the most important decisions you will make (in life) are

whom you marry, whom you are friends with, what you love,
what you despise, and how to control your impulses.
Employers dont care for marks as much as whether you

are creative, curious, persistent, bold, and can work in

teams.
~ Manish Sabharwal, Chairman, Teamlease Services
The Economic Times, June 30, 2013

Lecture 1 & 2
IIM Ranchi PGDHRM 2014-16

Dr. Amarendu Nandy

Assistant Professor
Indian Institute of Management, Ranchi
amarendu@iimranchi.ac.in

Office: Level 3, Suchana Bhawan

Consulting Hours: Flexible (Prior email
appointment preferable)
E-mail: amarendu@iimranchi.ac.in
Phone: (0651) 2280083 Ext. 120

Ph.D. National University of Singapore (NUS) Lee

Kuan Yew School of Public Policy (LKYSPP)

Research Interests:
Issues in International, Internal, Return Migration
Developmental aspects of Remittances
Socio-economic Impact of Demographic Changes
Economics of Social Security
India's Business Environment

Previous teaching experience Goa Institute

Management; National University of Singapore

Joined IIM Ranchi on June 20, 2011. Currently also the

Chairperson , PGDM & Area Chairperson - Economics

Lifes Guiding Philosophy: The true meaning of life is to

plant trees, under whose shade you do not expect to sit ~
Nelson Henderson

Passionate about: Food; Music; Photography

Happily married! One son (3 years 6 months)

Hometown: Durgapur, West Bengal

Web profile: http://www.iimranchi.ac.in/profile.php?i=1

Social network profiles:

http://in.linkedin.com/pub/amarendunandy/36/bb4/1b3
https://www.facebook.com/amarendu.nandy

of

Textbook
Mankiw, Gregory N. (2012), Principles of
Economics, 6th Edition (First Indian Reprint),
New Delhi: Cengage Learning
Recommended Alternate Textbook:
Samuelson, P. and Nordhaus, W.D. (Indian
adaptation by Chaudhuri, S. and Sen, A.)
(2010),
Economics, 19th Edition (Special
Indian Edition), New Delhi: Tata McGraw Hill
Education Private Limited .
Other Readings
Journal articles, news stories/analyses from
financial
dailies
(both
national
and
international), and various Reports, most of
which shall be shared online via the Course
Management System (CMS) Canvas
Some may be distributed in class.

You are also urged to read the following two books

written for the layman if you want to get a feel for
how economic principles can help to really
understand important aspects of the business
world and also government policy.
Harford, Tim (2006), The Undercover Economist,
London: Little Brown.

This book covers much of the ground we do in this course

(and more) but motivates concepts through excellently
chosen real world examples. The style is very engaging, so
you don't realize you are learning economics till after you
have
learnt
it!
Follow
his
website
at:
http://timharford.com/
or follow him on Twitter:
@TimHarford

Levitt, Steven D. and Stephen J. Dubner (2006),

Freakonomics, New York: Harper Collins.

The subtitle of the book A rogue economist explores the

hidden side if everything is apt. Reading this well written
and easy to read book will help you understand how
economic reasoning can help you analyze and understand
many supposedly non-economic problems. Follow their
blog at: http://www.freakonomics.com/blog/ or follow on
Twitter: @freakonomics

Resources related to the course is available on the Course Management System (CMS)
Canvas [https://canvas.instructure.com/courses/886515]. Please bookmark this page for a
quick access to the course.

You need to compulsorily register for the course, as lecture slides and notes, timetable,
additional reading resources, course announcements, online discussion board,
assignments, submissions, etc. shall be shared/conducted via the LMS. Please note that
participation in CMS shall be a graded component. Upload a picture for your profile.
Please register by September 24, 2014.

Deadlines for submission for assignments/term paper need to be adhered to, failing
which, you will not be graded in that component. No requests for consideration will be
entertained.

