Strictly speaking we don’t like to think about our relationships as property rights in other people.  Moreover, thinking in this way will lead to some very real lessons in how distorted expectations can become.  I was talking with a friend today about how jealousy, even if it had evolutionary reasons for existing in the status quo, has nothing much to offer the sophisticated individualist.  This willingness to think of almost any experience through the lens of the economics disipline has been a love affair with frustration.  We know economic models do not arrive at truth, but we still have to place experience within them and see if there is a coherent idea which will parsimoniously render.  The digestion of relationships seems more obviously out of place than most, so it is that much more compelling.

By the term individualist let me first tell you what I mean.  This is the person who is rational in the way that he constrains his self-interest.  It is this expectation which we can impose not only on ourselves, but also on others.  I know that I will not seek to maximize my pleasure without first learning what the costs will be, and I prefer these costs to be foreseeable, ceteris paribus.  In a relationship, monogamy has sprung up to minimize all sort of cost associated with our lives as sexual creatures (expectations, smoothing, aging).  Our expectations of belonging, while very rational, come from a part of our existence which is not individualistic.  I am compelled by the way that humans are born dependant.  No baby can live without the constant attention of other humans.  The mere presence of exposure is enough to kill a newborn.  So, it follows that there is a period of time in which we exist where we are dependant on others.  The individualist perhaps is more likely to tell you that this ends at the age of maturity.  We can think of a hermit, an example of a real case of an individual existing in isolation.

It is this that we mean by individual however, when we use this term we are often speaking of some characteristics of man apart from the group.  In this way individualism is most easily defendable.  There are some small perceived problems with this view.  The benefits which occur to the individual are desired by others because; in some way they are the product of that man’s effort, who is entirely dependant on his fellow-man for moral support.  In this abstract sense communism has spent a great deal of time explaining why private ownership is a violation of this relationship (this seems to be only a first approximation of the problem however).

Between two people jealousy is a similar violation of this relationship.  It is ignoring the investment other people have made in you, by benefiting from people who have not put in the same time, effort, display, or other sunk cost.  The same way that a child no longer depends on a parent, the lover can feel like there is nothing more to be gained from continuing a relationship.  The individualist (in his pejorative worst case) will say that an adult has nothing to owe the parents for the raising of his child-dependant self.  Somehow this lacks a reciprocity which cannot be easily expressed.  It is curious that the reciprocity is more focused on raising your own children, than paying the parents back for what they have given you.  In this way Dawkin’s “Selfish Gene” seems to be taking care of itself very well.  This explanation lacks tractability in fully appreciating the connection we all have to one another.  For example, those that are unable, or unwilling to have kids of their own often seek to repay this investment with raising other people’s children.  This expands our search for the determinants of reciprocity.  Moreover, what how can we begin to understand the compulsion of individuals to one another in monogamous relationships.

We have titles in our culture for people that enter into certain relationships.  There is no clear definition for when one passes from one stage of the relationship to another, but there are some culturally significant processes.  “Girlfriend” comes before “fiancé” which precedes “wife.”  All of these are distinct from the colloquial term “Baby-momma.”  In a way however they express ownership.  The first three in a purely theoretical sense and the last in a tangible sense more justly thought of in terms of property rights (mixing of the person with an outcome – new person).  This relationship also incorporates the continued line of reciprocity needed for the survival of the human race.  There is nothing distinct from the two series of terms aside from this theoretical and tangible paradigm.  A “baby-daddy” does nothing dissimilar from a “Husband.”  But the terms of approximation seek to do something in a more social context.  Calling someone my “girlfriend” imparts a sense of ownership, even if it only does so implicitly.  I would feel justified in feeling aggressive if someone made unappreciated sexual advances towards my “girlfriend” most likely citing this as my justification for feeling protective.  “My fiancé” is traditionally going to wear a ring, which at least attempts to communicate that she is no longer seriously evaluating competitive offers for sexual advances.  Am I then justified in feeling threatened personally when someone violates this signal?  Do I have justifiable reasons for asserting property rights, in this case referred to as jealousy?

The new entity now exhibits its own jealousness.  To not be jealous in the face of threats to the survival of this new entity is akin to that entity failing to be rationally self-interested.  I suspect that thinking of relationships as if they were individuals is problematic, but they have the reciprocity aspect which I have laid out already concerning all human relationships.  They exist in harmony with others.  As a kid I found it difficult to understand my parents as individuals, they always sought to hand down rules from this third party “Parent” perspective, which was a corporate creation of their making.  At some level this assisted them in making hard decisions.  This seems to be a description of some puppet, but I feel it accurately describes the mechanism as the best justification of monogamy.   

As an individualist, I am repulsed by the idea that someone could own part of me.  It strikes me however that this is precisely the case with relationships, which is the willing submission to this ownership.  An economist might say that no one willingly submits to be the slave of a company by accepting a wage, so my analogy is false, but consider how this is different.  I trade limited property rights (exclusion of competition) with another person to be paid in kind.  This attempts to render a third legal identity existing as a partial derivative of the two individuals.  In forming this corporate entity, the property rights now change.

The new entity now exhibits its own jealousness.  To not be jealous in the face of threats to the survival of this new entity is akin to that entity failing to be rationally self-interested.  I suspect that thinking of relationships as if they were individuals is problematic, but they have the reciprocity aspect which I have laid out already concerning all human relationships.  They exist in harmony with others.  As a kid I found it difficult to understand my parents as individuals, they always sought to hand down rules from this third party “Parent” perspective, which was a corporate creation of their making.  At some level this assisted them in making hard decisions.  This seems to be a description of some puppet, but I feel it accurately describes the mechanism as the best justification of monogamy.   

