book stores, students pay about 75% of the original price. Difficulty of identifying students willing to sell and students willing to buy used books raises transaction costs of bringing buyers and sellers together. Book stores take advantage of this difficulty or high transaction cost to raise prices of used books they sell and to depress prices of used books they buy. If transaction costs could be lowered, both buying students and selling students could directly trade among themselves to their mutual benefit. This alternative market mechanism could introduce competition to book stores.

The use of money for transaction lowers transaction costs. In olden days when barter of goods was a norm, double coincidence of wants was necessary for a transaction to take place. If I wanted to buy corn by bartering my lecture in economics, the transaction could take place only when my want of corn was matched with the want of a corn seller who wanted a lecture in economics. Use of money as a medium of exchange abolishes the need of double coincidence of wants. Unless specified otherwise, we will assume negligible transaction costs.

13. Market Equilibrium price and quantity

Quantity traded of a commodity and its price in the market are determined by the interaction of market demand and supply curves. Draw a demand curve and a supply curve in a graph. The equilibrium is the market price at which quantity demanded is equal to quantity supplied, i.e., the intersection of the demand and supply curves.

At any price lower than the equilibrium price, quantity demanded would exceed quantity supplied, creating a shortage of the good in the market. Show graphically. The shortage drives prices up to the equilibrium level. Similarly, at any price higher than the equilibrium price, quantity supplied would exceed quantity demanded, generating a surplus of the good. Show graphically. The surplus drives down prices to the equilibrium level.

14. Competitive Market and Efficient Allocation

With no government intervention, a competitive market achieves efficiency, i.e., maximizes social net benefits. Efficiency is the maximization of net benefits to the society.

Demand curve is a MB curve and supply curve is a MC curve. Use a graph to explain that market produces and consumes all those quantities for which MB > MC. It does not produce or consume quantities where MB < MC. By producing the equilibrium quantity, market captures all positive net benefits that can be made from transaction of goods. Therefore, the market equilibrium is efficient. Note that efficiency is achieved when production is done to a level where MB is equal to MC, and that is what happens at market equilibrium.

15. Consumer and Producer Surplus

Note that the big triangle bounded by demand and supply curves to the left of the equilibrium (show in a graph) is total surplus. It is the sum of the consumer surplus and the producer surplus. Total surplus is the measure of welfare of the society, a part, consumer surplus, goes to consumers and another part, producer surplus, goes to producers.

The above analysis assumed a competitive market. A market is called competitive when (a) there are many sellers and buyers in the market, (b) goods produced by all firms are homogeneous, and (c) every buyer and seller has perfect information about the goods. In a competitive market, a single seller or buyer or a group of sellers or buyers cannot control market prices. In other words, we are assuming a perfectly competitive market in which each buyer and seller is a price taker.

16. Price as a rationing criteria

Goods are essentially scarce. A good is scarce whenever people cannot obtain as much of it as they would like without being required to sacrifice something else of value. In a society where everyone is terrified of snakes, snakes may be rare but they cannot be scarce. In another society, where snakes are valued as food, they could be quite common but nonetheless scarce.

If a good is scarce, there would be competition among its potential users. The good must be rationed among competing demanders; market generally uses price as the rationing criterion. Market allocates goods to those demanders only who are able and willing to pay the price. Those who do not afford or are unwilling to pay are priced out of the market. Therefore, it is very likely that poor get less than rich in a market allocation.

Goods are not necessarily always rationed by price. An example is the allocation of grades in this course. Perhaps only 10 to 20% of students would get As. Students must compete among themselves for As. It is not the money price but the performance in the exams that rations grades in the class. When price is not a rationing criteria, demanders pay nonmonetary costs. Students spend time on studies and on preparation for exams.

Another example is the criterion for electing president. Every four years a couple of candidates declare their candidacy, but only one person is elected as the president. Candidates compete with each other for the post; the rationing criterion is the number of votes candidates receive. Candidates have to spend time campaigning and persuading constituents to vote for them.

When price is a rationing criteria, price paid by consumers is a revenue of sellers. But when price is not a criteria, demanders incur nonmonetary costs which are not a revenue of the sellers. These costs are perhaps simple waste of resources.

