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PROFESSOR: Now, what we're going
to do today is build on
what you learned in
section on Friday.
On Friday, you learned about how
supply and demand interact
to yield equilibrium.
So the sort of fundamental
concepts we talked about with
Adam Smith and his water-diamond
paradox of
supply and demand interacting
to yield a
market price and quantity.
And the way we're going to build
on your understanding of
this today is talk about what
happens when you shock that
supply and demand equilibrium.
When things change, how does
that change that supply and
demand equilibrium?
And that'll help build your
understanding of what you learned.
So to review, let's go to our
basic supply and demand graph,
Figure 2-1 in the handout.
You talked in section about
the market for pork.
That's the market
Perloff uses.
Seems good as any, so we'll
continue to rely on that, the
market for pork.
And in this pork market, you
have a demand curve and a
supply curve.
Now, it's critical to remember
what these curves represent.
Once again, for this course,
ideally, you understand all
concepts on three levels,
intuitively, graphically, and
mathematically.
But the intuitive is the most
important, especially for
those of you who aren't going
to go on and do a
whole lot of economics.
For instance, where it's just
one of the few economics
courses you'll take, it's very
important for your lives and
using economics you understand
this intuitively.
So intuitively, let's talk about
what the demand curve
represents.
Can anyone tell me, what's the
demand curve represent, from
what you learned on Friday?
Can anyone just take a shot?
We're just--
yeah, go ahead.
AUDIENCE: The willingness
of consumers to
buy a certain product.
PROFESSOR: Exactly.
The willingness of consumers--
I'm going to change your words
just a bit, because words are
important here.
The willingness of
consumers to pay.
The willingness to pay.
The difference with buy is
it's really because the
different amounts.
They're going to be willing
to pay different amounts.
So it's the willingness of
consumers to pay for the good.
The willingness of consumers
to pay for the good.
So what this says is that each
point in the demand curve
represents the price consumers
are willing to
pay for that quantity.
And it's downward sloping.
The demand curve is downward
sloping because as the price
goes up, consumers are willing
to buy less of a good.
So their willingness
to pay changes.
So that's the demand curve.
Now what about supply curve?
What's a supply curve
represent?
Anyone?
Yeah?
AUDIENCE: Pretty much
the opposite.
The willingness of producers
to produce, like, how much
they are going to charge for--
PROFESSOR: Yeah, the willingness
of producers to
supply the good.
So how much they're going
to charge for a given
quantity of the good.
And once again, that is upward
sloping because as the price
rises, they're willing
to supply more.
So as the price rises, consumers
demand less.
As the price rises, producers
produce more.
And equilibrium is that point
where supply equals demand.
Equilibrium equals happiness.
It's the point where suppliers
and demanders are both happy.
They're both happy because at a
point such as e, the amount
that consumers demand at that
price is equal to the amount
suppliers are willing to
supply at that price.
So jointly happy.
You've reached a point where
consumers want a certain
amount at a certain price.
At that price, producers say,
great, you want e, I'm happy
to produce e at that price.
So we've reached equilibrium.
Now, let's talk about what
happens when we shock that
equilibrium.
This is the market for pork.
Imagine that the price
of beef rises.
The price of beef rises.
Can anyone give me a guess as
to what that does to the
market for pork?
The price of beef rises.
What does that do to the
market for pork.
Yeah.
AUDIENCE: It reduces
the demand.
PROFESSOR: It what?
AUDIENCE: Reduces the demand.
PROFESSOR: Why would it reduce
the demand for pork?
AUDIENCE: Because the
price [INAUDIBLE].
PROFESSOR: But I didn't say
the price of pork rises.
The price of beef rises.
And how does beef
relate to pork?
AUDIENCE: They're substitutes.
PROFESSOR: They're
substitutes.
Exactly.
So when the price of beef
prices, how does that affect
people's demand for pork?
Increases it.
Exactly.
Because they're substitutes.
What we're going to learn
critically as we go through is
what's going to determine
these demand curves
importantly is going to be
substitutability across goods.
So here we have a situation
where the substitute for pork
has gotten more expensive.
As a result, people
want more pork.
That is a shift out in the
demand curve, or a shift up in
the demand curve.
A shift up or out, depending on
it's out into space or up
vertically in the
demand curve.
So what happens here is that
folks shift to consuming pork,
so they want more of it.
So we're initial equilibrium--
we just made up some numbers--
we're initial equilibrium here
at 220 millions of kilograms
of pork a year and a price
of $3 a kilogram.
That was the initial
equilibrium.
That was the point where
demanders and
suppliers were happy.
Now the price of beef has
gone up, maybe because--
I don't know.
Mad cow disease or something
like that has raised
the price of beef.
So now people are saying,
hey, we want more pork.
That shifts the demand
curve out.
Initially, if the price stayed
at $3, if the price remained
at $3, what would happen?
What would happen is people
would now-- and once again,
these numbers are made up.
But this is just to illustrate
an example.
People would now say, gee, at a
price of $3 and this further
out demand curve-- now I'm on
Figure 2-2, if you haven't
picked that up--
I want 232 millions of kilograms
of pork a year--
not I, personally.
That'd be like Homer.
Everybody wants 232 millions of
kilograms of pork a year.
