EC 131 - PRINCIPLES OF MICROECONOMICS Woods School Summer 2013
ORGANIZATION
ME
YOU!
TEXTBOOK
GRADES AND ETC Grade Midterm Exam (July 11th) - 35% Final Exam (August 1st) - 50% Problem Sets (Aplia) - 15% Extra credit activities - Extra points No make-up exams
GRADES AND ETC Problem Sets One or two per week 1 - all problems submitted, at least 50% of the points 0.5 - all problems submitted, less than 50% of the points 0 - not all problems submitted
APLIA Instructions in the Syllabus Problems? Email or office-hours Deadlines are strictly enforced. Solve problems before them!
CONTACT AND OFFICE HOURS Read emails! Office Hours Tuesdays: 5:00 PM - 6:00 PM Thursdays: 1:00 PM - 2:00 PM boin@bc.edu http://www2.bc.edu/inacio-bo/ (Slides available after class)
WHAT IS ECONOMICS?
Social science which studies how society manages and allocates its scarce resources
How it does Positive Economics How it should Normative Economics
MAIN QUESTION How markets work? How do they allocate resources? When do they fail? What can we do about it? What are the consequences when we do something about it?
CREATE BOSTON S RESTAURANTS FROM SCRATCH Find land to plant produce and grow livestock Different kinds of vegetables need different kinds of land and climate Train and hire farmers Transportation
TRANSPORTATION Different kinds of trucks for different kinds of trucks Plan which vegetables, meat and spices go to each type of restaurant Choices must be consistent with timing, delivery of trucks, allowed times for truck traffic in different parts of the city Right amount of food to be delivered at each restaurant More than necessary: lose food Less than necessary: lose clients
MORE PLANNING Consider changes in demand for different times and conditions More ice-cream during summer Chinese food during spring festival No lunch for arabs during ramadan Kosher restaurants need different suppliers
WHO IS PLANNING? Nobody! Nobody plans, each one just takes care of their own interest but things seem to work out fine Free markets are surprisingly efficient in allocating goods and services to and from individuals
ECONOMICS Economic History Study economic phenomena in the past Econometrics Application of math and statistics to economic data Economic Theory Mathematical models of economic subjects Microeconomics Macroeconomics
MICRO/MACRO Household and firms Interactions between households and firms Micro Markets Interest rates Inflation Unemployment Macro
MICROECONOMICS How consumers react to price changes How firms decide which price to change What is the most efficient way to reduce smoking or air pollution How individuals use information in their decisions
THINKING LIKE AN ECONOMIST
Doesn t mean becoming an evil individualist! It s a more methodic and precise way to see the world around us It can help you see unexpected points of view on common subjects
TRADEOFFS A consequence of the fact that resources are scarce There s no free lunch To get things we like, we usually have to give up something we like. Students allocating their time The more I study economics, the less I can study psychology The more I study economics AND psychology, the less I can watch TV
COSTS The cost of something is what you give up to get it What s the cost of college? Tuition for money Books money Room money Dining plan Really?
COSTS If you quit school you still need a room to stay You would spend money in a room anyway You would still spend money on food Real cost of college housing: college housing - alternative housing
COSTS More importantly: your time! If not in college you could be working, earning $$$$$. For most students, this is the largest cost. Opportunity cost: what you give up to get that item. Opportunity cost for Tim Cook to go backpacking in Europe for one month Cost of backpacking in europe when you re a student and when you re an adult?
