ECONOMICS 103 Dr. Emma Hutchinson, Fall 2017 http://web.uvic.ca/~ehutchin/teach/103/103f17.html Reminder: familiarize yourself with all course policies by reading the course outline and all posted info. Today s class: Introductions and reminders; Start of Topic 1: Introductory Concepts & Models Introductory Concepts - positive v normative statements, scarcity, trade-offs, benefits, costs, opportunity cost, sunk costs, marginal analysis, marginal benefit, marginal cost, marginal net benefit. Models - binary and non-binary decision making; marginal analysis.
WHAT IS MICRO? 2
WHAT IS MICRO? ISN T 3
WHAT IS MICRO? ISN T This isn t a course about: - Money - The stock market - Personal finance. - Etc. 4
WHAT IS MICRO? ISN T Nor is this course about: - Unemployment - Inflation - Recessions etc. - Etc. That s all macroeconomics (Econ 104) 5
WHAT IS MICRO? Principles of Microeconomics Macro deals with large scale phenomena. Micro begins at a much smaller scale. We start by thinking about things from the perspective of individuals. In particular, micro is the study of: - Decision-making at the level of the individual person, household, or firm; We call these decision-makers economics agents - The societal outcomes that arise from those decisions. Do we get good or bad outcomes? 6
MICRO AND MARKETS Principles of Microeconomics Often, interactions between economics agents occur in the context of markets. - Market: any environment in which buyers and sellers make exchanges. Exchanges often (but not always) those of goods for money. Why we will often focus on market exchanges: - Markets are important; they are a vital part of our modern society (like it or not). - Also, under certain conditions, mkts also do a pretty good job of allocating scarce resources across competing uses. 7
MICRO AND MARKETS Key questions of interest to us this term: What are those certain conditions under which market outcome are good for society? Do we believe such conditions hold (IRL), or not? This is a question of market success versus market failure. Note that using the phrase good for society requires us to have a rigorous way to distinguish good from bad. - In economics, we use the concept of efficiency for this. Another key goal this term is to develop a deep understanding of economic efficiency. Today, we will use an example to get a bit of a sense what efficiency is all about. 8
PUBLIC POLICY DESIGN Principles of Microeconomics Micro is also about public policy. When markets don t do such a great job, policy can be used to improve societal outcomes. Another key goal for 103 (and hopefully for every other Econ class you take...): - To understand how public policy can improve societal outcomes in the case of where market outcome are not so good for society. 9
WHAT IS MICRO? Principles of Microeconomics Recall: micro is the study of: - Decision-making at the level of the individual person, household, or firm; - The societal outcomes that arise from those decisions Problem: statement doesn t distinguish economics much from other social sciences. Where economics tends to differ from (say) sociology, poli sic, etc. is in terms of methodology. Methodology: how do we study what we study? 10
METHODOLOGY How is econ different from other policy-oriented social sciences? Two important aspects/assumptions: 1) Methodological individualism. We assume: - Social outcomes are best understood by analyzing the individual actions that underly them. - Individual actions motivated largely by a desire to be happy. - Doesn t mean people are selfish, horrible, hedonistic, etc. (That typically doesn t make us happy, right?) 11
METHODOLOGY How is econ different from other policy-oriented social sciences? Two important aspects/assumptions: 2) Rationality. We assume: - For the most part, people take actions that they believe will further their objectives (like being happy). - Doesn t mean people don t make mistakes/screw up. We ll talk more throughout the term about these assumptions. 12
WHAT IS MICRO? Recall: micro is the study of: Decision-making at the level of the individual person, household, or firm; and - we call these decision-makers economics agents The societal outcomes that arise from those decisions. How do we study this? More about our methodology. 13
