Saturday, May 26, 2007

Personal Plug

On June 19, 2007, at 7 pm at the Muscatine Public Library, I will be presenting my paper on Differentiated Product Markets and CD pricing. The main conference room on the second floor will host my dry run of a contestable market and how musicians set their price. I welcome all readers of my blog to attend. A copy of my paper will be available for those who attend.

On July 13, 2007, at 10:45 am at the Hotel Venetian in Las Vegas, I will be formally presenting my paper. Hey, if you're in the area, stop in.

I have an electronic version that I will send on request.

US News and World Report and Ethanol

I helped myself to Kurt Acord's US News while waiting in the teacher's lounge for the class bell to empty the cafeteria. I thumbed through his magaize and found the cartoon accompanying this blog. As the price of a good increases, the demand for its substitute increases as shown in the cartoon. Also, as postage increases, alternatives become more attractive and profitable so rivals will enter the market. Our text messagers to the right, are acting economically too. The marginal cost of sending a TXT is zero, so they will consume up to the point where price equals zero. Kids will continue to textmessage until the benefit equals the cost. Do you think technology is breaking down some the monopoly barriers to entry that the US Postal service has enjoyed? Thanks Kurt for suppling this every day example of 101 economics. The cartoon is a work of Marshall Ramsey/Copley News Service/The Clarion Ledger and appeared in the May 28, 2007, page 20, U.S. News & World Report.

Friday, May 25, 2007

Gas Arguement is Running Out of Gas

MSN ran a link to an article explaining the high cost of gas. The picture on the right is a Paul Sakuma/AP Photo. The article can be found at Will you humor me as I try to explain elasticity with little or no math?

A rubber band can be stretched and is my metaphor for elasticity. If prices are stretched upward, total revenue goes down. If a gas company raises prices then total revenue will go down. Gas companies are raising their prices and total revenue is going up. Therefore, gas companies are not charging the price that maximizes profits. This arguement simply means that gas companies are not a monopoly. I can futher argue that a firm's demand is inelastic when you can raise prices and total revenue increases, which seems to be the case for gas. Any econ 101 student will tell you that a monopoly does not operate on the inelastic portion of the demand curve. Gas companies are not a monopoly because the elasticity of demand seems to conclude that rising prices are increasing profits. How can that happen?

The MSN article infers that rising prices are increasing profits for companies. This would be true if gas companies were operating in a very competitive market where they are price takers instead of price makers. Simply put, the demand for gas increases and therefore the price. Companies enjoy more profit because they can now charge more for the same product so they cover their costs by a larger amount. For example, suppose the good you sell is so widely abundant that the price of the good is $1.00. Let's say that the good costs $.75 to produce. The firm makes a profit of $.25. If the good becomes more popular, the price of the good might increase to $2.00. If costs do not change, then the company now makes a profit of $2.00 - $.75, or $1.25. Profits increased because people wanted more. If the company could have sold the product for $2 instead of $1, don't you think they would have raised the price a long time ago?
Gas companies, like our mythical company are price takers. They are reacting to supply and demand fundamentals. As long as more gas is demanded, the price will go up.

Friday, May 18, 2007

Game Theory Joke

A Scorpion begged a Frog to carry him across the river because he could not swim. The Frog hesitated for fearing being stung by the Scorpion. The Scorpion said: "Don't worry, you know I won't sting you since we will both drown if I do that". So the Frog carried Scorpion across the river. But in the middle of the river, it happened--the Frog got a sting. Before he died, the Frog asked Scorpion in disbelief: "I don't understand why you did this!?" "Because I am not a game theorist and you are", replied the Scorpion.
Contributed by Ding Lu

I think our scorpion is a game theorist. It was his dominate strategy to sting all along. He is a noncooperating game player.

