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ECON 102.004 – Principles of Microeconomics

S&W, Chapter 2

Thinking Like an Economist

Instructor:

Mehmet S. Tosun, Ph.D.

Department of Economics

University of Nevada, Reno

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Labor Day: A Report Card for the American Worker

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Distribution of wealth matters

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American Workers Take Less Vacation

• Americans take about four weeks a year for vacation and holidays, according to the OECD

• The French take about seven weeks

• Italians take around eight weeks

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Homer’s Attitude Towards Management and Labor

Homer's response to an

ultimatum to come to work

today or don't bother to come

in on Monday

"Woo hoo! A four day weekend!"

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Lecture Outline

• Thinking like an economist

• Basic competitive model

• Role of incentives, property rights, prices and profit in market economy

• Alternatives to market system

• Basic tools of economists

Thinking Like an Economist

• Economics trains you to. . . . – Think in terms of alternatives.– Evaluate the cost of individual and social

choices.– Examine and understand how certain events

and issues are related.

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Thinking Like an Economist• Every field of study has its own terminology

– Mathematics• integrals axioms vector spaces

– Psychology• ego id cognitive dissonance

– Law• promissory torts venues

– Economics• supply opportunity cost elasticity consumer surplus

demand comparative advantage deadweight loss

The Scientific Method: Observation, Theory, and More Observation

• Uses abstract models to help explain how a complex, real world operates.

• Develops theories, collects, and analyzes data to evaluate the theories.

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The Role of Assumptions

• Economists make assumptions in order to make the world easier to understand.

• The art in scientific thinking is deciding which assumptions to make.

• Economists use different assumptions to answer different questions.

THE ECONOMIST AS POLICY ADVISOR

• When economists are trying to explain the world, they are scientists.

• When economists are trying to change the world, they are policy advisors.

Economists in Washington

• . . . serve as advisers in the policymaking process of the three branches of government:– Legislative– Executive– Judicial

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The Basic Competitive Model

• Rational consumers

• Profit‑maximizing firms

• Competitive markets

• Government is ignored for now

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Rational Consumers• Scarcity forces us to make choices.

• Economists assume individuals and firms make choices rationally:– Pursue what they see as their own self‑interest– Weigh costs and benefits as they see them– If benefits > costs, take the action– However, different people have different interests

• Economists do not judge people's preferences.

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Profit‑Maximizing Firms

• For firms; rationality means maximizing profits.

• Profit = revenue costs

• Revenue = pQ, where p = price and Q = quantity

• Profit = pQ costs

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Information Costs

• Individuals and firms often make decisions with little or no information.– Is the car a lemon?– Will the worker be productive?– Will the investment be profitable?

• Rationality applies to acquiring information to answer these questions.

• If the benefit of more information > the cost of acquiring the information, the information is acquired.

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Competitive Markets• Many firms sell identical products to many consumers.

• Firms and consumers are price takers in competitive markets.

• Firms provide as much output as consumers will buy.

• Each firm can sell as much as it wants: the size of the firm is small compared to the size of the market.

• If firms charge a price higher than the market price, they lose all their customers.

• All firms in the industry charge the same price.

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The Basic Competitive Model as a Benchmark

• Combines self‑interested consumers, profit‑maximizing firms, and competition

• The model is tested by comparing its predictions with actual markets.

• Economists believe this model can provide answers to the four basic questions:– What is produced, and in what quantities?– How are goods produced?– For whom are those goods produced?– Who decides the answers to the first three questions, and how?

• Government is not needed to answer these questions in the basic competitive model.

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Efficiency in the Basic Competitive Model

• The basic competitive model is efficient.– That means scarce resources are not wasted.– It is not possible to produce more of one good

without producing less of another good.– It is not possible to make one person better off

without making someone else worse off.– Known as Pareto efficiency

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Income

• Income is an incentive for consumers, workers, investors, and firms.

• Consumer or household income is personal income.

• Firm income is revenue divided between costs and profit.

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Property Rights• The right of the owner to use and sell his or her

property.

• With well‑defined property rights, access is excludable, rivalrous, and transferable.

• A combination of freedom and responsibility is crucial to markets.– Freedom: Individuals and firms must be free to be creative

and try new techniques.– Responsibility: Individuals must reap the reward if

successful or suffer the losses if not.

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Incentives versus Equality

• Well‑defined property rights permit incentives to provide rewards and costs.

• If rewards are tied to performance, then a problem arises when many people help to produce a good or service.– Who contributed what?– Who are the most productive employees; is the

hot salesperson good or just lucky?

