Economics 201

Introduction to Macroeconomics

Mark Witte

Northwestern University

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Messing with Supply & Demand

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What do Supply & Demand mean?

• The Demand Curve represents the willingness to pay for the marginal unit
• Equivalent to the marginal benefit (MB) of an extra unit
• The Supply Curve represents how much we have to pay to get an additional unit
• Equivalent to the marginal cost (MC) of an extra unit

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What’s great about markets? What are they made of?

What’s great about markets? What are they made of?

• Soylent Green

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• Consumer Surplus (“Rent” to consumer)
• Willingness to Pay > P

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• Producer Surplus (“Rent” to producer)
• P > Marginal cost of production

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• “Well functioning” markets maximize consumer and producer surplus

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• Maximize the wellbeing of society

Well functioning market: Point E!

• At point E, we are maximizing Consumer and Producer Surplus
• We are maximizing the social gain from this market!
• But...what if we somehow don’t produce the quantity that puts us at point E?
• “Market failure”
• Many possible causes of this
• Two big ones for this class:
• Lack of competition (monopoly, oligopoly)
• Externalities (not all costs of production borne by producers or buyers)

Consumer and Producer Surplus

• If someone creates a new product, how much of the social gain does the inventor get?
• Economist William Nordhaus thinks that creators of technology are only able to capture about 2% of the economic value created by that technology.
• The other 98% flows through to society as CS and PS.
• Technological innovation in a market system is inherently philanthropic, by a 50:1 ratio
• Who gets more value from a new technology, the single company that makes it?
• Or the millions or billions of people who use it to improve their lives?

“Deadweight Loss” (DWL)

• There’s a social gain from producing whenever MB > MC
• So we should produce up to Q₁

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Market Failure: Q where Social MB ≠ Social MC

• For most things, private and social are the same
• Sometimes private benefits differ from social benefits
• Beneficial social spillovers
• Beneficial externalities
• Sometimes private costs differ from social costs
• Pollution
• Negative externalities

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Or maybe markets work just fine, and we just screw them up with dumb policies.

Messing with markets

Messing with markets

• Quotas
• Legal min or max limit on quantity 
• For our purposes, we will just consider a max q
• Price Floors
• Legal minimum price
• Can cause surplus if above market price
• Price Ceilings
• Legal maximum price
• Can cause shortage if below market price

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• Wait...this ceilings and floors thing seems backwards!

Price ceilings, floors,

Quotas

Price Ceiling: Maximum legal price

Price ceiling below the equilibrium price

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Bad for producers!

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Good for consumers who are able to buy the good!

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Bad for consumers who would have been willing to pay the equilibrium price (or more) but now can’t get the good.

Price Ceiling: Maximum legal price

• If P_max > P_market ⇒ No effect on market

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• If P_max < P_market ⇒ Excess Demand, Shortage

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• Quantity sold falls
• DWL

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• Examples
• Rent controls
• Price controls
• Usury limits on interest rates
• Creates "black markets" to allocate scarce Q
• At Q = 1.8, marginal willingness to pay is about $1,200 >> $800

DWL

Price Floor: Minimum legal price

• If P_min < P_market ⇒ No effect on market

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• If P_min  > P_market ⇒ Excess Supply, Surplus

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• Quantity sold falls
• DWL

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• Examples
• Minimum wage
• Agricultural price supports

DWL

Price Floor: Minimum legal price

Minimum Wage

by state

In 2022, just 1.3% of the 156 million civilian workers were paid the federal minimum wage. Most of those employees were younger than 25 years old

Minimum Wage

Real Purchasing Power of the Minimum Wage

Blue line: What the law set the minimum wage to be.

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Black line: The purchasing power of the minimum wage, which falls as the average price of goods and services rise.

Evanston Minimum Wage, Jan. 9, 2024

Councilmembers debated a proposed ordinance that would set the minimum wage at $15.50 for businesses with four to 99 employees and at $16.25 for businesses with 100 or more employees beginning in July.

The ordinance was originally brought to the council by Ald. Devon Reid (8th) last year and has been discussed in three meetings prior to Monday.

The proposed minimum wages exceed those of Cook County and Illinois, which are set at $14. The ordinance would have also increased the minimum wage annually to adjust for inflation, capped at 2.5% each year, but council members voted to remove the automatic increase from the policy.

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Alternative to the Minimum Wage: EITC

• A much bigger program is the Earned Income Tax Credit
• The biggest cash welfare program for poor families
• It’s a wage subsidy for low income families
• It adds up to 40 cents per dollar earned to low income people, maxing out at $5,500 per year for family incomes of $14,000 per year
• The burden of the minimum wage is on the employers of low wage workers, those who are making jobs for these these workers
• The burden of the EITC is on all US taxpayers, a much broader sharing of the cost

The EITC

has

become

really

important

Quota: A legal maximum Q

• One quantity, two prices!
• Forcing a smaller market quantity drives up prices and creates DWL.
• The “wedge” is the benefit that goes to whoever controls access to this market.  

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Quota example: Taxi Medallions

• Forcing a smaller market quantity drives up prices and creates DWL.  
• These things have sold for $250,000 or more

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Economic Inequality

• Market systems often experience high inequality
• But should we care about inequality?
• I am low paid by economist standards, but am well paid by lecturer standards
• Should I be happy, or sad?
• I should be very happy! Because my needs are more than covered.
• “The only time you look in your neighbor's bowl is to make sure that they have enough. You don't look in your neighbor's bowl to see if you have as much as them.”
• Henry Simons: “Surely there is something unlovely, to modern as against medieval minds, about marked inequality of either [wealth or political power]. A substantial measure of inequality may be unavoidable or essential for motivation; but it should be recognized as evil and tolerated only so far as the dictates of expediency are clear.”

Redistribution versus Pre-distribution

If we want to reduce income inequality, what are some possible ways to do so?

• We could tax everyone and send the proceeds to farmers.
• Or we could put a price floor on wheat and use taxes to buy up the surplus.

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• Redistribution:
• Reduce inequality after income is earned
• Taxes on those with more to finance transfers to those with less
• Welfare, food stamps, housing subsidies, Medicaid, progressive taxation

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• Predistribution:
• Prevent inequality before income is earned
• Minimum wages, price ceilings or floors, quotas, import tariffs, labor unions, antitrust regulation, limiting immigration, hiring discrimination, education subsidies

Redistribution versus Pre-distribution

• A lot of people hate redistribution because it seems to take from one person and give to another
• Redistribution also has explicit government budgetary costs that have to be paid (and can be cut)
• Predistribution seems to be free; it doesn’t appear in the budget
• There are no obvious payments coming from some people and going to others
• But predistribution is often very costly in terms of economic distortion
• Probably more costly than redistribution

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• People generally don’t feel good about getting redistribution payments
• People tend to feel that they have earned what they get through predistribution, which makes them happier

Next up!

Market failure

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Elasticity