Econ 1

Production, technology, and costs

Jim Campbell

UC Berkeley

Fall 2024

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Where stuff comes from

“If you wish to make an apple pie from scratch, you must first
invent the universe.” (Carl Sagan, 1980)
Today we’ll be exploring production, supply, and firms in more detail.
Last time we ended by talking about choice on the ‘demand side’:
people faced constraints and chose according to their objectives
Today it’s all about choice on the ‘supply side’: what are the
objectives and constraints here?
How do economists build models of production?
How do the complicated products around us come to be?
How might a producer choose how much of something to make?
This relates to chapter 7 and 8 of OpenStax and Units 6 and 7 of
CORE

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Overview of topic 3

Constraints and objectives for producers of stuff

I Last time we talked about models of choice: trying to advance goals in
the face of constraints
I Today we’ll look at a specific example: what if a producer wants to
make as much money as possible?
I They are constrained by technology
Technology tells us: what do we need in order to produce something,
and how much does it cost?
I We’ll learn jargon and visualizations for both of those things
The model of profit maximization in general, and an application of it
to a special case called perfect competition
I “Thinking at the margin” as the solution to a profit maximization
problem
We’ll take a look at how the nature of jobs in the U.S. has changed,
and the role played by automation of production

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Where stuff comes from

‘Production’ means turning stuff (inputs) into other stuff (outputs)

Stop here a second: exactly what inputs does it take to make
something?
Pick an example of good or service
I What goes in to the making of it?
I Where do those inputs come from?
I How do they come to be combined and how did the good or service
end up with the user?
e.g. Thomas Thwaites’s ‘Toaster Project’:
http://www.thomasthwaites.com/the-toaster-project/

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Production functions
A production function relates the amount of inputs you use to the
maximum amount of output you could make with those inputs
This is the producer’s constraint
A really common model in economics is to think of the production
function as Y = f (K , L): amount of output as a function of capital
and labor
Of course in reality there are many, many inputs to produce
something!
Let’s visualize one possible relationship between the amount of one
single input and an output, for example Y = f (L), output as a
function of labor
I This could be a true one-input production process (which might be a
bit too unrealistic!)
I Or: imagine holding the amount of other inputs fixed
I Example: input ‘hours’, output ‘lecture slides produced’
I Example: input ‘number of chefs’, output ‘number of pizzas made’

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The production function

The production function shows the maximum output you could get for a
given amount of input
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The production function

Technological innovation can push the production function up

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Marginal products
The slope of the one-input production function we just drew is the
marginal product of the input
This depends on technology (more deeply, it depends on the laws of
physics etc)
It is the rate at which you can turn input into output
The fact that the slope is first steep and then shallow means that in
the example we just drew this production process has diminishing
returns to the input
I If that’s the case, the extra output you get from each unit of input gets
smaller as you add more and more of it
I That is: the marginal product of the input is decreasing
I What would a constant or increasing returns situation look like?
Another thing we sometimes care about is the average product of the
input (productivity); for example, YL would be ‘output per unit of
labor’

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Returns to an input vs. returns to scale

Think of a production function with lots of different types of input

The return to an input: at what rate is output increasing as we
increase the amount of one input, holding the amount of other inputs
fixed?
I e.g. ‘diminishing returns to labor’: each extra worker-hour added
increases the amount of output by a smaller and smaller amount
I Returns to an input can be diminishing, increasing, or constant
I Notice that diminishing returns doesn’t mean output is getting lower!
It’s about the rate of increase
The return to scale: at what rate is output increasing as we increase
the amount of all inputs proportionally?
I e.g. ‘constant returns to scale’: if we scale up all inputs by 10% we’d
get 10% more output
I Returns to scale can be diminishing, increasing, or constant

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More than one input

How can we visualize more than one input?

