Experiments with Economic Principles:
Macroeconomics
Theodore Bergstrom
UCSB
John H. Miller
Carnegie Mellon University
May 8, 2000
c 2000.
ii
Contents
1 Innovation, Employment and Wages
Hot Dogs and Buns . . . . . . . . . . . . . . . .
Selling Joint Output {Session 1 . . . . . . .
Eects of a Productivity Increase{Session 2
Price Supports for Hot Dogs{Session 3 . . .
Occupational Mobility{Session 4 . . . . . .
Warm-up Exercise . . . . . . . . . . . . . . . . .
Discussion of Experiment 1 . . . . . . . . . .
Productivity Increases and Income . . . . . . . .
Short Run and Long Run Equilibrium . . .
Equilibrium in Session 1 . . . . . . . . . . .
Short Run Equilibrium in Session 2 . . . . .
Price Supports{Session 3 . . . . . . . . . . .
Long Run Competitive Equilibrium . . . .
Some Conclusions and Remarks . . . . . . .
Lab Notes for Experiment 1 . . . . . . . . .
Homework for Experiment 1 . . . . . . . . .
2 Employment, Income, and Demand
A Macronesian Economy . . . . . . . . . . .
Session 1{Production and Consumption . .
Session 2{\Cash-on-the-Barrelhead" . . . .
Session 3{ Governmental Pump-priming . .
Discussion of Experiment 2 . . . . . . .
Equilibrium Wages and Prices in Session 1 .
Motivation for the Buyer Values . . .
Eects of a Credit Collapse . . . . . . . . .
Government Intervention in Session 3 . . .
Lab Notes for Experiment 2 . . . . . .
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iv
CONTENTS
Records of Wages and Prots in Session 1
Records of Wages and Prots in Session 2
Homework for Experiment 2 . . . . .
What Caused the Crash? . . . . . .
National Product Accounting . . . .
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Experiment 1
Innovation, Employment and
Wages
Hot Dogs and Buns
Life is simple in the land of Oz. Consumers consume only one product, hot
dogs on buns. Workers can choose one of two jobs. They can be butchers
or 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. Each
butcher can produce one hot dog and each baker can produce one bun.
Butchers and bakers are given colored slips of paper representing hot dogs
and 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 dog
without a bun is worthless and so is a bun without a hot dog. Butchers and
bakers should roam around the room trying to make a deal with a workers
of the other type. A butcher and a baker can any arrangement they like
about how to divide the $20 that they will get for their joint product. If
they agree on terms, they should ll out a sales contract, present it to the
market manager and display their hot dog and bun slips. The manager will
credit the butcher and baker with their agreed-on shares of $20.
This experiment is based on a parable told by Paul Krugman on pages 18-23 of
The Accidental Theorist, a nice book of essays on economic topics written for a general
audience.
1
2
Experiment 1. Innovation, Employment and Wages
Eects of a Productivity Increase{Session 2
Congratulations are in order for buchers! A new invention has doubled their
productivity. Now every butcher can produce two hot dogs instead of one.
Butchers will be given a second slip of paper, representing a second hot
dog. Bakers still produce only one hot dog. In order to sell two hot dogs,
a butcher must make separate deals with two dierent bakers. As before, a
hot 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 sell
a 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 this
experiment, in which everything is as in the second round, but everyone is
now 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 a
drastic fall in the price of hot dogs and in the income of butchers. In
response to the butchers' misfortune, the government decides to introduce
\price supports" for hot dogs. In order to restore the pre-invention price of
hot 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 can
make 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 support
program is costly, and the government will pay for this program by assessing
an equal amount of tax on all participants in the experiment. The total
cost of the program will be equal to $10 times the number of hot dogs the
government buys.
When the rst round of Session 3 is completed, you will either discuss
what would happen with a support price of $5 rather than $10, or if there
is 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 able
to change occupations. We will denote three degrees of mobility. There will
be immobile workers, who must maintain the same occupation that they
had in previous sessions, mobile workers who can change occupations at the
beginning of the session if they want to and there will be highly mobile
workers 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, two
workers will be designated as highly mobile workers, and the remainder will
be immobile workers.
