Can you please help me answer two questions based on the readings below. 1 How would you contrast the mainstream economics view of consumer behavior in 9.3, with the demand curve in general, and also with the views of political economists and behavioral economists described in 11.3-11.5. 2 How would you contras the mainstream economics view of the supplier behavior in 11.4, with the views of political economists and behavioral economists in 11.5. What are the conceptual issues from these? Thanks so much for your help:)

MARKETS AND HOW THEY WORK If we assume that the government has put all of the necessary characteristics of markets in place, then we can use the supply and demand model to analyze how prices and quantities of various goods are likely to change in response to shifts in consumer, producer, and government regulatory behavior. The supply and demand model is the cornerstone of mainstream economics. l \\JOI ex '0 {3 9.3 THE ASSUMPTIONS OF THE SUPPLY AND DEMAND MODEL OF MAINSTREAM ECONOMICS m Analysis of changes in prices and quantities is at the center of much mainstream economic analysis. Together, prices and quantities are the main mechanism by which resources are allocated in market capitalist economies. In markets that pursue maximum prots, prices provide crucial information, signaling whether companies should allocate more or less resources to the production of a particu lar product and causing rms to change the quantity of the product they supply. Similarly. prices signal to consumers that an item is more or less expensive rela- tive to other commodities, which affects their purchasing decisions. Quantity is another crucial variable, indicating how many goods or services that busi- nesses produce. something that affects how many resources they need to pur- chase and how many workers they need to hire in order to produce those goods and services. Their demand for workers in turn affects w0rkers. households, and communities. To analyze the forces that cause prices and quantities to change, economists developed the model of supply and demand. Like all economic models, the supply and demand model rests on a series of assumptions. Understanding these assump tions helps you determine when the model is useful in understanding economic phenomena and when it is less likely to apply. The supply and demand model makes assumptions about what markets are like as well as assumptions about suppliers and demanders. Making these assumptions is what allows us to make systematic predictions about how supply and demand will change in response to a variety of factors and how these changes will likely affect prices and quantities. The supply and demand model is a simplied approximation of how markets work that focuses on a key set of characteristics present in most markets. This chapter focuses on markets for commodities like pizza, beer, gas, wheat, and clothing operating in the short run. Markets for inputs such as labor and mar kets for nancial assets work on slightly different principles. We will examine these markets later in the book. Also, different dynamics play out in the long run that cannot be captured by the supply and demand model alone. The supply and demand model of commodities markets is based on ten major assumptions. l. MARKETS. SUPPLY AND DEMAND Transactions take place in a capitalist market system with privately owned rms and individual consumers. Markets are perfectly competitive or at least competitive enough to mirror the behavior of perfectly competitive markets. In perfecrly competitive markets, (a) suppliers sell an identical good or service and (b) no individual buyer or seller can inuence the market price by themselves. Suppliers and demanders engage in optimizing behavior, with sup- pliers maximizing prots and demanders maximizing the satisfac- tion. or \"utility,\" that they get from purchases. Markets tend toward a stable equilibrium, settling on an equilibrium price and quantity. The specic assumptions about demanders (consumers) are as follows: Consumers are rational, calculating, fully informed, and self-inter- ested about their purchasing options. They engage in optimizing behav ior. carefully weighing their options. Note that this assumption eliminates purchases driven by impulse buying and by emulating onc's peers. Consumers prefer having more to having less, but they have a limited budget so they cannot buy all that they want, and they get less and less satisfaction from having more and more of the same good. This assumption implies that consumers have an insatiable demand for goods and services in general but they don't want too much of any one item. There are substitutes for each good, and consumers can rank goods according to how much of each good they want at various prices. This leads them to want more ofa good at lower prices and less ofa good at higher prices. Consumers have a good idea about the quality of substitute goods and how much satisfaction they will get from each type of good. Consumers behave like minicomputers. tabulating how much satisfaction they will get from each dollar of spending on each good, choosing to purchase the items that give them the most satisfaction per dollar until they exhaust their budget. The result is that rational, fully informed consumers desire to purchase smaller quantities of a good at high prices and larger quantities of a good at low prices. The specic assumptions about suppliers are the following: Firms pursue as much short-term prot as possible and, in doing so decide what to produce. how much to produce, and how to produce it. Capital and technology are fixed in the short run. The short run is a period in which rms are stuck with the existing size of operations, usually a period of 112 months during which rms do not have time to dramatically expand the size oftheir business or develop new technologies. This means they cannot produce beyond their maximum capacity in the short run. . ........|.\".JllllLlimswem.._ \"1 Firms are encouraged to increase the quantity of a good supplied when the price increases. With a xed size of operations in the short run, it usually costs rms more to supply more. Thus. the only way to encourage rms to supply more is to offer them a higher price. If these assumptions hold reasonably well, then the supply and demand model can 1,; a powerful tool to analyze markets. Let's consider the local market for pizza in the United States as it compares to the assumptions above. Most of the assumptions hold reasonably well: The pizza market in the United States is operated by private rms in a market capitalist sy5_ (cm. Consumers are generally well informed about the quality of pizzas from dif. fercllt pizzerias in their town. along with other options for quick food (substitutes) such as sandwich shops and Chinese restaurants. However. pizza is nota completely homogeneous product: There are quality and location differences. Nonetheless, most economists think that pizzas are close enough substitutes for each other that we