It’s tricky because we can only draw (easily) in two dimensions
One approach is to use isoquants: these are lines that show different
combinations of inputs that produce the same amount of output
The math name for this technique is that we’re drawing level sets of
the function—this is often used in econ but is beyond the scope of
our course!
I Example: a moving company might be able to move a whole office
building in a day with 10 people and two moving trucks, or 15 people
and 1 moving truck
The slope of an isoquant tells me the technical rate of substitution,
a.k.a. the marginal rate of technical substitution
I Example: how many robots do you need to replace 10 workers on a car
assembly line?

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Technology
Technology is a concept that is fundamental all through economics
In macroeconomics, technology is important in models of economic
growth
I The ‘Solow residual’ from the Solow growth model is typically
interpreted as representing technology
I The difference between total growth in output for the economy, minus
those parts that you can explain with capital accumulation or an
increase in the labor force
In microeconomics, technology is important to understand market
structure
I It’s important to industrial organization, which is how the type of
product affects the structure of its industry
I The economics of innovation is all about where technology comes from
Here, technology also determines marginal products and technical
rates of substitution: it’s an important part of the producer’s
constraint!
Can you see why a producer might have an incentive to innovate?
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The producer’s objectives

Let’s turn now to the producer’s objective (the equivalent of the person’s
preferences from last time)—what are some possibilities here?
Produce as much stuff as possible within a budget
I Example: non-profit wants to deliver as many meals as it can to hungry
people in the local community
Deliver the highest quality product you can without losing money
I Example: a restaurant owner is passionate about trying to make the
tastiest food in town
Becoming famous and powerful
I Example: an inventor wants to become widely known for their invention
This boils down to, in essence: what is the producer’s ‘favorite’ point on
or underneath their production function?

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Profit maximization
A very common assumption in economics is to model producers as if they
want to maximize profit
Profits are denoted by π in economics:

π = Revenue − Cost = R − C (1)

This would be a producer driven by making as much money as they

can. This is complicated!
I Can there be a tension between short and long run profits?
I Is the person making the decisions for the producer the same as the
person who gets the profit? (This is the foundational issue in
‘principal-agent theory’ in economics)
Profit-maximization is mathematically equivalent to cost minimization
I This is potentially problematic: e.g. is it acceptable for a producer to
pay the people in the production process as little as possible?
I Throughout history we see public policy sometimes step in to try to
protect workers and make laws and regulations about employment and
labor
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Do producers maximize profits?
Wait... do producers in the real world actually try to maximize profits?
Not all production in the economy is done by ‘for profit’ firms; what
might the objective function be for other types of person or
organization?
I Public agencies, regulators
I Charities and other not-for-profit organizations
Is profit the objective for ‘for-profit’ firms?
I Short or long term? Shareholder value? Empire-building?
I Ethical or social objectives or constraints?
I See Kahneman, Knetsch & Thaler (1986) on how public attitudes to
fairness help shape firm objectives...
I Profit maximization isn’t always as straightforward as it seems
(efficiency wages, for example)
Would producers even be any good at maximizing anything?
I David Romer (2006) used NFL 4th down data to argue that NFL
teams are not good at maximizing their chances of winning

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‘Evil corporations’

What is the general perception of ‘firms’ by the public?

There is a tension between two claims: the ‘invisible hand’ pursuit of
profit incentivizing creation and invention and leading to efficient use
of resources, and the ‘callous’ pursuit of profit incentivizing
consumerism and greed and leading to exploitation of people and
nature
We can try to unpack this tension as we study models of firm behavior
What words do you associate with businesses, corporations, firms?
Can you think of examples of corporations in pop culture? How are
they presented?
For more on this, see Angela Allan
(https://www.theatlantic.com/business/archive/2016/04/evil-
corporation-trope/479295/)

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Unpacking profit

Profit is revenue minus costs

Revenue is money coming in: the amount of stuff you sell multiplied
by the price you sell it for
Cost is money going out: the total amount you had to pay to produce
the amount of output you chose
I Notice that this depends on technology! The producer’s constraint is
folded in to the profit function
I (By the way, there’s a difference between accounting profit, which is
about explicitly incurred costs, and economic profit, which also
accounts for implicit opportunity cost)
I (For example: it’s all very well if your business earns $50,000 profit per
year, but what could you have earned by working somewhere else?)