ECONOMIC MODELS
ECONOMIC MODELS Real-life economic interactions are very complex The bus driver may let his friend enter without paying A person may buy a gift to another because of friendship, love or second intentions People may go to college more because of the parties than because of a higher future income Impossible to take all effects into consideration and have something useful
SIMPLIFYING ASSUMPTIONS We can make simplified versions of what we re trying to study When asking how long it would take for a marble ball to fall from a building, disregard air resistance Air effect is insignificant for our question If it is a piece of paper, air resistance is significant and that simplification isn t adequate anymore
ECONOMIC MODELS A tool to learn something about the world, where by using some simplifying assumptions (what s truly important ) we are able to give better answers to some questions
OUR FIRST MODEL: PPF
ASSUMPTIONS Entire economy produces only two goods Pizzas Burritos Let economy have 10,000 workers and labor is all you need to produce them (Inputs) In one day, a worker produces 2 pizzas or 10 burritos (Technology)
1 worker 1day 2 Pizzas 1 worker 1day 10 Burritos If all resources (workers) are devoted only to make pizzas, what does the economy produce? 2 x 10,000 = 20,000 pizzas and 0 burritos If all resources (workers) are devoted only to make burritos, what does the economy produce? 10 x 10,000 = 100,000 burritos and 0 pizzas
50 40 30 Pizzas (P) 20 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 40 30 Pizzas (P) Feasible combinations: inside and including PPF 20 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 40 30 Pizzas (P) Not Feasible combinations: outside PPF 20 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 40 Points inside PPF are inefficient: it is possible to increase production of one good without decreasing the production of the other 30 Pizzas (P) 20 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 40 Points at the PPF are efficient: increases in the production of one good must come with the reduction of the other. Efficient production induces a tradeoff. 30 Pizzas (P) 20 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 40 Points at the PPF are efficient: increases in the production of one good must come with the reduction of the other. Efficient production induces a tradeoff. 30 Pizzas (P) 20 10,000 12,000 Pizzas 50,000 40,000 Burritos 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Q: What is the cost of producing 2,000 pizzas? 40 30 Pizzas (P) 20 10,000 12,000 Pizzas 50,000 40,000 Burritos 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Q: What is the cost of producing 2,000 pizzas? A: 10,000 burritos 40 30 Pizzas (P) 20 10,000 12,000 Pizzas 50,000 40,000 Burritos 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Q: What is the cost of producing 2,000 pizzas? A: 10,000 burritos 40 Opportunity cost of 2,000 pizzas is 30 10,000 burritos Pizzas (P) 20 10,000 12,000 Pizzas 50,000 40,000 Burritos 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Opportunity cost of 2,000 pizzas is 10,000 burritos 40 Pizzas (P) 30 Opportunity cost of 1 pizza is 5 burritos 20 10,000 12,000 Pizzas 50,000 40,000 Burritos 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Opportunity cost of 10,000 burritos is 2,000 pizzas 40 Pizzas (P) 30 Opportunity cost of 1 burrito is 1/5 pizza 20 10,000 12,000 Pizzas 50,000 40,000 Burritos 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 One is the inverse of the other (5 and 1/5). 40 Not a coincidence! Opportunity costs of two goods in this 30 model are one the inverse of the Pizzas (P) other. 20 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Slope: 40 20 100 = 1 5 30 Pizzas (P) 20 Opportunity cost of good in the horizontal axis 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 40 Opportunity cost of good in the vertical axis: Pizzas (P) 30 1 Slope 20 12 B 10 A PPF 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
Shift in the PPF: 1,000 more workers 50 40 30 Pizzas (P) 22 20 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
Shift in the PPF: 1,000 more workers 50 40 30 Pizzas (P) 22 Opportunity cost doesn t change! 20 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
Improvement in pizza technology: each worker can now produce 5 pizzas per day 50 40 30 Pizzas (P) 22 20 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
Improvement in pizza technology: each worker can now produce 5 pizzas per day 50 New Opportunity Costs: Pizzas (P) 40 30 22 20 Burrito = 50 100 = 1 2 P izza = 100 50 =2 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
Economy we just studied had a linear PPF You can switch between pizzas and burritos at a constant rate Opportunity cost is constant along the PPF
Think about alternative economy: iphones and Burritos The input is still the same: labor Some workers are better at making iphones (engineers) and others are better at making Burritos (cooks)
50 Bowed-out PPF 40 30 iphones (I) 20 19 16 11 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 40 Everyone works making iphones: 20 iphones Everyone works making burritos: 100 Burritos 30 iphones (I) 20 19 16 11 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Start from situation where all workers are producing iphones 40 Take the best cooks that are making iphones and put them to make Burritos 30 iphones (I) 19 iphones and 30 Burritos 20 19 16 11 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Opportunity cost of 30 Burritos: 1 iphone 40 Opportunity cost of 1Burrito: 1/30 iphone 30 Opportunity cost of iphone: 30 Burritos iphones (I) 20 19 16 11 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Now start from 60 Burritos /16 iphones 40 Produce 20 more burritos. Some IT guys are allocated to mexican kitchens 30 iphones (I) 11 iphones and 80 Burritos 20 19 16 11 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Opportunity cost of 20 Burritos: 5 iphones 40 30 Opportunity cost of 1Burrito: 1/4 iphone Opportunity cost of iphone: 4 Burritos iphones (I) 20 19 16 11 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
50 Indeed, slopes change 40 Steeper (high-value) slopes = 30 high opp cost for Burritos iphones (I) low opp cost for iphones 20 19 16 11 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 Burritos (B)
Opportunity cost of iphone is higher when many iphones are produced (many cooks making iphones) Opportunity cost of iphone is low when economy is producing few iphones (we can get the top engineers)
GAINS FROM TRADE
What are the main sources of US imports?
