LECTURE 2: MODELS IN ECONOMICS. Today s Topics
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1 LECTURE 2: MODELS IN ECONOMICS Today s Topics >
2 LECTURE 2: MODELS IN ECONOMICS Today s Topics 1. Economists apply the scientific method. >
3 LECTURE 2: MODELS IN ECONOMICS Today s Topics 1. Economists apply the scientific method. 2. Assumptions and models in economics. >
4 LECTURE 2: MODELS IN ECONOMICS Today s Topics 1. Economists apply the scientific method. 2. Assumptions and models in economics. 3. Two simple models. >
5 LECTURE 2: MODELS IN ECONOMICS Today s Topics 1. Economists apply the scientific method. 2. Assumptions and models in economics. 3. Two simple models. 4. Micro v. macro. >
6 LECTURE 2: MODELS IN ECONOMICS Today s Topics 1. Economists apply the scientific method. 2. Assumptions and models in economics. 3. Two simple models. 4. Micro v. macro. 5. Description v. prescription. >
7 LECTURE 2: MODELS IN ECONOMICS Today s Topics 1. Economists apply the scientific method. 2. Assumptions and models in economics. 3. Two simple models. 4. Micro v. macro. 5. Description v. prescription. 6. Why economists may disagree. >
8 Lecture 2 A G S M 2004 Page 2 THE SCIENTIFIC APPROA CH
9 Lecture 2 A G S M 2004 Page 2 THE SCIENTIFIC APPROA CH Obser vation: prices are rising rapidly Theor y: government printing money too quickly? Test: obser ve data on prices and money supply over time in many countries evidence of theory?
10 Lecture 2 A G S M 2004 Page 2 THE SCIENTIFIC APPROA CH Obser vation: prices are rising rapidly Theor y: government printing money too quickly? Test: obser ve data on prices and money supply over time in many countries evidence of theory? Obser vation: sales of airconditioners lower than normal Theor y: cooler weather the cause? Test: obser ve patterns of temperature, humidity, and compare with patterns of A/C sales
11 Lecture 2 A G S M 2004 Page 3 USE NATURAL EXPERIMENTS
12 Lecture 2 A G S M 2004 Page 3 USE NATURAL EXPERIMENTS effect on national economies of a spike in the world price of oil (e.g. Gulf War I)?
13 Lecture 2 A G S M 2004 Page 3 USE NATURAL EXPERIMENTS effect on national economies of a spike in the world price of oil (e.g. Gulf War I)? effect on CD sales of Napster and its demise and the growth of peer-to-peer file sharing on the Internet?
14 Lecture 2 A G S M 2004 Page 3 USE NATURAL EXPERIMENTS effect on national economies of a spike in the world price of oil (e.g. Gulf War I)? effect on CD sales of Napster and its demise and the growth of peer-to-peer file sharing on the Internet? effect on house prices of higher interest rates?
15 Lecture 2 A G S M 2004 Page 3 USE NATURAL EXPERIMENTS effect on national economies of a spike in the world price of oil (e.g. Gulf War I)? effect on CD sales of Napster and its demise and the growth of peer-to-peer file sharing on the Internet? effect on house prices of higher interest rates? effect on house prices of the chang es in flight patterns at Sydney Airpor t?
16 Lecture 2 A G S M 2004 Page 4 ASSUMPTIONS
17 Lecture 2 A G S M 2004 Page 4 ASSUMPTIONS make the world easier to understand a 1:1 road map would not be of much use!
18 Lecture 2 A G S M 2004 Page 4 ASSUMPTIONS make the world easier to understand a 1:1 road map would not be of much use! an art in making the appropriate assumptions: what to ignore? over what time period?
