[ Music ]

>> Okay, let's continue with

the classical economic theory
of markets.
Recall the last time we
talked about households.
Households were the fundamental
decision-making units
in our theory, and they have
preferences over alternatives.
Now, the general idea
is households do no
behave randomly.
They behave in some
goal-directed fashion.
We're going to make that less
vague, make that more precise,
by saying they maximize utility
subject to a budget constraint.
We call that utility as simply
a representation of preferences.
So you may not know your
own utility function,
but if you have preferences then
under certain regularity
conditions we can represent
those preferences by a
utility function, and, hence,
describe your behavior
as maximizing utility
subject to constraints.
So let's recall the
generic problem
of utility maximization
we talked about.
It's written on the board here.
The household wants
to maximize utility,
and in this case the
alternatives are vectors
of commodities.
For simplicity, there's
only two elements
in this vector, x1 and x2.
And there's the budget equation.
So the first thing I want to
do is describe in more detail,
where does income come from?
Remember that they have some
income or resources they want
to allocate to expenditure
on these goods,
and that's denoted y.
There's different approaches,
but for our purposes a
useful approach is to say
that y is based on some
endowment, in particular,
they're endowed with some
amount of the first good.
Call that x1 bar.
And they're endowed with some
amount of the second good.
Call that x2 bar.
This is what the
household starts with,
and in the classical
theory one way
to represent the
resources available is
to say it's the price of the
first good times your endowment
of that good plus the price
of the second good times
your endowment of that good.
This is quite useful.
In particular, if I
substitute this expression
for your resources y into
the original budget equation,
I could rewrite the
budget equation as follows.
After some minor algebra,
x2 is x2 bar minus p1
over p2 times x1 minus x1 bar.
So this says the household
could consume their endowment
of the second good.
They could consume more or
less than their endowment.
Let's draw the picture.
This is the same as the picture
we talked about before in x1,
x2 space, so these are the
quantities of the first
and second good that the
household wishes to consume,
and the budget line now is
a downward sloping line,
and it goes through the point
called the endowment point,
x1 bar, x2 bar.
Household is always free
to consume their endowment.
They don't have to trade, but
they can trade, and, in fact,
they're allowed to choose
any point on the budget line
or below the budget line,
but they're not going
to waste resources because
this problem is set up in
such a way they've
already determined to go
and to spend all
these resources.
It's only a matter of allocating
them to the two goods.
Where they go on the budget
line depends on preferences,
and remember that
preferences could be described
by utility function.
And there were these objects
called indifference curves
which describe preferences
in the full and useful sense.
Every point on an indifference
curve gives the same utility.
The household wants to get to
a higher indifference curve,
but it's constrained
by available resources.
The way I'm drawing
this example,
if I can draw another
indifference curve,
it looks like the
highest indifference curve
that could be achieved given
these resources is at this point
that I'm pointing to now.
So on the budget line the
indifference curve is tangent
to the budget line, so
the household cannot get
to any higher level of utility.
So we would describe the
resulting point as the x1,
x2 bundle the household will
consume at those prices.
That's important,
at those prices.
You see, the choice x1, x2 is
going to depend on the prices.
Now, a very important
point in economics is
that the two prices,
P1 and P2 only matter
in terms of the ratio.
That's typically referred
to as the relative price.
Only the ratio, P1 over P2,
appears in the budget equation,
and since prices did not appear
in the utility function
the solution
to the problem will
depend on the prices
through the ratio, P1 over P2.
As an exercise, you might
think about what happens
when the ratio, P1
over P2, changes.
When I say, "What happens,"
what happens to the budget line?
I'll give you a hint.
It rotates.
Try to figure out how.
Another point is
that the solution
to this problem will involve
choices for x1 and x2,
which are functions
of the relative price.
We typically denote
it like this.
The quantity chosen, x1, is
a function, I'm also using x1
for the function, of
the relative price.
If we change the prices and,
hence, change the price ratio,
the budget line will rotate,
and that will cause consumers
in general to choose a different
point on the budget line.
We typically refer to these two
functions as demand functions.
X1 is the demand for
x1, or the demand
for the first commodity
and similarly for x2.
