Principles of Economics Murat Usman Lecture 1 July 7

Lecture plan Syllabus A short Introduction: what is economics? Book. Lecture Notes. HWKs, the exam, grading. A short Introduction: what is economics? and then… A short case study: What would you do, if you were …

The book Economics, 2e. Gregory Mankiw & Mark Taylor 928 pages, 28x22.3cm Shipping Weight: 4.1 pounds Book website: http://cws.cengage.co.uk/mankiw _taylor2/students/stu_title.htm

Meet the author Gregory Mankiw (rhymes with thank you)

You don’t need to read the book You don’t need to read the book. The library has multiple copies of the book. I have a few copies in my office that you can borrow overnight.

Book recommendation

The course webpage https://ais.ku.edu.tr/course/24056/Default.html

Grading 5 HWK assignments each worth 10 points 5 x 10 points = 50 points Must do them to learn the material You can work in groups of 2 - 3 (3 is max), but you must write individual answers (discuss but don’t directly copy from others’ HWK) In-class exam (second lecture on Wed July 23) 30 points Class participation 20 points Total 100 points

How is your course grade computed? Less than 50 is “No Pass” Between 50 and 80 is “PASS” Above 80 is “PASS with distinction”

Class participation In class experiments / activities / discussions… Please bring a pen/pencil and a piece of paper to each class.

House rules Please turn off laptops, tablets, phones, etc Avoid behavior like always arriving late for class; keeping steady conversation with neighbors during class, engaging in activities unrelated to our class. Be attentive, pay attention to the lecture. Ask questions. If I ask a question make an attempt to come up with a response …

Lecture Notes. PPT slides Detailed, regularly updated. No substitute for lectures. To learn economics you need to do the HWK assignments Exam Multiple choice questions (mostly from the HWKs) + a few short answer questions- simple math calculations (mostly already discussed in class).

Principles of economics Summer 2014: Goals and objectives I want people to… be happy learn some economics pass with distinction

A 5 minute lecture on “What is economics?” Now… A 5 minute lecture on “What is economics?”

Economics is about the allocation of scarce resources.

Example : Your best friend invites you to a open buffet brunch. Money is no object; you can eat as much as you want for free. Time is not an obstacle; it is Saturday, you have all afternoon and would enjoy spending it in the company of your friend. What is the scarce resource here?

If there is scarcity then you have to make choices If there is scarcity then you have to make choices. The trade-off principle: When there is scarcity, then having more of one good thing means having less of another. Dictionary definition of trade off is “a situation in which you must choose between or balance two things that are opposite or cannot be had at the same time” Güzellik mi iyi huy mu?

Now something a little bit confusing… Economics starts with the assumption that people have well- defined objectives/goals and (most of the time) choose the correct way to achieve them. More specifically, economics assumes that people are rational!

Now something really confusing… Which means people follow this simple rule: Do activity x if and only if B(x) > C(x), B(x) is the benefit of activity x (to the individual) C(x) is the cost of activity (to the individual)

A very short case study Now it is your turn

You are the general manager of IL JK company You are the general manager of IL JK company. The company provides extermination services (böcek ilaçlama). There are some administrative personnel who cannot be laid off (işten çıkarma) and … 196 workers who do the actual extermination work and can be.

More information… The company started 5 years ago. It is owned by three families. The work requires only a low level of skills so that each worker needs only one week of training. Almost all workers have been with the company for 3 to 5 years. The company pays its workers more than the minimum wage. The workers’ wages, including overtime, are between TL 1,500 and 1,900 per month. The minimum wage in 2013 was about 970 TL. The company gives its workers all the benefits required by law.

Current situation Until recently, the company was very profitable. As a result of the continuing economic recession, however, there has been a big decrease in profits though the company is still making profits.

