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JONATHAN GRUBER: All
right, let's get started.

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Today, we're going to continue
our discussion of factor

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markets.

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If you recall, last
Monday, we started

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talking about the labor market.

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And we talked about how workers
make the decision between work

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and leisure.

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And we talked about
the implications

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for setting the wage
rate in the labor market.

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What I want to do today is
return to that labor market

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equilibrium and talk
about the important case

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of the minimum wage.

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So today, I want to talk about
the labor market equilibrium

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and how it's affected
by the minimum wage

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because it's an interesting case
which allows us to introduce

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some complications as to how we
think about the labor market.

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So let's go back and think
about the labor market.

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So let's go to figure 16-1.

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The labor market,
like any other market,

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has a price and a quantity.

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The quantity is the
amount of labor supply.

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That's on the x-axis.

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The price is the wage.

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That's on the y-axis.

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The supply curve
that's upward sloping--

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typically we'll assume an
upward-sloping supply curve.

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But as we discussed last time,
that doesn't have to be true.

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If income effects dominate
substitution effects, which

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they very well may,
you could actually

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have a backward-bending or
downward-sloping supply curve.

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So we talked about
that last time.

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Having taught that
interesting case,

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typically, we'll
assume supply is upward

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sloping or at least
not backwards bending,

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not downward sloping.

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But remember, that's
an assumption.

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So this upward-sloping
supply curve

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is not necessarily as obvious
as a downward-sloping demand

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curve is.

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Downward-sloping demand
will almost always

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exist unless there's
a weird Giffen

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good, whereas
upward-sloping supply is

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a little more questionable.

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So we have the equilibrium,
and we have this equilibrium

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at L1 workers at a wage W1.

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So now we know where
this comes from.

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So basically, going
all the way back

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to producer theory where
we just gave you a W,

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now we're telling
where the W comes from.

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We're telling you where the
wage comes from that you then

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plug into the firm's
optimization for them

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to produce goods.

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Now, let's imagine that
we have a minimum wage.

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So let's go to figure 16-2.

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So this is a
regulation which says

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that you're not
allowed to pay workers

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below some minimum level.

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And let's say we set that
minimum wage at the level W2

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above the market wage W1.

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Quick question.

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What would happen
if we passed a law

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and set a minimum wage
that was below W1?

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So there'd be a
regulation which insists

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you couldn't pay workers
below W2, but W2 is below W1.

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What would that do
to the labor market?

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Nothing.

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And here's the key point.

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Markets in economics
will always endeavor

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to avoid government
regulations if they can.

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So if a government regulation
is not binding, it won't matter.

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Markets will just avoid it.

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So the interesting case is
only where the minimum wage is

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binding, as in the figure 16-2.

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So what happens?

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Well, if you set a
minimum wage at W2,

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workers at that high wage
would love to work a lot.

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That's a high wage.

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They're high in
the supply curve.

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They would like to
work L sub s hours.

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They would like to
supply L sub s amount

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of labor supply to the market.

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Firms, however, if forced
to pay a high wage,

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W2, are going to
say, wait, I'm only

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going to pay that high wage if
the marginal revenue product

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of labor is sufficiently high.

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Remember, we talked about the
marginal revenue of product

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last time.

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It's the marginal product
of labor times the price.

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So if you're going
to raise the wage I'm

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going to have to pay workers,
unless that affects the market

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price, I'm going to need to
have a higher marginal product

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of labor, right?

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The demand equation
was, I said, the wage

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equal to the marginal product
of labor times the price.

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Well, if the price
hasn't changed

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with the minimum
wage going in, I'm

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going to need a high--
if the wage is forced up

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by the minimum wage, I'm
going to need a higher

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marginal product of labor.

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How do I get a higher
marginal product of labor?

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By hiring less workers because
the marginal product of labor's

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diminishing.

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So if you're going to force
me to pay a higher wage,

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you're going to force
me to only hire workers

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until the point where the
marginal product of labor

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justifies that higher
wage, which means I'm

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going to hire fewer workers.

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So firms demand only L sub d.

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Well, workers can't get jobs
firms don't want to give.

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So the equilibrium is L sub
d jobs at a wage W sub 2, OK?

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What does this do to welfare?

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We can see before, before the
minimum wage was in place,

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the market featured a consumer
surplus that-- here, consumers

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are firms, right?

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But there was a consumer
surplus of A plus B plus C.

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That is, firms
were willing to pay

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what was on the demand curve.

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They only had to pay W1.

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So their surplus
was A plus B plus C.

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Workers were willing to
work at a wage that's given

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by the supply curve S sub 1.

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They were paid at W sub 1.

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So they got a
surplus of D plus E.

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So here, the firms get
the consumer surplus.

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The workers get the
producer surplus

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because the workers
are now the producers.

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Now let's say you roll
in a set minimum wage.

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Well, two things have happened.

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One thing is you've then
transferred some resources

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to workers.

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That's the area B. You've taken
the area B that firms used

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to get, and now workers get it.

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That's the idea.

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You want to make
workers better off.

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So you transferred to
workers the area B.

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On the other hand, you've
created a deadweight loss

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of the area C plus
E. You've created

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deadweight loss in
the area C plus E

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because now there
are fewer jobs.

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There are workers
who would happily

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work at a higher
wage who are not

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being allowed to work by
the limited demand that

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comes from the minimum wage.

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So the bottom line is you end
up with fewer workers, a higher

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wage, and ambiguous
welfare implications.

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Clearly, social
welfare goes down.

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Whether worker
welfare goes up or not

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depends a bit on the size of
area B versus the size of area

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E. It's not clear if worker
surplus goes up or not.

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It depends on size of B
versus E. In this diagram,

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workers are a net better off,
but it doesn't have to be true.

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What's clear is that social
welfare has gone down.

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Because remember,
as I talked about,

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the cheat, the shortcut I
talked about when we talked

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about oligopoly, is,
roughly speaking,

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welfare is proportional to
the quantity in the market.

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Essentially, the
further you deviate

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from the perfectly
competitive quantity,

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the bigger the deadweight loss.

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So that's what happens if
you put in a minimum wage.

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Questions about that?

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OK?

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Well, that seems
pretty straightforward,

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and that's what I
learned growing up

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as a kid in economics class.

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But then some empirical
economists, some very famous

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empirical economists,
started doing

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a series of articles that
actually studied, gee,

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what happens when the
minimum wage does change.

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They did things
like, for example,

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comparing what happened
when New Jersey raised

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its minimum wage but the state
of Pennsylvania next door

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did not, and looked at fast
food workers in New Jersey,

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where the minimum
wage went up, compared

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to fast food workers
in Pennsylvania

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where the minimum
wage didn't go up.

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And what they found was
there was no difference

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in employment, that jobs
didn't fall in New Jersey

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even though the
minimum wage went up.

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And a series of
follow-on studies

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continue to find that, actually,
higher minimum wages didn't

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seem to cause jobs to
fall, which is directly

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in contradiction
with this graph.

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So what's going on?

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That led to a big
question and revision

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of what's going on in these
markets that leads to that.

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And there's really
three possibilities

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for what's going on.

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Possibility one is that the
minimum wage wasn't binding.

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Maybe New Jersey set a minimum
wage below the market wage.

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But actually, empirically,
that's not true.

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We can look at what workers were
paid before the minimum wage.

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It was well below where
the minimum wage was

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set for restaurant
workers that were studied

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in that most famous study.

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So this is not true.

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The minimum wage was binding.

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There's a second
possibility that's

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absolutely consistent with a
perfectly competitive market.

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What's a possible
answer for why I

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could impose a minimum wage in
a perfectly competitive labor

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market and have
employment not go down?

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Yeah?

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AUDIENCE: Price goes up.

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JONATHAN GRUBER: The price
that the firm charges goes up.

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But in a perfect
competitive labor market,

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that still wouldn't happen.

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You might see some
price adjustment,

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but you'd still
see some adjustment

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in the marginal
product of labor.

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But what else
about this diagram?

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Yeah.

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AUDIENCE: The firm's demand for
labor is perfectly inelastic.

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JONATHAN GRUBER: The firm's--
actually, you're close.

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It'd be the worker's supply of
labor is perfectly inelastic.

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It's the right idea.

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If workers are perfectly
inelastic in their supply

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of labor, then the
same amount of workers

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will work no matter
what the wage.

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So basically, you're just
going to essentially end up--

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you'd also, in fact--
that's a good point-- also

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get inelastic demand,
the same thing.

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If either supply or
demand is inelastic,

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you'll end up with no
effect of a minimum wage.

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So that's another possibility.

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But in fact, we've
done a lot of studies.

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So you could have
inelastic supply or demand.

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But in fact, we've done lots
of studies of supply and demand

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in these markets,
and that's not true.

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Remember, supply was
largely inelastic for men,

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but it was somewhat
elastic for women.

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And these low-income
markets have

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a good mix of men and
women working in them.

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Demand has been shown
to be somewhat elastic.

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So neither supply nor
demand's very elastic,

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but they're sufficiently elastic
that that rules out as zero.

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So the third possibility and the
one economists have focused on

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00:10:01,880 --> 00:10:05,070
is that we're not in a
competitive labor market.

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00:10:05,070 --> 00:10:13,060
They're focused on a
noncompetitive labor market.

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Just like we discussed
noncompetitive markets

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for goods with a
monopoly and oligopoly,

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00:10:19,120 --> 00:10:22,990
you can have noncompetitive
markets for labor.

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It's the basic same idea.

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So now let's look at--

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so when we thought
about-- let's go back,

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think about perfect
competition, the basics

250
00:10:31,570 --> 00:10:32,848
of perfect competition.

251
00:10:32,848 --> 00:10:34,390
We thought about
perfect competition.

252
00:10:34,390 --> 00:10:36,700
The basic idea was, remember,
I talked about laying out

253
00:10:36,700 --> 00:10:40,330
a bunch of rugs in a market
where you could literally

254
00:10:40,330 --> 00:10:42,760
shop costlessly across
all the people selling

255
00:10:42,760 --> 00:10:46,450
their little fake Eiffel towers,
little statue Eiffel towers.

256
00:10:46,450 --> 00:10:47,680
And you could perfectly shop.

257
00:10:47,680 --> 00:10:50,125
It was easy to go
from carpet to carpet.

258
00:10:50,125 --> 00:10:51,250
There was full information.

259
00:10:51,250 --> 00:10:52,760
The prices were posted.

260
00:10:52,760 --> 00:10:54,760
And so basically
what you ended up

261
00:10:54,760 --> 00:10:59,680
was perfectly elastic demand
facing any given firm.

262
00:10:59,680 --> 00:11:01,780
Any given firm, if
they tried to charge

263
00:11:01,780 --> 00:11:05,630
one cent more for their Eiffel
tower, no one would buy it.

264
00:11:05,630 --> 00:11:08,980
If they charged one cent less,
they'd immediately run out.

265
00:11:08,980 --> 00:11:10,420
Everyone'd buy it.