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Costs

Let’s dig deeper into costs

There are a few definitions for types of cost
And there are a few concepts for different aspects of cost, each of
which is useful for different things
Our first big distinction in costs:
1 Fixed costs

I Constant costs that must be paid by the producer regardless of how

much output is produced
2 Variable costs
I Costs that depend on how much output is produced
What kind of things might belong to each of these?

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Marginal and average costs
Marginal cost is the rate at which your costs increase if you produce a
little more
I Informally but more understandably: the amount your costs would
increase to produce one more unit of output
C
Average cost is your total cost divided by the amount you produce: Y
Average variable cost is the total variable part of your costs divided
by the amount you produce
Average cost includes fixed costs, but marginal cost doesn’t since
they don’t change when you produce more
Average cost plays a role in determining your profit margin:

π =R −C (2)
π R C
= − (3)
Y Y Y
Profit per unit of production is average revenue minus average cost
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Types of cost

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Visualizing costs

Marginal cost and average cost curve: these are commonly used curves,
but their shape could be different depending on the product we’re talking
about
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That shape for costs
Why is that shape for costs often considered ‘normal’ ?
At first, you have startup costs / fixed costs that you need to pay to
produce anything at all, so MC and AC are high
As you produce more and more, you are spreading the fixed costs
across more units of production so your average cost is falling
And you only have to pay variable costs
But eventually you might experience diminishing returns to your
inputs, so the marginal cost of producing more stuff increases and
eventually might drag the average cost up
By the way, it’s a mathematical fact that if the MC and AC curves
intersect each other, it must be where AC is at its lowest point. Can
you see why?
Costs could look completely different in some industry though!
What about an app or a computer program? What do you think the
cost structure might look like there?
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The long run

The long run is defined as the time when all inputs can be varied; the
short run is when at least one input must be used in a fixed amount
For example, one input could be ‘land’, and it might take longer for
the firm to acquire more land than to put a new machine on its
existing land
Equivalently, in the short run there are fixed costs...
... but in the long run all costs are variable!
In particular, if you’re a producer you could shut down your operation
in the long run and walk away, but in the short run you’re on the
hook for the costs of the input that must be paid
An analogy: right now you might be locked in to an apartment lease
even if you move away, but once the lease runs out you’re free of
obligations

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Returns to scale and costs
Recall: returns to scale is a long-run concept about what happens when
we scale up all inputs in the same proportion
1 Decreasing returns to scale

I e.g. If we increase all inputs by 10%, we get less than 10% more output
I Average cost rising as output is increased
2 Constant returns to scale
I e.g. If we increase all inputs by 10%, we get exactly 10% more output
I Average cost constant as output is increased
3 Increasing returns to scale
I If we increase all inputs by 10%, we get more than 10% more output
I Average cost falling as output is increased
‘Scaling up’ every factor of production is a tough thought experiment
‘Economies of scale’ is sometimes used a little informally relative to
how stringent the thought experiment is
Something can have diminishing returns to each input, but have
constant or increasing returns to scale. Can you see why?
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Average costs and economies of scale

Long run average cost is the lower envelope of short run average costs

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Economies of scale

Economies of scale is a different concept than returns to scale: if we

increase output, what happens to the average cost of production?
Economies of scale: if we increase output, average cost will go down
Diseconomies of scale: if we increase output, average cost will go up

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Finding the profit-maximizing level of output
To find the profit-maximizing output for a producer, we can ask:
compared to the current plan, could they make more profit by producing a
little more or a little less?
That is: marginal revenue and marginal cost of more output
Should a profit-driven producer increase the amount they produce?
I More production means more cost: you need to use more inputs, in a
way that depends on technology
I More production means more revenue: you can sell the extra stuff
I If MR > MC , you should produce the extra stuff!
Should a profit-driven producer decrease the amount they produce?
I Less production means less cost: you can use fewer inputs, in a way
that depends on technology
I Less production means less revenue: you have less stuff to sell
I If MR < MC , you should produce less stuff!
So the way we model the choices of profit-driven producers in an
economic model is to look for where MR = MC