Warm-up Exercise
Suppose that you are butcher. Trading is nearly completed and you see
that there are many more bakers who haven't sold their buns and not many
butchers who haven't sold their hot dogs. What share of the $20 from sale
of a hot dog with bun would you ask for when trying to make a deal with a
baker?
If you are a butcher and if you believe that there more buns than hot dogs
have produced, what share of the $20 would you request when bargaining
with bakers?
If you are a butcher and you believe that more hot dogs than buns have
been produced, what share of the $20 would you request when bargaining
with bakers?
In Session 4, if you are a mobile worker, how would you decide which
occupation to choose?
In session 4, if you are a highly mobile worker, how would you decide
which 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 very
quickly and other adjustments take place only slowly. For example, when
productivity changes, prices and wages can usually adjust quite quickly. On
the 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 will
have to wait until much of the current labor force is retired and replaced by
new workers.
Equilibrium in Session 1
In the rst session, there was one baker for every butcher. Thus every
butcher and every baker can nd a partner to produce a hot dog with bun.
Butchers and bakers have $20 to divide between them. Neither occupation
has any bargaining advantage over the other and we expect the outcome to
be that each butcher-baker pair will split the dierence and each will get a
share of $10.
Suppose that we start with equal numbers of butchers and bakers and
that we run several rounds of this session, where anyone is allowed to switch
occupations if they like. Since butchers make exactly the same amount of
prots as bakers, neither butchers nor bakers have an incentive to change
jobs.2 The outcome in which there are equal numbers of butchers and bakers
and where butchers get $10 for a hot dog and bakers get $10 for a bun is
therefore a long run equilibrium.
Short Run Equilibrium in Session 2
In Session 2, each butcher can produce two hot dogs, while each baker can
still produce only one bun. Since there are equal numbers of butchers and
In fact if a butcher decided to become a baker and if nobody else switched, the result
would be that there would be more buns than hot dogs. In this case, some baker is not
going 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.
2
PRODUCTIVITY INCREASES AND INCOME
5
bakers, there are now twice as many hot dogs available as buns. In the short
run, nobody can change occupations. Butchers will be eager to sell their hot
dogs and be willing to accept a wage of less than $10. Bakers will see that
there are going to be many hot dogs that go unused and are in a position to
demand more than $10 for a bun. In fact, so long as the price of hot dogs
is greater than zero, butchers will be trying to sell more hot dogs than the
number of buns available. The short run equilibrium price of hot dogs will
be zero. 3
Price Supports{Session 3
In the short run equilibrium of Session 2, butchers have much lower incomes than bakers. This seems ironic, because the productivity of butchers
increased and the productivity of bakers did not change.
In the real world, we often see similar eects. In agriculture, the introduction of machinery and of improved strains of crops and livestock resulted
in dramatic increases in the productivity of farmers. As crop production
rose, the prices of farmers' output fell and so did the income of small farmers. In heavy manufacturing industries, in mining, and in ship-building,
innovations in production processes greatly increased the amount of output
per laborers. This resulted in falling incomes for many workers in these
industries at a time when the rest of the economy was booming.
One way to soften the blow of income shifts resulting from changes in
productivity is for the government to "support" the prices of goods whose
prices have fallen by purchasing these goods and disposing of them. In
Session 3, the government oers to buy hot dogs at a price of $10 each. This
means that bakers will have to give butchers at least a $10 share to get them
to help make a hot dog and bun rather than sell to the government. In short
run equilibrium the price of hot dogs is $10 and the price of buns is $10 and
butchers and bakers who get together split their gains equally.
The government's price support program is costly. The government buys
half of the hot dogs that are produced for a price of $10. We suppose that
these costs are paid for by taxes collected equally from all market participants. The cost of the support program is $5 for every market participant.4
Because a hot dog is worthless without a bun, in short run equilibrium, the price of
hot dogs must be zero and the price of buns must be $20. If your class runs only one or
two 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.
