Okay, so last time we dealt with the law of diminishing marginal utility, the fact that as the supply of a good increases, the value of each unit of a good goes down.
In other words, the marginal utility of a good goes down.
And also talk about the two basic band curve, meaning how much the consumers will buy at any given price.
Okay, on the law of diminishing marginal utility, there's a key thing that this is accomplished
and History of Economics Thought
Adam Smith, the alleged founder of economics, actually he really wasn't, but
he was, I guess, one of the founders of economics as a separate discipline
uh...
Senator Walter Nations, which was a famous
first
classic
economic classic, said there's a value paradox
that's called value paradox
and he said he couldn't solve it, and that's very peculiar in the history of thought, but if he had solved it twenty years earlier in his lectures
which were published much later, about nineteen hundred or so
so it's a very peculiar situation in the history of thought
in fact it had been solved by scholastic philosophers since the late sixteenth century
and all of a sudden he creates this problem
called the value paradox
and it goes as follows, namely
how is it
why is it that
uh...
things like bread and water, which are
let's take bread, it's usually called the diamond water paradox
but water has those extra complications
anyway, bread, which is the staff of life, it's very important philosophically to man
because you need it for life, and water of course needs more
and yet here, bread is very important, it has a high use value
and yet
on the market it's very cheap. Bread in those days was much cheaper than a bucket of loaf.
Water in those days was free, quote unquote.
But anyway, it's very cheap.
It's cheap on the market, therefore it has a low exchange value.
So, that's one
puzzling situation. Here's something which has a high use value and a low exchange value.
On the other hand, this is bread and water.
You can probably think of other things. Nails are pretty important
for construction. Nails are cheap.
On the other hand, you have other things, which are luxuries. They're fripries.
And Smith, I think, is one of the reasons why Smith fell under. Smith was a Scottish Calvinist.
He wasn't a hard-core Calvinist, but he was a soft-core Calvinist. So he hated luxury anyway.
He didn't like luxurious consumption.
Diamonds are a mere flippery. As he put it, they have no value.
No use value.
A little extreme.
Most of us will say, well, they have, you know, philosophically, they do not have a very high value.
They have low use value.
Diamonds.
Crusoe, and Robinson Crusoe, and his dozen island, will not go for diamonds as the first
highest priority, obviously.
And yet, look at diamonds. Diamonds are extremely expensive on the market. They have a high
and my exchange value, okay?
And, well, it's a very strange thing.
I can't solve it.
And Ricardo, his disciple, said the same thing.
I can't solve it.
This is a value paradox.
Therefore, we can't say anything about consumers, the value to consumers, the whole utility analysis.
I can't say anything about it because they're stuck in this thing.
They have to deal with the entrepreneurs and business and labor and all that sort of stuff.
and consumer analysis drops out of the picture except in France where they never went close to this
but Britain has a dominant economic doctrine in the 19th century
so we were, unfortunately, took a hundred years to get out of this
to solve the value paradox
and from this idea you see comes the left-wing position like Veblen and these other characters in late 19th century America and later
saying, wow, capitalism, market economy, stresses production for profit and not for use, they produce things like diamonds which are for profit of a high value, they don't produce bread and water or something which are of a low value, use value, alright, so this dichotomy between production for profit and production for use has a very important history of left-wing thought, by this time we have the tool, you have the tool in your possession to realize the fallacy
The basic fallacy is that people do not choose on philosophic value.
We don't sit around deciding on one big vote, like a world vote.
Supposing, let's put it this way, I like to use models, in macro I use a model which I call the Angel-Gabriel model.
Let's go back to the model of the grand old, I can say the grand old science fiction movies of the 50s,
In the 1850s and 60s, some space character interfered blocks into old television sets, all of a sudden we're asked what channel you want, some guy is speaking to you from a planet Ongo or something and he hands Earthlings, he says Earthlings listen, have peace, conclude peace now or die in six days, something like that.
Well, this, the planet, some outer planetary character now comes to earth and presents us with a choice, okay, you got your choice, folks.
