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JONATHAN GRUBER: All
right, let's get started.
Today, we're going to continue
our discussion of factor
markets.
If you recall, last
Monday, we started
talking about the labor market.
And we talked about how workers
make the decision between work
and leisure.
And we talked about
the implications
for setting the wage
rate in the labor market.
What I want to do today is
return to that labor market
equilibrium and talk
about the important case
of the minimum wage.
So today, I want to talk about
the labor market equilibrium
and how it's affected
by the minimum wage
because it's an interesting case
which allows us to introduce
some complications as to how we
think about the labor market.
So let's go back and think
about the labor market.
So let's go to figure 16-1.
The labor market,
like any other market,
has a price and a quantity.
The quantity is the
amount of labor supply.
That's on the x-axis.
The price is the wage.
That's on the y-axis.
The supply curve
that's upward sloping--
typically we'll assume an
upward-sloping supply curve.
But as we discussed last time,
that doesn't have to be true.
If income effects dominate
substitution effects, which
they very well may,
you could actually
have a backward-bending or
downward-sloping supply curve.
So we talked about
that last time.
Having taught that
interesting case,
typically, we'll
assume supply is upward
sloping or at least
not backwards bending,
not downward sloping.
But remember, that's
an assumption.
So this upward-sloping
supply curve
is not necessarily as obvious
as a downward-sloping demand
curve is.
Downward-sloping demand
will almost always
exist unless there's
a weird Giffen
good, whereas
upward-sloping supply is
a little more questionable.
So we have the equilibrium,
and we have this equilibrium
at L1 workers at a wage W1.
So now we know where
this comes from.
So basically, going
all the way back
to producer theory where
we just gave you a W,
now we're telling
where the W comes from.
We're telling you where the
wage comes from that you then
plug into the firm's
optimization for them
to produce goods.
Now, let's imagine that
we have a minimum wage.
So let's go to figure 16-2.
So this is a
regulation which says
that you're not
allowed to pay workers
below some minimum level.
And let's say we set that
minimum wage at the level W2
above the market wage W1.
Quick question.
What would happen
if we passed a law
and set a minimum wage
that was below W1?
So there'd be a
regulation which insists
you couldn't pay workers
below W2, but W2 is below W1.
What would that do
to the labor market?
Nothing.
And here's the key point.
Markets in economics
will always endeavor
to avoid government
regulations if they can.
So if a government regulation
is not binding, it won't matter.
Markets will just avoid it.
So the interesting case is
only where the minimum wage is
binding, as in the figure 16-2.
So what happens?
Well, if you set a
minimum wage at W2,
workers at that high wage
would love to work a lot.
That's a high wage.
They're high in
the supply curve.
They would like to
work L sub s hours.
They would like to
supply L sub s amount
of labor supply to the market.
Firms, however, if forced
to pay a high wage,
W2, are going to
say, wait, I'm only
going to pay that high wage if
the marginal revenue product
of labor is sufficiently high.
Remember, we talked about the
marginal revenue of product
last time.
It's the marginal product
of labor times the price.
So if you're going
to raise the wage I'm
going to have to pay workers,
unless that affects the market
price, I'm going to need to
have a higher marginal product
of labor, right?
The demand equation
was, I said, the wage
equal to the marginal product
of labor times the price.
Well, if the price
hasn't changed
with the minimum
wage going in, I'm
going to need a high--
if the wage is forced up
by the minimum wage, I'm
going to need a higher
marginal product of labor.
How do I get a higher
marginal product of labor?
By hiring less workers because
the marginal product of labor's
diminishing.
So if you're going to force
me to pay a higher wage,
you're going to force
me to only hire workers
until the point where the
marginal product of labor
justifies that higher
wage, which means I'm
going to hire fewer workers.
So firms demand only L sub d.
Well, workers can't get jobs
firms don't want to give.
So the equilibrium is L sub
d jobs at a wage W sub 2, OK?
What does this do to welfare?
We can see before, before the
minimum wage was in place,
the market featured a consumer
surplus that-- here, consumers
are firms, right?
But there was a consumer
surplus of A plus B plus C.
That is, firms
were willing to pay
what was on the demand curve.
They only had to pay W1.
So their surplus
was A plus B plus C.
Workers were willing to
work at a wage that's given
by the supply curve S sub 1.
They were paid at W sub 1.
So they got a
surplus of D plus E.
So here, the firms get
the consumer surplus.
The workers get the
producer surplus
because the workers
are now the producers.
Now let's say you roll
in a set minimum wage.
Well, two things have happened.
One thing is you've then
transferred some resources
to workers.
That's the area B. You've taken
the area B that firms used
to get, and now workers get it.
That's the idea.
You want to make
workers better off.
So you transferred to
workers the area B.
On the other hand, you've
created a deadweight loss
of the area C plus
E. You've created
deadweight loss in
the area C plus E
because now there
are fewer jobs.
There are workers
who would happily
work at a higher
wage who are not
being allowed to work by
the limited demand that
comes from the minimum wage.
So the bottom line is you end
up with fewer workers, a higher
wage, and ambiguous
welfare implications.
Clearly, social
welfare goes down.
