MBA 814

Introduction to Applied Economics: Resource

allocation, production, and human choices
A. Overview: Scarcity and the price system
Economics is the study of allocation of scarce resources in society.
Without scarcity there is nothing to study. Every individual would satiate their
``wants.'' Such an environment may characterized as a ``Garden of Eden''
economy, in which resources are unlimited (except of course for apples), and
people live forever. For all practical purposes, scarcity always exists. Among
the most important of these resources, our time, is scarce because we live
lives of finite length. When resources are scarce, the problem faced by
individuals, firms, and society becomes how do we allocate those resources
among their most ``valued'' uses?
This question beckons another important question: as ``valued'' by
whom? By individuals? By the managers of multinational corporations? By
government policy makers? In a market-oriented economy, these values are
determined largely by consumers and workers. Consumers base their
purchases on their assessments of the alternative values of goods or services
in consumption. Workers decide whether to ``supply their labor'' to a firm
based on their assessments of the value of alternative uses of their time.
Notice that in both of these instances there is no explicit dollar amount placed
on these values. For example, the value of homes is almost certainly larger
than the price paid by homeowners or more precisely the price that
homeowners could receive if they sold their homes. Similarly, if parents decide
not to work, but instead to stay home and care for their children, we only know
that the value to parents of raising their own children must be at least as large
as the wage or salary less the cost of child care that they would have received
from working. These consumption and labor supply decisions result from
individuals' values and ultimately determine the allocation of resources in
society. They determine who works, what is produced, and how the output of
society is distributed among its members.
At its most fundamental level economics is the study of human choices.
In a market-oriented economy, the functioning of the price system reflect
these choices. A price is the value placed on a good or service by those
consumers who are just indifferent between buying that good or service or
some other alternative. Even in situation in which a producer ``sets'' or
``fixes'' a price for the product, there exists some consumer who is
approximately indifferent about purchasing the product and buys it, and
another who also is just indifferent about buying the product and does not buy
it. If this producer were to reduce its price, additional consumers would buy
the product. But what does the price system have to do with resource

1
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allocation? Because when these additional consumers purchase the producers'
product, they are now NOT buying the products of other producers. This
change in consumption changes how resources such as labor, materials,
natural resources, and entrepenerial skills are allocated among producers.
The price system, therefore, signals to economic ``agents'' how their
resources (ie. their time, their natural resources, their capital) are valued by
others who have used the marketplace. If the transmission of information
were costless, we would know that the current (market) price represents the
highest value of a particular resource by an alternative user. When the price
rises above an individual's own value for a product, that individual should sell
it.
A striking example of this choice facing individuals has arisen recently in
the wine market for fine Bordeaux wines. In recent years average wine prices
have approximately doubled and the prices of some wines have gone up by
even more. Wine connoisseurs are now faced with the dilemma that $30
bottles of wine that they had purchased as their ``pizza'' wine is sometimes
selling at auction for nearly $100 a bottle. The question is what is the cost of
drinking this wine with their Domino's Pizza or a plate of spaghetti? Is it the
$30 that they paid for the wine in the first place (the historical cost) or is it the
$100 that it is currently fetching at auction (the replacement cost)? Some wine
connoisseurs report that they no longer can afford to drink the wine stored in
their own cellars!
Because of the central role that the price system plays in allocating
resources in industrialized economies, this course amounts to a course in
``price theory.'' The objective of this course is that you understand (i) the
important role of a well functioning price system in allocating resources in a
market economy; (ii) how to use the analytical tools developed in this course
to examine broader questions of economic policy; and (iii) how to apply these
tools to problems facing the firm.

B. A Historical Perspective:
The problem of resource allocation is an old problem that has attracted
the attention of philosophers for at least three millennia. Economic and
political writings from ancient China document early interest in the role that
production and exchange play in the ``wealth of nations.'' Consider the
following excerpts from two different ancient texts.1

When Duke Tai (ca. 1122 - 1078 B.C.E.) arrived in his country [Qi], he
improved government, conformed to the [local] customs, simplified the rites,

1 See Guanzi: Political, Economic, and Philosophical Essays from Early China,
W. Allyn Rickett, translator, Princeton, NJ: Princeton University Press, pp. 9, 118.
(The Guanzi is believed to have been written or compiled around 250 B.C.E.
Italics are added for emphasis).
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extended the work of merchants and artisans throughout the country, and
facilitated the making of profit from fish and salt. Thus, people came to Qi in
large numbers and the Qi became a great country.

