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    Chapter 2 2 Key Assumptions in Economies Feonomic analysis, like mathematics, depends on several assumptions. These assumptions reflect a set of core beliefs about human behavior and the world in which we live. Feonomists can and do dispute the validity of these assumptions, but for the vast majority of problems, econo- ‘mists will adopt these assumptions as part of their analysis. ‘Thus, you should not believe that economists adopt these assumptions blindly or without reservation, Many’ econo- mists have criticized the assumptions, and this chapter will ‘consider their weaknesses. So, with a spirit of skepticism, this chapter will present the five key assumptions used by economists and consider their validity. When you finish you should have leamed about: 1. Scareity and its impact on human behavior 2. ‘The concept of opportunity costs and how to define it witha production possibility frontier. 3. How the extra returns of any increased activity decline ith the activity. ‘The importance of sel-nterestin economic analysis, ‘The concept ofa utlty function ‘The tole ofa budget constraint in economic models. Why firms seek to maximize theit own profits. Why people are not fooled by changes in pices maehed by changes in income. |In some ways this is the most important chapter in the cntire course. In this chapter I lay out the fundamental con- eps and ideas that define modem neo-classical econom- ies. Ineffect, this chapter presents the complete definition of economics. the Heals of Navions by Adan Smith in 1776 she begine hing of modem economic analysis. Although Smi work fas many faulls relative to modern economic analy- sis, it started economists on the road that led to moder Almost all of the economic analysis we present inthis course was developed by the mid-1900's. This makes eco- nomics a relatively young discipline, compared to other fields like physics and astronomy, Yet, 150 years is not a trivial amount of time, and it has taken almost that much {ime for economies to evolve into the form you will recog- nize after taking this course. ‘That i, it has taken over 150 ‘years for economists to develop economic analysis to the point we see today, During that time, economists have investigated many intellectual dead-onds. Eventually, attr generations of study and insight, economists have devel- Key Assumptions in Economics 15 ‘oped a well-conceived body of knowledge and methods that in one way or another depend on the five assumptions quantity Q=50 R=PoxQ Ro 4250 Pw=wage Pwn5 P= price of plastic Pe=10 L = labor Le K = plastic K=200 C=PixL+Paak =8x704 10200 = 350+ 2000 2,380 Pr=R-C Pr=PoxQ-(P,xL+PqxK) Pr=$4.280-2,580~ 51,900 Figure2 12 In our example shown in Figure 2-12, you can eam a profit of $1,900 by selling 50 keyboards at $85 each, hiring 70 houts of labor at $5 per hout, and 200 units of plastic at a price of $10 per unit Assuming that because of competi tion you cannot change the price of keyboards, could you find another combination of quantities for labor and plastic inputs that generate increased profits? The answer is com- plicated and must wait for other ssetions of this course For now, simply consider how you might try to achieve ‘greater profits by changing the amount of labor and plastic used to produce keyboards. That is, you should wonder if ‘reducing the amount of labor and increasing the amount of plastic would increase output and thus increase profit, ‘What about increasing both labor and plastic, or reducing both labor and plastic? ‘You can't answer these questions vet, but posing the questions should accustom you to the idea that managers maximize the profits of thei firms by changing the amount of the inputs they use, You want to consider this point because many students, when asked how to inerease profits first think of changing the sales price of the product. OF course, ifthe manager of ACME Keyboards could inerease the price of its product without reducing the number’ of Chapter 2 This index has inereasod from 82.4 in 1980 to 156.9 in 1996 for a pereentage increase of 90.4%. Remember that both average production wages and average food prices increased by only 77.3%, From this perspective, the aver= age wage rate of production workers did not keep up with the prices of the goods and services they purchase. For people buying this average market basket of goods, it seems as if their purchasing. power fell over this time period. Thus, even though their wages grew, they were in fact poorer in terms of what they could purchase Real versus Nominal Values ‘The distinction between the simple face value of a person's income and the aetual purchasing power of the income is so important that economists developed special words. The ‘nominal value of money is the simple numerical value of ‘the money. In our example, average wages for production ‘workers changed fiom $6.66 in 1980 t SI1.81 in 1996, ‘isis an example of a change in nominal wages. In 1980, the nominal price of gasoline for California consumers equaled approximately $1.23 per gallon, In 1996, the nominal price had risen to approximately $1.33, per gallon, These are the actual numerical prices of gaso- line in the years 1980 and 1996. These are nominal ‘changes in the price of gasoline because they are not expressed relative tothe prices of other goods in the evon= omy The real value of money equals the purchasing power ‘of the money relative to the goods and service it ean pu chase. Thus, weal values take into account the price of goods and services. However, to better understand real values We need 10 see how economists measure average prices. cP How can we measure the real value of money? ‘To answer this question, consider the problem of determining whether the production worker experienced increased living stan- dards when her or his wage increased from $6.66 10 SULR1, We also saw that the average price of all goods and services purchased by urban consumers inreased from, 824 to 156.9 during this same time period ‘The measurement of average prices used in this exam- ple is known as the CPI-U, the consumer price index for lurban consumers. This is the most popular measure of average prices since it is an average of the price ofall the types of goods atypical urban consumer purchases. We'll refer to it simply as CPL How is the CPI formed? First, economists studied the expenditure pattems of urban residents to make a list of ood and services purchased by the typical urban con- Key Assumptions in Economics. 