can still talk about a local market for pizza. Pizza rms are not all small opera- tions. either. As Figure 9.2 shows, Domino's and Pizza Hut both have very large shares of the market. On the other hand, even small towns have lots of local corn- petitors in addition to the national chains. so the pizza market is reasonably close to being a competitive market. The prices that different restaurants charge for a similar size and type of pizza in a particular location cluster together, varying only slightly. This makes sense, because no restaurant wants to charge signicantly more than its competitors for fear of 105ng business. The price of a large cheese pizza in the Theater District in Manhattan was $13.50 in 2014, and there was remarkably little variation among serious restaurants. In Lewisburg, Pennsylvania, a 14-inch cheese pizza went for $10 in 2018. Gourmet pizzerias can charge more, and some discount pizzerias charge less, but most pizzerias charge a price within $1 of each other. To mainstream economists, this means that the market for pizza has settled on an equilibrium M__ Mam Papa Murphy's 1.30% California Pizza Kitchen 1.74% Marco's Pizza Chuck E. Cheese/Peter Piper Pizza Sbarro Round Table Pizza 1.11% 1.07% 1.04% FIGURE 9.2 Table showing the ten largest pizza companies in 2019. Source: Pizza Today. CONSUMER AND SUPPLlEFl BEHAVIOR marginal utility, which means the more they consume of a particular good, the less they want additional units of that good. This gives the demand curve its downward slope. However. we do not always see downward~sloping demand curves. 11.1.1 Veblen goods As we saw earlier when we studied Veblen's ideas, most goods have a "use value" or \"utility." as well as a \"display value" or "honorific" character. When people think that purchasing a good will give them higher status, they are willing to pay more for itas in the case of buying a Rolex watch instead of a Timex. This can result in a dierent outcome than we normally see with a downward-sloping demand curve: With a Veblen good, the quantity of the good demanded increases as the price increases because the scarcity and exclusivity associated with the good increase the display value and honoric character of the good. Most luxury goods are Veblen goods. Luxury goods depend on scarcity and exclusiv- ity to drive the demand for their products. If the companies that produced luxury goods were to lower their prices, this could erode the aura of exclusivity associated with the product and reduce the demand for it. Elite universities have found that raising the price of tuition signals a degree of exclusivity and actually increases the number of applications, which is a sign of the demand for a college education at that university. On the other hand, lowering the price of tuition can signal to applicants that a university is of lower quality. Interestingly, recent research indicates that the act of paying more for a status good even increases consumers' satisfaction with that good! Researchers at the Stanford Graduate School of Business and the California Institute of Technology found that a person who thought they were tasting a $45 bottle of wine would experience more pleasure than a person who thought they were tasting a 55 bottle of wine, even though the wines were identical.1 Believing that you are consuming something that is expensive makes it more likely you will actually enjoy consuming it! This shows how hardwired we are to think in terms of expensive and exclusive items being better than others. This is sometimes called the snob e'ect, where a higher price is assumed to represent better quality. Similarly, low prices are assumed to represent low quality. 11.1.2 Pecuniary emulation and herd behavior Another area in which we see Veblen's analysis ceme to life is with the band- wagon eff'ect, where the more people who have a good, the more other people also want that good. In this case, we see Veblen's notion of pecuniary emulation in action: People desperately want to have the same goods that everyone else hasthey want to jump on the bandwagon and t in with their social group. College campuses are often prime examples of the bandwagon effect. One year Ugg Boots are the hot item that everyone has to have. The next year the hot prod- uct might be Vineyard Vines shirts. Yoga pants were only worn to exercise in until MARKETS. SUPPLY AND DEMAND the mid-20105, when they became normal dress for college women. In cases ofthe bandwagon effect, demand keeps increasing the hotter the item becomes, even if prices increase. This contradicts the normal \"law of demand.\" We see similar behavior when consumers buy products based on onlinc reviews and recommendations. By trusting the opinions of online reviewers, we jump on the bandwagon and buy the same goods that others like. And we see this when consumers bypass an empty restaurant to wait in line at a busy restaurant that they are unfamiliar with, assuming that there is a reason why other consumers want to eat at the busy restaurant. We even see such behavior in nancial markets. Investment banks followed each other into the sub-prime mortgage market on the assumption that others already in that market knew about a good business opportu- nity. Similarly, in the early 19805 banks followed each other in loaning large sums of money to governments of impoverished developing countries, despite the high risks. In both cases, this herd behavior resulted in nancial crises! We also sometimes see herd behavior due to network efciencies, when con- sumers benet by purchasing the same products used by others so that collaboration is easier. For example. it is easier to work collaboratively if everyone uses Google Docs or Skype. It is hard to overstate how important pecuniary emulation and herd behavior are in shaping human decisions. However, it is difcult to analyze such behavior systematically. It is hard to predict when a particular item will become hot or when a particular bandwagon will prove irresistible to jump on. Such analysis requires deep knowledge of actors and close observation of their behavior. 