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Econ Class Notes 8/27
Course Goals:
1) Think economically based on 4 agents
2) Learn to use simple models for complex systems (Basically what macro is)
Business: Profit is the most important, skill of making profit
Econ: Social science of people trying to make profits, purchasing power, circular
flow
 How money relates to life and society basically
 Interactions between the 4 agents of the economy: households, firms,
government and foreigners (republican paradise)
 Use econ way understand how 4 factors work
 Make economy as efficient as possible
 Ex: cigarette, economist says analyze how expensive now and over time and
the chance you get cancer and make a rational decision about if you think
you’ll be better off after consideration (no morals involved)
2 parts of Brain: Limbic system I~ lizard brain and system II: Prefrontal cortex ~
rational side
 Prospect theory: see D. Kahneman, Thinking Fast and Slow for details of
what follows:
 There is always a battle between system I (fast) and system II (slow). System
I always on. System II is lazy, requires effort. System I always on, automatic
and throws up suggestions as to what to do: eat, have sex, enjoy sensual
pleasure. System II: wait, there may be negative consequences of those
things. Economic models system II but allows mistakes to arise from system
I. This analysis suggests a definition of rationality that most economists
accept.
Rational: learn from mistakes, not that you never make mistakes
 Rational according to each individual, no one standard of rationality
 Being rational comes from learning to suppressing lizard brain and learning
to be analytical
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Macroeconomics: Simple models capture essence of the real economy ~ takes
minute details out of play
 Argue that on average modeled behavior is essentially correct using data and
numbers
 Numbers are useless unless you know the variance (fluctuation of variability
in data using standard deviation)
 Think statistically: look at standard deviations, variance, bell curve of 95%
based on random effects, margin of error and determine if data is truly
statistically significant
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Problems in economy, Keynesian fluctuation, time scale (short run of a
quarter or a year vs. long run of years)
Ex: market forcing someone to be rational: stupid person saying a 2 dimes is
better than a quarter because 2 coins are better than one. Competition tends
to eliminate irrational behavior like this. Someone always willing to give 3
coin 2 dimes and one penny and then 4 coins, etc. Equilibrium: 7 coins: 2
dimes and five pennies.
Brownstone house listed for $250k cannot be sold for this amount if
comparables exist for $400k .
This example is from a very good supplementary book: Charles Naked Economics:
takes out math of economics and economic thinking
 House valued at 400,000, on market for 250,000: competition drives up price
based on demand; listing agent buys and puts on market for 350,000
Equilibrium base on indifference
 Not that you don’t care, just a coin flip
 Indifference leads us to a number you can put on any intangible or subjective
feeling.
 Always something with a price that you are indifferent to!
Average vs. Marginal: What was the cost of coming to class today? Marginal cost is
not the average of total $$ paid for all UVM classes, divided by total number of
hours. Marginal cost of coming to class is what you had to give up to come to this
class. Marginal cost excludes sunk cost: cannot say that cost of driving to campus is
part of cost of coming to this class today, if you were going to drive to campus
already.
Why are you taking this class: You want to! Most important driver for economics:
preferences. Preferences often cannot be explained or even rationalized. There is
no such thing as “good preferences” or “bad preferences” there are just preferences.
Resist effort to label people who don’t appreciated environmental amenities or
people who smoke as bad people, (Normative: what people should do. Objective:
social science of what we do when we make economic decisions—no “should”
involved.)
 Economic theory assumes freedom to make choices. Hence: No economic
theory of children (no rationale) since their choices are highly constrained by
parents.
Class cost = cost benefit analysis and opportunity cost (cost of going to class vs.
everything else you could be doing-including time and money of other fork. )
Opportunity Cost: What you did do vs. the next best thing (in your mind)
 Marginal benefit vs. marginal costs
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Basically what YOU think is the best rational thing to do (so long as you learn
from your mistakes.)
Opp. Cost: Loss of value if you didn’t do something; what it “cost” you to
choose the better option.
Starbuck’s vs. normal coffee: Is $3 worth it to you personally vs. cheaper
option (make your own coffee) Who can say it is “wrong” to buy expensive
coffee. Opp cost of good coffee is the next best thing you would have spent
the $3 on (not necessarily coffee-could be a book or literally anything else)
People who think they’re better off are better off
Dollar value for everything due to indifference
Evaluate value of opportunity cost at the fork in the road (the choice)
Sunk Costs: irrelevant to marginal decisions/thinking
Marginal cost of one class vs. college: Is it worth it to go to class TODAY
 Decision not influenced by what you’ve already decided i.e. being on campus
(you have to be; doesn’t count)
Adam Smith Diamond vs. water paradox. water is essentially more valuable than
diamonds but costs less than diamonds because of the amount: a cup of diamonds
worth more than water because there are more cups of water than diamonds.
