WEEK 1
Chapter 1 - Thinking like an economist
Microeconomics = the study of how people choose under conditions of scarcity.
Every choice involves important elements of scarcity.
The cost-benefit approach to decisions
If C(x) denotes the costs (= the value of all the resources you must give up in order to do x) of doing x
and B(x) denotes the benefits (= maximum monetary amount you would be willing to pay to do x), it
is:
If B(x) > C(x), do x; otherwise don’t.
Reservation price = the price at which a person would be indifferent between doing x and not doing
x.
Common pitfalls in decision making
I. Ignoring implicit costs.
If doing activity x means not being able to do activity y, then the value to you of doing y (had
you done it) is an opportunity cost of doing x.
Opportunity cost = the value of all that must be sacrificed in order to do the activity.
You must also take into account the value of the most attractive alternative you will forgo by
heading for activity x/y.
II. Failing to ignore sunk costs.
Sunk costs = costs that are beyond recovery at the moment a decision is made.
These costs should be ignored!
III. Measuring costs and benefits as proportions rather than absolute monetary amounts.
Contextual clues are important for a variety of ordinary judgements. You shouldn’t think in
percentage terms though when comparing costs and benefits. For example, you can buy a
clock radio at the nearby campus store for 20$ or at the superstore for only 10$ (15 minute
walk tho). Also, you want a new television. You can buy it at the nearby campus store for
1010$ whereas the superstore sells it for 1000$. Would you walk 15 minutes? Most people
say the trip would be worth making for the clock radio, but not for the television. However, it
is exactly the same 10$. Therefore, you should express costs and benefits in absolute euro
terms.
IV. Failure to understand the average-marginal distinction.
Marginal cost = the cost of an additional unit of activity. The increase in total cost that results from
carrying out one additional unit of an activity.
Marginal benefit = the benefit of an additional unit of activity. The increase in total benefit that
results from carrying out one additional unit of an activity.
The cost-benefit rule tells us to keep increasing the level of an activity as long as its marginal
benefit exceeds its marginal costs.
Average cost = the average cost of undertaking n units of an activity is the total cost of the activity
divided by n.
Average benefit = the average benefit of undertaking n units of an activity is the total benefit of the
activity divided by n.
Using marginal benefit and marginal cost
For activities that are continuously variable, it is usually convenient to display the comparison of
marginal benefit and marginal cost graphically.
Whenever the level of activity varies continuously it makes sense to equate marginal cost and
marginal benefit. MC(x) and MB(x) denote the marginal cost and the marginal benefit.
, Would parents want their daughter/son to marry Homo Economicus?
Homo Economicus = the stereotypical decision maker in the self-interest model. The only thing he
cares about are personal material costs and benefits. He does not experience the sorts of sentiments
that motivate people to do good stuff.
Selfish motives are important.
Positive questions and normative questions
Positive question = a question about the consequences of specific policies or institutional
arrangements.
It has a definitive answer.
Normative question = a question about what policies or institutional arrangements lead to the best
outcome.
It does not have a definitive answer. It is a question that involves value judgement about what
ought to be or should be. Economic analysis cannot answer such questions. It is for society to
decide.
Microeconomics and macroeconomics
The study of individual choices and the study of group behavior in individual markets both come
under the rubric of microeconomics.
Macroeconomics, by contrast, is the study of broader aggregations of markets.
Chapter 4 - Rational consumer choice
The theory of rational consumer choice underlies all individual purchase decisions, which in turn add
up to the demand curves.
Rational choice theory begins with the assumption that consumers enter the marketplace with well-
defined preferences. Taking prices as given, their task is to allocate their incomes to best serve these
preferences. Two steps are required to carry out this task:
1) Describe the various combinations of goods the consumer is able to buy. These combinations
depend on both her income level and the prices of the goods.
2) Select from among the feasible combinations the particular one that she prefers to all others.
Analysis of step 2 requires some means of describing her preferences; in particular, a
summary of her ranking of the desirability of all feasible combinations.
The opportunity set or budget constraint
Bundle = a particular combination of two or more goods.
Consumption is always measured as a flow, which means a physical quantity per unit of time. Income
is also a flow.
Budget constraint = the set of all bundles that exactly exhausts the consumer’s income at given
prices. Also called the budget line. The consumer is also able to purchase any bundle that lies within
the budget triangle bounded by it and the two axes.
Budget constraint is the vertical intercept plus its slope (which is negative).
Affordable set = bundles on or below the budget constraint; bundles for which the required
expenditure at given prices is less than or equal to the income available.
I. Budget shifts due to price or income changes.
A. Price changes.
, Increase in price of good x → vertical intercept stays the same, but the BC rotates inward
about this intercept.
Increase in price of good x and y (same rate) → slope stays the same, but BC shifts either
left or right.
The slope of the budget constraint tells us only about relative prices.
B. Income changes.
Cutting the income by half is no different from doubling each price. The slope stays the same
but the vertical intercept falls from e.g., 10 to 5.
II. Budgets involving more than two goods.
With only two goods (N = 2), the budget constraint is a straight line. With three goods (N =
3), it is a plane. When we have more than three goods, the budget constraint becomes what
mathematicians call a hyperplane, or multidimensional plane.
Composite good = in a choice between a good X and numerous other goods, the amount of money
the consumer spends on those other goods. By convention, the units of the composite good are
defined so that its price is 1 euro / unit.
III. Non-linear budget constraints.
When relative prices are constant, the opportunity cost of one good in terms of any other is
the same, no matter what bundle of goods we already have.
Non-linear budget constraints are not uncommon. For instance, any offers of the form, ‘buy
one get one free’, ‘free delivery if you spend over $40’, or ‘20% off if you spend over $50’,
cause the budget constraint to be non-linear. Two-part tariffs where there is a lump sum to use
the service, for example a gym or phone network, as well as cost per unit used, also cause the
budget constraint to be non-linear.
, Consumer preferences
Preference ordering = a ranking of all possible consumption bundles in order of preference.
Economists generally assume five simple properties of preference orderings.
1) Completeness.
A preference ordering is complete if it enables the consumer to rank all possible combinations
of goods and services. So either A>B, A<B, or A=B.
2) Transitivity.
If a preference ordering is transitive means that, for any three bundles, A, B and C, if he
prefers A to B and prefers B to C, then he always prefers A to C.
When judging transitivity, remember that preferences are over bundles of goods and not
goods.
3) More-is-better.
This means that, other things equal, more of a good is better preferred to less. As long as
people can freely store or dispose of goods they don’t want, having more of something can’t
make them worse off.
4) Continuity.
A preference ordering is continuous if, for any two bundles Z and W, where the consumer
prefers Z to W then any bundle sufficiently close to Z is also referred to W.
Indifference curve = a set of bundles among which the consumer is indifferent.
In general, bundles that lie above an indifference curve are all preferred to the bundles that lie on it.
Similarly, bundles that lie on an indifference curve are all preferred to those that lie below it.
Indifference map = a representative sample of the set of a consumer’s indifference curves, used as a
graphical summary of her preference ordering.
Three important properties of indifference curves and indifference maps:
- Indifference curves are ubiquitous. Any bundle has an indifference curve passing
through it. This property is assured by the completeness property of preferences.
- Indifference curves are downward sloping. An upward-sloping curve would violate
the more-is-better property by saying a bundle with more of both goods is equivalent
to a bundle with less of both.
