Modern Economic Issues in Industry

Lecture 1: Introduction
Harry van der Weijde
h.vanderweijde@ed.ac.uk
 This lecture
1. Course overview & housekeeping
2. What is economics about?
3. A quick history of economics
4. Mathematics refresher
COURSE OVERVIEW &
HOUSEKEEPING
 Outcomes
From DRPS:
“On completion of the module, students should be
able to:
• Apply economic principles to market situations
(e.g. pricing and investment).
• Appraise different methods of dealing with
environmental issues in manufacturing.
• Assess the importance of the EU in trade”
But we will do much more!
 Course overview: Material
Three blocks
1. Introductory microeconomics (weeks 1-3)
Aim: Understand and be able to apply various tools
to analyse different types of economic problems,
including product pricing and manufacturing
decisions, regulation, policy making, etc.
 Course overview: Material
2. Environmental economics
Aim: Be able to use the tools above to understand
environmental problems, value environmental
goods, do environmental cost-benefit analysis and
critically discuss environmental policies.
 Course overview: Material
3. Basic macroeconomics (weeks 8-10)
Aim: understand and apply various tools to analyse
macroeconomic problems, including in international
trading and labour markets.
 Course overview: Delivery
• 2hr Lectures (weekly)
• Tutorial questions + videos: regularly
• Reading + other material on Learn
– Contact me for more material/questions/etc.: I
can adapt the course to your interests!
• I will assume no previous knowledge. Don’t
be afraid of economics –– but ask for help if
needed, don’t suffer in silence!
 Course overview: Assessment
• One coursework assignments (instructions on
Learn soon)
Environmental economics: analyse environmental
problem in a country of your choice, due week 7
• One exam with three questions
 Housekeeping
• I will sometimes use TopHat for tutorials, perhaps
lectures
– Bring a phone/tablet/laptop with internet access if
you have one
– Go to app.tophat.com, log in, add yourself to the
course with join code 814502
– I also extensively use Learn. Check it regularly.
• Post questions in Learn discussion board or e-
mail them
• Lectures will be captured and will be available to
watch via Learn
 Housekeeping
• Office hours: by appointment, but I’d rather
you email me your question or ask it on Learn
so I can answer it in a Learn post or video so
everybody can see it.
• Research, jobs etc.: Twitter @hvanderweijde
WHAT IS ECONOMICS?
 What is economics?
• Question: fundamentally, economics is
– Boring
– About money
– About business
– About people
– About choice
– Difficult
 Definitions
• “Economics is a science which studies human
behaviour as a relationship between ends and
scarce means which have alternative uses”
– Robbins, Lionel (1932). An Essay on the Nature and
Significance of Economic Science.
• In other words, economics studies how people
(/organisations/societies) make choices about
ways to use scarce resources to fulfil wants and
needs
• Let’s take that step by step…
 Resources
• Things which we need to produce other goods
or services
– Natural, e.g., land, water, sunlight, fossil fuels, fish
– Human, e.g., time
– Other produced goods, e.g., petrol, parts
– Capital (money)
– Etc.
 Scarcity
• Almost everything is scarce: there are limited
amounts of them. We may have unlimited
wants but these cannot all be satisfied
 Choice
• Because resources are limited, choices must
be made
– There are trade-offs: picking one thing over
another
– E.g., what could you have done instead of coming
to this lecture?
• Economists often use the term “opportunity
cost” to define trade-offs
 Opportunity cost
• Value of the next best thing
• If you didn’t do x, you would have done y
– Value of y to you = opportunity cost of doing x
• E.g.,
– if you don’t show up for work, opportunity cost is
lost wage
– If you don’t come to the tutorial, opportunity cost
