COURSE GUIDEBOOK Economics Pact I: Mierneranamies Lecture I: How Economists Think Lecture 2: The Fundamentals of Supply and Demand Lecture 3: Reconciling Policy with Supply and Demand, Lecture 4: The Labor Market and Wages Lecture 5: Interest Rates and che Detnand Side of the Capital Morkes Lecture 6: Financial Investment from the Supply Side Lecture 7; The Environment and Negative Ex Lecture 8: Technology, Positive Externalities, and Public Goods Lecture 9: Poverty and Inequality Lecture 10: Regulation to Ensure Free Markers ‘Gna int 1-800-TEACH-12 (1-800-832-2412) & www BANS 4151 Lafayerte Center Dri ite 100 Chantilly, ewe as sodey, Aout, s0ss2J041g ram J Meg ‘sormrouosg7 | COURSE GUIDEBOOK Economics Professor Timothy Taylor Macalester College Part I: Microeconomics ‘EACHING COMPANY330 T Taylor, Timothy Economics 1494723 5 Cass./1 Book ‘Timothy Taylor Editor, Journal of Economic Perspectives ‘Macalester College Timothy Taylor is Managing Editor of the Journal of Economic Perspectives, an academic journal published quarterly by the American Economic Association. The purpose of the journal i to encourage communication and cross-fertilization across. the many fields of ‘econotnies, Taylor received his Bachelor of Aris degrve from Haverford College in 1982, and a Master's degree in Economies from Stanford University in 1984, He then worked as an editorial writer for the Sat Jase Mercury-News fot two years, before taking the job of starting the Journal of Economic Perspectives in 1986. He has taught introductory economics in a number of contexts. At ‘Scanford University and the University of Minnesota, he taught large lecture courses cf 300-500 students. Ai Stanford, he was winner of the avvard for excellent teaciting in a large class given by the Associated Suxlents of Stanford University in 1992. Since moving to the University ‘of Minnesota in 1994, he has been named a Distinguished Lecturer by the Department of Economics in 1996, and voted Teacher of the Year by the Master's degree students at the Huber H. Humphrey Institute of Public Affairs in 1997, He has also been a guest speaker for groups of teachers of high school economies, visiting diplomats from castem Europe, radio talk shows, and community groups. From 1989 to 1097, Tim wrote an economies opinion colunin for the San Jose Mereury= News; many of his columns were disseminated nationally over the KnightRidder-Tribune wire. He has recorded several courses for The Teaching Compaty: Economics: An Iuroduetion, Legacies of Great Econonisis, and A History of the US. Economy in the 20th Century ‘Timothy and his wife Kimberley live with their son Nathaniel near Lake Harriet in the southwest corner of Minnespolis,Table of Contents Economics Part | Microeconomics Course Seope and Learning Objectives Lecture One: How Economists Think Lecture Two: The Fundamentals of Supply and Demand 10 Reconciling Policy with Supply and Demand ... 16 + The Labor Market and Wages. 2 Interest Rates and the Demand Side of the Capital Market a7 Lecture Six: Financial Investment from the Supply. 3 Lecture Seven: ‘The Environment and Negative Externalities ... 39 Lecture Eight: Technology, Positive Externalities, and Pal Goods sone 5 Lecture Nine: Poverty and Inequality Lecture Ten: Regulation to Ensure Free Markets 56 Glossary: SA aradat atti Readings and Reference Materis Biographical Notes ECONOMICS Scope of Course: The wisdom of economists is neatly proverbial, but in a negative sor of way. Despite this prevailing prejudice. economics does have use lessons for understanding the world around us and the purpose of this series of lectures is to contribute to this undersianding, The course is aimed at providing a basic level of sophistication in economic matters that will help explain both the ULS. and global economies. This, the course i divided into the traditional categories of ‘microeconomics (kow individuals and basinesses operate in the context of supply and demand) and macroeconomies (how governments act 10 cconstiain or release economic forces), Thus, the topies of the course will explain, and relate to one another, the terms that are frequently encountered in newspapers, hoth on the front page and in the business section: supply and demand, interest rates, wages, financial markets, public goods versus private interests, regulation and deregulation, employment, poverty level, inflation, trade balances. budge's and deficits, taxation, exchange rates and the new “global economy.” The course is sited at nor-cconomis's who are concemed and interested citizens who Woald like f know more about the subject of economics and how it affects thei lives Learning Objectives: Upon completion of these lectures. the student should be able 1 1. Explain the roots of the underlying power behind of market forces, and evaluate their positive and negative effects 2. Outline the range of economic analysis, from mieroeconomies oF individuals and businesses, 10 the mactoeconomics of national economies and the global economy’ 3. Summarize the eeonomic assumptions of rational, purposeful behavior, 4. Discuss ark! apply the supply and demand framework in goods, labor, and cay 5. Identity those objectives which fiee markets are especially likely to achieve, 6 Discuss situations in whici an unfettered market is likely to run into problems (2, poverty, pollution, technological research) and explain the economic prescriptions for these problems 7. Summarize the main gcals of macroeconemi policy: economic ‘growth, low uncmployment, low inflation, and a sustainable balance of trade 8. Describe the goals and mechanisn of fiscal and monetary policy 9. Explain the argument for free trade, and defend it against some: ‘common erificisms. tal markets.10. 6 the determinants ofthe exchange rte, and discuss the policy arguments about what level it~ should be. Lecture 1: How Economists Think Scope: Economics isa structured and disciplined way of looking a! the ‘world, This first lecture begins by openly discussing seme of the grave doubts and suspicions that eritics have expressed about his economic perspective over the years, As we will atiemipt to show, many of these criticisms are based on a misguided notions of what economics as 2 subject is all about The discussion then moves to identify sete of the fundamental ways in which economists have trained themselves to think differently than the typical person on the street about human motivations, uadeoffs, and the workings of markets. Several ‘conimon pattems will ozcus here, One is thatthe principle may sound reasonable enough, but as the discussion continues, the listener may find that it has unexpected implications. Another pattem is that the principle may sound unreasonable or ncomfortable, but upon reflection, it may be more plausible than the alternatives. Economies has a strong ingredient of realism: it insists on seeing people as having an incentive to benef themselves, and it insists on acknowledging that even desirable altersatives may hav inpleasant side-effets Finally, this Tecture lays out the overall structure of these lectures and @ number of terms that will be useful as we nvestigate the interesting world of economies. Outline 1. Economies and economist have earned a poor publie reputation over time, This is reflected in both jokes and serious commentary A. Jokingaside, much of the reason for 1s from fundamental understandings about what economies actully is. B, Another factor lies in the distinction between how economists see the world and how others see i C. Feonemies is not about making money or forecasting the future; rather i’sa structured way of thinking about fundamental questions and connections, such as what to produce, how fo produce it and who gets I An economic and political system will define itself by the way that it answers these fundamental questions. The questions themselves are unavoidable,aT B. LiL, We need to investi ange of potential answers lies somewhere between complete goverment control and anarchy’ Few believe in in complete government coatrot of every decision about work, produetion, and market deci believe in no government whatsaever. Mainstream economics takes place in the middle ground, irying to identify cases where ‘markets work well, where they Teave something to be desired. and what should be done in the latter eases. jons. Pew te carefully the things economists believe that ‘most people really don't A bd. Economists take tradeoffs seriously. Most people feel that if something is @ good idea overal, admitting any downside is sirategically bad. 1. Ifyou confess that there are tradeoffs, perhaps your argument will appear weaker. 2 But what may be good strategy it an argument is bad strategy for a serious analyst, who needs to admit and consider all the consequences, goo and bad. Economists believe in “statistical people.” not real people, 1, Ancedetes tell us about one person or situation, but even ‘when they are completely accurate, they can't reveal whether that particular example i typical or a rare exception 2. Economics requires that decisions about social policy need 10 be made on the basis of overall judgements about coffects acrost society, not individual eases. Selfishness can be an effective principle of social ‘organization. 1. Itmay seem implausible that good can ever come of selfishness. But one of the fundamental insights of cere, is that people often engage in productive economic behavior (working, saving, comparison shopping, providing high quality goods) out of selfish motives. A “invisible Hand” can Teal selfishness to be socially prodoetive. Economies tells us not to believe that individual people or businesses set prices, L 1. Prices are the outcome of interactions between alte buyers in the market and alle sellers in dhe market 2. Prices are not about morality o: justice. A company can't just raise prices without considering whether other -, dating back te. Adam Smith in 1776 and even og conpetitors will undersel it, and whether consumers will ccoxtinue to buy. It can't just cut prices without considering how it will pay workers and supplisrs. Even « free market places heavy constraints on individuals and businesses in ‘hat market. A fundamental premise is that incentives matter. 1. People often ciaim that they have no way to reacting wo higher prices, except to suffer. 2. Rusinesses often claim that they have no way of reacting to higher wages or government regulations, except to suffer. But in fact, when confronted by ehanges in prices or other conditions, people and businesses do find ways to react. Economie policy is based on the notion that if incentives change, behavior will often change, too, Exchange creates wealth, 1. Wealth does not ultimately reside in physical things; it rests ip the satisfaction and pleasure that people tukimately get from those things, Exchange leads to patterns of specialization, where producers become proficient at eertain skills, and it leads to items being sold to those who want them. Changing prices is not the way to redistribute commodities or services. 1. Ifyou want vo make someone better off it is usually more sensible to give them money directly than to try to ater the prices that they face. 2. The problem with altering prices is that it changes the incentives in the market (see paragraph TILE. above), and it changes thei for every the subgroup you are seeking to help, + not just ‘We mus include opportunity costs in economic ealeulations. 