Microeconomics: Foundations and Models – Chapter 1 Study Notes

Economics: Foundations and Models

Introduction to Economics

Economics is the study of how individuals, firms, and societies make choices to attain their goals, given their scarce resources. Scarcity is a fundamental concept, referring to the situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economists use models—simplified versions of reality—to analyze real-world economic situations.

• Scarcity: Unlimited wants vs. limited resources.

• Economics: Study of choices under scarcity.

• Economic Models: Simplified representations used for analysis.

Three Key Economic Ideas

Three foundational ideas guide economic analysis: rationality, incentives, and marginal decision-making.

• People are rational: Individuals use all available information to achieve their goals, weighing costs and benefits to make optimal decisions.

• People respond to economic incentives: Changes in incentives alter behavior. For example, policies or rewards can influence choices.

• Optimal decisions are made at the margin: Most decisions involve doing a little more or less of something. Marginal analysis compares the additional benefit (marginal benefit, MB) and additional cost (marginal cost, MC) of an action.

Marginal Analysis Formula:

$\text{Optimal decision:}\ \text{Take action if}\ MB \geq MC$

The Economic Problem That Every Society Must Solve

Every society must answer three fundamental questions due to scarcity:

1. What goods and services will be produced? Choices must be made about resource allocation, leading to trade-offs.

2. How will the goods and services be produced? Firms decide on production methods, balancing costs and efficiency.

3. Who will receive the goods and services produced? Distribution depends on income, government policies, and societal values.

• Trade-off: Producing more of one good means producing less of another.

• Opportunity cost: The highest-valued alternative forgone when a choice is made.

Example: Funding space exploration may mean less funding for cancer research.

Types of Economies

Societies organize their economies in different ways:

• Centrally planned economy: Government decides resource allocation.

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

• Mixed economy: Most decisions are made in markets, but government plays a significant role.

Additional info: The U.S. is best described as a mixed economy, with both market forces and government intervention.

Efficiency and Equity in Market Economies

Market economies are generally more efficient than centrally planned ones, but efficiency does not always mean equity.

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

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

• Voluntary exchange: Transactions make both buyer and seller better off.

• Equity: Fair distribution of economic benefits, which may conflict with efficiency.

Example: Taxing income may reduce efficiency but can fund programs for the poor, increasing equity.

Economic Models and Scientific Method

Economists use models to analyze and predict economic events and policies. The process involves:

1. Deciding on assumptions.

2. Formulating a testable hypothesis.

3. Using data to test the hypothesis.

4. Revising the model if necessary.

• Assumptions: Simplify reality; e.g., consumers maximize well-being, firms maximize profit.

• Economic variable: Measurable quantity that can change (e.g., employment, price).

Types of Analysis:

• Positive analysis: Concerned with what is (facts, cause-effect).

• Normative analysis: Concerned with what ought to be (value judgments).

Microeconomics vs. Macroeconomics

Economics is divided into two main branches:

• Microeconomics: Study of how households and firms make choices, interact in markets, and how government influences these choices.

• Macroeconomics: Study of the economy as a whole, including inflation, unemployment, and economic growth.

Examples of Microeconomic Issues	Examples of Macroeconomic Issues
How consumers react to changes in product prices	Why economies experience recessions and unemployment
How firms decide what prices to charge	Why some economies grow faster than others
Which government policy best reduces opioid addiction	What determines the inflation rate
Effect of AI on costs and employment in industries	What determines currency exchange rates

Economic Skills and Careers

Studying economics develops analytical skills valuable in many careers, including business, government, and research.

• Forecasting demand and market trends

• Analyzing costs and benefits of decisions

• Interpreting policy impacts

Company/Organization	Role of Economist
Ford Motor Company	Forecast demand for electric cars
Goldman Sachs	Forecast interest rates using models
Federal Reserve Bank	Forecast employment and production trends
Federal Trade Commission	Analyze competition and mergers

Additional info: Many CEOs and leaders have economics backgrounds, which may correlate with higher incomes, though causation is debated.

Important Economic Terms

Economics uses specific terminology. Key terms include:

• 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.

• Bar graphs and pie charts: Show market shares and proportions.

• Time-series graphs: Track variables over time.

• Plotting price and quantity: Visualizes demand and supply relationships.

• Slope calculation: Measures rate of change between variables.

Slope Formula:

$\text{Slope} = \frac{\text{Change in value on vertical axis}}{\text{Change in value on horizontal axis}}$

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 of Rectangle (Total Revenue):

$\text{Area} = \text{Base} \times \text{Height}$ $\text{Total Revenue} = \text{Quantity} \times \text{Price}$

Area of Triangle:

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

Additional info: Nonlinear relationships have varying slopes; use tangent lines for slope at a point.

Summary: Using Formulas

• Understand the concept behind the formula.

• Use the correct formula for the problem.

• Check if the result is economically reasonable.