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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
   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

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

   The aim of microeconomics if to answer the
    following questions of consumers and
       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 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

         You are here
        Modelling and microeconomics

   Modelling in microeconomics
     Assume a simplified agent and
      environment (even if you know that this is
     Understand how things work in this ideal
     Then relax the simplifying assumptions
      one by one and see how the mechanisms
        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

   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 variables
     A variable is a quantity that can change
      values and be measured on a given scale
     Temperature, pressure, income, wealth
   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

                      y  f r , s, t
                                   
    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 !!
                What is a function ?

   3: Algebraic representation
       This is the “scary” one, because it involves
        “maths” (algebra, actually)
                 y  10  0.9r  0.5s 2  et
       The problem is that to express a function this
        way, you need to know exactly:
          The “functional form” (Linear, quadratic,
          The values of the parameters
       Finding these is often part of the work of an
                  What is a function ?

    4: Graphic representation
         Often the most convenient way of representing a

(kg/m2)      Crop yields as a function of rainfall

                                                     y  f r , s, t
                                                                 

                   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
(kg/m2)       Crop yields as a function of rainfall
                              t1>t                    y  f  r , s, t1 
                                                              
                                                                     

                                                      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).
           satisfaction  f  q1 , q2 ,..., qn 
                  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
                       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
     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 ?

                    Slope = 0

                A               C
    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
                  y  f  x
 The first derivative is the function f’ such
  that            dy
              s      f  x
  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 ?

   f  x                f  x
k (constant)                 0

     x                       1
    x   n
                        n x n 1
                         2 x
   ln x                  1x
   ex                       ex
                What is a function ?

   Partial derivatives
       What if the function f is a function of several
        variables ? (often the case in economics !)

                    z  f  x, y   x 2  y 3

   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 ?

                z  f  x, y   x  y
                                    2        3

   Partial derivative of f with respect to x
                      f x  x, y   2 x
   Partial derivative of f with respect to y
                    f y  x, y   3 y 2

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