Download Lecture 13 - UCSB Economics

Introduction to Economics
Microeconomics
The US Economy
Llad Phillips
1
Fall
2002
Median
47
Max
72
Midterm Scores
7064-69
58-63
52-57
47-52
41-46
35-40
28-34
19-27
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Grade
A+
A
AB+
B
BC+
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CD+
Number
1
2
9
25
27
27
13
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Fall
2001
Midterm Scores
7366-72
60-65
54-59
48-53
42-47
36-40
30-35
24-29
-23
Grade
A+
A
AB+
B
BC+
C
CD+
Number
1
10
15
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33
21
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13
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1
Outline: Lecture Thirteen
The Free Market Story
 The Wealth of Nations

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4
Why Has the Market Economy
(Economic System) Prevailed?
It has taken about 130 years, but it seems
socialism and communism, not to mention
fascism have fallen by the wayside. Why?
 What are the strengths of market systems?
 Are there weaknesses?

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Returns to Scale and Economic
Efficiency

Constant returns to scale
 if
you double inputs, then you double output
 so output per worker (average product) and
marginal product would be constant
 total cost of the factor inputs would increase
proportionally with output
 so average cost per unit of output and marginal
cost per unit of output would be constant
 a given constant average cost firm could
expand, or new firms could enter and produce
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A Free Market Economy
Assumes Resources Are Mobile
New firms can enter or leave an industry
 Existing firms can expand or contract

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7
Assuming Constant Returns to
Scale for Simplicity
The supply curve of the firm is its marginal
cost curve ( constant under constant returns
to scale)
 The supply curve of the industry is the
same, the marginal cost curve

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Supply Curve of the Firm
Cost per
Unit of
Output
Supply Curve of the Firm
Average cost &
marginal Cost
QCOMP
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Supply Curve of the Industry
Cost per
Unit of
Output
Supply Curve of the Industry
Average cost &
marginal Cost
QCOMP
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Add Market Demand to the Picture
Market Demand
Average cost &
marginal Cost
PM
Market Supply
QCOMP
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Consumers Benefit
Consumers pay a market price for output
equal to the marginal cost of resources used
in production
 So resources are allocated efficiently
 Consumers also reap a benefit: consumer
surplus

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Consumer Surplus
The first consumer that enters the market is
willing to pay a high price
 The next consumer is willing to pay a little
lower.
 The last consumer that enters at the market
price is just willing tp pay that price.
 The consumers that are willing to pay a
higher price but only have to pay the market
price benefit

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Price the
P1
Market Demand
first
consumer
Surplus to the first
consumer = P1 - PM
is willing
to pay
PM
Market Supply
QCOMP
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Total Consumer Surplus: A Measure of Consumer Welfare
Market Demand
Consumer Surplus
PM
QCOMP
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Summary of the Free Market Story

Efficient use of resources
 resources
flow to produce what consumers want
 consumers pay a market price equal to the
marginal cost of resources to produce a unit of
output
 the surplus is surplus that goes to consumers
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What Can Go Wrong?
Monopoly: the concentration of economic
power
 The role of international trade: free trade
can break down monopoly power in a given
nation and promote competition and hence
efficiency

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Santa Barbara News-Press
Saturday, Nov 10, 2001
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Outline: The Wealth of Nations
Sources of Growth
 Can the US sustain Prosperity?
 Competitition

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The Wealth of Nations (1776)
Adam Smith
Smith first raised the question: what causes
a country to prosper?
 Why is the USA so prosperous?

 Growth
of population and labor force
 accumulation of capital, machines, buildings
and tools
 technological improvements and inventions

How important is each contribution?
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Chapter 23, Figure 23.3
Percentage Contribution to Real GDP Growth
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Input-Output Schematic
Labor
Capital
Output
Technology
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Aggregate Production Function,showing the effect
of increasing capital and land from K1 to K2
Output, Q
Value
Added
Q = f(L, K2)
Q = f(L, K1)
Capital per worker
C
increases
and output
per worker increases
with capital accumulation
L1
Input, Labor, L
Source: Lecture Six, National Accounting
Sources of Growth
Capital deepening
 technological change and increased
productivity
 social infrastructure
 competitive markets and trade

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Capital Deepening
capital per worker increases
 so output per worker increases

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Output Per Worker Has Been Growing
As measured by real GDP per capita
 As measured by output per manhour