A BIT MORE ON METHODOLOGY In economics we use formal models to think about the decision-making behaviour of different economic agents. Models allow us to take basic concepts and assumptions and analyze them rigorously and logically. Can also use models to make predictions about behaviour and behavioural changes. Models also allow us to make (and distinguish between) normative and positive statements. 14
METHODOLOGY OF ECONOMICS Positive statement: a state about what is. - Descriptive analysis. - Ex: The carbon tax in BC is currently $30/tonne of CO2. Normative statement: a state about what should be. - Prescriptive analysis. - Ex: The carbon tax in BC should be higher. To make normative statements we need a normative criterion. - More (much more) on this soon. 15
MODELS IN ECONOMICS Recall: models allow us to take basic concepts and analyze them rigorously and logically. Models begin with assumptions and use deductive logic to arrive at conclusions. Models are: - Necessarily simplifications - not replications - of reality. - Only as good as the assumptions on which they are built. One aim of Topic 1 is to develop a couple of basic models to understand some key concepts in economics. - Initial context: a simple example of individual decision-making. 16
Bruce Springsteen announces a concert date in Victoria. - I love Springsteen. How do we measure love? Principles of Microeconomics MAKING DECISIONS: AN EXAMPLE - By how much I am willing to pay (WTP) for the concert. Before ticket prices are announced, I figure out that the MOST I am WTP is $200. - This is a dollar value of the happiness I will get from concert. Suppose ticket prices are then listed at $150. Question: do I buy a Springsteen ticket? 17
MAKING DECISIONS: AN EXAMPLE Going to Springsteen buys me $200 of happiness at cost $150. - I get a net gain ( happiness profit?) of $50. Seems like a pretty good deal. But.. What else might I do with my time and money that night? There are lots of things I could do: - Study econ 103, go to a movie, work a shift in my job, etc. What matters to us is what I would do, absent the Springsteen concert. - I need to identify the next best alternative use of of my time and money, in order to make a decision. 18
MAKING DECISIONS: AN EXAMPLE Let s assume that (bizarrely) U2 is also holding a concert in Victoria on the night of the Springsteen concert. - If I don t go to Springsteen, I will go to U2. - I love U2 also, (not as much as I love Springsteen, though). Suppose I am WTP (at most) $150 for a U2 ticket. I m WTP more ($50 more) for Springsteen than U2. Does that mean I ll choose Springsteen over U2? - No - it depends on the cost of the U2 ticket as well. Assume that a U2 ticket costs $80. 19
MAKING DECISIONS: AN EXAMPLE U2 ticket buys $150 of happiness at cost $80. - Net gain = $70. Recall: Springsteen ticket buys $200 of happiness at cost $150. - Net gain = $50. Greater net gain from U2, even though I like Springsteen better. Springsteen is $50 better than U2, to me. - WTP for Springsteen ($200) - WTP for U2 ($150) = $50. BUT, Springsteen costs $70 more than U2. - Cost of Springsteen ($150) - Cost of U2 ($80) = $70. Extra Springsteen happiness from not worth cost: I shld go to U2. 20
MAKING DECISIONS: AN EXAMPLE Generalizing gives us a basic model of decision-making: - When faced with 2 mutually exclusive options, choose the one with the greatest net gain. - This will maximize my happiness; give me the greatest happiness bang for my buck. 21
SCARCITY & TRADE-OFFS Principles of Microeconomics Concert eg. illustrates importance of a key concept in economics. Decision-making is only meaningful in the face of scarcity. If all things simultaneously possible, no choices to be made. In reality, all (?) resources are scarce. - Examples: time, money, labour, oil, land, clean air, etc. - Scarcity means choices must be made about how to allocate resources across competing uses. Economic decision-making is all about making trade-offs. - Allocating more resources to one activity requires allocating fewer resources to some alternative activity. Have already seen an example of a trade-off: Springsteen v U2. 22
BENEFITS AND COSTS U2 won out because the additional benefit (happiness) of Springsteen was not worth the additional cost. Scarcity implies that all activities have costs as well as benefits. The benefits of an activity = all the good things that come from it. Note that benefits need not be directly monetary. - Concert example, for instance. But, oftentimes is either: Principles of Microeconomics - Easy to translate non-monetary benefits into monetary ones; or - Necessary to use (imperfect) monetary estimates of nonmonetary benefits. 23