11.2 HOUSEHOLD, COMMUNITY, AND CULTURE Mainstream economic theory tends to ignore the role of households, communi- ties, and cultures in shaping economic decisions. As we will see below, a variety of factors shape our value systems, and value systems shape the economic decisions we make. 11.2.1 Household decision making As feminist economists note, the household is at the center of many economic decisions. The idea that purchases are made by individuals acting purely out of self- interest ignores key aspects of economic decision making. Most decisions within a household are negotiated. Major purchases of large ticket items are usually made jointly by both partners in a relationship. There is, however, a gendered aspect to who makes which decisions that involves power and existing gender roles. In a heterosexual U. 5. household, women usually make most of the decisions regarding furniture, home accessories, small appliances. and cell phones, whereas men make most of the decisions regarding power tools. lawn and garden care, and consumer electronics. Even though women tend to do more Work than men in most households. averaging 50 more minutes of work per day according to the World Economic Forum. much of this is unpaid work that comes with iess earning power and status. Therefore, household dynam- its. including gender roles and power relations in each culture. are important in understanding household behavior regarding purchases, labor decisions, and other key aspects of the provisioning process by which households get the goods and services they need. 11.2.2 Fairness and cultural bonds Most transactions also involve a concern with fairness and the welfare of others. In the United States most people leave a tip of 15% at restaurants even though there is no law requiring them to do so. This is a display of a cultural norrn that trumps selsh economic gain. People give each other gifts and volunteer in their communities with no expectation of economic gain. We also see clear evidence of the importance of cultural norms and the value of fairness in the results from the ultimatum game from behavioral economies. In the ultimatum game, there are two players and a possible monetary payout. One player, known as the proposer, proposes a split of the payout. The second player. known as the responder. decides to accept or reject the split o'ered by the proposer. The two players each get to keep their share of the payout fth: responder agrees to the split o'ered by the proposer. If the responder rejects the split. then neither player gets any money. According to economic theory. rational economic man. who is utterly self interested and perfectly informed and has no notion of fairness and no cultural norms to abide. would always propose a very inequitable split as the proposer. As the responder. rational economic man would also accept any proposal no mat ter how unequal, because even an offer of 51 out of a $100 split would make the responder 31 better off. Knowing this, if the possible monetary payout is 8100. the proposer should propose a split of $99 for himself and $1 for the responder, know- ing that a rational responder would accept 31 even though it is highly inequitable. But how do people really behave? In repeated experiments in a variety of set- tings. most proposers offer 50%a fair split of the money. Also. offers of a split of 25% or less are frequently rejected by respondersthey reject unfair proposals even though they would benefit nancially from accepting the proposals. In these cases, it is more impertanr to the responder that the proposer be punished by losing the payout than it is for the responder to benet nancially. What we see is that human beings have a preference for fairness and reciprocity. and they are willing to make a sacrice in order to punish someone whose actions are viewed as unfair. Bowles et al. also report that proposers in societies in which giftgiving garners status often offered more than a 50% split. and societies that depended on coopera tion for survival tended to oer more than other societies. Interestingly, people LUHHLMEH AND SUPPLIER BEHAVIOR 244 MARKETS. SUPPLY AND DEMAND with exposure to markets. which require people to cooperate. bargain. and trade with others, also tended to make higher offers and were more likely to reject lower offers.2 Markets themselves evidently cultivate norms of fairness and reciprocity that are an important element in exchanges. This, of course, has important impli- cations for how someone should conduct business dealings. Taking advantage of people is unlikely to be a sound business practice! We also see cultural norms at play in the Haifa childcare experiment con- ducted by behavioral economists Uri Gneezy and Aldo Rustichini. Parents picking up children late from childcare is a chronic problem at almost all childcare centers. Gneezy was interested in how parents' behavior might change if they faced lines when they picked up their children late. According to economic theory based on rational economic man. levying a ne would discourage people from picking up their children late1 and that would then reduce the number of late pickups. In six of ten childcare centers in the town of Haifa. a small fine was levied on any parents who showed up more than ten minutes late to pick up their child. In the other four childcare centers no fine was imposed. The results were fascinating: lit the childcare centers where nes were levied n late pickups, parents were twice (15 likely to show up late as they were in childcare centers without nes! Ironically, the guilt parents felt from inconveniencing a day care worker was a much more powerful motivator than the fine. Breaking a social contract is seen as unacceptable behavior by many people. But once arriving late became a monetary transaction, many pa rents simply chose to pay a little more money to arrive late at the day care center, absolved of guilt now that the relationship had changed from a personal one to a financial one. Similarly, researchers have found that blood donations decline when people are paid to donate blood. People are more likely to donate blood when it is seen as a good deed for one's community than they are when a blood donation is seen as a monetary transaction. These examples show us that a series of complex factors inuence how con- sumers make decisions. First, their decisions depend on their household dynam ics. Secrind. decisions are shaped fundamentally by a community's cultural values, including norms of fairness and equity. Consumers also sometimes behave in ways that seem nonrational from the perspective of mainstream economics. 11.3 NONRATIONAL CHOICES Rational economic man is supposed to be fully informed and to make rational decisions taking into account all variables. This often fails to capture all aspects of economic decisions. For example. often we are overwhelmed with too many choices and too much information, so we tend to make quick, impulsive. emo- tional decisions that are not fully rational or well informed. Slower, deliberative thinking is much more likely to be rational and well informed. There are a number of categories in which people make decisions that. though not necessarily being CONSUMER AND SUPPLIER BEHAVIOR Irrational (not reasonable or logical), are nonrational at least when compared to hou- rational economic man is supposed to act. Non rational decisions are made by relying on intuition rather than on logic or close observation. 