Scarcity and choice, Slides of Decision Making

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Lecture 2

Scarcity and choice

Juuso Välimäki Sep 11, 2019

Main topic in this lecture: choice

• How much should I work? Ø Tradeoff between free time and fruits of labor Ø Home production: studying for an exam, agricultural production within the family Ø Working for a wage
• Should I spend now or should I save for retirement? Ø Tradeoff between consuming when young or in retirement Ø Different ways to save Ø How about borrowing now and paying later?

Big picture goal: how can we make sense of income and working hours across times and across countries?

Trade-off between work and leisure: studying to gain points on an exam Students choose how many hours to study which affects their grade (GPA). Guided by introspection and also some empirical evidence, we assume a positive relationship between GPA and the number of hours studied.

What can production functions tell us?

1. Marginal product Change in output per unit change in input (evaluated at a given point, holding other inputs constant) 2. Average product Average output per unit of input Slope = Marginal product ( hours of study) Slope = Average product (4 hours of study)

Studying example Diminishing marginal product: Studying becomes less productive, the more you study.

How to think about indifference curves?

• Think of a thought experiment: you can choose between two options A and B Ø Option A gives you 8h of free time (not including sleeping) and EUR 50 of consumption per day Ø Option B gives you 7h of free time and EUR x per day Ø If x is large enough, you want to take option B Ø If x is no larger than 50, you take A Ø Calibrate x so that you like the two options equally much Ø Repeat this for A versus C where C gives 6h of free time and EUR y per day, etc. Ø Plot all such options that you like exactly as much as A and you have the indifference curve through (8h, EUR 50)

How to think about indifference curves?

Ø Indifference curves are individual and subjective: Ø There are no right and wrong indifference curves Ø Two decision makers have generally different shapes for their indifference curves: some people enjoy leisure more while some appreciate exam grades more Ø This is just one instance of choice under scarcity Ø Time is scarce so you manage carefully your time budget Ø But other resources are scarce too: choosing how to use a fixed budget on food or clothing, or more concretely between apples and oranges

Opportunity cost

• Choices are limited by constraints and involve tradeoffs (Studying example: higher grades vs. more free time)
• The opportunity cost of an action is the net benefit of the next best alternative action
• MRS is a measure of this
• Compare actions based on economic cost Economic cost = monetary costs e.g. transport + subjective costs e.g. effort of work

The Feasible Frontier The feasible frontier shows the maximum output that can be achieved with a given amount of input The marginal rate of transformation (MRT) is the slope of the feasible frontier. It tells how many points you lose if you increase your free time per day by an hour.

Optimal Decision Making

The optimal choice in this case is where MRS = MRT If MRS is larger than MRT, you shoud study less, If MRS is smaller than MRT, you should study more.

More on optimal choice

• (This material is slightly more advanced)
• In general, the optimal choice is given by an option such that there is no other option in the feasible set that is better than the optimal choice
• This means that no other option is on a better indifference curve
• What if the indifference curves are straight lines? In this case, it could be that at no point MRS=MRT
• If this is the case, optimal choice is to choose zero of one of the goods (corner solution)

Optimal Decision Making

• Technological progress makes it feasible to both consume more and have more free time.
• Choice of free time/consumption depends on relative preferences and willingness to substitute one good for another. What happens when the feasible frontier changes?

Market example: Working for wages Budget constraint: consumption no larger than labor income Indifference curves demonstrate preferences over consumption and free time