Capitalism and Firm Behavior: An Economic Analysis, Appunti di Economia Politica

Scarica Capitalism and Firm Behavior: An Economic Analysis e più Appunti in PDF di Economia Politica solo su Docsity! POLITICAL ECONOMY LECTURE 1 ECONOMICS - the study of how people interact with each other and with their natural surroundings in producing their livelihoods, and how this changes over time. CAPITALISM – A new economic system in which private property, markets and firms play a major role. Under this new way of organizing the economy, advances in technology and specialization in products and tasks raised the amount that could be produced in a day’s work. This process, which is called the CAPITALIST REVOLUTION has been accompanied by growing threats of natural environment and by unprecedented economic inequalities. CAPITALISM is an economic system in which the main institutions (the laws and social customs governing the production and distribution of goods and services) are: private property, markets and firms. PRIVATE PROPERTY – ownership rights over possessions (self-sufficient, family-based production). An important type of private property is CAPITAL GOODS (the non-labor inputs used in production). Private property does not include some essentials, e.g. air, knowledge. MARKETS – a way for people to exchange products and services for their mutual benefits. Unlike other types of exchange, markets are: - Reciprocated (wzajemne) transfers - Voluntary - Usually there is competition FIRMS – business organization that uses inputs to produce outputs and sets prices to at least cover production costs. - Inputs and outputs are private property - Firms use markets to sell products - The aim is usually to make profit Capitalism led to growth of living standards because of: • IMPACT ON TECHNOLOGY: firms competing in markets had strong incentives to adopt and develop new technologies • SPECIALISATION: the growth of firms and the expansion of markets linking the entire world allowed historically unprecedented specialization in tasks and production. Together with the technological revolution, this increased worker productivity. SPECIALISATION – increases productivity of labor because we become better in producing things when we each focus on limited range of activities (learning by doing, taking advantage of natural differences in skill and talent, economies of scale). People can only specialize if they have a way to acquire (nabyć, pozyskać) the other goods they need. In capitalist society, this is done via markets. COMPARATIVE ADVANTAGE – all producers can benefit by specializing and trading goods, even when this means that one producer specializes in a good that another could produce at lower cost. Markets contribute (przczyniają się) to increasing the productivity of labor by allowing people to specialize. Not all capitalist economies are equally successful: - Economic conditions (firms, private properties or markets may fail) - Political conditions (capitalist institutions are regulated by the government) - The government also provides essential goods and services (infrastructure, education) Failure of the institutions of capitalism (private property, markets and firms) can explain divergence (rozbieżność) in economic growth across countries. POLITICAL SYSTEMS Capitalism coexists with many political systems. A political system determines how governments will be selected and how those governments will make and implement decisions. In most countries today, capitalism coexists with democracy (individual rights of citizens - freedom of speech; fair elections). But capitalism has co-existed with non-democratic systems too. ECONOMIC INEQUALITY – measures the disparity (rozbieżność) between a percentage of population and the percentage of resources (such as income) received by that population. Inequality increases as disparity increases. REASONS FOR ECONOMIC INEQUALITY: - Physical attributes (distribution of natural ability is not equal) - Personal preferences (relative valuation of leisure and work effort differs) - Social process (pressure to work or not to work varies across particular fields or disciplines or environments) - Public policy (tax, labor, education and other policies) Income inequality across regions has increased a lot over time. GDP PER CAPITA (Gross Domestic Product) – a measure of total income and output of the economy in a given period. Usually expressed in per-capita terms (as an average income). It is used to compare living standards in each country. GDP is a total value of everything produced in a given period of time. INDUSTRIAL REVOLUTION The industrial revolution happened first in 18th century, on an island of coast Europe (England and Scotland). Explanations why did it happen there:  Relatively high cost of labor & cheap local sources of energy  Europe’s scientific revolution and Enlightenment  Political and cultural characteristics of nations as a whole  Cultural attributes such as hard work and savings  Abundance of coal and access to colonies FIRM’S CHOICE Firms choose between technologies (specific combination of inputs) to produce outputs. Some technologies are dominated by other technologies. Firm’s choice: MNIMIZING COST Firms aim to maximize their profit, which means producing at the least possible cost. This is why firm’s choice of technology depends on economic information about relative prices of inputs. ISOCOST LINES – combination of inputs that give the same cost. The firm will always choose the least-cost technology. BENEFITS FROM INNOVATION Because relative prices of inputs changed, a firm that will switch to the new