1 00:00:00,040 --> 00:00:02,460 The following content is provided under a Creative 2 00:00:02,460 --> 00:00:03,870 Commons license. 3 00:00:03,870 --> 00:00:06,910 Your support will help MIT OpenCourseWare continue to 4 00:00:06,910 --> 00:00:10,560 offer high quality educational resources for free. 5 00:00:10,560 --> 00:00:13,460 To make a donation or view additional materials from 6 00:00:13,460 --> 00:00:16,180 hundreds of MIT courses, visit mitopencourseware@ocw.mit.edu. 7 00:00:23,070 --> 00:00:24,710 PROFESSOR: Today we're going to continue 8 00:00:24,710 --> 00:00:28,180 discussing firm behavior. 9 00:00:28,180 --> 00:00:32,830 But today we're going to deviate from our fantasy land 10 00:00:32,830 --> 00:00:36,580 of 14.01 to come to the real world a little bit which is to 11 00:00:36,580 --> 00:00:41,840 talk a bit about whether firms actually maximize profits. 12 00:00:41,840 --> 00:00:48,190 The whole presumption of producer theory is just as we 13 00:00:48,190 --> 00:00:51,130 think with consumer theory, consumers maximize utility. 14 00:00:51,130 --> 00:00:53,570 Except producers maximize profits. 15 00:00:53,570 --> 00:00:56,190 That turns out to be an incredibly useful shorthand 16 00:00:56,190 --> 00:00:57,780 for lots of things. 17 00:00:57,780 --> 00:01:00,470 And it will turn out to be, as with any simplifying 18 00:01:00,470 --> 00:01:05,519 assumption, largely right and largely will help us draw a 19 00:01:05,519 --> 00:01:08,320 lot of interesting conclusions about firms and markets. 20 00:01:08,320 --> 00:01:11,550 Nonetheless, it's clearly not right in 21 00:01:11,550 --> 00:01:14,110 reality for every firm. 22 00:01:14,110 --> 00:01:18,240 For example, we see lots of firms doing things which look 23 00:01:18,240 --> 00:01:20,940 pretty wasteful like big corporate jets or 24 00:01:20,940 --> 00:01:22,760 other things like that. 25 00:01:22,760 --> 00:01:26,780 More relevantly, huge pay for CEOs seems pretty wasteful. 26 00:01:26,780 --> 00:01:30,920 So, for example, on 2004 the net income of Eli Lilly, the 27 00:01:30,920 --> 00:01:33,800 drug manufacturer, fell by 29%. 28 00:01:33,800 --> 00:01:38,940 Yet the CEO got a 41% raise to to $12.5 million a year. 29 00:01:38,940 --> 00:01:42,040 Or even more so in the financial crisis, in 2009, 30 00:01:42,040 --> 00:01:45,285 Citigroup and Merrill each lost more than $27 billion. 31 00:01:45,285 --> 00:01:46,830 It's a pretty bad year for the financial 32 00:01:46,830 --> 00:01:48,390 sector, you might think. 33 00:01:48,390 --> 00:01:52,290 And yet their CEO's pay in each company rose by more than 34 00:01:52,290 --> 00:01:54,650 10% to about $15 million. 35 00:01:54,650 --> 00:01:59,380 So in the worst year for the financial system since 1929, 36 00:01:59,380 --> 00:02:02,350 the CEO pay increased in these two companies. 37 00:02:02,350 --> 00:02:05,610 So you might think that this sounds kind of off. 38 00:02:05,610 --> 00:02:06,630 How could we explain that? 39 00:02:06,630 --> 00:02:08,789 Well, there's two possible explanations. 40 00:02:08,789 --> 00:02:10,990 So one explanation is that things which look wasteful 41 00:02:10,990 --> 00:02:12,280 really aren't. 42 00:02:12,280 --> 00:02:14,510 That is that we pay CEOs a huge amount of money, but 43 00:02:14,510 --> 00:02:16,070 they're worth it. 44 00:02:16,070 --> 00:02:20,450 So, for example, even at his ultimate salary of $33 million 45 00:02:20,450 --> 00:02:23,600 per year, Michael Jordan was vastly underpaid. 46 00:02:23,600 --> 00:02:25,920 By any reasonable economic analysis of the value he added 47 00:02:25,920 --> 00:02:29,410 to the Chicago Bulls, it was well in excess of $50 million. 48 00:02:29,410 --> 00:02:31,380 So even though he was paid $33 million, 49 00:02:31,380 --> 00:02:34,020 Michael Jordan was underpaid. 50 00:02:34,020 --> 00:02:35,860 Similarly, just because someone gets paid a lot of 51 00:02:35,860 --> 00:02:37,830 money, doesn't mean that they're overpaid. 52 00:02:37,830 --> 00:02:39,840 These CEOs are very talented people. 53 00:02:39,840 --> 00:02:41,090 They may be underpaid. 54 00:02:41,090 --> 00:02:43,750 Now this is an argument you might have made with a 55 00:02:43,750 --> 00:02:45,930 somewhat straight face maybe 10 or 15 years ago. 56 00:02:45,930 --> 00:02:47,890 It's hard to make that with a straight face now. 57 00:02:47,890 --> 00:02:51,150 It's hard to believe that these CEOs of these companies 58 00:02:51,150 --> 00:02:53,500 aren't overpaid given their company performance and even 59 00:02:53,500 --> 00:02:56,340 the kind of facts we just talked about. 60 00:02:56,340 --> 00:03:00,150 So a better explanation for things like excessive CEO pay 61 00:03:00,150 --> 00:03:04,340 is something which we call the agency problem. 62 00:03:13,280 --> 00:03:16,520 And that's what I want to emphasize in today's lecture. 63 00:03:16,520 --> 00:03:22,000 In reality, we think of a firm as something where there's a 64 00:03:22,000 --> 00:03:23,710 guy who's an owner. 65 00:03:23,710 --> 00:03:25,340 He hires some machines and some workers. 66 00:03:25,340 --> 00:03:29,110 They make stuff that he thought of, and you produce 67 00:03:29,110 --> 00:03:31,270 it, and some profit is made. 68 00:03:31,270 --> 00:03:34,110 So the model we have in mind when we talked about the firms 69 00:03:34,110 --> 00:03:37,720 so far in this course is the model of what we might call a 70 00:03:37,720 --> 00:03:40,890 sole proprietorship or a partnership. 71 00:03:40,890 --> 00:03:43,830 It's a model where one individual, where there's 72 00:03:43,830 --> 00:03:45,640 basically a commonality. 73 00:03:45,640 --> 00:03:47,370 The key thing that we've discussed so far is a 74 00:03:47,370 --> 00:03:52,240 commonality of interest between the owners who own the 75 00:03:52,240 --> 00:03:56,740 company and the control of production. 76 00:03:56,740 --> 00:03:59,710 So the people who earn the money from the company also 77 00:03:59,710 --> 00:04:01,210 control the production. 78 00:04:01,210 --> 00:04:04,310 So when you start your start-ups when you graduate, 79 00:04:04,310 --> 00:04:06,370 you will start them as a sole proprietorship or a 80 00:04:06,370 --> 00:04:09,870 partnership where you own the company, and you control 81 00:04:09,870 --> 00:04:11,410 what's done. 82 00:04:11,410 --> 00:04:14,815 You're there 18 hours a day making sure the guys are doing 83 00:04:14,815 --> 00:04:16,570 what they're supposed to do. 84 00:04:16,570 --> 00:04:19,110 And you're who gets the money if they succeed or lose the 85 00:04:19,110 --> 00:04:21,070 money if they fail. 86 00:04:21,070 --> 00:04:24,120 And that's the model we've had in mind as we've thought about 87 00:04:24,120 --> 00:04:27,610 corporations or firms so far in our class. 88 00:04:27,610 --> 00:04:30,230 But, in fact, most production in the US 89 00:04:30,230 --> 00:04:32,260 doesn't happen that way. 90 00:04:32,260 --> 00:04:35,450 Most production in the US happens through the guise of 91 00:04:35,450 --> 00:04:36,700 corporations. 92 00:04:41,710 --> 00:04:46,790 Corporations are marked by a separation of 93 00:04:46,790 --> 00:04:48,600 ownership and control. 94 00:04:48,600 --> 00:04:52,140 What defines a corporation is a separation of 95 00:04:52,140 --> 00:04:54,240 ownership and control. 96 00:04:54,240 --> 00:04:57,800 The owners of corporations are the stockholders or what we 97 00:04:57,800 --> 00:05:02,350 call the equity holders, people who have invested money 98 00:05:02,350 --> 00:05:03,850 in the corporation. 99 00:05:03,850 --> 00:05:05,930 So the owners of the corporation are its investors, 100 00:05:05,930 --> 00:05:07,380 its stockholders, its equity holders. 101 00:05:09,940 --> 00:05:13,460 All of you, most of you, probably somewhere-- 102 00:05:13,460 --> 00:05:16,050 if you're Jewish, it's in some Bar Mitzvah gift you got, if 103 00:05:16,050 --> 00:05:18,250 you're not, it's in some other gift you got-- probably have 104 00:05:18,250 --> 00:05:21,570 some equity ownership in something somewhere. 105 00:05:21,570 --> 00:05:22,230 OK. 106 00:05:22,230 --> 00:05:24,360 You maybe have a little bond which says you own five shares 107 00:05:24,360 --> 00:05:25,830 of GM that someone gave you, because they thought it'd be 108 00:05:25,830 --> 00:05:27,420 cute or whatever. 109 00:05:27,420 --> 00:05:29,260 That's now worthless, but maybe some other company. 110 00:05:31,810 --> 00:05:32,590 We're equity holders. 111 00:05:32,590 --> 00:05:35,420 We invest in companies. 112 00:05:35,420 --> 00:05:38,110 But we don't make the production decision. 113 00:05:38,110 --> 00:05:40,670 The production decision is made by the firm's managers 114 00:05:40,670 --> 00:05:47,230 who are employees of the owners, the equity holders. 115 00:05:47,230 --> 00:05:48,910 Now these managers may have some ownership. 116 00:05:48,910 --> 00:05:50,430 And we'll talk about that in a little bit. 117 00:05:50,430 --> 00:05:54,090 But, by and large, the primary ownership of the firm is done 118 00:05:54,090 --> 00:05:56,370 by people who do not control the everyday decisions of 119 00:05:56,370 --> 00:05:56,990 production. 120 00:05:56,990 --> 00:05:59,260 And it sort of makes sense it has to be that way. 121 00:05:59,260 --> 00:06:02,830 When a company's as big as Microsoft, you 122 00:06:02,830 --> 00:06:04,190 couldn't have me. 123 00:06:04,190 --> 00:06:07,570 Somewhere, I'm sure if you add up my various stock funds I 124 00:06:07,570 --> 00:06:12,830 own, I own 0.000000000001% of Microsoft. 