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PROFESSOR: Today we're
going to continue
discussing firm behavior.
But today we're going to deviate
from our fantasy land
of 14.01 to come to the real
world a little bit which is to
talk a bit about whether firms
actually maximize profits.
The whole presumption of
producer theory is just as we
think with consumer theory,
consumers maximize utility.
Except producers maximize
profits.
That turns out to be an
incredibly useful shorthand
for lots of things.
And it will turn out to be,
as with any simplifying
assumption, largely right and
largely will help us draw a
lot of interesting conclusions
about firms and markets.
Nonetheless, it's clearly
not right in
reality for every firm.
For example, we see lots of
firms doing things which look
pretty wasteful like big
corporate jets or
other things like that.
More relevantly, huge pay for
CEOs seems pretty wasteful.
So, for example, on 2004 the net
income of Eli Lilly, the
drug manufacturer,
fell by 29%.
Yet the CEO got a 41% raise to
to $12.5 million a year.
Or even more so in the financial
crisis, in 2009,
Citigroup and Merrill each lost
more than $27 billion.
It's a pretty bad year
for the financial
sector, you might think.
And yet their CEO's pay in each
company rose by more than
10% to about $15 million.
So in the worst year for the
financial system since 1929,
the CEO pay increased in
these two companies.
So you might think that this
sounds kind of off.
How could we explain that?
Well, there's two possible
explanations.
So one explanation is that
things which look wasteful
really aren't.
That is that we pay CEOs a
huge amount of money, but
they're worth it.
So, for example, even at his
ultimate salary of $33 million
per year, Michael Jordan
was vastly underpaid.
By any reasonable economic
analysis of the value he added
to the Chicago Bulls, it was
well in excess of $50 million.
So even though he was
paid $33 million,
Michael Jordan was underpaid.
Similarly, just because someone
gets paid a lot of
money, doesn't mean that
they're overpaid.
These CEOs are very
talented people.
They may be underpaid.
Now this is an argument you
might have made with a
somewhat straight face maybe
10 or 15 years ago.
It's hard to make that with
a straight face now.
It's hard to believe that these
CEOs of these companies
aren't overpaid given their
company performance and even
the kind of facts we
just talked about.
So a better explanation for
things like excessive CEO pay
is something which we call
the agency problem.
And that's what I want to
emphasize in today's lecture.
In reality, we think of a firm
as something where there's a
guy who's an owner.
He hires some machines
and some workers.
They make stuff that he thought
of, and you produce
it, and some profit is made.
So the model we have in mind
when we talked about the firms
so far in this course is the
model of what we might call a
sole proprietorship
or a partnership.
It's a model where one
individual, where there's
basically a commonality.
The key thing that we've
discussed so far is a
commonality of interest between
the owners who own the
company and the control
of production.
So the people who earn the money
from the company also
control the production.
So when you start your start-ups
when you graduate,
you will start them as a sole
proprietorship or a
partnership where you own the
company, and you control
what's done.
You're there 18 hours a day
making sure the guys are doing
what they're supposed to do.
And you're who gets the money
if they succeed or lose the
money if they fail.
And that's the model we've had
in mind as we've thought about
corporations or firms
so far in our class.
But, in fact, most production
in the US
doesn't happen that way.
Most production in the US
happens through the guise of
corporations.
Corporations are marked
by a separation of
ownership and control.
What defines a corporation
is a separation of
ownership and control.
The owners of corporations are
the stockholders or what we
call the equity holders, people
who have invested money
in the corporation.
So the owners of the corporation
are its investors,
its stockholders, its
equity holders.
All of you, most of you,
probably somewhere--
if you're Jewish, it's in some
Bar Mitzvah gift you got, if
you're not, it's in some other
gift you got-- probably have
some equity ownership in
something somewhere.
OK.
You maybe have a little bond
which says you own five shares
of GM that someone gave you,
because they thought it'd be
cute or whatever.
That's now worthless, but maybe
some other company.
We're equity holders.
We invest in companies.
But we don't make the
production decision.
The production decision is made
by the firm's managers
who are employees of the owners,
the equity holders.
Now these managers may
have some ownership.
And we'll talk about that
in a little bit.
But, by and large, the primary
ownership of the firm is done
by people who do not control
the everyday decisions of
production.
And it sort of makes sense
it has to be that way.
When a company's as big
as Microsoft, you
couldn't have me.
Somewhere, I'm sure if you add
up my various stock funds I
own, I own 0.000000000001%
of Microsoft.
It'd be crazy to have
me involved with a
0.000000000001% of the
decision making.
I don't know anything about
anything that Microsoft does.