If you were driving along Braddock Road recently you would have seen many signs with people’s names on them.  An insight into this phenomena would be that elections are coming up shortly.  Dr. Williams asks the class:  How many of you vote? and: Why do you vote?  His conclusion is that there are non-trivial costs associated with voting and benefits are close to zero (following from the idea that one would only value voting when their vote decides an election).  There is a distinction to be made between the political sphere and the market in this way.  A vote cast in the political world doesn’t do anything if the election is not decided by one vote (the marginal vote changes nothing, has no understandable marginal impact).  A vote cast in the market (by spending a dollar) not only has a marginal impact, the person casting the vote understands exactly what they are getting out of casting that vote (in terms of whatever is exchanged for the dollar).

A second question posed by Dr. Williams:  Does your reputation belong to you?  There was some real confusion in the class over this one.  There is something in business likened to “goodwill” for a company.  This is accounted as an asset for a business.  Is there something also valuable that is associated with an individual?  Dr. Williams infers from this question that libel and slander should be legal.  In the marketplace for information in the absence of libel and slander laws, the relative price of libel and slander would be reduced and there would be lots of misinformation offered at a price where it would not be noisy, the good information and the bad information would come at the same price.  A person could not be ruined by gossip if there were no cost associated with someone putting their name to a statement.  The value of using slander would fall.  There is a property rights issue associated with this argument.  I do not own the thoughts another person has about me.  I cannot protect my reputation inside another person’s head.  Although it was not said in class, I feel that people have the ability to build up creditability based on experience with another person.  This relationship aspect is very important in considering how we view economic insight into this question.  If I do not have the right to protect you from hearing bad ideas about me, I to some extent am not able to fully “own” my reputation (where own means keep, acquire, and control).

Economics is able to answer questions by looking at the process and the outcome.  If I were to look at the following data:

Poker Players               Percentage of wins

A                                 75

B                                  15

C                                 10

I cannot immediately make implications about the fairness of play involved in the game.  For example, if I were to investigate and conclude that the game was played faithfully following well documented rules (according to hoyle) decided beforehand by all players, I would then conclude that the process was “just and fair.”  This is the economic interpretation of the process, and certifies the outcome through these further insights.

Income distribution is a result; what are the underlying process questions?  Did all people have access to the system?  Did people start with similar endowments?  Was anyone excluded from the market? 

Recall: Demand and Supply have a component of elasticity that increases in the long-run.  People adjust their behavior.  The classic Alchein example is the use of water.  If the price of water rises we don’t immediately expect to see people change all of their water consumption.  If the higher price persists, we expect to see people start to employ water saving devices (though they find out about these from the marketers of these devices who have a profit incentive to market these).  A squeeze nozzle will be employed on the hose, a showerhead will be placed in the bathroom, a rock garden could be substituted in the backyard as opposed to the grass which was there before.

Supply: shows various amounts of a commodity for which a producer will supply at a given price for a given time period.  Quanity supplied is a function of price.

Determinants of supply:

1)      Technology: Invention, Innovations

2)      Number of sellers

3)      Input prices (the wages of labor and capital)

4)      Price of all other goods (if a farmer has a choice of growing corn or wheat on his land and the price of corn rises, he will substitute more land and labor into growing corn than he would have before, he will also move out of wheat due to a change in the relative price)

5)      Expectations (If you grow coffee, and you expect that the price of that coffee will rise next week, you therefore perceive the price for coffee this week is relatively low and you will withhold coffee from the market this week in lue of selling quantities of coffee at the higher price next week.  The converse should also be true, that if you expect coffee prices to fall, the price today is relatively high).

Note:  For the first part of the semester we will be considering property to be certain, for property rights to be fixed and well known, and for all people to understand this (this assumption relaxes after the introduction of Demsetz’s theory on these issues). 

Supply and Demand a review:  Stable equilibriums:  if something happens to upset the static point (change Q* or P* ; forces will act to bring things back to the initial level.  At prices above the market level there is excess demand which forces the market back to equilibrium, at prices below this market clearing level there is excess supply which also works to return to market clearing level.  If you drop a marble into a steel bowl, there is a point in the bowl where the marble will come to rest (stable).  If you turn that bowl upside down and upset the marble on top of the bowl, it will not return to its initial position (unstable). 

If we involve politicians into this theory we have to change the assumptions about equilibrium.  These politicians can look at the market and determine that the equilibrium is in some way unfair.  This leads to things like price floors (a law saying price cannot fall beneath a certain value) and price ceilings (a law saying price cannot rise above a certain value).  An example of this is rent control. If an artificially low price is set the market does not clear.  The market on the short-side always dominates.  Although the intention was to make the housing more affordable for the lowest income persons, there is no way to make the suppliers offer the same quality of housing to the occupants at this lower price.  Since we are in a situation of excess demand, we see that lower quantities of housing are supplied at this new low price.  This is a net flow out of the market (depreciation of current capital stock).  The supply curve starts to shift leftward (over time).  A new higher price is reached which clears the market and eliminates the excess demand.  This new higher price takes into account a difference of the new higher price (PH) minus the price ceiling (PC) at the short side quantity of the market (Quantity supplied).  It is has been observed in the past that this differential (PH – PC) is paid out in non-pecuniary ways, or at least in creative ways like key deposits which never get returned, or in-kind payments (grey market). 