I hope you guys don't get tired
of Simpsons references.
So what that says is consumers
say, gee, I want a lot more
pork at that price.
If it's going to be $3, and the
price of beef just went
up, I'm going to want
a lot more pork.
So what you're going to have
initially is excess demand,
because at that price of $3,
suppliers are only willing to
supply 220 million kilograms.
They were happy, right?
They were happy at point e1.
When you come along, and you say
consumers now want more,
they say, well, we're
not happy to provide
more at that price.
If you want more, we're
going to have to
charge a higher price.
So they say, if you want more
pork, we're going to have to
produce more.
So we are going to slide
up the supply curve.
So if you start at a point like
e1, they say, gee, you
want more pork?
Well, we're going to have to
slide up that supply curve.
So we're moving up the supply
curve and saying, we're going
to have to charge you a higher
price if you want more.
Well, as the price goes
up, consumers say,
well, wait a second.
If the price is going up, I
don't want quite as much more.
And you meet at the new
equilibrium e2.
So what happens is producers
say, gee, if you want more,
I'm going to charge you
a higher price.
Consumers say, well, gee, if
you're charging a higher
price, I'm going to go back
up the demand curve.
I don't quite want as much
at that higher price.
And the new equilibrium is e2.
That's where consumers and
producers are now happier with
that outward shift
in demand curve.
But the key point is consumers
are not getting as much as
they originally wanted at the
original price, because the
original price will not hold.
The price is going to change.
Given the price is going
to change, the
quantity is going to change.
And you end up with both a
higher price and a higher
quantity for pork.
So think about it.
This is pretty interesting.
The price of beef rising raised
the price of pork.
It didn't just increase the
demand for pork, but through
increasing the demand,
it raised the price.
So price in one market affects
the price in another market,
not just the quantity but the
price in another market.
And that's our new
equilibrium.
That's the shift in
the demand curve.
And once again, suppliers
and demanders are happy.
They're happy at this new
point e2, this new
equilibrium, because given the
new demand curve, at a price
of $3.50 a kilogram, producers
are happy to produce the 228
million kilograms of pork a
year that consumers want.
And at that price, that's
what consumers want.
If they're going to say, oh,
it's $3.50, I want about 228.
I want more than I wanted
before, because beef's gotten
more expensive, but not as much
as I would have wanted if
you hadn't increased
your price.
And that's the new equilibrium
is e2.
Yeah.
AUDIENCE: But is it possible
that changing the price of
pork could affect the
price of beef?
PROFESSOR: Excellent.
So the question is, could there
be a feedback effect
where, basically, now the pork
market's changed, could that
go back and affect
the beef market?
In principle, yes.
In practice, we're going
to make your life
easy by saying no.
In principle, it could.
And that gets into something
called "general equilibrium."
And that's way too complicated
for this course, so we are
going to ignore those kinds of
feedback effects for now.
That's something you can learn
about more in future courses.
But you're right.
In principle, it could affect
the demand for everything.
You could imagine that as the
price of beef goes up, that
means that, for example,
the cost of
restaurant meals goes up.
So I'm not going to eat at the
restaurant as much, so maybe
I'll go to the movies more.
So in principle, the price of
beef going up could raise the
demand for movies.
It's crazy.
It's hard to know
where to stop.
So we're going to make your life
easy by stopping at one
level here.
But you're right.
In principle, there could be
these wide range of feedbacks.
And once again, I talked in
the first lecture about
simplifying assumptions.
We're going to try to teach you
the basic concepts but try
to make simplifying assumptions
that make it more
manageable.
That's the kind of simplifying
assumption we'll make for our
modeling here in this course.
So that's a shift in
the demand curve.
Yeah.
AUDIENCE: How do you
quantify the shifts
in the demand curve?
PROFESSOR: Excellent.
And that will be exactly--
basically, the way we're going
to learn in this course, we're
going to do things a
couple of times.
When we talk about producer
theory, we will teach you
where this supply curve
comes from.
Basically, firm
profit-maximizing decisions
will determine the supply curve
and how much it shifts,
and we'll teach you that when we
teach you producer theory.
So this is sort of
a big overview.
You're good MIT students.
You're immediately thinking,
where the hell do these demand
and supply curves come from?
That's where we're
going to get to.
That's the whole point of
consumer theory will give us
the demand curve.
Producer theory will give
us the supply curve.
All right.
Good questions.
So now, let's talk about
a different case.
Let's talk about a shift
in the supply curve.
So now, let's suppose
there's a drought.
And let's suppose it's
a drought that
only affects pork.
Because if the drought affected
beef, that would then
have these other feedback
effects.
Let's imagine there's
a pork drought.
I don't know what that
would mean, but let's
imagine that happened.
So suddenly, it becomes
more expensive--
or let's just say there's
mad pig disease.
Let's imagine there's
mad pig disease.
So suddenly, it becomes more
expensive to produce pork.
Because there's fewer
pigs, it's more
expensive to produce it.
So what that would do is that
would cause a shift in in the
supply curve-- inward or upward
of the supply curve.
Suddenly, on you get the fact
that given that it's more
expensive to produce pork,
suppliers say, well gee, to
produce a given amount of pork,
I need to get paid a
higher price.