It makes sense that there's a
separation of ownership and
control once companies
get big enough.
But the fact that there is a
separation of ownership and
control can lead to this agency
problem and can lead to
firms not maximizing profits.
So, basically, the point is that
managers care not just
about the profits they
make but also how
happy their life is.
And things which make their life
happy may be things which
aren't profit maximizing.
The managers who are in charge
of production may have their
own agenda that deviates from
profit maximization.
And the problem is it may be
hard to figure that out if
you're the owner of the firm.
So the agency problem is the
first example of a problem
we'll talk about later in the
semester of imperfect
information.
This is the first time we'll
see imperfect information.
We've assumed in our class so
far, and we'll assume in our
class going forward that there's
perfect information
the world, that everyone knows
what stuff costs, that
everyone can shop costlessly
across providers, et cetera.
But, in fact, the world
is marked by imperfect
information.
As an owner of Microsoft, as a
trivial owner of Microsoft, I
don't know for sure that every
Microsoft employee is doing
what's profit maximizing
for the company.
I can't.
It's just impossible
for me to own that.
So that creates an
agency problem.
And the agency problem arises
because it's in the employees'
interest, perhaps, to do things
which aren't profit
maximizing.
So so as a simple example,
imagine that you're an
investor in the company that's
a medium-sized company.
And the head of that company is
jealous because all of his
friends at bigger companies have
their own jets, and he's
got to fly commercial.
He says, I want my own jet,
because I'm not cool enough.
There's this great episode of
the Simpsons where Burns goes
to the billionaires club.
And he's in the billionaires
club.
And then eventually his wealth
drops so low he gets thrown
into the millionaires club, and
it's these yokels in the
millionaires club.
He's like, I want to be back
in the billionaires club.
The point is managers of
companies care about how they
look and who they
hang out with.
And you've got this manager of
a medium-sized company who
wants his own private jet.
But he knows that that's
not profit maximizing.
Because he knows that if he
figures out his travel, and
prices it out at competitive
prices, it'll be cheaper to
just travel commercial.
So what does he do?
He puts together a glossy
PowerPoint which he presents
to you, the owner of the
company, showing that
financially it would be more
prudent to own a jet than to
fly commercial.
What he doesn't point out and
put into that PowerPoint is
that in putting together the
commercial prices he used, he
chose the highest rates from
flying from point A to point
B, not the lowest rates.
Now, unless you're an expert
on the cost of flying from
point A to point B, you
won't know that.
You'll say, well, that's
a pretty impressive
presentation.
Yes, you can show you've saved
20% by having your own plane.
Go get it.
But it turned out he
didn't save 20%.
He just cooked the numbers in
a way to make his life nicer
even if it wasn't profit
maximizing.
And that's an example of the
kind of problem that arises
with imperfect information.
And I could go through examples
all the time.
But I think you guys probably
all understand what I'm
talking about, which is there's
lots of ways employees
of companies might make their
lives nicer that aren't profit
maximizing.
Now, corporations have
recognized this from time
immemorial.
And they've recognized that
their owners are too diffuse
to monitor this.
So what corporations do
is they have set up an
intermediary between the owners
and the producers
called the board of directors.
The board of directors is a set
of individuals appointed
by the owners that are supposed
to actually pay
attention to what's going
on in production.
The owners say, look, we can't
afford to pay attention.
But we're going to appoint you,
the board of directors,
and we're going to pay you
quite a lot of money.
A typical director on the
Fortune 500 company will make
$100,000 plus a year.
It's a part-time job.
We appointed you to keep
an eye on the tools of
production.
The problem is the board
of directors aren't
that good at it either.
Because it turns out to be
really hard to figure out
exactly what's going on.
And this is made worse, because
the members of the
board of directors are often
chosen by management of the
company, by the people
running the
production, not by the owners.
So they'll make selections of
who's going to be on the board
of directors.
And they'll pack it with
their friends who
will be nice to them.
So, for example, Richard Grasso
was the CEO of the New
York Stock Exchange.
He started out in the mail
room, worked his way up.
He became CEO of the New York
Stock Exchange and retired
with $187 million severance
package which was outrageous
and totally unearned.
But the board of directors were
a bunch of his buddies
who'd known him since
he was a kid.
And they said, he seems
like a nice guy.
Let's give him a
bunch of money.
And a lot of the board of
directors, when actually
grilled on it, didn't actually
know he'd gotten that much.
They were like, wow.
We didn't realize
his retirement
package was that big.
So it turns out having the board
of directors does not
solve the agency problem.
