Basic Principles Behind Economic Models Chapter 1 With Illustrations from Ch. 3 and 4

Ten Principles Underlying Economic Models Today’s Focus

How do We Model How People Make Decisions The Basic Foundation Key assumptions Greg’s Second Principle Cost of something is what you have to give up “opportunity cost” – next best alternative/good given up when you chose a good Benefit of good A (chosen) versus benefit of good B Cost of good A includes the cost of not being able to purchase good B Key to modelling decisions will incorporate this tradeoff For each person, some goods are scarce Each person desires many goods Each person is willing to give up some of one economic good to get more of another economic good Tradeoffs Opportunity Cost

A First Model of the Economy Production Possibilities Frontier Curve DEFINITION of 'Production Possibility Frontier - PPF' A curve depicting all maximum output possibilities for two or more goods given a set of inputs (resources, labor, etc.). The PPF assumes that all inputs are used efficiently. A production-possibility frontier is a budget constraint presented by the limitation of available factors of production.

Production Possibilities Frontier Image: Animated Figure 2.1 Lecture notes: Let’s begin by imagining a society that produces only two goods—pizzas and wings. This may not seem very realistic, since the entire economy is comprised of millions of different goods and services, but the benefit of this approach is that it allows us to understand the trade-offs in the production process without making the analysis too complicated. The figure shows the production possibilities frontier for our two-product society. It is important to remember that the number of people and the total resources of this two-product society are fixed. If the economy uses all of its resources to produce pizzas, it can produce 100 pizzas and zero wings. If it uses all of its resources to produce wings, it can make 300 wings and zero pizzas. These outcomes can be found by locating points A and B on the production possibilities frontier. It is unlikely that the society will choose either of these extreme outcomes because it is human nature to enjoy variety. At any combination of wings and pizzas along the production possibilities frontier, the society is using all its resources to be productive. These points are considered efficient because society is producing the largest possible output from its resources. But what about point F, and all the other points located in the purple shaded region? These points represent an outcome inside the production possibilities frontier and are, therefore, inefficient. Whenever society is producing along the production possibilities frontier, the only way to get more of one good is to accept less of the other

Production Possibilities Frontier Why is the PPF downward-sloping? Must give up one good to increase production of another Opportunity Costs Why are we unable to produce certain combinations? Scarcity and limited resources Efficient points Points ON the PPF (A, B, C, and D) Inefficient points Points INSIDE the PPF (F) Workers goofing off, unused buildings Unattainable (for now) points Points OUTSIDE the PPF (E) Lecture notes: Downward-sloping PPF illustrates opportunity costs of production. When we produce more wings, we have to give up some pizza. If we are on the PPF, we can’t JUST produce more wings since we are already using all our resources. If we want more wings, we must take away some resources currently devoted to pizza production. Inefficient points are attainable (we COULD produce at F), but undesirable in the sense that we would do better. F has us producing 40 pizzas and 70 wings. We could produce 40 pizzas and 270 wings. We’re not doing as well as we can. We say “unattainable (for now)” because point E may become attainable later on if we experience economic growth, which may increase resources or technology.

PPF and Opportunity Cost What is opportunity cost Highest-valued alternative foregone What we give up as a result of an action Opportunity cost in this case is the slope of the PPF Slope = rise over run ∆y/∆x = (y2-y1)/(x2-x1)

Production Possibilities Frontier Linear PPF – Opp Costs are constant No Specialization of Labor (or any input) Image: Animated Figure 2.1 Lecture notes: Let’s begin by imagining a society that produces only two goods—pizzas and wings. This may not seem very realistic, since the entire economy is comprised of millions of different goods and services, but the benefit of this approach is that it allows us to understand the trade-offs in the production process without making the analysis too complicated. The figure shows the production possibilities frontier for our two-product society. It is important to remember that the number of people and the total resources of this two-product society are fixed. If the economy uses all of its resources to produce pizzas, it can produce 100 pizzas and zero wings. If it uses all of its resources to produce wings, it can make 300 wings and zero pizzas. These outcomes can be found by locating points A and B on the production possibilities frontier. It is unlikely that the society will choose either of these extreme outcomes because it is human nature to enjoy variety. At any combination of wings and pizzas along the production possibilities frontier, the society is using all its resources to be productive. These points are considered efficient because society is producing the largest possible output from its resources. But what about point F, and all the other points located in the purple shaded region? These points represent an outcome inside the production possibilities frontier and are, therefore, inefficient. Whenever society is producing along the production possibilities frontier, the only way to get more of one good is to accept less of the other

Principle 3: Rational decisions are made at the “margin” What do we mean? When making an economic decision, e.g. to purchase 1 more unit of a good, we compare the marginal (or incremental) benefits against the marginal costs For example When studying for an exam Given you’ve already studied 8 hours, when deciding whether or not to study 1 more hour, you compare the expected benefits (a “marginal” improvement in your grade Versus the next best (highest valued) use of your time E.g., sleeping, eating, time with friends

Making Decisions at the Marginal Back to the First Law of Demand How much of a good do you buy? If the marginal/incremental value of the next unit is less than what it costs, are you willing to buy it? MV < price Don’t buy! MV > price Do buy!

Totals versus Marginals When you make a “consumption” decision You may be comparing Total Value of consuming x amount of the good (TV(x)) to the Total Cost (TC(x)) But it’s really a step-wise comparison If TV(9) > TC(9) Buy at least 9 then check at x =10 If TV(10) < TC(10) Stop at 9 MV(10th unit) less than MC(10th unit) Easier and faster (fewer calculations) to compare marginals than totals

Optimal Decisions Made at the Margin For consumers If price > additional/incremental/marginal “use” value of the good -> don’t buy If price < MV -> buy For suppliers If P > marginal costs of producing that last unit -> supply it to the marketplace (sell it!) If P < MC then don’t produce it

Principle 4: People Respond (rationally) to Economic Incentives An example (Hubbard and O’Brien) Average age of the populations of US, Japan and most Europeans countries are getting older Declining birth rates (below replacement level) People living longer Post WWII baby boom (“mouse in the python”) Challenge for governments as Social security and medical care payments will increase as larger % of population retires Fewer younger folks replacing them in the workforce -> tax payments are decreasing

An Interesting Solution Estonia UN estimated that population would decline by 0.7M by 2050 (from 1.4M to 0.7M) Starting in 2007 Working women paid entire salary up to 15 months for having a child Non-working: $200 per month (avg income ~$650) Impact Birth rate increased from 1.6 to 2.1 children per woman 45 other european countries in the process of adopting a similar set of incentives

Will Women Have More Babies if the Government Pays Them To? Learning Objective 1.1 Making the Connection Will Women Have More Babies if the Government Pays Them To? The Estonian government is encouraged by the results of providing economic incentives and is looking for ways to provide additional incentives to raise the birthrate further.