Wednesday, May 16, 2007

Contestable Market and Wal-Mart

William Baumol advanced a theory that even a monopolized market can be penetrated by smaller firms with the same cost curves. Dr. Baumol christened his theory the contestable market--a market in which firms can enter at will, grab profits, and exit. The theory is kind of like bringing doughnuts into the faculty lounge. Teachers will help themselves, the doughnuts will be eaten quickly, and disappear. If the doughnuts were profits, firms would enter costlessly and gobble up the profits, and move on. Did you ever hear the joke about two economists walking down the street and they see a $10 bill? Both won't bend down to pick it up because someone will beat them to it. This is how efficient markets work. A contestable market has all of the characteristics of a perfectly competitive market, but is characterized by few firms in the market. Kind of like a security guard watching over a store with many buyers only the security guard watches the prices.

If I see a band like Straiht Wikid Crew making money from producing a CD, I will say, "I too can make a CD and sell it." Then my band, Velociraptors, will produce a CD and steal profits from SWC and all garage bands. Maybe I only make 30 copies of my CD, These Dinosaurs Can Hunt, which makes up an infinitely small amount of market share, but I easily enter the market when I see profits. I don't incur any fixed costs either since I already had the guitars, drums, and recording equipment at home. I also rent out my sound equipment for punk shows to high school bands.

A contestable market might have one producer of a product such as cheese sandwiches but other producers are keeping an eye on her like a security guard. Since just about anyone can make a cheese sandwich, all producers have the same cost curves. If the monopolistic producer charges the monopoly price, MR=MC, then all the other producers start making cheese sandwichs and the profits are competed away.
In the graph, the monopoly price is $7 and the monopoly output is 4. The monopolist makes about $3 per unit. At this price, more suppliers enter the market and the market supply increases to 7 units with a price of $4. Some supplies will not make a profit and exit the market and the market will return to long-run equilibrium where P = MC = ATC = MR and produce an output of 5.
How many items does Wal-Mart supply that could be considered a contestable market? Why doesn't the price of say their deli chicken command a monopoly price? If Wal-Mart rolls up the price of chicken, KFC, McDonalds, HY-VEE, and countless others will grab their customers away with a lower, perfect competition price. This is why I don't bemoan the loss of the mom and pop stores. Wal-Mart just can come in and charge a price below the cost to make a product and then increase it later. A price increase will be followed by a return of the mom and pop stores and all Wal-Mart accomplished was to lose money. That doesn't sound like a profit-maximzing business.

Monday, May 14, 2007

Gas Prices

Economics 101 predicts that when the price of gas goes up, the demand for a substitute increases. I often see cartoons with consumers substituting motorcycles for SUVs, carpooling, or being shot out of a cannon. In other words when the price of gas increases, suave consumers will substitute.

My son, Jason, thinks that the substitution is really another form of paying a higher price. He's got a point. The market will ration and distribute the goods. Prices are good.

In his price theory textbook, Steven Landsburg makes a salient point. If profits increase when the price increases, then the oil companies must be on the inelastic portion of the curve. What monopoly operates on the inelastic portion of the curve? His conclusion is that oil companies are more of a price taker than a price maker. Mr. Landsburg argues that if oil companies had control over their prices, why did they wait until now to raise them?

Many of my friends are taking vacations this summer and are planning to fly instead of drive. "With the price of gas so high, it's cheaper to fly," said Kathy Haltmeyer. This simple statement describes a market force of supply and demand. The price will not keep raising because alternate forms of transportation become more attractive. The price of gas isn't price gouging by big oil but merely the reflection of supply and demand fundamentals.

Sunday, May 13, 2007

CD Prices and Third Degree Discrimination

My sixth hour economics class complied a CD to see if monopolistic competition models could predict price and output. The project was used to see if the model could predict sales in a differentiated market. This blog will discuss what I believe to be an irrational pricing error. This discussion assumes knowledge of price theory in markets that have pricing power and can be easily skipped by the casual reader.

