Principles of Microeconomics.ppt

7/27/2019 Principles of Microeconomics.ppt

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Chapter 1 Frank/Bernanke,

Principles of Microeconomics

Thinking Like An Economist


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Id like to introduce you to Marty Thorndecker.Hes an economist but hes really very nice.


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Hi, I am Marty.


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Hi, I am Marty.


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Can we express yourself?

Suppose you had the chance to meet the ChiefExecutive in a cocktail party. You were asked toexpress your opinion on minimum wage legislation inHong Kong.

How do you express your views and convincehim/her in five minutes?


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Can you express yourself?

Most students who take introductory economics leavethe course without really having learned even the mostimportant basic economic principles.

Their ability to answer simple economic questionsseveral months after leaving the course is notmeasurably different from that of people who never

took a principles course.*

*Hansen, W. L., M. K. Salemi, and J. J. Siegfried (2002)Use it or lose it:teaching economic literacy,American Economic Review(Papers andProceedings), 92 (May): 463-72.


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How do we learn a new language

Start simple

Repetition and drill

Active learning

Have fun

How much is this?


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Should there be 12 separate sections of Econ101, with 25 students each?


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Or should there be only one section, with 300students?
http://www.psu.edu/ur/archives/intercom_2001/Jan25/classroom.html


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What is the Optimal Class Size?

To maximize learning without consideration of cost?

How would considering costs change our answer?

A personal tutorial course in economics might cost$40,000

A class of 300 students might cost $200/student

Extreme case: a class of infinite students might costless than $0.1/student

What trade-offs must university administrators andstudents consider when choosing class size?


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The Scarcity Principle(also called no-free-lunch principle)

Boundless wants cannot be satisfied with limitedresources.

Therefore, having more of one thing usually means

having less of another. Because of scarcity we must make choices.

Even Bill Gates (once valued as having US$100 billion)still faces scarcity

There are only 24 hours


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Selling Seats Through An English Auction

In the classroom, the teacher owns the seats. As usual, theteacher can assign seats. Here, we do it in the economics way --the teacher will sell seats through an English auction. In anEnglish auction, bidders cry out their bid for a good item until noone is willing to submit a higher bid. The highest bidder will get

the item. This kind of auction has been used in Hong Kongsland auction. There is no restriction on how many seats astudent can buy or resale activity.

Bidders suggest a seat for auction. A suggestion is also taken asminimum bid of HK$0.5. The minimum price of the seat isHK$0.5. Each cry should be at a HK$0.5 or higher. When

submitting a bid, raise your number plate and cry out the bid.Students who do not get a seat will have to seat on the floor. The teacher will collect the money/ IOU and put it in a jar. The

money collected will be used to fund class refreshments asdetermined by the class later.


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What are the alternatives to English auction?

First come, first served;

Teacher assigned;

Class negotiation.


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Microeconomics

The study of how people make choices under conditionsof scarcity and of the results of those choices forsociety.

In a market system, allocation of resources occur viathe price system, incomes and preferences


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Rationality assumption and The IncentivePrinciple

People have goals and try to fulfill them as best as theycan.

The Incentive Principle: An agent (person, firm or

society) is more likely to take an action if its benefitrises, and less likely to take it if its cost rises.Incentives matter in our analysis of behavior and indesigning economic policies


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The Cost-Benefit Principle

An individual (or a firm or a society) should take anaction if, and only if, the extra benefits from taking theaction are at least as great as the extra costs

Should I do activity x?

C(x) = the costs of doing x

B(x) = the benefits of doing x

If B(x) > C(x), do x; otherwise don't.


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Should we make the econ class larger?

Benefit of making the class size larger = the reductionin cost per student = B(x)

Cost of making the class size bigger = The amountpeople would be willing to pay to avoid the reducedquality of instruction = C(x)


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Some relevant costs:

Faculty salary: $90,000 per course

Per student faculty salary cost:

1 section: $90,000/300 = $300

12 sections: $90,000/25 = $3600


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Benefits and costs

Benefit of increasing class size from 25 students to 300students = ($3600 - $300) = $3300 = B(x)

If you were currently in a class with 25 students, howmuch would you be willing to pay to avoid switching toone with 300 students? C(x)

If C(x) < $3300, then it makes sense to offer the largerclass.


