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Economists, I told my class, are the most empathetic and tolerant of people. Empathetic, as they learnt from game theory, because they strive to see the world through the eyes of others. Tolerant, because they never question anyone’s preferences. If I had the talent I’d have broken into song with a version of `Why Can’t a Woman be More Like a Man’ :
Psychologists are irrational, that’s all there is to that!
Their heads are full of cotton, hay, and rags!
They’re nothing but exasperating, irritating,
vacillating, calculating, agitating,
Maddening and infuriating lags!
Why can’t a psychologist be more like an economist?
Back to earth with preference orderings. Avoided the word rational to describe the restrictions placed on preference orderings, used `consistency’ instead. More neutral and conveys the idea that inconsistency makes prediction hard rather that suggesting a Wooster like IQ. Emphasized that utility functions were simply a succinct representation of consistent preferences and had no meaning beyond that.
In a bow to tradition went over the equi-marginal principle, a holdover from the days when economics students were ignorant of multivariable calculus. Won’t do that again. Should be banished from the textbooks.
Now for some meat: the income and substitution (I&S) effect. Had been warned this was tricky. `No shirt Sherlock,’ my students might say. One has to be careful about the set up.
Suppose price vector and income . Before I actually purchase anything, I contemplate what I might purchase to maximize my utility. Call that .
Again, before I purchase , the price of good 1 rises. Again, I contemplate what I might consume. Call it . The textbook discussion of the income and substitution effect is about the difference between and .
As described, the agent has not purchased or . Why this petty foggery? Suppose I actually purchase $x$ before the price increase. If the price of good 1 goes up, I can resell it. This is both a change in price and income, something not covered by the I&S effect.
The issue is resale of good 1. Thus, an example of an I&S effect using housing should distinguish between owning vs. renting. To be safe one might want to stick to consumables. To observe the income effect, we would need a consumable that sucks up a `largish’ fraction of income. A possibility is low income consumer who spends a large fraction on food.
Completed what I wanted about monopoly and launched into imperfect competition and introduced the nash equilibrium. I follow the set up in the chapter of pricing from my pricing book with Lakshman Krishnamurthi. The novelty, if any, is to start with Bertrand competition, add capacity and then differentiation. I do this to highlight the different forces at play so that they are not obscured by the algebra of identifying reaction functions and finding where they cross. We’ll get to those later on. Midterm Day, 12. I am, as Enoch Powell once remarked in another, unattractive context,
…. filled with foreboding. Like the Roman, I seem to see “the River Tiber foaming with much blood”.
Much of my energy has been taken up with designing homework problems and a midterm exam on monopoly. Interesting questions are hard to come by. Those lying around make me want to make gnaw my feet off. I started with the assumption, which I may live to regret, that my students are capable of the mechanical and have good memories. The goal, instead, is to get them to put what they have learnt in class to use. Here is an example. Two upstream suppliers, A and B, who each supply an input to a Retailer. The Retailer is characterized by a production function that tells you how much output it generates from the inputs supplied by A and B as well as a demand curve for the final product. Fix the price set by B to, w, say. Now compute the price that A should charge to maximize profit. Its double marginalization with a twist. Suppose the inputs are substitutes for each other. If B raises its price above w what effect will that have on A’s profits? There are two effects. The retailers costs will go up of course, so reducing its output. However, A will retain a larger share of the smaller output. Which will be bigger? Its a question that requires them to put various pieces together. I’ve had them work up to it by solving the various pieces under different guises in different problems. Am I expecting too much? I’ll find out after the midterm. Yet, I cannot see anyway around having questions like this. What is the point of the mathematics we require them to use and know if we don’t ask them to apply it when blah-blah alone is insufficient?
I now have a modest store of such problems, but coming up with them has been devilish hard. Working out the solutions is painful, because it involves actual algebra and one cannot afford errors (on that account I’m behind the curve). To compound matters, one is unable to recycle the exam and homework problems given various sharing sites. I begin to regret not making them do just algebra.
I spent these two classes going over two-part tariffs. Were this just the algebra, it would be overkill. The novelty, if any, was to tie the whole business to how one should price in a razor & blade business (engines and spare parts, kindle and ebooks etc). The basic 2-part model sets a high fixed fee (which one can associate with the durable) and sells each unit of the consumable at marginal cost. The analysis offers an opportunity to remind them of the problem of regulating the monopolist charging a uniform price.
