Lecture 1 - Introduction

Transcription

1 Lecture 1 - Introduction Spring Introduction What is economics? A social science of human decision-making, like psychology, sociology, anthropology. What are the objectives of economics? 1. To develop a systematic knowledge of individual choices. 2. To understand the collective (market) outcomes resulting from these choices. 3. To produce an abstraction or model of these phenomena. Problems that we encounter: (1) Everyone is different (2) Every situation is different (3) We have a few controlled experiments. The economy is a lousy experiment - Lucas We will abstract from (1)and (2). This iswhat models do. We will work extremely hard in this class to directly confront (3) -Emphasis on empirical methods in economics. 1

2 1.1 Methodology of Economics (Milton Friedman) Positive Economics The study of what is. A descriptive endeavor free of value judgements. Build models to make sense of and generalize the phenomena we observe. Make predictions based on those models. Normative Economics Assessing what ought to be done. Making economic policy prescriptions. Sometimes positive economics gives us all the tools we need to say that one policy is preferable to another. (Q: When is this the case? A: When one policy is Pareto superior to another. Not too many of these) Usually involves value judgements, ethical preferences, tradeoffs among competing goals (e.g., employment and inflation; equity and efficiency). Economics often makes these tradeoffs clear. We ll try to do this in this class Strength of economic approach Rigorous: assumptions are stated, methods are formal, conclusions are internally consistent. Cohesive: built on a foundation of first principles and theory. Refutable: makes strong, testable (refutable) predictions, many of which appear correct. Practical : will help you to better understand how the world works Weaknesses of the economic approach Economics is marked by a startling crudeness in the way it thinks about individuals and their motivations... - Krugman E.g., strong, simplifying assumptions that are often unpalatable and cannot be completely right (e.g., people act rationally to pursue self-interested -distinct from selfish - objectives...) 2

3 1.1.3 But is this a weakness? We have a model of the world. It s called the world - and it s too complicated to be useful. Friedman: An economic model is a [heuristic] device used to form hypotheses [about economic phenomena] by abstraction or reduction to essential elements. Friedman: The test of the validity of a model is the accuracy of its predictions about real economic phenomena, not therealismofits assumptions. Friedman: A hypothesis is important if it explains much by little. Our approach: simple models, significant insights Three significant insights of economic approach Study of People doing the best with what they have. Very simple idea gets you along way inunderstanding human action -both positively and normatively. Equilibrium - Market aggregates individual choices to produce collectively outcomes that are sometimes spectacularly different from individual decisions. Properties of equilibrium can be evaluated. Good outcomes: fundamental welfare theorems: self-interest peoduces efficiency Bad outcomes: externalities, information failures, market failures. 1.2 The Accidental Theorist - Paul Krugman Hypothetical economy Outputs: hot dogs Buns Inputs: 3

4 Labor: 120 million workers L HD + L B = 120 mil Production technology: Each hot dog takes 2 people to produce F HD (L) = Each bun takes 2 people to produce L HD 2 Initial state of the economy: L B F B (L) = 2 HD = 30 mil, B = 30 mil L HD = 60 mil, L B =60 mil How do we analyze the impact of a change in hot dog technology that reduces the labor requirements of hot dogs by 50%, i.e. F HD (L) = L HD? How many hot dogs will be produced? How many buns? How many jobs will be destroyed? Will society be richer or poorer? What are the distributional effects? What is the appropriate policy response? Is this a silly exercise? [Graph 1] 4

5 HD B = HD Graph PPF 60 B f H (L) = L H 2 f B (L) = L B 2 Efficient allocation: L H = L B =60 H = 30 B = 30 Why is this efficient? Technological improvement Q: What happens when unit labor requirements in the H sector fall by 50%? [Graph 2] 5

6 HD 120 B = HD 30 mil workers 45 Graph 2 60 PPF 60 B If we kept producing H = 30 L H =30 B = 30 L B =60 Unemployed = 30 mil f H (L) = L H f B (L) = L B 2 30 Unemployment rate = 120 = 25% Q: How could we help these displaced workers? A: The employed 90 million workers could each contribute part of their income to subsidize the unemployed workers. Q: What assumption is being made? Another possibility: [Graph 3] 6

7 120 B = HD Graph U 1 U 0 PPF 60 ½ LH =40 L B =80 ½ H = 40 B = 40 Unemployment = 0 10 million more served Hot dogs produced? 1 more 3 Buns produced? 1 more 3 Jobs destroyed? L 2 H 40 H 2 40 = = L 1 60, H million lost (in the hot dog industry) 20 million gained (in the buns industry) H Is society richer or poorer? Seemingly 1 richer in tangible terms. 3 7

