Experiments with Economic Principles: Macroeconomics

Experiments with Economic Principles:

Macroeconomics

Theodore Bergstrom

UCSB

John H. Miller

Carnegie Mellon University

May 8, 2000c 2000.

ii

Contents

1 Innovation, Employment and Wages 1

Hot Dogs and Buns . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Selling Joint Output {Session 1 . . . . . . . . . . . . . . . . . 1

E�ects of a Productivity Increase{Session 2 . . . . . . . . . . 2

Price Supports for Hot Dogs{Session 3 . . . . . . . . . . . . . 2

Occupational Mobility{Session 4 . . . . . . . . . . . . . . . . 2

Warm-up Exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Discussion of Experiment 1 . . . . . . . . . . . . . . . . . . . . 4

Productivity Increases and Income . . . . . . . . . . . . . . . . . . 4

Short Run and Long Run Equilibrium . . . . . . . . . . . . . 4

Equilibrium in Session 1 . . . . . . . . . . . . . . . . . . . . . 4

Short Run Equilibrium in Session 2 . . . . . . . . . . . . . . . 4

Price Supports{Session 3 . . . . . . . . . . . . . . . . . . . . . 5

Long Run Competitive Equilibrium . . . . . . . . . . . . . . 6

Some Conclusions and Remarks . . . . . . . . . . . . . . . . . 7

Lab Notes for Experiment 1 . . . . . . . . . . . . . . . . . . . 9

Homework for Experiment 1 . . . . . . . . . . . . . . . . . . . 13

2 Employment, Income, and Demand 17

A Macronesian Economy . . . . . . . . . . . . . . . . . . . . . . . . 17

Session 1{Production and Consumption . . . . . . . . . . . . . . . 17

Session 2{\Cash-on-the-Barrelhead" . . . . . . . . . . . . . . . . . 18

Session 3{ Governmental Pump-priming . . . . . . . . . . . . . . . 19

Discussion of Experiment 2 . . . . . . . . . . . . . . . . . . . . 20

Equilibrium Wages and Prices in Session 1 . . . . . . . . . . . . . . 20

Motivation for the Buyer Values . . . . . . . . . . . . . . . . 22

E�ects of a Credit Collapse . . . . . . . . . . . . . . . . . . . . . . 22

Government Intervention in Session 3 . . . . . . . . . . . . . . . . 24

Lab Notes for Experiment 2 . . . . . . . . . . . . . . . . . . . 25

iv CONTENTS

Records of Wages and Pro�ts in Session 1 . . . . . . . . . . . . . . 25Records of Wages and Pro�ts in Session 2 . . . . . . . . . . . . . . 27Homework for Experiment 2 . . . . . . . . . . . . . . . . . . . 29

What Caused the Crash? . . . . . . . . . . . . . . . . . . . . 29National Product Accounting . . . . . . . . . . . . . . . . . . 29

Experiment 1

Innovation, Employment and

Wages

Hot Dogs and Buns

Life is simple in the land of Oz. Consumers consume only one product, hotdogs on buns. Workers can choose one of two jobs. They can be butchersor they can be bakers. Butchers produce hot dogs, bakers produce buns.1

Selling Joint Output {Session 1

Half of the students are assigned to be butchers and half to be bakers. Eachbutcher can produce one hot dog and each baker can produce one bun.Butchers and bakers are given colored slips of paper representing hot dogsand buns. If a butcher and a baker agree to put their products together,they can sell a hot dog with a bun to the market manager for $20. A hot dogwithout a bun is worthless and so is a bun without a hot dog. Butchers andbakers should roam around the room trying to make a deal with a workersof the other type. A butcher and a baker can any arrangement they likeabout how to divide the $20 that they will get for their joint product. Ifthey agree on terms, they should �ll out a sales contract, present it to themarket manager and display their hot dog and bun slips. The manager willcredit the butcher and baker with their agreed-on shares of $20.

1This experiment is based on a parable told by Paul Krugman on pages 18-23 ofThe Accidental Theorist, a nice book of essays on economic topics written for a general

audience.

2 Experiment 1. Innovation, Employment and Wages

E�ects of a Productivity Increase{Session 2

Congratulations are in order for buchers! A new invention has doubled theirproductivity. Now every butcher can produce two hot dogs instead of one.Butchers will be given a second slip of paper, representing a second hotdog. Bakers still produce only one hot dog. In order to sell two hot dogs,a butcher must make separate deals with two di�erent bakers. As before, ahot dog without a bun worthless, but a hot dog and a bun are worth $20.As in Session 1, a butcher and baker who complete a sales contract can sella hot dog with bun and divide the $20 price as agreed on their contract.

If there is time, your instructor may have you do a second round of thisexperiment, in which everything is as in the second round, but everyone isnow aware of what happened in the �rst round.