So we get, once again,
initially, if the price stayed
constant-- so now I'm
on Figure 2-3.
If the price stayed constant,
we would not
begin with excess demand.
Because if the price stayed
constant, then consumers would
want 220 million kilograms of
pork, which is what they
wanted before.
Nothing's changed from
their perspective.
But producers would say, look,
at that price, I can only now
produce 205, because my supply
curve shifted up.
So once again, you have to
move to a new equilibrium
where suppliers and consumers
are happy.
That will happen at
a point like e2.
Because at e2, given the higher
price of producing
pork, producers will now say,
OK, I'm happy to sell 215
million kilograms at $3.55.
And consumers will say, well
gee, at $3.55, I don't want
quite as much as I
wanted before.
I only want 215.
And they're happy.
Here's what's striking.
We had two very different
phenomena.
We had a demand shift
and a supply shift.
Both led to the same outcome.
I'm sorry, both led
to a higher price.
Sorry, not the same outcome.
Both led to a higher price.
One led to higher demand,
to higher
quantity sold in the market.
So you go back to Figure 2-2.
The price went up, and the
quantity in the market went up
from 220 to 228.
In Figure 2-3, when the supply
shift happened, the price also
went up almost exactly
the same amount.
But here, the quantity fell.
So you can't tell from a price
increase what happened.
If the price of pork goes up,
you can't tell me whether that
was a demand or supply shift.
You need to know both the price
and quantity to be able
to tell me that.
Both changes led to the same
outcome in terms of prices.
Questions about that?
Now let's make it interesting.
So we have the supply and
demand equilibrium.
Supply shifts, demand shifts,
you move the points.
You guys can all do it
graphically, even if you don't
quite get it intuitively yet.
Now let's ask, what happens if
the government comes in and
messes this up?
Now, step aside to
my other hat.
The other course I teach is
called Public Economics, which
is all about the role of the
government in the economy.
In this course, most of what
you'll learn is there's a
clear role of the government
in the economy.
It's to screw it up.
Economics is fundamentally
a right-wing science.
Most of my colleagues are
Democrats, but that doesn't
change the fact that what we
teach is fundamentally very
conservative, which is the
market knows best, and
governments just
mess things up.
Now, later in the semester,
we'll talk about why that
might not be true.
And the whole point of my other
course, 14.41, is to
talk about why that might not be
true and where governments
can make things worse
and better.
But from your basic perspective,
you need to be
indoctrinated with this
fundamental position, that the
market gets it right.
The market equilibrates.
Governments mess things up.
And that's sort of where
we'll start.
So let's talk about the classic
example of government
messing things up,
the minimum wage.
You've all heard of the minimum
wage, the thing
workers get paid more.
That seems like a good thing.
Well, in fact, to economists,
it's a bad thing.
And let's talk about why.
To many economists, at
least this initial
analysis is a bad thing.
We'll come back later as to why
it might not be so bad.
To do that, let's talk about
equilibrium not in a market
for goods, like pork,
but in a market for
inputs, which is labor.
Labor is an input to the
production process.
We'll talk about this at great
length later in the semester.
But the key thing is, just like
there's a market for pork
where the equilibrium outcome is
the price you pay for pork
and the amount of pork sold,
there's a market for labor.
And in that market, things
are flipped.
Who are the consumers now?
Well, they're the firms.
The firms demand labor.
Who are suppliers now?
Well, they're you.
They're the people.
People supply labor.
So now we've flipped
things on its head.
The suppliers are the people.
The demanders are the firms. But
the analysis is the same.
This basic supply and demand
framework, which will turn out
to be so powerful this semester,
can be used, even
though we flipped the labels
of who's on what side.
So you see in Figure 2.4, we
have a labor market with an
upward-sloping supply curve.
What does that mean?
Why is the supply curve
upward-sloping?
Because the higher your
wage, the more
you're willing to work.
And we have a downward-sloping
demand curve.
Why is it downward sloping?
Because the higher the wage,
the fewer workers the firm
wants to hire.
It would rather use
machines instead.
So basically, you've got that
same supply and demand curve,
different stories as to where
they come from, but the same
effect in terms of determining
equilibrium.
We get an equilibrium at w1 l*,
which is at a wage w1, l*
workers are willing to work.
Or l* hours are supplied
of labor.
We think about hours
supplied, not
necessarily number of workers.
l* hours of labor
are supplied.
And at that w1, l* workers are
willing to provide l* hours,
and at that w1, firms demand
l* hours, and that's the
equilibrium.
Same analysis as before, just
different stories as to what's
behind the curve.
Now, let's say the government
rolled in and set, as in
Figure 2-5, a minimum wage.
The government says, look,
that wage w1 is too low--
or w* in this graph--
is too low.
Workers are not paid enough
in equilibrium.
We need to make sure that they
get paid a minimum amount.
So we are going to mandate that
workers cannot be paid
below w lower bar, which
is critically above w*.
Well, what happens
in that case?
Well, in that case, at that
wage, workers are thrilled.
They say, look at that wage.
We are delighted to work--
god, the numbers are--
I'm getting old--
ls hours.
I have my prescription
for my bifocals.
I've had it for, like, two
months, and I just can't quite
take it to the mall
and get them.
So eventually I'll get them.
