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Chapter 1

Preliminaries

©2005 Pearson Education, Inc. Chapter 1 2

Introduction

Review basic terminologies, methodologies, and key assumptions imposed in microeconomic theory.

What is economics?What is microeconomics?What are theories and models?What is positive and normative analysis?What is the difference between real and

nominal prices


Themes of Economics

Economics studies economic phenomena and the economic behavior of individual agents --- consumers, workers, firms, government, and other economic units as well as how they make choices so that limited resources are allocated among competing uses.

A fundamental assumption on individual behavior is that an individual is rational (i.e., self-interested).

Because resources are limited, but people's desires are unlimited, we need economics to study this fundamental conflict.


Four Basic Questions to be Answered by Any Institution:

What goods and services should be produced and in what quantity?

How should the product be produced? For whom should it be produced and

how should it be distributed?Who makes the decision?

The answers depend on economic institutions.


Two basic economic institutions used in the real world:

Market economic institution: Most decisions on economic activities are

made by individuals, it is mainly a decentralized decision system.

Planning economic institution: Most decisions on economic activities are

made by government, it is mainly a centralized decision system.


Themes of Modern Economics

The market economy has been proved to be only economic institution so far that can keep an economy with sustainable development and growth.

It is the most important economic institution discovered for reaching cooperation and solving the conflicts among individuals.

Modern economics studies various economic phenomena and behavior under market economic environment by using an analytical approach such the demand and supply model.


Themes of Microeconomics

Microeconomics: Branch of economics that deals with the behavior of individuals -- workers, firms and consumers– as well as how markets are organized

It deals with limits:Limited budgets; Limited time; Limited ability to produce

How do we allocate these limited resources?



Workers, firms and consumers must make trade-offs Do I work or go on vacation? Do I purchase a new car or save my money? Do we hire more workers or buy new

machinery?

How are these trade-offs best made?



Consumers Limited incomes Consumer theory – describes how

consumers maximize their well-being, using their preferences, to make decisions about trade-offs.

How do consumers make decisions about consumption and savings?



Workers Individuals decide when and if to enter the

work-forceTrade-offs of working now or obtaining more

education/training What choices do individuals make in terms of

jobs or work places? How many hours do individuals choose to

work?Trade-off of labor and leisure



Firms What types of products do firms produce?

Constraints on production capacity & financial resources create needs for trade-offs.

Theory of the Firm – describes how these trade-offs are best made



Prices How are prices determined?

Centrally planned economies -governments control prices

Market economies – prices determined by interaction of market participants

Markets – collection of buyers and sellers whose interaction determines the prices of goods.


Theories and Models

Economic theories are used to explain observed economic phenomena in terms of a set of basic rules and assumptions. The Theory of the Firm The Theory of Consumer Behavior The Theory of Markets

Theories are used to make predictions Economic models are created from theories Models are mathematical representations used to

make quantitative predictions


Theories and Models

Validating a Theory The validity of a theory is determined by the

quality of its prediction, given the assumptions.

Theories must be tested and refined Theories are invariably imperfect – but gives

much insight into observed phenomena


Positive & Normative Analysis

Positive Analysis – statements that describe the relationship of cause and effect Questions that deal with explanation and

predictionWhat will be the impact of an import quota on

foreign cars?What will be the impact of an increase in the

gasoline excise tax?


Positive & Normative Analysis

Normative Analysis – analysis examining questions of what ought to be Often supplemented by value judgments

Should the government impose a larger gasoline tax?

Should the government decrease the tariffs on imported cars?


What is a Market?

Markets Collection of buyers and sellers, through their

actual or potential interaction, determine the prices of products

Buyers: consumers purchase goods, companies purchase labor and inputs

Sellers: consumers sell labor, resource owners sell inputs, firms sell goods


What is a Market?

Defining the Market Many of the most interesting questions in

economics concern the functioning of markets

Why are there a lot of firms in some markets and not in others?

Are consumers better off with many firms?Should the government intervene in markets?


Types of Markets

Perfectly competitive markets Because of the large number of buyers and

sellers, no individual buyer or seller can influence the price.

Example: Most agricultural markets Fierce competition among firms can create a

competitive market


Types of Markets

Noncompetitive Markets Markets where individual producers can

influence the price.Cartel – groups of producers who act

collectivelyExample: OPEC dominates with world oil

market


Real Versus Nominal Prices

Comparing prices across time required measuring prices relative to some overall price level Nominal price is the absolute or current dollar

price of a good or service when it is sold. Real price is the price relative to an

aggregate measure of prices or constant dollar price.



Consumer Price Index (CPI) often used as a measure of aggregate prices. Records the prices of a large market basket

of goods purchased by a “typical” consumer over time

Percent changes in CPI measure the rate of inflation



Calculating Real Prices

yearcurrent yearcurrent

yearbase Price Nominal x CPI

CPI RealPrice

100baseyear


Real Price of College

Year Nom. Price

CPI Real Price

1970 $2,530 38.8

1990 $12,018 130.7

2002 $18,273 181.0

$3,569$12,018*130.738.8

$3,917$18,273*181.038.8

$2,530$2,530*38.838.8


Real Price of Wages

Observations The minimum wage has been increasing in

nominal terms since 1940.From 1930 at $0.25 to 2003 at $5.15

The 1999 real minimum wage was no higher in 1999 than 1950.


The Minimum Wage: Figure 1.1


Why Study Microeconomics?

Microeconomic concepts can be used to assist everyone in making choices as consumers and producers.

Examples show the numerous levels of microeconomic questions necessary in many decisions


Ford SUV’s

Built Ford Explorer in 1991, Ford Expedition in 1997 and the Ford Excursion in 1999

In each of these cases, Ford had to consider many aspects of the economy to ensure their introduction was a sound investment


Ford SUV’s

Questions How strong in demand and how quickly will it grow?

Must understand consumer preferences and trade-offs

What are the costs of manufacturingGiven all costs of production, how many should be

produced each year? Risk analysis

Uncertainty of future prices: gas, wages Ford had to develop pricing strategy and determine

competitors reactions?


Emission Standards

1970 Clean Air Act imposed emissions standards and have become increasingly stringent Questions

What are the impacts on consumers?What are the impacts on producers?How should the standards be enforced?What are the benefits and costs?

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Technology

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