Price Supports for Hot Dogs{Session 3

In Session 2, it is likely that the increase in their productivity caused adrastic fall in the price of hot dogs and in the income of butchers. Inresponse to the butchers' misfortune, the government decides to introduce\price supports" for hot dogs. In order to restore the pre-invention price ofhot dogs, the government agrees to buy hot dogs at a support price of $10.Butchers can now either sell their hot dogs to the government for $10 or canmake a deal with a baker to a hot dog with bun to the market manager.

The government will destroy the hot dogs that it buys. This supportprogram is costly, and the government will pay for this program by assessingan equal amount of tax on all participants in the experiment. The totalcost of the program will be equal to $10 times the number of hot dogs thegovernment buys.

When the �rst round of Session 3 is completed, you will either discusswhat would happen with a support price of $5 rather than $10, or if thereis time you may carry this out experimentally.

Occupational Mobility{Session 4

In Session 4, there will be no price supports, but some workers will be ableto change occupations. We will denote three degrees of mobility. There willbe immobile workers, who must maintain the same occupation that theyhad in previous sessions, mobile workers who can change occupations at thebeginning of the session if they want to and there will be highly mobileworkers who do not need to choose their occupation before trading begins,but can choose their occupation at any time before trading stops.

WARM-UP EXERCISE 3

About half of the workers will be designated as mobile workers, twoworkers will be designated as highly mobile workers, and the remainder willbe immobile workers.

Warm-up Exercise

Suppose that you are butcher. Trading is nearly completed and you seethat there are many more bakers who haven't sold their buns and not manybutchers who haven't sold their hot dogs. What share of the $20 from saleof a hot dog with bun would you ask for when trying to make a deal with abaker?

If you are a butcher and if you believe that there more buns than hot dogshave produced, what share of the $20 would you request when bargainingwith bakers?

If you are a butcher and you believe that more hot dogs than buns havebeen produced, what share of the $20 would you request when bargainingwith bakers?

In Session 4, if you are a mobile worker, how would you decide whichoccupation to choose?

In session 4, if you are a highly mobile worker, how would you decidewhich occupation to choose?

4Discussion of Experiment 1. Innovation, Employment and Wages

Discussion of Experiment 1

Productivity Increases and Income

Short Run and Long Run Equilibrium

Economists frequently distinguish between the short run and the long run.When the economic environment changes, some responses can occur veryquickly and other adjustments take place only slowly. For example, whenproductivity changes, prices and wages can usually adjust quite quickly. Onthe other hand, it may take a long time for people to change occupations.Indeed sometimes a major shift in the distribution of types of workers willhave to wait until much of the current labor force is retired and replaced bynew workers.

Equilibrium in Session 1

In the �rst session, there was one baker for every butcher. Thus everybutcher and every baker can �nd a partner to produce a hot dog with bun.Butchers and bakers have $20 to divide between them. Neither occupationhas any bargaining advantage over the other and we expect the outcome tobe that each butcher-baker pair will split the di�erence and each will get ashare of $10.

Suppose that we start with equal numbers of butchers and bakers andthat we run several rounds of this session, where anyone is allowed to switchoccupations if they like. Since butchers make exactly the same amount ofpro�ts as bakers, neither butchers nor bakers have an incentive to changejobs.2 The outcome in which there are equal numbers of butchers and bakersand where butchers get $10 for a hot dog and bakers get $10 for a bun istherefore a long run equilibrium.

Short Run Equilibrium in Session 2

In Session 2, each butcher can produce two hot dogs, while each baker canstill produce only one bun. Since there are equal numbers of butchers and

2In fact if a butcher decided to become a baker and if nobody else switched, the resultwould be that there would be more buns than hot dogs. In this case, some baker is notgoing to be able to sell a bun and there will be competitive pressures pushing down the

price of buns in general. So switching is likely to be costly to the person who switches.

PRODUCTIVITY INCREASES AND INCOME 5

bakers, there are now twice as many hot dogs available as buns. In the shortrun, nobody can change occupations. Butchers will be eager to sell their hotdogs and be willing to accept a wage of less than $10. Bakers will see thatthere are going to be many hot dogs that go unused and are in a position todemand more than $10 for a bun. In fact, so long as the price of hot dogsis greater than zero, butchers will be trying to sell more hot dogs than thenumber of buns available. The short run equilibrium price of hot dogs willbe zero. 3

Price Supports{Session 3

In the short run equilibrium of Session 2, butchers have much lower in-comes than bakers. This seems ironic, because the productivity of butchersincreased and the productivity of bakers did not change.

In the real world, we often see similar e�ects. In agriculture, the intro-duction of machinery and of improved strains of crops and livestock resultedin dramatic increases in the productivity of farmers. As crop productionrose, the prices of farmers' output fell and so did the income of small farm-ers. In heavy manufacturing industries, in mining, and in ship-building,innovations in production processes greatly increased the amount of outputper laborers. This resulted in falling incomes for many workers in theseindustries at a time when the rest of the economy was booming.

