Lecture 2 PDF

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Lecture 2: Economic models:  

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Underlying theory of economic models is rationality Decision makers are rationale, they: o Have well defined objectives o Make choices that are consistent with achieving those objectives For example, firms take actions consistent with profit maximisation Typically, consumers, firms or the government Must be simple, and not include every part of the economy Simplify reality in order to improve our understanding of it

Assumptions:  Make the world easier to understand  Example: o To study the effects of international trade, we make the assumption there are only two countries in the world and these two countries only produce two goods  For studying short term effects, we assume prices do not change much  For studying the long-term effects, we assume that all prices are completely flexible Decision theories in economies:  Actions are associated with benefits and costs  The objective function: Net benefit (NB) = total benefit (TB) – total costs (TC)  The best (optimal) action for a rational decision-maker is the one that maximises net benefits How to measure costs:  When a decision-maker chooses an action, the resources used in taking that action become unavailable for alternative uses  The cost of an action should thus be measured in terms of those resource  To measure the value of those resources, we consider their next best alternative use  Opportunity cost: reflects the value of resources used in taking that action in their next best alternative use Resources used before making the decision:  At the time a decision-maker chooses an action, resources that were already used should not matter in the decision-making  Therefore, the value of those resources that were already used should not be considered opportunity costs  Sunk costs: reflect the value of resources that were used before making a decision which action to take o E.g. going to a football match, supposing that you already own a season ticket  Sunk cost is the season ticket price How to measure benefits:  A firm’s objective to maximise profits is the benefit

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Since profits = revenue – costs, the benefits in the objective function would be revenue Suppose a firm needs to decide whether to open a new branch, then the benefits that need to be accounted for would comprise expected revenue from having the new branch

Rational decision-makers think at the margin:  Marginal benefit (MB) = increment in total benefits by taking an action or by increasing the level of activity by one unit  Marginal costs (MC) = increment in total costs by taking an action or by increasing the level of activity by one unit  To maximise net benefit, one would take an action or increase the level of activity as long as MB >= MC  If an action or an increase in the level of activity confers MB < MC, it must no longer be optimal as NB would be decreasing...