CHAPTER 1 Introduction to...

1

CHAPTER 1

Introduction to Microeconomics

2Chapter 1: Introduction to Microeconomics

Introduction

Economics is the study of the ways in which people make decisions that impact their economic well-being. Because it focuses on the ways in which people make choices among alternatives in the face of limited resources, economics is considered to be a member of the social sciences family. Economics is generally divided into two main areas: macroeconomics and microeconomics.

The prefix macro means large. Macroeconomics is concerned with the economy as a whole—the overall picture of a country’s economy. For example, recessions such as the Great Recession of 2007-2009—and depressions—are large-scale events that economists study over time. These events and others, such as fiscal and monetary policy and the exploration of ways to move a country’s economy to long-term equilibrium, are the focus of macroeconomics. Additionally, macroeconomics deals with national output, employment, business spending, government spending, and a country’s central bank.

Now, consider the prefix micro and the measurement of a micron (one millionth, 10 6- ). Microeconomics, in contrast to macroeconomics, is the study of smaller components of the economy, for example, actions of individual firms, government intervention into the marketplace, consumer behavior, particular prices, and specific goods and services.

This course will focus on fundamental microeconomic concepts. The approach of this course is to study microeconomics in the context of hypothetical scenarios that involve a fictional firm, Rayon Pharmaceuticals, LLC (limited liability company). Using a fictional firm to illustrate economic concepts will help to explain the real-world events that economists study every day. The study of hypothetical examples anchored in real-world examples and described through a story-based fictitious company setting may give you a greater understanding of microeconomics and a more insightful perspective on the subject. Thus, we will describe many concepts through the lens of Rayon Pharmaceuticals to demonstrate how logical and rational choices are made determining which products are offered to consumers and which new products will be developed and produced.

Learning Objectives

After you complete this chapter, you should be able to

• Identify the six steps of the scientific method

•Differentiate between normative and positive research statements

• Identify ten basic economic concepts

•Construct a graph with price and quantity data, using standard economic conventions and multiple variables, and determine the graph’s application to economics

Key Terms

Hypothesis: a stated premise, assumption, or even a best guess used to guide an investigation

Law: an explanation or prediction of an event that can be observed and verified; often predicts the consequences of a single act

Marginal benefit: the value derived from doing one more activity or buying/selling one more item


Marginal cost: the cost of producing one additional unit

Marginal decisions: decisions that are made in incremental amounts

Marginal revenue: the change in a firm’s total revenue that results from a one-unit change in output

Normative statement: an opinion about what should be; a subjective statement or value judgment

Positive statement: an objective statement that can be tested or rejected by referring to the available evidence; an objective explanation and the testing and rejection of theories

Principle: an overarching, large body of knowledge composed of hypotheses, laws, and theories

Scarcity: the condition that exists when the desired amount of a good is greater than the amount that is readily available; in the free market, any good with a price is scarce

Scientific method: a set of procedures or techniques to investigate phenomena, acquire new knowledge, or correct previous knowledge by conducting research to test a hypothesis

Theory: a large working body of knowledge that explains verifiable observations

Economics and Business

Rayon Pharmaceuticals is an established firm with a rich history; Rayon executives invest in its future by understanding its past. They collect as much information as possible about Rayon’s history and past performance trends.

Rayon’s principle product is aspirin, and Rayon has entered several other drug categories with some success. Its new compound, Zinctec, is a breakthrough allergy medication that offers long-term relief from spring and summer allergies. Zinctec has the potential to propel Rayon to multinational status over the next three to five years.

Rayon also has had very impressive results with a new compound that is in preliminary clinical trials. It may be a cure for Alzheimer's disease. Alzeen—the patented brand name for the drug—is currently in clinical trials and has shown some success in reversing the devastating impact of Alzheimer's disease. Once cleared for human use, the drug could give Rayon a monopoly on the treatment of Alzheimer's disease, an achievement that would help Rayon make the transition from a solid, medium-sized company to a global leader.

Rayon, like all businesses, calculates costs and assesses advantages and risks when making decisions about its products. Decisions that are made in incremental amounts are called marginal decisions. Rayon executives ask, "What are the benefits of doing something when weighed against the costs of getting it done?" To produce something, costs are incurred. The cost of producing an additional unit is called the marginal cost.

An economist would say that executives weigh the marginal cost against the marginal benefit—the value derived from conducting one more activity or buying/selling one more item when making a decision. Businesses receive income, or revenue, from selling products. The change in a firm’s total revenue that results from a one-unit change in output is the marginal revenue.