2B ‘sumer We can call this list the CPL market basket. Next, every month the government sends people out to stores across the country to find out the current price of every= thing on thelist, everything from TV sets to potato chips, fiom beer to milk. All these prices are collected and then ‘weighted by the proportion each item represents of a typi- cal urban consumer's budget to form an average price for the CPL market basket. This almost completes our brief introduction to the CCPI, but there is one more thing you need to know, ‘The numbers 82.4 and 159.9 are not the actual average prices Instead, economists find it convenient to express the aver- age prices relative to some base year or years [nthe num= bers above, the period 1982-84 is the base period, This ‘means thatthe average price of a CPI market basket in this period is normalized to 100. You can find the numbers themselves and more information about how to compute the CPI from the Bureau of Labor Statistics, an agency within the U.S. Department of Labor Real Wages: Now that you understand the basics of the CPI, let's take up the issue of real wages. We have already’ seen how the purchasing power of the average production worker fell between 1980 and 1996 relative to the CPI. Now, we want 4 simple measure of what happened to the purchasing power for production workers, which we wil ref to asthe real wage rate ‘Ask yourself how much of a CPL market basket the average production worker could have purchased in 1980 With one hour of work. The average production worker could have purchased 0.081 of the CPL matket basket with fone hour of work. Similarly, the average production worker could have purchased 0.074 of the market basket in 1996 prices. Again, for convenience we should multiply these numbers by 100 to generate a measure of the real ‘wage rate for production workers in 1980 and 1996. As the lable in Figure 2-15 shows, our results show the real wage declined from 1980 10 1996. Since the CPI was eon structed so that the average CPI over the period from 1982 1o 1984 equals-100,-we would say that the real wage ‘expresses wages in constant 1982-84 dollars, 666 nat 810-—— 100 7402 100 4 1590 Figure 2-15 Real Gasoline Prices Another example should help solidify your understanding of real versus nominal prices and how economists compute L's return to the price of gasoline in California, them, 4 Key Assumptions in Economics Chapter 2 We saw earlier that between 1980 and 1996 the price of gasoline rose from $1.23 per gallon to $1.33 per gallon. This is the change in nominal gasoline prices, but what about the real price of gasoline? The following table shown in Figur 2-16 shows the nominal price of gasoline foreach year between 1980 and 1996, As with wage rates, we want to express these prices relative to the cost of other goods, Ihave chosen the CPL used earlier for this purpose, ‘This means that we wil be expressing the real price of gasoline relative to the purchas- ing power forthe CPI market basket of goods, Year Nominal Price CPI Real Price ones et iret nol eye) 1981 198 up 148 oe eS 1983011298 1.12 1984 0113039 4.09, 1985 111078 1.04 1996 087-006 0.80 1987 089113678, 1988 0901183076 1989 0.97 124078 1990 109307 oa, 1991 14518288 (oe Pr ees eae | ane | one) 194 121148282 1995 12318248 196132186908 Figure 2-16 The procedure is simple; divide the nominal gasoline price by the CPI and multiply by 100. Check it out for yourself For example, divide the nominal price in 1986 of 87 cents by the 1986 CPI of 109.6 and then multiply by 100 to ‘obtain 80 cents forthe real price of gasoline Price of Gasoline in California 0 wo} fom 00 on} 17S a) 1585 1 WHS 2D Figue 2-17 Beli leaving this example, let's look al Figure 2-47 Which is plot of th and real prices for gasoline ‘in California. The plotted values show elealy that although ‘gasoline prices began to rise in California after 1986, this did not reflect an increase in the real price of gasoline, Which stayed low Instead we ean conclude that the g4s0- line price inereases more or less matched the inflation rate in the CPI market basket of goods. Real and Nominal Interest Rates Finally, lets consider one more important example: real versus nominal interest rates. Begin by asking yourse why people save. Economists believe that people seek their own selFinteests and that they prefer to have their consumption now rather than later. Viewed this way, pes ple must be rewarded for saving, and their reward is earn- ing interest on their savings. Suppose you have $100 and need to have your pur chasing power increased by 3% per year to compensate you for saving instead of consuming now. Does this mean you ‘might purchase a five-year US Treasury Bond if the inter ext rate was 3% or more? Well, not quite, It would depend ‘on what you expected the inflation rate to be over the text five years. Ifyou expected the inflation rate to equal 2% lover the next five years, you would require 5% interest Tetum to compensate you for saving over the next five years. You need 3%% for deferring your consumption from the present to the future, and you need an extra 2% to com= pensate for the loss of purchasing power your money wil, experience while i's ted up in a US Treasury Bond, In other words, you would need 5% =3% + 2%. In view of these considerations, what is the interest rate on five-year US Treasury Bonds listed in the Wall Street Joumal every working day? For example, during the month of January 1998, five-year US Treasury Bonds traded in New York with an average interest rate of 5.42% This is what economists call the nominal intrest rate. AS ‘we have seen, the nominal interest rate equals the sum of \what it requires to induce people to save instead of spend ing plus their expected inflation rate. That i, the nominal interest rate equals the interest rate we observe in the finan

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