266
00:11:10,420 --> 00:11:12,787
Well, when we are
modeling labor markets--

267
00:11:12,787 --> 00:11:14,870
and I discussed this last
time, but not very well.

268
00:11:14,870 --> 00:11:16,240
So I want to come back to it.

269
00:11:16,240 --> 00:11:17,980
When we're modeling
labor markets,

270
00:11:17,980 --> 00:11:21,560
we're thinking about the same
feature of perfect competition.

271
00:11:21,560 --> 00:11:28,820
But here, it's not
consumers shopping

272
00:11:28,820 --> 00:11:30,320
over where to buy their goods.

273
00:11:30,320 --> 00:11:34,040
It's workers shopping
over where to work.

274
00:11:34,040 --> 00:11:36,980
It's workers saying, gee, in
a perfectly competitive labor

275
00:11:36,980 --> 00:11:41,180
market, the idea is I know
what I could earn at any firm

276
00:11:41,180 --> 00:11:43,130
and I can easily
shop across firms,

277
00:11:43,130 --> 00:11:44,690
see where I'm going to work.

278
00:11:44,690 --> 00:11:48,020
So if any firm tried to pay me
one cent less than the market

279
00:11:48,020 --> 00:11:50,230
wage, I'd never work there.

280
00:11:50,230 --> 00:11:53,090
And if they tried to pay me one
cent more than the market wage,

281
00:11:53,090 --> 00:11:55,710
every worker in the world
would want to work there.

282
00:11:55,710 --> 00:11:58,100
So in a perfectly
competitive labor market,

283
00:11:58,100 --> 00:12:03,410
any given firm faces a perfectly
elastic supply of labor.

284
00:12:03,410 --> 00:12:06,481
So we can see that
in figure 16-4,

285
00:12:06,481 --> 00:12:09,064
which we actually showed-- and
I'll let you skip this since we

286
00:12:09,064 --> 00:12:09,564
covered it--

287
00:12:09,564 --> 00:12:12,410
16-4, which I actually
showed in the last lecture.

288
00:12:12,410 --> 00:12:14,510
Remember the last lecture.

289
00:12:14,510 --> 00:12:16,820
I was focused on this
downward-sloping demand curve,

290
00:12:16,820 --> 00:12:19,430
but I casually threw in
this flat labor supply curve

291
00:12:19,430 --> 00:12:21,080
and botched explaining it.

292
00:12:21,080 --> 00:12:23,720
Now I'm explaining it,
hopefully more clearly, which

293
00:12:23,720 --> 00:12:28,850
is to any given firm,
the labor supply curve

294
00:12:28,850 --> 00:12:35,330
is perfectly elastic because
workers can perfectly

295
00:12:35,330 --> 00:12:37,290
shop across job opportunities.

296
00:12:37,290 --> 00:12:41,450
So if that firm tried to pay
less, they'd get no workers.

297
00:12:41,450 --> 00:12:46,100
So they faced a perfectly
elastic supply of labor.

298
00:12:46,100 --> 00:12:48,680
But just like, in
reality, there's

299
00:12:48,680 --> 00:12:51,265
no such thing as a perfectly
competitive product market,

300
00:12:51,265 --> 00:12:52,640
in reality, there's
no such thing

301
00:12:52,640 --> 00:12:54,770
as a perfectly
competitive labor market.

302
00:12:54,770 --> 00:12:59,060
In fact, we can't shop easily
across all possible jobs

303
00:12:59,060 --> 00:13:01,430
and know what every
job could pay.

304
00:13:01,430 --> 00:13:06,200
And the fact that we can't means
that firms on the labor market

305
00:13:06,200 --> 00:13:08,270
side will have market power.

306
00:13:08,270 --> 00:13:10,940
Just like we talked about
monopolists and oligopolists

307
00:13:10,940 --> 00:13:14,620
having market power
over consumers

308
00:13:14,620 --> 00:13:17,410
through barriers to
entry, firms will

309
00:13:17,410 --> 00:13:21,160
have market power over workers
because workers can't perfectly

310
00:13:21,160 --> 00:13:24,520
shop across their
job alternatives.

311
00:13:24,520 --> 00:13:28,570
So as a result, firms
may be able to get away

312
00:13:28,570 --> 00:13:32,883
with paying you less than
what you might earn elsewhere.

313
00:13:32,883 --> 00:13:34,550
In a perfectly
competitive labor market,

314
00:13:34,550 --> 00:13:35,930
a firm could never
pay you less than what

315
00:13:35,930 --> 00:13:37,850
you're worth elsewhere
because you'd just

316
00:13:37,850 --> 00:13:39,170
go work somewhere else.

317
00:13:39,170 --> 00:13:42,200
But now, if McDonald's wants to
pay you less than you might get

318
00:13:42,200 --> 00:13:45,260
at Wendy's, but it's hard to
go find out what Wendy's going

319
00:13:45,260 --> 00:13:47,690
to pay you-- you have to go
a distance down the road,

320
00:13:47,690 --> 00:13:49,430
and you have to ask
them, and you're shy

321
00:13:49,430 --> 00:13:51,950
and it's embarrassing-- then
McDonald's might be able to get

322
00:13:51,950 --> 00:13:56,480
away with paying you less than
you might earn at Wendy's.

323
00:13:56,480 --> 00:13:58,880
So this is very much
parallel to monopoly.

324
00:13:58,880 --> 00:14:01,520
In fact, we call
this a monopsony.

325
00:14:04,990 --> 00:14:08,300
A monopsony is a
labor market where

326
00:14:08,300 --> 00:14:11,270
firms have market
power over workers

327
00:14:11,270 --> 00:14:15,230
just like a monopoly is a
goods market where firms have

328
00:14:15,230 --> 00:14:18,800
market power over consumers.

329
00:14:18,800 --> 00:14:20,900
Now, this is not so crazy.

330
00:14:20,900 --> 00:14:24,980
And in fact, it applies
very much to me.

331
00:14:24,980 --> 00:14:27,350
Think about my situation at MIT.

332
00:14:27,350 --> 00:14:28,490
I've been here 25 years.

333
00:14:28,490 --> 00:14:30,130
I just got my 25th
year rocking chair,

334
00:14:30,130 --> 00:14:31,880
although actually it's
not a rocking chair

335
00:14:31,880 --> 00:14:34,102
because it comes in the box
with the rockers off it.

336
00:14:34,102 --> 00:14:36,560
And it arrived in my office,
so it's sort of a short chair.

337
00:14:36,560 --> 00:14:38,658
My wife's 5 foot, and
she always complains

338
00:14:38,658 --> 00:14:39,950
how chairs are too big for her.

339
00:14:39,950 --> 00:14:41,790
So she sat, and she's like,
it's a perfect chair for me.

340
00:14:41,790 --> 00:14:43,998
So now I have a nonrocking
rocking chair in my office

341
00:14:43,998 --> 00:14:44,810
that she sits in.

342
00:14:44,810 --> 00:14:48,740
But anyway, I've been
at MIT for 25 years.

343
00:14:48,740 --> 00:14:50,710
It's going to be really
hard for me to move.

344
00:14:50,710 --> 00:14:51,845
I like my house.

345
00:14:51,845 --> 00:14:52,720
I like my colleagues.

346
00:14:52,720 --> 00:14:54,440
I like my friends.

347
00:14:54,440 --> 00:14:56,810
Kind of, I like my
view out the window.

348
00:14:56,810 --> 00:14:59,090
It's going to be kind
of hard for me to move.

349
00:14:59,090 --> 00:15:01,220
Moreover, it'd be pretty
hard for me to figure out

350
00:15:01,220 --> 00:15:02,870
what I'd get paid if I moved.

351
00:15:02,870 --> 00:15:04,770
I can't go to other
universities and say,

352
00:15:04,770 --> 00:15:06,870
hey, what would you
pay me if you hired me?

353
00:15:06,870 --> 00:15:08,490
That's be awkward.

354
00:15:08,490 --> 00:15:10,490
I can't really ask my
colleagues what they make.

355
00:15:10,490 --> 00:15:12,080
That's awkward.

356
00:15:12,080 --> 00:15:16,220
So at the end of the day,
MIT has market power over me

357
00:15:16,220 --> 00:15:18,343
because I don't
really want to move

358
00:15:18,343 --> 00:15:19,760
and I can't really
figure out what

359
00:15:19,760 --> 00:15:22,070
I'd get paid if I did move.

360
00:15:22,070 --> 00:15:24,170
And MIT will exploit
that market power over me

361
00:15:24,170 --> 00:15:28,280
by paying me less than
I might earn elsewhere.

362
00:15:28,280 --> 00:15:32,360
And we know this as a
fact because in academia,

363
00:15:32,360 --> 00:15:35,480
the only way to get a raise is
to go get an offer from someone

364
00:15:35,480 --> 00:15:38,710
else and have them say how
much more they'll pay you,

365
00:15:38,710 --> 00:15:41,618
and then you take that to your
boss and they say, match this.

366
00:15:41,618 --> 00:15:43,160
But if you're not
willing to do this,

367
00:15:43,160 --> 00:15:45,760
as, frankly, MIT knows
I'm not willing to do,

368
00:15:45,760 --> 00:15:48,830
then MIT can
essentially underpay me.

369
00:15:48,830 --> 00:15:53,270
So basically, any
responsible profit-maximizing

370
00:15:53,270 --> 00:15:57,020
or even nonprofit employer
will exploit this market power

371
00:15:57,020 --> 00:16:01,380
and they'll pay me less
than my market wage.

372
00:16:01,380 --> 00:16:06,120
And that means that MIT
will earn surplus on me.

373
00:16:06,120 --> 00:16:08,370
In a perfectly
competitive labor market,

374
00:16:08,370 --> 00:16:10,680
the firm earns no
surplus on the worker.

375
00:16:10,680 --> 00:16:14,080
They pay the worker their
marginal revenue product.

376
00:16:14,080 --> 00:16:16,750
So if you go to this figure,
what am I paying the worker?

377
00:16:16,750 --> 00:16:18,990
What I'm paying them is
exactly the marginal revenue

378
00:16:18,990 --> 00:16:22,890
product just like, in
a competitive market

379
00:16:22,890 --> 00:16:28,745
for the goods, a firm is selling
at exactly their marginal cost.

380
00:16:28,745 --> 00:16:30,870
So just like a firm makes
no surplus in a perfectly

381
00:16:30,870 --> 00:16:34,710
competitive goods market,
a firm hiring workers

382
00:16:34,710 --> 00:16:37,270
makes no surplus in a
competitive labor market.

383
00:16:37,270 --> 00:16:40,620
But in a monopsony market, the
firm makes surplus over me.

384
00:16:40,620 --> 00:16:43,590
They pay me less than they'd
have to because I don't shop

385
00:16:43,590 --> 00:16:47,330
and find a better opportunity.

386
00:16:47,330 --> 00:16:49,817
Now, are there questions
about how that market works?

387
00:16:49,817 --> 00:16:51,650
I'm not going to do all
the math and graphs.

388
00:16:51,650 --> 00:16:53,960
It's all the same as monopoly,
just flipping demand and supply

389
00:16:53,960 --> 00:16:54,190
curves.

