this is 1401 i'm john gruber and uh this is uh microeconomics um today i want to i want to cover three things i want to talk about the course details uh i want about what is microeconomics and then i'll talk start our start uh the substance of the course by talking about supply and demand a couple of points about the course the course will have a distinct sort of policy angle to it i sort of do economic policy is government policy is my thing so i i think it's what makes economics exciting and it sort of offers i think an interesting angle to understand why we're learning what we're learning i think sometimes in an intro class it's sort of hard to understand why the heck you're doing things um however that's just sort of a slight flavor if you're really more interested in this i teach a whole course called 1441. i'm not teaching it this year but it'll be taught by a visitor in the spring uh kristen butcher from wellesley and i'll be teaching it next year that dies much more into these policy issues so i'm going to sort of use government policy sort of an organizing theme but it won't be sort of the dominant theme of the class finally three points about my teaching style um i don't write everything in the board we're not in high school anymore you're actually responsible for what i say not what i write uh partly that's because my handwriting is brutal um as you can tell already um uh so what that means is please please do not be afraid to ask me what the hell i just wrote on the board okay there's no shame in that don't just lean to your neighbor and say what the hell is writing the board like ask me because if you can't read it i'm sure someone else can't read it so feel free to ask and in general please feel free to engage with questions in this class the other point of my teaching style is i talk way too fast and the longer i go there's a mathematical function which is the longer i go without interruption the faster i speak until i just spin off okay so basically please ask questions if anything's not clear or you just want to ask questions about some related tangent or whatever please feel free to do so you might think how would that work in a class this big there's always way too few questions even a class is big so never be afraid that like it'll slow me down or whatever i ask a question we have plenty of time on the class and you'll be doing your classmates a favor because it'll slow me down um finally last point i have this terrible tendency to use the term guys in a gender-neutral way so this class i like to see looks like it's a fairly healthy representation both males and females when i say guys i don't mean men i mean people i mean people so don't take it women don't take it personally guys means economic agents it means people it doesn't mean men it's just the way just a bad tendency drives my life crazy but i've decided better to just apologize up front than try to try to fix it throughout which is impossible okay so let's talk about what is microeconomics okay so fundamentally microeconomics how people took ap high school econ okay um how many people for how many for how many was it taught really well okay that's about that right that's why i did my high school online class that's the answer i wanted to hear um uh okay so uh tell your friends still in high school we're taking its lecon if your high school econ teacher isn't great tell them to go on edx and take the class uh and and help out your friends still in high school okay so um what is microeconomics microeconomics is the study of how individuals and firms make decisions in a world of scarcity scarcity is what drives microeconomics okay basically what microeconomics is is a series of constrained optimization exercises where economic agents be they firms or individuals try to make themselves as well off as possible given their constraints yeah i will but not as much as i should uh essentially we have another course in the department called 1413 behavioral economics which gets in that much more i will sprinkle it throughout but uh but not as much as i actually believe in it uh in other words the way we think about economics is it's best to sort of get the basics down before you start worrying about the deviations find better to climb the tree before you start going out in the branches um okay so basically um what this course is then about is it's about trade-offs it's about how do you given that you're constrained how do you trade off things to make yourself as well off as possible and behind this notion of trade-offs is going to be i'll say about a hundred times this is the most important thing in the course so just ignore that but this is one of the most important things i'll say one of the most important things in the course is the notion of opportunity cost opportunity cost is a very important concept that uh we teach sort of the first concept we teach um which is that every action or every inaction has a cost and that you could have been doing something else instead okay so if you buy a shirt you could have bought pants if you sit at home and watch tv you could have been out working everything you do has the next best alternative you could have done instead and that is called the opportunity cost okay and that's a critical concept in economics and that is why in some sense we are called referred to casually as the dismal science economics referred to as the dismal science first of all i'm flattered we're considered a science uh or called the dismal science because our whole point is that nothing is free there's always a trade-off there's always an opportunity cost anything you do