11.3.1 Anchoring One example of nonrational judgment occurs with anchoring, a phenomenon that occurs when people rely too heavily on the rst piece of information shared with them when making a decision. This is a tactic used very effec- tively by retailers. There is a reason that Amazon and other retailers create a "list\" price and then show you an \"actual" or \"deal" price that is lower: By establish- mg a high anchor point. it makes consumers think they are getting a good deal even when they are not. This is an example of what psychologists call cognitive bias, where people experience systematic deviations from logical, rational behavior due to characteristics of our cognitive abilities. Another example of cognitive bias occurs when stores list the price of a product as $49.99 instead of 850. Our brains tend to latch onto the rst digit, which makes us feel like a product whose price is $49.99 has a much lower price than a product selling for $50. In his book Priceless, William Poundstone reports on eight studies that demonstrated that items priced just below the "rounded\" prices (99 cents vs. $1.00) sell on average 24% more often. Apple iTunes is famous for getting people who previously downloaded music for free illegally to pay 99 cents for each song. Evidently consumers see 99 cents as almost free. In many cases. human beings make choices based on some anchor or reference point, which often pushes our decision making into the realm of nonrational behavior. 11.3.2 Overoptimism People also tend to be overly optimistic about many things. Homeowners tend to assume that home renovations will cost half as much as they actually will. Students tend to assume that it will take much less time to write a paper than it actually does. The author of this textbook assumed that he would be able to write this book more quickly than was actually the case. Investors are often wildly optimistic about the potential returns from an investment, especially during boom periods (which even tually turn into busts). Lottery winners assume that they will be responsible with their money, so they take it all as an immediate, lump sum. When we are overly optimistic, we are also being nonrational with our decision making. 11.3.3 Loss aversion Ironically, at the same time we are overly optimistic about some things, we are also extremely reluctant to accept losses. Daniel Kahneman and Amos Tversky conducted a series of experiments to demonstrate that people feel a loss much more MARKETS. SUPPLY AND DEMAND acutely than they feel a gain. For example. once investors have lost money on a sroelt they purchased, they become reluctant to sell the stock and "realize" the loss even if the stock's future prospects are not good. Similarly. homeowners are extremely unwilling to sell their house for less money than they paid for it. even if the real estate market has changed fundamentally. This causes many homeowners to reject sound offers and to continue to pay out money for taxes and maintenance rather than to accept a loss on their house's value. This, too. is nonrational. allow- ing one's feelings to trump sound decision making. 11.3.4 Status quo bias Loss aversion is related to status quo bias. where we oppose changing our minds unless we have a very strong reason to do so. For example, many people tend to stick with their cell phone company, cable television provider. and electricity sup- plier. even if better options exist. The risk of making a change does not outweigh the potential benets for most people. In these instances, we do not behave as fully rational, calculating individuals. We stick with what we know. 11.3.5 Nudge People also tend to choose the default option that is given to them unless they have a strong reason to do otherwise. Economist Richard Thaler calls this a nudge- when consumers are gently encouraged to make a particular choiCe. Workers are more likely to save for retirement if enrollment in a retirement plan is automatic instead of optional. More people choose to be an organ donor if that is the default option than if the default option is not to be an organ donor. People tend to view the default option as the safe. authoritative choice, and if they trust the person giving them the options they are more likely to choose the default option than to make other choices. Retailers also give consumers nudges when they put up big displays to draw attention to particular products and when they put up a big sign advertising an "everyday low price" that is not a sale price. By drawing attention via displays and signs, retailers are nudging consumers in a particular direction. often in a somewhat manipulative fashion. In all of these cases. we see that people do not always behave like rational eco- nomic man. Rather, they often behave like imperfect human beings with limited information and a host of cognitive biases that inuence their behavior. One of your tasks as a student of economics is to develop your own sophisticated analysis of which factors you nd most important in human decision making based on the ideas of mainStream economists, behavioral economists. and political econo- mists such as Veblen. We also nd similar differences between how mainstream economists and political and behavioral economists analyze the prot-maximizing behavior of suppliers. The mainstream model focuses on short-term optimizing behavior. whereas political economists and behavionl economists look at longer term decision making and a decision-making process that is more complex. \"hnsumen AND SUPPLIER BEHAVIOR 11.4 THE MAINSTREAM MODEL OF SUPPLY DECISIONS: DERIVING THE SUPPLY CURVE m As with the consumer model, mainstream economists view suppliers as rational maximum who make optimal. informed decisions. Specically, suppliers maxi- mize prots by producing every unit that allows the rm to generate more in rev- enue than it generates in costs. The mainstream model of supply decisions rests on several key assumptions: 1. Markets are competitive. 2. Firms are small and experience an upward-sloping marginal cost (supply) curve in the short run. 3. Firms engage in optimizing behavior, maximizing short-run prots by com- paring marginal revenue and marginal cost based on complete information. 4, Markets tend toward an equilibrium price in the short term. I." Long-term considerations such as innovation and achieving monopoly power are beyond the scope of the model. As we will see later. political economists and behavioral economists have somewhat di'erent views on how suppliers make decisions and what types of decisions are important. In the mainstream model of supply and demand, supply curves are derived from the rm's short-run costs of productiOn. The short run is the period of time in which the supplier cannot adjust the size of operations (their capacity). The supplier's capital stock (buildings. machinery, and equipment) is xed. Suppliers are only able to adjust their variable inputs in the short run, especially the amount of labor they hire. The long run is the period of time in which all inputs are variable and can be adjusted. Suppliers can build entirely new plants, install new technology and equipment, and increase their productive capacity in the long run. For example, consider the costs in the short run and long run of a small restau rant that specializes in selling burritos. In the short run, the restaurant has a xed size of kitchen, with a xed number of stoves. a xed amount of equipment. and a