Comment Cards fall 2009
September Comment Cards
Q: If the minimum wage rises and the price is not greatly affected, consumers should be able to purchase more. Why is this not always the case?
A: Conservative economists make an argument that higher minimum wages will be passed along to consumers in the form of higher prices. If that's correct and say on average wages have increased by five percent and general prices have also increased by five percent, then the average worker/consumer is no better off. They will not be able to purchase any more commodities than when their wages were five percent lower. History has shown, however, that generally a rise in wages is followed by an increase in production and sales. This means that producers increase output as well as prices when Americans' incomes rise. On the whole, an increase in the minimum wage translates into increasing demand for output, increasing production of output and more jobs. To conservatives, raising the minimum wage will cost low-skilled workers their jobs because employers can no longer afford to pay these workers a higher rate and still yield a profit from their output. So, this is still an on-going debate in economics. Each side thinks it's a settled issue.
Q: How does supply affect the elasticity of demand?
A: It doesn't. The elasticity of demand is a measure of how consumers respond to price changes. If the elasticity of demand has a value greater than one then demand is said to be elastic -- a one percent change in price will cause a one percent change in quantity demanded in the opposite direction (rise in price --> fall in demand and vice versa). The determinants of elasticity of demand are factors such as whether the good is a luxury or a necessity, whether it is a large or small percentage of a consumer's budget, whether it has a few or many close substitutes and the length of the time period changes in consumer behavior are measured after a price change..
Q: How would an increase in wages, quantity demanded and quantity supplied affect the supply and demand curve in a time of recession or depression?
A: Changes in quantity demanded and quantity supplied are caused by changes in the price of a commodity and are represented by movements along a curve while changes in demand or supply are caused by one of the ceteris paribus conditions (e.g., changes in income and taste affect demand while changes in technology and factor prices affect supply) and are represented by shifts in the whole curve. Since this is microeconomics it would be difficult to make a statement about any one market (where fluctuations in demand and supply are relevant) to incidents of recession and depression, both of which are phenomena that occur at the level of the whole economy. At the level of the macro economy we can say that a fall in wages will cause a decline in demand for output and layoffs, all things that are consistent with a recession. If a single commodity market is typical of the whole economy then it will likely suffer a decrease in demand (leftward shift of demand) and subsequently a decrease in supply (leftward shift in supply). We're unlikely to see an increase in wages during a time of recession -- employers are more than likely cutting wages and laying off workers.
Q: How can we use supply and demand in the real world since there are so many variables that affect them and they could all be changing at once?
A: You are correct. It isn't a precise science but some sense of the direction of a market can be arrived at by observing changes over time. It's the business of industry economists to attempt forecasts of consumer behavior based upon the variables we look at and even more sophisticated measures of the mood of the buying public. Look at the table in chapter 5 of the text that estimates price elasticities for various commodities and services. These close estimates are useful for producers when setting price.
Q: I'm still confused on the question about if employers would rather hire new workers when there is a greater demand or if they would just raise the wages of existing workers.
A: If producers have significant amounts of inventory then an initial rise in demand (say the beginnings of a recovery) may likely only result in a draw down of inventories to satisfy the up-tick in demand for product. If the recession has gone on for some time and they have cut production, laid off workers and drawn down inventories then they may have to either hire more workers to produce additional output or pay existing workers over-time wages to raise output. It partly depends on whether producers feel the increase in demand is permanent or temporary. If they believe it's temporary they'll probably just pay existing workers more money to work more hours.
Q: Do changes in demand affect changes in supply directly?
A: Since the model holds every variable constant with the exception of price then the answer is no. Price can cause a shift along the supply and demand curves (changes in Qs and Qd). As above, only changes in the ceteris paribus conditons will cause shifts in the curves themselves (causing changes in demand or changes in supply). In the model, those things that would cause a change in demand would not cause a change in supply and vice versa. But if wages rose, for example, then demand would increase (rightward shift in the demand curve) and price would rise as the equilibrium intersection would slide up along the unchanged supply curve. Quantity-supplied has increased in response to the rise in price but the supply curve has remained unchanged because none of the conditions that would affect a shift in supply have changed.
Q: As far as inelasticity, a large change in price leads to a relatively small change in Qd but if there was a very large price cut for an item, logically, shouldn't the demand for that item then increase as it is now significantly cheaper?
