Econ 201 Summer 2009 1.01 Economics: Foundations & Models.

Econ 201Summer 2009

1.01

Economics:

Foundations & Models

Overview

• Basic assumptions underlying economic modeling– Rationality and self-interest

• Marginal analysis – Totals versus marginal (incremental analysis)

• Basic questions economics addresses• Alternative Market approaches to

production and allocation• Modeling and the Scientific method

Basic Assumptions

• People are rational

• People respond to economic assumptions

• Optimal decisions are made at the margin

1. Rationality

• Individuals will make economic decisions in their own best interest, based on the information that they have available– Imperfect information (due to costs of

obtaining it, difficulty in interpreting and evaluating it) may “appear” to lead to less than “optimal” or “best” choices

• Gary Becker’s weaker assumption– Individuals do not systematically make

irrational decisions

1. Rationality

• 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

1. Rationality

• Becker’s point– As long as people don’t buy more when the

price goes up and even if they randomly buy more/less; they will behave as though they are adhering to the First Law of Demand

• A more rigorous version (for consumers)– Individuals seek to maximize their

utility/satisfaction subject to their income/budget constraint

1. Rationality

• More rigorously:

( , ) x x y yMax U x y subject to I p Q p Q

2. 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

•Will Women Have More Babies if the Government Pays Them To?

Makingthe

Connection

Learning Objective 1.1

The Estonian government is encouraged by the results of providing economic incentives and is looking for ways to provide additional incentives to raise thebirthrate further.

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

• 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 < priceDon’t buy!

MV < priceDo buy!

Totals versus Marginals

• When you make a “consumption” decision– You may be comparing Total Value of consuming x

amount of the good (TV(x)) to the Total Cost (TC(x))– But it’s really a step-wise comparison

• If TV(9) > TC(9) – Buy at least 9– then check at x =10

• If TV(10) < TC(10)– Stop at 9– MV(10th unit) less than MC(10th unit)

– Easier and faster (fewer calculations) to compare marginals than totals

Optimal Decisions Made at the Margin

• For consumers– If price > additional/incremental/marginal

“use” value of the good -> don’t buy– If price < MV -> buy

• For suppliers– If P > marginal costs of producing that last

unit -> supply it to the marketplace (sell it!)– If P < MC then don’t produce it

Key Questions in Economics

• What goods and services will be produced?

• How will the goods and services be produced?

• How will the goods and services be allocated?– How do we decide who gets them?

A Simplification of Market Types

• Two Extremes1. Centrally Planned Economies

– Government determines what goods get produced, who produces them and how they are allocated– E.g. Soviet Union’s 5-year plan (1917-1991)

2. Market Economies– Market determines all

– Prices signal consumer willingness to pay for goods and services

– Firms respond to price signals by comparing consumers WTP to the firm’s (marginal) cost of producing goods

– Goods are allocated to those with highest WTP (and hence value them most)

In Reality

• Real-world markets have mixes of both Market and Centrally planned structures– Market failure may require government

regulation (e.g., monopolies, pollution, fisheries)

– Public goods may require subsidies (e.g., national defense, education, clean energy)

– Lobbying to protect certain groups• Dairy farmers, energy producers

Scientific Method

Economic Models

• The Scientific Method (Hubbard and O’Brien)

1. Decide on assumptions to be used in developing the model

2. Formulate a testable hypothesis3. Use economic data to test the hypothesis4. Revise the mode if it fails to explain well the

economic data5. Retain the revised model to help answer

similar economic questions in the future

Role of Assumptions

• Assumptions– Role of assumptions is to

• reduce the complexity of the problem to its key elements and,

• focus on the items that have the most significant impact (“80/20” rule)

– 80% of the impact is due to 20% of the factors

• Robust– If relaxing the assumptions has minimal impact on

your conclusions then the model is deemed “robust” and is largely unaffected by these testable or non-testable assumptions

– “robustness” is a desirable property

Normative and Positive Analysis

• Positive economics– “what is”, e.g., if prices go up, quantity

demanded will go down• If rates increase faster than the rate of growth in

income then demand for telephone (or electricity) services will decline

• Normative economics– “what ought to be” or “what is fair”

• Everyone should be able to afford basic telephone (or electric) services

– “universal service” mandate

Macro- versus Microeconomics

• Microeconomics– Focuses on analysis of consumers and firms in

specific individual markets• E.g., automobile, PC computers, wireless telephone service

– Several sub disciplines• Labor, Industrial Organization, Natural Resources, Industry

Types, Theory, International Trade, Finance, Health Care

• Macroeconomics– Focuses on aggregate economic behavior

• All markets lumped into GDP = C+I+G+NX• Look at impact of government impact (taxes, subsidies,

regulation, monetary and fiscal policy), trade policies on GDP, employment

Economics as a Social Science

• Is economics a science?