From now on, you have a world parliamentary decision, you all vote, you know, on your TV set or something.
You have a choice of losing from forevermore, from now on until the end of eternity, either all the bread in the world or all the water outside, whichever, or all the diamonds in the world.
And that's the choice that human race is faced with. Well, given that choice, I'm sure we'd choose bread or water rather than diamonds.
And the space people would, whatever they are, will go off of the diamonds.
So the point is, in real life, we're not faced with this kind of a choice. We're not faced with all-encompassing class choice.
We're faced with unit choices, marginal choices. That's the whole point of a unit.
When somebody goes to buy something, they're not faced with a situation of,
oh gee, here's all the bread in the world versus all the diamonds.
No, you're faced with thinking, should I buy this loaf of bread?
Or should I buy this diamond with 12 carats or something?
In that situation, the marginal unit becomes extremely important,
and the law of diminishing marginal utility becomes decisive.
Namely, it so happens that bread and water are super-abundant.
the money is abundant, they're everywhere. Water, of course, is not plentiful in some states.
Basically, bread and water are supermarkets. There's a huge supply of it.
Even if you start, there's one loaf of bread on the world, one gallon of water, you have a very, very high marginal utility.
This is quantity.
If you only had one loaf of bread on the world for some reason, or one gallon of water, you have extremely high.
We spend hundreds of thousands of dollars for this one little loaf or one little gallon.
Fortunately, we have lots of bread and lots of water all over the place.
This is a marginal utility curve. We're out here somewhere.
Each unit, because we deal in units in the real world,
each unit, each gallon of water, each quart of water, or each pound of bread is very cheap
It's cheap, because it's a low marginal value. When we choose units, as I say we don't choose, it's like Crusoe with 20 logs instead of one.
It depends on what the supply is. We have a huge supply, fortunately, a huge supply of both water and bread.
Therefore, it's cheap. Units are cheap. On the other hand, with diamonds, supply is very rare, limited, scarce.
It's true we have a government cartel monopoly, which makes it scarcer. I'll get to that when we get to monopoly.
It's run by the South African government, a collaboration of the Beers & Company.
But anyway, it's still extremely scarce.
South Africa virtually has the only diamond mines.
So even though the first unit is much lower, say the least, than the first unit of bread or water,
there are not that many units around, as the supply is limited.
So we have a higher price for diamonds on the market. In other words, a higher valuation
by consumers for each unit, for each carat. I guess it's the unit, the unit of weight of diamonds for a carat, C-A-R-A-T.
The value placed by people on each carat is much higher than the value placed on each loaf of bread.
There's nothing wrong with that. There's nothing paradoxical. There's nothing unphilosophic.
There's nothing unnatural about it. It's perfectly legitimate. Once you see what the whole picture is,
Once you see the interpenetration between supply and valuation, it's marginal. Once you realize about the margin, this whole thing clears up.
So, anyway, that solves the value of power. It took until the Austrians and other economists in 1871, the marginal utility theorists, around 1871, to solve this paradox for marginal utility school.
For a hundred years, economics had been misled by Adam Smith into this cul-de-sac where they couldn't analyze consumers' behavior, they couldn't analyze consumer actions because they couldn't understand the value paradox.
And they left themselves wide open for leftists to say, wow, gee, it's a terrible thing.
And there's no conflict between production for profit and production for use.
Profit is, what's profitable is what's most useful to the consumer, most valuable.
And the demand is highest. We'll get into the demand as we go along.
Anyway, that solved the value paradox.
The other thing about exchange, I'm not going to mention it before, the other thing about
any exchange that takes place in the market is that people would only exchange because
it's more valuable for them.
They prefer what they're getting to what they give up.
They prefer the marginal units.
In other words, you work, you exchange your labor service of 40 hours a week or whatever
for a certain amount of money or exchange money for loaves of bread or stereos or whatever,
you're doing that because you prefer the value you're getting for the value you're giving
up an exchange.
And so each step of the way, each kind of exchange is made on a mark, literally millions
of exchanges benefit both parties to the exchange.