I just can't quite admit
I'm that old.
So workers are like, great.
At that wage, we'll supply
l sub s hours.
That sounds great to us.
We're all good.
But the firm says,
wait a second.
No, we don't want to hire l
sub s hours at that wage.
That's way too high.
We only want to hire at that
high wage l sub d hours.
So suddenly, here you have
a case of excess supply.
Not excess demand,
excess supply.
Workers want to supply more
hours than firms want to hire.
Now, in our previous example,
what would happen?
What would happen is, if there's
excess supply-- well,
let me ask you.
If there's excess supply in
the market, how would the
market equilibrate?
What would happen?
Yeah.
AUDIENCE: It would lower
the price so that the--
PROFESSOR: In this case,
the price is what?
AUDIENCE: The number of--
PROFESSOR: The wage.
The wage.
So exactly.
In our previous example,
the wage would fall.
Workers would suck it up
and get a lower wage.
Firms would be happy to
pay a lower wage.
You'd reach a point where
they were happy.
You'd reach a point like e.
But you can't now.
You can't, because the
government said you can't pay
less than w lower bar.
So you end up with
excess supply.
And we call that excess supply
"unemployment." You end up
with unemployment, because at
that high wage, firms are not
willing to hire as
many workers as
are willing to work.
And you end up in
disequilibrium.
You end up not in equilibrium
but disequilibrium.
Now, disequilibrium is kind of
hard to think about, because
in some sense, this course
is all about equilibrium.
So I'm not talking about chaos
or cats and dogs living
together, breakdown
of social order.
That's not what I'm
talking about.
Disequilibrium, there is
still a market outcome.
The market still settles
at a point.
In this case, what happens is
the market settles at a wage
of w lower bar because it has
to and at an amount of labor
delivered at l sub s, that low
amount of labor delivered.
Because when you're in
disequilibrium, the outcome of
quantity and prices
is determined by
the constrained party.
That's the way I like
to think about.
You can think about it
however you want.
But here's the point.
Workers can't work if firms
won't hire them.
So if you want to say, look,
we're going to end up at w
lower bar, how much labor is
going to be in the market?
Well, it's up to the firms.
They get to decide.
They're going to say, look, we
don't want more than l sub d,
so that's how many jobs they're
going to provide.
So the new outcome is going to
be at a wage w lower bar and
an amount of hours l sub d.
So basically, you end up with
this unemployment situation
where only l sub d workers
are hired and the
wage is w lower bar.
Now, let me ask a question.
What would happen if w sub lower
bar was set below w*?
What if I'd redrawn this
diagram so w lower
bar was below w*?
Yeah.
AUDIENCE: The market would
equilibrate and--
PROFESSOR: Yeah, nothing would
happen at the end of the day.
And here's the key point--
very important point
to remember--
which is that markets are very
robust. Economic markets are
very robust. And if they can
undo the effective government
intervention, they will.
So if the government tries to
come and intervene in a way
which markets can undo and get
back to where they wanted to
be, they will.
That original point e is where
the market wants to be.
That was where it was happy.
It can't get there in the
example I taught here with w
lower bar above w*.
But if w lower bar was below w*,
it could get there and be
happy, so government
intervention would make no
difference.
That's one example of a
government intervention.
Let's do another example.
Then I want to talk about the
pros and cons of these
government interventions.
Let's do another example.
Gas price ceilings.
So let's consider a cap on how
much can be charged for gas.
Seems a pretty sensible
policy.
Gas is crazy expensive.
We all like to drive.
So let's consider a cap
on the price of gas.
Imagine, for example, we're
initially in equilibrium, in
Figure 2-6, with demand of
Q2 and a price of P1.
We're all happy.
Now let's imagine there's an oil
crisis, because, say, oil
companies decide it's a good
idea to drill eight miles
underground, and everything
explodes, and we suddenly run
out of oil.
So all of a sudden, there's a
constraint in the supply.
Suddenly, there's a--
I'm sorry, my bad.
We're initially in equilibrium
at e1.
My bad.
We're initially at equilibrium
at e1, with a price of P1.
There's a bit of mislabeling
here.
On the vertical axis, that
upper price should be P2.
So on the vertical axis, you see
there's P1 equals P. Then
above it, it says P1 again.
That should say P2.
So we're initially in
equilibrium at point e1 with a
price of P1 and a
quantity of Q1.
Now oil tanks blow up
all over the world.
Suddenly, that means there's
a restriction in
the supply of gas.
Suddenly, there's not as much
gas as can be produced.
So that's an upward shift in the
supply curve, just like we
talked about before.
And absent any government
intervention, the supply curve
would shift up to s2, consumers
would want less gas,
and you'd reach a new
equilibrium at e2.
And once again, let's talk about
equilibrium as being
where people are happy.
Now, you could say, well gee,
people aren't happy paying a
higher price for gas.
Well, that's why I'm a bit glib
using the term "happy."
It's a point where the suppliers
and demanders are
jointly willing to
make the deal.
And they're willing to
make the deal at e2.
They're willing to say, look,
given how many oil rigs have
blown up, we are happy to
equilibrate the market now at
a higher price and
a lower quantity.
But then it's September, 2010.
There's an election
two months away.
President Obama isn't very
happy about this.
