Transcript us road map
Introduction Chapter 1 Slides by Pamela L. Hall Western Washington University ©2005, Southwestern Introduction Knowledge of economic theory provides a road map for Understanding how economy operates How individuals interact as groups of consumers and producers Road map describes how a decentralized system of resource allocation Can result in efficiently allocating limited resources Ability to understand economic theory and apply it to everyday choices Will provide you with power to make correct choices and understand choices made by others Road map can aid us in addressing practical, realistic problems such as Environmental degradation Cartels Dishonest used car salespeople Discrimination 2 Introduction Epistemology Field of philosophy that critically investigates nature, grounds, limits, and criteria or validity of human knowledge A theory of cognition • Act or process of knowing Economic theory contains a great deal of epistemology Theory for examining how human behavior affects economic decisions • For example, economists have worked to specify minimal number of assumptions required for characterizing an individual consumer’s preferences Applied economist Combines economic theory with knowledge of institutions and environment to address practical problems 3 Economics Defined Riches in terms of fewness of wants are what economics is all about Unfortunately we are unable to satisfy all of our wants— there are limits For a society these limits take form of scarce resources • For example, land, water, labor, and physical capital Economics is study of how to allocate these limited resources to satisfy unlimited wants Economics is a social science, in contrast to a natural science Deals with human society or its characteristic elements, such as individual, family, or state Scarcity means there are not enough resources to satisfy every possible demand 4 Economics Defined Economics Social science concerned with allocation of scarce resources for satisfying unlimited wants • E.g., with a federal budget surplus, do we pay down national debt, cut taxes, maintain social programs, or fly to Mars? Society Interaction of individuals within an environment • E.g., United States and other countries Social welfare Happiness for society as a whole • E.g., economists have suggested modifications to a country’s gross national product as a surrogate measure for social welfare 5 Economics Defined Local bliss Social welfare is maximized for a given resource constraint • E.g., a time of peace and prosperity Global bliss (or bliss) There are no resource constraints and all wants are satisfied • E.g., our dreams Agent Household or firm within an economy • E.g., you Economy Group of agents interacting to improve their individual and joint satisfaction • E.g., interaction of buyers and sellers in a free society 6 Economics Defined Using resources in one way has an opportunity cost of not being able to use them in another way For example, opportunity cost of allocating time for studying is lost enjoyment of seeing a movie instead Scarce resources are continuously changing through time Nonrenewable resources are declining Renewable resources may increase or decline over time Capital, both human and physical, will depreciate over time • Must be augmented to maintain or increase present levels Change in resources is a constraint (limitation) that prevents complete satisfaction Assuming individuals’ wants are insatiable 7 Economics Defined Individuals’ wants are also continuously changing Depending on age, location, and even time of day Economics is concerned with way society chooses to allocate a continuously changing set of limited resources Among a continuously changing set of unlimited wants Would you be sorry if all your wants were satisfied? Yes, because tomorrow these current wants will change Economics is a philosophical inquiry into process of resource allocation Outlines how a society allocates its scarce resources to achieve prosperity and well-being for its citizens Objective of economics • Maximize happiness for society as a whole (social welfare) subject to limited resources 8 Economics Defined Economics provides a theory for determining What commodities to produce When to produce them How to produce them For whom to produce them Theory describes economic environment in which agents (households and firms) interact Knowledge of this environment provides an understanding of how an economy operates Economic theory offers both an explanation for and predicts how agents within an economy operate • Must understand this operation of an economy to make efficient decisions on how to allocate resources With understanding of economic theory, ability to explain, predict, and control economy is possible Economic theory could be used as a basis for • Design of policies by governments wishing to control outcome of a program or • As a critique of control actions governments might take 9 Economics Defined For example, economic theory can describe How price of oil affects auto production Why a large increase in gasoline price results in little reduction in demand for gasoline Why a cattle rancher will stay in business even if she is losing money Why a firm with monopoly power can charge a higher price for its commodity than a competitive firm Economic theory is a very nonlinear use of language Full implications are more than just sum of parts Makes it a very powerful and exciting field of study Why study economics? Microeconomic theory offers solutions to practical problems 10 Taxonomy