Those are also very important concepts, as I mentioned last time, I reiterate it.
Both parties, what we have is a latticework of two-person exchanges in the market.
We have, as always for every unit exchange, there are two people or two groups and two commodities,
including two goods and services.
In other words, if I go downstairs and buy a newspaper, so I buy the post, then you have two things, you have me and the news dealer, and I give the news dealer $0.35, and I get the post, alright, so I'm getting, both of us benefit from the exchange, I give up the $0.35, I value getting the post more than getting the $0.35, the other hand, of course, the news dealer values the $0.35 a lot more than the post,
500, 325 posts, pretty obvious in his situation, but at any rate, both of us then benefit.
Each unit exchange has two people and two commodities, or two goods that serve one.
In a money economy, money is always one part of this equation here.
Money is exchanged for other things.
So if you work for IBM, if you graduate and work for IBM, you're exchanging your labor
service for salary, for money.
So that's, again, a situation with you and IBM, since IBM is not a person, it acts as a unit in this situation.
So you have money and then labor service exchange for it.
So each step of the way, and the lattice work of exchanges is both parties' benefit.
Otherwise they wouldn't make the exchange and do something else.
They go home, they make some other exchange, they keep their money, they go to Bahamas or whatever.
Okay, we now get to the most important, we talked about the demand curve last time, we get to the most important property of the demand curve, the only property which really is important as a matter of fact.
Remember the demand curve is falling, it's all we really know about it.
So you have on the y-axis, you have price, on the x-axis you have quantity, and the demand
curve tells you, it's really the demand schedule, it's a geometric representation of the demand
schedule.
It tells you, at this price, how much will be bought, the price of 1 or better, 10 bucks
a loaf, this much will be bought, if the price is 5 dollars a loaf, this much, whatever, and
you get something like that.
In other words, the cheaper the price, the more will be purchased.
So you have a demand curve which is sloping, so-called falling demand curve, a demand curve which slopes downward and to the right.
You don't know how it's sloping, you don't know exactly how, you don't know if it's linear, you don't know if it's steep or shallow or flat.
Only know if it's falling.
Now, the important property of the demand curve is how much, if this is like a freeze-frame
situation telling you what's in the mind of consumers, of course you don't know that
the demand curve, you don't really know it, all you know is that it's falling.
There's no way to have an x-ray machine in the minds of every consumer and figure out
if you freeze today and find out, well, let's see, how much will they buy at different prices?
What you do now, as I say, is that it is falling.
If, so there are two, the property, the important property of the man curve is, if you change
the price, let's say if you cut the price from here to here, how much will the quantity
increase?
Okay, in other words, or at least in what direction?
We know it will increase, we don't know about how much, if it increases just a little bit,
You have a steep curve here, it can either do that or it can increase a lot, we have a much flatter curve, given the same point.
Now there's this property, the man curve is called elasticity.
Once again, it's borrowing the prestige of physics, where the question of example is if you put a certain different weights on a spring, how much will the spring give?
Now there are two different kinds of definitions for you. One kind, which is a textbook definition, there's nothing wrong with it, it's just kind of irrelevant.
That goes through a whole formula. Namely, you take the percentage of the quantity change.
In other words, let's say this is a 10% drop in price. If this is a 40% increase in elasticity, then you have all these ratios.
It's called a very elastic curve. If, on the other hand, you have a 10% drop in price and quantity only goes up by 5%, it's obviously very inelastic.
So, the more elastic is how much more give there is,
in other words, how much the quantity will increase when the price falls.
The reason why it's irrelevant is nobody knows anyway,
and it's also the really important thing, it's quality,
the really important thing for the businessman or for the industry is,
will total revenue go up or down? That's what they really care about.
If I cut the price, what's going to happen to my total revenue?
That's what I want to focus on here.
Now, total revenue, business income, net income, is total revenue minus total cost.
This is a very simplified way of looking at it, but basically it is how much money do you take in a year over the transom or over the cash register or whatever, how much money do you pay out?
