Basic Concepts

The Theory of Economics (…) is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions --- John Maynard Keynes

Economics: study the efficient allocation of scarce resources to produce valuable commodities. The use of scarce resources involves trade-offs and opportunity costs. The use of scarce resources involves trade-offs and opportunity costs.

The need for an understanding of the functioning of markets, and of when and how (which instruments) is Government intervention desirable (market failures). The need for an understanding of the functioning of markets, and of when and how (which instruments) is Government intervention desirable (market failures). A new way of thinking. A new way of thinking.

Economic Modeling Economists build models of economic phenomena. Economists build models of economic phenomena. Models are simplified representations of the reality, that focus on some essential features while disregarding others (less important). Models are simplified representations of the reality, that focus on some essential features while disregarding others (less important).

Economic Modeling What causes what in economic systems? What causes what in economic systems? At what level of detail shall we model an economic phenomenon? At what level of detail shall we model an economic phenomenon? Which variables are determined outside the model (exogenous) and which are to be determined by the model (endogenous)? Which variables are determined outside the model (exogenous) and which are to be determined by the model (endogenous)?

Economic Modeling Assumptions Two basic postulates: Two basic postulates: –Rational Choice: Each person tries to choose the best alternative available to him or her. –Equilibrium: Market price adjusts until quantity demanded equals quantity supplied.

Comparative Statics What happens to the endogenous variable(s) if the exogenous variables in the model change? What happens to the endogenous variable(s) if the exogenous variables in the model change?

Which Market Outcomes Are Desirable? We need a criterion to compare the efficiency of different allocation methods. We need a criterion to compare the efficiency of different allocation methods.

Pareto Efficiency Vilfredo Pareto; Vilfredo Pareto; A Pareto outcome allows no “wasted welfare”; A Pareto outcome allows no “wasted welfare”; i.e. the only way one person’s welfare can be improved is to lower another person’s welfare. i.e. the only way one person’s welfare can be improved is to lower another person’s welfare.

Pareto Efficiency A Pareto inefficient outcome means there remain unrealized mutual gains-to-trade. A Pareto inefficient outcome means there remain unrealized mutual gains-to-trade. Any market outcome that achieves all possible gains-to-trade must be Pareto efficient. Any market outcome that achieves all possible gains-to-trade must be Pareto efficient.

Pareto Efficiency The Pareto criterion is a positive concept, since it is silent as to the fairness of the market outcome (equity). The Pareto criterion is a positive concept, since it is silent as to the fairness of the market outcome (equity). Positive Economics versus Normative Economics. Positive Economics versus Normative Economics.