Because there's still too much
of an information imperfection
between the managers and the
board of directors, not to
mention the managers
and the owners.
So what do we do?
What do we do with this
agency problem?
Well, this was known
for a lot of years.
And about 25 years ago, the
thinking was, look, the way to
solve this problem is we need to
align the incentives of the
managers and the owners.
If we're going to solve this
problem, we need to get the
managers, the producers, to
actually care about maximizing
profits enough that they'll do
that even if it makes their
life a little uncomfortable.
And how do we do that?
We turn the managers
into owners.
We give the managers, the
producers, an ownership stake
in the company.
We say look, your income is
going to be directly derived
from the profitability
of this company.
So now you'll have a direct
incentive to do what's profit
maximizing even if it makes
your life a little
uncomfortable.
Even if it means flying
commercial, you recognize if I
have my own jet, then
I'm going to suffer.
So you align the incentives.
So we want to give
them an ownership
stake in the company.
Well, how do you do that?
How do you give managers
an ownership stake?
Well, there's two ways
you can do it.
One way is you can directly
give them stock.
So you can directly say, look,
instead of paying you in cash,
we are going to pay you
in company stock.
So your fortunes will directly
be tied to the performance of
this company if you
pay them in stock.
Or, alternatively, you can do
something which turns out to
be cheaper.
You can give them
stock options.
It turns out to be cheaper,
at least, in principle.
We can give them
stock options.
So let's talk about what
a stock option is.
And some of you may deal with
these along the way.
A stock is a piece of paper
which says you only 0.00001%
of the company.
A stock option is simply a piece
of paper which says we
are granting you the right to
buy the stock at some price.
Typically, it's today's price.
We're not giving you a
share of the company.
You have a piece of paper which
says if the value of
stock today is $100, you have a
piece of paper which says no
matter where the stock
ends up, you can
always buy it for $100.
Why is that valuable?
Well, that's valuable because
let's say you give a CEO of a
company a million options at
$100 each when the price of
the stock is $100.
Well, if the price of the stock
rises to $150, that CEO
can then take his million
options, say, I want to buy
the shares for 100, which I'm
allowed to by these pieces of
paper, and I'll turn around
and sell them for $150.
I've just made $50 million.
So a stock option is valuable
if the stock goes up.
But it's worthless if
the stock goes down.
So it's kind of the ultimate
incentive, if
you think about it.
Because what it says to the CEO
is, look, we're going to
incent you to do better.
And you make a lot of money
by doing better.
But if you do worse, you're
not going to get anything.
And as myself as the owner
it seems great,
because it's cheaper.
Because if the stock goes up,
I share some with the guy.
But I don't care.
I'm happy.
The stock goes up.
If it goes down, I don't have
to give him anything.
And, in fact, giving someone
a stock option costs,
effectively, about half as much
as giving them stock.
So if I say today's stock price,
if I instead of giving
you a share of stock, I give you
an option to buy a share
of stock at today's price, the
value to that, what it costs
me in the market is about half
of what it costs when I
actually give you the
share of stock.
So it seems like
the best deal.
You get all the incentives for
them to raise the price, but
it costs you half as much.
And, in fact, there's been
tremendous growth in use of
stock and stock options.
So if you look at Figure 12-1,
now, this sort of changes.
Before 1992, there's only
two categories.
And after '92, there's three.
So before '92, we just have to
divide into salary and bonus
versus options.
So you see there was essentially
no options in '84.
This is the mean CEO pay.
So the typical CEO in 1984 made
$500,000, and it was all
cash, all salary and bonus.
By 1992, they made about $1
million, and a decent share of
it started to be
stock options.
Now, starting after '92, we
actually break into three
categories which is salary,
bonus, and options.
But that doesn't
really matter.
The main thing is to pay
attention to the option share,
which you see grew
astronomically.
And so by its peak, in about
2002, first of all, the
typical CEO was making
$3.5 million.
Second of all, the majority of
that was in stock options.
In fact, if you look at salary
and bonus, it didn't grow that
much over time.
If you look at 1992 versus 2002,
over that decade, salary
and bonus barely grew, but
options went through the roof.
So there's a huge increase
in use of these.
And the motivation is pretty
basic economic intuition.
What we're going to do is this
is a cheap way to align the
incentives of owners
and managers.
And that was why
they took off.
And everyone thought
it was great.
And people like Michael Jensen
at Harvard Business School
made fortunes off having
suggested this, et cetera.
It was like we solved
the problem.
And, remember, we did pretty
damn well in the 1990s.
And a lot of it, people
attributed it to exactly
what's in this graph.