you could be doing something else instead okay and your constrained optimization means you're gonna have to pass up one thing uh to do another now some may call it dismal but as a former mit undergraduate i call it fun and this is why i think mit is the perfect place to be teaching economics because mit engineering is all about constrained optimization that's what engineering is and economics is just the engine it's just the principles you learn you learn engineering um uh applied in different contexts so there's if we think about the 2007 contest that still exists with the robots 2007. yeah okay the 2007 contest those you know is a contest where you're given a limited set of materials and you have to build a robot that does some tasks like pushing ping-pong balls off a table or something like that okay that's just constrained optimization it's got nothing to do with economics but it's constrained optimization so just think of um just think of uh microeconomics as like engineering but actually interesting okay so think of microeconomics as engineering but instead of building something to push a ping pong ball off tables you actually build people's lives and businesses and understand the decisions that drive our economy okay so the same principles that you could think of for engineering classes but applied to people's lives and that's why in fact modern economics was born in this room either this room or 26-100 okay by paul samuelson in the 1940s and 50s who wrote the fundamental textbook that gave birth to modern economics because he was here and applied the kind of engineering principles of mit to actually develop the field of modern economics what we learned today was developed at mit so it's a great place to be learning it now with that as background okay any questions about that about what is microeconomics okay with that as background let's turn to our for the first model we'll talk about this semester which is the supply and demand model supply and demand now the way we're going to proceed in this course is going to drive you crazy because we're going to proceed by teaching very s as the very first question pointed out by teaching very simplified models okay we're gonna essentially what is a model a model is technically a description between any two or more economic variables or any two or more variables okay but unlike the models used in all your other classes these aren't laws by and large they're models so we don't have a relationship between energy and mass which you can write down to law and we're done we have models which are never 100 true but always pretty true pretty being somewhere between 10 and 95 percent true okay so basically the idea is to make a trade-off we want to write down in our models a set of simplifying assumptions that allow us with a relatively small set of steps to capture relatively broad phenomena okay so there's essentially a trade-off on the one hand we'd like a model that captures as well as possible the phenomenon the real world like equals nc squared but we want to do so in the most tractable possible way so that we can teach it from first principles and not you know don't need don't need an hour to teach every single uh every single insight we have okay so basically in economics we tend to resolve that by erroring on the side of tractability that is why i can teach you the entire field of microeconomics which is really sort of macro is kind of a fun application micro's really economics okay i could teach you the fire field of microeconomics at a semester because we're going to make a whole huge set of simplifying assumptions to make things tractable but the key thing is that you will be amazed at what these models will be able to do with a fairly simple set of models we'll be able to offer insights and explain a whole huge variety of phenomena never perfectly but always pretty well generally pretty well okay and so that is essentially the trade-off we're going to try to do uh this semester so the line i like is this the statistician george box said that all models are wrong but some are useful now obviously it doesn't apply to models models in the hard sciences but in the social sciences that's true and basically i'm going to write down a set of models like that now with every model i write down i'm going to try i would my goal is to have you understand it at three levels the first and most important level is the intuitive level okay the level which you sort of understand i call it passing the mom test you can go home and explain it to your mom at thanksgiving or at the end of the semester okay no offense to dads just call it the mom test okay so basically that's the intuitive level you really understand it way that you could explain it the second is graphical we were going to do most of our models here will develop in a graphical framework okay using xy graphs that we're really weak in economics we think delivers a lot of shorthand power and the third is mathematical okay the mathematical is probably the least important but it's the easiest to test you on so we're gonna need to know things mathematically uh as well okay um so let's start um by considering the supply and demand model by using the famous example uh brought up by adam smith adam smith is sort of considered the father of economics and paul sam's the father of modern economics adam smith the father of all economics his 1776 book the wealth of nations did an incredible job of actually laying out the entire core of the economics field uh no math just words but kind of he just nailed it and um he started one of his most famous examples was the water diamond