ECONOMICS 251H
Households, Firms &
Markets
Spring 1999
Introduction
slide 1
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.
Introduction
slide 2
EXAMPLES OF SOME
DECISIONS ECONOMISTS
HAVE ANALYZED
Whether 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.
Introduction
slide 3
Factors in decision making
1.
2.
3.
4.
Introduction
People face tradeoffs.
Opportunity cost.
Making decisions at the margin.
People respond to incentives.
slide 4
How individual decisions affect
others
5.
6.
Trade (exchange) can benefit everyone.
Markets are often a good way to
organize exchange.
7. Government can sometimes improve on
markets.
Introduction
slide 5
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)
Introduction
slide 6
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?
Introduction
slide 7
Methodology: Positive v. Normative
Economics
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?
Introduction
slide 8
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.
Introduction
slide 9
THE PARETO CRITERION
DEFINED
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.
Introduction
slide 10
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.
Introduction
slide 11
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.
Introduction
slide 12
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.
Introduction
slide 13
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.
Introduction
slide 14
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.
Introduction
slide 15
A model of heights
H
A
height
H = a + b(A)
ΔH
b=
ΔA
a
age in years
Introduction
slide 16
A better (nonlinear) model of
heights
naive (linear)
fancy
height
age in years
Introduction
slide 17
A better model?
Height = f(age, gender, parents’ heights,
nutrition, ...)
Introduction
slide 18
Gender effects in the better
model
Height = f(age, gender, parents’ heights,
nutrition, ...)
men
height
women
age
Introduction
slide 19
MODEL SUMMARY
Three ways to describe models
Graphs
Tables of values
Mathematical functions (equations)
Important concepts
Dependent and independent variables
Linear function, intercept and slope
Introduction
slide 20
AN ECONOMIC MODEL
The Production Possibility Curve
Purposes 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
Introduction
slide 21
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.
Introduction
slide 22
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.
Introduction
slide 23
PRODUCTION POSSIBILITY
CURVE
SPAGHETTI
400
Which points are attainable
and which points are unattainable?
300
200
100
0
0 10 20 30 40 50 60
PIZZA
Introduction
Go to hidden slide
slide 24
PRODUCTION POSSIBILITY
CURVE
SPAGHETTI
What’s the effect of an improvement
400
in the technology for producing
spaghetti?
300
200
100
0
0 10 20 30 40 50 60
PIZZA
Introduction
Go to hidden slide
slide 26
PRODUCTION POSSIBILITY
CURVE
SPAGHETTI
What’s the effect of an increase in
400
total resources (inputs)?
300
200
100
0
0 10 20 30 40 50 60
PIZZA
Introduction
Go to hidden slide
slide 28
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.
Introduction
slide 30
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.
Introduction
slide 31
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.
Introduction
slide 32
PRODUCTION POSSIBILITY
CURVE
SPAGHETTI
400
300
200
100
0
More pizza means less spaghetti
0
10
20
30
40
50
60
PIZZA
Introduction
slide 33
OPPORTUNITY COST
INCREASES AS MORE OF A
GOOD IS PRODUCED
Not 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.)
Introduction
slide 34
Production Possibility Curve
SPAGHETTI
400
300
Opportunity cost of more
pizza is constant.
200
100
0
0
10
20
30
40
50
60
PIZZA
Introduction
slide 35
We will use Production Possibilities Curves
that are straight lines (i.e., that have
constant opportunity cost) to illustrate some
important economic principles.
Introduction
slide 36