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MBA 530 ECONOMICS

Lecture 1: Introduction to Economics

** This material is the copyrighted property of Peter W. Schuhmann** Any form of distribution without written permission from the author is prohibited

INTRODUCTION TO ECONOMICS Welcome to economics. Over the course of our short time together, I’m going to try to convince you that the study of economics can be applied to just about anything that involves human behavior. My first econ professor (Bill Wadman) said “Economics is in everything and everything is in economics”. If you haven’t had much exposure to economics, you probably don’t believe it. I sure didn’t. But after a while I began to realize that this statement is very true. Why? Let’s do an exercise… Construct one or more of these lists:

1. List all the places you’d like to visit in the next 25 years. 2. List all the material possessions you’d like to acquire in the next 25 years. 3. List all things you’d like to do with your free time in the next 25 years.

Only list the places you want to go, the stuff you want to have or the things that you want to do. That is, base your list only on your wants, not what you can afford. Now look at your list and highlight only those things that you reasonably expect to accomplish in the next 25 years. Questions to consider:

1. Why did you circle only some of the items? 2. Why did you choose the items that you did choose? 3. What are the implications of choosing one place or item?

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First, we have to make choices because our time is limited, our financial resources are limited, and our energy is limited. We can’t have it all. Even the richest people in the world must make choices. Second, we make our choices based on our preferences, which are inherently personal and subjective. What you like and what you want to do will be different than what I like and what I want to do. We’re going to soon discuss the notion that economics is an objective discipline, but keep in mind that underlying much of our objective analysis is personal preferences. Finally, note that choosing one item on your list probably means forgoing some other item on your list. In other words, because we can’t have it all, choosing one item means sacrificing something else. Hopefully this exercise helps you see that what we’d like to do with our resources is virtually unlimited … if given enough time we could itemize everything and fill up pages and pages of cool stuff that we’d like to do or acquire. But we have to make choices. When we make choices we make trade-offs. So, getting back to the quote about economics being in everything, the discipline of economics can be used to study almost anything that involves human behavior, because most behaviors are rooted in choices. We have to study choices because our resources – time, money – are scarce. So we can say that economics is “the study of choices in the face of scarcity.” Some examples:

• Consumer decisions about what to buy • Producer decisions about what to sell and how to sell it • Everyday individual decisions such as when to go to bed, when to go out,

how much to study, how hard to work, how many kids to have… • Political and policy decisions made by government or other agencies, etc.

Considering all these levels of decision-making, it’s easy to see why the discipline of economics has more than a dozen sub-disciplines:

• Health economics • Public sector economics • Public finance

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• Labor economics • Economic history • International economics • Monetary economics • Economics of growth and development • Econometrics • Mathematical economics • Welfare economics • Regional economic impact analysis • Environmental economics • Natural resource economics

Obviously, tradeoffs are inherent in all of these areas. Generally speaking, we look at how people deal with scarcity and tradeoffs on two general levels:

1. The individual consumer or firm level:

• How consumers decide which goods and services to purchase, how to allocate your time,

• How firms decide which products to produce, and how to produce them, what inputs to use.

• Together, the analysis of buyers and sellers constitutes the study of markets.

These smaller level decisions in the presence of scarcity are studied under Microeconomics.

2. The society or economy-wide level:

• how markets interact to determine production in an entire economy • how nations interact to allocate goods and services through trade • how government intervenes in markets through policy.

These larger level decisions are studied in Macroeconomics.

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In this course we’re not going to get too far beyond the market level. We’ll spend a lot of time with a general representation of a market (the supply and demand model) then look at each side of the market (producers and consumers) in more detail. The two are not separate though. Most of the tools, models and intuition we get from microeconomics carry over and are used in macro, just in a larger context. ---------------------------- OPPORTUNITY COST At all levels of study, a central idea in the study of choices and trade-offs is the concept of opportunity cost. Basically, opportunity cost is what we give up when we make a choice. More formally, opportunity cost is the value of the next best (but unchosen) alternative. Some important points about opportunity cost: • Opportunity cost is the value of the next best alternative for our time or money,

not necessarily the price of that alternative. • Opportunity cost is not the sum of values of everything we could have done

with our time or money, only the value of the next best alternative. Here are some examples:

1. The opportunity cost of choosing to pursue an MBA is the value of the time and money that you sacrifice over the next two years. What is the next best use of that money? What is the next best use of the time you’ll dedicate to your studies? You can also consider an individual who chose to NOT pursue an MBA… what is the opportunity cost of that decision?

