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The Basics of Economics (in an hour)Purpose of TodayAgendaModels: SimilaritiesTransactions In a Simple EconomyBasic Assumptions of MarketsMarket-Based vs. Technological CostChallenges of Economic ModelingAgendaTechnology: Cutting GrassWith Several TechnologiesTechnology ChoiceExtending the Production FunctionAgendaSupply and DemandDemand FunctionsPrice Elasticity of DemandAggregating Demand FunctionsConsumer/Producer “Surplus”Taxes, Quotas, and Surplus EffectsAgendaGeneral EquilibriumDiscount RateCost/Benefit AnalysisOpportunity CostMarginal Abatement CostQuestions?MIT OpenCourseWare http://ocw.mit.edu15.023J / 12.848J / ESD.128J Global Climate Change: Economics, Science, and PolicySpring 2008For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.15.023/12.848/ESD.128 LectureFeb 20, 2008Travis FranckThe Basics of Economics (in an hour)Purpose of Today• The Flavor of Economics – How do economists think about problems?– What is the basic toolset?– Standard terminology– And a taste of the complexity involved…Agenda• Part 1: Overview of economic modeling• Part 2: Basic Production functions• Part 3: Supply and Demand• Part 4: Bigger Picture ConceptsEconomicExogenousVariablesPolicyParametersGDP, GHGsStructure• Components•Behavior• InteractionsEquilibrium solutionDynamics (investment)Estimation, calibrationModels: SimilaritiesNaturalforcingsGHGsParametersTemp, PrecipStructure• Components• Behavior• InteractionsEquilibrium solutionTransient solutionsEstimation, calibrationClimateTransactions In a Simple EconomyFactor InputsOutput or ProductionFinal Goods and ServicesLabor, capital, landIndividualsProducing UnitsFactor Incomes ($)Purchases ($)Basic Assumptions of Markets• Market efficiency depends on:– Perfect information– Perfect or complete competition• No single entity can influence prices– Clear and complete property rights– No transaction costs– Rational behaviorNext WeekMarket-Based vs. Technological Cost• General equilibrium– Full economy• Goods, capital, labor– Prices endogenous– Factors driving growth– International trade• Sacrifice technological detail– Production technology– Aggregation of sectors• Engineering cost– Technical detail– Zero-cost opportunities• Partial equilibrium– Key prices exogenous– Omit interactions• Direct costs, ignoring– Consumer surplus loss– Industrial structure– Transactions costsTop-Down vs. Bottom-upHybridsChallenges of Economic Modeling• Invention of new technologies• Foresight– Learning under uncertainty• Consumer preferences– Attitudes to risk• Values and political decisions– Prescriptive/descriptive dichotomyAgenda• Part 1: Overview of economic modeling• Part 2: Basic Production functions• Part 3: Supply and Demand• Part 4: Bigger Picture ConceptsTechnology: Cutting GrassKLPower Mower20 acres per day10 acres per dayWith Several TechnologiesKLPush MowerPower MowerRiding Mower10 acres per dayTechnology ChoiceKLPush MowerPower MowerRiding MowerPrices 1Prices 2KLKLKL)LbKb(aHLKttρρρ+=1Extending the Production Function• More than just capital and labor– Energy, materials– Products of one production function can be inputs to another production function• Extend to entire sectors– Eg, US agricultureAgenda• Part 1: Overview of economic modeling• Part 2: Basic Production functions• Part 3: Supply and Demand• Part 4: Bigger Picture ConceptsSupply and DemandQMPAn ideal market maximizes societal surplus.SDDemand FunctionsWineCheesePrices 1Prices 2Utility CurvePrice Elasticity of DemandEp= 0 (Inelastic)Ep= infinite (elastic)PP)/()/(PPQQEpΔΔ=Q QAggregating Demand FunctionsPQAggregateIndividualsConsumer/Producer “Surplus”PPPqAQMqBDPPqAQMqBSTaxes, Quotas, and Surplus EffectsQMPSDQuotaTaxDeadweight lossAgenda• Part 1: Overview of economic modeling• Part 2: Basic Production functions• Part 3: Supply and Demand• Part 4: Bigger Picture ConceptsGeneral Equilibrium• Supply/demand relationships do not exist in a vacuum.– If the US were to put a $2 tax on gasoline what would happen?•1st: Solve supply/demand equation for gasoline. Reduction in gasoline usage, reduction in gasoline price• In the US, goods that use gasoline as an intermediate will increase in price• Outside the US, lower gasoline prices will lead to increased consumption (“leakage”)• Eventually, consumers will move in order to drive less– Propagate changes until a new equilibrium is reachedDiscount Rate• Composed of:– Rate of Time preference– Marginal productivity of capital * marginal utility of money• Discount Rate is not Inflation: we use “constant” dollars• Usual expression:• Net Present Value = sum of all time periods, appropriately discounted. • Value judgment? Revealed preference? Long time horizon?ttrB−+= )1(Cost/Benefit Analysis• Cost of a decision– Money spent, opportunity cost• Benefit– Calculate quantity abated– Discount rate• The total benefit minus total cost is maximized at the point where the marginal cost = marginal benefit• Valuation– Revealed preferences, value of a human life, existence value, etc– But every decision has an implicit valuationOpportunity Cost• Most valuable alternative use of resource– Time, money, capital– Owning vs. renting– Opportunity cost of watching a free movieMarginal Abatement Cost• “MAC curve”• Include all options for reduction, ordered by price, with quantity available at that priceCFL LightbulbsDouble PaneWindowsSolarPanelsPriceCO2reductionQuestions?• (next week: Environmental


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MIT 15 023J - The Basics of Economics

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