principles of microeconomics economics 103ehutchin/resources/103/slides/econ103topic1... ·...

ECONOMICS 103

Topic 1: Introductory Concepts & Models• Introductory Concepts - micro v macroeconomics, 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.

Principles of Microeconomics

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WHAT IS MICRO?

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ISN’TWHAT IS MICRO?

• This isn’t a course about:- Money- The stock market- Personal finance.- Etc.

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• Nor is this course about:- Unemployment- Inflation- Recessions etc.- Etc.

• That’s all macroeconomics (Econ 104)

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• Macro deals with “large scale” phenomena.• Micro begins on 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?

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WHAT IS MICRO?

• 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.

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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 an understanding of economic efficiency.

• Next class, we will use a simple example to get a bit of a sense what efficiency is all about.

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MICRO AND MARKETS

• 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.

• [Efficiency example]

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PUBLIC POLICY DESIGN

• Reminder: iClicker use in lecture begins next week.• In-class example helped us to begin thinking about to “better” and

“worse” ways to allocate scarce resources: - First step on the path to understanding how economists think

about efficiency.• We did this in the context of understanding that micro is the study

of decision-making by economic agents, and how that decision making result in social outcomes.

• Next few posted slides talk about the methodology of economics.

- That material is important, so read those slides.• For now, we will start thinking about how economists model

decision-making by economic agents.10

Principles of MicroeconomicsWHAT IS MICRO?

• Bruce Springsteen announces a concert date in Victoria.- I love Springsteen.

• How do we measure love? - 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?

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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, were it not for the

Springsteen concert.- I need to identify the next best alternative use of of my

time and money, in order to make a decision.

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• 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.

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• 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.

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• 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.

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• 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 that matter 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.

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SCARCITY & TRADE-OFFS

• 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 :

- Easy to translate non-monetary benefits into monetary ones; or- Necessary to use (imperfect) monetary estimates of non-

monetary benefits.

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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?

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BENEFITS AND COSTS

• Key point: economic analysis properly accounts for ALL costs.• To do this, economists use the concept of opportunity cost.

- Formal definition shortly.• 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.

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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.

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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.

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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.

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OPPORTUNITY COST

“Happiness profit” we would get from U2

• 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”.

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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.

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OPPORTUNITY COST

• 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 Textbook questions for this type of example.

• 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.

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BINARY DECISIONS

• Recall decision-making rule:- Choose option with the highest net benefit (NB).- NB = Total benefits (TB) - Opportunity cost (OC).- OC = explicit cost + implicit cost.

• Springsteen v U2 example: - TB of U2 = WTP = $150.- Opportunity cost (OC)= ticket cost + value of forgone

Springsteen- Springsteen yielded $200 happiness at cost $150, so value of

forgone Springsteen = $50.- OC of U2 = $80 + $50 = $130.- NB of U2 = $150 - $130 = $20 > 0; so go to U2.

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MAKING DECISIONS

• Definition that we will pick up in Topic 3:- Consumer surplus (CS) is the formal term for the NB

from a decision to buy.• Consumer surplus (CS) = The benefits from a buying choice

minus the opportunity cost associated with that buying choice.- CS = WTP - OC.

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MAKING DECISIONS

• (45 seconds) Suppose you value Springsteen at $140, tickets cost $80, and if you didn’t go to Springsteen you would work that evening and be paid a total of $90.Then the opportunity cost to you of Springsteen is:a) $90.b) $80c) $170.d) $140.

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Principles of MicroeconomicsICLICKERS

• (Answer) Suppose you value Springsteen at $140, tickets cost $80, and if you didn’t go to Springsteen you would work that evening and be paid a total of $90.Then the opportunity cost to you of Springsteen is:a) $90.b) $80c) $170.

d) $140.

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OC = Implicit + explicit costsOC = $80 + $90OC = $170

• 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.

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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?

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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.

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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.

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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.

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SUNK COSTS

• 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.

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NON-BINARY DECISIONS

• 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.

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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.

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MARGINAL ANALYSIS

• 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 benefit of that step

with the cost of that step.- We call the benefits and costs of each step the marginal

benefits and costs (MB & MC).- If MB of a given beer > MC of that beer, drink it.

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MARGINAL ANALYSIS

• 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.

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MARGINAL ANALYSIS

• 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.

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MARGINAL ANALYSIS

• Q: (30 secs) Marginal benefit of beer, to me:- MB of 1st beer: $20- MB of 2nd beer: $12- MB of 3rd beer: $6- MB of 4th beer: $2

• Suppose beer costs $1 per pint. How many will I buy?a) 4 beers.b) 3 beer.c) 2 beers.d) 1beer.

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• A: (30 secs) Marginal benefit of beer, to me:- MB of 1st beer: $20- MB of 2nd beer: $12- MB of 3rd beer: $6- MB of 4th beer: $2

• Suppose beer costs $1 per pint. How many will I buy?a) 4 beers.

b) 3 beer.c) 2 beers.d) 1beer.

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• 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.

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MARGINAL ANALYSIS: SUMMARY

• Topic 1, we have looked at two simple ways to model decision-making:- 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.

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