9/5/2017. Introduction & Chapter 1

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1 Introduction & Chapter 1 Economics is the study of the allocation of scarce resources How do people make choices under scarcity and what are the results of these choices for society? While microeconomics studies decisions at the individual level, such as consumer and company decisions, macroeconomics studies the economy as a whole, such as the overall production, price, and employment levels 1 2 We will study economics based on seven core principles Since the principles appear throughout the textbook, you ll meet them often In the following, I introduce each principle After that, I will explain the course logistics Then we ll begin the course with Chapter 1 People have unlimited wants but limited resources, such as time, energy, production equipment, and knowledge This implies that our resources and the goods we can produce are scarce Scarcity implies trade-offs: Getting more of one good means giving up other goods 4 An individual, company, or society should take an action if, and only if, the additional benefit it achieves exceeds or equals the additional cost It only makes sense if your total benefits in life increase from doing it. The increase in total benefits is the added or marginal benefit minus the added or marginal cost, MB-MC. You should do it if and only if MB MC An economic incentive is the benefit relative to the cost of a certain action When the benefits increase or the costs decrease such that the economic incentive increases - people become more likely to take the action People respond to incentives 5 6 1

2 Your opportunity cost of taking an action is the value of what you forego to do it The comparative advantage principle says that everyone in society does best when the people with the lowest opportunity cost of producing good X the people who give up the least - produce it When you increase the production of a good, you should first employ the resources with the lowest opportunity cost That way, you and society only forego the bare minimum 7 8 Efficiency is when you maximize the value of production based on the inputs you have available (your time, energy, equipment, knowledge etc.). The efficiency principle says that maximizing efficiency is an important social goal all else constant, it is btter to make the pie larger A market in economics is a way for individuals to trade with each other An equilibrium is a situation where nobody has an incentive no one perceives they can benefit from acting differently The equilibrium principle says that when a market is in equilibrium leaves no unexploited opportunities for individuals, but they may be able to benefit from acting collectively, as a group. 10 Principles of Macroeconomics 6th Edition, by Robert Frank, Ben Bernanke, Kate Antonovics, and Ori Heffetz; McGraw-Hill Education Required app (for quizzes): download i-clicker to your smartphone, Required (for homework): subscribe to Connect. I will you the instructions I will also post the lecture syllabus & lecture slides at Course requirements 15 problem sets, 3% each 45% 2 midterms, 15% each 30% Final exam 20% In-class quizzes 15%

3 If you me in advance you can submit a single late problem set. You can also replace a single problem set with a 2- page write-up that uses your favorite textbook chapter(s) to explain a real-life situation. If you perfectly complete all the assignments, you can get 110%. The last 10% represent bonus points Chapter Economics: The study of how people make choices under scarcity andthe results of these choices for society. Scarcity is involved in The Scarcity Principle: People have unlimited wants and limited resources. Having more of one good means having less of another. Your spending choices How you focus your time at work and in school Government policies & elections Pollution Gas prices Also called No Free-Lunch Principle Take an action if and only if the extra benefits are at least as great as the extra costs You clip grocery coupons but Bill and Melinda Gates do not: the opportunity cost of their time is too high You speed on the way to work but not on the way to school: the benefit of speeding to work is higher as you avoid getting yelled at or fired. You clip grocery coupons but Bill and Melinda Gates do not At the ball park, you pay extra to buy a soda from the hawkers in the stands You speed on the way to work but not on the way to school You skip your regular dental check-up

4 The economic surplus of an action is equal to its benefit minus its opportunity cost Benefits Opportunity Cost Opportunity cost is the value of what you forego to undertake an activity It includes both explicit and implicit costs Here is an example of economic surplus and opportunity cost (next slide): Economic Surplus Friday night you can watch a movie for $10 Your best alternative use of time is to babysit and earn $20 The opportunity cost of the movie is your $10 explicit cost plus your $20 implicit cost Your economic surplus is your benefit from the movie minus the $30 opportunity cost. You only get a surplus, and it is only rational to go, if you value the movie at $30 or more Your business earns $100,000 in profit If you invest the $100,000 in new equipment, you can earn an extra $24,000 next year and resell the equipment for $80,000 Your best alternative is to invest the 100K in municipal bonds (=lend to the local government) at 5% interest. The economic surplus from the new equipment is $24K - ($100K-$80K) explicit cost - (0,05*100K) implicit cost = -$1,000 Though the explicit cost is only $20K, you have to add the implicit $5K cost Economic models are simplified descriptions of reality that help us to answer research questions They make assumptions and highlight some aspect of reality, while ignoring other aspects What are some examples: In order to explain people s economic decisions, we might assume that people are rational: they have well-defined goals and do their best to achieve them Then they should use the cost-benefit principle & only take actions if the benefits exceed or equal the cost The model predicts that you and I would pick up a $20 on the street, but Bill Gates would not We can compare the predictions with the evidence to test how realistic the model is or if the assumptions are flawed

