Economics for Democratic Socialism

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Economics for Democratic Socialism

• Drexel University
• Spring Quarter 2009

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Allocation of Resources

• Socialists are humanists and rationalists, and
  agree that production should be rationally
  directed to improve the conditions of human life.
  
• It is embarrassing, then, that a case can be made
  that the allocation of resources under market
  capitalism tends to be efficient.

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Resources

• land
• the "original and indestructible powers of the
  soil" and
• natural resources, such as coal, oil, and
  metallic ores
• labor
• and capital
• machinery
• houses and other buildings
• grapevines, fruit trees and hogs on the hoof
• and human capital

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Natural resources

• There are, of course, some important differences
  between land and some other natural resources.
  Coal and oil, once they are dug out or the ground
  and burned, are gone for ever. In other words,
  they are "wasting resources." On the other hand,
  the fertility of the soil does not have to be a
  wasting resource, if the farmer uses farming
  methods which maintain fertility. But this
  difference is not absolute. Copper ores, for
  example, may be used and then recycled.

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Capital

• Capital consists of all goods produced by human
  labor (with other resources) and used in the
  production of still more goods and services in
  other words, produced means of production. Some
  examples are
• machinery
• houses and other buildings
• grapevines, fruit trees and hogs on the hoof
• and human capital

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Neoclassical Economics

• For neoclassical economics, economics is the
  study of the allocation of resources. In this
  school of thought, economics is defined as "The
  study that considers human behavior as a relation
  between scarce means and alternative ends.
  (Robbins)
• Neoclassical economists regard the study of the
  allocation of resources as essentially a
  scientific, not a normative, study.

Lionel Robbins
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Scarcity

• Resources of all kinds are scarce. That simply
  means that we do not have enough resources to
  produce all of the goods and services that
  anybody might like to have. It means that we, as
  a society, must somehow answer some basic
  questions What resources will be used to produce
  which goods and services, and for whom? To answer
  these questions, and get the resources to the
  users, is to "allocate" resources. We would, of
  course, like to organize things so that the
  resources are used for the most urgent and
  rewarding kinds of production --that is, we would
  like to allocate resources "efficiently."

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A Model Illustrating Scarcity
For our model, let us think of an economy that
produces just two kinds of goods "machines" and
food. At any given time, a country cannot produce
more machines without producing less of something
else. (In this case, the country produces less
food). Table 1 on the next slide shows, for the
model country, how much food they can produce
given each respective output of machines. For
example, to increase machine output from 7000 to
8000, they would have to cut food output from
1020 to 720.
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Production Possibilities for Machines and Food
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In Diagram Form
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Opportunity Cost
A key point here is the trade-off between
machines and food. Whenever we increase the
output of machines we must decrease the output
of food. This is a cost it is the "opportunity
cost" of the increase in production of machines.
In general, economists define the "opportunity
cost" of any good or service as the value of all
the other goods or services that we must give up
in order to produce it.
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Opportunity Cost Footnote
The idea is that, in order to increase the
production of machines, we must use up resources
that could otherwise be used to produce food. We
give up the opportunity to produce a relatively
large amount of food. The opportunity cost of any
decision consists of everything we must give up
in order to carry out that decision (as, the
opportunity cost of the decision to increase the
output of gadgets in the model economy consists
of the food the model economy must give up as a
result).
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Opportunity Cost in the Example

• For example, going from 3000 to 4000 machines, we
  give up 1820-1680 140 carloads of food. This is
  the opportunity cost of the 1000 machines.
• Thus, the opportunity cost of one machine
  averages about 0.14 carloads of food over this
  range.

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Real Numbers
Here is the Production Possibility Frontier for
capital (vertical) and consumption goods
(horizontal) for the United States in 1996.
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Production Function
The "production function." is a relationship
between quantities of input and quantities of
output (of one particular good) that tells us,
for each quantity of input, the greatest output
that can be produced with those inputs. Here is
an example in the form of a table, with labor as
the only input.
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Diminishing Returns

• This production function provides an example of
  diminishing returns, and important principle
  for our understanding of production.
• With labor as the only variable input -- with
  other inputs, such as land and capital, fixed,
  even if only for the short run -- the law of
  diminishing returns will be applicable.
• This law was originally proposed by the first
  professor of economics in history -- Thomas
  Malthus.