19 Lecture 2 A G S M 2004 Page 5 ECONOMIC MODELS
20 Lecture 2 A G S M 2004 Page 5 ECONOMIC MODELS Models of words
21 Lecture 2 A G S M 2004 Page 5 ECONOMIC MODELS Models of words or diagrams
22 Lecture 2 A G S M 2004 Page 5 ECONOMIC MODELS Models of words or diagrams or numbers
23 Lecture 2 A G S M 2004 Page 5 ECONOMIC MODELS Models of words or diagrams or numbers or algebra
24 Lecture 2 A G S M 2004 Page 5 ECONOMIC MODELS Models of words or diagrams or numbers or algebra Models are built on assumptions: simplifications of reality
25 Lecture 2 A G S M 2004 Page 6 MODEL 1: THE CIRCULAR-FLOW DIAGRAM
26 Lecture 2 A G S M 2004 Page 7 Households
27 Lecture 2 A G S M 2004 Page 7 Firms Households
28 Lecture 2 A G S M 2004 Page 7 Markets for Goods & Services Firms Households
29 Lecture 2 A G S M 2004 Page 7 Markets for Goods & Services Firms Households Markets for Input Factors
30 Lecture 2 A G S M 2004 Page 7 Markets for Goods & Services Firms Households Markets for Input Factors Labour, land, capital
31 Lecture 2 A G S M 2004 Page 7 Markets for Goods & Services Firms Households Markets for Input Factors Labour, land, capital Wa ges, rent, profits
32 Lecture 2 A G S M 2004 Page 7 G & S sold Markets for Goods & Services Firms Households Markets for Input Factors Labour, land, capital Wa ges, rent, profits
33 Lecture 2 A G S M 2004 Page 7 Revenues G & S sold Markets for Goods & Services Firms Households Markets for Input Factors Labour, land, capital Wa ges, rent, profits
34 Lecture 2 A G S M 2004 Page 7 Revenues G & S sold Markets for Goods & Services G & S bought Firms Households Markets for Input Factors Labour, land, capital Wa ges, rent, profits
35 Lecture 2 A G S M 2004 Page 7 Revenues G & S sold Markets for Goods & Services Spending G & S bought Firms Households Markets for Input Factors Labour, land, capital Wa ges, rent, profits
36 Lecture 2 A G S M 2004 Page 7 Revenues G & S sold Markets for Goods & Services Spending G & S bought Firms Inputs Markets for Input Factors Households Labour, land, capital Wa ges, rent, profits
37 Lecture 2 A G S M 2004 Page 7 Revenues G & S sold Markets for Goods & Services Spending G & S bought Firms Households Costs Inputs Markets for Input Factors Labour, land, capital Wa ges, rent, profits
38 Lecture 2 A G S M 2004 Page 8 CIRCULAR FLOW What simplifications does the model make? What is missing from the model?
39 Lecture 2 A G S M 2004 Page 8 CIRCULAR FLOW What simplifications does the model make? What is missing from the model? Governments International trade Finance markets
40 Lecture 2 A G S M 2004 Page 8 CIRCULAR FLOW What simplifications does the model make? What is missing from the model? Governments International trade Finance markets Others?
41 Lecture 2 A G S M 2004 Page 9 MODEL 2: THE PRODUCTION POSSIBILITIES FRONTIER Assume: there are only two products: cars and computers. These two industries consume all of the economy s factor inputs.
42 Lecture 2 A G S M 2004 Page 9 MODEL 2: THE PRODUCTION POSSIBILITIES FRONTIER Assume: there are only two products: cars and computers. These two industries consume all of the economy s factor inputs. Want to plot the economy s Production Possibilities Frontier (PPF): the various combinations of output the economy can produce, given available input factors and production technologies.
43 Lecture 2 A G S M 2004 Page 10 THE PPF: AN EXAMPLE
44 Lecture 2 A G S M 2004 Page 10 THE PPF: AN EXAMPLE If all resources used in the car industry, then the economy produces 1000 cars/period and no computers (point L).
45 Lecture 2 A G S M 2004 Page 10 THE PPF: AN EXAMPLE If all resources used in the car industry, then the economy produces 1000 cars/period and no computers (point L). If all resources used in the computer industry, then the economy produces 3000 computers/period and no cars (point M).
46 Lecture 2 A G S M 2004 Page 10 THE PPF: AN EXAMPLE If all resources used in the car industry, then the economy produces 1000 cars/period and no computers (point L). If all resources used in the computer industry, then the economy produces 3000 computers/period and no cars (point M). If resources divided between the two industries, the economy could produce 700 cars and 2000 computers (point A).
47 Lecture 2 A G S M 2004 Page 11 THE PPF: PLOTTED Quantity of computers produced/period 3000 M 2000 A L Quantity of cars produced/period
48 Lecture 2 A G S M 2004 Page 11 THE PPF: PLOTTED Quantity of computers produced/period 3000 M D 2000 A L Quantity of cars produced/period
49 Lecture 2 A G S M 2004 Page 11 THE PPF: PLOTTED Quantity of computers produced/period 3000 M D 2000 A 1000 B 0 L Quantity of cars produced/period
50 Lecture 2 A G S M 2004 Page 11 THE PPF: PLOTTED Quantity of computers produced/period 3000 M D C 2000 A 1000 B 0 L Quantity of cars produced/period
51 Lecture 2 A G S M 2004 Page 12 THE PPF: FEASIBILITY, EFFICIENCY Point D not feasible: the economy does not have enough resources, and known technology does not allow existing resources to attain that rate of production.