Whether worker
welfare goes up or not
depends a bit on the size of
area B versus the size of area
E. It's not clear if worker
surplus goes up or not.
It depends on size of B
versus E. In this diagram,
workers are a net better off,
but it doesn't have to be true.
What's clear is that social
welfare has gone down.
Because remember,
as I talked about,
the cheat, the shortcut I
talked about when we talked
about oligopoly, is,
roughly speaking,
welfare is proportional to
the quantity in the market.
Essentially, the
further you deviate
from the perfectly
competitive quantity,
the bigger the deadweight loss.
So that's what happens if
you put in a minimum wage.
Questions about that?
OK?
Well, that seems
pretty straightforward,
and that's what I
learned growing up
as a kid in economics class.
But then some empirical
economists, some very famous
empirical economists,
started doing
a series of articles that
actually studied, gee,
what happens when the
minimum wage does change.
They did things
like, for example,
comparing what happened
when New Jersey raised
its minimum wage but the state
of Pennsylvania next door
did not, and looked at fast
food workers in New Jersey,
where the minimum
wage went up, compared
to fast food workers
in Pennsylvania
where the minimum
wage didn't go up.
And what they found was
there was no difference
in employment, that jobs
didn't fall in New Jersey
even though the
minimum wage went up.
And a series of
follow-on studies
continue to find that, actually,
higher minimum wages didn't
seem to cause jobs to
fall, which is directly
in contradiction
with this graph.
So what's going on?
That led to a big
question and revision
of what's going on in these
markets that leads to that.
And there's really
three possibilities
for what's going on.
Possibility one is that the
minimum wage wasn't binding.
Maybe New Jersey set a minimum
wage below the market wage.
But actually, empirically,
that's not true.
We can look at what workers were
paid before the minimum wage.
It was well below where
the minimum wage was
set for restaurant
workers that were studied
in that most famous study.
So this is not true.
The minimum wage was binding.
There's a second
possibility that's
absolutely consistent with a
perfectly competitive market.
What's a possible
answer for why I
could impose a minimum wage in
a perfectly competitive labor
market and have
employment not go down?
Yeah?
AUDIENCE: Price goes up.
JONATHAN GRUBER: The price
that the firm charges goes up.
But in a perfect
competitive labor market,
that still wouldn't happen.
You might see some
price adjustment,
but you'd still
see some adjustment
in the marginal
product of labor.
But what else
about this diagram?
Yeah.
AUDIENCE: The firm's demand for
labor is perfectly inelastic.
JONATHAN GRUBER: The firm's--
actually, you're close.
It'd be the worker's supply of
labor is perfectly inelastic.
It's the right idea.
If workers are perfectly
inelastic in their supply
of labor, then the
same amount of workers
will work no matter
what the wage.
So basically, you're just
going to essentially end up--
you'd also, in fact--
that's a good point-- also
get inelastic demand,
the same thing.
If either supply or
demand is inelastic,
you'll end up with no
effect of a minimum wage.
So that's another possibility.
But in fact, we've
done a lot of studies.
So you could have
inelastic supply or demand.
But in fact, we've done lots
of studies of supply and demand
in these markets,
and that's not true.
Remember, supply was
largely inelastic for men,
but it was somewhat
elastic for women.
And these low-income
markets have
a good mix of men and
women working in them.
Demand has been shown
to be somewhat elastic.
So neither supply nor
demand's very elastic,
but they're sufficiently elastic
that that rules out as zero.
So the third possibility and the
one economists have focused on
is that we're not in a
competitive labor market.
They're focused on a
noncompetitive labor market.
Just like we discussed
noncompetitive markets
for goods with a
monopoly and oligopoly,
you can have noncompetitive
markets for labor.
It's the basic same idea.
So now let's look at--
so when we thought
about-- let's go back,
think about perfect
competition, the basics
of perfect competition.
We thought about
perfect competition.
The basic idea was, remember,
I talked about laying out
a bunch of rugs in a market
where you could literally
shop costlessly across
all the people selling
their little fake Eiffel towers,
little statue Eiffel towers.
And you could perfectly shop.
It was easy to go
from carpet to carpet.
There was full information.
The prices were posted.
And so basically
what you ended up
was perfectly elastic demand
facing any given firm.
Any given firm, if
they tried to charge
one cent more for their Eiffel
tower, no one would buy it.
If they charged one cent less,
they'd immediately run out.
Everyone'd buy it.
Well, when we are
modeling labor markets--
and I discussed this last
time, but not very well.
So I want to come back to it.
When we're modeling
labor markets,
we're thinking about the same
feature of perfect competition.
But here, it's not
consumers shopping
over where to buy their goods.
It's workers shopping
over where to work.
It's workers saying, gee, in
a perfectly competitive labor
market, the idea is I know
what I could earn at any firm
and I can easily
shop across firms,
see where I'm going to work.
So if any firm tried to pay me
one cent less than the market
wage, I'd never work there.
And if they tried to pay me one
cent more than the market wage,
every worker in the world
would want to work there.
So in a perfectly
competitive labor market,
any given firm faces a perfectly
elastic supply of labor.
So we can see that
in figure 16-4,
which we actually showed-- and
I'll let you skip this since we
covered it--
16-4, which I actually
showed in the last lecture.