Say there's a McDonalds in the north end of Muscatine and a McDonalds in the south end, but the prices are higher in the north end. In theory, a profit maximizing entreprenuer could buy from the south end at a lower price and sell in the north end at a higher. The entreprenuer could take advantage of the price differences and make a profit from arbitrage. When the same good is sold in two different markets at different prices, the econ 101 term that is used is third-degree price discrimination. I believe our class errored in determining the price in both markets because the marginal revenue we captured was unequal and we would have realized more profit by concentrating in the market where marginal revenue was the greatest.

I think it's probably true that adults can pay more for a CD than a junior high student. To take advantage of the differences between the two groups, we charged adults $6 and students $3. At the Adult price, MR = $1.80. At the Student price, MR = $1.10. This suggests an opportunity for arbitrage in the amount of the yellow rectangle. The marginal cost curve is not shown, but we made a quantity decision of 200 units to breakeven. Even if no reselling of the product occurs, my class still should have constructed a price in which the marginal revenue was the same in both markets.
My class still has copies of Scarlet Fusion for anyone interested. We are now selling the CDs at a price we believe is closer to the competitive price of $2.

Saturday, May 12, 2007

Fixed Costs In a Perfect World

A friend of mine was complaining that her landlord was raising the rent on her business. "How can I stay in business," she said, "When I have to keep charging my customers more?" I explained that a in her business, she was a price taker and didn't have pricing power. In the accompanying graph, I will demonstrate that an increase in fixed costs affect the amount of profit she makes, but not the price or quantity of output.

Before the rent increase, the maroon ATC respresents the average cost of production. The business maximizes profits where MR = MC and makes 7 units. When the rent increases, the fixed costs increase and the yellow ATC curve now represents the average costs of the business. The firm should still produce at 7 units as the profit max point has not changed. The firm is only making a normal profit now, but shouldn't raise its prices. I believe if more business owners understood this concept, they could stay in business and not drive customers away to Wal-Mart when they raise their prices above the competitive ideal.

Urge to Merge

Is one monopoly better than two? How can a business own all of the resources needed to make a product and not be a regulated monopoly? That's the question I left the HNI Shareholders meeting thinking about. In this econ 101 blog, I will discuss how vertical integration can lower the price of a monopolized product to its competitive ideal. If you're a casual reader, please feel free to skip this blog as it's one of my more difficult ones to write. In this blog, I rely heavily on Steven Landsburg's Price Theory, 5th edition.

In economics, resources are anything that is used to make a good. A good being anything that brings utility. HNI makes office funiture and fireplaces. Is it bad for society if HNI owns all of the resources such as the wood, metal, and patents needed to make these goods? My econ 101 answer is no, if the acquistion of these materials leads to a lower production cost. In this blog, I will prove that production costs decrease, the quanity of furniture produced increases, and the price actually decreases as HNI acquires more of the factors of production needed to make office furniture.

The logic is intuitive. Suppose that HNI pays a monopoly price for its wood. HNI also charges a monopoly price for the furniture it produces. If HNI acquires the wood monopoly, then HNI is no longer charged a monopoly price for wood. Therefore, HNI can lower its costs because its not paying the higher monopoly price for wood. In fact, HNI would have every incentive to pass this savings on to consumers in a socially optimal way.

In my graph, HNI pays Pm for its resources and makes Qm. After the acquisition of a resource, HNI can now use all it wants of the resource. The marginal cost of the resources is now a straight line given by MC. HNI will now produce the quantity of goods that equals the competitive ideal which is at the point, P = MC or Qm'. As can be seen by the graph, more is made at a cheaper price. In this case, one monopoly is better than two.

HNI reduced costs this year by about $38 million. The reductions were offset by exongenous increases in energy and sticky price contracts. If HNI was not able to acquire resources through acquistions, the costs would have negatively impacted the earnings of the corporation and the 48 millions shareholders. If HNI could not vertically integrate, you would pay for fireplaces and furniture. How are higher prices good for consumers?

Friday, May 11, 2007

David A. Anderson Replies to Present Value

David Anderson is the manager of the list serve for the college board that controls AP Economics. He is also the author of Economics by Example and Favorite Ways to Learn Economics. His comments about why students would buy cookies instead of a ticket to a concert are copied below and pertain to an earlier post. Mr. Anderson is an economics and law teacher at Centre College.

