Analyzing Economic Problems Chapter One

Chapter One Overview 1.Defining Microeconomics 2.Who Should Study Microeconomics? 3.Microeconomic Modeling Elements of Models Solving the Models 4.The Types of Microeconomic Analysis 1.Defining Microeconomics 2.Who Should Study Microeconomics? 3.Microeconomic Modeling Elements of Models Solving the Models 4.The Types of Microeconomic Analysis

Microeconomics Defined Microeconomics is the study of the economic behavior of individual economic decision- makers such as consumers, workers, firms or managers. This study involves both the behavior of these economic agents on their own and the way their behavior interacts to form larger units, such as markets. Chapter One

Who Should Study Microeconomics? Example: The Railroad Industry in the US  74.9% of all freight, 1929  39.8% of all freight, ’s: Poor profits, bankruptcies, and an inability to invest 1980’s: Loosened regulation and union rules improved profitability Chapter One

Analysis of these issues requires Microeconomic tools and the key players below need to know something about Microeconomics.  Policy Makers  Managers  Union Leaders  Lenders  Business Owners Who Should Study Microeconomics? Chapter One

Analysis of the impact of Global Warming on:  World Economic Stability  National Economic Policies  Consumer Spending  Economic Partnerships  Trade Agreements Microeconomics and Global Warming Chapter One

Key Societal Questions Societies must answer these questions that relate to microeconomics: 1.What goods and services will be produced and in what quantities 2.Who will produces these services and how will they produce them 3.Who will receive these goods and services and how will they get them Chapter One

Microeconomic Modeling Choice vs. Alternatives Resemble Reality Be Understandable Be an Appropriate Scale Models are like maps – using visual methods, they simply the process and facilitate understanding of complex concepts. Microeconomic models need to: Chapter One

Example: World-wide market for unprocessed coffee beans, December, 1997 Price Per Pound Quantity in Pounds Supply (P,W) Microeconomic Modeling Choice vs. Alternatives Chapter One

Demand (P,I) Price Per Pound Quantity in Pounds Supply (P,W) Example: World-wide market for unprocessed coffee beans, December, 1997 Microeconomic Modeling Choice vs. Alternatives Chapter One

Opportunity Cost Dependent on How One Specifies Alternatives The Opportunity Cost of a resource is the value of that resource in its best alternative use. Defined: $100 in facilities yields $800 Revenue $100 in R&D yields $1000 revenue Opportunity cost of investing in facilities = $1000 Opportunity cost if investing in R&D = $800 $100 in facilities yields $800 Revenue $100 in R&D yields $1000 revenue Opportunity cost of investing in facilities = $1000 Opportunity cost if investing in R&D = $800 Chapter One

The Objective Function Dependent on How the Objective Function is Specified The Objective Function specifies what the agent cares about. Defined: Does manager care more about raising profits or increasing “power”? Chapter One

The Constraints Constrains are whatever limits is placed on the resources available to the agent. Defined:  Time  Budget  Other Resources  Technical Capabilities  The Marketplace  Rules, Regulations, and Laws Chapter One

The Constraint Optimization Behavior can be modeled as optimizing the objective function, subject to various constraints. Facilities ( F ):N = budget / $30 R&D ( R ):N = budget / $100 Max N (F,R) Subject to: expenditure < $100 Where: N is the number of workers Facilities ( F ):N = budget / $30 R&D ( R ):N = budget / $100 Max N (F,R) Subject to: expenditure < $100 Where: N is the number of workers Manager’s Investment Choice Cost Per Unit of Time Facilities workers cost $30 R&D workers cost $100 Cost Per Unit of Time Facilities workers cost $30 R&D workers cost $100 Chapter One

The Constraint Optimization Consumer purchases Food (F), Clothing ( C ), Income (I) Price of food (pf), price of clothing (pc) Satisfaction from purchases: S = (FC)1/2 Max S(F,C) - subject to: pfF + pcC < I Note: "as if modeling" Consumer purchases Food (F), Clothing ( C ), Income (I) Price of food (pf), price of clothing (pc) Satisfaction from purchases: S = (FC)1/2 Max S(F,C) - subject to: pfF + pcC < I Note: "as if modeling" Chapter One

P F F + P C C = I F C 0 The Constraint Optimization Example – Consumer Purchases Chapter One

P F F + P C C = I F C 0 The Constraint Optimization Example – Consumer Purchases (FC) 1/2 = S 0 Chapter One

