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 in economics, referring to the situation in which unlimited wants exceed the limited resources available to fulfill those wants.

• Scarcity: Unlimited wants vs. limited resources.

• Economics: The study of choices made under conditions of scarcity.

• Economic models: Simplified versions of reality used to analyze real-world economic situations.

Example: Apple manufactures iPhones in China despite designing them in the United States, illustrating choices made due to resource constraints and cost considerations.

Three Key Economic Ideas

Core Principles in Economic Thinking

Economists rely on three key ideas when analyzing markets and decision-making:

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

• People respond to economic incentives: Changes in incentives lead to changes in behavior. Even criminals respond to incentives, as shown by reduced repeat offenses when DNA collection policies are implemented.

• 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.

Example: Deciding whether to study for an extra hour or watch TV involves comparing the marginal benefit of improved grades to the marginal cost of lost leisure time.

The Economic Problem That Every Society Must Solve

Basic Economic Questions

Every society must answer three fundamental questions due to scarcity:

• What goods and services will be produced?

• How will the goods and services be produced?

• Who will receive the goods and services produced?

These questions lead to trade-offs, as producing more of one good means producing less of another.

• Trade-off: Sacrificing one good or service to produce more of another.

• Opportunity cost: The highest-valued alternative that must be given up to engage in an activity.

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

Methods of Production

• Firms can choose different production techniques based on costs and available resources (e.g., using more machines vs. more labor).

Distribution of Goods and Services

• In market economies, those with higher incomes typically receive more goods and services.

• Government policies (taxes, welfare) can redistribute income.

Types of Economic Systems

Centrally Planned vs. Market Economies

• Centrally planned economy: The government decides how resources are allocated.

• Market economy: Households and firms interacting in markets determine resource allocation.

• Mixed economy: Most decisions result from market interactions, but the government plays a significant role.

Additional info: The U.S. is best described as a mixed economy due to significant government intervention.

Efficiency and Equity in Market Economies

• Productive efficiency: Goods and services are produced at the lowest possible cost.

• Allocative efficiency: Production matches consumer preferences; the last unit provides a marginal benefit equal to its marginal cost.

• Voluntary exchange: Both buyer and seller are made better off by the transaction.

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

Example: Taxing income may reduce efficiency but can fund programs that promote equity.

Economic Models

Building and Testing Economic Models

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: Models simplify reality and make behavioral assumptions (e.g., consumers maximize well-being, firms maximize profit).

• Economic variable: A measurable quantity that can take different values (e.g., employment, price).

• Hypothesis: A statement about an economic variable that can be tested.

Example: The hypothesis that increased use of robots causes a decline in manufacturing employment must be tested with data.

Positive vs. Normative Analysis

• Positive analysis: Concerned with what is (objective, fact-based).

• Normative analysis: Concerned with what ought to be (subjective, value-based).

Example: Economists may discourage tariffs based on positive analysis, but policymakers may value certain groups more, reflecting normative judgments.

Microeconomics and Macroeconomics

Distinguishing the Fields

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

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

Microeconomic Issues	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 can reduce opioid addiction	What determines the inflation rate
Effect of AI on costs and employment	What determines the value of currency
Efficient ways to reduce air pollution	Whether government intervention can reduce recessions

Economic Skills and Economics as a Career

Applications and Career Paths

Studying economics develops analytical skills useful in various careers, including business, government, and academia. Economists forecast demand, analyze costs and benefits, interpret policy, and conduct research.

Company/Organization	Role of Economist
Ford Motor Company	Forecast demand for electric cars
Goldman Sachs	Forecast interest rates using models
Restaurant Chains	Analyze expansion decisions
Pharmaceutical Company	Analyze cost and benefits of treatments
Federal Reserve Bank	Forecast employment and production trends
Federal Trade Commission	Analyze competition and mergers

Additional info: Many CEOs and leaders majored in economics, and economics majors tend to have higher median wages, though causation vs. correlation is debated.

A Preview of Important Economic Terms

Key Terms in Economics

• Technology: The processes a firm uses to produce goods and services.

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

Pay close attention to definitions, as terms may differ from other disciplines.

Appendix: Using Graphs and Formulas

Graphical and Mathematical Tools in Economics

Graphs and formulas are essential for analyzing economic relationships. Common types include bar graphs, pie charts, and time-series graphs.

• Bar graph: Represents data using bars of different heights.

• Pie chart: Represents data as slices of a circle.

• Time-series graph: Shows how a variable changes over time.

• Plotting price and quantity: Price is typically on the vertical axis (y-axis), quantity on the horizontal axis (x-axis).

Calculating Slope: The slope of a line is the change in the value on the vertical axis divided by the change on the horizontal axis.

• Formula: $\text{Slope} = \frac{\text{Change in value on the vertical axis}}{\text{Change in value on the horizontal axis}}$

Percentage Change Formula:

• $\text{Percentage change} = \frac{\text{Value in the second period} - \text{Value in the first period}}{\text{Value in the first period}} \times 100$

Area Calculations:

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

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

Always ensure the formula used matches the economic concept and that results are reasonable.

Summary of Using Formulas

• Understand the concept the formula represents.

• Use the correct formula for the problem.

• Check that the result is economically reasonable.