paradox okay he said think about water and diamonds so start with water nothing is more important for life than water it's the building block of all of life okay even when we look for life on other planets we start by looking for water now think of diamonds one of the more frivolous things you can buy certainly irrelevant to uh leading a successful or happy or productive life or any life okay yet for most of us water's free and diamonds are super expensive okay how can this be adam smith asked well the answer he posed is that what i first described was just demand that is we demand lots of water we demand fewer diamonds but we have to match that with the concept of supply okay and the supply of water is almost infinite while the supply of diamonds maybe not naturally maybe it's through uh decisions of various businesses but it's somewhat limited okay so basically um what what he developed is what we call the supply and demand scissors that you can't just think of supply or demand in isolation you have to put them together if you want to explain the real world phenomena we see like the fact that water's cheap and uh diamonds are expensive so let's just talk let's talk about an example so there's one graph that was handed out in the back okay um which is let's talk about the market for roses okay um so in the market for roses we have a demand curve and a supply curve so what we have here this is the kind of xy graph we're going to look at all throughout the semester okay on the x-axis is the quantity of roses on the y-axis is the price of roses the blue downward sloping line is the demand curve now what i'm going to do here i'm just giving you an overview we're going to we are going over the next six like five or six lectures dive into where this demand curve comes from okay we'll go to first principles and build it back up but for now we know about demand curve is it simply represents the relationship between the price of a good and how much people want it therefore we assume it is downward sloping at higher prices people want less of the good and we'll just we'll derive where that comes from shortly starting next lecture but for now i think it's pretty intuitive that if the price of roads is higher people want fewer of them and that's why it's downward sloping okay that basically as the price of roses goes up people want fewer roses the yellow curve is the supply curve now after we've derived the demand curve we'll then go and spend about 12 lectures to ride the supply curve that's a bit harder but once again we'll start from first principles and build it up for now you just need to know is that's how much firms are willing to supply given the price so basically as the price goes up firms want to produce more roses okay the higher price means you make more money so you want to produce more of them this is a slightly less intuitive than demand but we'll derive it and explain how it can be but for now just go with the basic intuition that if you're making something and you can sell in the market for a higher price you're going to want to make more of it okay and that leads the upward sloping supply curve where the points meet is the market equilibrium where supply and demand meets is the market equilibrium okay in the that is the point where both consumers and producers are happy to make a transaction consumers are happy because they are on their demand curve is the point 600 is the point three dollars and six hundred roses that is they are willing to buy six hundred rows at three dollars okay producers are happy because on their supply curve is the same point they are willing to supply 600 rows of three dollars that is the one point where consumers are happy and producers are happy therefore it's the equilibrium highly non-technical but that's the basic intuition okay the point at which they're both willing to make that transaction the point that they're both satisfied with that transaction is the equilibrium which in this case is three dollars per rose and 600 roses now this raises lots of questions where do the curves come from how does equilibrium get achieved um why the heck do we give roses these are a bunch of questions we will um we will all we will come to all these questions over the next set of lectures but the basic thing is to understand this intuition of adam smith's supply and demand model okay questions about that okay now um this model also raises another important distinction that will focus on the semester and it's easy to get mixed up so i want you to if you're ever unclear i want you to ask me about it and that's distinguishing between positive positive versus normative analyses positive versus normative positive analysis is the study of the way things are while normative analyses are this is the study of the way things should be okay positive analysis to study the way things are while normative analysis is to study the way things should be let me give you a great example which is uh ebay auctions okay auctions are a terrific example they're like the textbook example of the competitive market you can see it in your head demand comes a bunch of people going on and bidding people who want it more bid more so you actually get a demand curve the higher the price the fewer people are getting you're getting to bid supply is how much how many units of it are for sale on ebay you you bid until those two meet and then you have a market equilibrium at that bidded price okay now one um one example of an ebay auction that got a lot of attention a number of years ago early in the days of ebay was someone offered their kidney for auction they said look i got two kidneys you only need one to live there people out there need a kidney i'm putting my kidney on ebay for auction um and what happened bidding went nuts it started at 25 000 it climbed to 5 million before the auction was shut down and ebay decided they wouldn't allow you to sell your body on ebay bodily parts on ebay okay so this raises two questions the first is the positive question why did the price go so high so what's the answer to that what's the answer to the positive question okay let's look good but let's let's raise hands and give ants that's part of it yeah supply high demand demand is incredibly high because i die without it supply is low because like not a lot of us are willing to sell their kitties on ebay okay so low supply high demand led to a high price adam smith at work that's the positive analysis okay but this raises the north but then there's the normative question which is should you be allowed to sell your kidneys on ebay that's the normative question the positive question is what happens if you do the normative question is should you now the standard economics answer to start would be of course you should we're in a world where thousands of people die every year because there's a waiting list for a kidney transplant okay and these are people who would happily pay a lot of money to stay alive i presume okay meanwhile there's hundreds of millions of people walking around with two kidneys who only need one and many of these people are poor and lives could be changed by being paid a million dollars for their kidney and might be happy to take the risk that their other that one kidney will be fine as it is for most everyone for most of their life in return for having the life-changing payment from a stranger so economists say look here's a transaction to make both parties better off the person who gets the kidney gets to stay alive and they're what they are willing to pay a huge amount for that the person who sells the kidney in most probability is fine because almost all of us can make it through life fine with one kidney and get a life-changing amount of money that could allow them to pursue their dreams in various ways okay so that's the standard argument would be yeah you should be able to sell your kidneys on ebay okay so the question is why not why would we want to stop this transaction what are the counter arguments to that let's raise our rates yeah like i i think maybe the issue was like because it was ebay there's like no way to regulate it or like you don't like necessarily know like people could be like selling fake kidneys per se right so the first type of problem comes out of the category we call market failures market failures are reasons why the market doesn't work in the wonderful way economists like to think it should so for example this answer puts up that could be the problem of um fraud okay people might not be able to tell if they're getting a legit kidney or not okay there could be the example of imperfect information do you know what the odds are that you can spend the rest of your life with only one kidney i don't either okay we ought to know that before we start selling our kidneys okay there could be a perfect information okay these are the kinds of this is one type of problem which is the market maybe the market may fail like okay current system also helps people who are poor and have failed kidney um and which would be which are people to be completely screwed underwater the set a second problem is what we call equity or fairness equity or fairness which is we would end up with a world where only rich people would get kidneys okay currently there's a bunch of voluntary donors and people who are in accidents who have kidneys left over okay and those go to a people on the base of where they are in a waiting list actually a prioritized waiting list it's kind of a cool one of my colleagues nikhil agarwal if you think about i'll talk a lot this semester about the imperialistic view of economics all the cool things we can study so he actually uses economic models to study the optimal way to allocate organs to individuals right now it's just done based on a waiting list but but it may be that someone further down the waiting list needs it more than so and higher up the waiting list because they're more critical or whatever so there's various optimum ways to allocate but certainly although it allocate wouldn't be the rich guy gets it first that would be unlikely to be what society would necessarily want so there's an equity concern with that what else what other sorts yeah really since you know you can make money off of selling kidneys and you take advantage of people and it's very bad black market for kidneys right so there's sort of a third it's related to fraud but there's sort of a third class of failures that gets into the question about mis behavioral economics we talked that was raised earlier which we could just call so failing behavioral it's called behavioral economics for one of a better term which is essentially people don't always make decisions in the perfectly rational logical way we will model them as doing so this semester people make mistakes that's a word we hate using economics we hate saying mistakes ooh boo mistakes nobody makes mistakes we're all perfect little economic beings but we know that's not true increasingly over the past several decades economists have started incorporating insights from psychology into our models to not just say people make mistakes that's a lackadaisical but to rigorously model the nature of those mistakes and understand how mistakes can actually happen