Chapter 1 Manual for Microeconomics

CHAPTER 1 The Principles and Practice of Economics I. Key Ideas Economics is the study of people’s choices. The first principle of economics is that people try to optimize: they try to choose the best available option. The second principle of economics is that economic systems tend to be in equilibrium, a situation in which nobody would benefit by changing his or her own behavior. The third principle of economics is empiricism—analysis that uses data. Economists use data to test theories and to determine what is causing things to happen in the world. II. Getting Started The Big Picture The goal of this chapter is to introduce readers to economists’ perspective—we tend to envision a world populated by a variety of rational, self-interested people trying their best to make good decisions in the presence of numerous real-world constraints. These decision-making economic agents may be individuals, groups, or organizations, and they could be motivated by many different objectives, but they face a common problem: how to allocate scarce resources across competing ends. The authors identify three principles (optimization, equilibrium, and empiricism) that characterize economic thinking and distinguish it from the approach other social sciences take. These three underlying themes provide a foundation for subsequent chapters and a way for beginning students to draw connections between seemingly different branches of economics. We will use insights from cost-benefit analysis to describe the world (positive economics) and offer advice (normative economics) on everything from simple decisions to complex public policies. Where We’ve Been Students probably have not previously read the material found Chapter 1 in a typical textbook, so this chapter is their first exposure to ALL. However, while we haven’t been anywhere yet in ALL, your students have been other places. One could imagine a variety of possible student audiences who might take an economics course using this book. For instance, students may vary based on their experience with economics, math, or life (e.g., 18 year-olds, working thirty-somethings, retirees), citizenship, gender, religious preferences, or a host of other traits. It is often worthwhile to gather some basic information about your audience early in the term. A low-cost way to do this is by asking some of the following questions on a Student Information Card: Name (and how to pronounce it correctly) Phone number (to be used only in cases of academic emergencies, such as oversleeping for the final exam; this assumes the instructor can identify missing students, perhaps by labeling exams with student names) Hometown (and what is it known for) Anticipated major(s)/minor(s)/program(s) Previous economics or math courses Three interesting facts about you, the student Three favorite products, firms or industries Dream job Post-graduation plans Questions, concerns, comments, or topics you hope the class will cover Most students are happy to volunteer such information (on Facebook or in class) and collecting it can benefit an instructor in several ways. First, it signals that the instructor cares, regardless of whether there are 20 or 200 students. Second, it provides useful information about the level at which to pitch the material; if most students in the class have already taken a course in macroeconomics, then an instructor could proceed quickly through familiar topics such as supply and demand diagrams and welfare analysis, whereas if this is the first course for many, then one should expect to spend more time on the basics. Third, it helps the instructor tailor the course by using real world examples that will resonate with the class; for instance, one might discover that many students plan to move to New York to work on Wall Street, they like Under Armour or Lululemon clothing, or they frequent a local coffee shop. Fourth, it inspires conversations after class, during office hours, or by e-mail; students appreciate career advice, and some will likely ask for recommendations someday. Where We’re Going Chapter 1 sets the stage for the rest of the textbook by introducing the three principles of economics: optimization, equilibrium, and empiricism. Here’s a quick summary of the major topics of the first seven chapters, highlighting the presence and use of these three principles: Chapter 1 The Principles and Practice of Economics: introduction to the three principles, especially optimization and equilibrium; an empirical look at Facebook and the opportunity cost of your time Chapter 2 Economic Methods and Economic Questions: overview of empiricism; an empirical look at the returns to education Chapter 3 Optimization: Doing the Best You Can: the two major types of optimization (by levels and by differences); choosing apartment location based on commuting time and rent; an empirical look at why housing prices vary geographically Chapter 4 Demand, Supply, and Equilibrium: introduction to the competitive market equilibrium; an empirical look at why oil prices vary geographically Chapter 5 Consumers and Incentives: optimizing buyers generate demand curves (which are related to price-elasticity of demand and consumer surplus); an empirical look at how financial incentives affect the decision to quit smoking Chapter 6 Sellers and Incentives: optimizing sellers generate supply curves (which are related to costs, inputs, technology, and producer surplus); an empirical look at how ethanol subsidies affect ethanol producers Chapter 7 Perfect Competition and the Invisible Hand: in a competitive market, optimizing selfish individuals generate equilibrium with socially desirable characteristics; an empirical look at how markets function using experiments involving double oral auctions or open-air markets Subsequent chapters also feature optimizing agents, equilibrium models, and the empirically minded