390
00:16:54,190 --> 00:16:55,340
It's a pain in the ass.

391
00:16:55,340 --> 00:16:56,390
I'm not going to do it.

392
00:16:56,390 --> 00:16:58,910
I just want you guys to
understand the intuition.

393
00:16:58,910 --> 00:17:00,750
So please, since I
went through this,

394
00:17:00,750 --> 00:17:04,880
are there questions about
this or how it works?

395
00:17:04,880 --> 00:17:05,660
OK.

396
00:17:05,660 --> 00:17:08,045
Now let's take this
noncompetitive labor market

397
00:17:08,045 --> 00:17:11,220
and let's throw
in a minimum wage.

398
00:17:11,220 --> 00:17:13,859
Well, as before,
if the minimum wage

399
00:17:13,859 --> 00:17:15,900
is below what the firm
was already paying,

400
00:17:15,900 --> 00:17:16,947
there's no effect.

401
00:17:16,947 --> 00:17:18,780
So let's assume it's a
binding minimum wage.

402
00:17:21,920 --> 00:17:26,210
Now, let's say the
binding minimum wage

403
00:17:26,210 --> 00:17:29,990
is above what my true
market wage would be,

404
00:17:29,990 --> 00:17:32,510
what my wage would be in the
perfectly competitive market.

405
00:17:32,510 --> 00:17:34,400
So in a perfectly
competitive market,

406
00:17:34,400 --> 00:17:39,110
my wage would equal my marginal
revenue product of labor,

407
00:17:39,110 --> 00:17:40,550
right?

408
00:17:40,550 --> 00:17:42,530
That's in a competitive market.

409
00:17:42,530 --> 00:17:45,190
In this noncompetitive
market, my wage

410
00:17:45,190 --> 00:17:48,560
is below my marginal
revenue product of labor.

411
00:17:48,560 --> 00:17:51,440
Firms are exploiting me
because I can't effectively

412
00:17:51,440 --> 00:17:52,677
shop for a better job.

413
00:17:52,677 --> 00:17:54,260
I don't want to or
it's hard to do so.

414
00:17:56,850 --> 00:17:59,040
Now, in this
noncompetitive market,

415
00:17:59,040 --> 00:18:01,560
if we set a minimum
wage that's higher

416
00:18:01,560 --> 00:18:04,570
than the marginal
revenue product of labor,

417
00:18:04,570 --> 00:18:08,840
then the analysis is just
like it's a competitive firm.

418
00:18:08,840 --> 00:18:10,280
Once that marginal
wage is higher

419
00:18:10,280 --> 00:18:12,072
than the marginal
revenue product of labor,

420
00:18:12,072 --> 00:18:15,450
it's just like a
competitive firm.

421
00:18:15,450 --> 00:18:16,670
So it's not that interesting.

422
00:18:16,670 --> 00:18:20,870
The interesting case is, what
if the minimum wage comes in

423
00:18:20,870 --> 00:18:25,740
and it's above the wage I make
but below the marginal revenue

424
00:18:25,740 --> 00:18:27,250
product of labor?

425
00:18:27,250 --> 00:18:29,910
So let's say McDonald's,
someone working there

426
00:18:29,910 --> 00:18:33,030
yields a marginal revenue
product of labor of $10,

427
00:18:33,030 --> 00:18:35,550
but they're only being paid $7.

428
00:18:35,550 --> 00:18:38,100
Let's say you roll in
minimum wage of $9--

429
00:18:38,100 --> 00:18:39,930
so above what they're
being paid now,

430
00:18:39,930 --> 00:18:43,390
but below their actual marginal
revenue product of labor.

431
00:18:43,390 --> 00:18:47,520
Will the firm fire that worker?

432
00:18:47,520 --> 00:18:49,456
Why not?

433
00:18:49,456 --> 00:18:50,908
Yeah.

434
00:18:50,908 --> 00:18:53,823
AUDIENCE: They're still paying
them-- they're still making

435
00:18:53,823 --> 00:18:55,293
a profit off of that worker.

436
00:18:55,293 --> 00:18:57,210
JONATHAN GRUBER: They're
still making surplus,

437
00:18:57,210 --> 00:18:59,600
which is as long as the
marginal product of labor's

438
00:18:59,600 --> 00:19:02,990
bigger than the wage,
they love that worker.

439
00:19:02,990 --> 00:19:07,740
So before-- so let's write
down the numbers as an example.

440
00:19:07,740 --> 00:19:10,880
So imagine my marginal revenue
product of labor at McDonald's

441
00:19:10,880 --> 00:19:14,660
is $10, but my wage is $7.

442
00:19:14,660 --> 00:19:18,370
And then you come and you
set a minimum wage of $9.

443
00:19:18,370 --> 00:19:20,950
Well, 10 is still
greater than 9.

444
00:19:20,950 --> 00:19:24,430
So the firm has no
desire to fire me.

445
00:19:24,430 --> 00:19:27,130
So all you've done is
just given me money.

446
00:19:27,130 --> 00:19:30,640
And where'd that
money come from?

447
00:19:30,640 --> 00:19:32,700
The surplus the firm earned.

448
00:19:32,700 --> 00:19:36,330
So all you've done is
shifted the surplus from--

449
00:19:36,330 --> 00:19:38,960
you've shifted producer
surplus to consumer--

450
00:19:38,960 --> 00:19:41,980
I'm sorry, consumer surplus--
consumers are the firms--

451
00:19:41,980 --> 00:19:44,440
to producer surplus,
the workers.

452
00:19:44,440 --> 00:19:48,430
So in a monopsony
market, a minimum wage

453
00:19:48,430 --> 00:19:50,350
doesn't cause deadweight loss.

454
00:19:50,350 --> 00:19:52,750
It just shifts surplus around.

455
00:19:52,750 --> 00:19:55,670
And that's a really
important outcome

456
00:19:55,670 --> 00:19:58,130
because that, once again,
says the government isn't

457
00:19:58,130 --> 00:20:00,500
always bad here.

458
00:20:00,500 --> 00:20:02,390
This is just like--
if you want to think

459
00:20:02,390 --> 00:20:05,240
about this graphically, go
back to exactly the analysis we

460
00:20:05,240 --> 00:20:07,070
did of regulating monopolies.

461
00:20:07,070 --> 00:20:09,470
Remember we talked about
regulating monopolies.

462
00:20:09,470 --> 00:20:17,810
We talked about, if a regulator
comes in and sets a price

463
00:20:17,810 --> 00:20:21,680
below the monopoly price but
above the competitive price,

464
00:20:21,680 --> 00:20:24,500
it reduced the deadweight
loss of monopoly.

465
00:20:24,500 --> 00:20:25,410
It's the same thing.

466
00:20:25,410 --> 00:20:28,970
And if you set a minimum
wage above the market wage

467
00:20:28,970 --> 00:20:31,460
but below the marginal
revenue product of labor,

468
00:20:31,460 --> 00:20:33,710
then you simply transfer
surplus to workers

469
00:20:33,710 --> 00:20:36,270
without causing deadweight loss.

470
00:20:36,270 --> 00:20:38,050
Now, that raised the
question, of course,

471
00:20:38,050 --> 00:20:39,760
is the minimum wage
in between the wage

472
00:20:39,760 --> 00:20:42,340
of the marginal
product of labor?

473
00:20:42,340 --> 00:20:44,140
Well, we don't know,
but let's go back

474
00:20:44,140 --> 00:20:45,910
to the studies that
motivated this.

475
00:20:45,910 --> 00:20:47,440
The very fact that
the minimum wage

476
00:20:47,440 --> 00:20:48,940
doesn't seem to
cause unemployment

477
00:20:48,940 --> 00:20:52,900
suggests we are
hitting the sweet spot,

478
00:20:52,900 --> 00:20:55,570
suggests we are hitting
the sweet spot, that we're

479
00:20:55,570 --> 00:20:58,510
basically managing, with the
minimum wage policy, at least

480
00:20:58,510 --> 00:21:01,570
to date, to essentially
just find a way,

481
00:21:01,570 --> 00:21:03,370
without the government
spending any money,

482
00:21:03,370 --> 00:21:06,700
to shift resources from
businesses to workers.

483
00:21:06,700 --> 00:21:08,390
So what does this mean?

484
00:21:08,390 --> 00:21:13,090
Well, it means that around the
level of current minimum wages,

485
00:21:13,090 --> 00:21:15,620
we can raise the minimum
wage by a small amount pretty

486
00:21:15,620 --> 00:21:16,840
costlessly.

487
00:21:16,840 --> 00:21:20,728
It doesn't necessarily mean
that a $15 minimum wage is OK.

488
00:21:20,728 --> 00:21:22,270
So in some sense,
the existing-- this

489
00:21:22,270 --> 00:21:25,150
is the important thing
about empirical economics.

490
00:21:25,150 --> 00:21:27,580
You only learn the answer in
the range that you study it.

491
00:21:27,580 --> 00:21:29,200
So for example,
there've been studies

492
00:21:29,200 --> 00:21:32,320
that have looked at what happens
if you have a $10 minimum wage,

493
00:21:32,320 --> 00:21:33,848
and those show no unemployment.

494
00:21:33,848 --> 00:21:35,890
There haven't been studies
that show what happens

495
00:21:35,890 --> 00:21:37,870
if you have a $15 minimum wage.

496
00:21:37,870 --> 00:21:40,720
Now, Seattle just actually
put in a $15 minimum wage

497
00:21:40,720 --> 00:21:41,777
about two years ago.

498
00:21:41,777 --> 00:21:43,360
So we actually can
run the experiment.

499
00:21:43,360 --> 00:21:46,590
And the early evidence
is the Seattle $15

500
00:21:46,590 --> 00:21:50,390
minimum wage did lower
employment, that the Seattle

501
00:21:50,390 --> 00:21:53,360
$15 minimum wage actually went
above the marginal revenue

502
00:21:53,360 --> 00:21:54,830
product of labor.

503
00:21:54,830 --> 00:21:57,945
And once it's above, you're
back in the competitive case.

504
00:21:57,945 --> 00:22:00,320
You're back in the case where
you're lowering employment.

505
00:22:00,320 --> 00:22:00,980
Yeah?

506
00:22:00,980 --> 00:22:04,848
AUDIENCE: How can you increase
competitiveness in the market?

507
00:22:04,848 --> 00:22:06,890
JONATHAN GRUBER: Well,
that's the other question,

508
00:22:06,890 --> 00:22:09,200
is how could you
increase-- so you tell me.

509
00:22:09,200 --> 00:22:10,950
How could you increase
the competitiveness

510
00:22:10,950 --> 00:22:12,840
of a labor market?

511
00:22:12,840 --> 00:22:16,450
AUDIENCE: You make it easier
to tell how much money you

512
00:22:16,450 --> 00:22:17,870
would get at each place.