One way to soften the blow of income shifts resulting from changes inproductivity is for the government to "support" the prices of goods whoseprices have fallen by purchasing these goods and disposing of them. InSession 3, the government o�ers to buy hot dogs at a price of $10 each. Thismeans that bakers will have to give butchers at least a $10 share to get themto help make a hot dog and bun rather than sell to the government. In shortrun equilibrium the price of hot dogs is $10 and the price of buns is $10 andbutchers and bakers who get together split their gains equally.

The government's price support program is costly. The government buyshalf of the hot dogs that are produced for a price of $10. We suppose thatthese costs are paid for by taxes collected equally from all market partici-pants. The cost of the support program is $5 for every market participant.4

3Because a hot dog is worthless without a bun, in short run equilibrium, the price ofhot dogs must be zero and the price of buns must be $20. If your class runs only one ortwo rounds of Session 2, the price of hot dogs probably won't get pushed all the way to

zero, but it will probably fall well below $5.4This is true because half of the participants are butchers and each butcher produces

two hot dogs. On average, one hot dog per butcher is sold to the government. That means

that one hot dog is sold to the government for every two market participants. The cost


If prices are supported at $10, then each butcher sells two hot dogs fora price of $10 and has a before-tax income of $20. Each baker sells one bunfor $10 and has a before-tax income of $10. Since everybody has to pay atax of $5, the after-tax income of every butcher is $20 � $5 = $15 and theafter-tax income of every baker is $10 � $5 = $5.

We see that the e�ort to support butchers' incomes by supporting hotdog prices at the old price level makes butchers better o� than they werebefore their productivity increase and bakers worse o� than they were before.This is not very surprising, since butchers are now able to sell two hot dogsat the same price at which they used to be able to sell just one. With pricesupports for hot dogs at $10, therefore, we would expect that in the longrun where workers can change occupations more people would choose to bebutchers and fewer to be bakers. This is a really perverse outcome, since itis buns that are in scarce supply and hot dogs that are being bought up anddestroyed by the government.

Perhaps a more reasonable support price for hot dogs would be $5. Thenin short run equilibrium, half of the hot dogs would be sold to the governmentfor $5 and half would be combined with buns and sold as hot dogs with buns.In equilibrium, butchers would get $5 whether they sold to the governmentor made a deals with bakers. Butchers would have before-tax incomes of$2 � 5 = $10. Since butchers are getting $5 of the $20 price of a hot dogwith bun, bakers must be getting $15 for their buns. The cost of the supportprogram would be $5 times the number of butchers. When this cost isdivided equally among all participants, there is a tax of $2.50 per participant.Therefore after-tax income of butchers will be $10�$2:50 = $7:50 and after-tax income of bakers will be $15 � $2:50 = $12:50. Thus with a supportprice of $5, butchers are worse o� thn they were without the support priceand bakers are better o�.

We will leave it as an exercise for you to �nd a support price that wouldleave both butchers and bakers exactly as well o� as they were before theimprovement in the productivity of butchers.

Long Run Competitive Equilibrium

In the long run, there will be opportunities for butchers and bakers to changetheir occupations. Workers who are able to make a choice between the twooccupations will choose the occupation that gives them the higher income.In long run equilibrium, therefore, we expect that butchers and bakers will

of the support program is therefore $10� 1=2 = $5 per market participant.

PRODUCTIVITY INCREASES AND INCOME 7

have equal incomes, since otherwise some will want to switch. If this is to bethe case, it must also be that the number of hot dogs produced will equalsthe number of buns produced.

Since butchers produce two hot dogs and bakers produce one bun, itmust be that in long run equilibrium, there are twice as many bakers asbutchers. For butchers and bakers to be equally well o�, it must also bethat the price of a bun is twice the price of a hot dog. Thus we expect thatin long run equilibrium, two thirds of the workers are bakers and one thirdare butchers. If the price of a bun is twice the price of a hot dog, then sincethe price of a hot dog plus the price of a bun is $20, it must be that in longrun equilibrium, a hot dog is worth $6.33 and a bun is worth $12.66.

With these prices, we see that in long run equilibrium butchers andbakers both have incomes $12.33. Since before the improvement in produc-tivity, both types earned $10, we see that in the long run the improvementin butchers' productivity bene�ts both butchers and bakers.

Some Conclusions and Remarks

In this experiment, in the short run, increased productivity of butchersresulted in such a great fall in the price of hot dogs that their income fell.The income of bakers however increased as the price of hot dogs fell. In thelong run where there was time for workers to change occupations, enoughbutchers switched to baking to equalize production of hot dogs and buns.After the occupational switches have occured, both butchers and bakershave higher incomes than they did before the productivity increase.

While it is true that in long run equilibrium, butchers and bakers willboth be better o� because of the productivity increase, this may not be ofmuch comfort to today's butchers. Switching occupations may require aworker to retrain or move to another city. This may be especially di�cultor even impossible for older workers.