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Optimal class size

Observations

The bestclass from an economic point of view willgenerally not be the same as the bestsize from the

point of view of an educational psychologist.People will feel differently about the value of smaller

classes.


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Optimal class size

Who will opt for smaller classes:

Those who value smaller classes more.

Those who are less financially constrained.

Observations:

We have colleges of different class size.

Colleges of smaller class size generally charge highertuition fees.

But colleges and universities may also be subsidized


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Example 1.1Should I turn down my stereo?

You have settled into a comfortable chair and are listeningto your stereo when you realize that the next two trackson the album are ones you dislike.

If you had a programmable disc player or a remotecontrol, you would have programmed them not to play.

But you don't, and so you must decide whether to get upand turn the music down, or to stay put and wait it out.


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Example 1.1.Should I turn down my stereo?

Suppose C(x) = $1.00 = the minimum amount it wouldtake to get you out of your chair.

B(x) = the maximum you would be willing to paysomeone to turn down the volume.

If B(x) > $1, then turn your stereo down by yourself

If B(x) < $1, then don't.


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The Cost-Benefit Principle

An individual (or a firm, or a society) should take anaction if, and only if, the extra benefits from taking theaction are at least as great as the extra costs.

Critics of the cost-benefit approach often object thatpeople dont really calculate costs and benefits whendeciding what to do.


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People often behave as if they were comparingthe relevant costs and benefits.


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People often make bad decisions because theyfail to compare the relevant costs and benefits.


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Can cost-benefit analysis help you make betterdecisions?

Example 1.2You are about to buy a $20alarm clock at the campus storewhen a friend tells you thatFortress has the same alarmclock on sale for $10.

Do you travel toFortress?


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Example 1.3. You are about tobuy a $6510 laptop computerfrom the campus store when afriend tells you that Fortress hasthe same computer on sale for$6500.

Do you travel toFortress?


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Example 1.2 and 1.3Shouldyou travel to Fortress?

B(x) = benefit of traveling to Fortress= $10 in both cases.

C(x) = cost of traveling to Fortress= the same amount in both cases.

So your answer should be the same in both cases.


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Example 1.4. Choosing a public health program.

A rare disease will claim 600 lives if we do nothing. Wemust choose between the following two programs:

Which program would you choose? A or B?

Program A: save 200lives with certainty

Program B: save 600 liveswith probability 1/3, and savezero lives with probability 2/3


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Example 1.5. Choosing a public health program.

A rare disease will claim 600 lives if we do nothing. Wemust choose between the following two programs:

Which program would you choose? C or D?

Program C: 400 peoplewill die with certainty

Program D: 1/3 chance thatno one will die, and 2/3chance that all 600 will die


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Example 1.4 vs. Example 1.5

In Example 1.4, most people choose to save 200 liveswith certainty (Program A).

In Example 1.5, most people choose to save all 600lives with prob. 1/3 (Program D).

Yet the two pairs of programs are equivalent:

A=C and B=D


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Illusions

If the list of alternatives among which we choose arethe same in two cases, then the particular alternativewe choose should also be the same in both cases.

Yet people seem to prefer the safe alternative when thealternatives are framed as choices between differentnumbers of lives saved, and to prefer the riskyalternative when the alternatives are framed as choicesbetween different numbers of lives lost.


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Example 1.6. Losing a $100 bill

Do you buy a ticket and see the play anyway?

You have just arrived at thetheater to buy your ticket and

discover that you have lost a$100 bill from your wallet.


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Example 1.7. A lost theater ticket.

You have just arrived at the theater anddiscover that you have lost the $100 ticketyou purchased earlier that day.

Do you buy another ticket and seethe play anyway?


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Example 1.6 vs. Example 1.7

In both cases, you are $100 poorer than before.

