Download Chpt 1 Intro to Micro

Big Questions
1. What is economics?
2. What are the fundamental concepts
underlying economic models?
3. How do we model/predict economic
behavior?

And does it work?
Key Terms
 Common understanding of key terms
 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
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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
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:
1. Incentives
2. Trade-offs
3. Opportunity cost
4. Marginal thinking
5. Trade creates value
Foundations underlying the Model
 The five underlying concepts of economic models:
Incentives – people respond to incentives
1.


Price is an incentive - lower price -> buy more
Lowering tuition costs
Trade-offs – buy one good -> can’t buy others
2.

Compare value/price of alternative use of income/time
Opportunity cost – what is given up
3.

Value of “best” alternative not chosen
Marginal thinking
4.

compare “additional” value of 1 more unit to its price when
making purchase decision (not total value/cost of all units)
Trade creates value
5.

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



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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
 Production possibilities frontier
 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
Production Possibilities Frontier
Pizzas
Chicken W
100
70
50
0
Cost of +1 CW
0
90
150
300
Cost of +1 Pizza
-0.33
-0.33
-0.33
Can’t Produce
Technology
Constraint
Economically
Inefficient
-3
-3
-3
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


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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


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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


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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)
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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
Learning Objective 1.1
Making Will Women Have More Babies
the
if the Government Pays Them To?
Connection
Estonian Gov’t Increased Paid Time-Off for Mate
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
 Trade
 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
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Gain from Trade - Specialization
Key Assumptions About Individual
Economic Behavior
Alchian and Allen
1. For each person, some goods are scarce -> choices
2. Each person desires many goods and goals -> tradeoffs
3. Each person is willing to give up some of one economic
good to get more of another economic good -> basis for
trade
4. The more one has of a good, the lower is its personal
marginal value -> diminishing marginal value
5. Not all people have identical tastes and preferences
6. 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.
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