"People prefer $1 today over $1 next week because, by having it today, they can put that dollar in the bank and have more than a dollar, namely 1 + R (where R is the weekly interest rate), next week. Alternatively, if the money holder discounts the future at a rate greater than the interest rate, the money holder can go ahead and spend the money now.

Just as one dollar today yields 1*(1+R) = 1+R next week, 1/(1+R) today yields (1+R)*1/(1+R) = 1 next period. Thus, the present value of $1 to be received next period is 1/(1+R). If the students have the dollar today, as seems to be the assumption in paragraph 5, the present value is $1 rather than .9090. Only if they would not receive the dollar until next period would the PV be .9090 today.

If the spending options are as close together as a week, I would suggest that it is not the weekly interest rate (in reality, something like .03/53=.0006) or discounting of the future that drive the behavior. Instead, I would simply look at the two options at face value. The opportunity cost of going to the concert is not being able to buy two cookies and spend the concert time studying economics ....

In the last paragraph the "x" determines how many times .50 goes into 1. This is an indication of how many cookies they can buy if they don't go to the concert, so it is indeed the opportunity cost of going to the concert (aside from the value of the time spent going to the concert), but I wouldn't relate it to the discount rate concept. That is, the relative 2-to-1 price ratio of concerts and cookies does not imply that the students discount future benefits by 200%."

Wednesday, May 09, 2007

HON Shareholders Meeting

The first time Natalie talked to me was before class. She said, "My dad thought you might like to look at this." It was a pie chart of market share for the office funiture market. HON, ticker symbol HNI, was the second largest producer of office furniture in the US. HON is located in Muscatine, Iowa. "My dad is really good at econ," Natalie said.

Natalie's dad is the CEO of HON Industries, a fortune 400 company. On May 8, 2007, I heard Mr. Askren address the shareholders of record at the annual shareholders' meeting. I took notes to see how much 101 economics were discussed in his 45-minute presentation. Below are a few of the notes that I wrote down that command a share price of $50 with roughly 48,000,000 holders.

Forbes Magazine has recognized HNI as one of the best managed corporations in the US. Management is always looking for cost reducing innovations. One econ 101 concept that was applied was substituting a naturally grown agrimaterial for fiberglass. As the price of fiberglass increased, more of a substitute good was demanded. The use of fiberglass was not eliminated--just less demanded at every price than before.

The construction of housing and fireplaces are complementary goods. As the supply of houses decreased, raising the costs of building a home, the demand for hearth products decreased. Fireplaces make up about 50% of HNI revenues.

Mr. Askren mentioned a Split and Focus approach to specialization. In other words, the company let's workers work in the area that they will be the most effective. The econ 101 concept is comparative advantage. Workers specialize making more of a product then they could if their talents were diluted by performing many tasks. Specialization leads to more for less.

HNI is listed as the second largest office funiture producer in the US. Their goal is to be number one. The econ 101 concept is competition leads to a more efficient use of materials that matches the value society places on the materials. Competition leads to a more efficient use of land, labor, and capital closer to the alternate uses that the resources could be employed.
I want to thank Mr. Askren and Diana Stelzner for inviting my class to the annual shareholders meeting. In my next blog, I want to discuss how mergers and acquitions have help HNI reduce costs while gaining market share.

Tuesday, May 08, 2007

The Ace of Spades

On a episode of the Simpsons, Marge opens her own business as a handiman. Marge can fix anything. Marge advertises, but no one hires her. So Marge has Homer solicit work acting as the handiman, then Marge completes the work. In the cartoon, the customers have a clear preference on who they hire to work for them. The cartoon is a perfect example of customer discrimination. Marge's customers prefer men over women for handiman jobs.