513
00:22:17,870 --> 00:22:21,320
JONATHAN GRUBER: So Norway
has a day every year

514
00:22:21,320 --> 00:22:24,110
they call Envy Day,
which was yesterday,

515
00:22:24,110 --> 00:22:26,960
I believe, where they literally
can go online and look up

516
00:22:26,960 --> 00:22:29,240
anybody's income in Norway.

517
00:22:29,240 --> 00:22:33,270
They literally make public
every single person's tax return

518
00:22:33,270 --> 00:22:33,770
in Norway.

519
00:22:33,770 --> 00:22:36,540
And you can go online and
look at what everybody makes.

520
00:22:36,540 --> 00:22:38,900
That would do it.

521
00:22:38,900 --> 00:22:41,150
So you could provide
more information.

522
00:22:41,150 --> 00:22:43,130
You could make it easier
to move between jobs.

523
00:22:43,130 --> 00:22:45,422
For example, there's a lot
of restrictions in our labor

524
00:22:45,422 --> 00:22:48,110
market, like noncompete
clauses, which

525
00:22:48,110 --> 00:22:49,760
say that if you
work for one firm,

526
00:22:49,760 --> 00:22:51,385
you can't ever go
work for another firm

527
00:22:51,385 --> 00:22:54,260
in that industry for x years.

528
00:22:54,260 --> 00:22:57,125
That gives some monopsony
power to firms, et cetera.

529
00:22:57,125 --> 00:22:59,750
So we could do things which try
to loosen the flow of the labor

530
00:22:59,750 --> 00:23:03,680
market, and that would
close this gap between wage

531
00:23:03,680 --> 00:23:06,650
and marginal revenue
product of labor.

532
00:23:06,650 --> 00:23:09,020
Now, let's go back to Seattle,
just to conclude this.

533
00:23:09,020 --> 00:23:11,870
This doesn't mean the
Seattle policy was a bad one.

534
00:23:11,870 --> 00:23:14,420
The bottom line is what
we learned from Seattle

535
00:23:14,420 --> 00:23:20,360
was that basically,
employment fell a small amount

536
00:23:20,360 --> 00:23:23,100
and a bunch of workers
made a bunch more money.

537
00:23:23,100 --> 00:23:24,070
So is that good or bad?

538
00:23:24,070 --> 00:23:24,600
Well, it depends.

539
00:23:24,600 --> 00:23:26,600
If you're one of the
people that lost their job,

540
00:23:26,600 --> 00:23:27,345
it's really bad.

541
00:23:27,345 --> 00:23:29,970
If you're one of the workers who
got a raise up to $15 an hour,

542
00:23:29,970 --> 00:23:30,930
it's good.

543
00:23:30,930 --> 00:23:32,670
How do you weigh them
against each other?

544
00:23:32,670 --> 00:23:36,400
That's exactly what we'll talk
about in a couple lectures.

545
00:23:36,400 --> 00:23:39,720
So once we start talking
about normative economics,

546
00:23:39,720 --> 00:23:42,480
about is a policy good or bad,
there's typically trade-offs.

547
00:23:42,480 --> 00:23:43,988
And this is a classic example.

548
00:23:43,988 --> 00:23:46,530
What we're learning here is, is
the minimum wage in the range

549
00:23:46,530 --> 00:23:51,930
we are now, right now, the
federal minimum wage at $7.25--

550
00:23:51,930 --> 00:23:55,020
the evidence suggests
it could easily rise

551
00:23:55,020 --> 00:23:56,767
without causing that trade-off.

552
00:23:56,767 --> 00:23:58,350
The evidence suggest
we could increase

553
00:23:58,350 --> 00:24:02,120
the federal minimum wage
by some nontrivial amount,

554
00:24:02,120 --> 00:24:04,980
at least up to $9 or
$10, without causing

555
00:24:04,980 --> 00:24:06,150
much of a trade-off.

556
00:24:06,150 --> 00:24:07,800
But once you get too
far ahead of that,

557
00:24:07,800 --> 00:24:09,817
there starts to be a trade-off.

558
00:24:09,817 --> 00:24:10,650
Question about that?

559
00:24:10,650 --> 00:24:11,200
Yeah.

560
00:24:11,200 --> 00:24:14,360
AUDIENCE: Are there any states
where it's actually still

561
00:24:14,360 --> 00:24:14,987
that low?

562
00:24:14,987 --> 00:24:16,070
JONATHAN GRUBER: Oh, yeah.

563
00:24:16,070 --> 00:24:18,650
Many states don't have
their own minimum wage.

564
00:24:18,650 --> 00:24:22,242
Massachusetts is at $11,
but we're pretty unusual.

565
00:24:22,242 --> 00:24:23,450
We're one of the higher ones.

566
00:24:23,450 --> 00:24:27,990
A number of states have $7.25
as the minimum wage, OK?

567
00:24:27,990 --> 00:24:30,490
And the evidence seems to be,
from states like Massachusetts

568
00:24:30,490 --> 00:24:33,138
and others which are on the
$10, $11 range, it doesn't

569
00:24:33,138 --> 00:24:34,180
seem to lower employment.

570
00:24:34,180 --> 00:24:35,680
It seems like we could clearly--

571
00:24:35,680 --> 00:24:37,960
we'd be safe raising that
federal minimum wage.

572
00:24:37,960 --> 00:24:41,325
We would simply be
transferring resources and not

573
00:24:41,325 --> 00:24:42,200
causing unemployment.

574
00:24:42,200 --> 00:24:42,788
Yeah?

575
00:24:42,788 --> 00:24:44,860
AUDIENCE: Is there
anything about the cost

576
00:24:44,860 --> 00:24:47,530
of living in areas where the
minimum wage is more expensive?

577
00:24:47,530 --> 00:24:51,340
Is it possible that if a
McDonald's worker makes

578
00:24:51,340 --> 00:24:53,256
more money in this
state, McDonald's is

579
00:24:53,256 --> 00:24:54,040
more expensive in that state?

580
00:24:54,040 --> 00:24:55,748
JONATHAN GRUBER: That's
a great question.

581
00:24:55,748 --> 00:24:58,600
So what I assumed was I
assumed firms would just say,

582
00:24:58,600 --> 00:24:59,800
oh, you got me.

583
00:24:59,800 --> 00:25:01,900
I'm going to throw some
of my profits at workers.

584
00:25:01,900 --> 00:25:02,770
Firms don't have to do that.

585
00:25:02,770 --> 00:25:04,330
Firms could say, well, if
you make me pay workers more,

586
00:25:04,330 --> 00:25:06,070
I'm going to raise my price.

587
00:25:06,070 --> 00:25:09,310
Now, if it's a
competitive output market,

588
00:25:09,310 --> 00:25:11,350
that shouldn't happen, right?

589
00:25:11,350 --> 00:25:15,270
Because in a competitive
output market--

590
00:25:15,270 --> 00:25:15,790
well, no.

591
00:25:15,790 --> 00:25:16,780
Marginal cost goes up.

592
00:25:16,780 --> 00:25:17,470
It's not clear.

593
00:25:17,470 --> 00:25:19,470
It's not clear whether
that would happen or not,

594
00:25:19,470 --> 00:25:21,070
and the evidence is
that it's unclear

595
00:25:21,070 --> 00:25:22,750
whether higher minimum
wage causes higher prices

596
00:25:22,750 --> 00:25:24,417
or whether it just
comes out of profits.

597
00:25:24,417 --> 00:25:25,860
We don't know yet, OK?

598
00:25:25,860 --> 00:25:28,360
All right, so that's what I
want to say about labor markets.

599
00:25:28,360 --> 00:25:30,568
Now I want to move on and
talk about capital markets.

600
00:25:35,490 --> 00:25:38,450
Now, as confusing as our
discussion of labor markets

601
00:25:38,450 --> 00:25:40,470
was, that's easy compared
to capital markets.

602
00:25:40,470 --> 00:25:42,860
Capital market's a lot
harder to understand.

603
00:25:42,860 --> 00:25:45,137
And that's because
capital itself--

604
00:25:45,137 --> 00:25:46,970
labor's something you
get your hands around.

605
00:25:46,970 --> 00:25:49,130
It's the time you spend at work.

606
00:25:49,130 --> 00:25:51,440
Capital is this sort
of amorphous thing

607
00:25:51,440 --> 00:25:53,630
that I've kept
pushing off defining.

608
00:25:53,630 --> 00:25:55,012
So I'll define it now.

609
00:25:55,012 --> 00:25:57,470
We talk about capital as this
vague collection of buildings

610
00:25:57,470 --> 00:26:01,190
and machines and the other
stuff that goes into production.

611
00:26:01,190 --> 00:26:03,240
And we know where
labor comes from.

612
00:26:03,240 --> 00:26:04,730
It comes from our work.

613
00:26:04,730 --> 00:26:07,140
But where does
capital come from?

614
00:26:07,140 --> 00:26:09,900
Well, capital is
a harder concept,

615
00:26:09,900 --> 00:26:14,070
but there's one unifying thread
that all elements of capital

616
00:26:14,070 --> 00:26:17,820
have, which is they
represent the diversion

617
00:26:17,820 --> 00:26:22,990
of current consumption
towards future consumption.

618
00:26:22,990 --> 00:26:26,920
Capital is about
diverting consuming today

619
00:26:26,920 --> 00:26:30,000
towards consuming in the future.

620
00:26:30,000 --> 00:26:33,380
In fact, the original concept
of capital came from farmers.

621
00:26:33,380 --> 00:26:38,400
Farmers, every year, when
they would pick their grain,

622
00:26:38,400 --> 00:26:39,150
they had a choice.

623
00:26:39,150 --> 00:26:41,180
They could eat all
the grain, or they

624
00:26:41,180 --> 00:26:44,860
could save some to plant
for next year's grain.

625
00:26:44,860 --> 00:26:48,050
Now, the more they saved, the
more they'd have next year,

626
00:26:48,050 --> 00:26:50,290
but the less they'd have today.

627
00:26:50,290 --> 00:26:52,390
So farmers faced a trade-off--

628
00:26:52,390 --> 00:26:56,030
literally, consumption today
or consumption next year.

629
00:26:56,030 --> 00:26:57,520
That's what we mean by capital.

630
00:26:57,520 --> 00:27:01,090
In other words, in
today's market economy,

631
00:27:01,090 --> 00:27:04,240
the link is not that direct,
but it's the same basic idea--

632
00:27:04,240 --> 00:27:07,870
that firms have a choice,
firms and their investors

633
00:27:07,870 --> 00:27:09,140
have a choice.

634
00:27:09,140 --> 00:27:12,400
They can take what they
make and eat it now,

635
00:27:12,400 --> 00:27:17,240
or they can invest it in
having more in the future.

636
00:27:17,240 --> 00:27:20,507
So basically, when we
think about capital,

637
00:27:20,507 --> 00:27:22,965
we're not going to think about
capital as physical capital.

638
00:27:22,965 --> 00:27:26,030
We're really thinking about
capital as financial capital.

639
00:27:26,030 --> 00:27:30,740
What links all types of capital
is their financial aspect.