52 Lecture 2 A G S M 2004 Page 12 THE PPF: FEASIBILITY, EFFICIENCY Point D not feasible: the economy does not have enough resources, and known technology does not allow existing resources to attain that rate of production. An outcome is efficient if the economy is squeezing all the output it can from the scarce resources available.
53 Lecture 2 A G S M 2004 Page 12 THE PPF: FEASIBILITY, EFFICIENCY Point D not feasible: the economy does not have enough resources, and known technology does not allow existing resources to attain that rate of production. An outcome is efficient if the economy is squeezing all the output it can from the scarce resources available. Points on the frontier (such as L, M, and A) are efficient;
54 Lecture 2 A G S M 2004 Page 12 THE PPF: FEASIBILITY, EFFICIENCY Point D not feasible: the economy does not have enough resources, and known technology does not allow existing resources to attain that rate of production. An outcome is efficient if the economy is squeezing all the output it can from the scarce resources available. Points on the frontier (such as L, M, and A) are efficient; points outside (such as D) are infeasible;
55 Lecture 2 A G S M 2004 Page 12 THE PPF: FEASIBILITY, EFFICIENCY Point D not feasible: the economy does not have enough resources, and known technology does not allow existing resources to attain that rate of production. An outcome is efficient if the economy is squeezing all the output it can from the scarce resources available. Points on the frontier (such as L, M, and A) are efficient; points outside (such as D) are infeasible; points inside (such as B) are inefficient.
56 Lecture 2 A G S M 2004 Page 12 THE PPF: FEASIBILITY, EFFICIENCY Point D not feasible: the economy does not have enough resources, and known technology does not allow existing resources to attain that rate of production. An outcome is efficient if the economy is squeezing all the output it can from the scarce resources available. Points on the frontier (such as L, M, and A) are efficient; points outside (such as D) are infeasible; points inside (such as B) are inefficient. Point B is inefficient: output could be higher in terms of cars or computers or both (to the NE).
57 Lecture 2 A G S M 2004 Page 13 THE PPF: TRADE-OFFS People face trade-offs: possible to move from point A to point C, and produce 200 more computers, but at the expense of producing 100 fewer cars.
58 Lecture 2 A G S M 2004 Page 13 THE PPF: TRADE-OFFS People face trade-offs: possible to move from point A to point C, and produce 200 more computers, but at the expense of producing 100 fewer cars. The cost of something is what you must forgo to get it:
59 Lecture 2 A G S M 2004 Page 13 THE PPF: TRADE-OFFS People face trade-offs: possible to move from point A to point C, and produce 200 more computers, but at the expense of producing 100 fewer cars. The cost of something is what you must forgo to get it: at point A the oppor tunity cost of 200 computers is 100 cars.
60 Lecture 2 A G S M 2004 Page 14 THE PPF: TRADE-OFFS DIFFER
61 Lecture 2 A G S M 2004 Page 14 THE PPF: TRADE-OFFS DIFFER The shape of the PPF reflects the fact that when the economy is focussed on making cars (near point L), the opportunity cost of computers in terms of cars forgone is low.
62 Lecture 2 A G S M 2004 Page 14 THE PPF: TRADE-OFFS DIFFER The shape of the PPF reflects the fact that when the economy is focussed on making cars (near point L), the opportunity cost of computers in terms of cars forgone is low. But when the the economy is focussed on computer manufacturing (near point M), the oppor tunity cost of computers in terms of cars forgone is high.
63 Lecture 2 A G S M 2004 Page 14 THE PPF: TRADE-OFFS DIFFER The shape of the PPF reflects the fact that when the economy is focussed on making cars (near point L), the opportunity cost of computers in terms of cars forgone is low. But when the the economy is focussed on computer manufacturing (near point M), the oppor tunity cost of computers in terms of cars forgone is high. It is also possible to ask what the cost is in terms of computers forgone of making an additional car.
64 Lecture 2 A G S M 2004 Page 15 HOW CLOSE ARE WE TO THE PPF?
65 Lecture 2 A G S M 2004 Page 15 HOW CLOSE ARE WE TO THE PPF? Without having a clear idea where the PPF is (it depends on available resouces and technologies), can we tell whether we re near it or not?