If you take in $100,000 a year, you pay out $80,000 total cost, and your net profit is $20,000, you're in fairly good shape.
If, on the other hand, your total revenue is $60,000 and you pay out $80,000 and you're in pretty poor shape, and you suffer net losses of $20,000.
So therefore, total cost we'll get to later on in the course, but right now we're focusing on total revenue, total revenue of part.
Total revenue is of any firm, any person, it doesn't matter, and it equals the price of anything times the quantity sold, P times Q.
Let's take a Wonderbread example.
The curve is based on the schedule.
Let's say the price is ten bucks a loaf.
You have very few loaves, so let's say a thousand.
thousand very wealthy winter bread freaks
if you have a total revenue then of P times Q equals TR
you sell
ten bucks a loaf, you sell a thousand loaves, you get ten thousand dollar total revenue, very simple concept
simple but important
if the price is one dollar, you might be selling a hundred thousand loaves
so then your total revenue is a hundred thousand dollars
if the price is a nickel a loaf
I don't know, you might be selling
Five hundred thousand. What's that? That's five thousand dollars, isn't it?
Anyway, that gives you an idea. You take the price per unit, multiply by the number of units sold, and you get your total revenue.
So, what we're interested in here is, what happens to total revenue?
When, let's see, this is the man curve here.
Here's price on the y-axis, quantity on the x-axis.
If this is one point out of the man curve, it means that the price is, whatever this is, let's say a low for $10 a case or whatever happens to be, times a thousand, that means the total revenue is, the geometry of the total revenue is the total area.
What's the price times the quantity? Then what happens when you lower the price?
If the case of Wonder Belt can be a huge increase in total revenue, other cases it could be of course only even lower total revenue.
If you have a relatively flat curve like that, you wind up, let's say from here to here,
So the new total revenue, which would be a lot bigger.
In other words, in this diagram here, I've postulated, a fall in price leads to an increase in total revenue.
Increase in TR.
And then looking at, this is $9 or something, whatever this is, if you go back, of course the reverse happens.
In other words, you increase, you start with here, you raise the price to here, you get a big drop in total revenue.
So this is the other side of a coin, given the same two points.
So here you have a rise in price, leading to a fall in total revenue.
This situation, when a demand curve is in this situation, it's called an elastic demand curve in that zone, in that region, because it does change all the way up and down the curve.
But what you have here, this is a definition of an elastic demand curve.
In other words, the key thing I'm focusing on here is the direction. What happens to total revenue, or the change in price?
If when you cut the price, if in other words quantity increases by a greater proportion, you have an increase in total revenue, that's an elastic demand curve. Raise the price, then you have a fall in total revenue.
So some demand curves will be elastic. It's not easy to forecast in advance what the demand curve will be, because it will change across the zone, and it can be different from different things.
Usually, we consider that wheat has an elastic demand curve. It's not necessarily true, but anyway.
So that's an elastic demand curve.
The other hand, if you have a demand curve which is relatively steep, and goes like that, a fall in price,
Then you have this total revenue. The new total revenue, the new area will be smaller.
In other words, the increase in quantity is not enough to offset the drop in price.
So the result will be a lower demand, lower total revenue.
So in this situation, a situation where a fall in price leads to a fall, a drop in total revenue, or looking at it again the other way around, if you raise the price from here to here, you've got an increase in total revenue.
Rise in price. This is something that businessmen are very interested in. They don't care that much about the percentage, the amount, the formula.
They care about what happens to the damn total revenue in this.
In the real world, businessmen don't know that the man curves are not listed on the book for them.
They have to try to find out. It's not easy to find out. It's part of the job of the entrepreneur or the businessmen to try to figure out what's going on.
Okay, so rise in price leads to then an increase in total revenue.
This situation is called an inelastic demand curve, inelastic.
So in other words, we're setting up here a new definition of elastic and inelastic.
Instead of concentrating on percentages, what I'm saying is if the, I'm concentrating on the direction of total revenue,
If the total revenue increases or falls at a falling price, you have an elastic demand curve. If it drops to the falling price, you have an inelastic demand curve.