“Short of aerial bombing there is nothing that can destroy a city more efficiently than rent control.”

One of the unintended effects of this change is that there is substitute investment in higher end housing.  The capital that otherwise would have been profitable in the low income housing market will now be used to increase the higher end market, this has the effect of making housing cheaper for the opposite demographic than the one for which the intervention was originally intended. 

We can also apply this analysis to the gas market.  If there is a price ceiling placed on gas at a below market level, then we expect to see long lines at the pump.  The gas stations have no incentive to provide capacity for this excess demand, so that there is less gas supplied at this lower level.  The weighting inceidence is almost entirely on the consumers of the gas, the supplier is under little pressure to respond to this excess demand, so that the gas may be cheaper in money terms, but is now more expensive in total terms, when you include the opportunity costs of the time spent weighting in line at the pump (not to mention the gas used to keep the car running while you are waiting).  Price controls reduce welfare not only by the dead weight loss, but also by the forgone consumer and producer surplus which is lost and no one gains. Side note on the gas question:  Historical costs do not determine price – replacement costs are relevant to the price that is charged for the commodity, not the paid in costs.

Price ceilings lead to allocation by seller preferences.  Assume in Fairfax the max you can now rent a two bedroom apartment is going to be $500 a month.  It pays now for the landlord to be selective on who he allows to rent the property from him.  These preferences can be as subjective as they are arbitrary.  Remember that low-income people can always outbid the higher income people.  Take for example a brownstone building in the city.  One family is renting this building on a lease at $1200 a month.  A group of lower income families (6) offer to move into the building, if the owner will make 6 separate apartments and rent them each at $ 300 a month.  The lower income family will win even in the case of discrimination because the landlord decides that he doesn’t want to indulge his taste for discrimination at that price.  Think of a fat ugly smelly cigar smoking man that runs around town with a young beauty.  You would conclude that this man has a large deal of money.  The competitive differential is the money (the only way a fat ugly man can compete with Dr. Williams). 

A price floor.  If we want to keep the wage artificially high (on the premise that it is a living wage) we will create unemployment (excess supply of labor).  If this state persists for long enough, the labor supply decreaces due to the discouraged worker effect (low-skilled workers without employment options stop looking for a job).  The amount of this excess supply is equal to the displacement of low-skilled workers who were supposed to be the nominal recipients of this legislation.  This also opens the door for discrimination by buyer preference.  The employer can choose any category that he/she wants to discriminate on the workers, the pool of labor is sufficiently skilled to pick from on subjective criterion (pretty people get jobs).  The rational was to help, it ended up hurting the low-skilled workers.  Minimum wage can be though of as helping the unions.  This tool eliminates the low-skilled worker from the labor supply, so that the union workers are safe from competition.  Imagine a fence building industry.  If it takes 3 low-skilled workers to build a fence and they each charge $10 an hour, the most that a high skilled worker can charge is $30 for the same task.  If however the high skilled worker would like to make $40 an hour, he need go no further than convince the union, the preacher, the politician, and the public to change the min. wage (living wage) to $15 an hour.  He can claim to be fighting for the rights of these lower-skilled workers.  In this case he can now charge up to $45 an hour to do the project and be a better deal than the low-skilled workers.   The low-skilled workers are now out of work, however they can sleep better at night waiting for a higher wage job to appear…

Dr. Williams researched this in South Africa during apartied.  The stated goals of the white unions was to set the black min. wage at a high price so that there would be less of an incentive for employers to defect from the entrenched racial status quo.  Controlling anything to do with market prices opens the door for discrimination on non-price terms by either the buyer or the seller.  A market allows less preferred groups or individuals to compete by charging lower prices, or by paying higher prices.

Think of your grocery store:  The cube steak is $4 (basically offering you $5 to take it home and eat it instead of the alternative) and the Filet Migon is $9, regardless of the fact that F.M. is a better cut of meat, the cube steak outsells the F.M. every day.  If the government were to pass an “equal steak law” that set the price at $9 for all cuts of meat, the cube steak would not leave the store.

The incidence of taxation does not fall only on the statutory recipient of the tax.  If you tax suppliers, the consumer pays some of the tax as well. 

Applications in general of the law of demand (married couples with children go to more theatre than single couples, relative to movies).

“When you see someone doing something more than someone else – assume that it is cheaper (always relatively).”

                                    Dinner and the theatre               Movie theatre

Without children           $120                                        $50

With children                $150                                        $80

(including a babysitter)

In the first case there is a thirty dollar difference for the baby-sitter (same comparison in the second).

The relative price  2.4 (12/5) for D& T and  1.88 (15/ of the trade off One dinner and theatre costs the couple without children 2.4 movies, and the couple with children 1.88 movies, you conclude that it is relatively cheaper for the couple with children to go to the theatre and dinner more often than the other couple. We can ignore tastes and get the same result as if we looked carefully at the effect different tastes would have on this example. 

GMU parking; ex, in 1972 daily parking was $4 a day and the fine for parking illegally was $12 with an expected rate of getting caught at 50%.  In 2005 the daily rate of parking is $7.50, and the expected value of getting caught is the same.  Since your expected value of getting caught is $6, then you conclude that rational actors will park legally in 1972, and these same type of people would park illegally in 2005, based solely on the price of each option.  This counters the folks who claim that kids these days are less respectful of traffic law, when they are actually just acting rationally.

Corporations don’t pay taxes, people pay taxes, corporations are legal fictions and have at least these two options in the face of higher taxes:  lower dividends and lower employment.

