Preliminary Economic Concepts and Principles:



Foundations of Economics:(“Economics” – Chapter 1)Three goals of the present discussion…Define economics (along with the main branches of microeconomics and macroeconomics)Distinguish between fact-based and opinion-based statements (positive/normative distinction)Discuss how economists model human behavior (cost-benefit analysis)Economics is the social science that studies how people make decisions in the face of scarcity and the resulting impact of such decisions on both society as a whole and on the individual members therein.Social Science => central focus of study is how people behave and interact with each otherScarcity => resources (e.g., time, personal income, amount of labor in economy) are available in finite, limited amountsSince resources are scarce, decision makers face tradeoffs: having more of one thing means getting by with less of something else.Microeconomics versus Macroeconomics:Microeconomics – the branch of economics which studies how individual decision-makers behave and interact with each other (often with a focus on how households and firms behave and interact with each other in markets).Macroeconomics – the branch of economics which studies the functioning and performance of a society’s economy as a whole (often with a focus on levels of and changes in aggregate measures such as the unemployment rate, inflation rate, and Gross Domestic Product growth rate).Micro and Macro are closely related, since the performance of the “economy as a whole” is a result of all of the “individual decisions of every distinct household and firm.”e.g. – What is the effect of “more generous unemployment benefits on labor market outcomes”?A Macroeconomist might attempt to determine the impact of the policy change on the overall unemployment rate for the economyBut to do so properly, she would likely have to address the “micro level issue” of how the change in policy impacts the behavior of individual labor market participantsMicroeconomics: focuses on the individual unit (i.e., it examines the “trees”)Macroeconomics: focuses on the aggregate or whole (i.e., it examines the “forest”)“Positive Statements” versus “Normative Statements”:Positive Statement – a claim that attempts to describe how the world actually is or how the world actually functions“fact based” statementssimply provide observations or predictions, without any judging of their desirabilityNormative Statement – a claim that attempts to assess the desirability of how the world is or functions, perhaps with suggestions of things that could be done to improve mattersinvolve “value judgments” and “priorities,” to make comparisons on the relative desirability of different optionsPositive Statements can (in principle) be confirmed or refuted by evidence/data. Normative Statements cannot be so judged, since they involve values as well as facts.Examples from Economics:Normative: the government should increase the minimum wage to help poor people.Positive: a minimum wage increases unemployment among young and unskilled workers.Distinction between “Positive/Normative” is not unique to economics => 8/2/1939 letter from Einstein to FDR:Positive: possible to make a uranium bomb.Normative: U.S. government should assist physicists in the country working on related research. Albert Einstein Old Grove Rd. Nassau Point Peconic, Long Island August 2nd 1939F.D. RooseveltPresident of the United StatesWhite HouseWashington, D.C.Sir: Some recent work by E.Fermi and L. Szilard, which has been communicated to me in manuscript, leads me to expect that the element uranium may be turned into a new and important source of energy in the immediate future. Certain aspects of the situation which has arisen seem to call for watchfulness and, if necessary, quick action on the part of the Administration. I believe therefore that it is my duty to bring to your attention the following facts and recommendations: In the course of the last four months it has been made probable - through the work of Joliot in France as well as Fermi and Szilard in America - that it may become possible to set up a nuclear chain reaction in a large mass of uranium, by which vast amounts of power and large quantities of new radium-like elements would be generated. Now it appears almost certain that this could be achieved in the immediate future. This new phenomenon would also lead to the construction of bombs, and it is conceivable - though much less certain - that extremely powerful bombs of a new type may thus be constructed. A single bomb of this type, carried by boat and exploded in a port, might very well destroy the whole port together with some of the surrounding territory. However, such bombs might very well prove to be too heavy for transportation by air.The United States has only very poor ores of uranium in moderate quantities. There is some good ore in Canada and the former Czechoslovakia, while the most important source of uranium is Belgian Congo. In view of the situation you may think it desirable to have more permanent contact maintained between the Administration and the group of physicists working on chain reactions in America. One possible way of achieving this might be for you to entrust with this task a person who has your confidence and who could perhaps serve in an official capacity. His task might comprise the following:a) to approach Government Departments, keep them informed of the further development, and put forward recommendations for Government action, giving particular attention to the problem of securing a supply of uranium ore for the United States;b) to speed up the experimental work, which is at present being carried on within the limits of the budgets of University laboratories, by providing funds, if such funds be required, through his contacts with private persons who are willing to make contributions for this cause, and perhaps also by obtaining the co-operation of industrial laboratories which have the necessary equipment. I understand that Germany has actually stopped the sale of uranium from the Czechoslovakian mines which she has taken over. That she should have taken such early action might perhaps be understood on the ground that the son of the German Under-Secretary of State, von Weizs?cker, is attached to the Kaiser-Wilhelm-Institut in Berlin where some of the American work on uranium is now being repeated. Yours very truly, INCLUDEPICTURE "" \* MERGEFORMATINET INCLUDEPICTURE "" \* MERGEFORMATINET INCLUDEPICTURE "" \* MERGEFORMATINET (Albert Einstein)Disagreement Among Economists:“Patient Protection and Affordable Care Act” => signed into law by President Obama on 3/23/103/11/10: 40+ economists (including Daniel Kahneman, one of two co-recipients of the 2002 Nobel Prize in economics) wrote a letter supporting the legislationthe reforms “include serious measures that will slow the growth of health care spending” and constitute a “serious, multi-faceted initiative to improve the quality and efficiency of American medical care”3/18/10: 130+ economists (including Vernon Smith, the other co-recipient of the 2002 Nobel Prize in economics) wrote a letter opposing the legislationthe bill would “threaten jobs and decrease economic growth” and “increase the cost of health coverage”Observation by Nobel Laureate Paul Samuelson in 1966:“If Parliament were to ask six economists for an opinion, seven answers would come back – two, no doubt, from the volatile Mr. Keynes! If economists cannot agree among themselves, how can the rest of the world be expected to agree with them and to respect their recommendations?”Why do economists so often appear to give conflicting advice to policymakers? Two possible reasons:they “disagree” about the validity of different positive theories about how the world works.they have different “priorities” and “values” and therefore differing normative views about what policy should attempt to accomplish.there is generally “more agreement” among economists on Positive Statements than on Normative Statements.There is generally “more agreement” among economists on statements about microeconomics than on statements about macroeconomics.All this being said, we do not want to overstate the degree of disagreement => there is “general agreement” among economists on the following:A ceiling on rents reduces the quantity and quality of available housing. [95.5%]Tariffs and import quotas usually reduce the general welfare of society. [94.1%]The U.S. should NOT restrict employers from outsourcing work to foreign countries. [90.1%]Fiscal Policy has a significant stimulative impact on a less than fully employed economy. [88.6%]Cash payments increase the welfare of recipients to a greater degree than do transfers-in-kind of equal cash value. [88.0%]The government should restructure the welfare system along the lines of a “negative income tax.” [85.3%]The federal budget should be balance over the business cycle rather than yearly. [85.2%]The U.S. should eliminate agricultural subsidies. [85.2%]A large federal budget deficit has an adverse effect on the economy. [81.3%]A minimum wage increases unemployment among young and unskilled workers. [80.8%]How economists model human behavior…Focus on choices made by rational decision makers. A rational decision maker is someone with a well-defined goal, who takes actions to achieve the goal as best as possible.There are typically both costs and benefits associated with different actions.Total Benefits – the gains that a person realizes from an action or outcomeTotal Costs – the burdens that a person incurs from an action or outcomeTake deliberate care to think of and measure benefits and costs as separate and distinct from each other. From here:Total Economic Surplus – the difference between Total Benefits and Total CostsGoal of a rational decision maker is to make Total Economic Surplus as large as possible. This is typically accomplished by applying the following principle:“Cost-Benefit Principle” – a rational decision maker should undertake an activity if and only if the Marginal (or additional) Benefit of doing so is greater than the Marginal (or additional) Cost of doing so.Example: Carl needs to decide how many days per week he should spend growing carrots. His Total Benefits and Total Costs (measured in dollar terms) are stated below:Days workedTotal BenefitsTotal Costs00016020210540314060416580518010061901207195140Goal is to maximize Economic Surplus. Economic Surplus refers to the difference between his Total Benefits and Total Costs.# DaysTBMarg. BenefitMarg. CostTC00not definednot defined016060-0 = 6020 = 20-0202105105-60 = 4520 = 40-20403140140-105 = 3520 = 60-40604165165-140 = 2520 = 80-60805180180-165 = 1520 = 100-801006190190-180 = 1020 = 120-1001207195195-190 = 520 = 140-120140The best level is “4 days worked.”This gives an Economic Surplus of 165-80 = 85 (any other level would result in a smaller Economic Surplus).Insights on how rational people respond to incentives…Incentives Matter – The choices that people make are highly dependent upon benefits and costs => as benefits or costs change, people will often alter their behavior.“Incentive Principle” – (i) if the marginal benefit of an activity increases, then a rational person will engage in more of the activity, whereas (ii) if the marginal cost of an activity increases, then a rational person will engage in less of the activity.Example: Decision to go to College.One Benefit: Higher Income. 2010: average income of High School grad was $32,552; average income of College grad was $53,976. Difference of $21,424.One Cost: Tuition and fees. $3,243 per semester over 8 semesters is a total of $25,944.Would it affect your decision to attend College if:Income gain was smaller (only $10,000 difference)?Total cost was larger ($160,000 tuition)?Example: In numerical example, what if we tax labor by taking 40% of output (worker keeps (.60)(total output))?# DaysTBMarg. BenefitMarg. CostTC00not definednot defined01363620 = 20-0202632720 = 40-20403842120 = 60-40604991520 = 80-60805108920 = 100-801006114620 = 120-1001207117320 = 140-120140Best level is now 3 days worked => individual works less, since the tax made the gain from working smallerImportance of “Incentive Principle” to “Public Policy”:Direct impact of many “government policies” is to alter costs and benefits => as a result, individual behavior will often change, so that the impact of the policy is NOT exactly what might have been expected or intendedExample:Increased automobile safety requirements enacted starting in 1960’s (e.g., padded dashboards, seat belts, collapsible steering columns, etc.)Intended to make automobile transportation safer (one observable outcome: reduce number of deaths to drivers)Sam Peltzman (University of Chicago) found there was essentially no change in number of accidental deaths to drivers after the regulations were enactedWhy didn’t the number of driver deaths decrease?“Safer car” reduces the “cost of fast/reckless driving” (e.g., playing with radio, talking on cell phone, etc.)Drivers “applied Cost-Benefit Principle” and chose to drive “faster and more recklessly” in their “safer cars”Peltzman found that after the regulations, there werefewer “deaths per accident” (as a result of cars being “safer”), butmore accidents (as people changed their driving behavior)Two effects were of “relatively equal magnitude” and “cancelled each other out” => essentially no change in the number of accidental deaths to automobile drivers“Unintended Side Effect”: there was an increase in number of deaths to pedestrians (who, after all, get no benefit from padded dashboards and seatbelts)Do you find it hard to believe that people would really “choose” to “increase the likelihood of an accident” by driving “faster and more recklessly” in a “safer car”?i.e., that people would voluntarily “tradeoff” the “cost of an accident” against the “benefits of driving faster and/or paying less attention to the road”…Recognize that one way to “restate this observation” is to note that it simply implies that people would “drive more cautiously” in a car that is “more dangerous.”Consider the following “hypothetical automobile safety feature” [suggested by Armen Alchian (UCLA) and Gordon Tullock (Geroge Mason University)]:Install a sharp, irremovable, foot long, iron spike to the steering wheel of every car, aimed right at the driver’s heart.What would be the effect of this “safety feature” on the number of automobile accidents?If you had such a spike in your car, would you drive 80 mph and tailgate the car in front of you while talking on your cell phone?So, are “automobile safety features” a “good thing”?Yes, but not just since they “make cars safer,” but also since they “let us drive faster and more recklessly.”Main point: direct impact of many “government policies” is to alter costs and benefits => behavior often changes, so that the impact is NOT exactly what was intended.The recognition that people are self-interested…Self-Interested Individual – someone who makes his own personal assessment of the benefits and costs associated with different outcomes, and who subsequently uses these measures as the basis for decision makingby definition, a self-interested person places more weight on his own priorities than on the priorities of othersfurther, most people care much more about their own well-being than they care about the well-being of othersConsider the following scenario (modified from Adam Smith’s The Theory of Moral Sentiments (1759)):A.You cut off the tip of your pinky finger.B.Your favorite sports team gets eliminated from the playoffs.C.Your favorite entertainer dies unexpectedly.D.A tsunami in Myanmar kills 1,000 people.When you get home your best friend calls. You say, “I have horrible news, ___________________.”Focusing on “A” doesn’t mean that you are a “bad person,” it just means that you are a person => People are Self-Interested.James Miller (Game Theory at Work (2003)) and Arthur Brooks (Who Really Cares (2006)) quote Mel Brooks: “Tragedy is [if] I cut my finger. Comedy is if you fall into an open manhole and die.”To say a person is Self-Interested does NOT mean that the person cares ONLY about himself. Rather, it simply recognizes that he cares more about himself (and those close to him) than he cares about most other people. ................
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