Remember the last lecture.
I was focused on this
downward-sloping demand curve,
but I casually threw in
this flat labor supply curve
and botched explaining it.
Now I'm explaining it,
hopefully more clearly, which
is to any given firm,
the labor supply curve
is perfectly elastic because
workers can perfectly
shop across job opportunities.
So if that firm tried to pay
less, they'd get no workers.
So they faced a perfectly
elastic supply of labor.
But just like, in
reality, there's
no such thing as a perfectly
competitive product market,
in reality, there's
no such thing
as a perfectly
competitive labor market.
In fact, we can't shop easily
across all possible jobs
and know what every
job could pay.
And the fact that we can't means
that firms on the labor market
side will have market power.
Just like we talked about
monopolists and oligopolists
having market power
over consumers
through barriers to
entry, firms will
have market power over workers
because workers can't perfectly
shop across their
job alternatives.
So as a result, firms
may be able to get away
with paying you less than
what you might earn elsewhere.
In a perfectly
competitive labor market,
a firm could never
pay you less than what
you're worth elsewhere
because you'd just
go work somewhere else.
But now, if McDonald's wants to
pay you less than you might get
at Wendy's, but it's hard to
go find out what Wendy's going
to pay you-- you have to go
a distance down the road,
and you have to ask
them, and you're shy
and it's embarrassing-- then
McDonald's might be able to get
away with paying you less than
you might earn at Wendy's.
So this is very much
parallel to monopoly.
In fact, we call
this a monopsony.
A monopsony is a
labor market where
firms have market
power over workers
just like a monopoly is a
goods market where firms have
market power over consumers.
Now, this is not so crazy.
And in fact, it applies
very much to me.
Think about my situation at MIT.
I've been here 25 years.
I just got my 25th
year rocking chair,
although actually it's
not a rocking chair
because it comes in the box
with the rockers off it.
And it arrived in my office,
so it's sort of a short chair.
My wife's 5 foot, and
she always complains
how chairs are too big for her.
So she sat, and she's like,
it's a perfect chair for me.
So now I have a nonrocking
rocking chair in my office
that she sits in.
But anyway, I've been
at MIT for 25 years.
It's going to be really
hard for me to move.
I like my house.
I like my colleagues.
I like my friends.
Kind of, I like my
view out the window.
It's going to be kind
of hard for me to move.
Moreover, it'd be pretty
hard for me to figure out
what I'd get paid if I moved.
I can't go to other
universities and say,
hey, what would you
pay me if you hired me?
That's be awkward.
I can't really ask my
colleagues what they make.
That's awkward.
So at the end of the day,
MIT has market power over me
because I don't
really want to move
and I can't really
figure out what
I'd get paid if I did move.
And MIT will exploit
that market power over me
by paying me less than
I might earn elsewhere.
And we know this as a
fact because in academia,
the only way to get a raise is
to go get an offer from someone
else and have them say how
much more they'll pay you,
and then you take that to your
boss and they say, match this.
But if you're not
willing to do this,
as, frankly, MIT knows
I'm not willing to do,
then MIT can
essentially underpay me.
So basically, any
responsible profit-maximizing
or even nonprofit employer
will exploit this market power
and they'll pay me less
than my market wage.
And that means that MIT
will earn surplus on me.
In a perfectly
competitive labor market,
the firm earns no
surplus on the worker.
They pay the worker their
marginal revenue product.
So if you go to this figure,
what am I paying the worker?
What I'm paying them is
exactly the marginal revenue
product just like, in
a competitive market
for the goods, a firm is selling
at exactly their marginal cost.
So just like a firm makes
no surplus in a perfectly
competitive goods market,
a firm hiring workers
makes no surplus in a
competitive labor market.
But in a monopsony market, the
firm makes surplus over me.
They pay me less than they'd
have to because I don't shop
and find a better opportunity.
Now, are there questions
about how that market works?
I'm not going to do all
the math and graphs.
It's all the same as monopoly,
just flipping demand and supply
curves.
It's a pain in the ass.
I'm not going to do it.
I just want you guys to
understand the intuition.
So please, since I
went through this,
are there questions about
this or how it works?
OK.
Now let's take this
noncompetitive labor market
and let's throw
in a minimum wage.
Well, as before,
if the minimum wage
is below what the firm
was already paying,
there's no effect.
So let's assume it's a
binding minimum wage.
Now, let's say the
binding minimum wage
is above what my true
market wage would be,
what my wage would be in the
perfectly competitive market.
So in a perfectly
competitive market,
my wage would equal my marginal
revenue product of labor,
right?
That's in a competitive market.
In this noncompetitive
market, my wage
is below my marginal
revenue product of labor.
Firms are exploiting me
because I can't effectively
shop for a better job.
I don't want to or
it's hard to do so.
Now, in this
noncompetitive market,
if we set a minimum
wage that's higher
than the marginal
revenue product of labor,
then the analysis is just
like it's a competitive firm.
Once that marginal
wage is higher
than the marginal
revenue product of labor,
it's just like a
competitive firm.
So it's not that interesting.
The interesting case is, what
if the minimum wage comes in
and it's above the wage I make
but below the marginal revenue
product of labor?