I feel miserable right now... I am seriously on the verge of minimalism...  do I care if my seriously reduced consumption speding adversely affects the economy?  No.  Why?

Lately I've been feeling extreme content towards consumption in general.  Branding and the manipulative use of imagery in advertising are bringing my perspective on freedom down.  I feel like 90% of personality is dictated by this "infotainment telesector".  What ever happened to culture?  In my opinion, there is really no such thing as "authentic" western culture.  American culture is created by the largest service industry, advertising.  Who is your typical blue-collar, rural living man?  Well, of course, its the guy with the Rangler jeans changing the oil on his Dodge Ram 1500 while drinking a Coors (silver bullet).  

Over half of a two year old's vocabulary consists of disney characters. care bears, and wiggles.

I've had too much to drink.  I will continue this conversation later with more rationality.               

Sweet dreams.

Several Pieces of “Evidence” (This theory became more creditable when all alternatives were exhausted).  No one came to the RBC theory because of real evidence, or because it was overwhelmingly persuasive.  (This is opposed to the accepted validity of Keynesian economics to correct macro downturns). 

First Criteria: Logical stories of rational behavior models should not include systematic mistakes being made on the part of the rational actors (internal consistency).  Keynesian economics had fooling.  Bob Lucas’ model – “Islands model” allowed for people to be tricked by surprises in the movement of the monetary variables. Even he admitted that his model contained inconsistencies, i.e. that people could just look at the wall street journal and know what direction the macro variables were moving, leading logically to no fooling. 

Second Criteria: The unit root test (Long and Plosner first introduced).  To explain the unit root test: Think about unemployment.  If someone told you that the unemployment rate was 14% and asked for your best forecast in 10-15 years a normal reaction would be to posit that the new rate would be somewhere around 4-6% (the possible natural rate), before you would suggest that the rate would stay at 14%.  This is not unit root.  A unit root would be more like stating that the current growth rate is 3.3% and your best estimate for the future is that the growth rate would stay the same.  An example is to flip a coin to create a time series.  (In class we started at a 2% growth rate and each time the coin was flipped heads meant a rise of 1% and tails meant a fall of 1%).  The result was suitably random looking.  At the end of this process the best prediction for the rate 10 coin flips from now would be the last observed rate, it would be absurd to measure a mean of flips and predict that based on past observation.  This is truly a unit root.  The hypothesis of a unit root could not be rejected in the long piece (when null testing you set up a thesis you would like to prove wrong, thereby giving the alternative higher creditability).  The result of this essay was to suggest that the business cycle could be thought of as the equivalent of a random coin flip.  People stopped thinking that every move in the data was a business cycle move which could be explained by high theory.  This is like the equivalent in basketball, that a shooter could have a “hot hand” and should not be taken out of the game.  A shooter is no more likely to hit a basket after hitting 7 in a row than he was when he had missed 7 in a row.  When this theory came out it forced people to think more about the assumption that the error term on the Robert Solow model could be completely explained.  Real Business cycle theory posits a way to look at this problem even in the presence of randomness.  “When this first came out, I was held captive by trying to explain every little movement in the data with an explanatory variable, Now this randomness is taken for granted.” 

3) Litterman and Weiss (1983).  Vector Autoregression (1983) VAR- No structure (in terms of a hypothesis and model) this was a rather large set of vectors, or matrix, of data useful in talking about the macro economy.  A huge correlation matrix was computed on the data.  This was much like data mining for significant relationships.  One of the big insights is that the real interest rate had no statistically significant relationship with the aggregate measure of money (contrary to theory, and suggesting that money doesn’t matter in determining interest rates).  This contrasts with the theories of the Keynesians and the monetarists.  “If we can’t even find a pattern between money and interest, we really don’t understand what is going on in the macroeconomy.”  McCallen suggested that maybe the interest rate moves before money, meaning that the money wouldn’t be as important in describing the changes in interest rate, this was a changed mindset. 

4) Simulations were offered as “Evidence”  The Solow model is a dependant variable of growth rate as a function of (technology shocks or new ideas, labor, and capital).  Solow’s original decomposition said that three-quarters of the growth variable could be explained by the new ideas variable.  (this leaves labor and capital explaining only a quarter and the residual being counted as all tech).  The tech variable is never measured it is only the residual term for the model which measures capital and labor contribution to explaining growth (the revised models which include better measures of capital and labor do a better job of predicting growth). 

The internet is a perfect example of a productivity shock.

Real Business Cycle – says that Solow was right all the time.  Technology was really the driving force; with some randomness.  Growth (trend component) – take this portion out of the data.  Cyclical part is left.  The residual can be described as the “pure cycle” or the randomness.  The RBC theorists would think this is the worst intellectual move, the cycle is caused by some underlying components of the total data, to divorce these would be to loose explanatory potential.    Solow wanted to keep the decomposition and show accept the random part of the cycle. (TC does not like the Solow model).

Long-Plossner:  How much could, would, did, this number technology measurement change and then output vary?  Katrina (was this a negative shock?) we will see what happens in the evidence, if no negative shock then this provides evidence against.

This model IS complete with the error term (for whatever else bad you can say about it, it is one of the more simple and powerful models in explanation).  We can look at Prescott and the others who defend the RBC model and see them posing the questions for additional microeconomic research.  These programs should focus on further developing the productivity, technology components of the error term in the Solow model.  We should continue to tease any other variables out of the residual.  During the 90’s the work on understanding the technology effect of computers on output could be looked at in the broadest sense as promoting the same program of study as these RBC theorists.  Remember that we are useful in explaining much of history with the business cycle model, looking at agricultural society, we can say that rain is the exogenous shock which then helps determine the labor and capital effects on output, similarly this technology exogenity is to be considered. 

