Thursday, 30 June 2011

What you must know to pass an Economics Exam/Interview 2-Introduction to Macro-Economics and AS-AD:

In Macro-Economics we deal with the market for goods as a whole, treating all the markets for different goods-such as the markets for agricultural products and for medical services as a single market. Similarly, we deal with the labour-market as a whole, abstracting from differences between the markets, for, say unskilled labor and doctors. We deal with the assets market as a whole, abstracting from differences between the markets for IBM shares and for Rembrandt paintings.

The study of macroeconomics is organized around three models that describe the world, each model having its greatest applicability in a different time frame.Growth theory describes the behavior of the economy in the long run, when capital, labour and technology can all vary, and the AS-AD model describes the behavior of vthe economy at all shorter horizons, with different assumptions about the slope of the aggregate supply curve determining the time horizon over which the model is applicable.
The AS-AD model shows how the demand for products(described by the AD curve)interacts with the supply of products(described by the AS curve)to determine the equilibrium price level and output of the economy.

In the long run, because all inputs are fully employed, the AS curve is vertical at the level of potential output, and output is determined by AS alone. In the short run, a period of time so brief that prices do not have time to adjust at all, the AS curve is flat and output is determined by AD alone.


  1. The AS-AD model is used to show the determination of the equilibrium levels of both output and prices.
  2. The AS schedule, shows at each level of prices the quantity of real output firms are willing to supply.
  3. The Keynesian supply schedule is horizontal, implying that firms supply as many goods as are demanded at the existing price level. The classical supply schedule is vertical. It would apply in an economy that has full price and wage flexibility. In such a frictionless economy, employment and output are always at the full-employment level.
  4. The AD, shows at each price level the level of output at which goods and asset markets are in equilibrium. This is the quantity of output demanded at each price level.Along the AD schedule fiscal policy is given, as is the nominal quantity of money.
  5. A fiscal expansion shifts the Ad curve up and to the right, as does an increase in money stock , by the same proportion as an increase in the money stock.
  6. Supply side economics makes the claim that reducing tax rates generates very large increases in AS. In truth, tax cuts produce very small increases in AS and relatively large increases in AD.
  7. Over long periods, output is essentially determined by AS and prices by movement of AD relative to the movement of AS.

Wednesday, 29 June 2011

What you must know to pass an economics exam/interview1-Consumer Choice

                       Rational Consumer Choice

1.The model of Rational Consumer Choice takes consumer preferences as given and assumes they will try and satisfy them in the most efficient way possible.

2.The first step in solving the budgeting problem is to identify the set of bundles of goods that the consumer is able to buy. The consumer is assumed to have an income level given in advance and to face fixed prices. Prices and income together define the consumer’s budget constraint, which in the simple two-good case, is a downward-sloping line whose slope, in absolute value, is the ratio of the two prices. It is the set of all possible bundles that the consumer might purchase if he spends his entire income.

3.The second step in solving the consumer budgeting problem is to summarise the consumers preferences. Here, we begin with a preference ordering by which the consumer is able to rank all possible bundles of goods. This ranking scheme is assumed to be complete and transitive and to exhibit the more is better property. Preference orderings that satisfy these restrictions give rise to indifference maps, or collections of indifference curves, each of which represents combinations of bundles among which the consumer is indifferent. Preference orderings are also assumed to have diminishing marginal rate of substitution in the sense that if you have pepsi on the y-axis and pizza on the x axis then for a lot of pepsi and less of pizza the consumer will be willing to give up a lot of pepsi for a unit extra of pizza, and when there is a lot of pizza and a little bit of pepsi the consumer will require a lot more of pizza for giving up an unit of pepsi.

4. The budget constraint tells us what combinations of goods the consumer can afford to buy. To summarise the consumer’s preferences over various bundles, we use an indifference map. The best affordable bundle occurs at a point of tangency between an indifference curve and the budget constraint. At that point, the marginal rate of substitution is exactly equal to the rate at which the goods can be exchanged for one another at market prices.