A: Price elasticity refers to relative percentage changes not absolute changes in price and Qd. Assuming a linear demand curve we would then expect a proportionate reaction by consumers to a given percentage change in price. However, you have opened up another question. The price elasticity of demand can change from relatively elastic at high prices (and correspondingly low levels of quantity demanded) to relatively inelastic at low prices (and correspondingly high levels of quantity demanded). This is just a quirk of mathematics but it's very real to the seller because she will experience it in quite different results in terms of changes in total revenue -- a subject to come.
Q: I'm curious as to how microeconomics applies to law.
A: Economists have testified in civil law and criminal law suits about many issues regarding a business' conduct. An on-going case involves the lawsuit filed against Microsoft for anti-trust violations in preventing or inhibiting competitors from competing with MS software when used on the Windows operating system. Since Windows is on virtually every PC when you buy it, Microsoft has an advantage in tailoring its software to operate more efficiently with its OS. The European Union in particular has been partially successful in forcing Microsoft to give up its programming code or face significant fines.
Q: There were many questions about normal and inferior goods and the attendant concepts of the income and substitution effects. Here is another explanation.
A: Normal goods are those for which the income elasticity of demand is positive. So, as income rises (falls) we tend to buy more (less) normal goods. Inferior goods are those for which the income elasticity is negative. So, as our income rises (falls) we tend to buy less (more) of inferior goods. A student mentioned the example of Ramen noodles (great example!). When he is at college he has less disposable income and often purchases this inexpensive food (we all remember our Ramen days), but when he is at home he would rarely buy Ramen noodles. That is the income effect.
The substitution effect is simply the response of a consumer to an increase or decrease in the price of a good. We buy less of goods whose price has increased and more of substitute goods whose price has stayed constant or dropped. This is reflected, for example, by a slide down the demand curve of a good whose price has decreased (quantity-demanded has increased). In response, the demand curve for a substitute good would shift to the left (the price of the first good, a substitute, has fallen).
Now, the last bit in this narrative is the peculiar case of the income effect of a price change for an inferior good. Since an increase in the price of a good you normally buy results in a fall in your real income (the purchasing power of your money income) then you are forced to buy fewer goods. But what if the price of an inferior good has increased? Here, the income and substitution effects of a price change fight against each other. Your real income has gone down and so the tendency is to buy more inferior goods and fewer normal goods. So, let's say the price of Ramen Noodles rises by 100 percent while you are at college. Your real income has fallen. Would you buy more Ramen noodles? The income effect says you would but the substitution effect (price has increased) indicates you wouldn't. Since the substitution effect is always stronger than the income effect, then even in the case of inferior goods you would buy less of them when they experience a rise in price. The only exception to this is said to have been potatoes during the Irish famine of the 19th century. Irish families were miserably destitute when the blight struck the potato fields. The price of potatoes increased and (so it is said) Irish families cut down on everything else and bought more potatoes -- still the cheapest food source available. That is the one documented (somewhat -- there are those who dispute it) case of the law of demand being violated.
Q: What is the purpose of the "mid-point" in the Mid-point Formula?
A: This is a bit complicated. A percentage change in the quantity of something is straightforwardly [(chg in Q)/(Q1)] / [(chg in P)/(P1)] where Q1 is the initial quantity and P1 is the initial price. However, if the move is between two quantities in one direction (say up) the coefficient will be different than when it moves in the opposite direction between the same two quantities (down). The way to solve this dilemma is to use a number exactly halfway between the two quantities and two prices so the coefficient is the same regardless of whether you are moving from the lower to the higher or vice versa. Here is a simple example:
Price Quantity
$1 10
2 8
So, if price rises between $1 to $2 the Ed formula would be (2 /10)/(1/1) = .20. But if price falls from $2 to $1 then the Ed is (2/8)/(1/2) = .50. Since you want the elasticity coefficient to be the same value when you're moving between the same two prices you can use the Mid-points Formula and you'll get (2/9)/(1/1.5) = .33 regardless of which direction you move.
Q: I'm not completely clear on how an inelastic demanded good could lower price, increase Qd and still result in a fall in Total Revenue. Even if price falls, the rise in quantity-demanded should result in a rise in total revenue.
