Stiglitz Chapters 1 & 2
Opportunity cost
sunk cost
Production Possibility curve (PPC)
implicit/explicit
positive/negative slope
Stiglitz begins Ch. 1 with a discussion of the computer industry. Why do you think he does that?
1. real world example which addresses a number of important economic issues
2. highly relevant/topical
What questions does this example raise?
1. What is relationship between technology and economy?
2. What is role of government?
3. How is market power established and maintained?
We’ll come back to the computer example later, and will also be revisiting all these questions repeatedly.
What do economists do?
They generally look at either the micro or macro economy. They may specialize even further by looking only at labor, product or capital markets.
Many economists view themselves as scientists, although I am not one of them. Economists generally develop models (graphical/mathematical/verbal) of how the economy works, based on economic theory. They theorize causal relationships and test their theories by examining data.
Three things to keep in mind:
1. Unlike scientists, economists do not generally do experiments, so they look for 'natural experiments' - ie historical events - which provide the conditions they seek.
2. All models require simplifying assumptions.
3. Economic analysis generally combines both positive and normative aspects.
Positive is a description of what is.
Normative is a statement of what ought to be.
BOTH the positive and normative aspects of economics are open to debate, although the former may be tested using data, the latter is more a matter of ideology.
Throughout the course we will try to identify how both differing positive and normative views may impact economists' analysis, thus pointing to the reasons why there is no ONE right answer in economics and why economists may disagree.
Key to understanding economics:
language used
models being used to explain the economy
nature of the data being utilized
assumptions being made (implicit and explicit)
Implicit: something implied or understood though not directly expressed; contained in the nature of something though not readily apparent. In the case of economics, what is identified on the axes of the graphs is generally explicit, while other factors that impact the graph are implicit.
We will work on both understanding and critiquing the models, assumptions and data.
Economists look at a variety of questions:
Some micro/some macro
Macroeconomics is the big picture - how is the economy doing overall?
Microeconomics is the study of particular markets, and individual and firm behavior.
Examples of questions economists ask:
How are wages determined?
How many cars will be purchased at a given price?
What happens to the rest of the economy when the price of oil goes up?
Why do we have unemployment, inflation, growth?
How do constraints affect individuals/societies? Main constraints include time and resources. (Scarcity)
Given an economy's resources, what can they produce?
How do costs impact an individual’s decision?
Concept of relevant costs:
Example
standing in line at the bookstore
arrive at line and estimate you will have a 20 minute wait
opportunity cost of standing in line is 20 minutes, or more accurately what else you could have done during that time
After standing in line for 10 minutes you realize that you will probably be in line for 25 minutes total. At this point you have to decide whether to continue standing in line or not. What is the relevant cost to think about now?
15 minutes, since 10 minutes have already been spent (can't get them back).
25 total cost
10 minutes sunk cost
15 minutes opportunity (or marginal/additional) cost
At the beginning of your decision, the relevant cost was 25 (although you didn't know it at the time), but after 10 minutes, the relevant cost is only 15.
A simplified model for examining the economy is the production
possibilities curve (PPC)
Use PPC model to illustrate:
1. Technological change
2. Efficient resource use
3. the economic advantages of free trade.
Before we do that - a very simple, straight line PPC:
An individual can construct a PPC for a 24 hour period (as we did in class.) Because graphs are only 2 dimensional, can only model 2 behaviors - sleeping and reading. Can illustrate opportunity cost using PPC - each hour you sleep is one less hour you can read.
Suppose we want to come up with an abstract representation of the total production available to an economy. Why might we want to do that? What do we need to know?
We need to know what resources – labor, land (actually natural resources including land, water, etc.) and capital – a country has. Resources are inputs (some economists focus on input markets). In the PPC model inputs are implicit, only outputs are explicit or viewed on the graph. Yet the availability of inputs is important and defines both where the graph is. Also, information about resource use can tell us whether we are on the line or not.
Once something is produced it becomes an output (product) which is then consumed.
Economists tend to look at each of these steps in isolation (one of the simplifying assumptions they make.)
For now we will examine the output side -- what is the maximum an economy can produce, given its resources? This can be very simplistically represented by the PPC.
Assume that you have fixed inputs - hours of labor, area of land and other resources, such as water. (These are implicit to the graph. If you change your assumption about the inputs available, the location of the line will change.)
You may produce shirts and or bread with your inputs, but once you are using all your inputs, in order to produce more of one good, you have to give up some of the other (opportunity cost - OC)
Opportunity set:
|
SHIRTS |
BREAD |
OC OF 250 BREAD (IN SHIRTS) |
|
750 |
0 |
|
|
700 |
250 |
50 |
|
625 |
500 |
75 |
|
500 |
750 |
125 |
|
0 |
1000 |
500 |
We can graph shirts and bread on either axes (there is no rule in the case of PPC - There WILL BE a rule when it comes to Supply and Demand).
If an economy is functioning on the PPC line, then it is 'efficient' in the sense that all resources are in use.
All points on the PPC are efficient. Where a country ends up will depend on tastes of consumers.
Moving along the PPC provides an example of opportunity cost - what must be given up to gain something.
Starting at 750 shirts, you have to give up 50 shirts to get 250 loaves of bread, but if you start at 700 and 250 then you give up 75 shirts to get 250 more loaves.
What does a point like 600 shirts and 100 loaves of bread represent?
How about 800 shirts and 100 loaves of bread?
Going back to the question of opportunity cost:
If country 1 is producing 750 shirts and 350 loaves of bread, what is the opportunity cost of 350 additional loaves of bread? 250 shirts. Why isn't it 500 shirts?
Can we calculate what the cost of a single loaf of bread is? Need to calculate a ratio - 50/shirts divided by 250 loaves = 1/5
PPC provides a useful way of thinking about the economy and can help us understand concepts such as efficiency (which we will discuss in more detail later in the course), opportunity cost, trade, technological change, etc. but does have its limits.
Efficient resource use involves the use of all resources. When all resources
are in use, the economy is on the PPC line. If there is unemployment, the point
representing the economy will be somewhere inside the line. Points outside the
line are unattainable, although trading can change that outcome.
(Illustrated graphically next class.)
What happens to the graph when there is a technological change? It depends
on what form it takes. If it affects the bread production only, the curve
will swing outward, but the end point on the X axis (shirts) will stay the
same. An example would be improved wheat seeds.
Some technologies, such as an improved fertilizer, that affect both
cotton and wheat will shift the entire line outward.
Conversely, a drought would shift the line inwards.
(Illustrated graphically in class.)
As can be seen in the appendix, economists find graphs very useful. The PPC graphs two outputs. Economists usually look at graphs with two variables explicitly modeled (and the others implicit in the model.) Graphs are useful simplifications, but can only capture the relationship between two variables at one time. Economists generally graph price on the Y axis, quantity on the X axis. (PPC is an exception, as price is implicit).
Keep in mind that when two variables rise together they are said to be positively related.
I will ask you to revisit the appendix to Ch. 2 as we progress through the chapters, to refresh your memory on some points raised here.