                                                 Individual and Market Demand

  1. How do individual and market demands respond to variation in prices and incomes. To generate a demand curve for an individual consumer for a specific good X, we first trace out the price-consumption curve in the standard indifference curve diagram. The PCC is the line of optimal bundles observed when the price of X varies, with both income and preferences held constant. We then take the relevant price-quantity pairs from the PCC and plot them in a separate diagram to get the individual demand curve.

  1. The Income analog to the PCC is the income consumption curve, or ICC.It too is constructed using the standard indifference curve diagram.The ICC is the line of optimal bundles traced out when we vary the consumer’s income, holding preferences and relative prices constant. The Engel curve is the income analog to the individual demand curve.We generate it by retrieving the relevant income-quantity pairs from the ICC and plotting them in a separate diagram.

  1. Normal goods are those which a consumer buys more of when income increases and inferior goods are those the consumer buys less of as income rises.

  1. The total effect of a price change can be decomposed into two separate effects:1) the substitution effect, which denotes the change in quantity demanded that results because the price change makes substitute goods seem either more or less attractive, and 2) the income effect, which denotes the change in quantity demanded that results from the change in real purchasing power caused by the price change. The substitution effect always moves in the opposite direction from the movement in price: price increases (reductions)always reduce(increase)the quantity demanded. For normal goods, the income effect also moves in the opposite direction from the price change, and thus tends to reinforce the substitution effect. For inferior goods, the income effect moves in the same direction as the price change, and thus tends to undercut the substitution effect.

  1. The fact that the income and substitution effects move in opposite directions for inferior goods suggests the theoretical possibility of a Giffen good, one for which the total effect of a price increase is to increase the quantity demanded.

  1. Goods for which purchase decisions respond most strongly to price tend to be ones that have large income and substitution effects that work in the same direction. For example, a normal good that occupies a large share of total expenditures and for which there are many direct or indirect substitutes will tend to respond sharply to changes in price. For many consumers, housing is a prime example of such a good. The goods least responsive to price changes will be those that account for very small budget shares and for which substitution possibilities are limited. For most people, salt has both those properties.

  1. A central analytical concept in demand theory is the price elasticity of demand, a measure of the responsiveness of purchase decisions to small changes in price. Formally, it is defined as the percentage change in quantity demanded that is caused by a one percentage change in price. Goods for which the absolute value of elasticity exceeds 1 are said to be elastic; those for which it is less than 1, inelastic; and those for which it is equal to 1, unit elastic.

  1. Another important relationship is the one between price elasticity and the effect of a price change on total expenditure. When demand is elastic, a price reduction will increase total expenditure; when inelastic, total expenditure falls when the price goes down. When demand is unit elastic; total expenditure is at a maximum.

  1. The value of the price elasticity of demand for a good depends largely on four factors: substitutability, budget share, direction of income effect, and time.1) Substibutabiility. The more easily consumers may switch to other goods, the more elastic demand will be.2)Budget share. Goods that account for a large share of total expenditures will tend to have higher price elasticity.3)Direction of income effect .Other factors the same, inferior goods will tend to be less elastic with respect to price than normal goods.4) Time. Habits and existing commitments limit the extent to which consumers can respond to price changes in the short run. Price elasticity of demand will tend to be larger, the more time consumers have to adapt.
  1. Changes in the average income level in the market will generally shift the market demand curve. The income elasticity of demand for a good X is defined analogously to its price elasticity.It is the percentage change in quantity that results from a one percentage change in income. Goods whose income elasticity of demand exceed zero are called normal goods, those for which it is less than zero are called inferior goods;those for which it exceeds one are called luxuries; and those for which it is less than one are called necessities. For normal goods an increase in income will shift market demand to the vright; and for inferior goods, an increase in demand will shift it to the left. For some goods, the distribution of income, not just its average value, is an important determinant of market demand.

  1. The cross price elasticity of demand is a measure of the responsiveness of the quantity demanded of one good to a small change in the price of another.If cross price elasticity is positive the goods are substitutes and if negative, complements.

