Economics I - Microeconomics: Lecture 1 - Hockey Stick

Introduction to Microeconomics

• Etymology: The word "micro" originates from the Greek word mikrós, meaning "small."

• Definition: Microeconomics studies the behavior of small, single, or individual economic actors.

• Key Actors: Consumers, employers, employees, investors, and businesses/firms.

• Course Outline:

  • I. Introduction to Economics: Focuses on the principle that "there is no free lunch."

  • II. Demand Side: Examination of consumer behavior.

  • III. Supply Side: Decision-making of firms.

  • IV. Markets: Analysis of when markets work and when they fail.

• Gross Domestic Product (GDP):

  • Broad Definition: Measures the monetary value of all final goods and services produced within a specific period (e.g., a year) within a market or country.

  • OECD Formal Definition: An aggregate measure of production equal to the sum of the gross values added of all resident and institutional units engaged in production, plus any taxes and minus any subsidies on products not included in the value of their outputs.

  • Role: It serves as an (imperfect) indicator of economic and social progress.

Malthus’ Law and the "Hockey Stick" Growth

• Thomas Malthus (1766 – 1834): Author of An Essay on the Principle of Population (1798).

• Malthus’ Argument: He contended that due to the Earth’s limited resources, simultaneous population growth and sustainable improvement of living conditions were not feasible.

• Zero Growth: Historically, for centuries, the world experienced "Zero Growth," where living standards remained stagnant despite changes in population.

• The Hockey Stick Transition: This refers to the dramatic upward turn in GDP and productivity following centuries of stagnation.

• Industrial Revolution (ca. 1760 - 1840): This period marked the pivot point from stagnation to sustained growth.

• Technological Progress Examples:

  • Information Storage: In 1956, the IBM Model 350 held 5MB of data. Modern Micro SD cards can hold 128,000MB.

  • Efficiency: Rapid improvements in how information is processed and stored illustrate the "Hockey Stick" curve.

  • Environmental Consequences: Increased production and population growth impact the environment globally (climate change) and locally (pollution, deforestation).

Adam Smith and the Foundations of Economics

• Adam Smith (1723 – 1790): Often cited as the father of modern economics.

• The Theory of Moral Sentiments (1759): Smith explored how humans develop moral judgments. He argued that people observe others, are self-aware, and desire to be perceived well. This creates a "mutual sympathy of sentiments," suggesting humans are not motivated solely by self-interest but also by natural sympathy for others.

• The Wealth of Nations (1776): Smith famously described the "Invisible Hand."

• The Invisible Hand: An individual intending only his own gain is led by an invisible hand to promote the public interest, often more effectively than if he intended to do so.

• The Butcher/Brewer/Baker Quote: "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. We address ourselves, not to their humanity but to their self-love…"

• Compatibility of the Two Books: While they seem to contrast, scholars argue they are compatible: Moral Sentiments covers "sympathy" while Wealth of Nations covers "markets and competition" as mechanisms that keep self-interest in check.

• Division of Labor: Smith identified three circumstances that increase productivity through division of labor:

  1. Dexterity (Geschicklichkeit): Increased knowledge and learning-by-doing for individual workmen.

  2. Saving of Time: Reducing set-up time lost when passing from one task to another.

  3. Invention of Machines: Machines facilitate and abridge labor, enabling one man to do the work of many (this also drives further specialization in machine making).

• Market Expansion: Increasing division of labor results in higher productivity, and trade results in larger markets, creating incentives for further specialization and more machines.

Economic Models and Methodology

• Definition: A model is a simplified description of the real world used to understand human actions and their outcomes.

• The "Map" Metaphor: Just as a subway map (like the MVV in Munich) is a simplified representation of geography that is more useful for commuters than a literal landscape photo, an economic model simplifies reality to highlight specific mechanics.

• Criteria for a Good Model:

  1. Clarity: Helps us better understand something important.

  2. Accuracy in Prediction: Predictions match empirical evidence.

  3. Communication: Helps users understand what they agree or disagree about.

  4. Utility: Can be used to find ways to improve the economy.

• The Scientific Process in Economics:

  • Asking: Defining questions (e.g., "How does the minimum wage affect unemployment?").

  • Predicting: Developing a model to describe actions and outcomes.

  • Checking: Testing the model against empirical evidence (predicted outcome vs. actual outcome).

Scarcity and Constraint Optimization

• Central Tension: Scarcity exists because Resources are less than (<) Needs/Wants.

• Lionel Robbins (1932): Defined economics as the science studying human behavior a relationship between ends and scarce means which have alternative uses.

• Constraint Optimization Formula: $\max_{x,y} f(x, y) \text{ subject to } g(x, \leq d$. In this framework, $(x, y)$ are choice variables (e.g., different products, foods, leisure vs. status). $f(x, \text{ is objective function profit, health, grade average, happiness}).$ $g(x, \text{ constraint limited production capacity, budget, } 24\text{-hour day}).$

• Problems arising from Scarcity:

  • Intra-personal: How an individual manages their own time/money; managing trade-offs.

  • Inter-personal: Who gets the resource? This leads to:

    • Allocation Problems: How to allocate resources efficiently.

    • Distribution Problems: How to allocate resources fairly.

    • Methods of Allocation: Market prices, Lotteries, First-come-first-served, Voting, Top-down assignment, or Brute force.

Pareto Efficiency

• Vilfredo Pareto (1848 – 1923): Shifted economics from moral philosophy toward a data-driven, mathematical approach focused on choice rather than the "reason" behind the choice.

• Definitions:

  • Allocation: The assignment of specific parts of a resource to specific individuals.

  • Pareto Improvement: A reallocation (moving from allocation $A$ to $B$) that improves the utility of some individuals without hurting the utility of any others.

  • Pareto Efficient (Pareto Optimal): An allocation where no further Pareto Improvement is possible. It is impossible to make someone better off without making at least one person worse off.

• Example: Allocating $6$ White Sausages:

  • Utility Values for Albert (A): $0\text{ sausages } = 0, 1 = 1, 2 = 2, 3 = 3, 4 = 4, 5 = 5, 6 = 5$.

  • Utility Values for Brenda (B): $0\text{ sausages } = 0, 1 = 1, 2 = 2, 3 = 3, 4 = 3, 5 = 3, 6 = 3$.

  • Analysis of Allocation $(6, 0)$: This means Albert has $6$ and Brenda has $0$.

    • Is it Pareto-efficient? No.

    • Improvement: Moving to allocation $(5, 1)$ delivers utility $5$ to Albert and utility $1$ to Brenda. Albert is not worse off (his utility for $6$ is the same as for $5$), but Brenda is better off.

  • Analysis of Allocation $(5, 1)$:

    • Is it Pareto-efficient? Yes. To give Brenda one more sausage, Albert would have to drop to $4$ sausages, which reduces his utility from $5$ to $4$. Since someone must be made worse off to make another better off, $(5, 1)$ is Pareto-efficient.