So let's say McDonald's,
someone working there
yields a marginal revenue
product of labor of $10,
but they're only being paid $7.
Let's say you roll in
minimum wage of $9--
so above what they're
being paid now,
but below their actual marginal
revenue product of labor.
Will the firm fire that worker?
Why not?
Yeah.
AUDIENCE: They're still paying
them-- they're still making
a profit off of that worker.
JONATHAN GRUBER: They're
still making surplus,
which is as long as the
marginal product of labor's
bigger than the wage,
they love that worker.
So before-- so let's write
down the numbers as an example.
So imagine my marginal revenue
product of labor at McDonald's
is $10, but my wage is $7.
And then you come and you
set a minimum wage of $9.
Well, 10 is still
greater than 9.
So the firm has no
desire to fire me.
So all you've done is
just given me money.
And where'd that
money come from?
The surplus the firm earned.
So all you've done is
shifted the surplus from--
you've shifted producer
surplus to consumer--
I'm sorry, consumer surplus--
consumers are the firms--
to producer surplus,
the workers.
So in a monopsony
market, a minimum wage
doesn't cause deadweight loss.
It just shifts surplus around.
And that's a really
important outcome
because that, once again,
says the government isn't
always bad here.
This is just like--
if you want to think
about this graphically, go
back to exactly the analysis we
did of regulating monopolies.
Remember we talked about
regulating monopolies.
We talked about, if a regulator
comes in and sets a price
below the monopoly price but
above the competitive price,
it reduced the deadweight
loss of monopoly.
It's the same thing.
And if you set a minimum
wage above the market wage
but below the marginal
revenue product of labor,
then you simply transfer
surplus to workers
without causing deadweight loss.
Now, that raised the
question, of course,
is the minimum wage
in between the wage
of the marginal
product of labor?
Well, we don't know,
but let's go back
to the studies that
motivated this.
The very fact that
the minimum wage
doesn't seem to
cause unemployment
suggests we are
hitting the sweet spot,
suggests we are hitting
the sweet spot, that we're
basically managing, with the
minimum wage policy, at least
to date, to essentially
just find a way,
without the government
spending any money,
to shift resources from
businesses to workers.
So what does this mean?
Well, it means that around the
level of current minimum wages,
we can raise the minimum
wage by a small amount pretty
costlessly.
It doesn't necessarily mean
that a $15 minimum wage is OK.
So in some sense,
the existing-- this
is the important thing
about empirical economics.
You only learn the answer in
the range that you study it.
So for example,
there've been studies
that have looked at what happens
if you have a $10 minimum wage,
and those show no unemployment.
There haven't been studies
that show what happens
if you have a $15 minimum wage.
Now, Seattle just actually
put in a $15 minimum wage
about two years ago.
So we actually can
run the experiment.
And the early evidence
is the Seattle $15
minimum wage did lower
employment, that the Seattle
$15 minimum wage actually went
above the marginal revenue
product of labor.
And once it's above, you're
back in the competitive case.
You're back in the case where
you're lowering employment.
Yeah?
AUDIENCE: How can you increase
competitiveness in the market?
JONATHAN GRUBER: Well,
that's the other question,
is how could you
increase-- so you tell me.
How could you increase
the competitiveness
of a labor market?
AUDIENCE: You make it easier
to tell how much money you
would get at each place.
JONATHAN GRUBER: So Norway
has a day every year
they call Envy Day,
which was yesterday,
I believe, where they literally
can go online and look up
anybody's income in Norway.
They literally make public
every single person's tax return
in Norway.
And you can go online and
look at what everybody makes.
That would do it.
So you could provide
more information.
You could make it easier
to move between jobs.
For example, there's a lot
of restrictions in our labor
market, like noncompete
clauses, which
say that if you
work for one firm,
you can't ever go
work for another firm
in that industry for x years.
That gives some monopsony
power to firms, et cetera.
So we could do things which try
to loosen the flow of the labor
market, and that would
close this gap between wage
and marginal revenue
product of labor.
Now, let's go back to Seattle,
just to conclude this.
This doesn't mean the
Seattle policy was a bad one.
The bottom line is what
we learned from Seattle
was that basically,
employment fell a small amount
and a bunch of workers
made a bunch more money.
So is that good or bad?
Well, it depends.
If you're one of the
people that lost their job,
it's really bad.
If you're one of the workers who
got a raise up to $15 an hour,
it's good.
How do you weigh them
against each other?
That's exactly what we'll talk
about in a couple lectures.
So once we start talking
about normative economics,
about is a policy good or bad,
there's typically trade-offs.
And this is a classic example.
What we're learning here is, is
the minimum wage in the range
we are now, right now, the
federal minimum wage at $7.25--
the evidence suggests
it could easily rise
without causing that trade-off.
The evidence suggest
we could increase
the federal minimum wage
by some nontrivial amount,
at least up to $9 or
$10, without causing
much of a trade-off.
But once you get too
far ahead of that,
there starts to be a trade-off.
Question about that?
Yeah.
AUDIENCE: Are there any states
where it's actually still
that low?
JONATHAN GRUBER: Oh, yeah.
Many states don't have
their own minimum wage.