You may start a discussion in CMS on any topic which is of relevance for this course. All
discussion threads/posts need to be on aspects related to the course. I shall reserve the
right to remove any post which I may deem inappropriate/irrelevant. Make sure that even
while you debate/discuss a point refuting your colleagues point(s), do so respectfully.

Also make extensive use of our digital resources:

http://www.iimranchi.ac.in/?page_id=195

Class room lectures

In-class active learning exercises and case discussions
Social learning through Course Management System (Canvas)
In-class/online exposure to relevant academic research and case studies/mini-cases
Reading assignments sourced from scholastic journals, news stories/articles from financial
dailies, blogs, and various reports; and
Group project work

Academic Honesty
Cheating or plagiarism is breach of academic honesty, and may result in F grade in the course. It is a
fraudulent act to sign the attendance sheet if you do not intend to stay for the whole class segment.

Class Etiquette
You are advised to maintain an environment of mutual respect to foster learning and encourage debate.
Please be respectful towards everyone in the classroom. This includes, at a minimum: arriving to class on
time; not interrupting me or your colleagues; raising your hand to make a point and waiting for your turn
to speak; and turning off your cell phones before class.
Laptop Use
Laptop computer use is not permitted in my classroom. Occasionally there may be learning-by-doing
benefits to certain exercises and lectures presented in class. In those instances a laptop computer will be
allowed for your use in the classroom.
Grading
Although I shall try my best to be objective, there may be some subjectivity in grading. A student who may
be on the border between two grades and has exhibited effort and improvement could be pushed up to
the higher grade. A student who has been habitually late, rude, and obnoxious shall remain where he/she
is on the grading scale. I shall reserve the right to change the seating, deduct grade points, or drop any
student who persists in acting in a puerile manner.

Source: Facebook Page, Grayscale (IIM Ranchi)

 to learn a way of thinking

to understand society (E.g. - Industrial
Revolution)
to understand
affairs better

global

affairs/current

The events of September 11, 2001, dealt a blow

to the tourism industry and left airlines in deep
financial trouble; Global financial and
economic crisis of 2008-09 emanating from the
U.S. led to worldwide impact on individuals and
businesses.

to be an informed voter
When we participate in the political process,
we are voting on issues that require a basic
understanding of economics.

 In a business school, the test of good (theory) is always that of its

practicality or usefulness. Many of the tools that shall be a part of your
practical training will be based on economic theory.
For example, in finance you will learn all about the efficient market hypothesis
which is an amazingly important tool for investment analysis that really makes sense
only if you understand the law of demand and supply or market rationality.

Economics is to business school what boot camp is to the Marine Corps!

Just as in boot camp, you may endure sleepless nights of seemingly pointless
activity, all with the goal of toughening you for the grim years of combat that lie
ahead.

Economics shall help you examine the world in a very particular way. And this
approach can be useful to non-economists.

 Why give grades? - Grades are expensive and

complicated. Large amounts of resources are
devoted to the giving and getting. An economic
analysis is often begun by asking why resources
are used in a particular way.
This question is way to broad and so the next
step will be to break it down into smaller
questions.
An economic approach to the puzzle begins by
asking
why do professors supply them and
why do students demand them.

Why do professors supply grades?

Pecuniary Rewards: By offering tests and promising grades, the class becomes more valuable to the student
(why?) and so the student is willing to pay (participate) more.
Non-Pecuniary Rewards (Utility): Most Profs enjoy their subject, think its important and want their students to
learn (or at least stay awake during part of the lecture). Grades motivate the student to learn (or not to fall
asleep!).

Why do students demand grades?

They Dont! Employers and grad schools are the real users of grades, and so the demand for grades is actually a
derived demand - the students demand for grades is actually derived from the employers demand (in much the
same way that Maruti Suzukis demand for steel is really derived from the demand for cars).

Why do employers and grad schools demand grades?

Grades are an absolute measure of knowledge (consistent with the HUMAN CAPITAL theory of education).
Grades are a relative measure of knowledge (consistent with the SIGNALING/SORTING theory of education).

