Lecture 2; U3+4
Economics > making assumptions about the world > simplify world because of complexity > predictions
Assumptions
Unit: individuals & firms
Homo economicus > view of human in which human is first and foremost an economic being:
- Humans are rational;
- Self-interested;
- Perfect information (> they know what the outcome will be > decision based on this);
- Individualistic.
Simplify enough that its clear but not to much that it doesn’t’ say anything > start with complex or
simple > economics start with simple unrealistic assumptions > improve upon idea > more complex
Production function > turning inputs into output > the relationship between the amount of outputs
(products & services) produced and the amount of inputs (labor & capital) used to produce it, holding
other factors constant (production environment)
>>> Describes what is technically feasible when the firm operates efficiently.
Firm internal structure and its production process as a black box
Basic assumptions about firm’s production processes:
• Technology is given
• The output is a result of only 2 input factors – capital and labour (can be extended for other
input factors in a similar way, like land or raw materials).
• The firms are always willing to produce as efficiently as possible.
Diminishing Marginal Returns: Situation in which the use of an additional unit of a factor of production
results in a smaller increase in output than the previous increase
Marginal product (MP): Change in output per one-unit change in input (at a given point, holding other
inputs constant) > slope of production function
Average product (AP): Average output per units of input (at a given point, holding other inputs
constant) > total output/total input (at certain point)
Preferences determine choices
Scarcity principle:
- Infinite desires vs. limited resources
- To get A > give up B
➢ For this tradeoff, economists look at economic costs
o Economic costs = explicit costs + opportunity costs
o Opportunity costs > the net benefit of the next best alternative action
➢ Indifference curve
,An indifference curve shows all combinations of two goods that give the same utility (satisfaction)
Marginal rate of substitution (MRS): the slope of the indifference curve. It represents the willingness to
trade one good for another (example: higher grades vs. more free time).
Indifference curves can’t cross.
Lower indifference curve is lower utility.
Choices are constraint > what is possible / feasible?
➢ Feasible frontier > all the possible outcomes that you can have
Feasible frontier: Maximum output that can be achieved of one good (grade) for every possible level of
the other good (free time)
Outside feasible frontier > not possible
Inside feasible frontier > feasible but inefficient > feasible set
Marginal rate of transformation (MRT): The tradeoff (opportunity costs) that an individual faces. The
slope of the feasible frontier.
Optimal choice (utility maximizing choice) > The amount of one good the individual is willing to trade off
for the other good (MRS) equals the actual tradeoff between the two goods (MRT)
➢ MRS = MRT
➢ Where MRS meets MRT > not cross, because then there will always be a line with a higher
utility
>>> Feasible frontier shows what you can, indifference curve shows what you want.
Game theory:
- Theory of goal-directed behavior in interdependent decision situations
- Mainly used to model to explain (solve) social dilemmas
- Social dilemma = a situation in which actions taken independently by self-interested
individuals result in a socially suboptimal outcome
Game involves:
- Players > (individuals, firms, countries, etc.) who make strategic decisions that take into
account each other’s actions and responses
- Strategies > a list of possible actions for each player
- Payoff > a value (e.g. in €) associated with a possible combination of strategies; typically the
expected net gain (benefits minus costs)
o Payoff matrix > Table showing payoff to each player given its decision and the
decision of its competitor.
,Outcome of the simultaneous-choice one-period game (Prisoners dilemma for example):
• Dominant strategy: optimal choice for each player no matter what the opponent does → for
both A and B to confess
• Nash equilibrium: if X is a best reply strategy of player A against Y and Y is a best reply strategy
of player B against X
• Pareto optimal: if there is no other strategy combination that yields higher payoffs for at least 1
player, and not lower for the other player(s).
Prisoners’ dilemma > individual decision making can create Nash equilibrium that is not pareto optimal
Examples: coordination game; rock, paper, scissors; volunteers’ dilemma
Repeated game → Game in which actions are taken and payoffs received over and over again.
• With a finite number of repetitions, the rational outcome is for both to Confess and not
cooperate with the other person.
• With infinite repetitions of the game, the expected gains from cooperation with the other
person (Lying) will outweigh those from competition
→ A repeated prisoners’ dilemma can have a long-lasting cooperative outcome.
