Microeconomics
Reading Assignments:
Under the heading, Lecture Schedule, I have assigned one chapter or two
for you to read each session. Ideally, you may want to read it once before the
lecture. It will be somewhat easier for you to understand the lecture that is
being covered. A second reading should be done after the lecture.
Examinations:
Two exams plus the final examination, equally weighted. Also, a case
report on a specific economic problem in Hong Kong. Each student is asked to
prepare a report on it. Length: 10 – 20 pages.
Bonus Points:
1. Every once in a while, I may ask you some bonus questions. If you
answer it correctly, you receive a bonus point. Each bonus point is worth 1% of
total score.
2. If I make a mistake and you correct it, you would get a bonus point (which
applies to only important points).
Introduction
In the beginning, economics was not diversified, and all economic topics were
lumped together and called "economics." After the great depression of the
1930s, there emerged two branches of economics: microeconomics and
macroeconomics.
Most of the time, a manager’s decisions deal with microeconomic decisions of
a firm, although some managers have to pay attention to macroeconomic
indicators such as interest rates and exchange rates.
Micro means small, "Macro" means large.
Ragnar Frisch (1895-1973), a Norwegian economist (who along with the Dutch
economist, Jan Tibergen, won the first Nobel prize in economics) coined the
words "microdynamics" and "macrodynamics" in 1933, to denote what we now
mean by micro and macroeconomics.
Two main differences:
1. Microeconomics deals with the choice of individuals, individual
households or individual firms. Macroeconomics deals with economic
aggregates, total production, total consumption, etc.
Even in microeconomics, sometimes we also use aggregate concept such
as aggregate demand for a product. Still, we are focusing on a single product in
microeconomics. In macroeconomics, we talk of GNP, which is an aggregate
over many different products.
2. In microeconomics, relative prices play an important role. In
macroeconomics, we pay attention to general price level, interest rates, etc., but
not to individual prices or markets for specific products.
SCARCITY AND CHOICE
Individuals make choices:
 whether to get an MBA or not
 whether to buy a house or rent
 whether to buy a car or use bus or train
 whether to marry or stay single.
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Some are non-economic choices
moral decisions
religious decisions
Economic decisions
some are purely economic decisions
others are moral or religious decisions that have some economic
consequences.
If moral decisions are made, regardless of economic consequences, those
decisions can be truly noneconomic decisions.
It is difficult to find any decisions that are totally independent of economic
consequences.
 most decisions yield economic consequences, or are affected by economic
events.
Many moral and social decisions have often economic consequences. When
economic consequences are taken into account, moral and social decisions are
not purely moral or social decisions.
There may be tradeoffs between moral/social and economic activities. Societies
often do not tolerate tradeoffs  Lexicographic preferences (no tradeoffs).
Throughout the semester, we will be concerned only with economic decisions
of economic agents.
This does not mean that managers should ignore moral and social consequences
of economic decisions. However, such consequences will be ignored in this
course, as it is beyond the scope of economic analyses.
Example: Managers are supposed to maximize profits.
There may be legal means
Illegal means
Illegal means often yield a higher level of profits than legal means. Hence, the
former method is often subject to criticism and prosecution.
Heidi: broker of prostitution ring.
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Similarly, producers also have a number of choices:
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what product to produce
whether to expand output
whether to shut down a plant
whether to buy inputs from abroad
whether to produce abroad
POSITIVE VS NORMATIVE ANALYSIS
(vs. = versus)
It is common knowledge that economists often agree. These differences result
from different assumptions or hypotheses about how things are or from
different views about how things ought to be.
different opinions about what is (facts)
different opinions about what ought to be (value judgment)
Positive economics deals with the question of what is:
 Positive statements deal with assumptions about the state of the world and
some conclusions.
 The validity of a positive statement can be verified in principle, no matter
how difficult it might be.
Example 1: The weight of the earth is 1 octillion (10 27) metric tons.
Example: An increase in minimum wage increases unemployment among
teenagers.
Positive statements do not involve value judgments or opinions. These are
normative statements.
 Verifying the validity of a positive statement is often difficult in practice.
"If the price of a good declines, consumers will buy more of that product."
The verifying process often requires some judgment as regards to the specific
method to be adopted to verify a claim.
To verify this, one has to observe the consumption pattern over a period.
How long should one observe the consumer? (normative)
Tracking the same consumer is impractical. Consumers do not cooperate
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long enough to permit your experiment or observations.
How large the sample should be to confirm the result? (normative)
Should one observe all consumers?
Observing all consumers is impossible.
Men are mortal (can't observe all)
Researchers can observe only a sample, a small fraction of the entire
population.
How big should the sample be? 0.0001%, 1%, 99%, or 100%?
So to verify a positive statement, one has to be content with a small sample.
Some individuals use a single sample.
"I will never make the same mistake" or “I will never date another man (or
woman).”
Those who keep making the same mistake believe that their samples are
too small. The same move may eventually produce a different result.
Why Assumptions?
Verifying the validity of a positive statement is not that simple. It actually
involves making some assumptions about the statement of the world. So
economists lump all these things that they do not want to verify into a set of
assumptions, and start from there. It is just too costly to verify the reality or
validity of the assumptions.
For instance, we will assume that consumers are "rational", i.e., consumers
should maximize utility. Producers are rational, and hence they should
maximize profits, etc. With these assumptions, we try to prove or predict the
behavior of consumers or producers.
Remark:
1. Real world problems are much more complicated than those we study in this
course. For instance, there are many irrational people out there. Or most of the
rational people are sometimes irrational. A certain behavior may appear to be
irrational, but it may be rational in a broader framework. That is, there may be
a good reason for an apparently irrational behavior.