of Economics Economics may be classified into a number of divisions Economic philosophy • Positive and normative Major fields • Micro and macro Economists tend to specialize in one of the major fields In their applications they will generally employ both positive and normative economic philosophies 11 Microeconomics and Macroeconomics Microeconomics Concerned mainly with economic activities of individual consumers and producers or groups of consumers and producers, known as markets • Examples include Consumers’ demand for food Cost to a firm for a particular volume of production Per-unit price a firm charges for a specific volume of its output Macroeconomics Concerned with behavior of economic aggregates or economy as a whole • Examples include Total volume of output for a nation General level of prices and employment Total level of income and expenditures 12 Microeconomics and Macroeconomics Complement each other Microeconomics deals with efficient allocation of resources within an economy Macroeconomics deals with maintaining a stable economic environment resulting in full employment with stable prices If macroeconomists are unable to maintain full employment of resources • Microeconomists need not worry about efficiently allocating these resources Since unemployed resources are not scarce or limited Microeconomics is of limited use unless resources are fully employed Reverse is also true—if microeconomists are unable to efficiently allocate resources • Even with fully employed resources social welfare will not be maximized 13 Microeconomics and Macroeconomics Fallacy of composition states What is true of parts is not necessarily true of whole In terms of economics, generalizations made at microeconomics level may not always be true at macroeconomics level For example, rising unemployment may result in workers’ increasing their savings Microeconomics would predict an increase in individual savings However, unemployed may decrease their savings to maintain their living standards Macroeconomic effect of combining workers’ and unemployed’s savings levels may result in a decrease in savings • Called Paradox of Thrift 14 Microeconomics and Macroeconomics Converse of fallacy of composition is fallacy of division What is true of whole is not necessarily true of the parts Generalizations made at macroeconomic level may not always be true at microeconomic level For example, in aggregate (macro), level of prices may be stable Specifically, there is no inflation, defined as a general rise in prices However, in a particular market (micro), prices may be rising rapidly Micro- and macroeconomics are not distinct areas of study Both can be used to investigate same policy action For example, an increase in government taxes affects consumers and producers can be analyzed with • Microeconomic tools Investigate effect on markets for specific commodities, such as housing or automobiles • Macroeconomic tools Analyze effect on aggregate employment, inflation, and national income 15 Positive and Normative Economics Positive economics Concerned with what is, was, or will be Considers actual conditions that have occurred or will occur in an economy If two people disagree over positive statements in economics • Should be able to settle their controversy by logical thinking and appealing to • facts For example, the statement “A 10% increase in the price of gasoline will have no effect on the number of vacationers going skiing,” is a positive statement Can be tested by empirical research Number of skiers before price hike can be compared with number of skiers after Normative economics Concerned with what ought to be Involves value judgments—statements about what is good and what is bad, what ought to have occurred, or what ought to occur in an economy If two people disagree over normative statements • They are disagreeing over value judgments and may not be able to reach an agreement For example, “Only Bohemian residents should be allowed to vacation in Bohemia,” is a value judgment that cannot be tested Empirical evidence cannot be used to destroy one’s belief about the issue 16 Applied Economics Applied Economics is closely related to normative and positive economics Belongs to neither category but to a category called art of economics Distinction dates back to father of John Maynard Keynes, John Neville Keynes Positive economics is study of what is and the way the economy works Normative economics is study of what should be Art of economics is applied economics that accepts some set of goals determined in normative economics Pure science, not applied economics It is also not applied economics Discusses how to achieve those goals in reality, given insights of positive economics Relates conclusions derived in positive economics to goals determined in normative economics 17 Applied Economics Positive economics is abstract thinking about abstract problems Immediate or even future relevance is of little or no concern to a positive economics researcher Methodology for art of economics is broader, more inclusive, and less technical than methodology for positive economics Requires a knowledge of institutions and of social, political, and historical phenomena Mechanisms for using available data in addressing current economic problems are developed as economic art Applied economics relies on all other disciplines to support positive economics Engineering, biology, and ecology are improving technology • Helps produce more desirable commodities from limited resources Mathematics, computer science, and