Tit-for-Tat: Strategy for repeated PD, with the highest outcome
Tit-for-Tat is:
- Nice: Starts with defect (i.e., lying to the cops)
- Provocable: Reacts to defect other player
- Forgiving: stops punishment after show of remorse
Lecture 3; U6+7
What is a firm:
Firm is a business organization which:
- Employs people
- Owns capital goods and purchases inputs to produce market goods and services
- Sets prices greater than the cost of production to make profit
Concentration of economic power in the hands of owners/managers allows them to issue
commands to workers.
Different levels of hierarchy:
- Owners decide on long-term strategy
- Managers implement decisions by assigning tasks to workers and monitoring them
- Employees execute tasks; create networks of colleagues; acquire skills necessary for the job; etc.
> leads to problem of asymmetric information between different hierarchy levels
Principal-agent models capture interactions under incomplete contracts
, Incomplete contracts arise when:
- Information is not verifiable
- The relationship covers periods of time
- There is uncertainty
- There are difficulties with measurement
- Judiciary is absent
- Preferences for omitting some information
Agents take action that is hidden from principal. Principal cannot verify it.
Why large firm?
> Economies of scale
Cost advantages > decreasing averages costs for production in large quantities leads to
emergence of large firms
Due to:
- High fix costs for machinery
- High first unit costs (R&D etc.)
- Input purchases to better terms (bargaining power)
Demand advantages > value of output rises with number of users (network effects) support the
rise of dominant firms
Firm's problem: how much to produce and at what price?
Cost functions > to make pricing and production decisions, managers need to know costs of production.
A firm's costs depend on its scale of production and the type of production technology it has.
> show how total production costs vary with quantity produced
Fixed Cost > All costs independently arising from any level of production Q.
Examples: rental costs, interest payment on debt
Variable Cost > All costs varying with the level of production Q.
Examples: raw material, labor
Total cost > Total economic cost of production, consisting of fixed and variable costs
Average cost (AC) > average total cost per unit produced
> slope of the ray from origin to a given point on cost function
> determine (dis)economies of scale
Economics > making assumptions about the world > simplify world because of complexity > predictions
Assumptions
Unit: individuals & firms
Homo economicus > view of human in which human is first and foremost an economic being:
- Humans are rational;
- Self-interested;
- Perfect information (> they know what the outcome will be > decision based on this);
- Individualistic.
Simplify enough that its clear but not to much that it doesn’t’ say anything > start with complex or
simple > economics start with simple unrealistic assumptions > improve upon idea > more complex
Production function > turning inputs into output > the relationship between the amount of outputs
(products & services) produced and the amount of inputs (labor & capital) used to produce it, holding
other factors constant (production environment)
>>> Describes what is technically feasible when the firm operates efficiently.
Firm internal structure and its production process as a black box
Basic assumptions about firm’s production processes:
• Technology is given
• The output is a result of only 2 input factors – capital and labour (can be extended for other
input factors in a similar way, like land or raw materials).
• The firms are always willing to produce as efficiently as possible.
Diminishing Marginal Returns: Situation in which the use of an additional unit of a factor of production
results in a smaller increase in output than the previous increase
Marginal product (MP): Change in output per one-unit change in input (at a given point, holding other
inputs constant) > slope of production function
Average product (AP): Average output per units of input (at a given point, holding other inputs
constant) > total output/total input (at certain point)
Preferences determine choices
Scarcity principle:
- Infinite desires vs. limited resources
- To get A > give up B
➢ For this tradeoff, economists look at economic costs
o Economic costs = explicit costs + opportunity costs
o Opportunity costs > the net benefit of the next best alternative action
➢ Indifference curve
,An indifference curve shows all combinations of two goods that give the same utility (satisfaction)
Marginal rate of substitution (MRS): the slope of the indifference curve. It represents the willingness to
trade one good for another (example: higher grades vs. more free time).
Indifference curves can’t cross.
Lower indifference curve is lower utility.
Choices are constraint > what is possible / feasible?