A: If the percentage fall in price is greater than the percentage rise in quantity-demanded then total revenue will fall. This is a product with an inelastic demand. It means that consumers don't respond much to changes in price. An example would be the table in the previous question. Notice the elasticity coefficient is less than one (.33). Notice as well that when price falls from $2.00 to $1.00 total revenue falls from $2 x 8 = $16 to $1 x 10 = $10. Consumers simply have not bitten very hard on the lower price. The seller was selling 8 units for $2 a piece. She reduced price and consumers bought more but the increase wasn't enough to offset the lower price.
Q: I don't understand the substitution effect.
A: It is simply reflected in a movement along a demand curve for a given commodity as price changes. If price rises, consumers will substitute other goods and reduce the amount they buy of the good whose price has increased. If price falls, consumers will substitute this good for others whose price has remained unchanged. So the substitution effect is simply the movement of consumers to relatively cheaper substitutes as price changes.
Q: Why do all these theories assume that consumers WANT to spend all of their money? What about saving it like a sane person?
A: Assuming a given budget does not rule out savings. A certain amount of income is devoted to purchases and for the sake of understanding income effects of a price change the model assumes consumers stick to those budgets. It is equally possible that consumers will increase savings when prices fall and reduce savings when prices rise so they can maintain the same standard of living. In fact, that is what often happens. Oddly enough the collective response to changes in economic fortunes often reinforces the direction in which the economy is moving. If a member of your family loses his job the family will cut back on purchases --- a sane reaction. So, if a serious recession hits and everyone cuts back on purchases then it makes the downward spiral even worse. This is why George W. Bush went on television after 9-11 and told everyone to go to the mall and get on airplanes. They were afraid the economy was going to crash. Benjamin Franklin said, "a penny saved is a penny earned". True for the individual but not always true for the whole economy.
Another student asked a similar question. He wondered if saving money was anti-capitalist (or thought that I had implied it was). He further wrote that a lot of economists on television advocate saving money. There is a paradox here. Saving money is a wise thing for the individual or family, especially if it is put into an income-earning asset that is reasonably safe. But there is what Keynes referred to as "the paradox of thrift". In a rapidly expanding economy, a positive level of national savings provides much needed finance capital for growing businesses but if a deep recession hits and everyone cuts back on spending we can experience a positive feedback loop -- falling aggregate demand, more lay-offs and another fall in production and income followed by another decrease in aggregate demand and so forth. Savings is no longer a virtue.
Q: How does government factor into the circular flow?
A: An excellent question! The circular flow is an extremely over-simplified diagram of an economy. The government represents another important sector that is left out so the focus can be put on how markets work. But clearly the government affects the circulation of money and goods. The government taxes us and thereby reduces our disposable income (the amount we can spend for goods) and the government buys things (airplanes, tanks, labor power etc.) and transfers income (social security benefits, medicare etc.) and thereby affects the distribution of income and the kinds of goods that are produced. The other sector that is not in the simplied circular flow is the trade sector -- exports and imports. All these sectors are added as you move through microeconomics to macroeconomics.
Q: Is there a more realistic model than the neoclassical? And, why do we study something so vague?
A: Ouch! I could answer this but it would take another course. Enroll in my Contemporary Political Economy course in the spring and we'll talk. Regarding your second question, a market economy is a large, complicated and unwieldy thing. In order to make some sense out of it, economists have built a rather elaborate model but, on the other hand, it is a model that freezes a lot of the moving parts so something useful can be said about it. The demand and supply model may seem complicated but imagine wrestling with thousands of variables to make sense of the prices, costs, and output levels of the automobile industry. Economists spend their entire careers studying just a few commodities or just one industry and building sophisticated regression equations to attempt a forecast of what consumers will do next month. It's far from an exact science but it is necessary if even a moderate level of stability is to be established.
Q: Would it make sense for a company to hire 10 new employees without increasing the amount of hours available to divide up between many workers? Does the company make more money by paying more workers less money and long-time employees, that have a higher salary, get hours cut?
A: It seems you have several questions here which cross back and forth between favoring workers and favoring management. The first sentence reminds me of a practice that labor unions promote during an economic downturn. If existing workers each accepted fewer hours then the employer could cut production without laying off anyone or, as you seem to state, hire even more workers while keeping the total labor hours constant (implying again that each worker would be working fewer hours but at least everyone would have a job). The second sentence describes a situation that clearly favors management -- cut the hours of workers with higher pay and hire cheaper substitute labor. Regardless of which question you are asking, it should be clear that the contemporary workplace is often a contested space between economic actors with distinctly different class interests. There are alternative workplaces that operate on a cooperative basis -- profit-sharing arrangements and shared decision-making characterizing these less hostile work environments.
