Llad Phillips1 Introduction to Economics Microeconomics The US Economy

Fall 2002 Median 47 Max 72

Fall 2001

Llad Phillips4 Outline: Lecture Thirteen The Free Market Story The Free Market Story The Wealth of Nations The Wealth of Nations

Llad Phillips5 Why Has the Market Economy (Economic System) Prevailed? It has taken about 130 years, but it seems socialism and communism, not to mention fascism have fallen by the wayside. Why? It has taken about 130 years, but it seems socialism and communism, not to mention fascism have fallen by the wayside. Why? What are the strengths of market systems? What are the strengths of market systems? Are there weaknesses? Are there weaknesses?

Llad Phillips6 Returns to Scale and Economic Efficiency Constant returns to scale Constant returns to scale  if you double inputs, then you double output  so output per worker (average product) and marginal product would be constant  total cost of the factor inputs would increase proportionally with output  so average cost per unit of output and marginal cost per unit of output would be constant  a given constant average cost firm could expand, or new firms could enter and produce

Llad Phillips7 A Free Market Economy Assumes Resources Are Mobile New firms can enter or leave an industry New firms can enter or leave an industry Existing firms can expand or contract Existing firms can expand or contract

Llad Phillips8 Assuming Constant Returns to Scale for Simplicity The supply curve of the firm is its marginal cost curve ( constant under constant returns to scale) The supply curve of the firm is its marginal cost curve ( constant under constant returns to scale) The supply curve of the industry is the same, the marginal cost curve The supply curve of the industry is the same, the marginal cost curve

Llad Phillips9 Q COMP Supply Curve of the Firm Cost per Unit of Output Average cost & marginal Cost

Llad Phillips10 Q COMP Supply Curve of the Industry Cost per Unit of Output Average cost & marginal Cost

Llad Phillips11 Market Demand PMPM Q COMP Market Supply Add Market Demand to the Picture Average cost & marginal Cost

Llad Phillips12 Consumers Benefit Consumers pay a market price for output equal to the marginal cost of resources used in production Consumers pay a market price for output equal to the marginal cost of resources used in production So resources are allocated efficiently So resources are allocated efficiently Consumers also reap a benefit: consumer surplus Consumers also reap a benefit: consumer surplus

Llad Phillips13 Consumer Surplus The first consumer that enters the market is willing to pay a high price The first consumer that enters the market is willing to pay a high price The next consumer is willing to pay a little lower. The next consumer is willing to pay a little lower. The last consumer that enters at the market price is just willing tp pay that price. The last consumer that enters at the market price is just willing tp pay that price. The consumers that are willing to pay a higher price but only have to pay the market price benefit The consumers that are willing to pay a higher price but only have to pay the market price benefit

Llad Phillips14 Market Demand PMPM Q COMP Market Supply Price the first consumer is willing to pay P1P1 Surplus to the first consumer = P 1 - P M

Llad Phillips15 Market Demand PMPM Consumer Surplus Q COMP Total Consumer Surplus: A Measure of Consumer Welfare

Llad Phillips16 Summary of the Free Market Story Efficient use of resources Efficient use of resources  resources flow to produce what consumers want  consumers pay a market price equal to the marginal cost of resources to produce a unit of output  the surplus is surplus that goes to consumers

Llad Phillips17 What Can Go Wrong? Monopoly: the concentration of economic power Monopoly: the concentration of economic power The role of international trade: free trade can break down monopoly power in a given nation and promote competition and hence efficiency The role of international trade: free trade can break down monopoly power in a given nation and promote competition and hence efficiency

Llad Phillips18 Santa Barbara News-Press Saturday, Nov 10, 2001

Llad Phillips19 Outline: The Wealth of Nations Sources of Growth Sources of Growth Can the US sustain Prosperity? Can the US sustain Prosperity? Competitition Competitition

Llad Phillips20 The Wealth of Nations (1776) Adam Smith Smith first raised the question: what causes a country to prosper? Smith first raised the question: what causes a country to prosper? Why is the USA so prosperous? Why is the USA so prosperous?  Growth of population and labor force  accumulation of capital, machines, buildings and tools  technological improvements and inventions How important is each contribution? How important is each contribution?

