Pi-Han Christine Tsai 0

Week 1
§ Microeconomics is the study of how individuals and firms make
themselves as well off as possible in a world of scarcity, and the
consequences of those individual decisions for markets and the
entire economy.
§ We examine how individual consumers and firms make
decisions and how the interaction of many individual decisions
affects markets.
§ Microeconomics is also often called price theory,
demonstrating the important role that prices play in
determining market outcomes.

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§ Microeconomics is concerned with the behavior of individual
entities such as markets, firms, and household.
★Adam Smith, The Wealth of Nations,1776.
§ Macroeconomics is concerned with the overall performance of
economy.
★John Maynard Keynes, General Theory of Employment, Interest and
Money ,1935.

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1. Microeconomics: the application of scarce resources
Microeconomics is the study of the allocation of scarce
resources
2. Models
Economists use models to make testable predictions
3. Uses of Microeconomic models
Individuals, governments, and firms use microeconomic
models and predictions in decision making

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§ Scarcity implies trade-offs.
§ Which goods and services to produce?
§ Because resources are limited
§ How to produce?
§ To produce a given level of output, a firm must use more of
one input if it uses less of another input.
§ Who gets to consume the goods and services?
§ The more you get, the less someone else gets.
§ Who makes the decisions?
§ Individuals (consumers)
§ Firms
§ Government

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§ Prices determine resource allocation
§ Prices link the decisions about which goods and services to
produce, how to produce them, and who gets them.
§ Prices answer these important questions by influencing decision-
makers.
§ Markets
§ Prices of goods and services are determined in a market.
§ A market is where interactions between consumers, firms, and the
government occur.
§ We concern how prices are determined within a market.
§ The organization of the market, especially the number of buyers
and sellers in the market and the amount of information they have,
helps determine whether the price equals the cost of production.
§ In the absence of a market, serious problems, such as high pollution
levels, result.
§ Many government actions affect prices and hence the allocation
decisions.
§ French bonus-malus (reward-penalty) incentive system
§ Twinkie tax
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§ 2008 Vehicle Incentive System: subsidize low CO2 emission
vehicles and penalize high emission vehicles.
§ Purpose: to reduce emissions of CO2, the main greenhouse gas.

§ Effect:
§ Which vehicles are produced, as manufacturers offer new
environmentally friendly model.
§ How vehicles are produced, as manufacturers reformulate
their cars to meet the new standards.
§ Who gets these vehicles as consumers, as consumers look
for relatively inexpensive, non-penalized or subsidized
vehicles.

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§ Twinkie tax: a tax on unhealthful fatty and sweet foods or a tax
on sugary soft drinks
§ Purpose: to reduce obesity and cholesterol problems,
particularly among children
§ Effect:
§ Which foods are produced, as firms may offer new low-fat
and low-sugar products
§ How fast-foods are produced, as manufacturers reformulate
their products to lower their tax burden
§ Who gets these goods, as consumers replace them with less
expensive and untaxed products

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§ Economists use a model to explain how individuals and firms
allocate resources and how market prices are determined.
§ A model is a description of the relationship between two or
more economic variables.
§ Understanding this relationship allows economists to
predict how a change in one variable will affect another
variable.
§ Economic models:
§ have assumptions that simplify things relative to the real
world
§ make theoretical predictions that we can test empirically
§ involve maximizing something (e.g. consumer satisfaction,
firm profits) subject to resource constraints
§ are used to make positive rather than normative
statements
§ The truth of a positive statement can be tested.
§ A normative statement contains a value judgment that
can’t be tested. 8
§ A testable hypothesis about matters of fact such as cause-and-
effect relations.
§ “Positive” does not mean that we are certain about the truth of
our statement; it indicates only that we can test whether it is true.
§ Research Methods
§ Experimental Study (randomized study): the subjects are
randomly assigned to either the treatment group or the control
group.
§ Observational Study: Use data obtained by observing and
measuring actual behavior outside of an experimental setting.
§ Quasi-experimental study (natural experiments): identify
situations in which outside circumstances in effect randomly
assign people to control and treatment groups.

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§ A normative statement is a conclusion as to whether something
is good or bad.
§ Cannot be tested because a value judgement cannot be
refuted by evidence.
§ It is a prescription rather than a prediction.

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IDENTIFYING POSITIVE VS. NORMATIVE
Which of these statements are “positive” and which are
“normative”? How can you tell the difference?
a. Prices rise when the government increases the quantity of
money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of burritos will cause an increase
in consumer demand for music downloads.

