Microeconomics

This is originally posted on Wednesday, 23 May 2012 at 00:15

Foreword

Before you read any further, here are some disclaimers:

1. Everything was by trial and error. What works for me may not work for you. 

2. UoL teaches Neoclassical Economics, the mainstream school of thought which is gradually being outmoded. If you want to score in exams, UoL is for you. If you want economics that squares closely with reality, please look elsewhere. Find out about other schools of thought: Neuroeconomics, Behavioral Economics, Socioeconomics, Political Economy, Institutional Economics.

3. If you want a superficial quick fix such as memorizing graphs etc, don't take Microeconomics. You will probably fail. 

Neoclassical Economics

At first glance, the microeconomics we study may seem pointless, and rightly so. This is because neoclassical economics is steeped in abstraction and mathematical elegance, often ignoring the actual facts of life. 

From this point on, I will simply call what we study in UoL as "economics", although this is a narrow definition that implies that neoclassical economics is the only way to approach the discipline 

So if you find this kind of economics pointless, it's okay because I think so too. I think there is some semblance of reality in what we study, but most of them are crap.

However note that we are still taking a degree- the grades matter. Most of you don't have a personal interest in economics, so just make sure you clear this module with minimal re-sit.

Even if you are deeply interested in real-world economics and desire to refute neoclassical economics, you need to first master it to criticize it.

So there we go- we might as well try to do well for this module. 

Two Languages

To grasp UoL economics, one needs to be fluent in two languages. The first is obviously english, since it is the medium of instruction and examination. 

Guess what's the second language?

It's not mandarin, french, japanese or korean- it's MATHS. 

Mathematics is the language of neoclassical economics, especially at the Micro level. Every model in Microeconomics is likely to be presented in a mathematical format: graphs, game theory, etc. 

That's Rule Number One: You need to master the translation of english to math, and vice-versa.

A Personal Story

Remember I shared that I nearly failed every subject in Secondary 3 and nearly could not promote? The story barely scratched the surface. Out of all my subjects, my lowest score was A Maths (regular F9).

The second subject is the Physics component of my Combined Science (Physics/Chemistry). I'm almost hopeless in that subject- it was something that I had struggled throughout Secondary 3. I don't even know how to read the vernier calipers.   

Then at the start of my Secondary 4,  my Physics teacher started an interesting exercise. He will ask questions during lessons. Anyone who did not get it correct will drop 10 (do pushups) on the spot. It was unconventional but it worked. I didn't want to keep doing pushups. In addition, that teacher has the ability to strike fear in our hearts. Everyone is usually on his best behavior when he is in class. At that point, I dislike Physics. It was a basket case because I never passed a single Physics test in my Secondary 3. 

I started paying more attention in class. I read all the physics notes he provided. I practiced every question, memorized every definition and seek to grasp everything that I ought to learn. Incidentally, it was also a busy period for me. Every day after school, I  will sit at the bus stop outside Bishan MRT, read my physics notes, survey students who passed by, finish the survey, sit down again and start reading my notes. Rinse and repeat over a few weeks. I read physics everywhere: on the bus, MRT and at home. In retrospect, I had never studied so hard for a subject since I left primary school. 

Then something amazing happened. There was an Physics class test in March. When the results came out, most of us showed marked improvement. The majority of the class will usually fail, but this time many people improved to a pass. I recall a classmate got 27/35. He was rather cocky (in a playful manner) because he got 77% (A1), the highest in our class at that point in time. When it was my turn, I took my results hoping not to fail again. But I got the shock of my life. My classmate (the 27/35 guy) saw my paper and he said "Wa lau eh f**k you la!" (in a joking manner). I scored 29/35 (around 83%). I top my class for that test. Since then, I never looked back. I started to enjoy Physics and for my O levels, I came out of the exam hall fully certain that I will get A1 (which I did).

This is not to boast of my achievement, since we are already taking a degree. However this story of fail to topping the class left a deep impression upon me. It showed me that as I do my best, God will do the rest. It highlights the fact that if we want to live for God as a student, we need to step out of our comfort zone to serve God diligently and yet also put in an incredible amount of hard work too.