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Law of Diminishing Returns
The Law of Diminishing Returns when a fixed
input is combined in production with a variable
input, using a given technology, increases in the
quantity of the variable input will eventually
lead to decreasing productivity of the variable
input. Malthus argued that land is the fixed
input, labor the variable input, and that
decreasing productivity of labor would depress
incomes. Malthus knew that technological progress
could reverse this prediction, but probably
underestimated the real impact of technology.
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Productivity

• In most statistical discussions of productivity,
  we refer to the average productivity of labor
• In microeconomics, however, we will focus more on
  the marginal productivity.

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In other words,

• marginal productivity of labor is
• the additional output as a result of adding one
  unit of labor, with all other inputs held steady
  and ceteris paribus.
• is an approximation to this.

20
Remember --

• When 300 labor-days per week are employed the
  firm produces 2505 units of output per week.
• When 400 labor-days per week are employed the
  firm produces 3120 units of output per week.
• It follows that the change in labor input,
• ?Labor, is 100.
• It also follows that the change in output,
• ?Output, is 615.

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So

• Applying the formula above, we approximate the
  marginal productivity of labor by the quotient
  615/100 6.15.
• We can interpret this result as follows over the
  range of 300 to 400 man-days of labor per week,
  each additional worker adds approximately 6.15
  units to output.

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Diminishing Returns, Again

• Law of Diminishing Returns (Modern Statement)
• When the technology of production and some of the
  inputs are held constant and the quantity of a
  variable input increases continually, the
  marginal productivity of the variable input will
  eventually decline.
• The inputs that are held steady are called the
  "fixed inputs." We are treating land and capital
  as fixed inputs. Labor is the variable input.

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Average and Marginal Productivity
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An Example

• Ajit is a farmer who grows lentils on two fields
  in North India.
• He has a field on a hill and a field beside a
  small river.
• The riverside field is more fertile than the
  hilltop field.
• Ajit has only a limited amount of labor to divide
  between the two fields.
• He can work at most 300 days, total, on both
  fields.
• He wants to get the largest possible crop of
  lentils from his two fields.
• How should he 'allocate his labor' between the
  hilltop field and the riverside field?

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The Production Functions
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Here are the Numbers
What happens is when Ajit allocates more labor
to the river field, marginal productivity on
that field decreases, and eventually it is less
productive at the margin.
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Visualizing --
We can visualize the efficient allocation of
resources with a graph like this one.
Labor on the more fertile field
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Marginal Productivity
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Implication

• Allocating 215 to the river field produces the
  largest output.
• If you start from any other quantity, moving
  toward 215 increases output at the margin.
• Rule -- equimarginal principle
• When the same product or service is being
  produced in two or more units of production, in
  order to get the maximum total output, resources
  should be allocated among the units of production
  in such a way that the marginal productivity of
  each resource is the same in each unit of
  production.

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Interim Summary

• Output depends on productivity
• For many economic applications, it is marginal
  productivity that is more important.
• When there is a single variable resource, it is
  subject to diminishing marginal productivity.
• This leads to and important principle of resource
  allocation
• Make MP equal in every use of the resource.

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Revised Reading Assignment for Next Week

• Ragnar Ohlsson, Morals Based on Needs, Ch. 5,
  handout.
• The Preference Approach to Marginal Benefit and
  Consumer Demand, McCains website,
• http//faculty.lebow.drexel.edu/mccainr/top/prin/
  txt/MUch/pref1.html

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Production Possibility Frontier, Again

• We want to allow for production of more than one
  kind of output.
• So return to the Production Possibility Frontier
  model

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Efficiency
Suppose we ask ourselves how many machines (of a
specific kind) would it be efficient to produce?
Define "net benefits" as "benefits minus
costs." One concept of "efficient output" is "the
output that maximizes the net benefit from
machines." That is the concept of efficiency we
will use. It is approximative, of course -- since
"benefits" and "costs" are money approximations
to nonmonetary utility and opportunity costs --
but it will give the right answers all the same.
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Plan or Market

• That sounds like a criterion for a planner to use
  -- and it could be. But we are interested in
  market economies.
• Proposition A planner could do no better than
  the equilibrium of supply and demand.