sections entitled Evidence-Based Economics. Number of Lectures Of all of the chapters an instructor chooses to cover, this is probably the one that s/he would trust students to read on their own, though it introduces some material, particularly the concept of opportunity cost, that is essential for beginning students to understand. There is little math—just the annual opportunity cost of spending an hour each day on Facebook—and the essence of the chapter is introducing the three principles of optimization, equilibrium, and empiricism, which are covered in more detail in the next few chapters, and which will appear consistently throughout the ALL text. Depending on the students’ backgrounds, anticipated pace of the term, and instructor’s faith in the ability of students to grasp nuances by reading, one could spend up to one 60-minute lecture presenting Chapter 1. Opening Question and Evidence-Based Economics “What is the cost of using Facebook?” This is a terrific way to open the textbook for many reasons. First, it is a topic to which today’s students can easily relate; many of them may have been on Facebook shortly before reading this chapter! Second, it introduces a clear choice about how students use their time. Third, it immediately forces them to ponder the meaning of the word “free”—should it refer only to out-of-pocket costs (direct cash outlays) or should it include the opportunity cost of time spent on Facebook? Finally, it gets them thinking about how one might compute the true cost of spending hours on Facebook and prepares them to start thinking mathematically about such matters. The way the authors start the book is often a good way to start class: presenting an interesting, accessible, real-world problem to motivate the lecture and continually reinforce the idea that there is a compelling reason to learn what’s about to be taught. It is hard to produce a one-size-fits-all book, so if a particular example is not familiar or it is possible to find a similar example that students will find more accessible or interesting, by all means adapt the material to appeal to the audience. For instance, the essence of the Facebook scenario is the student would be spending an hour on an activity with no explicit cost; s/he could just as easily be reading a library book, watching YouTube videos, playing the latest hit video game, or taking a long walk. III. Chapter Outline The Scope of Economics When told to wash the family car, the teenage daughter has several options, including “she can move out (admittedly a drastic response, but still a choice).” One may find that the dramatic—yet feasible—responses can launch fruitful discussions in or after class. For example, if a student needs a truck and two helpers in order to move from campus to an apartment, there are numerous interesting ways to get a truck (buy it, rent it, build it, steal it) or labor (pay cash, barter, use guilt, use physical threat); modern society frowns on the more controversial of these, but one can see how someone may have justified them using cold-hearted cost-benefit analysis. Indeed, plenty of laws are designed to prevent economics from becoming an over-riding concern in issues, such as euthanasia for the terminally ill. Teaching Idea: Ask your class the following question: What are some of the choices you made today leading up to this minute? A: Breakfast (whether to eat, what to eat, how much to eat), clothing (bring an umbrella?), attend class, transportation (walk, run, bike, bus, drive, hitchhike). Economic Agents and Economic Resources—A wide variety of individuals, groups, and organizations make choices regarding scarce resources; the most common economic agents are households, firms, and governments. Because we have unlimited wants but resources are limited, we face interesting choices about how to allocate these scarce resources. In several pages, the authors will discuss optimization, the idea that each of the economic agents makes choices to pursue a particular objective. To the current list in Exhibit 1.1 one might add government, regulatory agency, or bureaucrat, and ponder what it is that motivates each of these decision makers. Economic agents are the players in our fanciful world of economic theory, in which economists can pretend to be Zeus, throwing lightning bolts at the mere mortals just to see how they respond and react to the changing environment. Teaching Idea: Ask your class: Which different types of economic agents does one find at a college or university? A: The institution (usually a non-profit), various schools or divisions, departments, faculty, students, administrators (president, provost, deans), support staff “…decisions determine how scarce sports cars are allocated in a modern economy: to the consumers who are able and willing to pay for them.” One might ask students whether this seems fair and refer them to the discussion of fairness in Chapter 18 (Social Economics). One might highlight the statement, “Economists don’t want to impose our tastes … on you,” and introduce the Latin phrase De gustibus non est disputandum, which means there is no accounting for taste: Economists are more interested in the fact that you prefer Lady Gaga’s music to Katy Perry’s music, rather than the reasons behind that preference. Definition of Economics—Economics is the study of how agents choose to allocate scarce resources and how those choices affect society. Agents may not be aware of all of the ways their choices affect other agents. Positive Economics and Normative Economics—Economists describe the choices agents actually make (positive economics) and prescribe or recommend the choices that agents should make (normative economics). Economists are well equipped to offer advice on public policy, such as ongoing legislation to tax sugary sodas in order to curb obesity. It is important to remember that economists have no moral