1IntroductionECON 370: Microeconomic TheorySummer 2004 – Rice UniversityStanley GilbertLecture 1Econ 370 - Ordinal Utility 2Course Outline Consumer Theory Subjective ValueProduction TheoryCost of ProductionTheory of Decision MakingSupply and Demand of Market InputsGeneral Equilibrium and a Theory of EconomicWelfare(MC = MB)Industrial Organization1. Perfect Competition2. Monopoly3. MonopolisticCompetition4. OligopolyRevenue of ProducerIndividual DemandMarket DemandProductMarketsPricing in Econ 370 - Ordinal Utility 3Scarcity and Choice• Micro – entails study of how people choose under conditions of scarcity.• Relevant for developed countries (where material scarcity largely thing of the past)?• Scarcity relevant even when material resources abundant.• Example: Aristotle Onassis, – at his death: Billionaire.– but victim of debilitating and progressive neurological disease;– time, energy and physical skill needed to carry out ordinary activities were scarce.Econ 370 - Ordinal Utility 4Scarcity and Time• Time is scarce resource for everyone• Example: Deciding which movie to see•often time NOT price of admission that constrains most of us.• Time and money not only important scarce resources.2Econ 370 - Ordinal Utility 5Other Scarcity• Friend invites you to all-you-can-eat buffet brunch.– Your problem is to decide how to fill your plate.– Money no object, since you can eat as much as you want for free.– Time not an obstacle, since you have all afternoon.– Important scarce resource is capacity of your stomach.– Eating another waffle → less room for more scrambled eggsEcon 370 - Ordinal Utility 6Scarcity is Fundamental• Every choice involves elements of scarcity.• If resources were not scarce, we would not need to make a choice!• sometimes most relevant scarcity will be of monetary resources• many of our most pressing decisions it will not!• coping with scarcity in one form or another is essence of human condition.Econ 370 - Ordinal Utility 7Cost-benefit Analysis• Q: Should I do activity x?– for movie goer x= “see Matrix Reloaded tonight”– for person attending buffet lunch x= “eat another waffle”• A: Compare costs and benefits of doing activity in question.–Let C(x) denote the costs of doing x–Let B(x) denote the benefits.–If B(x) > C(x) then do x, otherwise don’t. Econ 370 - Ordinal Utility 8Cost-Benefit Application• To apply rule, need to define & measure costs and benefits.• Monetary values useful common denominator.• Define B(x) as maximum dollar amount you would be willing to pay to do x.• Often hypothetical magnitude (since no money may change hands)• Define C(x) as value of all resources you must give up to do x.• For most decisions, some benefits and/or costs will not be readily available in monetary terms.3Econ 370 - Ordinal Utility 9Cost-Benefit Example• Should I turn down my stereo?– Next two tracks on album are ones you dislike.– Have to decide whether to get up & turn music down or stay put & wait it out.– Benefit: not having songs you don’t like blare at you.– Cost: inconvenience of getting out of your chair.– If extremely comfortable and music only mildly annoying, prob. stay put.– If you haven’t settled for long and/or music really burdensome, then most likely to get up.Econ 370 - Ordinal Utility 10Valuing Costs and Benefits• Possible to translate relevant costs and benefits into monetary framework.• Consider costs of getting out of chair• Probably turn down 1 penny to get out of chair.• Probably jump instantly out of chair if offered $1000.Econ 370 - Ordinal Utility 11Reservation Price• c ∈ (0.01, 1,000) is Reservation Price: the minimum amount it takes to get out of chair• To see where c lies, imagine mental auction in which you keep boosting offer by small increments from 1 cent up to point at which it is barely worthwhile to get up• Where this point lies depends upon your circumstances– Tend to be higher for rich person than for poor person– Tend to be higher the less energetic (or more tired) you feelEcon 370 - Ordinal Utility 12Cost-Benefit Comparison• Suppose c = $1.• Similarly for benefits conduct (hypothetical) auction to determine max. amount willing to pay someone to turn the music down.• Suppose b = $0.75.•Since b < c, you should remain in the chair.4Econ 370 - Ordinal Utility 13The Concept of Marginal Analysis• Costs and benefits that really matter are those at the margin– Example: How much memory should your computer have?– Suppose RAM can be added to your computer at cost of $10 per megabyte– Q. Not “Should I do x?” But “How much x should I buy?”• Equivalently, ask: “Should I buy an additional unit of x?”– Yes, if marginal benefit exceeds marginal cost. No, otherwise.Econ 370 - Ordinal Utility 14Megabytes ofmemoryPrice ($/megabyte)406000C400100200300 500251710Marginal benefit(Value of an additionalmegabyte)Optimal memoryMarginal cost(Cost of an additionalmegabyte)73.50Optimal MemoryEcon 370 - Ordinal Utility 15ObjectionThe idea that anyone might actually calculate costs and benefitsof turning down a stereo might sound strange, or even absurd.Economists have come under heavy criticism for making unrealistic assumptions about how people behave, and outsiders are quick to wonder what purpose is served by the image of a person trying to decide how much he would pay to avoid getting up out of his chair.Econ 370 - Ordinal Utility 16Response 1• We can make useful predictions if we assume people act as if they made such calculations.• Milton Friedman illustrates this point by looking at techniques expert pool players use.– Shots they choose, specific ways they attempt to make them can be predicted by assuming players take careful account of all relevant laws of Newtonian physics.– Despite fact that very few expert pool players have formal training in physics, they never would have become experts unless they played as dictated by the laws of physics.5Econ 370 - Ordinal Utility 17Economic Application• Like pool players, rest of us must develop skills for coping with our environments.• Many economists, including Friedman, believe that useful insights into our behavior can be gained by assuming that we act as if governed by rules of rational decision making.• By trial and error we eventually absorb these rules, just as pool players absorb laws of physics.Econ 370 - Ordinal Utility 18Response