principles of economics sylvain barde. the rules of the game lectures seminars the marking: exams...

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 weekTo 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

Principles of Economics

What is economics ?

The microeconomic approach

Modelling and microeconomics

What is a function ?

The microeconomic approach

Microeconomics tries to understand the behaviour of agentsResources are limited, therefore agents

have to make choices.These depend on the incentives faced by the

agentBecause agents are different, they can

benefit from exchangeProducers 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 ?

Principles of Economics

What is economics ?

The microeconomic approach

Modelling and microeconomics

What is a function ?

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 NiceYou don’t know your way around, and you

get lost.You ask a passerby where you areThis 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

You are here

Modelling and microeconomics

Modelling in microeconomicsAssume 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

Principles of Economics

What is economics ?

The microeconomic approach

Modelling and microeconomics

What is a function ?

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 variablesA variable is a quantity that can change

values and be measured on a given scaleTemperature, pressure, income, wealth etc.

For example, crop yields (in kg/m2) are a positive function of average rainfall (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 average rainfall, 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, r is average rainfall, s is average sunlight and t is temperature.

But... When read out, this just corresponds to the literary version !!

, ,y f r s t

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

210 0.9 0.5 ty r es

What is a function ?

4: Graphic representation Often the most convenient way of representing

a function...

y (kg/m2)

r (cm/m2)

, ,y f r s t

Crop yields as a function of rainfall

What is a function ?

... But a diagram can only represent a link between two variables (y and r here)

If temperature t increases, then a whole new curve is needed to describe the relation

y (kg/m2)

r (cm/m2)

1, ,y f r s t

Crop yields as a function of rainfall

t1>t

, ,y f r s t

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). 1 2, ,..., nsatisfaction f q q q

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

q

Maximum Graphically, that’s easy!

But generally, how do you find this maximum ?

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 !

What is a function ?

Y

X

B

A

s

1

C

1

-s

Slope > 0 Slope < 0

Slope = 0

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

y f x

dys f xdx

What is a function ?

k (constant) 0

x 1

nx n 1n x

x

ln x 1 xxe xe

f x f x

1

2 x

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

2 3,z f x y x y

What is a function ?

Partial derivative of f with respect to x

Partial derivative of f with respect to y

2 3,z f x y x y

, 2x

zf x y x

x

2, 3y

zf x y y

y