Aug 22

Characteristics demand theory

Characteristics demand theory states that consumers derive utility not from the actual contents of the basket but from the characteristics of the goods in it. This theory was developed by Kelvin Lancaster in 1966 in his working paper “A New Approach to Consumer Theory”.

This approach allows us to predict how preferences will change when we change the options or baskets presented to consumers by studying how these vary according to the change in the characteristics that make them up. With conventional theory, the introduction of a new option meant that we could not reliably predict how this would slot into the consumer’s preference map. However, by relying on a study of the characteristics rather than the goods or service involved, we can predict how changes will affect a consumer’s behaviour without needing to start once again empirically.

This allows us to calculate ‘shadow prices’ for different attributes without having a price for the good itself by associating utility to the characteristics that make up the good rather than the good itself. With these ‘shadow prices’, we can solve utility maximisation problems for baskets or options for which we do not have empirical evidence, as Lancaster demand also lends itself to building utility functions (based on the amount of each type of characteristic rather than the amount of each type of good in a particular basket).

Characteristic demand theory also helps justify the existence of brands. Luxury brands are able to charge a surprice for their products by differentiating themselves from competitors that sell similar goods. In the first diagram, if we suppose that both brands have the same characteristics and are perfect competitors, then we will choose the basket that maximises our total consumption. This means will tend to opt for the cheaper brand, which allows us to reach the highest utility curve: for a given amount of money, we are able to buy either a certain amount of brand 1 (point B) or a certain amount of brand 2 (point A). We choose A since it’s on a higher indifference curve. Point C represents a higher utility curve achieved by a drop in the price of brand 1. However, even though brand 1 got cheaper, we’ll still consume A, since it remains on a higher indifference curve.

In the second diagram, if we look at Lancaster demand, our utility functions will be based on the characteristics that each basket contains rather than on the amount of each type of good. Here, it is no longer ‘all or nothing’- we can allow for convex demand curves that represent our preference for variety in consumption: point C. This time, if the price of one brand drops, we will change our outcome: we can opt for point D.

Video – Characteristics demand:

Aug 22

Lope Gallego

Neoclassical synthesis

Neoclassical synthesis (NCS) refers to an economic doctrine that appeared in the U.S. in the early 1940s, and would remain the dominant paradigm until the late 1960s, when monetarism took over. It was Paul Samuelson, in his book “Economics”, 1955, who gave this doctrine its sense of synthesis, since it can be described as Keynesian in the short run and neoclassical in the long run. This is, policy makers will be able to adjust the economy (especially using fiscal policies, seen by NCS’ economists as far more effective than monetary policy) in the short run, but considering also that equilibrium will be reached in the long run without the need for public intervention. Theoretical and empirical studies by NCS’ economists are mainly based on the IS-LM model and the Phillips curve.

The IS-LM model was first developed by John Hicks in 1937 and Hansen expanded and popularized it in 1949. It is built on the premises put forward by J. M. Keynes in his “General theory”, 1936, and gives fiscal policy a higher degree of efectiveness (IS-LM policies effects, NCS view).

The Phillips curve, derived from an empirical study, gave a relationship between unemployment and inflation, which was not explicit in Keynes’ analysis. The validity of this relationship has been highly criticized by different schools of economic thought, such as monetarism, the New Classical Macroeconomics and the New Keynesian Economics.

Other renowned NCS’ economists are Modigliani, for his analysis of consumption under an intertemporal utility maximization frame, known as the life-cycle hypothesis; Jorgenson, for his work on the investment function; and Tobin and Baumol, for their studies on the demand and supply of money.

The NCS as a macroeconomic mainstream started struggling in the late 1960s, following a high inflation episode in the U.S., which could not be explained using the theoretical framework of this doctrine. Not long after, in the mid-1970s, stagflation in the U.S. meant the rise of monetarism and the subsequent fall of the NCS.

Aug 21

Lope Gallego

Goods

Goods are something that provides its holder some kind of satisfaction, and therefore has a utility. There are different kinds of goods, and different classifications can be arranged and identified. We can differentiate between consumption goods (durable or perishable) and capital goods. Classification depending in responsiveness to incomes changes (normal goods and inferior goods) and to price changes (ordinary goods and Giffen goods) can also be made.