RBC helped to reestablish market clearing rationality, rational expectations (the converse was a formula for more government, like the Keynesian framework).   Now it is the most fundamental of the theories, the building block for discussing the macroeconomy and for the last 25 years has been the newest developing theory in macro.  Two ways of thinking about RBC:  1) enough brainpower applied to these models and we will eventually crack the theory (Prescott) 2) useless b/c there are always going to be phantom variables which we cannot predict the effect of on output (black). 

Big Business cycle countries: Tailand and Argentian (recently).  The U.S. and other developed economies seem relatively unaffected by the business cycle factors.  Big questions include things like: why Japan has experienced slow growth.  In a way the RBC model is the best model that we have for understanding the recent history of the science. 

Any good Business cycle model must contain and explain these 3 things:

1)      Persistence (lasts for awhile)

2)      Co-movement (many sectors go up and down together)

3)      Changes in the labor supply (employment)

To be a serious model you should generate these three things.  Only model that does “almost fit” the 3, but really only satisfies the first two.  Needs to prove.  The 1^st assumption – one person (a dramatic assumption since it assumes away problems like coordination failure).  And output = input.  The example: A farmer.  Two animals, ducks and chickens.  They both lay eggs and the farmer can either consume the eggs or let them grow into additional chickens.  A farmer smoothes consumption of eggs over time.  The technology shock in this case is the decreased fertility of the ducks.  Fewer eggs are available, so that the farmer feels poorer, has a lower flow of outputs.  He will then start eating fewer duck eggs, and more chicken eggs (substituting into chicken eggs).  The farmer lowers total consumption due to lower production.  The process of substitution accounts for the business cycle.  A farmer who “takes a bigger lump up front” does not experience the business cycle, but the farmer who substitutes does.  Models are rigged so that the substitution effect is the dominant effect, the labor supply effect (or the weaker the farmer gets with fewer eggs), is going to be small in comparison (except in Long and Plossner where the cancel out). 

Long and Plossner: Define technology shocks that are big enough to match the actual movement in the data from the real economy, then they model this movement.  This mimicked movement looks remarkably like the real world data due to the embedded propagation mechanism between sectors (2/3 of the time).  Model, however, fails to capture movements in the labor supply (the movement is significantly muted).  There is no accounting for intertemporal substitution, and when comes to labor market this is not a side show (it is a central issue of importance in policy).  Working more when you are paid more does not happen in the real world data. 

Few core facts:

1)      Real world changes in the hours worked are much greater than the changes in productivity.

2)      Hours worked and productivity are not correlated

3)      When you have a downturn it is not that people work less, it is that some people get fired.  These people do not work at all, but the people with jobs still are working about the same amount that they always did.

4)      Growth (for example China) is not actually working the way it would in the model.  People do not work less now because they think that productivity (and therefore wage) will rise in the future; in fact they were hard now.

There is a theory of indivisible labor which tacks on a fixed cost associated with supplying labor.  These include the cost of the commute, the baby sitter, or any other number of forgone things that have facilitated your time at work.  This adds a bit of lumpiness to the cost of labor.  Two cases when the MPL falls:

A)    8 hours becomes 7 hours for all employees across the board

B)     Fire 1/8 of all the people employed at the company

In the case of more fixed costs the employer is going to opt more often for the case of B. 

(people could contract for a lower wage)

Keynesians would complain that this model does not explain the labor market.

Katrina, if it is viewed as a capital shock, we could see a unit root effect where the output stays permanently lower.    We could also imagine a case where the MPK rises such that new capital is brought online.  If it were a labor shock, we would see that this has to be recovered in some way.  If we just think of it as a technology shock than we see the same unit root effect.  This feeds the question:  Should we rebuild New Orleans.  This model’s major failure is to leave out social and moral capital.  All the looting has fundamentally changed the way that N.O. people behave.  Will the same mixture of workers return to the city?  The poor?  The middle class?  What would be the effect of a large government subsidy to the city?

A preview for next week:  Optimal clustering (think about a city in these contexts: space and time).  Cities do exist due to some agglomeration, there is clustering in time (this is why the classroom is empty on the nights and the weekends. 

The traditional explanation is that there are lags in the market for wages, for equilibrium aggregate supply and demand (if aggregate demand can even be fully conceptualized), and expectations.

Real business cycles say that even when markets clear there can be changes in the total economy.  The biggest of these changes is that the marginal productivity of labor somehow drops (this can be the removal of complimentary capital investment, or at least slowing in the replacement rate).  Higher than market interest rates could slow the investment in capital, allowing capital stock to depreciate, reducing the absolute total. 

“Many economists find the real-business cycle theory totally unbelievable. No one can observe the technological shocks that are at the heart of this explanation, and it strikes many as simply ridiculous to argue that the unemployment during a recession is voluntary. On the other hand, the economists who have formed these arguments are among the brightest of the profession, and they can show that the patterns that their mathematical models generate are remarkably similar to the patterns that the real world generates.”  -- http://ingrimayne.saintjoe.edu/econ/Connections/Real-Business.html 

From the archive, Tyler’s previous comments:

http://www.marginalrevolution.com/marginalrevolution/2004/10/why_real_busine.html 

Note:  Capital is used to produce consumption goods (or other capital goods whose final end purpose is consumption goods, the production process eventually ends with consumption).  Trade off therefore is necessarily intertemporal, the same with leisure.  In fact there seems to be an intuitive link between higher consumption and higher leisure.

