Core Principles in Economics

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Core Principles in Economics

• Lecture 2

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In This Lecture

• Chapter 1 introduces you to nine principles or
  ideas that will reappear throughout this course
• Four principles for understanding how individuals
  make choices
• Five principles for understanding how individuals
  interact (how markets work)

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How Do Individuals Choose?

• Four Principles

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1) Resources are Scarce

• If there was no scarcity in life, would
  individuals ever have to make a choice between
  alternative goods or activities?
• While income is often thought to limit ones
  choices, time is the most limiting factor
  individuals face.
• History is replete with examples of attempts to
  overcome scarcity or limitations.

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2) The real cost of a good or activity is what
you have to give up to get it

• To choose means you have not done some
  alternative activity -- the value of what you
  have not done is the OPPORTUNITY COST of the
  activity you have done.
• Your out of pocket expenditures will often
  understate the cost of an activity
• No Free Lunch -- there is nothing free in life,
  everything has an opportunity cost

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Opportunity Cost

• If the price of a pizza is 10 and a movie is 5,
  what is the opportunity cost of a pizza in terms
  of movies?
• Answer
• What is the opportunity cost of a movie in terms
  of pizza?
• Answer

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Opportunity Cost

• The Cost of a Life
• (See handout)
• What is the opportunity cost in life years of
  implementing a national 55 mph speed limit
  instead of mandating that motorcyclists wear
  helmets?
• A) 87,000 life years
• B) 44.5 life years
• C) 0.02 life years
• D) 445 life years

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4) Individuals seek their self interest

• Most fundamental assumption in economics -- the
  weighting of the benefits and costs of
  alternative decisions
• Doesnt mean that all individuals have the same
  self interest or desires (they will not
  necessarily make the same choices if confronted
  with the same set of choices)
• Consumer Sovereignty -- individuals know what is
  in their best interest
• Individuals reveal their self interests through
  their choices -- Theory of Revealed Preferences

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Individuals make different type of economic
decisions

• Whether to decisions
• To enter the labor market
• To buy a car
• How much decisions
• How many hours to work
• How much to pay for transportation services

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3) Decisions are made on the margin

• Many decisions are not all or nothing decisions
  but more of how much type of decisions
• This principle is more about process of making
  decisions -- individuals continually ask
  themselves can they improve upon what they are
  doing -- than the nature of the decision
• If individuals have only local information can
  they still find what is in their best interest?

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Thinking on the Margin

• At x, y f(x) is maximized
• The slope of f(x) is equal to
• f(x)?y/?x
• f(x)gt0 if xltx
• f(x)0 if xx
• f(x)lt0 if xgtx
• Goal is find x where f(x)0

x
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Father of Marginal Analysis Alfred Marshall
(1842-1924)
Brought mathematics into the study of economics
but never wanted the mathematics to overshadowed
the economics. Consequently, his books were
aimed toward the layman. Taught Pigou and Keynes
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A Comment on Economic Time

• The exact time period that we will analyze is
  fixed but its length (day, month, year) is rarely
  specified.
• Micro analysis is concerned with flows not
  stocks. For example, how much of income will I
  spend on housing services this year?
• When this time period is over, the next will
  begin. The question the individual faces is how
  much will they want undertake in each time
  period, assuming that the conditions they face
  remain the same.

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How Do Individuals Interact?

• Five Principles

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5) There are gains from trade

• This principle will be the focus of next lecture.
• Voluntary trades will be beneficial to both
  parties, otherwise why would they have traded?
• Everyone will have a comparative advantage in
  some activity and consequently there will be
  gains to specializing in that activity and using
  surplus production to trade for other goods or
  services.

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6) Markets move toward equilibrium

• Markets -- interaction between individuals
• free markets are where there is no coercion to
  trade or interact
• Coordination of the interaction of individuals is
  achieved through prices (trading rates).
• Equilibrium -- where no individual has an reason
  to change their action
• If individuals are free to trade then trading
  will continue until no one else wishes further
  trades

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7) Resources should be used efficiently to
achieve societys goals

• Efficiency -- the inability to improve one
  persons well being without hurting someone else
  (Pareto Optimality)
• If we are inefficient in our use of resources, we
  are wasting them.
• Why would you want to deny someone additional
  welfare if it didnt hurt anyone elses welfare?
• This is a normative statement. What about other
  goals for society such as fairness or equity in
  the distribution of societys wealth?

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8) Market usually lead to efficiency

• This statement is often taken to mean that
  society (a collective decision perhaps taken by
  government) should not interfere with individual
  choice. A positive statement leading to a
  normative conclusion.
• But markets can fail to achieve an efficient
  result-- for example, congestion on the highways.

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9) When markets are not efficient, government
intervention can lead to improvement in social
welfare

• Yet there isnt a guarantee that governments will
  improve upon the market outcome. Rather they
  hold out the possibility to improve upon the
  efficiency of the outcomes of individual choice.
• Important to remember -- it is not that
  individuals make bad choices it is that market
  has failed to coordinate their decisions

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Summary Nine Principles

1. Resources are scarce
2. Every Choice has an Opportunity Cost
3. Choices are made at the margin
4. Individuals seek their self interest
5. There are gains from trade
6. Markets move toward equilibrium
7. Resources should be used efficiently
8. Markets usually lead to efficiency
9. When markets dont achieve efficiency, government
   intervention can improve social welfare

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Will we exhaust the world supply of oil?

• Argument by Analogy
• Imagine this room filled with pistachio nuts
  (with their shells on). I tell you could eat as
  many of the nuts as you wished and you could
  invite as many friends into the room as you
  wished who could also eat the pistachio nuts with
  the only restriction that you could not take the
  shells out of the room. There is no time limit
  or limit on the number of friends that you can
  invite. Would all of the nuts be eaten?

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Checking Out

• Supermarket Model -- gather all of your purchases
  into your cart and selecting which line (in front
  of store) to pay for purchases
• Department Store Model -- pay for purchases in
  the department where the goods are located
• Airport/Bank/Post Office Model -- Enter a single
  line and when at head of line go to first
  available clerk
• Why do certain stores adopt one method and not
  the other?

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Assignment for Next Lecture

• Do Homework 1 on Homework Assignment -- this
  homework will cover material on todays lecture
  (odd numbered problems from end of Chapter 1)
• Read Chapter 2 and Appendix
• Topics Next Time
• Economic modeling of trade-offs and the benefits
  to trade