Economics & Physics

When I entered year 2 of UoL, this experience came as an epiphany. As mentioned earlier, the languages of neoclassical economics are maths and english- it is parallel to Physics.

It is hardly surprising. The earliest contributors to this school of thought includes Alfred Marshall, John Stuart Mill, William Stanley Jevons and Leon Walras- proponents of marginalism, utilitarianism, tendency to equilibrium and the "scientific method". The influence of the physical sciences on neoclassical economics is so tangible that it was referred to as a form of "social physics".

Since neoclassical economics  is conceived as akin to physics, the mode of study and assessment would have largely resembled that of physics.

With this insight, I started to reflect upon my Secondary school Physics experience.

Sec 3 Physics & Microeconomics

My sec 3 story taught me certain key lessons that I applied in my study of UoL economics:

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Precision is key

I recall that time when my Physics teacher compelled us to memorize the definition of every keyword and phrase. He told us that by prelims, we should know the definitions at the back of our hand. Towards the prelims, lessons become pretty dynamic. We will jump across the syllabus, barking out esoteric definitions of Newton's 2nd Law to Specific Heat Capacity to  Fleming's Left Hand Rule, all within the span of 5 minutes.

I know many people take issues with it. Some criticize this as a negative demonstration of rote learning- the anathema of our education which suffocates creativity. Others trivialize definitions as if it is a minor distraction to the long exam questions which may offer more marks.

"Aiyah, never mind la. Sounds similar can already."

Not true. Sounding similar is not good enough- infact it is a half-assed excuse that gets in the way of comprehending the subject. For those who think I'm overreacting, here are some reasons why you should take definitions seriously:

(a) Definitions are prerequisites to linking concepts.

For example: Allocative efficiency is an outcome when both Productive and Consumption Efficiencies are attained. The relative Marginal Utilities of every good consumed are equal to their relative prices, and the relative ratio of the Marginal Productivity of all Factors are equal to the relative ratio of their respective payments. 

Confused at what I'm talking about? Of course you will be. That's because you don't know the definitions of Allocative Efficiency, Productive Efficiency, Consumption Efficiency, Marginal Utility, Optimal Consumption Ratio, Factor Price Ratio and the Marginal Productivity of Factor. If you understand the definitions, you can at least link across these concepts and decipher what I'm saying. 

(b) Definitions help us to construct models and diagrams accurately.

For example: The Budget Constraint depicts the bundles of goods available to a consumer, given a certain level of income. 

The definition sort out certain misconceptions:

- The Budget Constraint has nothing to do with Utility, which is expressed by the Indifference Curve.

- The Budget Constraint is dependent on a certain level of income. Therefore if the income level of the individual changes,the Budget Constraint should naturally reflect the change in income. 

The above example is a basic example. Time for some mental gymnastics.

"Each Indifference Curve depicts all the bundles of goods that provides the same specific level of utility to an individual. It adheres to the axioms of completeness, transitivity and non-satiation of rational individuals."   

With the above definition in mind and assuming a world of two goods X and Y, what will be the shape of the indifference curves of an individual who derives no utility from good Y and solely from good X?

Let the vertical axis represent Good Y and the horizontal axis represent Good X in a diagram.  

Here are a few ideas based on the definition and the question:

- If the individual only derives utility from good X, any amount of good Y is inconsequential.

- However each indifference curve only represents a specific level of utility.

- The indifference curves of an individual follows the axiom of transitivity (cannot intersect each other)

- and non-satiation (greater consumption increases the overall utility level, although it may provide diminishing marginal utility). 

His indifference curves will be perfectly vertical. Utility will increase rightwards, corresponding to the quantity of Good X consumed.

Numerical explaination: Imagine 10 X and 4 Y provides 10 utils. 

- 10 X and 10 Y will still provide 10 utils. Y is inconsequential. 10 utils as long as 10 X consumed. Any amount of Y will not affect his utility. Hence the indifference curve will be vertical.

- 11 X and 10 Y however will provide 11 utils since utility increased with quanity of X consumed. On horizontal axis, 11 X is at the right side of 10 X. Therefore the indifference curve representing a higher utility level  is also positioned to the right. 