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Gross National Product Per Capita in 1929 $ .
1400
1200
1000
$
800
600
400
200
1950
1946
1942
1938
1934
1930
1926
1922
1918
1914
1910
1906
1902
1898
1894
1890
1886
1882
1878
1874
0
Date
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1954
1949
1944
1939
1934
1929
1924
1919
1914
1909
1904
1899
1894
1889
1884
1879
1874
Index
Output per Manhour, Index=100 in 1929
.
250
200
150
100
50
0
Year
28
Aggregate Production Function: As capital per
worker increases, output per worker increases
And the marginal product per worker increases
Q = f(L, K2)
Output, Q
Value
Added
Q = f(L, K1)
C
L1
Input, Labor, L
Output per
Worker
Average,
Marginal
Product
Things Improve with capital deepening:
Output per worker
increase, shifting APL
Labor Supply1874
Labor Supply1954
Real Wage1954
MPL1874
APL
Real Wage1874
MPL1954
L1874 L1954
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Input, # of workers
30
An increase in capital increases the marginal product of labor
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Chapter 23, Figure 23.2
31
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1954
1949
1944
1939
1934
1929
1924
1919
1914
1909
1904
1899
1894
1889
1884
1879
1874
Index
Output per Manhour, Index=100 in 1929
.
250
200
150
100
50
0
Year
32
U.S. Annual Productivity Growth
Years
1959-1968
1968-1973
1973-1980
1980-1986
1986-1994
1994-2000
Annual Growth Rate %
3.5
2.5
1.2
2.1
1.4
2.5
Source: Text, Ch. 23, Table 23.3
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Los Angeles Times
Thursday Nov. 8, 2001
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Total Factor Productivity Index, 1920-1957,
1929=100 .
200
180
Total Factor
Productivity
Exponential Trend
140
120
100
y = 78.386e 0.022x
R2 = 0.9599
80
60
40
1956
1953
1950
1947
1944
1941
1938
1935
1932
1929
1926
1923
20
0
1920
Index
160
Year
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Indices of Labor Input and Capital Input, 1929=100 .
160
140
Labor Input Index
Capital Input Index
120
80
60
40
20
1954
1949
1944
1939
1934
1929
1924
1919
1914
1909
1904
1899
1894
1889
1884
1879
0
1874
Index
100
Year
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Total Factor Productivity: About the
Same for Every Measure
Years
Quantity
Growth Rate
1920-1953 GNP, ‘29 $
0.0326
1920-1957 Total Input
Index
Difference or
Residual
1920-1957 Total Factor
Productivity
1920-1957 Output Per
Manhour
0.0109
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0.0217
0.022
0.0267
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USA Avoids the Malthusian Trap

Even though population has grown for the
last 125 years, and the labor force has
grown, output has grown faster
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Llad Phillips
1954
1949
1944
1939
1934
1929
1924
1919
1914
1909
1904
1899
1894
1889
1884
1879
1874
Index
Labor Input Index, 1929=100 .
120
100
80
60
40
20
0
Year
39
source: US Department of Commerce, Long Term Economic Growth(1966)
Gross National Product in 1929 $ .
250000
150000
100000
50000
1949
1944
1939
1934
1929
1924
1919
1914
1909
1904
1899
1894
1889
1884
1879
0
1874
Millions
200000
Year
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Output per
Worker
Average,
Marginal
Product
US avoids the Malthusian trap, but
without a moderation in population
growth, workers could have eaten up the
gains!
Labor Supply1874
Labor Supply1954
MPL1874
APL
Real Wage1874
MPL1954
L1874 L1954
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Input, # of workers
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Sources of Growth
Capital deepening
 technological change and increased
productivity

 invention
 importance
of educated work force
• education and the public sector
 innovation
 entrepreneur
social infrastructure
 competitive markets and trade

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Aggregate Production Function,showing the effect
of increasing productivity from technological change
Output, Q
Value
Added
Q = f(L, K1, T2)
Q = f(L, K1,T1)
Technological progress
C
increases
and output
per worker increases
with new technology
L1
Input, Labor, L
Output per
Worker
Things Improve with Technological Change:
Average,
Marginal
Output per worker
Product
Labor Supply
1874
increases, shifting APL
Labor Supply1954
Real Wage1954
MPL1874
APL
Real Wage1874
MPL1954
L1874 L1954
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Input, # of workers
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Table 23.2
Source of Real GDP Growth, 1929-1982 (average annual
percentage rates)
Due to capital growth
0.56
19 %
Due to labor growth
1.34
46 %
+ technological progress
1.02
35 %
Output growth
2.92
100 %
Source: Edward F. Denison, Trends in Economic Growth 1929-82
(Washington, DC: The Brookings Institution, 1985).
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Chapter 23, Figure 23.3
Percentage Contribution to Real GDP Growth
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Growth Rate Accounting
Output
 Labor Input
 Capital Input
 Growth Rate in Output Equals Growth Rate
in Inputs (Labor and Capital) + Residual
 Residual: Growth in Output Per Unit Input
Attributable to Technology