125 00:06:12,830 --> 00:06:15,500 It'd be crazy to have me involved with a 126 00:06:15,500 --> 00:06:18,800 0.000000000001% of the decision making. 127 00:06:18,800 --> 00:06:21,620 I don't know anything about anything that Microsoft does. 128 00:06:21,620 --> 00:06:23,640 It makes sense that there's a separation of ownership and 129 00:06:23,640 --> 00:06:26,330 control once companies get big enough. 130 00:06:26,330 --> 00:06:29,240 But the fact that there is a separation of ownership and 131 00:06:29,240 --> 00:06:32,630 control can lead to this agency problem and can lead to 132 00:06:32,630 --> 00:06:36,690 firms not maximizing profits. 133 00:06:36,690 --> 00:06:42,220 So, basically, the point is that managers care not just 134 00:06:42,220 --> 00:06:44,320 about the profits they make but also how 135 00:06:44,320 --> 00:06:46,310 happy their life is. 136 00:06:46,310 --> 00:06:49,220 And things which make their life happy may be things which 137 00:06:49,220 --> 00:06:51,530 aren't profit maximizing. 138 00:06:51,530 --> 00:06:54,850 The managers who are in charge of production may have their 139 00:06:54,850 --> 00:06:59,410 own agenda that deviates from profit maximization. 140 00:06:59,410 --> 00:07:02,630 And the problem is it may be hard to figure that out if 141 00:07:02,630 --> 00:07:04,950 you're the owner of the firm. 142 00:07:04,950 --> 00:07:08,200 So the agency problem is the first example of a problem 143 00:07:08,200 --> 00:07:11,090 we'll talk about later in the semester of imperfect 144 00:07:11,090 --> 00:07:12,680 information. 145 00:07:12,680 --> 00:07:18,610 This is the first time we'll see imperfect information. 146 00:07:18,610 --> 00:07:22,160 We've assumed in our class so far, and we'll assume in our 147 00:07:22,160 --> 00:07:24,780 class going forward that there's perfect information 148 00:07:24,780 --> 00:07:27,380 the world, that everyone knows what stuff costs, that 149 00:07:27,380 --> 00:07:30,540 everyone can shop costlessly across providers, et cetera. 150 00:07:30,540 --> 00:07:32,800 But, in fact, the world is marked by imperfect 151 00:07:32,800 --> 00:07:34,780 information. 152 00:07:34,780 --> 00:07:39,070 As an owner of Microsoft, as a trivial owner of Microsoft, I 153 00:07:39,070 --> 00:07:41,960 don't know for sure that every Microsoft employee is doing 154 00:07:41,960 --> 00:07:43,630 what's profit maximizing for the company. 155 00:07:43,630 --> 00:07:45,150 I can't. 156 00:07:45,150 --> 00:07:46,650 It's just impossible for me to own that. 157 00:07:46,650 --> 00:07:49,050 So that creates an agency problem. 158 00:07:49,050 --> 00:07:52,340 And the agency problem arises because it's in the employees' 159 00:07:52,340 --> 00:07:53,970 interest, perhaps, to do things which aren't profit 160 00:07:53,970 --> 00:07:54,590 maximizing. 161 00:07:54,590 --> 00:07:58,130 So so as a simple example, imagine that you're an 162 00:07:58,130 --> 00:08:01,120 investor in the company that's a medium-sized company. 163 00:08:01,120 --> 00:08:03,910 And the head of that company is jealous because all of his 164 00:08:03,910 --> 00:08:05,840 friends at bigger companies have their own jets, and he's 165 00:08:05,840 --> 00:08:07,610 got to fly commercial. 166 00:08:07,610 --> 00:08:12,375 He says, I want my own jet, because I'm not cool enough. 167 00:08:12,375 --> 00:08:16,370 There's this great episode of the Simpsons where Burns goes 168 00:08:16,370 --> 00:08:17,940 to the billionaires club. 169 00:08:17,940 --> 00:08:19,130 And he's in the billionaires club. 170 00:08:19,130 --> 00:08:21,136 And then eventually his wealth drops so low he gets thrown 171 00:08:21,136 --> 00:08:23,020 into the millionaires club, and it's these yokels in the 172 00:08:23,020 --> 00:08:23,580 millionaires club. 173 00:08:23,580 --> 00:08:25,970 He's like, I want to be back in the billionaires club. 174 00:08:25,970 --> 00:08:29,980 The point is managers of companies care about how they 175 00:08:29,980 --> 00:08:31,300 look and who they hang out with. 176 00:08:31,300 --> 00:08:33,090 And you've got this manager of a medium-sized company who 177 00:08:33,090 --> 00:08:33,909 wants his own private jet. 178 00:08:33,909 --> 00:08:36,820 But he knows that that's not profit maximizing. 179 00:08:36,820 --> 00:08:39,460 Because he knows that if he figures out his travel, and 180 00:08:39,460 --> 00:08:41,905 prices it out at competitive prices, it'll be cheaper to 181 00:08:41,905 --> 00:08:43,270 just travel commercial. 182 00:08:43,270 --> 00:08:43,900 So what does he do? 183 00:08:43,900 --> 00:08:48,270 He puts together a glossy PowerPoint which he presents 184 00:08:48,270 --> 00:08:51,060 to you, the owner of the company, showing that 185 00:08:51,060 --> 00:08:54,780 financially it would be more prudent to own a jet than to 186 00:08:54,780 --> 00:08:56,005 fly commercial. 187 00:08:56,005 --> 00:08:58,186 What he doesn't point out and put into that PowerPoint is 188 00:08:58,186 --> 00:09:00,270 that in putting together the commercial prices he used, he 189 00:09:00,270 --> 00:09:02,820 chose the highest rates from flying from point A to point 190 00:09:02,820 --> 00:09:04,990 B, not the lowest rates. 191 00:09:04,990 --> 00:09:06,656 Now, unless you're an expert on the cost of flying from 192 00:09:06,656 --> 00:09:08,010 point A to point B, you won't know that. 193 00:09:08,010 --> 00:09:09,110 You'll say, well, that's a pretty impressive 194 00:09:09,110 --> 00:09:09,650 presentation. 195 00:09:09,650 --> 00:09:12,640 Yes, you can show you've saved 20% by having your own plane. 196 00:09:12,640 --> 00:09:13,630 Go get it. 197 00:09:13,630 --> 00:09:15,640 But it turned out he didn't save 20%. 198 00:09:15,640 --> 00:09:18,050 He just cooked the numbers in a way to make his life nicer 199 00:09:18,050 --> 00:09:20,300 even if it wasn't profit maximizing. 200 00:09:20,300 --> 00:09:23,170 And that's an example of the kind of problem that arises 201 00:09:23,170 --> 00:09:24,420 with imperfect information. 202 00:09:27,420 --> 00:09:29,070 And I could go through examples all the time. 203 00:09:29,070 --> 00:09:31,470 But I think you guys probably all understand what I'm 204 00:09:31,470 --> 00:09:33,930 talking about, which is there's lots of ways employees 205 00:09:33,930 --> 00:09:36,290 of companies might make their lives nicer that aren't profit 206 00:09:36,290 --> 00:09:37,300 maximizing. 207 00:09:37,300 --> 00:09:39,450 Now, corporations have recognized this from time 208 00:09:39,450 --> 00:09:41,010 immemorial. 209 00:09:41,010 --> 00:09:43,080 And they've recognized that their owners are too diffuse 210 00:09:43,080 --> 00:09:43,730 to monitor this. 211 00:09:43,730 --> 00:09:46,350 So what corporations do is they have set up an 212 00:09:46,350 --> 00:09:52,430 intermediary between the owners and the producers 213 00:09:52,430 --> 00:09:53,680 called the board of directors. 214 00:09:58,710 --> 00:10:01,570 The board of directors is a set of individuals appointed 215 00:10:01,570 --> 00:10:04,320 by the owners that are supposed to actually pay 216 00:10:04,320 --> 00:10:07,040 attention to what's going on in production. 217 00:10:07,040 --> 00:10:09,470 The owners say, look, we can't afford to pay attention. 218 00:10:09,470 --> 00:10:11,350 But we're going to appoint you, the board of directors, 219 00:10:11,350 --> 00:10:12,510 and we're going to pay you quite a lot of money. 220 00:10:12,510 --> 00:10:15,460 A typical director on the Fortune 500 company will make 221 00:10:15,460 --> 00:10:17,770 $100,000 plus a year. 222 00:10:17,770 --> 00:10:20,330 It's a part-time job. 223 00:10:20,330 --> 00:10:22,120 We appointed you to keep an eye on the tools of 224 00:10:22,120 --> 00:10:22,850 production. 225 00:10:22,850 --> 00:10:24,470 The problem is the board of directors aren't 226 00:10:24,470 --> 00:10:25,180 that good at it either. 227 00:10:25,180 --> 00:10:27,880 Because it turns out to be really hard to figure out 228 00:10:27,880 --> 00:10:30,600 exactly what's going on. 229 00:10:30,600 --> 00:10:33,240 And this is made worse, because the members of the 230 00:10:33,240 --> 00:10:35,560 board of directors are often chosen by management of the 231 00:10:35,560 --> 00:10:37,900 company, by the people running the 232 00:10:37,900 --> 00:10:39,650 production, not by the owners. 233 00:10:39,650 --> 00:10:42,190 So they'll make selections of who's going to be on the board 234 00:10:42,190 --> 00:10:42,720 of directors. 235 00:10:42,720 --> 00:10:43,885 And they'll pack it with their friends who 236 00:10:43,885 --> 00:10:45,040 will be nice to them. 237 00:10:45,040 --> 00:10:49,010 So, for example, Richard Grasso was the CEO of the New 238 00:10:49,010 --> 00:10:50,610 York Stock Exchange. 239 00:10:50,610 --> 00:10:53,320 He started out in the mail room, worked his way up. 240 00:10:53,320 --> 00:10:55,290 He became CEO of the New York Stock Exchange and retired 241 00:10:55,290 --> 00:10:59,120 with $187 million severance package which was outrageous 242 00:10:59,120 --> 00:11:01,520 and totally unearned. 243 00:11:01,520 --> 00:11:03,570 But the board of directors were a bunch of his buddies 244 00:11:03,570 --> 00:11:05,070 who'd known him since he was a kid. 245 00:11:05,070 --> 00:11:06,250 And they said, he seems like a nice guy. 246 00:11:06,250 --> 00:11:08,300 Let's give him a bunch of money. 