In both cases, the benefit of seeing the play is thesame.

In both cases, the additional cost you must incur to seethe play is exactly $100.

Since the relevant costs and benefits are the same inboth cases, your decision should also be the same.


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Example 1.8. How much memory should yourcomputer have?

Suppose that random accessmemory can be added to yourcomputer at a cost of $0.50 per

megabyte.

How many megabytes of memory should you purchase?


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Cost-benefit principle:

Buy an additional megabyte if the marginal benefit ofRAM is at least as great as its marginal cost.

Marginal benefit = added benefit from having 1 moreunit.

Marginal cost = added cost of having 1 more unit.


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Cost-benefit principle:

MB

MC

4000300020001000

Megabytes

of memory

Value of an additionalmegabyte

Dollars permegabyte

2.00

0.500.25

Cost of an

additional

megabyte

1.00

Optimalamount ofmemory


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Everyday Choices

"Should I do X?"

"How much X should I buy?"

"Should I buy an additional unit of X?"


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Some Common Pitfalls for Decision Makers

Pitfall 1: Measuring cost and benefits asproportions rather than absolute dollar amounts


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Example 1.9. Proportion vs. absolute

Your employer has a travel discount voucher that canbe redeemed on one of your next two business trips.

You could use it to save $100 on a $2000 plane ticket

to Tokyo; or you could save $90 on a $200 plane ticketto Chicago?

If your goal is to do what would be best for your company,

for which trip should you use the coupon?


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Pitfall 2: Ignoring Opportunity Costs

If doing activityx means not being able to do activityy,then the value to you of doingy is an opportunity

cost of doingx. Many people make bad decisions because they tend to

ignore the value of such foregone opportunities.


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Pitfall 2: Ignoring Opportunity Costs

It will almost always be instructive to translatequestions like

"Should I dox?"into ones like

"Should I dox ory?"

In the latter question,y is simply the most highlyvalued alternative to doingx.


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Example 1.10. Should I go skiing today?


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From experience you can confidently say that a day onthe slopes is worth $50 to you.

The charge for the day is $30 (which includes bus fare,lift ticket, and equipment).

But this is not the only cost of going skiing. You mustalso take into account the value of the most attractive

alternative you will forego by heading for the slopes.


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Suppose that if you don't go skiing, you will work at yournew job as a research assistant for one of yourprofessors.

The job pays $40 dollars per day, and you like it just wellenough to have been willing to do it for free.

"Should I go skiing or stay and work as a research

assistant?"


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C(x) = cost of skiing plus value of forgone earnings

= $30 + $40

= $70

B(x) = $50 < C(x),

So don't go skiing.


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Willing to do it for free

The fact that you liked your job just well enough tohave been willing to do it for free is another way ofsaying that there are no psychic costs associated withdoing it.

This is important because it means that by notdoingthe job you would not be escaping somethingunpleasant.


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Many jobs, of course, are not pleasant.


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Example 1.11Unwilling to do the job for less than $25/day

Suppose instead that your job had been to scrapeplates in the dining hall for the same pay, $40/day, andthat the job was so unpleasant that you would beunwilling to do it for less than $25/day.

Should you go skiing?


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I. One of the benefits of going skiing is nothaving to scrape plates.

B(x) = $25 + $50 = $75

C(x) is the same as before, namely the $30 ski charge

plusthe $40 opportunity cost of the lost earnings, or$70.

So now B(x) > C(x), which means you should go skiing.


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Example 1.11 makes clear that there is a reciprocalrelationship between costs and benefits.

Not incurring a cost is the same as getting a benefit. By the same token, not getting a benefit is the same as

incurring a cost.

Economic Surplus is the benefit of taking any actionminus its cost

The goal of economic decision makers is tomaximize their economic surplus.


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Example 1.12. Is it fair to charge interestwhen lending a friend some money?

Suppose a friend lends you $10,000, and her primaryconcern in deciding whether to charge interest is todecide if it would be "fair" to do so.

She could have put that same money in the bank, whereit would have earned, say, 5 percent interest, or $500each year.