cost-minimizing technology will have an advantage over its competitors. INNOVATION RENT – the change in profit is equal to the fall in costs associated with adopting the new technology. CREATIVE DESTRUCTION – the process by which old technologies and the firms that do not adapt are swept away by new, because they cannot compete in the market. ENTREPRENEURIAL FIRM – a firm that is willing to try out new technologies and to start a new business. The first adopters will enjoy Schumpeterian (innovation) rents. TECHNOLOGICAL CHANGE IN INDUSTRIAL REVOLUTION One of the first sectors to undergo technological change was textiles. Before the Industrial Revolution, making clothes for the household were time-consuming tasks. By the late 19th century, a single spinning mule operated by a very small number of people could replace more 1000 spinsters. These machines were powered by water wheels and later by coal-powered steam engines instead of using human labor. Why was Britain first?  English wages were higher than the wages elsewhere, and coal was cheaper in Britain than in any other country. The combination of capacity to innovate and changing relative prices of inputs led to a switch to energy-intensive technology. EXPLAINING STAGNATION Explaining economy before the industrial revolution (before 18th century). PRODUCTION FUNCTION – gives maximum output for a given set of inputs. LAW OF DIMINISHING (malejący) AVERAGE PRODUCT OF LABOUR If we hold one input fixed (land) and expand the other input (labor), the average output per worker is going to fall. MALTHUS’ MODEL Key ideas: 1. Population expands if living standards increase. 2. But the law of diminishing average product of labor implies that as more people work on the land, their income will fall. Population and income will stay constant. Malthus’ model predicts a self-correcting response to a new technology. An increase in productivity will result in increased population, but not in the increased wages. CONDITIONS REQUIRED TO STAY IN THE MALTHUSIAN TRAP: 1. Diminishing average product of labor. 2. Rising population in response to increases in wages. 3. An absence of improvements in technology to offset (zrównoważyć) the diminishing average product of labor. The permanent technological revolution meant that third condition no longer holds, and explains why Britain was able to escape the Malthusian trap. MALTHUSIAN MODEL OF POPULATION 1. Population will expand (zwiększy się) if food output per person increases and contracts (kurczy się) if it decreases. - Better nutrition means lower death rate. - Better nutrition means earlier marriage and higher birth rate. - NOTA BENE: when food per person is below the subsistence (utrzymywanie przy życiu), the fall will be rapid. 2. Diminishing average product of labor implies that if the population increases, food output per person will fall. THE GREAT IRISH FAMINE OF 1845-1850 (also known as: THE GREAT IRISH HUNGER) Poorest population depended on potato almost exclusively. Potato blight arrives in 1845 and destroys much of the potato harvest through 1848. Famine caused 1 million deaths (one eighth of the Irish population). In terms of the Malthusian model, the potato blight caused a reduction in the average product of labor. During the famine, working in potato fields yields many fewer potatoes per person than before. The Malthusian Model predicts a decline in Irish population through starvation due to the potato blight. The Great Famine and Irish Emigration By 1850 there had been about one million deaths and one million emigrants due to the famine, reducing the population of Ireland from 8 million to 6 million. The potato blight did not permanently damage Irish agriculture, but the large-scale outmigration sparked continued emigration throughout the 19th century. MALTHUS’ MODEL: permanent technological change enabled economies to escape the economic stagnation. LECTURE 7 GAME THEORY – it is a theoretical framework for coneiving social situations among competing players. In some respects, game theory is the science of strategy or at least the optimal decision- making of independent and competing actors in a strategic setting. Tools of game theory can be used to model social interactions and explain social dilemmas. SOCIAL DILEMMA – a situation in which actions taken independently by self-interested individuals result in a socially suboptimal outcome (e.g. traffic jam, climate change). Social dilemmas occur when people do not fully account for the effects of their actions on others. Social dilemmas can be resolved by social preferences, peer punishment or binding agreements. - TRAGEDY OF THE COMMONS – common property or common resources are often overexploited - FREE RIDING – one person/party bears all the costs while everyone enjoys the benefits GAME THEORY: KEY CONCEPTS SOCIAL AND STRATEGIC INTERACTIONS: - SOCIAL INTERACTION – a situation involving more than one person/party, where one’s actions affect both their own and other people’s outcomes - STRATEGIC INTERACTION – a social interactions where people are aware of the ways that their actions affect the others - STRATEGY – actions that people can take when engaging in a social interaction GAME – a game describes a social interaction: - PLAYERS – who are involved in the interaction - FEASIBLE STRATEGIES – actions each player can take - INFORMATION – what each player knows when choosing their action - PAYOFFS – outcomes for every possible combination of actions OPTIMAL DECISION-MAKING - BEST RESPONSE – a strategy that yields the highest payoff, given the other’s player’s strategy. - DOMINANT STRATEGY – the best response