247 00:11:08,300 --> 00:11:09,810 And a lot of the board of directors, when actually 248 00:11:09,810 --> 00:11:11,780 grilled on it, didn't actually know he'd gotten that much. 249 00:11:11,780 --> 00:11:12,200 They were like, wow. 250 00:11:12,200 --> 00:11:13,340 We didn't realize his retirement 251 00:11:13,340 --> 00:11:14,860 package was that big. 252 00:11:14,860 --> 00:11:17,610 So it turns out having the board of directors does not 253 00:11:17,610 --> 00:11:19,040 solve the agency problem. 254 00:11:19,040 --> 00:11:21,710 Because there's still too much of an information imperfection 255 00:11:21,710 --> 00:11:24,450 between the managers and the board of directors, not to 256 00:11:24,450 --> 00:11:27,150 mention the managers and the owners. 257 00:11:27,150 --> 00:11:28,170 So what do we do? 258 00:11:28,170 --> 00:11:29,240 What do we do with this agency problem? 259 00:11:29,240 --> 00:11:32,110 Well, this was known for a lot of years. 260 00:11:32,110 --> 00:11:37,120 And about 25 years ago, the thinking was, look, the way to 261 00:11:37,120 --> 00:11:41,780 solve this problem is we need to align the incentives of the 262 00:11:41,780 --> 00:11:43,365 managers and the owners. 263 00:11:43,365 --> 00:11:45,270 If we're going to solve this problem, we need to get the 264 00:11:45,270 --> 00:11:48,480 managers, the producers, to actually care about maximizing 265 00:11:48,480 --> 00:11:50,440 profits enough that they'll do that even if it makes their 266 00:11:50,440 --> 00:11:52,300 life a little uncomfortable. 267 00:11:52,300 --> 00:11:53,460 And how do we do that? 268 00:11:53,460 --> 00:11:56,190 We turn the managers into owners. 269 00:11:56,190 --> 00:11:59,150 We give the managers, the producers, an ownership stake 270 00:11:59,150 --> 00:12:00,410 in the company. 271 00:12:00,410 --> 00:12:05,670 We say look, your income is going to be directly derived 272 00:12:05,670 --> 00:12:07,620 from the profitability of this company. 273 00:12:07,620 --> 00:12:10,100 So now you'll have a direct incentive to do what's profit 274 00:12:10,100 --> 00:12:11,470 maximizing even if it makes your life a little 275 00:12:11,470 --> 00:12:12,500 uncomfortable. 276 00:12:12,500 --> 00:12:17,596 Even if it means flying commercial, you recognize if I 277 00:12:17,596 --> 00:12:19,530 have my own jet, then I'm going to suffer. 278 00:12:19,530 --> 00:12:21,050 So you align the incentives. 279 00:12:21,050 --> 00:12:22,540 So we want to give them an ownership 280 00:12:22,540 --> 00:12:23,270 stake in the company. 281 00:12:23,270 --> 00:12:24,820 Well, how do you do that? 282 00:12:24,820 --> 00:12:26,360 How do you give managers an ownership stake? 283 00:12:26,360 --> 00:12:28,110 Well, there's two ways you can do it. 284 00:12:28,110 --> 00:12:31,460 One way is you can directly give them stock. 285 00:12:31,460 --> 00:12:34,840 So you can directly say, look, instead of paying you in cash, 286 00:12:34,840 --> 00:12:37,630 we are going to pay you in company stock. 287 00:12:37,630 --> 00:12:42,940 So your fortunes will directly be tied to the performance of 288 00:12:42,940 --> 00:12:46,180 this company if you pay them in stock. 289 00:12:46,180 --> 00:12:49,730 Or, alternatively, you can do something which turns out to 290 00:12:49,730 --> 00:12:50,790 be cheaper. 291 00:12:50,790 --> 00:12:52,200 You can give them stock options. 292 00:12:52,200 --> 00:12:54,940 It turns out to be cheaper, at least, in principle. 293 00:12:54,940 --> 00:12:56,540 We can give them stock options. 294 00:12:56,540 --> 00:12:58,350 So let's talk about what a stock option is. 295 00:12:58,350 --> 00:12:59,840 And some of you may deal with these along the way. 296 00:13:03,260 --> 00:13:06,210 A stock is a piece of paper which says you only 0.00001% 297 00:13:06,210 --> 00:13:07,660 of the company. 298 00:13:07,660 --> 00:13:10,730 A stock option is simply a piece of paper which says we 299 00:13:10,730 --> 00:13:15,610 are granting you the right to buy the stock at some price. 300 00:13:15,610 --> 00:13:18,180 Typically, it's today's price. 301 00:13:18,180 --> 00:13:19,550 We're not giving you a share of the company. 302 00:13:19,550 --> 00:13:21,270 You have a piece of paper which says if the value of 303 00:13:21,270 --> 00:13:23,900 stock today is $100, you have a piece of paper which says no 304 00:13:23,900 --> 00:13:25,400 matter where the stock ends up, you can 305 00:13:25,400 --> 00:13:27,540 always buy it for $100. 306 00:13:27,540 --> 00:13:28,860 Why is that valuable? 307 00:13:28,860 --> 00:13:33,020 Well, that's valuable because let's say you give a CEO of a 308 00:13:33,020 --> 00:13:36,630 company a million options at $100 each when the price of 309 00:13:36,630 --> 00:13:38,240 the stock is $100. 310 00:13:38,240 --> 00:13:42,690 Well, if the price of the stock rises to $150, that CEO 311 00:13:42,690 --> 00:13:45,290 can then take his million options, say, I want to buy 312 00:13:45,290 --> 00:13:47,400 the shares for 100, which I'm allowed to by these pieces of 313 00:13:47,400 --> 00:13:49,800 paper, and I'll turn around and sell them for $150. 314 00:13:49,800 --> 00:13:52,250 I've just made $50 million. 315 00:13:52,250 --> 00:13:55,110 So a stock option is valuable if the stock goes up. 316 00:13:55,110 --> 00:13:58,180 But it's worthless if the stock goes down. 317 00:13:58,180 --> 00:13:59,980 So it's kind of the ultimate incentive, if 318 00:13:59,980 --> 00:14:00,440 you think about it. 319 00:14:00,440 --> 00:14:03,890 Because what it says to the CEO is, look, we're going to 320 00:14:03,890 --> 00:14:05,240 incent you to do better. 321 00:14:05,240 --> 00:14:07,190 And you make a lot of money by doing better. 322 00:14:07,190 --> 00:14:09,860 But if you do worse, you're not going to get anything. 323 00:14:09,860 --> 00:14:12,200 And as myself as the owner it seems great, 324 00:14:12,200 --> 00:14:13,380 because it's cheaper. 325 00:14:13,380 --> 00:14:16,850 Because if the stock goes up, I share some with the guy. 326 00:14:16,850 --> 00:14:17,500 But I don't care. 327 00:14:17,500 --> 00:14:17,860 I'm happy. 328 00:14:17,860 --> 00:14:18,850 The stock goes up. 329 00:14:18,850 --> 00:14:20,880 If it goes down, I don't have to give him anything. 330 00:14:20,880 --> 00:14:23,940 And, in fact, giving someone a stock option costs, 331 00:14:23,940 --> 00:14:27,060 effectively, about half as much as giving them stock. 332 00:14:27,060 --> 00:14:30,350 So if I say today's stock price, if I instead of giving 333 00:14:30,350 --> 00:14:32,170 you a share of stock, I give you an option to buy a share 334 00:14:32,170 --> 00:14:35,520 of stock at today's price, the value to that, what it costs 335 00:14:35,520 --> 00:14:36,930 me in the market is about half of what it costs when I 336 00:14:36,930 --> 00:14:38,670 actually give you the share of stock. 337 00:14:38,670 --> 00:14:40,210 So it seems like the best deal. 338 00:14:40,210 --> 00:14:42,700 You get all the incentives for them to raise the price, but 339 00:14:42,700 --> 00:14:45,240 it costs you half as much. 340 00:14:45,240 --> 00:14:48,330 And, in fact, there's been tremendous growth in use of 341 00:14:48,330 --> 00:14:49,890 stock and stock options. 342 00:14:49,890 --> 00:14:55,810 So if you look at Figure 12-1, now, this sort of changes. 343 00:14:55,810 --> 00:14:59,610 Before 1992, there's only two categories. 344 00:14:59,610 --> 00:15:01,250 And after '92, there's three. 345 00:15:01,250 --> 00:15:06,750 So before '92, we just have to divide into salary and bonus 346 00:15:06,750 --> 00:15:08,170 versus options. 347 00:15:08,170 --> 00:15:11,970 So you see there was essentially no options in '84. 348 00:15:11,970 --> 00:15:13,690 This is the mean CEO pay. 349 00:15:13,690 --> 00:15:16,970 So the typical CEO in 1984 made $500,000, and it was all 350 00:15:16,970 --> 00:15:19,220 cash, all salary and bonus. 351 00:15:19,220 --> 00:15:23,585 By 1992, they made about $1 million, and a decent share of 352 00:15:23,585 --> 00:15:25,520 it started to be stock options. 353 00:15:25,520 --> 00:15:28,000 Now, starting after '92, we actually break into three 354 00:15:28,000 --> 00:15:31,070 categories which is salary, bonus, and options. 355 00:15:31,070 --> 00:15:32,380 But that doesn't really matter. 356 00:15:32,380 --> 00:15:34,560 The main thing is to pay attention to the option share, 357 00:15:34,560 --> 00:15:36,590 which you see grew astronomically. 358 00:15:36,590 --> 00:15:41,000 And so by its peak, in about 2002, first of all, the 359 00:15:41,000 --> 00:15:43,070 typical CEO was making $3.5 million. 360 00:15:45,620 --> 00:15:50,360 Second of all, the majority of that was in stock options. 361 00:15:50,360 --> 00:15:52,840 In fact, if you look at salary and bonus, it didn't grow that 362 00:15:52,840 --> 00:15:55,370 much over time. 363 00:15:55,370 --> 00:15:59,660 If you look at 1992 versus 2002, over that decade, salary 364 00:15:59,660 --> 00:16:03,650 and bonus barely grew, but options went through the roof. 365 00:16:03,650 --> 00:16:06,660 So there's a huge increase in use of these. 366 00:16:06,660 --> 00:16:10,910 And the motivation is pretty basic economic intuition. 367 00:16:10,910 --> 00:16:14,420 What we're going to do is this is a cheap way to align the 368 00:16:14,420 --> 00:16:16,665 incentives of owners and managers. 369 00:16:19,490 --> 00:16:20,790 And that was why they took off. 370 00:16:20,790 --> 00:16:21,880 And everyone thought it was great. 371 00:16:21,880 --> 00:16:23,800 And people like Michael Jensen at Harvard Business School 372 00:16:23,800 --> 00:16:25,890 made fortunes off having suggested this, et cetera. 373 00:16:25,890 --> 00:16:27,460 It was like we solved the problem. 