If she charges you $500 interest for each year the loanis out, she is merely recovering the opportunity cost of

her money.

If she didn't charge you any interest, it would be thesame as giving you a gift of $500/yr.


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Example 1.13. Is it fair to charge interestwhen lending a friend some money?

If someone chooses not to give you a gift, is thatunfair?

If not, it makes no more sense to say that recoveringthe opportunity cost of lending someone money isunfair.


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Example 1.13.Why do banks pay interest in the first place?

Suppose you owned a bank and someone deposited$10,000 in it on January 1 without your having to payhim interest.

You could then take the money and buy a productive

asset, such as a row of trees. Suppose that each year trees grow at the rate of 6

percent annually, and that the price of a tree isproportional to the amount of lumber in it.

At the end of the year you could then sell the trees for

$10,600, and have $600 more than before. But that same option was available to the person who

put his money in your bank. Why should he give youthe $600 he could have

earned?


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Example 1.14.Why do banks pay interest in the first place?

Why should he give youthe $600 he could haveearned?

He will be willing to let you use his money only if youcompensate him for the opportunity cost of not using ithimself.

If you pay him 5 percent interest, he will get $500,which will probably be acceptable to him because hewon't have to go to the trouble of tending the trees

himself (or of lending the money to someone who willtend them).

You get to keep the remaining $100 for taking care ofthat.


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Opportunity cost

As simple as the opportunity cost concept is, it is one ofthe most important in microeconomics.

The art in applying the concept correctly lies in beingable to recognize the most valuable alternative that issacrificed by the pursuit of a given activity.


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Marginal cost versus sunk cost

Sunk costs are costs that have already been incurredand which cannot be recovered to any significantdegree.

Marginal cost is the additional cost required to make asuccessful bid.


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Pitfall 3: Failure To Ignore Sunk Costs

An opportunity cost will often not seem like a relevantcost when in reality it is.

Another pitfall in decision making is that sometimes anexpenditure will seem like a relevant cost when inreality it is not.

The only costs that should influence a decision about

whether to take an action are those that we can avoidby not taking the action.

Sunk cost is a cost that is beyond recoveryat themoment a decision must be made


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Example 1.15: The Pizza Experiment

How much should you eat at an all-you-can-eatrestaurant?

A local pizza parlor offers an all-you-can-eat lunch for

US$3.You pay at the door, and then the waiter brings you as

many slices of pizza as you like.

The "waiter" selects half of the tables at random and

gave everyone at those tables a US$3 refund beforetaking orders.

If all diners are rational, will there be any difference inthe average quantity of food consumed by these two

groups?


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"Should I eat another slice of pizza?"


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For both groups, C(x) is exactly zero.

Because the refund group was chosen at random, B(x)

should be the same for each group, on the average.

People from both groups should keep eating until B(x)falls to zero.


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So the two groups should eat the same amount ofpizza, on the average.

The US$3 admission fee is a sunk cost, and should haveno influence on the amount of pizza one eats.

In fact, however, the group that did not get therefund consumed substantially more pizza.


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Four Important Decision Pitfalls

Pitfall 4: Failure To Understand the Average-Marginal Distinction

Marginal Benefit: The increase in total benefit that

results from carrying out one additional unit of anactivity.

Average Benefit: The total benefit of undertaking nunits of an activity divided by n.

Marginal Cost: The increase in total cost that resultsfrom carrying out one additional unit of an activity.

Average Cost: The total cost of undertaking nunitsof an activity divided by n.


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Example 1.15. Should NASA expand the spaceshuttle program?

NASA currently makes four launches per year.

Should NASA expand the space shuttle program fromfour launches per year to five?

BenefitsTotal of $24 billion

Average of $6 billion/launch

Costs

Total of $20 billion

Average of $5 billion/launch


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Example 1.14. Should NASA expand the spaceshuttle program?

# of Launches Total Cost Average Cost Marginal Cost($ billion) ($ billion/launch) ($ billion/launch)

What is the optimal number of launches?

