Your lecturer today and tomorrow:

Your lecturer today and tomorrow: Dr Alfred Kleinknecht CV: 1972-77: Study of Economics in Berlin 1977-84: Junior researcher, Wissenschaftszentrum Berlin and Free University of Amsterdam 1984-88: Lecturer in economics at Univ. of Maastricht 1988-94: Researcher at Univ. of Amsterdam 1994-97: Professor of Economics, Free Univ. of Amsterdam Since 1997: Professor, Economics of Innovation, TU Delft 2006: Visiting Professor, Università la Sapienza, Rome 2009: Visiting Professor, Université Panthéon Sorbonne, Paris I

Structure of lectures: • Introduction to some basic micro-economic principles • Application of micro-economic principles to management decisions • From micro-economics to innovation theory • Measuring innovation • Labour relations and innovation • Macro-economic aspects of innovation

What is economics (1)? General Economics: Micro-economics (choices made by individual firms, households or persons) Macro-economics (aggregate economy) International economics (including development economics) Economics of the public sector (Efficient taxing and public spending) Evolutionary and institutional economics: innovation

What is economics (2)? Management economics: Accounting (balance sheets, cost estimates, etc.) Finance and investment Organisation and strategic management Marketing and market research Human Resource Management Innovation management

Values and political preferences Positive economics: • Factual or predictive statements • (e. g.: "During a hot day, we sell more ice cream") Normative economics: • Value judgments (e. g.: "Income distribution should be more equal") Is economics a "value-free" science? • Not in the selection of topics for research (a scarce resource!) • Political/ideological views can play an (often hidden) role • Economists involved in policy advice may be too closely engaged with the subject of their research and with vested interests

A key difference between economics and natural sciences: Economists can not do physical experiments! Alternative: Economic models Economic models: • Concentrate on features considered essential for understanding reality (ignoring details; using simplifying assumptions) • Outcomes from models can be confronted with observed statistical data → A good 'fit' gives confidence on the model's suitability for predictions (typical research path: interaction between data analysis and model building) • There can be competing models! The choice between models should not depend (but often it does) on ideological preferences of the economist

Micro-economics as a theory of choices: Typical questions: How can I spend my money in a way that I get maximum satisfaction/utility from it? How can I distribute my time between work (= utility of money) and free time (= utility of leisure)? How can I best spend my study time: Reading a book in a library or attending this lecture? How can I distribute my income between immediate consumption and future consumption (savings)? Etc.

Basic question: How to maximise my utility, using scarce resources efficiently? Some standard assumptions: Wants are unlimited but resources are limited Self-interested behaviour: I maximise my individual utility (or my company's profits) Personal/individual preferences Rational behaviour Responsive to incentives (e.g. price change) Simplified models with ceteris paribus assumption ('everything else unchanged') Decision in the margin: important is the decision about the "last unit" (produced / bought / invested) → "marginal utility versus marginal costs …"

Opportunity costs: Utility foregone … Choosing between alternatives: • A certain quantity of energy can be used for warming your house or for driving your car → the opportunity cost of using it for driving is that you can not warm your house • This principle applies to every factor of production • This also applies to allocating your scarce time • This also applies to the choice between current consumption and future consumption (consume now or save?) • Your choice will be influenced by (changes in) relative prices, taxes etc.

Demand and supply for apples: Price S Equilibrium Price: the market can "clear" D Quantity Equilibrium (market clearing) quantity: all apples are sold; no unsatisfied demand

Demand and supply for apples Producers on the green part of the supply curve (S) are not willing to supply as their marginal costs of production are higher than marginal revenues (= the market equilibrium price) The demand curve (D) stands for peoples' "willingness to pay" which depends on personal preferences. People on the dark green part of the curve have a high preference for apples and are willing the pay the equilibrium price (they would have paid even more!) S Equilibrium Price: the market can "clear" People on this red part of the curve are not willing to pay the equilibrium price as they have a lower preference for apples Suppliers on this part of the curve are willing to supply: their marginal costs of production are below the equilibrium price D Equilibrium (market clearing) quantity: all apples are sold; no unsatisfied demand

Consumer Surplus: surface PeBC. People on part C - B of the demand curve are lucky as the market price is lower than what they would have been willing to pay! Price C Supply Producer surplus: surface PeAB. Firms on part A-B of the supply curve are lucky as they could have supplied at prices below the market price! B Pe Demand A Quantity Qe

Two types of efficiency: • Productive efficiency: production at lowest possible costs • Allocative (Pareto) efficiency: Not more and not less than the amount of goods or services desired by consumers is produced: the market is fairly democratic! How is allocative efficiency achieved?