Top sources of US imports (2011) 1 - China: U$ 398 Billion 2 - Canada: U$ 320 Billion 3 - Mexico: U$ 262 Billion
What are the main destination of US exports?
Top destinations of US exports (2011) 1 - Canada: U$ 234 Billion 2 - Mexico: U$ 160 Billion 3 - China: U$ 97 Billion
FIRST TRADE MODEL Two individuals A rancher, who can produce only meat A farmer, who can produce only potatoes Without trade, rancher eats only meat, farmer eats only potatoes They could trade and exchange some meat for potatoes, giving them a less boring meal. Both would be better off.
A LESS OBVIOUS EXAMPLE Mario and Luigi work 10h/day Mario: 1 pizza in 1:00h or 4 burritos in 1:00h Luigi: 3 pizzas in 1:00h or 6 burritos in 1:00h Luigi is more productive in both products! Can they still benefit from trade?
Luigi's PPF 50 48 46 44 42 Pizzas 40 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 Opp costs: Burritos=30/60=1/2 Pizza=2 0 0 10 20 30 40 50 60 70 80 Burritos
Mario's PPF 50 48 46 44 42 40 Pizzas 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 Opp costs: Burritos=10/40=1/4 Pizza=4 0 0 10 20 30 40 50 60 70 80 Burritos
Opp cost of Pizza Opp cost of Burrito Mario 4 Burritos 1/4 Pizza Luigi 2 Burritos 1/2 Pizza
Luigi is currently producing 15 pizzas and 30 burritos (chosen based on his preferences) 15 pizzas, 3 pizzas/h = 15/3 = 5h 30 burritos, 6 burritos/h = 30/6 = 5h (5h,5h)=10h (Feasible and Efficient)
Mario is currently producing 5 pizzas and 20 burritos (chosen based on his preferences) 5 pizzas, 1 pizza/h = 5/1 = 5h 20 burritos, 4 burritos/h = 20/4 = 5h (5h,5h)=10h (Feasible and Efficient)
They could do the following: Mario spends all the 10h making burritos (20x4=40) and Luigi spends 2h making Burritos (2x6=12) and 8h making pizzas (8x3=24)
Without trade With trade Gains from Trade Prod & Cons Production Trade Consumption Increase Mario Luigi Pizzas Burritos Pizzas Burritos 5 20 15 30 0 40 24 12 Get 6 Give 19 Give 6 Get 19 6 21 18 31 +1 +1 +3 +1
Luigi s consumption after trade Pizzas Luigi's PPF 50 48 46 44 42 40 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 10 20 30 40 50 60 70 Burritos 80
Mario s consumption after trade Pizzas Mario's PPF 50 48 46 44 42 40 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 10 20 30 40 50 60 70 Burritos 80
What happened? Pizzas/h Burritos/h Opp cost of Pizza Opp cost of Burrito Mario 1 4 Mario 4 Burritos 1/4 Pizza Luigi 3 6 Luigi 2 Burritos 1/2 Pizza Luigi has absolute advantage over Mario in the production of both goods Absolute advantage: ability to produce more with the same inputs Mario has comparative advantage over Luigi in the production of Burritos Comparative advantage: ability to produce a good at a lower opportunity cost
What happened? Opp cost of Pizza Opp cost of Burrito Mario 4 Burritos 1/4 Pizza Luigi 2 Burritos 1/2 Pizza Mario has comparative advantage over Luigi in the production of Burritos Luigi has comparative advantage over Mario in the production of Pizzas Since opportunity costs are inverses, one always has comparative advantage on one good! (Unless they have the same opportunity cost)
Each one specialized on the good on which they have comparative advantage and then traded. Think about it: to obtain one more burrito, Luigi has to give up on 1/2 pizza. Mario can say I can make that Burrito. Give me 1/3 of a pizza. Mario can then reduce production of Pizza by 1/3. This allows him to increase production of Burritos by 4/3 (4 Burritos per pizza). Result: Luigi got his burrito for cheaper than 1/2 pizza and Mario had a profit of 1/3 burrito.