Austrian:

The Austrian Business Cycle Theory (ABCT), by contrast, recognizes that monetary injections alter relative prices as they typically enter the capital market first before spreading to the rest of the economy. By lowering the interest rate and bidding up prices for capital goods relative to those of consumer goods, the additional money in the capital market will change the allocation of resources in favor of capital-constructing investments, which will have to be liquidated when the policy of monetary injections is ended.

Friedman --

Workers will initially interpret [an unexpected rise of prices and wages] as a rise in their real wage—because they still anticipate constant prices—and so will be willing to offer more labor (move up [on] their supply curve), i.e. employment grows and unemployment falls. Employers may have the same anticipations as workers about the general price level, but they are more directly concerned about the price of the products they are producing and far better informed about that. They will initially interpret a rise in the demand for and price of their product as a rise in its relative price and as implying a fall in the real wage rate they must pay measured in terms of their own product. They will therefore be willing to hire more labor (move down [on] their demand curve). -- 1976, p.223

In the Friedman-Lucas Model, there will only be prolonged periods of above and below average growth under the unrealistic assumption that people err systematically— continuously overestimating prices in the boom and continuously underestimating them in the bust (Garrison, 1989, p.1 . Under the far more realistic assumption that workers and producers will try to take inflation into account--let alone the new classical assumption of “rational” (i.e. model consistent) expectations--there will be no periods of booms and recessions but only random deviations from trend growth. In sum, fooling people into supplying more of their products and services does not generate cycles.” -- http://www.mises.org/journals/scholar/maanen.pdf

Two major problems with the theory of representative agents:  Even if we eliminate the tails of a distribution capital and labor still do not functions homogenously.  However, through infection across the many vectors of subcategory, the effects are able to offer somewhat general observations (read Freidman’s defense of positive economics). 

?my question: So can’t we understand people to be rational optimally (the survivors) and irrational in the aggregate?  Differentials will change over time.  I don’t know how one would measure this change, but it should theoretically exist.

You cannot underestimate the problem of central bank involvement, if you are going to posit a business cycle.  The central bank acts to make sure that nominal prices (somehow real prices are effected unequally across sectors, or at least until a lag completes its cycle) do not depreciate, as one of the main goals of a central bank.  In another way, if the nominal prices are changed continually as a matter of policy, but the central bank, does this provide a propagation mechanism?

A look specifically at deflation, despite occasional economic sophistry Salerno is one of my favorite Austrians:  http://www.mises.org/journals/scholar/salerno.pdf

Recall: Consumption is destruction of utility.  How does this work in the public good context?  Consider a piece of artwork.  If I look at the art, that doesn’t destroy the utility that others viewing the product after me would get from the painting.

We need the concepts of public and private goods to explain how this works.  As with many things in theory, there are two pure cases which are relevant and then there are necessarily things which lay between.  A pure private good is a good for which the total of this good is the sum of all of the good that is consumed.  Each person who consumes a portion of this good will reduce the total amount of the good (destroying the ability for someone else to create utility from that same unit of the good).  A pure public good does not have this property.  One person who enjoys a public good leaves as much for the consumption of others which was available before they consumed.  If I decide to view a sunset, then I do not reduce the amount of sunset which is available for all other people to view.  We refer to this property as non-rival in consumption.  The cup of coffee that Dr. Williams consumes is rival in nature because if he enjoys it, then I can no longer enjoy it.  This is also true of national defense, it is non-excludable.  I cannot prevent someone who refuses to pay taxes from being subject to the same protection which national defense provides.  If I have more, you have more, we have the same amount.  It is very seldom for which you can find a pure public good.  My hot rod car is enjoyed by everyone who sees me drive by, I am very unlikely to have the opportunity to collect rents from the people who have benefited from viewing by hot rod.  Dr. William’s neighbor looks at Mrs. Williams garden and all of the pretty flowers that she has planted.  This same neighbor has not contributed to the upkeep costs associated with these flowers. 

Should Blackmail be illegal?  Dr. Williams builds a case which says no, it should be perfectly legal.  In this way we can eliminate people extorting others.  If you promise to withhold information for a certain price, then you have an enforceable contract which would ensure that the person did not break the “gag order.”  Mrs. Williams would be for legal blackmail because this would create many people wishing to monitor Dr. Williams actions to prevent him from doing anything “fishy.”  The cost of bad behavior has now risen because of the increased expected value of getting caught. 

Say there is an auction for steak.  Bill Gates wants steak, and I want steak.  Bill Gates has 40 billion, and I have $11.  I can always outbid Bill Gates for steak.  For example, say Bill Gates offers $20 for the 1 lb of steak.  I can offer $11 for half, thereby beating Gates bid on that section of the meat.  Further, if he raises his price, I can bid all my money for the quarter of the steak.  In this way the market system assures that I can always get some steak, no matter how small that piece turns out to be.  In poor neighborhoods we see the effect of the market.  There are always some nice cars.  There are always some nice booze.  There are seldom nice schools.  The provision of these other consumption goods reflects the way in which the market is efficient at providing them.  The poor school is poor because no one can afford to move to the school district they would otherwise want to send their children.  An implication of these theme is that Emminem always outsells Pavarotti. 

