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.
2.
3.
4.
People face tradeoffs.
The cost of something is what you give up to get it.
Rational people think at the margin.
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?