4
This 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
3
6Discussion of Experiment 1. Innovation, Employment and Wages
If prices are supported at $10, then each butcher sells two hot dogs for
a price of $10 and has a before-tax income of $20. Each baker sells one bun
for $10 and has a before-tax income of $10. Since everybody has to pay a
tax of $5, the after-tax income of every butcher is $20 , $5 = $15 and the
after-tax income of every baker is $10 , $5 = $5.
We see that the eort to support butchers' incomes by supporting hot
dog prices at the old price level makes butchers better o than they were
before 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 dogs
at the same price at which they used to be able to sell just one. With price
supports for hot dogs at $10, therefore, we would expect that in the long
run where workers can change occupations more people would choose to be
butchers and fewer to be bakers. This is a really perverse outcome, since it
is buns that are in scarce supply and hot dogs that are being bought up and
destroyed by the government.
Perhaps a more reasonable support price for hot dogs would be $5. Then
in short run equilibrium, half of the hot dogs would be sold to the government
for $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 government
or 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 dog
with bun, bakers must be getting $15 for their buns. The cost of the support
program would be $5 times the number of butchers. When this cost is
divided 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 aftertax income of bakers will be $15 , $2 50 = $12 50. Thus with a support
price of $5, butchers are worse o thn they were without the support price
and bakers are better o.
We will leave it as an exercise for you to nd a support price that would
leave both butchers and bakers exactly as well o as they were before the
improvement in the productivity of butchers.
:
:
:
:
Long Run Competitive Equilibrium
In the long run, there will be opportunities for butchers and bakers to change
their occupations. Workers who are able to make a choice between the two
occupations 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 be
the case, it must also be that the number of hot dogs produced will equals
the number of buns produced.
Since butchers produce two hot dogs and bakers produce one bun, it
must be that in long run equilibrium, there are twice as many bakers as
butchers. For butchers and bakers to be equally well o, it must also be
that the price of a bun is twice the price of a hot dog. Thus we expect that
in long run equilibrium, two thirds of the workers are bakers and one third
are butchers. If the price of a bun is twice the price of a hot dog, then since
the price of a hot dog plus the price of a bun is $20, it must be that in long
run 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 and
bakers both have incomes $12.33. Since before the improvement in productivity, both types earned $10, we see that in the long run the improvement
in butchers' productivity benets both butchers and bakers.
Some Conclusions and Remarks
In this experiment, in the short run, increased productivity of butchers
resulted 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 the
long run where there was time for workers to change occupations, enough
butchers switched to baking to equalize production of hot dogs and buns.
After the occupational switches have occured, both butchers and bakers
have higher incomes than they did before the productivity increase.
While it is true that in long run equilibrium, butchers and bakers will
both be better o because of the productivity increase, this may not be of
much comfort to today's butchers. Switching occupations may require a
worker to retrain or move to another city. This may be especially dicult
or even impossible for older workers.
A case can be made for some kind of government measures to lessen the
shock of unexpected productivity changes. A price support program is one
possibility.
A major disadvantage of price support program is that it reduces the
incentive for workers to move from an occupation whose product is not in
high demand to one where it is in high demand. As we saw in our hot dog
example, the social gains from increased productivity in one occupation may
not be realized until there has been movement between occupations.
In our hot dog example, a $10 support price would leave butchers better
o than bakers even though more hot dogs are being made than buns. In the
8Discussion of Experiment 1. Innovation, Employment and Wages
long run, such a high subsidy would lead to the perverse result that bakers
would 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 equally
well o given the support price. (You will be asked to nd this price in
your homework.) The trouble with a support price that equalizes after tax
incomes of butchers and bakers is that there is not incentive for butchers
to switch to baking. But we need these switches to occur in order for the
economy to realize the benets of the increased productivity of butchers.
