PRINCIPLES OF MACROECONOMICS
Ranjit Dighe
WEEK 2 (LECTURES 4 & 5)
Jan. 31 - Feb. 4, 2000

[In these lectures we reviewed some microeconomic principles, starting with the economic way of thinking and then moving on to demand. The corresponding chapters of Case & Fair's textbook are Chapters 2 and 4.
-- Yes, these lectures follow a slightly different sequence from the one on the course syllabus; still, by the end of week three (by Fri., Feb. 11), we will have covered the first six chapters.
-- Note: this class did not meet on Wed., Feb. 2, 2000, owing to a snafu on my part. I will hand out makeup lecture notes at some future date.]

WEEK 2, LECTURE 4
Mon., Jan. 31, 1999

0. IMPEDIMENTA

* Get Problem Set 1 (review of micro).
* Today: Review of microeconomics, Part I
I. The economic way of thinking: scarcity and tradeoffs
II. The economic way of thinking: rationality and marginal analysis
III. Scarcity, tradeoffs, and efficiency
IV. Demand (begin)
 

I. THE ECONOMIC WAY OF THINKING: SCARCITY AND TRADEOFFS

SCARCITY (A resource is scarce if...)

-- Most resources have more than one use.
----> The use of a scarce resource has an OPPORTUNITY COST, which is the (forgone) value of its next best alternative use.
------ What is the opportunity cost of going to class?  Probably sleeping.
------ "no free lunch" (other uses of that time: shopping a class, going to the gym, buying your course books...)
------ tradeoffs (if you want more of one thing, you have to settle for less of another)
 

II. THE ECONOMIC WAY OF THINKING: RATIONALITY AND MARGINAL ANALYSIS

How people (are assumed to) behave:

* Economic reasoning (cost-benefit analysis): For any decision, people compare the costs and benefits.
-- If benefits > costs, do it.
-- If costs > benefits, don't do it.

* Optimization (a bit stronger than merely saying people compare costs and benefits): Individuals (and firms) make the best decisions for themselves. People know ~what's best for themselves, and that's what they do. (No $500 bills on the sidewalk.)
-- Obviously not the most realistic model of human behavior, but it is about the simplest, because you don't have to worry about people's errors. Modeling mistakes is hard.
---- "You're here because you have nothing better to do."
---- What is it that people optimize?
------ People maximize "utility" (happiness/satisfaction)
------ Firms maximize profits (revenues - costs)

--> Marginal analysis (not a separate assumption, but rather something that can be deduced from the assumption that everyone optimizes): "optimal," "rational" decisions are generally made at the margin (e.g., in cost-benefit analysis, does marginal benefit exceed marginal cost?)
---- Ex.: selling a house in Oswego: Do I wait for prices to rise back up to what I paid for the house, so that I can break even (or, better yet, sell it at a profit)? Or do I just sell the house now, cut my losses, and move on? If you don't expect prices to rise anytime soon, you cut your losses and move on. What you paid for the house is a sunk cost -- it cannot easily be recovered. A rational decision about whether to sell it now or later is not affected by what you paid for the house, but where prices are now and where they'll be in the future.
---- Ex.: airlines' student travel discounts. One such discount was student round-trip tickets to the West Coast for $189, which is a small fraction of what those tickets normally go for. Suppose the average cost is about $300. Why would the airlines go along with a program like that?
------ A: For a plane that's about to take off with some seats empty, the MC of another passenger is essentially zero (or whatever the Coke and peanuts are worth); the total cost of the trip is essentially unchanged by an extra passenger.
--------> Setting aside a few seats for discounts (incl. standby) can be profitable even if the fare for those seats is far below the AC per seat. As long as the MR ($189) > MC ($0), setting aside an extra seat is profitable.
 

III. SCARCITY, TRADEOFFS, AND EFFICIENCY

Scarcity and opportunity costs imply ...
"tradeoffs" (if you want more of one thing, you have to settle for less of another)
--> PRODUCTION POSSIBILITY FRONTIER (PPF): a graph that shows all the combinations of goods (in a 2-good economy) that can be produced if all of society's resources are used efficiently (i.e., no waste)
-- [We saw an overhead of a PPF in class. A very similar PPF appears on p. 31 (Figure 2.3) of Case & Fair's textbook. I also drew a point inside the PPF, which corresponds to point D in Case & Fair's diagram.]
---- Efficiency: producing at the least possible cost (no waste)
---- Q: What's wrong with the point inside the PPF?
---- A: It's inefficient - it's possible to have more of both goods, so why not just produce more of both?
---- Along the PPF, the slope (rise over run, Dy/Dx) is negative, because there is a ...
------ TRADEOFF: more of one good means less of the other
------ slope = opportunity cost (of producing one more unit of the good on the horizontal axis)

The PPF is curved this way ("convex") because of
DIMINISHING RETURNS: as you produce more and more of a good, the cost of producing that good increases. That is, producing an extra unit of output requires more inputs than it did before.
-- Why: Production generally exhibits diminishing returns in the short run because some factors (capital, land) tend to be fixed in the short run.

