Transcript Advanced Microeconomics - Department of Economics

Advanced Microeconomics
Prof. Rous
Hickory Hall 220f
[email protected]
What is Economics?
• “The study of the economy” – Jane Q. Public
• “Economics is the science which studies human
behavior as a relationship between given ends
and scarce means which have alternative uses.”
– Robbins, Lionel (1932). An Essay on the Nature and
Significance of Economic Science., p. 16
• While the phenomena or behavior economists
study largely involve choice under scarcity, the
same can be said of other social science
research.
Topics for Economists,
and other Social Scientists
• Phenomena under Robbins definition:
– To what extent does public housing reduce
homelessness?
– Does Head Start improve educational outcomes?
– Does lowering the tax rate on the top 1% increase job
creation?
– Why is the marriage age rising?
– Does the death penalty deter crime?
– Why did Americans choose suburban living after
WWII?
• So research topics do not differentiate economics.
Back up, what is social science?
• Physicists, chemists, biologists, etc. study
phenomena that do not have conscious thought
but are instead “passive adherents to the laws of
nature (Silberberg, 1990).”
• Along with sociologists, anthropologists,
economic geographers, planners, political
scientists, and other social scientists, economists
study human behavior.
• Studying human behavior is essentially nothing
more than the study of human decision making,
or choice.
Economic Schools of Thought
• Before differentiating economics from other
social sciences, we have to differentiate only
schools of thought.
• School of Thought: A particular idea or set of
ideas held by a specific group; doctrine. Any idea
that a group strongly believes in, be it through
practicing this idea in their everyday life or
through fighting for its adoption, can be
considered a school of thought.
(businessdictionary.com)
Schools of Thought
• 95% of economists in the US, 90% in Europe and
85% in the world are in the Neoclassical school
of thought
• Neoclassical economics evolved from the
Classical school defined by Ricardo, Smith, and
Marx. Classical school defined by:
– focused on the economy: productivity, growth,
economies of scale, gains from trade, land rent.
– understood a gap between value in use and value in
exchange
– prices assumed to be set by cost of production only
• value in use was inconsequential
Neoclassical Revolution:
Marginal Analysis
• Action is taken so long as the marginal benefit
exceeds the marginal cost, or, similarly, until the
marginal benefit equals the marginal cost.
• For example: Diamond-Water Paradox
– For all units of a good except the last one consumed,
the value in use exceeds the market price.
– For all units of a good except the last one produced,
the cost of production is lower than the market price.
– For the last unit produced and consumed, the
marginal value = marginal cost = price
• Other Schools of Thought
– Neo-Marxist Economics
– Institutional Economics
– Austrian Economics (Ron Paul and an increasing
number of Republicans live here)
– Feminist Economics
– Socio-Economics
– etc.
This course is about Neoclassical
Economics
• Which can be divided into:
– Positive
– Normative
Positive Economics
• Positive, the economics of what is.
• The goal: to explain and predict behavior
• How will economic actors (individuals, firms,
etc.) respond (direction and magnitude of
change in behavior) to changes in exogenous
variables? For example:
– Increasing the minimum wage 3% will cut
employment by .5%
– Increasing the percentage of adults with a college
degree by 10% will increase a city’s income by 2%.
Marginal Analysis Everywhere!
• Markets are the summation of economic actors
optimizing using marginal analysis.
• If marginal analysis can be used to explain
consumption and production behavior, then
how about applying it to crime, marriage,
decision to have children, drug addiction, etc.
• Economists used to be criticized for branching
out, but now there is a Freakonomics movie.
Normative Economics
• Normative, the economics of what ought to be.
• Policy should encourage efficiency, equity, social
welfare, etc.
– Attempting to maximize economic surplus is good
– Deadweight loss is bad
– Kaldor-Hicks uses consumer and producer surplus and
says that if those who gain from a policy could
theoretically compensate losers, it is good
– Pareto suggested that only policies that have NO
losers (i.e. Pareto improving), are good
Normative Economics
– Market transactions (without externality) are Pareto improving, so
markets are good.
– Increasing the minimum wage will increase deadweight loss, so it is
bad policy.
– Increasing the minimum wage will increase producer surplus, with
minimal deadweight loss so it is good policy.
– We should subsidize higher education because the long term
economic growth will more than payoff current taxpayers.
– Market based health reform is superior because it is more efficient.
– Carbon taxes are good because they reduce a negative externality.
– Carbon taxes are bad because they increase the cost of driving for
the poor.
– A progressive tax system is good because it is fair for the rich to pay
disproportionately more.
– A progressive tax system is bad because it is unfair for the rich to
pay disproportionately more.
Normative Economics is Currently Out
of Favor Academically
• No interpersonal comparisons of utility possible, so
income redistribution is not necessarily “good.”
• Marginal benefit (the basis of consumer surplus) does
NOT measure utility, but instead something that is
heavily income dependent, so this calls into question
consumer surplus as a tool for allocation.
• The only moves we can say unequivocally improve
social welfare are those that are Pareto improving.
– Not many policies can be shown Pareto improving,
although we do tend to argue for policies that increase
efficiency.
– In recent decades, focus on positive economics.
What Differentiates
Positive Neoclassical Economics
(henceforth, “economics”) from all
other Social Science Research?
• What doesn’t set us apart
– The phenomena of interest -- all human behavior
• What sets us apart
– Methodology
Most Influential Neoclassical
Economists (1920s-40s)
• Many came from a hard science background.
• Brought the scientific method and
mathematical models of natural systems with