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The Alternative?
We will -- as usual -- think in terms of a model
economy (Economia) that produces only 2 goods,
with the production possibility frontier shown.
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Cost in Economia 1

• In Economia, as always, cost is the opportunity
  given up.
• In Economia, that means the cost of machines is a
  quantity of food.
• We can construct a total cost curve rather
  simply invert the possibility frontier!

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Cost in Economia 2
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Cost in Economia 3
Marginal cost is always the concept of cost most
important for the allocation of resources.
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Cost in Economia 4
Marginal Cost of Machines
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Benefits in Economia 1
We can measure the total benefit from machine
production in terms of food. The measure of
benefit is the amount of food that the citizens
would be willing to trade for the given quantity
of machines. Perhaps we could do a questionnaire
survey.
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Benefits in Economia 2
Assumed total benefits of machines in Economia
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Benefits in Economia 3
As before, it is the marginal benefits that are
relevant to the efficient allocation of
resources.
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Benefits in Economia 4
Here is the relationship between machine
production and marginal benefit expressed in a
diagram.
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Optimal Plan 1
RULE The output at which marginal benefit is
equal to marginal cost is the output at which the
net benefit of output is at its greatest. This is
the optimal output, and when each industry has
just enough resources to produce the optimal
output (and the industries use the resources
efficiently), that is the optimal allocation of
resources.
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Optimal Plan 2
Remember Reason backward!
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But!

• In a perfectly competitive market,
• demand is the same as marginal benefit and
• supply is the same as marginal cost.
• Therefore, to say that quantity supplied equals
  quantity demanded is to say that marginal benefit
  equals marginal cost

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The Argument 1
A consumer will always maximize her net benefit
(or consumers surplus, as it is called) by
buying a quantity like B, at which priceMB.
Therefore, the MB curve is the demand curve.
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The Argument 2
A firm will always maximize its profits by
selling the quantity that corresponds to
priceMC. Therefore, the MC curve is the supply
curve.
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The Vision

• FUNDAMENTAL PRINCIPLE OF MICROECONOMICS If
• All goods, services and resources are paid for by
  those who benefit from them, and
• the payment is at supply-and-demand equilibrium
  prices,
• then
• output quantities are efficient.

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Yes, But -- 1

• First, markets may not be Perfectly Competitive.
  Prices may not be determined by supply and
  demand, and outputs may deviate from the
  perfectly competitive norm.

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Yes, But -- 2

• Second, people may not pay for the goods,
  services, and resources they use. for example, in
  Equador, the loggers pollute water and thus
  destroy the businesses of the fish-farmers
  downstream. The loggers are using a resource they
  do not pay for -- fresh water -- and thus
  depriving the fish-farmers of it, even though
  (probably) the fish-farmers can make more
  effective use of it. In economics this sort of
  problem is called an "externality."

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Yes, But -- 3

• Finally, even if the Perfectly Competitive
  equilibrium is efficient, there may be other
  objectives besides efficiency. For example,
  efficiency can coexist with great inequality. A
  slave economy could be efficient. Most of us
  wouldn't want to adopt a slave system even so, I
  suspect.

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Conclusions

• The efficient market economy, with marginal cost
  equal to marginal benefit in every market,
  defines the potential of a complex economy, even
  if it is not perfectly realized.
• Thus, in microeconomics, it defines the benchmark
  against which the performance of the actual
  economic system is measured.
• It also provides a challenge and a high standard
  for advocates of economic planning to meet.
• One thing that is missing is any consideration of
  need.
• We will address that next week, and planning the
  following week.