Chapter 2Chapter 2Economic Tools and Economic Economic Tools and Economic ThinkingThinking

Chapter 2Chapter 2Economic Tools and Economic Economic Tools and Economic ThinkingThinking

• making choices

• functions

• supply and demand

• empirical methods

• making choices

• functions

• supply and demand

• empirical methods

With scarcity, must chooseWith scarcity, must chooseWith scarcity, must chooseWith scarcity, must choose

• making rational choices

• maximizing something• given certain limits or constraints

• maximize well-being, profits, etc.

• making rational choices

• maximizing something• given certain limits or constraints

• maximize well-being, profits, etc.

• we assume people maximize their utility• (a measure of well being)

• we assume firms maximize their profits

• constraints:• income, prices, time

• we assume people maximize their utility• (a measure of well being)

• we assume firms maximize their profits

• constraints:• income, prices, time

• Choose X

• to maximize V(X)

• subject to constraints involving X and Z• X is endogenous variable• (choose X)• Z is exogenous variable• (Z is given)

• Choose X

• to maximize V(X)

• subject to constraints involving X and Z• X is endogenous variable• (choose X)• Z is exogenous variable• (Z is given)

exampleexampleexampleexample

• choose # of children (X)

• to maximize utility, V(X)

• constrained by• earnings (Z1)• cost of children (Z2)

• choose # of children (X)

• to maximize utility, V(X)

• constrained by• earnings (Z1)• cost of children (Z2)

• best choice of X =X*• X* depends on V(X), and Z

• best choice of X =X*• X* depends on V(X), and Z

What affects choice of X?What affects choice of X?What affects choice of X?What affects choice of X?

• how does choice of X change when Z changes?• comparative statics

• how does choice of X change when Z changes?• comparative statics

exampleexampleexampleexample

• how is # of children affected by• female earnings?• male earnings?• cost of education?

• how is # of children affected by• female earnings?• male earnings?• cost of education?

Using modelsUsing modelsUsing modelsUsing models

• simplification of reality

• better understand how something works

• to use:• make assumptions• apply them to a framework• look at implications

• simplification of reality

• better understand how something works

• to use:• make assumptions• apply them to a framework• look at implications

• if model is too simple• implications are not helpful

• if model is too complicated• no implications

• test the model• do the implications match real

world data?

• if model is too simple• implications are not helpful

• if model is too complicated• no implications

• test the model• do the implications match real

world data?

FunctionsFunctionsFunctionsFunctions

• relationship between variables• utility function• production function

• relationship between variables• utility function• production function

Utility functionUtility functionUtility functionUtility function

• U = U(X,Y)• utility depends on X and Y• X and Y are consumptions goods

• X, Y are arguments of the function

• U = U(X,Y)• utility depends on X and Y• X and Y are consumptions goods

• X, Y are arguments of the function

• more utility is better • so if U(choice 1) > U (choice 2)• always pick choice 1• rational choice

• more utility is better • so if U(choice 1) > U (choice 2)• always pick choice 1• rational choice

• If we observe people making choice 1,

• then choice 1 must have higher utility• revealed preference

• If we observe people making choice 1,

• then choice 1 must have higher utility• revealed preference

example 1example 1example 1example 1

• if my U(married) > U(not married),

then I get married

OR

• given I am married, then we conclude• U(married) > U(not married)

• if my U(married) > U(not married),

then I get married

OR

• given I am married, then we conclude• U(married) > U(not married)

example 2example 2example 2example 2

• we observe that most U.S. households contain > 1 person

• so we conclude• U(living with people) > U(living

alone)

• we observe that most U.S. households contain > 1 person

• so we conclude• U(living with people) > U(living

alone)

Production functionProduction functionProduction functionProduction function

• amount of output depends on

amount of inputs• labor• capital (machines, factories, etc)

• amount of output depends on

amount of inputs• labor• capital (machines, factories, etc)

household productionhousehold productionhousehold productionhousehold production

• household good production depends on• time (T)• other inputs (Z)

• G = G(T, Z)

• household good production depends on• time (T)• other inputs (Z)

• G = G(T, Z)

example of household goodexample of household goodexample of household goodexample of household good

• meals• inputs:

-- food

-- pots/pans

-- appliances• time to make it

• meals• inputs:

-- food

-- pots/pans

-- appliances• time to make it

working with functionsworking with functionsworking with functionsworking with functions

• interested in total of function• total production• total utility

AND

• interested in marginal changes• change in function value if one of

arguments changes

• interested in total of function• total production• total utility

AND

• interested in marginal changes• change in function value if one of

arguments changes

marginal changesmarginal changesmarginal changesmarginal changes

• how much does my utility change if eat one more oreo?• marginal utility of an oreo

• how much does my utility change if eat one more oreo?• marginal utility of an oreo

dimishing marginal utilitydimishing marginal utilitydimishing marginal utilitydimishing marginal utility

• marginal utility falls as I consume more and more• 1st oreo adds more utility than 10th

oreo

• marginal utility falls as I consume more and more• 1st oreo adds more utility than 10th

oreo

• how many more meals can I make if I get a microwave?• marginal product of a microwave

• how many more meals can I make if I get a microwave?• marginal product of a microwave

diminishing marginal returnsdiminishing marginal returnsdiminishing marginal returnsdiminishing marginal returns

• marginal product declines with more and more input

• first microwave boosts my meal output more than 2nd or 3rd microwave• at some point I really have no need

for additional microwaves

• marginal product declines with more and more input

• first microwave boosts my meal output more than 2nd or 3rd microwave• at some point I really have no need

for additional microwaves

Supply and DemandSupply and DemandSupply and DemandSupply and Demand

• model behavior of buyers• Demand

• model the behavior of sellers• Supply

• buyers & sellers determine quantity & price

• model behavior of buyers• Demand

• model the behavior of sellers• Supply

• buyers & sellers determine quantity & price

MarketMarketMarketMarket

• haircuts in CNY per week

• what factors affect buyer decisions?• price of haircuts• income• population• fashion• price of substitutes

• haircuts in CNY per week

• what factors affect buyer decisions?• price of haircuts• income• population• fashion• price of substitutes

• what factors affect sellers decisions?• price of haircuts• costs of haircuts• profitability of alternative business

• what factors affect sellers decisions?• price of haircuts• costs of haircuts• profitability of alternative business

Assume:Assume:Assume:Assume:

• first look at relationship between quantity and price• hold other factors constant

• men and women do not differ in buying decision

• men and women not viewed differently by sellers

• first look at relationship between quantity and price• hold other factors constant

• men and women do not differ in buying decision

• men and women not viewed differently by sellers

DemandDemandDemandDemand

• relationship between• quantity of haircuts demanded

(Qd)• price of haircuts

• as price rises, Qd falls• holding other factors constant• Law of Demand

• relationship between• quantity of haircuts demanded

(Qd)• price of haircuts

• as price rises, Qd falls• holding other factors constant• Law of Demand

why does Qd fall when price rises?

• substitution effect• substitute less expensive goods

• income effect• higher prices leave you feeling

poorer

why does Qd fall when price rises?

• substitution effect• substitute less expensive goods

• income effect• higher prices leave you feeling

poorer

Demand scheduleDemand scheduleDemand scheduleDemand schedule

P Qd

$30 15,000

$20 20,000

$10 25,000

P Qd

$30 15,000

$20 20,000

$10 25,000

P

Q haircuts

$30

15K

$20

20K

$10

25K

D

SupplySupplySupplySupply

• relationship between• quantity of haircuts supplied• price of haircuts

• as price rises, Qs rises• holding other factors constant• Law of Supply

• relationship between• quantity of haircuts supplied• price of haircuts

• as price rises, Qs rises• holding other factors constant• Law of Supply

Supply scheduleSupply scheduleSupply scheduleSupply schedule

P Qs

$30 25,000

$20 20,000

$10 15,000

P Qs

$30 25,000

$20 20,000

$10 15,000

P

Q haircuts

$20

20K15K

$10

$30

25K

S

the marketthe marketthe marketthe market

• supply and demand together

• graph each schedule• supply and demand together

• graph each schedule

P

Q haircuts

$30

15K

$20

20K

$10

25K

DS

P = $20Q = 20K

equilibriumequilibriumequilibriumequilibrium

• P=$20, Q=20,000

• Qs = Qd

• with other factors constant,

P & Q will stay at this point

• P=$20, Q=20,000

• Qs = Qd

• with other factors constant,

P & Q will stay at this point

Allow factors to changeAllow factors to changeAllow factors to changeAllow factors to change

• CNY population increases• more people,• more haircuts demanded at every

price• increase in demand

• CNY population increases• more people,• more haircuts demanded at every

price• increase in demand

P

Q haircuts

$20

20K

DS

D’

D increases:P increasesQ increases

Allow factors to changeAllow factors to changeAllow factors to changeAllow factors to change

• NY increases fee for cosmetology license• more costly to provide haircuts• fewer haircuts supplied• decrease in supply

• NY increases fee for cosmetology license• more costly to provide haircuts• fewer haircuts supplied• decrease in supply

P

Q haircuts

$20

20K

DS

S’

S decreases:P increasesQ decreases

Men vs. women & haircutsMen vs. women & haircutsMen vs. women & haircutsMen vs. women & haircuts

• assume sellers view women’s haircuts as more costly• at any price, sellers willing to

provide fewer haircuts for women than for men• Women’s supply curve to the left

of men’s supply curve

• assume sellers view women’s haircuts as more costly• at any price, sellers willing to

provide fewer haircuts for women than for men• Women’s supply curve to the left

of men’s supply curve

P

Q haircuts

DS men

S women

Women’s haircutshave a higher price

• assume women are less price sensitive to haircuts than men• price increase causes small

decrease in Qd• women’s demand for haircuts is

less elastic than men’s• women’s demand curve is steeper

than men’s

• assume women are less price sensitive to haircuts than men• price increase causes small

decrease in Qd• women’s demand for haircuts is

less elastic than men’s• women’s demand curve is steeper

than men’s

P

Q haircuts

D menS

Women’s haircutshave a higher price

D women

is this discrimination?is this discrimination?is this discrimination?is this discrimination?

• some laws forbid different prices for men vs. women• haircuts• drycleaning

• is this fair?

• is this efficient?

• some laws forbid different prices for men vs. women• haircuts• drycleaning

• is this fair?

• is this efficient?