Chapter 1 Introduction Cynical definition of economics: common sense made difficult; The primary goal of the text: to offer explanations of various social events, in order that the reasons why certain things occur in the economic system may become clear. The Economy: Prices and Markets No single person directed any more than a tiny part of the production of any of these goods, and no single individual could on their own produce any of these goods. Their knowledge is confined to only a small facet of the finished good. There is no ?central planner,? the decision process is highly decentralized. In unplanned, market economies, these activities are based on mutual benefits coordinated by prices determined in the market. These prices are determined both by the actions of consumers, which we designate as demand, and by the action of producers, which we call supply. We will study how the forces if supply and demand interact in order to coordinate and direct output. What Economics in Not About: Economics can identify reasons why some individuals rather than others, or, more importantly, why some nations accumulate wealth. However, individuals who become rich usually acquired their skills in places other than economics textbooks. Economics: Part of Social Science It is scientific in that it seeks explanations of events which take place in the real world. An important aspect of science is the ability to predict that when certain situations arise, certain other events will occur. Economics uses a set of principles, or propositions, to analyze human behavior, and that is what makes economics part of social science. Economics believe that it is important to separate one?s own beliefs about what is desirable from what we believe to be true or false. We say that economic science should consist of positive statements, not normative statements. For example, there are many bills that are introduced in Congress to reduce the quantity of various goods that can be imported into the United States. Analyzing the effects of laws and policies such as trade restrictions is part of the positive science of economics. We make predictions about the effects of changes in various ?rules? governing people?s actions, and in the process, offer explanations of why the events we predict are likely to occur. The scientific analysis ends, however, with the discussion of the effects of some action. Scientific analysis doesn?t provide recommendations. There is no law that is universally beneficial. Social and Physical Sciences: Some Differences Explanations and Refutable Propositions The only way we can reject some facts and accept others as having some bearing on any particular problem, is to have some conceptual framework in which we think. Economists use theories because the facts rarely, if ever, speak for themselves. The only way we can choose the relevant facts is to have some notion, or theory, as to what is important to observe and what is unimportant. We can then test the assertions of the theory against specific facts. This is the way all sciences progress. A theory, therefore, consists of assertions or propositions we consider to be universally true. Economics does have a theory (the laws of supply and demand) - postulates economists believe to be universally true. This theory is useful both because it provides a set of unifying ideas with which we can analyze certain problems (generality), and because it consists of only a few simple ideas (simplicity). Both are useful qualities of theories, but increasing either one of these attributes often decreases the other. Theories that explain only one event are called ad hoc, they?re useless. Economics insists on explanations in terms of an accepted framework that provides explanations for more than just on event. The explanations that are most interesting and useful are those that could be wrong and turn out correct. Statements or propositions that could in principle be wrong are called refutable propositions. A theory says that some postulate A implies some event B. If we observe B, we cannot validly infer that A is true. It is called affirming the consequent. A common terminology is to say that when we find evidence that supports a theory, the theory is confirmed. ?Confirmed? does not mean ?proven;? it just means ?consistent with the theory.? Usually, our confidence in a theory grows in only after it is confirmed in repeated tests. Figure 1-1: Two Theories of the Shape of the Earth Many times, when the occurrence of two different events seem to be correlated, that is, when one occurs more frequently, the other is more likely (or less likely) to occur, it is tempting to assign some sort of causality (??????) to the events. We are tempted to say that one event (or its absence) is causing the other. The conclusion of causality from mere correlation is in fraught with danger. (Example, catching cold; storks and babies; Scholar?s neighbor?s visit to Marmaresch ;) The Economic Paradigm The occasion for studying economics, or, for that matter, all of the social science, is scarcity of goods and resources. Scarce is different from limited, because in order to be scarce, something must actually be a good. Essentially??????all goods are scarce. How are these scarce goods to be distributed among members of society? What rules will help to make these decisions? How shall society decide to what uses, and to what extent it will utilize a country?s resources? Economics is the study of how scarce resources, that have alternative uses, are allocated amongst competing ends. This problem can be separated into two parts: production, i.e. deciding what to produce and how much; and allocation, i.e. deciding who gets the goods society produces. All societies must somehow come to grips with the production and allocation of resources and goods. The outcomes depend on such matters as the skills of the population, the degree of industrialization of the country, and the laws customs of the country. Scarcity and Competition Scarcity is pervasive empirical fact about the world, and it is decided by the demands on the world?s resources. Only laws can do is changing the means by which people compete for the scarce goods and resources. Compete is used in business when