Tuesday, 28 June 2011

Explaining tastes: the importance of altruism

Micro-Economics and Behavior II

Explaining tastes: the importance of altruism and other non-egoistic behavior:

The central assumption of microeconomic analysis is that people are rational. Two important definitions of rationality are the so-called present-aim and self-interest standards. (Derek Parfit, Reasons and Persons, Oxford:Clarendon,1984.).A person is rational under the present-aim standard if she is efficient in the pursuit of whatever aims she happens to hold at the moment of action. No attempt is made, under this standard, to assess whether her aims themselves make any sense.Under the self-interest standard, by contrast, it is assumed at the outset that people’s motives are congruent with their narrow material interests.

In textbook accounts of rational choice, economists often embrace the present-aim standard. The difficulty with the present-aim standard is what we might call the ‘crankcase oil’ problem. If we see a person drink the used crankcase oil from his car, and he then writhes in agony and dies, we can assert that he must have really liked crankcase oil.

With this difficulty in mind, most economists assume some version of the self-interest standard of rationality in their actual research. It helps explain, for example, why car pools form in the wake of increases in gasoline prices. Without question, self-interest is an important human motive.

Yet narrow self interest is surely not the only human motive. Travelers on interstate highways leave tips for waitresses they will never see again. Participants in bloody family feuds seek revenge even at ruinous cost to themselves. People walk away from profitable transactions whose terms they believe to be “unfair.” In these and countless other ways, people do not seem to be pursuing interests of the usual egoistical sort.

An application of the present-aim standard: altruistic preferences

Because we know from experience that not everyone has the narrowly selfish preferences assumed by the self-interest model, it is tempting to broaden the analysis by simply adding additional tastes-by assuming, for example, that people derive satisfaction from a variety of behaviors that conflict with narrowly defined self interest, such as donating money to charity, voting, disposing of litter properly, and so on.Let us explore how the notion that some people have altruistic preferences can be incorporated formally into our model of rational choice.

Consider, for example, the case of Tashu, who cares not only about her own income level but also about Mun’s. Such preferences can be represented in the form of an indifference map defined over their respective income. Tashu’s indifference curves are negatively sloped, which means that she is willing to tolerate a reduction in her income in return for a sufficiently large increase in Mun’s.Her indifference curves exhibit diminishing MRS, which means that the more income Tashu has, the more she is willing to give up in order to see Muns have more.

The question that Tashu confronts is whether she would be better off if she gave some of her income to Muns. Suppose her initial income level is $50,000/yr and that Mun’s is $10,000.What are Tashu’s options? She can retain all her income. Or she can give some of it to Muns, in which case she will have $1 less than $50,000 for every $1 she gives him.

If Tashu keeps all her income, her MRS exceeds the slope of her budget constraint,it is clear that she can do better. The fact that MRS greater than one at the original point tells us that she is willing to give up more than a dollar of her own income to see Muns have an extra dollar. But the slope of her budget constraint tells us that it costs her only a dollar to give Muns an extra dollar. She is therefore better off if she gives some of her income to  Muns.

The Strategic Role in Preferences

The attractive feature of the present-aim standard of rationality is that it lets us broaden our analysis to embrace nonegoistic motives whose existence is well documented. Yet as noted, the lingering methodological difficulty is that unless we impose some constraints on ourselves, the present-aim standard allows us to explain virtually any bizarre behavior by simply positing a taste for it. Our dilemma is how to expand our view of human motives without at the same time becoming vulnerable to the crankcase oil objection.

Biologists have discovered a way out of this dilemma, one that rests on an analysis that is quintessentially microeconomic in character. In biology, an organism’s tastes are not arbitrarily given as they are in economic models. Rather, biologists assume that tastes are forged by the pressures of natural selection to help organisms solve important problems in their environments. For example in the biologist’s account, our taste for sweets is a characteristic we inherited from our ancestors, in whom it evolved for functional reasons.

There is evidence that this particular taste is no longer functional in our current environment. In earlier times, the sugar found in ripened fruits were sufficiently scarce that there was no practical danger of over consuming them. Now, with sweets so plentiful, our taste for them sometimes leads us to overindulge,with various adverse consequences.