to all possible strategies of the other player (does not always exist!) - DOMINANT STRATEGY EQUILIBIRUM – an outcome of a game in which everyone plays their dominant strategy NASH EQUILIBRIUM – a set of strategies (one per player), such that each player’s strategy is the best response to the strategies chosen by everyone else. In Nash equilibrium, no player has an incentive (motywacja, inicjatywa) to deviate (odbiec, zboczyć) unilaterally (jednostronnie). Note: there may be more than one nash equilibrium in a game. When there is more than one Nash equilibrium and individuals choose independently, the socially optimal outcome may not be selected. A multiple Nash equilibrium can cause coordination problems (the socially optimal outcome may not be selected). Economic and political institutions can help achieve socially optimal outcomes. THE PRISONERS’ DILEMMA – a play with a dominant strategy equilibrium, in which playing the dominant strategy yields (przynosi) lower individual and total payoffs compared to other strategies. WHY DID WE PREDICT THIS OUTCOME? - Players only care about their own payoffs - Nobody could make players pay for the consequences of their actions on others - Players could not coordinate their actions beforehand LEARNING ABOUT PREFERENCES Economists sometimes use experiments to learn about preferences. LAB EXPERIMANETS: - Can control participants’ decisions and their outcomes - Can create a control/treatment group for comparison - Results can be replicated - Can control for other variables FIELD EXPERIMENTS: - Lab experiments may not predict the real-world decision making - More realistic concept in which people make decisions SOCIAL PREFERNCES: - ALTRUISM (a behavior consisting benefiting the others) – Social dilemmas arise only when players care about only their own payoffs. However, in experiments, many players how altruism by choosing the dominated strategy. Altruistic preferences affect the shape of the indifference curves. - INEQUALITY AVERSION – disliking the outcome in which some individuals receive more than the others. - RECIPROCITY – being kind/helpful to others who are kind/helpful, and vice versa (we evaluate whether others have been “kind” or “helpful” according to social norms (common understanding of how to act in situations when one’s actions affect others). These motives affect outcomes in the PUBLIC GOODS GAME (a standard of experimental economics) and the ULTIMATUM GAME (a game that has become a popular instrument of economic instruments). THE ULTIMATUM GAME – a sequential game (sekwencyjny, następujący po kolei) where players choose how to divide up economic rents (e.g. cash prize). The proposer’s offer may be motivated by altruism, fairness (50/50 split), inequality aversion, social norms or reciprocity (wzajemność). REPEATED GAMES – Better outcomes can arise in repeated interactions due to social norms, reciprocity (wzajemność) and peer punishment (unrestricted punishment; everyone can punish everyone else). Behaving selfishly in one period has consequences in future periods, so it may no longer be a dominant strategy. LECTURE 9 INSTITUTIONS (the rules of the game) matter for social outcomes. They can affect the income that people receive for their work. ALLOCATION – outcome of an economic interaction (describes who DOES what and who GETS what). An allocation is PARETO EFFICENT if nobody can be better off (zamożniejszy) without making somebody worse off (biedniejszy). PARETO EFFICENCY is unrelated to fairness. Many allocations that could be unfair are pareto efficient (e.g. giving to your friend a 1 cent of 100$ you found on the street). THE PARETO EFFICENCY CURVE – a set of all pareto efficient allocations (also called: the contract curve). It joins together all points in the feasible set where MRS = MRT. The joint surplus (mutual gain) is the same, but distribution of the surplus differs at each point of the curve. ALLOCATIONS may be considered UNFAIR for two reasons: - SUBSTANTIVE JUDGEMENT OF FAIRNESS – inequality of final outcome (e.g. wealth, well- being). - PROCEDURAL JUDGEMENT OF FAIRNESS – how they come about (e.g. force vs. fair play, equal opportunity, confirming to social norms). Economics does not provide judgements about what is fair. But, economics can clarify: - How institutions (rules of the game) affect inequality. - Tradeoffs (wymiana) in the fairness of outcomes (e.g. giving up the equality of income equality of opportunity). - Which public policies can address unfairness, and how. COMBINED FEASIBLE SET – shows all possible allocations of production between two parties. The chosen allocation depends on institutions and policies. THE FEASIBLE FRONTIER (granica) shows all the TECHNICALLY FEASIBLE outcomes (limited by technology). THE BIOLOGICAL SURVIVAL CONSTRAINT shows all the BIOLOGICLY feasible outcomes (limited by survival). Feasible allocations are given by the intersection (skrzyżowanie, przecięcie) of these constraints (ograniczenia, wymogi). COERCION - Imposing (narzucanie) allocation by force. RELATIONSHIPS WITHIN THE FIRM Unlike in markets, relationships within a firm may extend over a long period of time. - Creation of network of colleagues - Acquisition of skills necessary for the job These skills, networks and friendships are FIRM-SPECIFIC ASSETS. They are valuable only while worker remains employed in a particular firm. When the relationship ends, value is lost to both sides. MANAGERS ARE NOT OWNERS! SEPARATION OF OWNERSHIP AND CONTROL – when managers decide on the use of other people’s funds. ASYMETRIC INFORMATION - Owners and managers do not always know what their