A case can be made for some kind of government measures to lessen theshock of unexpected productivity changes. A price support program is onepossibility.

A major disadvantage of price support program is that it reduces theincentive for workers to move from an occupation whose product is not inhigh demand to one where it is in high demand. As we saw in our hot dogexample, the social gains from increased productivity in one occupation maynot be realized until there has been movement between occupations.

In our hot dog example, a $10 support price would leave butchers bettero� than bakers even though more hot dogs are being made than buns. In the


long run, such a high subsidy would lead to the perverse result that bakerswould switch to butchering and the surplus of hot dogs would only increase.We could �nd a lower support price such that butchers and bakers are equallywell o� given the support price. (You will be asked to �nd this price inyour homework.) The trouble with a support price that equalizes after taxincomes of butchers and bakers is that there is not incentive for butchersto switch to baking. But we need these switches to occur in order for theeconomy to realize the bene�ts of the increased productivity of butchers.

Reasonable arguments can be made both for and against a low-levelprice support program. If hot dog support prices are set low enough sothat the after-tax income of butchers is less than that of bakers, then in thelong run, some butchers would want to become bakers. A low level supportprogram o�ers the bene�t of reducing the risk to workers of major incomelosses due to productivity changes. On the other hand, even a low levelysupport program is likely to slow the rate at which workers switch out of anoccupation that currently has too many workers.

LAB NOTES FOR EXPERIMENT 1 9

Lab Notes for Experiment 1

In Table 1.1, record the division of payments for each deal made between abutcher and a baker in Sessions 1 and 2. (If you ran more than one roundof either session, record only the results of the last round.)

Table 1.1: Deals Made in Sessions 1 and 2

Session 1 Session 2

Deal # Dog's Share Bun's Share Deal # Dog's Share Bun's Share

1 1

2 2

3 3

4 4

5 5

6 6

7 7

8 8

9 9

10 10

11 11

12 12

13 13

14 14

15 15

16 16

17 17

18 18

19 19

20 20

21 21

22 22

23 23

24 24

25 25

10

Lab Notes for Experiment 1. Innovation, Employment and

Wages

In Table 1.2, record the division of payments for each deal made by abutcher and a baker in Session 3, for Round 1 (with a $10 support payment)and in Round 2 (with a $5 support payment).

Table 1.2: Deals Made in Session 3

Round 1 Round 2


1 1

2 2

3 3

4 4

5 5

6 6

7 7

8 8

9 9

10 10

11 11

12 12

13 13

14 14

15 15

16 16

17 17

18 18

19 19

20 20

21 21

22 22

23 23

24 24

25 25

The number of hot dogs sold to the government was in

Round 1 and in Round 2 of Session 3.


In Session 4, the number of workers who chose to be butchers was

, and the number who chose to be bakers was .

The number of hot dogs produced was and the number of buns

produced was .

In Table 1.3, record the division of payments for each deal made by abutcher and a baker in Session 4. (If your class ran more than one round ofSession 4, record only the results from the last round.)

Table 1.3: Deals Made in Session 4


1 21

2 22

3 23

4 24

5 25

6 26

7 27

8 28

9 29

10 30

11 31

12 32

13 33

14 34

15 35

16 36

17 37

18 38

19 39

20 40

In the last round of Session 4, the number of butchers was

, and the number of bakers was . The total number of

12

Lab Notes for Experiment 1. Innovation, Employment and

Wages

hot dogs produces was and the total number of buns produces

was .

NAME SECTION

Homework for Experiment 1

Problem 1:1 In Session 1 of this experiment:

Part a) how many hot dogs with buns were sold?

Part b) the average income of butchers was

Part c) the average income of bakers was

Part d) the total of income of all workers was

Problem 1:2 In Session 2 of this experiment:


Part b) how many hot dogs were left unused?

Part c) how many buns were left unused?

Part d) the average price per hot dog was

Part e) the average income of butchers was

Part f) the average income of bakers was

Part g) the total of income of all workers was

Problem 1:3 In Round 1 of Session 3:


Part b) how many hot dogs were sold to the government?

Part c) how much money did the government spend on hot dogs?Part d) Each worker pays a tax equal to the government's expenditure on

14

Homework for Experiment 1. Innovation, Employment and

Wages

hot dogs divided by the number of workers. How much is the tax that each

worker must pay?


Part a) the average before-tax income of butchers was

Part b) the average after-tax income of butchers was

Part c) the average before-tax income of bakers was

Part d) the average after-tax income of bakers was

Part e) the total after-tax income of all workers was



Part b) how many hot dogs were sold to the government?

Part c) how much money did the government spend on hot dogs?Part d) Each worker pays a tax equal to the government's expenditure onhot dogs divided by the number of workers. How much is the tax that each

worker must pay?