640
00:27:30,740 --> 00:27:33,470
What links machines and
buildings is all the aspect

641
00:27:33,470 --> 00:27:36,600
that, by putting
money into them today,

642
00:27:36,600 --> 00:27:39,690
you have less you can
spend on fun stuff today,

643
00:27:39,690 --> 00:27:42,330
but more you'll be
able to spend tomorrow.

644
00:27:42,330 --> 00:27:43,890
And it's this
financial aspect that

645
00:27:43,890 --> 00:27:47,080
links all forms of capital.

646
00:27:47,080 --> 00:27:49,420
Now, how do firms get
the money to invest

647
00:27:49,420 --> 00:27:51,720
in machines and buildings
and stuff like that?

648
00:27:51,720 --> 00:27:55,950
They get it through going
to the capital market.

649
00:27:55,950 --> 00:27:58,830
Where do firms get this
money that they invest?

650
00:27:58,830 --> 00:28:02,550
They get it through going
to the capital market, which

651
00:28:02,550 --> 00:28:06,060
is basically the pool of
money that firms can draw on

652
00:28:06,060 --> 00:28:08,835
to make their investments.

653
00:28:08,835 --> 00:28:10,460
So think of it
literally as I'm a firm.

654
00:28:10,460 --> 00:28:12,335
I want to build a building
and buy a machine.

655
00:28:12,335 --> 00:28:14,860
I literally go over, and
there's a big pool of money.

656
00:28:14,860 --> 00:28:18,710
And I have to take the money out
of there to go buy my machine

657
00:28:18,710 --> 00:28:21,780
or build my building.

658
00:28:21,780 --> 00:28:25,320
And where does the money
in that pool come from?

659
00:28:25,320 --> 00:28:29,940
It comes from household
savings decisions.

660
00:28:29,940 --> 00:28:32,180
So the capital
market is a market

661
00:28:32,180 --> 00:28:38,520
where the demand for capital
comes from firm's interest

662
00:28:38,520 --> 00:28:42,030
in investing and having
more in the future.

663
00:28:42,030 --> 00:28:47,110
The supply of capital comes
from people's decisions to save.

664
00:28:47,110 --> 00:28:50,110
And essentially,
the money firms use

665
00:28:50,110 --> 00:28:54,010
to buy stuff is
borrowed from people.

666
00:28:54,010 --> 00:28:57,780
And that's the bottom line
of how capital markets work.

667
00:28:57,780 --> 00:29:03,320
So just as the
supply of labor that

668
00:29:03,320 --> 00:29:05,930
determines how many
workers a firm can hire

669
00:29:05,930 --> 00:29:08,870
comes from your decision
of how hard to work,

670
00:29:08,870 --> 00:29:11,180
the supply of capital
that determines

671
00:29:11,180 --> 00:29:15,110
how many machines a firm can
buy comes from your decision

672
00:29:15,110 --> 00:29:18,060
of how hard to save.

673
00:29:18,060 --> 00:29:21,840
So let's look at figure 16-5,
equilibrium in capital markets.

674
00:29:25,080 --> 00:29:26,330
Let's start with the demand.

675
00:29:26,330 --> 00:29:29,060
We already talked, last
lecture, demand for capital.

676
00:29:29,060 --> 00:29:32,870
The demand for capital comes
from the marginal revenue

677
00:29:32,870 --> 00:29:34,610
product of capital.

678
00:29:34,610 --> 00:29:36,560
It's the marginal product
of the next machine.

679
00:29:36,560 --> 00:29:39,410
So the demand comes from
the marginal product

680
00:29:39,410 --> 00:29:41,780
of the next machine times
the price the firm can

681
00:29:41,780 --> 00:29:44,270
get for its output, which
is the marginal revenue

682
00:29:44,270 --> 00:29:46,430
product of capital.

683
00:29:46,430 --> 00:29:48,290
So it's the same
logic as for labor.

684
00:29:48,290 --> 00:29:49,940
There's nothing
interesting there.

685
00:29:49,940 --> 00:29:52,490
Same logic as for labor.

686
00:29:52,490 --> 00:29:54,830
The supply's what's
more interesting here.

687
00:29:54,830 --> 00:29:56,870
Where does supply come from?

688
00:29:56,870 --> 00:30:00,440
The supply comes from
household savings,

689
00:30:00,440 --> 00:30:03,610
how much money is
around for firms

690
00:30:03,610 --> 00:30:06,460
to actually get to
get these machines.

691
00:30:06,460 --> 00:30:07,780
And how do they get it?

692
00:30:07,780 --> 00:30:09,130
They borrow.

693
00:30:09,130 --> 00:30:10,600
And what do they borrow at?

694
00:30:10,600 --> 00:30:13,540
They borrow at the
interest rate I.

695
00:30:13,540 --> 00:30:18,220
So I represents the
rate that firms pay

696
00:30:18,220 --> 00:30:21,560
households to get their money.

697
00:30:21,560 --> 00:30:24,430
So think of this as-- we'll
talk about how it really works.

698
00:30:24,430 --> 00:30:27,240
But in theory, the idea is
think of literally a marketplace

699
00:30:27,240 --> 00:30:28,690
in the center of town.

700
00:30:28,690 --> 00:30:31,420
Downtown Boston, Haymarket,
there's this marketplace.

701
00:30:31,420 --> 00:30:33,850
And a firm comes and says,
I need to borrow money

702
00:30:33,850 --> 00:30:35,110
to buy a machine.

703
00:30:35,110 --> 00:30:36,830
And a person's there
with their savings

704
00:30:36,830 --> 00:30:38,110
and they say, well, I'll
loan you some money.

705
00:30:38,110 --> 00:30:40,030
What interest rate
you going to give me?

706
00:30:40,030 --> 00:30:41,890
And that's the
market for capital.

707
00:30:41,890 --> 00:30:44,800
So where the supply of capital
meets the demand of capital

708
00:30:44,800 --> 00:30:47,030
yields the interest rate.

709
00:30:47,030 --> 00:30:50,820
So basically, what this means is
as the interest rate's higher,

710
00:30:50,820 --> 00:30:53,660
what that means is I have
to pay people back more

711
00:30:53,660 --> 00:30:54,920
to borrow their money.

712
00:30:54,920 --> 00:30:59,240
So an interest rate of 10%,
if I borrow $10 from you,

713
00:30:59,240 --> 00:31:02,990
I pay you back
$1.10 next period.

714
00:31:02,990 --> 00:31:05,450
If I borrow $10, I pay you
back $1.10 next period.

715
00:31:05,450 --> 00:31:08,330
If the interest rate's
20%, if I borrow $10--

716
00:31:08,330 --> 00:31:09,200
if I borrow $1--

717
00:31:09,200 --> 00:31:09,932
I'm sorry.

718
00:31:09,932 --> 00:31:12,140
If I borrow $1 from you, I
pay you $1.10 next period.

719
00:31:12,140 --> 00:31:16,450
If I have 20% and I borrow $1, I
pay you back $1.20 next period,

720
00:31:16,450 --> 00:31:17,960
et cetera, OK?

721
00:31:17,960 --> 00:31:21,200
So basically, that
is essentially

722
00:31:21,200 --> 00:31:22,340
how the transaction works.

723
00:31:22,340 --> 00:31:24,680
And the key point
here is the reason

724
00:31:24,680 --> 00:31:27,260
the supply curve is
upward sloping is

725
00:31:27,260 --> 00:31:29,300
the more you're willing
to pay me for my money,

726
00:31:29,300 --> 00:31:31,250
the more I'm
willing to lend you.

727
00:31:31,250 --> 00:31:33,290
So if you come to me
and say give me $1

728
00:31:33,290 --> 00:31:35,960
and next year I'll give you
back $1, I'm like, I don't know.

729
00:31:35,960 --> 00:31:36,793
Why would I do that?

730
00:31:36,793 --> 00:31:39,470
If you say, give me $1 and next
year I'll give you back $1.10,

731
00:31:39,470 --> 00:31:41,510
you're like, OK, now
I'm interested. $1.20,

732
00:31:41,510 --> 00:31:43,832
I'm very interested.
$1.50, for sure.

733
00:31:43,832 --> 00:31:45,290
Literally, I just
give you my money

734
00:31:45,290 --> 00:31:46,790
and, next year, I
get back 50% more?

735
00:31:46,790 --> 00:31:48,470
Why not?

736
00:31:48,470 --> 00:31:50,700
So basically, the higher
the interest rate,

737
00:31:50,700 --> 00:31:52,370
the more I'm willing
to loan the firm

738
00:31:52,370 --> 00:31:54,662
and, therefore, you get an
upward-sloping supply curve.

739
00:31:57,380 --> 00:31:59,515
Now, of course,
in reality, people

740
00:31:59,515 --> 00:32:02,015
don't actually-- we don't sit
in Haymarket, downtown Boston,

741
00:32:02,015 --> 00:32:03,440
and give money to firms.

742
00:32:03,440 --> 00:32:06,410
In reality, this
transaction happens

743
00:32:06,410 --> 00:32:09,350
through capital markets.

744
00:32:09,350 --> 00:32:13,700
And essentially, there are three
mechanisms by which implicitly

745
00:32:13,700 --> 00:32:16,820
I loan money to firms.

746
00:32:16,820 --> 00:32:24,090
The first is I could
literally buy corporate debt.

747
00:32:24,090 --> 00:32:27,790
I could literally loan
the money to firms.

748
00:32:27,790 --> 00:32:30,310
I could literally go
and the firm could say,

749
00:32:30,310 --> 00:32:34,270
I, General Motors,
am issuing a bond.

750
00:32:34,270 --> 00:32:35,980
This is through
bond, issuing a bond.

751
00:32:35,980 --> 00:32:39,610
And the way that bond works is
I promise that for every dollar

752
00:32:39,610 --> 00:32:43,990
you spend buying my bond,
you'll get 1 plus I dollars back

753
00:32:43,990 --> 00:32:46,160
at the end--

754
00:32:46,160 --> 00:32:49,007
or next year, say, depends
on how long the bond is.

755
00:32:49,007 --> 00:32:51,590
So literally, you're loaning the
money to the firm by buying--

756
00:32:51,590 --> 00:32:54,430
you're buying their
promise to pay you back.

757
00:32:54,430 --> 00:32:57,400
Now, a second way you can
loan money to the firm

758
00:32:57,400 --> 00:32:59,890
is through investing
in their equity.

759
00:32:59,890 --> 00:33:01,870
You can buy their stock.

760
00:33:01,870 --> 00:33:06,400
The way this works is GM says
to you, buy a piece of me

761
00:33:06,400 --> 00:33:09,490
and you'll get paid back not
some fixed interest rate,

762
00:33:09,490 --> 00:33:13,080
but you get paid back
according to how well GM does.

763
00:33:13,080 --> 00:33:16,170
So with corporate
debt, I get paid back

764
00:33:16,170 --> 00:33:18,270
something that's predetermined.

765
00:33:18,270 --> 00:33:21,210
When I buy stock or
equity, I don't get back

766
00:33:21,210 --> 00:33:22,573
a predetermined amount.