speak of maintaining or increasing one?s market share relative to others who provide a similar service or good. What rule that can make competition less warlike and more benign is an important issue in economics. Cost Because of scarcity, every human action has a cost associated with it. In economics, cost (opportunity cost or alternative cost) always means a forgone alternative resulting from some action or decision. When resources are scarce, a decision to do one thing necessarily means that something else doesn?t get done. That something else is at least part of the cost. (Examples, the cost of attending college; Diamond; Concert ticket; Grocery ;) To economists, cost is always defined by what a person must give up, or forgo, in order to consume something, or pursue some activity. Cost means alternative, or opportunity cost. (Military) Demand and Supply When presented with competing opportunities, humans choose. We seek regularities of behavior so that refutable propositions about human actions are possible. The theory of demand (the theory of consumer): an analysis of the choices individuals make with regard to the goods and services they consume directly for their enjoyment. Demand The theory begins by separating the influences in our choices into two distinct classes: Constraints, or opportunities; Tastes, or preferences. A list of constraints: Income; Prices of goods; Time; Technology; Laws and customs; the state of our health; our education, skills, etc. These items are measurable. We assume that however tastes are defined or measured; they do not change during the course of investigation. Any changes in observable events can then be attributed to changes in observable constraints. In particular, we assert that all individuals strive to mitigate, or reduce the adverse consequence of the constraints they face; if any constraint changes, people will respond so as to reduce rather than reinforce these adverse effects. Fig.1-2: demand curve: Higher prices are associated with smaller quantities. Consumers mitigate the damages of the higher price by decreasing the level of their consumption, and this is called as the law of demand. Supply The cost of producing additional units tends to increase, due to the inability to replicate the most efficient resources. The relationship between the price of a good and the willingness of individuals to offer the good for sale is called a supply curve. The curve is positively sloped. Putting it together The intersecting point qE occurred. This important market equilibrium is the subject of most of economics. Diary, certain kind of clothing, agriculture products ? examples for market competitive. People act rationally Economics assume that people engage in purposeful behavior. ?People act rationally ?self-interest Microeconomics and Macroeconomics Clue Sunday 6:30-8:00 Mary Gates Hall 231 Chapter 2 the Theory of Consumer Behavior 2.1 Economic Behavior People engage in some sort of purposeful behavior, and this sort of behavior is called rational behavior or maximizing behavior. Without a theory of human behavior, it is impossible to state scientifically interesting propositions. The goal of economic is to seek always to develop statements that could be wrong but which withstand repeated testing. In order to be useful, the economic postulates have to be stated in terms of actions that can be observed. We assert that certain behaviors are true for all individuals at all times. We would then judge the postulates as to how useful they were in analyzing problems. If the wrong answers were to become significant, the theory would at that point have to be revised. (E.g. elementary chemistry) Individual, not Group Preferences Proposed postulates if behavior are all about individual preferences, not group preferences. The reason is that we have reason to believe that we cannot accurately describe the preferences of a group. (E.g. three individuals as a group to vote ? the voting paradox) 2.2 The postulates of Behavior Postulate 1. People have preferences?heterogeneous preferences People can do rank various alternatives and act on those preferences. Economist express this by saying that we can measure the utility or pleasure we get from consuming goods only as an ordinal number, not as a cardinal number. Binary preference relation >: strictly preferred >=: at least as preferred =: equally attractive a) Completeness b) Transition c) Continuity Utility function: A real-valued function such that U (A)>=U (B) A=bundle A B=bundle B If and only if A>=B Postulate 2. More is preferred to less The items must be goods. The postulate refers to greater access to goods. Postulate 3. People are willing to substitute one good for another People are willing to made trade-offs(??). (E.g. safety driving; testing drugs; marriage; criminal) The Meaning of Value The willingness of individuals to trade off one good for another is a fundamental observation of economics. Moreover, it provides the only operational, i.e., observable definition of the concept of value. In economics, we measure value by what we are willing to give up in order obtaining something. The value of a good is determined solely by the willingness of human beings to give up other goods in order to get that particular good. Intrinsic value is an assertion that these goods have a value determined without regard to the actions of individuals. The process by which people decide the value they place on consumption goods is largely beyond economics. Measuring the Value of Life It is simply an observation from the marketplace based on actual human behavior. The value of life also enters public policy in assessing a manufacturer?s liability for damages in the case of defection products. Marginal versus Total Values Economics makes an important distinction between the amounts a person would be willing to pay (Forgo of other goods) in order to consume an additional unit of some good, versus what a person would pay in order to consume all units presently consumed of some good, rather than none at all. The marginal value of a good is the amount of other goods we would be willing to give up in order to obtain an incremental amount of that good. The total value is the amount a person would will