We went over Q12 from A-A: E&P

Specialization is possible with unequal endowments.  It is possible to enjoy higher living standards with specialization than was possible under autarky (people do what they are better at doing and assuming they have a skill others want, their consumption will increase).  A person specializes in something when they have the lowest opportunity costs of specialization in that good.  We can go from a relatively inefficient outcome of autarky and increase everyone’s consumption of one good without lowering the consumption of the other good, than we can assume we are moving toward the Production Possibility Boundary.  In the example from class (A=30W and 20C; B=20W and 10C; 1/3 time and 2/3 time each), One unit of corn costs “Anderson” 3 units of wheat.  The same unit of corn would have cost “Brooks” 4 units of wheat, therefore “Anderson” should specialize in corn.  For specialization to make sense trade opportunity must exist.  Anderson needs 30 W to trade 10 corn; Brooks offers up to 40 W to trade 10 corn.   Assuming equal bargaining power the result will be b 35W for the 10 corn.  Exchange conserves social totals. 

Money Distinct from barter) *Is a good which facilitates exchange* (WW: money is a man-made innovation) Money must pass the test of sellers and buyers, it serves important functions

1)      standard of value – what are commodities worth in this Base or specie

2)      Money acts as a store of value – stores value over time allows people to take advantage of money to consume over time. 

3)      Facilitates Exchange

Good money is useful (cheap) – Gold and Silver emerged as money because of several properties that they contained.

1)      Portability (relative):  This is a high value / weight

2)      Durability (lasts over time): Keeps value during relevant time period

3)      Divisible/ Fusible:  Previous commodity moneys may had a divisibility component, but the fusibility of cattle as a payment methods is limited.

4)      Recognizable/ Assayable: Gold and silver have desirable qualities in being about to pass certain purity tests in a relatively quick fashion.  Experts in gold metallurgy can certify the purity of a metal. 

Gresham’s law is misleading (according to Dr. Williams) in the following way:  A money starts of as “pure monetary gold” A king then devalues the money by recalling and debasing the money as a alloy of lead.  The pure gold coins then become “bad to give away”  the debased alloy becomes “good to use in exchange.”  Since money’s value in Dr. Williams definition derives its usefulness by contributing to exchange this is the correct way to see the Gresham’s law.  A restatement might be “Good money drives out bad.” 

Demand:  A market is any place of institution which enables people to negotiate exchange.  Cities, for example, emerged primarily to facilitate exchange.  This is why the major historical cities were close to ports or along rivers, natural places to set up a market.  Ex: Until relatively recently it was cheaper to ship goods from Philadelphia to London than it would have been to transport goods over land to Lancaster, PA from the same original point. 

The rate of consumption of any good depends on it price.  Any given demand schedule depends on the time period under consideration to derive the change in price and the resulting change in demanded quantities.  Quantity demanded in a time period is a function of price.  At each market price there is a definite amount people choose to demand at this price.  There is an inverse relationship between price and quantity.  The first fundamental law of demand states that a price exists whereby people can be induced to take more (less) of something.

WW: “If I lower my wage enough I can get a job as a quarterback for the Philadelphia eagles.”  This implies that Dr. Williams could come up with a negative wage sufficient to induce the management to hire him as a back-up quarterback (The Philadelphia eagles are a profitable enterprise). 

Economists don’t like to say that people “need” something.  The concept of need is a refutation of the first fundamental law of demand (the word need is useful in tricking someone, but not useful in economics). 

Time component:  If the price of filet mignon fell from $9.25 to $3, how much more would you buy?  This is a meaningless question w/o the time requirement.  A demand graph has to have a time period implicit, or explicit. 

Determinants of Demand:  Things demanded depend on more than price.  These shift the curve “changes in demand” which is distinctive from “a change in the quantity of demand.” 

1)      Income

2)      Taste

3)      Price of all other goods (POAG)

4)      Expectations – This weeks price or plywood prices are low relative to next weeks if we expect a storm.

Speculators buy oil before a storm because they see that prices might rise after the same storm, they increase the price before hand, due to activity, and lower the price afterwards do to activity, which averages the price over time (eliminating extremes), they are doing society a favor strictly as a result of their self-interest. 

We impound the determinants of demand by assuming “Ceteris Paribus,” any time we talk about the demand schedule (curve). 

Elasticity of demand: Consumers are more responsive (in terms of change in quantity demanded) to a change in price with a higher elasticity of demand.  *This is the ratio of the % change in the quantity demand to the % change in price is a measure of the elasticity of demand for a good.

General: ratio of % change in dependant variable to the % change in the independent variable. 

Elasticity of Demand depends on the definition (excluding or not – substitutes) Elasticity depends on substitutes.  It is possible to define the quantity demanded of a the underlying good, where the good is broad enough not to have any substitutes. 

Concept of elasticity is important: It is this reason that we have the second fundamental law of demand.   “The longer any price change exists the greater will be the elasticity of demand (or supply) (greater in the long vs. the short-run).  If WW beats his wife how many additional lashes will it take to reduce her bad behavior one unit?  Another example, how does the effect of one additional year in prison effect the behavior of criminals. 

Adjustments to demand in price are cheaper in long-run than short-run.  Ergo, I could unload my Cadillac tomorrow if I were willing to accept a much lower price than I would if I actually was selective of many buyers.  The 2^nd law – with less haste things approach the median price. 