them.
• Initially summarized in Samuelson’s 1947
“Foundations of Economic Analysis”
– Theories should derive from first principles.
– Theories should be refutable, or they have no
value.
Silberberg’s Definition of
Neoclassical Economics
• “Economics is that discipline within social
science that seeks refutable explanations of
changes in human events on the basis on
changes in observable constraints, utilizing
universal postulates of behavior and
technology, and the simplifying assumption
that the unmeasured variables (‘tastes’)
remain constant.” (Silberberg, 1990, p. 6).
“refutable explanations”
• If a theory cannot be tested and proved false, it has no
value.
• For example
– After WWII, Americans moved to the suburbs (larger lots,
separation of land uses) because lower cost automobiles
lowered the cost of transportation. Allowing people to live
further away from employer and other land uses.
– This could be refuted by finding examples where more
expensive automobile ownership led to less suburban
development.
– As opposed to: Americans moved to the suburbs because
Building housing developments became big business and
greedy developers wanted to maximize profit over quality
of life for those that bought the houses (actual theory)
“universal postulates of behavior and
technology”
• For example, start with first principles we all can
agree on, but nothing more
– Individuals maximize utility subject to preferences and
available choices (rationality)
– Preferences are well behaved
• Axioms
– complete
– transitive
– reflexive
• Assumptions
– continuous
– convex
– monotonic
“the simplifying assumption that the
unmeasured variables (‘tastes’) remain
constant.”
• Tastes and preferences are assumed constant not
because we believe it, but as a simplifying
assumption.
• Without it, we cannot identify the effects of
changes in observable constraints separately from
potential changes in preferences.
“on the basis on changes in
observable constraints”
• “The challenge of economics is always to search
for explanations based on changes in
constraints; explanations based on changes in
tastes are to be viewed with skepticism and as
indicative of inadequate insight.” - Silberberg,
1990, p. 7.
• So we assume changes in behavior are driven by
changes in prices, income, technology,
institutional constraints, etc.
For example
• For example, after WWII, Americans built and
moved to the suburbs because they started to
value estate like housing (pretentious trappings
of wealth) over community and quality of life.
(actual theory)
• But to argue changes in behavior can be
attributed to changes in preferences is to give
up on an explanation that can be tested and
proven false... or confirmed.
The Scientific Method
•
•
•
•
Observation of phenomena
Research question posed
Hypothesis in the form of a theory
Empirical testing
Theory
• The model: the purely theoretically aspect of a
theory.
– Models can be logically valid or invalid, but cannot be
tested empirically.
– For example, individuals optimize an objective
function z = f(x,y) subject to constraint, αx+βy = M
• How a model becomes a theory: “when
assumptions relating theoretical constructs to
real objects are added.”*
– The objective function represents utility, U = U(x,y),
and x and y are goods that provide utility and α and β
are the price of x and y and M is income.
* (Silberberg, 1990, p. 14)
Theory
• “Theories can be false either because the
underlying model is logically unsound, or
because the empirical facts refute the
theory.”*
* (Silberberg, 1990, p. 14)
Realistic Assumptions Necessary?
• There is an ongoing debate (mainly among
philosophers) as to whether unrealistic
assumptions are a fatal flaw.
• Milton Friedman argued that predictive power
is the only test that matters.
– E.g., whether people are rational or not, if they act
as if they are, then the assumption is good.
Refuting a Theory
• Worthwhile theories have refutable
propositions.
– That is, when certain test conditions occur, values
of some of the variables in the model must be
restricted (Silberberg, 1990, p. 15).
– Law of supply and demand restricts equilibrium
price to rise when supply decreases. Since it is
possible for price to fall, it is possible for the model
to be refuted.
– Profit maximization restricts quantity of a factor
demanded to fall when it’s price rises. Since the
quantity hired can rise, this theory can be refuted.
Comparative Statics
• The method of comparative statics is how
testable propositions are derived from a model.
• The model of supply and demand
• Model:
» Inverse Demand: P = a-bQd a > 0, b > 0
» Inverse Supply: P = c+dQs c > 0, d > 0
» Solve to get, P* =
𝑎𝑑+𝑏𝑐
𝑏+𝑑
, and Q* =
𝑎−𝑐
𝑑+𝑏
• While it is impossible to theoretically hypothesize values
for P* and Q* as doing so would require information on
preferences and production technology, we can (by only
assuming the linear functional forms) hypothesize a
change in equilibrium if a, b, c, or d changes.
Comparative Statics
• We can hypothesize a change in P* and
Q* given a change in an exogenous
factor. Even if we don’t know values for
a, b, c, or d.
• Assume a>c
• Comparative Statics
ad  bc
P* 
bd
ac
Q* 
bd
P
a
slope = d
S
P*
slope = -b
D
c
Q*
Q
dP *
d

 0,
da b  d
dP * d (c  a )

 0,
2
db  b  d 
dQ *
1

0
da
bd
dQ *
ca

0
2
db
b  d 
dP *
b

 0,
dc
bd
dP * b(a  c )

 0,
2
dd
b  d 
dQ *
1

0
dc
bd
dQ *
ca

0
2
dd
b  d 
Similar to being unable to predict P*
and Q*, it is impossible to create
theories to predict
• The obesity rate in the US.
• The size of shopping carts.
• That people will work a certain number of
hours at the current tax rate.
• The number of drunk driving fatalities in a
state.
Instead
• Theories that predict
– The change in the obesity rate in each county in the US
as a function of a change in the availability of medical
technology.
– The change in the size of shopping carts as a function
of the LFPR of women.
– The change in the number of hours people work if the
tax rate changes.
– The change in the number of drunk driving fatalities in
a state as BAC limits fall and penalties rise.
• Although we often do this in cross section
This Semester
• In many ways
– principles = intermediate = advanced
– Consumer Choice √
– Theory of the Firm √
– Competition √
– Monopoly √
• But at a level between intermediate and a PhD
advanced micro class.