ECONOMICS BY SANDEEP NARULA INTRODUCTION TO MICROECONOMICS 2

ECONOMICS IS ABOUT DECIDING MicroEconomics is about making choices and it deals with allocation of given resources having alternative uses-----Said by Robbins Introduction

EXAMPLES OF SOME DECISIONS ECONOMISTS HAVE ANALYZED Whether to buy a car this week. Whether to have pizza for dinner tonight, or something else. Whether to go for tuition How hard to study for this course. Whether to go to college, and if so, which one. Whether to buy a lottery ticket in Your city Introduction

Factors in decision making 1. People face tradeoffs.(EQUILIBRIUM) 2. Opportunity cost. 3. Making decisions at the margin. 4. People respond to incentives. Introduction

How individual decisions affect others 5. Trade (exchange) can benefit everyone. 6. Markets are often a good way to organize exchange. 7. Government can sometimes improve on markets. Introduction

MICROECONOMIC AGENTS Firms Consumers Produce and sell goods and services Buy inputs (labor, capital & raw materials) Consumers Buy goods and services Sell inputs (labor services, loanable funds) Introduction

Methodology: Positive v. Normative Economics Positive econ. -- Studies the way the world is. How much will a new gasoline tax raise the price of gasoline? Will an increase in the minimum wage increase unemployment? Why is the price of corn $4.20 per bushel? How much will a drought in the corn belt raise the price of corn? Of wheat? What will be the effect on Byron Brown’s pizza consumption if we take $1000 away from Tom Izzo and give it to Brown? Introduction

Methodology: Positive v. Normative Economics Normative econ. -- Studies the way the world should be. Should there be a new tax on gasoline? Should there be an increase in the minimum wage? Should $1000 be taken from Mr. Chetan to Jatin What should the price of corn be? Introduction

Models and theories Model -- a hypothesis about the relationships among variables. Everyone uses models. Because a model abstracts from reality it makes mistakes. Models can contain two kinds of errors or mistakes: the wrong explanatory variables may be included. the functional form may be incorrect. Introduction

Contents of models List of variables, especially a clear statement of what is to be explained Dependent v. independent variables Hypothesized relationships among the variables. Using tables of values, graphs, or equations. Introduction

A model of heights H height A H = a + b(A) a b = H/A age in years Introduction

A better (nonlinear) model of heights naive (linear) fancy height age in years Introduction

A better model? Height = f(age, gender, parents’ heights, nutrition, ...) Introduction

Gender effects in the better model Height = f(age, gender, parents’ heights, nutrition, ...) men women height age Introduction

MODEL SUMMARY Three ways to describe models Important concepts Graphs Tables of values Mathematical functions (equations) Important concepts Dependent and independent variables Linear function, intercept and slope Introduction

AN ECONOMIC MODEL The Production Possibility Curve Purposes of model Show scarcity constraint Illustrate economic efficiency Introduce opportunity cost concept Variables Quantities of goods that may be produced Givens Total amounts of inputs available Technology of production Introduction

PPF DEFINED The Production Possibility Curve (or frontier) shows the maximum amount of two goods you can produce given the total amounts of inputs available, and given the technology of production. Introduction

PPC EXAMPLE Assumptions: There are only two goods, wheat and machines There are limited inputs and given technology of production. Definition: The PPC shows the maximum amount of wheatyou can produce, given the amount of machines to be produced. Introduction

PRODUCTION POSSIBILITY CURVE machines 400 Which points are attainable and which points are unattainable? 300 200 100 10 20 30 40 50 60 Go to hidden slide Introduction

PRODUCTION POSSIBILITY CURVE machines 400 What’s the effect of an improvement in the technology for producing machines 300 200 100 10 20 30 40 50 60 Go to hidden slide Introduction

PRODUCTION POSSIBILITY CURVE machines 400 What’s the effect of an increase in total resources (inputs)? 300 200 100 10 20 30 40 50 60 wheat Go to hidden slide Introduction

Points “inside” the PPC are inefficient. For any point “inside” there corresponds some point that represents more production of both goods. Note that while points on the PPC are efficient, we cannot say at this time whether some are better for society than others. Introduction

OPPORTUNITY COST DEFINED The opportunity cost of doing something is what you must give up in order to do it. The cost of a wheat what you must give up to consume it, which in this case is easily computed in money. The cost of a college education includes both money and other foregone alternatives. For example, the cost of a year at DU includes not only tuition and books, but the income you could have earned working on a full time job. The cost of attending a baseball game includes the value of the time you could have spent studying economics. Introduction

The PPC can show opportunity cost Suppose you are at some point on a PPC. Then suppose you want to consume one more wheat. The opportunity cost of one more unit of wheat is the amount of machines you must give up in order to get it. Note that this opportunity cost is equal to minus the slope of the PPC. Introduction

PRODUCTION POSSIBILITY CURVE machines 400 300 More wheat means less machines 200 100 10 20 30 40 50 60 wheat Introduction

OPPORTUNITY COST INCREASES AS MORE OF A GOOD IS PRODUCED Not only does more wheatean less machines, but each additional wheatcosts more than the one before it. This idea shows up as the PPC being concave to the origin. (The curve bows out.) Introduction

Production Possibility Curve machines 400 300 Opportunity cost of more wheat is constant. 200 100 10 20 30 40 50 60 wheat Introduction

We will use Production Possibilities Curves that are straight lines (i We will use Production Possibilities Curves that are straight lines (i.e., that have constant opportunity cost) to illustrate some important economic principles. Introduction