If we were to represent
that on a different diagram,
what is common is to
put the quantity chosen
on the horizontal axis
and put the relative price
on the vertical axis.
We do this even though
since high school you
probably recall we tend
to put the dependent
variable on the vertical axis.
In this case the dependent
variable is quantity.
Price is taken as
given by the household.
Nonetheless, since
Alfred Marshall,
economists typically draw
the diagram that way.
And so if I change
relative prices and trace
out how the chosen
quantity x1 varies
with the prices,
we'll get some curve.
I've drawn it like this.
Let's call that the
demand curve.
Demand is simply a function
of the relative price.
I've drawn it as
sloping downward.
That's sometimes referred
to as the law of demand.
When the relative price
of a good goes up,
you want to consume less of it.
That doesn't have to be true.
If you work out this
problem in detail,
the demand curve does not
have to be downward sloping,
although for many
commodities it is.
We'll come back to that later.
>> So let's move now
from the generic theory
of household behavior to
a particular application.
This is important because
this is a course on markets
with frictions, and one of
the key topics we'll talk
about is the labor
market and unemployment.
To make that interesting
it's useful to go back
to classical theory and
see what they think,
what they say about
labor markets.
So here's an application.
[ Pause ]
In particular labor supply.
Many, many economic problems
can be framed as special cases
of this generic household
problem.
In particular consider
the following.
I'm going to define
my two commodities
to be not just arbitrary
X1 and X2,
but to give them some content.
To give them some life, let's
call the first good leisure
and represent it by a script
L. I'm using L instead of X1
to convey the idea that this
is not just some mathematical
object, this is leisure.
And I'll tell you what I
mean by leisure in a second.
The second good let's
call consumption.
I could have stuck with X2,
but to give it some content
let's use the letter C
to represent consumption.
So this is going to
be an application
where the household is going
to choose a time allocation
and a consumption allocation
to maximize utility.
Let's write down the problem.
Maximize by choosing L and C,
some leisure time
and some consumption.
Now, of course, we all wants
lots of leisure and lots
of consumption, but in
economics there are trade offs.
Let's write them down in
terms of the budget equation.
So the constraint the
household is subject
to in general can be written
as a linear budget equation,
but I want to put
more content on it.
I want to use the price
of leisure; I'll catalogue
that down here, as the wage,
W. You may not have anticipated
this, but your time is valuable.
Time is money as they say.
How much is the cost
to take more leisure?
Well, the cost is your wage.
If you hadn't of taken the
leisure time you could have
worked and earned some income.
So the budget constraint
is going to say
in this particular application
P1 X1 is simply the wage times
your leisure.
To that I'm going to add your
expenditure on consumption.
And let's let P denote
the price of consumption.
I could have used X2 and P2, but
since I only have one commodity
that has one consumption
good C I'm not going
to subscript the
price by a number.
So this is your total
expenditure.
And in general that
should equal your income
or your resources available.
But in particular
let's use this approach
where households start
off with an endowment.
And suppose they have some
endowment L bar of time.
L bar minus L would be your
time not allocated to leisure.
That's the time you spend
working for paid compensation.
So I put W multiplied by that
and that's your labor income.
You may also have some
endowment of consumption goods,
so P times C bar represents your
endowment of consumption goods.
Let me just add some more
details for the record.
The price of the first good
is W which is the wage,
and P2 is now denoted P,
it's some generic consumption
good priced at price P.
So this is nothing new.
This is just a relabeling
of some of the variables
in the generic household
problem.
But it has lots of
interesting implications.
In particular let's
draw the standard
and difference curve
diagram where I put leisure
and consumption on the axes,
and I note there's
some endowment point,
say C bar L bar.
The household is
endowed with some time.
You might think of that as 7
days a week, 24 hours a day,
52 weeks a year, depending
on what you're talking
about in terms of
the issues at hand.
And the household
is free to consume
in their endowment point.
But they have a budget
line saying they don't have
to consume their
endowment point.
They could trade.
They could trade
off, for example,
some time for some consumption.
There's going to be a
budget line the same
as in the generic application,
however, I'm going to note
that we may restrict attention
to choices where L is less
than or equal to L bar.