767
00:33:22,573 --> 00:33:24,990
I get back some-- it depends
on how well the company does.

768
00:33:24,990 --> 00:33:26,920
But it's the same basic idea.

769
00:33:26,920 --> 00:33:29,160
I'm giving the company
some money today

770
00:33:29,160 --> 00:33:32,950
in return for my getting
more money, I hope, tomorrow.

771
00:33:32,950 --> 00:33:34,590
That's the diversion
of consumption

772
00:33:34,590 --> 00:33:36,670
from today to tomorrow.

773
00:33:36,670 --> 00:33:41,110
And the third thing I could do
is I could put it in the bank.

774
00:33:41,110 --> 00:33:43,000
Now, how is that
loaned to companies?

775
00:33:43,000 --> 00:33:46,210
Because the bank then
loans it to companies.

776
00:33:46,210 --> 00:33:50,485
Why do banks say they'll pay
you interest on your money?

777
00:33:50,485 --> 00:33:51,610
Why did banks going crazy--

778
00:33:51,610 --> 00:33:52,327
I'll give you 1--

779
00:33:52,327 --> 00:33:53,410
it used to be interesting.

780
00:33:53,410 --> 00:33:54,520
Now it's 1%, 2%.

781
00:33:54,520 --> 00:33:56,920
When I was a kid, I
was like 10%, 12%.

782
00:33:56,920 --> 00:33:58,175
We'll give you lots of money.

783
00:33:58,175 --> 00:34:00,550
And we'll talk later about
why it was so much higher when

784
00:34:00,550 --> 00:34:02,343
I was a kid.

785
00:34:02,343 --> 00:34:03,760
Why are banks so
eager to do that?

786
00:34:03,760 --> 00:34:05,170
It's not out of the
goodness of their heart.

787
00:34:05,170 --> 00:34:06,965
It's because when you give
them dollars, they turn around

788
00:34:06,965 --> 00:34:07,870
and loan them.

789
00:34:07,870 --> 00:34:09,412
They add a bunch to
the interest rate

790
00:34:09,412 --> 00:34:10,550
and loan them out to firms.

791
00:34:10,550 --> 00:34:12,580
So those dollars
you're giving the banks

792
00:34:12,580 --> 00:34:14,350
and they're paying
you 2% interest,

793
00:34:14,350 --> 00:34:17,580
they loan to firms at 6%.

794
00:34:17,580 --> 00:34:20,110
And that's why bankers are rich.

795
00:34:20,110 --> 00:34:22,965
So basically, the reason a bank
exists is because it's a way--

796
00:34:22,965 --> 00:34:24,340
corporate debt
and equity markets

797
00:34:24,340 --> 00:34:25,955
are hard and complicated.

798
00:34:25,955 --> 00:34:27,830
It's much easier to put
your money in a bank.

799
00:34:27,830 --> 00:34:28,800
You put your money in a bank.

800
00:34:28,800 --> 00:34:30,383
But when you put
your money in a bank,

801
00:34:30,383 --> 00:34:32,409
you're essentially
loaning it to companies.

802
00:34:32,409 --> 00:34:34,570
That's essentially
what you're doing.

803
00:34:34,570 --> 00:34:38,510
So through these mechanisms,
we have a capital market

804
00:34:38,510 --> 00:34:42,190
where essentially, by my
putting money away and diverting

805
00:34:42,190 --> 00:34:44,235
from today's consumption,
I'm loaning to a firm.

806
00:34:44,235 --> 00:34:45,610
They'll produce
more, and they'll

807
00:34:45,610 --> 00:34:49,070
pay me back more in the future.

808
00:34:49,070 --> 00:34:51,889
Questions about that?

809
00:34:51,889 --> 00:34:55,170
OK, so let's talk about where
the supply curve comes from.

810
00:34:55,170 --> 00:34:56,920
We know where the
demand curve comes from.

811
00:34:56,920 --> 00:34:58,837
It just simply comes
from the marginal revenue

812
00:34:58,837 --> 00:35:00,350
product of capital.

813
00:35:00,350 --> 00:35:01,940
Where does supply
curve comes from?

814
00:35:01,940 --> 00:35:08,000
The supply curve comes from what
we call intertemporal choice.

815
00:35:11,870 --> 00:35:15,020
As I said, economists like
putting fancy names on things.

816
00:35:15,020 --> 00:35:17,840
That helps us get
paid more money.

817
00:35:17,840 --> 00:35:21,760
It just means choosing over
time, intertemporal choice.

818
00:35:21,760 --> 00:35:24,400
Intertemporal choice
is essentially about

819
00:35:24,400 --> 00:35:27,280
how do you decide
how much to save.

820
00:35:27,280 --> 00:35:29,410
What's going to
determine that is

821
00:35:29,410 --> 00:35:31,690
going to be your
decision of how much you

822
00:35:31,690 --> 00:35:35,050
value money today versus
valuing money tomorrow.

823
00:35:37,710 --> 00:35:40,980
So for ease, let's imagine
I'm considering two periods,

824
00:35:40,980 --> 00:35:42,105
this year versus next year.

825
00:35:42,105 --> 00:35:44,563
When I talk about periods, I'm
talking about days and years

826
00:35:44,563 --> 00:35:45,450
and whatever.

827
00:35:45,450 --> 00:35:46,380
It's the basic logic.

828
00:35:46,380 --> 00:35:47,680
It's about now
versus the future.

829
00:35:47,680 --> 00:35:49,597
Whether I say days or
years, it doesn't really

830
00:35:49,597 --> 00:35:50,305
matter right now.

831
00:35:50,305 --> 00:35:52,805
The point is I'm just talking
about today versus the future.

832
00:35:52,805 --> 00:35:55,000
So let's talk about this
year versus next year.

833
00:35:55,000 --> 00:35:57,020
And let's imagine prices
aren't going to change.

834
00:35:57,020 --> 00:35:58,460
I'll come back to
prices next lecture.

835
00:35:58,460 --> 00:36:00,590
But let's imagine the price of
goods aren't going to go up.

836
00:36:00,590 --> 00:36:02,183
There's no inflation
in this economy,

837
00:36:02,183 --> 00:36:03,350
which is roughly true today.

838
00:36:05,438 --> 00:36:07,480
And let's suppose I'm
going to take next year off

839
00:36:07,480 --> 00:36:09,063
to care for my children.

840
00:36:09,063 --> 00:36:11,230
Lord knows why I'd want to
do that when the youngest

841
00:36:11,230 --> 00:36:15,310
one's 19, but imagine
they still need my care.

842
00:36:15,310 --> 00:36:18,280
So let's say I'll take next--
this example gets dated.

843
00:36:18,280 --> 00:36:22,580
Let's say I take next year
off to care for my children.

844
00:36:22,580 --> 00:36:27,580
And let's say my income
is $80,000 a year.

845
00:36:27,580 --> 00:36:29,193
Now, here is my--

846
00:36:29,193 --> 00:36:30,985
but I'm going to take
next year off unpaid.

847
00:36:33,670 --> 00:36:35,740
So I'm going to work
this year for 80k.

848
00:36:35,740 --> 00:36:38,580
Next year I'm going
to take off unpaid.

849
00:36:38,580 --> 00:36:40,320
So I have a couple of choices.

850
00:36:40,320 --> 00:36:44,770
I could work this year,
earn my 80k, spend my 80k,

851
00:36:44,770 --> 00:36:48,150
and have nothing
next year to live on.

852
00:36:48,150 --> 00:36:50,190
I could work this
year and eat nothing

853
00:36:50,190 --> 00:36:52,770
and save all of
the 80k to live on,

854
00:36:52,770 --> 00:36:54,640
or some combination in between.

855
00:36:54,640 --> 00:36:56,640
And we could illustrate--
but the key difference

856
00:36:56,640 --> 00:36:59,370
is every dollar
that I don't consume

857
00:36:59,370 --> 00:37:03,738
this year that I save to consume
next year earns interest.

858
00:37:03,738 --> 00:37:05,280
And that's where
the trade-off comes.

859
00:37:05,280 --> 00:37:06,488
So let's look at figure 16-6.

860
00:37:09,650 --> 00:37:13,430
This is a familiar-looking
optimization diagram.

861
00:37:13,430 --> 00:37:18,020
Now my optimization is not
over pizza versus cookies,

862
00:37:18,020 --> 00:37:21,740
but my optimization is over
consumption this period

863
00:37:21,740 --> 00:37:23,180
versus consumption next period.

864
00:37:23,180 --> 00:37:24,350
It's a bit mind-blowing.

865
00:37:24,350 --> 00:37:27,140
We're a little
science-fictiony here, right?

866
00:37:27,140 --> 00:37:29,540
We're now not talking about
choosing between two goods,

867
00:37:29,540 --> 00:37:33,160
like leisure and consumption
or cookies and pizza.

868
00:37:33,160 --> 00:37:36,720
Now I'm talking about two time
periods, consumption today

869
00:37:36,720 --> 00:37:38,280
versus consumption tomorrow.

870
00:37:38,280 --> 00:37:40,460
But that's the key
thing about the tools

871
00:37:40,460 --> 00:37:41,725
we learn with consumer choice.

872
00:37:41,725 --> 00:37:43,225
Those tools are
incredibly powerful.

873
00:37:43,225 --> 00:37:45,865
You just need to shove your
problem into that framework.

874
00:37:45,865 --> 00:37:48,240
And we're going to shove our
problem into this framework.

875
00:37:48,240 --> 00:37:52,240
The problem we're facing is how
do I decide how much to save.

876
00:37:52,240 --> 00:37:56,710
Well, savings is a bad
just like labor's a bad.

877
00:37:56,710 --> 00:37:59,590
What do we do when we
have a bad to model?

878
00:37:59,590 --> 00:38:00,850
We don't model the bad.

879
00:38:00,850 --> 00:38:03,190
We model the complementary good.

880
00:38:03,190 --> 00:38:05,860
So our choice is, how
much do I consume today?

881
00:38:08,760 --> 00:38:12,630
My choice is, how much
do I consume today

882
00:38:12,630 --> 00:38:16,100
and how much am I going to save?

883
00:38:16,100 --> 00:38:20,263
Well, saving is a bad, but the
other way to think about it

884
00:38:20,263 --> 00:38:21,680
is, how much am I
going to consume

885
00:38:21,680 --> 00:38:24,350
today versus how much am I
going to consume tomorrow?

886
00:38:24,350 --> 00:38:28,220
Then that's two goods and I can
model them against each other.

887
00:38:28,220 --> 00:38:30,650
And that's what I
do in figure 16-6.

888
00:38:30,650 --> 00:38:34,940
I model consumption today
versus consumption next year.

889
00:38:34,940 --> 00:38:36,930
So here's my choices.

890
00:38:36,930 --> 00:38:40,170
As I said, if I consume
everything today,

891
00:38:40,170 --> 00:38:42,470
I'm at the
x-intercept at 80,000.

892
00:38:42,470 --> 00:38:45,900
I have 80,000 to consume
today, nothing next year.

893
00:38:45,900 --> 00:38:49,750
If I consume everything
next year, what do I get?