Reasonable arguments can be made both for and against a low-level
price support program. If hot dog support prices are set low enough so
that the after-tax income of butchers is less than that of bakers, then in the
long run, some butchers would want to become bakers. A low level support
program oers the benet of reducing the risk to workers of major income
losses due to productivity changes. On the other hand, even a low levely
support program is likely to slow the rate at which workers switch out of an
occupation that currently has too many workers.
LAB NOTES FOR EXPERIMENT 1
Lab Notes for Experiment 1
9
In Table 1.1, record the division of payments for each deal made between a
butcher and a baker in Sessions 1 and 2. (If you ran more than one round
of 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
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2
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10
Lab Notes for Experiment 1. Innovation, Employment and
Wages
In Table 1.2, record the division of payments for each deal made by a
butcher 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
Deal # Dog's Share Bun's Share Deal # Dog's Share Bun's Share
1
1
2
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The number of hot dogs sold to the government was
Round 1 and
in Round 2 of Session 3.
in
LAB NOTES FOR EXPERIMENT 1
11
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 a
butcher and a baker in Session 4. (If your class ran more than one round of
Session 4, record only the results from the last round.)
Table 1.3: Deals Made in Session 4
Deal # Dog's Share Bun's Share Deal # Dog's Share Bun's Share
1
21
2
22
3
23
4
24
5
25
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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
was
.
and the total number of buns produces
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 a) how many hot dogs with buns were sold?
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 a) how many hot dogs with buns were sold?
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?
Problem 1 4 In Round 1 of Session 3:
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 5 In Round 2 of Session 3:
Part a) how many hot dogs with buns were sold?
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
:
hot dogs divided by the number of workers. How much is the tax that each
worker must pay?
Problem 1 6 In Round 2 of Session 3:
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:
Part a) how many hot dogs with buns were sold?
:
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 of
butchers 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 minus
the price of a hot dog. Since taxes are equal for everybody, the after-tax
income of butchers will equal that of bakers when their before-tax incomes
are 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 to
:
set 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 destroy
:
the hot dogs that it buys in order to support hot dog prices. Could the
government achieve a more ecient outcome by buying hot dogs for the
support price and selling these hot dogs to bakers who would make hot dogs
with buns? Explain
Experiment 2
Employment, Income, and
Demand
A Macronesian Economy
Sailors returning from the turbid waters of the Archipelago of Macronesia
bring strange tales of the isle of Carousel. The ercely independent natives
of Carousel engage in no trade with the outside world. They consume only
one commodity{ small, handcrafted automobiles which they build in local
factories.
About one-third of the islanders operate automobile-producing rms and
two-thirds of them are workers. Firms start each session with an endowment
of $20. Each rm can produce 0, 1, 2, or 3 cars and needs to hire one worker
for each automobile that it produces. A worker can work for only one rm.
Each worker is also an automobile consumer. Workers can buy either
0, 1, or 2 automobiles. A worker will receive a payment of $20 from the
market manager for each automobile that he or she purchases. Workers are
not 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 rm
can 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 of
laborers 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 the
check to the worker.
In Stage 2, workers can buy cars from rms. The market manager
will 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 buy
0, 1, or 2 cars. Workers are not allowed to buy cars from their own
employers. When a worker buys a car, the worker writes a check for
the price of the car and gives it to the rm. Workers who received a
paycheck from rms will nd a check blank for purchasing a car on the
same sheet of paper as their paycheck. Extra checks will be available
from the market manager.
Workers can make prots in two separate ways. In the rst stage of
the round, they earn wages by agreeing to work for rms. In the second
stage they can make prots if they are able to buy cars for less than $20. A
worker's total prot in a round is the wage that the worker earns plus $20
for each car that he or she purchases, minus the total amount of money that
he or she spends on buying cars.
Each rm starts out with $10 cash in hand. Firms are able to borrow
money, so that they can spend more on wages than their original cash endowments. A rm's total prot (loss) from a round is the amount of money
that it receives for the cars it sells, minus the total wages that it pays for
the labor that it hires. At the end of the round, each rm's total gains will
be its initial $10 plus or minus any prots or losses from the session.
