Introduction History of Economic Thought Evolution of Economic Ideas - Economic Research Role of Scientific Researchers

History of Economic Thought Pamphlets on particular questions of economic policy written mostly by business men with practical knowledge of institutions and operation of the economy Emerged as a discipline Scholastic writings providing insight into the functioning of the developing Western European economy. 300 BCAristotle’s condemnation of the use of money in the exchange of commodities Adam Smith, trained in moral philosophy, shaped the economic literature into political economics in his Wealth of Nations.

History of Economic Thought (continued) Political economics became “economics” and economics became professionalized. 1930’s The Great Depression increased government involvement in economic activity which spurred interest in economic education. Most economists were academics concerned with with abstract, theoretical issues, rather than practical economic issues Methodologies for testing theories advanced. Technology and increased data availability facilitated the development and tests of theories in new areas present

Evolution of Economic Ideas - Economic Research Students and professors present their current and/or recent research to other economists in seminars and professional meetings. They refine their work, based on feedback about their presentations, until it is suitable for publication in economic texts and journals. Material in economic text books and journals are the basis of economists’ education. Ideally, open competition among researchers results in progressive research programs and the rejection of incorrect ideas.

Role of Scientific Researchers Develop and logical theories that lead to empirically testable propositions. Test the propositions. The theories become part of economic thought if the results of the tests support the propositions. Tools for analyzing economic behavior are based on generally accepted economic theories.

Tools for Analyzing Economic Behavior Supply and Demand Indifference Curves and Budget Lines Aggregate Supply and Demand Aggregate Savings and Investment Production Possibility Frontier

Tools for Analyzing Social Behavior Correlation Analysis Regression Analysis

Tools for Analyzing Economic Behavior Supply and Demand Supply: the relationship between quantity supplied and price of a well defined product, when all other factors that affect quantity supplied are constant. Quantity Supplied: the quantity that producers are willing and able to sell at a given price level. Demand: the relationship between quantity demanded and price of a well defined product, when all other factors that affect quantity demanded are constant. Quantity Demanded: the quantity that consumers are willing and able to buy at a given price level.

Tools for Analyzing Economic Behavior Supply Schedule Demand Schedule QuantityPrice Quantity $10 30$2 40$1 $3 20 $2 10$ $4 $5 $4 Supply and Demand

Tools for Analyzing Economic Behavior Supply and Demand. * * * * * Supply

Tools for Analyzing Economic Behavior Supply and Demand. * * * * *. Supply Demand

Tools for Analyzing Economic Behavior Supply and Demand Supply Demand $3.70. Price

Tools for Analyzing Economic Behavior Supply and Demand S D Price Quantity

Tools for Analyzing Economic Behavior Supply and Demand Supply: the relationship between quantity supplied and price of a well defined product, when all other factors that affect quantity supplied are constant. Quantity Supplied: the quantity that producers are willing and able to sell at a given price level. Demand: the relationship between quantity demanded and price of a well defined product, when all other factors that affect quantity demanded are constant. Quantity Demanded: the quantity that consumers are willing and able to buy at a given price level.

Tools for Analyzing Economic Behavior Indifference Curves: plot the combination of goods that yield the same level of satisfaction to a consumer. Budget Line: Plots the combination of goods the consumer can buy, given income and prices of the goods. Consumer Equilibrium: the combination of goods on the budget line that that lies on the highest possible indifference curve. Indifference Curves and Budget Lines

Tools for Analyzing Economic Behavior Example of Consumer Equilibrium: Indifference Curves and Budget Lines Income = $100 P 1 = $1 P 2 = $5 The consumer can buy 100 units of good 1 by spending all income on good 1. The consumer can buy 20 units of good 1 by spending all income on good 2.

Tools for Analyzing Economic Behavior Indifference Curves and Budget Lines... *.

Tools for Analyzing Economic Behavior Indifference Curves and Budget Lines Labor Supply Decision Good 1 is Labor/Leisure. Good 2 is income. Income is the value of all goods (other than leisure) the consumer can buy. Leisure is a normal good. The slope of the budget line is the negative of the wage rate. The higher the wage rate, the steeper the budget line.

Tools for Analyzing Economic Behavior Indifference Curves and Budget Lines Labor Supply Decision:Example Wage rate = $10. The consumer has 16 hours to either work or consume as leisure.

Tools for Analyzing Economic Behavior Indifference Curves and Budget Lines *..

Tools for Analyzing Economic Behavior Indifference Curves and Budget Lines *.... b

Tools for Analyzing Economic Behavior Indifference Curves and Budget Lines *b*b...

Economics for the Real World What is Thaler’s theory of mental accounting?  People estimate gains and losses in a way that can lead to seemingly odd choices  On busy days the cab drivers work fewer hours than on slow days. What behavior of New York cab driver’s does Thaler use to demonstrate the theory? According to Thaler, is this behavior consistent with traditional economic theory?  No. According to Thaler, economic theory dictates that they should at least work a full day on busy days. Do you agree with Thaler?

New York Cab Drivers Income  Labor/Leisure  Budget line on a good day

New York Cab Drivers Income  Labor/Leisure  Budget line on a good day

Economics for the Real World What is loss aversion?  Greater sensitivity to losses than too gains.  Investors are more likely to sell a stock when the price increases than when the price decreases. How is this demonstrated in investors behavior? Is this consistent with economic theory?

P 1. Q P Supply P .Q1.Q1 P 2..Q2.Q2 Market for a Stock

P 1. Q P P 2. Supply P .Q1.Q1.Q2.Q2 Market for a Stock

Utility Loss/Gain.. Utility Function for a Loss Averse Individual

Utility Loss/Gain. $10 -$10. Utility gained by selling a stock when the price increases by $10 above purchase price. Utility lost by selling a stock when the price decreases by $10 below the purchase price. Utility Function for a Loss Averse Individual

Economics for the Real World How is loss aversion evident in employees behavior concerning participation in 401k plans provided by employers?  They are more likely to participate in presumptive plans than in voluntary plans. What is another way of explaining this behavior?  Hyperbolic discounting: a person is more likely to continue participating in the plan than they are to make the initial decision to participate. Are these behaviors consistent with economic theory?

Investment Programs Gross Income = $1,000 Presumptive Participation Investment Program Deduction = $50 Net Income w/o Opting Out = $950 Net Income Opting Out = $1,000 Gain from Opting Out = $50

Investment Programs Gross Income = $1,000 Voluntary Participation Investment Program Deduction = $50 Net Income w/o Participating = $1,000 Net Income with Participation = $950 Loss from Participating = $50

Utility Loss/Gain. $50 -$50. Utility gained by opting out of the investment program. Utility lost by opting into the investment program. Utility Function for a Loss Averse Individual

Utility Loss/Gain Utility gained by a $10 wage increase. Utility lost by a $10 wage decrease. Utility Function for a Loss Averse Individual

Utility %  Nominal Wage. 2% -1%. Utility gained by a 2% increase in nominal wage rate when inflation is 5%. Utility lost by a 1% decrease in nominal wage rate when inflation is 2%. Utilit|y Function for a Loss Averse Individual The change in the real wage rate is -1% in both cases.

Economics for the Real World What are the implications for employers’ cost cutting strategies?  Employees are less likely to complain about wage increases that are are below inflation, than to complain about nominal wage decreases that result in the same change in the real wage rate.