INTRODUCTION

Review of Key Topics from Micro Principles

Topics of Discussion

Microeconomics: The Allocation of Scarce Resources

Models Use of Microeconomic Models Ten Principles

Economics is the study of how society manages its scarce

resources. Resources such as natural resources, fertile

land, labor etc are limited.

Therefore not everyone can have everything they want. That is what we mean by scarcity.

Microeconomics is the study of how individuals and firms can make themselves as well off as possible in a world of scarcity, and the consequences of those individual decisions for markets and the entire economy

Microeconomics: The Allocation of Scarce Resources Individuals and firms allocate their

limited resources to make themselves as well off as possible

Consumers Firms Government

TRADE-OFFS

A society faces three key trade-offs: Which goods and services to produce? How to produce? Who gets the goods and services?

Who makes the decision?

How prices determine allocations Prices link the decisions about which

goods and services to produce, how to produce them and who gets them

Models

To explain how individuals and firms allocate resources and how market prices are determined, economists use models: a description of the relationship between two or more economic variables

Assumptions Testing Theories Maximizing subject to constraints Positive Vs Normative

Use of Microeconomic Models?

Review of Key Microeconomic Principles: Ten principles

First 4 Principles: How people make decisions

1. People face tradeoffs.2. The cost of something is what you give

up to get it.3. Rational people think at the margin.4. People respond to incentives.

Principle #1: People Face Tradeoffs.

“There is no such thing as a free lunch!”

Principle #2: Opportunity costs:

The cost of something is what you give up to get it.

The opportunity cost of something is what you would receive in the next best alternative usage.

2. Opportunity costs:

Example: Opportunity cost of time spent studying in the university is the money that you have earned if you were working instead.

Can you think of any other examples?

Principle #3: Rational people think at margin

When making decisions people often think of the effects of small or incremental changes in the current course of action.

Example: Instead of thinking about cost/benefit of getting a PhD they might consider the effects of one or two more years of school.

Can you think of any other examples? (Assignment for next time)

3. Rational people think at margin: People make decisions by comparing

costs and benefits at the margin.

The decision to choose one alternative over another occurs when that alternative’s marginal benefits exceed its marginal costs!

3. Rational people think at margin: Airline: 30 seats costs $15,000 AC=$500

Suppose the plane is scheduled to take off in an hour. What if, at the last minute, a potential passenger offers $300 for a seat on the plane. Should the airline allow this passenger to board?

3. Rational people think at margin: If airplane not full, and willingness to pay

$300, then for airline the MC of the passenger is small since the plane is still planning to make trip but MB of passenger is $300.

3. Rational people think at margin: Consider staying up an extra hour to

study:

MB of 1 more hour of studying on grade. MC of losing 1 hour of sleep on grade

3. Rational people think at margin: Firm’s hiring decision:

MB of 1 more worker (increase production) MC of 1 more worker (wages, health insurance)

Employee’s work decision: MB of working 1 more hour (more realistically

or a few more hours a week) MC of working 1 more hour (less leisure time,

less sleep time, less time with friends and family)

Principle # 4: People respond to incentives:

Since people make decisions based on benefits and costs, then decisions may change when costs or benefit change.

Example: Increase in wage may encourage workers to work more.

Increase in wage will most likely cause firm to hire less workers.

Decrease in cost of education may encourage people to attain more years of education

Next 3 Principles: How people interact with each other.

5. Trade can make everyone better off.

6. Markets are usually a good way to organize economic activity.

7. Governments can sometimes improve economic outcomes.

Principle # 5:Trade off can make everyone better off

Without trade each family would grow own food, make clothes and houses.

Trade allows specialization.

Also applies to international trade. Some countries specialize in oil production growing certain crops, manufacturing.

Principle # 6: Markets are good way to organize economic activity

Market economy vs. command economy (USSR, state makes all decisions)

In a market economy, households decide what to buy and who to work for, and firms decide who to hire and what to produce

How is there not chaos when everyone making decisions individually? Idea of invisible hand by Adam Smith 1770

6. Markets are good way to organize economic activity:

Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social costs of their actions.

In most cases p= value to society of a good=cost to society of a good

6. Markets are good way to organize economic activity:

Competition leads to Efficiency: when there is competition firms have to minimize costs, use the least inputs necessary (use inputs efficiently or else they will go out of business)

Principle # 7: Government can sometime improve market outcomes

Market failure occurs when the market fails to allocate resources efficiently.

In other words, the interaction of supply and demand don’t lead to best outcome

Externality: when an action of one person or firm affects many people but the effects are not internalized.

A benefit or cost from production or consumer accruing without compensation to non-buyers and non-sellers of the product.

7. Government can sometime improve market outcomes:

Examples:

Pollution : from production Market power: government regulates

monopoly

Last 3 Principles: The forces and trends that affect how the economy as a whole works. 8. The standard of living depends on a

country’s production.

9. Prices rise when the government prints too much money.

10. Society faces a short-run tradeoff between inflation and unemployment.

New Topic: Thinking Like an Economist “Assumptions”

Assumptions are statements to make world simpler and easier to understand.

“Assumptions”

We would like to have assumptions that are generally close to reality

Menus and sticky prices in short run Rational consumers (lowest price)

“Assumptions”

Sometimes we will see assumptions that seem unrealistic

Either by ‘loosening’ that assumption doesn’t change model/how we solve problem but assumption makes problem easier to think about.

Need a jumping off point and in the future basic model helps economist solve more real model.

Review of Supply and Demand Market: a group of buyers and sellers of

a particular good or service. May be centralized or not: grocery stores,

all selling wheat bread Stock market (more centralized)

Buyers determine demand Sellers determine supply

Competitive market:

large number of buyers large number of sellers homogenous product free entry/exit perfect information

Competitive market:

For now, the most important thing to remember is that since there are a large # of buyers and sellers, so one individual or firm cannot significantly have an impact on price. In other words, everyone is a price taker. If all stores are selling milk at $2.50 per

gallon but one decides to sell at $5, will anyone buy from that store?