The taste for sweets is a simple preference, in the sense that it would have been useful to an individual irrespective of whether others in the population shared that taste. Other tastes, however, are more complex, in the sense that the usefulness of having them depends on the fraction of other individuals in the population who share them. This second type we call a strategic preference, one that helps the individual solve important problems of social interaction.

A Parable of Hawks and Doves
Consider a population which differs in its taste for aggressive behavior. Thus it is divided into hawks, the aggressors and doves, the pacifists. If these two types engage in a fight for scarce resources which one will win out? Well, at first glance one would assume that the hawks who are more aggressive would win out, but this precludes a confrontation between two hawks. Since both individuals are predisposed to be aggressive a bitter confrontation might ensue. Depending on the consequences of such a fight, it may indeed be costly to be a hawk.

The potential disadvantages of being a hawk become even clearer, when we consider what happens when two doves confront each other over sharing of a resource, in this case the costs of a bloody battle are avoided and the two decide to share the resource.

In our hypothetical population pairs of individuals interact with one another at random and there are three possible pairings 1) two hawks, 2) a hawk and a dove, 3) two doves. To see how this population will evolve we need to know the payoffs for each of these three types of interaction.

Suppose the conflict involves food that contains 12 calories. When two doves interact, they share the food so that each receives a payoff of 6 calories. When a hawk and a dove interact, the dove defers to the hawk so that the hawk gets 12 calories the dove gets none. Finally, when two hawks interact, the winner gets twelve calories the loser gets none. The confrontation however, consumes ten calories for both the hawks, which means the winner gets 12-10=2 calories, and the loser gets -10 calories. Of course over the course of many interactions, any given hawk can be expected to win half the time, and lose half the time. Thinking of hawks as a whole then, the average payoff for the hawk-hawk encounters is expected to be (2-10)/2=-4 calories per individual.

Thus summarizing: when two hawks meet, a fight ensues that consumes 10 calories each, leaving an average net payoff of -4 calories per hawk. When doves and hawks meet, doves defer, so hawks get 12 calories, doves 0.When two doves meet, they share the food, so each gets 6 calories.

With the working of the hawks and doves model in mind, we will focus on how certain unselfish motives often help people solve an important class of problems that arise in economic and social interaction.

The Commitment Problem

One of the most frequently discussed examples in which the pursuit of self-interest is self defeating is the so called prisoners dilemma. Two prisoners are held in separate cells for a serious crime that they did, in fact commit. The prosecutor, however has only enough hard evidence to convict them of a minor offense, for which the penalty is, say, 1 year in jail. Each prisoner is told that if one confesses while the other remains silent, the confessor will go scot free while the other will spend 20 years in prison.If both confess, they will get an intermediate sentence, say, 5 years. The two prisoners are not allowed to communicate with one another.

The dominant strategy in the prisoners dilemma is to confess.No matter what Y does, X gets a lighter sentence by speaking out-if Y too confesses, X gets 5 years instead of 20; and if Y remains silent, X goes free instead of spending a year in jail.The payoffs are perfectly symmetric, so Y also does better to confess no matter what X does. The difficulty is that when each behaves in a self-interested way, both do worse than if each had shown restraint. Thus, when both confess, they get 5 years, instead of the 1 year they could have gotten by remaining silent.

Although the prisoners are not allowed to communicate with one another, it would be a mistake to assume that this is the real source of difficulty. Their problem is rather a lack of trust. A simple promise not to confess does not change the material payoffs of the game.(If each could promise not to confess, each would still do better if he broke his promise.)

The prisoners dilemma is an example of a broader class of problems called commitment problems. The common feature of these problems is that people can do better if they can commit themselves to behave in a way that will later be inconsistent with their own material interests. In the prisoners dilemma, for example, if the prisoners could commit themselves to remain silent, they would do better than if left free to pursue their narrow material interests.