Q: I had some trouble understanding if the employer would hire a worker at a certain output rate.
A: The concept can be expressed in a straightforward way. If the next worker (or hour of labor) produces more (or an equal amount of) product value then the employer will hire her. Technically that means the employer continues hiring workers until the wage rate is equal to the value of the last worker's marginal product. For example:
#Workers* Output Marginal Product
1 100 100
2 175 75
3 225 50
4 250 25
* Each working an eight-hour day.
If we assume each unit of output sells for a $2.00 and each worker is paid $100 for an 8-hour day ($12.50 an hour), then the employer would hire no more than three workers. The third worker contributes just 50 x $2 = $100 to total revenue and the employer pays her $100. The fourth worker contributes only 25 x $2 = $50 to total revenue and so the employer would lose $50 if she were hired. It's not because the fourth worker is less skilled or lazy that she contributes only $50 of work. It's because she has fewer tools, equipment and space -- in fact the amount of work contributed by every other worker goes down as well once she is hired for the same reasons.
Q: I still don't understand why an employer would hire a worker when his marginal product value is equal to his wages.
A: It is because the producer sets the price of the product at a level that includes a normal profit. Even if that were not true the employer makes money on every previous worker and loses nothing on the last worker hired. Look at the example above. The employer pays the first worker $100 and she contributes 100 x $2 = $200 of total revenue. The second worker is paid $100 and contributes 75 x $2 = $150 to total revenue. Only with the third worker does the employer just break even. Finally, the last argument for using this strategy is that market share is an important consideration. Hiring the third worker gives the producer a bigger market share which translates into a more powerful position against her rivals.
Q: Consumer sovereignty cannot be true! Think about all those infomercials you see on TV. Do you think anyone wanted a ped-egg or shoes-under? The producers of these goods are out for profit and they prey on consumers.
A: Boy, I've never heard of those products. In any event, I accept your point. The claim, and I kind of agree with it, is that a product cannot be produced and sold that has no use-value whatsoever. It is possible, however, for a product to have almost no use-value and still command a positive exchange-value in the market. Remember we don't know what it is that consumers are getting from a product. It might be just a warm, fuzzy feeling or a whiff of their youthful selves or because their neighbor has one. The C.E.O. of Avon once famously said, "We don't sell cosmetics, we sell hope".
Q: If a business goes bankrupt, but you bought goods on credit, do you still have to pay them after they shut down?
A: Once a business goes into receivership the business' creditors are going to want to collect every dime owed to that business so they can recover some of their losses. The bankruptcy court may arrange for a collection agency to continue the effort to collect debt owed to the firm or attach the property sold to consumers of the firm's products.
Q: Could you go over the budget line and indifference curve concepts?
A: Assume the following simple example. You ordinarily spend about $40 a month on coffee and cranberry juice (There is no accounting for your taste).
budget = $40, price of coffee = $5.00 and price of cranberry juice = $8.00 (the premium brand)
Budget Qty Coffee Qty Juice
$40 8 0
40 0 5
You have found the vertical intercept of the budget line (the most you can buy of coffee -- I put coffee on the vertical axis without asking you. It's a perfectly arbitrary choice.). In other words, you have spent all your budget on coffee this month because you plan on studying really hard for the exam in microeconomics. On the second line, you have calculated the horizontal intercept (the most you can buy of cranberry juice if you spent all $40 on it). Here you have chosen to be healthy rather than well-educated -- it is a life choice. In any event, you now can draw the linear budget line by simply connecting the vertical with the horizontal intercept of the function. Now, where you maximize your satisfaction per dollar spent, i.e., what combination of coffee and orange juice is the satisfaction-maximizing level given your budget, is dependent upon the indifference curve which is convex to the origin (diminishing marginal utility). At the point where the budget line just touches the highest indifference curve is where the ratio of prices (Pj/Pc) is equal to the ratio of marginal utilities (MUj/MUc). So an equilibrium point (maximum satisfaction given one's budget) in this case would be where the extra satisfaction from your last unit of juice purchased is just 1.6 times the amount of satisfaction you derived from the last unit of coffee you purchased. That makes sense since juice is exactly 1.6 times as expensive as coffee --- it had better give you 1.6 times the satisfaction.