The conclusion of the basic 2-part model suggests charging a high price for razors and a low price for blades. This seems to run counter to the prevailing wisdom. Its an opportunity to solicit reasons for why the conclusion of the model might be wrong headed. We ran through a litany of possibilities: heterogenous preferences (opportunity to do a heavy vs light user calculation), hold up (one student observed that we can trust Amazon to keep the price of ebooks low otherwise we would switch to pirated versions!), liquidity constraints, competition. Tied this to Gillete’s history expounded in a paper by Randall Pick (see an earlier post ) and then onto Amazon’s pricing of the kindle and ebooks (see this post). This allowed for a discussion of the wholesale model vs agency model of pricing which the students had been asked to work out in the homework’s (nice application of basic monopoly pricing exercises!).
The `take-away’ I tried to emphasize was how models help us formulate questions (rather than simply provide prescriptions), which in turn gives us greater insight into what might be going on.
On day 6, went the through the standard 2 period durables good problem, carefully working out the demand curve in each period. Did this to emphasize later how this problem is just like the problem of a multi-product monopolist with substitutes. Then, onto a discussion of JC Penny. In retrospect, not the best of examples. Doubt they shop at JC Penny, or follow the business section of the paper. One student gave a good summary of events as background to rest of class. Textbooks would have been better.
Subsequently, multi-product monopolist; substitute and complement. Emphasized this meant each product could not be priced in isolation of the other. Now the puzzle. Why would a seller introduce a substitute to itself? Recalling discussion of durables good monopolist, this seems like lunacy. A bright spark suggested that the substitute product might appeal to a segment that one is not currently selling to. Yes, but wouldn’t that cannibalize sales from existing product? Time for a model! Before getting to model, formally introduced price discrimination.
Day 7, talked briefly about homework and role of mathematics in economic analysis. Recalled the question of regulating the monopolist. Lowering price benefits consumers but harms seller. Do the benefits of customers exceed harm done to seller? Blah, blah cannot settle the issue. Need a model and have to analyze it to come to a conclusion. While we represent the world (or at least a part of it) mathematically, it does not follow that every mathematical object corresponds to something in reality. Made this point by pointing them to the homework question with demand curve having a constant elasticity of 1. Profit maximizing price is infinity, which is clearly silly. Differentiating and setting to zero is not a substitute for thinking.
Went on to focus on versioning and bundling. Versioning provides natural setting to talk about cannibalization and catering to new segment. Went through a model to show how the competing forces play out. Then to bundling.
Discussion of reasons to bundle that do not involve price discrimination. Then a model and its analysis. Motivated it by asking whether they would prefer to have ala carte programming from cable providers. In the model, unbundling results in higher prices which surprises them and was a good note to end on.
On day 5, unhappy with the way I covered regulation of monopolist earlier, went over it again. To put some flesh on the bone, I asked at conclusion of the analysis if they would favor regulating the price of drug on which the seller had a patent? Some discomfort with the idea. A number suggested the need to provide incentives to invest in R&D. In response I asked why not compensate them for their R&D? Ask for the R&D costs and pay them that plus something extra if we want to cover opportunity cost. Some discussion of how one would monitor and verify these costs. At which point someone piped in that if R&D costs were difficult to monitor, why not have the Government just do the R&D? Now we really are on the road to socialized medicine. Some appeals to the efficiency of competitive markets which I put on hold with the promise that we would return to this issue later on in the semester.
Thus far class had been limited to a uniform price monopolist. Pivoted to discussing a multi-product monopolist by way of a small example of a durables good monopolist selling over two periods. Had the class act out out the role of buyers and me the seller cutting price over time. It provided an opportunity to discuss the role of commitment and tie it back to the ultimatum game played Day 1. On day 6 will revisit this with a discussion of JC Penny, which will allow one to get to next item on the agenda: price discrimination.
Day 3 was a `midterm’ testing them on calculus prerequisites. Day 4, began with double marginalization. Analyzed the case when the upstream firm dictates wholesale price to the downstream firm. Subsequently, asked the class to consider the possibility that downstream firm dictates price to upstream firm. In this case `double marginalization’ disappears. Connected this pack to the power take it or leave it offers discussed day 1 and related this to Amazon vs Hachette. Concluded this portion with discussion of two part tariffs as alternative to merger to `solve’ double marginalization.
Double marginalization was followed by computing total consumer surplus by integrating the inverse demand function. Ended on optimal regulation of monopolist, showing that pricing at marginal cost maximizes producer plus consumer surplus. Brief discussion of incentives to be a monopolist if such regulation was in place. Then, asked the class to consider regulating a monopsonist and whether a minimum wage would be a good idea.