➢ Feasible frontier > all the possible outcomes that you can have
Feasible frontier: Maximum output that can be achieved of one good (grade) for every possible level of
the other good (free time)
Outside feasible frontier > not possible
Inside feasible frontier > feasible but inefficient > feasible set
Marginal rate of transformation (MRT): The tradeoff (opportunity costs) that an individual faces. The
slope of the feasible frontier.
Optimal choice (utility maximizing choice) > The amount of one good the individual is willing to trade off
for the other good (MRS) equals the actual tradeoff between the two goods (MRT)
➢ MRS = MRT
➢ Where MRS meets MRT > not cross, because then there will always be a line with a higher
utility
>>> Feasible frontier shows what you can, indifference curve shows what you want.
Game theory:
- Theory of goal-directed behavior in interdependent decision situations
- Mainly used to model to explain (solve) social dilemmas
- Social dilemma = a situation in which actions taken independently by self-interested
individuals result in a socially suboptimal outcome
Game involves:
- Players > (individuals, firms, countries, etc.) who make strategic decisions that take into
account each other’s actions and responses
- Strategies > a list of possible actions for each player
- Payoff > a value (e.g. in €) associated with a possible combination of strategies; typically the
expected net gain (benefits minus costs)
o Payoff matrix > Table showing payoff to each player given its decision and the
decision of its competitor.
,Outcome of the simultaneous-choice one-period game (Prisoners dilemma for example):
• Dominant strategy: optimal choice for each player no matter what the opponent does → for
both A and B to confess
• Nash equilibrium: if X is a best reply strategy of player A against Y and Y is a best reply strategy
of player B against X
• Pareto optimal: if there is no other strategy combination that yields higher payoffs for at least 1
player, and not lower for the other player(s).
Prisoners’ dilemma > individual decision making can create Nash equilibrium that is not pareto optimal
Examples: coordination game; rock, paper, scissors; volunteers’ dilemma
Repeated game → Game in which actions are taken and payoffs received over and over again.
• With a finite number of repetitions, the rational outcome is for both to Confess and not
cooperate with the other person.
• With infinite repetitions of the game, the expected gains from cooperation with the other
person (Lying) will outweigh those from competition
→ A repeated prisoners’ dilemma can have a long-lasting cooperative outcome.
Tit-for-Tat: Strategy for repeated PD, with the highest outcome
Tit-for-Tat is:
- Nice: Starts with defect (i.e., lying to the cops)
- Provocable: Reacts to defect other player
- Forgiving: stops punishment after show of remorse
Lecture 3; U6+7
What is a firm:
Firm is a business organization which:
- Employs people
- Owns capital goods and purchases inputs to produce market goods and services
- Sets prices greater than the cost of production to make profit
Concentration of economic power in the hands of owners/managers allows them to issue
commands to workers.
Different levels of hierarchy:
- Owners decide on long-term strategy
- Managers implement decisions by assigning tasks to workers and monitoring them
- Employees execute tasks; create networks of colleagues; acquire skills necessary for the job; etc.
> leads to problem of asymmetric information between different hierarchy levels
Principal-agent models capture interactions under incomplete contracts
, Incomplete contracts arise when:
- Information is not verifiable
- The relationship covers periods of time
- There is uncertainty
- There are difficulties with measurement
- Judiciary is absent
- Preferences for omitting some information
Agents take action that is hidden from principal. Principal cannot verify it.
Why large firm?
> Economies of scale
Cost advantages > decreasing averages costs for production in large quantities leads to
emergence of large firms
Due to:
- High fix costs for machinery
- High first unit costs (R&D etc.)
- Input purchases to better terms (bargaining power)
Demand advantages > value of output rises with number of users (network effects) support the
rise of dominant firms
Firm's problem: how much to produce and at what price?
Cost functions > to make pricing and production decisions, managers need to know costs of production.
A firm's costs depend on its scale of production and the type of production technology it has.
> show how total production costs vary with quantity produced
Fixed Cost > All costs independently arising from any level of production Q.
Examples: rental costs, interest payment on debt
Variable Cost > All costs varying with the level of production Q.
Examples: raw material, labor
Total cost > Total economic cost of production, consisting of fixed and variable costs
Average cost (AC) > average total cost per unit produced
> slope of the ray from origin to a given point on cost function
> determine (dis)economies of scale