My finance lives next to a man who performs landscaping. The man claims to have the lowest prices in town. He does beautiful work. The Ace of Spades happens to be a black American. If there is any evidence of discrimination, it's in the wage that Ace receives. According to the 1980 US Census, self-employed workers who have the same productive traits and are black, make 19% less than white. This clearly shows that customers are selective in who works in their yard.
In the north American states, the term Ace of Spades is meant to convey the blackest color. It's a pun in the title because the owner of the business uses a shovel for landscaping. I think he should change the name of his business so his customers won't play the race card against him.

The High Cost of Hate?

Suppose that two companies both sell the same good. If one company discriminates against minorities and women while the other does not, the company will not make as much in total revenue. In the graph, the shaded areas represent the total area under the marginal revenue product curve or total revenue. This is the same analysis used in the diamond-water paradox. It's easily seen that it is not in the best interet of a company to discriminate assuming the business competes in a perfectly competitive industry. There must be other characteristics such as schooling or geographical area that businesses consider when hiring or they would hire more women and minorities at the competitive wage rate and make more money.
I want to thank Garth Brazelton at for this next trick. Simply click on the graph to enlarge. Thanks, Garth.

Monday, May 07, 2007

You Won't Get Rich Diggin' a Ditch

I used to love to dig with my dad's army shovel. I enjoyed the physical labor of digging all day. When my dad arrived home from work, he'd say, "You won't get rich digging a ditch." I understood that I wouldn't find a treasure or strike oil. My dad meant that anyone could dig a ditch and I would never command a high wage. If my wages were high for whatever reason, then my employer would substitute a machine for me. He meant I would be dirt poor.

I have watched many minimum wage workers work two jobs in order to live. These workers aren't lazy but hard working. How come they don't earn a high wage? Like little Mikey digging a ditch, there's just so many people who can do the minimum wage work that they are paid a subsistence wage. Is this one reason why increasing the minimum wage leads to unemployment? As the minimum wage increases, employers substitute machines for labor. Displaced workers increase the supply of labor in illegal markets driving wages in those markets down. Because there's now a higher demand for skilled labor to operate the machines, the wages in the skilled market increases. Voila! You have wage inequity. Since black workers and teenagers are the first to be let go after a minimum wage hike, is it any wonder why some wage differential exists?

Sunday, May 06, 2007

Do I Have to Do Everything Around Here?

Have you ever heard your mom or your wife say that? It might be possible that women have a high preference for housework and are willing to supply more of their labor to have a clean house.

Suppose Sally was working as a part-time receptionist when she met Harry at work. Sally was finishing up her master's degree in education. Harry has a nice job in finance. They marry and then Harry gets a promotion but they have to move to Muscatine, Iowa. Do you think Sally is going to demand that Harry give up his job so she can pursue her teaching career? I think Sally will quit her job and look for a teaching job in her new town while making their new house a home.

Sally has always wanted to be a teacher. Now a position opens up at Muscatine Community College--the only college around without a two-hour commute. How much will she earn? To answer this question, we use the monopsony model which is used when there is only one buyer of a resource. Since there is only one community college, in this case MCC, the college will pay Sally a wage lower than the competitive ideal. In the graph, the competitive wage rate is $10 with employment of 50,000 workers. But because there's only one place to work in the town, 38,000 will work for $8.50.
Because workers might not be willing to travel or they prefer to stay at home to be close to their mate, women might earn less income, excluding the value of making a house a home. In the case of Sally and Harry, Sally will accept a lower paying job because she's willing to give up that extra income she could make by being a teacher at MCC, working at home, and letting Harry climb the corporate ladder. And yes, she has to do everything.

Are You Married? Planning on Having Kids?

Suppose that Felica is applying for a job at Muscatine High School as a teacher. Can the employer ask her marital status? Can the employer ask her if she's planning on having children? The quick and dirty answer is no. Let's look at some of the logic behind the law.

Women often leave the workforce to have children and usually take time off from work. Research shows that it is often the mother who is called when a child is sick and needs to be picked up from school. So it is very likely that the woman who has a child will miss work. I like to say that missing work is like summer vacation for my students. They forget things that they have learned. Some of their skills depreciate. But, for those men who remain on the job, their skills improve and they receive additional training. Does this explain the wage gap between men and women?