Llad Phillips21 Chapter 23, Figure 23.3 Percentage Contribution to Real GDP Growth

Llad Phillips22 Output Labor Capital Technology Input-Output Schematic

Output, Q Value Added Input, Labor, L Aggregate Production Function,showing the effect of increasing capital and land from K 1 to K 2 Q = f(L, K 1 ) Q = f(L, K 2 ) Source: Lecture Six, National Accounting C Capital per worker increases and output per worker increases with capital accumulation L1L1

Llad Phillips24 Sources of Growth Capital deepening Capital deepening technological change and increased productivity technological change and increased productivity social infrastructure social infrastructure competitive markets and trade competitive markets and trade

Llad Phillips25 Capital Deepening capital per worker increases capital per worker increases so output per worker increases so output per worker increases

Llad Phillips26 Output Per Worker Has Been Growing As measured by real GDP per capita As measured by real GDP per capita As measured by output per manhour As measured by output per manhour

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Output, Q Value Added Input, Labor, L Q = f(L, K 1 ) Q = f(L, K 2 ) C L1L1 Aggregate Production Function: As capital per worker increases, output per worker increases And the marginal product per worker increases

Llad Phillips30 Average, Marginal Product Input, # of workers APL MPL 1954 Things Improve with capital deepening: Output per Worker MPL 1874 Labor Supply 1874 Real Wage 1874 L 1874 Labor Supply 1954 L 1954 Real Wage 1954 Output per worker increase, shifting APL

Llad Phillips31 An increase in capital increases the marginal product of labor Chapter 23, Figure 23.2

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Llad Phillips33 U.S. Annual Productivity Growth Source: Text, Ch. 23, Table 23.3

Llad Phillips34 Los Angeles Times Thursday Nov. 8, 2001

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Llad Phillips37 Total Factor Productivity: About the Same for Every Measure

Llad Phillips38 USA Avoids the Malthusian Trap Even though population has grown for the last 125 years, and the labor force has grown, output has grown faster Even though population has grown for the last 125 years, and the labor force has grown, output has grown faster

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Llad Phillips40 source: US Department of Commerce, Long Term Economic Growth(1966)

Llad Phillips41 Average, Marginal Product Input, # of workers APL MPL 1954 US avoids the Malthusian trap, but without a moderation in population growth, workers could have eaten up the gains! Output per Worker MPL 1874 Labor Supply 1874 Real Wage 1874 L 1874 Labor Supply 1954 L 1954

Llad Phillips42 Sources of Growth Capital deepening Capital deepening technological change and increased productivity technological change and increased productivity  invention  importance of educated work force education and the public sectoreducation and the public sector  innovation  entrepreneur social infrastructure social infrastructure competitive markets and trade competitive markets and trade

Output, Q Value Added Input, Labor, L Aggregate Production Function,showing the effect of increasing productivity from technological change Q = f(L, K 1, T 1 ) Q = f(L, K 1, T 2 ) C Technological progress increases and output per worker increases with new technology L1L1

Llad Phillips44 Average, Marginal Product Input, # of workers APL MPL 1954 Things Improve with Technological Change: Output per Worker MPL 1874 Labor Supply 1874 Real Wage 1874 L 1874 Labor Supply 1954 L 1954 Real Wage 1954 Output per worker increases, shifting APL

Llad Phillips45 Table 23.2 Source of Real GDP Growth, (average annual percentage rates) Due to capital growth % Due to labor growth % + technological progress % Output growth % Source: Edward F. Denison, Trends in Economic Growth (Washington, DC: The Brookings Institution, 1985).

Llad Phillips46 Chapter 23, Figure 23.3 Percentage Contribution to Real GDP Growth

Llad Phillips47 Growth Rate Accounting Output Output Labor Input Labor Input Capital Input Capital Input Growth Rate in Output Equals Growth Rate in Inputs (Labor and Capital) + Residual Growth Rate in Output Equals Growth Rate in Inputs (Labor and Capital) + Residual Residual: Growth in Output Per Unit Input Attributable to Technology Residual: Growth in Output Per Unit Input Attributable to Technology

Llad Phillips48 Research and Development as a Percentage of GDP Chapter 23, Figure 23.5

Llad Phillips49 Sources of Growth Capital deepening Capital deepening technological change and increased productivity technological change and increased productivity social infrastructure social infrastructure competitive markets and trade competitive markets and trade

Llad Phillips50 Social Investment in Infrastructure Transportation Transportation  coastal shipping  canals  roads  railroads  highways  airports communications communications Schools Schools Hospitals Hospitals

Llad Phillips51 Example: in 1999, Hurricane Mitch strikes Honduras, worst on record in this hemisphere. Seventy percent of crops destroyed, bridges and roads damaged. "Overall, what was destroyed over several days took us 50 years to build.” Honduran President Carlos Flores Loss: $4 Billion

