Chapter 1
Preliminaries
Introduction
 What are the key themes of
microeconomics?
 What is a market?
 What is the difference between real and
nominal prices?
 Why study microeconomics?
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Themes of Microeconomics
 Microeconomics deals with limits
Limited budgets
Limited time
Limited ability to produce
 How do we make the most of limits?
 How do we allocate scarce resources?
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Themes of Microeconomics
 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?
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Themes of Microeconomics
 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?
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Themes of Microeconomics
 Workers
Individuals decide when and if to enter the
workforce
 Trade-offs
of working now or obtaining more
education/training
What choices do individuals make in terms of
jobs or workplaces?
How many hours do individuals choose to
work?
 Trade-off
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of labor and leisure
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Themes of Microeconomics
 Firms
What types of products do firms produce?
 Constraints
on production capacity and financial
resources create needs for trade-offs
Theory of the Firm – describes how these
trade-offs are best made
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Themes of Microeconomics
 Prices
Trade-offs are often based on prices faced
by consumers and producers
Workers make decisions based on prices for
labor – wages
Firms make decisions based on wages and
prices for inputs and on prices for the goods
they produce
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Themes of Microeconomics
 Prices
How are prices determined?
planned economies – governments
control prices
 Market economies – prices determined by
interaction of market participants
 Centrally
Markets – collection of buyers and sellers
whose interaction determines the prices of
goods
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Theories and Models
 Economics is concerned with explanation
of observed phenomena
Theories are used to explain observed
phenomena in terms of a set of basic rules
and assumptions:
 The
Theory of the Firm
 The Theory of Consumer Behavior
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Theories and Models
 Theories are used to make predictions
Economic models are created from theories
Models are mathematical representations
used to make quantitative predictions
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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
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Positive & Normative Analysis
 Positive Analysis – statements that
describe the relationship of cause and
effect
Questions that deal with explanation and
prediction
 What
will be the impact of an import quota on
foreign cars?
 What will be the impact of an increase in the
gasoline excise tax?
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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?
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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
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What is a Market?
 Market Definition
Determination of the buyers, sellers, and
range of products that should be included in
a particular market
 Arbitrage
The practice of buying a product at a low
price in one location and selling it for more in
another location
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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?
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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
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Types of Markets
 Noncompetitive Markets
Markets where individual producers can
influence the price
– groups of producers who act
collectively
 Example: OPEC dominates with world oil
market
 Cartels
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Market Price
 Transactions between buyers and sellers
are exchanges of goods for a certain
price
Market price – price prevailing in a
competitive market
 Some
markets have one price: price of gold
 Some markets have more than one price: price
of Tide versus Wisk
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Market Definition
 Market Definition
Which buyers and sellers should be included
in a given market?
This depends on the extent of the market –
boundaries, geographical and by range of
products, to be included in it
 Market
for housing in New York or Indianapolis
 Market for all cameras or digital cameras
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Market Definition
 Importance of market definition
In order to set price, make budgeting
decisions, etc., companies must know
 Their
competitors
 Product-characteristic and geographic
boundaries of the market
Important for public policy decisions
 Should
government allow a merger between
companies in same market?
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Real Versus Nominal Prices
 Comparing prices across time requires
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
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Real Versus Nominal Prices
 Consumer Price Index (CPI) is 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
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Real Versus Nominal Prices
 Calculating Real Prices
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Real Price of College
Year
Nom.
Price
CPI
1970
$2,530
38.8
Real Price

1990 $12,018 130.7
2002 $18,273 181.0
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* $2,530  $2,530
38.8

38.8
* $12,018  $3,569
130.7

38.8
* $18,273  $3,917
181.0
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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
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The Minimum Wage: Figure 1.1
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Why Study Microeconomics?
 Microeconomic concepts are used by
everyone to assist them in making
choices as consumers and producers
 Examples show the numerous levels of
microeconomic questions necessary in
many decisions
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Ford SUV’s
 Built Ford Explorer in 1991, Ford
Expedition in 1997 and 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
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Ford SUV’s
 Questions
How strong is demand and how quickly will it
grow?
 Must
understand consumer preferences and
trade-offs
What are the costs of manufacturing?
 Given
all costs of production, how many should
be produced each year?
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Ford SUV’s
 Questions (cont.)
Ford had to develop pricing strategy and
determine competitors’ reactions
Risk analysis
 Uncertainty
of future prices: gas, wages
Organizational decisions
 Integration
of all divisions of production
Government regulation
 Emissions
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standards
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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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