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Modern Economics

Stiglitz, Walsh (2006) Economics Chapter MI1

What is Economics?
Economics studies how individuals, firms, the

government, and other organizations make choices and how those choices determine societys use of its resources.

Modern Economics Thinking Like an Economist

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Five Core Concepts


trade-offs

incentives
exchange information

distribution

Modern Economics Thinking Like an Economist

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Trade-off
All choices involve trade-offs.

Trade-offs stem from scarcity.

limited money, time and resources

Modern Economics Thinking Like an Economist

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Incentives
Incentives are benefits that motivate a

decision maker in favor of a particular choice.

Prices reflect incentives: rewards and costs.

Incentives also are affected by the return

people expect to earn from different activities.

Modern Economics Thinking Like an Economist

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Exercise 1
How does each of the following affect the incentive to go to college?
a) b) c) d)

An increase in tuition costs. A fall in the interest rate on student loans. A rise in wages for unskilled jobs. An increase in incomes of college graduates.

Modern Economics Thinking Like an Economist

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Exchange
Exchange is the trade of goods and services.

Voluntary exchange in markets determines which

goods and services to produce. A market is any situation in which an exchange takes place.

Modern Economics Thinking Like an Economist

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Information
Making informed choices requires

information. Information is like any other good or service. Information is unlike any other good or service.

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Distribution
Markets determine who gets which goods

according to the demand and supply of goods, labor, and capital. For whom are goods produced.

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The Three Major Markets


The product market

where final goods and services are exchanged


where workers sell labor and firms hire workers where households, firms, and government save and raise funds

The labor market

The capital market

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The Three Major Markets

consumers workers

investors

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The Two Branches of Economics


Microeconomics: focuses on the decisions of

households and firms and the detailed study of prices and production in specific industries.
Macroeconomics: focuses on the behavior of

the economy as a whole and the behavior of aggregate variables.

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The Science of Economics


Economics is a social science.

Economic theory is composed of:


Assumptions or hypotheses and the conclusions derived from them. Theories are logical exercises that lead from assumptions to conclusions. If the assumptions are correct, then the results follow.

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Positive and Normative Economics


Positive economics is the study of how the

economy works, it describes facts.

uses word BE

Normative economics deals with the

questions. There are no right answers.

uses word SHOULD BE

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Thinking Like an Economist


Stiglitz, Walsh (2006) Economics Chapter MI2

The Basic Competitive Model


Rational consumers

Profit-maximizing firms
Competitive markets Government is ignored for now

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Rational Individuals
Scarcity forces us to make choices.

Economists assume individuals and firms

make choices rationally:


what they see as their own self-interest weigh costs and benefits as they see them if benefits > costs, take the action different people have different interests

Economists do not judge people's

preferences, they take them as given.


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Competitive Markets
Many firms sell identical products to many

consumers. Firms and consumers are price takers. Firms provide as much output as consumers will buy. Each firm can sell as much as it wants.

the size of the firm is small compared to the size of the market

If firms charge a price higher than the market price,

they lose all their customers. All firms in the industry charge the same price - the market price.
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The Basic Competitive Model as a Benchmark


Combines self-interested consumers, profit-maximizing firms, and competition. This model can provide answers to the four basic questions:
1.

2.
3. 4.

What is produced, and in what quantities? How are goods produced? For whom are those goods produced? Who decides the answers to the first three questions, and how?

The model is not a perfect representation of actual economies.


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Modern Economics Thinking Like an Economist

Efficiency in the Basic Competitive Model


The basic competitive model is efficient -

known as Pareto efficiency.


Scarce resources are not wasted. It is not possible to produce more of one good without producing less of another good. It is not possible to make one person better off without making someone else worse off.

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Exercise 2
A rational consumer is often said to be which of the following? a) self-interested b) capable of making better choices than other consumers c) liable to make decisions without weighing trade-offs d) None of the above.

Opportunity Sets
Opportunity sets are combinations of goods.

Due to the scarcity of money or time, not all

combinations of goods are attainable. The opportunity set is limited by budget or time constraints.