1. All costs should be theught ofas foregone opportunities if you had acted in one way. what_might you have had inswead? 2, Money ean capture ene aspect of opportunity cost, but i's important to remember that time and fost opportunities are abo a cost Markets are & powerful force of nature. 1. Markets accomplish remarkable feats of ceordination, bringing together skills and technologies from all over the slabe to make products that we think of as everyday things, Markets feed eities every day.2. It can make perfect sense to dislike aspects of market forees, orto advocate policies to change some market ‘outcomes, but it never makes sense to pretend that markets are not powerful, or that they ean be ignored. IV. Now that we have diseussed some of the features of the ecaniomic outlook, we need 19 define and discuss the distinetion between miero~ and macroeconomics. icroeconomies isthe study of how households and firms make decisions in goods, lator, and capital markets, and the siudy of how an why those markets sometimes fail BM nice takes an overall view of the economy, Tocusing on policies with regard to goals like ‘unemployment, inflation, economie growth, and the balance of trade, and how the polices of national governments can affect, these cutcomes in # global economy. Readings (General Note: Following each leeture we have ineluded a list of esseutial and supplementary readings identified by author title, journal in which appearing(as appropriate) and chapter and pages. Full annotated bibliographic citations, along with an explanation ‘on how best to use the reference material for further learning, ave contained in the appendix entitled “Bibliozraphy”) Essenttal: Hirshleifer, Jack, "Capitalist Ethics: Tough er Soft?” Journal of Law cand Economies, October 1959, 2, pp. 114-119. Leonard, George, "Competition," Esquire, May 1984, pp. 134-136. Read, Leonard E., "I, Peneil," The Freeman, December 1958, pp. 32- 3 Kerr, Steven, "On the Folly of Rewarding A. While Hoping for 8,” ‘vactemy of Management Journal, 1975, 18: 769-83. Supplementary: Alston, Richard M., LR, Kearl, and Michael B. Vaugin, "ls There a ‘Consensus Among Economuiss in the [990's?" American Economic Review, May [992, 82:2, pp. 203-209, Stigler, George, "The Intellectual and the Marketplace," published as Chapter 18 of Ail About Eeonomies ‘Questions for Consideration: 1 Diseuss the power of markets in bringing together ingredients and creating produets, Think about the products thet you use Uhat come from far away, of that have components or ingredients that come fiom far anay. Also think about everyday products that you would have an especialy hard time making for yourself Consider the good and bad sides of competitive ‘considering how an event like the Olympics may bring out the best ‘or the worst inthe competitors. Then think about how these same good or bad charecter tits may occur among people running a basiness. (To help spur your thinking on this subject, it may be helpful to read the article by George Leonard listed above) Identity the key assumptions that economists make about how people think. Compare them with how economists think, What ‘mit be the ramifications brought bout by the two different modes oF thought?Scope: 10 Lecture 2: The Fundamentals of Supply and Demand This lecture discusses the findamental market forces of supply and demand, Any market involves both buyers and sellers, ‘who must come to agreement on a price if any exchange is 10 ‘occur. Economists refer to the cornbined force of the buyers as thar of demand, and the combined force ef the sellers as that of supply. The markets for goods and services in the economy as 4 whole can usefully be divided into three categories. The ‘market for goods and services features houscholds as the demanders, and businesses as suppliers. The labor market features households as suppliees of labor, and businesses as demanders, Wages are the prices in the labor market. In the capital markel, all savers are suppliers of capital, whether they are individuals or businesses, while all borrowers are demanders of eapital, Interest rates are the prices in the capital marke. Economists, in their structured way of thinking, insist on seeing and explaining prices, wages, and interest rates as ‘ouitoames of the process of eupply andl demand in these vs markets. Questions of whether prices reflect true "values" are set aside as interesting for arguing over good or bad policy, but not helpful in understanding why things are the way that they are. Changes in prices are explained as movemeats of the forces of supply and demand, an approach which hiss proven remarkably accurate and usefUt in describing price movements in economies all over the world. The supply and demand framework predicts that markets will tere toword an equilibrium at a price where the quantity supplied and the quantity demanded in the market are equal to teach other, This situation is what economists mean when they refer t efficiency: at the prevailing price, there is no extra supply going unpurchased, nor are there demanders willing to pay the going price whe eannot purchase what they wish, OF ceourse, £0 say something. is efficient is not to say that it is unchangeable, of even that it is good, But the forces of ‘supply and demand neod to be acknowledged and understood, fas they are in this lecture, before we can discuss. public policies for adjusting them, which is the task of the next lecture LL, We fist need to ask what economists mean by price. Ou It is usefil to visualize microzconomic interactions 2s a circular flow in three markets of goods, labor snd capital, with households and flims being the suppliers and demaders: 00d x 5 households > labor > firms «ay me) capital A. Notice from the direction of the arrows that households demand goods and supply labor and capital; firms supply ‘goods, but represent demand for labor and eapital B, Some would draw the capital market arrows going in bot directions, to show that households also demand capital when they borrow to purchase a house or car, and firms supply capital when they loan money or earn a profit and choose to save and reinvest those funds. C. Because this diagram is a circle it helps show how anything that affects one conneetion ie likely to alco have offecte elsewhere in the economy. A, Price is nota value-laden term. 1. Most people refer to prices being "too high" or “too low" asa sort of judgement about the way they think the workd caught co be, 2, To an economist, this is a liule like saying tat the weather on a given day is "too cold" or "too het." Such Judgments tell something about the preferences of the person who i expressing the opinion, but it docsnt tell {you anything about why the price (or the temperature) is otal atthe level that itis, B, Adam Smith's diamond-water paradox can help explain price (or value in exchange). 1, Diamonds have great value in exchange, bat relatively Fitle value in use. Water is a basic necessity of life, with reat value in-use, but it is oflen very cheap or even falls from the skies for free.2, Clearly, value in exchange does nox always match value in use, and it would be incorrect 0 imply that because something has a low price (say, water, that is not useful. 3. Markets are about value in exchange, and the forces of supply and demand, not value in use. ices are nothing but supply and demand: to think like an ‘economist, you should begin by purging your mind of thoughts about the underiying metaphysical value of goods, and instead think enly of howw supply and demand determine the price. LIL, Next, we need (0 specify exactly what economists mean by “demand” and "supply." A Demand and supply are unseen forees (or lines on a graph), not ‘observed quantities 1. There is often a semantic confusion berveen “demand” and "quantity demanded," and a parallel confusion between *supply” and "quantity supplied.” 2 Quantity demanded or supplied refers to specific amounts that ace desired at a given price. The terms “demand” or “supply” reler to how much is desired at every price, 3. Quantity demanded and supplied are points; demand and supply are curves Demand is defined as the relationship between quantity demanded and any given price. Demand curves slope down, which shows that the quantity demanded tends to fll es price Demand ean shift as follows: 1. When demand inereases, it must be that at every single price, nowa higher quantity is demanded than betore When demand decreases, it must be that at every single price, a lower quantity is demanded than before. 3. Demand for a particular good may shift because of changes in population, income, or prices of substitute or complementary goods. Supply is defined as the relationship between quantity supplied ‘and any given price, Supply curves slope up. which means that ‘quantity supplied tends to inerease as price rises, Supply can shift as Follows: 1. When supply increases, it must be that at every single price, now a higher quantity is supplied than before. ‘When supply decreases, it must be that at every single price, a lower quantity is supplied than before. Ww. 3. Same reascn for & shift in supply include tectnology, ‘weather, regulation, ofthe price of input goods. Supply and demand combined 10 determine an “equilibriua’ price. AL The following chert and explanation demonstrate haw demand and supply determine an "equilibrium" price price | B demand equilibrium supply qua 1, Combi the ideas of supply and demand, At low pric the qemiy supplied. ll be Tow, ard the ant damanded will be high. As the price rises, the quantity supplied stats going up, and the quantity demanded stats coming down, At some price quantity demande fs eq te quantty supplied. ‘That point is known as equlirur, 2. Avia price above equilibrium, quamity supplied excesds (uantly demanded, ‘There are extra goods pling up on thsivs: To get rid of fy sllrs wll sta reducing thei prices, which moves price toward the equilibrium level 3. Ata price below equiv, quantity demanded exceeds auantiy supplied. Sellers become aware that exerything they put out on the stilWes. Is belng. snapped “up immediately, 0 they ein to wate pres to make more tone, which moves price toward the ecu lee Why ulin is “etter.” 1. An efficient machine has no wasted motion, no extra parts, In economic terns, at ihe cquilibrin, the qua demanded is equal to the quantity supplied. This means that there isn't extra goods piling up on shelves, which ‘nould ebviously be inefficient. More subtly, it means that buyers who are willing to pay the market price are notc shopping around or waiting in line and Fading that none is available, because supplies have been sold out 2. To phase the same idea in a different way, efficien means that all sellers willing 10 take the market price ean find a buyer, and all buyers willing (o pay the market price can find aseller. Tere are some impoctant limitations, inner meanings and complaints about economic equilibrium that we must consider, 1, Not everyone will be happy at equilibrium. Remember, there will always be buyers who would like the price to be lower, and sellers who would like the price to be higher 2. Prices are not set by the producers. Producers face two problems: one is their competition, the other is what people are willing to pay. If a firm hed a monopoly with rho competition, and people would pay any price For its procuct, then the fim can set whatever price it wants. But the overwhelming majority of goods don't fall into this category. Both sides of the markels set prices, not individual produ 3, Real people dont think this way, which is too theoretival Actually, lot of businesses certainly do think this way it’s what managers are trained to do in business school. As to individual behavior of consumers, when you try 10 predict wat someone will do, you don't always look into their comicious mind, Imagine that you were trying to predict the speed and are of a pass from a football {quarterback (0 & receiver. You would use equations of physies about the weight of the ball, the farce of gravity, the speed of the wind, and 50 on. However, the quarterback may not know any of those formulas: he has: just practiced a lot to throw the ball where he wants to. ‘Similarly, economists believe dhat this way of thinking captures whet people actually do, even if they don't go through this exact thought process. 