Illustration:The Cheating Problem

The functional role of unselfish motives can be seen more clearly with the help of the example of a simple ecology in which egoists are pitted against nonegoists in a struggle to survive. The commitment problem they face arises in joint business ventures, each of which consist of a pair of individuals. In these ventures each person can behave in each of two ways. He can “cooperate” which means to deal honestly with his partner, or he can”defect:” which means to cheat his partner. The payoffs to each of the partners, depend on the combination of the behavior of both. Thus if they both defect, each gets a payoff of 2, each gets 4 by cooperating. The defector gets 6 if the other person cooperates and the cooperator in turn gets zero

These payoffs thus confront the partners with a monetary version of the prisoners dilemma.. They get a higher payoff by defecting no matter what the other does. If one believes the other will behave in a self interested way, he will predict that the other will defect. And, if only to protect himself he may feel compelled to defect as well. When both defect, each gets only a 2-unit payoff. The frustration as in all dilemmas of this sort, is that both could have done better. Had they cooperated, each would have gotten a 4 unit payoff.

Wednesday, 22 June 2011

Thinking LIke an Economist


Thinking Like an Economist

Many Economics books like Mankiw start with a chapter on: “Thinking like an Economist.”But the book that does this best from a behavioral viewpoint is Robert Frank’s “MicroEconomics and Behavior”.

This book initiates its chapter on “Thinking Like an Economist” with a negation of the typical ‘material’ view of scarcity. Giving the example of Aristotle Onassis who suffered from ‘myasthenia gravis’, a debilitating and progressive neurological disease, the author states that despite being worth several billion dollars at his death Onassis ‘confronted the problem of scarcity much more than most of us will ever have to.’
‘For him, the scarcity that mattered was not money but time, energy and the physical skill needed to carry out ordinary activities.’

As a teacher I like to give the following example of scarcity: It is possible you have thousands of rupees in your pocket but because you are a very busy executive you do not have the time to see the latest movie ‘Ready’. Or, maybe you do have one evening (say, Saturday) free, but your wife or girlfriend wants to spend the evening in a Chinese Restaurant having dinner instead.

Costs and benefits of decisions.-When we are sitting in an armchair in our sitting room, we may want to lower the volume of the stereo, increase the speed of the fan, turn off the light, but we may be too lazy to do any of these activities, it is as if we compare the costs and benefits of alternate actions, getting up or remaining seated. (the author in the chapter explains how to translate this decision into a monetary framework.)

The Role of Economic Theory-It might sound not just strange but absurd that someone might actually calculate the costs and benefits of turning down a stereo. Making unrealistic assumptions is a charge often levied against economists. Two responses are made to this criticism. Economists don’t assume that people make explicit calculations of this sort at all-is the first response. Rather, we can make useful predictions if we assume that people act as if they made such calculations, is what many economists argue. Milton Friedman expresses this view forcefully by arguing that the shots expert pool players choose, and the specific ways they attempt to make them, can be predicted extremely well by someone who assumes that the players take careful account of all the relevant laws of Newtonian Physics. Not that they would have had training in Physics but, Friedman argues, they would never have become expert players in the first place unless they played as dictated by the laws of physics. Unrealistically, our theory of pool player behavior assumes, that pool players know the laws of physics. We are urged to judge this theory by Friedman  not by how accurate its central assumption is but by how well it predicts behavior. And it performs very well indeed, on this score.

 Friedman like many other economists, believes that useful insights into our behavior can be gained by assuming that we act if governed by the rules of rational decision making. By trial and error, he feels, we eventually absorb these rules, just as pool players absorb the laws of physics.

Conceding that actual behavior does often differ from the predictions of economic models, is a second response to the charge that economists make unrealistic assumptions. Thus, as economist Richard Thaler puts it, we often behave more like novice than expert pool players.

But even where economic models fail on descriptive grounds, they often provide very useful guidance for making better decisions, they may often give insights into how we may achieve our goals more efficiently, even if they don’t always predict how we do behave.

Common Pitfalls in Decision Making-
Ignoring Implicit Costs: some costs are not explicit, we should include the opportunity cost ie the value of the most highly valued alternative to the chosen alternative. If doing activity x means not being able to do activity y, then the value to you of doing y (had you done it) is an opportunity cost of doing x. Many people make mistakes while making decisions because they fail to see that while making a decision, the foregone alternative should be considered. Thus it would always be instructive to translate questions such as “Should I do x?” into ones such as “Should I do x or its most highly valued alternative y?