That by finally figuring out how
to align the incentives of
producers and owners, we'd
figured out a way to change
the economy.
And people thought we sort of
entered this new economic era
of massive productivity.
Well people, as we know
now, were wrong.
Things slowed down in the
2000s and then now have
completely crashed.
And why were they wrong?
Well, they're wrong because what
makes economics fun is
unintended consequences.
And these stock options had
two kinds of unintended
consequences.
The first unintended consequence
is that they lead
to excessive gambling.
And what I mean by that is that
once your stock option is
out of the money, once, if
you've got it for 100,
you're below 100.
You don't care how
low it goes.
If you're at 99 or 20,
you don't care.
All we care about is being
100 verses above.
What that means is as an owner,
as a manager, you'll
take excessive risks to go into
the positive territory.
Even if there's a huge
risk you'll get
nailed on the downside.
Contrast to guys working
for a company that's
currently worth $100.
One is given stock, and one is
given stock options at $100.
Imagine they're both going to
leave the company in one year.
Because there's dynamics with
the long run issues.
Let's put that aside.
They're both going to
leave in one year.
One today is given a share of
stock, and one today is given
an option to buy at $100.
And then they're given the
choice of a risky investment.
Someone comes to them
and says, have I
got a deal for you.
I've got an investment that
has a 10% chance it will
double the value of your company
and a 90% chance the
value of your company
will fall by 20%.
So there's a 10% chance of a
100% return and a 90% chance
of a 20% decline in your
company's value.
Now, what is the profit
maximizing thing
to do in this situation?
Well, to do that, we have to
consider the concept of what
delivers the company the
highest expected value.
Expected value is a concept
we'll use-- and we'll come
back to this later when we
talk about uncertainty--
it's a concept we use to measure
how you value things
when there's uncertainty.
So the expected value of a
gamble is the probability that
you win times the value if you
win plus the probability that
you lose times the value
if you lose.
That's the expected
value of a gamble.
And the profit maximizing thing
to do would be to take
gambles of expected values
of greater than zero.
The expected value is
the summation of the
value of that gamble.
This gamble has an expected
value of 0.1 times 100--
100% return and a 10% chance--
plus 0.9 times negative 20--
a 90% of losing 20-- or an
expected value of minus 8%.
That is if you take this gamble,
and you took it an
infinite number of times,
you would end up
losing 8% on average.
Any one time might work out.
But by the law of large numbers,
if we took this
enough times, you'd lose
8% on average.
So you will lower the value
of your company.
You will reduce profits
by taking this gamble.
Your company is worse off
if you take this gamble.
Well, what would the person who
got the $100 in stocks do?
They won't take the gamble.
Because their $100 in stock will
be worth, on average, 8%
less if they take this gamble.
So I'm not taking the gamble.
This is stupid.
But now let's look at the
guy who got the option.
His gamble is a little
bit different.
Because he doesn't care whether
the value of the
company is 99 or 80.
He just cares about how much
it goes above 100.
So what is his calculation?
Well, his calculation is he
has a 10% chance of making
100% and a 90% chance of what?
Zero, ending up with zero.
He can't lose.
He has a 90% chance of zero.
So what is his calculation?
Well, he uses the positive
10% gamble.
He makes money on this gamble,
because head he wins, tails he
walks away.
The guy who owns the stock loses
if it's tails with this
weighted coin that only hits
heads 10% of the time.
This guy only wins.
So he says, sure.
Any gamble which has a huge
upside, I'm going to take.
Because I get all the upside,
and I don't bear the downside.
So what this does is it leads
to excessive gambling,
excessive risk taking.
And that's exactly what we saw
in economy, was companies
gambling on things which sounded
very good, managers
gambling on things which sounded
very good, some of
which worked out very well
and some of which didn't.
And that's the first problem
we have with the
use of stock options.
And questions about that?
Yeah.
AUDIENCE: What about using a
package of options like a
number of stock options
[INAUDIBLE PHRASE]
package of stock options
[INAUDIBLE PHRASE].
PROFESSOR: Certainly there are
more sophisticated ways you
can do that.
I mean, there's certainly
more sophisticated
ways you can do that.
But that's a great segue to the
second problem with these.
The second problem is who
decided the structure of the
stock options?
The managers.
So the managers had executive
compensation committees that
designed the stock options
the managers got.
So the second problem
was there was
just outright cheating.
So what you just described would
be a great structure
which would incentivize them
maximally, but it would not
make them the most money.
So the second problem we had
was outright cheating.
So there's a wonderful
investigation by the Wall
Street Journal that investigated
a whole list of
stock option arrangements.
And what they found was
companies would frequently do
what's called backdating
stock options.