Now put yourself in an employer's position where there's a man and a woman applying for the same job with everything else equal (ceterius paribus). Who will the employer hire and at what wage?

Saturday, May 05, 2007

How Come He Gets Paid So Much?

My son tells me of a new business that sells links to advertisers who want Google to list their site in the top 10. This can earn a business $50,000 in a month. I know a nurse who literally saves lives and she only earns $1,600 a month. How come people who work with technology get paid more than people who save lives? To solve this paradox, we have to solve the diamond-water paradox that baffled Adam Smith nearly 200 years ago.

Adam Smith wondered why diamonds sell for more than water when water sustains life. The quick and dirty answer is that the question confuses total utility with marginal utility. In other words, diamonds have a high marginal utility, but a low total utility. The total value of diamonds is the yellow shaded area. Water, which is more plentiful, has a low marginal utility but a high total utility. The total value of water is the teal shaded area. Just think of all of the uses water has including bathing, washing clothes, filling up swimming pools, and being used in squirt guns. Water is so plentiful using another gallon is cheap so water gets used to scrub floors and fill up balloons. Diamonds are used as an expression of love.
Economists explain the slope of the demand curve as the marginal utility of a good and the area under the curve as the total utility. Utility diminishes as one travels down the curve because more and more consumption results in less and less utility. It's like eating Easter candy. The first jelly bean tastes the best, but the 100th one makes you sick. In the diamond graph, there's a high price and high marginal utility, but the yellow area explains there's little total utility. Because water is plentiful, the marginal utility is low, but the shaded green area explains that the total utility is great. The total utility is great because water has so many uses.

The diamond-water paradox is used to explain wage differentials. A baby sitter is plentiful but a computer programmer who knows html is scarce. At the margin, the programmer is more valuable than the babysitter, but the total value to society is greater for the babysitter. Can it be that the marginal cost of the babysitter compared to the programmer is a reflection of supply and that explains the wage differentials? Can wage differentials be explained by how plentiful some occupations are so market forces are determining wage differences and not discrimination?
In his book, The Hidden Order, David Friedman explains how the economics explains what is not obvious. The teenager working behind the cash register at McDonalds might think she's worth more than $6.15, but there's so many workers like her that employing her is cheap.

The High Cost of Cheaper Gas

Doug Calkins teaches driver's ed at Muscatine High School. The high cost of gas affects his ability to teach students how to drive on the interstate and around time. He spends 4 hours a day with students driving by Loos gas station and the local BP. Doug is accutely aware of changing gas prices. I think Doug is rational so I'm going to assume that he prefers more to less. For example, Doug prefers more free time to less. He prefers more income to less. So it follows that he prefers to drive more than less.

How would lower gas prices affect Doug? He'd drive more. If everyone behaved like Doug, then there would be more pollutants, more congestion on our streets, and more maintenance needed to keep our plant both green and efficient. In this normative discussion, maybe the higher prices are good and everyone should understand that the economy is working to distribute gas efficiently.

High Cost of His Girlfriend

He's the one of nicest young man I know. Robbie politely asked me if he could sell my CD, Scarlet Fusion, at lunch even though he's not in my Enriched Economics class. He volunteered his time for two weeks giving up his lunch to help me. On my way to the Howe Commons to see how sales were going, I saw him talking with his girlfriend. Really she was doing the talking. Really she was doing the shouting. I noticed that every time I found Robbie talking to his girlfriend she was shouting at him. In man talk, Robbie's girlfriend is high maintenance. In economics, she's high cost.

The law of demand states, that the higher the cost of a good, the less will be demanded. What's the cost of Robbie's girlfriend? The cost is the 20 textmessages she sends him, walking her to class so he can't look at other women, constant phone calls to him on his cell, and the need to "talk" to him on a regular basis. From an economic perspective, the quantity of time Robbie demands with her decreases as he substitutes selling CDs for me. In the language of economics, the price of good girlfriend increased, so Robbie demands more of substitute good selling CDs.

