Economic Incentives Flashcards

Microeconomics 1.2 Notes

Recap of Previous Lecture

• Malthusian Trap: Explains long-term subsistence living standards.

• Industrial Revolution: Changes in input mix (capital and labor), increase in CO2 emissions, escape from the Malthusian trap.

Today's Lecture Outline

• Key Concepts:

  1. Opportunity cost and economic rent

  2. Comparative advantage, specialization, and gains from trade

  3. Basic production functions

  4. Isocost curves

Economic Decisions

• Decisions based on costs and benefits:

  1. Explicit Financial Costs: Direct monetary expenses.

  2. Non-Financial Costs: Other sacrifices (time, effort).

• Economic Costs: Combination of financial and non-financial aspects.

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Net Benefit

• Definition: Value of something after accounting for costs.

• Example:

  • Concert:

  • Net benefit = value of enjoyment - cost of ticket

  • Net benefit = €55 - €25 = €30

  • Babysitting:

  • Net benefit = payment received - value of effort

  • Net benefit = €40 - €18 = €22

• Optimal Decision: Attend the concert.

Opportunity Cost

• Definition: Value of the next best alternative foregone.

• Economic Cost Formula:
  ext{Economic Cost} = ext{direct costs} + ext{opportunity costs}

Example of Opportunity Cost

• Earnings Foregone:

  • Attending university incurs direct costs and also opportunity costs regarding earnings lost.

Economic Cost Example

• Concert Example:
  ext{Economic Cost} = ext{ticket cost} + ext{opportunity cost of babysitting}
  = €25 + €22 = €47

• Benefit: Value of enjoyment from concert = €55.

Economic Rent

• Definition: Difference between the net benefit of chosen option and its opportunity cost.

• Example:

  • Concert economic rent = €30 - €22 = €8

• Positive economic rent indicates a beneficial course of action.

Specialization

• Factors Increasing Specialization:

  1. Learning by doing

  2. Differences in ability

  3. Economies of scale

• Application: Across individuals, firms, and countries.

Comparative Advantage

• Definition: Ability to produce goods at a lower opportunity cost.

• Absolute Advantage vs. Comparative Advantage:

  • Absolute Advantage: Ability to produce more of a good with the same resources.

  • Comparative Advantage: Ability to produce goods at a lower opportunity cost than others.

Production Possibility Analysis

• Example: Greta and Carlos’ production possibilities:

  • Greta: 1,250 apples or 50 tonnes of wheat

  • Carlos: 1,000 apples or 20 tonnes of wheat

• Assessment of Opportunity Cost:

  • Carlos has a comparative advantage in apples; Greta has a comparative advantage in wheat.

Gains from Trade

• Self-Sufficiency: Must produce what is desired; leads to inefficiencies compared to specialization.

• Specialized Production: Maximizes joint output and consumption.

• Illustration: Production possibilities frontier demonstrates gains through specialization.

Implications of Gains from Trade

• Even parties with an absolute disadvantage benefit from trade.

• Trade can significantly enhance overall living standards.

Factors of Production & Production Functions

• Definition: Relates how production factors (labor, land, capital, raw materials) combine to make output.

• Example Function:
  Y = f(L,K,E) where L, K, and E represent inputs.

Comparing Production Functions

• Characteristics:

  • Fixed proportion technologies

  • Constant returns to scale

• Comparison Visuals: Distinguishing labor intensity vs. energy intensity across production functions.

Cost Functions in Production

• Cost Formula: ext{Cost} = (w imes N) + (p imes R) Where:

  • w = wage rate

  • N = number of workers

  • p = price per unit of coal

  • R = units of coal used

• Different combinations yield isocost lines, which visualize cost alternatives.

Changing Input Prices

• Impacts on production cost and technology choice.

• Effects: A shift to cheaper technology can initiate cost reduction and profit alterations, leading to shifts in competitive dynamics (creative destruction concept by Joseph Schumpeter).

Summary

1. Economic decisions involve opportunity costs.

2. Specialization and trade yield benefits for all, including those with an absolute disadvantage.

3. Input price changes influence optimal production technologies and decisions.

Next Lecture Topics

1. Changes in labor/leisure time choices with output.

2. Decision making under scarcity.

3. Preferences and indifference curves.

4. Feasible consumption sets.