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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.