Econ 281Intermediate Microeconomics •Consumer Behavior

•Theory of Production and Cost•Various Market Structures

Lorne Priemaza, M.A.

Lorne.priemaza@ualberta.ca

Various material courtesy of Katharine Rockette and Wiley & Sons INC.

Chapter 1

What is economics?Microeconomics and

MacroeconomicsEconomic ToolsPositive and Normative Analysis

What Is Economics?

• Economics is the science that deals with the allocation of limited resources to satisfy unlimited wants.

Limited Resources

Choices

Unlimited Wants

Outcome

Microeconomics and Macroeconomics

• Microeconomics

-from the Greek mikros meaning small-studies economic behavior of individual decision makers (people, firms, etc.)

-What price should Apple charge for Ipods?

-How much House should Kim watch?-How does owning an Ipod and watching

House affect Jon’s utility?

Microeconomics and Macroeconomics

• Macroeconomics

-from the Greek makros meaning large-studies aggregate economic behavior (nation, world, business cycles, etc.)

-What should the tax on MP3 players be?-How do tv shows such as House affect

productivity and unemployment?-How does MP3 and tv demand fluctuate?

Economics and Models

• “Economists work with models.”

-Life is too complicated for an economist to analyze all at once

-In order to analyze one aspect of life, economists build a simplified model to represent that aspect of life

-The results of the model are then tested against real life

-Models require assumptions

Economics and Assumptions

• “Assume there’s a can opener!”

-Every economic model relies on assumptions (much like a house relies on foundations)-ie: Assume people are rational; assume firm A understands people’s tastes

-If the assumptions are invalid, the model suffers-ie: Assume all students read the text

Exogenous and Endogenous Variables

• Exogenous Variables

-values that are taken as given-values that are decided outside the model

Ie: GIVEN that Joe’s costs are $10 per shoe (exogenous variable), how much should he sell shoes for?

Exogenous and Endogenous Variables

• Endogenous Variables

-values that are determined within the model

Ie: What price (endogenous variable) should Joe charge for shoes and what quantity demanded (endogenous variable) will he face?

Exogenous and Endogenous Variables

• Relationship Model

John is trying to woo his sweetheart Jenni.

-Jenni’s feelings towards John are exogenous

-John’s attempts to woo Jenni are endogenous

-Jenni’s reaction is endogenous

Mathematical Tools-Economic agents react rationally or irrationally given their available information.-Economists assume agents react rationally to maximize their utility/profit or minimize their work/cost using:

Constrained OptimizationEquilibrium AnalysisComparative Statics

Mathematical Tools• Constrained Optimization

“If I had one thing I would be happy – everything.”

-Generally, people cannot be satisfied with everything, there are limits to buying power/production, etc.

-Constrained Optimization maximizes utility, cost, etc. given a constraint (money, production function, etc)

Constrained Optimization ExampleDr. House enjoys two things: riding his

motorcycle and saving lives. Unfortunately, he cannot do both at the same time. Therefore Greg’s model is:

Max U(Riding,Lives) ->Objective Function

Subject to the constraint (s.t.)Hour Per Day = 8 = Riding + Lives

House Optimization Example

One may say House should spend his full 8 hours on riding or saving lives; whichever he likes more.

But House probably enjoys the first few hours of riding his bike or saving lives more than the last few hours.

We’re concerned with MARGINAL happiness. (Happiness gained from the last hour’s activity)

House Example

Assume House gets the following satisfaction from riding his bike or saving lives:

2 Hours 4 Hours 6 Hours 8 Hours

Riding 4 7 9 10

Saving Lives 3 6 7 8

What should House do to maximize his happiness? (Remember that he’s planning his day 2 hours at a time – marginally)

Example: House’s Happiness

U1(Riding, Saving Lives)

U2(Riding, Saving lives)

Riding + Saving Lives = 8

R

SL0

House will pick the mixture of riding and saving lives that maximizes his happiness, subject to the fact he only has 8 hours.

4

4

8

8

Dealing with the marginal

Assume that you bought a lemon car – a 2002 Pontiac Sunfire that has caused you nothing but problems. You paid $8,000 for it and have spent $2000 in repairs over the last year.

Your kartoflemonometer just broke and will cost $1000 to fix. After this last job you’ve basically replaced the entire car. On the other hand, you can buy a reliable 2002 Ford Escape for $7000.

What do you do?

Dealing with the marginal

If you fix your Pontiac, it will have cost you a total of $11,000 to buy a car that works, whereas the Ford would have cost you a total of $7000.

But right now you already have the Pontiac. To get a car that works, you need an ADDITIONAL $1,000 or an ADDITIONAL $7,000. You will fix the Pontiac.

Rational people deal with marginal decisions.

Mathematical Tools• Equilibrium Analysis

-Equilibrium is a state that will continue indefinitely as long as exogenous factors don’t change

-If a variable is higher than equilibrium, market forces will pull it down,

-If a variable is lower than equilibrium, market forces will pull it up

Example: The Market for IphonesPrice

Quantity

Supply

Demand

•

Q*

P*

If price is too high, supply will exceed demand and price will fall.

If price is too low, demand will exceed supply and price will rise

Surplus

Shortage

P1

P2

Mathematical Tools• Comparative Statistics

-In the real world, many exogenous variables are moving at the same time; affecting many endogenous variables

-Comparative Statistics aims to measure the effect a change in one exogenous variable on one endogenous variable.

Comparative Statistics Example

Originally, assume that the chicken market is in equilibrium, with Qsupply = QDemand. Originally, we have equilibrium price and quantity.

Assume that due to a cold winter in chickenland chicken reproduction has increased. Analyze the effect of colder weather on chicken prices and chickens sold.

Example: ChickenPrice per pound

Quantity, pounds

Old Supply

Demand (P,I)

•

New Supply

•POld

PNew

QOld QNew

Cold weather has caused a decrease in chicken prices and and increase in chickens sold.

Positive and Normative AnalysisPositive and Normative Analysis

• In order to carry out effective policy, the policy maker must understand how the economy works

• The is called POSITIVE ECONOMICSPOSITIVE ECONOMICS;; The economics of facts & theory

-ie: Minimum wage increase causes unemployment increase

Positive and Normative AnalysisPositive and Normative Analysis

• In order to conduct policy, the policy maker must have some goals in mind

• NORMATIVE ECONOMICSNORMATIVE ECONOMICS is the study of what the goals of the economy shouldshould be

--ie: We should lower the minimum wage in order to lower unemployment

Positive and Normative AnalysisPositive and Normative Analysis

• Positive economics is important to understand the economy

• Normative economics is important to policy makers

• Classify the following:

– “When the price of the Xbox 360 rises, more people buy the Playstation 3.”

– “We should buy Lorne a Playstation 3 to increase his utility.”