Author unknown, from the Shi ji

32/3a

The marketplace determines the value of goods. Hence, if goods are

kept cheap, there will be no [exorbitant] profits. If there are no [exorbitant]
profits, production will be well organized, and if it is well organized,
expenditures will be properly controlled. Now production materializes through
planning, succeeds through diligent attention, but fails through negligence.
Without planning it will never materialize, without diligent attention it will
never succeed. However, unless there is negligence, it will not fail. Therefore it
is said that the marketplace may know order or disorder, abundance or
scarcity [on its own]. There is a proper way to manage [markets and
production].

Attributed to Guan Zhong, ca. 645

B.C.E.,

In particular in the second excerpt notice the author's view of how ``value'' is
determined. Economists today would be comfortable with this proposition.
However it is important to recognize that the ancients' understanding of
economics differed considerably from our own. This point can be understood
from the origins of the word itself. ``The word 'economics,' Greek in origin, is
compounded from oikos, a household, and the semantically complex root,
nem-, here its sense of `regulate, administer, organize.' '' (A simpler translation
of these words might be ``household management.'') For more approximately
two millennia the standard work on economics, Oikonomikos, was written by
the Greek philosopher, Xenophon during the 4th century B.C.E. ``In Xenophon,
however, there is not one sentence that expresses an economic principle or
offers any economic analysis, nothing on efficiency of production, ``rational''
choice, the marketing of crops.''2 By our understanding today, his was a work
on ethnics, and not economics. This emphasis continued into the 18th century
and is seen even in the work of Francis Hutcheson, Adam Smith's teacher, in
his book entitled Short Introduction to Moral Philosophy.
During the 18th century, the subject of economics as we understand it
today began to take form culminating in the publication of the Wealth of
Nations in 1776. This important book was part of a growing body of literature
characterized by the French as l'economie politique which dealt with issues

2 see M.I. Finley, The Ancient Economy, Berkeley, CA: University of California
Press, 1973, pp, 17 - 19.
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such as money, trade, national income, and economic policy. For more than a
century the term political economy was understood to refer to the ``science of
the wealth of nations.'' The term ``economics'' did not come into common use
until after the publication in 1890 of the Principles of Economics, by the British
economist, Alfred Marshall.
The important contribution of Smith and others and their intellectual
departure from the work of previous scholars is that they developed a
conceptual framework for understanding a wide range of economic activities
such as farming, manufacturing, labor, finance, taxation, money, and so on.
More recently, the ``economic'' activities examined using by this framework
have been expanded to include marriage, addiction, suicide, fertility, the
forming of firms, organizations, associations, or clubs. This framework is what
is often referred to today as microeconomics.

C. The Modern Economy in a Dangerous World:

Given the historical roots of the subject as the science of the wealth of
nations, it is appropriate to begin our examination of price theory or
microeconomics looking at the national economy. A useful fact to take away
from this course is that the U.S. economy produces approximately $8 trillion
worth of goods and services each year. This figure known as the ``gross
domestic product'' or ``GDP'' is a measure of the value of all goods and
services produced and sold in the market place each year. To appreciate the
relative size of this output, 25 percent of world output is produced in the
United States. As shown by the pie chart, Japan and Germany generate 13 and
8 percent of world output, respectively. Thus, together these three countries
generate approximately 45 percent of world output. (By contrast, they
constitute less than 10 percent of the world's population.)3
But why is this $8 trillion figure so useful? One way think about this
figure is to recognize that it approximates the productive capacity of the
economy. Consider the graph discussed in lecture that sometimes is referred to
as the ``production possibility frontier.'' Individuals in a society have choices
about how to employ their resources to produce final products. In the simplest
of cases we can think of the economy as producing two types of goods ``guns''
and ``butter.'' At some point if existing technology is being used effectively,
decisions must be made that involve trading off guns and butter. In the graph,
we can think of the slope of the line as representing the relative price of guns
and butter: an extra gun costs so many sticks of butter.

