Thinking Like an Thinking Like an EconomistEconomist

Lecture by Dr. Villamor VitalLecture by Dr. Villamor VitalProfessor, Economic AnalysisProfessor, Economic Analysis

Asian Social InstituteAsian Social InstituteJuly 11, 2007July 11, 2007

Basic Competitive Model of the Basic Competitive Model of the EconomyEconomy

Firms compete for customers, using Firms compete for customers, using priceprice

Consumers compete, using priceConsumers compete, using price Assumptions:Assumptions:

1.1. How consumers behave – rationalHow consumers behave – rational

2.2. How firms behave – profit maximizingHow firms behave – profit maximizing

3.3. How markets behave – competitiveHow markets behave – competitive

Incentives & Information: Incentives & Information: Prices, Property Rights, & Prices, Property Rights, &

Profits Profits Market economies provide information Market economies provide information

and incentives through and incentives through pricesprices, , profitsprofits, , & & property rightsproperty rights..

Prices – most willing & able to pay; Prices – most willing & able to pay; scarcity indicator; consumers adjust.scarcity indicator; consumers adjust.

Profits – motivates producers/sellers.Profits – motivates producers/sellers. Wages – must provide incentives to Wages – must provide incentives to

work.work. Private property & property rights – use Private property & property rights – use

& dispose/sell as the owner sees fit& dispose/sell as the owner sees fit

Incentive-Equality Trade-offIncentive-Equality Trade-off

Some persons perform Some persons perform better than othersbetter than others

Incentives for better Incentives for better performers result in performers result in higher total output, higher total output, but creates inequality.but creates inequality.

Are there societies Are there societies where there are no where there are no incentives for good incentives for good performance? Is there performance? Is there equality here?equality here?

When Property Rights FailWhen Property Rights Fail

Ill-defined property rights: The Grand Ill-defined property rights: The Grand Banks storyBanks story

Restricted Property RightsRestricted Property Rights Entitlements as Property Rights – e.g. Entitlements as Property Rights – e.g.

right to occupy an apartment for liferight to occupy an apartment for life

The Grand Banks StoryThe Grand Banks StoryFish are a valuable resource. Not so long ago, the area Fish are a valuable resource. Not so long ago, the area

between Newfoundland and Maine, called the Grand between Newfoundland and Maine, called the Grand Banks, was teeming with fish. Not surprisingly it was Banks, was teeming with fish. Not surprisingly it was also teeming with fishermen, who saw an easy also teeming with fishermen, who saw an easy livelihood scooping out the fish from the sea. Since livelihood scooping out the fish from the sea. Since there were no property rights, everyone tried to there were no property rights, everyone tried to catch as many fish as they could. A self-interested catch as many fish as they could. A self-interested fisherman would rationally reason that if he did not fisherman would rationally reason that if he did not catch the fish, someone else would. The result was a catch the fish, someone else would. The result was a tragedy: the Grand Banks was overfished, to the tragedy: the Grand Banks was overfished, to the point where not only was it not teeming with fish, but point where not only was it not teeming with fish, but commercial fishing became unprofitable. Today commercial fishing became unprofitable. Today Canada and the United States have a treaty limiting Canada and the United States have a treaty limiting the amount of fish that fishermen from each country the amount of fish that fishermen from each country can take from the Grand Banks, and gradually, over can take from the Grand Banks, and gradually, over the years, the fish population has been restored. the years, the fish population has been restored.

Rationing (alternative to the Rationing (alternative to the price system)price system)

Def: When individuals get less of a good Def: When individuals get less of a good than they would like at the terms offeredthan they would like at the terms offered

RationingRationing– By Queues – to those willing to wait in line By Queues – to those willing to wait in line

(Phil. Examples: gov’t. rolling stores, relief)(Phil. Examples: gov’t. rolling stores, relief)– By Lotteries – fair but inefficient (Lotto, PCSO)By Lotteries – fair but inefficient (Lotto, PCSO)– By Coupon – e.g., military gas coupon By Coupon – e.g., military gas coupon

(National Defense College), BSP rice coupon(National Defense College), BSP rice coupon

Opportunity Sets & Trade-Opportunity Sets & Trade-offsoffs

Opportunity set – the group of Opportunity set – the group of available optionsavailable options

Constraints – limit choice & define the Constraints – limit choice & define the opportunity set, usually, time and opportunity set, usually, time and money.money.

