6/25/14

An introduction to microeconomics


What is economics? The science of resource allocation. Microeconomics can be thought of as the study of decision making.

Why is this important? Scarcity… unlimited wants and desires but limited resources. (any examples where scarcity doesn’t take place? Air/water, etc.--while these aren't scarce in the classic sense, clean air and water are scarce)

In economics we use models, simplified versions of the real world, like a map. A map is a terrible representation of the real world, but is extremely valuable as a tool.

Three key ideas going forward in economics:

1. People are rational, this doesn’t mean that they are smart but that they make decisions in their best interest. This generally holds true, ie. People eat food, etc.
2. People respond to incentives, in general people will buy things that are cheaper, or avoid costly mistakes. Think about why people avoid parking citations and hate taxes, but love sales and raises. We can think of it from the carrot/stick point of view.
3. Optimal decisions are made on the margin, it is that next purchase or decision that matters. Imagine you are in school and get a job offer. Example, I spent $200 on a flight to Greece which I missed. I had the option to buy another for $100. Was the cost $300? No, the cost of the next purchase was $100.

We face tradeoffs: Tradeoffs- because of limited resources and unlimited desires we need do decide how they are allocated.

The foregone activity or choice in a tradeoff is called an opportunity cost. Formally defined an opportunity cost is the highest value alternative choice/activity that is given up.

Examples, coming to visit this website, what did you give up?

In addition to us, society’s face tradeoffs as well, they must answer the following questions when deciding how to allocate scarce resources:
1. What to produce?
2. How to produce it?
3. Who gets it?

Types of economies, centrally planned vs. market. Centrally planned economies answer the three questions directly, while a market economy uses the price system.

These ideas can be thought of as a spectrum, because no true centrally planned or market economy exists, we always land somewhere in the middle, which we call a mixed economy. A country with any form of government whatsoever isn’t a pure market economy, and even pure communist countries have elements of black market transactions moving them from the edge:

Pure Market ----------------Mixed --------------------------Pure Centrally Planned

Think about how the previous three questions are answered in a market vs. centrally planned economy.
Why does this matter? Because of the efficiency/equity tradeoff.

Efficiency means that production of goods and services occurs at the lowest possible cost (productive efficiency) and that the goods produced are those that are most highly valued by society (MB=MB, allocative efficiency). A perfectly efficient allocation of resources may benefit some more than others, and because of this economics also considers equity. Equity is generally defined as having an equal distribution of income, or making sure resources go to the most needy. (The affordable care act is an example of improving equity over efficiency).

Market economies are generally efficient because they rely on voluntary exchange. People and firms are allowed to buy and sell goods and services that make themselves better off.

Centrally planned economies are theoretically more equitable because they can redistribute income more easily.

How can we test if an allocation is efficient or equitable? Is it possible to analyze the tradeoff between efficiency and equity? Yes, with economic models:

We use simplified versions of the real world to analyze different scenarios. Why use economic models?

Firms use the models to make production decisions, governments can analyze different policy decisions, and individuals also use economic models in their decision making (although not formally).

In economics we focus on analysis of what is (positive analysis) instead of what ought to be (normative analysis). Positive analysis is analysis that can be tested with hypotheses.

Examples of positive analysis, what happens to unemployment if we raise minimum wage? What life expectancy if we make healthcare free? What happens to unemployment if we lower taxes?

Examples of normative analysis: increasing minimum wage is the right thing to do. We should protect all remaining forests. Raising taxes on the rich is a bad for the economy.



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