statistics are developing new tools for advancing both applied economics and positive economic theory Applied economics incorporates theories from political science, sociology, and psychology 18 Models Economics is based on belief that most behavior can be explained By assuming agents have stable, well-defined preferences • Make rational market choices consistent with these preferences Economics is distinguished from other social sciences by its general acceptance of this belief Paradigm in economics • Foundation for building economic models Models are basic tool used by scientists to increase our understanding of real world Simplified representations of reality Reality is simplified in different ways in a model Depending on objectives of model and particular situation • For example, a map is a simplified model of world, but not all information about world can be placed on one map 19 Assumptions A model is used to simplify reality from which conclusions are logically deduced about some system A system is a group of units interacting to form a whole • For example, consumers and producers interact to form a market system Assumptions are assertions about system properties that are observable in real world Can be evaluated for their degree of realism Properties are traits and attributes of a system A model describes essential features of a system, based on theory, in a way that is simple enough to understand and manipulate Close enough to reality to yield meaningful results Consider a model of consumer behavior with following assumptions Consumer is rational and attempts to maximize satisfaction (utility) • Consumer has a fixed level of income Commodities (goods and services) vary continuously, and utility consumer derives from them is measurable • Consumer has a given set of preferences for these commodities Commodity prices are constant 20 Assumptions Based on this set of assumptions, can conclude that a consumer will maximize utility By equating marginal (additional) utility per dollar for all the commodities he purchases In this model, variables—commodity prices, income, and consumer preferences—are assumed to influence consumer’s purchases of commodities Called exogenous variables Based on economic theory, we can develop a model where these exogenous variables cause change in other variables Called endogenous variables (in this case, consumer’s purchases) Assumptions characterize type of world for which a model is intended, but model is not an exact representation of reality For example, when at supermarket you do not count level of utility you receive per unit of commodity • However, a model provides a reasonable abstraction 21 Assumptions Abstracting from reality is part of scientific method Minimizes influences of personal and cultural beliefs in explaining reality Economists employ scientific method to develop and test models that are accurate representations of reality Hypothetical models are important in any science Even if these models are artificial, they are useful Real test of such models is whether they lead to conclusions that help to further scientific objectives Explanation, prediction, and control 22 Analysis Value of economic models is not in how realistic are their assumptions As illustrated in Figure 1.1, economists employ scientific method for analyzing these models Considering reality (the real world) as a starting point, an economist reduces the complexities of reality to manageable proportions But in how useful are conclusions derived from them By developing a model of a real-world system based on economic theory • Results in a logical model suited to explain system observed By logical argument (deduction), logical or model conclusions can be derived Hypotheses of relationship among variables • Hypotheses are then transformed into conclusions about real world Economists may also employ econometrics (application of statistics to economics) to analyze reality For developing an econometric model, economists use experimental abstraction based on economic theory, which leads to experimental design Model is then useful in testing hypotheses derived from economic theory Theoretical and econometric models complement each other in developing realworld conclusions 23 Figure 1.1 Scientific method 24 Analysis Relative emphasis on theoretical versus statistical models has changed over time Greek tradition proves things with abstract principles (theoretical models) • For example, proof of Pythagorean Theorem does not depend on particular size of a right triangle Babylonian tradition discovers things by computation • Such as fact that a million different right triangles all have same relation among squares of their sides Greek tradition prevailed in works of past Nobel laureates such as Paul A. Samuelson and Kenneth J. Arrow Applied mathematical reasoning to a minimum of data Ever-decreasing cost of computation due to advanced technology has increased cost of Greek science (theoretical modeling) relative to Babylonian science (econometric modeling) Elegant analysis still costs as much time and effort as it ever did, but number crunching becomes ever cheaper The kinds of practical questions consumers, firms, governmental policymakers, and economists are asking are more amenable to answers from Babylonian economics For example, an econometric model can show magnitude of a reduction in pollution from a change in a pollution standard In contrast, a theoretical model will generally only provide an indication of direction of change and not magnitude 25 Tools Tools employed