What they'd say is, look, the
value of the company just went
up from $100 to $15 last week.
We're going to give you
an option at $100.
And let's pretend it was issued
before the company
value went up.
We've just given you money.
You haven't done anything
to earn that.
We've just given you money.
And the Wall Street Journal
found incredible evidence of
backdating stock options.
So they had one CEO.
They Yeah, I'm sorry.
AUDIENCE: Is the company
paying the money?
I thought it was like the
market who gives it.
PROFESSOR: The owners are paying
the money, the owners.
AUDIENCE: People who are
buying the stock are
exercising the option to.
PROFESSOR: No.
But here's the thing.
When I gave it to you, then,
basically, I gave you
something of value.
I have to pay for that
thing of value.
Now, ultimately,
the transaction
happens in the market.
But, basically, in other words,
I give you this option
to buy the stock at $100.
This is an important point that
I wasn't clear enough on.
I give you an option to
buy a stock at $100.
The stock is now worth $150.
That means that stock I could
have had at $150 as an owner.
And it's worth $150.
But by letting you take it at
$100, I let you keep the extra
$50 instead of me getting it.
I have a share of stock
which [INAUDIBLE]
$150.
I've given that to you.
I've, essentially, transferred
to you $150.
AUDIENCE: So when companies
[INAUDIBLE PHRASE].
PROFESSOR: They'll keep
some amount of shares.
The owners, they
will sell stock
and they'll do offerings.
But the owners own the majority
of the stock.
That's what makes
them the owners.
Maybe that's the right
way to put it.
AUDIENCE: [INAUDIBLE PHRASE].
PROFESSOR: No.
Well, in principle, the board
of directors approves stock.
They don't decide.
An executive management
committee decides.
The executive management
committee consists of all the
golf buddies of the CEO.
They decide.
The board of directors is
supposed to make sure nothing
untoward happens.
The board of directors, they're
just a bunch of
retired former executives
who are also golf
buddies of the manager.
So they don't really
get it right.
So there's outright cheating.
So, for instance, one CEO,
he got six stock options.
Each one happened to be issued,
happened to be issued
the day before-- at least on
paper-- was issued the day
before a huge increase
in the stock price.
Now, the CEO said he
was just lucky.
But the Wall Street Journal
did a simulation and
calculated that there's a 1 in
1 billion chance he could've
been that lucky.
That, in fact, what clearly
happened was he got the stock
options later, and they were
backdated to make it seem like
he got them before the
price went up.
But that's not the
best example.
The best example
is Cablevision.
They granted and backdated
options to their vice chairman
from 1997 to 2002.
So from 1997 to 2002, they gave
them options and they
kept backdating them to
make them look good.
The only problem was that
he died in 1999.
So, basically, they were just
giving money away to this
guy's heirs.
Clearly they weren't
incentivizing his performance.
As the quote said, trying to
incentivize a corpse suggests
they were not complying with
the spirit of shareholder
approved stock option plans.
They were just giving money to
his heirs, because they felt
bad for him, because they
weren't keeping their yacht up
or whatever.
So, basically, this is an
example of a kind of cheating.
Of course, then you can
go further, and
there's outright fraud.
The backdating is sort
of cheating.
You can go even further.
I don't know what determines
fraud versus cheating.
You can just do what
Enron did.
What Enron did is the executives
there just lied
about how much money
they were making.
They just went public with
figures that were wrong.
The stock price went up.
They cashed in their
options and quit.
And as long as you don't get
caught, that's a great deal.
And if you do get caught, well,
they fine you for 1/3 of
what you made.
So who cares?
So basically it was
outright fraud.
And this was a lot
of what happened.
A lot of the wealth that we
thought was created in the
1990s in the stock market was
really just false wealth
created by people saying their
company's were worth more than
they actually were.
Yeah.
AUDIENCE: Who decides the salary
[INAUDIBLE PHRASE].
PROFESSOR: No.
I mean, once again, it varies
by company to company.
But, basically, the dividend
payout would be something that
a different set of managers
would decide, once again,
subject to approval
of the owners.
But, once again, the point is
that the owners of a company,
of a big company, are just a
diffuse set of people who
don't know what they're doing.
The managers know exactly
what they're doing.
The board of directors is in
between and is half clueless,
half knows what it's doing.
And that's what leads to
the agency problem.
What's so interesting about
this example is it sort of
points out, like in many things
in economics, why we're
called the dismal science.
There is no right answer here.
On the one hand, if you don't
incentivize your owners, then
they might not do what's
profit maximizing.