3 For those who are following the debate on granting ``fast track authority''
to President Clinton in order to extend NAFTA, approximately 2.5 percent of
world output is produced in Canada, and 5 percent of world output is produced
by all of the remaining countries in the Western Hemisphere. See Latin
American View, Citicorp Securities, Inc., Global Research Emerging Markets,
September 1997, Issue 8.
MBA 814 5
In the first graph, this (relative) price is treated as a constant. But it is
easy to imagine that a more realistic characterization of technology is to
assume that there are diminishing returns associated with this tradeoff, so that
extra guns ``cost'' an increasing number of sticks of butter. We can also
characterize the impact of technological change on an economy's productive
capacity by a rightward shift in the production possibility frontier. The
implication of this shift is that the economy can have both more guns and
more butter. Because technological change allows individuals to produce and
consume more of all goods using the same resources, it is sometimes referred
to as the true ``free lunch'' in economics.
As the United States dramatically demonstrated to the rest of the world
during World War II, an economy can quickly shift along its production
possibility frontier. Indeed, one can argue that the Japanese decision to bomb
Pearl Harbor in 1941 was one of the great military miscalculations of the
century. Why? Because the decision appears to ignore the implications of the
industrial capacity of the United States. True enough at the time the U.S.
military was small in size compared to other world powers and destroying the
Pacific Fleet would seem likely to deliver a crippling blow to the United States'
ability to fight a war. However, the implications of the diagram are that such an
analysis was misguided because in the long run the bombing of Pearl Harbor
would have little consequence to the outcome of the war. What the Axis
Powers needed in order to achieve victory was to destroy the U.S.'s industrial
capacity.
By contrast Winston Churchill appears to have understood completely
the consequences of the U.S.'s entry into the war. He recognized the economic
impact that the U.S. would have on war despite it having a relatively weak
military. A story from the invasion of Normandy serves to illustrate the point.
During the initial hours of the invasion a U.S. navel intelligence officer reported
asking a colonel ``how things were going?'' The colonel replied, ``we are
screwing up so badly that you would not believe it, but you know we have so
many ships, and so many tanks, and so many airplanes, that it won't make any
difference. The invasion will still be successful anyway.'' The economic impact
of the U.S. participation in the war was decisive. Indeed, the outcome became
clear once the U.S. gained air superiority and was in a position to
systematically destroy not simply the military installations, but the industrial
capacity of Germany and Japan.
Saddam Hussian provides a more recent example of a military
``strategist'' who probably knew but could not comprehend what it meant for
an economy to have an $8 trillion GDP. After he invaded and occupied Kuwait,
Hussian asserted that U.S. ground troops would not stand much of a chance
against his battle tested troops who had spent nearly a decade fighting a
bloody war with Iran. As evidence, he asserted that whereas his troops could
live off the desert and endure many hardships, ``soft'' American troops could
MBA 814 6
never get by without their ``bottles of Evian water.'' Of course Saddam may
well have been right, but more importantly what he failed to appreciate was
that an $8 trillion economy can supply a 1/2 million troops with a bottle of
Evian each day and no one will notice! Similarly, an economy this size also can
fly 2,000 ``sorties'' per day over Baghdad without this activity measurably
affecting day to day civilian life.
Finally, we can consider the economic lessons of the Cold War. Much has
been written about the consistent resolve of the U.S. and its allies during the
decades long struggle with the former Soviet Union having been an important
factor in determining the outcome of the Cold War. But clearly the most
important factor was the substantial and growing difference between the
economic capacity of the U.S. and Western Europe and of the U.S.S.R and its
allies. ``Glasnost'' and the fall of the Soviet Union revealed the reason for the
Cold War's outcome. As shown by the graph the industrial capacity of the U.S.
economy meant that despite substantial expenditures on the military, U.S.
citizens could still enjoy an affluent lifestyle. The same could not be said of
citizens of the Eastern Block. Indeed as the Cold War dragged on the disparity
grew, even during the 1980s as the U.S. substantially increased its miliary
expenditures.

Discussion Questions:

1. Suppose technological change affected only the production of butter. In

other words a chemical engineer designs a new process that yields more sticks
of butter with the same resources. By contrast, guns continued to be produced
the same old fashion way. Given this form of unbalanced technological change,
would it still be possible for society to ``consume'' both more guns and more
butter?

2. One of the U.S. Congress's favorite activities is to prevent the closing of

domestic military bases and installations that the U.S. military has determined
serve no strategic value. Congressmen (and Congresswomen) argue that
critics of their behavior ignore the beneficial impact that these bases have on
the number of jobs in their communities. Without these jobs, the economy
would weaken because fewer people would be working. Evaluate this
argument of U.S. Congressmen.

