323ec01 preliminaries

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Chapter 1

Preliminaries


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2005 Pearson Education, Inc. Chapter 1 2

Introduction

Review basic terminologies,methodologies, and key assumptionsimposed in microeconomic theory.

What is economics?

What is microeconomics?

What are theories and models?

What is positive and normative analysis?What is the difference between real and

nominal prices


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Themes of Economics

Economics studies economic phenomena andthe economic behavior of individual agents ---consumers, workers, firms, government, and

other economic units as well as how they makechoices so that limited resources are allocatedamong competing uses.

A fundamental assumption on individualbehavior is that an individual is rational (i.e.,

self-interested).

Because resources are limited, but people'sdesires are unlimited, we need economics tostudy this fundamental conflict.


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Four Basic Questions to be

Answered by Any Institution:

What goods and services should beproduced and in what quantity?

How should the product be produced?

For whom should it be produced andhow should it be distributed?

Who makes the decision?

The answers depend on economicinstitutions.


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Two basic economic institutions

used in the real world:

Market economic institution:

Most decisions on economic activities are

made by individuals, it is mainly adecentralized decision system.

Planning economic institution:

Most decisions on economic activities are

made by government, it is mainly acentralized decision system.


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Themes of Modern Economics

The market economy has been proved to beonly economic institution so far that can keep aneconomy with sustainable development and

growth. It is the most important economic institution

discovered for reaching cooperation and solvingthe conflicts among individuals.

Modern economics studies various economicphenomena and behavior under marketeconomic environment by using an analyticalapproach such the demand and supply model.


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Themes of Microeconomics

Microeconomics: Branch of economics

that deals with the behavior of individuals

-- workers, firms and consumers as wellas how markets are organized

It deals with limits:Limited budgets;

Limited time; Limited ability to produce

How do we allocate these limited

resources?


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Workers, firms and consumers must

make trade-offs

Do I work or go on vacation? Do I purchase a new car or save my money?

Do we hire more workers or buy new

machinery?

How are these trade-offs best made?


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Consumers

Limited incomes

Consumer theory describes howconsumers maximize their well-being, using

their preferences, to make decisions about

trade-offs.

How do consumers make decisions aboutconsumption and savings?


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Workers Individuals decide when and if to enter the

work-force

Trade-offs of working now or obtaining moreeducation/training

What choices do individuals make in terms ofjobs or work places?

How many hours do individuals choose towork?

Trade-off of labor and leisure


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Firms

What types of products do firms produce?

Constraints on production capacity & financialresources create needs for trade-offs.

Theory of the Firm describes how these

trade-offs are best made


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Prices

How are prices determined?

Centrally planned economies -governmentscontrol prices

Market economies prices determined by

interaction of market participants

Markets collection of buyers and sellers

whose interaction determines the prices ofgoods.


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Theories and Models

Economic theories are used to explain

observed economic phenomena in terms of a

set of basic rules and assumptions.

The Theory of the Firm

The Theory ofConsumer Behavior

The Theory ofMarkets

Theories are used to make predictions

Economic models are created from theories

Models are mathematical representations used to

make quantitative predictions


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Theories and Models

Validating a Theory

The validity of a theory is determined by the

quality of its prediction, given theassumptions.

Theories must be tested and refined

Theories are invariably imperfect but gives

much insight into observed phenomena


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Positive & Normative Analysis

Positive Analysis statements that

describe the relationship of cause and

effect Questions that deal with explanation and

prediction

What will be the impact of an import quota on

foreign cars?

What will be the impact of an increase in the

gasoline excise tax?


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Positive & Normative Analysis

Normative Analysis analysis examining

questions of what ought to be

Often supplemented by value judgments Should the government impose a larger

gasoline tax?

Should the government decrease the tariffs on

imported cars?


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What is a Market?

Markets

Collection of buyers and sellers, through their

actual or potential interaction, determine theprices of products

Buyers: consumers purchase goods,

companies purchase labor and inputs

Sellers: consumers sell labor, resource owners

sell inputs, firms sell goods


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What is a Market?

Defining the Market

Many of the most interesting questions in

economics concern the functioning ofmarkets

Why are there a lot of firms in some markets

and not in others?

Are consumers better off with many firms?

Should the government intervene in markets?


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Types of Markets

Perfectly competitive markets

Because of the large number of buyers and

sellers, no individual buyer or seller caninfluence the price.

Example: Most agricultural markets

Fierce competition among firms can create a

competitive market


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Types of Markets

Noncompetitive Markets

Markets where individual producers can

influence the price. Cartel groups of producers who act

collectively

Example: OPEC dominates with world oil

market


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Real Versus Nominal Prices

Comparing prices across time required

measuring prices relative to some overall

price level Nominal price is the absolute or current dollar

price of a good or service when it is sold.

Real price is the price relative to an

aggregate measure of prices or constantdollar price.


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Consumer Price Index (CPI) often used

as a measure of aggregate prices.

Records the prices of a large market basketof goods purchased by a typical consumer

over time

Percent changes in CPI measure the rate of

inflation


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Calculating Real Prices

yearcurrent

yearcurrent

yearbasePriceNominalx

CPI

CPIRealPrice !

!100baseyear


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Real Price of College

Year Nom.

Price

CPI Real Price

1970 $2,530 38.8

1990 $12,018 130.7

2002 $18,273 181.0

$3,569$12,018*130.7

38.8!!

$3,$18, 3*181.

38.8!!

$2,530$2,530*38.8

38.8!!


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Real Price ofWages

Observations

The minimum wage has been increasing in

nominal terms since1940

. From 1930 at $0.25 to 2003 at $5.15

The 1999 real minimum wage was no higher

in 1999 than 1950.


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The Minimum Wage:Figure 1.1


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Why Study Microeconomics?

Microeconomic concepts can be used to

assist everyone in making choices as

consumers and producers.Examples show the numerous levels of

microeconomic questions necessary in

many decisions


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Ford SUVs

Built Ford Explorer in 1991, Ford

Expedition in 1997 and the Ford

Excursion in 1999 In each of these cases, Ford had to

consider many aspects of the economy

to ensure their introduction was a sound

investment


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Ford SUVs

Questions

How strong in demand and how quickly will it grow?

Must understand consumer preferences and trade-

offs What are the costs of manufacturing

Given all costs of production, how many should be

produced each year?

Risk analysis

Uncertainty of future prices: gas, wages

Ford had to develop pricing strategy and determine

competitors reactions?


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Emission Standards

1970Clean Air Act imposed emissions

standards and have become increasingly

stringent Questions

What are the impacts on consumers?

What are the impacts on producers?

How should the standards be enforced? What are the benefits and costs?

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