Session 2{\Cash-on-the-Barrelhead"
Gadzooks! The stockmarket has crashed! Many people are unable to repay
their loans. Banks have failed, savings-and-loan institutions have collapsed.
Many of yesterday's multi-millionaires have declared bankruptcy. Because
of the nancial collapse, hardly anyone is able to borrow money. The only
money that workers can spend on cars is money that they have already
earned as wages. Firms have cash balances of $10 and are able to borrow
up to $20 more to pay wages. Thus the most a rm can spend on wages
is $30. After they have sold their cars, rms must repay their loans or go
bankrupt. Typically we will run two or more rounds of this session. Firms
that have gone bankrupt will not be able to operate in the next round.
In all other respects, procedures and payos in this session are the same
as 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 this
session along with Sessions 1 and 2. Eventually we plan to develop another
experiment to be performed in the class meeting following Sessions 1 and
2, in which this session and one or two other policy measures designed to
restore prosperity are applied.
In Session 3, as in Session 2, workers can spend no more money on cars
than they earned in wages. In this session, however, there is an additional
source of employment. The market manager, acting as the \government" is
will 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 in
the experiment must pay an equal fraction of the tax, regardless of whether
they supplied labor.
After the rst two stages, when rms have made their production decisions and sold all of the cars that they have produced, we will survey the
class to see if there are any individuals who have not yet bought a car but
have 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 oered for sale to workers. If, after all of these cars
are sold, there still remain some workers with money to spend, rms will
get another chance to produce. We continue this procedure until there are
no workers left to produce or no workers who have money to buy a car, at
which 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 pretty
much at the same time. These markets are interdependent in many ways.
Some of these goods are used in the production of other goods, the usefulness
of some goods depends on the price and availability of other goods, the
income that one has to buy some goods depends on the price that they
receive 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 as
general equilibrium analysis. The study of a single market in isolation is
called partial equilbrium analysis.
This experiment is an exercise in general equilibrium analysis, where
we study two interacting markets; the market for labor and the market for
automobiles. In the labor market, the amount that automobile rms are
willing to pay to hire workers clearly depends on the price that the rms
expect 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. In
the second session, workers will be unable to spend more on cars than the
amount of money they earn in the labor market.
In competitive equilibrium, wages and car prices must be such that supply 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 case
where there are 20 worker-consumers and 10 rms. We start by drawing the
demand curve for cars. Each worker has a Buyer Value of $20 for each of
two cars. At prices higher than $20, nobody wants to buy a car. At any
price below $20, everybody would want to buy 2 cars. At a price of exactly
$20, everybody would be indierent between buying 0, 1, or 2 cars. Thus
the 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 change
the number of cars available. Therefore the supply curve will contain a
vertical line located at the quantity of cars that have already been built. If
the supply curve is a vertical with fewer than 40 cars built, we see that the
competitive 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
30
25
20
15
10
5
0
0
5
10 15 20 25 30 35 40
2.1, the vertical supply curve is drawn at the quantity 20 cars.
Figure 2.2: Supply and Demand for Labor
30
25
20
15
10
5
0
0
5
10 15 20 25 30 35 40
Now that we know that the equilibrium price of cars is $20, it is not hard
to draw the demand curve for labor. If a car sells for $20 and it takes one
worker to make a car, rms will not hire any workers at wages above $20.
At wages below $20, a rm makes a prot on every car that it produces, so
it would maximize its prots by producing its full capacity of 3 cars, using 3
workers. Since there are 10 rms, at any wage lower than $20, the demand
for labor will be 3 10 = 30 workers. At a wage of exactly $20, rms will
22Discussion of Experiment 2. Employment, Income, and Demand
be indierent between hiring any number of workers from 0 to 3 and the
demand curve will include a horizontal line at a height of $20, running from
0 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 for
any positive wage, the labor supply curve is vertical at 20 workers. We see
from Figure 2.2 that the equilibrium wage of labor is $20 and the equilibrium
supply of labor will be 20 workers.