Let us consider an example of granting of visas by US Embassies. If the US government so desires, the U.S. embassies can auction visas to grant to highest bidders. This is a procedure of using price to ration visas. The procedure would increase revenue of the government. It would enable only those individuals to enter the United States who are sufficiently skilled to at least cover the cost of obtaining visa. The price, or the bid value, in such an auction would approach the equilibrium point where demand for visa and supply of visa intersect. However, note that the U.S. government does not use this procedure for granting visas. Instead, there is a nonrefundable fee of $45 per visa applicant. At that level of fee, there is a shortage of visa (show graphically). Number of demanders of visa exceed the number of visas to be granted. Demanders line up in a queue in front of embassies. Often the lines are long. Unlike fee, time costs expended by demanders is not a revenue to the US government. Loss of demanders' time is a deadweight loss, it benefits no one.

17. Government interventions in market

Despite the fact that market allocation, in the absence of government intervention, is efficient, governments intervene in market. One reason is inequity of market allocations. Market allocates goods to those buyers who are able and willing to pay the price. This raises the possibility that market allocation is "unfair" to poor people. Market considers $100 of net benefits to one person equivalent to $1 of net benefits to each of 100 persons. Although a $1 bill may be more valuable to a poor than to a rich, market does not discriminate between a $1 bill coming from a poor and a $1 bill coming from a rich. Efficiency does not guarantee equity. This is often a reason of government intervention.

18. Price Ceiling - Rent Control

Consider an example of rent control. In some cities, like New York and Santa Monica, there are price ceilings on monthly rents that can be charged for an apartment. Price ceiling is a legally mandated maximum price at which a commodity can be sold. Such a ceiling is legislated only when law makers feel that market price, or rent, is too high and unfair to poor people. Price ceiling is set lower than the equilibrium market price. What would happen in the apartment rental market under a price ceiling regime?

At the price ceiling, the number of apartments demanded would exceed the number of apartments supplied. There would be a shortage of rental apartments (graph). The housing gap in New York is estimated to be around 200,000 rental units.

Because rent does not ration scarce apartments, demanders have to incur nonmonetary costs of finding landlords who are willing to rent them apartments. Nonmonetary costs may include potential discrimination demanders suffer at the hands of some landlords on the basis of income status, ethnicity, or something else.

Sometime, demanders may have to pay other monetary costs over and above monthly rent. It is said that prospective renters in Santa Monica have to offer "key money", $5,000 or more up front, to landlords to lease rental apartments. The practice of key money is illegal.

Low rents discourage landlords from maintaining existing apartments and developers from developing new rental units. More than 150,000 housing units are dilapidated or abandoned by landlords in New York.

Those who are able to find an apartment may have to rent almost anything available. A large family may be cramped into a small housing unit, and a small family may be living in a large unit unnecessarily. Government intervention leads to wastage of resources, a loss of social welfare (graph).

19. Price Floor - Minimum Wage

Now let us consider an example of minimum wage. Minimum wage is another kind of legally mandated price; it is a price floor, i.e., the minimum price below which a commodity cannot be traded. Employers cannot buy labor services below the legally mandated minimum wage. Federal minimum wage started from 1938. The recent revision in 1996 increased the minimum wage in two stages, from $4.25 to $5.15 an hour. Only when the equilibrium market wage is below the minimum wage, the minimum wage becomes effective. It causes number of labors supplied by households to exceed number of labors demanded by firms, generating unemployment, especially when the economy is not growing sufficiently (graph).

A study claims that even in boom, minimum wage destroys jobs. Summarize the Wall Street Journal piece of August 20, 1997. Despite the minimum wage revision in 1996, the national unemployment rate remained stable at 5.3% in the quarters just before and after the revision. This is contrary to the assertion of the theory that minimum wage generates unemployment. The Journal piece, however, forwards two reasons to explain this contradiction. One, the revised minimum wage was irrelevant in many metropolitan areas because market wages were already higher than the minimum wage. Two, the national unemployment rate is not an appropriate measure of the impact of minimum wage. The impact should actually be measured among entry level/low level jobs, especially the first jobs of teenagers, minorities, and single mothers who are trying to get off welfare. According to the piece, during the quarters just before and after the revision, unemployment rates among teenagers rose from 16.6% to 17.0%, among blacks from 10.5% to 10.9%, and among women heading families from 8.5% to 9.1%. Unemployment among these groups increased despite of the growing economy.

