Introduction to Microeconomics

Lecture 1What is economics?

What is economics• Microeconomics studies subjects like

⁻ Choices of individuals⁻ Choices of Firms⁻ The determinants of prices and quantities in specific markets⁻ Government policies for monopoly, how markets operate, decisions about

investment in health, education, etc.

• Macroeconomics studies subjects like⁻ The performance of national economies⁻ Long run growth and prosperity⁻ Short run booms and busts⁻ Government policies to change performance, reduce inequality

• Core Question - when is it best to let the private decisions prevail, and when does it make sense to use collective action or government to change economic outcomes and welfare.

The main players

• The text mentions three economists – Adam Smith, Alfred Marshall, John Maynard Keynes

• The first two are key in this course – Keynes will be central in macro economics.

• Other economists who will be prominent in this course are– Joseph Schumpeter (champion of capitalism)– Milton Freidman (advocate of free markets)– Herbert Simon (critic of rational decision making)– Joseph Stiglitz (co-developer of the concept of market

failure)

Economics as a social science• Economics tries to generalize human behaviour when it comes to

making decisions about – Producing goods/services– Consuming goods and services– Distributing goods and services

• Abstract and often highly mathematical models are used to focus on the core issue

• Simplifying assumptions are common• Decisions are assumed to be rational

– This the core abstraction– The reality is that humans individually and collectively find in hard to

behave rationally

Definitions of economics

Scarcity – The Robbins definition in the text is standard• That definition focuses on stuff (possessions, raw materials,

etc.)..\..\Videos\george carlin talks about stuff.mp4

• Even if we had enough stuff, human life has several key features– Time which flows in one direction, implying that we have ever less

of it– While humans are conscious of their limited lives, most seem to

treat our time as unlimited making it a free good. Thinking about time reveals key economic ideas.

Trade-offs - we need to make choices – giving up some things to get others.

Where does an industry come from?Problem: In the last decade storage lockers have become very large business, dominated by three large North American firms.Question 1: Why has this industry emerged?Question 2: Why is the TV show Storage Wars a ratings success?

Answer 1: Increased mobility among workers created a demand for facilities for temporary storage.Answer 2: The recession caused may locker renters to default on payments and the firm then auctions the contents to recover losses. The show is really based on the bankruptcies of many American families and small businesses.

The arrow of time• Imagine your life can be represented by

simple rope I need two volunteers from the audience (no there is no extra credit!)

• Let us assume (….the most import three words in economics)1. Assumption 1 - I will live to be 852. Assumption 2 - I will live completely healthy until

my instant death doing what I love best (teaching economics of course!)

I am using the ceteris paribus technique of holding everything else equal

What is the basis for these simplifying assumptions?

Assumptions are basic to economics• Simplifying the problem makes it solvable• Yes --- everything is connected to everything

else.• Economics rests on two key concepts1. It is possible to reduce any problem to core essential

principles and elements 2. The ceteris paribus process and Occam’s razor are used to

focus on the essentials.

Occam’s Razor – select any explanation/theory with the fewest assumptions

Cost – benefit decision rule• When difficult cases occur, they are difficult chiefly because while we

have them under consideration, all the reasons pro and con are not present to the mind at the same time …

• To get over this, my way is to divide half a sheet of paper by a line into two columns; writing over the one “Pro”, and the other “Con”. Then … I put down under the different heads short hints of the different motives … for and against the measure … I endeavour to estimate their respective weights; where I find one on each side that seem equal, I strike them both out. If I find a reason pro equal to two reasons con, I strike out three … and thus proceeding I find at length where the balance lies …

• And, though the weight of reasons cannot be taken with the precision of algebraic quantities, yet when each is thus considered, separately and comparatively, and the whole lies before me, I think I can judge better, and am less liable to take a rash step.

Benjamin Franklin

Cost-benefit principle• Any decision where the benefits exceed the costs will

be beneficial.• Obviously, if one can only do one activity (go to a

movie, attend this class, work at a part-time job…), do the activity that produces the highest benefit to cost result.

• Two complications:1. Short vs. long run benefits and costs2. Some benefits and costs are not easily

expressed in money terms.

Cost-benefit or benefit-cost?

It makes no difference.

Most economists prefer benefit-cost because it shows the amount of benefit per dollar of cost.

Example of cost-benefit problems

• Is the long-term gain (in terms of expected lifetime earnings) of post-secondary education worth the cost (and emotional pain) of paying for the education and giving the wages that could be earned?

• Does it pay-off to have compulsory vaccination for girls and boys of age 12 for the HPV virus (the primary cause of cervical cancers).

• Does public (government) support for a new football stadium?

Hint: The word “public” typically refers to government spending and actions while “private” refers to spending decisions and actions made by households, businesses, etc.

Thought experiment 1• Imagine life as a time line

• Assumption 3 – once a minute (hour, day, week…) has passed – it is gone forever. (This is more a fact than an assumption).

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Opportunity cost 1

• Cost in economics is not spending money. • Money only keeps score, but it is not the cost.• The is why “economic cost” and “accounting

costs” are different.• Cost is the reduction in any resource.

Who here has never wasted time?What are examples of how you have wasted

time?

Opportunity cost 2

• Opportunity cost is the value of the foregone alternative:– The value of the time lost on doing something else

than taking this course.– The value of the alternative uses for any spending.– Explicit opportunity cost involves a direct

expenditure of money or resources (not including time)

– Implicit opportunity cost is typically the value of time given up.

Sunk Costs

• Thought experiment 2

– Who has stood in a Starbuck or Tim Horton’s line in the last month?

– Who has ever left the line before being served?

– Why – was that not irrational, given the time you had already spent?

– You demonstrated the benefit cost principle

Failure of ignoring sunk costs• You have invested $300,000 in a small incomplete manufacturing and

worthless in its current state. • It will cost another $290,000 to finish the job. • But you could start a new, equally valuable manufacturing shop from

scratch for only $275,000. • Two options—

– finishing off the original shop or – starting a new shop from scratch

• The key is that the original $300,000 has already been spent. That money is gone; it is a sunk cost.

• For the same return, you can either invest an additional $290,000 or invest an additional $275,000.

• Starting a new shop from scratch is the rational choice.

Average and marginal • Applied to costs/benefit– Marginal costs/benefit is the increase in

cost/benefit associated with one unit extra or less of an activity.

– Average cost/benefit is cost/benefit averaged across all units of an activity.

– The marginal cost/benefit may be greater or lower than the average cost/benefit.

A restaurant decides to hire a new part-time server, estimating that the increased cost ($400 for a 20 hour shift, will be exceeded by the average sales of $p

Key issues for economics 1 • Simplifying assumptions are used to expose

the main causal relations.– Example: Will a higher tax on cigarettes increase revenues?

Reduce smoking by children? Reduce smoking in general?

• Proving causal relationships is hard, and confounded by spurious correlations.– Example: Most people over 20, who contract cancer are

not virgins … therefore sex causes cancer.

Key issues for economics 2

• Fallacy of composition– Example: The example of farmers in the text is good. One

farmer with a large crop may be better off, unless all farmers do well and prices drop

• Production – what and when to produce

• Consumption – what to consume and when

• Distribution – who receives the outputs? – Example: Modes of distribution (first come first save,

willingness to pay, administrative (command) rule (from each according to their ability to each according to their needs…)

Data, data, data. I cannot make bricks without clay! (Sherlock Holmes)

• Economics must be an empirical science

• Facts, trends, statistics all support the testing of economic theories

• Just thinking about economic data will encourage thought

ExampleQuebec exports more maple syrup than any other province/state/country.

Why does it maintain a strategic reserve of maple syrup?