Robbie's girlfriend could make herself more attractive by making their time together less costly.

Friday, May 04, 2007

A Breakfast Toilet Paper Roll

At breakfast Dan Kitchen was discussing the monopoly the local grocery store had on toilet paper. His point was that a monopoly can't charge whatever price it wants because there'll either be too much of too little of the good. Dan believes that there's an optimal price that best sells the product. He mentioned a time when toilet paper became so scare that they couldn't keep it on the shelves so the manager raised the price. At the newer price, the store had plenty of toilet paper because people would use a phone book, wall paper, or napkins instead.

Notice that in the graphs above, a price of $30 creates a shortage of 400 rolls and a price of $70 leaves 400 rolls on the shelf. The graph seems to indicate that a price of $50 is optimal. Dan worked for a store that had a monopoly because of its location. How come the store didn't take advantage of the opportunity to exploit its monopoly power? The answer is simple market forces will prevent the wrong price being offered to its customers.

Big oil is no different. Companies like Exxon are at the mercy of the market. Too high of prices or too low prices will not optimize their revenues and retain their monopoly position in the market. Thanks Dan. I'll miss you next year.

Thursday, May 03, 2007

Big Oil Monopoly

My breakfast friends found a way to wake me up today. Doug Calkins mentioned that the big oil companies raised their prices in order to reap BIG profits at the expense of the little guys like us. Nothing could be farther from the truth. Not only do oil companies not have the ability to raise prices, but it's stupid for them to do so.

All companies maximize their profit by operating at the point where marginal revenue equals marginal cost. Anyone with a little knowledge of geometry will immediately see this. In the graph to the right, total revenue is equal to the price times the quantity. In this case $7 times 6 1/2 or $45.50 (gray plus yellow). The firm must pay out some in costs which is shown in yellow and equals $26 which is $4 times 6.5. Thus, profit is equal to $19.50 or the gray rectangle.

Suppose the firm want to gouge the little guy by charging $10 as seen below. How much profit does the firm make now? Total revenue will equal $10 or $10 times 1 and profit will equal $6. The reader will see that the area is smaller and it is not in the best interest of the firm to raise the price above the $7 mark. How much would the firm sell if the price was $20.00? With the information given by the graph above, the firm would sell nothing. Raising prices isn't the way to make the most money so there must be other reasons why the price has increased besides price gouging.

Wednesday, May 02, 2007

Bending Over Backwards

There's only 168 hours in a week. When people decide they want to work, they must make choices on how to use their finite hours in a week. Usually this involves a trade off such as less sleep for more work. In my economic world the trade off is between work and leisure. A person can choose to sleep during their leisure time or go see Spiderman 3. Leisure is the time spent not working. The law of supply in introductory textbooks is usually illustrated at a positive relationship between price and quantity. This positive relationship is meant to show that higher prices induce suppliers to supply more. The wage rate is the "price" of labor in the factor market. Does this linear relationship predict how labor will supply their labor?

After I wake up in the morning and drink my usual diet Mountain Dew, I'm off to work. After I work eight hours, I want to go home unless there's a monetary incentive such as overtime pay. But will i keep working the whole 24 hours? Not me. After so long at work, I will value my leisure time more and start to substitute my free time for work. This is called the substitution effect. In the mornings after my caffeine jolt, the incentive to work means more to me than my leisure so I go to work. This is called the income effect since i'm choosing to earn money by working longer. The push and pull of the income effect and substitution effect creates a backward bending supply curve for labor. In other words, people will work for the money for a while then eventually they'll need some time off. In the graph, this is shown at L2 hours of labor.
Do you think that one reason why students will not do homework is the substitution effect? After working in school all day, students are natually prone to value their leisure time. Most students I know plan several activities after school so their "free" time is more valuable. In my class, I bend over backwards to make sure that students have the concepts before they leave the room because I know that the value of their leisure is greater than the value of the grade they'll earn.