I just crafted vertical indifference curves based on how an indifference curve is defined.

The question may change wildly to:

- X is a "bad good" which reduces utility while Y provides utility.   

- Consumer will only eat one box of  Y if it is accompanied by 2 cups of X (perfect complements).

If I meet an alien question like those two above, my mind does not panic and run wild. Instead I review my definitions and see how it applies to the question. This leads to the point below:

(c) Definitions keep your thought process focused and anchored.

This is crucial especially under exam conditions. If you did Intro to Econs, you would have realized that examiners like to play mind games by coming up with unfamiliar questions. Without clear definitions, you will drown in misconception and confusion.

Time is wasted on "Shit what is this question talking about? Why the diagram look so different from the lecture one?"

rather than

"Ok relax, Marginal Product is defined as the additional unit(s) of output produced from the marginal increase of a factor employed. This scenario considers  labor (L) and capital (K) as perfect complementary technologies. Since it wants me to find the Marginal Product of Capital when K increases from 3  to 4 units, I just need to observe that the mere increase in K does not lead to more output (to produce more output, L must also increase to complement the iincrease in K). The marginal increase of K does not lead to any additional output. Therefore the Marginal Product of Capital is zero."  

It is kind of obvious why those who merely memorize superficial stuff cannot match those who had clearly defined and internalized various concepts. The speed, fluidity and coherence of thought is way more efficient among those who know their definitions by heart.

However it is noteworthy that definitions can't be applied if you merely memorize the words.

How do I truly know I understood my definitions and by extension, what I learnt?

Albert Einstein once said "“If you can't explain it simply, you don't understand it well enough”

I will go one step further to suggest a few things to check your understanding:

1. Explain it in singlish or other languages.

2. Share with people who have no clue about economics. If you share such things, people are bound to either be totally confused or they will grasp a little but seek to clarify in depth with you. If you can't answer them definitively, you don't know your stuff well enough. 

3. Draw comics or sketches to illustrate your concepts. Create interesting scenarios to explain certain concepts like Adverse Selection and Moral Hazard. 

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Economics Models

Essentially, most of the things we study in UoL economics involve economic models. Only certain things (eg. Shut Down Rule) doesn't involve economic modelling. 

In this case, I'm not referring to econometric models. I'm referring to the various theoretical models created to illustrate economic principles. Here's an interesting idea:

 Theory, Concept, Models and Assumptions are not the same thing.

1. A concept is the basic building block of any model. It refers to an economic object.

Example: Profit Maximization, Barriers to Entry, Costs (Total, Marginal & Average) are all concepts.

2. A Theory gathers Concepts and establishes a relationship between them. The purpose of a theory is to explain causation (cause and effect).

Example: For a firm to maximize profit, it must produce up to a point where the Marginal Cost incurred matches its Marginal Revenue. 

Notice that the Theory of Profit Maximization is made up of three concepts: Profit Maximization, Marginal Cost (MC) and Marginal Revenue (MR).

Note: Profit maximization refers to the firm's chief economic motive to maximize its profits irregardless of the market structure it operates in

You may have initially understood the concept of Profit Maximization but only the Theory of Profit Maximization unites the concepts of MC, MR and Profit Maximization. It postulates the cause-and-effect: MC=MR leads to Profit Maximization.

3. A Model is a concrete expression of a theory (or multiple theories), usually in graphical or algebric terms. In most situations, a model can be applied many different scenarios.

Modelling is theory(s) operationalized.

Example: The Budget Constraint and Indifference Curves are models to express the Theory of the Rational Consumer. 

Imagine if I just tell you that a rational consumer's preferences are complete, transitive and non-satiable (Theory of Rational Consumer). They are helpful to know, but they won't help you to answer scenarios like "What if the consumer loses his income? How will his choice be affected?" 

To answer the above scenario, we need the Budget Constraint (to model the real income of the consumer) and Indifference Curve (to model the preferences of the consumer).  

However the Model doesn't just answer one scenario. A Model has the advantage of flexibility- preserving certain causal relationships while adapting to changing variables- it allows us to predict different outcomes as conditions and assumptions change.