Therefore, in equilibrium, 20 workers are hired and they produce 20
cars. 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 $20
for each car, so that they make zero prots.
Motivation for the Buyer Values
The rules of this experiment are that workers can buy up to two cars and
will nd it protable to do so as long as they can get cars for less than $20
each. This means that it is possible for workers to spend more money on
cars than they earn in the labor market. You may wonder whether this is
realistic. If workers have no other source of income, how can they spend
more than they earn?
The story that motivates the $20 Buyer Values is this. The twenty lab
dollars that the market manager gives a car buyer is meant to represent
the 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 money
which will be repaid out of future income so that they can consume more
than their current income.
Eects of a Credit Collapse
In Session 2, you almost certainly saw a drastic fall in wages from those
in Session 1. But these lower wages did not help rms. In fact, quite
the opposite happened. Many rms, probably most of them made prots
in Session 1 and lost money in Session 2. Quite possibly you also saw a
signicant amount of unemployment as well. Probably if you ran more than
one 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 in
Session 1, because they expected that car prices would be low. Why did
they expect car prices to be low? Because workers can't spend more for a
car than they earn in wages. So if wages are low, then car prices will be
low. 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 logical
circle.1
Let us state the problem once again. Wages paid depend on the demand
for labor and the demand for labor depends on the price that car-makers
expect to get for their cars. But the price that car-makers will get for their
cars 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 combinations
that lead to equilibrium in both markets. There turn out to be two dierent
equilbrium 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, because
of the limits on borrowing possibilities of rms. Recall that there are more
workers than rms, so that if every worker is to be employed, it must be
that some rms hire two or more workers. But the most that any rm can
spend on labor is $30, so no rm can hire more than one worker at a wage
of $20.
Let us try another candidate for equilibrium|a very unfortunate outcome, indeed. The proposed equilibrium is one in which the wage is $0, and
there is no employment, no output, no production, and no prots. If the
wage is $0, then rms know that they will not be able to get any money
for cars that they produce since no laborer will have money to buy a car.
Firms can not make a prot by hiring workers, even at zero wage. At this
wage, the demand for labor is zero and the supply of labor is zero. In the
car market, the demand for cars is zero, and since rms know they can't sell
any cars, the supply of cars is also zero.
Is the zero-wage equilibrium is the only equilbrium outcome for Session
2? What about an outcome where everybody is paid the same wage, but this
wage is less than $20, so that rms can aord to hire at least two workers
within their credit constraint. For example, suppose that all rms oer to
hire as many workers as they can get for a wage of $15 and suppose that
the price of cars is $15. Then we can have full employment with some rms
hiring two workers and some rms hiring 1 worker. Each worker is able
to buy one car at $15. Since the number of cars available is equal to the
number of cars built, the supply equals demand in the car market. Since
the price of cars is $15, rms are willing to pay just $15 for a worker and
so supply equals demand in the labor market. Supply equals demand, but
participating rms get zero prots. This \equilibrium" is a delicate one that
:::
1
We are, after all, on the Isle of Carousel.
24Discussion of Experiment 2. Employment, Income, and Demand
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 prots. Suppose that the
other rms are paying $15 and some rm tries to hire labor for $14. In the
actual 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 prot by
selling its car for more than $14 to one of the other rms' employees who
makes $15. Then one of the rms paying $15 wages would surely make a
loss, 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 dierent wages than others, the
rm that is paying the highest wage must sell to a worker who is paid less
than 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 wage
or to stop producing. This process is likely to continue until wages and
employment 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, otherwise
quite unstable, equilibrium of full employment with car prices of $20 and
wages of $20. Since only 3/4 as many cars are produced as the number of
workers, 1/4 of the workers will keep their wages and not buy a car. Since
cars cost $20, these workers are no worse o than those who bought cars.
