ECN 203 1st EditionExam # 1 Study Guide Lectures: 1 - 18Unit 1 – Intro to Micro - Opportunity Cost: the best forgone option. It is the price you “paid” for your choiceo We face this cost due to scarcity o Time is the ultimate scarcity - Assumptions o allows the scientist to abstract from the complication of changes in those surrounding conditions  Made in order to make analysis manageable o Strong Assumptions  Abstracts significantly from what is considered reality.  In effect, strong assumption holds a lot of reality at bay o Weak Assumptions  More realistic  Does not hold much reality at bay. o A model constructed on strong assumptions is less credible than weak assumptions. The weaker the model’s assumptions, the stronger is the model’s foundation - Relaxing Assumptions o Starting with strong assumptions is easy, but unrealistic o To relax an assumption: to move from a stronger to a weaker assumption, to move from what is perceived as less to a more realistic set of conditions o Each time we relax an assumption we define more terms to deal with growing complexity - Ceteris Paribus o Other things being equal o As the model develops, we will try to be explicit with what we are assuming but sometimes we will say, ceteris paribus Unit 2 – Modeling Individual Choice- Definitions o Utility – satisfaction  Assume we must maximize our utility o Consume – the act of deriving utility o Goods and Services – things that get us utility - Assumptions o An individual consumes goods and services in order to maximize utility o We must assume: Everyone knows her own preference ordering  Everyone is rational - Diminishing Marginal Utility o Util – measure of a unit of utility o Marginal utility (MU) The one under consideration  The unique, individual effect of each successive unit consumed: how much did this satisfy me? Marginal choice involves making decisions about individual units in a succession of units, the smaller the units the more finely tuned your choices will be. Total utility (TU)- The sum of all these marginal effects: on the whole, how much satisfaction did I get from eating?- If the margin is negative, the marginal utility becomes negative. - The Initial Decision Rule o Decision rule – represents how we make choices  General decision rule: Consume until MU = 0 This decision rule is not realistic.  We start with this general rule because it provides s first approximation of realitybased on a strong assumption  From this point, we will begin relaxing our assumptions and build complexities of:- Scarcity, production, the future, risk, and uncertainty.- Relaxing our “No Scarcity” Assumptiono Decision Rule Under Scarcity o Constrained Optimization Problem: maximizing utility in the face of a scarcity, by balancing at the margin. - Relaxing our “No Production Necessary” Assumption o How do we get the most utility out of our resources?o Eventually diminishing marginal production  Example: Studying – first you get more and more productive because your brain starts slowly, then you get on a roll. Your marginal productivity is increasing. Then things happen to reduce your marginal productivity – it gets hard, you get tired- Relaxing our “No Future” Assumption o Addressing Time  When we include that reality of a future to consider our choices become complex because they are intertemporal- Choices have consequences across time. - In order to make a choice one must compare options. - Different choices = different flows of utility o Discounting the Future Discount – to diminish the value  Ceteris Paribus people don’t want to wait, they want their utility sooner than later. o Discount Rates  Waiting premium – the price paid for waiting or one’s discount rate.  One’s discount rate measures the degree to which one would discount the future, which represents how much you would have to be compensated for waiting. o Present Value  With a discount rate one can take those future flows of utility and measure their present value. Present value is the value of those future utilities all telescoped back into a single value now. o What does building in the future do to our decision rule? PV1=PV2=PV3=…=PVn  V =productivity and preferences  PV=present value- Relaxing Our “No Risk and Uncertainty” Assumption o Risks Things that might affect our plans for better or worse and about which we have some sense of probability as to whether they will happen o Uncertainties  Things that might affect our plans for better or worse, but we have not imagined so we do not assign probability o Building Risk into the Decision Rule  Expanding the decision rule to include risk expands our scope of our decision rule beyond the present value (PV) to the expected present value (EPV)- The E reflects how much one expects to enjoy this utility give this perception of risk: the higher the perceived risk, the lower that expectation.  EPV1=EPV2=…=EPVn- The V (value) captures our individual productivity and preferences atthe margin- The P (present) reflects the fact that the future stream of utility that the choice generates is discounted back into the present based on our individual discount rate- The E (expected) represents our adjustment for our perception of the risk associated with that choice  You can change a person’s behavior by manipulating a risk o On Role Models Preferences- If you never see a person of your gender or your race in the role of (for example) a lawyer, then it is hard to imagine yourself in that role. - It won’t be in your preference ordering Discount rate - If your role models prefer immediate gratification – then it is more likely you will too - Meaning you have a high discount rate  Risk - Even if you can imagine being a lawyer, an absent role model sends a signal that the probability that you will make it is low - Low probability = high risk - High risk = ceteris paribus, a reduced likelihood you’ll make that choice.Unit 3: Interdependent Choice and Market Coordination - Relaxing our “No Interdependence Assumption” Individual decision rule remains the same  The Challenge:- Coordinating interdependent choices to produce and consume and save and invest - If interdependence creates an additional challenge…o Why not live our lives in isolation?o Why impose the challenge of interdependence on ourselves?- According to Adam Smith humans