Allocative efficiency: firms produce what consumers want Assume the market for pea nuts is in equilibrium at q e and P e. Suddenly, sales rise strongly, as newspapers report that pea nuts are good for your hart. And what happens if newspapers report that pea nuts cause cancer? As prices rise, producers move along their supply curve from A to B B Supply of pea nuts p * "Pea nuts are good for your hart" → demand curve shifts from D to D * D * Extra demand makes prices rise p e A D = Original demand For pea nuts If pea nuts cause cancer … q e q *

Demand & Supply: Movement along versus shift of the curves . A shift from S to S* can be due to a lower numbers of sellers or higher prices of production factors, or some exogenous shock (e. g. a bad harvest). Price A producer's willingness to supply increases with price S* S A buyer's willingness to pay declines due to income and substitution effects D D* Quantity A shift from D to D* can be due to lower income, changing preferences or price reduction of substitute goods

Demand & Supply: The market disturbed by government →What happens if government imposes minimum or maximum prices? Examples: • Minimum prices for agricultural goods in the European Union to protect peasants • A maximum milk price to protect poor children • A minimum wage against excessive exploitation of labour?

If government imposes maximum prices: People have to queue up! S Equili-brium Price Maxi-mum Price D q S* q e q D* Chronic shortage of goods as supply shrinks and demand expands

If government imposes minimum prices: Chronic over-production! Minimum Price S Equili-brium Price D q D* q e q S* Overproduction as supply expands and demand shrinks

The perfect competition model: An ideal market Assumptions behind the model: • A very large number of buyers and sellers: Nobody has a notable influence on supply, demand or price • Homogeneous products: All produce the same thing in the same quality • Free entry to and exit from markets (resources are mobile) • Everybody has adequate knowledge of prices and technology • Technology is given exogenously

The perfect competition model: implications • Nobody has market power • Everybody is a 'price taker' (accepting the market price, you can sell as much as you want) • Demand curves are horizontal (to individuals) • Everybody tends to earn a 'normal' profit (above-normal profits lead to entry of new firms; below normal profits lead to exit) Question: Are there markets that fulfil these assumptions?

Summarizing: • Allocation of scarce resources will be more efficient to the degree that the assumptions behind the model of perfect competition are fulfilled • If the assumptions are fulfilled, markets will always tend towards equilibrium (no clients queuing up; no unsold goods: "market clearing") • If an equilibrium is disturbed (e.g. by a bad harvest), the market will "from alone" move towards a new equilibrium → markets are "stable" (=always striving towards equilibrium) • Note: Markets not only "clear"; the way this happens is also efficient (= welfare maximizing!) • → How?

An example of efficient market clearing: A bad harvest drastically reduces the supply of apples (Supply curve S shifts to S *) Efficient solution: thanks to a higher price, the "right" people will stop buying apples! These are the true apple lovers! They derive so much utility from apples that they are willing to pay Price P * These people derive enough utility from apples to buy at the equilibrium price, but not enough utility to pay price P * S * P * = New equili-brium price S These people derive so little utility from apples that they are not willing to pay the equilibrium price! P e = Initial equilibrium price D q * q e Efficient (welfare maximizing) solution: Scarce apples go to those that derive the highest utility from them!

Imagine, the harvest was abundant; the market is flooded by apples! How will the market solve this? • The abundant harvest shifts supply from S to S *. • Prices decline from P e to P *. • At price P *, people on the green part of the Demand curve become willing buying apples, hence the extra supply (Q e - Q *) can be sold S People deriving lower utility from apples start buying, thanks to the lower price P e S * P * Q e Q * Extra apples from marvellous harvest

Another example: the market for savings and credit. The market is in equilibrium (at i e and q e), but suddenly people become scared about the future and start saving excessively → the supply curve shifts to the right (from S to S *) These people have a high preference for credit: They are willing to pay interest rate ie These people have a moderate preference for credit. As the interest rate declines, they start taking credit and absorb the extra savings Initial supply of savings Initial interest rate i e New supply of savings Low preference for credit: they are not even willing to pay the new interest rate New interest rate i * S Demand for credit S * q * q e Quantity

