Advanced Microeconomics

Advanced Microeconomics

Prof. RousHickory Hall 220fjrous@unt.edu

What is Economics?• “The study of the economy” – Jane Q. Public• “Economics is the science which studies human

behavior as a relationship between given ends and scarce means which have alternative uses.”– Robbins, Lionel (1932). An Essay on the Nature and

Significance of Economic Science., p. 16• While the phenomena or behavior economists

study largely involve choice under scarcity, the same can be said of other social science research.

Topics for Economists, and other Social Scientists

• Phenomena under Robbins definition:– To what extent does public housing reduce

homelessness?– Does Head Start improve educational outcomes?– Does lowering the tax rate on the top 1% increase job

creation?– Why is the marriage age rising?– Does the death penalty deter crime?– Why did Americans choose suburban living after

WWII?• So research topics do not differentiate economics.

Back up, what is social science?• Physicists, chemists, biologists, etc. study

phenomena that do not have conscious thought but are instead “passive adherents to the laws of nature (Silberberg, 1990).”

• Along with sociologists, anthropologists, economic geographers, planners, political scientists, and other social scientists, economists study human behavior.

• Studying human behavior is essentially nothing more than the study of human decision making, or choice.

Economic Schools of Thought• Before differentiating economics from other

social sciences, we have to differentiate only schools of thought.

• School of Thought: A particular idea or set of ideas held by a specific group; doctrine. Any idea that a group strongly believes in, be it through practicing this idea in their everyday life or through fighting for its adoption, can be considered a school of thought. (businessdictionary.com)

Schools of Thought• 95% of economists in the US, 90% in Europe and

85% in the world are in the Neoclassical school of thought

• Neoclassical economics evolved from the Classical school defined by Ricardo, Smith, and Marx. Classical school defined by:– focused on the economy: productivity, growth,

economies of scale, gains from trade, land rent.– understood a gap between value in use and value in

exchange– prices assumed to be set by cost of production only• value in use was inconsequential

Neoclassical Revolution:Marginal Analysis

• Action is taken so long as the marginal benefit exceeds the marginal cost, or, similarly, until the marginal benefit equals the marginal cost.

• For example: Diamond-Water Paradox– For all units of a good except the last one consumed,

the value in use exceeds the market price.– For all units of a good except the last one produced,

the cost of production is lower than the market price.– For the last unit produced and consumed, the

marginal value = marginal cost = price

• Other Schools of Thought– Neo-Marxist Economics– Institutional Economics– Austrian Economics (Ron Paul and an increasing

number of Republicans live here)– Feminist Economics– Socio-Economics– etc.

This course is about Neoclassical Economics

• Which can be divided into:– Positive– Normative

Positive Economics• Positive, the economics of what is.• The goal: to explain and predict behavior• How will economic actors (individuals, firms, etc.)

respond (direction and magnitude of change in behavior) to changes in exogenous variables? For example:– Increasing the minimum wage 3% will cut

employment by .5%– Increasing the percentage of adults with a college

degree by 10% will increase a city’s income by 2%.

Marginal Analysis Everywhere!

• Markets are the summation of economic actors optimizing using marginal analysis.

• If marginal analysis can be used to explain consumption and production behavior, then how about applying it to crime, marriage, decision to have children, drug addiction, etc.

• Economists used to be criticized for branching out, but now there is a Freakonomics movie.

Normative Economics• Normative, the economics of what ought to be.• Policy should encourage efficiency, equity, social

welfare, etc.– Attempting to maximize economic surplus is good– Deadweight loss is bad– Kaldor-Hicks uses consumer and producer surplus and

says that if those who gain from a policy could theoretically compensate losers, it is good

– Pareto suggested that only policies that have NO losers (i.e. Pareto improving), are good

Normative Economics–Market transactions (without externality) are Pareto improving, so

markets are good.– Increasing the minimum wage will increase deadweight loss, so it is

bad policy.– Increasing the minimum wage will increase producer surplus, with

minimal deadweight loss so it is good policy.–We should subsidize higher education because the long term

economic growth will more than payoff current taxpayers.–Market based health reform is superior because it is more efficient.– Carbon taxes are good because they reduce a negative externality.– Carbon taxes are bad because they increase the cost of driving for the

poor.– A progressive tax system is good because it is fair for the rich to pay

disproportionately more.– A progressive tax system is bad because it is unfair for the rich to pay

disproportionately more.

Normative Economics is Currently Out of Favor Academically

• No interpersonal comparisons of utility possible, so income redistribution is not necessarily “good.”

• Marginal benefit (the basis of consumer surplus) does NOT measure utility, but instead something that is heavily income dependent, so this calls into question consumer surplus as a tool for allocation.

• The only moves we can say unequivocally improve social welfare are those that are Pareto improving.– Not many policies can be shown Pareto improving, although

we do tend to argue for policies that increase efficiency.– In recent decades, focus on positive economics.

What Differentiates Positive Neoclassical Economics

(henceforth, “economics”) from all other Social Science Research?

• What doesn’t set us apart– The phenomena of interest -- all human behavior

• What sets us apart– Methodology

Most Influential Neoclassical Economists (1920s-40s)

• Many came from a hard science background.• Brought the scientific method and

mathematical models of natural systems with them.

• Initially summarized in Samuelson’s 1947 “Foundations of Economic Analysis”– Theories should derive from first principles.– Theories should be refutable, or they have no

value.