On the other hand, if they
incentivize your owners, they
might do cheating to maximize
their profits as opposed to
the company's profits.
And that's why you need
complicated structures, the
type that was suggested
in the back.
And that's why, for example,
they find that companies with
much more concentrated
ownership, the ones that
Warren Buffett owns 20% of, they
do a much better job in
their CEO compensation than
the ones where it's just a
bunch of people owning
a tiny, tiny percent.
So that's exactly the kind of
difficulty you face in setting
up executive compensation.
Now, this was a real departure
from the kind of things we
talked about, just
one example.
Partly what we want to do in
this course, I want to teach
you about basic economics.
I partly want to excite you
about what else you can go on
and do in economics.
What I've just done in the last
half hour is a microcosm
of the field of corporate
finance.
There's an entire field
in economics
called corporate finance.
We teach it in course 15.
And it's a terrific course.
15.401 and 15.402 are the
introductory courses.
And if you find this stuff
exciting, as I'm sensing some
of you are, that's a great
place to take what we're
learning in this course and go
on and actually dive in.
Realize that half the stuff
I've told you, I'm
talking out of my ass.
I don't really know for sure.
But those guys do
in course 15.
And you can really get into
these agency relationships and
understand our corporations work
and how you set up these
kinds of compensation
arrangements.
So this is kind of just
a very exciting area.
Now, we're going to go back
after this and assume
corporations maximize
profits again.
And, once again, as with any
assumption we make, by and
large, it's right.
And by and large it will deliver
the kind of important
knowledge that we need to know
about how firms function.
But it's important to remember
that these kinds of
things are behind it.
What we do in this course
is teach you the basics.
Then you go on in these other
electives and actually learn
about this kind of more
interesting tweaks
and what we do here.
And other questions about
this before I move on?
OK.
Now we're going to stop with
that topic, and we're going to
move to sort of an
in between topic.
That is, we've been talking
about firms and firm profit
maximization.
And we talked about how that
depends on the structure of
the market and perfect
competition.
Starting in two lectures, we're
going to start talking
about alternative market
structures like
monopoly and oligopoly.
But in order to talk about them,
we need to introduce a
new concept we haven't
used before.
And that's what we'll
do the rest of this
lecture and next lecture.
We need to move from positive
economics to normative
economics, from positive
economics to normative.
Positive analysis is the study
of the way things are.
So positive analysis is
explaining why do firms
produce this many widgets?
Why do they hire this
many workers?
Why did I buy this many CDs?
That's a positive analysis,
trying to explain the way
things are.
That's what we've done,
by and large, so far.
Normative analysis is the
analysis of the way
things should be.
Is it good that I bought
that many CDs?
Is it good that the company
made that much profits?
Would be better if we have a
minimum wage or don't have a
minimum wage?
Normative analysis is the
analysis of the way things
should be as opposed to
the way they are.
So, for example, we showed in
the last lecture that in the
long run, with free entry and
exit, all firms are driven to
zero profit, and the supply
curve is horizontal.
Well, is that a good thing?
We don't know.
We just said it happened.
I described why it happened.
But I didn't tell you
if it was a good
thing or a bad thing.
Zero profits, I make a lot of
money off the profits that the
companies I own make.
I don't know if I want to
work with zero profits.
I've got a lot of
stock and stuff.
And I'm making money because
these companies make profits.
I don't think I'd
be that happy to
work with zero profits.
How do we think about whether
that's a good
world or a bad world?
How do we think about whether
we like these outcomes or
don't like them?
These are the tools of normative
economics or what we
will refer to as welfare
economics.
Now, let me be clear here.
The term welfare, as you might
have heard it, often refers to
money you give to low
income populations.
And we'll talk about that
kind of welfare
later in the semester.
Here, when I say welfare,
I mean well-being.
Welfare is the term economists
use as the measure of
well-being.
We need to start talking about
welfare economics, measuring
the impact of economic outcomes
on well-being, not
just studying what happens when
firms maximize profits or
consumers maximize utility,
but measuring how we feel
about it, measuring whether
it's good or bad, and
measuring whether some
outcomes might be
preferred to others.
Because if we don't do that, we
can't ever talk about the
role of the government
in the economy.
Until you start talking about
welfare, you can't talk about
whether we should
have government
interventions or not.
You can only talk about
what happens, not
whether it should happen.
Now, the problem of welfare
economics is that it's a lot
harder because of something
I mentioned when we
talked about utility.
Utility is an ordinal concept,
not a cardinal concept.
Utility is an ordinal concept,
not a cardinal concept.
That is, utils are
meaningless.