subordinates know or do, not all of their directions or commands are necessarily carried out. OWNERS AND MANAGERS: CONFLICT OF INTERETS The firm’s profits legally belong to the people who own the firm’s assets. - Manager’s actions have impact on profits. - But if profits increase thanks to manager’s work, they will not automatically benefit. This creates a CONFLICT OF INTEREST between managers and owners. ALIGNING INTERESTS To solve the conflict of interest between managers and owners: - Link the manager’s pay to the performance of the company’s share price. - Monitor the manager’s performance. INCOMPLETE CONTRACTS Hiring employees is different from buying other goods and services. The contract between a firm and its employees is INCOMPLETE: - Some tasks depend on future (unknown) events. - Some aspects of the job are difficult to measure and base wages on (e.g. effort). Incomplete contracts do not only occur in employment relationships. Incomplete contracts arise when: - Information is not verifiable - The relationship covers periods of time - There is uncertainty - There are difficulties with measurement - Judiciary is absent - Preferences for omitting some information PIECE RATE PAY PIECE RATE WORK – a type of employment in which the worker is paid a fixed amount for each product made. PIECE RATE PAY gives workers an incentive to exert effort (wyweirać presję). Nevertheless, they are rarely used in most today’s firms: - It is difficult to measure output in modern jobs. - Employees often work as a part of a team. WORKES’ EFFORT If firms can’t directly measure the effort, why do workers work hard? - Work ethic - Feelings and responsibility - To reciprocate a feeling (odwzajemnić uczucie) of gratitude for good working conditions - Benefits for measurable output - Promotions - Fear of being fired EMPLOYMENT RENT – cost of job loss, which includes: - Lost income while searching for a job - Costs required to start a new job (e.g. relocation) - Loss of non-wage benefits (e.g. medical insurance) - Social costs (stigma of being unemployed) Employees fear getting fired when they are paid more than their reservation option = they receive the EMPLOYMENT RENT. CALCULATING EMPLOYMENT RENTS RESERVATION WAGE = value of next best option (other employment or unemployment benefits). EMPLOYMENT RENT = wage – reservation wage – disutility of effort The employer cannot directly measure the worker’s effort. Large employment rent -> large cost of job loss -> worker puts in more effort to reduce the chance of getting fired One way to increase the cost of job loss is for the firm to raise wages. THE EMPLOYMENT GAME 1. The employer chooses wage. As long as the worker works hard enough, he will keep her job at the offered wage. 2. The worker chooses a level of work effort, taking into account the costs of losing her job if she does not provide enough effort. Payoffs: - Firm: profit = worker’s output – wage - Worker: employment rent WORKER’S BEST RESPONSE CURVE – shows the optima; amount of effort workers will exert for each wage offered. It represents the firm’s FEASIBLE FRONTIER for wages and effort. Slope of the best response curve = MRT. FIRM’S BEST RESPONSE – The combination of effort and wage that minimizes the cost per unit of effort. To maximize profits, firms want to minimize the costs of production. The best response function will shift in reaction to changes in: - The utility (użyteczność) of the things that the wage can buy - The disutility (bezużyteczność) of effort - The reservation wage - The probability of getting fired at each effort level ISOCOST LINE – the cost of effort is the same at all points. Slope of isocost curve = MRS = the rate at which the employer is willing to increase wages to get higher effort. EFFICENCY WAGE – wages set higher than the reservation wage so workers will care about losing the job and provide more effort. INVOLUNTARY UNEMPLOYMENT – being out of work, but preferring to have a job at the wages and working conditions that otherwise identical employers workers have. There must be involuntary unemployment in the labor discipline model. Because in equilibrium, both wages and involuntary unemployment have to be high enough to ensure employment rent is high enough for workers to put in effort. COOPERATIVE – a firm that is mostly or entirely owned by its workers, who hire and fire the managers. Because profits are paid out to workers, there is less need for supervision and monitoring. PRINCIPAL-AGENTS MODELS – capture (zdobywać) interactions under incomplete contracts (e.g. the firm is the principal and the worker is the agent). Agent takes action that is hidden from the principal, which is why the principal cannot verify it. HIDDEN ACTION PROBLEMS occur when: - There is a conflict of interest between the principal and the agent - Over some action that may be taken by the agent - And this action cannot be subjected to a complete contract The information about the action may be either asymmetric or unverifiable. ISPROFIT CURVE – show price-quantity combinations that give the same profit. Economic profit = total revenue (dochód) – total costs PROFIT MAXIMISATION - DEMAND CURVE = firm’s feasible frontier (slope = MRT) - ISPROFIT CURVES = firm’s indifference curves (slope = MRS) Firm maximizes profits by choosing point where MRS = MRT. MEASURING SURPLUS CONSUMER SURPUS (CS) – the total difference between willingness-to-pay and purchase price. PRODUCER SURPLUS (PS) – the total difference between revenue (dochód) and marginal cost (Profit= PS – fixed costs). TOTAL SURPLUS = consumer surplus + producer surplus = total gains from trade (shaded