Introductionslide 1 ECONOMICS 251H Households, Firms & Markets Spring 1999

Introductionslide 2 ECONOMICS IS ABOUT DECIDING Economists do not restrict themselves to considering only decision problems involving money and markets, though that is a big part of economics.

Introductionslide 3 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 marry your sweetheart. How hard to study for this course. Whether to go to college, and if so, which one. Whether to buy a lottery ticket in the Michigan lottery.

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

Introductionslide 5 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.

Introductionslide 6 MICROECONOMIC AGENTS Firms –Produce and sell goods and services –Buy inputs (labor, capital & raw materials) Consumers –Buy goods and services –Sell inputs (labor services, loanable funds)

Introductionslide 7 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?

Introductionslide 8 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 M. Peter McPherson and given to Byron Brown? What should the price of corn be? Methodology: Positive v. Normative Economics

Introductionslide 9 THE PARETO CRITERION A rule used by economists to decide whether a change in the world results in an increase in social welfare (the welfare of society as a whole). The importance of the rule is that we can use it to evaluate policy changes. It would be in society’s interest to adopt those policies that improve social welfare and reject those policies that reduce social welfare.

Introductionslide 10 A change improves social welfare if as a result of the change at least one person is better off and no one is worse off. THE PARETO CRITERION DEFINED

Introductionslide 11 PARETO CRITERION NOTES It’s the only value judgment economists use in their official role as scientists. Not all changes can be judged using the criterion (changes in income distribution) It’s a very conservative rule -- equivalent to demanding unanimity to adopt a policy. Effectively banishes from economics as a discipline the question of how income ought to be distributed.

Introductionslide 12 PARETO OPTIMALITY A state of the world is Pareto Optimal if no improvements are possible as judged by the Pareto Criterion. A Pareto Optimal state is sometimes called “efficient” or Pareto efficient. When we are in an efficient state it is impossible to make someone better off without hurting someone else. Of course, it’s better to be efficient than inefficient.

Introductionslide 13 ECONOMISTS’ USES FOR THE IDEA OF PARETO OPTIMALITY We will show how the market form called monopoly is inefficient, while that called perfect competition is often efficient. We will analyze the efficiency of some kinds of taxes. We will show why the presence of externalities or neighborhood effects causes inefficiency. We will explore some of the proposed cures for inefficiency.

Introductionslide 14 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.

Introductionslide 15 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.

Introductionslide 16 A model of heights age in years height H = a + b(A) a  H AA ΔA ΔH b 

Introductionslide 17 A better (nonlinear) model of heights naive (linear) age in years height fancy

Introductionslide 18 A better model? Height = f(age, gender, parents’ heights, nutrition,...)

Introductionslide 19 Gender effects in the better model Height = f(age, gender, parents’ heights, nutrition,...) height age men women

Introductionslide 20 MODEL SUMMARY Three ways to describe models Graphs Tables of values Mathematical functions (equations) Important concepts Dependent and independent variables Linear function, intercept and slope

Introductionslide 21 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

Introductionslide 22 PPF DEFINED The Production Possibility Curve (or frontier) shows the maximum amount of a good you can produce given the amounts of other goods produced, and given the total amounts of inputs available, and given the technology of production.

Introductionslide 23 PPC EXAMPLE Assumptions: There are only two goods, pizza and spaghetti. There are limited inputs and given technology of production. Definition: The PPC shows the maximum amount of pizza you can produce, given the amount of spaghetti to be produced.

Introductionslide 24 PRODUCTION POSSIBILITY CURVE SPAGHETTI PIZZA Which points are attainable and which points are unattainable? Which points are attainable and which points are unattainable? Go to hidden slide

Introductionslide 25 PRODUCTION POSSIBILITY CURVE SPAGHETTI PIZZA attainable unattainable

Introductionslide 26 PRODUCTION POSSIBILITY CURVE SPAGHETTI PIZZA What’s the effect of an improvement in the technology for producing spaghetti? What’s the effect of an improvement in the technology for producing spaghetti? Go to hidden slide

Introductionslide 27 SPAGHETTI PIZZA An improvement in spaghetti technology

Introductionslide 28 PRODUCTION POSSIBILITY CURVE SPAGHETTI PIZZA What’s the effect of an increase in total resources (inputs)? What’s the effect of an increase in total resources (inputs)? Go to hidden slide

Introductionslide 29 Effect of an increase in resources. SPAGHETTI PIZZA

Introductionslide 30 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.

Introductionslide 31 OPPORTUNITY COST DEFINED The opportunity cost of doing something is what you must give up in order to do it. The cost of a pizza is 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 MSU includes not only tuition and books, but the income you could have earned working on a full time job. The cost of attending a Lugnuts baseball game includes the value of the time you could have spent studying economics.

Introductionslide 32 The PPC can show opportunity cost Suppose you are at some point on a PPC. Then suppose you want to consume one more pizza. The opportunity cost of one more pizza is the amount of spaghetti you must give up in order to get it. Note that this opportunity cost is equal to minus the slope of the PPC.

Introductionslide 33 PRODUCTION POSSIBILITY CURVE SPAGHETTI PIZZA More pizza means less spaghetti

Introductionslide 34 OPPORTUNITY COST INCREASES AS MORE OF A GOOD IS PRODUCED Not only does more pizza mean less spaghetti, but each additional pizza costs more than the one before it. This idea shows up as the PPC being concave to the origin. (The curve bows out.)

Introductionslide 35 Production Possibility Curve SPAGHETTI PIZZA Opportunity cost of more pizza is constant.

Introductionslide 36 We will use Production Possibilities Curves that are straight lines (i.e., that have constant opportunity cost) to illustrate some important economic principles.