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Research and Development as a Percentage of GDP
Chapter 23, Figure 23.5
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Sources of Growth
Capital deepening
 technological change and increased
productivity
 social infrastructure
 competitive markets and trade

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Social Investment in Infrastructure

Transportation
 coastal
shipping
 canals
 roads
 railroads
 highways
 airports
communications
 Schools
 Hospitals

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Example: in 1999,
Hurricane Mitch
strikes Honduras,
worst on record in
this hemisphere.
Seventy percent of
crops destroyed,
bridges and roads
damaged.
"Overall, what was
destroyed over several
days took us 50 years
to build.” Honduran
President Carlos Flores
Loss: $4 Billion
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Examples from US History of
Infrastructure & Input Growth
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United States History: Land as an Input
Source: http://www.yardeni.com/
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United States History: Social Investment in Infrastructure
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United States History: Social Investment in Infrastructure
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United States History: Population (labor) as an Input
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Value of Schools Built in Ohio in Thousands of Current Dollars
7000
6000
Thousands of $
5000
4000
3000
2000
1000
0
1850
1860
1870
1880
1890
1900
1910
1920
Year
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Sources of Growth
Capital deepening
 technological change and increased
productivity
 social infrastructure
 competitive markets and trade

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Competition Spurs Efficiency

With competition, firms are forced to be
efficient and low cost
 otherwise
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they are driven out of business
60
If a country protects its industry from
competition, then it becomes inefficient

Monopoly power can lead to perpetuating
the status quo
 example:

the US auto industry
Tariffs and quotas cushion firms from
competition, allowing inefficiency
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Globalization has led to increased
world trade, increased competition

Link between trade and growth
 trade
makes firms in countries more
competitive
 competition makes firms more efficient
 efficiency conserves resources and makes them
available to finance growth
 the drive for efficiency spurs invention and new
technology
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Can the USA Maintain Its Growth?
How does the US compare?
 Can we maintain capital deepening?
 Can we maintain technological progress?

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A Key to Success: Capital Formation
Net investment means new capital
 New technology is usually introduced
through new capital

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Capital Formation
National
Savings
Gross
Investment
+
-
Net
Investment
Capital Stock
Depreciation
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Capital Formation: Analog to Personal Wealth
Personal
Savings
Investment
+
+
Net
Investment
Stock of
Financial Capital
capital gains,
dividends
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Capital Formation, National Savings
& Gross Investment
Consumer Savings = Income Minus Consumption
Gross
National Savings
Investment
Profits = Revenue Minus Costs
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Personal Savings Rate
http://www.yardeni.com/
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Personal Savings in Billions of Dollars
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Policy Issues
Good News:Long Run Increase in
Productivity, ~ 2.2%
 Bad News

 Consumer
savings is low
 productivity decrease in the 70’s and 80’s

Parents have to care enough about their kids
to save and invest in the next generation
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What’s at Stake? Welfare of Workers
Chapter 23, Figure 23.4
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Prosperity Schematic
Consumer Savings
National Savings
Profits
Net Investment
Capital
Competition
Technology
Immigration
Population
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Labor
GDP per Capita
72
A possible essay question?
What Accounts for Economic Growth?
Why do some countries grow and prosper
and others do not?
 Why do civilizations rise and fall?
 What determines the economic well-being
of US citizens?

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Final 1999, Essay question #1
In the world Malthus envisioned, the population would end up miserable and
at a subsistence wage. Yet we look around us and see an affluent country
with an historical record of industrialization and economic expansion over the
past 150 years that has benefited the average person.
a. Discuss two major reasons why Malthus’ prediction did not come true
for modern developed economies.
b. Does Malthusian thinking have any relevance in today’s world? Are
there countries that come closer to fitting the Malthusian model? Could
the world as a whole face a Malthusian problem in the future?
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Summary-Vocabulary-Concepts











Adam Smith
labor index
capital index
total factor index
capital per worker
productivity
output per manhour
total factor
productivity
productivity residual
invention
innovation
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









entrepreneur
infrastructure
caring parents
average variable cost
marginal cost
average fixed cost
average total cost
price taker
firm’s break even
point
firm’s shut down point
75
Appendix
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Competition/Supply