The theory we have described has two important characteristics:

It is logically consistent, and more important

Give explanations that can, at least in principle, be refuted.

What is the use of this theory?

Theories can be a good guide to policy.

There are two basic grading policies: You can be graded on an absolute scale (e.g.,everybody who scores a 90
or better gets an A), or on a relative scale (the top 20% of the class gets an A)
If I believe that students work harder when in competition against an absolute scale and that employers are
interested in the absolute level of achievement, Id use an absolute scale. If I believe students work harder when
in competition against each other and that employers are interested in relative rankings, Id use a relative scale.

Corporate Decision Making: Fords Sport Utility Vehicle

The design and efficient production of Fords
SUVs involves not only some impressive
engineering, but a lot of economics as well.
Ford has to think carefully about how the
public would react to the design and
performance of its new products.
Ford had to be concerned with the cost of
manufacturing these cars.
Ford had to think about its relationship to the
government and the effects of regulatory
policies.

Public Policy Design: Automobile Emission Standards for the

Twenty-First Century
The design of a program like the Pollution Control Act
involves a good deal of economics.
First, the government must evaluate the monetary
impact of the program on consumers.
The government must determine how new standards
will affect the cost of producing cars.
Finally, the government must ask why the problems
related to air pollution are not solved by our marketoriented economy.

 Questions that managers must answer:

What are the economic conditions in a
particular market?

Market Structure?
Supply and Demand Conditions?
Technology?
Government Regulations?
International Dimensions?
Future Conditions?
Macroeconomic Factors?

Should our firm be in this business?

If so, what price and output levels achieve our
goals?

 Questions that managers must

answer:
How can we maintain a competitive
advantage over our competitors?
Cost-leader?
Product Differentiation?
Market Niche?
Outsourcing, alliances, mergers,
acquisitions?
International Dimensions?

 Questions that managers must answer:

What are the risks involved?
Risk is the chance or possibility that actual future outcomes will
differ from those expected today.

Types of risk

Changes in demand and supply conditions

Technological changes and the effect of competition
Changes in interest rates and inflation rates
Exchange rates for companies engaged in international trade
Political risk for companies with foreign operations

 Economics is the study of the choices consumers, business

managers, and government officials make to attain their goals,
given their scarce resources/subject to their constraints.
Need to make choices arises due to scarcity as factors of production are
finite. Scarcity exists when there is not enough of something
(product/service/resource) to satisfy everyones wants, at a zero price.
Goods, services, and productive resources that are scarce have a
positive price (economic goods). Commodities that have a zero price
because they are relatively unlimited in supply are called free goods.
The concept of scarcity is summarized in the economic admonition
that there aint no such thing as a free lunch (TANSTAAFL). All goods
and services have an opportunity cost. Even the resources used to
produce a free lunch could have been used to produce something
else.

 Human Nature and

Reality
People have unlimited wants.
People have limited resources
to acquire the things they
want.
As a result, they must make
choices.
Choices involve pursuing some
things while forgoing others.
The choices we make depend
on the incentives we face.
An incentive is a reward that
encourages an action or a penalty
that discourages an action.

 Factors of production are classified into one of four broad categories

Land - includes all natural resources (crude oil, water, air, minerals, etc.)
Labour encompasses both quantity and quality of human resources
Capital - term refers to final goods produced for use in further production
(fishing nets; blast furnaces, etc.)
Entrepreneurship - organize resources for new or better products; agent
of innovation and change.

Role of entrepreneurs in economic progress is a key issue in the

market versus government debate. The Austrian economist Joseph
Schumpeter argued that free markets unleash the animal spirits of
entrepreneurs, propelling innovation, technology, and growth.
Government regulation tends to stifle those very animal spirits.

 Depending on the nature of scarcity and the kind of choices it forces on us, three
core issues must be resolved:
WHAT to produce with our limited resources?
HOW to produce the goods and services that we select?
FOR WHOM goods and services are produced, i.e. who should get them?