Marginal cost of a cup of water is cost of additional cup (low); marginal cost of
diamond is cost of finding another diamond (high). Goods and services always
valued at the margin.
Marginal costs rather than average costs are the driving factors of decisions
Marginal benefit of an “A” vs marginal cost of doing the work to get it…this is the
decision you will HAVE TO MAKE IN THIS COURSE!
Econ Class Notes 8/29
Economic way of thinking: can’t lie spending one’s own money; Economics is not
about money, but about human activity: making things and trading them among
themselves.
people will spend according to their preferences
- individuals know their own self interest best
- highest fidelity of data is spending trends (unbiased data of what people
want) people may lie in an interview about their true preferences—called
cheap talk—but cannot lie when the actually buy something. This REVEALS
their true preferences. (unless coerced)
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Can’t trust gov to do what’s in our best interest, can only trust them do what’s in
gov’s best interest ( econ way of thinking)
Every person has a utility function
- utility defined only for households
- only ones that aren’t exclusive (everyone is part of a household) so no danger
of overlapping
- Pareto optimum of allocation of resources = efficiency
Pareto Optimum Principle:if it is true that no individual could be made better off
without making at least one individual worse off then we are in what is called a
Pareto Optimum
- Cornerstone of econ in terms of efficiency of resource allocation
- Aka: Pareto Optimum is the most efficient allocation of resources
- Makes people as better off as they can be w/o forcible reallocation (e.g.
taking from one person and giving to another.)
- Problems: doesn’t take into account social justice
- May not be feasible in the real world (Politicians violate the condition for
Pareto Optimality all the time. They seem to be quite willing to screw
someone over to improve the lot of their favored constituency whenever they
see fit. Once someone is hurt there is no way to say scientifically that the
economy as a whole is better off.)
- PO seems to challenge common notion of fairness: One person can take all
resources, but still efficient because all resources were used and no trade
was blocked (no waste and no one worse off since no one else has anything
to trade.)
- No one has the “best (anointed) preferences” ~ based on individual thinking
so everyone is viewed equally in economic way of thinking.
- Amusement park and natural park = same thing: both provide utility to their
users Nothing sacred about a national park. People who prefer national
parks are not ``better people” with “better preferences”
Ex: Nazi handing out chocolate and cigs once daily
- Allocation of SCARCE (not enough for free consumption) resources
- Without scarcity there would be no economics
- Not efficient because some people don’t like chocolate, heavier smokers
- Solution for scarcity: trade! Must be free of coercion (free not forced trade;
crime not part of economic theory)
- Market will clear at end of the day when everyone has what they want
Market clearing: no more trade because no one has any more reason to be there
(nothing they want, sold their stuff, no more $$)  people just leave and have no
more use for a market anymore  Pareto Optimum best outcome that we can
recognize scientifically.
Important point: Economists do not deny that after a market has cleared, it might
be possible to coerce one person, often thought to be a rich person, to give another
person, say a poor person, either choc or cigarettes. The loss to the rich person
may be less than the gain to the poor person. If so, then overall social welfare would
presumably rise.
The problem is that economists don’t know how to find these two people
(politicians often say they can). Since people can lie or misrepresent their
preferences, there is no scientific way to say that total welfare will actually rise as a
result of the coercion. This, according to economics, is a big problem. People on the
receiving end will always “say” they are better off, but there is no true way of
knowing that they are better off until they give up something for what they get.
This is why economics relies on PO despite its problems.
Market inefficiency: when something prevents (blocks) trades
Efficiency: No blocked trades, creates a distortion
-even if one person
Inefficiency = distortion
- Economic efficiency is Not heat efficiency: you don’t always want the most
efficient thing (like a heater), you want what is going to serve your needs
best (heater in desert; you want one that’s less hot and less efficient)
- (engineering efficiency or heat efficiency came from the study of steam
engines from physics in the late 18th century)
Distortion: arises from blocked trade. someone (e.g. govt) telling you what is in
your best interests even if it is economically not what people want (ex: kidney sales)
- Non zero sum exchange: each party in a free trade environment is better off
(ex: $$ for kidney; each party believes they are better off for the trade)
- Zero sum exchange: coercion; my loss = your gain (ex: you take my iPod)
Waste comes from a blocked trade and distortion  decrease in overall welfare
Market clearing = Pareto Optimum (equilibrium)
- Trades represent people’s best interests at least as far as economics knows.