374 00:16:27,460 --> 00:16:31,620 And, remember, we did pretty damn well in the 1990s. 375 00:16:31,620 --> 00:16:34,380 And a lot of it, people attributed it to exactly 376 00:16:34,380 --> 00:16:35,500 what's in this graph. 377 00:16:35,500 --> 00:16:38,940 That by finally figuring out how to align the incentives of 378 00:16:38,940 --> 00:16:41,980 producers and owners, we'd figured out a way to change 379 00:16:41,980 --> 00:16:42,820 the economy. 380 00:16:42,820 --> 00:16:46,540 And people thought we sort of entered this new economic era 381 00:16:46,540 --> 00:16:49,070 of massive productivity. 382 00:16:49,070 --> 00:16:52,390 Well people, as we know now, were wrong. 383 00:16:52,390 --> 00:16:54,630 Things slowed down in the 2000s and then now have 384 00:16:54,630 --> 00:16:57,020 completely crashed. 385 00:16:57,020 --> 00:16:58,100 And why were they wrong? 386 00:16:58,100 --> 00:17:01,270 Well, they're wrong because what makes economics fun is 387 00:17:01,270 --> 00:17:03,310 unintended consequences. 388 00:17:03,310 --> 00:17:07,430 And these stock options had two kinds of unintended 389 00:17:07,430 --> 00:17:09,569 consequences. 390 00:17:09,569 --> 00:17:12,869 The first unintended consequence is that they lead 391 00:17:12,869 --> 00:17:14,119 to excessive gambling. 392 00:17:25,200 --> 00:17:29,660 And what I mean by that is that once your stock option is 393 00:17:29,660 --> 00:17:32,220 out of the money, once, if you've got it for 100, 394 00:17:32,220 --> 00:17:33,390 you're below 100. 395 00:17:33,390 --> 00:17:35,740 You don't care how low it goes. 396 00:17:35,740 --> 00:17:39,020 If you're at 99 or 20, you don't care. 397 00:17:39,020 --> 00:17:41,630 All we care about is being 100 verses above. 398 00:17:41,630 --> 00:17:45,410 What that means is as an owner, as a manager, you'll 399 00:17:45,410 --> 00:17:48,890 take excessive risks to go into the positive territory. 400 00:17:48,890 --> 00:17:50,600 Even if there's a huge risk you'll get 401 00:17:50,600 --> 00:17:51,850 nailed on the downside. 402 00:17:54,500 --> 00:17:59,170 Contrast to guys working for a company that's 403 00:17:59,170 --> 00:18:01,616 currently worth $100. 404 00:18:01,616 --> 00:18:09,530 One is given stock, and one is given stock options at $100. 405 00:18:09,530 --> 00:18:12,060 Imagine they're both going to leave the company in one year. 406 00:18:12,060 --> 00:18:13,910 Because there's dynamics with the long run issues. 407 00:18:13,910 --> 00:18:14,880 Let's put that aside. 408 00:18:14,880 --> 00:18:16,580 They're both going to leave in one year. 409 00:18:16,580 --> 00:18:19,720 One today is given a share of stock, and one today is given 410 00:18:19,720 --> 00:18:21,810 an option to buy at $100. 411 00:18:21,810 --> 00:18:25,090 And then they're given the choice of a risky investment. 412 00:18:25,090 --> 00:18:26,130 Someone comes to them and says, have I 413 00:18:26,130 --> 00:18:27,880 got a deal for you. 414 00:18:27,880 --> 00:18:31,140 I've got an investment that has a 10% chance it will 415 00:18:31,140 --> 00:18:34,860 double the value of your company and a 90% chance the 416 00:18:34,860 --> 00:18:39,060 value of your company will fall by 20%. 417 00:18:39,060 --> 00:18:51,040 So there's a 10% chance of a 100% return and a 90% chance 418 00:18:51,040 --> 00:18:55,510 of a 20% decline in your company's value. 419 00:18:55,510 --> 00:18:57,910 Now, what is the profit maximizing thing 420 00:18:57,910 --> 00:18:59,190 to do in this situation? 421 00:18:59,190 --> 00:19:02,800 Well, to do that, we have to consider the concept of what 422 00:19:02,800 --> 00:19:05,375 delivers the company the highest expected value. 423 00:19:08,730 --> 00:19:10,850 Expected value is a concept we'll use-- and we'll come 424 00:19:10,850 --> 00:19:12,910 back to this later when we talk about uncertainty-- 425 00:19:12,910 --> 00:19:15,770 it's a concept we use to measure how you value things 426 00:19:15,770 --> 00:19:17,130 when there's uncertainty. 427 00:19:17,130 --> 00:19:20,980 So the expected value of a gamble is the probability that 428 00:19:20,980 --> 00:19:27,470 you win times the value if you win plus the probability that 429 00:19:27,470 --> 00:19:32,320 you lose times the value if you lose. 430 00:19:32,320 --> 00:19:35,570 That's the expected value of a gamble. 431 00:19:35,570 --> 00:19:38,210 And the profit maximizing thing to do would be to take 432 00:19:38,210 --> 00:19:42,200 gambles of expected values of greater than zero. 433 00:19:42,200 --> 00:19:45,460 The expected value is the summation of the 434 00:19:45,460 --> 00:19:47,480 value of that gamble. 435 00:19:47,480 --> 00:19:54,170 This gamble has an expected value of 0.1 times 100-- 436 00:19:54,170 --> 00:19:56,650 100% return and a 10% chance-- 437 00:19:56,650 --> 00:20:01,590 plus 0.9 times negative 20-- 438 00:20:01,590 --> 00:20:06,790 a 90% of losing 20-- or an expected value of minus 8%. 439 00:20:06,790 --> 00:20:09,060 That is if you take this gamble, and you took it an 440 00:20:09,060 --> 00:20:11,450 infinite number of times, you would end up 441 00:20:11,450 --> 00:20:14,110 losing 8% on average. 442 00:20:14,110 --> 00:20:15,710 Any one time might work out. 443 00:20:15,710 --> 00:20:17,340 But by the law of large numbers, if we took this 444 00:20:17,340 --> 00:20:20,530 enough times, you'd lose 8% on average. 445 00:20:20,530 --> 00:20:22,800 So you will lower the value of your company. 446 00:20:22,800 --> 00:20:26,840 You will reduce profits by taking this gamble. 447 00:20:26,840 --> 00:20:28,300 Your company is worse off if you take this gamble. 448 00:20:28,300 --> 00:20:31,810 Well, what would the person who got the $100 in stocks do? 449 00:20:31,810 --> 00:20:33,640 They won't take the gamble. 450 00:20:33,640 --> 00:20:37,310 Because their $100 in stock will be worth, on average, 8% 451 00:20:37,310 --> 00:20:38,390 less if they take this gamble. 452 00:20:38,390 --> 00:20:39,590 So I'm not taking the gamble. 453 00:20:39,590 --> 00:20:41,000 This is stupid. 454 00:20:41,000 --> 00:20:43,210 But now let's look at the guy who got the option. 455 00:20:43,210 --> 00:20:44,830 His gamble is a little bit different. 456 00:20:44,830 --> 00:20:47,496 Because he doesn't care whether the value of the 457 00:20:47,496 --> 00:20:49,410 company is 99 or 80. 458 00:20:49,410 --> 00:20:51,370 He just cares about how much it goes above 100. 459 00:20:51,370 --> 00:20:53,400 So what is his calculation? 460 00:20:53,400 --> 00:20:57,600 Well, his calculation is he has a 10% chance of making 461 00:20:57,600 --> 00:21:03,910 100% and a 90% chance of what? 462 00:21:03,910 --> 00:21:06,880 Zero, ending up with zero. 463 00:21:06,880 --> 00:21:09,030 He can't lose. 464 00:21:09,030 --> 00:21:10,740 He has a 90% chance of zero. 465 00:21:10,740 --> 00:21:12,350 So what is his calculation? 466 00:21:12,350 --> 00:21:16,250 Well, he uses the positive 10% gamble. 467 00:21:16,250 --> 00:21:20,135 He makes money on this gamble, because head he wins, tails he 468 00:21:20,135 --> 00:21:21,590 walks away. 469 00:21:21,590 --> 00:21:24,550 The guy who owns the stock loses if it's tails with this 470 00:21:24,550 --> 00:21:28,550 weighted coin that only hits heads 10% of the time. 471 00:21:28,550 --> 00:21:30,260 This guy only wins. 472 00:21:30,260 --> 00:21:31,250 So he says, sure. 473 00:21:31,250 --> 00:21:34,330 Any gamble which has a huge upside, I'm going to take. 474 00:21:34,330 --> 00:21:38,500 Because I get all the upside, and I don't bear the downside. 475 00:21:38,500 --> 00:21:41,070 So what this does is it leads to excessive gambling, 476 00:21:41,070 --> 00:21:41,990 excessive risk taking. 477 00:21:41,990 --> 00:21:44,910 And that's exactly what we saw in economy, was companies 478 00:21:44,910 --> 00:21:48,820 gambling on things which sounded very good, managers 479 00:21:48,820 --> 00:21:50,970 gambling on things which sounded very good, some of 480 00:21:50,970 --> 00:21:54,890 which worked out very well and some of which didn't. 481 00:21:54,890 --> 00:21:56,660 And that's the first problem we have with the 482 00:21:56,660 --> 00:21:58,300 use of stock options. 483 00:21:58,300 --> 00:22:01,690 And questions about that? 484 00:22:01,690 --> 00:22:01,900 Yeah. 485 00:22:01,900 --> 00:22:04,876 AUDIENCE: What about using a package of options like a 486 00:22:04,876 --> 00:22:07,356 number of stock options [INAUDIBLE PHRASE] 487 00:22:10,332 --> 00:22:13,320 package of stock options [INAUDIBLE PHRASE]. 488 00:22:13,320 --> 00:22:15,290 PROFESSOR: Certainly there are more sophisticated ways you 489 00:22:15,290 --> 00:22:16,260 can do that. 490 00:22:16,260 --> 00:22:17,710 I mean, there's certainly more sophisticated 491 00:22:17,710 --> 00:22:18,600 ways you can do that. 492 00:22:18,600 --> 00:22:22,180 But that's a great segue to the second problem with these. 493 00:22:22,180 --> 00:22:25,500 The second problem is who decided the structure of the 494 00:22:25,500 --> 00:22:26,950 stock options? 495 00:22:26,950 --> 00:22:28,600 The managers. 496 00:22:28,600 --> 00:22:32,060 So the managers had executive compensation committees that 497 00:22:32,060 --> 00:22:34,830 designed the stock options the managers got. 498 00:22:34,830 --> 00:22:36,360 So the second problem was there was 499 00:22:36,360 --> 00:22:39,460 just outright cheating. 500 00:22:39,460 --> 00:22:41,670 So what you just described would be a great structure 501 00:22:41,670 --> 00:22:43,700 which would incentivize them maximally, but it would not 502 00:22:43,700 --> 00:22:45,470 make them the most money. 503 00:22:45,470 --> 00:22:47,690 So the second problem we had was outright cheating. 