Important: Who should answer these questions?

Should market participants decide how much water to supply? Who gets it? Or, should
government intervene to assure adequate water supply?
Should individuals take care of health and retirement? Or, should government provide
safety net of health and pensions?
Should the government regulate airfare? Or, should airlines set prices?
Should interest rates be set by private banks? Or, should government control interest
rates?
Should Microsoft decide what features get included in a computers OS, or should the
government make that decision?

 Microeconomics

The branch of economics that

examines the functioning of the
economy at the level of individual
consumers, workers, firms, goods, and
markets.
looks at the individual unit - the
household, the firm, the industry. It
sees and examines the trees.

Macroeconomics
The branch of economics that
examines the economic behavior of
aggregates - income, employment,
output, and so on - on a national
scale.
looks at the whole, the aggregate. It
sees and analyses the forest.

Examples of Microeconomic and Macroeconomic Concerns

DIVISION OF
ECONOMICS
Microeconomics

Macroeconomics

PRODUCTION

PRICES

INCOME

EMPLOYMENT

Production/output in
individual industries and
businesses

Price of
individual
goods and
services

Distribution of
income and
wealth

Employment by
individual businesses
and industries

How much steel

How much office space
How many cars

Price of medical
care
Price of
gasoline
Food prices
Apartment
rents

Wages in the auto

industry
Minimum wage
Executive salaries
Poverty

Jobs in the steel

industry
Number of employees
in a firm
Number of
accountants

National income

Employment and
unemployment in the
economy

National production/output Aggregate price

level
Total industrial output
Gross domestic product
Growth of output

Consumer prices Total wages and

Producer prices salaries
Rate of inflation Total corporate
profits

Total number of jobs

Unemployment rate

Managerial
economics
applies
microeconomic
theory to business problems
How to use economic
analysis to make decisions
to achieve firms primary
goal of maximizing the value
of
the
firm/
profit
maximization, and do so
most efficiently

Mathematical Economics
Expresses and analyzes
economic models using the
tools of mathematics.

Econometrics
Employs statistical methods
to
estimate
and
test
economic models using
empirical data.

Positive economic analysis: addresses

factual questions, typically about
economic choices or market outcomes. It
describes what exists and how it works.
What did happen? What will happen?
What would happen?
Historical fact-finding
Forecasting
Cause-and-effect analysis of actions
and their consequences

Stick to objective facts and avoid value

judgments

Normative economic analysis:

addresses questions that involve

value judgments concerning the
allocation of resources
What ought to happen?
What should happen?

Makes ethical judgments value

judgments.

COMPARING POSITIVE AND NORMATIVE QUESTIONS

Positive Questions

Normative Questions

If the government increases the minimum

wage, how many workers will lose their
jobs?

Should the government increase the

minimum wage?

If two office-supply firms merge, will the

price of office supplies increase?

Should the government block the merger

of two office-supply firms?

How does a college education affect a

persons productivity and earnings?

Should the government subsidize a

college education?

How do consumers respond to a cut in

income taxes?

Should the government cut taxes to

stimulate the economy?

If a nation restricts shoe imports, who

benefits and who bears the cost?

Should the government restrict imports?

Model:Models are simplified and analytical depictions of reality. The point of the model is to
sharpen intuition - learn what is important and why; and give us testable predictions.
To develop a model, economists generally follow these steps:
1.

Observe and identify phenomenon to be explained.

2.

Formulate an explanation: An economic theory.

3.

Develop a model to formalise the theory.

4.

Decide on the assumptions to use in developing the model.

5.

Formulate a testable hypothesis.

6.

Collect and analyze real-world economic data to test the hypothesis.

7.

Revise the model if it fails to explain well the economic data.

8.

Retain the revised model to help answer similar economic questions in the future.

Ockhams razor : The principle that irrelevant detail should be cut away. Do not multiply
entities: Simple is better.