Budget constraints – limited by money Budget constraints – limited by money held (say, for a Worker)held (say, for a Worker)

Time constraints – time limit (say, for Time constraints – time limit (say, for a billionaire)a billionaire)

Budget Constraint: Figure Budget Constraint: Figure 2.12.1

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0 1 2 3 4 5 6

B1

D

E

F

B2

Figure 2.2 Time constraint: Figure 2.2 Time constraint: Opportunity set for watching TV Opportunity set for watching TV

vs. Other Activitiesvs. Other Activities

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28

0 4 8 12 16 20 24

Hours spent watching TV

Hours spent on all other activities

Time constraint

D

More on Thinking Like an More on Thinking Like an EconomistEconomist

Production Possibilities FrontierProduction Possibilities Frontier– Trade-offsTrade-offs– Efficient CombinationEfficient Combination– Diminishing ReturnsDiminishing Returns

Opportunity CostsOpportunity Costs Marginal Costs and BenefitsMarginal Costs and Benefits

Figure 2.3 The Guns & Butter Figure 2.3 The Guns & Butter Trade-offTrade-off

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20

40

60

80

100

120

0 40 70 90 100

Guns (Millions)

Butter (Millions of Tons)

FC

B

A

G

Society’s production possibilities frontier

The production possibilities curve reflects diminishing returns.

Figure 2.4 The Wheat & Corn Figure 2.4 The Wheat & Corn Trade-offTrade-off

60,000

150,000

200,000150,000

C

B

A

Firm’s production possibilities curve

This production possibilities curve shows that as wheat production increases, it becomes necessary to give up larger and larger amounts of corn. Or, to put the same point a different way, as corn production falls, the resulting increase in wheat production gets smaller and smaller. Point A illustrates an inefficient outcome, falling inside the opportunity set.

Table 2.3 Diminishing Table 2.3 Diminishing ReturnsReturns

Labor in Labor in cornfield cornfield (no. of (no. of workers)workers)

Corn Corn output output (bushels)(bushels)

Labor in Labor in wheat wheat field (no. field (no. of of workers)workers)

Wheat Wheat output output (bushels)(bushels)

1,0001,000 60,00060,000 5,0005,000 200,000200,000

2,0002,000 110,000110,000 4,0004,000 180,000180,000

3,0003,000 150,000150,000 3,0003,000 150,000150,000

4,0004,000 180,00180,00 2,0002,000 110,000110,000

5,0005,000 200,000200,000 1,0001,000 60,00060,000

Costs in terms of Trade-offsCosts in terms of Trade-offs

An opportunity set like the budget An opportunity set like the budget constraint, the time constraint, or the constraint, the time constraint, or the production possibilities curve specifies the production possibilities curve specifies the cost of one option in terms of another.cost of one option in terms of another.

Operating on the constraint or curve, it is Operating on the constraint or curve, it is possible to get more of one thing only by possible to get more of one thing only by sacrificing some of another.sacrificing some of another.

The “cost” of one more unit of one good is The “cost” of one more unit of one good is how much you have to give up of the how much you have to give up of the other.other.

Costs in terms of trade-offs: Costs in terms of trade-offs: Budget Constraint (Cont’d.)Budget Constraint (Cont’d.)

E.g., trade-offs based on E.g., trade-offs based on relative relative priceprice, ratio of the prices of CDs and , ratio of the prices of CDs and DVDs, whereDVDs, where Price of CD = $10,Price of CD = $10,

Price of DVD = $20.Price of DVD = $20.

Then relative price = $20/$10 = 2. Then relative price = $20/$10 = 2. For every DVD one gives up, one can For every DVD one gives up, one can buy 2 CDs.buy 2 CDs.