- Trades may be blocked (e.g. drugs, kidneys) for moral or other reasons and
this may be acceptable to society (through the political process). Blocked
trades cannot be justified, however, on strictly economic grounds.
There are only 4 agents of economy: firms, households, government and foreigners
- Can often overlap; all individuals just sometimes using different hats
- People in economy serve as consumers (households) and workers (firms)
Efficient allocation of scarce resources does not depend on what people say but
rather what they do. There is no way to tell what an efficient allocation is to by only
asking the individuals
-Gov not reliable to speak on behalf of the people since they are made up of
the very same people who are in the economy and are looking out for their own
interests.
Economics says: cooperation yes! Coercion no!
Murder is only economically rational if someone else was trying to murder you and
the police force was inefficient
- Judicial and economic thinking is along the same though line
Utility: function of all goods and services
Best thing for gov to do: look for ways to maximize efficiency. Best govt from
economics point of view would be a Paretian Govt. One that only made people
better off and never hurt anyone.
Govt policy should focus on facilitating trades not redistributing goods and services
once the trades have been made in service of some higher principle like social
justice (At least according to economic theory)
This kind of policy is sorely needed because sometimes people are not aware of
potential trades. (e.g. person in VT may not know of a great job offer in California.)
Asymmetric information itself can BLOCK TRADES: people aren’t given same
amount of info and know that they don’t have the same info (ex: used car market)
Econ Class Notes 9/3
NPR: Why Housing is So essential to any economic recovery
 Housing recovery: highest level in 4 years and in 14% growth
 20% more homes under construction than a year ago
 New houses  money multiplier ($$ flows through economy when materials
are bought, pay for labor, etc.)
 7% increase in jobs over 1.5 years
 Previous: short fall, short recovery whereas this one was a slow decline and a
slow recovery is sure to follow
 Toll brothers has strong earnings
 Economists: worried about mortgages long term on economy
 Any other market besides the housing market would have led to a quick
spike rather than the lengthy one right now; reiterates how important
housing is to the economy
Housing demand = elastic even if the ratio of people to houses is one to one not all
houses will necessarily be occupied. Depends on economic conditions
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Multiple people can live in 1 residence
Can be empty houses as well
Financial crisis came from high supply of houses and low demand, failed to
recover because still a lot of houses, recovering because demand is slowly
catching up to supply
Housing is good because it is mainly domestic goods and services
Local purchases = good for only short run
Income = Expenditure is the basis of the balancing of a SAM and all National
Accounting
 True of all 4 agents
 Includes savings
In economic theory all physical things fall into one of three groups:
1. Factor of Production (land, labor, capital)
2, Intermediate goods ~ raw materials: not generally seen/counted (ex: factors of
production like a stove or an egg when making a pancake)
 Cost of stove of length of lifetime divided by cost
3. Goods for final consumption:
Economic activity is then based on the circular flow
Firms: Groups of producers that come together that produce goods and services,
combine factors of production owned by households (humans own land, labor and
capital) to create products
 Purchase factors of production
Circular flow is the relationship between firms and households; households and
firms (like an inner tube: size fluctuates based on air aka demand)
Firms use the factors of production owned by households to make the final goods
and services households buy from firms. Intermediate goods are made along the
way, but are incorporated into the final goods and not counted separately.
Multiplier: Demand multiplies through economy  more purchases that
reverberate through the economy (like an echo)
 Most important part of macro—much of the debate in macro is about the size
of the multiplier.
 Introduction of $10 of new demand into economy: 10+5+2.5+1.25….  18.75
 Ex: House ~ $500,000; not just 500,000 into the economy, multiplies as it
changes hands (house  sawmill  sawmill employee  motorcycle)
 Multiplier x 2 = $1 million (loses speed but gains mas as dollar makes is way
through the economy.)
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Loses speed b/c of Impediments: savings (people won’t spend 100% of
savings on average) and foreign (demand for goods outside the domestic
economy)
Effects not just single house or housing market, goes through multiple
industries (like motorcyles) and then the employees of motorcycle firms buy
other things, food , clothing toys for their kids, and so on.
The numerical value of the Multiplier is about 2.0 ~ keeping an eye on
multiplier: could be LESS than 2 if $$ “lost” to foreign markets, not really lost in the
long run because it will eventually come back (ex: US economy  China
economy). In the short run, it is lost since the part of the demand stimulus “leaks”
into foreign countries like China.
Foreigners: everyone who resides outside of the us and doesn’t contribute to the
domestic economy even if US citizens.