Output:Inputs
 output:labor
 average
product of labor
 marginal product of labor

Output:Costs
 output:variable
cost
 average
variable cost
 marginal cost
 output:fixed
cost (if capital isn’t variable)
 output:total cost
 total
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cost=variable cost + fixed cost
77
Variable Cost Curve is the Mirror Image of Total Product Curve
B
Production Function
Output
A
B
Bushels of
Tomatoes
Variable Cost Curve
A
Total
Product Curve

Variable cost =
number of workers* wage
Input
number of workers
1. average variable cost, AVC, is minimum, A , where APL is maximum, A
2. marginal cost, MC, is infinite, B, where MPL is zero, B
3. At A, APL = MPL, and at A, AVC = MC
4. The range of production for the firm is between A and B, or A and B
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$
B
Variable Cost
A


$ per unit output
Average
Variable
Cost, AVC
Marginal
Cost, MC
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Output
AVC
MC
Output
79
Cost per unit
of output
marginal cost per unit of output
average variable cost
per unit of output
A
output
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If the Firm Is One of Many Suppliers
then the firm is a price taker, and the price
for output is the market price, pM
 The firm sets price equal to marginal cost to
determine how much output to produce
 If the market price drops below minimum
average variable cost, I.e does not cover
variable cost, then the firm shuts down

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Cost per unit
of output
marginal cost per unit of output
Average variable cost
per unit of output
Market price
A
Shutdown output
s
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output
82
Cost per unit
of output
marginal cost per unit of output
average variable cost
per unit of output
Market price
A
Output produced
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output
83
Variable Cost
$
Variable Cost
B
Fixed Cost
A
Fixed Cost
$ per unit output
Average
Variable
Cost, AVC
Output
AVC
Marginal
Cost, MC
Average Fixed
Cost, AFC
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MC
AFC
Output
84
Total Cost
$
Variable Cost
Fixed Cost
Total Cost
B
Variable Cost
A
Fixed Cost
$ per unit output
Average
Variable
Cost, AVC
Output
ATC
AVC
Marginal
Cost, MC
Average Fixed
Cost, AFC
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MC
AFC
Output
85
Cost per unit
of output
marginal cost per unit of output
average variable cost
per unit of output
Market price
Average total cost
per unit of output
A
Output produced
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Average total
cost per unit
of output
output
86
Profit Margin Per unit of output
Cost per unit
of output
marginal cost per unit of output
average variable cost
per unit of output
Market price
Average total cost
per unit of output
Profit margin
A
Output produced
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Average total
cost per unit
of output
output
87
Short Run Average Cost and Short Run Marginal Cost
Chapter 8, Figure 8.3
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If the Firm Is One of Many Suppliers
then the firm is a price taker, and the price
for output is the market price, pM
 gross revenue, R, for the firm is the product
of the given market price, pM, and the
amount the firm produces, Q

R

= pM*Q
average revenue, or revenue per unit of
output produced is the market price
 R/Q

= pM
Since price does not depend on the output of
this firm, marginal revenue equals average
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Break Even Point of Production for the Firm
C
PM = Min ATC Variable Cost
Fixed Cost
Total Cost
$
Average
Variable
Cost, AVC
$ per unit of output
Marginal
Cost, MC
Average Fixed
Cost, AFC
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Total Cost
Revenue
B
Variable Cost
A
Fixed Cost
Output
ATC
AVC
pM
MC
AFC
QBE Output
90
Shut Down Point of Production for the Firm
C
PM = Min AVC Variable Cost
Fixed Cost
Total Cost
$
Average
Variable
Cost, AVC
$ per unit of output
Marginal
Cost, MC
Average Fixed
Cost, AFC
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Total Cost
Revenue
B
Variable Cost
A
Fixed Cost
Output
ATC
AVC
pM
MC
AFC
QSD Output
91
Managing Production for the Firm

Break Even Point
 revenue
equals, i.e. covers, total costs
R
= TC = VC + FC
 pM = ATC =AVC + AFC

Shut Down Point
 revenue
equals, i.e. covers variable costs
 note
fixed costs remain even if you shut down
 R = VC
 pM = AVC =MC
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Profit Maximizing Point of Production for the Firm
PM = MC
C
Variable Cost
Fixed Cost
Total Cost
B
Variable Cost
A
Average
Variable
Cost, AVC
Total Cost
Revenue
Fixed Cost
Output
ATC
pM
Marginal
Cost, MC
Average Fixed
Cost, AFC
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AVC
MC
AFC
Q Output
93
MC
AVC
AFC
QSD
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Output Varies with Capital, Labor
Q = f(L, K)

output per worker varies with capital per
worker: Productivity of Labor Perspective
 Q/L =
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f(K/L)
95
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