1. Markets 101: The Case for Markets Sabina Shaikh University of Chicago CIS Summer Teacher Institute Understanding the Global Economy: Bringing the World Market into your Classroom June 22, 2009

2. Why Markets and Globalization? The Benefits of Competition and Trade The Benefits of Competition and Trade More Choices More Choices Lower Prices and Rising Incomes Lower Prices and Rising Incomes Productivity, Efficiency Productivity, Efficiency Innovation Innovation But, Competition Necessarily Creates Winners and Losers But, Competition Necessarily Creates Winners and Losers Does Economics Ignore the Losers? Does Economics Ignore the Losers? $20 $480 $100

3. The Study of Economics Resources are Scarce Resources are Scarce “There is no such thing as a free lunch” “There is no such thing as a free lunch” Opportunity Cost: What did you give up to be here today? Opportunity Cost: What did you give up to be here today? Individuals see to Maximize Utility Individuals see to Maximize Utility Abstract Measure of Satisfaction Abstract Measure of Satisfaction Is it Happiness? Not exactly Is it Happiness? Not exactly Preferences and Choice Preferences and Choice Comparison of Benefits and Costs Comparison of Benefits and Costs Maximize Benefits Maximize Benefits Minimize Costs Minimize Costs Incentives Affect Behavior Incentives Affect Behavior Economics tries to be positive not normative Economics tries to be positive not normative Economics has no morals? Economics has no morals?

4. Specialization, Advantage and Trade Specialization Specialization Parents send kids to school instead of home schooling Parents send kids to school instead of home schooling You visit a doctor when you’re sick You visit a doctor when you’re sick Pay a plumber to fix a leak Pay a plumber to fix a leak Absolute Advantage and Comparative Advantage in Production Absolute Advantage and Comparative Advantage in Production Specialization by Comparative Advantage can lead to mutually-beneficial trades Specialization by Comparative Advantage can lead to mutually-beneficial trades Gains from Trade Example Gains from Trade Example

5. Competitive Markets Demand for Goods and Services Demand for Goods and Services Price and Value (Marginal Benefit) Price and Value (Marginal Benefit) Marginal Benefit is Diminishing Marginal Benefit is Diminishing Supply of Goods and Services Supply of Goods and Services Price and Marginal Cost Price and Marginal Cost Marginal Cost is Increasing Marginal Cost is Increasing Invisible Hand and Market Equilibrium Invisible Hand and Market Equilibrium Assumptions of a Competitive Market Assumptions of a Competitive Market Price Takers Price Takers No Market Power No Market Power No Government Intervention No Government Intervention “Perfect” Information “Perfect” Information No Externalities or Public Goods No Externalities or Public Goods Homogenous Goods Homogenous Goods

6. The Graphical Market P Demand = Marginal Benefit Supply = Marginal Cost Q Q* P* Supply new P new Q new Equilibrium will change with shifts in Supply or Demand Equilibrium will change with shifts in Supply or Demand Supply Shifts: Input prices, technology, weather Supply Shifts: Input prices, technology, weather Demand Shifts: Income, tastes, prices of other goods Demand Shifts: Income, tastes, prices of other goods Demand new Q new

7. Market Impacts: Global Food Prices Could we have predicted these impacts? Could we have predicted these impacts? Could we have predicted the magnitude of these impacts? Could we have predicted the magnitude of these impacts? Q corn P S D Subsidy to Ethanol Blenders Increases the Demand for Corn: Price of Corn goes up D new Q soy S D P Higher Price of Corn increases the demand for land for corn. Land diverted from other crops. Supply of Soy decreases. Price of Soy goes up. (Same happened to CRP land) S new Q milk S D P S new Higher Price of Corn increases the costs of feeding dairy cows raising the price of milk. (Think about the substitution effects here) CORN SOYMILK

8. Measuring Market Impacts: Elasticity and Welfare Measurement PS Q Q* P* D The slope of the curves represent the elasticity of demand or supply to price. Elasticity measures how much demand or supply change for a 1% change in price? Elasticity can also be used for income or prices of substitutes or complements Consumer Surplus measures the extra value to the consumer: Value – Expenditure Producer Surplus measures the extra value to the producer: Price – Cost Together the two comprise the total market value or the net benefit. Efficiency requires that this net benefit be maximized.

9. Sources of Market Failure In an otherwise efficient competitive market, the following can induce market failure: Government Intervention Government Intervention Price or Quantity Controls Price or Quantity Controls Price Ceilings, Price Floors, Quotas Price Ceilings, Price Floors, Quotas International Trade: Tariffs, Quotas, Protectionist Measures International Trade: Tariffs, Quotas, Protectionist Measures Subsidies and Taxes Subsidies and Taxes Market Power: Loss of Competition Market Power: Loss of Competition “Imperfect” Information “Imperfect” Information Externalities and Public Goods Externalities and Public Goods

10. Government Intervention as Market Failure: Minimum Wage 35 80 100 115Q labor P labor =Wage S D P min =6 P*=5 At the minimum wage, there is a surplus of labor: the Quantity of labor supplied exceeds the Quantity demanded. This is an inefficient market condition or market failure.