Massachusetts is at $11,
but we're pretty unusual.
We're one of the higher ones.
A number of states have $7.25
as the minimum wage, OK?
And the evidence seems to be,
from states like Massachusetts
and others which are on the
$10, $11 range, it doesn't
seem to lower employment.
It seems like we could clearly--
we'd be safe raising that
federal minimum wage.
We would simply be
transferring resources and not
causing unemployment.
Yeah?
AUDIENCE: Is there
anything about the cost
of living in areas where the
minimum wage is more expensive?
Is it possible that if a
McDonald's worker makes
more money in this
state, McDonald's is
more expensive in that state?
JONATHAN GRUBER: That's
a great question.
So what I assumed was I
assumed firms would just say,
oh, you got me.
I'm going to throw some
of my profits at workers.
Firms don't have to do that.
Firms could say, well, if
you make me pay workers more,
I'm going to raise my price.
Now, if it's a
competitive output market,
that shouldn't happen, right?
Because in a competitive
output market--
well, no.
Marginal cost goes up.
It's not clear.
It's not clear whether
that would happen or not,
and the evidence is
that it's unclear
whether higher minimum
wage causes higher prices
or whether it just
comes out of profits.
We don't know yet, OK?
All right, so that's what I
want to say about labor markets.
Now I want to move on and
talk about capital markets.
Now, as confusing as our
discussion of labor markets
was, that's easy compared
to capital markets.
Capital market's a lot
harder to understand.
And that's because
capital itself--
labor's something you
get your hands around.
It's the time you spend at work.
Capital is this sort
of amorphous thing
that I've kept
pushing off defining.
So I'll define it now.
We talk about capital as this
vague collection of buildings
and machines and the other
stuff that goes into production.
And we know where
labor comes from.
It comes from our work.
But where does
capital come from?
Well, capital is
a harder concept,
but there's one unifying thread
that all elements of capital
have, which is they
represent the diversion
of current consumption
towards future consumption.
Capital is about
diverting consuming today
towards consuming in the future.
In fact, the original concept
of capital came from farmers.
Farmers, every year, when
they would pick their grain,
they had a choice.
They could eat all
the grain, or they
could save some to plant
for next year's grain.
Now, the more they saved, the
more they'd have next year,
but the less they'd have today.
So farmers faced a trade-off--
literally, consumption today
or consumption next year.
That's what we mean by capital.
In other words, in
today's market economy,
the link is not that direct,
but it's the same basic idea--
that firms have a choice,
firms and their investors
have a choice.
They can take what they
make and eat it now,
or they can invest it in
having more in the future.
So basically, when we
think about capital,
we're not going to think about
capital as physical capital.
We're really thinking about
capital as financial capital.
What links all types of capital
is their financial aspect.
What links machines and
buildings is all the aspect
that, by putting
money into them today,
you have less you can
spend on fun stuff today,
but more you'll be
able to spend tomorrow.
And it's this
financial aspect that
links all forms of capital.
Now, how do firms get
the money to invest
in machines and buildings
and stuff like that?
They get it through going
to the capital market.
Where do firms get this
money that they invest?
They get it through going
to the capital market, which
is basically the pool of
money that firms can draw on
to make their investments.
So think of it
literally as I'm a firm.
I want to build a building
and buy a machine.
I literally go over, and
there's a big pool of money.
And I have to take the money out
of there to go buy my machine
or build my building.
And where does the money
in that pool come from?
It comes from household
savings decisions.
So the capital
market is a market
where the demand for capital
comes from firm's interest
in investing and having
more in the future.
The supply of capital comes
from people's decisions to save.
And essentially,
the money firms use
to buy stuff is
borrowed from people.
And that's the bottom line
of how capital markets work.
So just as the
supply of labor that
determines how many
workers a firm can hire
comes from your decision
of how hard to work,
the supply of capital
that determines
how many machines a firm can
buy comes from your decision
of how hard to save.
So let's look at figure 16-5,
equilibrium in capital markets.
Let's start with the demand.
We already talked, last
lecture, demand for capital.
The demand for capital comes
from the marginal revenue
product of capital.
It's the marginal product
of the next machine.
So the demand comes from
the marginal product
of the next machine times
the price the firm can
get for its output, which
is the marginal revenue
product of capital.
So it's the same
logic as for labor.
There's nothing
interesting there.
Same logic as for labor.
The supply's what's
more interesting here.
Where does supply come from?
The supply comes from
household savings,
how much money is
around for firms
to actually get to
get these machines.
And how do they get it?
They borrow.
And what do they borrow at?
They borrow at the
interest rate I.
So I represents the
rate that firms pay
households to get their money.
So think of this as-- we'll
talk about how it really works.
But in theory, the idea is
think of literally a marketplace
in the center of town.
Downtown Boston, Haymarket,
there's this marketplace.
And a firm comes and says,
I need to borrow money
to buy a machine.
And a person's there
with their savings
and they say, well, I'll
loan you some money.
What interest rate
you going to give me?
And that's the
market for capital.
So where the supply of capital
meets the demand of capital
yields the interest rate.
So basically, what this means is
as the interest rate's higher,
what that means is I have
to pay people back more
to borrow their money.