And he says, forget it.
We're going to cap the price at
P. We were paying P before.
We can pay P again.
Those stupid oil companies
can suck it up.
They're the ones who drilled
eight miles underground.
They're the ones who
blew everything up.
They can suck it up.
We're keeping the price at P.
We'll help the consumer.
We'll keep the price.
Well, what happens?
What happens is that consumers
are now, great, we
continue to want Q1.
That's where we were before.
We're happy.
But producers say, well, you
know what, President, we can't
supply that much
at that price.
Because it costs us so much to
drill oil now that if you're
going to force us to keep the
price at P1, we are only going
to supply Q sub D because
we just can't
supply at that low price.
We're going to supply Q sub D.
So what happens, you end
up with excess demand.
Consumers want Q
sub D gallons.
Producers are willing to produce
only Q sub S. And you
end up with disequilibrium.
And in this case, once again,
the amount sold is what the
producers are willing to sell.
It doesn't matter how much
consumers want if producers
aren't willing to sell it.
You end up with disequilibrium,
and you end up
with much, much less
gas being sold.
So yeah, the price stays low,
but the amount of gas being
sold is much lower than if
the president allowed
the price to rise.
So that's another example of
a government intervention
causing disequilibrium.
Any questions about that?
Yeah.
AUDIENCE: In the last chapter,
we talked about, can the
government then come in and
give a subsidy to the oil
producers to produce
the same amount?
PROFESSOR: Great.
Hold that thought for 14.41.
But that's exactly what the
government could do.
The government has
lots of tools.
So it can come in and say, well,
on the one hand, we'll
set a price cap.
But then we'll come in on the
other hand and give a subsidy
to oil producers to make
sure they do that.
That has two problems. One is,
not so good with the voters.
Like, gee, we're going to give
subsidies to oil companies.
Isn't that a great idea.
Two is, you've got to raise the
money somehow, which means
you've got to raise taxes.
Also not so good with
the voters.
So it's, in general, not a good
idea, because you screw
it up on the one hand
to screw up again.
Two wrongs don't make a right,
something I learned
from an early age.
If the government's messed up
the market on the one hand,
it's not, generally, a good idea
to try to mess with it
again to fix that.
But that's exactly the kind of
stuff we'll discuss in 14.41.
AUDIENCE: I've got a question
about that.
Will that mean that there's
a [INAUDIBLE] because
[INAUDIBLE]?
PROFESSOR: Great segue into
what I want to talk about
next, which is, what are the
costs and benefits of these
kinds of market interventions,
of a minimum wage
or gas price ceiling?
Why do we do this?
The government, these aren't
stupid people, by and large.
Why do governments do
things like this?
What are the costs
and benefits?
Now, later in the semester,
we'll talk
about welfare economics.
By welfare, welfare
has two meanings.
We often think of welfare as
being money distributed to
poor people.
That's one meaning.
But when we say "welfare
economics," we actually mean
the well-being of society.
And we'll talk about the
well-being of society later on
in the semester.
But let's talk for a minute
about this general topic.
And how do we think about the
kind of welfare economics of
these restrictions?
Well, there's two costs and
one benefit to these
restrictions.
The first cost is the
efficiency loss.
So the costs of things like the
minimum wage and gas price
ceilings, the first cost
is the efficiency loss.
And we are going to be
much more precise.
This lecture is sort of a chance
to be loosey-goosey
about things that I'll then
make much more precise
throughout the semester.
We'll be precise about
what we mean by this
throughout the semester.
But the key point is, in
economics, whenever there is a
trade that can be made that
makes both parties better off,
and it is not made, that
is an inefficiency.
So in economics, we define
"efficient" as when all trades
that can make both parties
better off are made.
And whenever anything comes
up that interferes--
so a trade that could
make both parties
better off is not made--
that is inefficient.
There is an efficiency loss.
And think about it.
It makes sense.
If both parties could be better
off by a trade and
don't let it happen, then
society is worse off.
That's the idea of an efficiency
loss in economics.
Economics is all about trading
to make things work more
efficiently.
When you don't let that happen,
you've hurt society.
You have a welfare loss, because
you have something
that could've made both people
better off, that would've been
a good thing to do.
You haven't allowed
that to happen.
And if we think about it, in
both these examples, Figure
2-5 and 2-6, there are trades
that would've made both
parties better off that we're
not allowing to happen.
So in the labor market case,
think about a wage that's
above w* and below
w lower bar.
So a wage in that interval.
At that wage, workers
would be happy--
and take unemployed workers.
Unemployed workers would be
happy to work it a wage
somewhat below w bar.
Firms would be happy to hire
them at a wage somewhat below
w lower bar.
But it isn't happening, because
the government has
interfered.
That's an efficiency loss.
Likewise, look at Figure 2-6.
Consumers would be happy to pay
a somewhat higher price
and get some more gas.
Producers would be happy
to produce more
at that higher price.
But it's not happening.
That's an efficiency loss.
So an efficiency loss is
whenever there are trades that
can make both sides better
off that don't happen.
Once again, this is
loosey-goosey here.
We'll make this all more
precise as the
semester goes on.
But it's important to get the
big picture concept of what we
mean by efficiency in economics,
which is trades
being made that make both
parties better off.