If you're endowed with 7 days a
week you cannot get an 8th day
because there's a certain number
of hours in a day and days
in a week, and that's
an upper bound
in your consumption of leisure.
You can, however,
consume less leisure.
And if you work it out
you'll see the slope
of this budget line
is minus W over P,
often referred to
as the real wage.
Just like in the generic
household problem,
demand is a function
of the relative price.
In this case your demand
for leisure is a function
of the relative price, W over P.
If you think about it you'll see
that W over P is the rate
at which you can trade
off time and consumption.
If you work a little more,
that is take less leisure,
your income goes up
by W, and divided by P
that tells you how much more
consumption you can have.
So if I were to draw the
indifference curves I would find
one where there's a
tangency, and we'll see
that this point achieves
the maximum
of the consumer's
utility function.
That is this is the most
preferred alternative
for the household subject
to the constraint there
on the budget line.
Subject also to this total time
constraint but in this example
that I've drawn, that
constraint's not binding.
Now, just like in general we
have demand curves for X1 and X2
in our generic household
problem,
the problem in this application
is going to kick out a demand
for L as a function
of the real wage.
This is your demand for
leisure as a function
of the relative price
of time and goods.
And it's going to kick out
a demand for consumption
as a function of the
same relative price.
We could draw the demand
for these two goods, leisure
and consumption just like we
draw a generic demand curve.
In many applications, however,
it's useful to define labor
supply as your endowment
of time minus your
demand for leisure.
And since leisure is a
function of the real wage
and L bar is a constant, 24
hours a day or 7 days a week,
the labor you supply will be
a function of the real wage.
And I could draw that.
Just like in a standard
household problem
with arbitrary goods, X1 and X2,
I could draw the demand curve,
and I could draw it
as downward sloping,
but it may not be downward
sloping as a matter of theory.
Symmetrically I could draw
labor demand or labor supply.
Let's do supply just
for variety.
The real wage is on this axis,
even though it's the independent
variable, labor supply is
down here, and as I say it may
or may not be upward
sloping just
like the generic demand curve
may or not be downward sloping.
Let's draw it as upward sloping
for the sake of argument.
If you want to think
about a case
where it's not upward sloping
imagine you're currently paid a
certain amount, say $3 an hour,
and you're working a certain
amount, say 8 hours a day.
If they increased your wage
to $4 an hour you may choose
to work more, assuming
you have that choice.
And classical frictionless
theory does assume you have
that choice.
What if they paid
you $300 an hour?
Well, you might choose
to work a lot less
because you don't
need the money.
So although we can't be sure
that in general the labor supply
curve slopes upwards let's draw
it by way of example
as upward sloping.
>> So that's the classical
theory of labor supply.
Now before we move
onto other applications
of the classical model
of household behavior,
let's jump ahead just a little
bit and talk about equilibrium.
I'm going to leave a space here
and fill it in in a second.
The classical theory
of equilibrium is a way
to describe prices and
allocations; sometimes we refer
to it collectively as outcomes,
in terms of in equilibrium.
And in this kind of
model it's in equilibrium
when supply equals demand.
We now have the theory of
labor supply for a household.
Let's ask where labor
demand comes from.
For that we have to change from
the theory of the household
to the theory of the firm.
Firms are actually a little
bit easier than households
because the primitive in this
theory, and that's technology.
Just like for households your
primitive was your preferences.
You start off having some
preferences describing how you
feel about different
alternatives.
Well firms don't have
preferences as such;
rather they have a technology
and by way of example,
suppose a firm has a technology
represented by a function F
that says they could
produce consumption goods.
How do they produce them?
By using labor and
potentially other inputs.
So there could be a long list
of inputs; labor, capital,
by which I mean machines,
factories, raw materials,
energy, etc. I'm going to
draw a little picture of this.
If I put the input, so I'm going
to focus attention on the case
where other inputs like
capital etc. are fixed,
but there's one variable
input, labor,
I could draw the consumption
goods produced by this firm
as a function of their
labor input as follows.
F of L describes how much
output you get in terms
of the consumption good
by varying the amount
of labor as an input.