Part a) the average before-tax income of butchers was

Part b) the average after-tax income of butchers was

Part c) the average before-tax income of bakers was

Part d) the average after-tax income of bakers was

Part e) the total after-tax income of all workers was

Problem 1:7 In the last round of Session 4:


HOMEWORK FOR EXPERIMENT 1 15

Part b) how many butchers were there?

Part c) how many bakers were there?

Part d) how many hot dogs were left unused?

Part e) how many buns were left unused?

Problem 1:8 In the last round of Session 4:

Part a) the average price per hot dog was

Part b) the average price per bun was

Part c) the average income of butchers was

Part d) the average income of bakers was

Part e) the total of income of all workers was

Problem 1:9 In Session 3:

Part a) what would the government support price have to be in order for

butchers and bakers to be equally well o�?Hint: Since butchers have two hot dogs to sell, the before-tax income ofbutchers is twice the price of hot dogs. Since butchers and bakers share the$20 price of a hot dog with bun, the before-tax income of bakers is $20 minusthe price of a hot dog. Since taxes are equal for everybody, the after-taxincome of butchers will equal that of bakers when their before-tax incomesare equal.

Part b) what would the after-tax income of butchers and bakers be with

this support price?

Problem 1:10 Why might it not be a good idea for the government toset a support price that makes butcher and bakers equally well o�? Hint:Compare after-tax incomes with this support price to incomes in Session 4

16

Homework for Experiment 1. Innovation, Employment and

Wages

if there is occupation-switching and no support price.

Problem 1:11 It seems really wasteful for the government to destroythe hot dogs that it buys in order to support hot dog prices. Could thegovernment achieve a more e�cient outcome by buying hot dogs for thesupport price and selling these hot dogs to bakers who would make hot dogswith buns? Explain

Experiment 2

Employment, Income, and

Demand

A Macronesian Economy

Sailors returning from the turbid waters of the Archipelago of Macronesiabring strange tales of the isle of Carousel. The �ercely independent nativesof Carousel engage in no trade with the outside world. They consume onlyone commodity{ small, handcrafted automobiles which they build in localfactories.

About one-third of the islanders operate automobile-producing �rms andtwo-thirds of them are workers. Firms start each session with an endowmentof $20. Each �rm can produce 0, 1, 2, or 3 cars and needs to hire one workerfor each automobile that it produces. A worker can work for only one �rm.

Each worker is also an automobile consumer. Workers can buy either0, 1, or 2 automobiles. A worker will receive a payment of $20 from themarket manager for each automobile that he or she purchases. Workers arenot permitted to buy an automobile from the same �rm that they work for.

Session 1{Production and Consumption

This session is divided into two stages, as follows:

� In Stage 1, �rms hire workers and produce automobiles. Each �rmcan hire up to three workers. Each worker can work for only one �rm.The number of cars that a �rm produces is equal to the number oflaborers that it hires. If a �rm and a worker agree on a wage, the �rm

18 Experiment 2. Employment, Income, and Demand

writes a check to the worker for the amount of the wage and gives thecheck to the worker.

� In Stage 2, workers can buy cars from �rms. The market managerwill credit each worker with $20 for each car that he or she purchases.Each �rm can sell as many cars as it produced. Each worker can buy0, 1, or 2 cars. Workers are not allowed to buy cars from their ownemployers. When a worker buys a car, the worker writes a check forthe price of the car and gives it to the �rm. Workers who received apaycheck from �rms will �nd a check blank for purchasing a car on thesame sheet of paper as their paycheck. Extra checks will be availablefrom the market manager.

Workers can make pro�ts in two separate ways. In the �rst stage ofthe round, they earn wages by agreeing to work for �rms. In the secondstage they can make pro�ts if they are able to buy cars for less than $20. Aworker's total pro�t in a round is the wage that the worker earns plus $20for each car that he or she purchases, minus the total amount of money thathe or she spends on buying cars.

Each �rm starts out with $10 cash in hand. Firms are able to borrowmoney, so that they can spend more on wages than their original cash en-dowments. A �rm's total pro�t (loss) from a round is the amount of moneythat it receives for the cars it sells, minus the total wages that it pays forthe labor that it hires. At the end of the round, each �rm's total gains willbe its initial $10 plus or minus any pro�ts or losses from the session.

Session 2{\Cash-on-the-Barrelhead"

Gadzooks! The stockmarket has crashed! Many people are unable to repaytheir loans. Banks have failed, savings-and-loan institutions have collapsed.Many of yesterday's multi-millionaires have declared bankruptcy. Becauseof the �nancial collapse, hardly anyone is able to borrow money. The onlymoney that workers can spend on cars is money that they have alreadyearned as wages. Firms have cash balances of $10 and are able to borrowup to $20 more to pay wages. Thus the most a �rm can spend on wagesis $30. After they have sold their cars, �rms must repay their loans or gobankrupt. Typically we will run two or more rounds of this session. Firmsthat have gone bankrupt will not be able to operate in the next round.