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Performance‑Based Compensation

• Even if pay can be tied to performance, how does one measure performance?

• If compensation is tied to performance, this leads to inequality since different people perform differently.– However, if this inequality is from luck, would

another criterion of compensation do "better"?– Some economists hold equality as a value in its

own right.

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When Property Rights Fail• In many cases property rights are not clearly defined.

• This causes problems with the efficient allocation of resources.– Example:

• In the early days of radio broadcasting, many broadcasters used the same frequency and jammed each other's broadcasts.

– Property rights were ill defined; anyone could infringe on others' uses of the airwaves.

– The government established a licensing system, which created well‑defined property rights.

• Broadcasters became the sole owners of frequencies.

• They could sue to protect their property.

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Nontransferable Property Rights

• Sometimes the ability to dispose of property is restricted by law; some property rights are not transferable.

• Water rights cannot, in general, be sold.– If water rights were sellable, ranchers could sell

water to thirsty cities.– Both benefit:

• Ranchers earn extra income.• Cities pay less for water.

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Consensus among Economists on Incentives

• Providing appropriate incentives is a fundamental economic problem.

• Profits provide incentives for firms to produce the goods individuals want.

• Wages provide incentives for individuals to work.

• Property rights provide people with important incentives, to invest, save, and to put their assets to the best possible use.

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Alternative to the Price System

• In a market, those individuals who are willing to pay the most receive the good.

• The allocation of goods is based on a price system.

• Rationing is an alternative to price allocations.

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Types of Rationing• Queues: If the price of a good or service is set below

market price, customers may have to wait in line to buy it.– The wasted time is a waste of resources.

– There are long lines for food in countries with price controls.

• Lottery: Customers are picked at random.• Coupons: One must pay both the market price and a

coupon to buy a good.– Coupon rationing is favored during wartime.

– Often goods and coupons may be traded in a black market.

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The Inefficiency of Rationing

• Those who are most willing to pay for the rationed good or service do not necessarily get the good or service.

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Opportunity Sets

• Opportunity sets are combinations of goods.

• Due to the scarcity of money or time, not all combinations of goods are attainable.

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Budget Constraint (a)

• Alice has $160 to spend on CDs and books. The price of a CD is $16 and the price of a book is $20.

• She can buy either 10 CDs and no books or 8 books and no CDs or some combination in between.

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Budget Constraint (b)

• If the price of books falls to $10, Alice's budget constraint rotates outward along the book axis (the x axis).

• Alice's new budget constraint is:– Flatter than her previous budget constraint because

books are relatively cheaper now.– Farther from the origin than her previous budget

constraint. The lower price for books has increased her purchasing power, and her opportunity set has expanded.

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Time Constraint

• Bob has 6 hours of free time every day after we subtract time spent:– Working– Getting ready for work– Commuting– Sleeping

• It takes Bob 1 hour to listen to a CD and 2 hours to watch a video.

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Time Constraint (cont.)• Bob can listen to 6 CDs and watch no videos or watch 3 videos

and listen to no CDs or some combination in between.

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The Production Possibilities Curve (PPC)

• The PPC is a producer's constraint.

• With a given quantity of inputs, a firm can only produce certain quantities of goods.

• Guns versus butter

• The boundary of what can be produced is the production possibilities curve.

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The Production Possibilities Curve (PPC) (continued)

• PPCs are curved, bowed out from the origin. Why?

• Guns and butter have different inputs.– Steel makes great artillery shells but not butter.– Cows' udders do not make good weapons.

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Optimal Production on the PPC

• Inside the PPC, a firm can produce more of both goods by moving out to the curve.– So points interior to the curve are not efficient.– Economists want to know the source of these

inefficiencies, what resources are unemployed.

• The optimal production mix is always on the curve.

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Costs• The opportunity cost is the value of the next best alternative

when one makes a choice.– Time and budget constraints and production possibilities curves

illustrate the cost of one option in terms of the other: opportunity cost.– The cost of an education is:

• Tuition• Room and board• Books• Travel expenses• Opportunity cost: lost earnings from not working for four years

• The opportunity cost is often used by the government when it considers the costs and benefits of a program.

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Sunk and Marginal Costs

• Sunk costs are non-recoverable expenditures.– Sunk costs play no role in deciding whether to

continue an activity.

• Marginal costs are the extra costs of small changes in production or consumption.– Marginal costs are the additional costs of

producing or consuming one additional unit.– Monthly electric bills are marginal costs.