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Llad Phillips53 Examples from US History of Infrastructure & Input Growth

Llad Phillips54 United States History: Land as an Input Source:

Llad Phillips55 United States History: Social Investment in Infrastructure

Llad Phillips56 United States History: Social Investment in Infrastructure

Llad Phillips57 United States History: Population (labor) as an Input

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Llad Phillips59 Sources of Growth Capital deepening Capital deepening technological change and increased productivity technological change and increased productivity social infrastructure social infrastructure competitive markets and trade competitive markets and trade

Llad Phillips60 Competition Spurs Efficiency With competition, firms are forced to be efficient and low cost With competition, firms are forced to be efficient and low cost  otherwise they are driven out of business

Llad Phillips61 If a country protects its industry from competition, then it becomes inefficient Monopoly power can lead to perpetuating the status quo Monopoly power can lead to perpetuating the status quo  example: the US auto industry Tariffs and quotas cushion firms from competition, allowing inefficiency Tariffs and quotas cushion firms from competition, allowing inefficiency

Llad Phillips62 Globalization has led to increased world trade, increased competition Link between trade and growth Link between trade and growth  trade makes firms in countries more competitive  competition makes firms more efficient  efficiency conserves resources and makes them available to finance growth  the drive for efficiency spurs invention and new technology

Llad Phillips63 Can the USA Maintain Its Growth? How does the US compare? How does the US compare? Can we maintain capital deepening? Can we maintain capital deepening? Can we maintain technological progress? Can we maintain technological progress?

Llad Phillips64 A Key to Success: Capital Formation Net investment means new capital Net investment means new capital New technology is usually introduced through new capital New technology is usually introduced through new capital

Llad Phillips65 Capital Stock Depreciation Net Investment - Gross Investment + Capital Formation National Savings

Llad Phillips66 Stock of Financial Capital capital gains, dividends Net Investment + + Capital Formation: Analog to Personal Wealth Personal Savings

Llad Phillips67 Capital Formation, National Savings & Gross Investment National Savings Consumer Savings = Income Minus Consumption Profits = Revenue Minus Costs Gross Investment

Llad Phillips68 Personal Savings Rate

Llad Phillips69 Personal Savings in Billions of Dollars

Llad Phillips70 Policy Issues Good News:Long Run Increase in Productivity, ~ 2.2% Good News:Long Run Increase in Productivity, ~ 2.2% Bad News Bad News  Consumer savings is low  productivity decrease in the 70’s and 80’s Parents have to care enough about their kids to save and invest in the next generation Parents have to care enough about their kids to save and invest in the next generation

Llad Phillips71 What’s at Stake? Welfare of Workers Chapter 23, Figure 23.4

Llad Phillips72 GDP per Capita Labor Population Immigration CapitalTechnology Net Investment National Savings Profits Consumer Savings Prosperity Schematic Competition

Llad Phillips73 What Accounts for Economic Growth? Why do some countries grow and prosper and others do not? Why do some countries grow and prosper and others do not? Why do civilizations rise and fall? Why do civilizations rise and fall? What determines the economic well-being of US citizens? What determines the economic well-being of US citizens? A possible essay question?

Llad Phillips74 Final 1999, Essay question #1

Llad Phillips75 Summary-Vocabulary-Concepts Adam Smith Adam Smith labor index labor index capital index capital index total factor index total factor index capital per worker capital per worker productivity productivity output per manhour output per manhour total factor productivity total factor productivity productivity residual productivity residual invention invention innovation innovation entrepreneur entrepreneur infrastructure infrastructure caring parents caring parents average variable cost average variable cost marginal cost marginal cost average fixed cost average fixed cost average total cost average total cost price taker price taker firm’s break even point firm’s break even point firm’s shut down point firm’s shut down point

Llad Phillips76 Appendix

Llad Phillips77 Competition/Supply Output:Inputs Output:Inputs  output:labor  average product of labor  marginal product of labor Output:Costs Output:Costs  output:variable cost  average variable cost  marginal cost  output:fixed cost (if capital isn’t variable)  output:total cost  total cost=variable cost + fixed cost

Llad Phillips78 Output Input Bushels of Tomatoes number of workers Production Function Total Product Curve Variable cost = number of workers* wage  A B A B Variable Cost Curve 1. average variable cost, AVC, is minimum, A, where APL is maximum, A 2. marginal cost, MC, is infinite, B, where MPL is zero, B 3. At A, APL = MPL, and at A, AVC = MC 4. The range of production for the firm is between A and B, or A and B Variable Cost Curve is the Mirror Image of Total Product Curve