And vice versa. If the total revenue falls off at an increase in price, you have an elastic demand curve. If it goes up at an increase in price, you have an inelastic demand curve.
So what can we say about when things will be elastic or inelastic?
Well, one thing we can say that other things being equal, given the range of choice, I mean a larger range of choice will lead to a greater elasticity.
In other words, let's say this is the, let's say this is the, back to our wonder bread example, here's the price of wonder bread, say a buck, this is a buck a loaf.
And, let's say Mr. Wonder, you know, huge increase in price, it's gonna, sales are gonna fall off tremendously because all the other breads will remain the same price.
Rolls, breads, everything is a buck a loaf or so, he's raising his price to $5, $10 a loaf, it means a tremendous falling off, it means that the man curve is very elastic for Wonder bread.
they have a big falling off in total revenue so that's one of the reasons
not going to do it if he's sane on the other hand if all the breads go up
together for one reason or another but some kind of a situation all bread
prices go up to two bucks that's a different story then they'll still be a
falling off but people won't be able to shift out fast from one to out of Wonder
Bread into Pepperidge form or whatever they'll all be going up so in that situation be much
It's much steeper. It could still be elastic, but be less elastic than for each given firm, or each given brand.
Same way on the way down. If you have a...
If this one cuts its price and all the others remain the same, it'll pick up a lot of sales.
It's going to be very elastic demand.
On the other hand, if all bread prices go down, it'll pick up some, but not as much.
So one thing we can conclude from this is that the demand curve, in all cases, regardless of how elastic the demand curve is,
the demand curve for the firm, any given firm, is more elastic than the demand curve for the industry as a whole.
Unless, of course, there's only one firm in the industry, in which case it's the same thing.
So, more elastic than demand for the industry.
And when you, this sets up a temptation, in the case of where there's a big gap, and we'll see later on,
there's various reasons why demand curve for every firm is going to be elastic, or also what firm it is.
It's going to be elastic.
Where some demand curves for industries are inelastic, some are elastic.
When you have a big gap between the two of them, let's say the man curve of each firm is quite elastic and the man curve of the industry as a whole is inelastic, it sets up a temptation for a cartel agreement among the firms because it means that they can get together, I'll get to that later on when we get to monopolies, they can get together and agree to cut production and raise price, they'll all benefit, all the firms will benefit because they can, let's say they raise price by 20%, their production gets cut by 10%, they pick up more total revenue. But it's only if each firm will keep the
Agreement. As I'll point out later on in the course, there are inexorable conditions in the free market that lead to a breaking up, a very quick breaking up of all cartel agreements.
The only reason why a cartel agreement ever remains in action is because the government enforces it. When the government steps in, what's the matter out there? I'm going to close the door.
I only have a few minutes. Eager class for the next hour, I say. Well, God bless them.
Okay, so the, where was I, what was I talking about, cartel, yeah, so if a cartel, the only time a cartel will last for any length of time is when a government steps in and enforces, it prevents new competition from coming in, it prevents anybody from breaking the agreement, and this is what's happening in Europe a lot and so on, we'll get to that later, this is just a teaser on cartel, so this is,
sets up a big gap between the industry of the man curve and the firm of the man curve, sets up the conditions for at least a temptation for that sort of agreement.
Okay, now there are some, all these man curves, they might look flat or steep, but you can only tell the relative elasticity when they're from the same point.
If you have this kind of situation, and going down from that price, you have a flat curve, this is a steep curve, you know this is more elastic than that.
But if you just look at a curve like that, or look at that, it's not necessarily true that this will be more elastic throughout the entire range.
As a matter of fact, when you get up high enough in this thing, it will be elastic, even if it's steep.
You get to the point finally where people can't afford to buy more, whatever it is, if the price goes up, even if it's something which is inelastic, even if it's weak or something like that.
So you can't gauge by looking at it, you can only gauge by looking at the focal point here and looking at it, what happens when you go up or down from that point and have a common point.