It is possible for one person to have absolute advantage in both goods It is impossible for a person to have comparative advantage in both goods When does nobody have comparative advantage over the other? Only if both have the same opportunity costs Gains from specialization comes from comparative advantage, not absolute advantage. If opportunity costs differ, both can gain from specialization and trade.
PRICE OF TRADE Which trades will make both better off? Let s look back at the trade between Mario and Luigi
Without trade With trade Gains from Trade Prod & Cons Production Trade Consumption Increase Mario Luigi Pizzas Burritos Pizzas Burritos 5 20 15 30 0 40 24 12 Get 6 Give 19 Give 6 Get 19 6 21 18 31 +1 +1 +3 +1 Mario gave 19 Burritos and got 6 pizzas Each pizza cost 19/6=3.17 burritos Luigi gave 6 pizzas and got 19 Burritos Each burrito cost 6/19=0.31 pizza
Without trade With trade Gains from Trade Prod & Cons Production Trade Consumption Increase Mario Luigi Pizzas Burritos Pizzas Burritos 5 20 15 30 0 40 24 12 Get 6 Give 19 Give 6 Get 19 6 21 18 31 +1 +1 +3 +1 Each pizza cost 19/6=3.17 burritos Each burrito cost 6/19=0.31 pizza Opp cost of Pizza Opp cost of Burrito Mario 4 Burritos 1/4 Pizza Luigi 2 Burritos 1/2 Pizza
Opp cost of Pizza Opp cost of Burrito Mario 4 Burritos 1/4 Pizza Luigi 2 Burritos 1/2 Pizza Any trade made at a price between both opportunity costs is beneficial. Pizza between 2 and 4 burritos Burrito between 1/4 and 1/2 pizza
INTERNATIONAL TRADE Just as people can benefit from specialization and trade, so can different countries That s why the US sells and buys so much from the same countries: trading is a game in which both can be made better off Comparative advantage theory says that if each good is produced at the country with comparative advantage in that good every country can then benefit from trade Trade among nations has more complex issues, since some individuals can be made worse off though the country as a whole is better off. Example: if country specializes in Burritos, pizza makers may lose their jobs.
INTERNATIONAL TRADE Imports: goods produced abroad and sold domestically Exports: goods produced domestically and sold abroad
BOWED-OUT PPF AND TRADE Can two countries with the same exact PPF be better-off by trade? Yes if they are bowed-out PPFs!
100 90 A 80 70 X 60 Pizzas 50 40 B 30 20 10 0 0 10 20 30 40 50 60 70 80 90 100 Burritos
100 90 A 80 70 X 60 Pizzas 50 40 B 30 20 10 0 0 10 20 30 40 50 60 70 80 90 100 Burritos
100 90 A' 80 70 A A's Imports X B's Imports A's Exports 60 B's Exports Pizzas 50 B B' 40 30 20 10 0 0 10 20 30 40 50 60 70 80 90 100 Burritos
FOR NEXT CLASS Catch-up readings: Chapters 2 and 3 Next lecture readings: Chapter 4 Problem set is available and due next Tuesday