894
00:38:49,750 --> 00:38:52,900
Well, let's say the
interest rate is 10%.

895
00:38:52,900 --> 00:38:56,450
What that means is then
I'll have $88,000 next year.

896
00:38:56,450 --> 00:38:57,820
Why will I have more next year?

897
00:38:57,820 --> 00:39:00,850
Because by saving,
I earn interest.

898
00:39:00,850 --> 00:39:04,090
By diverting my consumption to
the future, I earn interest.

899
00:39:04,090 --> 00:39:07,730
At 10%, that means I would
have $88,000 next year.

900
00:39:07,730 --> 00:39:11,530
So my budget constraint is the
line with the slope minus 1

901
00:39:11,530 --> 00:39:16,670
plus I. My budget constraint is
the line with the slope minus 1

902
00:39:16,670 --> 00:39:20,720
plus I. In other words,
the price of consumption

903
00:39:20,720 --> 00:39:27,130
today in terms of consumption
tomorrow is minus 1 plus I.

904
00:39:27,130 --> 00:39:28,220
OK, let me think about it.

905
00:39:28,220 --> 00:39:29,137
Let me say that again.

906
00:39:29,137 --> 00:39:30,930
It's really confusing.

907
00:39:30,930 --> 00:39:35,553
The price of consuming today
instead of consuming tomorrow,

908
00:39:35,553 --> 00:39:37,470
assuming no inflation--
so prices are the same

909
00:39:37,470 --> 00:39:38,550
in the market--

910
00:39:38,550 --> 00:39:41,940
is minus 1 plus I.
Think about that.

911
00:39:41,940 --> 00:39:45,120
I find it useful to think back
to the labor case for parallel.

912
00:39:45,120 --> 00:39:49,530
In the labor case, what did we
say was the price of leisure?

913
00:39:49,530 --> 00:39:50,780
What was the price of leisure?

914
00:39:50,780 --> 00:39:52,322
Someone raise their
hand and tell me.

915
00:39:52,322 --> 00:39:53,280
In the labor-- yeah?

916
00:39:53,280 --> 00:39:53,670
AUDIENCE: The wages.

917
00:39:53,670 --> 00:39:54,060
JONATHAN GRUBER: The wages.

918
00:39:54,060 --> 00:39:54,835
Why?

919
00:39:54,835 --> 00:39:57,540
AUDIENCE: Just because that's
the opportunity cost of not--

920
00:39:57,540 --> 00:39:57,870
JONATHAN GRUBER: Right.

921
00:39:57,870 --> 00:39:59,430
So by that same
logic, can tell me

922
00:39:59,430 --> 00:40:02,610
why is the price of
consuming today 1 plus I?

923
00:40:06,010 --> 00:40:07,810
AUDIENCE: Because if
you choose to save,

924
00:40:07,810 --> 00:40:09,708
then we're effectively richer.

925
00:40:09,708 --> 00:40:10,750
JONATHAN GRUBER: Exactly.

926
00:40:10,750 --> 00:40:13,000
The opportunity
cost-- remember, we

927
00:40:13,000 --> 00:40:16,240
are an annoying discipline
with a dismal science.

928
00:40:16,240 --> 00:40:19,103
We're telling you, hey, enjoy
that cookie, but by the way,

929
00:40:19,103 --> 00:40:21,520
if you weren't eating that
cookie, you could have 1 plus I

930
00:40:21,520 --> 00:40:23,890
cookies tomorrow.

931
00:40:23,890 --> 00:40:27,310
So just like we nag you for
sitting around watching TV,

932
00:40:27,310 --> 00:40:29,800
we nag you for eating
today by saying,

933
00:40:29,800 --> 00:40:33,940
hey, the more you consume today,
the less you can have tomorrow.

934
00:40:33,940 --> 00:40:37,200
And in fact, that trade-off
is that for every cookie

935
00:40:37,200 --> 00:40:41,220
you consume today, you forgo
1 plus I cookies tomorrow.

936
00:40:41,220 --> 00:40:42,630
So that's the budget constraint.

937
00:40:42,630 --> 00:40:45,390
The slope is the opportunity
cost of consuming today

938
00:40:45,390 --> 00:40:47,250
in terms of
tomorrow's consumption

939
00:40:47,250 --> 00:40:49,380
or next year's
consumption, which

940
00:40:49,380 --> 00:40:52,645
is 1 plus I. That's the slope
of the budget constraint,

941
00:40:52,645 --> 00:40:54,920
is the opportunity cost.

942
00:40:54,920 --> 00:40:58,272
And then, then we say, OK, well,
that's the opportunity cost.

943
00:40:58,272 --> 00:40:59,480
That's the budget constraint.

944
00:40:59,480 --> 00:41:00,890
Well, how do I decide?

945
00:41:00,890 --> 00:41:03,110
Well, then we know how to
make these decisions, which

946
00:41:03,110 --> 00:41:04,700
is go to utility function.

947
00:41:04,700 --> 00:41:07,070
You can write down the
utility function, which

948
00:41:07,070 --> 00:41:08,795
is a function of C1 and C2.

949
00:41:12,520 --> 00:41:13,720
Now, what is C?

950
00:41:13,720 --> 00:41:16,450
C is all my pizza and cookies,
but we're aggregating it up.

951
00:41:16,450 --> 00:41:18,970
Just like our utility
function last time

952
00:41:18,970 --> 00:41:22,680
was a function of
leisure and consumption--

953
00:41:22,680 --> 00:41:25,347
we said consumption was
the bundle of goods you eat

954
00:41:25,347 --> 00:41:26,430
and leisure is this thing.

955
00:41:26,430 --> 00:41:28,515
Now we're saying, OK,
our utility function now

956
00:41:28,515 --> 00:41:30,210
is a function of this trade-off.

957
00:41:30,210 --> 00:41:31,853
Now, you might
say, wait a second.

958
00:41:31,853 --> 00:41:33,520
How can both those
be utility functions?

959
00:41:33,520 --> 00:41:35,937
And the answer is you have
some meta-utility function that

960
00:41:35,937 --> 00:41:38,250
includes consumption today,
tomorrow, leisure, pizza,

961
00:41:38,250 --> 00:41:40,170
cookies, et cetera.

962
00:41:40,170 --> 00:41:43,650
But we can think about
this in sequential steps.

963
00:41:43,650 --> 00:41:47,160
First, we decide how we're
going to split our income.

964
00:41:47,160 --> 00:41:49,710
Then we can decide what to
spend it on each period.

965
00:41:49,710 --> 00:41:52,155
Then you can do a separate
consumer maximization decision.

966
00:41:52,155 --> 00:41:53,655
But our first
question is simply how

967
00:41:53,655 --> 00:41:54,972
am I going to split my income.

968
00:41:54,972 --> 00:41:56,430
Well, that's going
to be a function

969
00:41:56,430 --> 00:42:01,430
of my taste for consumption in
this period versus next period

970
00:42:01,430 --> 00:42:05,300
and the price the bank will
pay me for delaying consumption

971
00:42:05,300 --> 00:42:07,850
till next period.

972
00:42:07,850 --> 00:42:09,590
Now, what happens?

973
00:42:09,590 --> 00:42:12,090
Questions about that?

974
00:42:12,090 --> 00:42:14,100
Now, what happens
in the scenario

975
00:42:14,100 --> 00:42:16,580
when the interest rate goes up?

976
00:42:16,580 --> 00:42:18,900
What do you think happens if
the interest rate goes up?

977
00:42:22,352 --> 00:42:22,852
Yeah?

978
00:42:22,852 --> 00:42:26,622
AUDIENCE: There's [INAUDIBLE].

979
00:42:26,622 --> 00:42:27,580
JONATHAN GRUBER: Right.

980
00:42:27,580 --> 00:42:29,140
So what do you
think you should--

981
00:42:29,140 --> 00:42:31,810
what do you think will happen
to your consumption pattern?

982
00:42:31,810 --> 00:42:32,350
Yeah?

983
00:42:32,350 --> 00:42:33,760
AUDIENCE: You should
spend less today.

984
00:42:33,760 --> 00:42:34,540
JONATHAN GRUBER:
Spend less today

985
00:42:34,540 --> 00:42:36,490
and save more because
it's rewarded.

986
00:42:36,490 --> 00:42:39,650
And why is that not
necessarily true?

987
00:42:39,650 --> 00:42:40,430
Yeah?

988
00:42:40,430 --> 00:42:42,350
AUDIENCE: Because you might only
need a certain amount of money

989
00:42:42,350 --> 00:42:42,850
to live.

990
00:42:42,850 --> 00:42:44,835
So you don't have to
save as much today

991
00:42:44,835 --> 00:42:45,710
because you'll make--

992
00:42:45,710 --> 00:42:48,860
JONATHAN GRUBER: Because
of what two effects?

993
00:42:48,860 --> 00:42:50,620
Income and substitution effects.

994
00:42:50,620 --> 00:42:53,790
You gave exactly the intuition
that the substitution effect

995
00:42:53,790 --> 00:42:54,460
gives you.

996
00:42:54,460 --> 00:42:57,670
The substitution effect
is exactly right.

997
00:42:57,670 --> 00:42:59,620
If the interest
rate goes up, that's

998
00:42:59,620 --> 00:43:02,747
like the price of
consumption today going up.

999
00:43:02,747 --> 00:43:04,330
And if the price of
something goes up,

1000
00:43:04,330 --> 00:43:07,410
the substitution effect
says you do less of it.

1001
00:43:07,410 --> 00:43:10,873
But if interest rate
goes up, you're richer.

1002
00:43:10,873 --> 00:43:12,790
And if you're rich, you
do more of everything,

1003
00:43:12,790 --> 00:43:14,500
including consuming today.

1004
00:43:14,500 --> 00:43:16,770
The income effect
goes the other way.

1005
00:43:16,770 --> 00:43:17,598
It's like labor.

1006
00:43:17,598 --> 00:43:19,390
Once again, income and
substitution effects

1007
00:43:19,390 --> 00:43:22,117
is why we bothered
telling you so.

1008
00:43:22,117 --> 00:43:24,450
Because income and substitution
effects, in these cases,

1009
00:43:24,450 --> 00:43:25,367
go against each other.

1010
00:43:25,367 --> 00:43:29,400
Let's look at figure 16-7, OK?

1011
00:43:29,400 --> 00:43:33,760
In figure 16-7, we
start at point A.

1012
00:43:33,760 --> 00:43:38,510
Now imagine the interest
rate doubles to 20%.

1013
00:43:38,510 --> 00:43:41,300
Now imagine the
interest rate doubles.

1014
00:43:41,300 --> 00:43:44,270
As you said, that pivots the
budget constraint upwards.

1015
00:43:44,270 --> 00:43:46,560
You could still consume
only $80,000 this year,

1016
00:43:46,560 --> 00:43:50,950
but now for every dollar you
save, you get $1.20 next year.

1017
00:43:50,950 --> 00:43:52,570
That has two effects
on your decision.