Minimum wage pushes many workers to sectors where minimum wage does not apply or is not enforced (jobs such as picking fruit, cleaning homes, and sewing in illegal sweatshops). Many job seekers are priced out of the market, generating welfare loss (graph). To ration scarce jobs, employers use non-wage criteria to screen job applicants. This can give rise to different forms of discrimination in job market. Also note that those employed benefit (a higher wage) at the expense of those unemployed.

Draw a graph of labor market with minimum wage and show welfare loss arising from a price floor. This and the previous example show that government intervention results into loss of efficiency. Minimum wage creates unemployment, and it is the poor people who are generally unskilled and most likely to be unemployed. It is also the poor people who are unlikely to come up with "key money" to lease apartments when there is rent control. They are the ones who are likely to face discrimination by landlords. Therefore, one may wonder whether interventions really protect poor from "unfair" allocation of market.

20. Tradeoff between Efficiency and Equity

These examples show that there is a tradeoff between equity and efficiency. Efficiency ensures the biggest possible national pie, but the pursuit of equity through intervention in the market generally reduces the size of the pie (because of welfare losses). Therefore, it would probably be better to let market produce the biggest pie and only then the government should engage in "equitable" distribution of the pie through income transfer programs such as food stamps and housing vouchers.

21. Comparative Statics (Impacts of different factors on market)

Change in consumer income

Normal goods. Increase in income shifts demand to right, increasing both price and quantity traded (graph).

Inferior goods. The reverse.

Change in consumer preference

A favorable change in preference increases demand, increasing price and quantity traded (graph). Reverse would be the case with an unfavorable change in preference.

Change in prices of substitutes

Increase in price of substitutes increases demand, increasing price and quantity traded (graph).

Change in prices of complements

Increase in price of complements decreases demand, decreasing price and quantity traded (graph).

Change in resource prices, or cost of production

Increase in labor wage decreases supply, increasing price but decreasing quantity traded (graph).

Improvement in technology of production

Improvement in technology increases supply, decreasing price and increasing quantity traded (graph).

A supply shock

A bad weather reduces supply, increasing price and reducing quantity traded (graph).

IV. MARKET FAILURE CASES AND POSSIBLE GOVERNMENT FAILURES

(Chapters 5 and 6)

1. Reasons of Market Failure

Earlier we talked about government interventions in the market for the sake of equity, despite the fact that market allocation was efficient. But, there are instances when market allocation is not efficient, and governments intervene for achieving efficiency.

2. Market Failure Cases

Imperfect competition

In a perfectly competitive market each seller and buyer is a price taker. Only collectively, buyers and sellers determine price and quantity traded. But when there is only one seller (a monopolist) or when there are only few sellers (oligopoly) who overtly or covertly collude to collectively act as a monopolist, sellers are not price takers. They can restrict supply and raise prices (graph). This lack of competition (although good for sellers individually) can result into overall welfare loss to the society.

Lack of competition provides a rational for the government to intervene and correct market failure to achieve efficiency. Intervention can take various forms such as direct control on pricing decisions and/or regulations and antitrust laws against monopolistic practices.

Externalities

Markets can also fail to achieve efficiency when benefits of a commodity spill over to persons other than the buyers or when costs spill over to persons other than the producers of the commodity. Spillover benefits are called positive or beneficial externality. Planting of flowers by homeowners in their frontyard is an example of positive externality, because neighbors too enjoy the beauty of flowers but they do not pay for the enjoyment. Spillover costs are called negative externality. Pollution generated by producers is an example of negative externality. Pollution causes health damages to persons other than the producers.

Market demand curve represents marginal benefits of a commodity to its buyers, it does not include spillover benefits to non-buyers. The actual social MB, therefore, is higher when spillover benefits are included (graph). Market ignores external benefits and produces a quantity lower than the efficient level (graph). The government can correct this market failure by subsidizing production of goods that yield external benefits. This is one rational for taxpayers' subsidy to public education, as a better educated society is expected to have fewer crimes, better debates of social issues, and smarter design and implementation of social policies.

Market supply curve represents marginal costs of producing goods that are borne by the producers. Any cost spilled over to others is not included in the supply curve. For example, the supply curve of paper industry does not reflect the cost the industry imposes on the society by discharging effluents to the environment. Costs of pollution to others do not show up in the books of account of paper manufacturers. Therefore, the true marginal cost of production to the society would be higher when external costs are included, (graph). Because the industry ignores external costs, market allocation is higher than the efficient level. Government can intervene in the market in the form of taxes on production (that are equal to the marginal cost of pollution) to lead market allocation towards efficiency.