area). DEADWIGHT LOSS – a loss of total surplus relative to a Pareto efficient allocation (unexploited gains of trade). TOTAL SURPLUS is the highest when DEMAND = MARGINAL COST (Pareto efficient allocation). PRICE ELASTICITY OF DEMEAND – degree of responsiveness (of consumers) to a price change. MR (marginal revenue) is always positive when the price is elastic. A FIRM’S MARKUP (profit margin as a proportion of the price) is INVERSELY PROPORTIONAL (odwrotnieproporcjonalna) to price elasticity of demand. PRICE ELASTICITY AND POLICY - The effect of good-specific taxes depends on the elasticity of demand for those goods. - Governments raise more tax revenue by levying taxes on price inelastic goods. - Several countries (e.g. Denamrk and France) have introduced taxes on unhealthy foods – to reduce consumption not to raise revenue. PRICE ELASTICITY AND MARKET POWER A firm’s profit margin depends on the elasticity on the elasticity of demand, which is determined by competition: - Demand is relatively inelastic if there are a few close substitutes. - Firms with market power have enough bargaining power to set prices without losing consumers to competitors. PRICE-TAKING FIRMS PRICE TAKING FIRMS cannot benefit from choosing different price from the market price, and cannot influence the market price. - DEMAND CURVE (feasible set) is completely flat - Maximize profits when MC=P (slope of isoprofit = 0) - Firm’s supply curve = MC curve Firms choose quantity, not price! MARKET SUPPLY CURVE – the total amount produced by all firms at each price. If firms have identical cost functions, MARKET SUPPLY CURVE = MARKET MARGINAL COST CURVE. COMPETITIVE EQULIBRIUM - All buyers and sellers are price-takers. - At the prevailing (panujący, dominujący) market price, SUPPLY = DEMAND. COMPETITIVE EQUILIBRIUM: Characteristics All gains from trade are exploited in equilibrium (no deadweight loss). Equilibrium allocation is Pareto efficient, assuming: - Participants and price-takers - Contracts are complete - Transaction only affects buyers and sellers (no external effects) COMPETITIVE EQUILIBRIUM: CAVEATS (zastrzeżenia, upomnienia) - Allocation may not be pareto efficient if assumptions do not hold - Fairness: the distribution of total surplus depends on the elasticities of demand and supply (share of total surplus inversely related to elasticity) - Hard to find price-takers in real life CHANGES IN SUPPLY AND DEMAND The entire supply or demand curve can shift due to EXOGENOUS SHOCKS (e.g. technological change, popularity). Buyers and sellers adjust their behavior so that the market clears (e.g. improved baking technology; 1. Supply of bread increases at every price (supply curve shifts) 2. Excess supply at the going market price (move along the demand curve) 3. Price falls to a new equilibrium). MARKET ENTRY The supply curve can also shift due to market entry/exit. If existing firms are earning ECONOMIC RENTS and COSTS OF ENTRY are not too high, other firms may enter the market. TAXES Throughout history, governments have used taxes to raise revenue. Taxes on suppliers/consumers shift the supply/demand curve because the price is higher at each quantity. PERFECT COMPETITION A PERFECTLY COMPTETIVE MARKET has the following properties: - The good or service being exchange is homogeneous - Very large number of potential buyers and sellers - Buyers and sellers all act independently of one another - Price information easily available to buyers and sellers CHARACTERISTICS OF PERFECT COMPETITION: - LAW OF ONE PRICE: all transactions take place at single price - At that price, the market clears (supply = demand) - Buyers and sellers are all price-takers - All potential GAINS FROM TRADE are realized Perfect competition may not hold completely in reality, but can be a good approximation to actual firm behavior. PRICE SETTERS vs. PRICE TAKERS PRICE SETTERS (Monopoly) - MC < Price - Deadweight losses (Pareto inefficient) - Owners receive ECONOMIC RENTS in both long- and short-run - Firms advertise their unique product - Firms invest in R&D, seek to prevent copying PRICE-TAKERS (Perfect Competition) - MC = Price - No deadweight losses (can be Pareto efficient) - No economic rents in the long-run - Little advertising expenditure - Little incentive for innovation Summary 1. Model of price-taking firms - COMPETITIVE EQUILIBRIUM where demand = supply - Firms maximize profits where MC = Price - PERFECT COMPETITION is a special case - Comparison with price setting firms 2. Used model to show how equilibrium can change - EXOGENOUS SHOCKS of demand/supply or market entry - Effect of TAXATION on surplus Gini coefficient will rise with: - Unemployment rent - Real wage - Markup - Productivity LABOR UNION – an organization consisting predominantly of employees. Its main activities include the negotiation of rates of pay and conditions of employment for its members. WAGE BARGAINING THE BARGAINED WAGE can be above the wage-setting curve - The wage-setting curve is about the employer’s threat of firing a worker - The union can threaten to “dismiss” the employer by going on strike BARGAINING CURVE – indicates the wage that the union-employer bargaining process will produce for every level of employment. Its position above the wage-setting curve depends on the relative bargaining power of the union and the employer. LABOR UNIONS AND UNEMPLOYMENT In equilibrium, wage is unchanged, but employment and firm’s profits are lower. The model tells us that labor unions will increase unemployment rates. THE UNION VOICE EFFECT Providing employees with a VOICE in how decisions are made may induce them to provide more effort for the same wage. - The bargained wage curve shifts downward - The overall effect of labor unions on employment is ambiguous LABOR MARKET POLICIES 1. Shifts in the PRICE-SETTING curve: - Education and training: labor productivity (UP) - Wage subsidy: production costs and prices (DOWN) 2. Shifts in the WAGE-SETTING curve: - Lower unemployment benefit: reservation wage (DOWN) 3. Shifts in LABOR SUPPLY curve: - Immigration policies: labor supply (UP) - Childcare provision: female labor participation (UP) Summary: 1. Behavior of firms sets WAGES and EMPLOYMENT in the economy - THE WAGE-SETTING CURVE tracks combination of wages and unemployment feasible with workers’ effort. - THE PRICE-SETTING CURVE determines the real wage corresponding to profit-maximizing price. 