Eaton Micro 6e Ch01

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© 2005 Pearson Education Canada Inc.1.1

Chapter 1

Microeconomics:

A Working Methodology




The economic environment poses manycomplex questions.

The only way to understand economicbehaviour is to find a method for settingout and then solving microeconomicproblems.

This methodology consists of a relativelysmall set of ideas that are applicable to avast number of situations.

Throughout this book you will be

introduced to the ideas of economicanalysis and shown how to use them toanswer many economic questions.




A Water Shortage Problem

An imaginary island is sub-dividedinto the 100-home Estates.

Water for these homes comes from a

series of wells owned by the EstatesWater District at a total cost of $50000 per year.

Every household pays a flat fee of $500 per year for water (non-metered scheme).




A Water Shortage problem

All householders are identical andthe typical household uses 80 000litres of water over July and August.

Water is sometime unavailable inAugust.

The householder currently has an

unbalanced water use profileconsisting of 60 000 litres in July and 20 000 in August.




A Water Shortage Problem

The householder would actuallyprefer to consume 40 000 litres of water in each of July and August (the

balanced water profile).However the householder cannot

achieve the preferred water profileby his/her own effort, even thoughtotal water consumption under bothprofiles is the same.




A Water Shortage problem

To see why suppose just one householderreduces personal water use from 60 000to 40 000 litres in July, leaving 20 000additional litres for August.

In August this water conserving householdwould get only 1/100 (2 000 litres) of thisadditional water as all other householddraw on the extra water supply.

Figure 1.1 shows all the water use profilesthe householder can personally achieveunder the non-metered scheme.




Figure 1.1 Attainable water use profiles




From Figure 1.1

What is the most preferred waterprofile along DCU?

Because all 100 householders see

the problem in the same way, theyfind an equilibrium at 60 000 litres inJuly and 20 000 litres in August.

There is nothing an individualhouseholder by themselves can do toattain a more preferred profile.




From Figure 1.1

However, this equilibrium is unattractive.Even though total water usage is thesame, every householder would prefer toconsume the balanced profile of 40 000litres in each July and August.

Put differently, each householder could bebetter off if there were some way to

induce everyone to save 20 000 litres inJuly for use in August.




A Water Monitoring Scheme

A metered water scheme, where theprice was sufficient to reduce Julyconsumption, could bring about the

balanced water profile. If it costs nothing to monitor water

consumption, all revenues raised by

the per litre charge could be used toreduce the householders fixed yearlyfee.




A Water Monitoring Scheme

Monitoring is not costless.

The expense of collecting fees, mustbe compared with the benefits of

balanced water use.Such a comparison will determine if

the water monitoring scheme is

preferable to the non-monitoredscenario.




Common Property Problems

The water shortage problem is referred toas a common property problem.

In the non-metered scheme, the district’s

wells are common property and there isinsufficient incentive to curb water usage.

With the metered scheme, the wellsbecome private property, the water is sold

to users and the cost of usage providesincentives for conservation.




Competitive Equilibrium




Agricultural Price Supports




Describing an Economy: Four

Building Blocks

Resource endowment consists of all

resources available to an economy.

Technology specifies how resources can

be used to produce goods.

Preferences of individuals determines

what goods are produced in an economy.

Institutions are the rules by which the

economic “game” is played.




The Equilibrium Method

An equilibrium consists of a set of choicesfor the individuals and a correspondingsocial state such that no individual can be

better off by making some other choice. Comparative static analysis is the method

of analyzing the impact of a change by comparing the equilibrium resulting fromthat change with the original equilibrium.




Positive and Normative Economics

Positive economics is concerned withfactual matters. The answers to positiveeconomic questions can be settled by

factual observation. Normative economics involves value judgements. The answers to normativeeconomic questions are based on

judgements (opinions) and cannot besettled by appealing to the facts




The Pareto Criterion

In comparing two social states (stateI and J) - state I is Pareto preferred to state J if no one is worse off in

state I then in state J, and if at least one person is better off in state I than in state J.




Pareto Optimality

A social state is Pareto-optimal if noother attainable social state isPareto-preferred to it.

Pareto-optimal is synonymous witheconomic efficiency.




Cost-Benefit Analysis

Net social benefits equals gross social benefits minus gross social costs

In the move from social state I to social

state J, if net social benefit is positive,then the cost-benefit criterion ranks J as

preferred to I.

If net social benefit is negative, then the

cost-benefit criterion ranks state I as preferred to state J.




The Circular Flow of Economic Activity

Eaton Micro 6e Ch01

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