0 0 0

1 3 3

2 7 3.5

3 12 4

4 20 5

5 32 6.4

Assume: Average Benefit = MarginalBenefit = $6 billion

3

4

5

8

12


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Example 1.15. Fishing boat allocation

Suppose you own a fishing fleet consisting of a givennumber of boats, and can send your boats in whatevernumbers you wish to either of two ends of an extremelywide lake, east or west.

Where should you

send your boats?


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Example 1.15. Fishing boat allocation

Under your current allocation of boats, the ones fishingat the east end return daily with 100 pounds of fisheach, while those in the west return daily with 120pounds each.

The fish populations at each end of the lake arecompletely independent, and your current yields can besustained indefinitely.

Average Catch:West End: 120 lbs/boatEast End: 100 lbs/boat

True or False: If you shift some of your boats from theeast end to the west end, you will catch more fish.

E l 1 16 Sh ld f


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Example 1.16. Should you move one of yourboats from the east end to the west end?

Currently two boats are sent to the east end and twoto the west end.

Average output per boat

Number of boats East end West end

1 100 lbs/boat 130 lbs/boat




E l 1 16 Sh ld f


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Average output per boat

Number of boats East end West end



3 100 lbs/boat 110 lbs/boat4 100 lbs/boat 100 lbs/boat

Number of boats

East end West end Total output

2 2 440 lbs

3 1 430 lbs

1 3 430 lbs

4 0 400 lbs

0 4 400 lbs

E l 1 16 Sh ld f


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Average output per boatNumber of boats East end West end





Marginal output per boat

The n-th boat East end West end

1 100 lbs 130 lbs

2 100 lbs 110 lbs (= 240-130)

3 100 lbs 90 lbs (=330-240)

4 100 lbs 70 lbs (400-330)


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Rules for allocating resources

The general rule for allocating a resource efficientlyacross different production activities is:

Allocate each unit of the resource to the productionactivity where its marginal benefit is highest.

For a resource that is perfectly divisible, and foractivities for which the marginal product of the resourceis not always higher in one than in the others, the rule

is:Allocate the resource so that its marginal benefit is

the same in every activity.

N ti E i


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Normative Economicsvs. Positive Economics

Normative Economic Principle

One that says how people should behave

Example: Cost-benefit principle

Positive Economic Principle

One that predicts how people will behave

Example: The incentives matter principle

A person (or a firm or society) is more likely totake an action if its benefit rises and less likelyif its cost rises


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Economics: Micro and Macro

Microeconomics

The study of individual choice under scarcity and itsimplications for the behavior of prices and quantities

in individual markets.

Macroeconomics

The study of the performance ofnational economies,

and of the policies that governments use to try toimprove that performance.


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Economic Naturalism

Applications

Use cost-benefit analysis to explain some pattern ofevents or behavior you have observed in your own

environment

Start simple

Repetition and drill

Active learning apply to real life phenomena


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Economic Naturalism

Ask interesting questions

Provide plausible answers

Observe things happening around us


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Ask an interesting question

Why do so many computer hardware manufacturersinclude more than $1,000 worth of free softwarewith a computer selling for only slightly more thanthat?


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Why dont automobile manufacturers make carswithout heaters?


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Why do the keypad buttons ondrive-up automatic teller machineshave Braille dots?


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Ask an interesting question .

Why are round-trip faresfrom Hawaii to themainland US higher thanthe corresponding fares

from the mainland US toHawaii?


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Why is airline food so bad?


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Why does a telecommunications equipmentmanufacturer offer free BMW sedans to employeeswith more than one year of service?

BMW lease price was$9000/year.

Why not give

employees$9000/year inextra salaryinstead?


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Criteria for choosing a film to see:

Is it by a well-known director?

Does it feature a favorite actor or actress?

Has it gotten rave reviews in the media?

Word of mouth?

The only foreign films with a chance to make it inthe HK market are reallygood onesthose able togenerate strong reviews and word of mouth.

Why are foreign films so good?


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Principles of Microeconomics.ppt