authority on such matters. Furthermore, it may be difficult for an economist to remain fully objective because his/her personal opinions and values are likely to affect such advice. Public policies create winners and losers, so there may be much to gain by agents who can influence the political process—or economists’ advice—to their advantage. Hence, policy analysis naturally inspires the appearance of lobbying. The words should and ought typically indicate a normative statement. Similarly, words such as better or worse project a subjective opinion, whereas words like increase and decrease seem more objective. Microeconomics and Macroeconomics—Microeconomists study small pieces of the economy, such as the output, pricing, and hiring decisions of a single firm, or of several firms in a particular market, whereas macroeconomists study the economy as a whole, which consists of many firms in many markets. Different types of problems require different types of models. In general, a macroeconomy can be thought of as an aggregation of many microeconomic parts, but in order to construct working models of national economies, macroeconomists need to make simplifying assumptions (e.g., imagining a representative household or firm instead of millions of heterogeneous individual actors). For example, in the well-known Keynesian model, total spending in a macroeconomy could be decomposed into nation-wide spending by households, businesses, governments, and those involved in international trade; in contrast, a microeconomist might model a household’s demand for a laptop, the local market for laptops, or the effect of an educational policy that subsidized the purchase of laptops by families with high school students. Common Mistakes or Misunderstandings: The division between macroeconomics and microeconomics is not always clear. We tend to analyze the minimum wage and hiring decisions in microeconomics but focus on broader labor market issues, such as the labor force participation rate and the unemployment rate, in macroeconomics. For example, the national market for low-skilled workers could be thought of as either a particular labor market (microeconomics) or a national labor market (macroeconomics). Macroeconomic fiscal policy, such as an income tax cut, works by altering the budget constraints of millions of individual households, each of which is solving a microeconomic optimization problem. The division is useful for beginning students, but by the time economics majors are seniors, we hope that they see the two branches of economics are closely linked. 1.2 Three Principles of Economics Economics is a social science, but economists look at the world differently than do anthropologists, historians, political scientists, psychologists, and sociologists. In particular, economists highlight three key concepts: optimization, equilibrium, and empiricism. It’s useful to point out that a well-read student can view the world through several perspectives, and no single perspective is right or wrong, though we are confident that the economist’s perspective is particularly useful because of our explicit, up-front assumptions, (mostly) mathematical models, and use of data to continually test whether the models help us make real world predictions. One might contrast economics and history to get a better sense of the economist’s perspective. An economist might try to model and understand my lunchtime dining optimization problem, and once s/he understands my incentives and behavior, then s/he can better understand how my colleagues behave. That is, economists like to set up generalizable problems that can be used to solve a variety of similar, related problems. In contrast, historians may focus on a particular event and argue that unique circumstances generated a noteworthy outcome. In short, economists seem more likely to try to answer a range of similar questions, whereas historians (stereotypically) are more likely to claim that each unique question has a unique answer. 1.3 The First Principle of Economics: Optimization A fun exercise is to make a list of the real world constraints that make choices interesting. For instance, constraints might be financial (just $20 in my wallet), chronological (just 24 hours until the final exam), physical (can’t dunk a basketball), legal (can’t buy ecstasy at CVS), social (shunned for nonconformance), spiritual (it’s against my religion), mental (can’t understand phrenology), philosophical, ethical, guilt-based, etc. Cultural differences also go a long way in explaining why people from different backgrounds may act differently in a given situation—and these different actions may be perfectly rational! Another fun exercise is to make a list of all of the things one could be doing right now instead of sitting in class. Optimization means choosing the highest ranked option out of a menu of options. “It is important to note that the test of optimization is the quality of your decision, and not the outcome.” Economists tend to be forward-looking: if you made the best decision at the time, given limited information and other constraints, then you did the best that you could. “…what we optimize varies from person to person and group to group.” If someone makes a very different choice from what you would do, it could be due to different preferences or different constraints. Also, “most governments are trying to optimize a complex mix of policy goals.” If it seems difficult to understand government, remember that it’s likely that there is much more going on than meets the eye. Armed with insights from solving simple optimization problems, we can turn our attention to more complex problems. Teaching Idea: Several important concepts are covered in this section, and the order of presentation in the book—budget constraints before opportunity costs—may not be ideal for everyone. Another approach is to start with resource