2. Suppose you are deciding where to go to lunch. You’ve got it down to 3

choices: PT’s, El Cerro, and Elizabeth’s. For simplicity, assume that you’ll spend approximately the same amount at any of the restaurants. If you decide to go to PT’s, what is the opportunity cost of that decision? The opportunity cost would be the value of the meal at whichever restaurant would have been your second choice. Note that it’s not the combined value

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of both other restaurants, because you didn’t have the opportunity to go to both other restaurants.

3. Suppose that it’s the night before your first economics exam and a close friend of yours is having an annual party that you always attend. You have to choose between going to the party and studying. Suppose you choose to stay home and study. What is the opportunity cost of that decision? If you choose to go to the party, what is the opportunity cost of that decision?

4. After graduation the Cameron School of Business with an MBA, suppose that you face the following job choice:

• job option 1 = working as a private consultant with income = $45,000/

year. You set your own hours, dress the way you want to, essentially you are your own boss.

• job option 2 = working for a big invesment firm on Wall Street with income = $85,000/ year. Corporate dress code, boss looking over your shoulder, 60-hour work week, daily grind.

Suppose that you select option 1, and in doing so, you give up the Wall Street job because you can’t do both. What is the opportunity cost of taking the private consulting firm job?

Answer: the opportunity cost of accepting the private firm job is the full value of the Wall Street job. That is, in order to appreciate the opportunity cost of this decision, we have to ask: what is the Wall Street job worth? It is worth $85,000, plus whatever other benefits, corporate advancement, lifestyle and prestige go with it. The opportunity cost of the private consulting job is all that stuff. Hopefully, you didn’t simply subtract salaries and conclude that the opportunity cost of accepting the private firm job was $40,000. It’s not. When you turned down the Wall Street job, you said “no” to $85,000 and all the benefits etc. so that is precisely what you gave up.

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POSITIVE AND NORMATIVE ANALYSIS Within all branches of economics, we spend a great deal of time engaged in something known as positive analysis. Positive analysis is analyzing or predicting the effects or consequences of actions that take place within economic systems (households, firms, markets, nations) without making subjective judgments. Much of positive analysis amounts to completing “if…then” statements. Positive analysis relies on the use of facts, data, theories and models to understand cause and effect. Much of what we do in economics is purely objective – just looking at facts without interjecting our personal beliefs or opinions. We can break positive economics into 2 general ideas: • descriptive economics (describing facts based on specific data) • economic theory (generalizations about relationships that are commonly held

true based on a collection of observations) Some micro examples of questions that might be addressed with positive analysis: • What will happen to the quantity of a particular good demanded when its price

is raised by 10%? • What will happen to the revenue of the company that sells the product when

price is raised by 10%? • What will happen to employment and wages when a new minimum wage law is

passed? • What happens to the price of a good when it becomes more fashionable? Less

fashionable? Macro egs: • What will happen to housing puchases if the Federal Reserve decides to raise

interest rates next quarter? • What happens to the price of US goods when trade restrictions with Mexico are

lifted? • How will economic growth be affected if federal income taxes are increased for

households earning more than $500,000?

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So, positive analysis focuses on: • cause and effect • what is actually going on or what might actually take place • things that can be empirically proven or disproven The opposite of positive analysis is normative analysis, which is based on value judgments regarding whether an outcome or state of the world is a “good” thing or a “bad” thing. A distinction that I like is as follows: Whereas positive analysis focuses on “what is”, normative analysis focuses on “what ought to be”. As we study economics throughout the semester we’re going to do a lot of “real- world” examples, and naturally we’re going to encounter issues where normative questions are raised. Examples include:

• Analysis of price controls such as minimum wages • Analysis of the incidence of sales taxes • Analysis of taxes on pollution • Analysis of free trade and “outsourcing” of jobs to other nations • Analysis of the tradeoff between economic efficiency and equity (fairness)

We all likely have opinions on these topics, perhaps strong opinions. But our job as students of economics is to leave those opinions at home and focus on what we know and what we can prove. For the most part we’re going to steer clear of making any normative conclusions, simply because we’re all individuals and we have our own opinions as to what “ought to be”. I consider it my job to teach you how to do the positive part – how to see what is happening and what the effects are but I’ll leave it up to you when we get to deciding whether or not the effects are a good or bad thing. Typically, economists don’t do normative analysis – politicians do.

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COST-BENEFIT ANALYSIS and “RATIONAL” DECISION MAKING In many areas of life, we are faced with “yes/no” choices. A simple economic tool called “cost-benefit analysis” can help us make these decisions. Most of us have probably engaged in informal cost-benefit analysis when we make lists of pros and cons of alternatives (different houses or apartments, cars, trips, etc). The formal process of identifying, measuring, monetizing and comparing costs and benefits is called cost-benefit analysis (or benefit-cost analysis). Comparing costs and benefits helps us make “rational” choices. Rational simply means pursuing actions for which the (expected) benefits outweigh the costs. --- Note: Economists are often criticized for assuming that people are rational. However, when we recognize that benefits need not be directly associated with money (emotional benefits are real benefits), and that costs include opportunity costs, we see that most people are indeed perfectly rational by this definition. I think the criticism stems from the fact that most people operate under a different definition of the word “rational”. We should recognize that the assumption that people are rational is necessary for modeling cause-and-effect. If we wish to predict the outcome of a potential change, we need to be able to predict how people will behave. If we can assume that people will pursue actions for which the benefits exceed the costs and forgo actions for which the costs exceed the benefits, then we have a strong foundation upon which to build models of human behavior. --- Regarding yes/no decisions, the rational decision-making rule is relatively straightforward: If the benefits of a given choice outweigh the costs (including opportunity costs) then you gain from making the choice. The difference between benefits and costs is labeled as a net gain, and the action is considered a good idea. It’s basic common sense and in most situations in life we don’t even think about it. It’s just the fundamental way we make decisions. Some everyday examples of cost-benefit analysis: • Should you get up at 6:00 AM tomorrow? • Should you pursue an MBA? • Should you go to class on Monday night?

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• Should we hire a new staff member? • Should our firm increase our advertising budget for the summer? • Should we postpone the launch of the new product? • Should the U.S. allow offshore drilling in deep waters off the east coast? • Should the tax on gasoline be increased? Answering each of these questions would require a systematic measurement of costs and benefits. In some cases, this is straightforward, but in other cases the costs and benefits may be difficult to measure and monetize. We often must rely on estimates, the derivation of which is beyond the scope of this class. Obviously, costs and benefits aren’t the only things that drive our decisions, but they do make up an important component. THINKING AT THE MARGIN The common-sense decision-making process of cost-benefit analysis can be a very powerful tool when it is applied incrementally or “at the margin”. --- Note: Perhaps one of the most important terms in economics is “MARGINAL” which means on the edge, or on the border. The marginal unit is the next unit, or the “incremental unit”, or the “additional” unit. --- Marginal Analysis is a type of cost-benefit analysis. We need marginal analysis, because sometimes choices are not as simple as “yes/no”, but rather are a decision of quantity (“how many” or “how much”). What is the best number or size of something? Examples of quantity decisions: • How many slices of pizza to eat? • How many beers to drink? • How big of a house to build (how many bedrooms or square feet)? • How many workers to hire? • How much to spend on advertising? • How many units to produce this quarter?

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When this is the type of decision we have to make, comparing total costs and total benefits (as we did with cost-benefit analysis) doesn’t really cut it. We have to look at a comparison of marginal costs and marginal benefits. Such a comparison is called “Marginal Analysis”. There are many examples of marginal analysis in micro and macroeconomics, and nearly all of them are associated with optimizing behavior, such as profit- maximization by firms or utility-maximization by consumers. When we engage in marginal analysis and pursue only those incremental units for which the marginal (additional) benefits exceed the marginal (additional) costs, we end up with the optimal quantity. This is the quantity that results in the highest net gain. Consider the following consumer example: Suppose you’re sitting in a local pizza shop, eating slices of pizza one at a time. Your decision: how many slices to purchase? Assume price of each slice is $1.50. Note that this unit price is the marginal cost of each unit for the consumer. That is, each slice costs you an additional $1.50. Also assume we can measure your marginal (additional) benefit from each slice in dollars as follows: Slice marginal benefit 1 4.50 2 2.75 3 1.51 4 0.75 Note that these marginal benefits represent the value to you of each unit. It should make sense that marginal benefits are diminishing in quantity. As you consume more units of something, your satisfaction wanes, and the incremental benefits you derive from each unit decline. This idea is known as the principle of diminishing marginal benefits, and can be applied to most goods, assuming that units are of the same quality.

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--- More notes about marginal benefit (MB): The marginal benefit that you receive from a unit represents what that unit is worth to you and as such, reveals your maximum willingness to pay for that unit. For a consumer, this willingness to pay is termed the reservation price (or “choke price”). The consumer will not purchase the unit for any price above their reservation price. Sellers also have a reservation price, which is the minimum price at which they are willing to sell. Seller’s reservation price is usually the same as the marginal costs of producing the unit. --- Getting back to the pizza example, let’s now compare the marginal benefits and marginal costs of each unit, calculate net gains from each unit, and decide how many slices of pizza to purchase… Slice marginal benefit marginal cost net gain 1 4.50 1.50 3.00 2 2.75 1.50 1.25 3 1.51 1.50 0.01 4 0.75 1.50 -0.75 Hopefully you see that the best quantity in this example is 3 slices. For each slice up to and including the 3rd, we have MB > MC, so we receive a net gain. But after the 3rd slice, we have MC > MB, so we experience a net loss. That’s marginal analysis. Simply compare the additional benefits with the additional costs of each unit, and then make a rational decision.

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Looking at this example graphically: $ (mb, mc) 3 2 1

1 2 3 4 5 Q pizza A few interesting things to consider:

1. What if the marginal benefit from the 3rd slice had been $1.50 instead of $1.51?

Would you consume that 3rd slice? That is, would you pay $1.50 for something that is worth $1.50 to you? I think the answer is yes, we will pay up to our reservation price for a particular unit, though if you express some form of indifference you’re probably correct.

2. What if we had applied cost-benefit analysis to the following question: Should you consume 4 slices, yes or no? And to answer that question we compared the total costs and total benefits of 4 slices as:

Total cost of 4 slices = 1.50 x 4

= $6.00 Total benefits of 4 slices = sum of MB from each

= 4.50 + 2.75 + 1.51 + 0.75 = $9.51

Note that TB > TC and consuming 4 slices yields a net gain of $3.50. A cost-benefit analysis here might lead us to an inefficient (though rational) solution. We have a positive net gain, but not the maximum possible net gain.

MC MB

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Note that the total net gain from 3 slices is $4.26, hence consuming 3 slices is a better decision than consuming 4. I used the term efficient in that discussion, and that warrants a little explanation: In economics, efficiency or being efficient is getting the most gain for the least cost. More simply, being efficient means getting the highest possible net benefits given your available resources. We’ll get back to the notion of efficiency many times during the semester and in many contexts.

3. Marginal benefits can be zero or negative. Suppose that after eating 5 slices of pizza, you’re very full. The 6th slice may give you zero benefit (you would not pay anything for it) or it might make you sick (you’d experience pain from eating it and therefore be willing to pay to not eat it).

4. There are many situations where we pay for an unlimited quantity of

something by way of a flat fee. Examples include cable TV (watch all you want for one price), unlimited cell phone minutes, all-you-can-eat buffets, and internet access. When we pay a flat fee for something, the marginal cost of additional units is zero. There are many interesting questions and problems that pertain to flat fees and the associated zero marginal cost. Consider how a rational decision maker would determine the optimal quantity to consume when marginal cost = 0 and you’ll see why many of these goods are “over-consumed”.

A couple of terms to wrap up this introductory material: Net gain = “economic surplus” = excess of benefits over costs. Any economic agent can receive an economic surplus from a transaction. For example, a consumer receives a “consumer surplus” when they purchase a good for less than their reservation price (price < max WTP). A producer receives a “producer surplus” when they sell a good for more than their reservation price.

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We’ll use the concepts of opportunity costs, marginal analysis, economic surplus and efficiency throughout the course, in both micro and macro contexts. Next we’re going to learn about efficiency and gains from trade by studying the concept of comparative advantage.