An opposite example: there is suddenly a great demand for credit (shift from D to D *) Due to rising interest rates, banks supply more credit D * Banks' supply of credit New interest rate i * D Initial interest rate i e New demand for credit Initial demand for credit q * q e Quantity

Another example: The labour market for professors in full employment equilibrium Question: How could we get long-lasting (mass) unemployment among professors? ? As professors become cheaper, universities buy more of them (as with apples!) Profes-sors' Wages S = Supply of professors As wages rise, more people exchange the utility of free time against the utility of earning a professor's salary Equilibrium wage W e D= Demand for professors Quantity of professors to be traded Market clearing equilibrium quantity: Every professor who is willing to work at wage We can be employed; every university ready to pay We can find professors

Professors get unemployed as their wages are too high! Overcoming unemployment? Follow the green arrows! Profes-sors' wages deter- mined by aggres-sive trade unions S = Supply of professors Market clearing wage for professors D = Demand for professors q e Q Due to high wages, universities demand fewer professors Due to too high wages, supply of professors is too high Unemployed professors

Summarizing (continued) • We think of an economy as a large number of markets (so-called 'partial' markets) • There are markets for (almost) everything: steel and potatoes, savings and credit; labour; shares and bonds, land, houses, art, services, marriages, etc. • Micro-economics tends to analyse these markets in isolation from each other (interaction between markets → macro-economics) • Under perfect competition, all markets tend towards equilibrium → general equilibrium • Problem: How to explain major crises (business cycles; depressions; financial crises)?

Discussion: More revenues through lower prices? The London city council discusses about how to reduce the public transport company's losses by raising more revenues: →The Tories argue that ticket prices should be increased in order to raise more revenues →The Labour Party suggests the opposite: Attract more people to public transport with cheaper tickets! How to decide who is right or wrong?

Price Elasticity of Demand (PED): Percentage change in quantity demanded divided by percentage change in price Inelastic demand (or low elasticity of demand): • Weak reaction of quantity sold to price change Highly elastic demand: • Strong reaction of quantity to price change Note: →As a rise in prices usually leads to a decline in demand, PED has a negative sign)

Effects of price changes on Total Revenues (TR = P x Q) depend on Price Elasticity of Demand (PED)! TR gained through price increase TR lost through lower price P P P* S S Po P 0 P * D D Q Q TR lost through price increase TR gained through lower price Highly inelastic demand: The Tories are right! Highly elastic demand: Labour is right!

What influences price elasticities of demand? • Availability of (close) substitutes • Time needed by consumer to adjust to price change (long-run PED is higher than short-run PED) • Costs incurred for switching to a substitute product (lock-in through standards? Earlier investments that may be lost?) • Relative importance of a good (as a percentage of your total budget)

Income elasticity of demand →Percentage change in goods demanded divided by percentage change in income →Note that income growth will lead to more demand. Other than the price elasticity of demand, income elasticity for typical goods has an upward slope →Law on diminishing marginal utility: increasing consumption of a good will lead to lower utility from the last unit consumed →You arrange your consumption such that the last Euro spent on each good gives you the same utility as the last Euro spent on any other good (this explains why the demand curve slopes down: with falling prices you rearrange your choices)

Cross (price) elasticity of demand →Demand of a good not only depends on its 'own' (positive) income elasticity of demand and it's 'own' (negative) price elasticity of demand, but also on prices of other (substitute or complementary) goods Example: • Rising prices for potatoes will lead to more demand for rice and pasta (cross elasticity is positive) Definition: • Percentage change in demand for potatoes, divided by percentage change in price of (substitute) good (rice or pasta).

The opposite holds for complementarygoods: • Complementary goods: e.g. automobiles and motorways →If the price of one good increases (e.g. higher road tolls), the complementary good will also be less in demand (higher road tolls lead to lower car sales) →The cross price elasticity of complementary goods is negative →The cross price elasticity of substitute goods is positive

Choices in using scarce resources – e. g. allocating scarce health services →Suppose you are a doctor in a jungle hospital, and you have medicines for treating 5 people, but 10 heavily sick people reached your hospital: How to decide which of the 5 people you treat and which you let die? • On a first-come, first-served basis? ('bureaucratic solution') • Auctioning to the highest bidder? ('market solution') • Other criteria? (e.g. discrimination by age, sex or education?)