Should I go skiing today or work as a research assistant?
there is a skiing area near your campus in which the cost of skiing is $40, the benefit of skiing to you is $60, but there is a choice to that, you can work as a research assistant to your professor, and be paid $45 for that, you like the job enough such that you are willing to do it for free.
Here the cost of skiing is not just the explicit cost of $40 for skiing, but the opportunity cost of the lost earnings ($45). Therefore the total costs are $85, which exceed the benefits of $60. So, you should stay on the campus and work for your professor. Someone who ignored the opportunity cost of the foregone earnings would decide incorrectly to go skiing.
It is an important point that you are willing to do the job for free, meaning there are no psychic costs attached to the job. This is important because it means that by not doing the job you would not have escaped something unpleasant.
Not all jobs fall into this category. Suppose your job involves scraping plates at the dining hall for which you will get the same $45 per day. The job is so unpleasant that you would not be willing to do it for less than $30 per day. Let us now reconsider the decision of whether to go skiing assuming that your boss allows you to have one day free in your job.

Should I scrape plates or go skiing today?
There are two alternative ways of looking at this decision. One is that, one of the benefits of going skiing is not having to scrape plates. Since you would never scrape plates for less than $30 per day, one could say that going skiing is worth that much to you. So the indirect benefit of going skiing is $30.The direct benefit of going skiing is still the same $60.So the total benefit of going skiing is $90. Whereas the costs of going skiing is the same the opportunity cost of the lost earning which is $45 plus the explicit cost of skiing which is $40, so the total cost of going skiing is $85.So, in this alternative the costs of skiing are less than the benefits of skiing, $85 is less than $90, indeed it makes sense to go skiing.
There is an alternate way of looking at this problem. Looking at the unpleasantness of the job as an offset against the salary. In that case we would subtract the $30 unpleasantness cost from the $45 salary, so the opportunity cost of not doing the job would be only $15, and the cost of going skiing would be $40+ $15=$55.The benefits of skiing are $60.And, again the benefits are greater than the costs.
The valuation of the unpleasantness of scraping the plates can thus be handled either way, however it is important that you handle the valuation in one of the alternative ways do not count it twice.
Clearly there is a reciprocal relationship between costs and benefits. Not incurring a cost is the same as getting a benefit. Similarly not getting a benefit is the same as incurring a cost.
Consider the case of a graduate student who was returning home after getting his degree from US. Now he could get a car from US without paying duty according to the rules for a returning student. This story is of way back in the 60’s.The car the student planned to get was an Impala. He planned to sell it in India at the rate of its cost plus the amount of duty he would have had to pay otherwise. However his uncle asked him to bring back the Impala for him and told him he would pay him the cost of the car. Obviously the student could not charge his uncle the duty. Not getting this benefit was the cost paid by the student.

Should I work first or go to college first?
The cost of going to college is not only the cost of fees, books, hostel room and board but also the cost of time and money foregone by not working, this cost is the least when yoyu are straight out of school, so most people go to college right after school.

Is it fair to charge interest-Yes it is, interest is merely the lender’s opportunity cost of not having deposited money in a bank, but this begs the next question.

Why do banks pay interest in the first place?
Because interest is the reimbursement for the opportunity cost of money, yet there is hostility towards money lenders because they are the richer part of the transaction.

Pit  fall 2-Failure to ignore sunk costs-there are two examples given in the book, one is if we compare the cost of say going to Bombay from ahmedabad by bus and car, if we would take the cost of going by car as the petrol, maintenance, insurance and interest cost that would be a mistake because, they would be the same whether or not you drive to Bombay, they would not vary with the amount of km traveled, thus these costs are unrecoverable at the time at which the decision is made.Another eg is an all u can eat dinner of pizzas, the relevant choice is which restaurant to go based on the per head charge and other factors , once this decision is made, getting your moneys worth should just depend, on how hungry you are, and how much you like pizza not on how much you paid for the dinner, yet this is often the case.