Week 1a: Economic Decision
Making
1
Economics is about people making
themselves happy
• Moves away from the traditional definition of
“allocating scarce resources among competing
goals”.
• Individuals, like society, must do such allocating,
choosing among competing goods with limited
resources, a budget constraint.
• Behaviors of others and institutions like
businesses and government are additional
constraints on individual choices.
• I like to build economics up from the individual
and see how policies affect individual happiness.
2
Economics improves policymaking
• Can better see the tradeoffs policy entails
• Spotted Owl Protection
– Stop logging, costs jobs
– Preserve wilderness, increase utility for
environmentalists, both those out in the forests
and those who like “existence value”.
– Increases tourism jobs
– See the tradeoffs. Economics is about tradeoffs.
3
Example: Medicare Catastrophic
Coverage Act (MCCA)
• Really pretty simple – increased Medicare for
“Catastrophic coverage”.
• Funded by a tax on high income/wealth Medicare
recipients.
• Overall, additional benefits (in dollar savings) =
additional costs (in new taxes) among all
Medicare recipients.
• Distribution of benefits and costs
– Additional Benefits=Additional Costs, 22%
– Additional Benefits>Additional Costs, 48%
– Additional Benefits<Additional Costs, 30%
• So, good or bad policy?
4
Comparing Outcomes
• In MCCA, average benefit = average cost
• Some people won (22%, mostly the poorest
members of the group, many won “big”), some
lost (30%, mostly the wealthiest members of the
group, few lost “big”)
• As a group, were they better off or worse off?
• To answer, would have to value some members
utility more than others. Economists try not to
do this – no special powers to decide “who is
deserving”. Leave that to politics.
5
A basis for comparison: The Pareto
Criteria
Let S1 and S2 be two states of the world.
• S1 is Pareto Superior to S2 if all individuals are
better off in S1 than in S2.
• If S1 is Pareto Superior to S2, then S2 is Pareto
Inferior to S1.
• If no state is Pareto Superior to S1, then S1 is
termed Pareto Optimal.
• If S1 is not Pareto Superior to S2 and S2 is not
Pareto Superior to S1, S1 and S2 are termed
Pareto Noncomparable.
6
Pareto Criteria (continued)
• Economists seek and want Pareto Superior
outcomes.
– Means there is no way to make someone better off
without making someone else worse off.
– Does not mean the outcome is socially desirable.
• Highly skewed distribution of income can be Pareto Optimal.
• But may cause social unrest, and not meet overall social
values.
• Almost all policy making is a choice between
Pareto Noncomparable outcomes.
7
Policy Making for Pareto Improvement
• Although most policies choose among Pareto
Noncomparables (meaning what?), policy design
can move to a Pareto superior outcome.
• Good microeconomic policy making falls mostly
in defining property rights. Property rights means
that some person’s or groups utility is considered
more important than others.
• Smoking is a good example
– Before 1970s, property rights belonged to smokers.
– Now, property rights belong to nonsmokers. Why?
8
Why do Property Rights work?
• Individuals make decisions based on their
private benefits and costs.
• If someone without property rights values the
right more than someone with it, they might
be willing to buy it from the holder.
• Examples:
– Marketable permits
– Tolls
– Catch limits in fisheries
9
Goals of Policy Making
• Efficiency
– Tolls (how)
– Marketable Permits (how)
– Catch limits (how)
• Equity
– MCCA (what)
– Social Security (what)
– Catch limits (what)
10
Marginal Analysis: a way to get the
most value
• Marginal Benefit: The value of the last unit of
an action.
• Marginal Cost: The cost of the last unit of an
action.
• Total Value = Total Benefit – Total Cost
• Maximize Total Value by setting marginal value
equal to marginal cost
11
Maximizing Total Value
Let b(x) be the total benefit and c(x) be the total
cost of doing x units of some activity.
Let T ( x)  b( x)  c( x) be the total benefit. To
maximize T(x)
T ( x) b( x) c( x)


0
x
x
x
b( x) c( x)


x
x
Do x until marginal benefit = marginal cost.
12
Applications of Marginal Optimization
• Studying
• Speed limits
• Law enforcement
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