Now I've drawn it satisfying
several assumptions.
Your typical assumptions
in standard economic theory
would include the following.
F of zero equals zero.
If you have no workers you're
not going to produce any output.
Doesn't have to be that way.
Some factories use
only robots but by way
of example let's
consider the case
where labor is an essential
input in the production.
Other assumptions, the
derivative of F with respect
to L is positive, so
F prime is my notation
for the first derivative.
It says the slope of this curve
is positive and that means
if you use more inputs
you get more outputs.
Seems somewhat unobjectionable,
although one could think
of counter examples.
Also the second derivative
is negative.
In terms of this curve it means
while its scope is positive,
the slope is declining.
This is sometimes referred
to as diminishing
marginal product of labor.
When you hire more
workers you get more output
but the additional output from
the hundredth worker is not
as great as the additional
output
when you went from nine to ten.
One reason may be they're
sharing the capital stock
or maybe they're just
bumping into each other.
Okay nonetheless this is
the primitive description
of what's going on in
the theory of the firm.
Now what the firm has to
do is make some choices
and their choices are
represented as follows.
They want to maximize
some notion
of profit, sounds reasonable.
There are other theories
of the firm
but this is certainly
one way to go.
What's their profit?
It's the price of the good that
they're selling times the amount
of production, F of L. This is
total revenue, price times L
where output is a
function of the input.
The firm also has some costs,
so the wage times the labor
input is the cost to the firm.
It's called the wage
bill sometimes
and that's a variable cost
because by hiring more
or fewer workers you'll have
a higher or lower wage bill.
There could be some other costs,
particular you may have to pay
for some capital but we're
assuming that's fixed.
Nonetheless I'll
put it in there.
We typically interpret
the capital good,
at least in standard
macroeconomics,
as the same object as
the consumption good,
so it has the same price P,
but the key for this discussion
is that this is fixed.
[Writing sounds] In the short
run it cannot be varied.
How short is the short run?
Economists use the notion
of short run in a sense
that when capital is fixed,
that is the short run.
In the long run variables
aren't fixed.
You can vary everything
in the long run.
So let's not get bogged down in
those details but simply look
at this example of a firm who
wants to maximize their profit,
which is total revenue
minus total cost.
Some costs are variable.
In this case the wage
bill is variable,
and some costs are fixed.
In this case the
investment capital
or the capital stock is fixed.
But this is a pretty
simple problem.
Before I solve it let
me make an observation.
If you want to maximize profit,
which is somehow price times
quantity sold minus your total
cost, you get the
same choice for labor
if instead you maximize
real profit.
Let's divide profit by P.
[ Writing Sounds ]
Why am I doing that?
I'm doing that to emphasize
that in the theory of the firm,
just like the theory
of the household,
all that matters is
the relative price,
in this case the real
wage, W over P. So,
so what this firm is going
to do is solve this
maximization problem.
If you know calculus it's
useful to bring it to bear
in the problem, maximizing pi
over P involves simply setting
the derivative of output
with respect to labor,
equal to the real wage.
If you don't know calculus
that's not important.
The more important
concept is that at the end
of the day the firm's problem
is going generate a solution L,
which depends on the real wage.
That is called labor demand.
At the same time,
given labor demand,
we can talk about
output supplied.
The consumption good produced
by this firm is a function
of their labor input and since
labor input is a function
of the real wage, the output
of this firm is a
function of the real wage.
So we're building
towards a discussion
of general equilibrium.
We're building towards
it in small steps.
We earlier we talked about
households and what were they
and what was the primitive
feature of a household
that was their preferences.
We use that to derive
a utility function
which is a conceptual idea.
It's a description of
what households want,
how they rank alternatives,
and then we made mathematically
precise the household problem
as one of maximizing utilities
subject to a budget constraint.
From that we generated a
supply of labor and a demand
for consumption goods.
Now we're considering the other
side of the economy, firms.
They have a technology,
that's the primitive theory
of the firm, and what they want
to do is maximize their profit,
which is revenue minus cost.
So the solution to the problem
was set in the marginal product
of labor, or F prime,
equal to the real wage,
W over P. From that we
derived the demand for labor.