So an interest rate of 10%,
if I borrow $10 from you,
I pay you back
$1.10 next period.
If I borrow $10, I pay you
back $1.10 next period.
If the interest rate's
20%, if I borrow $10--
if I borrow $1--
I'm sorry.
If I borrow $1 from you, I
pay you $1.10 next period.
If I have 20% and I borrow $1, I
pay you back $1.20 next period,
et cetera, OK?
So basically, that
is essentially
how the transaction works.
And the key point
here is the reason
the supply curve is
upward sloping is
the more you're willing
to pay me for my money,
the more I'm
willing to lend you.
So if you come to me
and say give me $1
and next year I'll give you
back $1, I'm like, I don't know.
Why would I do that?
If you say, give me $1 and next
year I'll give you back $1.10,
you're like, OK, now
I'm interested. $1.20,
I'm very interested.
$1.50, for sure.
Literally, I just
give you my money
and, next year, I
get back 50% more?
Why not?
So basically, the higher
the interest rate,
the more I'm willing
to loan the firm
and, therefore, you get an
upward-sloping supply curve.
Now, of course,
in reality, people
don't actually-- we don't sit
in Haymarket, downtown Boston,
and give money to firms.
In reality, this
transaction happens
through capital markets.
And essentially, there are three
mechanisms by which implicitly
I loan money to firms.
The first is I could
literally buy corporate debt.
I could literally loan
the money to firms.
I could literally go
and the firm could say,
I, General Motors,
am issuing a bond.
This is through
bond, issuing a bond.
And the way that bond works is
I promise that for every dollar
you spend buying my bond,
you'll get 1 plus I dollars back
at the end--
or next year, say, depends
on how long the bond is.
So literally, you're loaning the
money to the firm by buying--
you're buying their
promise to pay you back.
Now, a second way you can
loan money to the firm
is through investing
in their equity.
You can buy their stock.
The way this works is GM says
to you, buy a piece of me
and you'll get paid back not
some fixed interest rate,
but you get paid back
according to how well GM does.
So with corporate
debt, I get paid back
something that's predetermined.
When I buy stock or
equity, I don't get back
a predetermined amount.
I get back some-- it depends
on how well the company does.
But it's the same basic idea.
I'm giving the company
some money today
in return for my getting
more money, I hope, tomorrow.
That's the diversion
of consumption
from today to tomorrow.
And the third thing I could do
is I could put it in the bank.
Now, how is that
loaned to companies?
Because the bank then
loans it to companies.
Why do banks say they'll pay
you interest on your money?
Why did banks going crazy--
I'll give you 1--
it used to be interesting.
Now it's 1%, 2%.
When I was a kid, I
was like 10%, 12%.
We'll give you lots of money.
And we'll talk later about
why it was so much higher when
I was a kid.
Why are banks so
eager to do that?
It's not out of the
goodness of their heart.
It's because when you give
them dollars, they turn around
and loan them.
They add a bunch to
the interest rate
and loan them out to firms.
So those dollars
you're giving the banks
and they're paying
you 2% interest,
they loan to firms at 6%.
And that's why bankers are rich.
So basically, the reason a bank
exists is because it's a way--
corporate debt
and equity markets
are hard and complicated.
It's much easier to put
your money in a bank.
You put your money in a bank.
But when you put
your money in a bank,
you're essentially
loaning it to companies.
That's essentially
what you're doing.
So through these mechanisms,
we have a capital market
where essentially, by my
putting money away and diverting
from today's consumption,
I'm loaning to a firm.
They'll produce
more, and they'll
pay me back more in the future.
Questions about that?
OK, so let's talk about where
the supply curve comes from.
We know where the
demand curve comes from.
It just simply comes
from the marginal revenue
product of capital.
Where does supply
curve comes from?
The supply curve comes from what
we call intertemporal choice.
As I said, economists like
putting fancy names on things.
That helps us get
paid more money.
It just means choosing over
time, intertemporal choice.
Intertemporal choice
is essentially about
how do you decide
how much to save.
What's going to
determine that is
going to be your
decision of how much you
value money today versus
valuing money tomorrow.
So for ease, let's imagine
I'm considering two periods,
this year versus next year.
When I talk about periods, I'm
talking about days and years
and whatever.
It's the basic logic.
It's about now
versus the future.
Whether I say days or
years, it doesn't really
matter right now.
The point is I'm just talking
about today versus the future.
So let's talk about this
year versus next year.
And let's imagine prices
aren't going to change.
I'll come back to
prices next lecture.
But let's imagine the price of
goods aren't going to go up.
There's no inflation
in this economy,
which is roughly true today.
And let's suppose I'm
going to take next year off
to care for my children.
Lord knows why I'd want to
do that when the youngest
one's 19, but imagine
they still need my care.
So let's say I'll take next--
this example gets dated.
Let's say I take next year
off to care for my children.
And let's say my income
is $80,000 a year.
Now, here is my--
but I'm going to take
next year off unpaid.
So I'm going to work
this year for 80k.
Next year I'm going
to take off unpaid.
So I have a couple of choices.
I could work this year,
earn my 80k, spend my 80k,
and have nothing
next year to live on.
I could work this
year and eat nothing
and save all of
the 80k to live on,
or some combination in between.
