Lecture 2! Introduction to Economic Actors: Households and Firms

Transcription

1 Lecture 2! Introduction to Economic Actors: Households and Firms

2 Agents/Sectors in Economics! Individual (Household) Firms Private Banks Central Banks The Government Other Countries/Rest of World

3 Today! Households and Firms. (Why households and not individuals?) Case study: Xbox 360.

4 What I want you to learn! Review micro approach to household & firm choice & behaviour under certainty & uncertainty.

5 U<lity Maximisers Sa<sficers Something in between? 1. Households 2. Firms Profit Maximisers Growth Maximisers 4. Government 3. Banks & Central Banks Constraints Fiscal Policy Monetary Policy Balance Sheet approach Monetary Policy

6 Part 1. Households! Microeconomics is all about the household/individual. Aristotle: Economics is: Good management of income, consumption, and saving. In micro 101, you assumed 1) households as consumers of stuff prefer more to less (monotonicity), 2) Households can rank their preferences (transitivity) and 3) Households can form complete choice sets. Gives us a Utility Function U(x) like U(x 1, x 2 ) = x *x 2 0.5

7 Households! Then maximise that utility function subject to a budget constraint: p 1 x 1 Indifference Curve Max U(x 1, x 2 ) = x *x St p 1 x 1 +p 2 x 2 M Household happiest here. Budget Line U(x 1, x 2 ) p 1 x 1 +p 2 x 2 M p 2 x 2 See Screencast on Solving Constrained op<misa<on problems

8 Works for Saving/Work/Portfolio Decisions too.! In class: Pick two periods, {young, old}. Allocate consumption c young, and c old, using the reasoning in the diagram above. Discuss amongst yourselves. What should the shape look like? Why? Young Old

9 Slight change for rational choice under risk! People are assumed to be able to weigh up risks correctly, at least on average Attitudes to Risk connected with the idea of a fair gamble 1. Risk Neutral 2. Risk Loving 3. Risk Averse

10 A lottery.! (A) Lottery L1 promises a sure win of 30, lottery L2 is a 80% chance to win 45 (and zero in 20% of the cases). (B): Lottery K1 promises a 25% chance of winning 30, lottery K2 is a 20% chance to win /@stephenkinsella!!

11 Allais paradox! For (A) Typically, L1 is strictly preferred to L2. For (B) Here, the typical choice is K2 over K1 although situation B differs from situation A only in that in each lottery, three quarters of the original probability of winning a positive amount are cancelled

12 Nerdy Bit! A utility function of the form% E(U) = p1u(c1) + p2u(c2) where p represents the probability of a given state, and u is the utility from consuming a given amount, c.

13 Let s imagine an agent with wealth, ω, of 20. Now the agent is presented with a choice (gamble): win 10 with probability of 50% or lose 10 with probability of 50%. The expected value, E(ω), of this is:% 0.5 ( ) ( 20 10) = 20. The expected utility is E(U(ω)) = p1u(ω1) + p2u(ω2)% = 0.5 u( ) u( 20 10)% = 0.5 u( 30) u( 10) If E(U(ω)) < U(E(ω)), i.e. the expected utility of wealth is less than the utility of expected wealth, we say the person is risk averse. 0.5 u( 30) u( 10) < u( 20)

14 Applications to! Insurance Information Asymmetry --Moral Hazard and --Adverse selection Game theory, strategic defense

15 Useful models because of! Comparative statics. Shift value of 1 variable/ parameter, watch model change Welfare analysis. See how better/worse off they are if forced to save, if goods change, etc Policy analysis. See how behaviour changes if risk attitudes change.

16 Elements of Rational Decision Making! Individuals make choices to maximize some objective function (usually utility function) under the constraints that they face, utility function must be stable If there is uncertainty, individuals maximize expected utility by assigning probabilities to different states of the world Theory implies people compare opportunity cost of various decisions - Pursue an activity until marginal benefit equals marginal cost - Sunk costs are sunk - Consistent behaviour across time/choices/markets/etc - More choice is better, less choice is always worse. Useful because we can rely on choices to infer preferences idea of revealed preference.

17 Quite different from Keynesian theory of consumption! Idea: when disposable income (YD) rises, households spend more. A psychological theory. Formally Household s Marginal Propensity to consume increases. This is MPC= C/ Y. Inverse of Marginal propensity to save. Consumption function C = C 0 + MPC*YD Related to permanent income hypothesis.

18 25.0 Private Final Consump2on Expenditure in Ireland, Billions of Euros, Quarterly, Seasonally Adjusted

19 Wealth and Consumption! Changes in perceived wealth will change consumption. How?

20 Another view: household as balance sheet! Assets Tangible Capital Equities Bills Money Deposits Cash Loans Liabilities Net Worth (+/-) At any moment, these two sides must balance.

21 Those pictures are benchmarks! Assumes a lot in terms of rationality, information, computation, availability of goods, competitive markets. Also psychologically falsified. New(ish) field of behavioural economics shows how.

22 Behavioural Economics! Rationality: essentially behaving consistently with respect to your goals. An ancient and deep debate exists over whether people are rational in some sense. People do respond to incentives, but only sometimes, and not as theory would predict.