4. The market may efficiently produce things I don't like, like pomography or dr is complaint is certainly true, and there are eases in which society will want to limit the power of the market. Many of the lectures that follow \will discuss the rationale and methods for such limitations. However, notice that this complaint concedes that markets ‘are powerful and efficient, albeit at doing bad things, what is oiten called “consumer sovereignty ‘The test of these ideas is whether they work, and they do. A supply and demand framework is an extraordinarily useful and applicable way of thinking about why prices are atthe levels, they are,and why they are rising or falling. It's an explanation that works forall sorts of products, in markets all over the ‘world, and a all different times ofhistory. Fscontial readings: Friedman, Milton and Rese, "The Power of the Market." Appearing as Ch. | of Free to Choose. New York: Harcourt Brace Jovanovich, 1980. Milton Friedman is one of the mast eminent Economists ofthe century. In public iscourse, he Is often known miore for his politically conservative views rather than for his brilliance as an economist. But he is one of the few top-notch academic economists who also has worked hard at bringing the ideas of 1 of thishook discusses his views ‘of the market, he price mechanist, an the limited role of government, Many of the subjects he raises here will be discussed in later lectures. Whether you ‘with Friedman's political views or not, it is @ useful disciplise to separate in your mind the pure economies of his views fiom the political conclusions he draws. Supplementary readi The most useful way of making sure you understand the concepts of supply and. slomand isto stat anplying them in new and unfamiliar 9 contexts, even when those articles are not explicitly economic in nature. Four examples of | such articles eppent here: two fairly straightforward examples and two examples with heavier moral considerations. In considering each article, draw a supply and demand diagram; consider whether the effects discussed in the article would cause a shift insupply or in demand: and what the results would be for cequifitrium price and quantity “Phinking about Drinking” and "Fungi 1o be with.” The Economist, December 25, 1993, p. 106-108. The Mist article suggests there may be a genetic reason why Europeans can metabolize aleobol faster than east Asians, and offers some speculation about the genetic component of alcoholism, Assuming this scientific evidence turns out to bbe rue, draw uifferent demand curves for alcobiolies, east Asians, and Europeans, How do they compare? Ifthe supply curve for alcohalie products is the same in all counties, how might the equilibrium price differ in each country? ‘The second article diseusses the invention of truffle farming, How ‘would you expect new developments in this area to affect equilibrium price and quantity in the cule marke? Gubernick, Liss, "How Much is That Baby in the Window?" Forbes, October 14, 1996, pp. 90-98Lecture 3: Reconciling Policy with Supply and Demand A straightforward market in babYes is legal, of course. Bat when there comand for children to adopt and a supply of mothers who are uncertain about parenthood, a market-like mechanism will come into place. Ifthe legal rales ‘were revised to facilitate adoption, ase a supply and demand framework to analyze how it would affeet the price of adaption. Scope: One of the most confusing things in thinking about supply and demand is that when economists talk about these forces being inevitable, it ean sometimes sound as if nothing can be done Hylton, Keith H., "The Law and Eeonomies of Organ Procurement," Law aind about them. The pessimistic conclusion that nothing can be Poly, July 1990, 12:3, pp. 107-224, e done is wrong, However, when you take sctions that affect rarkets, actions which take the inevitable forces of supply and demand inte account and work with them will texd to work: Detter than actions which pretend that supply and demand just don't matter. forward market in internal organs is illegal, 100. But when there are sick people with 2 demand for organ transplants and people dying every day with healthy organs that could be used by others, some mechanism will come in place to bridge the gap. This article examines the choice between non-market ‘mechanisms (like encouraging people to sign donor cards) and more ‘market-oriented mechanisms, ‘The mast commen actions that work on the assumption that supply and demand dont mater are price Moors, which set a level below which prices are not allowed to fall, and price ceilings, which seta level above which prices are not allawed to rise, Both will push the price away from the equilibrium level, and thus ereate a situation where the quantity demanded is not equal to the quality supplied, and ineMTcieney exists. A range of altsmative policies place taxes or offer subsidies to the damand side or the supply side of the market. These pliics lave ht effect of shifing the entire demand or supply ‘carve to a new location, ‘Thus, they will affect equilibrium price and quantity, but they wil allow the market to reach a rhew equilibrium, For a complete understanding of what economists mean by “supply and demand." itis necessary to work through a systematic explanation. All of the four textbooks listed inthe bibliography (see pp. 69 — 70), as well as any cxher repucable textbook, will cover this material thoroughly in an early chapter: Ifyou desire a serious grasp of economies, there is no substitute for working ‘through such a chapter. There is often a tendency for the public and the politic prefer price floors and ceilings over tax and subsidy policies, because price regulation appears to have zero cost to the public, and because they allow some evasion of what the likely effects are on price and quantity. But while price regulations don't have a cost in terms of tax dollars, they do impose costs ‘on coxsuimers, and producers, and create inefficioney Outline 1. Disagreements over the outcome of matkeis are inevitable. A. Suppliers will abvays want a higher price. This is true whether ‘we are talking about businesses selling a certain product, or peopl selling their labor, or banking think’ B, Demanders will always want a lower price, This is trie whether ‘we talk about consumers wanting co buy a certain, or 16iP. nh. businesses wanting to hire labor, or those who want to borrow money, C. Notice that these appeals are almost nakedly self-interested, are of public diseussions by talking, certain way. 1. Businesses, for example, talk about how they will create Jobs ard prosperity if only they could get a "fair" price (hat is, ‘ahigher price) for their goods 2, InGividuals will talk about how itis only “fair” that the interest mie they pay or the amount they pay for a gallon of ‘gasoline should be lower, ‘What happens when politicians react with price controls? A. When demanders win, price ceilings are the sult. 1. A price ceiling is a ease where the price is not allowed io, tise above & certain level. Rent contral is an example, 2, Ifthe price ceiling is set so dha priee’fs Held Tower than it would etherwise be (and the entire purpose is lower prices, of course), then the market will not reach ‘equilibriuny instead, quantity demanded will exceed. {quantity supplied 1B. Market forces wriggle and writhe to avoid price ceilings. 1. When a price ceiling exists, market forees want to raise the price, but a higher price is not allowed, So there i a shortage, with many buyers willing to pay the regulated price 2, Many problems, as in the above example, may therefore arise: fewer now buildings, more subless, lose building maintenance. 3. How will ire decided who receives how much when price ceilings are instituted) Some possibilities are ration cards, which limit how much people can buy: long lines. so whoever gets in line first ean purchase the product, grey markets oe black markets in which people end up aying more to these who have a supply, and other methods, C. When suppliers price floors are the result 1. Apprice floor is « ease where the price is mot allowed 10 fall below a certain evel. The minimum wage and rules that keep the price of farm produce above a specified level are examples, 2. Ifthe price floor is sot so that price is held higher than it ‘would otherwise be (and the entire purpose is higher prices, of course), then the market will not reach cequilibriumy; instead, quantity supplied will exceed quantity demanded, D. Market forces also wrigale and writhe to avoid price Moors. 1. Whenaprice Noor exists, market forces want to reduce ihe price, but a lower price is not allowed. So there isa surplos, with many sellers willing to accept the regulated price, 2. Creating farm price supports, far example, inay have uuintended consequences, ke raising the resale value of farmland. E. Price regulation is an untargeted subsidy 1. inmost markets, some demanders or suppliers mey be in dire need of economic help: ethers will not need much help or any. 2. However, price regulation draws no distinct \who is needy and who is no: it changes the price for everyone. Some will recelve help who dort much need it, Others will bear the costs, even though th especially deserve to sutter, When both suppliers and demanders win, the answer is government deficits and economic chaes 1. [Cthe politicfans ty to please everyone, they will aso be trying to subsidize everyone; that is, they are trying to help demanders by holding down prices and belp suppliers by holding them up. The centrally planned economies of the former Soviet Union and Ching tried to do ths for a number of products. But someone, such as the taxpayer, has to pay for such subsidies. and not everyone can be subsidized, he market is 100 powerfil to ignore. Remember that what lies behind a willingness to supply is hatter it is possible to make a reasonable level of profi Remember also that what fies behind demand is whether, ‘compared with the other goods available, people want to buy iu Governments can alter prices, but as Long as individuals and businesses have freedom to act ina self-interested way, they Will react © the now price incentives by supplying or demarvling mote or les. in predictable ways, 19LV. Feasible policies are sought that work with supply and demand A. We consider afl framework 1. Instead of trying w assure affordable housing with rent ceoatral or other price regulation, consider some altematives. On the demand side, give money or housing vouchers to the poor 2. On the supply sido, subsidize building of low-cost housing, br require staller apartments through zoning ordinances, 3. Increasing demand or supply should both result in a higher equilibrium quantity of affordable housing B, We consider policy steps for tarmers ina supply and demand framework 1. Instead of trying to assure a decent standard of living to Farmers with price regulation to keep farm prices hi consider sone alternatives. 