SE201: PRINCIPLES OF MICROECONOMICS. Office Hours: By appointment Phone (office):

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1 SE201: PRINCIPLES OF MICROECONOMICS Fall AY Professor: Kurtis Swope Office: NI 042 Website: Office Hours: By appointment Room: SA106 Phone (office): Course Description: Economics is a social science that is concerned with the study of resource allocation problems. Economists are most interested in the decisions of individuals, firms, and government policy makers in their pursuit of economic objectives. This course is intended as the first in a two-part introductory economics sequence to expose students to the basic principles that underlie the study of resource allocation decisions. Key topics include the understanding of production possibilities, gains from trade, consumer preferences and choice, costs of production, market exchange, and market structure. The course also introduces the important concepts of allocative efficiency, equity, market failure, and government failure, and discusses the potential role (and limitations) of government policy for promoting market efficiency and addressing inefficiency and equity concerns. Learning Objectives: Upon completion of this course, students should: Understand the basic principles that lead to gains from trade, including voluntary market exchanges and international trade. Be able to use the model of supply and demand (including algebraic representations of both) to derive and explain changes in equilibrium prices and quantities in free, competitive markets. Students should also be comfortable explaining the importance of elasticity and taxes (and other government policies) as they relate to equilibrium market changes and market efficiency. Be able to identify and explain the most significant potential market failures including externalities, public goods, and market power. Students should also acquire a basic understanding of the importance of property rights and the role of government in a market economy, and be fully cognizant of the potential for government failure (that is, the economic and political limitations of government for addressing market failures). Be able to understand the nature of production costs and their importance for determining industry structure. Be able to distinguish between the factors of production (land, labor, physical capital, human capital) and how they are compensated in a free market. Students should also become comfortable with basic principles behind distributive justice and policies intended to address inequality in the distribution of wealth in a market economy. (Time permitting) be able to use calculus to derive the consumer s optimal consumption bundle through a constrained maximization problem. Textbook: N. Gregory Mankiw, Principles of Microeconomics, 7th ed. Grades: Your course grade is based on total points accumulated on: (A) (B) (C) 2 Midterm Exams 100 points each Final Exam (Cumulative) 100 points Homework and Weekly Writing Assignments 100 points Grading Scale: There will be a total of 400 points possible in this course. Your final letter grade will be based on the following scale - expressed as a percentage of 400 points: 1

2 A (90-100%) B (80-89%) C (70-79%) D (60-69%) F (59% and below) This grading scale is absolute (there will be no curve ). Everyone can get an A or everyone can get an F. A grade will be rounded up if the fractional part of the final average is equal to or above.5. A grade will be rounded down if the fractional part of the final average is below.5. For example: 89.5% becomes 90%, an A for the course. An becomes an 89%, a B for the course. Exams: All exams consist of multiple choice, short answer, essays, and problems. Tentative exam dates are listed below. Using calculators in text mode or to access pre-programmed material of any kind during an exam is not permitted. Students are reminded that plagiarism is the presentation of another s work as one s own. Plagiarism is the most serious example of academic dishonesty. Plagiarism and proper documentation techniques are discussed in The Longman Handbook for Writers and Readers. Any student found to have plagiarized either all or part of a course paper will receive a grade of zero and be charged with violation of the Honor Concept. Extra Credit: Under no circumstances will I give extra credit to individual students. However, during the course of the semester there may be optional class exercises in which extra credit may be earned. Homework and Weekly Writing Assignments will be announced in class. Both will be collected and checked. Students not in class the day an assignment is made or due are still responsible for completing the assignment on time. All assignments will be posted on the web for you to download if you are not in class. You should always check to see if an assignment has been made. Writing assignments must be typewritten. Assignments that are complete and represent a Good Faith Effort will receive a check. Some homework solutions will be posted on the web, when possible. Students are encouraged to work together on homework assignments, but each student is responsible for working through all problems. Simply copying work from a classmate to complete an assignment is dishonest and unacceptable behavior. 2

3 Tentative Schedule and Outline of Topics PART I: FREE MARKET EXCHANGE AND THE GAINS FROM TRADE 1. Ten Principles of Economics. 2. Thinking Like an Economist. Appendix: Graphing: A Brief Review. 3. Interdependence and the Gains from Trade. PART II: COMPETITIVE MARKETS AND THE MODEL OF SUPPLY AND DEMAND 4. The Market Forces of Supply and Demand. 5. Elasticity and Its Application. PART III: MARKETS, WELFARE, AND EFFICIENCY 7. Consumers, Producers, and the Efficiency of Markets. Exam 1 - week of Sept 28 - Oct 2 6. Supply, Demand, and Government Policies 8. Application: The Costs of Taxation. 9. Application: International Trade. PART IV: MARKET FAILURE AND THE ECONOMICS OF THE PUBLIC SECTOR 10. Externalities. 11. Public Goods and Common Resources. 12. The Design of the Tax System. Exam 2 - week of Nov 2 - Nov 6 PART V: FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY 13. The Costs of Production. 14. Firms in Competitive Markets. 15. Monopoly. 16. Monopolistic Competition. 17. Oligopoly. PART VI: FACTOR MARKETS AND DISTRIBUTIVE JUSTICE 18. The Markets for the Factors of Production. 19. Earnings and Discrimination. 20. Income Inequality and Poverty. PART VII: MICROECONOMIC THEORY 21. The Theory of Consumer Choice. Final Exam TBA (the final exam is cumulative and consists of a full AP Microeconomics exam) 3

4 SE201: Principles of Microeconomics Course Notes : Free Market Exchange and the Gains from Trade (Chapters 1 3) I. Introduction (Chapters 1 and 2) It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. As every individual, therefore, endeavours as much as he can both to employ his capital in support of the domestic industry, and so direct that industry that its produce may be of greatest value he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always worse for society that it was no part. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. (Book IV) Adam Smith, The Wealth of Nations, 1776 Adam Smith ( ) Economics is the study of is the study of how households and firms make decisions and how they interact in markets. 1 is the study of economy-wide phenomena, including inflation, unemployment, and economic growth. In the quotes above (perhaps the most famous in all of economics), Adam Smith explains how, even though individuals may (to a large extent) be self-interested in their decision-making, in a well-functioning market economy these many decentralized decisions lead to an allocation of resources that (frequently) promotes the well-being of society very effectively. 1 Microeconomics may also study the decisions and policies of governments and countries, particularly focusing on the impacts of those policies on households and firms and their responses to policy decisions 4

5 In the first quote, Smith identifies briefly why the market economy is so effective at allocating resources to satisfy society s wants and needs specialization and exchange While people can (and do) benefit from specialization and exchange in the absence of any formal government, government can play an important role in establishing and maintaining the necessary pre-conditions for markets to function properly. Government may also play an important role in addressing market failures and in providing a means for society to provide social insurance or address inequities in the distribution of wealth and well-being. You should read Chapters 1 and 2 of the textbook 5

6 II. Assumptions and Models In order to establish working theories about how resource allocation decisions are made, and to develop economic models (the supply and demand model being the most famous) to predict how external changes ( shocks or the implementation of a government policy such as a tax) will impact those decisions, it is necessary to start with a set of assumptions about human economic behavior. The main assumptions are: 1. People are rational. 6

7 2. People have objectives they are trying to maximize. 3. People are generally self-interested? (May or may not be an accurate assumption) Note: While people may (and often do) demonstrate selflessness (they give to charities, donate blood, risk their lives to save a fellow soldier), assuming that people will generally act in their own interest, as a general rule, seems more reasonable than assuming that people will always put others first. The dynamics of self-interested versus other-regarding behavior is a complex one. However, as Adam Smith noted, there are many instances in which acting in one s own interest can benefit others quite significantly. One example is working hard (in order to earn a living) by producing something that others want. Both you and others can gain though mutually beneficial exchange! 7

8 Finally, economists generally use assumptions and models to make positive statements, but may at times make normative statements. Positive statements Normative statements 8

9 III. The Production Possibilities Frontier and the Gains from Trade (Chapter 3) No man is an island, Entire of itself, Every man is a piece of the continent, A part of the main. If a clod be washed away by the sea, Europe is the less. As well as if a promontory were. As well as if a manor of thy friend's, Or of thine own were: Any man's death diminishes me, Because I am involved in mankind, And therefore never send to know for whom the bell tolls; It tolls for thee. John Donne, Fortunately, no man is an island and must earn a living in isolation. Our material well-being is greatly enhanced by the ability to cooperate and trade with our fellow man. A. The Production Possibilities Frontier (PPF) Imagine that Kevin and Jack live on separate islands. Each can produce apples and bananas that grow on the island. Each has 10 hours per day to collect fruit. 9

10 A Production Possibilities Frontier (PPF) shows the combinations of output that an economy can possibly produce given the available factors of production and the available production technology. Kevin s PPF can be illustrated as follows: Apples Kevin s PPF Bananas 10

11 Algebraically, we can express Kevin s PPF as:. Notice how the slope of Kevin s PPF is (minus). Kevin s opportunity cost of producing a banana is constant and equal to apples. He gives up apples for each banana he collects OC B K = Similarly, we can reverse the perspective and view the problem in terms of Kevin s opportunity cost of producing an apple (which is always the reciprocal of the opportunity cost of producing a banana) OC A K = While points along Kevin s PPF represent different production combinations that are possible with the 10 hours of labor he has available, a point like G (inside the PPF) is A point like H (outside the PPF) is 11

12 A brief aside on opportunity costs : Because we all face tradeoffs in deciding how to allocate scarce resources, the opportunity cost of a decision or course of action is a very important concept in economics. Formally, Opportunity cost is Opportunity costs can include both explicit and implicit costs. Explicit costs are Implicit costs are Consider the following examples: 1. William is the top high school basketball player in the nation. He decides to attend four years of college instead of going directly from high school into the NBA draft. He would have gotten a four-year contract with the Knicks worth $1 million per year. He receives a college scholarship for tuition and room and board, but must pay $500 per year for college textbooks. In calculating the opportunity cost of his decision to attend college, what are explicit costs and what are implicit costs? 2. Makena has received acceptance letters and full scholarship offers from Harvard University in Boston, MA; Stanford University in Stanford, CA; and Columbia in New York, NY. Makena had also applied to Yale in New Haven, CT, but was not accepted. Makena's first choice first choice is Harvard, her second choice is Yale, her third is Stanford and her fourth is Columbia. Which of the following is an accurate statement? (A) For Makena, there is no opportunity cost of attending college since she has been offered a full scholarship. (B) Makena's opportunity cost of attending Harvard is not being able to attend Columbia. (C) Makena's opportunity cost of attending Harvard is not being able to attend Stanford. (D) Makena's opportunity cost of attending Harvard is not being able to attend Stanford, Columbia and Yale. (E) Makena's opportunity cost of attending Harvard is not being able to attend Stanford and Columbia 12

13 3. What was your opportunity cost for attending the Naval Academy? Are these explicit or implicit costs? 13

14 Jack s Production Possibilities Frontier can be illustrated as follows: Apples Jack s PPF Algebraically, we can express Jack s PPF as: Bananas where A J is the number of apples Jack produces, and B J is the number of bananas he produces. Jack s opportunity cost of a banana is constant and equal to 0.5 apples. Jack s opportunity cost of an apple is constant and equal to 2 bananas. OC B J = OC A J = You should read Chapter 3 of the textbook: Interdependence and the Gains from Trade 14

15 B. Absolute and Comparative Advantage Question: Who has an advantage in producing apples? In producing bananas? Absolute advantage or Comparative advantage Jack has over Kevin at producing bananas (can produce 20 bananas with 5 hours of labor. It would take Kevin 10 hours to produce 20 bananas). Jack also has a at producing bananas. OC B J = OC B K = But Kevin has a at producing apples. OC A K = OC A J = ( has an absolute advantage at producing apples). 15

16 C. Gains from Trade It is precisely these differences in comparative advantage that give rise to gains from trade. Suppose Kevin were to focus exclusively on producing one good. What should he produce? Suppose Jack were to focus exclusively on producing one good. What should he produce? If Kevin and Jack were then to engage in trade, what would be an acceptable terms of trade? (or the price of banana = apple) For the two parties to gain from trade, the price at which they trade must lie between their two opportunity costs. The actual terms of trade would result from bargaining between the parties. The price of a banana could end up anywhere between and apples (depending on who is the better bargainer). Importantly, consider how specialization and trade at this rate would expand each person s consumption possibilities Kevin Jack Apples Apples Bananas Bananas 16

17 Why / how does comparative advantage arise between individuals or countries? We usually can identify one or more reasons: 17

18 Gains from trade can also occur (even if there are identical resources or identical capital / technology) if there are economies of scale associated with production of a good. Economies of scale The PPF s below are identical and bowed in, but Kevin and Jack could expand their consumption possibilities by specializing in producing either apples or bananas (they must coordinate), and then trading at say a price again of, say, one apple per banana. Kevin Jack Apples Apples Bananas Bananas 18

19 However, in some cases it is reasonable to expect a country s production possibility frontier to be bowed out. Why would this occur? What does it imply about the opportunity cost of producing more of a good? Apples 0 Bananas In general, moving along a PPF we calculate Example: Calculate the opportunity cost (OC X ) per unit for each of the following 10 unit production increases in Good X (and corresponding decreases in Good Y) along a country s PPF. What can you say about the opportunity cost of increasing production of Good X? Good X Good Y OC X

20 D. Opposition to International Trade If countries have so much to gain from international trade, why might some people oppose trade? 20