The amount of labor the firm
wants to hire is a function
of the real wage and through
the technology F we generate a
supply of goods.
Consumption goods
produced by the firm depend
on their labor input, which
depends on the real wage,
so we get a supply of
consumption goods C of W over P.
So we have the mirror
image from the firm side.
The household supplies
labor and demands goods.
The firm demands labor
and supplies goods.
Let's put them together and talk
about a classical
economic equilibrium.
[Silence] So let's take stock.
We've described household
behavior in terms
of their preferences,
which we used
to construct the
utility function
and then formalized the notion
of goal directed behavior
in terms of maximizing utilities
subject to a budget constraint.
In this application with
two consumer goods, leisure
and consumption, this generated
a supply of labor and a demand
for consumption goods.
On the other side of
the market we have firms
and their primitive is their
technology, represented here
by a production function.
They seek to maximize profit,
revenue minus total cost.
The solution to their problem
will involve setting the
marginal product, or F prime,
equal to the real wage,
W over P. This generates a
demand for labor, L of W over P.
And given the demand for labor
since output is a function
of the labor input, it generates
simultaneously a supply
of consumption goods,
C, as a function of W
over P. Now we want
to talk about more
than just an individual
household and an individual firm
because presumably in the
economy there's many firms
and many households and
they're all interacting.
We have to aggregate, but
let's consider a special case
where we abstract from the
heterogeneity across firms,
for example, and then we
say the total labor demand,
let's call that LD, which will
be a function of the real wage W
over P, in general equals
the sum of labor demand
that that real wage
across all firms.
If they happen to be homogeneous
then that's simply the number
of firms times the
individual labor demand coming
from the firm problem down here.
At the same time we can think
about the individual household
as having a labor
supply and if we add them
up across all households
we'll get the market supply.
Again let's abstract from
heterogeneity only for the sake
of simplicity, nothing
depends on this,
and we'll get a labor supply
at the market level, LS,
which is the number
of households
and H times the labor supply
of an individual household,
or this L, comes from the
household problem over there.
So now that I've got my
labor demand and labor supply
at the market level I can
go back to this picture here
and superimpose supply and
demand on the same diagram.
I already have labor supply
for an individual household
so let's add them
up across households
and get the market supply.
The labor demand curve I
haven't drawn but you can see
that it's a function
that describes L,
the choice as a firm, as a
function of the real wage,
and in fact interestingly enough
that you can prove
is downward sloping.
You could think about that.
I'll give you a hint.
It involved thinking
about these assumptions.
So let's draw it as such.
Labor demand is a
function of the real wage.
And again, for each individual
firm we talked about where
that came from, to
get it for the market
as a whole we simply add it
up across firms or multiply
by the number of firms
if they're the same.
This diagram conveys
a lot of information.
Classical theories of the
labor market describe outcomes
as follows.
There will be a real wage,
let's call it W over P star,
such that supply of labor
equals demand for labor
and the quantity
let's call L star.
If the real wage were anything
other than W over P star,
that is if we had a
dis-equilibrium, real wage,
there'd be some problems.
In particular, suppose
the wage is too high.
In that case supply
exceeds demand.
Households wish to work more
hours than firms are willing
to employ them at
that real wage.
That situation of excess
supply is a problem
because the market is
not in equilibrium.
The classical economic
theory suggests
that we'll put downward
pressure on the wage
and the wage would
continue to fall
until we re-achieved
equilibrium.
Whether that actually happens
in practice is another issue
but the theory assumes
in classical economics
the wage will adjust
until supply equals demand
in a downward direction.
Symmetrically if the real
wage happened to be too low,
you can see there'd be
excess demand for labor,
firms want to hire people, they
want them to work more hours
but people are not willing to
work at that lower real wage.
Classical theory says there
should be upward pressure
on the wage as firms
try to hire people
and people are not
that willing to work.
So at the end of the day the
only way this market could be
in equilibrium is at the
real wage W over P star.
Before moving on to talk
about some implications
of this classical
theory, let me get back
to something that I've missed.
There are two markets here.
There's the labor market and
I fully described the outcome
in terms of this picture.