The big decision You will soon have a meeting with the owners and your management team must decide how many workers to lay off. IL JK’s Finance Department has prepared the following forecast of annual profits:

Data Number of workers who will continue to be employed Expected annual profit in TL, millions 0 (all the workers will be laid off) Loss of 8 50 (146 workers will be laid off) Profit of 1 65 (131 workers will be laid off) Profit of 1.5 100 (96 workers will be laid off) Profit of 2 144 (52 workers will be laid off) Profit of 1.6 170 (26 workers will be laid off) 196 (no layoffs) Profit of 0.4

Your recommendation? I recommend continuing to employ ______ of the 196 workers in the company. Why? Provide a brief justification for your decision: _______________________________________

This survey question comes from a well known research article A SCEPTIC’S* COMMENT ON THE STUDY OF ECONOMICS by Ariel Rubinstein * someone who habitually doubts accepted beliefs

Ariel Rubinstein is one of the most important and creative economic theorists of our day. His work is in the area of game theory. “I categorically cannot see any case where game theory could be helpful.” http://consultingbyrpm.com/blog/2013/04/ariel-rubinstein-has-amazed-me.html

Short summary of the “A sceptic’s comments….” A survey (anket) was done for two groups of undergraduate economics students and four groups of students in mathematics, law, philosophy and business administration. The main survey question is about a conflict between profit maximisation and the welfare of the workers who would be fired to achieve it. Significant differences were found between the choices of the groups.

Results: Undergraduate students

Results from KU Econ 100 classes in the past…

9 30 section results (N = 80) Number of workers who will continue to be employed 65 2 2.5% 100 (profit max) 31 39% 144 32 40% 170 4 5% 196 11 14%   100% Average layoff 63 workers

11 00 section results (N = 77) Number of workers who will continue to be employed 65 2 3% 100 (profit max) 34 44% 144 25 32% 170 10 13% 196 6 8%   100% Average layoff 66 workers

Why? Justifications Profit-maximizers: “The manager should (ought to) maximize profits.” Non profit-maximizers: Firing too many workers may damage the firm indirectly (bad for company image, negative PR, cost of firing, etc.,) or may hurt the profits in the long run Some respondents (15 in the 9 30 and 18 in the 11 00 section) said we should also consider the welfare of the workers.

Economics start with the assumption that … Now, back to the lecture Economics start with the assumption that …

Economics start with the assumption that … Rational people do activity x if and only if B(x) > C(x), B(x) is the benefit of activity x (to the individual) C(x) is the cost of activity (to the individual) (pretty much ) Everything follows from this assumption.

How do we compute/find/represent the cost and benefit of an action How do we compute/find/represent the cost and benefit of an action? When I ask “what is the cost of a can of Pepsi at Migros”, the answer is clear. In some other situations, it may not be so. We will see more on this.

A detailed example: Should I iron my shirt? [from Ben Bernanke and Robert Frank’s Principles of Economics, 2008] You are going out with your girlfriend tonight, you have 20 minutes of time, your only clean shirt needs ironing! Question. Should you iron the shirt? What will the rational “you” do in this situation?

As a rational person I will Iron the shirt if … benefit > cost

What is the benefit? What is the cost? Benefit: You will look better. Cost: Exert effort, burn fingers? Cannot watch the end of the game/movie, etc. To compare cost and benefit we need to express them in a common unit of measurement. How to assign monetary values to B and C?

Measuring the benefit (in monetary units) We conduct a mental auction to determine the maximum you are willing to pay someone else to iron the shirt for you. Would you pay someone to iron your shirt for 1000 lira? Would you pay someone to iron your shirt for 10 kuruş? Suppose the answer to the 1st question is NO, The answer to the 2nd question is YES.

I will start with the high price of 1000 lira, each time you say NO, I will decrease it by a small amount. Suppose you say YES for the first time when I ask 3 lira for ironing the shirt for you. Then this means that the benefit of this action (iron the shirt) is 3 lira for you.

This is a very important idea: Economists measure the benefit of a good or service to a person by the maximum amount of money that person is willing to pay to obtain that good or service. Willingness to pay (WTP)

Measuring the cost of the action (in monetary units) Would you iron a shirt if I offered you 10 kuruş? Would you iron a shirt if I offered you 1000 lira? Suppose the answer to the 1st question is NO, The answer to the 2nd question is YES. Somewhere between these two extremes lies your reservation price, which is defined as the minimum amount it would take you to do the job.