And we could illustrate--
but the key difference
is every dollar
that I don't consume
this year that I save to consume
next year earns interest.
And that's where
the trade-off comes.
So let's look at figure 16-6.
This is a familiar-looking
optimization diagram.
Now my optimization is not
over pizza versus cookies,
but my optimization is over
consumption this period
versus consumption next period.
It's a bit mind-blowing.
We're a little
science-fictiony here, right?
We're now not talking about
choosing between two goods,
like leisure and consumption
or cookies and pizza.
Now I'm talking about two time
periods, consumption today
versus consumption tomorrow.
But that's the key
thing about the tools
we learn with consumer choice.
Those tools are
incredibly powerful.
You just need to shove your
problem into that framework.
And we're going to shove our
problem into this framework.
The problem we're facing is how
do I decide how much to save.
Well, savings is a bad
just like labor's a bad.
What do we do when we
have a bad to model?
We don't model the bad.
We model the complementary good.
So our choice is, how
much do I consume today?
My choice is, how much
do I consume today
and how much am I going to save?
Well, saving is a bad, but the
other way to think about it
is, how much am I
going to consume
today versus how much am I
going to consume tomorrow?
Then that's two goods and I can
model them against each other.
And that's what I
do in figure 16-6.
I model consumption today
versus consumption next year.
So here's my choices.
As I said, if I consume
everything today,
I'm at the
x-intercept at 80,000.
I have 80,000 to consume
today, nothing next year.
If I consume everything
next year, what do I get?
Well, let's say the
interest rate is 10%.
What that means is then
I'll have $88,000 next year.
Why will I have more next year?
Because by saving,
I earn interest.
By diverting my consumption to
the future, I earn interest.
At 10%, that means I would
have $88,000 next year.
So my budget constraint is the
line with the slope minus 1
plus I. My budget constraint is
the line with the slope minus 1
plus I. In other words,
the price of consumption
today in terms of consumption
tomorrow is minus 1 plus I.
OK, let me think about it.
Let me say that again.
It's really confusing.
The price of consuming today
instead of consuming tomorrow,
assuming no inflation--
so prices are the same
in the market--
is minus 1 plus I.
Think about that.
I find it useful to think back
to the labor case for parallel.
In the labor case, what did we
say was the price of leisure?
What was the price of leisure?
Someone raise their
hand and tell me.
In the labor-- yeah?
AUDIENCE: The wages.
JONATHAN GRUBER: The wages.
Why?
AUDIENCE: Just because that's
the opportunity cost of not--
JONATHAN GRUBER: Right.
So by that same
logic, can tell me
why is the price of
consuming today 1 plus I?
AUDIENCE: Because if
you choose to save,
then we're effectively richer.
JONATHAN GRUBER: Exactly.
The opportunity
cost-- remember, we
are an annoying discipline
with a dismal science.
We're telling you, hey, enjoy
that cookie, but by the way,
if you weren't eating that
cookie, you could have 1 plus I
cookies tomorrow.
So just like we nag you for
sitting around watching TV,
we nag you for eating
today by saying,
hey, the more you consume today,
the less you can have tomorrow.
And in fact, that trade-off
is that for every cookie
you consume today, you forgo
1 plus I cookies tomorrow.
So that's the budget constraint.
The slope is the opportunity
cost of consuming today
in terms of
tomorrow's consumption
or next year's
consumption, which
is 1 plus I. That's the slope
of the budget constraint,
is the opportunity cost.
And then, then we say, OK, well,
that's the opportunity cost.
That's the budget constraint.
Well, how do I decide?
Well, then we know how to
make these decisions, which
is go to utility function.
You can write down the
utility function, which
is a function of C1 and C2.
Now, what is C?
C is all my pizza and cookies,
but we're aggregating it up.
Just like our utility
function last time
was a function of
leisure and consumption--
we said consumption was
the bundle of goods you eat
and leisure is this thing.
Now we're saying, OK,
our utility function now
is a function of this trade-off.
Now, you might
say, wait a second.
How can both those
be utility functions?
And the answer is you have
some meta-utility function that
includes consumption today,
tomorrow, leisure, pizza,
cookies, et cetera.
But we can think about
this in sequential steps.
First, we decide how we're
going to split our income.
Then we can decide what to
spend it on each period.
Then you can do a separate
consumer maximization decision.
But our first
question is simply how
am I going to split my income.
Well, that's going
to be a function
of my taste for consumption in
this period versus next period
and the price the bank will
pay me for delaying consumption
till next period.
Now, what happens?
Questions about that?
Now, what happens
in the scenario
when the interest rate goes up?
What do you think happens if
the interest rate goes up?
Yeah?
AUDIENCE: There's [INAUDIBLE].
JONATHAN GRUBER: Right.
So what do you
think you should--
what do you think will happen
to your consumption pattern?
Yeah?
AUDIENCE: You should
spend less today.
JONATHAN GRUBER:
Spend less today
and save more because
it's rewarded.
And why is that not
necessarily true?
Yeah?
AUDIENCE: Because you might only
need a certain amount of money
to live.
So you don't have to
save as much today
because you'll make--
JONATHAN GRUBER: Because
of what two effects?
Income and substitution effects.
You gave exactly the intuition
that the substitution effect
gives you.
The substitution effect
is exactly right.
If the interest
rate goes up, that's
like the price of
consumption today going up.
And if the price of
something goes up,
the substitution effect
says you do less of it.
But if interest rate
goes up, you're richer.
And if you're rich, you
do more of everything,
including consuming today.
The income effect
goes the other way.
It's like labor.
Once again, income and
substitution effects
is why we bothered
telling you so.
Because income and substitution
effects, in these cases,
go against each other.
Let's look at figure 16-7, OK?
In figure 16-7, we
start at point A.
Now imagine the interest
rate doubles to 20%.
Now imagine the
interest rate doubles.
As you said, that pivots the
budget constraint upwards.
You could still consume
only $80,000 this year,
but now for every dollar you
save, you get $1.20 next year.
That has two effects
on your decision.
The substitution effect, we get
by drawing an imaginary budget
constraint-- that's
the dash line--
tangent to the original
indifference curve
but at the new slope.
By definition, that means
you consume less today.
You consume less
today by definition.
If the price of
something goes up,
the substitution effect
always says you do less of it.
You consume less today,
which means you'll save more.
Remember, savings is just
income minus consumption
in period one.
So just as labor was
24 minus leisure--
and so if we just solve for
leisure, we could get labor.
Savings is just income minus
consumption in period one.
So if we solve for consumption
in period one, we get savings.
People see that?
So basically, the point here
is the substitution effect
says, well, gee, the price
of consumption in period one
just went up.
It's more costly in terms
of future consumption.
I'm going to do less, but then
my savings is going to go up.
Substitution effect
says you save more.
But the income effect
says, wait a second.
You're now richer.
Every dollar of your
savings you are doing now
yields twice as
much in interest.
If you're richer, you'll consume
more of everything, including
period one consumption.
So the income effect takes
you back the other way.
Now, whether the income
effect dominates are not,
we don't know.
In this case, it
doesn't dominate.
In this case, you
still, on net, end up
consuming less in period
one and saving more.
But we don't know what's
going to dominate.
And in fact, the evidence
here is incredibly weak.
I won't spend a long
time on the evidence
because it's not nearly as
interesting and strong as labor
supply.
The evidence is incredibly
weak even about the sign.
And let's come to the intuition
that was given for why.
Well, think about how people
make savings decisions.
Lots of people
have savings goals.
I want to have x by
the time I retire.
Typical way if you ask
people about their savings--
if you ask them,
they typically say
I want to make sure I
have x in the bank in case
I'm in an accident.
I want to make sure I have
y by the time I retire.
Well, in those models, if
the interest rate goes up,
savings rates go down.
Because after all, to hit a
target with a higher interest
rate, I can save less.
So it's actually
not that surprising
that you'd have
a higher interest
rate leading to less savings.
It's kind of
intuitive, actually.
If people have savings
targets, a higher interest rate
would lead to less savings
because they can get
to their target more easily.
So actually, we don't even
know which way this goes.
It's, I think, one of the
great unsolved mysteries
in economics empirically,
is, once again,
we typically assume--
and with a gun to
my head, I would
say it's probably true that
higher interest rates leads
to more savings.
But the evidence on which
that rests is pretty weak.
And the key point for you is
to understand it's uncertain
and it depends on whether
income and substitution
effects dominate.
Questions about that?
OK.
So now let's step back
and put it all together
and think about you making
your decision about life.
You can think about
your decisions
about your life in three steps.
Step one is you decide
how hard to work.
Step one is you decide, how
much money do I want to make?
Well, that's about
maximizing utility
over consumption and leisure.
Step two is, having decided
how much you're going to make--
and that yields your labor.
Step two is, deciding how
much you're going to make,
you decide, well, how do I
want to spread that over time?
How much do I want to consume
today versus tomorrow?
Well, that's about
intertemporal choice.
That's about deciding
on C1 versus C2,
and that's going to
yield your savings.
Step three is, now that
I know how much I'm
going to consume
each period, now
I want to maximize utility
across all my goods
I might want to
consume-- x2, across all
the goods I want to consume.
That was our original
cookies and pizza example.
So you could think of
it as a hierarchical set
of consumer
optimization problems
that you're going to solve.
Now, you might say,
well, gee, Jon,
that's sort of confusing
because, in fact, the interest
rate and how much am I
saving could determine
how hard I work, right?
Let's say the interest
rate goes way up
and I have a savings target.
I have to work less hard
to hit that savings target.
And I'd say to
you, good for you.
Take more advanced economics.
More advanced
economics, we recognize
this is one integrated whole
and we allow these systems
to affect each other.
But for here, just think of
them as separatable steps,
independent steps.
But in practice,
I hope you can see
the steps will be integrated
and they'll affect each other.
Think of it.
If the price of a good
you really want to buy
goes up a lot, not only will
you buy less of that good;
you might save more to
buy it and work harder.
So you can imagine how
these things are integrated.
But for now, we'll keep
them separable, OK?
Questions about that?
OK.
Next time, we're to
come back and talk
about all the interesting
stuff in capital markets
and how we make decisions
about how much to save
and things like that.