2. On the supply side, just zive famers money. 3. On the demand side, subsidize buyers of food, perhaps trough food stamps or schoo! lunch programs. C. There are tradeois between economics ¥s. politics. 1. Eemamiats like ro have the tradeoffs clear. Politicians flea prefer to hide the casts if possible, Tax and subsidy policies make the costs and benefits more transparent than does price regulation 2, Economists like to be clear about who is being helped and who is paying. Politicians like w be fuzzy about who is paying, and would rater net draw too many distinctions about helping ony some, boeause they Fear alienating others 3. The spelal custs need to be considered Think of those ‘who suffer with reat control heeause they’ cant find an apartment~-or builders who would be willing to build ‘more, but can't, because they cant make mioney at it ‘Think of the consumers who buy less, or do without ina world of price floors. Think ebout other businesses who suffer because money is diverted to @ particular industry. Think ofthe waste of shortages and surpluses. None of these show up as an explicit tx nor as government spending, bur they all are costs. D._ The price is ultimately the messenger of econon neither inherently good nor bad. le housing in a supply and demand realities, Questions for Discussion: 20 1. Can you think of situations where a thiend, co-worker, or politician said that the price of something was "too low" or "too hig ‘when you fll that way yourself? “Try to come up with examples of ‘where someone might advocate price floors and price ceilings What would you predict would happen if such rules were actually enacted into law? 2. When society does not choose fo solve the problem of scarcity using the price mechanism, it must find some other way. Three possibilities are a system where everyone receives a fixed ration (as in wartime); making people waitin line: or having the government decide how the desired good wil be distributed. Consider, for each ofthese three sitvations in turn, what would happen if one moved {fom a prise mechanism to one of these other approaches. Who would berefit from such x move, and who would be hurt? (Remember, be honest, Don't just say what you hope would happen. ina perfeet world, if everyone were pleasant, reasonable, and ‘cooperative, but what your observation ofthe real world tells you is likely vo happent) Readings: Essential: Friedman, Milion, and George J. Stigler, "Roofs or Ceilings? The Current Housing Problem." Originally published in Popular Essays on Curreat Problems, vol, |, num. 2. New York: The Foundation For Economie Education, Inc., 1046, Reprinted with revisions, along with hnany otter articles on rent control, by the Fraser Institute, Rent Comirol: A Popular Parades. Vancouver: The Fraser Institute, 1975 pp. 87-103 ‘This article is aclassie analysis of rent control asa price ceiling. It offers a comparison between how San Francisco dealt with its housing shoriage in 1906, just after the severe euthquake demolished parts of the city. and how it dealt with the housing shortage in 1946, when many soldiers were returning from World War UL Inthe first case, te city ‘price rationing.” that is, the market was allowed to adjust reat prices. In the second, the city used rent controls. These episodes illustrate thatthe lessons and effects of rent control have been. predictable by economists over time. used "Pann Policy Reform,” in Council of Economic Advisers, Beonomic Report af the President Washington, D.C. Government Printing Office, February 1995, pp.141-151In this exeerpt, the CEA gives an overview of the important changes in the agricultural sector ever time. and what @ new foundation for farm policy should look like. The alert reader will notice that while the report nonpartisan, it carefully avoids oflering support fara policy of price Lecture 4: The Labor Market and Wages floors on agricultural produce, and instead focuses on issuies of risk, Seope: In the labor market, individuals are the suppliers of labor, global competition, the envizonment, R&D, and s0.0n. In 1996, many ‘hile businesses are the demancers of labor. Wages are the Of these changes were implemented as part ofa wide-ranging reform of price, ust as thers ars many goods, with different ‘America’s agricultural legislation. Readers witha particular characteristics, the market for labor is really many different farm isoues may want to cheek: out the 1986 and 1987 edi ‘markets, with many differen characteristics for workers. As ERD. both of which devote a full chapter to agricultural policy. Also, ‘one would expect from the logie of supply and demand, {abies at the back of the ERP give some background information on the higher wage (hat is, a higher price) encourages larger rnamber of workers on the fam Fam sales, land prices, and so on «quant o be supplied, but often causes a lower quantity 1 be omarded, Inthe end, businesses hire because they belisve Supplementary: that the amount the worker produces will be at leastas much as . the wage the business pays. Radford, R.A, “The Economie Organization ofa P.O.W. Cam ‘ : i Eeonomien, November 1945, pp. 129-201. “The lecture seeks to build an. intitve understanding ofthe fimetioning of labor markets by diseussing some prominent ‘This classi article describes the authors experienee in a German issues: 1 the minimum wage, an example of a pre floor; 2) P.0.W. camp during World War IL lt focuses on how the prisoners tie role of unions, both in terms of how they help thelr bbogan by bartering gooss with ench oxhe, then began to use cigarestes members hy raising wages and the potentially positive and as moneys and eventually created a besie Finetonal market. OF eoure negative effets they ean have onthe economy’ 3) labor all along the way. there are political pressures from various groups to market discrimination, both its size and the economic regulate the market, set price floors or ceilings, or redistribute income. arguments over its underlying causes; 4) the issue of how sa fassinating look at how market forces are expressed in what might wages, benefis, and payroll taxes for social insurance (like secm an unlikely environment, Social Security) fit toaster. Labor marke issues lke welfare reform and unemployment willbe discussed in more detail in ‘As noted in the suggested readings at the end of the previous chapter, later lectures, fora complete understanding of price Noors and ceilings, and how they i \work; it is nocessary to work through a textbook explanation. All of the Outline four basic textbooks listed in Uhe Readings and Re terial far as tbo ne ee Readnesand Heres Natal. 1. The economy is typeally described by what is produced, but itis inaterial thoroughly in an early chapter, Sorry to sound like a broken record here, but the Issues oF supply and demand are basic and fandamenial to understanding how ceonomists view the woe. ‘equally valid to think of it as the pattems of working people who carry out that production. Of course, these are just two different perspectives on the same overall set of interactions. TPhe size ef employers in the U.S, economy can be deceptive. A. Theres often a unstated belief that most people work For large corporations, But actually, more than half the workforce works. for employers that hire fewer than 100 people. B. Ofcourse, small and large corporations are often inter wined; small businesses make their money selling products to larger corporations |. Labor markets operate in terms of supply and demandDemand for labor comes from finns, 1, Demand isa relationship: in this case, between the wage andthe quaatity of work desired by employers. 2, A higher wage will make businesses demand a lower {quantity of labor, in the same way that a higher price will make consumers demand less of a good. “The demand for labor by businesses depends on how much they chink workers will produce: workers will only be to the point whore the business is confident that they will preduce more than their wage, ‘The supply of labor comes from households. 1, Supply is arelationship: in this case, between the wage and the quantity of work provided by households. One ‘might think that a higher wage should tend to lead to a hnigher supply of labor, and that is vertainly wue is some 2, However, many full-time workers have litte ability to adjust their hours of labor, so as a first approximation, its probably true to say that higher wages dont change the {quantity ef labor supplied by ouch, ‘Some factors that affect the supply of labor include changes in poptlation demographics and chifie in rocial expectations About who is expected 10 work. ‘There are many different markets for labor that has different et the equilibria wage will be detemined by where the quantity of labor supplied is equal to the quantity cemanded, This is ealled an “efficient” « situation. IV, We utilize some economic insights into current labor market re The minimum wage has Jong been in the news. 1, Interest groups in the northeast and south reacted lifferently co the call for 2 minimum wage law in 2. Arminimum wage is. price floor, and thus should be expected to lead to a shariage of employers willing to oller low-skilled jobs. 2. However, there ate reasons to believe that at present US. levels, this effect is fairly smal, and there may be political justifications for attempting to ensure that full-time ‘workers eam enough to live on. Nonetheless, there are alternative policies for boesting the income of low-svage workers, such as the earned income 8, tax credit, that work with the forces of supply and demand, and do not risk the same problems as raising the rninimum wage. Labor unions vary according te time and plac. 1. Inthe U.S., unions have been very weak by internat standards, curently ineluding ubout 13% of the work force, only 10% in the private sector. 2. When are unions @ problem? When they block any kind ‘of change simply to maintain high wages. 3. Labor unions can serve two factions: one i just 0 keep viages high by threatening employers with sikes: the cher is to help in building. better communication inthe workplace, and ultimately a more productive workforce. Discrimination in the labor market is another problem 1 Labor market discrimination oceurs when aa equally cualifed person is tumed down for a job, or paid less, because of their gender or race 2. However, lower wages do not always prove that cauplayers are discriminating, Instead, it may be that society is discriminating at an earlier stage, which leads same workers to have lower or different skill, ard the Inwer pay offered by employers reilects this pre-market ciscrimination. Different solutions to discrimination will depend on what sort of discrimination is occurring, Employers see various kinds of compensation in light of productivity. 1, There is often a sense that employees can do better if they can shift some costs on to employers: for example, by Having employers pay for thei healthcare benef, oF contribute to their Social Seeutity, or offer otter benefit. 2. Butwhen employers think about the wage that they pay. they dont much care whether its pad in the form ofa home pay or other benefits. They only pay for productivity. What usually happens is that when employees seek higher benefits from their employers, they end up with lower tuke-hotne pay. Readings EsseCouncil of Eeonomies Advisers, "The Labor Market." Chapter 4 of the Ecanomie Report of the President, Washington, D.C Government Printing Office, February 1997, pp. 139-162, This chapter offers an everview of the U.S. labor market, including overall labor demand and supply, wage trends, explanations of different ‘wages For different groups, and job loss and unemployment. Some of de issues will be discussed in greater detail in later lectures: for ‘example, all of Lecture 12 is devoted to unemployment, Bridges, William, pp. 62-74 he End of the Job," Fortune, September 19, 1994, Back in the 19th century, when the bulk of the population worked on farms, the idea of a "job" where you worked a fixed number of hours in a faciory owned by someone else was viewed with grave discontent. ‘Today, es more and more people become independent contractors, providing services by t from a distance, the notion of a again changing dramatically. ‘The author makes a provecative argument that the "job" as we have known it his las century "is vanishing like a species that has outlived its evolutionary time, Supplementary: Goldin, Claudia, Understanding the Gender Gap: An Economic History of American Women, New York: Oxford University Press, 1990, ‘This wonderfl, detailed history will ell you everything you want 10 now about the evolving economic status of American women in the 19th and 20th conturies. The book is heavy on statisties, descriptions ‘and blunt statements, I's siaightforward reading, but it’s a beok For the desk, not the hammock ‘Council of Economies Advisers, "Economie Inequality Am ‘and Ethnie Groups." Chapter 4 of the Eeonomie Report of the Presidemt, Washington, D.C.: Government Printing Office, February 1998, pp. 119-154, This useful chapter discusses differences in economic status, including income, unemployment and wages, among different racial and ethnie ‘groups: how those differences have evolved over time: and potential explanations for the differences tat tern "Phe Minimum Wage Debate," Hilson Quarterty, Autumn 1994, p. 54 ‘This one-age aticle gives a useful summary of the current arguments ‘baut the minimum wage. It reports the conventional evidence that a :minimum wage acts as a price floor, reducing employment among low skilled workers and also describes the recent revisionist atiempts 10 ‘argue that a minimum wage might uot be so harmful, [also deseribes how the economy has changed over the years, in a way that makes the minimum wage a less effective tool for reducing household poverty "The Future 0° Unions," "Trade unions: Adapt or Die." and “Unions for the Poor.” all appearing in The Ezonomist, July 1, 1995, pp. 15-16, $4, 56. ‘These three short articles all appearing in single issue of The Economist, offer a nice overview of the facts and arguments about the union movement: the decline in unionism workdwide: reasons bedind that decline; how unions can be either special interest pressure groups ‘or prosluctive economic contributors, Questions for Diseussi 1. Top professional azhletes con eam salaries of several million dollars per year. Taking a narrowly economic perspective, explain how such high salaries could be justified. Do you Find this economic fargament persuasive? Do you find the srgument more er less persuasive if applied to the high income ofa best-selling author? ‘What about a top corporate executive? Speeulate about supply and demand in the U.S. labor macket of the Tuture. For what jobs do you think there will be a growing demand? A shrinking demand? What sort of workers willbe in growing supply? .Lecture Interest Rates and the Demand Side of the Capital Market Scope: The previous lectures have focused on goods markels anil labor ‘markets. In this lecture and the next, we move inta the third of the three main markeis ~ the capital market. There is a longstanding prejudice a eis in western cllure ~ afterall, charging interest used to be considered a sin of usury, but it was never a sin to pay wages oF to buy a good This lecture focuses on the demand side of the capital markets which in this ease primarily means the demand for capital from. businesses that seck to invest it. The idea of present discounted value is used to explain how businesses consider the profitability investment projects, when the costs of such projects must be spent in the present while the returns are receive in future years. Firms can raise money in several way: through retained earings, borrowing ‘why mature firms tend 10 use retained earings oF borrowing 10 raise investment capital, rather than al stock, are discussed. Assuring a sufficient supply of long-term capital for investment isa key Factor in ensuring that America’s standard of living will rise over time, Outline People may sometimes feel that dhe price ina goods market or the ivage in the labor market isn't fair, but they rarely feel that the entire market should be treated as illeitimaie. However, many people have a nagging sense that the payment of interest, that is, the price in the capital market, is somehow wrong, Why might this be? A. Goods are tangible. Labor is something we exp exsily visualize, Interest payments and return on capital, on the ther kand, seer harder Tor many to grasp. B. ‘There isa long-staruting western teaition of being suspicious xy-lenders and interest payments. Usury, oF the payment of inieret, used to be considered asin in the mile ages. [nthe modern world, interest payments are sil considered a sin among some believers in Islam C. Confusion is common between financial and physical eapital 1. To economists, eapital markeis ate just another case of supply and demand. But there is « common semantic confusion about the idea of "investment. sometimes used to refer to financial investment in stocks tnd bonds. But “investment” is also sometimes used (0 refer to physical investment in new plants or equipment. The potential confusion here is that financial investment isthe supply side of the capital market, while physical investment is the demand side, Capital markets exist in the supply and demand framework. A. The supply of capital comes from savers 1. Supply is (as always) a relationship: in this case between the quantity of capital supplied from households (and firms) and the interest rate 2. One might expect the quantity of capital supplied to rise withthe interest rate; in Fat, it seems that it doesn’ tise rnuch, and that saving instead depends more on habits ard cultural patterns. 1B. The demand for capital is a relationship, 1. Demand is the relationship between the quantity of capital demanded by borrowers (and households) and she interest AS the interest rate rises, prospective borrowers will be less enthusiastic about taking out loans, and the quantity demanded of capital will Fall C._Asalways, equilibrium is where quantity demanded equals ‘quamity supplied. inthe capital market, this will happen ata particular interest rate D. There are three components oF interest rates: 1. Compensation for expected inflation: 2. Compensation for the level of risk (the interest rate minus the inflation rate is referred to as the “real” interest rate); ‘The time value of money: money new is worth more than money in the future . The key uadeofT in capital markets isthe time value of money A, Present dollars are worth more than future dollars 1. Getting a contain dollar amount of money now is better than getting that same dollar amount a Few yeats in the future. Having a certain level of dollar expenses now is worse than having that same level of dollar expenses i the future, 292. Even ifthere were no risk, even if there was no inflation, this relationship would stil be tue, B, The itea of present discounted value is critical to money ‘considerations 1. Present discounted value fs 4 way of taking costs or benefits that oceur at different points in time and comparing thet directly 2. The tick is to think about what any future expense would be worth in the presents that is, how much money in the present if it were invested at the prevailing available Jnterest rate for the appropriate amount of time, would be needed to equal the desired future amount, This tool lets amounts from different years be compressed into a single present value. 3. The formula for changing an future value into a present discounted value is POV ~ (FV (12), where FV isthe fate value, r isthe interest rata, and tis the number of | yeu, C, Present discounted value as many applications. 1, Inbusiness investment decisions, PDV is used to compare investment expenses incurred in the present with returns 10 he received inthe fare 2. PDY also explains the difference between the accounting and the economic idea of profits 3. But PV has many other applications, including thinking about home merwaves, lottery payments, and goverment regulatory expenses, IV. Firms that wish to invest for the fiture need to find a souree of money, aller they have paid their current expenses, A. Retained cami 1, Those are more commonly known as "profits." The word "retained" means that the firm decided to hold ento the ‘money and re-invest it, rather than paying it out 1© shareholders as dividends, 2. Thisis a primary source of investment capital for established firms. B. Borrowing 1. Companies can borrow in wo ways: either from a bank, or by using bond. In either ease, the company must make predetermined interest payments to is investors, 2, Ofcourse, the company will only borrow iPit believes that the retuen on its investment will allow it to make these interest payments and sill ave money le over asa profit A “junk bond” is only 2 higherisk bond that pays a high level of interest. C._ Equities (stock) Le Raising money dhrough equities, more commonly known as corporate stock, gives the owners of the stock part ‘ownership of the fla, Thus, ifthe firm pays dividends or is sold, the owner of stock receives money in proportion to their ownership of the firm's sock. However, unlike bonds with their predetermined imerest payments, there is no guarantee that the owner of stock ‘will receive anything in a given year. or anything at all 3. Siock is more often used as a way for younger and smaller ‘companies to raise money, rather than for more established companies. V. The U.S. ends to lag behind the industrialized world ia the proportion ofits economy devoted to investment, and in the long. ‘erm, this ca be detrimental to 2 country’s standard of living, Readings Essential: "The Lender's Long Lament," The 103-105. ‘conomist, Dezember 28, 1993, pp. Those who charge interest have been unpopular for centuries. Vet as this article shows, the history of public atiudes toward manevlenders over the last few centuries has been filled with ambiguity. The reader ight considera person's likely attitudes toward a bank when your loan for a home mengage has been approved, and your likely attitude ifthe bank foreclosed on a loan and sells off the property because the morteage payments werent made, "Banking Behind the Veil." The Economist, April 4, 1992, p, 49. Dietrich, Jef, “The Sin of Usury: Why is a Bank Purer than a Brothel?" Une Reader, March-April, 1995, p. 17. There are at kast two modern traditions that continue to feela strong ‘moral prohibition against charging oF payment of interest, The first is Islamic, and the first article here offers. look at how Islamic banks fanetion without the official payment of intrest, The accord is ax exireme version of Catholicism, and the