To find this number, (the minimum amount of money it would take you to do the job) we run the “mental” auction. I start with the low price of 10 kuruş, each time you say NO, I will increase it by a small amount. Suppose you say YES for the first time when I offer you 5 lira. Then this means that the cost of the action (iron the shirt) is 5 lira for you.

B = 3 (max amount you are willing to pay), C = 5 (min amount you must be paid to do job) Apply the decision rule: action x = iron the shirt B(x) = 3 C(x) = 5. B(x) < C(x)  Don’t do it.

Let’s try something slightly confusing

Defining the cost of an action is not always straightforward! We say that … “The cost of something is what you give up to get it.”

An example

Example : Should I go to the beach? Your best friend says that next Saturday you should go to the beach. A day at the beach is worth to you 60 TL. The cost of food, transportation and entrance fee is 40 TL. If you are rational, will you go to the beach? YES because B = 60 > COST = 40

Example : Should I go to the beach? Your best friend says that next Saturday you should go to the beach. A day at the beach is worth to you 60 TL. The cost of food, transportation and entrance fee is 40 TL. On Saturday your initial plan was to work as an RA, in Prof İskender Yılgör’s lab which pays 40 TL. You very much like this job, so you would do it for free. If you are rational, will you go to the beach? NO, B = 60 < COST = 40 + 40 (the second 40 is the opportunity cost)

Version 2 The first part is the same. Go to the beach etc. But the alternative now is to wash dirty dishes at the main campus dining hall. This job also pays 40 TL. BUT you don’t like it and you would not do it for less than 30 TL. If you are rational, will you go to the beach? YES, B = 60 > COST = 40 + (40 – 30) (the second 40-30 = 10 is the opportunity cost)

Opportunity Cost The value of the next-best alternative that must be forgone in order to undertake an activity. Even the use of a good we already own is not free. It could be sold or used for some other purpose. There is an opportunity cost. Always ask “if I don’t do this, what is my best alternative”?

The Opportunity Cost question You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. You would be willing to pay up to $50 to see Dylan. There are no other costs of seeing either performer. Question : What is the opportunity cost of seeing Eric Clapton? Briefly explain your answer. A. $0; B. $10 C. $40 D. $50

B. $10 is the correct answer, because… When you choose Clapton, you give up the net benefit of Dylan, which is your enjoyment (measured at $50) minus the ticket cost, which is $40. The net benefit of the Dylan concert is $10. This ($10) is what you give up if you choose Clapton. One more time… The opportunity cost of Clapton is $10, the net benefit of the (next-best) alternative, which is Dylan.

Paul Ferraro and Laura Taylor, asked this very same question, which is taken from page 4 of Robert Frank and Ben Bernanke’s textbook, Introduction to Microeconomics, to PhD students and professors at the ASSA meeting, in 2005. ASSA: Allied Social Science Associations meeting organized by the American Economic Association

Mentioned in the New York Times Paul Ferraro and Laura Taylor, “Do Economists Recognize an Opportunity Cost When They See One? A Dismal Performance from the Dismal Science.” Mentioned in the New York Times The Dismal Science, Dismally Taught - New York Times www.nytimes.com/2007/08/12/business/yourmoney/12view.html

How did the PhD students and professors answer this question? http://www2.gsu.edu/~wwwcec/docs/ferrarotaylorbep.pdf Respondents spent, on average, close to five minutes answering the survey. $0 25.1% $10 21.6% $40 25.6% $50 27.6%

A difficult opportunity cost question #1 You have a free ticket to a Eric Clapton concert. You can sell it for $35. Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. Dylan is worth to you $50. There are no other costs of seeing either performer. You choose Clapton. If you are a rational person, we can conclude that Clapton is worth to you at least ….

Suggested solution; a difficult opportunity cost question #1 As a rational person, you choose Clapton if B ≥ C. We first compute C of Clapton, and then choose the smallest B such that B ≥ C C = 10 + 35 Why? 10 = 50 – 40 is the net benefit of Dylan 35 is also part of the cost because you give up the opportunity to earn 35 when you choose Clapton. So, B must be at least 45.

End of the lecture