-Normal goods are those whose demand increases due to a rise in income levels, having therefore a positive correlation, which implies that the elasticity of this kind of goods is always higher than 0. Normal goods are divided in two categories, Superior goods and Necessary goods.

·Superior goods, also known as luxury goods, are those goods that displace the demand of inferior goods after a rise in consumers’ income. They are a kind of normal goods as their demand increases when income does as well, however, the difference is that they occupy the share of inferior goods. The elasticity of this kind of goods is, for this, always higher than 1.

·Necessary goods are those whose demand increases when income does, however the increase in demand is less than proportional to the rise in income. Elasticity of this goods is always between 0 and 1.

-Inferior goods are those whose demand moves in opposite direction to the income variation of consumers. This occurs because consumers’ preferences change to other goods that are more highly regarded.

-Ordinary goods are those goods whose demands move in opposite direction to the price variation. This means an increase in the price of the good will mean a decrease of its demand and the other way around.

-Giffen goods are those goods whose demand moves in the same direction as the price variation, this meaning, raising the price of the good will increase its demand, and the other way around. The explanation to this kind of goods comes from the “Snob Effect”, the more expensive a good is, the less people can afford it, and therefore becoming more precious and highly valued.

Aug 19

Lope Gallego

Laspeyres and Paasche indices

Price indices are used to monitor changes in prices levels over time. This is useful when separating real income from nominal income, as inflation is a drain on purchasing power. The two most basic indices are the Laspeyres index (named after Etienne Laspeyres) and the Paasche index (named after Hermann Paasche).

Both indices are very similar:

Laspeyres index:

Paasche index:

They work by dividing expense on a specific basket in the current period (the sum of p*q for each product in the basket considered when calculating the index) by how much the same basket would cost in the base period (period 0). The main difference is the quantities used: the Laspeyres index uses q₀ quantities, whereas the Paasche index uses period n quantities.

What this translates to is that a Laspeyres index of 1 means that, as the nominator is the same as the denominator, an individual can afford the same basket of goods in the current period as he did in the base period. As the quantities are the same, this just leaves price as a variable, which must remain unchanged. This translates to the concept of compensated variation (CV): by how much do we need to increase an individual’s income in order to offset inflation? This is, at the new level of prices, how much is required to compensate the effect of the price increase? In the top diagram, we see that an increase in the price of good x₁ means a move to a lower utility curve. The compensated variation is the theoretical amount of money the individual would need to maintain their level of utility, putting them back on their original utility curve.

What we can also see is that the Laspeyres index overestimates this CV: it assumes that inflation has a greater effect than it does. This can be more clearly seen in the bottom diagram. The change in price from P₀to P₁ leads to a change in the quantity of X consumed from X₀ to X₁. The green rectangle shows the Laspeyres effect associated with this, which is greater than the CV effect. The CS effect, the dark blue trapezoid, shows the loss of consumer surplus associated with the price variation.

A Paasche index of 1 means that the consumer could have afforded the same bundle of goods in the base period as they can now. This can be translated to the concept of equivalent variation (EV): how much income would we have to take away from an individual, at the base price level, to have the same impact on their utility as the inflation between the base period and period 1? That is, if we took the individual’s utility in 2009 at that price level, how much would we have to take away from it to have the same utility as a person on the same income with 2012’s level of prices? Applying the same dynamic we applied to the Laspeyres index, we can see from the top diagram that the Paasche index underestimates the equivalent variation.

We can see this more clearly in the bottom diagram: the consumer surplus is greater than the variation effect, which is in turn greater than the Paasche effect.

If we put this all together, it may be easier to understand each of the effects and understand their downisdes:

These diagramas are simply a combination of the two we saw individually. They help us, however see the differences between both indices. The main downside to these indices is the fact that they do not take into effect substitution effects. When the price of something rises, we tend to consume less of it. Because the Laspeyres index uses base period quantities, it tends to overestimate inflation by assuming that individuals’ income expense is still distributed in the same way. The opposite is true of the Paasche index: because it uses current period quantities, it underestimates inflation.

Therefore, for normal goods, if inflation exists:

L > CV > CS > EV > P

Video – Laspeyres index:

Video – Paasche index:

Aug 19

Lope Gallego

Production function

A production function shows how much can be produced with a certain set of resources. Generally, when looking at production, we assume there are two factors involved in production: capital (K) and labour (L), as this allows us graphical representations of isoquants. However, any analysis made with 2 factors can mathematically be extended to n factors.