secend artiee isa cal for the 31Catholic ehurch to worry less about sexual issues, and instead 10 reinstate the prohibition on interost. Both ofthese articles should be compared with the previous article in Tie Bconomisi, as well as with the maverial in the lecture, and your own feelings about capitel markets, ‘Supplementau Look in the tables athe back of a copy of the Economic Report of the President, and bevomne Familiae with some of the different sonts of nterest rates. Carry out the following exercises: Find the table en "Bond Yields and Interest Rates, Geta feeling for what “high” and "low" interest rates have been over the last few decades, and whether rates today are "high oF "low"; 3. Notice that there are many different types o they tend to rise and fall together, 4. Notice that borrowing by the U.S. government usually pays a lower interest rate than the other investments in the table, the reason that the federal government is far less likely te default, so investors don't need to be compensated for the extra risk with bi 5, Compate the interest rates to the inflation rates in an ear! and notice that interest rates and_ inflation tend to be high at roughly dhe sane time (as In 1974-73, oF 1981-82), showin Ue connection between nominal and real interest rates, yerest rates, and that Hakkio, Craig S., "Should We Throw Sand in the Gears of Financial Markeis?" Economie Review, Federal Reserve Bank of Kanses City, ‘Second Quarter 1994, pp. 17-30. (One sometimes hears proposals for a special tax on the buying and selling of stock and other Investments, The usual reasons for such a tax iss 1) to discourage waves of buying and selling that lead (o dramatic rises and falls in the market; and 2) to raise some money from the essentially unproductive behavior of swapping one asset for another. In this article, Hakkin offers a careful look atthe evidence on such taxes, as collected fiom various countries, and on whether such a tax would dolivor en its promises. He concludes thatthe ease for such a tax has not been proven Questions for Diseussion: 1, Do you feel that someone who receives a high amount of payments has "ezrned” the money? Da you feel that someone who chuatues interest fs behaving faitly? Consider both your own feelings, and how economists would look at these questions. As interest part of ths discussion, it would be helpful to read the article in The Feonamis listed under essential reading. (One sometimes ears proposals 10 "ax profits, not people.” Considersuch proposals from the perspective of a firm that is tuying to raise investment capital for productivity growth and expansion. Discuss the trade-offs ofa high (ax on corporate profits 33Lecture 6: Financial Investment from the Supply Side Seope: ‘The supply side of the capital market is an ornate name for a more basie question: how can T get rich through financial investments? One answer, of course, Is (0 be very, very lucky. Bat @ more useful answer for the purposes of fina planning i to take advantage of the power of compound interest to multiply one's money. This lecture focuses on the characteristics of investments, It lists the four major aspects of an investment that should be of concern: return, risk, liquidity, and tax status. These characteristics involve tradeofls, that is, something with less liquidity will bave to have a higher retum, of less risk, oF offer a tax break to make up for the lover liquidity. A wide variety ‘of invesunents are available w investors. Choosing between them will require thinking about time horizons and tolerance for risk, There is a strong economic arguuhent for not trying to outguess the professional stock-pickers, and instead investing your money ata steady'rate in broad mutual finds. Note and Disclaimer: This lecture eddres investment, looked at strictly from an academic, microeconomic perspective. The information contained lierein is not, and is not 1 be Jconstrued to be, personal finaneial advice. Rather it serves to illustrate the workings of microeconomic market forces. It also relates to certain neacroeconomic issues, such as the need to encourage savings as a key to 8 country’s long-term economie growth and well-being, as discussed in Part II of this lecture series. -The comparative academic analysis peseated herein of the pros and| cons oF different ypes of investments does not imply an endorsement by the Tecturer or The Teaching Company of any particular type of investment vehicle, nor dozs it imply an endorsement of any particular commercially available product or any financial institution, Investtnent advice is properly ard legally confined 10 licensed Financial advisors, who must understand the individual financial eireumstances, resources and goals of any potential investor, Such financial advisors must comply with all pertinent Federal and state regulations pertaining to solicitations and offerings to sell investments. sich as providing a prospectus preceding any investment and explaining fully the risks inherent in each particular investment option. You should therefore not make any investment decision based on the information provided in M these lectures, but ail qual Outline 1. How to get rich with the power of compound interest. A. Interest iscaleulated based on the amount in the acount at the start ofthe yeat, So interest for this year is paid not only on the ‘original amount invested, but interest is also paid on the previeusly accumulated interest! BR. The term used to describe interest being paid on earlier interest fs "compound interest." The formula for showing what a present value will tum into over a number of years at a cera interest rate is PY (1 + 1)'= FV. where PV is the present value, + isthe (annual) interest rate, tis the murmber of years, and FV is the value in the future. 1. Consider 5% interest an $1000 over 40 years—it increases by a factor of sever 2. ALIOM interest over 40 years, it increases by a factor of | 45 ML itferent fnyestments ean be exteyorized secon wg especially good in one charac involvesa tradeoff with other charactrisies: for example, high ‘elura (a good thing) aso typically iavolves higher risk or lower liquidity, or no tax break (ll bad things). wracterstes, Bei The relum factor is the first thing most people look atin an investment, 1. is usually expressed in pereent per year: 2. Remember that seemingly small differences will compound to larger anes over time. 1B, Risk and diversification Is the second factor, 1. Riss expresses the amount by which the renum is likely to je or fall. Investments like Treasury bonds have low k; you know pretty much what you're ening to get Investments in new technology companies or junk bonds have higher risk. Other things equal. more risk is a bad thing; that is, one only wants to take risk ifone is compensated for it, perips by a higher expected retum on average. The risk of investing in any single company can be reduced by diversifying one’s investments, and investing in a large 35« D. number of companies in different sectors. Odds are that even if some decline in value, olhers will rise. Investing in ‘a mutval find is «relatively easy way forthe individual investor to diversily inthis way. The third factor, liquidity refers to how easy itis to sell an Invesiment, A bank account is quite liquid: a house is not 90 liquid. More liquidity is generally thought of as good. Last, but not least, are the tax implications of an investment. 1, Some investments are favored by the tax code. Some hhoncis are exempt from federal income las: interest payments on home mortgages are deductible fiom taxable income; taxes on capital gains on stocks ean be postzoned Until the stock Is sold. 2. Tax breaks are obviously good: however, in a world of traleo'T, the higher tax break usually means less of something else. For example, iax-lree bonds pay a lower rotum than taxable bonds, The menu of investment choices is substantial AL DB Bank accounts offer low return and no tax breaks, but are very safe, very liquid Money’ market funds arc e better return than bank eseounts. case they"te invested in honds they're still quite liquid and quite safe, alhough not quite as good in these ways as a bank account and not explicitly federally guaranteed. Certificates of deposit offer a better roturn than money market fins, very low-risk. However, they're not lou sine they usually have *substancial penalty for early withdrawal.” In such « case, you get your money back, but not the interest A diversified portfolio of eomporate bonds offers a better retary thin certificates of deposit. bought through a mua fund, the bonds ae fairly liquid. However, risk is somewhat higher since they are tied to fluctuating intrest rates A diversified portfolio of eoporate blue-chip stocks offers a better retum than a bond portoti. Irbought through a mal fund, they’ fairly quid However, risk is semewhet higher, although the capital gains tx can be deferred until the stocks ‘ae sold. A diversified portfolio ofrisky "growth stocks" offers « better return than a portfolio of big, stable companies. IFbought through 2 mutual fund, fairy liquid. However the risk is somewhet higher because these are srall, unestablished companies G._ Real estat isa variable investment 1. Buying a home is misture of investment and buying housing services. Return on investment side can be highly variable, although typically positive over longer periods of ime. Liquidity is low When baby boomers were buyin boomed, but it has fallen off since. houses, the market z Gold and precious metals are very risky. For the individual investor, these are a gamble that it may not be worth taking IV. The investor can develop a portfolio that mixes high and low-cisk policies A. Some risks may be greater in the short term, but the potential ups and downs may cancel out ver the Long.run, [F youre planing to use money in 20 years for retirement, fer example, You nay worry less about daily upsand downs of the market and more about long-term averages. This is the scenario for stocks in a mutual und, B, Why not just pick the stocks that will pay the highest return? 1. Noone knows which stocks these are. Ifpeaple did know, then they would of course buy chose stocks unl their price want up to.a point whore they would no longer be a good a deal 2. The implication of this insight is the "random walk” theory of stock prices: sinc2 all past information that is available about a stock is pan ofthe current price, what moves stack prices is new information. Sinee now information is by its nature unpredictable. te movement of stock prices will be an unpredictable random walk as well 5. Maybe. although there's alot of controversy about it, sophiaticated professional working 50 hours a week ean find some ways (0 beat the market consistently, Bur the individual investor at home doesn’ have much of a chance. Despite this, the Forbes “dart board” experiment showed how random successfil stuck choices can be. portant to get started as early as possible 1. Every bit of investment advice is based on one staring, point: you need to put some money aside in the first place. Too many people put very litle esice until they are 35 or 0, and then suddenly worry about what they're going to retire on,There are always a million reasons not to save right now. But if you don't, there's no clever strategy that you ean deploy at age 63 to ensure a comfortable retirement Readings Essentiat: Congressional Budget Office, Savings Rate," April 1993, sessing the Decline in the National The CBO is a nonpartisan research arm of Congress. ‘This report, which is ubout 40 pages long, explores why savings were low in the [080s and even lower in the 1990s. Readers should focus their attention on the parts of the discussion that relate to personal savings, especially sections one and four of the report. OReilly, Brian, "Busted Boomers: Here's the Wake-Up Call" Fortune. July 24, 1995, p. 524 This issue of Fortune features 1 number of articles about retirement planning. The one listed here gives a useful overview, with an emptasis ion how saving ai a steady pace, letting the interest compound, translates into substantial wealth down the road. Other artiles focus on planning to pay for kids college: retirement accounts; mutual funds; and much’ Supplementary ‘Studenis often ask for a guide to investing their own money. As you ‘might imagine, Ym hesitant to offer such advice. But when pressed, 1 suggest two useful guides to thinking about personal investing. The first is practical, folksy, and readable: the second is thorough, zcademie, and complete, Chilton, David, The Healthy Barber: Everyone's Common to Becoming Financially Independent. Rocklin, Caliervi Publishing, 1991 ise Guide “This pleasant, breezy book is organized asa set of conversations that a ‘younger person has with ihe barber, 1¢turns out that the barber Financially independent, thanks to a thoughtful pattem of savings throughout his life, and now cuts bai just for the sake of keeping ‘active, Other customers relate their own financial worries, and how a sensible pattem af consistent savings helped to deal with them, The 38 overall theme is @ powerful endorsement of stating a steady pattem of savings while young, and investing ina diversified portfolio. Malkiel, Burte York, Norton, A Randow Walk Down Wall Street, Filth edition, New 000. youre like me, you've always been a litle bit intrigued by those promises from investment advisers that iTyou follow their adviee, the big, big money is just around the commer. In this accessible book, Malkiel caroflly describes the economic logie and academic work behind the random walk theory of financial markets. which (as discussed in the lecture) holds that the short-term movements the stock sarket are not predictable, at least not by corporate outsiders like m= (and probably you, too). If you want a thorough understanding, of the random walk theory, and what it implies for personal investing, this hook is the place to get it Questions for Diseussion: 1. Make a list ofhow your money is invested. Don't limit yourself just to financial investments, but include real esiate or “collectibles” that may grav in value, LUencify which assets are Tikely 10 have the highest and lowest rotum,; which are risky or safe; which are most Iiquid; and when you have to pay taxes on the gains. (Ifyou dont hhave any savings, you ean do this forthe lst of assets given under Roman numeral [Il of the chapter outline.) Are there some investment you have not made that you should consider aking in the Future? ‘You receive a brochure in the mail, It advertises investment advice. 1 promises that if you pay for a subscription to a newsletter, you ‘will make the money back many times over in higher profits on ‘your invesiments, Fave you ever received such a brochure, or seen ‘advertisements ofthis sort? Why might you be skeptical of such advice?Lecture 7: The Environment and Negative Externalities Scope: One concem about an unfettered free market is thar it will L 40 damage the environmeat, This concern is well-founded. In fact, environmental damage is part of a broader class of eoncerns thktt economists have labeled as “negative ‘esternalities,” These are situations where, in the buying and selling of goods, there are consequences felt by third parties ‘who are not part of the original transaction. A classic example would be a faetory muaking some manufactured product. ‘The seller of the product and its buyer mivht both be perfectly content, but third partiss could be affected by air or water pollution produced by the firm -- ankl those third parties were external to the original market wansaction, This lecture explains the idea of negative extemaiities, and then discusses the remedies for them, The conventional political answer has been fo regulate the Amount of pollution But while regulation bas its place, it can also be inflexible and coatly. Economists have instead proposed market-oriented environmental policies, Hike taxes on pollution or permits for pollution that ean be bought and sold ‘Some people feel that pollution is simply evil, and should be prohibited, not taxed oF traded. But ezcnomists point out that ike so many things, a matter of tradeotls. Few people believe, when it comes right down to it, in the abolition ff the ear or manufactured goods, so the real question is not how we eliminate pollution, out how we balance its casts and benefits. Outline Is the market the enemy of the environment? A. Strong environmentalists sometines see "the free market the enemy. Some connection is undeniable, but the connection may be less obvious than it may at first appear. 1B. After all, poor countries with weak markets often have environmental problems that are even worse than rich countries, Countries which have tried to eliminate market forces, like the former Soviet Union and eastern Europe, have hod terrible pollution problems. Ww. C. Meanwhile, despite the remaining problems, the U.S. environment has been getting cleaner for the last several dvcades, Perhaps the interaction between government and production is the issue ~ not the free mrarket per se. The economist is continually faced with the problem of cextomalities A. Whar if volunta exchange between two parties affects a third 1, The argument for fee markets is based in parton the notion that when a buyer and seller voluntarily agree on a archase, then in their own judgement, the deal must benefit them both, 2. But when a market transcetion affects a third panty who ‘sas not consulted, and did not have to pay as a buyer or Feesive money as a seller, then the argument for how markets work does not hold. B, We consider positive and negative externalities through th apariment party example 1. The third party who fs afected by the market transaction, Sut not consulted, can be allected either positively or segatively 2. Asam example, imagine a loud band hited by the seighbors fora big par. Ifyou like the music, you experience a positive extemality: if vou Gon' like it, then you sulTer a negative externality. To economists, pallution isa case where thitd panties are affected by spillovers from production or consumption, but are not part of the market transaction. For example, cigarette smoke is not pollution to the smoker ~ because the smoker voluntarily agreed to be purchase them. However, it may be pollution to the bystander, ‘who was not part of the market transaction. A. The idea of an externality can be explained by distinguishing between private and social costs. In atypical market transaction, the costs to the seller are privately felt by the seller, and the benefits are privately received by the buyer. B. However, in the ease of pollution, not all the costs are private ‘ones; instead, some additional costs are imposed on others. Beccuse praducers of pollution don't have to fake these social ccosis into account, they will tend te produce too much of i. A numberof policies bring these costs into line. aB b. 42 Command and coniol is a commen op 1. Command and control is the name wiven to the set of regulatory policies that specifies an amount of pollution that can legally be emitted, but prohibits any larger amount, This epproach certainly can be and has been 2 aknesses. The indusiry bein fluence the pellation standard trough the regulatery process. Sueh standards are inflexible, and often do not reward innovative ways of avoiding pollution oF ways of reducing pollution beyond the legal standard 3. There ate other problems: regulatory eaptare; the one~ sizefitsall solution; the lack of incentive to reduce pollution beyond the guidelines provide. ‘A pollution tax can be used to make sure that polluters face up to the social costs oftheir pollution 1. Iereatesreyenve for govemment 2. Such a tax gives polluters an incentive to reduce the amount o€polition, an just like @ commanceend-conicol regution, it can be set at whatever level society desires 4. OF course i also mare visible than eommand-and- ccomrolreguiaion, and its called a “ax,” so it may not be as politically tractive. Marketable permits are enother approach to this issue. 1. Marketable permits work by giving polluters a set of permits to emit a certain amount of pollution, Often, these pennits are scheduled to decrease the amount that can be emitted over time. 2. However, if polluter can reduce pollution by more than theamount of permit, then the permit ean be sold to another. Or iPa new proceer wanis to produce, that producer rust purchase a pollution permit from another The United States has hal some success with marketable permits in certain areas, like the reduction in sulfur dioxide emissions under the 1990 Clean Air Act Property rights must also be considered when discussing the 1. The ineeatives to produee or reduce pollution are often alfecied by the property rights involved. One way of thinking about the problem of pollution is that in an unregulated market, no one has a property right to clean air, 30 no one needs to compensate thom for ditying the 2, Bu it propery rights ave clear and enforceable, then ene pany or another will have the appropriste incentives to avoid negative externalities V. Options for dealing with the reenbouse effect -a case study A. Considora range of ways of secking to reduce carbon emissions: a quality too! like the standards that cars reach a certain level of fuel economy, a gas taxz a carbon tax; or inarketable permits For carbon emissions. B,_Allthings considered, some sort of carbon tax may be the most hopeful approzeh for dealing with the greenhouse effect. VIL Why zero pollution cannot be a policy goal A. Ina literal sease, zero pollution would have to mean that people dont exhale carbon dioxide or create sewage. It would also mean shutting down most of industry and the economy This just ist sensible. B. Face it: pollution has benefits as well as costs, and the reasonable policy goal for pellution is te think about balance. VIL How widespread are negative extemlities? |A. Some erties of the free market see negative externalities, ‘everywhere, and thus wpany’reasons for government intervention. B,_ The existence of negative extemalities doesn't mean that the market can be ignored, but instead that we must think seriously about the sizs of the extemalities and the tradeofl’s society wishes the market to take into account Readings Essential: favins, Robert N. and Bradley W. Whitehead, "Dealing with Pollution," Evmiconment, September 1992, 34:7, pp. 6-11 Iu this essay, two economists take the case for market-driven environmental poliey into a magazine that isa forum for environmertalisis, In other words, the article is a caretul explanation of this viewpoint written to a presumably skeptical audience,Blinder, Alan, "Cleaning Up the Environment: Sometimes Cheaper is Better." Appears as Chapter 5 in Hard Heads, Soft Hearis: Tough Minded Economics for a Just Society. Reading, Massachusetts: ‘Adgisoa-West Publishing Co,, 1987, pp, 136-159, Blinder is « beautifully lucid writer, as well as being a top-notch economist, This chapter