BENEFITS AND COSTS The benefits of an activity = the good things that come from that particular activity. The costs of an activity = all the good things that must be given up when resources allocated to that activity are taken away from some alternative activity. Like benefits, costs need not be monetary. - For instance, most things cost time as well as money. But, again, we will typically translate non-monetary costs into monetary costs. - Time is money, right? Principles of Microeconomics 24
OPPORTUNITY COST Key point: economic analysis properly accounts for ALL costs. To do this, economists use the concept of opportunity cost. - Formal definition shortly. Principles of Microeconomics For any activity under consideration, there are often many alternatives to which the resources could have been allocated. Which of these activities is the correct measure of the cost of going to Springsteen on that night? Answer: the alternative activity that would have been chosen if Springsteen was not an option. - What we ve called the next best alternative. - We ve already established this was U2. 25
OPPORTUNITY COST The alternative activity that would have been chosen is used to calculate the opportunity cost of an particular activity. Definition: the opportunity cost of an activity is the value of the next best alternative use of the resources allocated to that activity. Costs are always opportunities foregone. In econ, when we say cost, we always mean opportunity cost. - The proper measure of the cost of something includes all the things we must give up to have that thing. 26
OPPORTUNITY COST Example: Back to Springsteen and U2. Costs and Benefits of Springsteen: the incorrect approach. - Benefit (enjoyment): $200 - Cost of ticket: -$150 - Benefits - costs: $50 Using this approach, we would conclude that going to Springsteen is a good choice. - WRONG, because we are not considering other options. - We are only including explicit monetary costs. 27
OPPORTUNITY COST Example: Back to Springsteen and U2. Costs and Benefits of Springsteen: the correct approach. - Benefit (enjoyment): $200 - Cost of ticket: -$150 - Cost of missing U2: -$70 - Benefits - costs: $50 -$20 Once we account for the outside option, Springsteen isn t such a good deal. - Benefits - properly measured costs < 0. Happiness profit we would get from U2 28
OPPORTUNITY COST In the concert example, the ticket price is an explicit cost. - Explicit costs are those that involve paying money. Can think of these as out-of-pocket expenses. - Explicit cost is only part of the opportunity cost of Springsteen. The cost of giving up the U2 option is an implicit cost. - Implicit costs don t involve paying money, but matter. Good decision-making requires we account for both types of costs. Opportunity costs = explicit costs + implicit costs. True cost of Springsteen = $150 ticket price + $70 of foregone U2 happiness profit. 29
OPPORTUNITY COST Opportunity cost of Springsteen = $150 ticket price + $70 of foregone U2 happiness profit. Every time an economist says cost they mean opportunity cost. 30
BINARY DECISIONS Principles of Microeconomics Binary decisions are yes or no decisions. - Do I go to Springsteen, or do something else? - Another ex: Do I keep operating a business, or do something else? See Supplementary Exercises for this type of ex. General decision rule for binary decisions: - Add up all the benefits of the action. - Subtract all the costs, implicit AND explicit. - Are benefit minus costs > 0? (are there positive net benefits?) If yes, then this is the right choice. Note: not all decisions are binary - more on this very soon. 31
SUNK COSTS One more key point about costs. Economists makes a distinction between costs that are sunk, and costs that are not. Sunk costs are those that cannot be recovered, no matter what decision you make. We need to understand that sunk costs should not influence your decision-making, since you incur them anyway. 32
SUNK COSTS Back to the concert example. We know I have (or should have) bought a ticket for U2. Now suppose on the day of the concert, a friend offers me a free Springsteen ticket. - Assume that there isn t time for me to sell the U2 ticket. What should I do? - Is it relevant that I have already paid for the U2 ticket? 33
