ECONOMICS 251H Households, Firms

1
ECONOMICS 251HHouseholds, Firms
MarketsSpring 1999
2
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.

3
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.

4
Factors in decision making

• 1. People face tradeoffs.
• 2. Opportunity cost.
• 3. Making decisions at the margin.
• 4. People respond to incentives.

5
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.

6
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)

7
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 Browns pizza
  consumption if we take 1000 away from Tom Izzo
  and give it to Brown?

8
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?

9
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
  societys interest to adopt those policies that
  improve social welfare and reject those policies
  that reduce social welfare.

10
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.

11
PARETO CRITERION NOTES

• Its 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)
• Its 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.

12
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, its better to be efficient than
  inefficient.

13
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.

14
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.

15
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.

16
A model of heights
? H
height
?A
H a b(A)
?H
a

b
?A
age in years
17
A better (nonlinear) model of heights

• naive (linear)

fancy
height
age in years
18
A better model?

• Height f(age, gender, parents heights,
  nutrition, ...)

19
Gender effects in the better model

• Height f(age, gender, parents heights,
  nutrition, ...)

men
women
height
age
20
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

21
AN ECONOMIC MODELThe 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

22
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.

23
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.

24
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
Go to hidden slide
25
PRODUCTION POSSIBILITY CURVE
SPAGHETTI
400
300
unattainable
200
100
attainable
0
0
10
20
30
40
50
60
PIZZA
26
PRODUCTION POSSIBILITY CURVE
SPAGHETTI
400
Whats the effect of an improvement in the
technology for producing spaghetti?
300
200
100
0
0
10
20
30
40
50
60
PIZZA
Go to hidden slide
27
An improvement in spaghetti technology
SPAGHETTI
400
300
200
100
0
0
10
20
30
40
50
60
PIZZA
28
PRODUCTION POSSIBILITY CURVE
SPAGHETTI
400
Whats the effect of an increase in total
resources (inputs)?
300
200
100
0
0
10
20
30
40
50
60
PIZZA
Go to hidden slide
29
Effect of an increase in resources.
SPAGHETTI
400
300
200
100
0
0
10
20
30
40
50
60
PIZZA
30

• 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.

31
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.

32
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.

33
PRODUCTION POSSIBILITY CURVE
SPAGHETTI
400
300
More pizza means less spaghetti
200
100
0
0
10
20
30
40
50
60
PIZZA
34
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.)

35
Production Possibility Curve
SPAGHETTI
400
Opportunity cost of more pizza is constant.
300
200
100
0
0
10
20
30
40
50
60
PIZZA
36

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