At Rayon Pharmaceuticals, just as at real-world firms, many decisions are driven by the fundamentals of economics. Economists consider questions such as the following.

•Does increasing production of product make sense?

•Will the firm be able to generate enough additional revenue to cover the cost of increased production? In other words, will marginal revenue be higher than marginal costs?


Solving the Problems of a Business-Based EconomyEconomics is the study of the ways in which people make decisions about their economic well-being.

In microeconomics, the focus is primarily on the ways in which business leaders make decisions that lead to the economic well-being of their firms. In this text, the concepts of economics will be studied through the lens of a particular business. The study of economics becomes the study of the ways in which humans answer the questions or solve the problems of the production and consumption of goods and services. The problems businesses and economists attempt to solve relate to scarcity, which is the condition that exists when the desired amount of a good is greater than the amount that is readily available. Economists try to answer "who," what," and "how" questions in order to solve these problems.

Who•Receives our output?• Produces?

What• Should be produced?• Should the firm's lobbyists ask the government to do?

How• Should the firm grow?• Should the firm determine a good product mix?• Should the firm increase production? • Should the firm respond to staffing needs to meet production fluctuations?• Should we modernize or improve our physical manufacturing facilities?

Hypotheses, Laws, Theories, and Principles

HypothesisA hypothesis, sometimes referred to as a premise, an assumption, or even a best guess, is important

to scientific research. Depending on the research results, the hypothesis can be supported or shown to be inaccurate. If the data collected during the research step indicates the hypothesis is supported, then it may be true. The next step is for researchers to attempt to replicate the findings. If many observations and experiments confirm the hypothesis, it may become a law or a theory.

LawsA law explains or predicts an event that can be observed and verified. A law often predicts the

consequences of a single act. Examples of laws are the law of gravity, the first law of motion, the law of thermodynamics, and the law of supply and demand.

TheoriesA theory can contain many different laws. A theory is a large working body of knowledge that explains

verifiable observations. A theory explains interrelated concepts and ideas. A theory never becomes a law, unless it is about a very narrow topic. Examples of theories are music theory, learning theory, the theory of evolution, the theory that mycobacterium tuberculosis causes tuberculosis, and the theory of relativity.


PrinciplesA principle is an overarching, large body of knowledge composed of laws and theories. Examples are

the principles of general physics and the principles of democracy.

The Scientific Method

Asking the right questions can be the most critical part of the research that fuels companies. At Rayon, research scientists are actively involved in producing aspirin-based pain relief, allergy medications, and pen-delivered insulin. These scientists also engage in the research and development of new products. Rayon has two drugs in the clinical trial phase development. Basic research typically follows the standard scientific method. The scientific method, a set of procedures or techniques to investigate phenomena, acquire new knowledge, or correct previous knowledge, involves the following six steps.

Step 1: Asking Questions These questions can be simple or complex. The following is a simple question with a limited number of

variables: Does a positive correlation exist between the dose of our new antibacterial cream and the number of surviving bacteria? A more complex question with many variables to consider is the following: Should we expand our Powder River Plant?

Step 2: Conducting ResearchResearch should be logical and objective. Good research gathers facts, whether the facts seem to “fit” or not.

Objective research is unbiased. Scientists are vigilant in excluding biased statements from their research. Because biased statements depend on individual norms or values, they are also called normative statements. A normative statement—a subjective statement or value judgment, an opinion about what should be—is one that cannot be proven true or false by facts because it is based entirely on the values of the person making the statement. Normative statements differ from positive statements—objective statements that can be tested and proven to be correct or incorrect by referring to the available evidence. The following table illustrates the difference.

Table 1.1 Normative and Positive Statements

Normative Statement Positive Statement

Not enough bacteria were killed by the antibacterial cream.

The number of surviving bacteria decreased when the dose of our new antibacterial

cream increased.

The Research and Development budget is too low.

The Research and Development budget is 25% less than it was last year.

The bottling equipment is too old. The bottling equipment is fully depreciated and is over 7 years old.

Just because a statement is positive, or unbiased, does not mean that it is true. A positive statement may be false, or it may be proven to be false as a result of research. Logic must be used. Three positive statements follow.


The lab mouse died.

The lab mouse was part of the study.

The test drug killed the mouse.

The first two positive statements are true. However, the last may or may not be true. Until further research is completed, one cannot know if it is true or not true. It is not logical to assume that because the mouse died, and because the mouse was part of the study, the test drug killed the mouse. That assumption is a fallacy in logic. Further investigation would be needed to determine how and why the mouse died. However, because the last statement can be tested for accuracy or inaccuracy, it is a positive statement.