Silberberg’s Definition of Neoclassical Economics

• “Economics is that discipline within social science that seeks refutable explanations of changes in human events on the basis on changes in observable constraints, utilizing universal postulates of behavior and technology, and the simplifying assumption that the unmeasured variables (‘tastes’) remain constant.” (Silberberg, 1990, p. 6).

“refutable explanations”• If a theory cannot be tested and proved false, it has no

value.• For example– After WWII, Americans moved to the suburbs (larger lots,

separation of land uses) because lower cost automobiles lowered the cost of transportation. Allowing people to live further away from employer and other land uses.

– This could be refuted by finding examples where more expensive automobile ownership led to less suburban development.

– As opposed to: Americans moved to the suburbs because Building housing developments became big business and greedy developers wanted to maximize profit over quality of life for those that bought the houses (actual theory)

“universal postulates of behavior and technology”

• For example, start with first principles we all can agree on, but nothing more– Individuals maximize utility subject to preferences and

available choices (rationality)– Preferences are well behaved

• Axioms– complete– transitive– reflexive

• Assumptions– continuous– convex– monotonic

“the simplifying assumption that the unmeasured variables (‘tastes’)

remain constant.”• Tastes and preferences are assumed constant not

because we believe it, but as a simplifying assumption.

• Without it, we cannot identify the effects of changes in observable constraints separately from potential changes in preferences.

“on the basis on changes in observable constraints”

• “The challenge of economics is always to search for explanations based on changes in constraints; explanations based on changes in tastes are to be viewed with skepticism and as indicative of inadequate insight.” - Silberberg, 1990, p. 7.

• So we assume changes in behavior are driven by changes in prices, income, technology, institutional constraints, etc.

For example• For example, after WWII, Americans built and

moved to the suburbs because they started to value estate like housing (pretentious trappings of wealth) over community and quality of life. (actual theory)

• But to argue changes in behavior can be attributed to changes in preferences is to give up on an explanation that can be tested and proven false... or confirmed.

The Scientific Method

• Observation of phenomena • Research question posed• Hypothesis in the form of a theory• Empirical testing

Theory• The model: the purely theoretically aspect of a

theory.– Models can be logically valid or invalid, but cannot be

tested empirically.– For example, individuals optimize an objective function

z = f(x,y) subject to constraint, αx+βy = M• How a model becomes a theory: “when

assumptions relating theoretical constructs to real objects are added.”*– The objective function represents utility, U = U(x,y),

and x and y are goods that provide utility and α and β are the price of x and y and M is income.

* (Silberberg, 1990, p. 14)

Theory• “Theories can be false either because the

underlying model is logically unsound, or because the empirical facts refute the theory.”*

* (Silberberg, 1990, p. 14)

Realistic Assumptions Necessary?

• There is an ongoing debate (mainly among philosophers) as to whether unrealistic assumptions are a fatal flaw.

• Milton Friedman argued that predictive power is the only test that matters.– E.g., whether people are rational or not, if they act

as if they are, then the assumption is good.

Refuting a Theory• Worthwhile theories have refutable

propositions.– That is, when certain test conditions occur, values

of some of the variables in the model must be restricted (Silberberg, 1990, p. 15).

– Law of supply and demand restricts equilibrium price to rise when supply decreases. Since it is possible for price to fall, it is possible for the model to be refuted.

– Profit maximization restricts quantity of a factor demanded to fall when it’s price rises. Since the quantity hired can rise, this theory can be refuted.

Comparative Statics• The method of comparative statics is how

testable propositions are derived from a model.• The model of supply and demand

• Model: » Inverse Demand: P = a-bQd a > 0, b > 0

» Inverse Supply: P = c+dQs c > 0, d > 0» Solve to get, P* = , and Q* =

• While it is impossible to theoretically hypothesize values for P* and Q* as doing so would require information on preferences and production technology, we can (by only assuming the linear functional forms) hypothesize a change in equilibrium if a, b, c, or d changes.

Comparative Statics• We can hypothesize a change in P* and

Q* given a change in an exogenous factor. Even if we don’t know values for a, b, c, or d.

• Assume a>c• Comparative Statics

2 2

2 2

* * 10, 0

* ( ) *0, 0

* * 10, 0

* ( ) *0, 0

dP d dQ

da b d da b ddP d c a dQ c a

db dbb d b d

dP b dQ

dc b d dc b ddP b a c dQ c a

dd ddb d b d

*

*

ad bcP

b da c

Qb d

P

P*

S

D

a

cslope = -b

slope = d

QQ*

Similar to being unable to predict P* and Q*, it is impossible to create

theories to predict• The obesity rate in the US.• The size of shopping carts.• That people will work a certain number of

hours at the current tax rate.• The number of drunk driving fatalities in a

state.

Instead• Theories that predict– The change in the obesity rate in each county in the

US as a function of a change in the availability of medical technology.

– The change in the size of shopping carts as a function of the LFPR of women.

– The change in the number of hours people work if the tax rate changes.

– The change in the number of drunk driving fatalities in a state as BAC limits fall and penalties rise.

• Although we often do this in cross section

This Semester• In many ways– principles = intermediate = advanced– Consumer Choice √– Theory of the Firm √– Competition √– Monopoly √

• But at a level between intermediate and a PhD advanced micro class.