Chapter 2 Thinking Like an Economist

1
Chapter 2Thinking Like an Economist
2
The Basic Competitive Model

• Rational consumers
• Profit-maximizing firms
• Competitive markets
• Government is ignored for now

3
Rational Consumers

• Scarcity forces us to make choices.
• Economists assume individuals and firms make
  choices rationally
• Pursue what they see as their own self-interest
• Weigh costs and benefits as they see them
• If benefits costs, take the action
• However, different people have different
  interests
• Economists do not judge people's preferences.

4
Profit-Maximizing Firms

• For firms rationality means maximizing profits.
• Profit revenue ? costs
• Revenue pQ, where p price and Q quantity
• Profit pQ ? costs

5
Information Costs

• Individuals and firms often make decisions with
  little or no information.
• Is the car a lemon?
• Will the worker be productive?
• Will the investment be profitable?
• Rationality applies to acquiring information to
  answer these questions.
• If the benefit of more information the cost of
  acquiring the information, the information is
  acquired.

6
Competitive Markets

• Many firms sell identical products to many
  consumers.
• Firms and consumers are price takers in
  competitive markets.
• Firms provide as much output as consumers will
  buy.
• Each firm can sell as much as it wants the size
  of the firm is small compared to the size of the
  market.
• If firms charge a price higher than the market
  price, they lose all their customers.
• All firms in the industry charge the same price.

7
The Basic Competitive Model as a Benchmark

• Combines self-interested consumers,
  profit-maximizing firms, and competition
• The model is tested by comparing its predictions
  with actual markets.
• Economists believe this model can provide answers
  to the four basic questions
• What is produced, and in what quantities?
• How are goods produced?
• For whom are those goods produced?
• Who decides the answers to the first three
  questions, and how?
• Government is not needed to answer these
  questions in the basic competitive model.

8
Efficiency in the Basic Competitive Model

• The basic competitive model is efficient.
• That means scarce resources are not wasted.
• It is not possible to produce more of one good
  without producing less of another good.
• It is not possible to make one person better off
  without making someone else worse off.
• Known as Pareto efficiency

9
Income

• Income is an incentive for consumers, workers,
  investors, and firms.
• Consumer or household income is personal income.
• Firm income is revenue divided between costs and
  profit.

10
Property Rights

• The right of the owner to use and sell his or her
  property.
• With well-defined property rights, access is
  excludable, rivalrous, and transferable.
• A combination of freedom and responsibility is
  crucial to markets.
• Freedom Individuals and firms must be free to be
  creative and try new techniques.
• Responsibility Individuals must reap the reward
  if successful or suffer the losses if not.

11
Incentives versus Equality

• Well-defined property rights permit incentives to
  provide rewards and costs.
• If rewards are tied to performance, then a
  problem arises when many people help to produce a
  good or service.
• Who contributed what?
• Who are the most productive employees is the hot
  salesperson good or just lucky?

12
Performance-Based Compensation

• Even if pay can be tied to performance, how does
  one measure performance?
• If compensation is tied to performance, this
  leads to inequality since different people
  perform differently.
• However, if this inequality is from luck, would
  another criterion of compensation do "better"?
• Some economists hold equality as a value in its
  own right.

13
When Property Rights Fail

• In many cases property rights are not clearly
  defined.
• This causes problems with the efficient
  allocation of resources.
• Example
• In the early days of radio broadcasting, many
  broadcasters used the same frequency and jammed
  each other's broadcasts.
• Property rights were ill defined anyone could
  infringe on others' uses of the airwaves.
• The government established a licensing system,
  which created well-defined property rights.
• Broadcasters became the sole owners of
  frequencies.
• They could sue to protect their property.

14
Nontransferable Property Rights

• Sometimes the ability to dispose of property is
  restricted by law some property rights are not
  transferable.
• Water rights cannot, in general, be sold.
• If water rights were sellable, ranchers could
  sell water to thirsty cities.
• Both benefit
• Ranchers earn extra income.
• Cities pay less for water.