At the same time
there's a mirror image
which is the goods market.
Just like I derive supply
and demand for the market
by aggregating household
supply of labor and firm demand
for labor, I can do the
same thing with goods.
Let's put consumption on
that axis and here instead
of the real wage I'm
going to put its inverse,
P over W. Nothing
hinges on that, however,
typically economists think
about supply and demand
for a given object as
function of its price.
When I drew the labor market
I put in the numerator W
because the wage is
the price of time.
Down here I'm thinking
about supply and demand
for consumption goods, so
I put P in the numerator
because P is the
price of these goods.
And going through a similar
exercise I can get a market
supply [writing sounds] of goods
that comes from aggregating
across individual firms'
decision about how much
to produce and I can get a
demand for goods as a function
of the relative price of
goods in terms of time.
An equilibrium in the goods
market would be a real wage,
here I'm plotting the inverse
real wage P over W star,
so that supply equals demand,
and there'd be a certain amount
of consumption produced by firms
and consumed by households.
I could talk about excess supply
and excess demand if
prices were wrong.
For example if P over W was too
high I'd have an excess supply
and if it were too low
I'd have excess demand,
and the same notion of pressure
from the market would apply.
If there was excess supply
there'd be some downward
pressure on the relative price
of goods and symmetrically
if there was excess demand
there would be upward pressure.
So the market tends
to be in equilibrium
when the relative prices are
such that P over W equals P
over W star equating
supply and demand.
A little technical point
is that we don't need
to consider both
of these markets.
There's something called
Walras' Law after Leon Walras,
which says that if you have
several markets and all but one
of them are in equilibrium
the last one must be.
So if the labor market's
in equilibrium
so is the goods market
and vice versa.
Putting aside that technical
point the economic substance
here is the following.
Classical theory predicts
markets will be in equilibrium
and prices will adjust
until supply equals demand.
Hence, in terms of the
theory of the labor market,
there's no unemployment
and there's no vacancies.
You could imagine there being
unemployment in the sense
that not all workers are working
24 hours a day, 7 days a week,
but that is not really
unemployment,
that's just leisure.
Their choice when they solve
for the utility maximization
problem is
to have some leisure
and some consumption.
What we mean when we say
there's no unemployment
in the classical theory is that
people are supplying the amount
of labor that they would like
to at that relative wage.
At the same time firms are
employing the amount of labor
that they'd like to at that
real wage, so there's no notion
of vacancies going unfilled.
When we talk about markets
with frictions we'll bring
in unemployment and
vacancies explicitly.
Before we do that it's useful
to see exactly what the
classical theory had to say.
>> So what we have here is a
description by way of example
of the classical theory
of general equilibrium.
It's an example because we're
dealing with two commodities -
consumption and leisure.
The theory applies to vectors
of n commodities for any n.
In our simple example,
I was able to describe
it on the blackboard.
Households have preferences
which we can use
to derive utility functions.
That's useful because we can
describe their goal-oriented
behavior precisely in
terms of mathematics
as maximizing utility submit
to a budget constraint.
The outcome of that
is household supply
of labor and demand for goods.
Aggregating across
households, we can market supply
and demand for labor and goods.
On the other side of the
market, we have firms.
These firms maximize profit
given their technology.
The outcome of that exercise
is a demand for labor
and a supply of goods.
Aggregating across firms,
we get market supply
of goods and demand for labor.
Putting market supply
and demand together,
either in the labor
market or the goods market,
we can define a notion
of equilibrium.
The real wage will be such that
there is no excess demand nor
excess supply of labor
and the same for goods.
It's possible to talk about
situations of excess supply
if we're willing to consider
that the wage is too high
or excess demand if
the wage is too low.
You can't get excess supply and
excess demand at the same time.
So this classical theory,
as useful and powerful
as it may be,
cannot simultaneously generate
unemployment and vacancies.
Why? There are no
frictions in this market.
This is a frictionless market.
It's designed to talk about
the perfect case where wages
and prices can adjust, people
can adjust their labor supply,
firms can adjust
their labor demand,
and it doesn't take any
time or other resources.
In this course, we're
going to later talk
about labor markets
with frictions.
