Economics 103

Lecture # 12

Applications of the

Neoclassical Model.

Equilibrium … one more time … with feeling!!

Think of what you’ve learned so far:

-maximization.

-demand … individual and market.-supply … firm and market.

-and the idea that the force of maximization lead to the equilibrium of P* and Q*.

- CS and PS.

In this equilibrium MC = MV.

Those who value the goods most, get them.

Those who have the lowest costs, make them.

Together, the gains from trade are maximized.

This was Adam Smith’s great insight, the private vice of the individuals still led to the public virtue of maximized wealth.

Furthermore, we know in this equilibrium that every individual is also in equilibrium, and every firm is in equilibrium.

Changes in any parameter lead to changes in the equilibrium.

EG. Suppose there were three identical grocery stores, but not everyone lives the same distance from each store. The equilibrium might look like:

Now suppose the third store introduces an innovation that lowers its costs. What happens?

The supply curve of the third store falls, more people shop there.

Fewer people shop at the other two stores, demand falls.

In equilibrium, the prices, marginal values, and marginal costs are equal again across all of the stores.

For many, this means

But we don’t want to preach the virtues of the competitive world, we want to use this model to explain various things around us.

1. Shifting Curves around.

Why have human egg banks, started to appear?

At one time the costs were high and demand low.

Costs have fallen a tremendous amount and the delay of children has increased the demand, until a market arises.

2. Trade one more time.

Suppose Tom and Gary are not involved in trade. They generate consumer and producer surplus by themselves equal to the shaded area.

If they are allowed to trade:

There is a net benefit to both of them.

What would happen if a third person came along who produced pigs at a lower price than Gary?

Gain to Tom Loss to Gary Gain to Cindy

Net Gain to the Economy.

Will everyone be in favor of free trade?

- Not Gary!

3. The effect of a Tax.

a. A $1 per unit tax on human egg storage.

The first effect will be an increase in the MC of every firm of $1.

This means the market supply curve will increase by $1 everywhere.

The price to consumers goes up by 60 cents, the price to firms goes down by 40 cents.

What will the share depend on?

What happens if you put a $1 per unit tax on the consumers of this service?

Now the perceived demand to the firm has fallen

The interesting thing is the effect of the tax is the same.

Note, there is a DWL due to the tax.

Will the govt. want to tax goods with inelastic or elastic demands?

Suppose you wanted to be an egg farmer, but you only knew as much as these chickens.

Can you just start up an egg farm and send your product to market?

You’d run into someone like this:

4. To grow chickens, turkeys, eggs, milk, and by-products, you need a quota.

A quota is a license to grow a certain amount of output.

Using our model, what would be the effect of a quota?

Clearly the quota - decreases output - increases price - creates a deadweight loss - transfers wealth to some farmers

How much would a quota sell for?

Do new farmers benefit from the quota?

What are the incentives of the individual chicken farmer?

Without the quota the farmer wants to produce Q*, and makes zero profit.

With the quota the farmer can earn a profit equal to the shaded area if he follows his quota.

However, he has an incentive to produce Q’’ and make even more.

Thus quotas must be policed.

When the tariff is placed on wine imports, the price to domestic consumers increases by the amount of the tariff.

The quantity demanded falls, and the quantity domestically produced increases.

The total amount imported falls.

Is reducing the amount of imports a good thing?

The tariff generates a wealth transfer from consumers to the government in the form of tariff revenue.

The tariff also increases the price to domestic firms, causing a transfer from consumers to firms.

We generally don’t have much to say about transfers.

Finally the tariff creates two deadweight losses.

The yellow area is the lost consumer’s surplus.

The blue area is the DWL that results from increased costs of production.

At the international level, tariffs are often considered better than a quota because:

1. They generate revenue for the government. A quota just just generates revenue for the foreign firm.

2. They are relatively visible, and easy to reduce through trade deals.

6. Rent or Price Controls.

Rent controls are often popular because we tend to think of them as nothing but a transfer from wealthy landlords to poor tenants.