15
Consensus among Economists on Incentives

• Providing appropriate incentives is a fundamental
  economic problem.
• Profits provide incentives for firms to produce
  the goods individuals want.
• Wages provide incentives for individuals to work.
• Property rights provide people with important
  incentives, to invest, save, and to put their
  assets to the best possible use.

16
Alternative to the Price System

• In a market, those individuals who are willing to
  pay the most receive the good.
• The allocation of goods is based on a price
  system.
• Rationing is an alternative to price allocations.

17
Types of Rationing

• Queues If the price of a good or service is set
  below market price, customers may have to wait in
  line to buy it.
• The wasted time is a waste of resources.
• There are long lines for food in countries with
  price controls.
• Lottery Customers are picked at random.
• Coupons One must pay both the market price and a
  coupon to buy a good.
• Coupon rationing is favored during wartime.
• Often goods and coupons may be traded in a black
  market.

18
The Inefficiency of Rationing

• Those who are most willing to pay for the
  rationed good or service do not necessarily get
  the good or service.

19
Opportunity Sets

• Opportunity sets are combinations of goods.
• Due to the scarcity of money or time, not all
  combinations of goods are attainable.

20
Budget Constraint (a)

• Alice has 160 to spend on CDs and books. The
  price of a CD is 16 and the price of a book is
  20.
• She can buy either 10 CDs and no books or 8 books
  and no CDs or some combination in between.

21
Budget Constraint (b)

• If the price of books falls to 10, Alice's
  budget constraint rotates outward along the book
  axis (the x axis).
• Alice's new budget constraint is
• Flatter than her previous budget constraint
  because books are relatively cheaper now.
• Farther from the origin than her previous budget
  constraint. The lower price for books has
  increased her purchasing power, and her
  opportunity set has expanded.

22
Time Constraint

• Bob has 6 hours of free time every day after we
  subtract time spent
• Working
• Getting ready for work
• Commuting
• Sleeping
• It takes Bob 1 hour to listen to a CD and 2 hours
  to watch a video.

23
Time Constraint (cont.)

• Bob can listen to 6 CDs and watch no videos or
  watch 3 videos and listen to no CDs or some
  combination in between.

24
The Production Possibilities Curve (PPC)

• The PPC is a producer's constraint.
• With a given quantity of inputs, a firm can only
  produce certain quantities of goods.
• Guns versus butter
• The boundary of what can be produced is the
  production possibilities curve.

25
The Production Possibilities Curve (PPC)
(continued)

• PPCs are curved, bowed out from the origin. Why?
• Guns and butter have different inputs.
• Steel makes great artillery shells but not
  butter.
• Cows' udders do not make good weapons.

26
Optimal Production on the PPC

• Inside the PPC, a firm can produce more of both
  goods by moving out to the curve.
• So points interior to the curve are not
  inefficient.
• Economists want to know the source of these
  inefficiencies, what resources are unemployed.
• The optimal production mix is always on the curve.

27
Costs

• The opportunity cost is the value of the next
  best alternative when one makes a choice.
• Time and budget constraints and production
  possibilities curves illustrate the cost of one
  option in terms of the other opportunity cost.
• The cost of an education is
• Tuition
• Room and board
• Books
• Travel expenses
• Opportunity cost lost earnings from not working
  for four years
• The opportunity cost is often used by the
  government when it considers the costs and
  benefits of a program.

28
Sunk and Marginal Costs

• Sunk costs are non-recoverable expenditures.
• Sunk costs play no role in deciding whether to
  continue an activity.
• Setup costs are sunk costs.
• The installation charge to turn on electricity is
  a sunk cost.
• Marginal costs are the extra costs of small
  changes in production or consumption.
• Marginal costs are the additional costs of
  producing or consuming one additional unit.
• Monthly electric bills are marginal costs.