66 Lecture 2 A G S M 2004 Page 15 HOW CLOSE ARE WE TO THE PPF? Without having a clear idea where the PPF is (it depends on available resouces and technologies), can we tell whether we re near it or not? How?
67 Lecture 2 A G S M 2004 Page 15 HOW CLOSE ARE WE TO THE PPF? Without having a clear idea where the PPF is (it depends on available resouces and technologies), can we tell whether we re near it or not? How? Look at the markets for inputs is there unemployment? Look at the firms is there idle capacity?
68 Lecture 2 A G S M 2004 Page 15 HOW CLOSE ARE WE TO THE PPF? Without having a clear idea where the PPF is (it depends on available resouces and technologies), can we tell whether we re near it or not? How? Look at the markets for inputs is there unemployment? Look at the firms is there idle capacity? If Yes, then we re not at the PPF.
69 Lecture 2 A G S M 2004 Page 15 HOW CLOSE ARE WE TO THE PPF? Without having a clear idea where the PPF is (it depends on available resouces and technologies), can we tell whether we re near it or not? How? Look at the markets for inputs is there unemployment? Look at the firms is there idle capacity? If Yes, then we re not at the PPF. Does the converse follow?
70 Lecture 2 A G S M 2004 Page 15 HOW CLOSE ARE WE TO THE PPF? Without having a clear idea where the PPF is (it depends on available resouces and technologies), can we tell whether we re near it or not? How? Look at the markets for inputs is there unemployment? Look at the firms is there idle capacity? If Yes, then we re not at the PPF. Does the converse follow? No. Bad management could waste inputs that s where you come in!
71 Lecture 2 A G S M 2004 Page 16 THE PPF & NEW TECHNOLOGY The Production Possibility Frontier can shift as new technology appears. Two things happen:
72 Lecture 2 A G S M 2004 Page 16 THE PPF & NEW TECHNOLOGY The Production Possibility Frontier can shift as new technology appears. Two things happen: combinations of output previous infeasible (such as D) become feasible, and
73 Lecture 2 A G S M 2004 Page 16 THE PPF & NEW TECHNOLOGY The Production Possibility Frontier can shift as new technology appears. Two things happen: combinations of output previous infeasible (such as D) become feasible, and the opportunity costs (or trade-offs) can chang e.
74 Lecture 2 A G S M 2004 Page 17 THE PPF SHIFTS For instance,
75 Lecture 2 A G S M 2004 Page 17 THE PPF SHIFTS For instance, if a technological advance in the computer industry allows workers productivity (the number of computers a worker can make per period) to rise, then the economy can make more computers for any given number of cars.
76 Lecture 2 A G S M 2004 Page 17 THE PPF SHIFTS For instance, if a technological advance in the computer industry allows workers productivity (the number of computers a worker can make per period) to rise, then the economy can make more computers for any given number of cars. The production possibility frontier shifts outwards, as shown.
77 Lecture 2 A G S M 2004 Page 17 THE PPF SHIFTS For instance, if a technological advance in the computer industry allows workers productivity (the number of computers a worker can make per period) to rise, then the economy can make more computers for any given number of cars. The production possibility frontier shifts outwards, as shown. The economy might shift production from point A to point E: producing both more computers and more cars.
78 Lecture 2 A G S M 2004 Page 18 THE PPF SHIFT PLOTTED 4000 Quantity of computers produced/period A Quantity of cars produced/period
79 Lecture 2 A G S M 2004 Page 18 THE PPF SHIFT PLOTTED 4000 Quantity of computers produced/period A Quantity of cars produced/period
80 Lecture 2 A G S M 2004 Page 18 THE PPF SHIFT PLOTTED 4000 Quantity of computers produced/period A E Quantity of cars produced/period
81 Lecture 2 A G S M 2004 Page 19 MICRO v. MACRO Microeconomics: how households and firms make decisions, how they interact through markets (for output, and for inputs), how firms in an industry interact as they compete and perhaps collude, and looking inside the firm at outsourcing and contracting.
82 Lecture 2 A G S M 2004 Page 19 MICRO v. MACRO Microeconomics: how households and firms make decisions, how they interact through markets (for output, and for inputs), how firms in an industry interact as they compete and perhaps collude, and looking inside the firm at outsourcing and contracting. Examples: competition policy, the profitability of different industries, chang es in access to foreign markets and increased foreign competition in Australian markets.