Public goods

Public goods are those goods which once provided to one person are available to others also, irrespective of whether other persons pay for the goods or not. Example: air quality, national defense, light house, radio signals, etc. In other words, public goods generate external benefits to persons other than those who pay for them.

Two characteristics distinguish public goods from other goods ('private' goods). A burger I eat would not be available to another person. The seller can deny to give a burger to any one who does not pay (it won't be sold to the person). Burger is a private good. In contrast, any one can tune to a radio broadcast, once it is made available to one person. No one can be excluded from tuning in to the broadcast, whether they pay for it or not. Many of you may be watching Channel 6 in television. But how many of you have ever helped the channel with monetary contribution? Channel 6 keeps soliciting contributions. Very few people contribute, and those who do not contribute cannot be excluded from watching Channel 6's programs. Public goods are nonexcludable. Public goods are also nonrivalrous in consumption. My watching of Channel 6 in no way alters quality or enjoyment others derive from watching the channel. This is unlike the burger example above, my consumption of a burger makes that burger unavailable to you for consumption. Because of nonexcludability and nonrivalrous characteristics of public goods, consumers tend to free ride on consumption of public goods.

Market demand curve reflects only the marginal benefits to those who pay for consumption, it does not reflect benefits to free riders. The true marginal benefits to society is, therefore, higher when you also include free riders (graph). Since market understates benefits, market produces a quantity of public goods that is lower than the efficient level (graph).

Towards restoring efficiency, government can intervene in the market providing subsidies to private producers of public goods, to encourage them to produce more to the efficient level. Subsidy reflects the revenue lost by producers from free riders. Subsidy is an option only when there is a private producer willing to supply public goods. Generally private businesses are not willing to supply public goods. This is understandable because businesses cannot prevent consumers from consuming public goods even when they do not pay. This is the reason public goods are generally publicly provided, and government raises taxes to meet the costs of providing public goods. Note the difference between public goods (goods that possess the characteristics of nonexcludability and nonrivalrous) and publicly-provided goods (goods that are supplied by government irrespective of whether they are private goods or public goods).

Economic instability

An important function of government is to maintain economic stability. Instability creates uncertainty about future events, and producers and consumers base their decisions on poor information. They may resort to speculative and myopic behaviors. Lack of information may prevent people from making efficient decisions. In this course, we will talk a lot about economic fluctuations and their impact on economy.

3. Public Choice Theory and Government Failures

We saw that market fails in certain cases to achieve efficiency, and government can restore efficiency through appropriate interventions. This assertion, however, implicitly assumes that agents in the government - legislators, politicians, bureaucrats, and voters who are players in public policy decision process - pursue public interest, instead of private interest, in formulating public policies. This assumption contravenes the basic premise of economics that individuals are self interested, they weigh benefits and costs of an action to them before undertaking an action (remember, rational decision making). We know that politicians generally pursue their self interest of winning the next election, more than they pursue public interest. That is why, they often succumb to influences of lobbyists who contribute to their political campaign, while formulating public policies. Bureaucrats too pursue self interest. They seek largest possible budget for their department because that determines their perk, prestige, and power. Public choice theory challenges the assumption that agents in government pursue public interest. James Buchanan, the winner Nobel Prize in Economics in 1986, is the pioneer of public choice theory. This theory allows the possibility that agents in government may pursue private interests.

4. Comparison of some characteristics of decision making in private and public sectors

Competition generally exists in both sectors. Firms compete for market share in private sector, politicians compete for elected positions, and bureaucrats compete for budget.

In private sector, consumers bear the full cost of goods they consume. In public sector, consumption-payment link is generally weak. Food stamps allow some families to consume more food than they pay for, instead taxpayers pay for them. Senior citizens receive medicare by simply making a small copayment, taxpayers fund medicare services.

Above examples of food stamps and medicare show that provision of goods by government is collectively paid for by taxpayers. In the private sector, individual firms must pay individually the entire cost of supplying goods.

All payments in private sector are voluntary. People voluntarily pay for goods they buy. There is no compulsion to buy. Government can use legal sanctions to force some payments, like income taxes, property taxes, etc.