8 What are the distributional effects? Depends on whether skills are specialized. Could be zero, could be large Appropriate policy responses? Limit technological change in the hot dog sector? Subsidize bun producers? Stimulate additional demand for hot dogs to absorb surplus? Do nothing? Consider training programs for displaced hot dog workers? Hot Dog Economy: Was this exercise silly? William Greider, One World, ready or Not: The Manic Logic of Global Capitalism What if we said: Hot Dog = Manufacturing Buns = Services Between 1970 and 2001, manufacturing output increased by 140 percent. Total manufacturing employment declined by 9 percent. Over the same time, service productivity did not measurably increase, but service sector employment grew by 250 percent. During the period , the US economy added 61 million jobs and the unemployment rate was roughly constant. What if it turned out that productivity increase was a big lie? We were actually trading buns for Chinese hot dogs at the rate of 2 hot dogs per bun. We d produce 60 million buns, keep 40 million buns and trade 20 million for 40 million hot dogs = Net effect is the same. 8

9 1.3 Why Models Help Make assumptions transparent Can learn things from looking at a simple model that you d never learn by interviewing hot dog and bun producers. Most people have models in their heads for economic phenomena - they just don t know it, and the models are often wrong. While our hot dog model may be wrong, at least it s explicit so that we can have a sensible debate. 1.4 The approach in this class Positive: What does theory predict? Normative: which allocations of resources are better (or can we say)? Empirical issues: How can we test theories? My goal: to encourage you to think about problems like an economist. Not a math class. Just solving equations will not earn you an A. You will answer essay questions. Your answers to essay questions should be as lucid as a set of equations - but they should not be equations. 1.5 What we ll be discussing in Consumer choice and the theory of demand. Here you see the full-blown apparatus of modern mathematical economics. This is arguably the most tedious part of the course - but I make no apology. Need to understand this material to depart from it. Problems we ll study: the minimum wage, food stamps, price indexes (consumer price index), Christmas gifts. Choice and uncertainty Theory of decisions in the face of risk (previously certainty only) How do we make decisions when outcomes are uncertain and some of them are quite undesirable? Why do insurance markets exist and why do they work? Problems we ll study: Teen motherhood and the demand for abortion. Deviations from rationality in financial decisions. 9

10 Prices, perfect competition, general equilibrium and economic efficiency. What are the properties of social outcomes when people act independently in a rational, self-interested way? One of the great insights of Adam Smith was that self-interested behavior has tremendous virtues. Order emerges from chaos: The self-organizing society. Fundamental welfare theorems on the efficiency of markets. Problems we ll study: free trade sugar quotas, externalities. Economics of information: why is information different? And how does this impact the competitive market equilibrium from General Equilibrium theory? Insurance markets. Markets for products. Markets for people (also known as labor markets). Adverse selection, moral hazard, signaling. Problems we ll study: Health insurance, used cars. the G.E.D. ( high school equivalency ) certificate. Game theory: How do markets work when a market only includes a few people each aware of the others behavior (i.e. behavior is strategic) Problems we ll study: When do self-interested people cooperate? Network externalities - How standards evolve, and how these may create problems for markets. Trust on the internet (E-bay) 1.6 Requirements Readings are important. I will assign them before lectures. They will appear in problem sets and you will be tested on their substance. Problem sets: 7 plus one not for credit (see your class schedule). Handed in by 9 am on the due date (in class or outside my office) or no credit. TFs will discuss problem sets in recitation. Lowest score dropped. 25% of your grade. Exams: Two in class, one during exam period (all 90 minutes or two hours for third). Not cumulative. Each one is 25% of your grade. Exam scores likely to be closely correlated with problem set scores. Notify us the day before your exam if you are too deathly ill to attend. Only one makeup will be given. 10

11 Class participation matters. You won t be marked down if you are silent - but you can improve your grade by up to 2/3 rds of a letter grade (e.g. from B to A-) by contributing. You don t always have to be right. A word on class attendance. No one is taking attendance. But the textbook does not cover the class material: you will do poorly on exams if you don t come to class - even if you have mastered the book. Others who tried to do the class bythe book did badly. No letter grades until the course ends. Only scores and distributions. We can t assign a letter grade until we know everyone s point total for the semester. Problems with grading: submit your question in writing to a TF along with a copy of the problem set or exam within one week of the time returned. After TF has contacted you by , you may come to the TF s office to talk about it. Textbook: Details given on the website. Course pack: it s thin but needed. 11