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Textbook example of profit maximization

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Textbook example of profit maximization

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Perfect competition
Let’s study a famous example of applying the model of producers to make
predictions about a market: perfect competition
This is a thought experiment: what if there are many producers with
identical products who are all small relative to the total size of the
industry / the amount of the product that people want?
This is a really important benchmark model in economics, and in a
couple of weeks when we study market power we will compare this
situation to one in which producers are big and powerful
It is a model that tries to propose a situation where producers have to
take prices as given (i.e. ‘outside forces’ set the price and they just
react to it) and what the implications of that are
So for today we’re going to assume that price is fixed: the producer
faces a price and reacts to it but can’t change it: this means that
marginal revenue and average revenue are both just that price p

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Perfect competition
What are the assumptions of the model of perfect competition?
1 Price-taking

I Each player in the market is sufficiently small that its quantity choices
don’t influence the market price
I Contrast with monopoly and other situations with market power, for
later in our course
I We used this assumption in our supply and demand model: prices were
exogenous, coming from outside and taken as given by everyone
2 Identical firms, homogeneous goods
I Firms sell identical products; this is entwined with the price taking
condition
I If consumers see my product as different than yours, I have carved out
market power
I The semantic question seems silly but can become quite important:
Starbucks is not the only firm selling ‘cups of coffee’, but they’re the
only firm selling ‘cups of Starbucks coffee’

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Perfect competition

3 Perfect information
I All players in the market know what the good is and its price
I This assumption fails a lot because there’s a lot of information out
there
I But more worryingly, it fails big time in important cases like education,
health, insurance... we’ll study this later on
4 Free entry and exit in the long run
I Firms are allowed to enter and leave the industry at will, given enough
time to start up and wind down
I This generates very specific long run dynamics in the market, as we
shall see
I Short run here means the time when the number of firms is fixed, and
long run the time when the number of firms can vary as they enter and
leave

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Interpreting the assumptions

What would reality look like if this model was literally true?
The idea of the ‘going rate’ for goods and services
A ‘reserve army’ of entrepreneurs pouncing on profitable opportunities
A frictionless world—sometimes you will see economists make an
analogy to frictionless systems in physics when talking about perfectly
competitive markets
Each producer has to be ‘small’ relative to the total amount of
demand

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p=MC
What is the profit-driven producer’s optimal choice if they take price as
given?
Each extra unit produced can be sold at p: this is marginal revenue
So the profit maximization condition MR = MC becomes p = MC
This is a super important prediction of the model of perfect
competition!
It is sometimes called ‘efficient’ in the sense that if the price (that
someone is willing to pay?) justifies the resource cost to make the
thing, it’s made, and if not, it isn’t
But there are big problems with that claim:
I What if there are other costs to society besides just the cost of the
inputs to the producer? (Externalities: Topic 9)
I What does this mean for the people who work to the stuff? (Labor
markets: Topic 7)
I What if producers dictate prices? (Market power: Topic 6)
I What if people need the product but can’t afford p? (Prices and
policy: Topic 5)
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Visualizing the producer’s choice

Price is too low here for the producer to want to make anything in the
long run—they will never be able to cover their costs—but in short run it
may be worth making something if it covers fixed costs
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Visualizing the producer’s choice

Profit-maximizing choice for the producer is y ∗ : where MC meets

p(= MR) and MC is rising (why NOT the point with the arrow?)

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Visualizing the producer’s choice

As price changes, that optimal choice will change; supply curve traces MC

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Visualizing the producer’s choice

We can visualize the magnitude of profit on this diagram too

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An alternative goal for the producer

As an example: if the producer wants to produce and sell as much as they

can without making a loss, they’d pick y here

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p=MC

Here’s a question: what if marginal cost is really low or even zero?