Therefore, a production function can be expressed as q = f(K,L), which simply means that q (quantity) is a function of the amount of capital and labour invested. In the adjacent figure, q_x is function of only one factor, labour, and it can be graphically represented as shown (green).

It is well worth introducing here another concept: marginal productivity, which is how much more quantity we could produce by adding one unit more of a factor. As is logical, this will depend on how we are employing the factors we already have. The marginal product is the partial derivative of the production function with respect to the factor we are examining:

Marginal productivity decreases with each additional unit, as it can be seen in the above figure (cyan). At a certain point, the more workers we have, for example, the more each additional worker will be redundant if we do not invest in other necessary factors. This is the same as saying that the second derivative is negative. At that point, A, production is as efficient as possible.

Video – Production function:

Aug 19

Lope Gallego

Economies of scale

This economic phenomenon occurs when increasing output is translated into a decline of the firm´s average cost of production. Alfred Marshall was the first economist to distinguish economies of scale depending on their origin:

-Internal economies of scale occur when something inside the firm makes the average cost of production lower:

Purchasing: buying raw materials in large quantities or big bulks brings better prices and discounts which allow average cost to be reduced.
Specialisation: covering all areas of management and work can be very difficult, however when operating on a large scale, workers can specialize in the activities in which they are best and more productive.
Flexibility: a more efficient production process can be achieved by managers when scale means that different arrangement of the inputs can be made. Better capital can be purchased by firms that have more money, increasing the quality of their products and/or reducing cost of production.

-External economies of scale occur when something outside the business, but inside its industry, makes average cost of production lower. As the industry of the firm grows, more support may come from the suppliers’ side: more variety, more quality, more quantity, etc. Government may give extra aid if it considers that the industry has some special interest.

On the other hand, diseconomies of scale may appear due to the excessive scale of a firm. Diseconomies of scale occur when average cost per unit increases due to excessive size of production.

The main reasons for diseconomies of scale to appear are:

Demotivation issues: in firms with many workers, standing out becomes harder. Each individual may find himself as meaningless, and therefore cause him to stop working as hard as he would with fewer workers.
Communication: the communication process of larger firms becomes slower as information has to pass through more and more layers. Information can even become distorted either accidentally or deliberately. The longer it takes managers to make decisions, and these to be known by workers, the less efficient the firm becomes.

Aug 18

Lope Gallego

Keynes & Neoclassical Synthesis

John Maynard Keynes marked a hugely important turning point in the history of Economics. For the first time, Economics had become positive, allowing for differences of opinion. It was firmly a social science, not a collection of observations or ‘natural laws’ condemned to repeat their patterns ad eternum, but could be interfered with and changed. This brought about a chasm in economic thinking: differences of opinion could bring about real differences in the lives of many.

This became all too apparent with the advent of World War II, when economic intervention became all too urgent to help rebuild the lives of all those whose livelihoods had been quashed following a war and a recession that was already 10 years long. The important thing was to decide whether to intervene or leave it to the invisible, all regulating hand.

Keynesianism:

J. M. Keynes, the man who began it all.

Cambridge school, shifting from marginalism to Keynesian ideas.

Keynesianism, its main precursors and ideas.

Neoclassical Synthesis:

Neoclassical Synthesis: how neoclassical economics and Keynesianism reconciled.

John Hicks, the main precursor of the Neoclassical Synthesis.

IS-LL model, which marked the beginning of a new era in macroeconomic analysis.

Phillips curve, which pointed out a relation between unemployment and inflation, starting one of the greatest debates in economic history: can government intervention reduce unemployment?

Aug 16

Lope Gallego

IS-LL (Hicks’ IS-LM)

John R. Hicks, in his article “Mr. Keynes and the Classical; a Suggested Interpretation”, published in 1937 in the journal Econometrica, developed a model known as IS-LL, which will later become IS-LM. The purpose of the article was to compare classical economists’ view on the goods and money market, with Keynes’ views.
In a few words, Hicks would assume Keynes’ innovations (possibility of frictional unemployment, the impact of animal spirits on investment, as well as money illusion effects) to take place in the short run, while classical views (such as full employment, perfect competition and the ability of the economy to re-equilibrate itself without government intervention) to be valid on the long run.
Hicks starts with the following assumptions, which we will maintain:

-he considers the short term;

-the quantity of physical equipment is fixed;

-homogeneous labor;

-depreciation can be neglected;

-rate of money wages (w) can be taken as given;

-quantity of money (M) is given;

-price level of goods equals their marginal cost.