may be the value (to you) of sleeping for another
hour
 Economic questions
Examples:
• Individual: Which job offer should I accept?
How should I travel to the gym? Where
should I go on holiday? Should I get energy-
saving lightbulbs?
• Company: How much should I produce? How
many people should I employ? Should I limit
my carbon emissions?
• Society: How should we distribute wealth?
 Branches of economics
• Two major branches
1. Microeconomics: decisions of individuals and firms
– Sub-fields: Financial economics, Industrial
economics/industrial organisation, Applied economics:
energy economics, environmental economics (mostly), etc.
2. Macroeconomics: performance of an economy as a
whole
– Sub-fields: International economics, development
economics, etc.
• This course is mostly micro (theory + application)
 Related disciplines
• Mathematics
– We often use mathematical models to determine
which choices individuals/firms/societies will or
should make
– This may be as simple as formulating the profit of
a firm as function of its production, e.g.
• Profit = 100 q – 2 q2
• We can then maximise that to find the optimal q=25
– Operations research/management science
particularly relevant
 Related disciplines
• Engineering
– Scarcity of goods often related to engineering
challenges (e.g., amount of oil, electricity, etc.)
– Conversely, many engineering applications need
economic decisions (how to use resources, etc.)
• Sociology, human geography, etc.
– Can help give us information of how people make
decisions / what they care about
A VERY BRIEF HISTORY OF
ECONOMIC THOUGHT
 Early economic thought – some
highlights
• Fan Li (517BC-?): “golden rules and
safeguards” (e.g., don’t start price wars)
• Aristotle (property should be private)
• Thomas Aquinas (1225-1274): ‘just price’ =
cost of production.
• Duns Scotus (1265-1308): ‘just price’ is
difficult to agree on  if people agree on a
deal, it must be beneficial by definition.
Classical political economy (18th-19th c)
• Adam Smith (1723-1790): invisible hand
– People acting selfishly in a competitive market will
work for the good of all.
– Prices are not always equal to costs
– Government should keep markets in check (no
monopolies, cartels, etc.)
• Malthus, Ricardo, Mill: economic growth is
limited by land/natural resources
 Marxian economics
• Karl Marx (1810-1883): focus on labour as
input for production (not land) and
determinant of value
 Neoclassical economics (19th c)
• Jevons, Marshall, Pigou, Austrian School
• Economy works best without state
intervention : rational people maximize
utility/profits
• Value of products come from utility to
consumers
 Keynesian economics (20th c)
• John Maynard Keynes (1883-1946)
• Bigger role for government because demand is
important: spending in recessions
• Has been reconciled with neoclassical
economics in neoclassical synthesis.
 Energy and environmental economics
• Classical economists foresaw issues, since economic
growth was limited by land, etc.
• Energy/environmental economics: proper start in the
20th century
– 1930s: non-renewable resource management (Harold
Hotelling)
– 1960s: pollution, etc.: environment included in neoclassical
economic models
– 1970s oil crisis: explosion of literature
• Environmental economics:
– Ecological economics: economy is part of ecosystem
• Kenneth Boulding : spaceship earth
MATHEMATICS REFRESHER
 Mathematics refresher
• For this course, you will need to know about
– Basic calculus: derivatives, integrals
– Optimisation
• Unconstrained
• Equality-constrained
• Inequality-constrained
Derivatives: theory
Derivatives: theory
 Derivatives: theory
• Interpretation: derivative = slope = marginal
change = how much does your variable if
interest change as a result of a small increase
in an input variable.
• Marginal = important concept in economics
Derivatives/integrals: examples
𝑓𝑓 𝑥𝑥, 𝑡𝑡 = 𝑎𝑎𝑎𝑎 + 𝑏𝑏𝑏𝑏𝑏𝑏 + 𝑐𝑐𝑥𝑥 2

