Download - Class1 Micro
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Jihoon Lee
Northeastern University
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for the individual choice
for the choice interaction
for the economy-wide interaction
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Individual choice: the decision by an individual ofwhat to do, or what not to do
Basic principles Resources are scarce
The real cost of something is what you must give up toget it
How much? is a decision at the margin
People usually take advantage of incentives
3Basic Concepts ofEconomics
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A resource is anything that can be used toproduce something else
Ex.: land, labor, capital
Resources are scarce: unlimited needs withlimited resources
Ex.: fossil fuels, lumber, (clean) water/air, intelligence
4Basic Concepts ofEconomics
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The real cost of an item is its opportunity cost: what youmust give up in order to get it
Opportunity cost is crucial to understanding individualchoice Ex.: The cost of attending the economics classSleep? Coffee at
Starbucks with friends? Work?
I would rather be are referring to the opportunity cost
Its all about what you have to forgo, but remember its
the forgone value of the best alternative activity only,not the sum of all
5Basic Concepts ofEconomics
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Trade-off b/w costs and benefits of doingsomething
Marginal benefit-cost analysis: making trade-off at the margin
comparing the costs and benefits of doing a little bitmore of an activity vs. doing a little bit less
Ex.: Eating one more slice of pizza, studying one morehour, sleeping one more hour, hiring one more worker,etc.
6Basic Concepts ofEconomics
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An incentive is anything that offers rewards topeople who change their behavior
Ex.1: wage increase more people want to work
Ex.2: price of gasoline increase more peopledemand fuel-efficient vehicles
People respond to these incentives (or,
disincentives)
7Basic Concepts ofEconomics
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Interaction of choices: my choices affect yourchoices, and vice versa
Basic principles There are gains from trade
Markets move toward equilibrium
Efficient usage of resources is a good thing for thesociety
Markets usually lead to efficiency
When markets fail, government intervention can
improve social welfareBasic Concepts ofEconomics 8
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Due to specialization Each person specializes in
the task that he or she isgood at performing
The economy, as a whole,can produce and consumemore
Basic Concepts ofEconomics
9
Trade in a market economy: provide goods and servicesto others and receive other g/s in return
Gains from trade: get more of what they want throughtrade than they could under self-sufficiency
I hunt and she gathers otherwise we couldntmake ends meet. The New Yorker Collection 1991 Ed Frascino from cartoonbank.com.
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Equilibrium in an economic sense is a situationwhen no individual would be better off doingsomething different
Any time there is a change, the economy willmove to a new equilibrium
Ex.: What will happen to the price of gas when oilproducing countries decide to produce more barrels ofoil per day?
Basic Concepts ofEconomics
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An economy is efficient if all opportunities are taken tomake some people better off w/o making other peopleworse off
Then, is economic efficiency always the best policy goal?
issue of efficiency vs. equity Equity: everyone gets his/her fair shareWhat is fair?
Ex.: Handicapped-designated parking spaces in a busy parking lot
Equity side: making life fairer for the handicapped people
Efficiency side: letting several parking spaces left unused
How far should we go?
Basic Concepts ofEconomics
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The incentives built into a market economy helpresources be used efficiently
Prices are set where buyers and sellers agree with
No opportunities are left unexploited
Exceptions: market failure
The individual pursuit of self-interest in the markets canmake society worse off
The market outcome is inefficient
Basic Concepts ofEconomics
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Negative externalities: when producers (sellers) shiftcosts to others Pollution, for example, is a by-product of manufacture
Total cost = sellers production cost + pollution cost
When pollution costs are shifted, supply is greater than sociallyoptimal, and so is the pollution
Positive externalities: when consumers (buyers) maycreate benefits for others
Vaccinations, for example, can prevent neighbors from getting flue Total benefit = individual benefit + benefits to others
When more people want to enjoy free ride, the aggregate
demand for vaccinations is less than socially optimal
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The market outcome is socially optimal (socially efficient)only when The sellers pay the full costs of production, and
The buyers capture the full benefits of g/s
Government can help the market achieve the sociallyefficient level of outcome with regulations, taxes, andfines (for negative externalities) or subsidies (for positive
externalities) More discussion in detail are coming in later chapters!