(For the sake of simplicity, we will not consider differences between investment and consumption goods, nor the differences on the distribution of income.)

He also defines the following variables, which we will reformulate according to the level of simplicity we are aiming at:

-Y: total income;

-M: money quantity (which is given);

-I: investment;

-S: savings;

-i: rate of interest.

By uniting both classical and Keynesian views, Hicks writes the following three equations:

-M(Y,i) : we see that money quantity depends on both total income and the rate of interest;

-I(i) : investment depends on the rate of interest;

-I=S(Y) : investment must equal savings, which depend on total income.

From these three equations, we can see the relation between total income and the rate of interest in both markets:

-money market: since the money quantity is given, the LL curve (blue) will slope upwards, because an increase in income usually raise the demand for money (people need cash to consume goods) and an increasing rate of interest tend to lower money demand (the explanation of this can be made from two different angles: people will rather save more money since the interest rate is higher, therefore will spend less and demand less cash; or people are less willing to borrow money from banks, to spend it or invest it, because of the higher rate of interest);

-goods market: the IS curve (green) shows the relation between income and interest needed to make savings equal to investment. It slopes downwards because the lower the interest, the more people will invest, and therefore the higher will the total income be.

Income and the rate of interest are therefore determined where the IS and LL curves intersect (point P).

This model (more precisely, the IS-LM) is used nowadays to show the effect of diverse economic policies on a closed economy, and served as a starting point for the later Mundell-Fleming model, which helps understand their effects on an open economy.

Aug 11

Lope Gallego

Neoclassical Economics

Modern economics would look nothing like what they do without neoclassical economics which, for instance, implemented rigorous mathematical analysis into economics. Most of what we absolutely take for granted was discovered by the great economists of the time, and they are also responsible for providing enough of a framework to raise a century long controversy with the other great school of the 20^th century.

Neoclassical economics is really the birth of mathematics as an inescapable tool for constructing theories that are internally coherent (that is, explained in and of themselves without requiring casuistic examples), escaping the slightly lackadaisical approach of many classical economists like the great Ricardo. This allowed Economics to develop at a much faster pace, and provided the basis for how Economics is studied and investigated today.

Neoclassical economics also sees the first clear distinctions between branches of Economics, previously grouped together in the ever present “Principles of Economics” manuals. It sees the basis of the modern didactic framework that we still classify Economics under, and is, in short, the first time that Economics looks like something we might recognise today: consistent theories built upon a solid mathematical framework that aim to underpin the casuistics of what goes on around us.

Marginalism:

Marginal Revolution, around 1870, brought the prevailing classical view of value theory to an end.

William S. Jevons, who devised the concept of marginal utility.

Carl Menger, one of the founders of the Austrian school.

Léon Walras and his concept of “tâtonnement” revolutionized the study of general equilibrium.

Main neoclassical economists:

Alfred Marshall, the true founder of the neoclassical school of economics.

Francis Y. Edgeworth, whose mathematical contributions to economics are of great importance.

Arthur C. Pigou, precursor of welfare economics.

Vilfredo Pareto, who specially focused on allocation and efficiency matters.

Irving Fisher, the main American neoclassical economist.

Main neoclassical schools:

Although not included in this Learning Path (in order not to overwhelm you!), it is interesting to learn about the three main schools at the time: Cambridge school, Lausanne school and the Austrian school. Reading about these will help you put into context everything you’ve learned during this Learning Path.

Aug 11

Lope Gallego

Economic region of production

The economic region of production shows the combinations of factors at a certain cost that make economic sense. Areas outside the economic region of production mean that at least one of the inputs has negative marginal productivity. This region is marked by what are called ridge lines, which are simply the boundaries beyond which one of the two factors is being overused. Therefore, outside the economic region of production, there is clear inefficiency, and the company would be better off using less of one of the two factors, bringing costs down whilst maintaining equal production output. Graphically:

Video – Economic region of production: