Microeconomics Version 2007

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Basic Microeconomics

Adapted from the original work

by Professor R. Larry Reynolds, PhD

Boise State University

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Table of Contents

1 Introduction to Microeconomics.......................................................8

11 !%ono+i%s as a t#d$ o- Pro.isioning*1/ !%ono+i%s as a t#d$ o- the llo%ation o- %ar%e eso#r%es10

13 o%ial %ien%e and !%ono+i%s10

131 ole o- 2ndi.id#al in the Co++#nit$1113/ Cooperation, Co+petition and Cons%ription1/133 The at#re o- an !%ono+i% $ste+ and Pro%esses within a $ste+113 o%ial 2ntera%tion and Te%hnolog$15

1 The Proble+ o- Pro.isioning14

11 o%ial 2ntera%tion11/ !%ono+i% %ti.ities/1

2 The Problem of Provisioning...........................................................25

/1 2ntrod#%tion/5

// o%ial 2ntera%tion/4

/3 pe%iali6ation/4

/ Di.ision o- &abor/7

/5 Coordination o- !--orts/*

/4 !%ono+i% %ti.ities30

/41 Prod#%tion30

/4/ Distrib#tion31/43 Cons#+ption3//4 Coordination, Co+petition and Cooperation33

/ Te%hnolog$3

/7 !%ono+i% De%isions3

/71 #les 3/7/ 2nt#ition37/73 eason and ational 8eha.ior37/7 2n-or+ation37/75 ationalit$ and 2n-or+ation0

3 Introduction to Was of !no"ing....................................................#131 Fa%ts, 2n-or+ation, 9nowledge and :isdo+/

3/ ;$potheses, Theories, &aws and 5

5


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3 !xplanation, Predi%tion and tor$telling 50

35 &ogi%51

351 Ded#%ti.e easoning5/35/ 2nd#%ti.e easoning5/

353 bd#%ti.e easoning5334 !piste+olog$ and !%ono+i%


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414 Do+esti% @#sti%e1141 ational De-ense11417 Pro.ision o- %olle%ti.e or p#bli% goods 11741* Pro+ote Co+petition11*

4110 a-et$ et1/04/ Propert$ ights1/0

4/1 Propert$ ights nd


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101/ (/) Prod#%tion F#n%tion/0/1013 (3) Ti+e and Prod#%tion/03101 () Prod#%tion in the hortH#n /0 1015 Cost/0*

1014 Costs and Prod#%tion in the hortH#n/10101 raphi%al epresentations o- Prod#%tion and Cost elationships/111017 elationship o-


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1 Introduction to Microeconomics

1 $%T&'*T$'%T'+$*&'E*'%'+$*,

Archeological and written records of human existence suggest thatobtaining the material means to satisfy wants has been a perpetual problem&

:ood and shelter are re+uirements of human life& 4ther goods satisfy a range

of human desires and give pleasure or utility to individuals& he study of ways

that humans deal with these problems of provisioning is called ;economics&enophon ?652-577

C*@, $lato ?69-569 C*@ and #ristotle ?5A6-5 C*@) through the Classical

economists (e&g& #dam Smith ?195-19B1@, homas althus ?1988-1A56@ and

avid %icardo ?199-1A5@), economics was treated as part of philosophy,

religion and/or moral philosophy&

uring the 1Bthcentury, social science emerged and separate disciplines

were carved out& *conomics, psychology, sociology, politics, anthropology and

other branches of social science developed as separate fields of study& Dn the

last part of the 1Bthcentury, ;political economy< became ;economics&< Since

that time, economics has been fre+uently defined as ;the study of how scarce

resources are allocated to satisfy unlimited wants&< #s a professional

discipline, economics is often regarded as a decision science that seeks

optimal solutions to technical allocation problems& Dn this text, economics is

presented from two perspectives& :irst, the process of provisioning will be

A


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1 Introduction to Microeconomics

presented& he second perspective is the technical analysis of the processes

by which scarce resources are allocated for competing ends&

1.1 ECONOMICSASASTUDYOFPROVISIONING

Provisioning treats economics as a social science& *conomics as a studyof provisioning includes the historical and philosophical foundations and

context of economic behavior& he tradeoffs between the economic and non-

economic goals are considered& he interrelationships of economic life with

Eustice, ethics, morality, creativity, security and aesthetic values are of

concern& Fuman societies have attempted a broad array of alternative

systems to deal with the problem of provisioning& Some have been more

successful and other less so& Some systems have lasted for thousands of

years with few changes& 4ther systems have come and gone +uickly& Dn some

cases environmental problems have cause the demise of societies& Dn other

cases, the societies ended abruptly with social revolution& Dn other cases, the

societies adapted to changing circumstances and evolved over time& ayan,

*gyptian, %oman, Dncan are only a few of the societies that have come and

gone& #rcheological studies continually find evidence of societies that

flourished and ultimately failed& Dn some cases they were destroyed from

outside forces. the Spanish ended the #tec and Dncan societies& Dn other

cases, the causes were environmental. there is a hypothesis a drought is

responsible for a dramatic change in the ayan society&

*conomics as a study of provisioning is concerned with the relationships

among individuals, between individuals and the community, and between

individuals, society and natural and built environments& "atural environment

refers to the geographic (cultural and physical) and meteorological

phenomena& he built environment consists of the infrastructure and

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1.1 Economics as a Study of Provisioning

knowledge that a society has inherited and created& Dt should be noted that

humans have the capacity to alter their natural environment in both positive

and negative ways&

1.2 ECONOMICSASASTUDYOFTEA!!OCATIONOFSCARCERESOURCES

rom a technical perspective, economics is the study of how variousalternatives or choices are evaluated to best achieve a given obEective& he

domain of economics is the study of processes by which scarce resources are

allocated to satisfy unlimited wants& Ddeally, the resources are allocated to

their highest valued uses& Supply, demand, preferences, costs, benefits,

production relationships and exchange are tools that are used to describe the

market processes by which individuals allocate scarce resources to satisfy as

many wants as possible& his increasingly narrow focus is the domain of

modern, ;neoclassical,< microeconomic analysis&

This introductor. chapter is intended to introduce so/e o the

unda/ental issues in the stud. o econo/ics#

1." SOCIA!SCIENCEANDECONOMICS

There is substantial evidence and general agreement that humans live insocial groups& he Gestern tradition, as framed by the =reeks and the

Hudeo/Christian tradition, holds that humans are social animals&

$lato ?69-569 C*@ and #ristotle ?5A6-5 C*@ offer explanations of the

rise of the city-state& Dn The Repu!ic, $lato sees the origins of the city-state in

the +uest for Eustice& $lato describes a conversation between Socrates and a

group of students& hey are pondering the nature of Eustice& hey conclude

that Eustice is each person doing that which they are best suited to do& he

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1." Socia! Science and Economics

person best suited to be a baker should be a baker. the person best suited to

be a shepherd should be a shepherd& 4nce individuals specialie, the city-state

arises to facilitate the interactions among the individuals& ?The Repu!ic, ook

DD@

Dn Po!itics, $latos student, #ristotle, sees an organic composition of

society& he state becomes a natural community that is treated as an

organism& here is a natural progression from family to village to the city-

state& he city-state is then ;prior to the family and individual&< ?The Po!itics,

ook D, Chapter B@

Ghile $lato and #ristotle take different approaches, both see economic

behavior as an integral part of society& $latos focus is on Eustice and

#ristotles is on the ;good life&< 4ne of the fundamental problems that both

identify is the nature of the proper relationship between the individual and

society&

1##1 &'E'$%$3$A$%TE*'++%$T5

$n economics (and social sciences more generally), the nature of the roleof the individual in the community or state has been a persistent +uestion&*very society must address the +uestion (either implicitly or explicitly), ;Fow

can the autonomy (or freedom or liberty) of an individual be maintained and

at the same time provide for the commonweal (social welfare)I< Dn some

societies, the individual is regarded as more important than the community& Dn

other societies, the community has priority over the individual& :rom a

practical perspective, the problem is to balance the rights and freedom of theindividual with the functions of the community&

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1.".1 Ro!e of Individua! in the #ommunity

here are several perspectives about the most appropriate ways to achieve

that balance& Ghile dealing with this balance, the allocation or provisioning

problem must be resolved&

1##2 *''PE&AT$'%6 *'+PET$T$'%A%*'%,*&$PT$'%

$deally, each individual is free to make choices that are consistent withtheir desires (preferences, values) and at the same time, these choices are

consistent with the commonweal& Competition, cooperation and conscription

may be used to coordinate individual actions& ifferent societies have

attempted different approaches at different times&

1##2#1 *''PE&AT$'%A%*'%,*&$PT$'%

*ooperation implies voluntary agreements and a coordinated approach tothe solution of a problem& Conscription implies a non-voluntary or forced

behavioral choice in the allocation process& #n economic input (labor, capital,

land) or good can be conscripted& Conscription implies the ability of one

person or group to force another to make choices they would not prefer&Cooperation and coercion are opposite ends of a spectrum or range of

behavioral patterns& he degree to which a choice is voluntary or forced is not

always clear& # group of Dnuits above the #rctic Circle may use cooperation as

an important element of the coordination process& ;Cooperation< may be

encouraged by strongly held common values or necessity& *ach member of the

society understands that their chance for survival is reduced if she or he is not

a member of the community& # behavior that is not sanctioned by be

community (e&g& theft, murder, etc) may be result in the individual being

ostracied and expelled from the community, the result being death& Ds the

acceptance of group values and activities voluntary or coercedI Df a

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1.".$ #ooperation% #ompetition and #onscription

government (a formal social institution for allocating power and decision

making authority in a community) uses sanctions to force behavior or choice it

is clearly coercion or conscription& Df D threaten harm if you do not make a

given choice or act in a specific way, that is coercion& Df a persons mother

says, ;!our go ahead but it will break my heartJ< is that coercionI

3oluntary cooperation and coerced conscription lie at opposite ends of a

continuum& Dt is a variation of the arguments about whether individuals have

free will& he shift from voluntary coordinated behavior (cooperation) to

coerced coordinated behavior (conscription) is a matter of degrees& Dn both

cases, individuals have an incentive to coordinate their behavior& Dn the case

of coercion, the incentive is the costs created and imposed by other individuals

or groups of individuals& # student in high school may feel coerced by their

peers, the class bully or the rules of the system& # worker may be coerced by

other workers, the management of the firm or government regulations&

1##2#2 *'+PET$T$'%

+arket oriented societies focus on the use of competition to constrainindividual behavior& Dn Gestern industrial societies, competition is regarded as

the optimal way to coordinate economic behavior& # market exchange is a

contract between a seller and a buyer& he seller competes to get the highest

possible price (or best deal), while the buyer competes to by at the lowest

possible price& he competition between the buyer and seller is influenced by

the tastes (or preferences) of buyer and seller, information that each has and

alternatives that each has&

he word ;competition< has at least two meanings in economics& 4ne is to

refer to rivalry& Dn rivalry, there is a winner and a loser& he other is a

structural notion of ;pure< competition where the sellers do not see

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1.".$ #ooperation% #ompetition and #onscription

themselves as rivals (farmers are often thought of as being engaged in highly

competitive markets but do not see themselves as rivals&)

=enerally, societies use a mix of cooperation and competition& # firm is a

form of cooperation& Dn 1B59, %onald Coase published an explanation of why

business firms exist in a market economy (Coase, pp 55-77) Df a competitive

market economy were the optimal way of allocating resources, why would

firms be desiredI Coase argues that there are costs of using a market& Fe calls

these costs ;transaction cost&< here are also costs of creating and operating

an organiation& Df the transaction costs exceed the cost of organiing a

cooperative endeavor, a firm will be created to avoid the use of market

transactions&

1## TE%AT&E'A%E*'%'+$*,5,TE+A%P&'*E,,E,$T$%A,5,TE+

The study of economics can be approached at different levels& #t onelevel economics is the study of how the economic provisioning, or economic

systems, come into being and evolve over time& #t another level, economics

studies the structure and ways in which a particular system deals with the

allocation or provisioning problem&

he study of the structure and evolution of economic systems typically is

interdisciplinary& Dt may use a good deal of history, psychology, sociology, law

and philosophy in its analysis of the social process of provisioning& Ghen

economics is the study of a particular system, it tends to be narrower and

focus is on specific processes& Dn the Gestern industrial societies, the current

focus is on market oriented economic processes and is referred to as

;"eoclassical< microeconomics or ;price theory&< Dts focus is on the

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1."." The &ature of an Economic System and Processes 'ithin a System

competitive behavior of individuals and exchange transactions in a market

context&

1##4 ,'*$A$%TE&A*T$'%A%TE*%''85

umans have sought to solve the problem of provisioning through socialinteraction and the use of technology& Social interaction is used to refer to the

relationships between two or more individuals& Dn this context, an ;individual#4 *''&$%AT$'%6 *'+PET$T$'%A%*''PE&AT$'%

Each society must develop a set of social institutions (behavioralpatterns) to coordinate the activities of production, distribution and

consumption& here is a wide range of forms these institutions may take

depending on the physical environment, state of technical knowledge, social

values and other factors& hese institutions and behavioral patterns may rely

on competition, cooperation or some combination& arket systems tend to

focus on competition while other systems may have a larger role for

cooperation& # bicycle race is a useful metaphor& Dn a road race the riders

cooperate in the peleton (the large group of riders in a bicycle race) by

drafting (using the rider in front to reduce the wind drag)& Ghen a group

breaks away from the peleton, they typically form a pace line and each shares

the work of riding in front of the group& *ventually, the structure of the pace

line disintegrates and the riders compete in a sprint to the finish or they fall

back into the group& he race is a mixture of cooperation and competition&

Hoan %obinson argues that an economic system ;L re*uires a set of ru!es%

an ideo!ogy to 5ustify them% and a conscience in the individua! 'hich ma/es

him 6sic7 strive to carry them out.< (%obinson, p 15)

$roduction, distribution and consumption are interrelated& Ghat to produce

is influenced by what individuals want to consume& Ghat people want to

consume is influenced by the distribution process and what can potentially canbe produced& his coordination may come in the form of cooperative activities,

such as the creation of a business firm& he firm usually organies production

internally as a cooperative process but must compete externally& #lternatively,

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$.4.( #oordination% #ompetition and #ooperation

the coordination of activities may be accomplished by competition or some

combination of cooperation and competition&

2.( TECNO!OGY

Technology is knowledge about how resources, individuals and socialorganiation can be used to accomplish obEectives& echnology is more than a

set of skills to do things& Dt is a perspective about the relationships between

humans and their world& echnology is the sum total of the ways in which

human societies interact with natural and built environments& Fumans seek to

understand these interactions and develop technology by combining and

reorganiing existing technologies&

Dn economics, technology is the knowledge about the use of scarce

resources to produce goods and services that satisfy human wants& he

knowledge about how we do things, ;technology,< is not limited to machines&

he discovery of a calendar or the realiation that crops can be planted on a

three field rotation may be as important as the invention of the padded horse

collar, the steam engine or the $C& Knowledge about the use of organiational

structure to achieve an obEective is, in a sense, a form of technology&

he values and structure of society are connected to the state of

technology& Society is shaped by technology and at the same time is an

important force in the determination of the course of technological change&

his relationship between technology, society and the individual can be driven

by curiosity and/or material gain&

echnological change is pervasive& uring some periods of history,

technology changes at a slow pace& #t other times, the rate of change is more

rapid and more dramatic& uring the medieval period, technological change

was slow& Gith the development of mechanical clocks, the plague, moveable

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$.8 Techno!ogy

type, gunpowder, new techni+ues in art and other innovations, the

;%enaissance< (usually thought of as the 16th-19thcenturies) was a period of

dramatic change& uring the 19th and 1Ath centuries, the ;age of

*nlightenment< was fueled by technological change& he ;Dndustrial

%evolution< (which is often dated as about 1972) is another term used to

identify a period of rapid technological change& *ach of these periods involves

changes in ideas, values, knowledge and social institutions& *ach altered

economic and social processes&

here are opposing views as to the process of technological change& 4ne

view is the homas #& *dison perspective& Dn this case, technological

development is driven by profits& Df a technology is profitable, it will be

invented& he other view is that technology is a self-generating process& "ew

technology is the result of old technology(ies) being recombined in new ways

and used for new purposes& Dn the second view, profits cannot create the

development of technology but determine its uses&

Ghat an individual perceives as a resource is influenced by the nature of

technology& Dn the 1Athcentury, obsidian was an important resource among

the inhabitants of the western 0nited States. uranium was not& Dn the 1st

century, obsidian is not normally regarded as a very important resource while

uranium has become a resource&

:actor endowment may influence the direction that technology develops& Dn

a society with an abundance or arable land and a shortage of labor may

produce (and consume) different goods and seek different technologies to

produce them&

Dn the *dison view, the light bulb was invented because there was a

demand for it and it could be developed and produced for a profit& Dn the

second view, it is not possible to invent high-pressure steam engines, even

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$.8 Techno!ogy

though they may be profitable, until the technology of metallurgy develops

metals to contain the higher pressure& *ither view supports the argument that

technology builds upon itself& he creation of an internal combustion engine

depended on its connections to cannons, oil, aybachs spray carburetor,

levers and gears& *ach of these in turn depended on other technologies& Ghen

aimler and aybach built the automobile, it was the result of a series of

connections between technologies that had been developed by many people

over a long period& (see urke, #onnections, pp 197-1A5)

Dt is useful to think about technological change as a process& :irst, a piece

of knowledge emerges or an ;invention< occurs& Second, some one finds an

application for the new knowledge (innovation) and uses it& hird is the

process of dissemination, i&e& the use of the idea is spread through out the

social system& *ach stage of technological change may produce or re+uire

significant changes in values and social institutions& Changes in social structure

or the natural environment may encourage technological change&

echnology and the social system are interconnected& echnology has a

strong influence on the structure of society and individual behavior& he

Dndustrial %evolution may be thought of as a fundamental change in

technology of production that altered society& he development of the

mechanical clock was driven by the clergys desire to satisfy the institution of

prayers at specific times of the day&

he perception of and taxonomy of inputs or resources was influenced by

social structure& 'and was associated with the nobility and the clergy while

labor was associated with the serfs& #s trade developed, a merchant class

arose and became associated with capital&

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$.9 Economic 3ecisions

2.) ECONOMICDECISIONS

$na simple taxonomy, individual behavior may be influenced by rules(command), intuition, emotion, habit, reason or some combination&

$hilosophers and psychologists have struggled with the issue of fate and

freewill& he issue has not been resolved& Dt is not likely that it will be resolved

here& he +uestion for economics is to try to understand and explain how

humans try to resolve the problems of provisioning and allocation&

2#?#1 &E,

$f behavior is constrained or influenced by rules, rules of thumb or habits,the nature of those rules and the process by which the rules evolves is of

interest to economists& Df the agents decision is constrained, the nature of

those constraints is of concern&

%ules may by implicit or explicit& *xplicit rules often take the form of law

and maybe imposed by governments or organiations& =enerally, explicit rules

are conscious creations and must be communicated and enforced& Social

groups may also use explicit rules& usiness firms, churches, and other

organiations may explicitly impose rules& Dmplicit rules may also be important

constraints& Dmplicit rules are not consciously created but must still be

communicated&

Certain types of behavior are expected and influenced by such social

constructs as ;manners,< mores, custom, rules of thumb and traditions& hese

rules are short cuts to problem solving& Df over time a particular problem isalways or nearly always resolved by a specific approach, that approach

becomes a habit or rule of thumb& hese rules and habits provide ready made

solutions that do not have to be derived by reason or intuition&

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$.9.$ Intuition

2#?#2 $%T$T$'%

$n recent years, there has been a growing interest in the interrelationshipbetween psychology and economics& aniel Kahneman ("obel :oundation

prie winner) has explored intuition and reason as thinking and decision

processes& (Kahneman, pp 166B-1697) #ccording to Kahneman, intuition can

be powerful and accurate, re+uires practice and is ; rapid and effortless&< he

reasoning process provides a check on the intuitive process&

2#?# &EA,'%A%&AT$'%A:EA3$'&

'rthodox, modern economic analysis is generally regarded as the studyof alternative uses of resources to achieve obEectives& #t a technical level,

economic analysis is used to evaluate rational decisions& %ational behavior that

the agent has identified an obEective or goal and has evaluated all feasible

alternatives to select the alternative that best achieves the obEective&

2#?#4 $%'&+AT$'%

ithin any economic system, the agents must have information andthere must be a set of incentives to encourage appropriate actions& Ghether

the economic system primarily uses market exchange, reciprocity, eminent

domain or some other allocative mechanism, the agents must have

information about preferences, inputs, technology and alternatives&

Dn different economic systems, the decisions may be made by different

agents& Dn a planned economic system, some type of planning authority would

necessarily have to have information about the preferences of the members of

the systems, all inputs, all technology and all alternatives that are feasible&

his is an enormous re+uirement& Dn a market-oriented system based on

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$.9.( Information

exchange between individuals, the information re+uirement is altered&

Dndividuals only need to know about their own preferences and feasible

alternatives& Ghat is re+uired is a social system that provides for voluntary

exchanges between agents with appropriate information&

Dn the 1B2s and 52s there was a debate (he Socialist Calculation

ebate) about the ability of socialist systems to ac+uire necessary information&

4ne side of the debate lead by the #ustrians ('udwig von ises (1AA1-1B95)

and :riedrich Fayek (1ABB-1BB)) argued that it would be impossible for a

centrally planned economy run by rules to have the necessary information to

function& 4scar 'ange (1B26-1B87) and #bba $& 'erner (1B25-1BA) argued

that if planners were cost minimiers, the appropriate information could be

calculated& his is a simplistic description of the Socialist Calculation ebate

but emphasies the importance of information to the functioning of an

economic system&

Dn the Socialist Calculation ebate, #ustrians argued that command

economies could not be successful because there was insufficient information

to guide decisions in the economic process& hey believed that each individual

had information about their preferences and what they were capable and

willing to do& arkets were seen as the social institution that could provide

information about relative values through the voluntary, exchange interactions

of individuals& he market system was the process that provided the

information for the agents to make decisions& he #ustrians argued that the

command system had no process by which information would be revealed&

'ange accepted this criticism and suggested, ;market socialism< as an

alternative&

Dncentives are the forces that encourage or induce agents to behave in

particular ways& uty, authority or self-interest may guide an agents

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$.9.( Information

behavior& Since neoclassical economics is based on a conse+uentialist ethic

that is expressed through markets, the incentive provided by self-interest is

perceived as dominant& 4ther incentives may be e+ually as important& Smith

believed that self-interest would be constrained by systems of morality and

Eurisprudence&

2#?#@ &AT$'%A$T5A%$%'&+AT$'%

The allocation of scarce resources re+uires both information andincentives for the agents& Dnformation about the obEectives and feasible

alternatives is necessary if ;rational choices< are to be made& # rational choice

re+uires that the alternative that ;best< satisfies the obEective be selected&

his re+uires criteria to evaluate each alternative with respect to the obEective&

ased on the obEective, set of alternatives and the method of evaluation, the

optimal or best alternative can be selected& here are three fundamental steps

to the process of making ;rational< economic choices.

/dentify the ob0ective of the agent*

/dentify all feasible alternatives that are related to the ob0ective*

Develop the criteria to evaluate each feasible alternative with respect to the ob0ective*

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" Introduction to )ays of :no'ing

$%T&'*T$'%T'A5,'


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" Introduction to )ays of :no'ing

ethodology is generally seen as the system of values, beliefs, principles and

rules that guide analysis within a given discipline& he methodology(ies) that

prevails within a discipline plays a maEor role in the nature of +uestions that

are asked as well as the answers that are offered&

here is a large and growing body of literature on methodology in

philosophy and the sciences (both natural and social)& his trend has also

influenced economics& any economists have participated in the explorations

into methodology and epistemology& 4ne explanation for a renewed interest in

methodology in economics is that the basic processes created to explain the

development of market systems and mature industrial economies may need to

be adEusted if there are significant structural changes in the economy& he

study of the history of economic thought and methodology adds the +uestions

of

;87at do belie%e9#1#2 P&E,*&$PT$3E#1# A%E=A+PE

Knowledge about baking includes an understanding of the effects of

altitude, leavening, moisture, temperature, gluten and a host of other

phenomena on cakes& his knowledge is propositional knowledge& # cake can

be baked by someone in San :rancisco with a recipe (prescriptive knowledge)

and no knowledge about the effects of altitude on cakes& he recipe will work

as long as person doesnt try to bake a cake in Santa :e, " (elevation 922

feet)& o modify the recipe so it will work at the new elevation re+uires

propositional knowledge& he development of new recipes () re+uires some

proportional knowledge ()&

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".4.$ Brief Survey of Epistemo!ogy

#>#2 :&$E,&3E5'EP$,TE+''85

Karl $opper ?1B2-1BB6@ is the primary architect of falsification as a

method of science& Dn his The ogic of Scientific 3iscovery, 1B56, he outlines

the basic approach taken in what is called the scientific method& Fe proposes

that scientific knowledge grows through a process of making hypotheses abut

the nature of problems and the falsification or testing of those hypotheses&

$opper argues that it is the duty of every scientist to try to disprove or reEect

his or her hypotheses& Df a hypothesis cannot be reEected by empirical

evidence, it may be retained as ;probably true&< #ll knowledge then is

probabilistic. it has not yet been falsified& he process is subEect to what

statisticians call ype D and DD (or alpha and beta) errors& ype DD errors occur

when a false hypothesis is accepted as ;true&< Ghen a ;true< hypothesis is

reEected as false a ype D error has occurred&

homas Kuhn ?The Structure of Scientific Revo!utions, cd ed, 1B8,1B92@

offers another explanation for the evolution and change of scientific thought in

the ;hard sciences&< Fis explanation is often applied to economics and social

sciences& Kuhn used the concept of ;paradigms< and paradigm shifts to explain

the process& he term, paradigm, is often used and abused in discussions&

Kuhns approach is essentially a ;truth by consensus< which is contained in

the paradigm& his paradigm (and its associated ;truth by consensus


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he members of the science use this paradigm to resolve anomalies& Ghen

an anomaly of maEor significance or a large number of anomalies cannot be

explained, the paradigm must be +uestioned and a new paradigm for that

science developed& Dn this manner ;science progresses&


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anarchism&< :eyerabend argues that the ;success of science cannot be used as

an argument for treating yet unsolved problems in a standardied way< and

scientific achievements can ;be Eudged only after the event&< (:eyerabend, p

) :eyerabends approach to the methodology of science is radically different

because of his obEectives& Fe claims his purpose is ;humanitarian not

intellectual< in that he wants ;to support people not advance knowledge&< Fe

is ;against ideologies that use the name of science for cultural murder&? =@or the 4uantity of good > 3(ebecs5 plus the 4uantity of good @3@awls5, there are alternative 4uantities of =>and =@that can be produced* By limiting

the outputs to two goods, the model can be constructed in two;dimensional space 3on a

graph5* /f three goods are considered, the model re4uires a thee;dimensional space*

/nputs are: 3natural resources5 ? - 3labor5 ? 3capital5, these resources arefinite and given at any point in time*

'he state of technology is the information the agents have about the various waysof producing different 4uantities of goods > 3(ebecs, or =>5 and @ 3yawls, or =@5*

Df all inputs and the best technology available were allocated to the

production of xebecs (O>), a finite +uantity could be produced& Dn :igure 7&1

this is shown at point = on the > axis when 5 units are produced& Since no

inputs are allocated to the production of yawls (O!), none are produced& Df the

agents decided that some yawls were desired, they would have to take some

of the inputs from the production of xebecs to use in the production of yawls&

Since all the inputs (and best technology) were used to produce 5 xebecs in

our example, any reallocation of inputs from the production of xebecs to yawls

would re+uire a sacrifice, or the production and availability of fewer units of

xebecs& his can be shown as a move from point = (O>N 5. O!N 2) to point

: (O>N 51. O!N 12)& he production of 12 units of yawls re+uires the sacrifice

of 1 units of xebecs (5-51N1)& he inputs that are least effective in producing

xebecs would be reallocated to the production of yawls& he sacrifice of xebecs

would be minimied& (!ou would not shift the best resources to produce

xebecs into the production of yawl. that would maximie the sacrifice&)

#t point # (O>N 2. O!N 75), all inputs are allocated to the production of

yawls so no xebecs are produced& %esources can be reallocated from the

production of yawls to produce xebecs. the first five units of xebecs can be

produced by sacrificing the output of 5 yawls& #gain, the least effective inputs

in the production of yawls would be shifted to the production of xebecs& his

can be shown as a movement from point # to point & Sacrifice of one good to

produce more of the other is called ;opportunity cost&< Ge can locate other

AA


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A.".$ Production Possii!ities ;unction

output alternatives along the $$:. points #, , C, , *, :, = all represents

alternative outputs of xebecs and yawls& #ny point that lies on the $$: is an

output alternative that represents a combination of O> and O! that can be

produced given inputs and technology& #ny output combination inside the $$:

is possible but, would not be the maximum amounts of > and ! that could be

produced& 4utput combinations that lie outside the $$: are not attainable or

feasible given the inputs and technology available&

he output combination at point F (O>N18. O!N2) is clearly not efficient.

more > or ! or both can be produced given the inputs and technology&

(%emember, %, ', K and technology, inputs are fixed&) %esources can be

reallocated to produce more xebecs (a move to point *), to produce more

yawls (point C) or more of both (any point in the triangle F*C&

#ny output combination that can be shown as a point on the $$: can be

considered as ;technically efficient&< #ny output combination that falls inside

the $$: is technically inefficient. there are unused inputs or inputs are not

being used for the most appropriate purpose& Clearly there is a problem. there

are an infinite number of output combinations (any point on the $$:) which

are technically efficient& here are also an infinite number of output

combinations that lie inside the $$: that are technically inefficient&

Df we expand the model to include the ratio of output to inputs, an increase

in technical efficiency could be the result of.

an increase in the output of either good while the other good and inputs are heldconstant

an increase in both goods while inputs are held constant

a decrease in the inputs while the output is held constant

an increase in output and a decrease in inputs*

# movement from a point inside the $$: to a point on the curve is can be

regarded as an ;increase in efficiency&< #n improvement in technical

AB


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knowledge can also be regarded as an ;increase in efficiency< since the same

output combination could be produced with fewer inputs& he technological

improvement can also be envisioned as a shift of the $$:, more output can be

produced if the same +uantities of inputs are used& his is shown in :igure 7&&

here are an infinite number of technically efficient solutions to the

allocation problem& Fowever, there is only one allocation that achieves

economic or allocative efficiency&

A'*AT$3E '& E*'%'+$* E$*$E%*5

Since >ebecs (good O>) and !awls (good O!) are not the same things, it

does not make sense to add them together (case of adding apples and

oranges, O>PO!)& Df the values of the two (or more) goods were known or

there were an acceptable proxy for the value, it would be possible to add their

values& %emember that one of the tasks of the economic process is to allocate

resources to their highest valued use& echnical efficiency is a prere+uisite for

allocative efficiency&

*conomic or allocative efficiency takes into account the value of both the

inputs and outputs& *conomic efficiency is measured by a ratio of the value of

the output to the value of the inputs& 3alue is a complex notion and market

prices are often used as an indicator of exchange value& (%emember the

warning of 4scar Gilde. ;0 cynic is some one 'ho /no's the price of

everything and the va!ue of nothing&


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0sing the same production possibilities function as in :igure 7&1, allocative

efficiency can be described in :igure 7&5#Dn this example, the optimal output

alternative is that with the highest value& Since value cannot be measured

directly, neoclassical economists use market price as an approximation of

value& Dn order for market price to be a reasonable approximation, exchanges

must be voluntary exchanges of goods with exclusive property rights& Df the

price of xebecs were R6 and the price of yawls were R the ;value< of each

alternative identified in :igure 7& can be calculated& #lternative # is worth

R128, alternative is worth R12, C is worth R166, is worth R178, * is also

;valued< at R178& he output at alternative : is worth R166 and at = is worth

R1A& hese calculations can be seen in able 7&5& he highest valued output,

based on market prices will lie on the $$: between alternatives C (valued at

R178) and (also R178)&

Df the prices of the goods are accepted as the value of the goods, the

calculation of each alternative are shown in able 7&1

Df the price of good ! should rise to R5&72 (and the price of > stay at R6)

the alternative with the ;highest value< is at point C as shown in able 7&&

he alternative that is allocatively or economically efficient is dependent on

a set of prices that measures value& Ge will explore the ability of the market

to accurately reflect values of outputs& Dt is also important to note that there

are many things that humans value that cannot be expressed as a market

price&

B


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B5

Cigure ebecs 3=>5

=uantityof@awls3=

@5

D

AB

&

C

E

is R2 (R6x7units >), the value of good ! is R122 (Rx72 units !)&

he value of output of good > and ! is R12&

At D and the value of the output is J#

!

$

$*

Any alternative inside the PPC will be valued at less than the ma(imumvalue*

:

3J#"F53J#!"5

3J#


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able 7& #llocative *fficiency and 3alue of 4utput

#lternative

O> $>

3alue of output

of >

($>O>)

O! $!

3alue of

output of !

($!O!)

3alue ofoutput

($>O>P

$!O!)

# 2 R6&22 R2&22 75 R5&72 R1A7&72 R1A7&72

7 R6&22 R2&22 72 R5&72 R197&22 R1B7&22

C 18 R6&22 R86&22 62 R5&72 R162&22 R26&22

6 R6&22 RB8&22 52 R5&72 R127&22 R21&22

* B R6&22 R118&22 2 R5&72 R92&22 R1A8&22

: 51 R6&22 R16&22 12 R5&72 R57&22 R17B&22

= 5 R6&22 R1A&22 2 R5&72 R2&22 R1A&22

F 18 R6&22 R86&22 2 R5&72 R92&22 R156&22

B7


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A."." Pareto Efficiency

@## PA&ET'E$*$E%*5

At a technical level, economics provides a set of tools to aid in choosingamong competing alternatives& Dn 1B28 an Dtalian, :rench, Swiss, engineer,

sociologist, economist 3ilfredo $areto (1A6A-1B5) introduced the concept of

$areto optimality as a means to undermine the role of utilitarianism in

economics& Dnstead, it became the foundation for what is now called benefit

cost analysis and its derivative measures of allocative performance such as

rate of return on investment and cost effectiveness&

Consider a community of individuals& !our task is to choose an alternative

to maximie the welfare or utility of the group& Df there were an alternative

that would improve the welfare (or increase the utility) of at least one person

in the group without making any one worse off (decrease their welfare or

utility), you should choose to that alternative& Fowever, if all the alternatives

that would make at least one person better off would also make at least one

other person worse off, you cannot know if that alternative would improve the

wellbeing (utility) of the group&

Pareto eicienc. is the condition where all alternatives that would

increase the welfare of at least one person without decreasing the welfare of

others have been exhausted& here is nothing that can be done to improve the

welfare of anyone without making someone else worse off& Dn the $$: model

(:igure 7&6), $areto efficiency exists at any point on the $$: once you have

attained that point&

B8


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Pareto eicienc.can be used as a criterion to decide whether to chose

an alternative& Df a choice makes some one better off and no one any worse

off, it is a choice that will increase the achievement of the goal or end of

maximiing the utility or welfare of the group& his can be

;Pareto ,ae,< i&e& the output can be altered so someone is ;better off are traded for #" units of @* Si( fewer unitsof > at J each is a & of J!* 'he B is #" additional units of @ at J7*


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&ankin" o Alternative Fith Alternative E

Df alternative * were chosen over alternative F, 15 additional units of

xebecs would be produced (B-18N15)& his is the marginal benefit () of

the choice of reallocating resources from alternative F to *& Df xebecs were

valued at R6 each, that would be a of R7 in monetary terms& his can be

viewed as a move from row F to row * in able 7&5

his reallocation of resources would not reduce the output of yawls, so the

marginal cost of the reallocation is 2& Since the T C, the reallocation or

inputs to move the output alternative from F to * would be an improvement in

the achievement of the obEective (producing the highest valued output)& he

output of xebecs and yawls at point * is R1A8 (156 P 7. the value of the

output at F added to the of reallocation of inputs)

he relative prices of xebecs and yawls are irrelevant since the marginal

cost (C) is ero& #ny increased production of xebecs at any positive price

would be a $areto improvement& # reallocation to point , C or any output

combination that lies in the triangle F*C would be a $areto improvement (or

$areto superior to the allocation at point F)&

121

able 7&5#llocative *fficiency and 3alue of 4utput

#lternat

ive

O> $>

3alue ofoutput of >

($>O>)

O! $!

3alue ofoutput of !

($!O!)

3alue ofoutput

($>O>P $!O!)# 2 R6&22 R2&22 75 R5&72 R1A7&72 R1A7&72 7 R6&22 R2&22 72 R5&72 R197&22 R1B7&22

C 18 R6&22 R86&22 62 R5&72 R162&22 R26&22 6 R6&22 RB8&22 52 R5&72 R127&22 R21&22

* B R6&22 R118&22 2 R5&72 R92&22 R1A8&22: 51 R6&22 R16&22 12 R5&72 R57&22 R17B&22


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&ankin" o Alternative E Fith Alternative

Df the current output were at point * (O>N B and O!N 2), and alternative

: (O>N 51 and O!N 12) is considered& he marginal benefit (the benefit

associated with reallocating resources to point :) would be an additional 5

units of xebecs (51-BN5)& #t R6 each this is a of R1 in monetary terms&

Fowever, the reallocation of resources from F to : re+uires a sacrifice or C

of 12 units of yawls (2-12N12)& #t a price of R5&72 the C is R57 in

monetary value& he C N 57. N 1& # reallocation of inputs to move from

point * to point : would be trading R1 for R57. not a good idea&

&ankin" o Alternative E and Alternative

# reallocation of resources from alternative * to alternative would result

in an increased output of 12 yawls& #t a price of R5&72, the is R57& his

reallocation reduces the output of xebecs from B to 6, a marginal cost of 7

units of xebecs& #t R6 each this is a C of R2& Since the T C (57 T 2),

the reallocation of inputs from the production of the output at point * to point

is Eustified by our benefit/cost criterion& "otice that the net gain to society is

R17, so point is ;worth< R17 more than the output at point *& is ;valued $%T&'*T$'%T'TE&E,'TE8A+EA%E*'%'+$*,,5,TE+,

hether a society emphasies the use of exchange, reciprocity oreminent domain to allocate resources, ;0ny economic system re*uires a set of

ru!es% an ideo!ogy to 5ustify them% and a conscience in the individua! 'hich

ma/es him strive to carry them out&< (%obinson, p 15) his set of rules

includes informal institutions and values held by individuals as well as formal

law& he structure of the rules of the games shapes the societys economic

system& "eoclassical microeconomics does not often explicitly consider the

nature of these rules and their relation to economic behavior&

'.1 ECONOMICSYSTEMS

,ocieties that fail to meet minimum subsistence re+uirements for itsmembers become relics of the past& Ddeally, an economy will produce more

than necessary for subsistence and apply the additional output to improving

the lives of the members of society through development and/or economic

growth& he ideas of ;progress,< economic development and economic growth

came with the development of the commercial world that replaced the feudal

society of the medieval world&

#n economic system consists of a matrix of social institutions (law, political

institutions, religion, etc), agents (individuals or actors), organiations

(corporations, unions, charitable org, not-for-profit firms, etc) and society& he

principles, beliefs and values held by individuals are included in the structure

of society& he function of an economic system is to coordinate the activities of

agents in the processes of provisioning and allocation& "onmaterial

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4.1 Economic Systems

characteristics of life (social stability, low crime rates, a sense of community,

etc) are related to the economic processes and should be included&

%obert Feilbroner identifies thee basic types of economic systems& hese

are classified as markets, command, and tradition& Dn practice, most

economies are a mixture that includes elements of all three& Fowever, the

economic system is usually classified by the dominant approach& arkets and

command exist in traditional economies& radition and markets exist in

command economies& Gestern industrial societies categoried as ;market-

oriented< economies rely primarily on exchange, but contain elements of

tradition and command& Dn market economies tradition is important to such

decisions regarding values, expectations about behavior (trust, loyalty, etc&),

fashion, preferences about housing, choices about occupations and geographic

preferences& Command is also found in market economies as regulations and

laws regarding the allocation or resources and goods&

>#1#1 T&A$T$'%AE*'%'+$E,

Traditional economic systems are based the repeated use of solutions thathave worked in the past& Solutions to problems in the processes of production,distribution and consumption are embedded in the customs, mores and

cultural patterns of social life& hese solutions have been established through

trial and error. those activities that result in ade+uate production and an

acceptable distribution are retained and used often without +uestion& #gents in

traditional societies may engage in exchange transaction but these are

peripheral to the provisioning and allocation problems&

he traditional economic system tends to be found in non-industrial

societies that are engaged in hunting, gathering, pastoral, or basic agriculture&

4ften these are subsistence economies. there is little or no growth or

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4.1.1 Traditiona! Economies

progress& he aboriginal culture in #ustralia is an example of an economy that

has flourished for thousands of years (62,222 years by some estimates) as a

traditional economy&

raditional economies tend to depend upon a deontological ethic& uties to

other members of the family, tribe or clan and ;reciprocity< are the primary

allocative mechanisms& he forms of production that individuals engage in are

based on the processes that have worked in the past& Social institutions, such

as religion, may evolve to reinforce the traditional ways&

hese societies must communicate behavioral expectations to each new

generation& he most important form of knowledge may be contained in

stories and myths& ythology and story telling are important aspects of the

creation and communication of cultural values& Websters Encyclopedic

Unabridged Dictionary of the English Languagegives one of the definitions of myth

as.

an unproved co!!ective e!ief that is accepted uncritica!!y and is used to5ustify a socia! institution.

Keen and 3alley-:ox describe myths as.

- an intricate set of inter!oc/ing stories% ritua!s% rites and customs thatinform and give the pivota! sense of meaning and direction to a person%fami!y% community or cu!ture. (Keen, p xii)

ythology is one of the processes by which cultural values and

expectations about behavior are transmitted from generation to generation&

*ven in modern societies, stories are fundamental to the process of creating,

and perpetuating culture in societies&

%eciprocity is often a key element in traditional economies& %emember that

reciprocity is based on duty and involves obligatory gift giving. D do you a

favor and both you and D (and other members of society) expect that you will

return some unspecified favor at some unspecified time in the future& Dt

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re+uires a sense of duty, social values and a community to enforce

reciprocation& Social institutions give structure to the values, duties and

expectations about economic behavior&

Dn many societies, reciprocity becomes an important element of the social

process& Dn a ranching community %ancher Smith goes to the other ranchers

and says. ;D need some help branding my calves next uesday, Dd appreciate

some help&< 4n uesday, the ranchers show up at %ancher Smiths place and

help with the task& Df %ancher Hones does not come to help, it may be for a

good reason& Fowever, if he or she is perceived as shirking his or her duty, it

may be difficult for Hones to get neighbors to help with future tasks& Similarly,

if everyone helps %ancher Smith but then at some point in the future %ancher

Smith does not reciprocate by helping someone else fix his or her fence, then

%ancher Smith may find it difficult to get anyone to help in the future& here is

a community that expects that the other members will help when needed and

will reciprocate in the future& he community must communicate the

willingness of its members to participate in mutual aid and to sanction

members who do not fulfill their obligatory duties&

"otice that the substance of the event is different if %ancher # says. ;Dll

pay you R12 per hour to help me brand my calves&< Shifting the process from

reciprocity to a market exchange significantly alters the relationships and the

nature of the event& Dn the case of reciprocity, there is a sense of community&

he relationship between the members of the community may be of value in

and of itself& lood and organ donations are examples& oving a good or

activity into a market transaction may significantly alter its meaning or value&

# market exchange can take place between anonymous individuals&

#s communities become larger, more complex and social relationships are

altered. tradition may be less useful as an allocative mechanism& Dt is more

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difficult for the members of the community to communicate the extent to

which the members fulfill their duties& Social pressure to enforce obligations of

reciprocity and duty may become less effective since each person has more

relationships that may be more valued&

#nother weakness of a traditional economy is that it does not adapt +uickly

to changes in technology or the environment& So long as there are no (or few)

changes in the environment, technology or external forces, the traditional

economy is stable or static& Fowever, if there are sudden changes in the

environment, the traditional solutions may no longer suffice& roughts,

desertification, over hunting specific animals are examples of events that

traditional societies may not be able to deal with& "ative #mericans in the

plains developed societies that were dependent upon the bison& heir

economies, social structure, politics and religions were based on bison& Gith

the advent of *uropeans, firearms, railroads and a demand for hides, the

bison were hunted almost to extinction& any of the native societies found it

difficult to adapt to a system without bison& Ghaling, fishing, hunting,

agriculture based on single (or limited) crops are other examples of the

difficulty that traditionally based economies have in adapting to change&

>#1#2 *'++A%E*'%'+$E,

Eminent domain is the primary allocative mechanism used in a commandeconomy& #n economic system based on command re+uires an agent or

organiation with the authority to make allocation decisions& his authority

may be based on religion, military strength, political position, birth or wealth&

Command economies often rely on traditions as part of the allocative

process& his traditional process is subordinated to eminent domain& he

%oman society is an example of a command economy& :ascist =ermany, the

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4.1.$ #ommand Economies

former Soviet 0nion and aoist China are other examples of attempts to use

command& hese economies are often thought of as ;planned economies#4 &'E'8'3E&%+E%T

'ne of the maEor controversies is the proper role of government (and theuse of command) within a market based economic system& any of the issues

in this controversy are ideological in nature and result in the existence of

different ;schools of economic thought&< he Chicago School and the #ustrianSchool of economic thought argue that the role of government in the economy

should be minimied& (Fayek taught at the 0niversity of Chicago and was an

#ustrian economist&) he #merican or ;4ld< Dnstitutionalists and much of

"eoclassical microeconomics (in the Cambridge tradition) sees a more positive

or active role for government in many areas&

he :rench $hysiocrats ?led by :rancios Ouesnay, 18B6-1996@ advocated a

minimal role for government& Hac+ues Claude 3incent de =ournay ?191-197B@

is usually credited with the phrase !aisse faire% !aisse?passer Some

advocates of an extreme !aisse fairedoctrine argue that there is no or almost

no role for government& ost argue for limited government action in the

economy& 4thers, such as #dam Smith and :& # Fayek (above) see a positive

role for social institutions and government participation& #dam Smith ?195-

19B2@, who was familiar with the work of the $hysiocrats, advocated a social

system based on ethics, markets and Eurisprudence with a minimal role for

government&

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4.1.8 &ationa! 3efense

one of the best examples of a public or collective good& Dn the case of a public

good, it is impossible to exclude a person from the consumption of the good

and the marginal cost of an additional user is ero& Dn these conditions, the

state often provides the good&

>#1#? P&'3$,$'%'*'E*T$3E'&P:$*8'',

Public goods are those goods whose property rights are not exclusive. itis not possible to exclude anyone from their use and the additional cost

(marginal cost) of an additional user is ero& "ational defense is a case of a

public good& Df a baby is born in the country, it is not necessary to increase

national defense& Clean air is another example of a public good&

#dam Smith included other public goods in this category& Fe referred to

them as public institutions and public works& Dn the terminology of modern

economics, these goods are often called +uasi-public goods. the marginal cost

of additional uses may be ero, but it is possible to exclude users& %oads,

bridges, canals, navigational devices and the like could be paid for by tolls or

financed by government&

Smith includes education in this category of activities& Fe discusses

specifically education of youth& Fe also says.

In the progress of the division of !aor% the emp!oyment of the fargreater part of those 'ho !ive y !aor% that is% of the great ody of the

peop!e% comes to e confined to a fe' very simp!e operations% fre*uent!yone or t'oJ But the understandings of the greater part of men KsicL arenecessari!y formed y their ordinary emp!oyments. The man 'hose

'ho!e !ife is spent in performing a fe' simp!e operations% of 'hich% theeffects too are% perhaps% a!'ays the same% or very near!y the same% hasno occasion to e+ert his understanding% or to e+ercise his invention infinding out e+pedients for removing difficu!ties 'hich never occur. ,enatura!!y !oses% therefore% the hait of such e+ertion% and genera!!yecomes as stupid and ignorant as it is possi!e for a human creature to

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4.1.9 Provision of co!!ective or pu!ic goods

ecome.(Smith, Gealth of "ations , p 956)

Smith continues on the next page.

But in every improved and civi!ied society this is the state into 'hich

the !aouring poor% that is the great ody of the peop!e% mustnecessari!y fa!!% un!ess the government ta/es some pains to prevent it.

he role of government in the provision of education and arts for

individuals in society is controversial& Currently, there are a variety of debates

ranging from voucher systems to the appropriate level of funding for *nglish

as a second language and special education&

>#1#H P&'+'TE*'+PET$T$'%

The models of purely competitive markets show that the behavior of theindividual sellers (and buyers) will be consistent with social welfare in the long

run& Ghen there are impediments to competition, the prices are distorted and

incorrect signals encourage behavior that is less than socially optimal& #s a

result, governments often try to regulate the behavior or to promote

competition& ost industrial nations have laws that make monopoliation of

markets, price fixing, collusion, tying contracts and other anti-competitivepractices illegal& he Sherman #ntitrust #ct of 1AB2, the Clayton #ct of 1B16

and the %obinson-$atman #ct of 1B58 are examples&

Dnformation is important to any allocative system& Dt is necessary for

agents in a market exchange to have information to value goods and negotiate

contracts& ost societies see that one of the roles of government (if not a

moral system) is to prevent fraud, deceit, and other methods of distorting

information provided by buyers and sellers& he Securities *xchange

Commission attempts to regulate financial information provided to the financial

markets, insider trading is illegal, there are truth in advertising laws and

agencies that regulate the content and +uality of goods (food, drugs, etc&)&

11B


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4.1.G Promote #ompetition

he development of policy and law in these areas is often controversial and

vested interests attempt to manipulate the regulations in their favor&

(%emember =eorge Stiglers capture theory of regulation&)

>#1#10 ,AET5%ET

+ost civilied societies try to provide a safety net for individuals who areunable to care for themselves& here are many disagreements about the

criteria to be used to decide which people should be included in this group&

'.2 PROPERTYRIGTS

The concept of property rights is essential to any economic system& heanalysis of property rights is complicated by several factors&

:irst is the fact that when the term ;property rights< is used, the listener

usually subconsciously inserts the word ;private&< Dn addition to private

property, rights there are also public property rights and common property

rights& $rivate property rights, in theory should apply to individuals but oftenprivate property rights is applied to publicly chartered organiations&

Second, property rights can be Eustified by ;natural rights< or by logic and

pragmatism& Hohn 'ocke ?185-1926@, a natural law philosopher argues that

humans have a natural right to the ownership of private property& his natural

right to property stems from the fact that the individual has a right to their

own labor and therefore a property right to the fruits of that labor when mixed

with un-owned resources& 'abor is the Eustification for property& 'ocke places

two limitations on this right& Fe argues that the individual has a right to

ac+uire property so long as nothing is wasted and there are sufficient

resources left for others& ('ocke, pp 117-18)he emotional context of property

12


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4.$ Property Rights

rights associated with the natural rights approach that also complicates the

discussion and analysis of the structure of property rights in a social system&

# pragmatic Eustification of property rights is based on defining property

rights to achieve an obEective& hat obEective could be an optimal allocation or

to maximie the monetary value of assets& $roperty rights Eustified on natural

rights tends to be static while pragmatism tends to Eustify property rights that

evolve to meet the needs of changing circumstances (population, technology,

environment, etc&)& Fayek, a market oriented economist, seems to focus on a

pragmatic approach to property rights.

)here the !a' of property is concerned% it is not difficu!t to see that the

simp!e ru!es 'hich are ade*uate to ordinary moi!e things or chatte!are not suita!e for indefinite e+tension. )e need on!y turn to the

pro!ems 'hich arise in connection 'ith !and% particu!ar!y 'ith regard touran !and in modern !arge to'ns% in order to rea!ie that a conceptionof property 'hich is ased on the assumption that the use of a

particu!ar item of property affects on!y the interests of its o'ner rea/sdo'n. . . . .

The pro!em of the prevention of monopo!y and the preservation ofcompetition is raised much more acute!y in certain other fie!ds to 'hichthe concept of property has een e+tended on!y in recent times. I amthin/ing here of the e+tension of property to such rights and privi!eges

as patents for inventions% copyright% trademar/s% and the !i/e. It seemsto me eyond dout that in these fie!ds a s!avish app!ication of theconcept of property as it has een deve!oped of materia! thins has donea great dea! to foster the gro'th of monopo!y and that here drasticreforms may e re*uired if competition is to e made to 'or/. (Fayek,pp115-116) & & &

It seems to me that% in genera!% the freedom of the individua! y nomeans need to e e+tended to give a!! these freedoms to organiedgroups of individua!s% and even that it may on occasion e the duty ofgovernments to protect the individua! against organied groups. Itappears to me a!so as if historica!!y in the fie!d of the !a' of corporations'e had a situation rather ana!ogous to that in the fie!d of the !a' of

property to 'hich I have a!ready referred 0s in the !a' of property theru!es deve!oped for ordinary moi!e property 'ere e+tended uncritica!!yand 'ithout appropriate modifications to a!! sorts of ne' rights< andthus the recognition of corporations as fictitious or !ega! person has hadthe effect that a!! the rights of a natura! person 'ere automatica!!ye+tended to corporations.(Fayek, p 118)

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4.$ Property Rights

Fayek is +uoted at length because he is a market-oriented economist who

recognied that property rights must evolve with changes in the economy and

technology& Fe also recognies that the form the property rights laws take is

crucial to the operation of a market system&

>#2#1 P&'PE&T5&$8T,A%+A&


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4.$.1 Property Rights 0nd Mar/ets

Strong or non-attenuated property rights that facilitate the effective use of

market exchange have three basic characteristics.

(clusivity

nforceability

'ransferability

E=*,$3$T5

Dt is impossible for the property rights to any good or resource to be

completely exclusive& Fowever, the greater the exclusivity the more likely

market exchanges will produce improvements to the welfare of society& #n

exclusive property right is one where all the benefits and cost associated with

a choice fall on the person(s) making the choice& Df "igel drinks a cup of tea,

the costs and benefits of that act fall (for the most part) on "igel& # case of

nonexclusive property rights occurs when Farold smokes a cigar in church&

he smoke may impose significant costs on other members of the

congregation& Dt might be possible that #unt abel and others in the

congregation could contract (or pay) with Farold not to smoke& Df a voluntary

contract is made, Farold is better off because he prefers the payment to

smoking& #unt abel and the congregation are better off because they were

willing to pay Farold not to smoke& his assumes that Farold had a property

right to smoke& #n alternative view is to ban smoking in the church by

assigning the property rights to smoke free air to #unt abel and the others&

Df Farold wanted to smoke, he would have to contract with the congregation

for the right to do so&

E=TE&%A$T5

he failure of exclusive property rights results in three problems in the

market& :irst is the problem of ;externalities&< he example of second hand

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4.$.1 Property Rights 0nd Mar/ets

smoke in the previous paragraph is an example& $ollution from a steel mill or

odor from a pig farm are other examples& # negative externality results in ;too

much< or over use of a resource or good since the marginal costs to society

exceed the marginal cost to the economic agent who makes the decision& he

*nvironmental $rotection #gency was created to deal with many of the

problems of negative externalities&

*xternalities may also be positive& he marginal benefits to society are

greater than the marginal benefits to the decision maker or economic agents

engaged in an exchange& Df D landscape my front lawn, it may increase the

property values of my neighbor& he benefits to my neighbor are not taken

into account by my decision& Dn general, the market signals an under

utiliation of goods and resources that have positive externalities

P:$* 8'',

# second problem is that of ;public goods&< # public good is one in which

the marginal cost of an additional user is ero and it is impossible to exclude

anyone from its use& "ational defense is often used as an example of a public

good& here are other goods like roads, bridges, etc& that may be treated as

public goods even though it is possible to exclude users& hese are sometimes

referred to as ;+uasi-public goods&

*'++'% P&'PE&T5 &E,'&*E,

he third property rights problem is ;common property resources&< #

common property resource is one where users are not excluded but the

marginal cost of users is positive& =arret Fardins 1B8A article, ;ragedy of the

Commons< argues that common property tends to be overuse and can be

driven to extinction& $assenger pigeons, whales, #merican bison, and fisheries

are often cited as common property resources& he property rights for these

common property resources are not clearly defined and are ;fugitive#@ (@) A,T&$A%E*'%'+$*,

Carl enger and a group of followers (such as *ugen von Xhm-awerk

?1A71-1B16@, :riedrich von Gieser ?1A71-1B8@, 'udwig von ises ?1AA1-

1B95@ and :riedrich Fayek ?1ABB-1BB@) have developed an alternative view

of microeconomic behavior& he #ustrian approach views human behavior as

;purposive,< (as opposed to rational)& arkets are viewed as dynamic

processes rather than the comparative statics of e+uilibrium outcomes in

neoclassical economics& ehavior in conditions of dise+uilibria and processes

by which individuals and systems might move toward e+uilibrium has been the

focus of many #ustrians&

0ncertainty and lack of information play an important role in #ustrian

economics& #s a conse+uence, the role of information and learning becomes

an important aspect of economic behavior and participation in markets& :or

the #ustrians, value is subEective and is determined by the individual& any of

the ideas of the #ustrians have been incorporated into neoclassical or

mainstream economics& Gieser is credited with coining the term ;opportunity

cost&< Dmputing a value for inputs from the valuation of outputs has been

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8.1.$ Economic )ay of Thin/ing

integrated into mainstream economics& #ustrian economics supports the ideas

of individual choice and a minimal role for government&

7#1#2#>#> (>) $%,T$TT$'%AE*'%'+$*,

horstein 3eblen (1A79-1BB) is regarded as the founder of the

Dnstitutionalist school of economics& 3eblen reacted against the sterile,

individualism of neoclassical economics and coined the term ;neoclassical&< Fe

argued that neoclassical economics is static (it primarily uses comparative

statics) and is limited in its ability to deal with dynamic forces such as

technology& he Dnstitutionalists argue that human behavior is not ;rationalH the 4uantity of good >

P>H the price of good >

Prelated goodsH the prices of compliments or substitutes

/ncome 35 H the income of the buyers

Preferences H the preferences or tastes of the buyers

he demand function is a model

that ;explains< the change in the

dependent variable (+uantity of the

good > purchased by the buyer)

;caused< by a change in each of the

independent variables& Since all theindependent variable may change at

the same time it is useful to isolate

the effects of a change in each of the

172

Cigure ///*A*#

Demand

=uantityMut

Price

J#

J!

J7

J

JH price of the good,

179

Cigure ///*A*Panel A PanelB

AG

=>Mut =TMut

Price Price

A6

6*

A6**

P6

># >! >7

PGB

PG-

G-GB

$ompliments

Eoods > and T are compliments, An increase in

PT 3from PT#to PT!5 decreases the 4uantitydemanded for T from T#to T!* 'he demand forgood > decreases to D>%%* At P>the amountpurchased decreases from >!to >#* A decreasein PTshifts D>to D>% 3Amount of > increases

to >75*


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9.$ Supp!y ;unction

P/6PU'S H prices of the inputs 3factors of production used5

'echnology is the method of production 3a production

function5,

laws and regulations may impose more costly methods of

production

ta(es and subsidies alter the costs of production

S represents the number of sellers in the market*

'ike the demand function, supply can be viewed from two perspectives.

Supply is a schedule of 4uantities that will be produced and offered for saleat a schedule of prices in a given time period, $eteri! "aribu!*

A supply function can be viewed as the minimum prices sellers are willing

to accept for given 4uantities of output, $eteri! "aribu!*

?#2#1#1 (1) 8&AP',PP5

The relationship between the +uantity producedand offered for sale and the price reflects opportunity

cost& =enerally, it is assumed that there is a positive

relationship between the price of the good and the

+uantity offered for sale& :igure DDD&7 is a graphical

representation of a supply function& he e+uation for

this supply function is OsuppliedN -12 P $& able DDD

also represents this supply function&

?#2#1#2 (2) *A%8E$%A%T$T5,PP$E

Given the supply function, Oxs N fs($x, $inputs,ech, & & &), a change in the price of the good ($ >) will

be reflected as a move along a supply function& Dn :igures DDD&7 and DDD&8

as the price increases from R12 to R17 the +uantity supplied increases from 12

to 2& his can be visualied as a move from point # to point on the supply

17A

TA:E $$$#A#@

,PP5%*T$'%

$%DC* O0#"D!

R7 2

R12 12

R17 2

R2 52


159/301

9.$ Supp!y ;unction

function& # ;chan"e in Luantit. supplied is a /ove/ent alon" a suppl.

unction&< his can also be visualied as a movement from one row to

another in able DDD&7&

?#2#1# () *A%8E$%,PP5

iven the supply function, Oxs N

fs($x, $inputs, ech, & & &, YS), a

change in the prices of inputs ($ inputs) or

technology will shitthe supply function& #

shift of the supply function to the right will

be called an increase in supply& his means

that at each possible price, a greater

+uantity will be offered for sale& Dn an

e+uation form, an increase in supply can be shown by an increase in the

+uantity intercept& # decrease in supply is a shift to the left. at each possible

price a smaller +uantity is offered for sale& Dn an e+uation this is shown as a

decrease in the intercept&

=

17B

J#"

J


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9.$ Supp!y ;unction

)." E?UI!I$RIUM

,ester@s Ency!opedic Nnaridged 3ictionary of the Eng!ish anguagedefines e+uilibrium as ;a state of rest or a!ance due to the e*ua! action of

opposing forces,< and ; e*ua! a!ance et'een any po'ers% inf!uences% etc.

4 2> 2

@ 27 1

> 2> -1


171/301

G.1.1 Nti!ity

he 0 of the third unit is 8

Ghen the 0 is calculated by subtraction, it can be visualied as the slope of

the 0 between two points& his is shown in :igure D3&

arginal utility can be graphed, however remember that the 0 calculated by

subtraction is ;between< successive units of the good& Dt is the slope of an arc

defined by two points on a total utility function& his is shown in :igure D3&5

191

Fi"!re J.+.B

TKP

PiaHday

TKP

- B 2 4

-5

-1

B2B3B0

'he U can be visuali2ed as the slope of the'U between successive units of the good* /nthe graph to the right the U of the third unitof Pi22a is the slope of the 'U between points

A and B*'hink of the slope of a line as rise over run*

'U rise and = is the run* /n this e(amplethe = is # 3 from the third to the fourth unitis #5* 'he 'U is F 3!;#K5* rise over run

or the slope of 'U between points A and B isF*

=

TK

MK @TK

=

+

&

[U 7 = X'UX= =! #K

# =

F

#= F]

U ='U

Q=

K

#= K


172/301

G.1.1 Nti!ity

he relationship between total utility (0), marginal utility (0) and average

utility can be shown graphically& Dn :igure D3&6 the 0 function has some

peculiar characteristics so all-possible circumstances can be shown& Dn this

example the total utility (0) first increases at an increasing rate& *achadditional unit of the good consumed up to the OZ amount causes larger and

larger increases in 0& he 0 will rise in this range& #t OZ amount there is an

inflection point in 0& his is consistent with the maximum of the 0& Ghen

#0 is is a maximum, 0 N #0& Ghen 0 is a maximum, 0 is 2& his is shown

in :igure D3&6

19

Ci ur

Documents

Microeconomics Version 2007