But you should be starting to realize that changing prices away from their equilibrium levels lead to changes in behavior that are not always good.

What would the effect of a rent control be, and would it necessarily benefit tenants? All tenants?

The initial effect of a rent control is to lower the price to tenants.

This increases the quantity demanded.

It lowers the quantity supplied.

Creating a shortage.

You have a hard time finding an apartment in a rent controlled city.

The rent control creates a transfer and some DWL’s

The crosshated area is the transfer.

The blue area is the lost CS from tenants who no longer can rent.

The red area is the lost PS from landlords who can no longer rent.

However, at this reduced quantity supplied, the MV is greater than the marginal cost of housing. Consumers are willing to pay more for housing than landlords require to rent.

Competition among renters will compete this away.

This competition reduces the net transfer to tenants, and may or may not increase the DWL.

Whether we count the blue area as a DWL depends on how the competition takes place.

If waiting … DWL

If “key money” then transfer.

Note that, at the margin, rents are actually higher!!

7. Warm houses in Cold climates.

Here’s the puzzle:

1. when I visit Ottawa in the winter I’m too hot inside.

2. When I visit Christchurch in the winter, I’m too cold inside.

Why is it that inside temperatures vary inversely with the outside temperature?

What is the climate like in Vancouver?

What about Christchurch?

And what about our capital?

This doesn’t include wind chill or humidity!

Ottawa has the coldest average winter temp than any other capital city.

People in Ottawa obviously have to spend a lot on heating their homes, so why would they heat them more?

This sounds like a violation of the law of demand!

The key is to understand the very simple cost function for heating a home:

TC = price of heat x Barrier [ Temp inside – Temp outside ]

MC = price of heat x Barrier

The total cost functions for different houses looks like the following:

What is the difference between house 1 and 2?

What is the difference between house 1 and 3?

Let’s suppose the demand for heat is the same across all three cities. What would the choice be if all cities had the same type of house?

Everyone would have the same inside temperatures.

But the houses are not the same!

In Vancouver houses:

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In Ottawa: Houses are:

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In Christchurch the houses are different still.

Houses:

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Thus the different style of houses leads to different MC of heating.

Which location will have the highest cost of heat in total?

8. The Marriage Market.

The neoclassical model we’ve been looking at is great at predicting the terms of trade (price) and the volume of trade (quantity).

As long as we keep in mind that this is all this model can do, then there are no limits to the applications.

Thus we can use it to analyze the number of marriages, and the terms at which people get married.

We cannot use it to discuss institutional questions of marriage

… for that we’ll need to wait for a richer model. Chapters 15-17.

• With that in mind, let’s assume the following:

1. Men and women make their own choices of spouse.

2. All men and women rank each other the same.

3. Monogamy only.

4. No cheating in marriage.

5. A “price” of a spouse exits. This could be the form of a

dowry or bride price, but may just be the value of net

wealth brought to the marriage.

6. The value of wealth brought to a marriage may include

any economic good: dollars, beauty, genetics, personality,

future income, etc.

Under these terms we can draw demand and supply curves for spouses.

So here is a market for wives.

The men are doing the demanding and the women are doing the supplying.

In equilibrium the price is zero (no net transfer) and there are four million marriages.

What would the market for husbands look like?

The Market for husbands would be reciprocal.

That is, the demand for husbands is also the supply of wives, and vice versa.

Once again, there are 4 million marriages, and a zero net price.

If husbands paid $10000 for a wife, then 6M husbands would be demanded, and only 3M would be supplied.

The point of a model like this is to see if it can explain anything.

1. What would be the effect of Polygamy? (more than one wife)

This raises the demand for wives, increasing the price of wives.

Women better off, men worse off.

2. What about Polyandry? (more than one husband)

The same thing. Increased demand for husbands, increase in the price of husbands. Men benefit in this case.

Why does this grind against our intuition?

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According to this model, a key factor in terms of the “price” is the sex ratio: M/F.

If M/F is large, then the “price” to women will increase.

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If the M/F ration is low, then the “price” to women will fall.

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There are lots of examples of swings in the M/F ratio.

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