Keynes vs. Hayek: Late Economists Hip-Hop Legacy | PBS NewsHour | Dec. 16, 2009 | PBS.

A major theme of both the AP and IB Economics courses is the long-running debate between the Keynesian, demand-side theories of macroeconomic policy and those of the Classical, supply-side school. Today’s “Great Recession” has revived this debate, which itself dates back to the Great Depression of the 1930′s, when an Englishman and an Austrian could be found at the ideological centers of two different philosophies of the role government should play in the macroeconomy.

John Maynard Keynes and Friedrich Hayek were close friends whose views on government’s role differed greatly. Hayek was a classical, laissez faire libertarian who believed that any intervention by government in a nation’s economy disrupted the efficient functioning of the free market and threatened to stifle private enterprise. Keynes, the father, of course, of modern Keynesian economics, believed that free markets left unchecked were vulnerable to the volotile animal spirits of investors and speculators whose often irrational behaviors could create externalities such as unemployment and credit crunches, thereby harming society as a whole.

Paul Solman of PBS (who I recently met at an Economics teachers conference in Washington DC) interviews a modern Keynesian, Robert Skidelsky (Keynes’ biographer) and a neo-classical economist, Russ Roberts (who I also recently met in Richmond, VA).

What makes oligopolistic markets, which are characterized by a few large firms, so different from the other market structures we study in Microeconomics? Unlike in more competitive markets in which firms are of much smaller size and one firm’s behavior has little or no effect on its competitors, an oligopolist that decides to lower its prices, change its output, expand into a new market, offer new services, or adverstise, will have powerful and consequential effects on the profitability of its competitors. For this reason, firms in oligopolistic markets are always considering the behavior of their competitors when making their own economic decisions.

To understand the behavior of non-collusive oligopolists (non-collusive meaning a few firms that do NOT cooperate on output and price), economists have employed a mathematical tool called Game Theory. The assumption is that large firms in competition will behave similarly to individual players in a game such as poker. Firms, which are the “players” will make “moves” (referring to economic decisions such as whether or not to advertise, whether to offer discounts or certain services, make particular changes to their products, charge a high or low price, or any other of a number of economic actions) based on the predicted behavior of their competitors.

If a large firm competing with other large firms understands the various “payoffs” (referring to the profits or losses that will result from a particular economic decision made by itself and its competitors) then it will be better able to make a rational, profit-maximizing (or loss minimizing) decision based on the likely actions of its competitors. The outcome of such a situation, or game, can be predicted using payoff matrixes. Below is an illustration of a game between two coffee shops competing in a small town.

In the game above, both SF Coffee and Starbuck have what is called a dominant strategy. Regardless of what its competitor does, both companies would maximize their outcome by advertising. If SF coffee were to not advertise, Starbucks will earn more profits ($20 vs $10) by advertising. If SF coffee were to advertise, Starbucks will earn more profits ($12 vs $10) by advertising. The payoffs are the same given both options for SF Coffee. Since both firms will do best by advertising given the behavior of its competitor, both firms will advertise. Clearly, the total profits earned are less when both firms advertise than if they both did NOT advertise, but such an outcome is unstable because the incentive for both firms would be to advertise. We say that advertise/advertise is a “Nash Equilibrium” since neither firm has an incentive to vary its strategy at this point, since less profits will be earned by the firm that stops advertising.

As illustrated above, the tools of Game Theory, including the “payoff matrix”, can prove helpful to firms deciding how to respond to particular actions by their competitors in oligopolistic markets. Of course, in the real world there are often more than two firms in competition in a particular market, and the decisions that they must make include more than simply to advertise or not. Much more complicated, multi-player games with several possible “moves” have also been developed and used to help make tough economic decisions a little easier in the world of competition.

Game theory as a mathematical tool can be applied in realms beyond oligopoly behavior in Economics.  In each of the videos below, game theory can be applied to predict the behavior of different “players”. None of the videos portray a Microeconomic scenario like the one above, but in each case a payoff matrix can be created and behavior can be predicted based on an analysis of the incentives given the player’s possible behaviors.

Assignment: Watch each of the five videos below. For each one, create a payoff matrix showing the possible “plays” and the possible “payoffs” of the game portrayed in the video. Predict the outcome of each game based on your understanding of incentives and the assumption that humans act rationally and in their own self-interest.