A PRODUCTION FUNCTION shows the relationship between labor and output, and also illustrates the "law" of diminishing returns. It is curved in such a way ("concave") that its slope becomes flatter and flatter as you move from left to right. What that means is that as you add an extra unit of labor, the resulting addition to output becomes smaller and smaller. In other words, production is subject to diminishing returns.
-- [We saw an overhead of a typical production function in class. Case & Fair's book unfortunately does not have a picture of a production function, so at some point I will add a link to a picture of a production function that I've drawn myself.]

So now we've seen scarcity, in a picture. Now,

Q: How do we allocate all those scarce resources?
A: MARKETS and PRICES.

Microeconomic theory is often called PRICE THEORY, because in a free-market system the basic coordinating mechanism is price.

On a related note, you might think about the canned tuna fish that you buy at the supermarket. Some of it is marked "dolphin-safe," whereas some of it is not. Most of us naturally recoil at the thought of cute, intelligent dolphins being routinely slaughtered in tuna nets just because they happen to swim with tuna. Virtually nobody is completely indifferent to the plight of those poor dolphins. Yet tuna that is "dolphin-unsafe" continues to be sold, and in fact there is a type of tuna that has always been dolphin-safe: albacore tuna, because those tuna don't swim with dolphins.
--> So why wasn't everyone eating dolphin-safe tuna all along?
---- A: Non-albacore tuna is a lot cheaper. While everybody likes dolphins, a great many people are not willing to pay a bit more for their tuna in order to prevent dolphins from being killed. So "dolphin-unsafe" tuna is still on the supermarket shelves.  This brings us to the "Law" of Demand.
 

IV. DEMAND

Someone once said an economist is nothing more than a trained parrot that says "Supply and demand... Supply and demand..." over and over again. But, there are worse things you could teach a parrot to say, and we hear them every day.

Let's start with demand, which is really the simpler of the two concepts.

DEMAND CURVE: a graph showing how much of a given product people will be willing to buy at different prices.
-- "Law" of Demand: As the price of a good goes up, the quantity demanded of that good goes down
----> demand curves slope downward
-- [We saw an overhead of a demand curve, much like the demand curve in Case & Fair's Figure 4.2 (page 72).]
-- [I drew a second demand curve, for potato chips, using real numbers on the P and Q axes.]

Parting question: Why is it that when the price of a bag of potato chips is reduced from $1.50 to $1.25, people will buy more? There are two reasons - what are they?

***

[Wed., Feb. 5 - LECTURE CANCELED - I arrived more than 15 minutes late.]

***

WEEK 2, LECTURE 5
Fri., Feb. 4, 2000

0. IMPEDIMENTA

* Today: Micro review, Part II: Demand (finish)

* QUIZ (answers will be posted on the WWW at a later date)
 

DEMAND (finish)

Where we left off:

Q: Why do demand curves slope downward? If the price of potato chips falls from $1.50 to $1.25 a bag, why is it that people will buy more?

Why demand curves slope downward:
(1) INCOME EFFECT: As the price of a good falls, your real income (in terms of that good) rises; you can now afford to buy more of it, and so you do.
(2) SUBSTITUTION EFFECT: As the price of a good falls, its relative price (i.e., its price relative to other goods' prices) falls, causing you to buy less of other goods (especially close substitutes) and more of that good.
These two effects reinforce each other.

Note well:
CHANGES IN DEMAND (shifts of the demand curve)
are different from
CHANGES IN QUANTITY DEMANDED (occur in response to price; movements along the demand curve).
-- [I illustrated this in class with an overhead of two demand curves. Case & Fair's Figure 4.4 (p. 78) tells a similar story.]
-- The same goes for supply curves.

To repeat: A change in a good's price causes a movement along the demand curve for that good. What causes the demand curve to shift?

Things that cause demand to increase (demand curve shifts out, people are willing to pay more for the good, and want more of it):
(1) Higher incomes (for normal goods, as people get richer, they buy more of the good)
(2) Increased population
(3) Increased popularity of a good (from changes in people's tastes)
(4) Increases in the price of other, substitute goods
---- Ex.: If CD's become more expensive, the demand for tapes will go up.
(5) Decreases in the price of complementary goods (goods that are used together with the first good)
---- Ex.: If tape decks become cheaper, the demand for tapes will go up.

Exs.
 
Enrollment at SUNY-Oswego is up, so there is more demand for economics textbooks. 

--> demand curve shifts up;
      demand increases.

The College Store cut the price of new textbooks, so more economics textbooks are being sold. 

--> movement along the demand curve; 
      quantity demanded increases.

-- [The graphs that accompanied these examples were again similar, though not identical, to two of the graphs in Case & Fair's Figure 4.4 (page 78).]