Basic Concepts ofEconomics
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Basic Principles One persons spending is another persons income
If you spend less at a grocery store, the store employees mayeither lose their jobs, or take pay cuts
Overall spending may exceed or fall below the economysproduction capacity (or potential output)
If spending exceeds potential output, inflation is likely
If spending falls below potential output, economic recessionand increase in unemployment are likely
Government policies can change spending
Monetary/fiscal policies
Basic Concepts ofEconomics
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Comparative Advantage usingProduction Possibility Frontier
Circular-Flow Diagram
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A model is a simplified representation of realitiesthat is used to better understand real-lifesituations
Ex.: a model showing how much income people spendfor purchasing g/s;
C = + Y
Other things equal
This assumption means that all other relevant factorsremain unchanged for simplicity
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The production possibility frontier (PPF)
It illustrates the trade-offs facing an economy that
produces only two goods. It shows the maximumquantity of one good that can be produced for anygiven production of the other.
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Basic Concepts ofEconomics 19
2820 400
30
9
15
Quantity of coconuts
Production possibility frontier(PPF)
A
B
D
C
Feasible andefficient
in production
Not feasible
Quantity of fish
Feasible but
not efficient
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Basic Concepts ofEconomics 20
A
PPF
10 20 30 40 500
35
30
25
20
15
10
5
Producing the first20 fish . . .
requires giving up25 more coconuts
requires giving up5 coconuts
But producing20 more fish . . .
Quantity of coconuts
Quantity of fish
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Basic Concepts ofEconomics 21
Production is initially at pointA(20 fish and25 coconuts), it can move to point E(25
fish and 30 coconuts) due to economicgrowth
A
10 20 25 30 40 500
35
30
25
20
15
10
5
E
NewPPF
OriginalPPF
Quantity of coconuts
Quantity of fish
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Basic Concepts ofEconomics 22
28 400
30
9
(a)Toms Production Possibilities
Toms consumptionwithout trade
TomsPPF
Quantity of coconuts
Quantity of fish
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Basic Concepts ofEconomics 23
1060
20
8
HanksPPF
Quantity of coconuts
Quantity of fish
(a)Hanks Production Possibilities
Hanks consumptionwithout trade
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Toms OC Hanks OC
One fish 3/4 coconuts 2 coconuts
One coconut 4/3 fish 1/2 fish
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Both Tom and Hank are better off when theyeach specialize in what they are good at andtrade
Tom is good at fish: Toms OCf
< Hanks OCf
Tom has comparative advantage in and specializes in catching
fish
Hank is good at coconuts: Toms OCc> hanksOC
c
Hank has comparative advantage in and specializes in
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Basic Concepts ofEconomics 25
28 400
30
910
1060
20
810
(a) Toms Production and Consumption
Toms consumption
without trade
30
Hank'sPPF
Quantity of coconuts Quantity of coconuts
Quantity of fishQuantity of fish
Toms consumption
with trade
Toms production
with trade
(b) Hanks Production and Consumption
Hanks production
with trade
Hanks consumption
with trade
Hanks consumptionwithout trade
TomsPPF
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Comparative Advantage Lower opportunity cost to perform a task than the other person
Absolute advantage Lower production cost (or, higher productivity) to perform a task
than the other person
Comparative advantage matters! Tom has absolute advantage in both activities, but still specialize
in fishwhy? Because Tom gains benefits by doing so! (1more coconut & 2
more fish)
Hank also benefits by specializing in coconuts (2 more coco & 4more fish)
Mutual benefits from following comparative advantage!Basic Concepts ofEconomics 26
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Basic Concepts ofEconomics 27
0
1,500
1,000
Quantity of aircraft
(a) The U.S. Production Possibilities Frontier
321 0
3,000
2,000
1,500
10.5 1.5
U.S.PPF
CanadianPPF
Quantity of pork (millions of tons)
Quantity of aircraft
(b) Canadian Production Possibilities Frontier
U.S. consumptionwithout trade
U.S. consumptionwith trade
U.S.