504 00:22:47,690 --> 00:22:49,470 So there's a wonderful investigation by the Wall 505 00:22:49,470 --> 00:22:51,850 Street Journal that investigated a whole list of 506 00:22:51,850 --> 00:22:53,540 stock option arrangements. 507 00:22:53,540 --> 00:22:56,470 And what they found was companies would frequently do 508 00:22:56,470 --> 00:22:59,140 what's called backdating stock options. 509 00:22:59,140 --> 00:23:01,363 What they'd say is, look, the value of the company just went 510 00:23:01,363 --> 00:23:04,570 up from $100 to $15 last week. 511 00:23:04,570 --> 00:23:06,240 We're going to give you an option at $100. 512 00:23:06,240 --> 00:23:07,990 And let's pretend it was issued before the company 513 00:23:07,990 --> 00:23:08,980 value went up. 514 00:23:08,980 --> 00:23:11,400 We've just given you money. 515 00:23:11,400 --> 00:23:13,360 You haven't done anything to earn that. 516 00:23:13,360 --> 00:23:14,700 We've just given you money. 517 00:23:14,700 --> 00:23:18,480 And the Wall Street Journal found incredible evidence of 518 00:23:18,480 --> 00:23:20,040 backdating stock options. 519 00:23:20,040 --> 00:23:21,910 So they had one CEO. 520 00:23:21,910 --> 00:23:25,886 They Yeah, I'm sorry. 521 00:23:25,886 --> 00:23:28,251 AUDIENCE: Is the company paying the money? 522 00:23:28,251 --> 00:23:30,150 I thought it was like the market who gives it. 523 00:23:30,150 --> 00:23:34,840 PROFESSOR: The owners are paying the money, the owners. 524 00:23:34,840 --> 00:23:36,560 AUDIENCE: People who are buying the stock are 525 00:23:36,560 --> 00:23:37,910 exercising the option to. 526 00:23:37,910 --> 00:23:38,230 PROFESSOR: No. 527 00:23:38,230 --> 00:23:39,270 But here's the thing. 528 00:23:39,270 --> 00:23:42,460 When I gave it to you, then, basically, I gave you 529 00:23:42,460 --> 00:23:43,260 something of value. 530 00:23:43,260 --> 00:23:45,050 I have to pay for that thing of value. 531 00:23:45,050 --> 00:23:46,010 Now, ultimately, the transaction 532 00:23:46,010 --> 00:23:47,250 happens in the market. 533 00:23:47,250 --> 00:23:50,600 But, basically, in other words, I give you this option 534 00:23:50,600 --> 00:23:52,390 to buy the stock at $100. 535 00:23:52,390 --> 00:23:53,840 This is an important point that I wasn't clear enough on. 536 00:23:53,840 --> 00:23:56,230 I give you an option to buy a stock at $100. 537 00:23:56,230 --> 00:23:58,750 The stock is now worth $150. 538 00:23:58,750 --> 00:24:02,440 That means that stock I could have had at $150 as an owner. 539 00:24:02,440 --> 00:24:02,830 And it's worth $150. 540 00:24:02,830 --> 00:24:08,530 But by letting you take it at $100, I let you keep the extra 541 00:24:08,530 --> 00:24:09,810 $50 instead of me getting it. 542 00:24:09,810 --> 00:24:12,620 I have a share of stock which [INAUDIBLE] 543 00:24:12,620 --> 00:24:16,000 $150. 544 00:24:16,000 --> 00:24:18,290 I've given that to you. 545 00:24:18,290 --> 00:24:21,248 I've, essentially, transferred to you $150. 546 00:24:21,248 --> 00:24:23,638 AUDIENCE: So when companies [INAUDIBLE PHRASE]. 547 00:24:28,900 --> 00:24:30,700 PROFESSOR: They'll keep some amount of shares. 548 00:24:33,910 --> 00:24:36,450 The owners, they will sell stock 549 00:24:36,450 --> 00:24:37,430 and they'll do offerings. 550 00:24:37,430 --> 00:24:39,070 But the owners own the majority of the stock. 551 00:24:39,070 --> 00:24:40,450 That's what makes them the owners. 552 00:24:40,450 --> 00:24:42,250 Maybe that's the right way to put it. 553 00:24:42,250 --> 00:24:43,500 AUDIENCE: [INAUDIBLE PHRASE]. 554 00:24:48,310 --> 00:24:48,530 PROFESSOR: No. 555 00:24:48,530 --> 00:24:52,810 Well, in principle, the board of directors approves stock. 556 00:24:52,810 --> 00:24:53,510 They don't decide. 557 00:24:53,510 --> 00:24:55,520 An executive management committee decides. 558 00:24:55,520 --> 00:24:57,240 The executive management committee consists of all the 559 00:24:57,240 --> 00:24:59,162 golf buddies of the CEO. 560 00:24:59,162 --> 00:25:00,090 They decide. 561 00:25:00,090 --> 00:25:01,770 The board of directors is supposed to make sure nothing 562 00:25:01,770 --> 00:25:03,055 untoward happens. 563 00:25:03,055 --> 00:25:05,720 The board of directors, they're just a bunch of 564 00:25:05,720 --> 00:25:07,390 retired former executives who are also golf 565 00:25:07,390 --> 00:25:09,030 buddies of the manager. 566 00:25:09,030 --> 00:25:11,580 So they don't really get it right. 567 00:25:11,580 --> 00:25:12,820 So there's outright cheating. 568 00:25:12,820 --> 00:25:17,310 So, for instance, one CEO, he got six stock options. 569 00:25:17,310 --> 00:25:21,870 Each one happened to be issued, happened to be issued 570 00:25:21,870 --> 00:25:24,040 the day before-- at least on paper-- was issued the day 571 00:25:24,040 --> 00:25:26,900 before a huge increase in the stock price. 572 00:25:26,900 --> 00:25:28,655 Now, the CEO said he was just lucky. 573 00:25:28,655 --> 00:25:31,030 But the Wall Street Journal did a simulation and 574 00:25:31,030 --> 00:25:33,080 calculated that there's a 1 in 1 billion chance he could've 575 00:25:33,080 --> 00:25:34,400 been that lucky. 576 00:25:34,400 --> 00:25:36,350 That, in fact, what clearly happened was he got the stock 577 00:25:36,350 --> 00:25:39,040 options later, and they were backdated to make it seem like 578 00:25:39,040 --> 00:25:40,980 he got them before the price went up. 579 00:25:40,980 --> 00:25:42,610 But that's not the best example. 580 00:25:42,610 --> 00:25:44,990 The best example is Cablevision. 581 00:25:44,990 --> 00:25:47,670 They granted and backdated options to their vice chairman 582 00:25:47,670 --> 00:25:49,080 from 1997 to 2002. 583 00:25:49,080 --> 00:25:52,010 So from 1997 to 2002, they gave them options and they 584 00:25:52,010 --> 00:25:54,780 kept backdating them to make them look good. 585 00:25:54,780 --> 00:25:58,870 The only problem was that he died in 1999. 586 00:25:58,870 --> 00:26:01,380 So, basically, they were just giving money away to this 587 00:26:01,380 --> 00:26:02,000 guy's heirs. 588 00:26:02,000 --> 00:26:04,350 Clearly they weren't incentivizing his performance. 589 00:26:04,350 --> 00:26:07,400 As the quote said, trying to incentivize a corpse suggests 590 00:26:07,400 --> 00:26:09,650 they were not complying with the spirit of shareholder 591 00:26:09,650 --> 00:26:11,840 approved stock option plans. 592 00:26:11,840 --> 00:26:13,740 They were just giving money to his heirs, because they felt 593 00:26:13,740 --> 00:26:15,760 bad for him, because they weren't keeping their yacht up 594 00:26:15,760 --> 00:26:17,360 or whatever. 595 00:26:17,360 --> 00:26:20,520 So, basically, this is an example of a kind of cheating. 596 00:26:20,520 --> 00:26:21,850 Of course, then you can go further, and 597 00:26:21,850 --> 00:26:24,030 there's outright fraud. 598 00:26:24,030 --> 00:26:25,810 The backdating is sort of cheating. 599 00:26:25,810 --> 00:26:26,750 You can go even further. 600 00:26:26,750 --> 00:26:30,860 I don't know what determines fraud versus cheating. 601 00:26:30,860 --> 00:26:33,050 You can just do what Enron did. 602 00:26:33,050 --> 00:26:35,040 What Enron did is the executives there just lied 603 00:26:35,040 --> 00:26:36,590 about how much money they were making. 604 00:26:36,590 --> 00:26:39,100 They just went public with figures that were wrong. 605 00:26:39,100 --> 00:26:40,710 The stock price went up. 606 00:26:40,710 --> 00:26:44,480 They cashed in their options and quit. 607 00:26:44,480 --> 00:26:47,410 And as long as you don't get caught, that's a great deal. 608 00:26:47,410 --> 00:26:50,580 And if you do get caught, well, they fine you for 1/3 of 609 00:26:50,580 --> 00:26:51,640 what you made. 610 00:26:51,640 --> 00:26:53,080 So who cares? 611 00:26:53,080 --> 00:26:54,950 So basically it was outright fraud. 612 00:26:54,950 --> 00:26:56,630 And this was a lot of what happened. 613 00:26:56,630 --> 00:26:58,280 A lot of the wealth that we thought was created in the 614 00:26:58,280 --> 00:27:01,200 1990s in the stock market was really just false wealth 615 00:27:01,200 --> 00:27:03,160 created by people saying their company's were worth more than 616 00:27:03,160 --> 00:27:04,190 they actually were. 617 00:27:04,190 --> 00:27:05,006 Yeah. 618 00:27:05,006 --> 00:27:07,386 AUDIENCE: Who decides the salary [INAUDIBLE PHRASE]. 619 00:27:12,370 --> 00:27:13,690 PROFESSOR: No. 620 00:27:13,690 --> 00:27:16,010 I mean, once again, it varies by company to company. 621 00:27:16,010 --> 00:27:19,260 But, basically, the dividend payout would be something that 622 00:27:19,260 --> 00:27:22,110 a different set of managers would decide, once again, 623 00:27:22,110 --> 00:27:24,410 subject to approval of the owners. 624 00:27:24,410 --> 00:27:27,710 But, once again, the point is that the owners of a company, 625 00:27:27,710 --> 00:27:29,880 of a big company, are just a diffuse set of people who 626 00:27:29,880 --> 00:27:32,570 don't know what they're doing. 627 00:27:32,570 --> 00:27:34,790 The managers know exactly what they're doing. 628 00:27:34,790 --> 00:27:37,580 The board of directors is in between and is half clueless, 629 00:27:37,580 --> 00:27:38,960 half knows what it's doing. 630 00:27:38,960 --> 00:27:42,390 And that's what leads to the agency problem. 631 00:27:42,390 --> 00:27:44,920 What's so interesting about this example is it sort of 632 00:27:44,920 --> 00:27:48,160 points out, like in many things in economics, why we're 633 00:27:48,160 --> 00:27:49,630 called the dismal science. 