Maps are useful abstract representations of reality.

All Else Equal: Ceteris Paribus

ceteris paribus, or all else equal: A device used to analyze the relationship
between two variables while the values of other variables are held
unchanged.

Using the device of ceteris paribus is one part of the process of abstraction - so
that changes due to the factor being studied may be examined independently of
those other factors. In formulating economic theory, the concept helps us simplify
reality to focus on the relationships that interest us.

Expressing Models in Words, Graphs, and Equations

The most common method of expressing the quantitative relationship between two
variables is graphing that relationship on a two-dimensional plane.

Cautions and Pitfalls

post hoc, ergo propter hoc Literally, after this (in time), therefore because of this. A
common error made in thinking about causation: If Event A happens before Event B, it is
not necessarily true that A caused B.
fallacy of composition The erroneous belief that what is true for a part is necessarily
true for the whole.

association is not causation The mistaken assumption that because two events occur
together, one must cause the other. Also given as correlation is not causation.

violation of ceteris paribus This occurs when one attempts to analyze the effect of one
thing while holding everything else constant, when in fact other things have changed.

The Mechanisms of Choice

The Invisible Hand of a Market Economy
O

Adam Smith, in his classic work, The

Wealth of the Nations (1776) said the
invisible hand determines what gets
produced, how, and for whom. He urged
the government to leave it alone (laissez
faire).
O
O
O

WHAT: Producers are driven by profit

potential
HOW: To maximize profit, producers seek
lowest-cost method
FOR WHOM: Market distributes good to the
highest bidder (willing and able to pay for
the product)

The invisible hand is now called market

mechanism. The essential feature of
market mechanism is the price signal.

The Mechanisms of Choice

Government Intervention and Command Economies
O

Karl Marx, in the Communist Manifesto

(1848) and Das Kapital (1867) laid the
foundation for a communist state in which
the government would be the master of
economic outcomes.

Marx criticized Adam Smiths laissez-faire

policy, and emphasized how free markets
tend to concentrate wealth and power in
the hands of the few (the capitalists), at
the expense of many (the proletariat).

Marx argued that the government not only

had to intervene but had to own all the
means of production in order to savage
inequalities.

The Mechanisms of Choice

Government Intervention and Command Economies
O

John Maynard Keynes conceded that the

market was pretty efficient in organizing
production. However, individual producers and
workers had no control over the broader
economy.

A completely unregulated market might veer

off in one direction and then another as
producers all could rush to increase output at
the same time; or throttle back production at
the same time in a herd-like manner.

The government, Keynes reasoned, could act

like a pressure gauge, letting off excess steam
or building it up as the economy needed.

In Keyness view, government should play an

active but not all-inclusive role in managing
the economy.

Web Link
To read more about famous economists
and their thoughts, you are encouraged
to visit the website of the Federal
Reserve Bank of San Francisco at
www.frbsf.org/education and click on
Great Economists and Their Times
under Publications.

Categorizing nations by the extent of markets vs. government reliance

Market
Failure:
An
imperfection in the market
mechanism that prevents
optimal outcomes.
Government
failure:
Government intervention
that fails to improve
economic outcomes.
Mixed economies: Most
nations uses a combination
of market signals and
government directives to
select economic outcomes.
Web Link
Also take a look at the
Index
of
Economic
Freedom, published by the
Heritage Foundation at
www.heritage.org
Recommended Reading
Life After Capitalism by
Robert Skidelsky in Project
Syndicate (Jan 20, 2011):
http://www.projectsyndicate.org/commentary
/life-after-capitalism
Source: GlobeScan 2010 poll for Program on International Policy Attitudes, University of Maryland

Three Important Economic Ideas

1.

People are rational

O

Rational individuals weigh the benefits and costs of each action, and they choose an
action only if the benefits outweigh the costs.

Does not imply everyone always makes the best decision. Economists assume that
consumers and firms use all available information as they act to achieve their goals.