productionwith trade
Canadian productionwith trade
Canadian
consumptionwith trade
Canadianconsumptionwithout trade
Quantity of pork (millions of tons)
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U.S. PPF is relatively flat It implies that U.S. has a comparative advantage in pork
production
U.S. specializes In pork production and trade
Canadian PPF is relative steep It implies that Canada has a comparative advantage in aircraft
production
Canada specializes in aircraft production trade
Both countries gain from specialization and trade: bothenjoy more benefits than if they were self-sufficient
Basic Concepts ofEconomics 28
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Basic Concepts ofEconomics 29
Money
FactorsGoodsand services
Factors
Households
Firms
Factor Markets
Goodsand services
Money Money
Money
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Factor markets: determine income distributionamong factor owners wages, interests, rent
Real-world complications International trade
Transactions b/w firms
Government
Financial markets
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Description, and prediction: positive economics Its about facts, and describes how the economy actually works
Ex.: the average price of gas in May 2008 was higher than in May2007
Prescription: normative economics Its about values, and prescribes how the economy should work
Ex.: Gas prices are too high
A solution to normative economics
Ex.: If policy option A is more efficient that B for achieving thesame goal, then A is better than B
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Opportunity Cost
Marginal Analysis
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Its the sum of explicit cost and implicit cost Explicit cost: actual outlay of money
Implicit cost: forgone value of best alternative activity
Ex.: OC of an additional year of school
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Accounting profit: businesss revenue minus explicit costs
and depreciation
Economic profit: businesss revenue minus OC of its
resources
Ex.: Profits at Babettes Cafe
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Relevant to how much decisions Ex.: how many slices of pizza want to eat, how many workers want
to hire
Its an analysis at the edge, comparing additional benefit
to additional cost of one more unit of consumption (orproduction)
Marginal benefit: the additional benefit earned by
consuming (producing) one more unit of g/s Marginal cost: the additional cost incurred by consuming
(producing) one more unit of g/s
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Basic Concepts ofEconomics 37
76543210
Marginal benefit curve, MB
Marginal benefit (per wing)
Quantity of chicken wings
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Basic Concepts ofEconomics 38
76543210
$4.00
3.00
2.00
1.00
Marginal cost (perwing)
Quantity of chickenwings
Marginal cost curve, MC
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Its the quantity that generates the maximum possible
total net gain
And the total net gain is maximized when MB is equal toMC
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76543210
$4.00
3.00
2.00
1.00
MB, MC (per
wing)
Quantity of chickenwings
Optimal point
MC
MB
Optimal quantity
0
1
2
3
4
5
6
7
Total net gain(profit per serving)
Net gain(per wing)
Quantity ofchicken wings
$0
3.50
5.20
5.90
6.30
6.40
6.30
6.10
$3.50
1.70
0.70
0.40
0.10
0.10
0.20
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Sunk cost: a cost that has already been incurred andnon-recoverable
Ex.: You went to Sushi Buffet How many dishes you
want to have? Worth more than (or at least as much as)what you paid? Or, lets say, according to your marginal
analysis?
Sunk cost should be ignored in decisions about futureactions
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What is $x realized tyears in the future worthtoday?
It must satisfy this formula:
$V (1+r)t
= $x, or
$V =$x
(1+r)t
where $Vis the present value of$xrealized tyears inthe future at r, the annual interest rate
Ex.: Ifx = 1, r= 0.1, and t= 2, then V=1
1+0.1 2 0.83
Basic Concepts ofEconomics 42
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NPV of a project is the present value of current andfuture benefits minus the present value of current andfuture costs
Basic Concepts ofEconomics 43
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What are Free Trade Agreements (FTAs) and the WorldTrade Organization(WTO) Agreement? Explain therelationships between the two.
How many FTAs with how many countries does the U.S.
have in force?
With which countries does the U.S. has recently signedthe FTAs?
Discuss the possible pros and/or cons of having FTAs.
Basic Concepts of