2. There will always be INVOLUNTARY UNEMPLOYMENT - Incomplete contracts - DEFICIENT DEMAND 3. LABOR UNIONS bargain over wages with firms, which affects employment - VOICE to workers may improve their effort and productivity LECTURE 19 MONEY – a medium of exchange used to purchase goods or services (bank notes, bank deposits, cheques, …). Money allows PURCHASING POWER to be transferred among people. For money to do its work, everyone else must trust that others will accept your money as payment. WEALTH – stock (zapas, stan) of things owned or value of that stock (=buildings, land, machinery, capital goods – debts owned + debts owned to you). INCOME – the amount of money one receives over some period of time (flow). (from market earning, investments, government). DEPRECIATION = reduction in the value of stock of wealth over time. NET INCOME = the maximum amount that one could consume without running down wealth. (= gross income – depreciation). EARNINGS – wages, salaries and other income from labor. SAVINGS – income that is not consumed. INVESTMENT – expenditure on newly produced capital goods. CONSUMPTION OVER TIME There is a trade-off between consuming goods now and later. THE OPPORTUNITY COST of having more goods now is having fewer goods later. BORROWING AND LENDING allow us to rearrange our capacity to buy goods and services across time. BORROWING – allows us to buy more now, at the cost of buying less later. INTEREST RATE ( r ) – the price of bringing some buying power forward in time. (1+r)= Tradeoff between current and future consumption (MRT). PREFERENCES FOR CONSUMPTION Borrowing allows us to bring consumption forward. How much consumption an individual will bring forward depends on: - CONSUMPTION SMOOTHING (an individual smoothes their consumption to avoid consuming a lot in one period and little in the other; DIMINISHING MARGINAL RETURNS TO CONSUMPTION – the value of an additional unit of consumption declines, the more consumption the individual has); - PURE IMPATIENCE (being impatient as a person; MYOPIA – short-sightness, people experience the present satisfaction more strongly than the same satisfaction later; PRUDENCE – people know that they may not be around in the future, and so they want to consume now). OPTIMAL DECISION MAKING (p) – a measure of person’s impatience (consumption smoothing, pure impatience). Individual borrows at the point where discount rate = interest rate (MRS=MRT, (1+r = 1+p). BORROWERS AND SAVERS RESERVATION INDIFFERENCE CURVE – all the points at which the individual would be just as well off (być zamożnym) as at the reservation position. The borrower and the saver have different indifference curves because they have different endowments (wyposażenie). SAVING AND LENDING A SAVER smoothes his consumption by postponing it into future. LENDING money at interest expands saver’s feasible set, compared to simply storing it. INVESTMET – is another way to move consumption to the future. Combination of investing and borrowing can increase consumption in both periods. BALANCE SHEET – summaries what a household or firm owns and what it owes to the others. ASSTES – anything of value that is owned. LIABILITIES – anything of value that is owed. NET WORTH = assets – liabilities Wealth or net worth does not change when you lend or borrow. A LOAN adds both assets and liabilities to the balance sheet: - Borrowed money (cash) is an asset - The debt is an equal liability BANK – a firm that makes profits by lending and borrowing. Banks borrow from households (deposits), other banks and the central bank. The interest that pays on deposits is lower than the interest they charge on loans, which is how banks make profits. CENTRAL BANK – it is the only bank that can create legal tender (przetarg). - The central bank is usually owned by the government LENDING AND INEQULITY Inequality may increase when some people are in a position to profit by lending money to others. Credit-rationing increases inequality – people with limited wealth are not able to profit from the investment opportunities that are open to those with more assets. Summary: 1. Ways to move consumption forward/into the future - BORROWING, SAVING, INVESTING - Options available depend on individual’s endowment (wyposażenie) - Optimal choice depends on individual’s DISCOUNT RATE 2. Outline of the banking system - Banks create money (lend) to make profits - Central bank sets the POLICY RATE, which influences spending - Issues: PRINCIPAL-AGENT PROBLEM, CREDIT CONSTRAINTS LECTURE 21 MARKET EQUILIBRATION AN EXOGENOUS SHIFT in supply of demand means that the price has to change for the market to reach a new equilibrium. The market equilibrates through rent-seeking behavior on the SHORT SIDE of the market, in response to excess supply or demand. This is called MAKRET EQUILIBRATION THROUGH RENT SEEKING. MARKET