HO5e_Ch01 - Microeconomics
HO5e_Ch01 - Microeconomics ECON 120
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R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN FIFTH EDITION CHAPTER Economics: 1 Foundations and Models Chapter Outline and Learning Objectives 1.1 Three Key Economic Ideas 1.2 Every Society Must Solvet 1.3 Economic Models 1.4 Microeconomics and Macroeconomics 1.5 A Preview of Important Economic Terms APPENDIX: Using Graphs and Formulas What Is This Class About? People make choices as they try to attain their goals. Choices are necessary because we live in a world of scarcity. Scarcity: A situation in which unlimited wants exceed the limited resources available to fulfill those wants Economics is the study of these choices. Economists study these choices using economic models, simplified versions of reality used to analyze real-world economic situations. Typical “Economics” Questions We will learn how to answer questions like these: • How are the prices of goods and services determined? • How does pollution affect the economy, and how should government policy deal with these effects? • Why do firms engage in international trade, and how do government policies affect international trade? • Why does government control the prices of some goods and services, and what are the effects of those controls? Three Key Economic Ideas 1.1 LEARNING OBJECTIVE Explain these three key economic ideas: People are rational; People respond to economic incentives; and Optimal decisions are made at the margin. 1. People Are Rational Economists generally assume that people are rational. Rational: Using all available information to achieve your goals. Rational consumers and firms weigh the benefits and costs of each action and try to make the best decision possible. Example: Microsoft doesn’t randomly choose the price of its Windows software; it chooses the price(s) that it thinks will be most profitable. 2. People Respond to Economic Incentives As incentives change, so do the actions that people will take. Example: Changes in several factors have resulted in increased obesity in Americans over the last couple of decades, including: • Decreases in the price of fast food relative to healthful food • Improved non-active entertainment options • Increased availability of health care and insurance, protecting people against the consequences of their actions 3. Optimal Decisions Are Made at the Margin While some decisions are all-or-nothing, most decisions involve doing a little more or a little less of something. Example: Should you watch an extra hour of TV, or study instead? Economists think about decisions like this in terms of the marginal cost and benefit (MC and MB): the additional cost or benefit associated with a small amount extra of some action. Comparing MC and MB is known as marginal analysis. Making the Health Insurance and Obesity Connection Obesity is rising in America, for various reasons. Is one of those reasons health insurance? People with health insurance have less incentive to stay healthy than people without health insurance. Holding constant other factors like age, gender, and income, research shows people with health insurance are more likely to be obese. They are responding to economic incentives. The Economic Problem That Every Society Must Solve 1.2 LEARNING OBJECTIVE Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? 1. What Goods and Services Will Be Produced? Individuals, firms, and governments must decide on the goods and services that should be produced. An increase in the production of one good requires the reduction in the production of some other good. This is a trade-off, resulting from the scarcity of productive resources. The highest-valued alternative given up in order to engage in some activity is known as the opportunity cost. Example: the opportunity cost of increased funding for space exploration might be giving up the opportunity to fund cancer research. 2. How Will the Goods Be Produced? A firm might have several different methods for producing its goods and services. Example: A music producer can make a song sound good by • Hiring a great singer, and using standard production techniques; or • Hiring a mediocre singer, and using Auto-Tune to correct the inaccuracies. Example: As the cost of manufacturing labor changes, a firm might respond by • Changing its production technique to one that employs more machines and fewer workers; or even • Moving its factory to a location with cheaper labor 3. Who Will Receive the Goods and Services? The way we are most familiar with in the United States is that people with higher incomes obtain more goods and services. Changes in tax and welfare policies change the distribution of income; though people often disagree about the extent to which this “redistribution” is desirable. Types of Economies Centrally planned economies result when governments decide what to produce, how to produce it, and who received the goods and services. Market economies result when the decisions of households and firms determine what is produced, how it is produced, and who receives the goods and services. Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade Mixed economies have features of both of the above. Most economic decisions result from the interaction of buyers and sellers, but governments play a significant role in the allocation of resources. Efficiency of Economies Market economies tend to be more efficient than centrally-planned economies. Market economies promote: Productive efficiency, where goods or services are produced at the lowest possible cost; and Allocative efficiency, where production is consistent with consumer preferences: the marginal benefit of production is equal to its marginal cost These efficiencies come about because all transactions result from voluntary exchange: transactions that make both the buyer and seller better off. Caveats About Market Economies Markets may not result in fully efficient outcomes. For example: • People might not immediately do things in the most efficient way • Governments might interfere with market outcomes • Market outcomes might ignore the desires of people who are not involved in transactions – ex: pollution Economically efficient outcomes may not be the most desirable. Markets result in high inequality; some people prefer more equity, i.e. fairer distribution of economic benefits. Economic Models 1.3 LEARNING OBJECTIVE Understand the role of models in economic analysis. Economic Models Economists develop economic models to analyze real-world issues. Building an economic model often follows these steps: 1. Decide on the assumptions to use in developing the model. 2. Formulate a testable hypothesis. 3. Use economic data to test the hypothesis. 4. Revise the model if it fails to explain the economic data well. 5. Retain the revised model to help answer similar economic questions in the future. Important Features of Economic Models Assumptions and simplifications: every model needs them in order to be useful. Testability: good models generate testable predictions, which can be verified or disproven using data. Economic variables: something measurable that can have different values, such as the incomes of doctors. The Scientific Nature of Economics Economists try to mimic natural scientists by using the scientific method. But economics is a social science; studying the behavior of people is often tricky. When analyzing human behavior, we can perform: • Positive analysis: the study of “what is?”; and/or • Normative analysis: the study of “what ought to be?” Economists generally perform positive analysis. Making the Should Medical School Be Free? Connection Forecasts indicate a significant shortage of doctors, especially primary care physicians, by 2020. High costs of medical school may: • Prevent some people from becoming doctors • Lead people to pursue lucrative specialties instead of primary care Would more people become primary care physicians if medical school were free? And if so, would it be worth the cost? Economic models can find answers to the positive aspects of this debate. Microeconomics and Macroeconomics 1.4 LEARNING OBJECTIVE Distinguish between microeconomics and macroeconomics. Microeconomics and Macroeconomics Microeconomics is the study of • how households and firms make choices, • how they interact in markets, and • how the government attempts to influence their choices Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. A Preview of Important Economic Terms 1.5 LEARNING OBJECTIVE Define important economic terms. Terminology in Economics Like all fields of study, economics uses terms or jargon with specific, precise meanings. Sometimes these terms will be used in ways that differ even from closely related disciplines. Examples: Technology: the processes a firm uses for turning inputs into outputs of goods and services Capital: manufactured goods that are used to produce other goods and services Pay close attention to terms defined in class and in the textbook! Common Misconceptions to Avoid Believing economics is only about money. Confusing positive and normative analysis. Assuming familiar meanings for economic terms. Appendix: Using Graphs and Formulas LEARNING OBJECTIVE Review the use of graphs and formulas. A Map as a Graphical Model A map is a simplified model of reality, showing essential details only. Economic models, with features like graphs and formulas, can help us understand economic situations just like a map helps us to understand the geographic layout of a city. Street map of New York City. Copyright © 2011 City Maps Inc. Graphs of One Variable Panel (a) shows a bar graph of market share data for the U.S. automobile industry; market share is represented by the height of the bar. Panel (b) shows a pie chart of the same data; market share is represented by the size of the “slice of the pie”. Figure 1A.1 Bar Graphs and Pie Charts Time-Series Graphs Both panels present time-series graphs of Ford Motor Company’s worldwide sales during each year from 2001 to 2012. Panel (b) has a truncated scale on the vertical axis, while panel (a) does not. As a result, the fluctuations in Ford’s sales appear smaller in panel (b) than in panel (a). Figure 1A.2 Time-Series Graphs Graphs of Two Variables The figure shows a two- dimensional grid on which we measure the price of pizza along the vertical axis (or y- axis) and the quantity of pizza sold per week along the horizontal axis (or x-axis). Each point on the grid represents one of the price and quantity combinations listed in the table. By connecting the points with a