The operating assumption of behavioural economics is that cognitive biases often

prevent people from making rational decisions, despite their best efforts.
O

In one study where people were offered a choice of a fancy Lindt truffle for 15 cents and a
Hersheys kiss for a penny, a large majority (73%) chose the truffle. But when offered the same
chocolates for one penny less each - the truffle for 14 cents and the kiss for nothing - only 31% of
participants selected it. The word free, we discovered, is an immensely strong lure, one that
can even turn us away from a better deal and toward the free one.
Source: Ariely, Dan (2009), The End of Rational Economics, Harvard Business Review, July.
Those interested, may want to read Dans Predictably Irrational: The Hidden Forces That Shape
Our Decisions (HarperCollins, 2008). Also read: The Behavioural Economics of Thanksgiving!

Class Exercise
O

Price of a cup of coffee increases at

your favorite coffee shop
O Scenario A: From Rs. 72 to Rs.
79.20. Would you still buy that one
cup of coffee?
O Scenario B: From Rs. 63 to Rs.
69.30. Would you still buy that one
cup of coffee?
O Scenario C: From Rs. 74 to Rs.
81.4. Would you still buy that one
cup of coffee?

Three Important Economic Ideas

O

A 2011 NBER study indicates how individual decision-making may deviate from rationality. The
NBER study (http://www.nber.org/papers/w17030) focuses on "the used car market and asks
whether it is affected by consumers exhibiting a heuristic, or short cut, known as left-digit bias:
the tendency to focus on the left-most digit of a number while partially ignoring other digits."

Findings of the study:

Using data that come from wholesale auctions encompassing more than 22 million used car
transactions, the authors document significant price drops at each 10,000-mile threshold from 10,000
to 100,000 miles, ranging from about $150 to $200. For example, cars with odometer values between
79,900 and 79,999 miles, on average, are sold for approximately $210 more than cars with odometer
values between 80,000 and 80,100 miles, but for only $10 less than cars with odometer readings
between 79,800 and 79,899.consumers.

Any more examples?

Bounded Rationality is the idea that individual decision making is limited by personal information,
cognitive limitations, and time constraints.

The basic idea of economics is that people act in ways to maximize their self-interest. We do things
that will increase our utility, or happiness. It seems logical that we would make rational decisions in
order to accomplish that. Unfortunately, information asymmetry, cognitive biases and other factors
conspire to bound our rationality, and people often make choices that lead to outcomes that go
against their desires.

Benefits and Costs

Q: You are waiting in line at checkout #12 at the grocery store when you
notice that the line at checkout #1 is shorter and moving more quickly,
but you decide to stay in the line you are in. How can you justify, using the
concepts of marginal cost and marginal benefit, your decision not to
switch lines?

Benefits and Costs

Q: You are trying to decide which professor to take for Economics. (You don't want
to take it at all, but you have to.) Professor A is known to have great classes
(fascinating lectures with lots of fun stuff thrown in), but she gives very
challenging exams. Professor B's classes are quite dull, but his exams are quite
easy. What are the marginal costs and benefits of taking Economics from
Professor A rather than from Professor B? Who would you pick?

Three Important Economic Ideas

2. People respond to economic incentives
O

Human beings act from a variety of motives, including religious belief, envy, and
compassion. Economists emphasize that consumers and firms consistently
respond to economic incentives.

Article from Wall Street Journal, October 8, 2002 [Link: FBI Presses Banks to
Boost Security as Robberies Rise]
O

FBI couldnt understand why banks were not taking steps to improve security in the face
of an increase in robberies. FBI officials suggest that banks place uninformed, armed
guards outside their doors and install bullet-resistant plastic, known as bandit barrier in
front of the teller windows. Consider this:
O
O
O

Installing bullet-resistant plastic costs $10,000-$20,000

Well trained security guard receives $50,000 per year in salary and benefits
The average loss in a bank robbery is only $1,200

The economic incentive to banks is clear: it is less costly to put up with bank robberies
than to take additional security measures.