11. Government Intervention as Market Failure: Minimum Wage Q goods S D P new P* Q new Q* The increased cost of labor shifts the supply curve (which is also the cost of production curve). Consumer prices go up. This is the market impact. S new So, the theory says that minimum wages can lead to unemployment and less affordable consumer goods.

12. Another Example: Rent Controls Krugman and Wells, 2006

13. Externalities as Market Failure: Why Regulate Greenhouse Gases? Consider the market for coal-based electric power Consider the market for coal-based electric power What are the costs and benefits of generating electricity to the power company? What are the costs and benefits of generating electricity to the power company? What are the costs and benefits of purchasing electricity to the consumer? What are the costs and benefits of purchasing electricity to the consumer? Who bears the costs of pollution? Who bears the costs of pollution? How to “internalize” this externality? How to “internalize” this externality? An important note: the externality arises from the market for electric power. The power company would not be able to sell electricity at current prices without the consumers. An important note: the externality arises from the market for electric power. The power company would not be able to sell electricity at current prices without the consumers.

14. Market-Based Solutions to Market Failure The Role of Incentives The Role of Incentives People respond to changes in price People respond to changes in price Can we appeal to conscience? Can we appeal to conscience? Government Intervention Government Intervention Wait! Wasn’t this a source of market failure? Wait! Wasn’t this a source of market failure? Yes. Remember how we predicted the market impacts from minimum wage, price supports, etc. Yes. Remember how we predicted the market impacts from minimum wage, price supports, etc. We can use this to restore market efficiency as well. We can use this to restore market efficiency as well. Incentives: Price and Quantity Instruments Incentives: Price and Quantity Instruments Property Rights and the Coase Theorem Property Rights and the Coase Theorem Ronald Coase (1960): The Problem of Social Cost Ronald Coase (1960): The Problem of Social Cost As long as property rights are established, mutually-beneficial transactions exist even in the presence of externalities. As long as property rights are established, mutually-beneficial transactions exist even in the presence of externalities.

15. Simple Coase Theorem Example One bedrooms = $800/month, two bedrooms = $1400. Sally smokes causing Jim costs of $150/month. Can they still live together? OptionsCost ($)Net Gain ($) SallyJimSallyJim Live Alone80080000 Live Together700700+150100-50 Sally is willing to pay X<100 since she will still have a positive gain from sharing. Jim is willing to accept X>50 since then he will have a positive gain from sharing. Take $75 as an example. OptionsCost ($)Net Gain ($) SallyJimSallyJim Live Alone80080000 Live Together700+75 700+752525

16. Internalizing the Externality from CO2: A Market for Carbon? Recall the coal-based electric power example. Recall the coal-based electric power example. Now, given the market failure from the externality, suppose that we implement a market-based solution Now, given the market failure from the externality, suppose that we implement a market-based solution Carbon Tax Vs Cap and Trade Carbon Tax Vs Cap and Trade Substitution Effects Substitution Effects Supply Response: Wind, Solar, Carbon Capture Supply Response: Wind, Solar, Carbon Capture Demand Response: Energy Efficiency Demand Response: Energy Efficiency We should be able to predict these. A market could work but there’s a good chance an inefficient market will be established. We should be able to predict these. A market could work but there’s a good chance an inefficient market will be established. Economics does not always make good politics. Economics does not always make good politics. Does the Coase Theorem work for pollution? Does the Coase Theorem work for pollution?

17. Examples from Global Markets U.S. Auto Companies (Naked Economics) U.S. Auto Companies (Naked Economics) Increased competition from Japanese automakers in 1980’s Increased competition from Japanese automakers in 1980’s US auto company response US auto company response Market Solution: Make more fuel-efficient cars to compete OR Market Solution: Make more fuel-efficient cars to compete OR Political Solution: Lobby the government for tariffs and quotas and avoid fuel economy laws Political Solution: Lobby the government for tariffs and quotas and avoid fuel economy laws This could have been a success story for globalization This could have been a success story for globalization Ethanol Ethanol The Impact of Corn for Fuel The Impact of Corn for Fuel Sugarcane and Tariffs: Positive? Negative? Sugarcane and Tariffs: Positive? Negative? The Kyoto Protocol The Kyoto Protocol China and India exempt from Emissions Reductions. Why? China and India exempt from Emissions Reductions. Why? Marginal Costs of Environmental Protection: Specialization and Trade Marginal Costs of Environmental Protection: Specialization and Trade Income Elasticity of Environmental Protection Income Elasticity of Environmental Protection

18. Recommended References Naked Economics by Charlie Wheelan Naked Economics by Charlie Wheelan The Economist The Economist The New York Times: Freakonomics, Economix The New York Times: Freakonomics, Economix Textbook: Krugman and Wells, Economics Textbook: Krugman and Wells, Economics www.theclimatecommunity.com www.theclimatecommunity.com www.theclimatecommunity.com