634 00:27:49,630 --> 00:27:52,070 There is no right answer here. 635 00:27:52,070 --> 00:27:55,340 On the one hand, if you don't incentivize your owners, then 636 00:27:55,340 --> 00:27:57,500 they might not do what's profit maximizing. 637 00:27:57,500 --> 00:28:00,000 On the other hand, if they incentivize your owners, they 638 00:28:00,000 --> 00:28:02,735 might do cheating to maximize their profits as opposed to 639 00:28:02,735 --> 00:28:03,640 the company's profits. 640 00:28:03,640 --> 00:28:05,390 And that's why you need complicated structures, the 641 00:28:05,390 --> 00:28:07,050 type that was suggested in the back. 642 00:28:07,050 --> 00:28:09,480 And that's why, for example, they find that companies with 643 00:28:09,480 --> 00:28:11,760 much more concentrated ownership, the ones that 644 00:28:11,760 --> 00:28:14,795 Warren Buffett owns 20% of, they do a much better job in 645 00:28:14,795 --> 00:28:17,110 their CEO compensation than the ones where it's just a 646 00:28:17,110 --> 00:28:20,480 bunch of people owning a tiny, tiny percent. 647 00:28:20,480 --> 00:28:25,460 So that's exactly the kind of difficulty you face in setting 648 00:28:25,460 --> 00:28:27,380 up executive compensation. 649 00:28:27,380 --> 00:28:30,610 Now, this was a real departure from the kind of things we 650 00:28:30,610 --> 00:28:32,830 talked about, just one example. 651 00:28:32,830 --> 00:28:34,410 Partly what we want to do in this course, I want to teach 652 00:28:34,410 --> 00:28:35,300 you about basic economics. 653 00:28:35,300 --> 00:28:37,450 I partly want to excite you about what else you can go on 654 00:28:37,450 --> 00:28:39,390 and do in economics. 655 00:28:39,390 --> 00:28:41,820 What I've just done in the last half hour is a microcosm 656 00:28:41,820 --> 00:28:44,320 of the field of corporate finance. 657 00:28:44,320 --> 00:28:45,350 There's an entire field in economics 658 00:28:45,350 --> 00:28:46,100 called corporate finance. 659 00:28:46,100 --> 00:28:47,890 We teach it in course 15. 660 00:28:47,890 --> 00:28:48,950 And it's a terrific course. 661 00:28:48,950 --> 00:28:51,690 15.401 and 15.402 are the introductory courses. 662 00:28:51,690 --> 00:28:53,670 And if you find this stuff exciting, as I'm sensing some 663 00:28:53,670 --> 00:28:55,930 of you are, that's a great place to take what we're 664 00:28:55,930 --> 00:28:58,110 learning in this course and go on and actually dive in. 665 00:28:58,110 --> 00:28:59,540 Realize that half the stuff I've told you, I'm 666 00:28:59,540 --> 00:29:00,300 talking out of my ass. 667 00:29:00,300 --> 00:29:01,410 I don't really know for sure. 668 00:29:01,410 --> 00:29:03,880 But those guys do in course 15. 669 00:29:03,880 --> 00:29:07,830 And you can really get into these agency relationships and 670 00:29:07,830 --> 00:29:10,100 understand our corporations work and how you set up these 671 00:29:10,100 --> 00:29:11,925 kinds of compensation arrangements. 672 00:29:11,925 --> 00:29:14,970 So this is kind of just a very exciting area. 673 00:29:14,970 --> 00:29:16,460 Now, we're going to go back after this and assume 674 00:29:16,460 --> 00:29:18,390 corporations maximize profits again. 675 00:29:18,390 --> 00:29:21,200 And, once again, as with any assumption we make, by and 676 00:29:21,200 --> 00:29:21,910 large, it's right. 677 00:29:21,910 --> 00:29:25,200 And by and large it will deliver the kind of important 678 00:29:25,200 --> 00:29:27,280 knowledge that we need to know about how firms function. 679 00:29:27,280 --> 00:29:28,710 But it's important to remember that these kinds of 680 00:29:28,710 --> 00:29:29,470 things are behind it. 681 00:29:29,470 --> 00:29:32,110 What we do in this course is teach you the basics. 682 00:29:32,110 --> 00:29:34,540 Then you go on in these other electives and actually learn 683 00:29:34,540 --> 00:29:35,830 about this kind of more interesting tweaks 684 00:29:35,830 --> 00:29:37,930 and what we do here. 685 00:29:37,930 --> 00:29:41,590 And other questions about this before I move on? 686 00:29:41,590 --> 00:29:43,250 OK. 687 00:29:43,250 --> 00:29:46,840 Now we're going to stop with that topic, and we're going to 688 00:29:46,840 --> 00:29:51,380 move to sort of an in between topic. 689 00:29:51,380 --> 00:29:54,760 That is, we've been talking about firms and firm profit 690 00:29:54,760 --> 00:29:55,870 maximization. 691 00:29:55,870 --> 00:29:57,660 And we talked about how that depends on the structure of 692 00:29:57,660 --> 00:30:00,030 the market and perfect competition. 693 00:30:00,030 --> 00:30:03,370 Starting in two lectures, we're going to start talking 694 00:30:03,370 --> 00:30:05,170 about alternative market structures like 695 00:30:05,170 --> 00:30:07,240 monopoly and oligopoly. 696 00:30:07,240 --> 00:30:10,550 But in order to talk about them, we need to introduce a 697 00:30:10,550 --> 00:30:12,670 new concept we haven't used before. 698 00:30:12,670 --> 00:30:13,560 And that's what we'll do the rest of this 699 00:30:13,560 --> 00:30:16,010 lecture and next lecture. 700 00:30:16,010 --> 00:30:19,490 We need to move from positive economics to normative 701 00:30:19,490 --> 00:30:27,080 economics, from positive economics to normative. 702 00:30:30,670 --> 00:30:35,540 Positive analysis is the study of the way things are. 703 00:30:35,540 --> 00:30:37,990 So positive analysis is explaining why do firms 704 00:30:37,990 --> 00:30:39,360 produce this many widgets? 705 00:30:39,360 --> 00:30:41,080 Why do they hire this many workers? 706 00:30:41,080 --> 00:30:43,170 Why did I buy this many CDs? 707 00:30:43,170 --> 00:30:45,050 That's a positive analysis, trying to explain the way 708 00:30:45,050 --> 00:30:46,570 things are. 709 00:30:46,570 --> 00:30:49,150 That's what we've done, by and large, so far. 710 00:30:49,150 --> 00:30:52,130 Normative analysis is the analysis of the way 711 00:30:52,130 --> 00:30:54,100 things should be. 712 00:30:54,100 --> 00:30:56,380 Is it good that I bought that many CDs? 713 00:30:56,380 --> 00:30:58,690 Is it good that the company made that much profits? 714 00:30:58,690 --> 00:31:01,430 Would be better if we have a minimum wage or don't have a 715 00:31:01,430 --> 00:31:03,250 minimum wage? 716 00:31:03,250 --> 00:31:05,110 Normative analysis is the analysis of the way things 717 00:31:05,110 --> 00:31:08,690 should be as opposed to the way they are. 718 00:31:08,690 --> 00:31:12,780 So, for example, we showed in the last lecture that in the 719 00:31:12,780 --> 00:31:16,910 long run, with free entry and exit, all firms are driven to 720 00:31:16,910 --> 00:31:20,250 zero profit, and the supply curve is horizontal. 721 00:31:20,250 --> 00:31:22,860 Well, is that a good thing? 722 00:31:22,860 --> 00:31:23,300 We don't know. 723 00:31:23,300 --> 00:31:24,520 We just said it happened. 724 00:31:24,520 --> 00:31:25,565 I described why it happened. 725 00:31:25,565 --> 00:31:26,230 But I didn't tell you if it was a good 726 00:31:26,230 --> 00:31:27,710 thing or a bad thing. 727 00:31:27,710 --> 00:31:30,360 Zero profits, I make a lot of money off the profits that the 728 00:31:30,360 --> 00:31:32,800 companies I own make. 729 00:31:32,800 --> 00:31:35,500 I don't know if I want to work with zero profits. 730 00:31:35,500 --> 00:31:36,910 I've got a lot of stock and stuff. 731 00:31:36,910 --> 00:31:39,010 And I'm making money because these companies make profits. 732 00:31:39,010 --> 00:31:39,975 I don't think I'd be that happy to 733 00:31:39,975 --> 00:31:41,000 work with zero profits. 734 00:31:41,000 --> 00:31:42,110 How do we think about whether that's a good 735 00:31:42,110 --> 00:31:43,550 world or a bad world? 736 00:31:43,550 --> 00:31:46,240 How do we think about whether we like these outcomes or 737 00:31:46,240 --> 00:31:48,500 don't like them? 738 00:31:48,500 --> 00:31:51,635 These are the tools of normative economics or what we 739 00:31:51,635 --> 00:31:54,280 will refer to as welfare economics. 740 00:31:57,150 --> 00:31:59,010 Now, let me be clear here. 741 00:31:59,010 --> 00:32:01,330 The term welfare, as you might have heard it, often refers to 742 00:32:01,330 --> 00:32:03,040 money you give to low income populations. 743 00:32:03,040 --> 00:32:04,250 And we'll talk about that kind of welfare 744 00:32:04,250 --> 00:32:05,700 later in the semester. 745 00:32:05,700 --> 00:32:08,020 Here, when I say welfare, I mean well-being. 746 00:32:08,020 --> 00:32:10,350 Welfare is the term economists use as the measure of 747 00:32:10,350 --> 00:32:12,080 well-being. 748 00:32:12,080 --> 00:32:15,330 We need to start talking about welfare economics, measuring 749 00:32:15,330 --> 00:32:19,170 the impact of economic outcomes on well-being, not 750 00:32:19,170 --> 00:32:22,540 just studying what happens when firms maximize profits or 751 00:32:22,540 --> 00:32:26,180 consumers maximize utility, but measuring how we feel 752 00:32:26,180 --> 00:32:30,760 about it, measuring whether it's good or bad, and 753 00:32:30,760 --> 00:32:32,460 measuring whether some outcomes might be 754 00:32:32,460 --> 00:32:33,240 preferred to others. 755 00:32:33,240 --> 00:32:36,190 Because if we don't do that, we can't ever talk about the 756 00:32:36,190 --> 00:32:38,380 role of the government in the economy. 757 00:32:38,380 --> 00:32:41,480 Until you start talking about welfare, you can't talk about 758 00:32:41,480 --> 00:32:42,330 whether we should have government 759 00:32:42,330 --> 00:32:44,310 interventions or not. 760 00:32:44,310 --> 00:32:45,960 You can only talk about what happens, not 761 00:32:45,960 --> 00:32:48,160 whether it should happen. 