due to virus cognitive biases and other things in this world you can imagine people could make mistakes they could be they could not really sit down and quite understand what they're doing and they could have selling their kidney when it's really not in their own long-term interest yeah example be like if there's like a family that's like an extreme poverty like even though they only have one kidney they might sell the other one just to give them money for the family per se well i mean in subsets that would be once again in a if we took this factor out we took if we took if we took if the market worked well there's no behavioral effects we'd say well you know what that's their decision you know if they otherwise they starve who are you to say okay but once you choose this say well wait a second maybe they're not evaluating the trade-offs correctly even if there's no fraud even if there's perfect information they may not know how to process that information correctly okay but that is not standard economics that's not what we'll spend a lot of time in the semester but it's obviously realistic okay so those are a bunch of good comments great comments and that yeah they're also an inelastic demand such that people will always need kidneys that won't turn out to be a pro that doesn't turn out to be a problem okay we'll come back that's a great comeback though we talk about the shape and demand curves if you want to return to that question a few lectures but that doesn't actually cause a problem it's just that's more of a positive thing about why the price is so high but it's not a normative issue about whether you should allow it or not okay so basically these are exactly this isn't to me honestly i spend my life thinking a lot about these things i think these are really interesting issues but you can't get to the nordic issues without the positive analysis usually the positive analysis to understand the economic framework before you start jumping you're drawing conclusions that's no fun we all want to jump to draw conclusions saying this should happen it shouldn't happen you can't do that we have to be disciplined we have to start with the fundamental economic framework okay and basically the bottom line you know i said i'll teach this course with a policy bent but you have to recognize that economics at its core is a right-wing science economics at its core is all about how the market knows best okay and that basically governments only mess things up that's sort of the basic a lot of what we'll learn this semester as semester goes on and we'll talk about what's wrong with that view and how governments can improve things indeed i teach a whole course about the proper role of government economy but the standard of economics is the market knows best okay and that leads us to the last thing i want to talk about which is basically how freely should an economy function let's step back to the giant picture let's step back from a market for roses to the entire economy how freely should a market should an economy function we have what's known as a capitalistic economy in a capitalistic economy firms that individuals decide what to produce and consume may be subject to some rules of the road set by the government there's some minimal rules of the road to try to avoid fraud or misinformation but otherwise we let the dice roll firms and consumers decide sort of what to uh what to do now this has led to tremendous growth okay america was not a wealthy nation it was not very wealthy nation a hundred years ago 150 years ago it's led to tremendous growth where we are now the most powerful still the most powerful and wealthiest nation in the world okay largely driven by the capitalist nation capitalistic nature of our economy on the other hand we are a nation with tremendous inequality we are by far the most unequal major nation in the world okay the top one percent of americans has a much higher share of our income than in any other large country in the world any other large developed country in the world the bottom 99 has less of our income corresponding than anywhere else so it's led to major inequality and it's led to other problems it turns out that the government can appropriately set the rules the road to avoid things like fraud as we saw with enron if you remember back to that or a lot of what happened during the financial meltdown it turns out it's hard to get people perfect information etc so we've seen the problems we've grown very wealthy as a nation but we've introduced a whole set of problems through the system now the other extreme is what's called the command economy rather than a capitalist economy is what's called a command economy okay in this case the government makes all the production and consumption decisions the government needs to set the rules the road the government owns the road the government says we're going to produce this many cars this year okay and people can get them in some way it could be a lottery could be waiting in line however we decide to allocate them we're not going to let the market allocate them we the government will allocate them well okay how many get produced and who gets them okay and this was the model the soviet union that i grew up with okay this was the pre-1989 soviet union okay the government decided how many shirts cars cds every i mean it's sort of bizarre to think about literally everything the government decided how much to produce and by and large the government decided who got it partly through corruption that is the party p the party members party leaders got it first and often just through waiting in line for