P F F + P C C = I F C 0 The Constraint Optimization Example – Consumer Purchases (FC) 1/2 = S 0 (FC) 1/2 = S 1 Chapter One

P F F + P C C = I F C 0 The Constraint Optimization Example – Consumer Purchases (FC) 1/2 = S 0 (FC) 1/2 = S 1 (FC) 1/2 = S 2 S 2 > S 1 > S 0 Chapter One

Exogenous & Endogenous Variables Variables that have values taken as given in the analysis are exogenous variables. Variables that have values determined as a result of the model’s workings are endogenous variables. Defined: “How would a manager hire the most possible workers on a budget of $100?” vs. “How would a manager minimize the cost of hiring three workers?” OR “How much food and clothing should the consumer purchase in order to maximize satisfaction on a budget of I?” vs. “What is the minimum level of expenditure that the consumer must receive in order to reach a subsistence level of satisfaction?” “How would a manager hire the most possible workers on a budget of $100?” vs. “How would a manager minimize the cost of hiring three workers?” OR “How much food and clothing should the consumer purchase in order to maximize satisfaction on a budget of I?” vs. “What is the minimum level of expenditure that the consumer must receive in order to reach a subsistence level of satisfaction?” Chapter One

Equilibrium Defined: Equilibrium is defined as the point where demand just equals supply in this market (i.e., the point where the demand and supply curves cross). Equilibrium analysis is an analysis of a system in a state that will continue indefinitely as long as the exogenous factors remain unchanged. Chapter One

Equilibrium Example – Sale of Coffee Beans Chapter One

Demand (P,I) Equilibrium Example – Sale of Coffee Beans Chapter One

Q* P* Demand (P,I) Equilibrium Example – Sale of Coffee Beans Chapter One

Comparative Statics Analysis A Comparative Statics Analysis compares the equilibrium state of a system before a change in the exogenous variables to the equilibrium state after the change. Defined: Chapter One

Equilibrium Chapter One

Demand (P,I) Equilibrium Chapter One

New Supply (P,W) Demand (P,I) Equilibrium Chapter One

New Supply (P,W) Demand (P,I) Equilibrium Q* P*P* Q** P** Chapter One

Consumer Choice Revisited Chapter One

Consumer Choice Revisited (FC) 1/2 = S 0 Chapter One

P F F + P C C = I 1 (FC) 1/2 = S 0 Consumer Choice Revisited Chapter One

(FC) 1/2 = S 1 P F F + P C C = I 1 (FC) 1/2 = S 0 Consumer Choice Revisited Chapter One

C** C* F* F** (FC) 1/2 = S 1 P F F + P C C = I 1 (FC) 1/2 = S 0 Consumer Choice Revisited S 0 > S 1 I 0 > I 1 Chapter One

Defined: Marginal Impact The Marginal Impact of a change in the exogenous variable is the incremental impact of the last unit of the exogenous variable on the endogenous variable. Chapter One

Marginal Impact Advertising Example Budget = $1M to allocate between TV ( T ) and radio ( R ) Problem: Max B(T,R) (T,R) Subject to: pTT + pRR < $1m where: B is "barrels“ and pT, pR are the prices of TV and radio advertising, respectively. Budget = $1M to allocate between TV ( T ) and radio ( R ) Problem: Max B(T,R) (T,R) Subject to: pTT + pRR < $1m where: B is "barrels“ and pT, pR are the prices of TV and radio advertising, respectively. Chapter One

Marginal Impact Advertising Example Chapter One

Microeconomic Analysis Some Types Positive Analysis: Can explain what has happened due to an economic policy or it can predict what might happen due to an economic policy. Normative Analysis: Is an analysis of what should be done Positive Analysis: Can explain what has happened due to an economic policy or it can predict what might happen due to an economic policy. Normative Analysis: Is an analysis of what should be done Chapter One

Microeconomic Analysis Some Examples Example: “Should we increase income equality rather than focus on economic efficiency?” Example: “Should we impose a progressive income tax or a sales tax to increase income equality?” Example: “Will a progressive income tax reduce aggregate hours worked?” Example: “Should we increase income equality rather than focus on economic efficiency?” Example: “Should we impose a progressive income tax or a sales tax to increase income equality?” Example: “Will a progressive income tax reduce aggregate hours worked?” Chapter One