23 Ideas from Behavioural Economics! Status Quo Bias. A tendency! to make decisions by accepting the default option instead of comparing the marginal benefit to the marginal cost. Application to pensions. Framing. Allowing the way a decision is presented to affect the choice that is selected even though the marginal benefit and marginal cost are unaffected. Choice theory changes. Faulty discounting. Being too impatient when it comes to decisions that involve benefits that are received in the future or discounting future benefits inconsistently depending on when the delay in receipt of benefits occurs. Investments fail here.

24 Ideas from Behavioural Economics!! Overconfidence. Believing you will know what will happen in the future to a greater extent than is justified by available information. Desire for Fairness and Reciprocity. You punish people who treat you unfairly and you reward those who treat you fairly, even if you do not directly benefit from those punishments and rewards. Sunk Costs Matter. Allowing sunk costs, which have already been paid & do not affect marginal costs regardless of which option is chosen, to affect a decision.

25 Matt Rabin: Rationality is the Dead Parrot of Economics! Bayesian Information Signal Processors Have well-defined and stable preferences Maximise expected utility E(u) Apply exponential discounting rules Are self-interested (narrowly defined) Have preferences over outcomes not changes Have only instrumental tastes for beliefs and information See Rabin and Thaler (2001)

26 Macroeconomics & Behavioural Economics! The two haven t started talking properly yet, but some interesting papers here. See work of Prof. Liam Delaney at U. Stirling & UCD as well as Menz, 2008 for a bibliography.

27 U<lity Maximisers Sa<sficers Something in between? 1. Households 2. Firms Profit Maximisers Growth Maximisers 4. Government 3. Banks & Central Banks Constraints Fiscal Policy Monetary Policy Balance Sheet approach Monetary Policy

28 2. Firms! Firms assumed to utilise inputs of Capital (K) and Labour (L) to maximise their profits. Have a production function p.y=p.f(k, L). They d like to Max Profit st. w.l+r.k py Output, y Produc<on Func<on: Y=f(x 1, x 2 ) Isoprofit lines w.l+r.k p.y Good, x

29 Firms are also balance sheets! Assets Tangible Capital Financial Assets Liabili2es Loans Equi<es issued Net Worth

30 Digression on Net Worth!

31 Returns to scale! Q: Will the techniques of production work the same way when the level of production gets bigger or smaller? IRTS: Increasing CRTS: Constant DTA: Diminishing Output 1* good 2* good IRTS CTS Good DTS

32 Short vs Long Run! Short run: some inputs to production fixed, eg. Capital. Dell factory in Limerick. Long run: all inputs variable & fungible. Eg Dell moving from Limerick to Poland.

33 Output Money Wage Labour Employed Profit Rate Income Price Level Capital Employed

34 Firms equivalently minimise cost! Minimise cost function w.l+r.k Such that F(K, L) = y Firms maximise profits when they minimise costs Slope of isocost is the rate of technical substitution, -w/r K Isoquant: f(k, L) = y Isocost Line = - w/r L See Screencast on Solving Constrained op<misa<on problems

35 Obligatory cost curve porn.! Cost minimisation produces lowest marginal cost when supply=demand. Cost of Production Marginal Cost Demand=Average Revenue=Marginal Revenue Average Cost Quantity Produced 10

36 Another story: firms go for growth not max. profits.! Think of the firm as searching for a set of cost curves which (it thinks) will guarantee its survival into tomorrow. In any period any one firm can only borrow a finite amount of money, and this amount is usually based on the amount of internal funds the firm has accumulated in previous period

37 Firms as growth-maximisers! The principle of increasing risk holds that the higher the gearing or leverage ratio (externally generated funds/internally generated funds), the larger the potential volatility of earnings net of interest payments. In normal times, are free to borrow what they like at the current rate as a multiple of their previous retained earnings. In crisis periods, this reverses, and the multiple becomes a divisor, perhaps driving firms out of business.

38 The firm wants to retain its gross earnings,, before dividends and interest are paid out. Call K s the capital owned by shareholders, and K b the capital borrowed through loans and/or bond issues. The rates of interest on shares and borrowed capital are i s and i b. The retained earnings of the firm are equal to:

39 We can divide this expression by K to get the relationship between the rate of growth (g=i/k) of the firm and its rate of profit (r= /K). K b = µ( ik) Firm ploughs profits back in: K = I =( ik)+µ( ik) Rewrite I/K =(1+µ)( /K i) r = i + g/(1 + µ)

40 Finance Constrained firms! r=i+g/(1+µ) is the finance constraint of the firm. If the firm wants to grow at a faster rate, the firm has to collect a higher rate of profit. Finance vs expansion constraints look like this:

41 10 9 /K=r r r r g Expansion Frontier R G Finance Frontier g r I/K=g 10

42 SimplE Model of Price formation! Mark Up Labour Produc<vity Real Wage Effec<ve Demand

43 Summary! Households consume, save, invest, work, play, live & die via quite different rules than constrained optimisation allows. Firms more accurately maximise growth/ minimise debt through cycles than simply maximise profit. Tomorrow Banks and Central Banks