Llad Phillips79 A B $ Variable Cost   Output Average Variable Cost, AVC Marginal Cost, MC Output AVC MC $ per unit output

Llad Phillips80 Cost per unit of output output A marginal cost per unit of output average variable cost per unit of output

Llad Phillips81 If the Firm Is One of Many Suppliers then the firm is a price taker, and the price for output is the market price, p M then the firm is a price taker, and the price for output is the market price, p M The firm sets price equal to marginal cost to determine how much output to produce The firm sets price equal to marginal cost to determine how much output to produce If the market price drops below minimum average variable cost, I.e does not cover variable cost, then the firm shuts down If the market price drops below minimum average variable cost, I.e does not cover variable cost, then the firm shuts down

Llad Phillips82 Cost per unit of output output A marginal cost per unit of output Average variable cost per unit of output Market price s Shutdown output

Llad Phillips83 Cost per unit of output output A marginal cost per unit of output average variable cost per unit of output Market price Output produced

Llad Phillips84 A B Variable Cost Fixed Cost Output Average Variable Cost, AVC Marginal Cost, MC Average Fixed Cost, AFC Output AVC MC Fixed Cost AFC Variable Cost $ per unit output $

Llad Phillips85 A B Variable Cost Fixed Cost Total Cost Output Average Variable Cost, AVC Marginal Cost, MC Average Fixed Cost, AFC Output AVC MC Fixed Cost AFC Total Cost ATC Variable Cost $ $ per unit output

Llad Phillips86 Cost per unit of output output A marginal cost per unit of output average variable cost per unit of output Market price Output produced Average total cost per unit of output Average total cost per unit of output

Llad Phillips87 Cost per unit of output output A marginal cost per unit of output average variable cost per unit of output Market price Output produced Average total cost per unit of output Average total cost per unit of output Profit Margin Per unit of output Profit margin

Llad Phillips88 Chapter 8, Figure 8.3 Short Run Average Cost and Short Run Marginal Cost

Llad Phillips89 If the Firm Is One of Many Suppliers then the firm is a price taker, and the price for output is the market price, p M then the firm is a price taker, and the price for output is the market price, p M gross revenue, R, for the firm is the product of the given market price, p M, and the amount the firm produces, Q gross revenue, R, for the firm is the product of the given market price, p M, and the amount the firm produces, Q  R = p M *Q average revenue, or revenue per unit of output produced is the market price average revenue, or revenue per unit of output produced is the market price  R/Q = p M Since price does not depend on the output of this firm, marginal revenue equals average revenue Since price does not depend on the output of this firm, marginal revenue equals average revenue

Llad Phillips90 A B Variable Cost Fixed Cost Total Cost $ Output Average Variable Cost, AVC Marginal Cost, MC Average Fixed Cost, AFC Output AVC MC Fixed Cost AFC Total Cost ATC Break Even Point of Production for the Firm Q BE C Revenue pMpM Variable Cost P M = Min ATC $ per unit of output

Llad Phillips91 A B Variable Cost Fixed Cost Total Cost $ Output Average Variable Cost, AVC Marginal Cost, MC Average Fixed Cost, AFC Output AVC MC Fixed Cost AFC Total Cost ATC Shut Down Point of Production for the Firm Q SD C Revenue pMpM Variable Cost P M = Min AVC $ per unit of output

Llad Phillips92 Managing Production for the Firm Break Even Point Break Even Point  revenue equals, i.e. covers, total costs  R = TC = VC + FC  p M = ATC =AVC + AFC Shut Down Point Shut Down Point  revenue equals, i.e. covers variable costs  note fixed costs remain even if you shut down  R = VC  p M = AVC =MC

Llad Phillips93 A B Variable Cost Fixed Cost Total Cost Output Average Variable Cost, AVC Marginal Cost, MC Average Fixed Cost, AFC Output AVC MC Fixed Cost AFC Total Cost ATC Profit Maximizing Point of Production for the Firm QQ C Revenue pMpM Variable Cost P M = MC

Llad Phillips94 AFC AVC MC Q SD

Llad Phillips95 Output Varies with Capital, Labor Q = f(L, K) output per worker varies with capital per worker: Productivity of Labor Perspective output per worker varies with capital per worker: Productivity of Labor Perspective  Q/L = f(K/L)

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