Principles of Economics

Principles of Economics Sylvain Barde

The rules of the game • Lectures • Seminars • The marking: exams and exercises

The lectures • 14 weeks times 2 hours • Attendance to the lectures is compulsory • Make sure you do the reading each week • Prepare questions on lecture points or the reading that seem unclear • Do not hesitate to ask questions during the lecture • The course outline and lecture slides will be made available on the ENTG

The seminars • A short seminar will be organised during the first half hour of each lecture. • To go over the exercises for the week • To clarify problematic points • Make sure you prepare the exercises, they are part of the learning process ! • The exercises to be prepared for each week are given in the course outline

Exams and marks • The overall mark for the module is a weighted average: • 2/3 given by the seminar marks • 1/3 given by final exam • The final exam is composed of • Multiple choice questions • Review questions • A standard exercise • An applied exercise

Exams and marks • The seminar mark is composed of • 50% : 3 « galops d’essai » (mock exams) • 30% : average exercise mark • 20% : personal mark, that takes into account participation, turnout, etc. • The average exercise mark (incentives!) : • You are free to hand in exercises every week • The mark is the average of your best 6 results • If you hand in less than 6 exercises, then your average takes in the extra 0’s needed to make up the 6 marks...

Principles of Economics Introduction

Principles of Economics What is economics ? The microeconomic approach Modelling and microeconomics What is a function ?

What is economics ? • “A cool head and a warm heart” • The centuries of human history reveal [-] that warm hearts are not enough to feed the hungry and heal the sick. Finding the best course to follow on the road of economic progress requires a cool head, that weighs objectively the costs and benefits of the possible alternatives while keeping the analysis free from wishful thinking, as much as is humanly possible. (Paul Samuelson)

What is economics ? • Understanding the mechanisms behind market economies • Ex: gains from trade, incentives and disincentives, asymmetric information • This gives a better understand the issues that our societies face and the policies that try and address them. • Ex: global warming, poverty reduction, the subprime bubble, etc. • Acquire skills that will serve you beyond Sciences-Po and into your future occupations

Normative and positive economics • “Positive” statements: • Are objective statements on the way the economy works, typically extracted from a model • They can be shown to be true or false when checked against facts • “If taxes on tobacco are raised, the price of cigarettes will increase” • “Normative” statements: • Prescribe courses of action based on value judgements • They cannot be shown to be true or false, as these categories do not apply here ! • “Taxes on cigarettes should be increased to put smokers off”

Micro and Macroeconomics • Microeconomics • The study of the behaviour of individual agents and their interactions • The main focus is on obtaining economically meaningful insights from the optimising behaviour of individual agents • Macroeconomics • The analysis of aggregated economic variables : the unemployment rate, GDP, money, inflation, growth, etc

Overall course outline • Fall term : Microeconomics • Theories of the agent • Market structures and equilibrium • Microeconomic issues and public intervention • Spring term : Macroeconomics • Equilibrium in the goods market and the money market • Relaxing the fixed price hypothesis • International growth and trade

The microeconomic approach • Microeconomics tries to understand the behaviour of agents • Resources are limited, therefore agents have to make choices. • These depend on the incentives faced by the agent • Because agents are different, they can benefit from exchange • Producers and consumers therefore meet on markets that ensure an efficient use of these resources

The microeconomic approach • The aim of microeconomics if to answer the following questions of consumers and producers: • What to consume ? (Which combination of goods ?) • How much (Under which constraint ?) • What to produce ? (Which good ?) • How to produce it ? (Which technology ?) • How much to produce ? (Under which constraint ?)

The microeconomic approach • In order to answer these questions and understand how agents make their decisions, microeconomics models the decision making process of the agent • These decisions are then “aggregated” in order to obtain the decisions at the level of a market. • But how can a simple model explain the depth and complexity of human behaviour ?

Modelling and microeconomics • What is a model ? • “A simplified representation of reality” • In other words, a representation which removes the unnecessary complexity of reality to focus on the key mechanisms of interest • “A model’s power stems from the elimination of irrelevant detail, which allows the economist to focus on the essential features of economic reality.” (Varian p2)

Modelling and microeconomics • It is important to understand that models are central to how humans perceive reality • Human understanding of the world (not just in economics !) comes from understanding simplified versions of a complex world. • The role of the scientific process is to separate good and valid simplifications from invalid ones. • “One must simplify to the maximum, but no more” Albert Einstein

Modelling and microeconomics • Illustration of a general, simple “model” • You are in Nice • You don’t know your way around, and you get lost. • You ask a passerby where you are • This person gives you two possible answers as to your location • Which is the more useful (i.e. instructive model) ?

Modelling and microeconomics You are here

Modelling and microeconomics • Modelling in microeconomics • Assume a simplified agent and environment (even if you know that this is unrealistic) • Understand how things work in this ideal situation. • Then relax the simplifying assumptions one by one and see how the mechanisms change

Modelling and microeconomics • The simplified agent used is typically called the “Homo œconomicus” • Has complete knowledge of his objectives (preferences or production quantities) • Has complete knowledge of the conditions on all the markets (perfect information) • Has a very large “computational capacity” to work out all the possible alternatives and their payoffs. • These simplifications can be relaxed

What is a function ? • “ Many undergraduate majors in economics are students who should know calculus but don’t – at least not very well” (Varian, preface) • So before starting on the models and the theory, it is important to understand the components of models : functions

What is a function ? • A function is a relation between one variable and a set of other variables • A variable is a quantity that can change values and be measured on a given scale • Temperature, pressure, income, wealth etc. • For example, crop yields (in kg/m2) are a positive function of averagerainfall (in cm/m2), average sunlight (in W/m2) and temperature (in ˚C)

What is a function ? • The same function can have different “faces” • The same relation between variables can be expressed in different ways • 1: “Literary” representation • This is the one from the previous slide, and involves just mentioning the variables that enter the function • “Crop yields are a positive function of averagerainfall, average sunlight and temperature.”

What is a function ? • 2: Symbolic representation • A bit more “rigorous”, this uses symbols to represent the relation between variables Mathematical symbol meaning “function of” • Where y is the crop yield, ris average rainfall, s is average sunlight and t is temperature. • But... When read out, this just corresponds to the literary version !!

What is a function ? • 3: Algebraic representation • This is the “scary” one, because it involves “maths” (algebra, actually) • The problem is that to express a function this way, you need to know exactly: • The “functional form” (Linear, quadratic, exponential) • The values of the parameters • Finding these is often part of the work of an economist

What is a function ? • 4: Graphic representation • Often the most convenient way of representing a function... y (kg/m2) Crop yields as a function of rainfall r (cm/m2)

What is a function ? • ... But a diagram can only represent a link between two variables (yand r here) • If temperature t increases, then a whole new curve is needed to describe the relation y (kg/m2) Crop yields as a function of rainfall t1>t r (cm/m2)

What is a function ? • The microeconomic approach examines the decision of the agent: its aim is to choose the “best” possible outcome • The highest “satisfaction”, for consumers • The highest profit, for producers • Imagine a function f that gives satisfaction (or profits) as a function of all the quantities of goods consumed (or produced).

What is a function ? • In terms of modelling, finding the “best choice” is effectively like trying to find the values of the quantities of goods for which function f has a maximum satisfaction Maximum Graphically, that’s easy! But generally, how do you find this maximum ? q

What is a function ? • One can find the maximum (or minimum) of a function by finding the point for which the slope is equal to zero. • Imagine you are climbing a mountain blindfolded. • How do you know when you’re at the top? • When you feel like you’re walking on a flat surface !

Y X What is a function ? Slope = 0 B C A Slope < 0 Slope > 0 1 1 -s s

What is a function ? • So we know we can find a maximum (the “best” choice”) when the slope of the relevant function is zero • But we still need to find a way to calculate the slope of the function ! • This is where calculus comes in: • The first derivative of a function gives us this slope.

What is a function ? • Lets go back to our function f • The first derivative is the function f’ such that Is the slope of f at point x • Given a functional form for f, the first derivative can be found using the following, simple, rules

What is a function ?

What is a function ? • Partial derivatives • What if the function f is a function of several variables ? (often the case in economics !) • Several slopes can be calculated (as many as there are variables, 2 in our case) • Each is calculated by treating the other variables like constants

What is a function ? • Partial derivative of fwith respect to x • Partial derivative of f with respect to y

Principles of Economics