Step 3: Forming a Hypothesis The hypothesis is the researcher’s theory to be tested. The theory could be right or wrong. An example

of a hypothesis follows: Drug X at a dose of 20 milligrams will kill 80% of target bacteria within 1 hour.

Step 4: Investigating Through the Use of a Method or Procedure

In this step, the researcher selects a method to investigate and test the hypothesis. The investigation must be a methodical process which others can duplicate. For example, to test the hypothesis stated in Step 3, researchers could apply Drug X at the specified dose to a test tube or Petrie dish containing the target bacteria.

Step 5: Collecting Data and Making Observations The researcher records the results, describes what the results show, and notes what, if anything, went wrong

with the experiment. In testing Drug X, researchers could take a count of dead bacteria at certain intervals and record the results. These findings might be related to a human error or some variable not considered. Examples of unconsidered variables are the possibility that the bacteria in question flourish at certain temperatures and the fact that the lab temperature was not controlled.

Step 6: Drawing a Conclusion In her/his conclusion, the researcher answers the following questions: Why did the experiment turn

out the way it did? Was the hypothesis supported? If not, why not? If the hypothesis is not supported, the researcher repeats the third step, forming a new hypothesis.

Basic Economic Concepts

The following is a list of 10 basic economic concepts.

1. Benefits vs. costs: Firms and individuals do not pursue activities when the costs outweigh the benefits.

2. Efficiency: If production is efficient, then citizens enjoy a higher standard of living.

3. Equilibrium: Trades will continue to occur up to the point where there are no additional gains to individual participants; the marginal costs and marginal benefits are equal.

4. Gains from trade: If a trade occurs, both parties gain.


5. Government intervention: Governments can, and do, intervene in the marketplace, with mixed results.

6. Incentives: Firms, society, and individuals respond to incentives.

7. Increasing opportunity costs: Any activity may begin with relatively low costs; however, at some point, increasing activity means rising costs.

8. Opportunity cost: The best alternative that must be sacrificed in order to buy one more good or service or to conduct one more activity is the opportunity cost.

9. Rational decisions: Individuals and firms make rational choices that improve the overall well-being of these individuals and firms.

10. Scarcity: Resources, whether they are time or materials, are not available in unlimited quantities. Any good with a price is scarce. Scarcity results from the imposition of unlimited human wants onto limited resources. Economics is the study of the ways in which humans are forced by scarcity to choose among options.

Basic Graphing

A graph is a direct, pictorial way to present a substantial amount of information at a glance. Both business leaders and scientists use graphs to convey information. Graphs reveal the power of economics in a very simple-to-understand format. Since graphs are an integral part of the business world, it is important for students of microeconomics to understand basic graphing conventions.

At Rayon, many graphs describe the company’s current industry position. Some of the graphs are fairly simple. Others are more complex. While graphing techniques may seem complicated, many people use them without even realizing it. For example, playing a particular board game or using a spreadsheet requires aligning points on a grid, an activity which is rudimentary to graphing. Rayon, like many companies, employs the standard graphing methods used in mathematics–the Cartesian coordinate system (see Figure 1.1):

•The y-values are plotted on the vertical axis.

•The x-values are plotted on the horizontal axis.

Figure 1.1 Vertical (y-Axis) and Horizontal (x-Axis) Axes

8

7

6

5

4

3

2

1

00 1 2 3 4 5 6 7 8

y

x


Plotting a Line How is a line plotted (or drawn) on a graph? One method used to plot a line is to plot data points and

connect them. The following table represents three data points, which will be graphed as an example.

x y

0 0

1 4

2 8

Step 1. Plot the point (0, 0). This point, the origin, will be in the lower left-hand corner of the graph, as shown below.

4

3

2

1

00 0.2 0.4 0.6 0.8 1 1.2 1.4

(0, 0)

y

x

Step 2. Plot the point (1, 4), as shown in the following graph. The point (1, 4) is also called an ordered pair. The first value, in this case, the 1, is the x-coordinate. The second value, in this case, the 4, is the y-coordinate.

4

3

2

1

00 0.2 0.4 0.6 0.8 1 1.2 1.4

y

x

(1, 4)

Over 1

Up 4


Step 3. Plot the point (2, 8), as shown in the following graph.

0 0.5 1 1.5 2 2.5 3.53

8

4

2

0

6

y

x

(2, 8)

Over 2

Up 8

Step 4. Connect the data points with a straight line, as shown in the following graph.