D. The Role of the Market, the Firm, and the Household

To be sure, the $8 trillion GDP figure understates the true output of the
U.S. economy because it does not include the value of output and services
produced and consumed by households. For example, the value of meals
prepared at home, child care by parents, house cleaning, or home and
appliance repair are not included in official statistics unless the household hires
MBA 814 7
or contracts others to perform these tasks. The implication of this accounting
of GDP is that as two earner couples become more common, GDP necessarily
rises because households stop producing these services on their own, and
employ others to perform these tasks for them.
A simple way of thinking about the economy is to think of it consisting of
two institutions: firms and households; and two markets: final product and
factor markets. It is useful to think of the household as an enterprise or firm.
Households consume final products, but they also supply the factors used by
firms to produce products. The most important factor is labor, but households
also own (either directly or indirectly) all capital, land, and other resources
used in production. GDP measures the value of those final products purchased
by households.4
In his book entitled Price Theory, Milton Friedman describes the market
sector as the place in which the use and purchase of final products and of
factors of production ``organize the use of resources'' in a society. He goes on
to explain that

(i)n its simplest form, ... an economy consists of a number of individual

households, a collection of Robinson Crusoes, as it were. Each household
uses the resources it controls to produce goods and services that it
exchanges for goods and services produced by other households, on
terms that are mutually acceptable to the two parties to the bargain. It is
thereby enabled to satisfy its wants indirectly by producing goods and
services for others, rather than directly by producing goods for its own
immediate use. The incentive for adopting this indirect route is, of
course, the increased product made possible by division of labor and
specialization of function. Since the household always has the alternative
of producing directly for itself, it need not enter into any exchange unless
it benefits from it. Hence, no exchange will take place unless both parties
do benefit from it. Cooperation is thereby achieved without coercion.

Specialization of function and division of labor would not go far if the

ultimate productive unit were the household. In an modern society, we
have gone much further. We have introduced enterprises that serve as
intermediaries between individuals in their capacities as suppliers of
services and as purchasers of goods. We have introduced money to
facilitate exchange and avoid barter, thereby enabling the acts of

4 In reality there are two other important sectors: the government and the
nonprofit sectors. The government plays three roles: (i) it redistributes
``income'' among households; (ii) it produces or supplies final products (ie.
education or electricity) and (iii) it ``consumes'' final products (ie. provision of
national defense, or highways).
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purchase and sale to be separated into different parts. 5

E. The price system and the allocation of resources.

How does the market sector allocate resources? What are the dynamics
that cause resources in a market oriented economy to be allocated to their
highest ``valued'' user? A dramatic illustration of how this process works is
seen in the aftermath of a natural disaster. The historic flooding of the Red
River in North Dakota during the spring of 1997 demonstrated how quickly
nature can affect both the level and allocation of resources in a community.
Goods that one day seemed ``plentiful'' such as drinkable water, the next were
suddenly scarce. Did North Dakotan's demand for drinkable water suddenly
increase as a consequence of the flood? A common mistake is to assert that it
did, when it fact it probably declined to the extent that some members of the
community choose to leave the area and ``wait out'' the flood by staying with
relatives and friends.
However, how does an economy provide drinkable water to those
individuals who decide to stay behind? There are essentially two approaches:
(i) call in the National Guard and provide every individual with a daily ``ration''
of water; or (ii) do nothing and allow market forces to operate. But what do
market forces have to do with floods? If drinkable water in an area suddenly
becomes scarce and demand for water stays constant what should happen to
its price? The higher price provides incentives to providers of drinkable water
to ship water to the flood victims. Of course, unlike the National Guard,
providers of drinkable water are not likely to ship water for ``free.'' The flood
victims must pay the higher price for their water.
Both approaches described above result in North Dakotan flood victims
having fresh drinking water. But do these two approaches result in the same
outcomes? Experience suggests that the public actually prefers the non-
market approach to addressing the problem of scarcity following a natural
disaster. For example, long time residents of Northern climates know the likely
consequences for retailers who raise the price of their snow shovels following a
blizzard. In principle, such behavior makes sense from the point of view of
both the retailer and society, because it ensures that following a blizzard show
shovels are allocated their highest valued users.6 The price system ensures
that those persons or businesses who are willing to pay the most to begin
digging out from the snow storm receive the relatively scare resource.
Nevertheless, the public often refers to such pricing behavior in the
5 See Friedman, Milton, Price Theory, Chicago:Adline Publishing Company,
1976, pp. 5 - 6.
6 Notice that the nature of the scarcity is different. By contrast to drinking
water following a flood, the ``supply'' of show shovels has remained the same.
Instead the ``demand'' for snow shovels has increased.
MBA 814 9
aftermath of a natural disaster as ``price gouging.'' Sometimes businesses that
are alleged to practice such behavior are threatened with law suits. Application
8 - 1 on pages 285 - 286 in the text illustrates this point using the experience
of Hurricane Andrew in 1992. But, if ``price gouging'' leads to an ``efficient''
allocation of resources, why does the public often object to it? The reason is
that the outcome - how the snow shovels are allocated in the aftermath of a
snowstorm - does not seem ``fair.'' Some would assert that relying on the price
system to allocate resources following a natural disaster is ``crass'' and ``hard
hearted.'' Critics of the market system correctly point out that during these
times of exceptional hardship the most vulnerable in society are least likely to
receive ``needed'' resources such as drinkable water and snow shovels.
Individuals perceive that the non-market solution - calling the National Guard -
yields a fairer outcome. From a normative standpoint, the non-market solution
may be a ``good'' or the socially ``preferred ''outcome. Economic analysis
does not help us understand ``right '' from ``wrong'' or ``good'' and ``evil.''
None the less, some economists might suggest that a more ``efficient'' way
allocate resources following a natural disaster is to allow market forces to
operate and to ``subsidizes'' the poor and needy so they can buy drinkable
water or snow shovels.

Discussion Questions:

1. Since 1981 in the United States, labor productivity has grown at historically
unprecedented rates in the manufacturing sector. (By contrast, labor
productivity as measured in the services sector has grown very slowly.)
Starting in the 1920s and continuing until the 1980s, U.S. labor unions have
argued that wage increases for workers should be tied to productivity gains in
the industry. In the absence of unionization, would you expect that workers
wage gains would be proportional to gains in labor productivity? What would
happen if manufacturing wages began to rise relative to wages paid in the
service sector? How are wages helping to allocated labor resources? Is the
union wage policy sustainable?

2. The United States often is on the front lines advocating ``free trade,''
especially in agricultural products among other industrialized nations. French
farmers, notorious opponents of free trade, sometimes are signaled out as an
example of an impediment to lower world prices for agricultural products. At
the same time, the United States has engaged in some inefficient and
``protectionist'' agricultural policies of its own. A good example, are laws
governing the trading and pricing of water rights in many western U.S. states.
In California water is relatively cheap if used for farming, but is expensive when
used by urban residents for personal use.7 Could this outcome result from

7 For a more technical treatment of this example see Application 18-2 in the
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market forces? In general what should be the price difference between water
used for farming and water used for residential consumption? Given the
existing price differential between water used by farmers and urban residents,
what are the consequences of the resulting allocation of resources for the
prices of agricultural products? For housing prices in Los Angeles? Why did I
refer to these water rights laws as ``protectionist?''

3. Interest in the benefits of ``free trade'' dates back at least to the 18th
century and indeed this issue was one of the central purposes of the Wealth of
Nations. More than 150 years ago, economist David Ricardo rigorously
analyzed the economic consequences of the British ``corn laws.'' These laws
amounted to significant import restrictions on agricultural imports into Great
Britain. The crux of Ricardo's analysis was that these laws had lowered national
income and had reduced growth. The question to be resolved was similar to
that facing North American policy makers today with NAFTA. The ``North-
South'' question during Ricardo's time was the industrialized United Kingdom
and the relatively land rich Baltic countries. Ricardo successfully argued that
the corn laws distorted the allocation of British land and human resources and
as a consequence had hindered growth. Given the low cost of land in the Baltic
countries, too much British land was used for farming and too many British
subjects were farmers.8
Although the economy of Ricardo's time was much different that ours
today, the issues that he addressed in his influential work on free trade are
essentially the same as those encountered with NAFTA and other ``free trade''
arrangements. That the debate still rages about this topic after more than 200
years since the publication of the Wealth of Nations demonstrates in part how
difficult these issues are to understand and the point that not everyone
benefits from free trade.9
The question arises is why do trade agreements generate such heated
opposition? Would the nations of the world be better off with more protection?
One way to understand protection is that it prevents voluntary exchange
among individuals who reside in different countries. In other words, there are
two individuals who would both be better off if they could trade. If two citizens
of the same country wanted to engage in a similar transaction most would
agree that it would be inefficient to prevent the exchange. (But see water
text, pp. 679 - 681.
8 See Kouparitsas, Michael. ``Economic Gains From Trade Liberalization-
NAFTA's Impact,'' Chicago Fed Letter, Chicago:The Federal Reserve Bank of
Chicago, 122, October 1997.
9 A multi-country poll, conducted just prior to the 1997 G-7 conference in
Denver, which was hosted by President Clinton, revealed somewhat ironically
that the greatest support for free trade was among Russian citizens! In most of
the G-7 countries substantial numbers if not majorities opposed freer trade.
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rights discussion above.)10

If Country A can not successfully negotiate a free trade agreement with

Country B, would it still make sense for it to allow ``unfair'' trade between the
countries? Consider the following definitions:

Fair Trade:

Country A can sell its products to country B without barriers.

Country A can buy products from country B without barriers.

Unfair Trade:

Country A cannot sell its products to country B.

Country A can buy products from country B without barriers.

No Trade:

Country A cannot sell its products to country B.

Country A cannot buy products from country B.

How would you rank each of these regimes? Why?

4. During the late 1980s, the U.S. and Canada successfully negotiated a free-
trade agreement. President Bush intended that the agreement would become
a model that would subsequently become the basis for NAFTA. An interesting
obstacle arose during the negotiations when the U.S. objected because the
Canadians wanted to continue to subsidize their beer industry. The U.S.
argued that it would not be ``fair'' for Canadian producers to be subsidized
after tariffs were eliminated under the agreement. Disputes over a ``level
playing field'' often arise in trade negotiations. But the question is ``fair'' to
who?

F. Tools of the trade: Supply and demand

10 In the United States, the ``interstate commerce'' clause of the U.S.

Constitution prohibits states from establishing trade barriers. However, as a
result of the repeal of prohibition in the 1930s, alcohol is exempt from this
clause and states have in fact erected significant barriers to trade. For
example, Michigan has a state-owned monopoly on the wholesale liquor
business. Pennsylvania has a state-owned monopoly on the retail liquor
business. (If you can imagine such a thing wine made in Pennsylvania is
exempt!) This year the Florida state legislator enacted a law (allegedly to
protect minors) making it a felony for individuals to receive liquor that they
have had shipped across state lines.
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In the previous section, we developed the tools of economic analysis
without using any explicit quantitative framework or apparatus. Now we turn
to putting our discussion of these economic concepts into the context of the
familiar supply and demand framework. One of the best places to start any
analysis of prices is with agricultural markets. One reason for this is that they
often conform most closely to an economy consisting of many producers
(suppliers) and consumers (demanders). Under these conditions, the
framework that we develop in this course is the easiest to use and makes the
strongest predictions.
Consider the graph showing the relationship between the quarterly
demand for turkeys and their price. Since scientific studies revealed the health
benefits of eating turkey as opposed to red meat, turkey is now consumed year
round in the United States. However, the greatest demand is during the fourth
quarter of the year when American families often eat turkey during the
Thanksgiving and Christmas holidays. What appears to be the relationship
between the quantity consumed and the price of turkey? Once one
understands that the consumption patterns differ during the year, it is easy to
see that there are two demand curves for turkey: (i) the fourth quarter demand
curve is ``shifted'' out to the right and is steeper; and (ii) the rest of the year
demand curve which is flatter. The data plotted in the graph appear to tell us
something that makes a lot of sense: the demand for turkey is greatest in the
fourth quarter and consumers exhibit less sensitivity to price during that
period.11
The demand curve for turkey represents the amount of turkey that
consumers are willing to purchase at any given price. Therefore, the area
under the demand curve would be the total revenue that turkey producers
would receive if they could price discriminate and charge each consumer the
maximum price he/she would be willing to pay for a ``unit'' of turkey. 12 If
consumers value turkey more, then the demand curve shifts to the right.
Notice that this shift implies that at any given quantity of turkey, the value
placed on it by consumers has increased. The ``slope'' of the demand curve
tells us how sensitive consumers are to changes in price. A steep demand
curve means consumers behave as if price is NOT an important determinant of
their consumption decisions. By contrast, a flat demand curve, means
consumers behave as if price is a very important determinate of their
11 Thinking back to your time with Professor Rubin, how would you use your
knowledge of regression analysis to estimate the relationship between quantity
and price?
12 This statement is approximately true if the good involved constitues a
small portion of a consumers' expenditures. More generally, this amount
overstates the actual amount that consumers are willing to pay for a good. For
a technical treatment of this question see the discussion in the text on pages
110 - 119, 134 - 136.
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consumption decisions. In this case, a modest rise in the price of turkey would
lead consumers to stopping purchasing turkey and instead purchase a
``substitute'' such as chicken.
As we will discuss in the next lecture, the demand curve represents the
values that consumers place on a good or service. By contrast, the supply
curve represents the costs to producers of producing a product. These costs
reflect both the market prices for different factors of production, and also the
available technology for combining these factors and producing a final product.
Lets consider two supply curves: (i) the first represents a firm that buys factors
in competitive markets and uses a technology that exhibits constant returns to
scale; and (ii) the second supply curve represents either a firm buying factors
in noncompetitive markets and/or uses a technology that exhibits decreasing
returns to scale. The first supply curve is flat: it says that firms can produce an
unlimited amount of turkey at a constant (marginal) cost. The second supply
curve is increasing: it says that firms can produce more turkey but only at a
rising cost per unit. Lower factor prices or technological change shifts the first
supply curve down and the second curve to the right.
The prevailing competitive price is characterized by the intersection of
the demand and supply curve. At this point, the value placed on the turkey by
the ``marginal'' consumer exactly equals the cost of production. If a rare
disease were to ``hit'' turkey farms, the cost of supplying turkey would rise.
(The first supply curve shifts up; the second shifts back to the left.) As a
consequence, the price rises: turkey producers are not willing to produce
turkeys at the low pre-disease price, but some consumers continue to buy
turkeys at higher prices. Notice that consumers do not value turkey any more
as a result of the ``supply shock'' on the turkey farm. But the price has risen.
The higher price tells us that the ``marginal'' turkey consumer values turkey
more than previously.
This framework helps us to understand questions of economic value that
often puzzle individuals without any economics training. Consider the following
three questions:

(i) Everyone knows that water is essential to life and diamonds are
frivolous. But why is the price of water low and the price of diamonds
high? Does this outcome mean that something is wrong with the free
market?

(ii) Everyone knows that teachers and police perform essential work, yet
they are relatively low paid. By contrast, Michael Jordan is an entertainer
engaged in a frivolous or non-essential activity and yet makes $36
million per year. Does this outcome mean that something is wrong with
the free market?
MBA 814 14
(iii) In April 1992, child care workers in Seattle, Washington went on
strike for one day protesting their low wages and poor benefits. They
noted that while their hourly wages ranged between $5 and $6 per hour,
the wages of zookeepers in the Seattle zoo averaged $12 per hour.
Because care givers of children were being paid less than 1/2 the pay
received by care givers of monkeys and tigers, they argued that the
``free market'' was not functioning in the child care industry. Does this
outcome mean that something is wrong with the free market?

In each case comment on the argument that the ``market does not work.''
These three questions all ask the same thing. What do they have in common?

G. Economic v. technical efficiency

One confusing aspect about economics is that it uses an alternative
definition of efficiency than the one commonly used by the general public. 13 To
most people, efficiency refers to technical efficiency: how much output a
person or firm can generate from a fixed set of resources. An alternative
definition of efficiency is based on the answer to the question are these
resources allocated to their highest valued user? If yes, then the outcome is
efficient.
To understand this distinction more clearly consider our discussion above
of water rights laws. We could research the use of water by California farmers
and determine that they make efficient use of their water. However, from an
economic standpoint, unless they sell their water to urban users, their use of
water is inefficient. Laws and regulatory practice prevent water from moving
to its most valued user! Because urban consumers are willing to pay more for
water ``on the margin'' it would be socially more efficient for them to consume
more water. Such an allocation means that it would be more efficient for
Southern Californian homeowners to pay less to fill their swimming pools or
water their lawns and for everyone else to pay more for agricultural products!
Now consider an example that contrasts the labor intensity of hotel or
commercial construction in the United States compared with Mexico. In the
United States, building contractors construct multi-storied hotels with relatively
little labor. Instead, they save on labor costs by employing modern capital
equipment. By contrast, their counterparts in Mexico use relatively less capital
and make heavy use of labor. Labor productivity is much higher in U.S.
construction firms. But are the U.S. firms more efficient? The answer is
probably not. The difference in labor intensity or the capital-labor ratio used in
U.S. compared with Mexican construction results from the differences in
relative wages. U.S. workers are more expensive because they have higher
valued alternatives. As a result, it makes economic sense to employ building

13 To make matters worse, statisticians have another important definition of

efficiency.
MBA 814 15
(ie. production) technology that relies heavily on capital. The point is that even
if a Mexican construction firm were given the capital equipment, it would still
be more ``efficient'' (and profit maximizing!) for it to continue to use the labor
intensive mode of production and rent the capital equipment to a construction
firm in the United States!
The idea underlying the notion of economic efficiency is that all
resources, whether they be labor, capital, land, mineral resources, etc., have
an alternative use. Thus, the real cost of employing these resources to produce
one good or service equals the value of the good or service that would have
been produced had these resources gone to that use. If the price system
functions well, this cost should equal the prevailing price for these resources.
So if clerical workers in a community receive $12.00 per hour, this wage
implies that the alternative use of their time is worth $12.00 per hour. In other
words, if a clerical worker quit or was laid off from his/her job, he or she would
expect to find another job paying approximately $12.00 per hour.

_________________________________________________________________________
Footnote
See Guanzi: Political, Economic, and Philosophical Essays from Early China, W.
Allyn Rickett, translator, Princeton, NJ: Princeton University Press, pp. 9, 118.
(The Guanzi is believed to have been written or compiled around 250 B.C.E.
Italics are added for emphasis).
2
see M.I. Finley, The Ancient Economy, Berkeley, CA: University of California
Press, 1973, pp, 17 - 19.
3
For those who are following the debate on granting ``fast track authority''
to President Clinton in order to extend NAFTA, approximately 2.5 percent of
world output is produced in Canada, and 5 percent of world output is produced
by all of the remaining countries in the Western Hemisphere. See Latin
American View, Citicorp Securities, Inc., Global Research Emerging Markets,
September 1997, Issue 8.
4
In reality there are two other important sectors: the government and the
nonprofit sectors. The government plays three roles: (i) it redistributes
``income'' among households; (ii) it produces or supplies final products (ie.
education or electricity) and (iii) it ``consumes'' final products (ie. provision of
national defense, or highways).

See Friedman, Milton, Price Theory, Chicago:Adline Publishing Company,

5

1976, pp. 5 - 6.
6
Notice that the nature of the scarcity is different. By contrast to drinking
water following a flood, the ``supply'' of show shovels has remained the same.
MBA 814 16
Instead the ``demand'' for snow shovels has increased.
7
For a more technical treatment of this example see Application 18-2 in the
text, pp. 679 - 681.

See Kouparitsas, Michael. ``Economic Gains From Trade Liberalization-

8

NAFTA's Impact,'' Chicago Fed Letter, Chicago:The Federal Reserve Bank of

Chicago, 122, October 1997.

A multi-country poll, conducted just prior to the 1997 G-7 conference in

9

Denver, which was hosted by President Clinton, revealed somewhat ironically

that the greatest support for free trade was among Russian citizens! In most of
the G-7 countries substantial numbers if not majorities opposed freer trade.

In the United States, the ``interstate commerce'' clause of the U.S.

10

Constitution prohibits states from establishing trade barriers. However, as a

result of the repeal of prohibition in the 1930s, alcohol is exempt from this
clause and states have in fact erected significant barriers to trade. For
example, Michigan has a state-owned monopoly on the wholesale liquor
business. Pennsylvania has a state-owned monopoly on the retail liquor
business. (If you can imagine such a thing wine made in Pennsylvania is
exempt!) This year the Florida state legislator enacted a law (allegedly to
protect minors) making it a felony for individuals to receive liquor that they
have had shipped across state lines.
11
Thinking back to your time with Professor Rubin, how would you use your
knowledge of regression analysis to estimate the relationship between quantity
and price?

This statement is approximately true if the good involved constitues a

12

small portion of a consumers' expenditures. More generally, this amount

overstates the actual amount that consumers are willing to pay for a good. For
a technical treatment of this question see the discussion in the text on pages
110 - 119, 134 - 136.
13
To make matters worse, statisticians have another important definition of
efficiency.