Day 2 was devoted to marginal this, that and the other. I began by asking if a monopolist (with constant unit costs) who suffers an increase in its unit costs should pass along the full unit cost increase to their buyers? To make it more piquant, I asked them to assume a literal monopolist, i.e., sole seller. Some said maybe, because it depends on elasticity of demand. Others said, yes, what choice do buyers have? Alert ones said no, because you must be at an inelastic portion of the demand curve (thank you, markup formula). They will indeed increase the price but the increase is tempered by the high elasticity at the current profit maximizing price. Profit will go down. This example illustrates how both the demand side and cost side interact to influence profits. In day 1 we focused on how the demand side affected price, in day 2 we focus on the cost side.
To motivate the notion of marginal cost, I ask how they would define cost per unit to convey the idea that this is an ambiguous concept. A possible candidate is average cost but ist not helpful maing decisions about whether to increase of decrease output. For this, what we want is marginal cost. Define marginal cost, and onto constant, decreasing and increasing returns to scale and discussion of technologies that would satisfy each of these. Solving quadratics is a good example. The time to solve each is the marginal cost. If you have decreasing returns to scale in solving quadratics, a wit suggested, correctly, that one should give up mathematics.
Next, where do cost functions come from? Opportunity to introduce capital and labor and production function. Cost function is minimum cost way of combining K and L to produce a target quantity. Numerical example with Cobb-Douglas. Without explicitly mentioning isoquants and level curves, solved problem graphically (draw feasible region, move objective function hyperplane) as well as algebraically. Discussed impact of price change of inputs on mix used to produce target volume. Marginal productivity of labor, capital and marginal rate of technical substitution. Eyes glazing over. Why am I wasting time with this stuff? This is reading aloud. Never again.
Onto marginal revenue. By this time they should have realized the word marginal means derivative. Thankfully, they don’t ask why a new word is needed to describe something that already has a label: derivative. Marginal revenue should get their goat. Its a derivative of revenue, but with respect to what? Price or quantity? The term gives no clue. Furthermore, marginal revenue sounds like price. The result? Some students set price equal to marginal cost to maximize profit because thats what the slogan marginal revenue = marginal cost means. To compound matters, we then say the area under the marginal revenue curve is revenue. If marginal revenue is the derivative wrt quantity then integrating it should return the revenue. Does this really deserve comment? Perhaps watching paint dry would be more exciting. Wish I had the courage to dispense with the word `marginal’ altogether. Perhaps next year. Imagine the shock of my colleagues when the phrase `marginal blank’ is greeted with puzzled looks.
They’ve been very patient. Before class ends there should be a payoff. Show that marginal revenue = marginal cost is a necessary condition for profit maximization and is sufficient when we have decreasing returns to scale. This seems like small beer. What happens when we have increasing returns to scale? Why does this break down? Some pictures, of why the slogan is no longer sufficient and a discussion of how this relates to pricing for firms with increasing returns like a producer of an app who must rent server space and gets a quantity discount.
About a year ago, I chanced to remark upon the state of Intermediate Micro within the hearing of my colleagues. It was remarkable, I said, that the nature of the course had not changed in half a century. What is more, the order in which topics were presented was mistaken and the exercises on a par with Vogon poetry, which I reproduce below for comparison:
“Oh freddled gruntbuggly,
Thy micturations are to me
As plurdled gabbleblotchits on a lurgid bee.
Groop, I implore thee, my foonting turlingdromes,
And hooptiously drangle me with crinkly bindlewurdles,
Or I will rend thee in the gobberwarts
With my blurglecruncheon, see if I don’t!”
The mistake was not to think these things, or even say them. It was to utter them within earshot of one’s colleagues. For this carelessness, my chair very kindly gave me the chance to put the world to rights. Thus trapped, I obliged. I begin next week. By the way, according to Alvin Roth, when an ancient like myself chooses to teach intermediate micro-economics it is a sure sign of senility.
What do I intend to do differently? First, re order the sequence of topics. Begin with monopoly, followed by imperfect competition, consumer theory, perfect competition, externalities and close with Coase.
Why monopoly first? Two reasons. First it involves single variable calculus rather than multivariable calculus and the lagrangean. Second, student enter the class thinking that firms `do things’ like set prices. The traditional sequence begins with a world where no one does anything. Undergraduates are not yet like the white queen, willing to believe 6 impossible things before breakfast.
But doesn’t one need preferences to do monopoly? Yes, but quasi-linear will suffice. Easy to communicate and easy to accept, upto a point. Someone will ask about budget constraints and one may remark that this is an excellent question whose answer will be discussed later in the course when we come to consumer theory. In this way consumer theory is set up to be an answer to a challenge that the students have identified.
What about producer theory? Covered under monopoly, avoiding needless duplication.