Lecture 1

ECON 1116—Principles of Microeconomics Lecture 1 An Introduction to Microeconomics Economics Economics is the study of the choices people make to attain their goals, given their scarce resources. Scarcity—a situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economists study the choices people make using the scientific method. Economics Economics concerns agent behavior. Economic agents include consumers, firms, and government officials. As a social science, economics considers agent behavior in many different contexts, not just in the context of business. A popular misconception is that economics and business are the same thing. Economics is used to explain several different social phenomena, including legal rules, attending college, having children, and even marriage! Microeconomic Topics Microeconomics helps us to answer questions like: How are the prices of goods and services determined? How does pollution affect the economy, and how should government policy deal with these effects? Why do firms engage in international trade, and how do governmental policies affect international trade? Why does government control the prices of some goods and services, and what are the effects of these controls? Three Key Economic Ideas There are three key ideas governing human behavior: People are rational, People respond to incentives, and Optimal decisions are made at the margin. Rationality Economists generally assume that people are rational. Rationality—using all available information to achieve one’s goals. Rational consumers and firms weigh the benefits and costs of each action to make the best decision possible. e.g., firms in imperfectly competitive markets do not arbitrarily choose price; rather, they choose price to maximize profit. Incentives Individuals respond to incentives. e.g., changes in several factors have resulted in increased obesity in the U.S. over the last couple of decades, including: Decreases in the price of fast food relative to “healthy” food. Improved non-active entertainment options. Increased availability of health care and insurance, protecting people against the consequences of their actions. e.g., Estonia’s “mother’s salary.” Marginal Analysis Marginal analysis—involves comparing marginal benefits and marginal costs to dictate action. Marginal benefit—the additional benefit incurred by a one-unit increase in some action. Marginal cost—the additional cost incurred by a one-unit increase in some action. While some decisions are all-or-nothing, most decisions involve doing a little more or a little less of something. e.g., should you watch an extra hour of TV or study instead? The Economic Problem There are three components to the economic problem. What goods and services will be produced? How will these goods and services be produced? Who will receive the goods and services produced? What to Produce Individuals, firms, and governments decide on the goods and services that should be produced. An increase in the production of one good requires a reduction in the production of some other good. This is a trade-off resulting from the scarcity of resources. Trade-off—the idea that because of scarcity, producing more of one good or service means producing less of another good or service. Opportunity cost—the highest-valued alternative that must be given up in order to engage in an activity. What is the opportunity cost of receiving your degree? How to Produce A firm might have several different methods for producing its goods and services. e.g., a music producer can make a song sound pleasant by hiring a great singer and using standard production techniques, or by hiring a mediocre singer and using a computer program to correct the inaccuracies. e.g., as the cost of labor increases, a firm might respond by changing its production technique to one that employs more machines and fewer workers, or move its factory to a location with cheaper labor. Who Gets What Willingness and ability (a function of income) dictate who gets what in a market. Changes in tax and welfare policies change the distribution of income, which in turn, changes who gets what. There is disagreement about the extent to which income redistribution is desirable. Types of Economies Centrally planned economy—an economy in which the government decides what to produce, how to produce it, and who receives the goods and services. That is, the government decides how economic resources will be allocated. Market economy—an economy in which the decisions of households and firms jointly interacting in markets determine what is produced, how it is produced, and who receives the goods and services. Market—a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Mixed economy—a economy in which most economic decisions result from the interaction of buyers and sellers, but the government plays a significant role in the allocation of resources. The Efficiency of Markets Market economies tend to be more efficient than centrally planned economies. Market economies promote: Productive efficiency—goods and services are produced at the lowest possible per-unit cost. Allocative efficiency—production is consistent with consumer preferences, i.e., the marginal benefit of production is equal to its marginal cost These efficiencies arise because transactions result from voluntary exchange. Voluntary exchange—a situation that occurs in markets when both the buyer and seller of a product are made better off by the transaction. The Inefficiency of Markets Under certain circumstances, markets do not result in efficient outcomes. Market failure—the situation in which the allocation of resources is inefficient. There are a number of examples of market failures, including externalities and public goods. We will discuss these as the semester progresses. Additionally, markets tend to promote an unequal allocation of resources. Equity—the “fair” distribution of economic benefits. This is not about efficiency, but rather, about what is “fair” or “just.” Economic Models Economists develop economic models to analyze real-world issues, and they generally follow these steps: Decide on the assumptions to use in developing the model. Formulate a testable hypothesis. Use economic data to test the hypothesis. Revise the model if it fails to explain the economic data well. Retain the revised model to help answer similar economic questions in the future. Economic Models Every economic model relies on some set of assumptions. Economic models make behavioral assumptions about the motives of consumers and firms, e.g., consumers maximize utility or firms maximize profit. Good economic models generate testable predictions, which can be verified or disproven using data. Economic variable—something measurable that can have different values, such as the incomes of software programmers. Positive v. Normative Analysis There are two types of analyses: Positive analysis—concerned with what is. Describes and explains economic phenomena. Devoid of value judgments. e.g., the death penalty deters murder. Normative analysis—concerned with what ought to be. Advocates for a particular course of action. e.g., the death penalty ought to be prohibited because there is no room in a civilized society for it. Micro v. Macro Microeconomics—the study of how households and firms make choices, how they interact in markets, and how the government influences their choices. Macroeconomics—the study of the domestic economy as a whole, including topics such as inflation, unemployment, and economic growth.