The Logic of Choice: Ends and Means
Each of us acts purposefully
We have ends, goals, desires, objectives, etc
We use means in the world that we believe will achieve our ends
The Logic of Choice: Purpose
Acting with purpose is what distinguishes humans from everything else in the universe
Artificial intelligence researchers face "the frame problem"
- We thought: computation is hard, perception is easy
- We've found: computation is easy, perception is hard!
Methodological Individualism
Only individual people act
The individual is the base unit of all economic analysis
"How will action/choice/policy/institution [X] affect each individual's well-being?"
Goods and Services
Actions that satisfy human desires provide a service
An object that can provide services is called an economic good or a resource
Consumption
- Goods and services provide "utility" (satisfaction of a desire) when we consume them
Bads
- An economic bad is something that hinders our ability to satisfy our desires
Scarcity
Scarcity: human desires are practically unlimited, but our ability to satisfy them (with goods and services) is limited
How do we best economize limited resources to satisfy our unlimited desires "efficiently?"
Choice
We can only pursue one goal at a time
This implies that we must choose to forgo all other alternatives when we pursue each goal
Choice → Opportunity Cost
We can only pursue one goal at a time
This implies that we must choose to forgo all other alternatives when we pursue each goal
The (opportunity) cost of every choice is the next best alternative given up
- "You can't have your cake and eat it too"
The Parable of the Broken Window
Frederic Bastiat
1801-1850
- That Which is Seen and That Which is Not Seen
The Parable of the Broken Window
Frederic Bastiat
1801-1850
That Which is Seen and That Which is Not Seen
"That which is seen"
- The broken window
- Resources diverted into glassmaking
The Parable of the Broken Window
Frederic Bastiat
1801-1850
That Which is Seen and That Which is Not Seen
"That which is seen"
- The broken window
- Resources diverted into glassmaking
"That which is not seen"
- Opportunity cost of fixing the window
- Resources diverted away from other opportunities
Applying the Parable of the Broken Window
What does it mean to say that "spending money 'stimulates' the economy"?
Scarce resources used in one industry can not be used in other industries
Every (visible) decision to spend on
(X)yields more(X), and destroys an (invisible) opportunity to spend on(Y)
A Theory of Value
"Classical Economists" (c. 1776-1870)
Goods have "natural" prices, determined objectively by cost of production (wages+rents+profits)
- Labor theory of value: prices of goods determined by amount of "labor hours" to make
A Paradox!
The Solution (1870s)
The Marginalist Revolution
All human choices are made "on the margin," considering a small change from the status quo
Buying, selling, consuming, or producing a discrete unit of a particular good at a time
Each unit of a good provides marginal utility
Marginalism
Carl Menger
1840-1921
Value is thus nothing inherent in goods, no property of them, nor an independent thing existing by itself. It is a judgment economizing men make about the importance of the goods at their disposal for the maintenance of their lives and well-being. Hence, value does not exist outside the consciousness of men (pp. 120-121).
Menger, Carl, 1871, Principles of Economics
Marginal Utility Determines Prices: A Demonstration
Three Insights About Value
- Value is subjective
- Each of us has our own preferences that determine our ends or objectives
- Preferences are not comparable across individuals
- Only individuals know what alternatives they give up at the moment of choice
Three Insights About Value
- Value is measured as an ordinal concept
- We can rank our objectives relative to each other (but cannot quantify further)
- We pursue highest-valued objectives (highest marginal utility) first
- Pursuing one objective means not pursuing others!
Three Insights About Value
- Value inherently comes from the fact that we must make tradeoffs
- Pursuing one objective means not pursuing others!
- The objective we pursue at the moment must be worth the sacrifice of others! (i.e. highest marginal utility)
Value and the Margin I
The Law of Diminishing Marginal Utility: each marginal unit of a good consumed tends to provide less marginal utility than the previous unit, all else equal
Value and the Margin II
Example:
- Suppose you have 5 uses for water by their value to you. Assume each use requires exactly 1 gallon of water:
- Drink water
- Take a shower
- Wash car
- Water plants
- Change goldfish's water
Value and the Margin II
Example:
Suppose you have 5 uses for water by their value to you. Assume each use requires exactly 1 gallon of water:
- Drink water
- Take a shower
- Wash car
- Water plants
- Change goldfish's water
Suppose you have only 1 gallon of water, what will you do with it?
Value and the Margin II
Example:
Suppose you have 5 uses for water by their value to you. Assume each use requires exactly 1 gallon of water:
- Drink water
- Take a shower
- Wash car
- Water plants
- Change goldfish's water
Suppose you have have 2 gallons of water, what will you do with them?
Value and the Margin II
Example:
Suppose you have 5 uses for water by their value to you. Assume each use requires exactly 1 gallon of water:
- Drink water
- Take a shower
- Wash car
- Water plants
- Change goldfish's water
Suppose you have 5 gallons of water, and then suddenly spill one. Which activity will you stop doing?