Chapter 1 Introduction McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics What is microeconomics? Tools of microeconomics Themes of microeconomics Uses of microeconomics 1-2

The Focus of Economics Scarcity forces societies to confront three critical issues: What to produce How to produce goods Who gets what Economics examines how societies address these three issues: allocation of scarce resources 1-3

What is Microeconomics? Microeconomics: concerns individual decision making and its collective effect on allocation of a society’s resources Macroeconomics: concerns aggregate phenomena Much of modern macroeconomics involves applications of microeconomics 1-4

Institutions for Allocation Resources Institutions, including laws and customs, define a society’s procedures for allocating resources In a capitalist economy: Means of production are owned and controlled by and for the benefit of private individuals Resources are allocated by voluntary trading among businesses and consumers 1-5

Institutions for Allocation of Resources In a communist economy: Economic decisions are highly centralized The state owns and controls the means of production and distribution No economy is completely centralized or decentralized; all economies are a combination of both. Examine statistics on the size of government for a rough measure of centralization 1-6

Markets Markets are the most common form of economic decentralization Markets are economic institutions that provide people with opportunities and procedures for buying and selling goods and services May be governed by explicit rules (e.g., NYSE) or by custom (e.g., open bazaar) 1-7

What is a Market? In microeconomics, a market is: Associated with a single group of closely related products Offered for sale within particular geographic boundaries Products belong to the same market when they are highly interchangeable Some markets may be worldwide 1-8

Characteristics of Markets Markets include buyers and sellers Often, but not always, sellers are companies and buyers are individuals Trade in modern markets is usually governed by price, the rate at which someone can swap money for a good Markets can function only if a system of transferable property rights is established and enforced 1-9

Economic Motives Need to understand individual motives to determine what choices they will make Assume people are motivated by self-interest: Desire for goods and services Can include possibility that someone might care about someone else’s well-being Same motivation even if acting as consumer, firm, or employee 1-10

Positive Economic Analysis Positive economic analysis: addresses factual questions, typically about economic choices or market outcomes What did happen? What will happen? What would happen? Historical fact-finding Forecasting Cause-and-effect analysis of actions and their consequences Stick to objective facts and avoid value judgments 1-11

Normative Economic Analysis Normative economic analysis: addresses questions that involve value judgments concerning the allocation of resources What ought to happen? Turn normative questions into positive questions using the principle of individual sovereignty 1-12

Scope of Microeconomics Broad definition of “resources”, not just about money (time, for example) Range of topics is extremely wide: Marriage Crime Addiction Environment Many ways decisions by many individuals combine to produce social outcomes 1-13

Tools of Microeconomics Economists use the scientific method: Initial observation Theorizing Identification of additional implications Further observation and testing Refinement of the theory A useful theory must have broad application but also specific implications 1-14

Models and Mathematics Model: a simplified representation of a complex phenomenon Economists use models to provide an account of cause and effect, to help us understand how the world works Some economic models are quantitative (mathematical) so that they are more precise 1-15

Simplifying Assumptions All scientists build models based on assumptions, so do economists This allows the model to focus on the most important explanations for a particular phenomenon No economic model is literally true Some assumptions are easy to criticize The test of a model is its usefulness 1-16

Data Analysis Scientific method requires models to be tested with data, e.g., from: Records (financial accounts, customer databases) Surveys (Consumer Expenditure Survey, other government or private sources) Experiments Econometrics: application of statistical methods to empirical questions in economics 1-17

Why Economists Disagree Even with scientific method, still room to disagree Differences in scientific judgment lead to disagreements on positive questions e.g. Look at the same data but come to a different conclusion Likely began from different assumptions; may be able to resolve by empirically testing assumptions Can’t resolve normative disputes that arise from differences in values 1-18

Themes of Microeconomics: Decisions Theme 1: Trade-offs are unavoidable There’s no such thing as a free lunch Theme 2: Good choices are made at the margin Most decisions are a matter of degree Theme 3: People respond to incentives Theme 4: Prices provide incentives 1-19

Themes of Microeconomics: Markets Theme 5: Trade can benefit everyone Theme 6: The competitive market price reflects both value to consumers and cost to producers Theme 7: Markets have advantages Theme 8: Sometimes governments can improve on free-market resource allocations 1-20

Uses of Microeconomics Why study microeconomics? It’s useful! Tools for understanding and evaluating the effect of public policies Help make important personal and business decisions Stresses thinking at the margin, importance of trade-offs 1-21

Uses of Microeconomics Applications of microeconomics: Business investments Portfolio management Replacing an old car Environmental policy ….and many others 1-22