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2. Many economic decisions are solely based on economic factors, but are
partly affected by noneconomic factors. (Similarly, some noneconomic
decisions may be partly influenced by economic factors).
In this course, we are mostly concerned with economic reasoning:
(i) It is difficult to predict the behavior of irrational individuals.
(ii) The fraction of irrational individuals is small and their decisions do not alter
the overall pattern of consumer behavior.
Normative economics deal with the question of what ought to be or value
judgment.
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Practice
1.
A cut in wages will reduce the number of people who are willing to work.
2. High interest rates prohibit many young people from buying their first
home.
3. The government should reduce the number of minority members in the
military and increase the number of whites.
4. The government ought to supply a medical insurance scheme for everyone
free of charge.
5. The government ought to behave in such a way as to ensure that resources
are used efficiently.
6. Hong Kong government should increase its budget allocation to reduce the
number of illegal immigrants from China.
COMPARATIVE STATICS AND DYNAMICS
Equilibrium is a state of balance between opposing influences.
Comparative statics compares equilibrium positions when external conditions
change. Here we concentrate only equilibrium positions. We are not concerned
with how long it takes to achieve the equilibrium positions or by what channel
or path the equilibrium is achieved.
Dynamics is concerned with whether an economic system in disequilibrium
reaches an equilibrium position, how long it takes, and which path it follows to
do this.
SHORT RUN AND LONG RUN ANALYSIS
A short run is a time period during which consumers and producers have not
had enough time to make all the adjustments to the new situation. A long run is
a time period during which consumers and producers have had enough time to
make all the adjustments to the new situation.
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Consider a sudden increase in the oil price by OPEC.
The immediate impact: a sudden increase in the prices of refined oil and other
products that use oil.
After a while, consumers switch to fuel-efficient automobiles and appliances.
These adjustments reduce demand for oil, and lower the oil price.
How short is a short run and how long is a long run? This is a difficult question
to answer. It depends on the problem in question.
In the case of oil price increase by OPEC in 1973, Milton Friedman predicted a
decline in oil prices shortly thereafter. However, oil prices rose continuously
through the 1970s, and began to decline only in 1980. GM and Chrysler
Corporations thought that the oil price increase was temporary and resisted a
move to manufacture fuel-efficient cars. As a result, American auto
manufacturers lost a sizeable share to Japanese manufacturers.
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PARTIAL AND GENERAL EQUILIBRIUM ANALYSIS
Partial equilibrium analysis uses the ceteris paribus assumption. This is a
Latin phrase which means "other things being equal." In practice, other things
are never "equal" or remain the same. However, if the changes in the other
things are small, the ceteris paribus is a reasonable approximation.
Partial equilibrium analyses are used in two situations:
1. The first case is when we are interested in an event that affects only one
industry. An example is a labor strike which occurs only in one industry with
the impact on other industries almost negligible.
2. The second case is when we are concerned with first order effects, i.e., the
impact of an event only on one industry. The event may have impacts on other
industries, but these impacts may be outside the scope of the analysis or
interests. For instance, we may want to analyze the impact of an automobile
import quota. The primary effect is felt in the automobile industry. The auto
industry may ask an economist to study the impact on quota on automobile
prices. Obviously, such an import quota will have an impact on the steel
industry, the aluminum industry, the glass manufacturing industry, the
upholstery industry, etc. These effects are secondary or tertiary.
Partial equilibrium analysis was popularized by the English economist, Alfred
Marshall. (1842-1924) Most of the time, we use this approach. This approach
permits graphical analyses.
General Equilibrium analysis is concerned with the effects of a change (in
policy variable or exogenous conditions) after all sectors have made adjustment
to the new situation.
For instance, the import quota on automobiles will have impacts on gasoline,
steel, aluminum, glass, platinum, and other industries, and these in turn will
have further impacts on the auto industry.
Models
Economic analysis begins with models. What is a model? It is simply a
description of the economist's view of how the economy works.
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Economists generally build simple models and then gradually complicate them.
Why?
The modeler or the analyst has a finite mind, and cannot capture the reality
totally. He always looks at the real world from an angle.
The above picture shows wine production in a California winery. It has too
many details. While the picture may accurately describe the production activity
of a vineyard, it has too many unnecessary details that are not relevant to an
analysis at hand. Instead of five portraits of two sellers and three buyers in a
market, we may construct a sketch of such a market in the following diagram:
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The model must contain some essential aspects of the real world that need to be
analyzed. What are essential depends on the problem, i.e., they depend on the
purpose of the desired economic analysis.
However, since the real world is complicated, the economist's task of
constructing a simple model is not very simple.
In constructing a simple model, the economist has to make some "simplifying"
assumptions.
Examples:
No uncertainty
All consumers have the same tastes
One or two goods.
None of these assumptions are realistic. However, some aspects of reality are
irrelevant or negligible for the problem to be analyzed.
Some "unrealistic assumptions" are justified on the ground that they enable us
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to concentrate on the essential aspects of the problems while ignoring
irrelevant details.
A model is a simplified sketch of the real world. Economists favor simple
models because they are easier to understand, communicate and test with data.
There are two common criticisms:
(i) The model is oversimplified.
(2) Assumptions are unrealistic.
Remark 1: It is better to start with a simplified model, make sure that it is
working and predicts something, and then progressively complicate it.
Remark 2: Milton Friedman
To be important, a hypothesis must be descriptively false in its
assumptions.
Income Threshold Model
Hypothesis: Purchases of some durable consumption goods such as car, home
entertainment system, etc. are made only if household income exceeds a
threshold. For instance, Perloff notes that the income threshold for buying a car
is about $4,000. (These income thresholds depend on the durable goods in
question.)
Implication: As per capita income of developing country increases, suddenly
they will buy these durables. Thus, America should invest in those countries
whose per capita income approaches this threshold.
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