In all other respects, procedures and payo�s in this session are the sameas in Session 1.

SESSION 3{ GOVERNMENTAL PUMP-PRIMING 19

Session 3{ Governmental Pump-priming

There is usually not enough time during a single class hour to run thissession along with Sessions 1 and 2. Eventually we plan to develop anotherexperiment to be performed in the class meeting following Sessions 1 and2, in which this session and one or two other policy measures designed torestore prosperity are applied.

In Session 3, as in Session 2, workers can spend no more money on carsthan they earned in wages. In this session, however, there is an additionalsource of employment. The market manager, acting as the \government" iswill hire some workers to work on a \public works project" at a wage of $20.The cost of this project will be paid for by taxes, where every participant inthe experiment must pay an equal fraction of the tax, regardless of whetherthey supplied labor.

After the �rst two stages, when �rms have made their production deci-sions and sold all of the cars that they have produced, we will survey theclass to see if there are any individuals who have not yet bought a car buthave some money to do so. When this survey is completed, we will give�rms a chance to hire more workers and produce more cars if they wish.These cars will then be o�ered for sale to workers. If, after all of these carsare sold, there still remain some workers with money to spend, �rms willget another chance to produce. We continue this procedure until there areno workers left to produce or no workers who have money to buy a car, atwhich time the round is �nished.

20Discussion of Experiment 2. Employment, Income, and Demand

Discussion of Experiment 2

In real-world economies, thousands of goods are bought and sold, all prettymuch at the same time. These markets are interdependent in many ways.Some of these goods are used in the production of other goods, the usefulnessof some goods depends on the price and availability of other goods, theincome that one has to buy some goods depends on the price that theyreceive for selling other goods. Because of the interdependencies of markets,it is often important to be able to study more than one market at a time.The study of multiple markets that interact with each other is known asgeneral equilibrium analysis. The study of a single market in isolation iscalled partial equilbrium analysis.

This experiment is an exercise in general equilibrium analysis, wherewe study two interacting markets; the market for labor and the market forautomobiles. In the labor market, the amount that automobile �rms arewilling to pay to hire workers clearly depends on the price that the �rmsexpect to be able to get for their cars. In the �rst session of this experiment,the workers' demand for cars does not depend on their labor income. Inthe second session, workers will be unable to spend more on cars than theamount of money they earn in the labor market.

In competitive equilibrium, wages and car prices must be such that sup-ply equals demand both in the labor market and the automobile market.

Equilibrium Wages and Prices in Session 1

Let us try to �nd equilibrium wages and prices for Session 1 in the casewhere there are 20 worker-consumers and 10 �rms. We start by drawing thedemand curve for cars. Each worker has a Buyer Value of $20 for each oftwo cars. At prices higher than $20, nobody wants to buy a car. At anyprice below $20, everybody would want to buy 2 cars. At a price of exactly$20, everybody would be indi�erent between buying 0, 1, or 2 cars. Thusthe demand curve for cars is shown in Figure 2.1.

In Stage 2 of this experiment, where cars are sold, it is to late to changethe number of cars available. Therefore the supply curve will contain avertical line located at the quantity of cars that have already been built. Ifthe supply curve is a vertical with fewer than 40 cars built, we see that thecompetitive equilibrium price for cars must be $20. For example, in Figure

EQUILIBRIUM WAGES AND PRICES IN SESSION 1 21

Figure 2.1: Supply and Demand for Cars

0 5 10 15 20 25 30 35 400

5

10

15

20

25

30

2.1, the vertical supply curve is drawn at the quantity 20 cars.

Figure 2.2: Supply and Demand for Labor

0 5 10 15 20 25 30 35 400

5

10

15

20

25

30

Now that we know that the equilibrium price of cars is $20, it is not hardto draw the demand curve for labor. If a car sells for $20 and it takes oneworker to make a car, �rms will not hire any workers at wages above $20.At wages below $20, a �rm makes a pro�t on every car that it produces, soit would maximize its pro�ts by producing its full capacity of 3 cars, using 3workers. Since there are 10 �rms, at any wage lower than $20, the demandfor labor will be 3 � 10 = 30 workers. At a wage of exactly $20, �rms will


be indi�erent between hiring any number of workers from 0 to 3 and thedemand curve will include a horizontal line at a height of $20, running from0 to 30 workers. We show this demand curve in Figure 2.2.

Since there are 20 workers and since every worker is willing to work forany positive wage, the labor supply curve is vertical at 20 workers. We seefrom Figure 2.2 that the equilibriumwage of labor is $20 and the equilibriumsupply of labor will be 20 workers.

Therefore, in equilibrium, 20 workers are hired and they produce 20cars. Each of these 20 workers buys a car for $20. The 10 �rms, on average,produce 2 cars and receive $20 for each car. They have wage costs of $20for each car, so that they make zero pro�ts.