Another 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 they
can't aord a second car. There will be one rm who has not yet sold his car. The
remaining 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 holdout
worker is likely to get the car for less than $15. In the proposed equilibrium, if all goes
well for rms they each make zero prots. But each rm faces the possibility of dealing
with a hard-bargaining holdout and losing money.
2
LAB NOTES FOR EXPERIMENT 2
Lab Notes for Experiment 2
25
Records of Wages and Prots in Session 1
Use Table 2.1 to record the wages paid by each rm to each of its workers
in the last round of Session 1. A rms total costs are equal to the sum of
the wages it pays to its workers.
Table 2.1: Hiring Statistics for Firms
Wages of Worker
Firm ID Worker 1 Worker 2 Worker 3
The number of workers employed was
of workers who were unemployed was
Total Costs
and the the number
. The average wage paid
26
Lab 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 that
it sold in the last round of Session 1. A rm's total revenue is the sum of
the amounts of money it received for each car that it sold. A rm's prot is
the dierence between its revenue and its expenditures.
Table 2.2: Sales Statistics for Firms
Price of Cars
Total Firm's
Firm ID Car 1 Car 2 Car 3 Revenue Prot
How many rms made positive prots?
money?
How many lost
The sum of the prots of all rms was
The average prot per rm was
.
.
RECORDS OF WAGES AND PROFITS IN SESSION 2
27
Records of Wages and Prots in Session 2
Use Table 2.3 to record the wages paid by each rm to each of its workers
in the last round of Session 2. A rms total costs are equal to the sum of
the wages it pays to its workers.
Table 2.3: Hiring Statistics for Firms
Wages of Worker
Firm ID Worker 1 Worker 2 Worker 3
The number of workers employed was
of workers who were unemployed was
to workers was
Total Costs
and the the number
. The average wage paid
. 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
28
Lab 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 of
the amounts of money it received for each car that it sold. A rm's prot is
the dierence between its revenue and its expenditures.
Table 2.4: Sales Statistics for Firms
Price of Cars
Total Firm's
Firm ID Car 1 Car 2 Car 3 Revenue Prot
How many rms made positive prots?
money?
How many lost
The sum of the prots of all rms was
The average prot per rm was
.
.
NAME
SECTION
Homework for Experiment 2
What Caused the Crash?
To be completed....
National Product Accounting
Let us dene Net National Product (NNP) to be equal to the total
value of all production in Carousel. This can be calculated in two ways,
by measuring the output and calculating its value, or by calculating the
total income of all individuals in Carousel. Since the only good produced
in 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
of cars sold. Since a worker who buys a car at price will make a prot on
the deal of $20 , , total income of a worker who earns a wage and buys a
car for price is $(20 , ) + . Let be the total amount of money spent
by workers on cars and be the total amount of wages that rms pay to
these workers and let be the number of cars sold. Then adding together
the incomes of all workers, we nd that the total income of all workers is
$20 , + . The prot of a rm who sells a car for price and pays a
wages of will be , , so that the sum of all rms' prots will be $ , .
If we add the prots of all rms to the prots of all laborers, we have
N
p
p
w
p
p
w
X
W
N
N
X
W
p
w
p
w
X
$(20 , + ) + $( , ) = $20
N
X
W
X
W
W
N:
Complete Table 2.5 to record total wages of all workers ( ), total
amount of money spent by workers on cars ( ), and the total number of
cars produced ( ). Then calculate total prots of all workers (20 , ),
total income of all workers, ((20 , ) + ), and total prots of all rms
( , ).
W
X
N
N
N
X
W
X
W
P
Homework for Experiment 2. Employment, Income, and Demand
30
Table 2.5: National Income Statistics
Total Wages (W)
of all Workers
Total Money Spent by
Workers on Cars (X)
Total Number of
Cars Sold (N)
Total Prot of
All Workers (20N,X)
Total Income of
All Workers (20N,X+W)
Total Prots of
All Firms (W,X)
Net National
Product (20N)
Session 1 Session 2 Session 3
(Last Rd.) (Last Rd.) (Last Rd.)