The second cost here is what
we call "allocation
inefficiency." Remember in the
first lecture, I talked about
how prices play three
roles in the market.
They determine what is to be
produced, they determine how
it is to be produced, and they
determine who gets it.
That's called "allocation."
Price plays a critical role in
making sure that the people
who want the good
the most get it.
Because remember, that demand
curve is a willingness-to-pay
curve, or a willingness-to-buy
curve.
What that lets us know is the
further up the demand curve,
the more people want the good.
And we should make sure
that those people are
allocated that good.
So in a world of equilibrium,
we make sure that the
allocation happens.
Anybody who wants the good at
a price that consumers are
willing to sell it gets it.
Someone who doesn't want it at
that price doesn't get it.
Equilibrium takes care of
that allocation problem.
But in disequilibrium,
it doesn't.
Let's consider the
gasoline example.
Now we have a case where there
are many, many people-- in
fact, all the folks
who lie between Qs
and Qd on that x-axis--
all those folks want gas
at that low price
but can't get it.
There's only Qs being
supplied.
So what happens?
Well, what happened--
you guys weren't alive for this,
but in the 1970s, does
anyone know what happened
when we did price
ceilings of this type?
Does anyone know
what happened?
AUDIENCE: Gas shortage.
PROFESSOR: Gas shortage.
And how did people respond?
How was gas allocated in
that gas shortage?
AUDIENCE: There were lines.
PROFESSOR: Peopled waited
in huge lines.
Basically, we couldn't use
the price mechanism,
so what did we do?
We used the wait mechanism, just
like they used to do in
Russia all the time
and still do.
The point is the gas that's
limited-- that Qs--
has got to get allocated
somehow.
In the market, it gets allocated
by the price rising
until the price is high enough
that the set of people who
want it at that price get it.
With this gas price ceiling,
that can't happen.
So what happens?
Lines for gas.
Huge, hours-long wait.
This is sort of inconceivable
now.
Sometimes, you have to wait at
a gas pump, but pretty much,
you drive up, you get your gas,
you leave. In the 1970s,
literally, you would
wait hours--
multiple hours-- in
line to get gas.
That was how the gas was
allocated in the face of these
gas price ceilings.
Yeah.
AUDIENCE: What about things like
the government saying you
can't shut off someone's gas in
the winter, even if there
was a price ceiling?
PROFESSOR: OK, let me
come back to that.
Hold that thought for
a couple minutes.
I want to come back to that.
But I want to focus on these
gas price lines and why
they're bad.
Well, these gas price lines
are themselves a source of
inefficiency.
And why?
Why is it inefficient
to have people
waiting in line for gas?
Yeah.
AUDIENCE: Because they
could be working
or doing other things.
PROFESSOR: They could
be working.
They could be out making trades
that make everybody
better off.
Instead of being in line waiting
for gas, they could've
been at work, working for a wage
that they were happy to
earn and their employer
was happy to pay.
So a trade is not being made.
Unless they're equally happy
sitting in line waiting for
gas, which is doubtful, a trade
is not being made, which
makes both parties better off.
What else?
AUDIENCE: I have a question.
Did the government
know about this?
PROFESSOR: Yeah, believe
me, they did.
But they said, well gee, we
can't let people pay those
high prices.
Governments face really
hard decisions like
this all the time.
There's another program, of
course, which is, what happens
with people waiting
in line for gas?
They're idling and
using up gas.
So in fact, there was a direct
mechanical inefficiency as
well, which is all the gas that
was wasted while people
idled in line, waiting
to get their gas.
So that's the kind of
inefficiency you're used to
thinking about as engineers.
There's a mechanical
inefficiency, but the main
thing we care about is the
allocative inefficiency, which
is trades are not being made
because people are sitting in
their cars waiting for gas.
And that's inefficiency.
And that inefficiency arises
because we have to allocate
the gas somehow.
You can't get around
that problem.
Remember, we are the
dismal science.
We point out problems that
cannot be surmounted.
You can't get around
that problem.
That gas has to get
allocated somehow.
And if you don't let the price
mechanism allocate it, some
other, more inefficient
mechanism will arise to do so.
Now, the trade-off, of
course, is then you
keep the price low.
And the government's
got to decide--
once again, this gets into the
political economy of how the
governments make these
decisions.
And that's not really the
point of this course.
But that's the kind of decision
they have to make.
Now let's come-- and this will
touch on your question-- oh,
do you have a question
about this?
AUDIENCE: I have a question,
actually,
about the minimum wage.
So isn't it a little imbalanced,
because when
people need work more than
companies need people--
because, for example, there are
a lot of instances when
companies are paying hunger
wages, a dollar a day.
[INAUDIBLE]
they're not happy for it.
PROFESSOR: Yeah, basically, in
some sense, the bottom line
is, equilibrium is where people
are going to work for
what the company's
willing to pay.
Now, you can say, if people
want work when the company
wants to offer it,
that's sort of a
difficult subjective judgment.
But at the end of the day, if
people are willing to work for
a dollar and the company's
willing to hire them for a
dollar, then that's a trade
which should be made.
Except, that's a great example
to point out--
same person who just said
that, well then, tell me
what's the benefit of
a minimum wage?