Choices are pretty limited in public sector. For example, there were only two candidates for president in 1996 presidential election - Dole and Clinton. Your choice was limited to one of them. Compare that to number of choices generally available in a private market place. Just look at the numerous types of potato chips in a grocery store. When choices are limited, you may not be fully satisfied with your choice. Dole offered a certain package of public policies, whereas Clinton offered another package. It is possible that you find yourself in agreement with some policies in a package but not necessarily with all policies in the package. That may be true of both packages offered by Dole and Clinton. You are then forced to choose from two imperfect packages of policies. Imagine if you could choose separately for each policy.

Those with higher income generally hold greater power in a market place because only dollar vote counts in the market. In the public sector, those who can deliver more votes have greater power. Although each citizen has one vote, rational voter ignorance (see below) and the relative difficulty of organizing voter interest groups lend special interest groups such as Christian Coalition and Labor Union greater power in the political process.

5. Conflicts between good economics and good politics

A few characteristics of political process should convince you that there may arise conflicts between good economics and good politics.

Rational voter ignorance

It is a rational choice of voters to generally remain ignorant or uninformed prior to voting on a referendum or for a candidate. Consider yourself. If you really want to make an informed choice, you need to gather necessary information which may cost substantial time and money. In contrast, look at the benefit to you from your informed voting. For you to gain, your preferred candidate or policy has to win. This may happen even without your vote. The possibility that your single vote turns out to be the decisive vote on the referendum or election is almost negligible. When you find that the expected costs of making informed choice in voting exceed the expected benefits, it would be a rational decision on your part to remain uninformed or least informed on issues and candidates.

Special interest issue

Special interest issues tend to get more weight or precedence in public policy process. A special interest issue is an issue that delivers potentially large benefits to a very small group of people but spreads costs over a large population. For example, financing of Bronco stadium from sales tax is a special interest issue. The beneficiary is the Bronco franchise, but costs are borne by six county residents in and around Denver. Most of the six-county residents are likely to remain rationally ignorant on this issue, more so because the incidence of sales tax per resident would be small (although collectively it is a large amount of money). This reduces the possibility of a backlash from voters in the next election against politicians taking stands for or against the financing proposal of the stadium. On the other hand, politicians are likely to benefit if they support Bronco on this issue because the franchise may contribute to their campaign finance. You will find Bronco franchise and others who could gain from the construction of a stadium spending money on campaigning on media, to influence voters. On the other hand, those who have least to gain from the stadium and do not like the financing proposal would have hard time to raise resources to campaign against the proposal.

Short-sightedness effect

Both politicians and voters tend to be short sighted. Policies that make economic sense but generate benefits only in the long run may seem less attractive to politicians than those policies that generate immediate benefits before the next election cycle, although the latter policy may not make economic sense in the long run. If politicians can show immediate gains, it improves their electability in the next election. Voters also tend to concentrate more on short term events.

Rent seeking

The possibility that politicians can be influenced through lobbying and campaign contributions encourages rent seeking. Special interest groups spend (or waste) resources (that have other productive uses) on influencing politicians to obtain public policies that are more favorable to them or to their cause. Golf club membership fees paid by private companies for members of Congress and travels of members of Congress on private companies' expenses are examples of wastage of resources on rent seeking.

6. Possibility of government failure

The above issues or characteristics of the political process should raise doubt that whether government intervention can indeed restore efficiency. Government intervention is not necessarily the perfect answer to market failure cases.

A hands-off approach of the government may actually be helpful in certain cases, at least in the long run for the market to achieve efficiency. Consider a monopoly or oligopoly that makes a lot of money by artificially restricting supply. More than normal profit in this industry then entices other investors to offer competition. Extra profit may even encourage firms to spend resources on developing new technologies to compete with existing firm or firms in the industry. The market power of monopoly can gradually erode in the long run with newer technologies and firms entering the industry. Compare this to the case when government regulates prices in a monopolistic market. The regulation lowers prices, thus lowers profitability and incentive to other firms to spend resources on research and development of new technologies. This can help perpetuate monopoly for a long time. This is one reason monopolies often tend to favor regulation. They can influence government authorities in pricing regulations such that prices are sufficiently high for them to make money but not high enough to invite new firms in the industry.

This discussion, at the least, should convince you that if market can fail, it is possible that government too can fail in achieving efficiency.