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 economic 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 frameworks for analyzing economic phenomena.

Three Key Economic Ideas

People Are Rational

Economists assume that people use all available information to achieve their goals and make decisions that maximize their benefit. Rationality does not mean perfection, but rather purposeful behavior.

• Rationality: Weighing costs and benefits to make optimal choices.

• Example: Apple sets iPhone prices to maximize profit, not randomly.

People Respond to Economic Incentives

Incentives influence behavior. When incentives change, so do the actions of individuals and firms.

• Incentives: Rewards or penalties that motivate behavior.

• Example: DNA submission requirements for felons reduced repeat offenses by 17%.

Optimal Decisions Are Made at the Margin

Most decisions involve doing a little more or a little less of something. Marginal analysis compares the additional benefit and cost of an action.

• Marginal Benefit (MB): Additional benefit from one more unit of activity.

• Marginal Cost (MC): Additional cost from one more unit of activity.

• Marginal Analysis: Comparing MB and MC to make decisions.

• Formula: $MB = \frac{\Delta \text{Total Benefit}}{\Delta \text{Quantity}}$ $MC = \frac{\Delta \text{Total Cost}}{\Delta \text{Quantity}}$

• Example: Deciding whether to study an extra hour or watch TV.

The Economic Problem That Every Society Must Solve

What Goods and Services Will Be Produced?

Societies must decide which goods and services to produce, given limited resources. This leads to trade-offs and opportunity costs.

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

• Opportunity Cost: The highest-valued alternative given up when making a choice.

• Example: Funding space exploration vs. cancer research.

How Will the Goods and Services Be Produced?

Firms choose production methods based on costs and available technology.

• Production Techniques: Labor-intensive vs. capital-intensive methods.

• Example: Using Auto-Tune for singers or relocating factories for cheaper labor.

Who Will Receive the Goods and Services Produced?

Distribution depends on income and government policies.

• Income Distribution: Higher incomes allow greater access to goods and services.

• Redistribution: Tax and welfare policies can alter distribution.

Centrally Planned Economies vs. Market Economies

Types of Economic Systems

• Centrally Planned Economy: Government decides resource allocation.

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

• Mixed Economy: Most decisions are market-based, but 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

Types of Efficiency

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

• Allocative Efficiency: Production matches consumer preferences; last unit's MB equals MC. $MB = MC$

Voluntary Exchange

Both buyers and sellers are better off after a transaction, promoting efficiency.

• Voluntary Exchange: Mutually beneficial transactions.

Caveats About Market Economies

• Markets may not always be fully efficient.

• Government intervention can affect outcomes.

• Externalities (e.g., pollution) may be ignored by markets.

Equity

Efficiency does not guarantee fairness. Equity refers to the fair distribution of economic benefits.

• Equity: Fairness in economic outcomes.

• Trade-off: Policies that increase equity may reduce efficiency.

• Example: Income taxes may reduce work incentives but fund social programs.

Economic Models

Steps in Building and Testing Economic Models

• Decide on assumptions.

• Formulate a testable hypothesis.

• Use data to test the hypothesis.

• Revise the model if necessary.

Role of Assumptions

• Assumptions simplify reality and focus on key relationships.

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

Positive vs. Normative Analysis

• Positive Analysis: Concerned with what is (facts).

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

• Economists primarily use positive analysis, but policy decisions often require normative analysis.

Microeconomics and Macroeconomics

Distinguishing Microeconomics and Macroeconomics

• Microeconomics: Study of individual households, firms, and markets.

• Macroeconomics: Study of the economy as a whole (inflation, unemployment, growth).

Microeconomic Issues	Macroeconomic Issues
How consumers react to price changes	Why economies experience recessions
How firms set prices	What determines inflation rate
Effect of AI on production costs	What determines exchange rates
Best policy to reduce opioid addiction	How government can reduce severity of recessions

Economic Skills and Economics as a Career

Skills Developed by Studying Economics

• Analyzing choices and consequences for individuals, firms, and governments.

• Forecasting demand, prices, and economic trends.

• Applying models to real-world problems.

Company/Organization	Role of Economist
Ford Motor Company	Forecast demand for electric cars
Goldman Sachs	Forecast interest rates
McDonald's	Analyze expansion decisions
Pharmaceutical Company	Analyze cost-benefit of treatments
Federal Reserve	Forecast employment and production trends

A Preview of Important Economic Terms

Key Terms

• Technology: Processes used to produce goods and services.

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

Appendix: Using Graphs and Formulas

Types of Graphs

• Bar Graphs: Compare quantities across categories.

• Pie Charts: Show proportions of a whole.

• Time-Series Graphs: Track variables over time.

• Scatter Plots: Show relationships between two variables.

Plotting Price and Quantity

Price is typically plotted on the vertical axis (y-axis), and quantity on the horizontal axis (x-axis). Each point represents a price-quantity combination.

Calculating Slope

• Slope of a Line: Measures the rate of change between two variables.

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

• Example: If price decreases from $14 to $12 and quantity increases from 55 to 65:$\text{Slope} = \frac{12 - 14}{65 - 55} = \frac{-2}{10} = -0.2$

Nonlinear Relationships

• Nonlinear curves have varying slopes at different points.

• Approximate slope by measuring the tangent at a specific point.

Percentage Change Formula

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

• Example: If GDP increases from $19,610$ billion to $20,018$ billion: $\frac{20,018 - 19,610}{19,610} \times 100 = 2.1\%$

Area Calculations in Economics

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

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

• Application: Total revenue is area of rectangle (price × quantity).

Summary of Using Formulas

• Understand the concept behind the formula.

• Use the correct formula for the problem.

• Check if the result is economically reasonable.