“Batman – the Dark Night” – the Joker’s ferry game: the

“Princess Bride” – where’s the poison?:

“Murder by Numbers” – the interrogation:

“Golden Balls” – split or steal:

“The Trap” – the delicate balance of terror:

Discussion Questions:

1. Why is oligopoly behavior more like a game of poker than the behavior of firms in more competitive markets?
2. What does it mean that firms in oligopolistic markets are “inter-dependent” of one another?
3. Among the videos above, which games ended in the way that your payoff matrix and understanding of human behavior and rational decision making would have predicted?
4. How often did the equilibrium outcomes according to your analysis of the payoff matrices correspond with the socially optimal outcome (i.e. the one where total payoffs for all players are maximized or the total losses minimized)?

Competitively Priced Electricity Costs More, Studies Show – New York Times

The problem with monopolies, as our AP students have learned, is that a monopolistic firm, left to its own accord, will most likely choose to produce at an output level that is much lower and provide their product at a price that is much higher than would result from a purely competitive industry. A monopolist will produce where its price is greater than its marginal cost, indicating an under-allocation of resources towards the product. By restricting output and raising its price, the monopolist is assured maximum profits, but at the cost to society of less overall consumer surplus or welfare.

Unfortunately, in some industries, because of the wide range of output over which economies of scale are experienced, it sometimes makes the most sense for only one firm to participate. Such markets are called “natural monopolies” and some examples are cable television, utilities, natural gas, and other industries that have large economies of scale. (click graph to see full-sized)

Government regulators face a dilemma in dealing with natural monopolistic industries such as the electricity industry. A electricity company with a monopoly in a particular market will base its price and output decision on the profit maximization rule that all unregulated firms will; they’ll produce at the level where their marginal revenue is equal to their marginal cost. The problem is, for a monopolist its marginal revenue is less than the price it has to charge, which means that at the profit maximizing level of output (where MR=MC), marginal cost will be less than price: evidence of allocative inefficiency (i.e. not enough electricity will be produced and the price will be too high for some consumers to afford).

Here arises the need for government regulation. A government concerned with getting the right amount of electricity to the right number of people (allocative efficiency) may choose to set a price ceiling for electricity at the level where the price equals the firm’s marginal cost. This, however, will likely be below the firm’s average total cost (remember, ATC declines over a WIDE RANGE of output), a scenario which would result in losses for the firm, and may lead it to shut down altogether. So what most governments have done in the past is set a price ceiling where the price is equal to the firm’s average total cost, meaning the firm will “break even”, earning only a “normal profit”; essentially just enough to keep the firm in business; this is known as the “fair-return price”.

Below AP Economics teacher Jacob Clifford illustrates and explains this regulatory dilemma. Watch the video and see how he shows the effect of the two price control options on the firm’s output and the price in the market.

The article above examines the differences in the price of electricity in states which regulate their electricity prices and states that have adopted “market” or unregulated pricing, in which firms are free to produce at the MR=MC level:

“The difference in prices charged to industrial companies in market states compared with those in regulated ones nearly tripled from 1999 to last July, according to the analysis of Energy Department data by Marilyn Showalter, who runs Power in the Public Interest, a group that favors traditional rate regulation.

The price spread grew from 1.09 cents per kilowatt-hour to 3.09 cents, her analysis showed. It also showed that in 2006 alone industrial customers paid $7.2 billion more for electricity in market states than if they had paid the average prices in regulated states.”

The idea of deregulation of electricity markets was that removing price ceilings would lead to greater economic profits for the firms, which would subsequently attract new firms into the market. More competitive markets should then drive prices down towards the socially-optimal price, benefiting consumers and producers by forcing them to be more productively efficient in order to compete (remember “Economic Darwinism”?). It appears, however, that higher prices have not, as hoped, led to lower prices:

“Since 1999, prices for industrial customers in deregulated states have risen from 18 percent above the national average to 37 percent above,” said Mrs. Showalter, an energy lawyer and former Washington State utility regulator.

In regulated states, prices fell from 7 percent below the national average to 12 percent below, she calculated…

In market states, electricity customers of all kinds, from homeowners to electricity-hungry aluminum plants, pay $48 billion more each year for power than they would have paid in states with the traditional system of government boards setting electric rates…”

That $48 billion represents higher costs of production for other firms that require large inputs of energy in their own production, higher electricity bills for cash-strapped households, and greater profits and shareholder dividends for the powerful firms that provide the power. On the bright side, higher prices for electricity should lead to more careful and conservative use of power, reducing Americans’ impact on global warming (since the vast majority of the country’s power is generated using fossil fuels).

Here arises another question? Should we be opposed to higher profits for powerful electricity firms if their profits result in much needed energy conservation and a reduction in greenhouse gas emissions? An environmental economist might argue that if customers are to pay higher prices for their energy, it might as well be in the form of a carbon tax, which rather than increasing profits for a monopolistic firm would generate revenue for the government. In theory tax revenue could be used to subsidize or otherwise promote the development and use of “green energies”.