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§ Predicting individual decisions
§ How does inflation affect the decision whether to rent an
apartment? (Ch. 4)
§ Is going to college a good investment? (Ch. 15)
§ Should a homeowner purchase insurance? (Ch. 16)
§ Should you pay a lawyer by the hour or as a percentage of
winnings? (Ch. 19)

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§ Predicting government decisions
§ What is the impact of a new tax on tax revenues raised? (Ch.
2)
§ What is the effect of trade policies such as tariffs on markets?
(Ch. 9)
§ What are the effects on collusion of governments posting the
results of bidding? (Ch. 14)
§ How can governments use economics to reduce global
warming? (Ch. 17)

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§ Predicting firm decisions
§ Does price discrimination increase a firm’s profits? (Ch. 12)
§ Using game theory to analyze, what are firms’ strategic
decisions concerning pricing, advertising, quantities, and
whether to enter a market? (Ch. 13)
§ How do American Airlines and United Airlines compete on
the Chicago-Los Angeles route? (Ch. 14)
§ How does a mining company’s extraction decision depend
on interest rates? (Ch. 15)
§ Does a firm offer employees deferred payments to ensure
they work hard? (Ch. 19)

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The principles of HOW PEOPLE MAKE DECISIONS:
§ 1. People Face Tradeoffs:
§ Society faces an important tradeoff:
efficiency vs. equality
§ Efficiency: when society gets the most from its scarce
resources
§ Equality: when prosperity is distributed uniformly among
society’s members
§ Tradeoff: To achieve greater equality, could redistribute
income from wealthy to poor. But this reduces incentive to
work and produce, shrinks the size of the economic “pie.”

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§ 2. The Cost of Something Is What You Give Up to Get It
§ Making decisions requires comparing the costs and benefits
of alternative choices.
§ The opportunity cost of any item is whatever must be given
up to obtain it.
§ It is the relevant cost for decision making.

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§ 3. Rational People Think at the Margin
§ Rational people
§ systematically and purposefully do the best they can to
achieve their objectives.
§ make decisions by evaluating costs and benefits of
marginal changes, incremental adjustments to an
existing plan.
§ Examples:
§ When a student considers whether to go to college for an
additional year, he compares the fees & foregone wages to
the extra income he could earn with the extra year of
education.
§ When a manager considers whether to increase output,
she compares the cost of the needed labor and materials
to the extra revenue.
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§ 4. People Respond to Incentives
§ Incentive: something that induces a person to act, i.e. the
prospect of a reward or punishment.
§ Rational people respond to incentives.
§ Examples:
§ When gas prices rise, consumers buy more hybrid cars
and fewer gas guzzling SUVs.
§ When cigarette taxes increase, teen smoking falls.

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§ The principles of HOW PEOPLE INTERACT:
§ 5. Trade Can Make Everyone Better Off
§ Rather than being self-sufficient, people can specialize in
producing one good or service and exchange it for other
goods.
§ Countries also benefit from trade and specialization:
§ Get a better price abroad for goods they produce.

§ Buy other goods more cheaply from abroad than could be

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§ 6. Markets Are Usually A Good Way to Organize Economic Activity
§ Market: a group of buyers and sellers
§ “Organize economic activity” means determining
§ what goods to produce, how to produce them, how much of
each to produce, who gets them
§ A market economy allocates resources through the
decentralized decisions of many households and firms as they
interact in markets.
§ Famous insight by Adam Smith in The Wealth of Nations (1776):
§ Each of these households and firms acts as if “led by an
invisible hand” to promote general economic well-being.
§ The invisible hand works through the price system:
§ The interaction of buyers and sellers determines prices.
§ Each price reflects the good’s value to buyers and the cost of
producing the good.
§ Prices guide self-interested households and firms to make
decisions that, in many cases, maximize society’s economic
well-being.

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§ 7. Governments Can Sometimes Improve Market Outcomes
§ Important role for government: enforce property rights
(with police, courts)
§ People are less inclined to work, produce, invest, or
purchase if large risk of their property being stolen.
§ Market failure: when the market fails to allocate society’s
resources efficiently.
§ Causes of market failure:
§ Externalities, when the production or consumption
of a good affects bystanders (e.g. pollution).
§ Market power, a single buyer or seller has substantial
influence on market price (e.g. monopoly).
§ Public policy may also promote efficiency. Govt may alter
market outcome to promote equity.
§ If the market’s distribution of economic well-being is not
desirable, tax or welfare policies can change how the
economic “pie” is divided.

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The principles of HOW THE ECONOMY AS A WHOLE WORKS
§ 8. A Country’s Standard of Living Depends on Its Ability to
Produce Goods & Services
§ Huge variation in living standards across countries and over
time:
§ Average income in rich countries is more than ten times
average income in poor countries.
§ The U.S. standard of living today is about eight times larger
than 100 years ago.
§ The most important determinant of living standards:
productivity, the amount of goods and services produced
per unit of labor.
§ Productivity depends on the equipment, skills, and
technology available to workers.
§ Other factors (e.g., labor unions, competition from abroad)
have far less impact on living standards.

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§ 9. Prices Rise When the Government Prints Too Much Money
§ Inflation: increases in the general level of prices.
§ In the long run, inflation is almost always caused by
excessive growth in the quantity of money, which causes the
value of money to fall.
§ The faster the govt creates money, the greater the inflation
rate.

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§ 10. Society Faces a Short-run Tradeoff Between Inflation and
Unemployment
§ In the short-run (1–2 years), many economic policies push
inflation and unemployment in opposite directions.
§ Other factors can make this tradeoff more or less favorable,
but the tradeoff is always present.

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