Can you think of examples where this might be the case?
In what sense is p = 0 ‘efficient’ ?
Relevant for online markets, patents, copyright, and so on
These policies might create a monopoly specifically to prevent the
‘efficient’ competitive outcome...
A particularly gnarly situation is when there are big startup / fixed
costs but low marginal costs
We’ll study this all of this in Topic 7!

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An example of producer choice with fixed p

Let’s say a producer has fixed costs of $20

And marginal costs are given by 2Q.
And they face a price P = 10
What is their optimal choice? What is their revenue?
Total costs for this cost structure can be written as C = 20 + Q 2 .
What is average variable cost?
What is profit? Does the firm stay in business?
What if P = 8? P = 6?

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When to exit?

If price falls in region 1, then firm is profitable at its optimal choice of

quantity; region 2: loss in SR on positive output at its optimal choice, shut
down in LR; 3. optimal choice is to produce zero in SR, shut down in LR
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When to exit?

Expanding on that diagram:

If P > AC , all is well: the firm is making positive profit
If P < AVC , it’s not worth producing anything
If AVC < P < AC , you can’t cover fixed costs but can cover variable
costs
So keep producing in the short run, but shut down in the long run
Note what’s going on with fixed costs, by the way: in the short run,
fixed costs are sunk costs and so do not impact the decision
In the long run, fixed costs are not sunk and are part of the decision

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Long-run dynamics
The entry and exit assumption creates long run dynamics. A story:
1 Say P = MC but P 6= AC . Producers are making profits or losses.
2 Profits (excess returns to ownership after all inputs are paid) attract
new producers to enter; losses lead existing producers to shut down.
3 The amount of stuff that the industry is producing changes, which
causes price to fall or rise (why? We’ll see in topic 4)
4 This pulls profits for the firms that are operating towards zero.
This story ends if P = AC . And where does P = MC = AC ? The lowest
point of AC.
Next class will unpack arguments like point 3: where do prices come
from in competitive situations and why might they change?
But taking it as given for now: this ‘price tends to minimum AC’
argument is alleging that perfect competition leads to efficiency in the
long run in the sense that it leads to stuff being produced at the
lowest possible average cost
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Long run efficiency

Long run situation for a perfectly competitive firm

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Scale and market structure
The nature of returns to scale (especially in the short run) turns out to be
pretty important for the mechanics of the model of perfect competition
(and in general important to economists’ conception of industry structure)
Intuitively: in a coherent model of perfect competition, something has
to provide a disincentive for an individual producer to scale up,
producing more and more stuff
If an individual producer could continually grow and remain profitable,
how can the industry remain perfectly competitive?
This is an idea we’ll return to in our market power topic—economies
of scale for some prouduct are one potential explanation for why
market power might exist
Brief technical note: in the model, what we need is that marginal cost
be increasing. Two ways to get that:
I First: we could assume per-unit input costs start to increase if you
grow a lot—e.g. maybe it costs less to hire the first worker than it does
the 100th
I Second: we could assume that the production technology has

decreasing returns to inputs—the marginal cost to produce another

unit
Jim Campbell (UC is more than the last one
Berkeley) if 1it takes more resources to produce
Econ Fall 2024 that
45 / 61
Heterogeneity among firms

Finally, notice how we needed the assumption that firms are identical
If firms have different technology, then their cost structures are
different
Wouldn’t we have reason to suspect that their products are not
identical?
But even if products were identical, different technology means that
the firms would have different problems and make different choices

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Summing it all up

A quick summary of our model of a producer in a perfectly competitive

market:
1 A profit-maximizing producer will choose to produce where MR = MC
2 In a perfectly competitive market, MR is just the constant market
price of the product, so the profit-maximizing point is where p = MC
3 Comparing p to AC (or just computing profit) tells us whether the
maximum profit is positive or negative
4 If firms are making positive profit, entry of new firms drives price
down and so drives profit down
5 If firms are making negative profit, exit of firms drives price up and so
drives profit up
6 Once it’s all played out, profit is zero for the remaining firms: p = AC
Phew!