Before we do, it's critical to
understand the cost of theory
with the labor market,
and that's what we have
on the board right here.
>> So let's move on
to another example.
So far we've used
general equilibrium theory
of frictionless markets to
talk about the labor market
and markets for commodities.
It's best to interpret that
as a static model thinking
about allocations
at a point in time.
Let's not talk about time.
It's really no different
from the standard problem.
It's a special case thereof.
Households want to maximize
the utility over two goods,
X1 and X2 as always,
but we're going
to interpret X1 as
consumption today.
We're going to interpret
X2 as consumption tomorrow.
So tomorrow doesn't literally
mean 24 hours from now,
it means in the future.
It could be next
year or two years,
whatever the applications
suggest.
There's going to be a
standard budget equation.
Your total expenditure
on goods today and goods
in the future equals the
value of your endowment.
What is your endowment?
Well, individuals have
some current resources,
and they have some
resources in the future.
The right hand side of the
budget equation is the value
of your endowment
stream in current prices.
In fact, let me rewrite this in
a way that's quite interesting.
Consumption tomorrow in excess
of consumption today will be
equal to the relative price
in terms of today's goods
and future goods multiplied
by X bar 1 minus X1.
It's a simple matter
of rearranging the
original budget equation
to give the second equation.
The reason this is useful is
that on the right hand side
X bar 1 minus X1 can be
interpreted as savings.
Savings in real terms: it's
the amount of your endowment
of resources you are
not currently consuming.
What are you doing with them?
You're saving them.
If there's going to be a return
on your savings you might think
about P2 over P1 as being
the real rate of interest.
If you give up some resources
today you will get more
resources tomorrow.
That means the left hand
side can be positive.
You can consume in excess
of your endowment
tomorrow if you save today.
The relative price P1 over
P2 which we sometimes write
as R is the interest rate.
It tells you the
return on your savings.
Now, since this is a standard
consumer or household problem,
I can represent it in X1 X2
space in terms of two parts,
preferences described
by indifference curves
and the constraint which
I have described here.
And you can see it's a linear
function with a slope equal
to P1 over P2 or
equivalently a slope equal
to the interest rate.
As always, the budget line goes
through your endowment point.
So households are free to
consume their resources
in the present and consume
their resources in the future
but they don't have to.
For example, you're free
to consume in excess
of your resources in the present
which means X1 could
exceed X1 bar.
That means your savings
is actually negative.
That's not a problem;
it's called borrowing.
However, in the future
you're going
to be consuming less
than your resources.
So if you want to move from
relatively low consumption
to high consumption in the
present you're going to have
to move in the other
direction in the future.
You're going to have
to repay your loan.
If you borrow, well, at some
point the loan comes due,
and in the classical theory
it's an assumption you will pay
it off.
You don't have a choice.
You could, of course,
do something different.
You could decide to consume
a point such as that one
where your current
consumption is less
than your current resources.
That's positive savings.
That involves present
day sacrifice,
but in the future you get the
reward you consumed in excess
of your future resources.
Again, in the classical theory
this is a frictionless market.
So there's no question but that
you will receive the returns
on your savings.
There's no issue
about whether people
who borrow will repay,
it's assumed.
There's no issue
about whether people
who save will get the returns
for their savings, it's assumed.
Later when we introduce
frictions
that won't be so obvious.
It'll be perceived to
finish up the description
of the classical theory
of the credit market even
though it's no different
from the classical theory
of any other market,
it's useful to draw a
couple more pictures.
So let's put the real
interest rate on this axis.
After all, it's just
the relative price
of these two goods.
And let's put savings
on this axis.
I could describe as in any
household model according
to the classical
theory the solution
to this maximization problem
in terms of X1 as a function
of the interest rate, and X2 as
a function of the interest rate.
So just like in a generic
household problem there's two
commodities, your choice will
depend on the relative price.
I can describe consumption in
the present and consumption
in the future in terms
of its relative price,
which is the interest rate.
Or, I could move directly to
the savings function and note
that savings is simply
the endowment today minus
consumption today which depends
on the interest rate and,
therefore, savings is a function
of the real rate of interest.