lays out in detail the economies argument for using market-oriented tools to fight pollution, on the grounds that ne ‘matter how raueh reduction in pollution we want, surely it makes sense ‘to accomplisi this goal as cheaply as possible. Council of Economic Advisers, vironmental and Health Issues Washington, D.C.: Government Printing O' 155-80, Improving Economic Fificiency: " Economic Report of the President ice, February 1998, pp, ‘This first part of the chapter offers an overview of a number of leading problems in environmental regulation, Youl notice thatthe chapter begins as economists are wont to do, with a description of extemalities, tradeable permits, and other topics from the lecture, and then moves on. o applying these ideas 10 current problems, including greenhouse ‘Supplementary: Porney, Paul &. aid Katherin N. Probst, "Cleaning Up Supert Resources, Winter 1994, pp. 25. ‘Superfund is the colloquial name for a law passed in 1980, The notion ofthe law was clean up hazardous waste sites, The money Was to come from recoveri \were now out of business or untouchable for some reason, by a tax on petrochemical companies, Superfund has had real problems. Few sites have been cleaned up. Lots of moncy has gone fo arguing over what should be on the Superfund list, and who is responsible for paying for it, rather than actually cleaning up. Reauthorizing and restructuring Superfund is a hot public issue, Schelling, Thomas C., "Some Economies of Global Warming,” Aimerician Economic Review, March 1992, pp. (-L4. ‘This is the lecture given by Schelling when he was president of the American Economic Association 2 few years ago. Its 2 very nice ‘middle-of-the-road summary of the potential (eve 4s the costs from polluters, oF iP the polluters unproven) dangers of global warming, and how economies tools like pollution charges sight be used asa sort of insurance policy for dealing with those risks, ‘Those especially interested in environmental issues should note that the magazine, Resourves ~ cited above as the source of a good article about the Superfirnd -- is available free. 1's published by a Washington think- {ak called Resources for the Future, which has oftcn Fed the way in 1g economic analyses of environmental prolstems. To start a ion, write w Resources for the Future, 1616 P Sueet NW, Washington, D.C, 20036-1400. Questions for Discussion: Many peopte with sttong environmentalist feelings find it dificult to like or to trust market forces. Discuss why this isso. Then. explain how s person might combine strong environnrentalist iment and a belief in the power (iC not the righteousness) oF market foress. 1n You imagine a situation where society aims at "too litte” ppollutioa, in the sense thatthe easts of having se little pollution are Uuncomforiably high? As an extreme evample, consider a proposal to ban all automobile travel as a way of reducing air pollution.Scope: The previous lecture focused on negative externalities, whet 46 Lecture Technology, Positive Externalities, and Public Goods the market produces too much of a negative item, like pollution. This lecture iumns the tables and discussed positive externalities, where the market produces too litle of some {ood things, like scientific research, innovation, and education. Pollution was a case in whieh the market transaction imposed costs on others; these are eases in whieh the market transaction confers benefits on others in society, but those in the Iransaction receive no compensation for these benefits, and thus tend to provide too litle ofthese benetits. This Iecture first focuses on the development of new teclinology as an example of positive externality. Patents and copyrights have been the traditional tools for encourauit imovation. However. some otter tools wéuld include direct government support or tax eredits to industry. ‘An extreme example of a postiive externality is called a public jad. Public goods are non exeludable and non daplotable, ‘witich means that a potential seller cannot exclude people from. using the good, and that the good itself is not used up as more people use it, Examples might be national defense, or basic scientific research, Government is a way for people to band {ogetier and agree to pay for such good. Outline Many people tend to identify free markets with innovation, But in a truly free market. i's possible that very litle innovation would exist A. Why the conflict exists: appropriability 1, Imagine @ company that thinks about investing mon research and development. Ifthe praject fails. then the company will haye a lower rate of return than its competitors, and may be driven out of business 2. IF the project succeeds, however, ina perfectly free market the competitors will simply steal the idea. The result will be that the insovating company had higher expenses and ro special gain in revenues. It till has a lower rate of rotuin than its competitors, and may be driven out of business, Thus, the key element is a company's ability to appropriate a substantial share of the economic gains from iis investment in research and development. B. ‘Theaitempted solution: patents and copyrights 1. Historically, the main way to assure that companies received a retum on innovation was patents and copyrights, which used the force of law to prevent new ideas from being copied by others, atleast for a time. 2. But even with patents and copyrights in place, itis commonly estimated that an innovating company manages to get only 30-40% af the new value of what it ereates, While dhe rest is captured by other firms, Thus, the incentive to innovate is loss than it might be. C.Apositive extomality means that an economic actor is providing benefits for third parties, and not being compensated for those benefits, Because it is not being compensated fully. the firm will provide less innovation than it otherwise would 1. “There isa potential role for government to play in assuring that ‘conipanies reveive a greater share of the returns from innovation, and thus are encouraged to innovate more A. Direct government funding of research is one alternative, This ‘universities, private rescarch ‘organizations, or through firms, A condition sometimes (bat not always) imposed is tha if the government paid for it, hem ‘the results should be broadly available. . An indireet approach is to provide tax eredits to business for research and development. Tis has the effect of giving the ccornpany, say. 10 cents offen their taxes for every $1 that they spend on R&D. It is a loss centralized approach for the government than admintstering particular research grants. C. Government can also provide indirect support for research and development through subsidizing the spread of information, across organizations, aeross the country through methods like helping build the Internet, andl across international boundaries. D._ There are a number of proposals to strengtten imellectual property rights, like patent and copyright laws, as a way of Ielping companies appropriate more of their returns. Some of these Involve negotiating across international boundaries E, Research and development spending is an important issue, ‘especially in its distribution to the eivilian and military sectors respectively. a7Iv. 45 ‘A public good is an extreme example ofa positive externality. With 2 positive estemality, an invester gets only patt of the retum fiom the investment. With a public good, the investor might end up with a return of almost zero, ‘A. How public goods are non-depletable and non-excludable 1. A private good gets used up: itis depletable. Also its possible to make sure that people dort get the good without paying for it itis exeludable. 2. Public goods are non-cepletable and non-excludable. ‘They dant get used up, and its hard to prevent people from using them. A good example is the protective function of national defense. Ifsomeone doest't wish to be protected hy our armed forced, you cant really protect everyone else in the country and exclude them. And ifan extra bay is born, we dorit use up a greater degree of national defense services, B._ The free rider effect is another public goods prablem, 1. With a public good, there is always a teinpiation For people to be fee riders. Why should | offer to pay for tha serviee, they will say? The reasoning is that thetr little contribution wont make much cfference to the amount of the service provided, and no one ca atop them from using the service, So their preference would be for everyone else to chip in, while they act asa free rider. 2. Of course, if everyone reasons this way, the service isn't provided at al. C. Government and taxes are a way far society to decide that certain gous should be provided anid that everyone will pay for thems, whether they wish to purchase thax particular amount Of that particular good or not. It overcomes the tive tider problem by brute force. How important and widespread are positive externalities? A. Critics of the market, of course, are predisposed to see externalities everywhere, and thus ceasons for government intervention. Again, it should be remembered that an externality doesn't come up every time there is a generalized ‘unhappiness about markets, B. However, it’s also true that using public resourees to give special benefits to particular company will have tradeoffs, perhaps involving higher taxes or even layotts by other ‘companies who can no longer compete 1, The most persuasive cases for economists are behavior here some service Is systematically underprovided by the market 2. But there is a reasonably strong case that posit cestemalities do exist in many areas involving the creation and dissemination of new information: research and development, scientific research, and K-12 education, ‘What's true in theory, however, isn’t always true in practice Readings Essential: "science, Technology, and the U.S. Economy." in Couneil of Economie Advisers: Economic Report of the Presiden. Washington, D.C. Govemmen: Printing Ofice, January 1989, pp. 223-283 Ch. 6 in the 1989 ERP offers a solid overview ofthe nation’s science and technology policy, including spending. training, and ways oF encouraging the private sector to perform additional R&D. Since this chapter is & few years old, itis instructive to look up some more recent data, Look under “research and development” in your most recent Statistical Abstract, you will find a number of tables showing how much hhas been spent. how much is being spent in comparison to other countries, and so on, The Historical Tables 10 the annual U.S. budget alco include tables showing direct government support of RED over time. Supplementary: Cohen, Linda, and Roger Noll, "Privatizing Public Research: The New Competitiveness Strategy." Spence, A. Michael, "Science and Technology Investsent and Policy in the Global Economy." and Rosenberg, Nathan, "Uncertainty and Technological Change." All three articles anpearas chapters in The Mosale of Growt, ediced by Ralph, Landau, Timothy Taylor, and Gavin Wright. Stanford University Pres Stanford, CA, 1996. IF youre getting a copy of the book trom a library. Perhaps to make copies of the articles for your personal use, you should notice that nother chapter from this volume, the article by Harry Rowen, is ted under the "supplementary ” reading for Lecture The first two articles deseri sclence and technology policy: how can we build public support for funding of long-term scientific researciv? More and more, politicians of © s fundamental tension in eur present 49