xed seating area with a certain number of tables and chairs for patrons. Suppose that the restaurant expects a large increase in the demand for burritos next weekend due to a big festival in town. What can they do? They don't have enough time to build an addition onto their building. install new equipment, or find and set up a larger space. Their capital goodsbuildings. machinery. and equipmentare xed in the short term. All the burrito restaurant can do in the short term is adjust their variable inputs. such as hiring more labor and increasing the amount of ingredients they purchase. It would take the burrito meant-am several months to increase the in of their operation signicantly by building an addition onto their restaurant or nding a new. larger location that can accommodate and serve more people. Thus. the long term MARKETS. SUPPLY AND DEMAND for the burrito restaurant is a period of more than three months. a time period dur- ing which they have the ability to adjust all of their inputs to increase their capacity. In the mainstream economics theory of the firm, short-run costs of producticui are derived from a short-run production function that shows the relation. ship between the quantities of variable inputs (such as labor) and the amount of output produced, holding xed inputs (such as capital) con- stant. The most important variable input is laborwithout labor, nothing would be producedso we will focus on labor as we explain how a short-run production function works. The short-run production function is governed by two economic laws: The law of specialization and the law of diminishing returns. According to the law oi specialization. when laborers specialize in a specic task, their produc- tivity increases because (a) their skill and dexterity in completing that task improves. (b) they spend less time switching between jobs, and (c) specialized machinery and equipment can be developed to increase pro- ductivity related to the specialized task. Workers in a burrito restaurant get particularly good at preparing the ingredients, wrapping burritos, waiting tables, and taking orders and payments. Specialized equipment including kitchen appli ances, automated burrito wrapping machines, and cash registers improve the effi- ciency and productivity of these jobs. But in a small re5taurant with a fixed size of operations, eventually all of the specialized jobs are lled. Once the restaurant has one person specialized in cook- ing the ingredients, one person assembling and wrapping burritos, one person running the cash register, and one person waiting tables, there are no additional specialized tasks that exist to ll. Continuing to add workers once all of the spe- cialized tasks are lled will increase the output of burritos, but output will start to increase by smaller and smaller increments because there is no longer a productivity bump from specialization. We have now entered the realm of diminishing returns. According to the law of diminishing returns, as more units of a variable input (such as labor) are added to a xed amount of other inputs (such as capital), the marginal productivity of the variable input will eventually decrease (after all specialized tasks are lled). In other words, as you have more and more workers utilizing a limited amount of machinery and equipment in a limited size operation, eventually adding additional workers will add smaller and smaller amounts to output. Once the restaurant is fully staffed. adding an additional worker may result in a small increase in output, but the increase in output will be much smaller than when previous workers were added. As a realworld example of the law of diminishing returns, in the mid19705 IBM found that increasing the nuntber of programmers on a project definitely resulted in lower productivity of each additional programmer as more were hired. More programmers meant more time wasted in meetings, drafting plans, exchang ing emails, reaching consensus, conducting staff evaluations, and so on. We see similar phenomena in most small businesses and in some large businesses. CONSUMER AND SUPPLIER BEHAVIOR Figure 11.1 shows a hypothetical shortrun production function {or Mercado ihrrriro that displays the law of specialization and the law of diminishing returns. The rst two columns. showing the number of laborers hired (L) and the quantity oihurritos produced by those laborers per hour worked (Q) constitute the short- run production function. In this example. there is only one variable input. labor. All other inputs are xed. The producrion funcrion focuses on the output of bur- rrms from hiring a certain number of laborers for one hour. The third column in Figure 11.1 shows the marginal product of labor IMPLL which is the additional output that results from hiring an addi- rional unit of a variable input (labor): MPL =(AQ/ AL). in this case. the marginal product of labor is the additional output of burritos rlnt occurs when one more worker is hired for one hour. Notice that the marginal product of labor increases at rst, when the rst four laborers are being hired to ll specialized tasks. indicating the law of specialization. After hiring four laborers, the marginal product of labor declines. Hiring additional laborers increases the output of burritos by smaller and smaller amounts. Eventually, hiring the 11th laborer doesn't increase output at all. By this point, there are so many laborers working in a small space that they are actually getting in each other's way. Eighty-three burritos an hour is the maximum capacity for this small restaurant. When a 12th laborer is hired, output actually declines. Figure 11.2 plots out the production function, also called the total product of labor. TPL. and the marginal product of labor, MPL. Notice that while specializa- tion is occurring, MP L is increasing and the slope of the TPL curve is also increasing (the slope of the TPL curve is the MPL). When the law of diminishing returns sets Number of Quantity Marginal product Average laborers produced of labor Total variable Marginal east variable cost l Q MP1: balm. cost TVC=wxl MC=ATVCIAQ AVC=TVCIQ \"II__ -__- "nu__ 3 __ __ -.__5_ nun-__ -- n_-m n"mm \"__ -_.