So as I say, the elasticity will range over the, will stiffer over the range of each curve, except for three curves, which are hypothetical, which usually never exist.
The only cases where the elasticity is constant throughout the entire range of the curve, and those of you who are mathematically inclined will see the reason for this.
Three curves. One is the situation where you have an absolutely horizontal demand curve.
We've already seen you can't have it.
It's one of my big gripes with the later chapters on simple, perfect composition. There ain't no such thing because the band curve always has to be full.
If you had an infinite, this is if you ever had this crazy situation where
it means you could produce as much as you want, still have the same, still have the same price,
this would be an infinite elasticity. You know, E, epsilon, fireplace,
epsilon would be infinite size.
Throughout the entire range of the curve.
On the other hand, if you had a vertical demand curve, absolutely vertical, also which can't exist, we were already going through
for quite a while explaining that,
the elasticity would be zero throughout.
It means, regardless of what happens,
you never have a change one way or the other in the quantity, which is again absurd.
This is mathematical extreme cases.
Another point, another
constant elasticity, which is not absurd, it's just
I doubt whatever happens. I mean, it's extremely unrealistic, let's put it that way.
In a situation where the main curve is a rectangular hyperbola, it doesn't look like that, such that the total revenue is always constant, in other words, the area under the curve is always constant.
Like that. Regardless of what the price is, consumers always spend the same amount of money. That could happen. It could even happen for certain individual ranges, but there's no reason to assume it happens.
There's no evidence that it ever happens and whatever, but it's not logical, it's not absurd like the other two cases.
Now, oddly enough, in the history of economics, demand curves first come in about 1920.
For about 25 years or so, the textbook demand curves were always like this, a totally insane situation.
This is the way it was shaped.
And so they were assuming it all the time, but it really assumes away the whole point, which is changes in the elasticity, or changes in total revenue.
It's a very weird kind of assumption. Finally, in about 1943 or so, Professor Stiegler was a young economist then, wrote a price theory textbook, I guess it should now be called Intermediate Micro, and he since then got a Nobel Prize, etc.
Anyway, he starts off and he says, why are these like this? There's no evidence for this, no reason for it, just sort of fashion, and he says, the hell with it, it's ridiculous, let's make it a straight line.
So from then on, all of the man curves in the textbook are in straight lines. At least you don't have the assumption of constant total revenue.
On the other hand, there's no evidence of a straight line either. It's purely for convenience. These would be like that.
No evidence for a straight line.
So, I think Ronald McCluskey is sort of a maverick type, very interesting economist, kind of a nut, very interesting.
He has a textbook now recently on intermediate and micro. He has an anchor like that.
Well, okay, but I still prefer using a straight line. It's more simple to do it.
But always keep in mind that this is only for convenience.
See, what happens later on in the course, they start using tangency.
There was also some very important conclusions from nonsense. There's no reason.
If it ain't straight line, it ain't going to be tangent.
So at any rate, just keep that in mind. What happens in economics,
has happened for many years now that they start using math or diagrams as a convenience as sort of a graphic illustration of economic concepts
and after about some years of doing that they start thinking of the graphs as ends in themselves
and they forget about the economics and they start talking about tangencies and all sorts of other stuff
so we're trying to keep close to earth here
At any rate, this is the, so elasticity is a major property of demand curve, either elastic or inelastic, which means you only have a situation where total revenue either falls or increases and changes in price.
And it's obviously extremely important for businessmen to try to figure out what's going to happen.
In real life, there are no given demand curves, this is a no given cost curve right or wrong.
Businessmen are trying to find out what will happen if they raise the price or lower the price.
and that's a trial-error kind of procedure and it's much of a hunch and based on their intuitive insight into the market, which is first based on knowledge, but based on the sort of knowledge economists don't have, because we're not in the fish market or the computer market or whatever it is, each market is different, has different people in it, all sorts of stuff going on, dynamics, which only people involved in it can figure out what's going on. So, okay, I think that's enough for today. Press on.