AUDIENCE: [INAUDIBLE]
PROFESSOR: It's equity, that
thing economists like to not
think about, because
it's tricky.
It's fairness.
It's equity.
It's unfair that you would
work for a dollar a day.
And people might be exploited
and work for
unfairly low wages.
Likewise, it's unfair that we
pay a huge amount for gas.
So people, we should keep the
wage high and the prices low
to make it fair.
And that's the pro of
the minimum wage.
Yeah.
AUDIENCE: I didn't quite
get [INAUDIBLE]
it is giving a few people
a higher wage, right?
But it's causing unemployment,
so how is that better?
PROFESSOR: Wonderful point.
Wonderful point.
That's because in economics,
there's the direct effect and
the indirect effect.
And the direct effect is
what voters understand.
And the indirect effect
is what we understand.
In the case of gas, it
was easy to see.
The question, why didn't the
government realize this?
Everyone saw the direct effect,
which was low prices,
and indirect effect, which
was long lines.
With a minimum wage, it's
harder, because there's lots
of reasons for unemployment,
not just the minimum wage.
So the indirect effect is
a lot harder to see.
If you're a politician, you're
saying, look, I'll raise the
minimum wage.
I'll make sure you're
paid more.
Everybody goes, yay.
And then the economist says,
well, you have to understand,
according to this diagram,
that would lead to
unemployment.
People are like, whatever.
Shut up.
So basically, the
point is that,
basically, yes, you're right.
But for perceived equity,
this is the case.
But you're right.
There's a trade-off.
Just like they recognize the
trade between the price and
the lines, there's a trade-off
between the higher wage and
the employment.
And that comes so what we'll
talk about, empirical
economics, which is measuring
that trade-off.
Well, how big is
that trade-off?
How much unemployment does a
higher minimum wage cause?
In fact, we'll learn in about
nine lectures that it actually
doesn't cause that much
unemployment.
It actually doesn't.
So maybe the trade-off
isn't that bad.
But in principle, there's
a trade-off.
Now, that comes to your point
about shutting people's water
off and things like that, and
the government making sure
that the suppliers make
sure people's water
doesn't get shut off.
Once again, one way to do that
is just say to the water
company, you can't shut people's
water off, even if
they don't pay their bills.
Well, that's going to mean the
water company's going to lose
money on those people.
That'll raise the cost of
supplying water, and that will
lead to the same kind of
problems we've talked about.
AUDIENCE: But if a
price cap and a--
PROFESSOR: But if the government
then says, OK, a
price cap, and then we're
going to pay you for the
people who don't pay, that's
kind of like the idea before.
You can have these
countervailing interventions.
But then it starts
to get messy.
You've got to raise the money
to pay them, et cetera.
So that's why equity
is so hard.
If it's efficiency, it's easy.
You just don't do anything.
With equity, it gets a lot
harder, because government has
to intervene to address equity,
and then that causes
other problems. It causes
these equity efficiency
trade-offs.
And that's a lot of the
problems it raises.
So now let's talk about one
last example to stop.
I don't have a diagram for this
one, but let's talk about
the great example-- it's a
real world example that
happens a lot-- which
is water shortages.
How many people here
from California?
You guys know water shortages.
You guys know about
how this works.
You guys know the drill.
Which is that there'll be a
drought, and the government
will say, you can only use
x gallons per day.
You can't water your lawn or--
actually, let me ask
the Californians.
So does the government monitor
your meter or just tell you?
Is it enforced?
AUDIENCE: Tells us.
PROFESSOR: Just tells you.
So the government says,
you can't do this,
you can't do that.
Maybe they enforce it.
Maybe they don't.
Whatever.
But the government comes in and
says, look, there's not
enough water.
So as a result, we are going
to limit your use of water.
Yeah.
AUDIENCE: They also have
tiered pricing.
PROFESSOR: OK, hold on.
Time out.
That's because the government
got smart.
So let's go back 10 years ago.
So what they'll do is they'll
come in, and they'll say, you
can't use as much water.
Now, this has two problems,
just like we talked about.
First of all, there are
households which would happily
pay more to make sure
they got to use the
same amount of water.
And those trades are
not being made.
The first inefficiency.
Moreover, it's got the problem
that you're not allocating the
water appropriately.
Some guys are just dirty and
don't like to shower.
Some guys are clean and care
a lot about showering.
I want to allocate the water
to the clean guys.
But the government typically
doesn't do that.
It just says, don't use
more than x gallons.
So there's an allocation
inefficiency as well, where
the people that value the water
the most aren't getting
it the most. Now, tell me
about tiered pricing.
AUDIENCE: So it's like if you
use 0 to 80 gallons per year
or per month or whatever,
you pay a certain price.
And then if you use
81 to 120, you pay
extra on those gallons.
And then you pay even
more down--
PROFESSOR: Exactly.
So what the government
can do--
the right answer is that the
government can use the price
mechanism to deal with
the shortage.
And the way it can do that is by
saying, we're going to let
the price increase.
We're going to let the price
increase, and we are going to
allow the price to
be a function.
You see us pricing, but you make
that a function of the
underlying conditions
and water supply.
So basically, you have a tiered
pricing, and if there's
a drought, the prices
all go up.