ORGANIZATION Prices ultimately come from the interests of relationships between buyers and sellers. Market organization determines precisely how these relationships influence prices (e.g. trading between two parties/individuals vs. auctions). SHORT-RUN AND LONG-RUN EQUILIBRIA SHORT-RUN EQUILIBRIUM – we are holding something constant: the number of firms on the market. Firms are earning rents. LONG-RUN EQUILIBRIUM – is where a firm’s rent is 0 (P=MC=AC). The number of firms is EXOGENOUS (zewnętrzny, napływowy) in the short-run, but ENDOGENOUS in the long-run. This means that supply is more elastic in the long run, as more firms enter production. - Demand is not elastic in the short-run because of the limited substitution possibilities. THE VALUE OF ASSETS People buy assets for two reasons: 1. To benefit from owning it 2. To be able to sell it later THE VALUE OF ASSET (a security) depends on: 1. The size of the cash flows that it is expected to generate (dividends) 2. The uncertainty in one’s forecasts of these cash flows BONDS When the stream of payments from an asset is fixed, the price of the asset will be inversely related to the interest rate yields (zyski). BOND – a security that promises to pay fixed (stały) amount of money at specific intervals. - The risk of default (zaniedbanie) on government bonds is usually negligible (nieistotne, bez znaczenia) - Corporate bonds are not risk-free: high risk of default -> high interest rate demanded by investors -> lower bond price STOCKS (shares) – a claim (żądanie) on a part of assets of a firm, and hence (z tego powodu, stąd) on its profits. Stocks offer no specific promised stream of payments and the time period over which payments will be made is not fixed. Firms expected to generate greater net earnings will have higher valuations = higher share price. RISK Value of both bonds and stocks depends on uncertainty over its earnings. - SYSTEMATIC RISK – events that simultaneously affect broad classes of financial assets (undiversifiable). - IDIOSYNCRATIC RISK – events that affect only a given firm/asset (diversifiable and hence irrelevant for valuation). The rate of return that will induce (skłonić) investors to buy shares in a company is the MARKET CAPITALIZATION RATE. - Higher for companies subject to greater systematic risk TRADING STRATEGIES THE FUNDAMENTAL VALUE OF A SECURITY – share price based on anticipated future earnings and the level of systematic risk. TRADING STRATEGIES: - Buy assets that are priced below their perceived fundamental value, and vice versa. - Look for MOMENTUM in asset prices, buying when expecting prices to rise further, and vice versa. The trading mechanism in the financial market is called a CONTINUOUS DOUBLE AUCTION. 1. To buy, submit a LIMIT ORDER (quantity and reservation price) - BIDS are orders to buy and ASKS are orders to sell. 2. A trade takes place if there is a match between a bid and an ask. 3. If there isn’t anyone to trade with, the bid will be recorded in ORDER BOOK. The price is always adjusting to reconcile supply and demand and hence clear the market (equilibration through rent-seeking). ASSET MARKET BUBBLES Changes in asset prices are messages containing information about the firm’s health, etc. If markets are to work well, traders must respond to these messages. But when they interpret a price increase as a sign of further price increases (MOMENTUM TRADING) the result can be self-reinforcing (wzmocnić) cycles of price increases (BUBBLES) followed by sudden price declines (CRASHES). - Resale (odsprzedaż) value, ease (łatwość, swoboda) of trading, availability of borrowing may all make bubbles more likely MODELLING BUBBLES Good news about future profitability -> demand curve shifts to the right -> price increases -> positive feedback: the price increase is interpreted as signal of future good news -> further increases in demand STABLE EQUILIBRIUM An equilibrium is STABLE if there is a tendency for the equilibrium to be restored after it is distributed by a shock. THE PRICE DYNAMIC CURVE is flatter than the 45 degrees line. UNSTABLE EQUILIBRIUM An equilibrium is UNSTABLE if, when a shock disturbs the equilibrium, there is a subsequent tendency to move even further away from the equilibrium. THE PRICE DYNAMIC CURVE is steeper than the 45 degrees line. INSTABILITY AND BUBBLES A self-reinforcing bubble is an outcome of an unstable equilibrium. The instability can only happen in markets for goods that can be resold. MODELLING CRASHES The positive feedback process can continue indefinitely, until something happens to change the expectation of continuously rising prices. A trader can attempt to profit from identifying a bubble by short-selling. SHORT-SELLING – the sale of an asset borrowed by the seller, with the intention of buying it back at a lower price. - Missing information – calculating the exact costs imposed on each fisherman and each plantation’s contribution to pollution. - Enforcement – it may be difficult for a court to determine whether plantations have complied or not. - Limited funds – fisherman may not have enough money to pay plantations the compensation required. Solution #2: GOVERNMENT POLICIES - Regulation of production – cap at socially optimal amount (may be difficult to determine and enforce the right quota for each polluter). - PIGOUVIAN TAX/SUBSIDY – tax/subsidy on firms generating negative/positive external effects, in order to correct an inefficient market outcome. - Enforcing compensation for affected parties. Example: Pollution tax (government puts a per-unit tax on output, equal to the MEC); profit- maximizing producer chooses output