Foundations of Micro Economics

Big Questions What is economics? What are the fundamental concepts underlying economic models? How do we model/predict economic behavior? And does it work?

Key Terms Common understanding of key terms Scarcity Opportunity costs Use them as shorthand for the concept; but have a precise/exact meaning Scarcity There are not enough resources to produce and consume all of the goods and services we desire Opportunity costs What must be given up (next best alternative use of time/money) as a result of a decision or choice “No such thing as a free lunch” (Milton Friedman) Cost-benefit analysis Every decision/action has tradeoffs i.e., every decision has an opportunity cost

What is Economics 2 major fields of inquiry Microeconomics Study of individual markets and factors that affect market price, quantity supplied two principal actors: consumers/households and firms/producers Macroeconomics Study of a system of (national) markets focusing on national income (gross national product), price levels (inflation), employment/unemployment and international trade Focuses on the role of government (Congress and budgets, Federal Reserve Bank), regulation (and regulatory agencies, business cycles and their effect on the economy

Ten Principles of Economics Micro-economists study: How people and firms make decisions (choices) and what factors (incentives) affect their decisions How people and firms interact with one another in the marketplace It’s all about the incentives! What factors/incentive drive consumer/supplier behavior How do we model what they are reacting to, and why? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Scarcity The Key Economic Problem Scarcity means limited resources The limited nature of society’s resources (e.g. raw materials) means that we have to choose which goods get produced with scarce resources and how they are allocated/distributed to the consumer Economics Studies of how people(consumers) and firms(producers) make these decisions when constrained by scarcity Determine what are the key factors affecting their decisions and modelling their decision making process Lecture notes: “Scarcity” is often considered the most basic concept in economics. If scarcity didn’t exist, we wouldn’t have to study economics at all! You may have to ask the students what “allocate” means. Allocate: to distribute. How do I distribute my income? What do I buy? I can’t buy everything I want. How does the last bullet of making decisions make sense? We’ll talk about opportunity cost in a bit, but for now, you can think of it this way: If I have limited time, money, what do I do with it? I have to make a choice. If a society has limited land, labor, capital, timber, water, oil . . . What do we do with those resources? We have to make a choice!

Big Questions Economics is the study of how people allocate their limited resources (income and time) to satisfy nearly unlimited wants and how firms use limited resources (raw materials) to meet consumer demand The fundamental concepts on which economic models (decision-making) are based: Incentives Trade-offs Opportunity cost Marginal thinking Trade creates value

Foundations underlying the Model The five underlying concepts of economic models: Incentives – people respond to incentives Price is an incentive - lower price -> buy more Lowering tuition costs Trade-offs – buy one good -> can’t buy others Compare value/price of alternative use of income/time Opportunity cost – what is given up Value of “best” alternative not chosen Marginal thinking compare “additional” value of 1 more unit to its price when making purchase decision (not total value/cost of all units) Trade creates value Why people voluntarily enter into market transactions

How People Make Decisions Principle 1: People face trade-offs Making decisions Trade off one goal against another Student – time (sleeping versus studying) Consumers – income (consume or save) Clean environment vs. high level of income

Modelling Tradeoffs – Individual’s Choices Between 2 goods In microeconomic theory, an indifference curve is a graph showing different bundles of goods between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another.

Production Possibilities Frontier - Choice between producing 2 goods Combinations of outputs that a society can produce if all of its resources are being used efficiently Assumptions of this model Technology fixed Resources fixed Simplified two-good analysis Lecture notes: The assumptions of the model help preserve ceteris paribus. Our two goods are pizzas and wings.

Production Possibilities Frontier Pizzas Chicken W Cost of +1 CW Cost of +1 Pizza 100 -3 70 90 -0.33 50 150 300 Can’t Produce Technology Constraint 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 Economically Inefficient

How People Make Decisions Principle 2: The cost of something is what you give up to get it - each decision has an opportunity cost Because people face trade-offs when making choices – you have to give something up to get something Benefit/Cost Analysis to make decisions Compare cost with benefits of alternatives Implies opportunity cost (of what is not chosen) is incurred Whatever most be given up to obtain one item

How People Make Decisions Principle 3: Rational people think at the margin Rational people Systematically & purposefully do the best they can to achieve their objectives Rational decision maker – take action only if Marginal benefits > Marginal costs Marginal Benefits – change (or increase) in total benefits from choice Marginal Costs – change/increase in costs from choice (opportunity costs of “not chosen”)

3. Optimal 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 (e.g., price) 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

Marginal Decisions 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!

How People Make Decisions Principle 4: People respond to incentives Incentive Something that induces a person to act In economics – which incentives affect market behavior and how important is each Higher price Buyers - consume less Sellers - produce more Public policy Change costs or benefits Change people’s behavior

Incentives at work An example: the First Law of Demand As the price per unit of the good declines, a consumer (all other things held constant, e.g. their income) will choose to buy more of the good over the same time period

How People Make Decisions Principle 4: People respond to incentives Gasoline tax Car size & fuel efficiency; carpool; public transportation State will raise gasoline tax in July Reduced single-occupancy cars; less essential trips Increased demand for mass transit, car-pooling Highway 520 bridge tolls Revenues used to finance new construction Unintended consequences Policymakers fail to consider how their policies affect incentives Will toll increase increase/decrease revenues? (Elasticity)

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? Estonian Gov’t Increased Paid Time-Off for Maternity/Paternity Leave 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.

How People Interact Principle 5: Trade can make everyone better off Specialization Allows each person/country to specialize in the activities he/she does best People/countries can buy a greater variety of goods and services at lower cost

Gain from Trade - Specialization Image: Animated Figure 2.4 Lecture notes: Here, more resources allow to produce more of all goods. Additional resources could include more people, land, or natural resources. From the text: Because the additional resources make the production of more pizzas and wings possible at the same time, the curve moves from PPF1 to PPF2, expanding up along the y axis and out along the x axis. Like improvements in technology, additional resources expand the frontier and allow society to reach a point—in this case, H—that was not possible before.

Key Assumptions About Individual Economic Behavior Alchian and Allen For each person, some goods are scarce -> choices Each person desires many goods and goals -> tradeoffs Each person is willing to give up some of one economic good to get more of another economic good -> basis for trade The more one has of a good, the lower is its personal marginal value -> diminishing marginal value Not all people have identical tastes and preferences People are innovative and rational

An Example of a Model Built on These Assumptions A Model of Consumer Demand

What is Economics? Economics Analyzes the production and distribution/allocation of goods and services – i.e. how the market place works Or how “stuff” is made and bought, and how its market price is determined. who gets what how/who makes it Models how individuals and firms make decisions about: What to purchase (choosing how to allocate income among various goods, services and savings/future consumption) What goods are produced (and not) What technologies to use How goods get allocated to which consumers in the marketplace © 2011, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.