83 Lecture 2 A G S M 2004 Page 20 MICRO v. MACRO Macroeconomics: the study of the national economy, issues of growth, employment, exchang e rates, interest rates.
84 Lecture 2 A G S M 2004 Page 20 MICRO v. MACRO Macroeconomics: the study of the national economy, issues of growth, employment, exchang e rates, interest rates. Examples: impact of chang es in monetary policy on interest rates, on financial markets, and on the real economy; chang es in fiscal policy (government borrowing and spending).
85 Lecture 2 A G S M 2004 Page 21 THE ECONOMIST AS POLICY-MAKER Economics can describe economic interactions (positive economics) to aid our understanding, and can suggest ways to improve the efficiency and equity of the economy (normative economics).
86 Lecture 2 A G S M 2004 Page 21 THE ECONOMIST AS POLICY-MAKER Economics can describe economic interactions (positive economics) to aid our understanding, and can suggest ways to improve the efficiency and equity of the economy (normative economics). Economists have influenced government policy at both the micro and macro level: how to ration scarce facilities in an industry; parallel importation of books and music; monetary and fiscal policy.
87 Lecture 2 A G S M 2004 Page 21 THE ECONOMIST AS POLICY-MAKER Economics can describe economic interactions (positive economics) to aid our understanding, and can suggest ways to improve the efficiency and equity of the economy (normative economics). Economists have influenced government policy at both the micro and macro level: how to ration scarce facilities in an industry; parallel importation of books and music; monetary and fiscal policy. But MBA students focus on descriptions of how individuals, households, and firms behave and interact, with little focus on policy-making.
88 Lecture 2 A G S M 2004 Page 22 ECONOMISTS ARE HUMAN, TOO And they may disagree about policy. Why?
89 Lecture 2 A G S M 2004 Page 22 ECONOMISTS ARE HUMAN, TOO And they may disagree about policy. Why? because they disagree about which is the correct positive theory about how the world works, and/or
90 Lecture 2 A G S M 2004 Page 22 ECONOMISTS ARE HUMAN, TOO And they may disagree about policy. Why? because they disagree about which is the correct positive theory about how the world works, and/or because they have different values about how the world should be (e.g. public schooling is a good leveller, v. choice of schools is better than none, and competition prevents schools complacency).
91 Lecture 2 A G S M 2004 Page 22 ECONOMISTS ARE HUMAN, TOO And they may disagree about policy. Why? because they disagree about which is the correct positive theory about how the world works, and/or because they have different values about how the world should be (e.g. public schooling is a good leveller, v. choice of schools is better than none, and competition prevents schools complacency). Nonetheless, there is widespread agreement (see Table 2.2 in the text).
92 Lecture 2 A G S M 2004 Page 23 Issues in Microeconomics (Not for discussion today.) How can bad weather help farmers? How do borrowing and lending help smooth consumption across years? What impact does a fall in discount rates have on this pattern? Why do some people choose not to work? Why do some people choose not to work longer when their wage rates increase? Why is there a greater reliance on machiner y in Australian construction than in Chinese construction? When will higher tax rates raise tax revenues, and when will such revenues fall? Why do some firms go out of business? Why do some resturants offer weekday specials? Why do high interest rates discourage investment?
93 Lecture 2 A G S M 2004 Page 24 Why might price controls result in queuing? How could minimum wage laws result in lower employment? When might governments use quotas (which raise no revenues) rather than tariffs (which, as taxes on imports, do raise revenues)? How can growing demand for computers accompany lower prices for computers? How best should governments allocate scarce resources, such as the electro-magnetic spectrum? When is a monopoly not a monopoly? (Or, should the Australian Competition and Consumer Commission care that there is only a single manufacturer of Coca Cola in Australia?) Are Australian CD prices too high? If so, why, and what could the Government do to reduce them? Why have slide rules disappeared from sale? Why does Telstra charge a monthly amount, plus an amount per call? How could Telstra chang e its billing, and how would subscribers behaviour chang e?
94 Lecture 2 A G S M 2004 Page 25 What methods do firms use to reduce loafing on the job? Why are employee-owned firms rare? What is the difference between a firm s average cost and marginal cost? And does it matter? What information does the firm need to calculate both costs? How do decision makers respond to future uncertainty? What if adver tising were prohibited? What if coffee drinking (or cigarette smoking) were prohibited? What is Gresham s Law and why is it impor tant in times when the quality of goods and services is not easily obser ved before purchase? How to sell music? Bundled on a CD, or track by track over the Internet? <
In this chapter, look for the answers to these questions
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