supplementary reading 118-127

supplementary reading 118-127 - 1 Overview Economics is the...

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1 Overview Economics is the problem of the allocation of scarce resources. Microeco- nomics seeks to address the problem through the action of individuals. The basic assumption of Microeconomics is that individuals behave ratio- nally. In this context, rationality means that individuals optimize: consumers maximize preferences subject to constraints, firms maximize profits subject to constraints. A number of objections can be raised to the models we build of rational behavior: 1. They don’t explain why people behave in some particular way. 2. The basic premise is wrong: individuals don’t really optimize. 3. The models are too simple and leave out too many of the details. Some answers to these objections: 1. Newton’s law of gravity says that bodies attract each other by a force that varies directly as the product of the masses of the bodies and inversely as the square of the distance between them. On the basis of this law, Newton derived testable conclusions about planetary motion (Kepler’s three laws, in particular). When asked to explain why the law of gravity is true, Newton replied that this was not his job; he did not explain why things happen, only what happens. Similarly, we are satisfied if we can build a theory that has testable and correct implications about reality. 2. The assumption that individuals optimize is a description about the model, not necessarily about reality. What we care about is correctly describing how an individual behaves , not what goes on inside the in- dividual. When we watch Michael Jordan make a jump shot, we can 1
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describe it in mechanical terms: he is moving 1.3 ft/sec to his right, 1.5 ft/sec up, releases ball at height of 2.87 ft, at speed of 4.1 ft/sec, angle of 65 o . Of course Michael Jordan does not think any of these things, he just jumps, shoots, scores. The description is in modeler’s mind, not in Michael Jordan’s. [Models that assume less rationality of individuals may give better predictions. The di ffi culty with such models is that it is not so hard to make models of very smart individuals or of very stupid individuals — but it is very hard to make models of individuals who are about as smart as human beings.] 3. Models are maps of reality. Like road maps, their usefulness is not in proportion to their accuracy. If you were planning to drive from LA to the house I own in Lawrence KS, you would get a US map, a Kansas map, a Lawrence map — but you would not need a street map of every city on the Interstate, or a map showing the location of every exit on the Interstate, or even a map showing all the states you would go through. I could draw you the ncessary map on a napkin: Go North on I-405 to I-5, take I-80 East to Lawrence, get o ff at exit 77W, take a left at Vermont St. We want the model to have enough detail so that we can figure out what is happening — but not enough detail to become unmanageable.
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