Motivation for the Buyer Values

The rules of this experiment are that workers can buy up to two cars andwill �nd it pro�table to do so as long as they can get cars for less than $20each. This means that it is possible for workers to spend more money oncars than they earn in the labor market. You may wonder whether this isrealistic. If workers have no other source of income, how can they spendmore than they earn?

The story that motivates the $20 Buyer Values is this. The twenty labdollars that the market manager gives a car buyer is meant to representthe value to the buyer of the use that she gets from a car. In this session,workers can spend more than they earn because they can borrow moneywhich will be repaid out of future income so that they can consume morethan their current income.

E�ects of a Credit Collapse

In Session 2, you almost certainly saw a drastic fall in wages from thosein Session 1. But these lower wages did not help �rms. In fact, quitethe opposite happened. Many �rms, probably most of them made pro�tsin Session 1 and lost money in Session 2. Quite possibly you also saw asigni�cant amount of unemployment as well. Probably if you ran more thanone round of this session, you saw wages falling from each round to the next.

How did this come about? Perhaps �rms paid lower wages than inSession 1, because they expected that car prices would be low. Why didthey expect car prices to be low? Because workers can't spend more for acar than they earn in wages. So if wages are low, then car prices will below. But why did they expect wages to be low? Because they expected car

EFFECTS OF A CREDIT COLLAPSE 23

prices to be low: : : But now we seem to have gotten ourselves into a logicalcircle.1

Let us state the problem once again. Wages paid depend on the demandfor labor and the demand for labor depends on the price that car-makersexpect to get for their cars. But the price that car-makers will get for theircars depends on the demand for cars, which depends on the wages of labor.

How do we resolve this puzzle? Let us look for wages-price combinationsthat lead to equilibrium in both markets. There turn out to be two di�erentequilbrium combinations for this market.

Is the equilibrium outcome for Session 1 still an equilibrium in Session 2?in Session 1 there was an equilibrium with full employment, a wage of $20,and a car price of $20. This outcome is not possible in Session 2, becauseof the limits on borrowing possibilities of �rms. Recall that there are moreworkers than �rms, so that if every worker is to be employed, it must bethat some �rms hire two or more workers. But the most that any �rm canspend on labor is $30, so no �rm can hire more than one worker at a wageof $20.

Let us try another candidate for equilibrium|a very unfortunate out-come, indeed. The proposed equilibrium is one in which the wage is $0, andthere is no employment, no output, no production, and no pro�ts. If thewage is $0, then �rms know that they will not be able to get any moneyfor cars that they produce since no laborer will have money to buy a car.Firms can not make a pro�t by hiring workers, even at zero wage. At thiswage, the demand for labor is zero and the supply of labor is zero. In thecar market, the demand for cars is zero, and since �rms know they can't sellany cars, the supply of cars is also zero.

Is the zero-wage equilibrium is the only equilbrium outcome for Session2? What about an outcome where everybody is paid the same wage, but thiswage is less than $20, so that �rms can a�ord to hire at least two workerswithin their credit constraint. For example, suppose that all �rms o�er tohire as many workers as they can get for a wage of $15 and suppose thatthe price of cars is $15. Then we can have full employment with some �rmshiring two workers and some �rms hiring 1 worker. Each worker is ableto buy one car at $15. Since the number of cars available is equal to thenumber of cars built, the supply equals demand in the car market. Sincethe price of cars is $15, �rms are willing to pay just $15 for a worker andso supply equals demand in the labor market. Supply equals demand, butparticipating �rms get zero pro�ts. This \equilibrium" is a delicate one that

1We are, after all, on the Isle of Carousel.


is unlikely to be sustained in an actual market with face to face bargaining.What if all �rms paid $15 wages and all other workers bought cars for

$15. Then each �rm would make exactly zero pro�ts. Suppose that theother �rms are paying $15 and some �rm tries to hire labor for $14. In theactual confusion of face-to-face bargaining, there is some chance that the�rm will be able to get a worker for $14. If so, this �rm make a pro�t byselling its car for more than $14 to one of the other �rms' employees whomakes $15. Then one of the �rms paying $15 wages would surely make aloss, since it would have to sell a car for $14 or less to the worker making$14. Thus we would not expect a uniform wage of $15 to persist.2

In general, if some �rms are paying di�erent wages than others, the�rm that is paying the highest wage must sell to a worker who is paid lessthan the �rm's cost of producing a car. Therefore this �rm will lose money.Given that it lost money, this is likely in the future either to lower its wageor to stop producing. This process is likely to continue until wages andemployment are driven close to 0.

Government Intervention in Session 3

This discussion is yet to be completed.In this session, 1/4 of the laborers have government jobs which pay them

$20. This should be enough to sustain an outcome close to the, otherwisequite unstable, equilibrium of full employment with car prices of $20 andwages of $20. Since only 3/4 as many cars are produced as the number ofworkers, 1/4 of the workers will keep their wages and not buy a car. Sincecars cost $20, these workers are no worse o� than those who bought cars.

