MicroeconomicsAugust 24, 2011WORKSHEET 1 AVAILABLE AFTER CLASS TODAY Homework 1 available after class Friday EconomicsEconomics is the study of how people make decisions when faced with scarcity: What to produce?Which combination of factors of production should be used in production?- (IE.Tractors and fertilizers vs. tons of people)Who, if anybody, should allocate what is produced?A group of people? Markets?...Economics is a social scienceDeals with actions and interactions of peopleThe Scientific Method:QuestionDefine hypothesisTest hypothesis Controlled vs. natural experimentsCausation vs. correlation Revise original hypothesis Hypothesis that resist data testing become part of theories Economic ModesAbstract representation of the real word, a collection of rulesDifficult Behavioral economics: combine psychology, economic theories and other tools to model our behavior Goal: make good predictionsNot to describe the world in detail Role of simplifying assumptions:Focus on the important relationships Avoid unnecessary details Generalizations The consumer theory applies to a “regular consumer”Other-things-equal assumption “ceteris paribus”Allows to focus on one event only Graphical expression Unlimited wants… and limited resources (money, time, etc).. force us to make CHOICESEach choice has an opportunity cost (there is no “free lunch”)Important correctly measure opportunity costsValue of next BEST opportunityExampleMoving to another state to get a better paying jobYou currently earn $40,000 in MissouriValue of doing nothing: $38,000Opportunity cost of moving?$40,000$78,000- cannot add these together, it’s either one or the other so this iswrongCost Benefit AnalysisHow people make choicesImportant for producers/governments (taxes)Assumption: individuals are rational (consistent)Decision making process goal: make yourself as happy as possible = maximize your economic surplus Pro-con lists are similar representations of a cost-benefit analysisLists are different for every person (pro/cons considerations)List is based on your expectationsIf expectations are bad, you might make a bad decision (still rational)August 29, 2011 Cost Benefit Analysis - Pro-con lists are similar representations of a cost-benefit analysiso Lists are different for every person o List is based on your expectationso If expectations are bad, you might make a bad decision (still rational)o Decision can change due to incentives. Pro/Con List Pros (out of state school) Cons (out of state school)Better weather Higher travel expensesMore leisure opportunities Less chance to be with friends and familyChance to live in a new part of the country Higher cost of livingCost/Benefit AnalysisExpected Benefits (out of state school) Expected Cost (out of state school)Weather $2,000 Travel $5,800Leisure $3,000 Family and friends $1,500Geography $1,000 Cost of Living $3,200Total expected Costs $6,000 Total Expected Cost= $10,500*Expectations will change depending on the person and what the expectations meanto them. (Expected Costs for the out of state school will outweigh the expected benefits for the in state school. Therefore it is irrational to go to the out of state school.)Cost Benefit Analysis - Assumption; people make decision “at the margin” o Expected marginal economic surplus= expected marginal benefit- expected marginal cost.- Ignore sunk cost (not to be considered in the cost-benefit analysis because in any event you cannot recover the sunk cost.)Sunk Costs- You pay for a nonrefundable plane ticket and reconsider your decision later- You pay for a movie ticket and decide to stay or leave after the movie started.- Buy a share of stock and its price changes not according to your expectations. Conclusion - You made a bad decision (based on bad information/expectations)- Your decision was rational (increased your economic surplus)Market Failure – Externalities - Market failure due to imperfect information. Solutions: o Production of information (health, financial, transactions, etc.)August 31, 2011Market Failure- ExternalitiesMarket failure due to imperfect information. Solutions-Production of information (health, financial transactions, etc.)Market failure due to externalities:-Consumption or production decisions impact others and consumers or producers ignore the impact Solution:-Compare: “social” marginal benefit and “social” marginal cost Private Solution:-“Internalize the externality. Example: you pay your neighbor fornot playing loud music (reach an agreement between you and the person you and the other person, without a third party)-Limits to the option (Coase Theorem):# of people (transaction costs)property rights clearly defined Pigouvian Subsidies/Taxes:-Government encourages individuals (could be collection like agents, household, or a corporation/company) to “internalize” the externalities involved in some decisions-Individuals compare their private MB and private MC including subsidies or taxes and make the best decision for the society -Limits: information gathering (existence and size) Types of ExternailitesPositive consumption externalities:-education, exercising, flu shots (the more immune you get, the smaller probability of an outbreak to spread at a fast pace)-consumption falls short of the socially optimum-subsidyNegative consumption externalities:-smoking, antibiotics (if too much is consumed, creating worse situation)-too much consumption; not considering the fact that we are imposing a cost on the society-taxes Negative production externalities: (more common than proceeding)-production activities that pollute (of course we want things like air conditioning but it brings an effect to nature. How much is a forest valued?-too much production-taxesPositive production externalities:-space program-not enough production-subsidyExternalities Example1. 5 individuals deciding whether to vote or not on the next election.Best approach? Pigouvian subsidy or mandatory voting?Assuming there are no externalities (and no government intervention):# of votes? Social economic surplus?1 1 2 2 3 3 4 4 5 5MB MC MB MC MB MC MB MC MB MC$5 $3 $7 $4 $3 $5 $6 $9 $4 $5Person 1 = $2; Person 2 = $3; Person 3 = $0…Therefore social and economic surplus = $5Person 3, 4, 5 do not voteAssuming there is a positive voting externality equal to $2 and govt intervention:Amount of voters wont change, just social economic surplusPerson 1 = +$2; Person 2 = +$3; Person