Whether customers paying higher prices for traditionally under-priced electricity is a good or bad thing depends on your views of conservation. But whether higher profits for a powerful electricity company are more desirable than increased tax revenue for the government are beneficial for society or not seems clear. If we’re paying higher prices, the resulting revenue is more likely to be put towards socially desirable uses if it’s in the government’s hands rather than in the pockets of shareholders of fossil fuel burning electricity monopolies.

Discussion Questions:

1. Why do governments regulate the prices in industries such as natural gas and electricity?
2. Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?

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Essential Question: How does economic development differ from economic growth?

Objective: Whereas most assignments deal in information and analysis, this one deals in imagination. Here we ask you to portray what you believe more economically developed countries look like. And considering that development is a relative term, we also want to see how a country could end up if it only achieves economic growth, without any progress on development.

Goal: To visualize and depict the distinction between economic development and economic growth.

Process:

As you and your partner gather images online, keep in mind the definitions of growth and development. Images should portray these definitions in a creative way.

YouTube - ACDCLeadership’s Channel

More econ review videos from my new favorite YouTube channel, Jacob Clifford’s Econ Concepts in 60 Seconds.

To review for the upcoming test, you will join a small group and watch one of the four videos on the Perfect Competition. After watching and discussing one video with your group, you will be re-assigned to another group with students who watched a different video. You will then lead a short discussion on your original video with your new group.

With your first group – 15 minutes: As your group watches its assigned video, have your notes open in front of you and draw the graphs Mr. Clifford draws along with him. Pause the video where necessary to have time to draw graphs. Take notes while watching the video so you can teach it to another group. With your group, prepare a short discussion of the video’s main points, including:

• What rule or lesson about Perfect Competition does the video focus on?
• What did you already know that this video reminded you of or reinforced your understanding of?
• What did this video introduce that was new to you?
• How were graphs used to teach the concepts?

With your second group – 20 minutes: For the second part of this assignment, there should be four new groups, each including one member of the four original groups.

• Each group member should lead a 2-3 minute discussion of the video he or she watched in the first group.
• Go over each of the discussion points from above.
• Answer any questions your new group members have about video you watched.

Group 1 - The Profit Maximization Rule – MR=MC:

Group 2 - Perfect Competition in the short-run:

Group 3 - Perfect Competition in the long-run:

Group 4 - The Shut-Down Rule in Perfect Competition:

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YouTube - Chinas empty city – 10 Nov 09.

My buddy living in Shanghai posted this video to his Facebook profile today. It demonstrates how misaligned incentives in China lead local government officials to launch massive government infrastructure projects, all with the goal of meeting the growth targets handed down from Beijing.

Building roads to nowhere and cities that stand empty certainly creates jobs and new spending by the workers employed in their construction, so in that regard at least one goal of such projects is achieved. But whether or not all growth is good growth depends on whether efficiency in the economy is increase or decreased as a result of the growth strategies used.

Hundreds of billions of dollars worth of resources in China are currently being allocated by the government in Beijing towards massive public works projects such as this sparkling new city in remote Inner Mongolia. But it seems that government plans don’t always fall in line with the wishes of the nation’s people. A wise man once said, “build it… and they will come.” Apparently in China, that’s not always true.

I happen to have traveled in Inner Mongolia a few years ago with a group of students from my school in Shanghai. It was a sad thing in my opinion to witness the rampant development of the once pristine and culturally rich Inner Mongolian steppes. Ethnic Mongolians had been put on large reservations (not unlike the Native American people 150 years ago) and turned into tourist attractions. The cities were populated almost entirely with ethnic Han Chinese, there for the purpose of building more new cities, mining raw materials, and selling them to the rest of China’s industries.

Fiscal policy (the use of government spending and taxes to stimulate or reduce the overall level of demand in an economy) is a powerful tool for achieving the macroeconomic goals of full-employment, economic growth and price level stability. When used effectively, government spending can also improve efficiency in an economy by allocating society’s scarce resources towards socially and economically valuable projects. In China, it appears, the government’s incentives are aimed more towards pleasing the higher ups and continuing to inflate the speculative  bubble in real estate that has almost certainly formed, rather than pursuing socially desirable and allocatively efficient projects that actually help the Chinese people. Damn shame!

Discussion Questions:

1. What type of fiscal policy is the government in China pursuing? Expansionary or contractionary? What is the difference?
2. Why is government spending sometimes less efficient than private sector spending?
3. What would have been an alternative policy to allocating over $220 billion of public money into infrastructure projects that may have resulted in a more efficient allocation of China’s resources than projects such as the “empty city” in the video above?