We use utility functions to
decide whether you prefer
package A or package B. But the
actual amount of utils you
get, unlike profits, is sort
of a meaningless concept.
It's just sort of an index.
So what we do to do welfare
economics is we turn from
utils to dollars.
We measure welfare in dollars
which is easy on
the corporate side.
That's profits.
How do we do it on the
consumer side?
We do it through the concept
that we call compensating
variation, which is one of these
things where economists
use fancy terms for something
which isn't that hard to
understand.
But you need to know the fancy
terms, because that's kind of
how we teach, compensating
variation.
That is instead of asking, how
sad are you about outcome x,
we ask, how many dollars
would it take?
Instead of asking, how sad would
you be to not have a CD,
we ask, how much would
you pay to avoid
being in that situation?
So instead of asking, how sad
are you that you end up with
this car instead of that car,
we don't want to measure the
utils of driving a Hyundai
versus a Lexus.
We can't measure those.
What we can ask, is how much
more will you pay to get the
Lexus than the Hyundai?
And that's $1 measure
of your utils.
That's a compensating
variation.
How much do you have
to be compensated?
So, in other words, instead of
asking you how sad are you
that you couldn't get tickets
to a Lady Gaga concert--
maybe that's not a good example
because no one's sad
about that.
But let's say you were.
Let's say I am because my
daughter wants to see her.
How sad are you?
I ask, instead, how much would
you pay to get the tickets to
the Lady Gaga concert?
That's a measure of how
sad you were you
couldn't get them.
Because you'll pay an amount to
compensate yourself for the
sadness of not getting them.
So it's a way of turning
utils into dollars.
And that leads to the concept
that we'll refer to throughout
the semester.
That leads to the concept
of consumer surplus.
Consumer surplus measures the
benefit that a consumer gets
from consuming a good above
and beyond what they
paid for the good.
So it's the benefit of
consumption beyond the price.
So your consumer surplus--
surplus means extra--
is how much you enjoy consuming
something above and
beyond what you had
to pay for it.
In other words, the idea is if
you have to pay exactly as
much as you'd enjoy the good,
there's no consumer surplus.
So let's do an example.
So consider my demand to
buy a Lady Gaga CD.
I've got to update
my examples.
You guys don't buy
CDs anymore.
How many of you have bought
a CD in the last year?
Wow.
OK, let me ask another
question,
just one for the record.
Just because I have to decide
how hard a time to give my
16-year-old son.
How many of you typically
pay when you buy a song?
Wow.
OK.
Let me ask another one.
How many of you typically don't
pay when you buy a song.
Well, when you get a song, when
you download a song, you
know what I mean, when
you download a song.
So the majority of you don't pay
when you download a song.
Interesting.
OK.
I'll update this next year.
But, for now, we're still
10 years ago.
Consider my demand for
Lady Gaga CDs.
I'm trying to decide whether
to buy the marginal CD.
And let's say that it's
worth $15 to me.
I'd be willing to pay $15
for the Lady Gaga CD.
And let's say the
price is $15.
In that case, there's
no surplus to me.
There's nothing extra.
I've paid what I was
willing to pay.
So that's a case of a zero
consumer surplus.
The consumer surplus is how
much extra I got from
consuming it.
I've got no extra.
It was worth $15.
I paid $15, no surplus.
Now let's say that the
price was $10.
Then I've got a surplus.
I've got $5 in surplus.
I was willing to pay $15.
It makes me $15 happier to
have this Lady Gaga CD.
But I only had to
pay $10 for it.
So I've derived some surplus.
Well, how do we know what
people's willingness to pay
for a good is?
The demand curve.
That's the definition
of the demand curve.
The demand curve measures
your willingness to pay.
So let's go to the
second figure.
Think about the demand
curve for CDs.
There's some demand
curve for CDs.
What this measures is the
utility maximizing choice.
Every point in this demand curve
represents my utility
maximizing choice
at that price.
This is backwards.
That should be a $15 on the
y-axis and a $5 on the x-axis,
Sorry, guys.
It should be $15 on
the y-axis and a--
no.
Wait, hold on one second.
Time out.
At $5, I get no consumer
surplus.
Yeah, this graph is
kind of messed up.
Let me draw a new one here.
So you've got my demand
curve for CDs.
You've got the quantity
and the price.
And I've got some utility
function that delivers this
demand curve.
And let's say the way this
works, this demand curve for
CDs, let's say the way this
works is that I am
willing to buy 1 CD.
I'm willing to buy if the
price is $20, I'm
willing to buy 1 CD.
So at a price of $20, I'm
willing to buy 1 CD.
So if I get that 1 CD at $20,
then basically that's my
willingness to pay.