the remaining application now in theory this ensured equity by making sure that everybody is shot at things in practice it didn't work well at all and actually was what dragged down the collapse of the old soviet economy was that the command model simply doesn't work partly there's just too many opportunities for corruption when the government controls everything that means there's no checks and balances on the the the the opportunity for enormous corruption the capitalist economy puts some natural checks and balances on that and partly because it turns out that it's hard to control human nature and adam smith had it right adam smith talks about the invisible hand of the capitalist economy the invisible hand is basically the notion that the capitalist economy will manage distribute things roughly in proportion what people want okay and that's where peak folks want to be they folks who want a certain kind of car are going to want to get to that kind of car and the government has it wrong they're going to get upset and it's going to lead to a less functional economy okay so basically um adam smith's view is that the invisible hand view is that consumers and firms serving their own best interest will do what is best for society okay so the fundamental core of the capitalistic view is the consumers and firms serving their own best interests will do what ends up being best for society and that's essentially the model we'll learn to start in this course yeah um in that definition are we defining the best for society as you're like like everybody has the most money or like everyone has the best health or the best and from living like what is the best great great question we're going to spend a lot of the semester talking about that for now we're going to find best for society as the most stuff gets produced and consumed okay that's how we're going to find it obviously you've raised a set of issues about what about pollution what about health etc we're going to come to those but for the first two thirds of the course best for society means what we're going to call maximum surplus which is the most stuff gets produced that people value okay so that's that's how we're going to do it and in his view the visual hand does that and by and large by and large it's a very helpful framework to turn to okay however at least the outcomes that can lead to outcomes that are not very fair so the way we're going to proceed in this course is we're going to start by talking about how adam smith's magic works how does the magic happen how does individuals and firms act in their own self-interest without caring about anybody else end up yielding the largest si possible the the largest possible productive economy okay how does that happen okay and we're going to talk about that we'll start with demand which is how do consumers decide what they want given their resources we'll talk about the principle of utility maximization the idea that i have utility function that i can math mathematically write down what i want i'll have a budget constraint which is the resource i have and the ones do constrained optimization we'll say give them what i want and the resource i have what decisions do i make boom we get the demand curve then we'll turn to supply and we'll talk about how do firms decide what to produce that's much more complicated because firms have to decide what inputs to use and what outputs to produce and we'll talk about how firms operate can operate in very different markets there's a competitive market that smith envisioned but that doesn't always work sometimes we get monopoly markets okay where one firm dominates and you can actually end up outcomes which aren't the best possible outcome even with the invisible hand okay so we'll talk about different kinds of markets then we'll put it together to get market equilibrium and talk about sort of smith's principles and then from there we'll talk about how it breaks down in reality different change in reality how there are various market failures that can get in the way why we have to care about equity and what implications that has about behavioral economics about a set of other factors okay so that's basically how we're going to proceed uh this semester as i said the lectures are important but the rest stations are as well once we're sort of in steady state the rest station is about half uh working half new material and half working through problems to help you prepare for the next problem set so the problem sets are going to work is the problem set that's assigned will cover material that's taught up to that date so for example problem set one is to be assigned next friday that will cover everything you've learned up through next wednesday okay therefore in section on next friday we'll do a practice problem which will help which you should understand because we'll cover things we've taught in class and he'll prepare you for the problem set and we'll do that every week that about half the sections the other half the section will be new material okay this friday the section friday is all new material we're doing fridays cover the mathematics i don't like doing math i always get it wrong okay so i leave math for the tas who are smarter than i am okay so this friday we're doing the mathematics of supply and demand and how you take the intuition here and the simple graphics and actually turn it into mathematical representations which is what you need for the problem sets that this friday then we'll come back on monday and start talking about uh what's underneath the demand curve all right any other questions okay i'll see you on monday