- -_- FiGUREHJ Table showing speciaiization. diminishing returns. and firm costs for Mercado Burrito. U} Ul- (n MARKETS, SUPPLY AND DEMAND 250 85 80 TPL 75 Output (Q) MP L 0 1 2 3 4 5 6 7 8 9 10 11 12 Laborers (L) FIGURE 11.2 Production function (TP ) and the marginal product of labor (MP ). in, MP, falls and the slope of the TP, curve declines. Eventually the TP, curve hits its maximum when MP, hits 0. The next important step is to use the marginal product of labor to calculate the marginal cost of each burrito. First, we need to compute the total variable cost, which is the total cost of hiring variable inputs, such as labor. When labor is the only variable input, as it is in this case, total variable cost per hour is equal to the wage per hour multiplied by the number of laborers hired: TVC = WX L. In general, the wage rate is fixed at the equilibrium local wage rate, which in this example is $15 per hour. TVC can be seen in column 4 of Figure 11.1. We can then use the changes in TVC and Q to compute the marginal cost of each unit. Marginal cost is an extremely important concept in mainstream economics. Marginal cost (MC) is the increase in cost from producing another unit of a good. In mathematical terms, MC = - ATVC AQ Marginal cost is computed in column 5 of Figure 11.2. Notice that in this case, because the wage rate is considered to be fixed, we can rewrite the formula for MC:CONSUMER AND SUPPLIER BEHAVIOR MC=ATVC=waL _ w AQ AQ 'EE' Marginal cost in inversely related to the marginal product of labor. When workers become more productive due to the law of specialization, productivity increases and the cost of producing each additional unit decreases. Or, in economic lingo, when the marginal product of labor (MPL) increases. the marginal cost of pro- ducing each unit of output (MC) decreases. Similarly. when workers become less productive due to the law of diminishing returns, productivity decreases and the cost ofptoducing an additional unit of output increases. When MPL decreases, MC increases. We can also use the data in Figure 11.1 to compute average variable cost, which is the variable cost per unit of output: AVC = (TVC / Q). This can be found in the sixth column of Figure 11.1. We can use the information on MC and AVC to construct the rm's supply curve. The supply curve for a rm is the marginal cost curve above where MC intersects AVC. Let's explore why this is the case. First, in general, when rms engage in optimizing behavior, they use marginal cost to determine h0w many units to produce. Optimizing rms always build a small prot into their costs of production in order to accurately reecr the oppor- tunity cost of spending money on inputs. This usually means adding a prot of about 10% into all costs of production. If a rm has to pay $13.64 for an hour of labor, they will want to recoup 110% of that amount, $15, to cover the opportunity cost of using their money to hire labor (instead of investing it in the stock market or some other protable activity). All costs in economics include a built-in normal prqt to capture the opportunity cost of engaging in production. A normal prot is the rate of prot that is typical in competitive industries. (We will explore the idea of normal prot more in subsequent chapters.) A 10% prot is built into the cost of each item produced in such markets. In Figure 11.1I when six laborers are hired and the marginal cost of a burrito is 51.50, the rm is willing to sell those burritos for $1.50 each because the firm will make a small prot on each burrito at a price of $1.50. A 10% prot is included in the marginal cost gures. Thus. the marginal cost column tells us the lowest price for which a rm is willing to supply a certain quantity of goods. and that is the denition of a supply curve. The only exception to this rule is that the rm will nor want to supply any burritos if the price falls below the minimum number in the average variable cost column. The minimum AVC tells us the lowest price at which the rm can cover its labor costs. At any price below that. the rm would lose too much money by Staying open and should shut down its operations. Thus, the rm's supply curve is the marginal cost curve above the minimum average variable cost. as depicted in Figure 11.3. 252 MARKET 5- SUPPLY AND DEMAND Firm's supply curve is the MC curve to the right of this point MC, AVE (5) O 10 20 30 40 50 60 70 80 Quantity FIGURE 11.3 Marginal cost and average variable cost curves. Using the table in Figure 11.1 or the graph in Figure 11.3, we can determine that at a price of31.50, Mercado will supply a quantity of 63 burritos. If the price increases to $2.50. Mercado will supply 77 burritos. At a price of 87.50, Mercado will o'er 83 burritos for sale, the maximum amount they can produce in an hour. Our restaurant maximizes profits by selling every unit for which the price is greater than or equal to the marginal cost. We will explore rms and their supply curves extensively in the next section of the book. Now that we have gone in depth into the mainstream economics model of the supply curve. it's time to consider additional perspectives on how suppliers make decisions. 11.5 POLITICAL ECONOMISTS AND BEHAVIORAL EOONOMISTS ON SUPPLY DECISIONS The mainstream supply and demand model focuses on shortterm optimizing behavior. This captures some essential characteristics of markers and how they NSUMER AND SUPPLIER BEHAVIOR work much of the time. Political economists and behavioral economists focus 0n tiiirent aspects of markets. Regarding supply decisions, they are much more con- cerned with the complex realities of specic supply decisions. This includes under- standing how groups within rms negotiate decisions and the key issues involved in longer-term strategic decision making, including the cultivation of innovations and monopoly power. 11.5.1 Satisficing The mainstream model of supply decisions assumes that suppliers engage in opti- niizing behavior, comparing marginal revenue and marginal cost to determine the optimal level of output. This results in an elegant model in which supplier behav ior is nicely predictable. But how often do real suppliers actually behave this way? According to both political economists and behavioral economists, rather than malt- iug fully informed, optimal decisions, most suppliers engage in satiseingmak iug prudent decisions using rules of thumb given limited information. Firms rarely know what their marginal cost curve actually looks like. But they can easily determine the average cost of each unit they produce by adding up all of their costs and dividing by the quantity they are producing. Many rms simply take the average cost of a unit they are producing (including any opportunity costs) and then add a markup to average cost in order to gure out what price to charge. The amount of the markup they add on will depend on their best assessment of market conditions, including the interest of consumers in their product and the pricing and marketing campaigns of competitors. In addition, decision making within a rm is often complex. Behavioral and political economists see rms as coalitions of groups including managers, stock holders, workers, and suppliers. Decisions within rms are usually made via compromises between the groups. Managing a rm is incredibly complex. For example, a rm can choose to pay the lowest wages possible to employees in order to minimize costs. Or a rm can pay workers more than the lowest possible wage rate to improve morale and productivity and thereby reduce the need to monitor workers closely. Wellpaid workers who are given autonomy and responsibility are highly motivated and need little supervision, which boosts productivity and can actually reduce costs. And as we saw earlier in the case of Veblen goods, simply setting prices as low as possible does not make sense in some