0 0.5 1 1.5 2 2.5 3.53

8

4

2

0

6

y

x

Graphing Economic DataThe standard mathematical conventions, as illustrated above, are also used to graph economic data. Generally,

pricing/cost information is graphed on the vertical axis (y-axis), and quantity information is graphed on the horizontal axis (x-axis). Graphing economic data in this manner is called standard economic convention.

Rayon manufactures various pharmaceuticals. The data in the following table details the number of bottles of name-brand, extra-strength aspirin Rayon sells per day, at various prices.

Bottles of Aspirin (Thousands) Price

100 $5

150 4.50

200 4


To accurately plot this data, take the following steps:

Step 1. Plot the first row of data: 100 aspirin at $5, as shown in the following graph.

0 20 40 60 80 100 120

Price

Quantity of bottles (thousands) per day

(100, 5)$6

5

4

3

2

1

0

Step 2. Plot the second row of data: 150 aspirin at $4.50, as shown in the following graph.


0 50 100 150 200 250

Price

Over 150

Up to $4.50

(150, 4.5)

$6

5

4

3

2

1

0

Step 3. Plot the third row of data: 200 at $4, as shown in the following graph.


0 50 100 150 200 250

PriceUp to $4

(200, 4)

Over 200

$6

5

4

3

2

1

0


Step 4. Connect the data points, as shown in Figure 1.2.

Figure 1.2 Aspirin Sold per Day at Various Prices


0 50 100 150 200 250

Price

$6

5

4

3

2

1

0

SlopeThe slope of a line indicates how quickly something is changing. If you have been snow skiing or have

climbed a steep incline, you already know something about slope. Slope describes the steepness of the incline, or how quickly the up portion is changing in relation to the across portion.

Slope is described in the same way when graphing. Reexamine Figure 1.2. Make a triangle (see Figure 1.3). The long side of the triangle is the hypotenuse.

Next, measure the lengths of the sides of the triangle just constructed. First measure the difference in prices along the y-axis; this difference is the length of the vertical side. Note in Figure 1.3 that the dashed line begins at 4 and rises to 5. This side has a length of 1 ($5 - $4). This measurement is called the rise.

Figure 1.3 Aspirin Sold per Day at Various Prices (Illustration of Steps to Determine Slope)

1


0 50 100 150 200 250

Price

$6

5

4

3

2

1

0

Finally, measure the length of the difference in quantities, which is along the x-axis; this difference is the length of the horizontal side. The line begins at 100,000 and ends at 200,000. It has a length of 100,000 (200,000 - 100,000). This measurement is called the run.


Figure 1.4 Aspirin Sold per Day at Various Prices (Illustration of Steps to Determine Slope)

1


0 50 100 150 200 250

Price

100

$6

5

4

3

2

1

0

Slope, or steepness, is measured by dividing the rise by the run:

Slope = RiseRun

Change in y – valuesChange in x – values

=

In this example,

Slope = RiseRun

1100,000

=

Standard notation would also add a negative sign ( )- in front of the 1/100,000. Why? The slope is “falling” when the graph is viewed from left to right. If the line were “rising” when the graph is viewed from left to right, the slope would have a positive sign ( )+ ; often this positive sign is omitted.

As previously stated, graphs are used to pictorially convey information. What does Figure 1.4 say about consumers’ aspirin-buying habits? The graph is downward sloping. This downward slope indicates there is an inverse relationship between the price and the number of bottles of aspirin consumers purchase. When the price is lowered, consumers purchase more aspirin.

Slope can be used to determine change for just about any product—not just pharmaceuticals. The preceding example (see Figure 1.4) illustrates the amount sold in response to the change in the price of aspirin. Now we will look at the seller's response to a change in market price. The table in Figure 1.5 presents how the amount Rayon is willing and able to produce corresponds with various prices. In this example, we assume that Rayon is just one of many firms in the marketplace producing nearly identical painkillers—specifically, aspirin.


Figure 1.5 Aspirin Produced per Day at Various Prices: Direct Relationship Between Price and Quantity

Quantity (Thousands of Bottles) Rayon Is Willing to Make per Day Price

0 $0

2 1

4 2

6 3

8 4

10 5

0 2 4 6 8 1 0 1 2

10

5

Quantity (thousands of bottles) per day

Price

$6

5

4

3

2

1

0

Slope = RiseRun

+510,000

=

At a glance, the graph in Figure 1.5 illustrates a direct relationship between price and quantity. As the price increases, so does the amount Rayon is willing and able to bring to the marketplace.