762 00:32:48,160 --> 00:32:51,210 Now, the problem of welfare economics is that it's a lot 763 00:32:51,210 --> 00:32:53,670 harder because of something I mentioned when we 764 00:32:53,670 --> 00:32:55,550 talked about utility. 765 00:32:55,550 --> 00:33:00,200 Utility is an ordinal concept, not a cardinal concept. 766 00:33:00,200 --> 00:33:01,950 Utility is an ordinal concept, not a cardinal concept. 767 00:33:01,950 --> 00:33:04,660 That is, utils are meaningless. 768 00:33:04,660 --> 00:33:06,970 We use utility functions to decide whether you prefer 769 00:33:06,970 --> 00:33:09,830 package A or package B. But the actual amount of utils you 770 00:33:09,830 --> 00:33:14,100 get, unlike profits, is sort of a meaningless concept. 771 00:33:14,100 --> 00:33:17,060 It's just sort of an index. 772 00:33:17,060 --> 00:33:19,500 So what we do to do welfare economics is we turn from 773 00:33:19,500 --> 00:33:21,920 utils to dollars. 774 00:33:21,920 --> 00:33:24,810 We measure welfare in dollars which is easy on 775 00:33:24,810 --> 00:33:26,050 the corporate side. 776 00:33:26,050 --> 00:33:27,520 That's profits. 777 00:33:27,520 --> 00:33:28,650 How do we do it on the consumer side? 778 00:33:28,650 --> 00:33:31,730 We do it through the concept that we call compensating 779 00:33:31,730 --> 00:33:38,310 variation, which is one of these things where economists 780 00:33:38,310 --> 00:33:40,380 use fancy terms for something which isn't that hard to 781 00:33:40,380 --> 00:33:42,530 understand. 782 00:33:42,530 --> 00:33:44,210 But you need to know the fancy terms, because that's kind of 783 00:33:44,210 --> 00:33:46,700 how we teach, compensating variation. 784 00:33:46,700 --> 00:33:53,510 That is instead of asking, how sad are you about outcome x, 785 00:33:53,510 --> 00:33:56,325 we ask, how many dollars would it take? 786 00:33:59,110 --> 00:34:03,590 Instead of asking, how sad would you be to not have a CD, 787 00:34:03,590 --> 00:34:06,680 we ask, how much would you pay to avoid 788 00:34:06,680 --> 00:34:07,930 being in that situation? 789 00:34:10,120 --> 00:34:16,920 So instead of asking, how sad are you that you end up with 790 00:34:16,920 --> 00:34:20,639 this car instead of that car, we don't want to measure the 791 00:34:20,639 --> 00:34:22,980 utils of driving a Hyundai versus a Lexus. 792 00:34:22,980 --> 00:34:23,960 We can't measure those. 793 00:34:23,960 --> 00:34:27,810 What we can ask, is how much more will you pay to get the 794 00:34:27,810 --> 00:34:29,730 Lexus than the Hyundai? 795 00:34:29,730 --> 00:34:33,030 And that's $1 measure of your utils. 796 00:34:33,030 --> 00:34:34,260 That's a compensating variation. 797 00:34:34,260 --> 00:34:38,010 How much do you have to be compensated? 798 00:34:38,010 --> 00:34:41,719 So, in other words, instead of asking you how sad are you 799 00:34:41,719 --> 00:34:44,280 that you couldn't get tickets to a Lady Gaga concert-- 800 00:34:44,280 --> 00:34:46,159 maybe that's not a good example because no one's sad 801 00:34:46,159 --> 00:34:46,580 about that. 802 00:34:46,580 --> 00:34:48,630 But let's say you were. 803 00:34:48,630 --> 00:34:51,560 Let's say I am because my daughter wants to see her. 804 00:34:51,560 --> 00:34:52,650 How sad are you? 805 00:34:52,650 --> 00:34:56,050 I ask, instead, how much would you pay to get the tickets to 806 00:34:56,050 --> 00:34:57,300 the Lady Gaga concert? 807 00:34:59,630 --> 00:35:01,140 That's a measure of how sad you were you 808 00:35:01,140 --> 00:35:02,310 couldn't get them. 809 00:35:02,310 --> 00:35:05,490 Because you'll pay an amount to compensate yourself for the 810 00:35:05,490 --> 00:35:07,040 sadness of not getting them. 811 00:35:07,040 --> 00:35:10,340 So it's a way of turning utils into dollars. 812 00:35:10,340 --> 00:35:12,750 And that leads to the concept that we'll refer to throughout 813 00:35:12,750 --> 00:35:14,000 the semester. 814 00:35:15,760 --> 00:35:18,370 That leads to the concept of consumer surplus. 815 00:35:24,890 --> 00:35:30,620 Consumer surplus measures the benefit that a consumer gets 816 00:35:30,620 --> 00:35:34,740 from consuming a good above and beyond what they 817 00:35:34,740 --> 00:35:36,250 paid for the good. 818 00:35:36,250 --> 00:35:50,110 So it's the benefit of consumption beyond the price. 819 00:35:50,110 --> 00:35:51,770 So your consumer surplus-- 820 00:35:51,770 --> 00:35:53,480 surplus means extra-- 821 00:35:53,480 --> 00:35:56,400 is how much you enjoy consuming something above and 822 00:35:56,400 --> 00:35:59,210 beyond what you had to pay for it. 823 00:35:59,210 --> 00:36:04,450 In other words, the idea is if you have to pay exactly as 824 00:36:04,450 --> 00:36:07,390 much as you'd enjoy the good, there's no consumer surplus. 825 00:36:07,390 --> 00:36:08,930 So let's do an example. 826 00:36:08,930 --> 00:36:13,490 So consider my demand to buy a Lady Gaga CD. 827 00:36:13,490 --> 00:36:14,330 I've got to update my examples. 828 00:36:14,330 --> 00:36:15,400 You guys don't buy CDs anymore. 829 00:36:15,400 --> 00:36:19,680 How many of you have bought a CD in the last year? 830 00:36:19,680 --> 00:36:20,822 Wow. 831 00:36:20,822 --> 00:36:21,950 OK, let me ask another question, 832 00:36:21,950 --> 00:36:22,380 just one for the record. 833 00:36:22,380 --> 00:36:23,980 Just because I have to decide how hard a time to give my 834 00:36:23,980 --> 00:36:25,090 16-year-old son. 835 00:36:25,090 --> 00:36:29,283 How many of you typically pay when you buy a song? 836 00:36:29,283 --> 00:36:30,610 Wow. 837 00:36:30,610 --> 00:36:30,770 OK. 838 00:36:30,770 --> 00:36:31,200 Let me ask another one. 839 00:36:31,200 --> 00:36:35,790 How many of you typically don't pay when you buy a song. 840 00:36:35,790 --> 00:36:37,730 Well, when you get a song, when you download a song, you 841 00:36:37,730 --> 00:36:39,090 know what I mean, when you download a song. 842 00:36:39,090 --> 00:36:40,950 So the majority of you don't pay when you download a song. 843 00:36:40,950 --> 00:36:41,360 Interesting. 844 00:36:41,360 --> 00:36:42,610 OK. 845 00:36:44,900 --> 00:36:46,160 I'll update this next year. 846 00:36:46,160 --> 00:36:47,440 But, for now, we're still 10 years ago. 847 00:36:47,440 --> 00:36:49,810 Consider my demand for Lady Gaga CDs. 848 00:36:49,810 --> 00:36:53,310 I'm trying to decide whether to buy the marginal CD. 849 00:36:53,310 --> 00:36:58,380 And let's say that it's worth $15 to me. 850 00:36:58,380 --> 00:37:00,980 I'd be willing to pay $15 for the Lady Gaga CD. 851 00:37:00,980 --> 00:37:03,890 And let's say the price is $15. 852 00:37:03,890 --> 00:37:07,850 In that case, there's no surplus to me. 853 00:37:07,850 --> 00:37:08,980 There's nothing extra. 854 00:37:08,980 --> 00:37:11,005 I've paid what I was willing to pay. 855 00:37:11,005 --> 00:37:14,000 So that's a case of a zero consumer surplus. 856 00:37:14,000 --> 00:37:16,940 The consumer surplus is how much extra I got from 857 00:37:16,940 --> 00:37:17,330 consuming it. 858 00:37:17,330 --> 00:37:18,085 I've got no extra. 859 00:37:18,085 --> 00:37:19,460 It was worth $15. 860 00:37:19,460 --> 00:37:22,850 I paid $15, no surplus. 861 00:37:22,850 --> 00:37:27,730 Now let's say that the price was $10. 862 00:37:27,730 --> 00:37:29,130 Then I've got a surplus. 863 00:37:29,130 --> 00:37:30,340 I've got $5 in surplus. 864 00:37:30,340 --> 00:37:32,050 I was willing to pay $15. 865 00:37:32,050 --> 00:37:36,410 It makes me $15 happier to have this Lady Gaga CD. 866 00:37:36,410 --> 00:37:38,170 But I only had to pay $10 for it. 867 00:37:38,170 --> 00:37:40,930 So I've derived some surplus. 868 00:37:40,930 --> 00:37:43,670 Well, how do we know what people's willingness to pay 869 00:37:43,670 --> 00:37:46,680 for a good is? 870 00:37:46,680 --> 00:37:48,320 The demand curve. 871 00:37:48,320 --> 00:37:50,300 That's the definition of the demand curve. 872 00:37:50,300 --> 00:37:53,470 The demand curve measures your willingness to pay. 873 00:37:53,470 --> 00:37:55,530 So let's go to the second figure. 874 00:37:55,530 --> 00:38:00,300 Think about the demand curve for CDs. 875 00:38:00,300 --> 00:38:02,740 There's some demand curve for CDs. 876 00:38:02,740 --> 00:38:07,880 What this measures is the utility maximizing choice. 877 00:38:07,880 --> 00:38:12,030 Every point in this demand curve represents my utility 878 00:38:12,030 --> 00:38:15,240 maximizing choice at that price. 879 00:38:18,980 --> 00:38:22,000 This is backwards. 880 00:38:22,000 --> 00:38:24,830 That should be a $15 on the y-axis and a $5 on the x-axis, 881 00:38:24,830 --> 00:38:25,290 Sorry, guys. 882 00:38:25,290 --> 00:38:29,130 It should be $15 on the y-axis and a-- 883 00:38:29,130 --> 00:38:29,430 no. 884 00:38:29,430 --> 00:38:30,030 Wait, hold on one second. 885 00:38:30,030 --> 00:38:31,280 Time out. 886 00:38:33,190 --> 00:38:34,910 At $5, I get no consumer surplus. 887 00:38:45,072 --> 00:38:46,580 Yeah, this graph is kind of messed up. 888 00:38:46,580 --> 00:38:47,830 Let me draw a new one here. 889 00:38:51,000 --> 00:38:53,270 So you've got my demand curve for CDs. 890 00:38:53,270 --> 00:38:54,535 You've got the quantity and the price. 891 00:38:57,910 --> 00:39:04,390 And I've got some utility function that delivers this 892 00:39:04,390 --> 00:39:05,580 demand curve. 