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Foundations of Micro Economics
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Big Questions What is economics?
What are the fundamental concepts underlying economic models? How do we model/predict economic behavior? And does it work?
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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
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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.
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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
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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.
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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
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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
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The production possibilities frontier
Ch. 3 (b) The farmer’s production possibilities frontier (c) The rancher’s production possibilities frontier Meat (oz) 4 8 Meat (oz) 12 24 If there is no trade, the rancher chooses this production and consumption. If there is no trade, the farmer chooses this production and consumption. B A Potatoes (oz) 16 32 Potatoes (oz) 24 48 Panel (b) shows the combinations of meat and potatoes that the farmer can produce. Panel (c) shows the combinations of meat and potatoes that the rancher can produce. Both production possibilities frontiers are derived assuming that the farmer and rancher each work 8 hours per day. If there is no trade, each person’s production possibilities frontier is also his or her consumption possibilities frontier
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The production possibilities
1 The production possibilities Meat Potatoes Farmer Rancher 60 min/oz 20 min/oz 15 min/oz 10 min/oz 8 oz 24 oz 32 oz 48 oz (a) Production Opportunities Opp Cost 1oz M 1oz P Farmer 1M: 4P P -¼ oz M Rancher 1M: 2P P* -½ oz M What is the minimum price that Rancher would want for 1 oz of Meat? (in oz of Potatoes). I.e., what is R’s opportunity cost of producing 1 oz of Meat? What is the maximum price that Farmer would pay for 1 oz of Meat? (in oz of potatoes). I.e., what is F’s opp cost of producing 1 oz of meat ..or what would be F’s “avoided” cost if she “buys’ the meat?
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A Parable for the Modern Economy
Specialization and trade Farmer – specialize in growing potatoes More time growing potatoes Less time raising cattle Rancher – specialize in raising cattle More time raising cattle Less time growing potatoes Trade Willing to trade: 3 oz of meat for 1 oz potatoes Final trade -5 oz of meat for 15 oz of potatoes Both gain from specialization and trade
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Farmer’s Gains From Trade
Potatoes Meat No Trade With 32 28 29 1 24 26 2 20 23 3 16 4 12 17 5 8 14 6 11 7
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Rancher’s Gains From Trade
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Greg’s Final Solution (text)
2 Greg’s Final Solution (text) (a) The farmer’s production and consumption (b) The rancher’s production and consumption Meat (oz) 4 8 Meat (oz) 12 24 Farmer's production and consumption without trade Rancher’s production with trade Rancher’s production and consumption without trade Farmer's consumption with trade 18 12 13 B* A* 27 Rancher’s consumption with trade B 5 Farmer's production with trade 17 A Potatoes (oz) 16 32 Potatoes (oz) 24 48 Farmer and Rancher agree to trade 5 oz of Meat for 15 oz of Potatoes (3:1) Start at corners (specialization)
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