SAMS/Social Accounting Matrix: when income and expenditure are in balance for
agents present in the SAM, the sum of savings is equal to investment (Walras’ Law)
 Income expenditure balance = last row/column mathematically
 So if there are two agents, firms and HH, then there are 3 rows and cols in the
SAM. If the row and column sums are the same for firms and HH, then we
know that savings must be equal to investment.
 See class example of sam downloadable from web page.
Recycling: makes economy more efficient because capital/labor that would initially
be used to make intermediate goods can be used to make larger supply of goods
 Downside: can cause unemployment.
 Upside: can cause larger investment in new technologies
 Net benefit must include extra investment that recycling requires
Econ Class Notes 9/5
Typical test Qs. Some tricky must pick best answer among right answers. READ
ALL Qs and ALL answers during test. PUT OFF TRICKY Qs until the end.
At the margin: ignoring sunk costs, taking past decisions as irrevocable and
comparing marginal benefits with marginal costs
Rational actors learn from their mistakes
Agents who think they are better off are better off
If there are two right answers (for sure) and there is an option: all of the above,
then your best bet is to choose that option. Not foolproof however; e.g., if the third
answer is definitely incorrect then you can’t follow this rule and you must select the
best of the two correct answers.
Consumer surplus: monetary advantage of the trade calculated as the difference
between your marginal benefit and what you gave up.
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Ex: a $30 ticket that you would’ve paid $50 for it. $50 is your marginal
benefit. What you gave up to get that $50 is $30 so net marginal benefit is $20. This
is known as consumer surplus.
Opportunity Cost: What you are giving up vs. the cost of what you chose to do
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Ex: going to a free concert over going to a $30 concert you would’ve paid $50
for
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By going to the free one you are giving up a hypothetical (actually a true) $20
net benefit. Hence: opp cost of going to Clapton = $20 not 0, not 30, not anything
else. Point of this example: compute opp cost by looking a net benefit of the next
best alternative action
• Only a Classically irrational person would go to a concert with lower NET
marginal benefit.
Smith’s 1776 Wealth of Nations:
Adam Smith – Philosopher:
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What’s the status of selfishness? Good or bad? → Can be channeled to do
good? Generally impossible unless restrained by COMPETITION (jet fuel of
economy)
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Goods aren’t brought to market for love of society but for profit, which can
benefit society unintentionally
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Agents are rational and self interest people: Improve the well being of society
by acting upon their own self interest
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Selfishness restrained by competition—competition prevents people
exploiting each other as in the example of the kid who like to trade two dimes for a
quarter.
Wealth of Nations comes from specialization and trade.
→ people and countries gaining wealth through specialization (get better at
producing goods) but they couldn’t do this without trade that gives more efficient
allocation goods and services. In other words, trade allows for specialization.
Question: Were these principles related to laissez faire economics? Answer: laissez
faire economics is the same as no blocked trades. Only laissez faire economics can
arrive at PO.
Specialization: concentrating efforts in one field to trade with instead of trying to do
everything by oneself.
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Doing something at which you have comparative advantage-lowest
opportunity cost.
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Specialization → Capital accumulation and investment
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Ex: investing in a meat slicer if you start specializing in sandwiches
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Extent of market is small in hunter-gatherer society. Specialization and trade
are limited by small number of people in those societies. When humans turned to
farming, the size of societies increased and this permitted more specialization and
trade.
Absolute Advantage: Picking the best in the field even when it might have adverse
consequences
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Ex: Being a better hunter than sandwich maker so you hunt all the time, but
you still lose because you are losing out on advantage gained by being pretty good at
both?
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Solution: Worst hunter in group make sandwiches? Yes…b/c the worst
hunter has the lowest opportunity cost of sandwich making. Better hunters would
have to give up more deer to get the same sandwiches.
Consumer surplus: Happens through trade, competition and results from non zero
sum game
Zero sum game: Sum of trade is zero, when someone wins someone else always
loses and the loss exactly equals the win
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Common in animal world; primitive
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Ex: of NON-zero sum game: trading a piece of meat when you’re full for a
piece of meat next week when you will value when you’re hungry
Non zero sum game: reciprocal altruism (ability to cooperate)
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Trade in this fashion results in fundamental humans brain function being
altered through neuroplasticity. Brains of trading animals are different from ones
that don’t trade. We have evolved to trade and this by itself reduces war and
conflict.
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Understanding of mutual benefit, both sides think they are getting the better
deal. Ex: Darwin on Beagle in Tierra del Fuego trading with natives.
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No such thing as one person doing something nice for someone else “just
because” in economic theory. Pure altruism probably does not exist in an animal
world (including human animals). People who help others and never benefit
themselves from reciprocity are few in number and are not part of economic theory
(can’t be modeled since their behavior is essentially random).