where MPC = after-tax price, which is the socially optimal output; the tax forces producers to face the full cost of their decisions. Example: Compensation (government requires plantation owners to pay fisherman compensation for each ton produced); required compensation is equal to the difference between the MSC and the MPC; fishermen are fully compensated and producers choose the socially optimal level of output. Similar effect on profits compared to tax, but fishermen are better off (receive payment instead of the government). PRACTICAL LIMITS OF POLICIES: Similar limitations to those for bargaining: - Missing information – government may not know the exact compensation needed to correct the problem. - Measurement – marginal social costs are difficult to measure. - Lobbying – the government may favor the more powerful group, in which case it could impose a Pareto-efficient outcome that is unfair. WHY DO EXTERNAL COSTS/BENEFITS OCCUR? External costs cause market failure due to INCOMPLETE CONTARCTS. - Incomplete contracts do not specify, in an enforceable way, every aspect of the exchange that affects the interests of all affected parties. - Contracts that include external costs/benefits are not enforceable because the relevant information is not VERIFIABLE or ASYMETRIC (not known by decision-maker). - Therefore, in reality it is impossible to use contracts or property rights so that social costs/benefits are included in the decision-making process/benefits are included in the decision-making process. MARKET FAILURE: other types 1. PUBLIC GOODS Classification criteria: nature of good + institutions PUBLIC GOOD – non-rival (nierywalizacyjny); may or may not be excludable. NON-RIVAL – use by one person does not reduce its availability to others. NON-EXCLUDABLE – impossible to exclude anyone from having access. PUBLIC GOODS AND MARKET FAILURE Markets typically allocate private goods. But for the other 3 types, markets are not possible or likely to fail. - Non-rival goods have a marginal cost of 0, so it is not possible to set price = MC unless provision is subsidized. - It is impossible to set a price for non-excludable goods because the provider cannot exclude those who haven’t paid. Example: if one farmer invests in a community irrigation project, other farmers receive EXTERNAL BENEFITS, but it is difficult to make them pay for the benefits or write contracts that guarantee a Pareto-efficient irrigation level. 2. ASYMETRIC INFORMATION When the information is asymmetric, one party knows something relevant to the transaction but the other party does not. Two forms of asymmetric information: - HIDDEN ACTION – leads to a MORAL HAZARD problem (e.g. involuntary unemployment because employers cannot observe employees’ exact work effort). - HIDDEN ATRIBUTES – leads to an ADVERSE SELECTION problem (e.g. buyers of second- hand cars do not know all the attributes of the car e.g. quality, but sellers do). Example #1: Health insurance (health insurance is voluntary; to be profitable, the company must charge prices high enough and only the less healthy people are willing to buy; this adverse selection means that most people buying insurance already know they have a health problem; there is a MISSING MARKET: many (healthier) people who would like to buy insurance will remain uninsured. Example #2: Car insurance (any form of insurance also has a hidden action problem – buyer may take more risks now that he/she is insured; purchasing full coverage against damage may make someone careless in driving; insurance companies can put some limits in a contract, but cannot enforce other types of behavior, e.g. driving speed; this MORAL HAZARD problem is another PRINCIPAL-AGENT PROBLEM, and we can also think of it in terms of external effects (being careful gives external benefits to the company). Example #3: The banking system (borrowing and lending is another principal-agent problem in which the borrower’s decisions have external effects on the lender; for this reason, poor borrowers are often credit-constrained or credit-excluded, which is a form of credit market failure; another form of credit-market failure is the banks themselves: if they take risks and go bankrupt, other banks (whom they have borrowed from) will bear some of the costs: governments will also bail out banks that are “too big to fail”, which incentivizes risk-taking behavior. 3. PRICE > MARGINAL COST Firms may set price above marginal cost because of: - Limited competition (e.g. selling differentiated product) - Decreasing long-run average costs due to economies of scale (e.g. natural monopoly MARKET FAILURE because allocation is not Pareto efficient - Deadweight loss can be eliminated via price discrimination (allocation “unfair” because firms capture entire surplus) or competition policy SHOULD MARKETS ALLOCATE EVERYTHING? ARGUMENTS AGAINST USING MARKETS FOR EVERYTHING: - Repugnant (odrażające) markets: creating a market for certain goods/services would violate ethical/social norms (e.g. slavery) - Other institutions may be more effective (e.g. governments, families) - Market mechanisms may CROWD OUT (wypychać, wypierać) norms of social preferences - MERIT GOODS: goods that should be available to everyone, independently of their ability to pay (e.g. education) Summary: 1. Sources of market failure - External costs or benefits - Asymmetric information (hidden action/hidden attributes) - Limited competition (P > MC) 2. Possible solutions – regulation, taxation, compensation 3. Markets for other types of goods - Public goods and public “bads” - Limits to markets – not every good should have a market.