line, we can better illustrate the relationship between the two Figure 1A.3 Plotting Price and variables. Quantity Points in a Graph Calculating the Slope of a Line We can calculate the slope of a line as the change in the value of the variable on the y- axis divided by the change in the value of the variable on the x- axis. Because the slope of a Figure 1A.4 Calculating the Slope straight line is constant, of a Line we can use any two Changeinvalueon theverticalaxis y Rise points in the figure to Slope= Changeinvalueon thehorizontalaxis= x = Run calculate the slope of the line. Calculating the Slope of a Line—continued For example, when the price of pizza decreases from $14 to $12, the quantity of pizza demanded increases from 55 per week to 65 per week. Figure 1A.4Calculating the Slope of a Line So, the slope of Changeinvalue on theverticalaxis y Rise this line equals Slope= Changeinvalue on thehorizontalaxis x= Run –2 divided by 10, or –0.2. Priceof pizza ($12 $14) 2 Slope= Quantityof pizza (65 55) = 10 = 0.2 Showing Three Variables on a Graph The demand curve for pizza shows the relationship between the price of pizzas and the quantity of pizzas demanded, holding constant other factors that might affect the willingness of consumers to buy pizza. Figure 1A.5 Showing Three Variables on a Graph Showing Three Variables on a Graph (part B) If the price of pizza is $14 (point A), an increase in the price of hamburgers from $1.50 to $2.00 increases the quantity of pizzas demanded from 55 to 60 per week (point B) and shifts us to Demand curve . 2 Figure 1A.5Showing Three Variables on a Graph Showing Three Variables on a Graph (part C) Or, if we start on Demand curve and1 the price of pizza is $12 (point C), a decrease in the price of hamburgers from $1.50 to $1.00 decreases the quantity of pizza demanded from 65 to 60 per week (point D) and shifts us to Demand curve 3 Figure 1A.5 Showing Three Variables on a Graph Positive and Negative Relationships In a positive relationship between two economic variables, as one variable increases, the other variable also increases. In a negative relationship, as one variable increases, the other decreases. This figure shows the positive relationship between disposable personal income and Figure 1A.6Graphing the Positive consumption spending. Relationship Between Income and Consumption Correlation vs. Causation Figure 1A.7 Determining Cause and Effect Using graphs to draw conclusions about cause and effect is dangerous. For example, in panel (a), as the number of fires in fireplaces increases, the number of leaves on trees falls; but the fires don’t cause the leaves to fall. In panel (b), as the number of lawn mowers being used increases, so does the rate at which grass grows. Are Graphs of Economic Relationships Always Straight Lines? The relationship between two variables is linear when it can be represented by a straight line. Few economic relationships are actually linear. However linear approximations are simpler to use, and are often “good enough” in modeling. Slopes of Nonlinear Curves A nonlinear curve has different slopes at different points. This curve shows the total cost of production for various quantities of iPhones. We can approximate its slope over a section by measuring the slope as if that section were linear. Between C and D, the slope is greater than between A and B; so we say the curve is steeper Figure 1A.8a The Slope of a between C and D than Nonlinear Curve between A and B. Slopes of Nonlinear Curves—continued Another way to measure the slope of a nonlinear curve is to measure the slope of a line that is tangent to the point where we want to know the slope. Cost 75 = =75 Quantity 1 Cost 150 Figure 1A.8The Slope of a = =150 Nonlinear Curve Quantity 1 Formula for a Percentage Change One important formula is the percentage change, which is the change in some economic variable, usually from one period to the next, expressed as a percentage. Percentagechange= Valueinthe second period Valueinthe first perio× 100 Valueinthe first period The Area of a Rectangle The area of a rectangle is equal to its base multiplied Areaof a rectangle = Base× Height by its height; total revenue is equal to quantity multiplied by price. Here, total revenue is equal to the quantity of 125,000 bottles times the price of $2.00 per bottle, or $250,000. The area of the green- shaded rectangle shows the firm’s total revenue. Figure 1A.9 Showing a Firm’s Total Revenue on a Graph The Area of a Triangle The area of a triangle is equal to 1 Areaof a triangle= × Base× Height ½ multiplied by its 2 base multiplied by its height. The area of the blue-shaded triangle has a base equal to 150,000 – 125,000, or 25,000, and a height equal to $2.00 – $1.50, or $0.50. Therefore, its area Figure 1A.10 The Area of a Triangle equals ½ × 25,000 × $0.50, or $6,250. Summary of Using Formulas Whenever you must use a formula, you should follow these steps: 1. Make sure you understand the economic concept the formula represents. 2. Make sure you are using the correct formula for the problem you are solving. 3. Make sure the number you calculate using the formula is economically reasonable. For example, if you are using a formula to calculate a firm’s revenue and your answer is a negative number, you know you made a mistake somewhere.