Now, I drew this diagram
with a zero in the middle
because savings can be
positive or negative.
In general, although the
savings function doesn't have
to be upward sloping,
just like demand curves
in general don't have
to be downward sloping,
let's consider the case
where the savings
function is upward sloping.
What you can see is
that for this example
at high interest rates
savings will be positive.
At a low interest rate,
savings will be negative.
You're more inclined to borrow
at more favorable
terms of trade.
But remember you have
to repay the loan.
Similarly if you save
there's no doubt you're going
to earn the returns,
you're going
to get the returns
on your savings.
There's different reasons
why households may choose
to be savers or borrowers.
Let me draw you a
couple of pictures.
I'm going to draw a budget line,
and I could draw the same
budget line for two households
with different endowments.
One household, say the
breadwinner is an athlete,
has lots of resources
in the present.
But after the knees are gone,
not so many resources
in the future.
The other household where say
the breadwinner is a medical
student has relatively
low current resources
and relatively high
resources once they graduate.
So let's label these
points differently
so we can keep track.
A is the first household,
the athlete.
High current resources,
low future resources.
The other, say D for doctor,
has low current resources --
slight mistake, what
are you going to do?
The other household,
say the doctor,
has relatively low
current resources
and relatively favorable
future resources.
Even if these two households
have the same preferences,
in this case they both want
to consume relatively similar
quantities in the present
and the future, you can see that
the athlete should be saving,
consuming less today
than current resources,
where the doctor should be
borrowing consuming today
above his current resources.
In the market as a whole
when you add up the savings
of every individual for there
to be an equilibrium we have
to have aggregate
savings equal to zero.
This is no different from
supply equaling demand
in the other market.
I've just chose to
frame this in terms
of a savings function
and an interest rate.
For example in this
case if I were to draw,
let me draw it fresh, the
two households together --
[ Pause ]
-- what you can see is
the future doctor is going
to have less savings
at any interest rate.
And what we'd have to do
to find an equilibrium is
to pick an interest
rate where the savings
of all the medical
students which are negative,
they're borrowing, are
exactly offset by the savings
of the athletes which
are positive.
That would be an equilibrium.
Now, I could talk about
the interest rate being
out of equilibrium and talk
about excess supply
or demand for credit.
We've already done that for the
labor market, so let's focus
on something that's
slightly different here.
When we introduce frictions
the key point will not be
that there's excess supply or
excess demand for saving per se.
What we're going to focus
on is imperfect commitment.
As I said in the
classical theory anybody
who borrows must repay;
it's an assumption.
You cannot renege on a loan.
And anybody who saves
is guaranteed
to get the returns
on their savings.
Nobody can renege on them.
Before we talk about
that it's useful
to understand the
classical theory
of frictionless credit market
where commitment is
basically assumed.
>> So that's the classical
theory of the credit market.
I could have described it in
terms of demand for x1 and x2.
That would just be
a special case
of a general frictionless
market.
I chose to describe it instead
by the savings function.
It's mathematically equivalent.
Equilibrium will be an interest
rate that clears the market.
Net savings is 0.
Or in other words, savings by
people who want to consume more
than their endowment
in the future would exactly
be offset by borrowing today.
You can use this
model for many issues.
You can use it to address,
for example, what would happen
if the government stepped into
the market and tried to borrow?
You could try to talk about
a variety of other issues.
What would happen if you
taxed the return on savings?
The model is powerful and very
useful for many applications.
But one fundamental assumption
in a frictionless market
like this, is that
we have commitment.
If you want to borrow today,
you simply must repay your loan.
It's not a choice.
One can interpret that
as saying you commit.
Similarly, if you put some of
your resources into savings
by consuming less than
your current endowment,
there's no question but that
you will get the returns
on those savings.
There's commitment by borrowers
to savers, and vice versa.
In our study of frictional
markets that comes later,
we'll talk about what happens
when we relax that assumption.
When people do not
repay their loans.
When people potentially walk
away from their mortgage.
Although the classical theory
is powerful and useful,
there are certain issues
that cannot address,
including the lack of
commitment and credit.
But that's a topic
for the future.
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