Lecture 4 The Neoclassical Tradition An Introduction

  • Fundas of NM
    • Principles of Economics by Marshall: represents academically rigorous and acceptable economics - then and now
      • Distill the major assumptions and principles
      • Illustrated with captivating graphs
      • Visualization of complex mathematical relationships
      • Work is centered around: rationality, preferences and utility maximization
      • Efficiency has been the heart of the processes
    • Conceptual core assumes: - normative criterion
      • consistent preferences
      • maximization of personal satisfaction of preferences
    • Marshall created sound mathematical foundation, but was sensitive to its limitations. He mailed A.L. Bowley (1906)
      1. Use Mathematics as a shorthand language, rather than an engine of enquiry
      2. Keep to them till you have done
      3. Translate into english
      4. Then illustrate by examples, important in real life
      5. Burn the mathematics
      6. If you can't succeed in (4), burn (3)
    • Unrealistic assumptions, make the mathematician lose the track of the reality in the "maze of pretentious and unhelpful symbols"
    • Mervyn King (2016) critique of financial crisis 2007 - 2008, highlighted the limitations of too narrowly defined mathematical economics
    • Financial crash revealed that sometimes crucial factors are left out of economic models to make the math tractable.
    • Predictive models' failures surprised even the fans
  • Economic Entities
    • The Individual (consumer) - Utility
    • The Firm - Profits
    • Allocate each of their scarce resources in the most efficient manner to max their payoff
    • Interesting: same analytical machinery for both??
  • The Firm
    • Marshalls' NM work centered on characterizing 'the firm' = focus of microeconomics
    • Firms are assumed to sell homogenous (perfect substitutes)
    • Modern work: brand marketing = differentiating firms
    • Firms are assumed to be price takers
    • Assumed that there is free entry and exit in the market, at least in the long run
      • Far from reality bro
    • Assumed to have perfect information (no seller can sell at a higher price than their competitors)
    • Price elasticity of demand
    • Marshall's supply and demand curve...
      • Supply & Demand curves
      • Mkt equilibrium
      • Relationship between qty supplied/demanded and price
      • law of diminishing returns
    • Are these assumptions perfect representations? No! Milton Friedman voiced it out.
    • Firms seem like the ECON
  • The Consumer
    • Assumed to have complete, transitive preferences (can rank options)
    • These assumptions are often relaxed to work with reality. But for NM to work, people must conform to these characterizations.
    • Theory of revealed preferences
    • Descriptively flawed and predictably hopeless
    • Rigorous mathematical models deviated too much (less than perfect is better than nothing)
  • Marshall & Marginalism
    • Efficiency is always obtained at the margins of activity
    • e.g. increase production till \(MC=MR\)
      • cease production at the point of marginal unit loss
    • Stop consuming when the costs outweigh the benefits
    • People continue to be the the relationship even if they had been experiencing disutility for a long time... we forgive even though its inefficient... "we invested time"
    • Law of diminishing marginal utility (too many ice creams can cause disutility) > Happiness is in the increase... not in the state
    • Excessive game playing, twitter use (pathological behavior) are actual problems
  • Axioms of Consumer Behavior
    1. Completeness: Can rank all possible choice bundles
    2. Transitivity: \(A \succ B\) and \(B \succ C\) then \(A \succ C\)
    3. More-Is-Better: More of a good is preferred to less (Ceteris Paribus)
    4. Continuity: Small changes in quantity shouldn't cause abrupt preference shifts
    5. Convexity: Consumers prefer diversified bundles to extremes (e.g. mix of apples and oranges over only oranges or only apples)
  • Neoclassical Rationality
    • All five axioms \(\implies\) consistent behavior
    • Consistent behavior based on consistent preferences is a key aspect in defining rational behavior
    • Key Principles
      1. Marginal Analysis: Decisions are made incrementally: \(MC = MR\)
      2. Sunk Cost Fallacy: Rational agents ignore irrecoverable costs (But humans honor sunk costs (non-refundable concert tickets) due to loss aversion)
      3. Opportunity Cost: CBA must consider opportunity costs (explicit and implicit cost)
      4. Incentive Response: ECONs do respond. Law of behavioral psychology, simple animals allocate behavior in a way that maximize their total reward
  • The point of it all: Utility Maximization
  • Expected Utility Theory (EUT)
    • Von Neumann-Morgenstern Theorem:
      • Should behave in a manner to maximize expected value or utility
      • \(E[X] = 1.25\) and sure short \(X = 1\) then the first should be chosen.
    • Empirical violations
      • Risk Aversion (prefer certain outcomes)
      • Prospect Theory: (people evaluate losses differently from gains)