Trade-offs along the Production Trade-offs along the Production Possibilities FrontierPossibilities Frontier

E.g. Figure 2.3: Point A is the choice E.g. Figure 2.3: Point A is the choice where 40 million guns and 90 million where 40 million guns and 90 million tons of butter are produced.tons of butter are produced.

The trade-off can be calculated by The trade-off can be calculated by comparing points A and B. Society comparing points A and B. Society can have 30 million more guns by can have 30 million more guns by giving up 20 million tons of butter.giving up 20 million tons of butter.

Opportunity CostsOpportunity Costs

Include not only what you paid to acquire Include not only what you paid to acquire a good or enjoy an activity, but alsoa good or enjoy an activity, but also

What that amount paid could otherwise What that amount paid could otherwise buy andbuy and

Time you used up in the activity which Time you used up in the activity which you could have used for anotheryou could have used for another

Examples: Manny Pacquiao & Gerry the Examples: Manny Pacquiao & Gerry the Utility Man; Atty. Mel’s decision not to Utility Man; Atty. Mel’s decision not to have a second wife; Vince’s internet have a second wife; Vince’s internet date.date.

Sunk CostsSunk Costs

Expenditure made that cannot be Expenditure made that cannot be recovered no matter what choice is recovered no matter what choice is made.made.– E.g.: Bataan Nuclear Power Plant; much E.g.: Bataan Nuclear Power Plant; much

of Philippine foreign debt (NAPOCOR); of Philippine foreign debt (NAPOCOR); depreciation of the peso to encourage depreciation of the peso to encourage exports, & cost the economy OFWs bane;exports, & cost the economy OFWs bane;

– Globalization at the expense of domestic Globalization at the expense of domestic industriesindustries

Marginal CostsMarginal Costs Weighed against Marginal BenefitsWeighed against Marginal Benefits E.g. Effect of imposition of 12% VAT:E.g. Effect of imposition of 12% VAT:

MC = lower consumption, investment & MC = lower consumption, investment & employmentemployment

MB = higher Government Revenue, reduced MB = higher Government Revenue, reduced Budget deficitBudget deficit

E.g. Effect of trade liberalization (lower E.g. Effect of trade liberalization (lower Tariffs on imports):Tariffs on imports):MC = lower Government Revenue, higher Budget MC = lower Government Revenue, higher Budget

Deficit, shut down of domestic industries, Deficit, shut down of domestic industries, higher unemploymenthigher unemployment

MB = lower prices of and more goods available MB = lower prices of and more goods available to consumers, low inflation rate to consumers, low inflation rate

More on Marginal Costs vs. More on Marginal Costs vs. Marginal BenefitsMarginal Benefits

E.g. considering the inconvenient truth of E.g. considering the inconvenient truth of Global warming, what if we decide to Global warming, what if we decide to abolish the “Carbon Economy.” Effects are:abolish the “Carbon Economy.” Effects are:MC = shut down of carbon-based businesses, no MC = shut down of carbon-based businesses, no

more PUBs & PUJs so we walk, decline in more PUBs & PUJs so we walk, decline in investments, higher unemployment, decline in investments, higher unemployment, decline in GNPGNP

MB = clean air, clean water, reversal of global MB = clean air, clean water, reversal of global warming (assuming all countries do the same), warming (assuming all countries do the same), rise of carbon-less production activities, rise of carbon-less production activities, increased investments and employment in increased investments and employment in alternative activities. alternative activities.

Reading GraphsReading Graphs

The slope of a The slope of a curve like the curve like the budget constraint budget constraint gives the change in gives the change in the no. of CDs that the no. of CDs that can be purchased if can be purchased if one buys another one buys another DVD. Slope is DVD. Slope is negative.negative.

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Slope=-2

AE

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E

Rise/Run =(6-8)/(3-2) =-2

CDs

DVDs

Reading Graphs (Cont’d.)Reading Graphs (Cont’d.)

Positive slope

Income

Years of Schooling

The slope of a vertical line is infinite

y

x

The slope of a flat, horizontal line is zero

y y

x