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ECONOMICS 251H

Households, Firms &Markets

Spring 1999

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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.

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EXAMPLES OF SOME DECISIONS ECONOMISTS

HAVE ANALYZEDWhether 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.

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Factors in decision making

1. People face tradeoffs.

2. Opportunity cost.

3. Making decisions at the margin.

4. People respond to incentives.

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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.

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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)

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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?

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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

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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.

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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

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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.

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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.

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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.

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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.

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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.

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A model of heights

age in years

height H = a + b(A)

a

H

A

ΔA

ΔHb

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A better (nonlinear) model of heights

naive (linear)

age in years

height

fancy

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A better model?

Height = f(age, gender, parents’ heights, nutrition, ...)

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Gender effects in the better model

Height = f(age, gender, parents’ heights, nutrition, ...)

height

age

men

women

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MODEL SUMMARY

Three ways to describe modelsGraphs

Tables of values

Mathematical functions (equations)

Important conceptsDependent and independent variables

Linear function, intercept and slope

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AN ECONOMIC MODELThe Production Possibility CurvePurposes 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

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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.

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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.

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PRODUCTION POSSIBILITY CURVESPAGHETTI

PIZZA

Which points are attainableand which points are unattainable?Which points are attainableand which points are unattainable?

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PRODUCTION POSSIBILITY CURVESPAGHETTI

PIZZA

What’s the effect of an improvementin the technology for producing spaghetti?

What’s the effect of an improvementin the technology for producing spaghetti?

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PRODUCTION POSSIBILITY CURVESPAGHETTI

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What’s the effect of an increase in total resources (inputs)?What’s the effect of an increase in total resources (inputs)?

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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.

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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.

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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.

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PRODUCTION POSSIBILITY CURVESPAGHETTI

PIZZA

More pizza means less spaghettiMore pizza means less spaghetti

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OPPORTUNITY COST INCREASES AS MORE OF A

GOOD IS PRODUCEDNot 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.)

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Production Possibility Curve

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SPAGHETTI

PIZZA

Opportunity cost of more pizza is constant.

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