to pay to have all of his or her hamburgers rather than have no hamburgers at all. The value of something we desire is measured by the maximum amount of other goods we would be willing to give up in order to obtain the good. 2.3 Marginal Values and Demand Curves The total value of a number of unites of a good consumed is the amount a person would be willing to pay to have those entire units father than none at all. ?Given info on marginal values, we can compute total values (and verses versa) Table 2-1 Postulate 4. For all individuals and all goods, the marginal value of goods decreases, as more of that good is consumed, holding other things constant. ?synonymous with a desire for variety. (E.g. play golf at different place with different people) The only postulate consistent with actual behavior is diminishing marginal values. The veracity of this postulate is so highly regarded; it is commonly referred to as the law of diminishing marginal values. Total Values >= Total Expenditures Consumer Surplus = Total willingness to pay ? Total expenditures Consumer Surplus is typically positive because of diminishing marginal valuation. (Postulate 4) Table 2-2 Problem 16 Joe?s Ph=$4 Pff=$1 Jake?s Ph=$2 Pff=$3 If at Joe?s purchase 4 ham and 6 ff for a total value of $49 (=28+21) and consumer surplus 49-(16+6) =$27 If at Jake?s, purchase 5 ham and 4 ff for a total value of $48= (30+18) and C.S. 48-(10+12) =$26 The consumer will choose Joe?s. 2.4 The Law of Demand The quantity demanded of any good, or the level of any activity pursued, varies inversely with the price of that good or activity, holding other things constant. We do not concentrate on people?s taste, but we observe that when constraints changes, how will people behave. The market curve down sloping means that when prices decline, there are more consumers are willing to buy the good. As an individual, the demand curve down sloping means that the person had already bought one of the goods, so the willingness for him to buy another of that good go down sloping. The law of diminishing marginal values provides the central prediction of behavioral economics: the reason to a change in the price. As long as the values in the table remain stable, the quality of a good a person will choose to purchase varies inversely with the price. Examples of variables: consumer?s income; cases in which all other relevant influences on the demand for that commodity remain constant. As long as the marginal value exceeds the market price of a good, a consumer will find it to his or her advantage to purchase the good. The law of demand is the statement that this curve is negatively sloped. The law of demand is the central behavioral proposition in economics. Charity: noneconomic behavior? Pecuniary wealth is a good which, other things equal, we prefer more to less. Wealth allows us to purchase goods in the marketplace. This does not imply that no substitution can take place between pecuniary wealth and other goods. Economic analysis of charity consists of examining how charitable activities change when the price of giving to charity changes. 2.5 Market Demand Curves (Marginal willingness to pay curve) Keep all other constraints constant. The same curve, but only change the position of point A to point B, means that the quantity of purchasing changes when the price changes. The move of the whole curve means that the changes in demand. (prices of substitute good changes and so on) The demand curves of primary interest to economists are the aggregates of individuals? demands rather than an isolated individual?s demand. The transition from an individual?s demand curve to the market is elementary. The combined, or market demand curve is simply the sum of the amounts each consumer wants to purchase (demand) at each price ? the sum of all individual demand curves. Comparable Worth In like manner the wages of mechanics, nurses, and workers in general are the prices of the services they provide. They represent the marginal value of these services to consumers, through the goods they produce. These marginal values do not reflect the total usefulness of mechanics versus nurses to humans. They measure what consumers would be willing to pay in order to get the services of one more nurse or one more mechanic, a value dependent upon the amount of those services already available. 2.7 Consumption over the time An important choice made by consumers, relates to consumption over time, in particular, how one allocates income earned in different time periods to consumption. Elasticity: an attempt to measure the responsiveness of an endogenous variable when another (exogenous) variable changes. Elasticity between variables A and B: Percentage change in A for a percentage change in B: %?A/%?B=?A/A ÷ ?B/B =?A/?B × B/A (Own ? price) elasticity of demand ?=Percentage change in quantity/percentage change in price ?=?Q/Q÷?P/P=?Q/?P×P/Q Elastic vs. Inelastic demand at a point: 1) Elastic demand: -?<-1 ?????>1 2) Inelastic demand -1<1 ?????<1 3)unitary elastic demand ?=-1 or ?????=1 Calculus Aside: ?=dQ/dP × P/Q Social Science Physical Science Analyze human behavior: relationships of people to one another and to the environment. Analyze objects not having conscious thought. Economics can rarely set up a laboratory experiment to test some idea or theory. We have to wait until the world produces a situation that provides an empirical test. The world is the laboratory. Production and exchanges occur because of the mutual benefit of the persons involved. There is no conservation of net benefits law. Generally based on conservation laws. It is hard to unbiased in our analyses. There is a natural tendency to reject the scientific evidence in favor of maintaining our own biases. Hard to be objective. Q Marginal Value Total Value (sum of marginal value) 1 $10 $10 2 9 19 3 8 27 4 7 34 5 6 40 6 5 45 7 4 49 8 3 52 9 2 54 10 1 55 11 0 55 Price Quantity Total Expend Total Value Consumer Surplus 10 1 10 10 0 9 2 18 19 1 8 3 24 27 3 7 4 28 34 6 6 5 30 40 10 5 6 30 45 15 4 7 38 49 21 3 8 24 52 28 2 9 18 54 36 1 10 10 55 45 Q MV Ham TV Ham MV FF TV FF 1 10 10 6 6 2 8 18 5 11 3 6 25 4 15 4 4 28 3 18 5 2 30 2 20 6 0 30 1 21
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