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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 -18 Grade A+ A AB+ B BC+ C CD+ Number 1 2 9 25 27 27 13 10 7 6 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 15 33 21 21 13 4 1 Outline: Lecture Thirteen The Free Market Story The Wealth of Nations Llad Phillips 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? Llad Phillips 5 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 Llad Phillips 6 A Free Market Economy Assumes Resources Are Mobile New firms can enter or leave an industry Existing firms can expand or contract Llad Phillips 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 Llad Phillips 8 Supply Curve of the Firm Cost per Unit of Output Supply Curve of the Firm Average cost & marginal Cost QCOMP Llad Phillips 9 Supply Curve of the Industry Cost per Unit of Output Supply Curve of the Industry Average cost & marginal Cost QCOMP Llad Phillips 10 Add Market Demand to the Picture Market Demand Average cost & marginal Cost PM Market Supply QCOMP Llad Phillips 11 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 Llad Phillips 12 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 Llad Phillips 13 Price the P1 Market Demand first consumer Surplus to the first consumer = P1 - PM is willing to pay PM Market Supply QCOMP Llad Phillips 14 Total Consumer Surplus: A Measure of Consumer Welfare Market Demand Consumer Surplus PM QCOMP Llad Phillips 15 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 Llad Phillips 16 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 Llad Phillips 17 Santa Barbara News-Press Saturday, Nov 10, 2001 Llad Phillips 18 Outline: The Wealth of Nations Sources of Growth Can the US sustain Prosperity? Competitition Llad Phillips 19 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? Llad Phillips 20 Chapter 23, Figure 23.3 Percentage Contribution to Real GDP Growth Llad Phillips 21 Input-Output Schematic Labor Capital Output Technology Llad Phillips 22 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 Llad Phillips 24 Capital Deepening capital per worker increases so output per worker increases Llad Phillips 25 Output Per Worker Has Been Growing As measured by real GDP per capita As measured by output per manhour Llad Phillips 26 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 Llad Phillips 27 Llad Phillips 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 Llad Phillips Input, # of workers 30 An increase in capital increases the marginal product of labor Llad Phillips Chapter 23, Figure 23.2 31 Llad Phillips 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 Llad Phillips 33 Los Angeles Times Thursday Nov. 8, 2001 Llad Phillips 34 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 Llad Phillips 35 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 Llad Phillips 36 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 Llad Phillips 0.0217 0.022 0.0267 37 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 Llad Phillips 38 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 Llad Phillips 40 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 Llad Phillips Input, # of workers 41 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 Llad Phillips 42 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 Llad Phillips Input, # of workers 44 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). Llad Phillips 45 Chapter 23, Figure 23.3 Percentage Contribution to Real GDP Growth Llad Phillips 46 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 Llad Phillips 47 Research and Development as a Percentage of GDP Chapter 23, Figure 23.5 Llad Phillips 48 Sources of Growth Capital deepening technological change and increased productivity social infrastructure competitive markets and trade Llad Phillips 49 Social Investment in Infrastructure Transportation coastal shipping canals roads railroads highways airports communications Schools Hospitals Llad Phillips 50 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 Llad Phillips 51 Llad Phillips 52 Examples from US History of Infrastructure & Input Growth Llad Phillips 53 United States History: Land as an Input Source: http://www.yardeni.com/ Llad Phillips 54 United States History: Social Investment in Infrastructure Llad Phillips 55 United States History: Social Investment in Infrastructure Llad Phillips 56 United States History: Population (labor) as an Input Llad Phillips 57 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 Llad Phillips 58 Sources of Growth Capital deepening technological change and increased productivity social infrastructure competitive markets and trade Llad Phillips 59 Competition Spurs Efficiency With competition, firms are forced to be efficient and low cost otherwise Llad Phillips 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 Llad Phillips 61 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 Llad Phillips 62 Can the USA Maintain Its Growth? How does the US compare? Can we maintain capital deepening? Can we maintain technological progress? Llad Phillips 63 A Key to Success: Capital Formation Net investment means new capital New technology is usually introduced through new capital Llad Phillips 64 Capital Formation National Savings Gross Investment + - Net Investment Capital Stock Depreciation Llad Phillips 65 Capital Formation: Analog to Personal Wealth Personal Savings Investment + + Net Investment Stock of Financial Capital capital gains, dividends Llad Phillips 66 Capital Formation, National Savings & Gross Investment Consumer Savings = Income Minus Consumption Gross National Savings Investment Profits = Revenue Minus Costs Llad Phillips 67 Personal Savings Rate http://www.yardeni.com/ Llad Phillips 68 Personal Savings in Billions of Dollars Llad Phillips 69 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 Llad Phillips 70 What’s at Stake? Welfare of Workers Chapter 23, Figure 23.4 Llad Phillips 71 Prosperity Schematic Consumer Savings National Savings Profits Net Investment Capital Competition Technology Immigration Population Llad Phillips 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? Llad Phillips 73 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? Llad Phillips 74 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 Llad Phillips 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 Llad Phillips 76 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 Llad Phillips 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 Llad Phillips 78 $ B Variable Cost A $ per unit output Average Variable Cost, AVC Marginal Cost, MC Llad Phillips 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 Llad Phillips 80 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 Llad Phillips 81 Cost per unit of output marginal cost per unit of output Average variable cost per unit of output Market price A Shutdown output s Llad Phillips 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 Llad Phillips 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 Llad Phillips 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 Llad Phillips 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 Llad Phillips 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 Llad Phillips Average total cost per unit of output output 87 Short Run Average Cost and Short Run Marginal Cost Chapter 8, Figure 8.3 Llad Phillips 88 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 Llad Phillips 89 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 Llad Phillips 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 Llad Phillips 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 Llad Phillips 92 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 Llad Phillips AVC MC AFC Q Output 93 MC AVC AFC QSD Llad Phillips 94 Output Varies with Capital, Labor Q = f(L, K) output per worker varies with capital per worker: Productivity of Labor Perspective Q/L = Llad Phillips f(K/L) 95 Llad Phillips 96