Constructing a Graph From a Linear EquationIn addition to being able to graph a (trend) line using various given data points, as shown in the graph

in Figure 1.5, a line can be graphed when an algebraic equation is given. One of the standard forms for the equation of a line is called the slope-intercept form:

y mx b= + ,

where x and y are the respective x and y data pair, m is the slope of the line, and the value of b is the point where the line “cuts” the y-axis.


For example, we will graph the equation ( )y21 0 5=- +5y x=- +

The line for this equation can be plotted by substituting values for y and x and then solving the equation. Let x be 0 and solve for y.

( )y21 0 5=- +

5y =

x y

0 5

Now, let y be 0 and solve for x.

x021 5=- +

Subtract 5 from both sides.

x521- =-

Multiply both sides by -2.

( ) x5 221 2- - =- -^ h

10 x=

Our data points are presented in the following table.

x y

0 5

10 0

Given just these two data pairs, we can quickly sketch a graph (see Figure 1.6).


Figure 1.6 Using Two Data Points to Sketch a Graph

0 2 4 6 8 10 12

6

5

3

1

4

2

0

y

x

Considering that price is given on the y-axis and quantity on the x-axis, we can substitute price for y and quantity for x. So P = -1/2x + 5. At a quantity of 8, price would be -1/2(8) + 5, or 1. For a quantity of 6, price equals -1/2(6) + 5, or 2. The resulting line, as depicted in Figure 1.6, shows the quantity desired by consumers at each price.

We would use the same techniques for graphing the relationship between price and quantity supplied by Rayon. The amount Rayon would be willing to supply at each market price can be determined by the following formula:

Price = 21 Quantity

P Q21= ,

where P is the price and Q is the quantity.

To graph the line P Q21= , let price equal 0.

Q021=

Q0 =

Our first data point is presented in the following table.

Q P

0 0

Next, let the quantity equal 10.


P Q21=

P21 10= ^ h

P = 5

Our two pairs of data are illustrated in the following table.

Q P

0 0

10 5

We have enough data to sketch a graph of the two points.

Quantity (bottles) per day

0 2 4 6 8 10 12

$

5

3

1

4

2

0

Aspirin Produced per Day at Various Prices

Price

As the formula P = 1/2Q indicates, Rayon would be willing to supply eight bottles at a price of $4, six bottles at a price of $3, four bottles at a price of $2, and two bottles at a price of $1.

With just a quick glance, we can learn a great deal of information from the graph. For example, if Rayon can’t derive revenue from selling aspirin, company executives may decide to stop producing it. The graph also shows that as the price Rayon can charge for aspirin increases, the company is willing to produce greater quantities of aspirin.


Summary

Microeconomics is the study of smaller components of the economy than those studied in macroeconomics. For example, the components studied in microeconomics are the actions of individual firms, government intervention into the marketplace, consumer behavior, particular prices, and specific goods and services. Scientists and economists attempt to answer marketplace questions. Fundamental questions they seek to answer include the following.

•What should we produce?

•How do we produce it?

•Who gets the production?

•How do we handle growth?

•What is/should be the role of government?

Researchers in an individual firm apply the scientific method to determine if their premise, or “best guess,” supports the questions asked. While using the scientific method, these researchers attempt to avoid bias (i.e., avoid making normative statements) and faulty logic. The scientific method has six steps:

Step 1: Asking questions

Step 2: Conducting research

Step 3: Forming a hypothesis

Step 4: Investigating through the use of a method or procedure

Step 5: Collecting data and making observations

Step 6: Drawing a conclusion

If data is statistically significant, and can be replicated, a hypothesis may become a law or part of a theory. It is important to understand the differences between these terms:

Hypothesis: a stated premise, assumption, or even a best guess used to guide an investigation

Law: an explanation or prediction of an event that can be observed and verified

Theory: a large working body of knowledge that explains verifiable observations

Principle: an overarching, large body of knowledge composed of hypotheses, laws, and theories

Scientists and economists use graphs for a quick “snapshot” of the effect changes in pricing might have on quantities produced and purchased. Standard economic conventions for graphing include the following.

•The vertical axis (y-axis) represents price and cost information.

•The horizontal axis (x-axis) represents quantity information.

Chapter 2 will explore the concepts of scarcity, gains from trade, and rational decisions.

CHAPTER 1 Introduction to...

Documents

Transcript of CHAPTER 1 Introduction to...