𝜕𝜕𝑓𝑓 𝜕𝜕𝑓𝑓
=? =?
𝜕𝜕𝜕𝜕 𝜕𝜕𝑡𝑡

𝑒𝑒
� 𝑓𝑓 𝑥𝑥, 𝑡𝑡 𝑑𝑑𝑑𝑑 = ?
𝑑𝑑
Derivatives cont’d: the chain rule
𝜕𝜕𝜕𝜕 𝑓𝑓 𝑥𝑥 𝜕𝜕𝜕𝜕 𝜕𝜕𝑓𝑓
=
𝜕𝜕𝑥𝑥 𝜕𝜕𝑓𝑓 𝜕𝜕𝑥𝑥

𝑓𝑓 𝑥𝑥 = 𝑎𝑎 + 𝑏𝑏𝑥𝑥 2
𝜕𝜕𝜕𝜕
=?
𝜕𝜕𝜕𝜕
Derivatives cont’d: the product rule
𝜕𝜕 𝑔𝑔 𝑥𝑥 𝑓𝑓 𝑥𝑥 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
= 𝑓𝑓 + 𝑔𝑔
𝜕𝜕𝜕𝜕 𝜕𝜕𝑥𝑥 𝜕𝜕𝜕𝜕

𝑓𝑓 𝑥𝑥 = 𝑥𝑥 + 𝑥𝑥 4 𝑥𝑥 + 𝑏𝑏𝑒𝑒 𝑥𝑥
𝜕𝜕𝜕𝜕
=?
𝜕𝜕𝜕𝜕
 Optimisation: theory
• How to find the maximum or minimum of a
function?
= constrained optimisation: theory
Max 𝑓𝑓 𝑥𝑥, 𝑦𝑦 s.t. 𝑔𝑔 𝑥𝑥, 𝑦𝑦 = 0
• Set up Lagrangian function:
𝐿𝐿 = 𝑓𝑓 𝑥𝑥, 𝑦𝑦 − 𝜆𝜆𝑔𝑔 𝑥𝑥, 𝑦𝑦
• Find optimum of L as usual:
𝜕𝜕𝐿𝐿 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
= = =0
𝜕𝜕𝑥𝑥 𝜕𝜕𝑦𝑦 𝜕𝜕𝜕𝜕
 = constrained optimisation: example
• You can produce gas from two wells
– Cost at well 1: 2𝑥𝑥1 − 0.1𝑥𝑥1 2
– Cost at well 2: 𝑥𝑥2
– You need to produce 100 units
= constrained optimisation: example
2
Max −2𝑥𝑥1 + 0.1𝑥𝑥1 +𝑥𝑥2
s.t. 𝑥𝑥1 + 𝑥𝑥2 = 100
2
𝐿𝐿 = −2𝑥𝑥1 + 0.1𝑥𝑥1 − 𝑥𝑥2 − 𝜆𝜆 100 − 𝑥𝑥1 − 𝑥𝑥2
𝜕𝜕𝜕𝜕
= −1 + 𝜆𝜆 = 0 → 𝜆𝜆 = 1𝐿𝐿
𝜕𝜕𝑥𝑥2
𝜕𝜕𝜕𝜕
= −2 + 0.2𝑥𝑥1 +𝜆𝜆 = 0 → 𝑥𝑥1 = 5
𝜕𝜕𝑥𝑥1
𝑥𝑥2 = 95
 = constrained optimisation: example
• Interpretation of Lagrange multiplier 𝜆𝜆: cost of
breaking constraint
• In this example: increase in cost if you
produce one more unit
• In economics, 𝜆𝜆 if often called shadow price
• Cost of constraint, even if nobody pays for it
 >= constrained optimisation: theory
• Set up Lagrangian as before
• (for well-behaved problems, incl. linear and most
others we will see): formulate KKT conditions
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
– As before = 0 for each variable, = 0 and
𝑥𝑥 𝜆𝜆𝑠𝑠
𝜆𝜆𝑠𝑠 ≥ 0 for all multipliers
𝜕𝜕𝜕𝜕
– New: 𝜆𝜆𝑠𝑠 = 0
𝜆𝜆𝑠𝑠
– If constraint is binding, 𝜆𝜆𝑠𝑠 > 0, otherwise 𝜆𝜆𝑠𝑠 = 0
– Economic interpretation: scarcity means positive price
>= constrained optimisation: example
• You own two power plants:
– Nuclear: variable costs £1/unit, capacity 50 units
– Gas: variable costs £2, capacity 100 units
• Energy demand is 100 units, consumers pay
£3 per unit
• How do you maximise your profits?
>= constrained optimisation: example
𝜋𝜋 = 300 − 𝑥𝑥1 − 2𝑥𝑥2
s.t.
𝑥𝑥1 ≤ 50, 𝑥𝑥2 ≤ 100, 𝑥𝑥1 +𝑥𝑥2 = 100

Lagrangian:
L = 300 − 𝑥𝑥1 − 2𝑥𝑥2 − 𝜆𝜆1 𝑥𝑥1 −50
− 𝜆𝜆2 𝑥𝑥2 −100 − 𝜆𝜆3 (100 − 𝑥𝑥1 − 𝑥𝑥2 )
>= constrained optimisation: example
Stationarity:
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
= =0
𝑥𝑥1 𝑥𝑥2
Primal feasibility: 𝑥𝑥1 ≤ 50, 𝑥𝑥2 ≤ 100, 𝑥𝑥1 + 𝑥𝑥2 =
100,
Dual feasibility: 𝜆𝜆1 , 𝜆𝜆2 , 𝜆𝜆3 ≥ 0
Complementary slackness:
𝜆𝜆1 𝑥𝑥1 −50 = 0
𝜆𝜆2 𝑥𝑥2 −100 = 0
EXERCISES
 Exercises
1. Which economic problems had you had to
solve today before arriving in the lecture
theatre?
 Exercises
2. Consider an electricity network with two generators, which generate 𝑃𝑃𝐺𝐺𝐺
and 𝑃𝑃𝐺𝐺2 , respectively. In a given hour, demand is 500MW, which has to be
met, so 𝑃𝑃𝐺𝐺𝐺 + 𝑃𝑃𝐺𝐺2 = 500.
Generating costs for each generator are given by:
𝐶𝐶𝐺𝐺𝐺 𝑃𝑃𝐺𝐺𝐺 = 20𝑃𝑃𝐺𝐺𝐺 + 0.01𝑃𝑃𝐺𝐺𝐺 2 $/ℎ𝑟𝑟
𝐶𝐶𝐺𝐺2 𝑃𝑃𝐺𝐺2 = 15𝑃𝑃𝐺𝐺2 + 0.03𝑃𝑃𝐺𝐺2 2 $/ℎ𝑟𝑟
Generator 1 cannot produce more than 200MW
Generator 2 cannot produce more than 400MW and not less than 200MW

Which generation levels 𝑃𝑃𝐺𝐺𝐺 and 𝑃𝑃𝐺𝐺𝐺 meet demand at the lowest cost?
How much would the costs of generating electricity go up if demand was
501MW instead of 500MW?
 Next lectures
• Basic microeconomics
– Consumer theory: how can we describe/analyse
how consumers make decisions
– Theory of the firm: same for firms
– Equilibrium: how does it all come together?