Three Important Economic Ideas

O

How incentives/disincentives work:

O

Incentives for drivers who avoid traffic jams (The New York Times, June 11,
2012): Link

Nudging using behavioural economics to improve the effectiveness of

government policies (The Economist, March 24, 2012): Link
O

A letter sent to non-payers of vehicle taxes was changed to use plainer English, along
the line of pay your tax or lose your car. In some cases the letter was further
personalised by including a photo of the car in question. The rewritten letter alone
doubled the number of people paying the tax; the rewrite with the photo tripled it.

APPLYING THE CONCEPTS

PEDALING FOR TELEVISION TIME
Do people respond to incentives?
To illustrate the notion that people are rational and
respond to incentives, consider an experiment conducted
by researchers at St. Lukes Roosevelt Hospital in New
York City. The researchers addressed the following
question: If a child must pedal a stationary bicycle to run
a television set, will he watch less TV?

Children were put into two groups:

Control group: Obese children randomly assigned to a TV with a
stationary bike in front of the TV no pedaling required to watch TV.
Treatment group: Obese children randomly assigned to a TV with a
stationary bike in front of it pedaling is required to watch TV.
Outcome: The control group watched TV 21 hours on average and the treatment group
only 2 hours on average per week.

APPLYING THE CONCEPTS

FREAKONOMICS
Economist Steven Levitt, one of the authors of the best selling book Freakonomics,
answers a host of questions typically not tackled by most economists. One of the questions
is related to realtors and agency relationships. In other words, do realtors really work for real
estate sellers? Does a real estate agent have an incentive to get you the highest price?
According to Levitt, it is in the best interest of the realtor to convince sellers to take an
offer lower than they would receive if the property remained on the market.
Since the percentage of the sales price that real estate salespersons receive from selling
a house is a very small fraction, a $10,000 increase in sales price might net a real estate
professional another $150 commission for a tremendous amount of additional work.
It is in the real estate salespersons best interest to convince the seller to make the quick
sale and take the first reasonable offer.

Levitt points toward evidence that real estate professionals tend to leave their own
properties on the market longer and receive 2-3% more in sales price.
Economics is truly a social science that can be used to explain quite a bit of human behavior.

Will Women Have More Babies if the Government Pays Them To?

More than 45 countries in

Europe and Asia have taken
steps to try to raise their
birthrates.
These
policies
suggest that people may
respond to economic incentives
even when making the very
personal decision of how many
children to have.

Source: Hubbard and OBrien (2010), Microeconomics, 3e.

The Rational-Actor Paradigm

O

The rational-actor paradigm assumes that people act rationally, optimally, and selfinterestedly. To change behavior, you have to change incentives.
O

Good incentives are created by rewarding good performance.

A well-designed organization is one in which employee incentives are aligned with

organizational goals. By this we mean that employees have enough information to
make good decisions, and the incentive to do so.

You can analyze any problem by asking three questions:

(1) Who is making the bad decision?

(2) Does the decision maker have enough information to make a good decision?; and
(3) the incentive to do so?

Answers to these questions will suggest solutions centered on

(1) letting someone else make the decision, someone with better information or incentives;
(2) giving the decision maker more information; or
(3) changing the decision makers incentives.

Three Important Economic Ideas

3. Optimal decisions are made at the margin
O

Some decisions are all or nothing! But most decisions in life

involve doing a little more or a little less (marginal).
O Should you watch another hour of TV or spend that hour studying for the

exam next day?

O Should Apple produce an additional 200,000 iPads?
O

Optimal decision is to continue any activity up to the point where

the marginal benefit equals the marginal cost, i.e. MB = MC.

Three Important Decision Pitfalls

Economic analysis predicts likely behavior
O
Three general cases of mistakes
1. Measuring costs and benefits as proportions instead of
absolute amounts
2. Ignoring implicit costs
3. Failure to think at the margin
O

Pitfall #1
O Measuring costs and

benefits as proportions
instead of absolute
amount
O Would you walk to

town to save $10 on a

$25 item?