markets. A rm that produces luxury goods needs to work more to establish brand name recognition and to cultivate exclusiv- ity rather than to sell products as cheaply as possible. From this perspective, the act of managing a rm is an artistic balancing act. rather than a mechanical decision to produce as long as marginal revenue is greater than or equal to marginal cost. This is the reason why the great \"value investor" Warren Buffet puts so much weight on the management team of a rm when he is deciding where to invesr. Management and the organizational structure of a rm are especially crucial in the long~term strategic success of a business. MARKETS. SUPPLY AND DEMAND 11.5.2 Long-term strategic decisions Firms certainly need to pay attention to prices. revenues. and costs. which are the focus of the supply and demand model. But they also need to attend to much broader. long-term considerations. especially the strategic direction of the firm and the besr way to insure a steady ow of prots. From a political economy perspec. tive. business competition is competition for prots. The goal and focus is link. ing prots in whatever way possible. This includes price competition and efforts to optimize revenues and minimize costs. But it also includes competition for break. throughs and to establish monopoly power. indeed. the primary determinants of the long-term success of a company include the ability to cultivate innovation and to dominate and control markets. As we discussed earlier in the book. one of the major dynamics in capital- ism is creative destruction. Businesses are forced to invent constantly to stay one step ahead of the competition. and creative, new industries inevitably destroy and replace older ones. A major determinant of the long-term survival of a business is its ability to anticipate and manage the forces of creative destruction. A business must be constantly on the watch for new opportunities and threats. Figure 11.4 lists some of the major U.S. industries that are in the midst ofsuf fering steep declines. and Figure 11.5 lists the industries expected to grow the most rapidly in the near future. Currently the major sources of creative destruction are competition from online and foreign competition. The major industries with highest expected growth in employment often sur- prise people, but some analysis of the trends makes it possible to anticipate such changes. Given the aging population of the United States, it makes sense that health care is among the list of growth industries. The increasing emphasis on sustainabil- ity. especially in energy production, has increased the demand for installers of wind turbines and solar panels. In addition. the increasing importance of online sales and social media. along with the massive amount of data being accumulated in this arena. is increasing the need for statisticians and data scientists. as well as cybersecurity. Consider the implications of the constant destruction of old industries and development of new ones for existing businesses. Any rm that is content to maxi- mize its current profits without taking steps to plan for the future is likely to end up in the dustbin of history. A key part of business activity is investing substantial _ Newspapernublismns Recorded media manufacturing {DVDs. CDs) Streaming. pirating Tools and hardware. tiothes, shoes Cheap foreign competition Retail sales (Sears. Macy's, malls) Unline sales [Amazon] FIGURE 11.4 Table showing U.S. Industries in decline. MER AND SUPPLIER BEHAVIOR 255 Occupation Growth rate 2019 Median pay Wind turbine service technicians 61% $52,910 Nurse practitioners 52% $109,820 Solar photovoltaic installers 51% $44,890 Occupational therapy assistants 35% $61,510 Statisticians 35% $91,160 Home health & personal care aides 34% $25,280 Physical therapist assistants 33% $58,790 Medical & health services managers 32% $100,980 Physician assistants 31% $112,260 Information security analysts 31% $99,730 Data & mathematical scientists 31% $94,280 FIGURE 11.5 Table showing industries with highest projected growth in employment. Source: Bureau of Labor Statistics. funds to generate innovations that will keep the firm ahead of the competition or that will move the firm out of a dying industry and into a growing one. Amazon is famous for making very little in the way of annual profits because Amazon invests relentlessly in new initiatives for the long term. These investments have clearly paid off: Amazon's value as a company increased from $438 million in 1997 to $1,672,000 million in 2021, and their sales increased from $90 million per quarter in 1998 to $125,600 million in the last quarter of 2020. Innovation may be the single most important ingredient in a company's long-term economic success, fol- lowed closely by the firm's ability to cultivate a degree of monopoly power. 11.5.3 Cultivation of monopoly power In extremely competitive markets, it is impossible to make much profit. So in an economic system focused on profit, one of the essential business tactics is to make an industry less competitive. This can be done in a number of ways. You can drive competitors out of business with fair or unfair practices. You can create brand name identity so consumers buy your products instead of those of your competitors. Once you grow bigger than your competitors, you can use your financial power to buy out or merge with competitors. You can buy up patents and innovations and either use them or shelve them so competitors cannot use them. The most profitable industries in the United States are those with significant degrees of monopoly power when firms have the power to raise prices without losing too many consumers. As Warren Buffett, the most successful investor in modern history, once said, The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10%, then you've got a terrible business.256 MARKETS, SUPPLY AND DEMAND There is a direct correlation between market share and profitability: The more a firm dominates its market, the higher its profits are likely to be. As you can see in Figure 11.6, Apple was the most profitable U.S. company in 2019 thanks to its dominance (monopoly power) in the smart phone, tablet, and laptop markets. The financial industry has seen many mergers and acquisitions over the last two decades, leaving the industry heavily concentrated. By the late 2010s three huge banks, JPMorgan Chase, Bank of America, and Wells Fargo, controlled about one- third of U.S. banking, with Citigroup not far behind. With this degree of monop- oly power, four of the ten most profitable U.S. companies in 2019 were financial institutions. Meanwhile, Google (Alphabet) with its dominance of search engines finished third, and Facebook with its control over social media was the sixth most- profitable company. These companies can use their market dominance to stay on top, buying up competitors and new technologies. It will likely take significant antitrust action by the government to break up the control that these huge compa- nies