5 To explain US total consumer spending we might assume that people respond to after-tax earnings, interest rates (return to saving/cost of borrowing), and expectations about the economy s future: C=4+0.7*(Y-T)-100*r +0.5*E C=Total US Consumer spending ($ trillions) Y-T = Total Household Income Taxes, r = the average interest rate in the economy E=consumer confidence, average answer to a survey interview question: how optimistic do you feel on scale from 1 to 5) Get statistical data for the economic variables C,Y,T,r,E Model might predict 2016 consumer spending C=4+0.7*($18.6tr-$4tr)-100* (2) = $13.2tr Compare the predicted C values to the actual C value in 2016 ($12.8tr, a bit off) Get more data (ex. monthly or many years back), check the model fit to reality People measure costs and benefits as proportions instead of absolute amounts 2. People ignore implicit costs 3. People fail to think at the margin Field of behavioral/psychological economics is a growing research area It studies situations where people do not act rationally. People measure costs and benefits as proportions instead of absolute amount Would you walk to town to save $10 on a $25 item? Would you walk to town to save $10 on a $2,500 item? #2 People ignore implicit costs You have a frequent flyer coupon, so you can fly for free But you forgot you also need to go to your sister s wedding Using the frequent-flyer coupon has an implicit cost: the wedding-trip ticket you need to buy after you use it. People fail to think at the margin Imagine you already bought an $80 Broncos ticket in Denver, but the Broncos are playing bad this year Your added or marginal benefit would be $10, but the marginal cost $20 (gas, time) People feel they should go because they paid $80, but the $80 are a sunk or irrecoverable cost. The surplus from going is -$10<

6 Apart from ignoring sunk cost, people sometimes compare the average rather than marginal benefits and costs: Consider a space shuttle example Assume each space shuttle adds $6billion benefits # of Launches Total Cost ($B) 0 $0 1 $3 2 $7 3 $12 4 $20 5 $32 Marginal Cost ($B) If each space shuttle adds $6billion benefit, the total benefit is higher than the total cost up to 4 shuttles: $6*4 = $24 > $20 Then the average benefit is also higher than the average cost (divide by 4 on both sides, inequality still holds: $24/4 > $20/4 Does this mean we should send up 4 shuttles? $3 $4 $5 $8 $ Look at the marginal benefits and costs instead of the average The MB is only higher than the MC cost up to THREE shuttles: If we send up the 4 th shuttle, the MB = $6 < $8 = the MC, we lose $2 The total surplus at 3 shuttles is 3*$6-$12 = $6 The total surplus at 4 shuttles is 4*$6 -$20 =$4 We should only send up 3 shuttles to maximize the economic surplus An economic incentive is the benefit relative to the cost of a certain action The incentive principle says that when the benefits increase or the costs decrease such that the economic incentive increases - people become more likely to take the action If the marginal benefit of the 4 th shuttle increased from $6 to $9>$8 (MB>MC), NASA would be more likely to send it up. If in-class quizzes count for a bigger % of grade, people are more likely to attend class Normative economics says how people should behave according to a value system We should reduce inequality in the United States This statement assumes inequality is bad, perhaps because we inherently dislike it or because it hurts other goals, like economic growth Positive economics explains how people will behave If we cut public school spending, inequality will increase If we tax imports from China, American textile producers benefit and consumers lose

7 How do households decide how much sugar to buy? How much sugar are they willing to buy at different prices? How do sugar producers decide how many workers to hire? How much sugar will they produce at different prices? How does the interaction between the demand and supply/production of sugar affect the price and quantity of sugar that is traded in the sugar market? How do students decide what college to go to, which subjects to study, whether to study or work? What determines the value of total or overall production in America in a given year? What determines total US consumer spending? What determines the overall price level of US goods? What determines the overall interest rate in the US and how does the overall interest rate affect the economy? What determines the overall unemployment level? How can government policies like taxes and government spending influence the economy? The UW Colors are A. Red & Blue B. Blue & Yellow C. Blue & Purple D. Brown & Blue E. Brown & Gold I ll post similar questions on the the powerpoints and start the quiz session