BackMicroeconomics Chapter 1: Foundations and Models – Study Notes
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Economics: Foundations and Models
Introduction to Economics
Economics is the study of how individuals and societies allocate scarce resources to satisfy unlimited wants. Scarcity is a fundamental concept, driving the need for choices and trade-offs in every economy.
Scarcity: A situation in which unlimited wants exceed the limited resources available to fulfill those wants.
Economics: The study of the choices people make to attain their goals, given their scarce resources.
Three Key Economic Ideas
People are Rational
Economists generally assume that individuals act rationally, making decisions that they believe will maximize their happiness or utility.
Rationality: People make choices based on what they believe will make them better off, weighing costs and benefits.
Example: Deciding whether to watch a movie at Cineplex involves considering the cost and the expected enjoyment.
Note: Rationality does not mean perfection; people can make mistakes due to imperfect information or cognitive biases.
People Respond to Incentives
Changes in costs and benefits influence people's actions. Incentives are crucial in shaping economic behavior.
Incentives: Rewards or penalties that motivate behavior.
Example: If the cost of repairing a car decreases, the owner is more likely to repair it before selling.
Application: Policy makers use incentives (such as taxes or subsidies) to influence economic outcomes.
People Make Decisions at the Margin
Most decisions involve incremental changes, known as marginal analysis. Individuals compare the additional (marginal) benefits and costs of a little more or less of something.
Marginal Cost (MC): The additional cost associated with a small extra amount of an action.
Marginal Benefit (MB): The additional benefit from a small extra amount of an action.
Marginal Analysis: Comparing MC and MB to make optimal decisions.
Example: Deciding whether to watch an extra hour of TV or study instead.
The Economic Problems All Societies Must Solve
What Goods and Services Will Be Produced?
Societies must decide which goods and services to produce, given limited resources. Producing more of one good means producing less of another, leading to trade-offs.
Trade-off: Sacrificing one good or service to produce more of another.
Opportunity Cost: The value of the best alternative forgone when a choice is made.
Example: Increased funding for health care may mean fewer university scholarships.
How Will the Goods and Services Be Produced?
There are often multiple methods for producing goods and services. The choice depends on resource costs and technology.
Production Techniques: Firms may choose between labor-intensive and capital-intensive methods.
Example: A music producer can use a great singer or rely on technology like Auto-Tune for a mediocre singer.
Application: Firms may relocate production to areas with cheaper labor or invest in machinery to reduce costs.
Who Will Receive the Goods and Services?
Distribution depends largely on income. Those with higher incomes can afford more goods and services. Governments can influence distribution through taxation and transfers.
Income Distribution: Determines who can purchase goods and services.
Government Role: Taxation and transfer payments can redistribute income.
Types of Economic Systems
Centrally Planned Economies vs. Market Economies
Economic systems differ in how decisions are made regarding resource allocation.
Centrally Planned Economy: The government decides how resources are allocated.
Market Economy: Households and firms interact in markets to allocate resources.
Mixed Economy: Most decisions result from market interactions, but the government plays a significant role.
Example: Canada is a mixed economy; hospitals are centrally planned, while fast food is market-driven.
Efficiency and Equity
Market economies tend to be more efficient than centrally planned economies, but equity (fairness) is also an important goal.
Productive Efficiency: Goods and services are produced at the lowest possible cost.
Allocative Efficiency: Production matches consumer preferences; every good is produced up to the point where the last unit provides marginal benefit equal to marginal cost.
Voluntary Exchange: Both buyer and seller are better off after a transaction.
Equity: The fair distribution of economic benefits.
Note: Markets may not always be fully efficient due to externalities, government intervention, or imperfect information.
Economic Models
Developing and Testing Economic Models
Economists use models to analyze real-world issues. Models simplify reality to focus on essential relationships.
Steps in Model Building:
Decide on assumptions.
Formulate a testable hypothesis.
Use data to test the hypothesis.
Revise the model if necessary.
Retain the revised model for future analysis.
Assumptions: Simplify complex reality to make models useful.
Hypothesis Testing: Models generate predictions that can be verified or disproven using data.
Economic Variable: Something measurable that can take different values (e.g., income).
Scientific Nature of Economics
Economics uses the scientific method but remains a social science, often influenced by value judgments.
Positive Analysis: Based on facts and logic.
Normative Analysis: Based on value judgments (uses words like "should" or "ought").
Note: Economics strives to focus on positive analysis.
Microeconomics and Macroeconomics
Distinguishing Microeconomics from Macroeconomics
Economics is divided into two main branches: microeconomics and macroeconomics.
Microeconomics: The study of how households and firms make choices, interact in markets, and how governments influence these choices.
Macroeconomics: The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.
The Language of Economics
Key Economic Terms
Economics uses specific terminology with precise meanings. Understanding these terms is essential for clear communication.
Technology: The processes a firm uses to turn inputs into outputs of goods and services.
Capital: Durable manufactured goods used to produce other goods and services.
Note: Pay close attention to definitions provided in class and textbooks.
Common Misconceptions
Economics is not only about money.
Do not confuse positive and normative analysis.
Do not assume familiar meanings for economic terms; always check definitions.
Appendix: Using Graphs and Formulas
Graphs in Economics
Graphs are essential tools for visualizing economic relationships. Common types include bar graphs, pie charts, and time-series graphs.
Bar Graphs: Show market share or other data using the height of bars.
Pie Charts: Represent data as slices of a circle, showing proportions.
Time-Series Graphs: Display data over time, useful for identifying trends.
Plotting Economic Data
Economic variables such as price and quantity are often plotted on two-dimensional grids, with price on the vertical axis and quantity on the horizontal axis.
Example: Plotting the price and quantity of pizza sold to illustrate their relationship.
Calculating Slope
The slope of a line on a graph measures the rate of change between two variables.
Formula:
Example: If the price of pizza decreases from 12 and quantity demanded increases from 55 to 65, the slope is:
Linear and Non-Linear Relationships
Linear relationships can be represented by straight lines, while non-linear relationships require curves. The slope of a non-linear curve varies at different points and can be measured using tangent lines.
Percentage Change Formula
Percentage change is used to measure the change in an economic variable over time.
Calculating Area for Economic Analysis
Rectangle (Total Revenue): Area = Base × Height
Formula:
Triangle (Consumer/Producer Surplus): Area = ½ × Base × Height
Formula:
Best Practices for Using Formulas
Understand the economic concept the formula represents.
Use the correct formula for the problem.
Check that the calculated result is economically reasonable.