It equals a price, so there's
no consumer surplus.
Really imagine it's right
next to that y-axis.
Now let's the price
falls to $15.
Sorry.
That's a 1.
That's the 1.
That's a 20.
At a price of $20, I'm
willing to buy 1.
At a price of $15, I'm
willing to buy 5.
I'm willing to buy 5 CDs.
Now, what is my consumer
surplus?
Well, let's ask.
For the first CD, I got
no consumer surplus.
But for the second, I
was willing to pay.
When the price was $20, I
got no consumer surplus.
Now let's say the
price is $15.
So what was I willing to
pay for the first CD?
$20.
So what's my consumer surplus
on the first CD?
5.
So on that first CD, I got
a consumer surplus of 5.
The second CD, I was willing to
pay less because I've got
diminishing marginal utility.
But I was still willing
to pay more than $15.
So I've got some
surplus there.
Third CD here, et cetera.
But on the fifth CD, I derive
no surplus, because I was
willing to pay $15 for that
fifth CD, and I paid $15 for
that fifth CD.
What that means is that all of
this is my consumer surplus.
Because on every unit, because
I paid a fixed price of $15,
and for my fifth CD, that
delivered no surplus, that was
indifferent.
But in my first through fourth
CDs, that made me very happy.
Because I was willing to pay
more than $15 for those.
So my consumer surplus is the
amount by which I derive
utility above what
I was willing to
pay, above the price--
I'm sorry-- the amount
that I was willing to
pay about the price.
The amount I'm willing to pay is
every point on this curve.
So anything I buy that I was
willing to pay more for the
price for, I derived
surplus on.
So this becomes my
consumer surplus.
So, basically, consumer surplus
is the area under the
demand curve above the price.
So, graphically, consumer
surplus is going to be the
area under the demand curve
above the price.
Intuitively, why is that?
Intuitively, what's going on is
that every unit above the
price under the demand curve
are units which I valued
higher than the price.
So I get surplus on them.
OK.
Question?
Yeah.
AUDIENCE: If you're
[UNINTELLIGIBLE] this, would
you start at zero?
PROFESSOR: Yeah.
Really, in some sense, you'd
want to start at zero.
It's really the integral
of this whole area.
The problem is it's discrete.
I should have a stepwise
curve here.
I made it discrete.
But, really, it's the integral
of this area.
Yeah.
AUDIENCE: [INAUDIBLE PHRASE].
upward sloping demand curve?
PROFESSOR: I'm sorry.
AUDIENCE: With an upward
sloping demand curve.
PROFESSOR: With an upward
sloping demand curve, well, as
I said, we don't believe
in Giffen goods.
We think they are a fantasy.
So with an upward sloping
demand curve,
how would that work?
So an upward sloping demand
curve, then that would say
that if the price is here, then
you'd have an infinite
consumer surplus.
It wouldn't be well-defined.
It wouldn't be well-defined.
So I don't know how
you'd do that.
That's why we don't like upward
sloping demand curves.
Yeah.
Question?
No?
OK.
So, basically, what you end up
with is this consumer surplus
concept which, basically, as
pointed out mathematically, is
the integral of this area.
But we're not going to
make you integrate.
It's basically this triangle
which is basically all the
units above the price, all the
units for which you're willing
to pay more than the price.
And you get consumer surplus
on every unit you buy up to
the point where your
willingness to
pay equals the price.
And that's our normative
measure of welfare.
That's our normative measure
of how happy you are.
And the key that drives this is
diminishing marginal utility.
That's why we don't like upward
sloping demand curves.
What drives this is diminishing
marginal utility.
It's that with each additional
unit I'm willing to pay less
and less for.
So I'm going to get less and
less surplus off each
additional unit I buy.
And that's going to
be the key thing.
The key intuition that you guys
have to remember is that
the last unit that I'm willing
to buy at that price, by
definition, I get no surplus
on, or I get a $0.001 of
surplus on.
Because if I've got a lot of
surplus, I'd buy 1 more.
So, by definition, the marginal
unit is the one where
surplus is driven to 0.
And units before that are the
ones with positive surplus.
And that's why an important
intuition to have is the
amount of surplus you're going
to get from a purchase is
going to be about how far away
from the price point you are.
Those first units are going
to give you more surplus.
And that's going to dwindle as
you get to the actual last
unit you buy at that price.
Any questions about that?
OK.
Let me stop there.
We will come back next time, and
we're going to spend the
whole lecture talking about
welfare economics, we'll
introduce producer surplus,
and talk about how we then
think about whether changes
are good or bad.