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Budget Constraint
Michelle has $120 to spend on either CDs or

DVDs. The price of a CD is $10 and a price of a DVD is $20.


DVDs 6 5 4 3 2 1 0
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CDs 0 2 4 6 8 10 12
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Exercise 3
Kathy has $20 a week to spend; she spends it either on junk food at $2.50 a snack, or on gasoline at $1 per gallon. Draw Kathys opportunity set. What is the trade-off between junk food and the gasoline?

Exercise 3 cont.
Now draw each new budget constraint she would face if
a)

b) c)

a kind relative started sending her an additional $10 per week; the price of a junk food snack fell to $2; the price of gasoline rose to $2.50 per gallon.

In each case, how does the trade-off between junk food and gasoline change?

Time Constraint
The sum of what an individual spends her

time on each day must add up to 24 hours.

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Exercise 4
Suppose that you have 24 hours to split between studying, sleeping, and skiing. Which of the following is not in your opportunity set? a) 6 hours of studying, 10 hours of sleeping, and 6 hours of skiing. b) 7 hours of studying, 10 hours of sleeping, and 6 hours of skiing. c) 8 hours of studying, 9 hours of sleeping, and 6 hours of skiing. d) 9 hours of studying, 9 hours of sleeping, and 8 hours of skiing.

The Production Possibilities Curve


A production possibility curve defines a firms

or societys opportunity set, representing the possible combinations of goods that it can produce. Lets consider guns (military spending) and butter (civilian spending).

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The Production Possibilities Curve


PPS is curved, bowed out from the origin.
Guns (millions) 100 90 70 40 0
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Butter

(millions of tons)
0 40 70 90 100
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The Production Possibilities Curve


Guns and butter have different inputs and the

trade-offs of the society are not fixed.

steel makes great guns, no butter; cows do not make good weapons

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Exercise 5
Draw the production possibility frontier according to data provided.
choice food machines

A
B C D E F

0
10 20 30 40 50

150
140 120 90 50 0

Optimal Production on the PPC


Inside the PPC, a firm can produce more of

both goods by moving out to the curve.


So points interior to the curve are inefficient. Economists want to know the source of these inefficiencies, what resources are unemployed.

The optimal production mix is always on the

curve.

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Exercise 6
The opportunity set describes which of the following? a) what an individual or firm wants to do b) what an individual or firm should do c) what an individual or firm is doing d) what an individual or firm can do

Principle of Diminishing Returns


Adding successive units of any input to a

fixed amount of other inputs increases the output, or amount produced, but by less and less.

you get more out of the first hour of studying than the tenth

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Opportunity Costs
the cost of using any resource

measured by looking at the next-best use to

which that resource could be put


Time and budget constraints and production

possibilities curves illustrate the cost of one option in terms of the other: opportunity cost.

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Opportunity Costs
The cost of an education is:

Tuition Room and board Books Travel expenses Opportunity cost: lost earnings from not working for three years

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Sunk Costs
a past expenditure that cannot be recovered,

no matter what choice is made in the present rational decision makers ignore them

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Marginal Costs
the additional cost of producing or consuming

one additional unit

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Basic Steps of Rational Choice


1. Identify the opportunity sets.

2. Define trade-offs.
3. Calculate the costs correctly, ignoring sunk

costs, taking into account opportunity costs and marginal costs.

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Exercise 7
Why is the opportunity cost of a woman with a college education having a child greater than the opportunity cost of a woman with just a high school education having a child?

Exercise 8
Characterize the following events as microeconomic, macroeconomic or both.
a) b)

c)
d) e) f)

Unemployment increases this month. A drug company invents and begins to market a new medicine. A bank lends money to a large company but turns down a small business. Interest rates decline for all borrowers. A labor union negotiates for higher pay. The price of oil increases.

Exercise 9
Provide examples to the following economic areas: a) microeconomics b) macroeconomics c) positive economics d) normative economics e) budget constraint f) time constraint g) production possibility frontier h) opportunity costs i) sunk costs j) marginal costs