CMGT 599 Economic Impact of Innovation

ECON 500 Week 1

ECON 500 –Microeconomic Theory

Week 1 Preliminaries ECON 500 Week 1

Microeconomic Theory

In economics, explanation and prediction are based on theories. Theories are developed to explain observed phenomena in terms of a set of basic rules and assumptions.

Economics uses theory to explain actions and predict future actions.

A model is a mathematical representation, based on economic theory, of a firm, a market, or some other entity.

Theory does not work well all the time. The market test of theory is how well it does in comparison to another theory. A theory must have the possibility to being proved wrong. ECON 500 Week 1

Economics:

οἰκονομία

οἶκος (oikos, "house") νόμος (nomos, "custom" or "law") ECON 500 Week 1

Economics:

The social science concerned with:

How to allocate scarce resource, with alternative uses between unlimited and competing wants ECON 500 Week 1

"Economics is the science of choice. It began with Aristotle but got mixed up with ethics in the Middle Ages. Adam Smith separated it from ethics, and Walrus mathematized it. Alfred Marshall tried to narrow it, and Keynes made is fashionable. Robbins widened it, and Samuelson dynamized it, but modern science made it statistical and tried to confine it again.

But the science won't stay put. It keeps cropping up all over the place. There is an economics of money and trade, of production and consumption, of distribution and development. There is also an economics of welfare, manners, language, industry, music, and art. There is an economics of war and an economics of power. There is even an economics of love.

Economics seems to apply to every nook and cranny of human experience. It is an aspect of all conscious action. Whenever decisions are made, the law of economy is called into play. Whenever alternatives exist, life takes on an economic aspect. It has always been so. But how can it be?

It can be because economics is more than just the most developed of the sciences of control. It is a way of looking at things, an ordering principle, a complete part of everything. It is a system of thought, a life game, an element of pure knowledge. ECON 500 Week 1

The fundamental economic problem: Scarcity

Seemingly unlimited human needs and wants, need to be satisfied in a world of limited resources.

Society has insufficient productive resources to fulfill all human wants and needs, therefore not all of society's goals can be pursued at the same time; trade-offs are made of one good against others.

Opportunity Cost:

The maximum benefit forgone by using scarce resources for a particular purpose. It is the benefit provided by the next best use of that resource. ECON 500 Week 1

microeconomics

Branch of economics that deals with the behavior of individual economic units—mainly, consumers and firms—as well as the markets that these units comprise and the interactions therein. ECON 500 Week 1

AGENDA

Economic Lens Theories and Models Marginal Thinking Demand and Supply

Consumer Theory Firm Theory Utility Maximization Profit Maximization Preferences and Budget Productivity and Costs

Market Structures Competition and Welfare Imperfect Competition and Market Power Input Demand, Capital and Time Market Failures ECON 500 Week 1

A model is a mathematical representation, based on economic theory, of a firm, a market, or some other entity.

Models inevitably make heroic abstractions (arguably more so than other sciences) from the complexities of the real world, but they still provide aid in understanding economic behavior.

Theories and models do not work well all the time. Another important purpose of science is to separate good ones from the bad. ECON 500 Week 1

Two general methods used to verify economic models:

Direct approach Tries to establishes the validity of the model’s assumptions

Indirect approach Tries to show that the model correctly predicts real-world events ECON 500 Week 1

An Example: Profit Maximization Model

Assumes that profits are the only relevant goal of the firm.

Other possibilities such as power, prestige, revenue, stock price, shareholder satisfaction are treated as unimportant.

Assumes that the firm has sufficient information about the cost and market conditions.

Direct Approach Indirect Approach Can we validate the assumptions? Can we find testable predictions? Inconclusive Yes. In accord with reality ECON 500 Week 1

An Example: Profit Maximization Model

A firm can sell all the output that it wishes at a price of p per unit

Total costs of production, C, depend on the amount produced, q

Profits = π = pq – C(q)

The profit-maximization output level, q* is determined by

First-order condition: Output level for which price is equal to marginal cost, C’(q)

Second-order condition: Marginal cost must be increasing at q* ECON 500 Week 1 Deriving a testable prediction:

First-order condition:  d  p  C'( q )  0 or p  C'( q ) dq   Second-order condition:  d 2  2  C"( q )  0 or C"( q *)  0 dq  d( p C '( q *)  0)dq * 1 C "( q *)  0 dp dp dq* 1    0 dp C"( q *) ECON 500 Week 1

General Features of Economic Models:

Ceteris Paribus assumption

“Other things the same”

Focus on only a few forces at a time Other variables are assumed to be unchanged ECON 500 Week 1

Optimization assumption

Economic actors are assumed to be rationally pursuing some goal

Consumers: maximize utility Firms: maximize profits (or minimize costs) Government regulators: maximize public welfare

Generates precise, solvable models Appear to perform fairly well in explaining reality ECON 500 Week 1

Positive-normative distinction

Positive economic theories Seek to explain the economic phenomena that are observed

Normative economic theories Focus on what “should” be done ECON 500 Week 1

General Structure of Economic Models: ECON 500 Week 1

Thinking at the Margin

Very small changes from status quo are essential in decision making ECON 500 Week 1

Very small changes from status quo are essential in decision making

Idea goes back to:

…external goods have a limit, like any other instrument, and all things useful are of such a nature that where there is too much of them they must either do harm, or at any rate be of no use.

Aristotle Politics ECON 500 Week 1 ECON 500 Week 1

Economic activity persists until benefits and costs are equal at the margin

Consumer context: Marginal Utility vs Marginal Cost Producer context: Marginal Revenue vs Marginal Cost Social Context: Social MB vs Social MC ECON 500 Week 1

Theory of Value and the development of the Marginalist Revolution

The Marginalist Revolution

The exchange value of an item is determined by Not the usefulness of the aggregate But by the usefulness of the last unit consumed

Water is plentiful, therefore additional units has a low value in exchange Diamond is scarce, therefore additional units have high value in exchange ECON 500 Week 1

Theory of Value and the development of the Marginalist Revolution

The Marshallian Supply-Demand Analysis

Prices reflect both the marginal valuation that consumers place on goods and the marginal costs of producing the goods

Supply and demand simultaneously operate to determine price ECON 500 Week 1 ECON 500 Week 1

A more general model

qD = a + bp qS = c + dp

Equilibrium  qD = qS

a + bp = c + dp

a c p*  d b ECON 500 Week 1

Comparative Statics:

What happens to the equilibrium price if either demand or supply shift?

dp* 1   0 da d b

dp* 1   0 dc d b

An increase in demand (an increase in a) increases equilibrium price

An increase in supply (an increase in c) reduces price ECON 500 Week 1

From Partial to General Equilibrium

The Marshallian model is a partial equilibrium model that focuses on price determination in only one market at a time.

Prices are signals that communicate the relative scarcity of goods across various markets.

For more general questions, we need a model of the entire economy that includes the interrelationships between markets and economic agents

One Simple model that provides a few general equilibrium insights is the production possibilities frontier model. ECON 500 Week 1 ECON 500 Week 1

PPF Model highlights that the resources in an economy are scarce and the economy is always faced with trade-offs and provides two insights that are not clear in Mashallian partial equilibrium

Each choice has opportunity costs

Opportunity costs depend on how much of each good is produced in a systematic way ECON 500 Week 1