scarcity, then introduce the necessity of making choices, which requires thinking about trade-offs, and for every choice there is an alternative forgone (an opportunity cost); finally, we use a budget constraint (in an intuitive, algebraic, and/or graphical form) to help with our analysis of how to make these trade-offs. Common Mistakes or Misunderstandings: Warn students not to go too far in assuming that households try to maximize income and firms try to maximize profit. It is usually easier to convert payoffs into dollars, but economics isn’t preoccupied with making money. In the upcoming discussion of opportunity cost, it is convenient to dollarize options such as working locally at a family restaurant or moving to New York to work in finance, but the fundamental issue is that one person cannot be in two places at one time, so the resource constraint (scarce time) forces the decision. Trade-offs and Budget Constraints—In order to get one thing, we must give up something else; we illustrate this simple trade-off concept with a budget line, which shows all of the combinations of goods that are affordable with one’s current income. Teaching Idea: Students could revisit the list of choices they have already made today and make a corresponding list of things they didn’t choose. A student who had cereal for breakfast may have chosen not to have pancakes, fresh fruit, or an omelet. The two easiest budget constraints to think about involve dollars and hours. $100 could be spent on smartphone apps or food, and 24 hours in a day could be allocated to sleeping, studying, exercising, or other activities. If you can exactly afford something then you have a binding budget constraint, whereas if something is affordable and you still have leftover resources, then that budget constraint is non-binding. For example, Exhibit 1.2 shows six different combinations of hours web-surfing and hours working at a part-time job; in all six cases, the two types of hours sum to five, so they are exactly affordable and the five-hour time constraint is binding. Opportunity Cost—For every option chosen, there is at least one option not chosen, and we refer to the best of these forgone options as the opportunity cost. It is often useful to use the value of the best alternative forgone, and if we conservatively value a set of hours spent on one activity, we can imagine those hours spent on a part-time job earning the going wage. Teaching Idea: A useful exercise is to ask students to identify the costs of attending college for a fifth year. Students are quick to list the explicit costs of tuition and books, but they tend to overlook the implicit cost of a year’s forgone salary. An important insight is that opportunity costs are often hidden and easily overlooked. The opportunity costs of using a resource are often the income one could obtain by selling or renting out that resource; this is true whether the resource is a building, a vehicle, or a person’s time. Cost-Benefit Analysis—To compare two or more alternatives we identify all of the relevant costs and benefits, compute net benefit (equal to that alternative’s total benefit—total cost) for each option, and then identify the alternative(s) with the highest net benefit. Maximizing net benefit is equivalent to optimizing. It can be tricky to assign dollar values to some activities. One could use an hour on Sunday evening to do homework, watch Netflix, read a book, or go to bed early. Here, it makes sense to think of the one hour expended as the cost and then pick the activity that makes one happiest, rather than trying to convert the hour of time and the happiness into dollars. The authors write, “Economists are not popular for making some of these ‘cold-hearted’ calculations.” One could add that people needn’t follow the advice of economists, but our perspective does provide a starting point for discussions on how to proceed. The book’s example of whether to fly or drive to Miami focuses on the cost savings and the value of the time spent driving (the opportunity cost). One could ask a class what other things should be taken into consideration. For example, the analysis omits whether one enjoys hitting the open road, listening to music, chatting for hours, eating at small town diners, speeding, etc. The point is that we should identify and count all relevant costs and benefits. Evidence-Based Economics: What is the cost of using Facebook? A straightforward approximation of the annual opportunity cost of spending one hour per day on Facebook multiplies a reasonable after-tax wage for 16- to 24-year-old students by the number of hours on Facebook per day, and by the number of days in a year: The authors suggest alternative ways of spending $3,650 and ask whether 365 hours of Facebook is indeed preferable to the alternatives (such as leasing a sports car or taking short trips to Paris and the U.S. Virgin Islands). To launch an entertaining and useful discussion, one might ask whether students are aware of this cost, what benefits they get from using Facebook, and whether we should use this reasoning to evaluate a daily hour of exercise, reading, or personal hygiene. 