1018
00:43:52,570 --> 00:43:56,020
The substitution effect, we get
by drawing an imaginary budget

1019
00:43:56,020 --> 00:43:57,880
constraint-- that's
the dash line--

1020
00:43:57,880 --> 00:44:00,590
tangent to the original
indifference curve

1021
00:44:00,590 --> 00:44:02,230
but at the new slope.

1022
00:44:02,230 --> 00:44:06,880
By definition, that means
you consume less today.

1023
00:44:06,880 --> 00:44:08,823
You consume less
today by definition.

1024
00:44:08,823 --> 00:44:10,240
If the price of
something goes up,

1025
00:44:10,240 --> 00:44:12,820
the substitution effect
always says you do less of it.

1026
00:44:12,820 --> 00:44:16,240
You consume less today,
which means you'll save more.

1027
00:44:16,240 --> 00:44:22,120
Remember, savings is just
income minus consumption

1028
00:44:22,120 --> 00:44:25,030
in period one.

1029
00:44:25,030 --> 00:44:30,280
So just as labor was
24 minus leisure--

1030
00:44:30,280 --> 00:44:33,770
and so if we just solve for
leisure, we could get labor.

1031
00:44:33,770 --> 00:44:38,150
Savings is just income minus
consumption in period one.

1032
00:44:38,150 --> 00:44:40,790
So if we solve for consumption
in period one, we get savings.

1033
00:44:44,500 --> 00:44:45,910
People see that?

1034
00:44:45,910 --> 00:44:48,910
So basically, the point here
is the substitution effect

1035
00:44:48,910 --> 00:44:52,300
says, well, gee, the price
of consumption in period one

1036
00:44:52,300 --> 00:44:53,800
just went up.

1037
00:44:53,800 --> 00:44:56,460
It's more costly in terms
of future consumption.

1038
00:44:56,460 --> 00:44:58,960
I'm going to do less, but then
my savings is going to go up.

1039
00:44:58,960 --> 00:45:01,090
Substitution effect
says you save more.

1040
00:45:01,090 --> 00:45:03,290
But the income effect
says, wait a second.

1041
00:45:03,290 --> 00:45:05,080
You're now richer.

1042
00:45:05,080 --> 00:45:07,030
Every dollar of your
savings you are doing now

1043
00:45:07,030 --> 00:45:09,280
yields twice as
much in interest.

1044
00:45:09,280 --> 00:45:13,210
If you're richer, you'll consume
more of everything, including

1045
00:45:13,210 --> 00:45:14,950
period one consumption.

1046
00:45:14,950 --> 00:45:18,048
So the income effect takes
you back the other way.

1047
00:45:18,048 --> 00:45:20,090
Now, whether the income
effect dominates are not,

1048
00:45:20,090 --> 00:45:20,810
we don't know.

1049
00:45:20,810 --> 00:45:22,227
In this case, it
doesn't dominate.

1050
00:45:22,227 --> 00:45:24,200
In this case, you
still, on net, end up

1051
00:45:24,200 --> 00:45:27,840
consuming less in period
one and saving more.

1052
00:45:27,840 --> 00:45:30,637
But we don't know what's
going to dominate.

1053
00:45:30,637 --> 00:45:32,720
And in fact, the evidence
here is incredibly weak.

1054
00:45:32,720 --> 00:45:33,940
I won't spend a long
time on the evidence

1055
00:45:33,940 --> 00:45:35,830
because it's not nearly as
interesting and strong as labor

1056
00:45:35,830 --> 00:45:36,580
supply.

1057
00:45:36,580 --> 00:45:39,108
The evidence is incredibly
weak even about the sign.

1058
00:45:39,108 --> 00:45:41,400
And let's come to the intuition
that was given for why.

1059
00:45:41,400 --> 00:45:44,800
Well, think about how people
make savings decisions.

1060
00:45:44,800 --> 00:45:47,380
Lots of people
have savings goals.

1061
00:45:47,380 --> 00:45:49,720
I want to have x by
the time I retire.

1062
00:45:49,720 --> 00:45:52,342
Typical way if you ask
people about their savings--

1063
00:45:52,342 --> 00:45:53,800
if you ask them,
they typically say

1064
00:45:53,800 --> 00:45:55,800
I want to make sure I
have x in the bank in case

1065
00:45:55,800 --> 00:45:56,650
I'm in an accident.

1066
00:45:56,650 --> 00:45:59,080
I want to make sure I have
y by the time I retire.

1067
00:45:59,080 --> 00:46:01,930
Well, in those models, if
the interest rate goes up,

1068
00:46:01,930 --> 00:46:04,335
savings rates go down.

1069
00:46:04,335 --> 00:46:06,710
Because after all, to hit a
target with a higher interest

1070
00:46:06,710 --> 00:46:08,510
rate, I can save less.

1071
00:46:08,510 --> 00:46:10,045
So it's actually
not that surprising

1072
00:46:10,045 --> 00:46:11,420
that you'd have
a higher interest

1073
00:46:11,420 --> 00:46:13,280
rate leading to less savings.

1074
00:46:13,280 --> 00:46:15,170
It's kind of
intuitive, actually.

1075
00:46:15,170 --> 00:46:17,600
If people have savings
targets, a higher interest rate

1076
00:46:17,600 --> 00:46:18,710
would lead to less savings
because they can get

1077
00:46:18,710 --> 00:46:20,520
to their target more easily.

1078
00:46:20,520 --> 00:46:22,040
So actually, we don't even
know which way this goes.

1079
00:46:22,040 --> 00:46:24,123
It's, I think, one of the
great unsolved mysteries

1080
00:46:24,123 --> 00:46:27,120
in economics empirically,
is, once again,

1081
00:46:27,120 --> 00:46:29,000
we typically assume--

1082
00:46:29,000 --> 00:46:30,470
and with a gun to
my head, I would

1083
00:46:30,470 --> 00:46:32,810
say it's probably true that
higher interest rates leads

1084
00:46:32,810 --> 00:46:34,660
to more savings.

1085
00:46:34,660 --> 00:46:38,930
But the evidence on which
that rests is pretty weak.

1086
00:46:38,930 --> 00:46:41,420
And the key point for you is
to understand it's uncertain

1087
00:46:41,420 --> 00:46:43,480
and it depends on whether
income and substitution

1088
00:46:43,480 --> 00:46:46,540
effects dominate.

1089
00:46:46,540 --> 00:46:49,030
Questions about that?

1090
00:46:49,030 --> 00:46:49,640
OK.

1091
00:46:49,640 --> 00:46:51,740
So now let's step back
and put it all together

1092
00:46:51,740 --> 00:46:55,873
and think about you making
your decision about life.

1093
00:46:55,873 --> 00:46:57,290
You can think about
your decisions

1094
00:46:57,290 --> 00:47:02,040
about your life in three steps.

1095
00:47:02,040 --> 00:47:06,820
Step one is you decide
how hard to work.

1096
00:47:06,820 --> 00:47:09,760
Step one is you decide, how
much money do I want to make?

1097
00:47:09,760 --> 00:47:12,010
Well, that's about
maximizing utility

1098
00:47:12,010 --> 00:47:15,530
over consumption and leisure.

1099
00:47:15,530 --> 00:47:18,200
Step two is, having decided
how much you're going to make--

1100
00:47:18,200 --> 00:47:20,713
and that yields your labor.

1101
00:47:20,713 --> 00:47:22,880
Step two is, deciding how
much you're going to make,

1102
00:47:22,880 --> 00:47:25,693
you decide, well, how do I
want to spread that over time?

1103
00:47:25,693 --> 00:47:27,860
How much do I want to consume
today versus tomorrow?

1104
00:47:27,860 --> 00:47:29,660
Well, that's about
intertemporal choice.

1105
00:47:29,660 --> 00:47:32,480
That's about deciding
on C1 versus C2,

1106
00:47:32,480 --> 00:47:35,980
and that's going to
yield your savings.

1107
00:47:35,980 --> 00:47:38,260
Step three is, now that
I know how much I'm

1108
00:47:38,260 --> 00:47:40,070
going to consume
each period, now

1109
00:47:40,070 --> 00:47:42,280
I want to maximize utility
across all my goods

1110
00:47:42,280 --> 00:47:44,890
I might want to
consume-- x2, across all

1111
00:47:44,890 --> 00:47:46,870
the goods I want to consume.

1112
00:47:46,870 --> 00:47:50,240
That was our original
cookies and pizza example.

1113
00:47:50,240 --> 00:47:52,510
So you could think of
it as a hierarchical set

1114
00:47:52,510 --> 00:47:55,240
of consumer
optimization problems

1115
00:47:55,240 --> 00:47:57,100
that you're going to solve.

1116
00:47:57,100 --> 00:47:59,230
Now, you might say,
well, gee, Jon,

1117
00:47:59,230 --> 00:48:02,290
that's sort of confusing
because, in fact, the interest

1118
00:48:02,290 --> 00:48:04,180
rate and how much am I
saving could determine

1119
00:48:04,180 --> 00:48:06,160
how hard I work, right?

1120
00:48:06,160 --> 00:48:07,933
Let's say the interest
rate goes way up

1121
00:48:07,933 --> 00:48:09,100
and I have a savings target.

1122
00:48:09,100 --> 00:48:11,320
I have to work less hard
to hit that savings target.

1123
00:48:11,320 --> 00:48:12,830
And I'd say to
you, good for you.

1124
00:48:12,830 --> 00:48:14,488
Take more advanced economics.

1125
00:48:14,488 --> 00:48:16,030
More advanced
economics, we recognize

1126
00:48:16,030 --> 00:48:18,322
this is one integrated whole
and we allow these systems

1127
00:48:18,322 --> 00:48:20,080
to affect each other.

1128
00:48:20,080 --> 00:48:24,490
But for here, just think of
them as separatable steps,

1129
00:48:24,490 --> 00:48:25,630
independent steps.

1130
00:48:25,630 --> 00:48:27,280
But in practice,
I hope you can see

1131
00:48:27,280 --> 00:48:29,910
the steps will be integrated
and they'll affect each other.

1132
00:48:29,910 --> 00:48:30,410
Think of it.

1133
00:48:30,410 --> 00:48:33,190
If the price of a good
you really want to buy

1134
00:48:33,190 --> 00:48:36,310
goes up a lot, not only will
you buy less of that good;

1135
00:48:36,310 --> 00:48:38,505
you might save more to
buy it and work harder.

1136
00:48:38,505 --> 00:48:40,630
So you can imagine how
these things are integrated.

1137
00:48:40,630 --> 00:48:43,340
But for now, we'll keep
them separable, OK?

1138
00:48:43,340 --> 00:48:45,210
Questions about that?

1139
00:48:45,210 --> 00:48:45,710
OK.

1140
00:48:45,710 --> 00:48:47,293
Next time, we're to
come back and talk

1141
00:48:47,293 --> 00:48:49,940
about all the interesting
stuff in capital markets

1142
00:48:49,940 --> 00:48:52,910
and how we make decisions
about how much to save

1143
00:48:52,910 --> 00:48:54,880
and things like that.