Advanced Microeconomics

Advanced Microeconomics

Advanced Microeconomics Prof. Rous Hickory Hall 220f [email protected] What is Economics? The study of the economy Jane Q. Public Economics is the science which studies human behavior as a relationship between given ends and scarce means which have alternative uses. Robbins, Lionel (1932). An Essay on the Nature and Significance of Economic Science., p. 16 While the phenomena or behavior economists study largely involve choice under scarcity, the

same can be said of other social science research. Topics for Economists, and other Social Scientists Phenomena under Robbins definition: To what extent does public housing reduce homelessness? Does Head Start improve educational outcomes? Does lowering the tax rate on the top 1% increase job creation? Why is the marriage age rising? Does the death penalty deter crime? Why did Americans choose suburban living after WWII?

So research topics do not differentiate economics. Back up, what is social science? Physicists, chemists, biologists, etc. study phenomena that do not have conscious thought but are instead passive adherents to the laws of nature (Silberberg, 1990). Along with sociologists, anthropologists, economic geographers, planners, political scientists, and other social scientists, economists study human behavior. Studying human behavior is essentially nothing more than the study of human decision making, or choice. Economic Schools of Thought

Before differentiating economics from other social sciences, we have to differentiate only schools of thought. School of Thought: A particular idea or set of ideas held by a specific group; doctrine. Any idea that a group strongly believes in, be it through practicing this idea in their everyday life or through fighting for its adoption, can be considered a school of thought. ( Schools of Thought 95% of economists in the US, 90% in Europe and 85% in the world are in the Neoclassical school of thought Neoclassical economics evolved from the Classical

school defined by Ricardo, Smith, and Marx. Classical school defined by: focused on the economy: productivity, growth, economies of scale, gains from trade, land rent. understood a gap between value in use and value in exchange prices assumed to be set by cost of production only value in use was inconsequential Neoclassical Revolution: Marginal Analysis Action is taken so long as the marginal benefit exceeds the marginal cost, or, similarly, until the marginal benefit equals the marginal cost. For example: Diamond-Water Paradox

For all units of a good except the last one consumed, the value in use exceeds the market price. For all units of a good except the last one produced, the cost of production is lower than the market price. For the last unit produced and consumed, the marginal value = marginal cost = price Other Schools of Thought Neo-Marxist Economics Institutional Economics Austrian Economics (Ron Paul and an increasing number of Republicans live here) Feminist Economics Socio-Economics etc.

This course is about Neoclassical Economics Which can be divided into: Positive Normative Positive Economics Positive, the economics of what is. The goal: to explain and predict behavior How will economic actors (individuals, firms, etc.) respond (direction and magnitude of change in behavior) to changes in exogenous variables? For example: Increasing the minimum wage 3% will cut

employment by .5% Increasing the percentage of adults with a college degree by 10% will increase a citys income by 2%. Marginal Analysis Everywhere! Markets are the summation of economic actors optimizing using marginal analysis. If marginal analysis can be used to explain consumption and production behavior, then how about applying it to crime, marriage, decision to have children, drug addiction, etc. Economists used to be criticized for branching out, but now there is a Freakonomics movie. Normative Economics

Normative, the economics of what ought to be. Policy should encourage efficiency, equity, social welfare, etc. Attempting to maximize economic surplus is good Deadweight loss is bad Kaldor-Hicks uses consumer and producer surplus and says that if those who gain from a policy could theoretically compensate losers, it is good Pareto suggested that only policies that have NO losers (i.e. Pareto improving), are good Normative Economics Market transactions (without externality) are Pareto improving, so markets are good. Increasing the minimum wage will increase deadweight loss, so it is bad

policy. Increasing the minimum wage will increase producer surplus, with minimal deadweight loss so it is good policy. We should subsidize higher education because the long term economic growth will more than payoff current taxpayers. Market based health reform is superior because it is more efficient. Carbon taxes are good because they reduce a negative externality. Carbon taxes are bad because they increase the cost of driving for the poor. A progressive tax system is good because it is fair for the rich to pay disproportionately more. A progressive tax system is bad because it is unfair for the rich to pay disproportionately more. Normative Economics is Currently Out of Favor

Academically No interpersonal comparisons of utility possible, so income redistribution is not necessarily good. Marginal benefit (the basis of consumer surplus) does NOT measure utility, but instead something that is heavily income dependent, so this calls into question consumer surplus as a tool for allocation. The only moves we can say unequivocally improve social welfare are those that are Pareto improving. Not many policies can be shown Pareto improving, although we do tend to argue for policies that increase efficiency. In recent decades, focus on positive economics. What Differentiates Positive Neoclassical Economics

(henceforth, economics) from all other Social Science Research? What doesnt set us apart The phenomena of interest -- all human behavior What sets us apart Methodology Most Influential Neoclassical Economists (1920s-40s) Many came from a hard science background. Brought the scientific method and mathematical models of natural systems with them. Initially summarized in Samuelsons 1947

Foundations of Economic Analysis Theories should derive from first principles. Theories should be refutable, or they have no value. Silberbergs Definition of Neoclassical Economics Economics is that discipline within social science that seeks refutable explanations of changes in human events on the basis on changes in observable constraints, utilizing universal postulates of behavior and technology, and the simplifying assumption that the unmeasured variables (tastes) remain constant. (Silberberg, 1990, p. 6).

refutable explanations If a theory cannot be tested and proved false, it has no value. For example After WWII, Americans moved to the suburbs (larger lots, separation of land uses) because lower cost automobiles lowered the cost of transportation. Allowing people to live further away from employer and other land uses. This could be refuted by finding examples where more expensive automobile ownership led to less suburban development. As opposed to: Americans moved to the suburbs because Building housing developments became big business and greedy developers wanted to maximize profit over quality of

life for those that bought the houses (actual theory) universal postulates of behavior and technology For example, start with first principles we all can agree on, but nothing more Individuals maximize utility subject to preferences and available choices (rationality) Preferences are well behaved Axioms complete transitive reflexive Assumptions

continuous convex monotonic the simplifying assumption that the unmeasured variables (tastes) remain constant. Tastes and preferences are assumed constant not because we believe it, but as a simplifying assumption. Without it, we cannot identify the effects of changes in observable constraints separately from potential changes in preferences. on the basis on changes in

observable constraints The challenge of economics is always to search for explanations based on changes in constraints; explanations based on changes in tastes are to be viewed with skepticism and as indicative of inadequate insight. - Silberberg, 1990, p. 7. So we assume changes in behavior are driven by changes in prices, income, technology, institutional constraints, etc. For example For example, after WWII, Americans built and moved to the suburbs because they started to value estate like housing (pretentious trappings

of wealth) over community and quality of life. (actual theory) But to argue changes in behavior can be attributed to changes in preferences is to give up on an explanation that can be tested and proven false... or confirmed. The Scientific Method Observation of phenomena Research question posed

Hypothesis in the form of a theory Empirical testing Theory The model: the purely theoretically aspect of a theory. Models can be logically valid or invalid, but cannot be tested empirically. For example, individuals optimize an objective function z = f(x,y) subject to constraint, x+y = Mx+y = My = My = M How a model becomes a theory: when assumptions relating theoretical constructs to real objects are added.* The objective function represents utility, U = U(x,y), and x

and y are goods that provide utility and x+y = M and y = M are the price of x and y and M is income. * (Silberberg, 1990, p. 14) Theory Theories can be false either because the underlying model is logically unsound, or because the empirical facts refute the theory.* * (Silberberg, 1990, p. 14) Realistic Assumptions Necessary? There is an ongoing debate (mainly among philosophers) as to whether unrealistic assumptions are a fatal flaw.

Milton Friedman argued that predictive power is the only test that matters. E.g., whether people are rational or not, if they act as if they are, then the assumption is good. Refuting a Theory Worthwhile theories have refutable propositions. That is, when certain test conditions occur, values of some of the variables in the model must be restricted (Silberberg, 1990, p. 15). Law of supply and demand restricts equilibrium price to rise when supply decreases. Since it is possible for price to fall, it is possible for the model to be refuted.

Profit maximization restricts quantity of a factor demanded to fall when its price rises. Since the quantity hired can rise, this theory can be refuted. Comparative Statics The method of comparative statics is how testable propositions are derived from a model. The model of supply and demand Model: Inverse Demand: P = a-bQd a > 0, b > 0 Inverse Supply: P = c+y = MdQs c > 0, d > 0 Solve to get, P* = , and Q* = While it is impossible to theoretically hypothesize values for P* and Q* as doing so would require information on

preferences and production technology, we can (by only assuming the linear functional forms) hypothesize a change in equilibrium if a, b, c, or d changes. Comparative Statics We can hypothesize a change in P* and Q* given a change in an exogenous factor. Even if we dont know values for a, b, c, or d. Assume a>c Comparative Statics ad bc P* bd

a c Q* bd P a slope = d S P* slope = -b D

c Q* Q dP * d 0, da b d dP * d (c a ) 0, 2 db b d

dQ * 1 0 da bd dQ * c a 0 2 db bd

dP * b 0, dc bd dP * b(a c ) 0, 2 dd bd dQ * 1

0 dc bd dQ * c a 0 2 dd bd Similar to being unable to predict P* and Q*, it is impossible to create theories to predict

The obesity rate in the US. The size of shopping carts. That people will work a certain number of hours at the current tax rate. The number of drunk driving fatalities in a state. Instead Theories that predict The change in the obesity rate in each county in the US as a function of a change in the availability of medical technology. The change in the size of shopping carts as a function of the LFPR of women. The change in the number of hours people work if the

tax rate changes. The change in the number of drunk driving fatalities in a state as BAC limits fall and penalties rise. Although we often do this in cross section This Semester In many ways principles = intermediate = advanced Consumer Choice Theory of the Firm Competition Monopoly But at a level between intermediate and a PhD

advanced micro class.

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