Introduction to Microeconomics Class 2 PDF

Introduction to Microeconomics Class 2 Marginal Analysis as a Solution to the Optimization Principle How to use “behavior is optimization” assumption to predict behavior? A Model of Consumer Choice with One Good What is a “good”? - Typically a (physical) commodity,...

Introduction to Microeconomics Class 2 Marginal Analysis as a Solution to the Optimization Principle How to use “behavior is optimization” assumption to predict behavior? A Model of Consumer Choice with One Good What is a “good”? - Typically a (physical) commodity, object What is a “good”? - Typically a (physical) commodity, object - Could also examine a "service" Or an an intangible good such as a novel, a scienti…c discovery, or a recipe for a new good (an invention) - But analysis would be di¤erent Contrast a "good" against a “bad”such as pollution - Could not study "bads" with the methods studied here (without some mod- i…cations) Example 1: A Decision Problem Suppose the task is to explain how many soda cans Joe buys. Suppose the task is to explain how many soda cans Joe buys. - How should we do that? Here is one approach that economists use to predict and explain what Joe does. Suppose we (somehow) know Joe’s “will- ingness to pay” for soda cans. Suppose we (somehow) know Joe’s “will- ingness to pay” for soda cans. How could we know that in practice? Ask Joe - “how much are you willing to pay for 1 soda can?” - “what about 2 cans?” - “what about 3 cans?” - “what about 4 cans?” - “what about 5 cans?” AND assume that Joe tells the truth. AND assume that Joe tells the truth. Farfetched! For now, Willingness to Pay is a theo- retical concept. For now, Willingness to Pay is a theo- retical concept. We hypothetically, magically, know the truth. Or assume that Joe himself knows, and we’re just modelling his behavior. Joe’s Total Willingness to Pay schedule: $4 for 1 Soda can $7 for 2 Soda cans $9 for 3 Soda cans $10 for 4 Soda cans $10 for $5 Soda cans TWP measures total bene…t in terms of money [Figure 2.1] Note that Joe’s willingness to pay is not the same as “how much Joe wants to pay” Note that Joe’s willingness to pay is not the same as “how much Joe wants to pay” “How much Joe wants to pay” is trivial; Note that Joe’s willingness to pay is not the same as “how much Joe wants to pay” “How much Joe wants to pay”is trivial; it is always zero. Joe’s willingness to pay for N soda cans depicts the maximum number of dol- lars he is willing to pay to get N soda cans. Joe’s willingness to pay for N soda cans depicts the maximum number of dollars he is willing to pay to get N soda cans. - If N soda cans costs more, he de…- nitely won’t buy them Joe’s willingness to pay for N soda cans depicts the maximum number of dollars he is willing to pay to get N soda cans. - If N soda cans costs more, he de…- nitely won’t buy them - If N soda cans cost less, he may or may not buy them Assume: Price of a can is $2.50. Q How many will Joe buy? Remember the “Behavior is optimiza- tion” assumption! Remember the “Behavior is optimiza- tion” assumption! - What does Joe maximize? A. Assume that Joe maximizes "Total Bene…t - Total Cost" A. Assume that Joe maximizes "Total Bene…t - Total Cost" Remember the “Behavior is optimiza- tion” assumption! A. Assume that Joe maximizes "Total Bene…t - Total Cost" Remember the “Behavior is optimiza- tion” assumption! - What is the optimal decision? We will use two solution strategies. - Yield the same answer Solution strategy 1. Calculate "Total Bene…t - Total Cost" for all possible quantities [Figure 2.2] Solution strategy 2. 1. Determine Marginal Willingness to Pay schedule. 2. Compare to price. What is meant by “marginal”? additional Joe’s MWP schedule: $4 for 1st Soda can $4 for 1st Soda can $7-$4 = $3 for 2nd Soda can $4 for 1st Soda can $7-$4 = $3 for 2nd Soda can $9-$7 = $2 for 3rd Soda can $4 for 1st Soda can $7-$4 = $3 for 2nd Soda can $9-$7 = $2 for 3rd Soda can $10-$9 = $1 for 4th Soda can $4 for 1st Soda can $7-$4 = $3 for 2nd Soda can $9-$7 = $2 for 3rd Soda can $10-$9 = $1 for 4th Soda can $10-$10 = $0 for $5th Soda can MWP measures marginal bene…t in terms of money MWP measures marginal bene…t in terms of money Price represents marginal cost (in terms of money, obviously) Why is this useful? An optimizing individual buys additional units as long as marginal bene…t > marginal cost. Marginal Bene…t for 1st can > price Marginal Bene…t for 1st can > price Marginal Bene…t for 2nd can > price Marginal Bene…t for 1st can > price Marginal Bene…t for 2nd can > price Marginal Bene…t for 3rd can < price Conclusion: Joe purchases 2 cans Conclusion: Joe purchases 2 cans Our prediction of how many units the consumer buys. Next we introduce a concept that will be useful in later analyses. “Demand curve” How many units consumer(s) buy(s) at any given price Joe’s demand curve? Solved from the MWP schedule [FIGURE 2.3] Why is this useful? [FIGURE 2.4] Example EXTRA: Jimmy’s TWP sched- ule for sunglasses is $100 for 1 pair of sunglasses $100 for 2 pairs of sunglasses $100 for 3 pairs of sunglasses $100 for 4 pairs of sunglasses $100 for 5 pairs of sunglasses Price of a pair of sunglasses is $20. How many will Jimmy buy? Ok. We can predict choices. Ok. We can predict choices. But can we measure Joe’s well-being? One approach: Net Bene…t TWP - Total Cost is a measure of well-being. Example 2: - Suppose that SodaClub members get a 50% discount on each soda can. Example 2: - Suppose that SodaClub members get a 50% discount on each soda can. - Suppose that a SodaClub membership costs $8. Example 2: - Suppose that SodaClub members get a 50% discount on each soda can. - Suppose that a SodaClub membership costs $8. - Will Joe become a member? We must calculate: 1. Joe’s optimal choice and net bene…t with membership. We must calculate: 1. Joe’s optimal choice and net bene…t with membership. 2. Joe’s optimal choice and net bene…t without membership. We must calculate: 1. Joe’s optimal choice and net bene…t with membership. 2. Joe’s optimal choice and net bene…t without membership. And compare the net bene…ts in the two cases. That is done in Problem Set 1 (see Learn)! Summary 1: - First application of marginal analysis - Marginal analysis a solution approach for the optimization principle Summary 2: Comparison of marginal bene…ts and marginal costs yields a behavioral prediction. Please work on Problem Set 1! - Email me by FRIDAY 5pm if you have trouble with some question.