for developing theoretical models and deriving conclusions are prose, geometry, mathematics, and computer programming Prose is ordinary language of people in speaking or writing • Disadvantage of prose was that key features of a model were lost as it was verbally transmitted or imitated among individuals Written communication solved this problem For relatively detailed models a great deal of writing was required Geometry alleviated this limitation—“a picture is worth a thousand words" • Geometric illustrations that complement writing allow a model to be • communicated and conclusions to be developed with greater efficiency Geometry is an excellent tool for describing a model with two variables, such as price and quantity Unfortunately, geometry is limited by its dimensions Geometry is not able to represent fourth, fifth, or any higher dimension Required of a model with more than three variables Mathematics allows us to enter worlds of higher dimensions and explore their vast areas with models designed to provide insights into their workings • If a picture is worth a thousand words, mathematics is worth the universe 26 Tools A model can always be communicated without mathematics But mathematics greatly reduces a model’s description and expresses it in a very concise manner As mathematical models become more complex Analytical solutions to models become difficult or impossible However, advancement of computer programming provides numerical solutions to these complex models Computer programs have provided solutions to some models that previously could not be solved 27 Models in Scientific Explanation, Prediction, and Control An educated person is someone who is able to explain relationships among facts Neither a list of facts nor a compilation of summary statistics from a survey are explanations Facts and statistics are generally called data An explanation is general relation underlying data • Data are interpreted or explained by applying theory to account for relationships among variables If a model does well in explaining relationships, it can be used for prediction Deriving some conclusion before it is observed Distinction between explanation and prediction Explanation is a conclusion observed first, with a model in support of the conclusion provided afterward Prediction is a conclusion deduced from a model before conclusion is observed 28 Models in Scientific Explanation, Prediction, and Control Control is altering of one or more exogenous variables in a model to predict a particular outcome Examples include • Changing price of a commodity to predict change in a consumer’s purchases • Changing pollution standard in a model to predict change in pollution For purposes of control, a model that provides valid explanations as well as accurate predictions is required Based on models developed in following chapters, we investigate changes in (control of ) exogenous variables—such as prices, wages, and income By comparing one equilibrium position to another • Called comparative statics analysis Table 1.1 lists a collection of optimization models along with comparative statics analysis developed and discussed in following chapters All optimization models involve either maximizing or minimizing an objective function Given a fixed level for exogenous variables, endogenous variables are varied to determine optimal level of objective function • Generally, objective function is subject to some constraint Such as limited income or a given level of technology 29 Table 1.1 Collection of optimization models developed in this text 30 Development of Microeconomics Marshallian-cross analysis Figure 1.2 shows an illustration of Marshallian cross Developed in 1880 by English economist Alfred Marshall Per-unit price of a commodity, p, is measured on vertical axis and quantity of commodity, Q, is measured on horizontal axis Marshallian cross is represented by market demand and supply curves • As price decreases, quantity demanded for a commodity by consumers is expected to increase Results in a downward or negatively sloping demand curve Decreasing supply of commodity Results in an upward or positively sloping supply curve • Firms supplying this commodity are expected to react to this price decline by • Point of intersection (crossing) represents market equilibrium level of price and quantity Quantity Supplied = Quantity Demanded No incentive for consumers or firms to change their market behavior Market-clearing price (pe) is most efficient mechanism for allocating scarce resources among unlimited wants Marshallian-cross analysis has been applied to a wide range of social behavior 31 Figure 1.2 Marshallian Cross 32 Partial-Equilibrium Versus GeneralEquilibrium Models Marshallian cross is only a partial-equilibrium model Only considers one market at a time rather than all markets in an economy For some questions, this narrowing of perspective gives valuable insights and analytical simplicity However, for broader questions about efficiency and welfare implications of economic activities • Narrow viewpoint may prevent discovery of important interrelations For answering broader questions, a general-equilibrium model is required Models whole economy or some major subset French economist Leon Walras created basis for such an investigation by representing economy with a number of simultaneous equations Created model that permits effects of a change in one market to be carried through into other markets In a sense, current macroeconomics is simply an example of applied general equilibrium analysis 33