have over the industries in which they operate. Another key point here is that in many industries there are significant econo- mies of scale: It is more efficient to be large than it is to be small. Large companies do not experience the law of diminishing returns in the same way as small firms. In fact, for huge firms in manufacturing and software, the larger they get, the lower their average cost of supplying each unit becomes as they create new specialized jobs and technologies. Market power also allows firms to negotiate better deals that reduce costs. Large firms like Apple and Walmart can demand lower prices from their suppliers as a result of their market dominance. Similarly, in financial services, more financial clout means more opportunities to make profits. Huge banks can pursue opportu nities around the globe and they can secure favorable rates for their services. Supply curves for such industries may be downward sloping rather than upward sloping because the firm's costs may decline as they get bigger, and the biggest firms Profits Company (millions of $) Apple $59,531.0 JPMorgan Chase $32,474.0 Alphabet $30,736.0 Bank of America $28,147.0 Wells Fargo $22,393.0 Facebook $22,112.0 Intel $21,053.0 Exxon Mobil $20,840.0 AT&T $19,370.0 Citigroup $18,045.0 FIGURE 11.6 Table showing the most profitable U.S. companies in 2019. Source: Fortune, https://fortune.com/fortune500/.i LUMER AND SUPPLIER BEHAVIOR will tend to have the lowest costs and the most options. A market with vast econo- mics of scale like this would not work in the same way the supply and demand model predicts. 11.5.4 Power and countervailing power The issue of monopoly power highlights a more general issue with markets: The Power of large corporations and the countervailing power of consumers, unions. communities, and governments. The famous institutionalist economist john Kenneth Galbraith observed that there were three main power centers in market economies: Businesses, governments (and the communities they represent). and workers (and the unions that represent workers). Galbraith believed that capitalism worked well when power was distributed relatively equally between those three power blocks. When businesses were too powerful, they exploited workers and gouged consumers. When governments were too powerful. they became authori- tarian and bureaucratic. If unions became too powerful, they could harm economic productivity. The ideal system, to Galbraith, was one in which the countervail ing power of each block could counteract the worst impulses of the other blocks: Businesses' bad behavior could be checked by unions and government regulations; government could be kept in line by businesses and workers; and workers' power would be checked by businesses and government regulations. But that perfect bal- ancing act is hard to maintain. Even in competitive markets there are power imbalances. We noted above that the pizza market is quite competitive, with dozens of restaurants in each town. In theory, the competitive nature of the pizza market limits the power of any one company and provides options and opportunities for consumers and workers. And yet we nd that the big players in the pizza market, especially Domino's and Pizza Hut. have substantial monopoly power. Workers at Domino's and Pizza Hut are paid low wages, usually near or at the local minimum wage. Both restaurant chains make large political donations to make sure that politicians enact laws that are good for their business. This includes lobbying efforts to oppose increases in the mini mum wage and to ght labeling laws that require health information to be put on menus and product labels. If the pizza industry lobbyists have their way, pizza will be classified as a \"vegetable\" for school lunch programs, so it can be served instead of dishes made up entirely of vegetables! Even the most competitive markets involve power relations of some sort, so understanding markets means grasping how those power relations are structured. The locus of power in a market starts with the rm and the power it has by con- trolling tesources (the means of production). Firms have direct control over their workers, what they are paid, and the conditions of work. If workers are skilled and/ or unionized, they will have some countervailing power to ensure that they are paid and treated well. If they are unskilled and nonunion, workers will have very little power and will have to accept what they are offered by the firm. 258 MARKETS. SUPPLY AND DEMAND Subsidy . General Atomics $533 5 Fiat Ch sler $405.0 FIGURE 11.? Table displaying the largest corporate subsidies of 2019. Source: Goad Jobs First, \"Subsidy Tracker,\" httpszllwwwgoodiobsfirst.org/subsidy-tr acker, accessed January 29. 2021. Fimis have substantial control over communities. When a large rm is decid- ing where to locate its operations. communities will engage in bidding wars to attract the firm. This will often include decades of tax holidays and the provision of free infrastructure and government services. The biggest corporate subsidies of 2019 are listed in Figure 11.7, showing four companies that received hundreds of millions of dollars in tax breaks or direct subsidies to locate operations in a particular place. The largest corporate subsidy in history was an 38.7 billion tax break given to Boeing by Washington State. By 2021, Amazon amassed 83.7 bil- lion in subsidies from state and local governments, including the $750 million they received in 2019. The larger the size of the corporation, the more power they have to demand subsidies and tax breaks. Communities, along with the local, state, and federal governments that represent them, do have some countervailing power. They can pass laws that restrict corporate power and enact taxes that make corpora- tions pay for their fair share of infrastructure and education costs. But judging by the huge expansion in corporate subsidies and the decline in corporate regulations and oversight over the last few decades, corporations have the upper hand. 11.5.5 Evolution and change vs. stability and equilibrium In general, the supply and demand model focuses on how shortterm prices tend to stabilize around an equilibrium price and quantity. The supply and demand model is particularly useful for analyzing how a variety of key determinants affect equi librium prices and quantities in the short term. The political economy approach is useful in studying the factors that cause industries to evolve and change, such as the forces of creative destruction and monopolization and the power relations within particular industries. One can nd both of these tendencies in most markers. The key is to determine which tendency is most useful for particular types of analysis. 11.6 CONCLUSION This chapter has expanded our analysis of markets to go beyond the supply and demand model in some key areas. The chapter began by analyzing consumer behav- ior that cannot be captured by a typical demand curve. This included the idea of