893 00:39:05,580 --> 00:39:08,210 And let's say the way this works, this demand curve for 894 00:39:08,210 --> 00:39:12,290 CDs, let's say the way this works is that I am 895 00:39:12,290 --> 00:39:16,280 willing to buy 1 CD. 896 00:39:16,280 --> 00:39:21,500 I'm willing to buy if the price is $20, I'm 897 00:39:21,500 --> 00:39:24,160 willing to buy 1 CD. 898 00:39:24,160 --> 00:39:28,200 So at a price of $20, I'm willing to buy 1 CD. 899 00:39:28,200 --> 00:39:32,290 So if I get that 1 CD at $20, then basically that's my 900 00:39:32,290 --> 00:39:33,540 willingness to pay. 901 00:39:33,540 --> 00:39:36,020 It equals a price, so there's no consumer surplus. 902 00:39:36,020 --> 00:39:38,180 Really imagine it's right next to that y-axis. 903 00:39:47,280 --> 00:39:52,740 Now let's the price falls to $15. 904 00:39:52,740 --> 00:39:53,040 Sorry. 905 00:39:53,040 --> 00:39:54,100 That's a 1. 906 00:39:54,100 --> 00:39:54,510 That's the 1. 907 00:39:54,510 --> 00:39:55,225 That's a 20. 908 00:39:55,225 --> 00:39:57,340 At a price of $20, I'm willing to buy 1. 909 00:39:57,340 --> 00:40:00,290 At a price of $15, I'm willing to buy 5. 910 00:40:00,290 --> 00:40:01,540 I'm willing to buy 5 CDs. 911 00:40:04,440 --> 00:40:06,680 Now, what is my consumer surplus? 912 00:40:06,680 --> 00:40:08,030 Well, let's ask. 913 00:40:08,030 --> 00:40:12,290 For the first CD, I got no consumer surplus. 914 00:40:12,290 --> 00:40:17,410 But for the second, I was willing to pay. 915 00:40:17,410 --> 00:40:19,120 When the price was $20, I got no consumer surplus. 916 00:40:19,120 --> 00:40:21,270 Now let's say the price is $15. 917 00:40:21,270 --> 00:40:24,840 So what was I willing to pay for the first CD? 918 00:40:24,840 --> 00:40:25,460 $20. 919 00:40:25,460 --> 00:40:27,363 So what's my consumer surplus on the first CD? 920 00:40:27,363 --> 00:40:28,670 5. 921 00:40:28,670 --> 00:40:32,150 So on that first CD, I got a consumer surplus of 5. 922 00:40:32,150 --> 00:40:35,780 The second CD, I was willing to pay less because I've got 923 00:40:35,780 --> 00:40:37,160 diminishing marginal utility. 924 00:40:37,160 --> 00:40:40,190 But I was still willing to pay more than $15. 925 00:40:40,190 --> 00:40:42,170 So I've got some surplus there. 926 00:40:42,170 --> 00:40:43,790 Third CD here, et cetera. 927 00:40:43,790 --> 00:40:47,870 But on the fifth CD, I derive no surplus, because I was 928 00:40:47,870 --> 00:40:51,535 willing to pay $15 for that fifth CD, and I paid $15 for 929 00:40:51,535 --> 00:40:53,080 that fifth CD. 930 00:40:53,080 --> 00:40:59,500 What that means is that all of this is my consumer surplus. 931 00:40:59,500 --> 00:41:05,640 Because on every unit, because I paid a fixed price of $15, 932 00:41:05,640 --> 00:41:08,640 and for my fifth CD, that delivered no surplus, that was 933 00:41:08,640 --> 00:41:09,330 indifferent. 934 00:41:09,330 --> 00:41:13,470 But in my first through fourth CDs, that made me very happy. 935 00:41:13,470 --> 00:41:16,900 Because I was willing to pay more than $15 for those. 936 00:41:16,900 --> 00:41:20,800 So my consumer surplus is the amount by which I derive 937 00:41:20,800 --> 00:41:22,740 utility above what I was willing to 938 00:41:22,740 --> 00:41:25,400 pay, above the price-- 939 00:41:25,400 --> 00:41:26,580 I'm sorry-- the amount that I was willing to 940 00:41:26,580 --> 00:41:28,010 pay about the price. 941 00:41:28,010 --> 00:41:31,070 The amount I'm willing to pay is every point on this curve. 942 00:41:31,070 --> 00:41:36,250 So anything I buy that I was willing to pay more for the 943 00:41:36,250 --> 00:41:37,710 price for, I derived surplus on. 944 00:41:37,710 --> 00:41:41,670 So this becomes my consumer surplus. 945 00:41:41,670 --> 00:41:46,380 So, basically, consumer surplus is the area under the 946 00:41:46,380 --> 00:41:50,000 demand curve above the price. 947 00:41:50,000 --> 00:41:52,810 So, graphically, consumer surplus is going to be the 948 00:41:52,810 --> 00:41:56,960 area under the demand curve above the price. 949 00:41:56,960 --> 00:41:59,110 Intuitively, why is that? 950 00:41:59,110 --> 00:42:04,510 Intuitively, what's going on is that every unit above the 951 00:42:04,510 --> 00:42:07,110 price under the demand curve are units which I valued 952 00:42:07,110 --> 00:42:08,350 higher than the price. 953 00:42:08,350 --> 00:42:11,310 So I get surplus on them. 954 00:42:11,310 --> 00:42:12,000 OK. 955 00:42:12,000 --> 00:42:13,100 Question? 956 00:42:13,100 --> 00:42:13,957 Yeah. 957 00:42:13,957 --> 00:42:15,556 AUDIENCE: If you're [UNINTELLIGIBLE] this, would 958 00:42:15,556 --> 00:42:17,160 you start at zero? 959 00:42:17,160 --> 00:42:19,050 PROFESSOR: Yeah. 960 00:42:19,050 --> 00:42:21,070 Really, in some sense, you'd want to start at zero. 961 00:42:21,070 --> 00:42:22,620 It's really the integral of this whole area. 962 00:42:22,620 --> 00:42:23,660 The problem is it's discrete. 963 00:42:23,660 --> 00:42:26,010 I should have a stepwise curve here. 964 00:42:26,010 --> 00:42:26,790 I made it discrete. 965 00:42:26,790 --> 00:42:30,020 But, really, it's the integral of this area. 966 00:42:30,020 --> 00:42:30,743 Yeah. 967 00:42:30,743 --> 00:42:33,158 AUDIENCE: [INAUDIBLE PHRASE]. 968 00:42:33,158 --> 00:42:34,610 upward sloping demand curve? 969 00:42:34,610 --> 00:42:34,980 PROFESSOR: I'm sorry. 970 00:42:34,980 --> 00:42:37,860 AUDIENCE: With an upward sloping demand curve. 971 00:42:37,860 --> 00:42:40,690 PROFESSOR: With an upward sloping demand curve, well, as 972 00:42:40,690 --> 00:42:42,150 I said, we don't believe in Giffen goods. 973 00:42:42,150 --> 00:42:43,870 We think they are a fantasy. 974 00:42:43,870 --> 00:42:46,650 So with an upward sloping demand curve, 975 00:42:46,650 --> 00:42:47,900 how would that work? 976 00:42:51,700 --> 00:42:56,300 So an upward sloping demand curve, then that would say 977 00:42:56,300 --> 00:43:05,500 that if the price is here, then you'd have an infinite 978 00:43:05,500 --> 00:43:05,990 consumer surplus. 979 00:43:05,990 --> 00:43:08,096 It wouldn't be well-defined. 980 00:43:08,096 --> 00:43:09,590 It wouldn't be well-defined. 981 00:43:09,590 --> 00:43:10,660 So I don't know how you'd do that. 982 00:43:10,660 --> 00:43:13,650 That's why we don't like upward sloping demand curves. 983 00:43:13,650 --> 00:43:14,360 Yeah. 984 00:43:14,360 --> 00:43:14,640 Question? 985 00:43:14,640 --> 00:43:15,420 No? 986 00:43:15,420 --> 00:43:15,890 OK. 987 00:43:15,890 --> 00:43:19,930 So, basically, what you end up with is this consumer surplus 988 00:43:19,930 --> 00:43:22,440 concept which, basically, as pointed out mathematically, is 989 00:43:22,440 --> 00:43:23,820 the integral of this area. 990 00:43:23,820 --> 00:43:25,200 But we're not going to make you integrate. 991 00:43:25,200 --> 00:43:28,480 It's basically this triangle which is basically all the 992 00:43:28,480 --> 00:43:33,010 units above the price, all the units for which you're willing 993 00:43:33,010 --> 00:43:34,290 to pay more than the price. 994 00:43:34,290 --> 00:43:37,990 And you get consumer surplus on every unit you buy up to 995 00:43:37,990 --> 00:43:39,420 the point where your willingness to 996 00:43:39,420 --> 00:43:41,230 pay equals the price. 997 00:43:41,230 --> 00:43:44,320 And that's our normative measure of welfare. 998 00:43:44,320 --> 00:43:47,660 That's our normative measure of how happy you are. 999 00:43:47,660 --> 00:43:49,510 And the key that drives this is 1000 00:43:49,510 --> 00:43:50,370 diminishing marginal utility. 1001 00:43:50,370 --> 00:43:52,540 That's why we don't like upward sloping demand curves. 1002 00:43:52,540 --> 00:43:55,280 What drives this is diminishing marginal utility. 1003 00:43:55,280 --> 00:43:57,860 It's that with each additional unit I'm willing to pay less 1004 00:43:57,860 --> 00:43:59,500 and less for. 1005 00:43:59,500 --> 00:44:01,680 So I'm going to get less and less surplus off each 1006 00:44:01,680 --> 00:44:03,790 additional unit I buy. 1007 00:44:03,790 --> 00:44:05,560 And that's going to be the key thing. 1008 00:44:05,560 --> 00:44:08,540 The key intuition that you guys have to remember is that 1009 00:44:08,540 --> 00:44:12,810 the last unit that I'm willing to buy at that price, by 1010 00:44:12,810 --> 00:44:21,100 definition, I get no surplus on, or I get a $0.001 of 1011 00:44:21,100 --> 00:44:22,510 surplus on. 1012 00:44:22,510 --> 00:44:26,520 Because if I've got a lot of surplus, I'd buy 1 more. 1013 00:44:26,520 --> 00:44:30,670 So, by definition, the marginal unit is the one where 1014 00:44:30,670 --> 00:44:32,850 surplus is driven to 0. 1015 00:44:32,850 --> 00:44:35,810 And units before that are the ones with positive surplus. 1016 00:44:35,810 --> 00:44:37,800 And that's why an important intuition to have is the 1017 00:44:37,800 --> 00:44:40,260 amount of surplus you're going to get from a purchase is 1018 00:44:40,260 --> 00:44:44,040 going to be about how far away from the price point you are. 1019 00:44:44,040 --> 00:44:45,680 Those first units are going to give you more surplus. 1020 00:44:45,680 --> 00:44:48,020 And that's going to dwindle as you get to the actual last 1021 00:44:48,020 --> 00:44:49,940 unit you buy at that price. 1022 00:44:49,940 --> 00:44:51,860 Any questions about that? 1023 00:44:51,860 --> 00:44:52,330 OK. 1024 00:44:52,330 --> 00:44:53,310 Let me stop there. 1025 00:44:53,310 --> 00:44:55,960 We will come back next time, and we're going to spend the 1026 00:44:55,960 --> 00:44:58,150 whole lecture talking about welfare economics, we'll 1027 00:44:58,150 --> 00:45:00,565 introduce producer surplus, and talk about how we then 1028 00:45:00,565 --> 00:45:02,720 think about whether changes are good or bad.