Growth & Business Cycles Macroeconomics Lesson 9 Spring 2012ICES High School WorkshopsPaul Mueller & Ryan Safner

Models of Markets Why model markets?

Three Facts About the World 1.Individual people pursue goals. 2.We live in a world of scarcity. 3.We have a functioning, complex, social order. ?

The Invisible Hand In civilized society [man] stands at all times in need of the cooperation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons… man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. Book I, Chapter 2.2 Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, …and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. Book I, Chapter 2.2 [Though] he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention…By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. Book IV, Chapter 2.9 Adam Smith ( ) Wealth of Nations (1776)

Human Action Paradigm Each of us acts purposefully. We have ends – desires, goals, objectives, etc We use means to achieve these ends. Only individual people act.

Some Economic Definitions A good is a means to an end. – Is capable of satisfying desires – Anything we want more of When intangible, called a service

Some Economic Definitions A bad is the opposite, hinders our desires, may reduce our utility

Some Economic Definitions We get utility from consuming goods

Subjective Value Each of us has our own preferences that guide our actions These are given, subjective, incomparable!

Three Facts About the World 1.Individual people pursue goals. 2.We live in a world of scarcity. 3.We have a functioning, complex, social order. ?

Scarcity Scarcity is the fundamental economic problem. Human desires are unlimited, our ability to satisfy them are limited.

The Fundamental Economic Problem Efficiency: In a world where finite resources are insufficient to satisfy all human desires, how do we determine how to best use those resources to satisfy desires? We want to “economize”

Choice We can only pursue one goal at a time. This implies that we must choose to pursue an action while forgoing all alternatives

Cost Opportunity cost of every action is the next best alternative forgone – More inclusive than “accounting cost” – “You can’t have your cake and eat it too”

Cost Accounting Cost Opportunity Cost -$120,000 $5.99 Learning a trade, working for 4 years and earning $40,000/year, +$160,000 OR Putting that $5.99 in a bank account, earning 3% interest Buying soup and salad for same price

Value We pursue our highest valued goals first, those that give us the highest utility Value is ordinal, a ranking of goals – This implies a tradeoff between pursuing different goals Subjective, different for each person

The Marginal Paradigm All human action takes place on “the margin” – The distance between two ends – When acting, we only consider how to potentially use an additional, or marginal good ?

The Diamond-Water Paradox How can something so vital as water be cheaper than diamonds, which are…not vital? How can something so vital as water be cheaper than diamonds, which are…not vital?

The Marginal Paradigm Consider if I have 5 gallons of water, and each action will require 1 gallon – My goals: 1.Drink Water 2.Take a Shower 3.Water my Plants 4.Wash my car 5.Change my fish tank – Now suppose I spill one gallon – What action will I not pursue?

The Marginal Paradigm The Law of Diminishing Marginal Utility: – For each additional unit of a good, all else equal, the less marginal utility is gained.

Sources & Further Reading Bastiat, Frederic. Economic Sophism. Menger, Carl Principles of Economics. Mises, Ludwig von Human Action. Smith, Adam An Inquiry into the Nature and Causes of the Wealth of Nations.