Microeconomics Chapter 1: Foundations and Models – Study Notes

Economics: Foundations and Models

1.1 Three Key Economic Ideas

This section introduces the foundational assumptions of economic analysis, focusing on how individuals and firms make decisions in the context of scarcity.

• People Are Rational: Economists assume individuals use all available information to achieve their goals, weighing costs and benefits to make optimal decisions. Example: A company like Apple sets prices to maximize profit, not at random.

• People Respond to Economic Incentives: Changes in incentives alter behavior. Even unintended consequences can arise from policy changes. Example: DNA collection for felons reduced repeat offenses by 17% because the risk of being caught increased.

• Optimal Decisions Are Made at the Margin: Most choices involve incremental adjustments. Marginal analysis compares the additional benefit (marginal benefit, MB) and additional cost (marginal cost, MC) of an action. Example: Deciding whether to study an extra hour or watch TV involves comparing the marginal benefit of studying to its marginal cost.

1.2 The Economic Problem That Every Society Must Solve

Scarcity forces societies to make choices about resource allocation, leading to three fundamental economic questions.

• What Goods and Services Will Be Produced? Due to limited resources, producing more of one good means producing less of another. The opportunity cost is the value of the next-best alternative forgone. Example: Funding space exploration may mean less funding for cancer research.

• How Will the Goods and Services Be Produced? Firms choose production methods based on costs and available technology. Example: A music producer may use either a skilled singer or technology like Auto-Tune; a manufacturer may automate or relocate to reduce labor costs.

• Who Will Receive the Goods and Services Produced? Distribution is often based on income, but government policies (taxes, welfare) can alter this distribution.

Centrally Planned vs. Market Economies

• Centrally Planned Economy: The government decides resource allocation.

• Market Economy: Households and firms interact in markets to allocate resources.

• Mixed Economy: Most modern economies, including the U.S., combine market mechanisms with significant government intervention.

Efficiency and Equity

• Productive Efficiency: Goods/services produced at lowest cost.

• Allocative Efficiency: Production matches consumer preferences; last unit provides MB = MC.

• Voluntary Exchange: Both buyer and seller are better off after a transaction.

• Equity: Fair distribution of economic benefits. There is often a trade-off between efficiency and equity. Example: Taxes may reduce efficiency but increase equity by funding social programs.

1.3 Economic Models

Economists use models—simplified representations of reality—to analyze economic issues and predict outcomes.

• Steps in Building a Model:

  1. Decide on assumptions.

  2. Formulate a testable hypothesis.

  3. Use data to test the hypothesis.

  4. Revise the model if necessary.

  5. Retain the revised model for future analysis.

• Behavioral Assumptions: Consumers maximize well-being; firms maximize profit.

• Economic Variable: A measurable quantity that can change (e.g., employment, price).

• Positive vs. Normative Analysis:

  • Positive Analysis: Describes what is (objective, testable).

  • Normative Analysis: Describes what ought to be (subjective, value-based).

1.4 Microeconomics and Macroeconomics

Economics is divided into two main branches:

• Microeconomics: Studies individual households, firms, and markets; focuses on choices and interactions.

• Macroeconomics: Studies the economy as a whole; focuses on aggregate variables like inflation, unemployment, and growth.

1.5 Economic Skills and Economics as a Career

Studying economics develops analytical and decision-making skills valuable in many careers. Economists analyze choices, predict consequences, and advise on optimal decisions.

• Career Applications: Economists work in business, government, and non-profits, applying cost-benefit analysis and data interpretation.

• Income: Economics majors often have higher median incomes, though causation vs. correlation is debated.

1.6 A Preview of Important Economic Terms

Economics uses specific terminology with precise meanings. Key terms include:

• Scarcity: Unlimited wants vs. limited resources.

• Opportunity Cost: Value of the next-best alternative forgone.

• Technology: Processes used to produce goods/services.

• Capital: Manufactured goods used to produce other goods/services.

Appendix: Using Graphs and Formulas

Graphs and formulas are essential tools for analyzing economic relationships and data.

• Types of Graphs: Bar graphs, pie charts, time-series graphs, and scatter plots illustrate data and relationships.

• Plotting Variables: Price and quantity are commonly plotted to show demand and supply relationships.

• Slope Calculation: The slope of a line is calculated as: $\text{Slope} = \frac{\text{Change in y}}{\text{Change in x}}$

• Percentage Change Formula: $\text{Percentage Change} = \frac{\text{Value in Second Period} - \text{Value in First Period}}{\text{Value in First Period}} \times 100$

• Area Calculations:

  • Rectangle: $\text{Area} = \text{Base} \times \text{Height}$

  • Triangle: $\text{Area} = \frac{1}{2} \times \text{Base} \times \text{Height}$

• Linear vs. Nonlinear Relationships: Most economic relationships are nonlinear, but linear approximations are often used for simplicity.

Term	Definition
Scarcity	Unlimited wants exceed limited resources
Opportunity Cost	Value of the next-best alternative forgone
Productive Efficiency	Goods/services produced at lowest cost
Allocative Efficiency	Production matches consumer preferences (MB = MC)
Voluntary Exchange	Both buyer and seller are better off after a transaction
Equity	Fair distribution of economic benefits
Microeconomics	Study of individual markets and agents
Macroeconomics	Study of the economy as a whole

Additional info: These notes expand on the provided slides and text, offering definitions, examples, and formulas to ensure a comprehensive understanding of foundational microeconomic concepts.