1.4 The Second Principle of Economics: Equilibrium Whereas optimization is about economic agents making self-interested choices in complex environments, equilibrium is the idea that an economy consists of an aggregation of many such agents who are simultaneously optimizing. The book’s presentation of equilibrium prepares students not only for the equilibrium in a competitive market, but also for the Nash equilibrium covered in Chapter 13. In equilibrium, no single player believes s/he would benefit by changing his or her own behavior, so the economic system reaches a point of stability. Alternative Teaching Examples: Some modest variations on the example of shoppers picking checkout lines are cars on a tollway queuing up to pay tolls, fans picking turnstiles at a major sporting event, or hungry customers picking lines at the Golden Corral or Old Country Buffet (all-you-can-eat buffet restaurants). One should go through the three conditions that must be satisfied for there to be equilibrium in the gas market, as this does a great job of establishing price as a rationing mechanism. In particular, one could highlight the fact that as gas prices rise, more and more wells around the world become profitable for producers to operate, whereas higher prices discourage buyers from using gas for low-value activities. In later chapters on supply and demand, the equilibrium price effectively chops off the upper right part of the market supply curve and the lower right part of the market demand curve, thereby eliminating those sellers and buyers who are not willing and able to transact at the going market price. The Free Rider Problem—Given human nature, it would not be a surprise to find situations in which one can enjoy benefits without bearing one’s share of the cost. The authors use lazy roommates (nobody wants to clean up) and turnstile jumpers (who enjoy using the subway without paying) as examples of free riders. Students are likely familiar with free riders in the context of group projects. The free rider problem is defined and explained further in Chapter 9. One might say that there can be good equilibria and bad equilibria. As the authors point out, if everybody jumped the subway turnstiles (i.e., nobody paid to ride the train), then the subway system would run out of cash. To prevent this from happening, authorities might intervene in a way that alters incentives, such as installing jumper-frustrating turnstiles, patrolling the area, installing security cameras, or otherwise raising the cost of turnstile-jumping. 1.5 The Third Principle of Economics: Empiricism Economists gather data and use statistical analysis to evaluate whether economic theories do a good job of explaining and predicting real world human behavior. They also try to understand causality—whether one event causes another to occur. This topic is covered well in Chapter 2. 1.6 Is Economics Good for You? Students who master the principles of economics will be better prepared to make decisions, both large and small. Teaching Ideas: At the beginning of the term, an instructor could ask a class for specific economic questions they would like to answer. It is surprising how many questions one can address in a term if one classifies them by lecture. For example, gather questions about labor markets, externalities, profit-maximizing firms, etc., and at the beginning or end of the labor market lecture, mention some of these questions and at least sketch out how one would go about answering them. Here are some situations in which knowing some economics can save (or make) one a lot of money: Deciding if/when/where to attend graduate school Negotiating a labor contract with a potential employer Choosing whether to buy or lease a living space Investing for retirement Shopping for a loan to buy a vehicle or living space Students new to economics sometimes cannot see the forest for the trees, so it can be helpful to reassure them that all of these topics in microeconomics are indeed related and can be connected quite nicely with the three themes. VI. Active Learning Exercises 1. (Trade-offs; Opportunity Cost; Cost-Benefit Analysis) A person in the community calls and asks you to babysit for four hours on Friday night. You know the job will pay $10 per hour. You are currently planning to hang out with your friends on Friday night. If you accept the offer to babysit, what can your friends determine about how much you would have valued the time spent with them? Solution: If you are willing to accept a job for $10 per hour and we assume you are optimizing, then we can say that you value the time with your friends less than $10 per hour. In other words, the opportunity cost of babysitting is the time you are giving up with your friends, and you must value this at less than $10 per hour or you would turn down the job. 2. (Trade-offs; Opportunity Cost; Cost-Benefit Analysis) Your friend Charles asks you to drive him to the airport. He says that he will reimburse you for the cost of going to the airport. It is a two-hour roundtrip to the airport, and you will use $15 of gas. If Charles pays for the cost of gas, has he paid your full cost of taking him to the airport? What other costs is Charles forgetting? Solution: The opportunity cost of driving Charles to the airport includes the direct cost of $15 for gas for driving to the airport. However, it also includes the depreciation in the value of the car used to drive to the airport (the car is now worth less with the additional miles) and the value of the best alternative use of the two hours you spent driving. It might have been working a part-time job, studying, or exercising. The opportunity cost of driving Charles to the airport is clearly more than the $15 in gas. 3. (Free rider problem) Professors sometimes assign group work so that students develop their ability to work in teams. In a few sentences, discuss the free-rider problem in the context of group work. Is the problem likely to be more or less significant in a group of students who are close friends when compared to a group of students who do not know each other? Solution: In group work, students have an incentive to let their peers do the work. The free rider problem is often less of a problem when the students know each other. This would be true if the friends were able to punish each other (if they do not do the work) with social pressure or in future interactions. If the students do not know each other and are not likely to interact in the future, then there may be less social pressure and the students could not punish a free-riding peer if the group will not be seeing the free rider again after the assignment.