SUNK COSTS Do the cost-benefit analysis. If I go to Springsteen: - I gain $200 of happiness at the concert. - I m out the $80 I paid for U2. - I forgo the $150 of U2-related happiness. If I go to U2: - I gain $150 of happiness at the concert. - I m out the $80 I paid for U2. - I forgo the $200 of Springsteen-related happiness. 34
SUNK COSTS Do the cost-benefit analysis. If I go to Springsteen: - I gain $200 of happiness at the concert. - I m out the $80 I paid for U2. - I forgo the $150 of U2-related happiness. If I go to U2: - I gain $150 of happiness at the concert. - I m out the $80 I paid for U2. - I forgo the $200 of Springsteen-related happiness. 35
SUNK COSTS No matter what choice I make, I m out the $80. - I can t get that back, no matter what. - It is unrecoverable; sunk. Because it is sunk it should not influence my choice. On the day of the concert, all that s relevant is who I like most. - Everything else is in the past. 36
NON-BINARY DECISIONS Principles of Microeconomics So far, we have looked just at binary decision-making. Not all decisions are yes or no choices Many decisions (most decisions?) are how much choices. - We model how much decisions using marginal analysis. Marginal analysis involves imagining decision making as occurring a little bit at a time. It is as if we effectively break down how much decisions into lots of little yes or no decision. 37
MARGINAL ANALYSIS Principles of Microeconomics Example: how many beers should I drink at the University Club on Friday evening? Note that this how much decision will literally be a series of yes or no decisions. - I don t need to buy all the beer at once; my purchases will be sequential over the course of the evening. Assuming that my aim is to maximize my happiness, all we need to do is think about happiness gained from each beer versus cost of each beer. 38
MARGINAL ANALYSIS How happy will beer make me on Friday evening? - 1st beer is worth: $20-2nd beer is worth: $12-3rd beer is worth: $6-4th beer is worth: $2 Think about why each additional beer worth less than the last. - Does this have to be true? (this is just an example, right?) If beer at the Club is $5 per pint, how much should I drink? - Beers 1, 2, and 3 give me enjoyment > cost: buy those. - 4th beer buys me $2 of enjoyment at cost $5: not worth it. - So I should buy 3 beers. Principles of Microeconomics 39
MARGINAL ANALYSIS Principles of Microeconomics The beer decision is an example of marginal analysis. - We are taking small steps - pushing out the margin of our choice - and asking: Was that step worth it? Should we take the next step? Each step is what we call a marginal choice. - Each step requires us to compare the marginal benefit (MB) to the marginal cost (MC). - If MB of a given beer > MC of that beer, drink it. 40
MARGINAL ANALYSIS Principles of Microeconomics Definitions. Given an activity, - The marginal benefit (MB) is the additional benefit gained by doing one more unit of that activity. - The marginal cost (MC) is the additional cost incurred by doing one more unit of that activity. - Marginal net benefit (MNB) = MB - MC. All how much decisions are analyzed in this way. - In each different choice environment, weigh up MB v MC. - All that changes as choice environment changes is what makes up the MB and MC terms. - Every model in 103 (all of econ) is about weighing MB & MC. 41
MARGINAL ANALYSIS Principles of Microeconomics Rewriting beer example using language of marginal analysis - MB of 1st beer: $20 - MB of 2nd beer: $12 - MB of 3rd beer: $6 - MB of 4th beer: $2 MC of beer = $5. Decision rule in beer example: buy another if MB > MC. - Equivalently, buy another beer if MNB > 0. 42
MARGINAL ANALYSIS Definitions: - MB = benefit gained from an additional unit. - MC = cost incurred from an additional unit. Decision rule for non-binary choices: - If MB > MC, do more. Or, if MB < MC, do less. - Equivalently, if MNB > 0, do more. Or, if MNB < 0, do less. Note: we ll return to beer example in Topic 3; make sure you understand it fully. 43
ROUND UP Topic 1, we have looked at two simple ways to model decisionmaking: - For binary decisions, choose the action with he highest NB. - For how much decisions, keep doing more of an action as long at the MB is at least as great as the MC. - Remember to fully account for all costs and benefits. This is the approach we will use throughout the term, looking at decision-making in a variety of different context. 44