2Another source of instability is the following. Suppose that one of the workers decides

to bargain for a car at a lower price? If the other workers spent $15 for a car, then theycan't a�ord a second car. There will be one �rm who has not yet sold his car. Theremaining �rm will have to make a deal with this holdout worker. If they do not make a

deal, the remaining �rm is stuck with a loss of $15. By stubborn bargaining, the holdoutworker is likely to get the car for less than $15. In the proposed equilibrium, if all goeswell for �rms they each make zero pro�ts. But each �rm faces the possibility of dealing

with a hard-bargaining holdout and losing money.


Lab Notes for Experiment 2

Records of Wages and Pro�ts in Session 1

Use Table 2.1 to record the wages paid by each �rm to each of its workersin the last round of Session 1. A �rms total costs are equal to the sum ofthe wages it pays to its workers.

Table 2.1: Hiring Statistics for Firms

Wages of Worker Total CostsFirm ID Worker 1 Worker 2 Worker 3

The number of workers employed was and the the number

of workers who were unemployed was . The average wage paid

26Lab Notes for Experiment 2. Employment, Income, and Demand

to workers was . The total amount of wages paid by all �rms to

all workers was .

Use Table 2.2 to record the prices received by each �rm for each car thatit sold in the last round of Session 1. A �rm's total revenue is the sum ofthe amounts of money it received for each car that it sold. A �rm's pro�t isthe di�erence between its revenue and its expenditures.

Table 2.2: Sales Statistics for Firms

Price of Cars Total Firm'sFirm ID Car 1 Car 2 Car 3 Revenue Pro�t

How many �rms made positive pro�ts? How many lost

money? The sum of the pro�ts of all �rms was .

The average pro�t per �rm was .

RECORDS OF WAGES AND PROFITS IN SESSION 2 27

Records of Wages and Pro�ts in Session 2

Use Table 2.3 to record the wages paid by each �rm to each of its workersin the last round of Session 2. A �rms total costs are equal to the sum ofthe wages it pays to its workers.

Table 2.3: Hiring Statistics for Firms

Wages of Worker Total CostsFirm ID Worker 1 Worker 2 Worker 3

The number of workers employed was and the the number

of workers who were unemployed was . The average wage paid

to workers was . The total amount of wages paid by all �rms to

all workers was .

Use Table 2.4 to record the prices received by each �rm for each car that

28Lab Notes for Experiment 2. Employment, Income, and Demand

it sold in the last round of Session 2. A �rm's total revenue is the sum ofthe amounts of money it received for each car that it sold. A �rm's pro�t isthe di�erence between its revenue and its expenditures.

Table 2.4: Sales Statistics for Firms

Price of Cars Total Firm'sFirm ID Car 1 Car 2 Car 3 Revenue Pro�t

How many �rms made positive pro�ts? How many lost

money? The sum of the pro�ts of all �rms was .

The average pro�t per �rm was .

NAME SECTION

Homework for Experiment 2

What Caused the Crash?

To be completed....

National Product Accounting

Let us de�ne Net National Product (NNP) to be equal to the totalvalue of all production in Carousel. This can be calculated in two ways,by measuring the output and calculating its value, or by calculating thetotal income of all individuals in Carousel. Since the only good producedin Carousel is cars, and each car is worth $20 to the person who buys it,the total value of output is found by multiplying $20 times the number Nof cars sold. Since a worker who buys a car at price p will make a pro�t onthe deal of $20�p, total income of a worker who earns a wage w and buys acar for price p is $(20� p) +w. Let X be the total amount of money spentby workers on cars and W be the total amount of wages that �rms pay tothese workers and let N be the number of cars sold. Then adding togetherthe incomes of all workers, we �nd that the total income of all workers is$20N �X +W . The pro�t of a �rm who sells a car for price p and pays awages of w will be p�w, so that the sum of all �rms' pro�ts will be $X�W .If we add the pro�ts of all �rms to the pro�ts of all laborers, we have

$(20N �X +W ) + $(X �W ) = $20N:

Complete Table 2.5 to record total wages of all workers (W ), totalamount of money spent by workers on cars (X), and the total number ofcars produced (N). Then calculate total pro�ts of all workers (20N � P ),total income of all workers, ((20N �X) +W ), and total pro�ts of all �rms(X �W ).

30Homework for Experiment 2. Employment, Income, and Demand

Table 2.5: National Income Statistics

Session 1 Session 2 Session 3(Last Rd.) (Last Rd.) (Last Rd.)

Total Wages (W)of all Workers

Total Money Spent byWorkers on Cars (X)

Total Number ofCars Sold (N)

Total Pro�t ofAll Workers (20N�X)

Total Income ofAll Workers (20N�X+W)

Total Pro�ts ofAll Firms (W�X)

Net NationalProduct (20N)

Documents

Experiments with Economic Principles: Macroeconomics