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Industrial organization

Perfect competition is at one end of a spectrum of economics models of

the amount of competition in an industry—understanding the reasons for
and implications of competition is important in business economics and for
public policy!

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Automation

When and why would a profit-driven producer seek to automate an aspect

of their production process?
It depends on the production function: how many machines does it
take to replace the function of a person?
I What kind of tasks can easily be automated?
I Does automation complement labor (i.e. I am more productive when I
have a machine to help me)?
I Does automation substitute for labor (i.e. I am obsolete when the
machine takes over)?
I Do I need new workers like technicians or programmers?
It depends on costs: what is the cost of a machine versus the cost of
a person?
I Maybe I can easily replace you with a machine, but is it cheaper?
I What is the cheapest point on a given isoquant?

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Isoquants

A profit-driven producer might ask: of the different ways to make 200

units of output, what’s the cheapest?

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Automation
A key question in the economics of automation is whether people and
technology are substitutes or complements
I Example: Jim is more productive at teaching because he has a
computer to create materials and answer student questions by email
and on Piazza
I Example: a grocery store can install self-checkout machines instead of
hiring cashiers
I More subtle example: live streaming technology might be good for a
superstar musician but not so good for the average musician
(Did you notice that these two forces, technology and costs, are here
playing a role a bit like preferences and prices in our “rational choice”
framework from last time?)
Popular and political concerns about automation are not at all new
Let’s see some figures from Autor (2015)
(https://economics.mit.edu/files/11563)

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Why are there still so many jobs?

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Why are there still so many jobs?

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Why are there still so many jobs?

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Why are there still so many jobs?

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Productivity and pay in the U.S.
From Stansbury and Summers 2018
(https://voxeu.org/article/link-between-us-pay-and-productivity)

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Labor share of income in the U.S.

From FRED (https://fred.stlouisfed.org/series/LABSHPUSA156NRUG)

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Artificial intelligence
A particular type of automation of contemporary relevance is AI and
machine learning
Agrawal, Gans, and Goldfarb (2019)
(https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.33.2.31) is a
non-technical explanation of some issues in how AI might affect labor
markets
Does AI replace labor or enhance labor? Is it different than
automation in general?
Example: AI can help to automate prediction but it is less good at
judgement and interpretation
What types of tasks or job types can be replaced with automated
prediction and what tasks or job types might be created or enhanced
by automated prediction?
Big issue: AI will bake in the choices and biases of its creators

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Tasks (https://xkcd.com/1425/)

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Coda: profit maximization and economics
Economics often assumes profit maximization and studies markets
‘Greed is good’ ?
I am not saying that profit maximization is good, right, or
commendable: those are normative statements
There is a huge academic literature on whether economists hold
different views on these types of questions than other people
I e.g. Bauman & Rose (2011): economists are less generous than other
professionals; economics students are less generous than other students
Question: if this evidence holds up, is it because different types of
people choose to study economics or because studying economics
makes people different?
Cipriani, Lubian, & Zago (2009), Etzioni (2015): evidence of both
This keeps me awake at night as an economics instructor
As we move forward, please be conscious and critical of the
assumptions, methods, and received wisdom of ‘standard’ economics

Jim Campbell (UC Berkeley) Econ 1 Fall 2024 60 / 61

Key stuff from this topic

1 As usual: understand / define / take a couple sentences of notes on

what the terms in italics mean
I (if you need help, please consult these notes, the textbooks, me, or the
GSIs and please do not Google them because I do not trust the average
Google result)
2 Understand what production functions are and some of their
properties
3 Explain the assumptions and implications of the model of perfect
competition
4 Solve simple profit maximization examples from equations or tables
like we saw earlier
5 Identify and sketch out marginal and average costs; be able to explain
the difference and why they’re important

Jim Campbell (UC Berkeley) Econ 1 Fall 2024 61 / 61