Reasons for market failure Market failure due to externalities: →Positive external effects: somebody else takes advantage from your effort without paying for it (e.g. costless imitation of your invention) →Negative external effects: somebody else has a disadvantage from your activities without being compensated for it (e.g. you pollute the environment for free)

An example of positive external effects: vaccination Crucial assumption: vaccines are traded on a free market; in your decision to pay for vaccination, you only think of your own individual utility derived from being vaccinated (you do not take into account that your vaccination also protects others!) . Under-investment in vaccination D * = Desired demand curve for vaccinations from society's viewpoint (taking account of individual and social benefits) P S D* D = Willingness to pay for vaccination, based on individual benefits D Q Amount of vaccinations individuals would choose Welfare maximizing amount of vaccinations

An example of a negative external effect: Pollution N.B.: In your individual decision to pollute, you do not take into account that your pollution has a negative utility for others! Overproduction if pollution is for free Optimum supply curve for society if costs of pollution are charged to the firm Price when pollution is charged to firm S* S Supply curve of firms that can pollute for free Price when pollution is for free D Quantity of production if costs of pollution are charged to the firm Quantity of production if pollution is for free

Economic effects of externalities: • Positive external effects lead to under-production (or under-investment) • Negative external effects lead to over-production (or over-investment) Cures? • Regulation by governments (emission standards, fees, tradable emission rights) • Pigouvian subsidies or taxes • Negotiation (only among small groups; Coase) "Under-production" from society's viewpoint – for the individual firm it's the right amount as it receives no compensation for externality "Over-production" from society's viewpoint – for the individual firm it's the right amount as pollution is for free

Another source of market failure:"Asymmetric information" (= one party in a market knows much more than the other) Examples: • Doctors know more about treatments and health than patients → as suppliers they can largely determine demand for their services! • Insurance companies can be easily cheated by their clients (e.g. with travel insurances) • Lawyers know more than their clients know and they want to maximize their declarations … • Second hand cars: the seller knows about hidden deficiencies of the car - but will he tell the buyer? • Noisy flats: the seller knows it but for the buyer it's hard to know

Market failure through asymmetric information: Consequences and cures • Markets for automobiles and flats can become "lemon" markets! (Cure: Guarantee rules) • As clients cheat, there will be overproduction of insurance services (Cure …?) • Profit maximizing doctors may "over-treat" their patients; the same holds for lawyers (unnecessary law suits). (Cures …?)

Adverse selection: The problem of "good" and "bad" risks • Mainly people with high risks (e.g. chronically sick people) buy insurances; healthy people may choose to carry risks themselves → insurances may become too expensive for those who really need them. • 'Bad' goods drive out 'good' ones: mainly noisy flats, or Monday-morning cars are offered for sale ('lemon markets') Cures? • Everybody is obliged to take an insurance and insurance companies have to accept everybody • Guarantees for cars

Moral hazard • There may be over-supply of insurance services (e.g. for theft insurances) since people (once insured) become less careful against theft • Patients will not complain against over-treatment by doctors, as their insurance will pay for it • People with an insurance for lawyers' costs will more easily sue somebody

Types of costs Fixed costs (FC): • FC do not vary with output (e. g. start-up costs, costs of fire insurance or lease contracts) Variable costs (VC): • FC vary with output (e. g. raw materials, energy costs) Total costs (TC): FC + VC

Note: Variable costs (VC) change according to the "law of increasing costs": given a certain level of fixed costs (FC) incurred, adding more and more VC will (in the short-run) result in diminishing returns to VC (VC will grow more quickly than production) Illustration: • Assume, there is one machine (FC), and the management can choose how many workers to add to the machine → There will be diminishing returns to adding more and more workers; each worker added may still increase production, but at a diminishing rate (see illustration in Heather p. 100)

Average costs: Average Fixed Costs (AFC) = FC / Q (Q = quantity produced) Average Variable Costs (AVC) = VC / Q Average Total Costs (ATC) = TC / Q = AFC + AVC

Marginal Costs (MC) and Marginal Revenues (MR) Marginal Cost (MC): Extra costs per additional unit of output, i.e.: MC = change in Total Costs / change in Q Marginal Revenue (MR): Extra revenue per additional unit of output, i.e.: MR = Change in Total Revenue / change in Q

Short-run costs of a hypothetical firm. Hint: Study this table carefully and try to draft the figures in a plot

Your lecturer today and tomorrow: