C6

Microeconomics Seminar 1: Opportunity Costs, Market Equilibrium, and Methodology

Opportunity Costs and Resource Allocation

  • Definition: The opportunity cost is the value of the best alternative given up when making a choice between two or more options. It is not purely a monetary cost or a price paid, but is always computed relative to a substituted alternative.

  • Key Resource Example: Time is a classic example of a resource subject to opportunity cost. An individual can choose to work or engage in leisure. The cost of leisure is the salary (wage) foregone by not working, while the cost of working is the loss of free time for leisure.

  • General Rules for Correct Statements regarding Opportunity Cost:

    • It is not limited to direct monetary costs.

    • Example Case: Iris is deciding between driving and public transport. The opportunity cost of driving equals the monetary costs (gas, tolls) plus the foregone value of what she could have done on the train (e.g., reading or working), making the statement that costs are equal to public transport costs false.

    • University Example: The opportunity cost of pursuing a degree includes the salary that could be earned right now. It does not necessarily include future pensions, as those are not immediate foregone alternatives.

    • Economic Context: The opportunity cost of attending university is actually LOWER during a recession because high unemployment makes it harder to get a job; therefore, the foregone wage (the cost) is lower compared to period of economic boom.

Microeconomics vs. Macroeconomics

  • Microeconomics Focus: Studies the choices of individual economic agents. This includes:

    • Households making consumption and savings decisions.

    • Firms making investment, pricing, and staffing decisions.

    • Individual markets for specific goods.

    • Public taxation that influences individual allocation and optimization.

  • Macroeconomics Focus: Studies the behavior of the entire economy as a whole. This includes:

    • National consumption and total investment evolution.

    • The banking system and total government taxation impact on the whole economy.

    • National savings rates and their relation to economic growth.

    • Inflation rates and their variation relative to the total money supply.

  • Classification Examples:

    • A family's savings decision: Micro.

    • Public regulation's impact on car pollution: Micro (relates to a specific market sector).

    • Effect of national saving rate on growth: Macro.

    • Company choosing the number of employees: Micro.

    • Relation between inflation and money supply: Macro.

Methodology: Correlation and Causality

  • Causality (x→yx \rightarrow y): A change in variable $x$ directly results in a change in variable $y$ (e.g., a specific policy improves labor outcomes).

  • Reverse Causality (y→xy \rightarrow x): What is thought to be the cause is actually the effect.

    • Named Example: The mortality rate is higher in hospital beds than in home beds. This does not mean the hospital kills you; rather, being severely ill ($y$) causes you to be in a hospital bed ($x$).

  • Spurious Correlation (z→x,yz \rightarrow x, y): A third, often unidentifiable factor $z$ causes both $x$ and $y$ to move together, but there is no causal link between $x$ and $y$.

    • Named Example: Positive correlation between violent crime and ice cream sales. Both are actually caused by warm weather ($z$).

  • Practical Application (School Performance):

    • Correlation: Higher teacher salaries and smaller class sizes correspond with better test results.

    • Proof: Observing this correlation does not prove causality. To prove causality, one needs formal experiments, thorough sample investigations, and specific environmental measurements. Simply observing two things happening together is not a guarantee of a causal nexus.

Market Equilibrium: Demand and Supply Analysis

  • Supply and Demand Shifts for Eggs:

    • Scenario 1 (Demand-driven): If brown eggs cost more than white eggs, it could be because the supply is the same for both, but demand for brown eggs is higher.

    • Scenario 2 (Supply-driven): Demand is the same, but the supply curve for brown eggs shifts to the left (lower supply), driving the price up.

  • Valentine’s Day Rose Market:

    • Observation: Prices increase right before the holiday.

    • Mechanics: This is an outward shift of the demand curve to the right. While quantity increases along the supply curve, the fundamental driver is the demand shift.

  • Algebraic Equilibrium Equations:

    • Given Demand: Qd=5−PQ_d = 5 - P

    • Given Supply: Qs=P−1Q_s = P - 1

    • To solve for equilibrium, set quantity supplied equal to quantity demanded: P−1=5−PP - 1 = 5 - P

    • Solve for Price: 2P=6→P=32P = 6 \rightarrow P = 3

    • Solve for Quantity: Substitute $P=3$ into either equation: Q=5−3=2Q = 5 - 3 = 2

    • New Supply after Production Cost Increase: Qs2=P−3Q_{s2} = P - 3

    • New Eq: P−3=5−P→2P=8→P=4P - 3 = 5 - P \rightarrow 2P = 8 \rightarrow P = 4

    • New Quantity: Q=5−4=1Q = 5 - 4 = 1

    • Economic Impact: Equilibrium price increases from $3$ to $4$, and quantity traded decreases from $2$ to $1$. Total spending (P×QP \times Q) decreased from $6$ to $4$.

Complements, Substitutes, and Market Spillovers

  • Definitions:

    • Substitutes: Goods that can be used in place of one another (e.g., Coffee and Tea). If the price of one increases, the demand for the substitute increases.

    • Complements: Goods used together (e.g., Coffee and Cookies). If the demand for one increases, the demand for the other typically increases.

  • The Wheat and Corn Scenario (Exercise 8):

    • Context: Wheat and Corn are substitutes. Both are affected by heavy rain/drought.

    • Wheat Market: A negative supply shock shifts the supply curve left, increasing the price of wheat and decreasing the quantity.

    • Corn Market Spillover: Because wheat is more expensive, people want to substitute toward corn (Demand shift right). However, heavy rains might simultaneously cause a negative supply shock in corn (Supply shift left).

    • Conclusion: The price of both goods will definitely increase. However, the exact change in quantity for wheat is uncertain (undetermined without more data) because it depends on the relative price variations. If the price of corn increases more than the price of wheat, people might stay with wheat despite its higher cost.

Economic Cost and Decision Making

  • Trade-off Example: Concert A (\$25 admission) vs. Concert B (Free, but provides \$15 of enjoyment utility).

    • Opportunity Cost: The cost of choosing A is the monetary price (\$25) plus the foregone enjoyment of B (\$15), totaling \$40.

    • Logic: If your pleasure from Concert A is \$35, you should not go, because \$35 is less than the total economic cost of \$40. If your pleasure is \$50, you should go, as you gain an economic rent of \$10.

  • Taxi Driver Example:

    • Earnings: \$50/day.

    • Ticket cost: \$40.

    • Utility of experience: \$100.

    • Decision: $100 - 50 - 40 = +10$. The driver benefits by \$10 in economic rent.

    • Failure to go to work makes the real cost \$90 (Opportunity Cost),

Market Deviations: Excess Demand and Minimum Wages

  • Market Clearing Price: The price where quantity supplied equals quantity demanded. If the price is different from this level, a shortage or surplus arises.

  • Excess Demand (Shortages):

    • Traffic Jams: Can be viewed as excess demand for finite road space supplied by the government.

    • Rental Apartments: Occur when demand exceeds supply at a given price (often due to price ceilings).

    • Concert/Stadium Tickets: Fixed supply of seats cannot meet high demand at the set ticket price.

  • Minimum Wage Analysis:

    • Excess Supply of Labor: If the government sets a minimum wage ABOVE the market equilibrium wage, the quantity of labor supplied by workers increases, but the quantity demanded by firms decreases.

    • Outcome: The gap between supply and demand results in unemployment (N−N∗N - N^*). In microeconomic terms, this is an excess supply of labor rather than an excess demand.

Questions & Discussion

  • Question (Class Size): Does the observation that salaries/class size influence performance prove anything?

  • Response: No, it only shows correlation. To prove the underlying mechanics (causality), deep econometric analysis or experiments are necessary.

  • Question (Corn Market): Why is the quantity in wheat undetermined in Exercise 8?

  • Response: Because we don't know the relative magnitude of the price changes. If $Price_{Corn}$ rises more proportionally than $Price_{Wheat}$, people won't substitute away from wheat as much as expected.

  • Question (Traffic): Is a traffic jam an excess supply of vehicles?

  • Response: No, the "good" being measured here is the road space. There is not enough road to meet the demand of people wanting to use it, signaling excess demand for the public good (road).