Introduction to Microeconomics: Principles, Methods, and Mathematical Tools

What Is Economics?

Definition and Scope of Economics

Economics is the study of how agents make choices among scarce resources and how those choices affect society. The field is much broader than just money; it encompasses all decisions involving trade-offs due to limited resources.

• Economic Agent: Any group or individual that makes choices, such as consumers, firms, parents, or politicians.

• Scarcity: Resources are limited relative to what people want, necessitating choices.

• Choice: Because we cannot have everything, we must make decisions about what to pursue.

• Trade-offs: Choosing one thing means giving up something else.

Key Point: The unifying feature of economics is choice, not money.

Why Study Economics?

Studying economics equips individuals with the ability to use economic reasoning and real-world data to make better decisions. This skill set is valuable in various fields, including business, consulting, finance, data analytics, government, policy, nonprofits, graduate school, and research.

Microeconomics vs. Macroeconomics

Economics is divided into two main branches:

• Microeconomics: The study of how individuals, firms, and governments make choices. Example questions include: How do consumers respond to price changes? Why do workers earn different wages?

• Macroeconomics: The study of the economy as a whole. Example questions include: Why does unemployment rise? What causes inflation?

This course focuses on microeconomics.

Positive vs. Normative Economics

• Positive Economics: Describes or explains what is. Example: A higher gasoline price reduces the quantity of gasoline consumers purchase.

• Normative Economics: Recommends what should be. Example: The government should increase the gasoline tax.

Economic analysis can inform policy debates without deciding values for us.

Three Big Ideas in Economics

Optimization, Equilibrium, and Empiricism

• Optimization: Making the best choice possible given available information and constraints.

• Equilibrium: A situation where choices interact such that no one would benefit from changing behavior, given what others are doing.

• Empiricism: Using data to evaluate economic ideas and answer real-world questions.

Optimization and Trade-offs

Optimization involves making the best possible choice with the information at hand. Every choice involves trade-offs, as selecting one option means forgoing others.

• Example: If you have one free hour, you might choose to study, sleep, exercise, watch Netflix, or spend time with friends. Whatever you choose, you give up something else.

Opportunity Cost

Definition: Opportunity cost is the best alternative use of a resource. It represents the value of the next best option foregone when a choice is made.

• Example: If you spend an hour watching Netflix, your opportunity cost is what you could have done instead, such as studying or working.

Is Social Media Free?

Even if a service has a zero-dollar price, it still has an opportunity cost. For example, if the opportunity cost of time is $13/hour and you spend one hour per day on social media, the annual opportunity cost is:

$1 \text{ hour/day} \times 365 \text{ days} \times \$13 = \$4,745$

This illustrates that time spent on 'free' activities can have significant economic costs.

Economics as a Science

The Scientific Method in Economics

Economists use the scientific method to answer real-world questions. The process involves:

• Model: Developing a simplified explanation of some part of the world.

• Evidence: Using data to evaluate whether the model’s predictions match observations.

Models provide predictions, and data help evaluate their accuracy.

What Is a Model?

Definition: A model is a simplified description of reality. It does not need to capture every detail to be useful; what matters is whether it generates useful predictions that can be tested with data.

• Example: An economist might build a model predicting how students respond to higher coffee prices, considering only price and income, while ignoring other factors like taste or sleep habits. The model can still be useful if it makes accurate predictions.

An Economic Model: Return to Education

Suppose a model assumes that one more year of education results in a 10% increase in future earnings. If a high school graduate earns $15/hour:

• 1 more year: $15 \times 1.10 = $16.50

• 4 more years: $15 \times (1.10)^4 = $21.97

The predicted percentage increase in earnings is:

$\frac{21.97 - 15}{15} \times 100 \approx 46.5\%$

Comparing Model Predictions with Evidence

Empirical data show that college graduates earn about $55,660, while high school graduates earn about $35,620. The observed percentage difference is:

$\frac{55,660 - 35,620}{35,620} \times 100 \approx 56\%$

While the model's prediction is close, this does not prove causation; other factors may be involved.

Correlation vs. Causation

• Correlation: Two variables are related or move together.

• Causation: Changing one variable directly produces a change in another.

Just because college graduates earn more does not mean college caused the earnings difference. Other factors may be at play.

Why Correlation May Not Be Causation

• Omitted Variable: A missing factor affects both variables, creating a misleading relationship. Example: Hot weather increases both ice cream sales and sunburns.

• Reverse Causality: Cause and effect may run in the opposite direction. Example: Does more police presence cause more crime, or does more crime lead to more police?

Identifying Causation: Randomized Controlled Trials (RCTs)

To identify causation, economists compare two groups that are similar except for one factor (the treatment). In an RCT, participants are randomly assigned to treatment or control groups, making it more credible to attribute differences to the treatment.

Math Review for Economics

Reading Graphs and Data

Economists use graphs to visualize data and relationships. A time series graph shows how a variable changes over time, helping to identify trends.

Mathematical Functions

A function describes the relationship between an input (x) and an output (y). A linear function takes the form:

$y = mx + b$

• b: Intercept (value of y when x = 0)

• m: Slope (how much y changes when x increases by one unit)

Slope

The slope of a line is calculated as:

$m = \frac{\Delta y}{\Delta x}$

• Positive slope (m > 0): x and y move in the same direction.

• Negative slope (m < 0): x and y move in opposite directions.

• Zero slope (m = 0): y does not change as x changes.

Example: For points (2, 17) and (6, 23):

$m = \frac{23 - 17}{6 - 2} = \frac{6}{4} = 1.5$

Areas Used in Economics

Economists use geometric areas to measure concepts like consumer surplus, producer surplus, and deadweight loss. Common area formulas include:

• Rectangle: $A = bh$

• Triangle: $A = \frac{1}{2}bh$

• Parallelogram: $A = bh$

• Trapezoid: $A = \frac{1}{2}(b_1 + b_2)h$

Example: A triangle with base 8 and height 6 has area:

$A = \frac{1}{2}(8)(6) = 24$

Percentage Change

Changes over time are often expressed as a percentage change or growth rate:

$\%\Delta x = \frac{\text{Final Value} - \text{Initial Value}}{\text{Initial Value}} \times 100$

• Example: If a textbook price falls from $120 to $90:

$\frac{90 - 120}{120} \times 100 = -25\%$

The negative sign indicates a decrease.

Key Takeaways

• Economics is the study of choices under scarcity and their effects on society.

• Economists use the concepts of optimization, equilibrium, and empiricism.

• Models are used to generate predictions, and data are used to evaluate them.

• Correlation does not imply causation; omitted variables and reverse causality are important considerations.

• A small mathematical toolkit—graphs, functions, slopes, areas, and percentage changes—is essential for economic analysis.