O Would you walk to

town to save $10 on a

$2,500 item?

Marginal
Benefits

Marginal
Costs

Action

Pitfall #2
O Ignoring implicit costs
O Consider your alternatives

Explicit
Costs

O The value of a Frequent Flyer

Opportunity
Cost
Implicit
Costs

coupon depends on its next

best use
O Expiration date
O Do you have time for
another trip?
O Cost of the next best trip

Pitfall #3
O Failure to think at the

margin
O Sunk costs cannot be
recovered

Marginal
Benefits

O Examples:
O Eating at an all-you-

can-eat restaurant
O Attend a second year
of law school

Marginal
Costs

There are gains from trade

Voluntary trades will be beneficial to both

parties, otherwise why would they have

traded?

Everyone

will have a comparative

advantage in some activity and
consequently there will be gains to
specializing in that activity and using
surplus production to trade for other
goods or services.

Markets move toward equilibrium

Markets -- interaction between individuals

free markets are where there is no coercion to trade or

interact

Coordination of the interaction of individuals is

achieved through prices (trading rates).

Equilibrium -- where no individual has an reason to

change their action

If individuals are free to trade then trading will

continue until no one else wishes further trades

Resources should be used efficiently to

achieve societys goals
Efficiency -- the inability to improve one persons well

being without hurting someone else (Pareto

Optimality)

If we are inefficient in our use of resources, we are

wasting them.

Why would you want to deny someone additional

welfare if it didnt hurt anyone elses welfare?

This is a normative statement. What about other

goals for society such as fairness or equity in the

distribution of societys wealth?

Market usually lead to efficiency

This statement is often taken to mean

that society (a collective decision

perhaps taken by government) should not
interfere with individual choice.
A
positive statement leading to a normative
conclusion.

But markets can fail to achieve an

efficient result-- for example, congestion

on the highways.

ECONOMIC ANALYSIS AND MODERN PROBLEMS

Economic View of Traffic Congestion
To an economist, the diagnosis of the congestion problem is straightforward.
When you drive onto a busy highway during rush hour, your car takes up space
and decreases the distance between the vehicles on the highway. The normal
reaction to a shorter distance between moving cars is to slow down. So when you
enter the highway, you force other commuters to spend more time on the highway.
One possible solution to the congestion problem is to force people to pay for using
the road, just as they pay for gasoline and tyres.
The job for the economist is to compute the appropriate congestion tax and
predict the consequences of imposing the tax.

APPLYING THE CONCEPTS

CONGESTION PROBLEM
What is the role of prices in allocating resources?

To illustrate the economic way of thinking, lets

consider again how an economist would approach
the problem of traffic congestion.
Use assumptions to simplify
Isolate variablesceteris paribus
Think at the margin
If the government imposes a congestion tax to reduce congestion during rush
hour, the question for the economist is: How high should the tax be?
Determine the cost imposed by the marginal driver:
Driver forces each of 900 commuters to spend 2 extra seconds on the
highway
Total travel time increases by 30 minutes
Value of time is Rs.100 per hour
Appropriate congestion tax is Rs. 50

When markets are not efficient, government

intervention can lead to improvement in social
welfare
Yet there isnt a guarantee that governments will

improve upon the market outcome. Rather they hold

out the possibility to improve upon the efficiency of
the outcomes of individual choice.

Important to remember -- it is not that individuals

make bad choices it is that market has failed to

coordinate their decisions

Summary of Principles
1)

Resources are scarce

2)

Every Choice has an Opportunity Cost

3)

Choices are made at the margin

4)

Individuals seek their self interest

5)

There are gains from trade

6)

Markets move toward equilibrium

7)

Resources should be used efficiently

8)

Markets usually lead to efficiency

9)

When markets dont achieve efficiency, government

intervention can improve social welfare