Friedman Article:  CR of neo-classical economics and the basic underlying assumptions out not or cannot be realistic.  The relevant criteria is predictive power.  **Does not have to be forward looking.  Makes assumptions because there is an infinite amount of information which would be needed otherwise.  The most important and significant theories have the least realistic assumptions, and the most dramatic assumptions.   WW: asked for examples (the gravity, the tree) Falseafiability vs. verifiability – can tentatively be accepted until it is proven wrong.  This follows because there are many theories that are consistent with any set of facts.  How can you get people that are honest w/ no agenda advocating policies that are total opposites?  Friedman seems to posit that the longer research goes on the more positive questions will be answered and the less room for dispute.  This is a theory of progress that will advance the economic science. 

WW: If you and I were in 12^th century Spain and one of us says that the world is flat, it would be valid to conclude that you could not sail to India by sailing west.  Valid but false conclusions are consistent with Friedman’s thesis.  We learn that we test these conclusions with the predictive and explanatory powers of theory in reality.  Reality contradicts that the world was flat, so the premise is no longer known as true, therefore the conclusions based on that premise are no longer made.  Economics would be better served if people were forced to be explicit about their initial premise.  There are different assumptions for different purposes.  We require different models to deal with different circumstances and research problems.

Nagel:  There are two linked spheres – theory and policy.  These are necessarily linked with reality.  Which tool best gives us facilitating ability can be better understood with this essay. 

WW: Assumptions (theory): Should have descriptive as well as predictive capability.  EX: Entrepreneurs should act “As if” they are maximizing profits.   This entrepreneur doesn’t have to know a damn thing, if he acts as if he does.  Nagel gives us the insight to know that Friedman’s essay should have the requirement of survival to understand why actors are assumed to act in a theoretical way, the ones that don’t, cease to exist. 

WW: Friedman did heavy lifting.  If Freidman is defending unrealistic assumptions that the distinction is irrelevant, if they are useful he has to redefine empiricism to render conclusive.  If economics as a profession is going to generalize there is work to be done, to get theory to this useful state. 

It is my prediction that the title of this piece is going to offer the most clear insight into what it is about.  This piece does not exist without the critique it makes on Milton Friedman’s article (detailed yesterday).  Nagel offers the observation that in a strictly logical sense Friedman doesn’t create a system which offers acceptable results.  In difference to this observation we still see that Nagel agrees with the conclusion.  In light of this fact, he points out that in logic, the process is just as important as the result.

Nagel breaks down the terminology: First we have a theory, “A set of statements, organized in a characteristic way, and designed to serve as partial premises for explaining as well as predicting and indeterminately large (and usually varied) class of economic phenomena.”  This will serves as Nagel’s best approximation for how the term is used in Friedman’s outline of positive economics (this is contrasted with a looser version, not characteristic of a single meaning). 

The assumptions have to be broken down into three categories.

1.      basic hypothesis – a premise

2.      Logically deduced theorems – somehow more advanced premise with the benefit of previous deduction

3.      Theoretical terms – gene, group, instantaneous acceleration, perfectly divisible commodity

In this way Nagel outlines the preliminary arrangement in economics which would outline a test for validity of conclusion.  In logic the premise – deduction – conclusion offers the tautology of logic to certify that the conclusion is valid if the premise is true.  Nagel refers to this system as “rules which are instrumental for drawing inferences.” 

Nagel also takes on the concept that different sciences will approach questions with different standards, and with different tools for explanation and description.  If you are asking a economic question, you filter the data through an economic process, and as long as you apply the result to economics you are fine.  This acknowledges that there is a natural limit to the insights provided by a discipline, but rightly so.  As a result, we expect results to have the following characteristics: 

1.      Systems should be simple (parsimonious) – Things should be eliminated which do not contribute significantly to the explanatory power of the model.

2.      The system of Null Hypothesis is a worthwhile pursuit. – It is this procedure which allows us to reject alternatives with a certain degree of confidence and indirectly test our premises.

3.      No economics question can be totally sterilized – The lab conditions for economic questions are limited in the degree of “purified” conditions or “idealized” objects.  This lack of “ideal” conditions does not limit the insights and the taxonomy of the economic discipline.

Rather than view assumptions as unrealistic, Nagel offers a way of viewing these assumptions in a logical context.  This exercise contributes validity to Friedman’s statements. 

1.      Approximations are justified – there is no appreciable loss of meaning and function in approximated models.

2.      Actors behaving markedly different from economic theory do not do so for long.

There still remains a degree of intuition in the science, but a formal structure grants a degree of creditability to the conclusions which is cost beneficial.   

The thrust of this essay is to develop a manner of referring to economics as a positive science.  This simply means that economics will focus on rules which determine testable statements about the economic environment.  To be a positive statement, a thesis must be testable and it must withstand some level of scrutiny over time.  The end result of this exercise is to contribute to the body of knowledge know as economics.

As a method of contrast we are given normative economics which are concerned only with matters of policy.  These can be reduced to the form “should” or “ought to” as indicators that we are speaking only about people’s value judgments about what would be “good” for society.

The “art” of economics takes on a form which is more ambiguous.  We can refer to this instrument as tacit knowledge, or something that is known and not expressible in simple terms.  Positive economics remains in a sequence of flux when the data simply is not available to know for sure which hypothesis is the correct one.  Short of testing (in the absence of reliable data about people’s actions) we are left with the best guess as to the questions we should be asking.  Theoretically over the course of time, the residuals in economics should be reduced, just like they were in any other developing science before data measurement blossomed substantially.  The best example for a case like this is flux as seen in astronomy and other “hard” sciences which are similarly facing measurement problems not yet satisfactory dealt with. 

One advantage to continuing to develop a system of positive economics is to provide a uniform tautology.