So the government sets the price
for water, and it says,
look, the price this
year will be higher
if there's a drought.
And what that will do is that
will make sure whoever wants
the water gets the water and
makes sure we allocate it to
the people who need
it the most.
Can anyone think of another
way you can do this?
Never really worked in reality,
but it's kind of a
fun way to think about it.
Well, imagine that what I did
is I said, every Californian
gets a certain amount
of water permits.
Every Californian gets--
I don't know how many gallons
of water people use.
I don't know.
You get 1,000 gallon a
year water permit.
How many gallons of water
people use in a year?
I've got no idea.
1,000?
Let's say 1,000.
1,000 gallon a year
water permit.
We're going to give you
1,000 pieces of paper.
Each one permits you to
use a gallon of water.
Now, what we're going to let you
do is trade those pieces
of paper with your neighbors.
So what we're going to do is
we're going to say, in normal
times, basically, there's
enough water,
everyone gets 1,000.
Then we're going to say, when
times are tight that
basically, you can only
use 900 gallons.
So what that's going to mean is
that you're going to have
to have permits that allow
you to use those gallons.
And you're going to
have to buy those
permits off your neighbors.
So basically, we can allow
neighbors to trade.
And the neighbor that
says, I don't care
about water so much--
so what's going to happen now
is the government's going to
say, this year, we only issue
900 gallon permits to each of
you, instead of 1,000.
Now, you're a clean person.
You say, wait a second, I wanted
to use 1,000 gallons.
So you go to your neighbor and
say, look, you're dirty.
You don't need more
than 800 gallons.
Sell me your extra hundred.
The government gave you 900.
I want my 1,000.
The government gave me 900.
Sell me your extra 100.
The neighbors says, sure.
And they set a price, and they
sell to you, and it works out
to be exactly the same outcome
as if the government had used
the proper pricing, because
that secondary market--
somebody asked about
black markets--
this secondary market can
evade the government
regulation.
So once again, the market
equilibrium is very robust.
And if you can figure out a way
to evade the government
regulation, you will.
If there's some way with
permits, if there's some way
to trade-- now, in reality, you
can't really trade water.
But if you could, then you could
use a market mechanism
to overcome this problem.
Yeah.
AUDIENCE: Is that what-- one of
the suggestions was for the
global warming type thing,
the carbon credits--
PROFESSOR: Exactly.
So global warming--
actually, I flew with Al Gore
over to Kyoto in 1997 and
negotiated the global
warming treaty.
So something near and
dear to my heart.
And with global warming, that's
exactly the solution
that's part of the Kyoto
protocol, the framework that
was set up at that meeting,
which is that basically, there
will be a certain limit on how
much carbon dioxide can be
emitted into the air.
But there'll be permits, and
countries can actually trade
across each other.
And the idea is, look, in the
US, it's incredibly expensive
to reduce the emissions we have.
Because what you have to
do is you have to take a
coal-fired plant and retrofit
it to use natural gas instead.
Well, in China, they haven't
built the plant yet.
They're building the plant.
And it's not that much more
expensive to build it to be
natural gas instead of coal.
So in China, it's pretty cheap
to reduce emissions.
You just say, OK, I was
going to build a coal.
I'll build a natural
gas instead.
It's pretty much the
same cost. I've
just reduced emissions.
So the idea is that we would
trade with China, we would
pollute more, China would
pollute less, but the global
total would be the same.
Now, as you hear that, you might
think that's kind of
controversial.
But in fact, it makes
total sense.
Just like it might be
controversial that dirty
neighbors are selling water
to clean neighbors.
You can imagine the newspaper
articles, the outrage.
People forced to be dirty
to make ends meet.
But that's not right.
What's right is you want to
allocate to people for whom
it's most efficient.
It is more efficient for China
to reduce emissions because
it's cheaper than for the
US to reduce emissions.
So the efficient system, we say,
here's the total amount
of emissions we're going to
reduce, and we're going to let
China do extra reduction, or
pollute less, and the US gets
to continue our slovenly
ways, and that's
the efficient outcome.
One last thing on this note.
Many of you may know who
Larry Summers is.
Larry Summers was actually my
thesis adviser who then went
on to be Secretary of the
Treasury, had a somewhat
failed stint as president of
Harvard and is now Obama's top
economic advisor.
Well, Larry Summers has gotten
himself in trouble two times.
You all know about the time
he said women are stupid.
But the other time he got
himself in trouble was in
1990, he actually signed
his name to a memo.
He didn't actually write it.
Signed his name to a memo saying
that the efficient
thing to do is we should
ship all our
garbage to poor countries.
And he said that's efficient
because poor countries, what
do they have?
They have lots of space
and not much money.
What do we have?
Lots of money and
not much space.
So the efficient thing to do is
we should take our garbage
and put on barges and
send it to Africa.
He was right.
That is the efficient
thing to do.
Africans would be better off,
because they have lots of
space they're not using,
and they'd be richer.
The US would be better off,
because we would be able to
get rid of our garbage, and
we're happy to pay to do it.
That's the trade to make
it better off.
And yet, it got him fired,
writing that memo.
That's why economics is the
dismal science, because we
point out things like this.
All right, let me stop there,
and we'll come back on
Wednesday and start talking
in more detail
about consumer demand.
