Introduction of

Microeconomics

Lecture 1
3
Introduction
 Economy. . .
. . . The word economy comes from a Greek
word for “one who manages a household.”
 TEN PRINCIPLES OF
ECONOMICS
• A household and an economy
face many decisions:
• Who will work?
• What goods and how many of them should be
produced?
• What resources should be used in production?
• At what price should the goods be sold?
 TEN PRINCIPLES OF
ECONOMICS
Society and Scarce Resources:
• The management of society’s resources is
important because resources are scarce.
• Scarcity. . . means that society has limited resources
and therefore cannot produce all the goods and
services people wish to have.
 TEN PRINCIPLES OF
ECONOMICS
Economics is the study of how society manages
its scarce resources.
 TEN PRINCIPLES OF
ECONOMICS
• How people make decisions.
• People face tradeoffs.
• The cost of something is what you give up to get it.
• Rational people think at the margin.
• People respond to incentives.
 TEN PRINCIPLES OF
ECONOMICS
• How people interact with each other.
• Trade can make everyone better off.
• Markets are usually a good way to organize
economic activity.
• Governments can sometimes improve economic
outcomes.
 TEN PRINCIPLES OF
ECONOMICS
• The forces and trends that affect how the
economy as a whole works.
• The standard of living depends on a country’s
production.
• Prices rise when the government prints too much
money.
• Society faces a short-run tradeoff between inflation
and unemployment.
Principle #1: People Face Tradeoffs.

“There is no such thing as a free lunch!”

Principle #1: People Face Tradeoffs.

To get one thing, we usually have to give up

another thing.
• Guns v. butter
• Food v. clothing
• Leisure time v. work
• Efficiency v. equity

Making decisions requires trading

off one goal against another.
Principle #1: People Face Tradeoffs

• Efficiency v. Equity
• Efficiency means society gets the most that it can
from its scarce resources.
• Equity means the benefits of those resources are
distributed fairly among the members of society.
Principle #2: The Cost of Something Is What
You Give Up to Get It.

• Decisions require comparing costs and benefits

of alternatives.
• Whether to go to college or to work?
• Whether to study or out for hang out?
• Whether to go to class or sleep in?

• The opportunity cost of an item is what you

give up to obtain that item.
Principle #2: The Cost of Something Is What
You Give Up to Get It.

LA Laker basketball star

Kobe Bryant chose to
skip college and go
straight from high
school to the pros where
he has earned millions
of dollars.
Principle #3: Rational People Think at the
Margin.

• Marginal changes are small, incremental

adjustments to an existing plan of action.

People make decisions by comparing

costs and benefits at the margin.
Principle #4: People Respond to Incentives.

• Marginal changes in costs or benefits motivate

people to respond.
• The decision to choose one alternative over
another occurs when that alternative’s marginal
benefits exceed its marginal costs!
Principle #5: Trade Can Make Everyone
Better Off.
• People gain from their ability to trade with one
another.
• Competition results in gains from trading.
• Trade allows people to specialize in what they
do best.
Principle #6: Markets Are Usually a Good
Way to Organize Economic Activity.
• A market economy is an economy that allocates
resources through the decentralized decisions of
many firms and households as they interact in
markets for goods and services.
• Households decide what to buy and who to work
for.
• Firms decide who to hire and what to produce.
Principle #6: Markets Are Usually a Good
Way to Organize Economic Activity.

• Adam Smith made the observation that

households and firms interacting in markets act
as if guided by an “invisible hand.”
• Because households and firms look at prices when
deciding what to buy and sell, they unknowingly
take into account the social costs of their actions.
• As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of
society as a whole.
 Principle #7: Governments Can Sometimes
Improve Market Outcomes.
• Market failure occurs when the market fails to
allocate resources efficiently.
• When the market fails (breaks down)
government can intervene to promote efficiency
and equity.
Principle #7: Governments Can Sometimes
Improve Market Outcomes.
• Market failure may be caused by
• an externality, which is the impact of one person or
firm’s actions on the well-being of a bystander.
• market power, which is the ability of a single
person or firm to unduly influence market prices.
Principle #8: The Standard of Living Depends
on a Country’s Production.
• Standard of living may be measured in different
ways:
• By comparing personal incomes.
• By comparing the total market value of a nation’s
production.
Principle #8: The Standard of Living Depends
on a Country’s Production.
• Almost all variations in living standards are
explained by differences in countries’
productivities.
• Productivity is the amount of goods and
services produced from each hour of a worker’s
time.
Principle #8: The Standard of Living Depends
on a Country’s Production.

• Standard of living may be measured in different

ways:
• By comparing personal incomes.
• By comparing the total market value of a nation’s
production.
Principle #9: Prices Rise When the
Government Prints Too Much Money.
• Inflation is an increase in the overall level of
prices in the economy.
• One cause of inflation is the growth in the
quantity of money.
• When the government creates large quantities
of money, the value of the money falls.
Principle #10: Society Faces a Short-run
Tradeoff Between Inflation and
Unemployment.
• The Phillips Curve illustrates the tradeoff
between inflation and unemployment:
Inflation  Unemployment
It’s a short-run tradeoff!
 Thinking Like an Economist
• Economics trains you to. . . .
• Think in terms of alternatives.
• Evaluate the cost of individual and social choices.
• Examine and understand how certain events and
issues are related.
 THE ECONOMIST AS A
SCIENTIST
• The economic way of thinking . . .
• Involves thinking analytically and objectively.
• Makes use of the scientific method.
The Scientific Method: Observation, Theory,
and More Observation
• Uses abstract models to help explain how a
complex, real world operates.

• Develops theories, collects, and analyzes data

to evaluate the theories.
The Role of Assumptions

• Economists make assumptions in order to

make the world easier to understand.
• The art in scientific thinking is deciding which
assumptions to make.
• Economists use different assumptions to
answer different questions.
Economic Models

• Economists use models to simplify reality in

order to improve our understanding of the
world
• Two of the most basic economic models
include:
• The Circular Flow Diagram
• The Production Possibilities Frontier
Our First Model: The Circular-Flow Diagram

• The circular-flow diagram is a visual model of the

economy that shows how money flow through
markets among households and firms.
Figure 1 The Circular Flow

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
•Firms sell Goods and
Goods
•Households buy services
and services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars

Copyright © 2004 South-Western

Our First Model: The Circular-Flow Diagram

• Firms
• Produce and sell goods and services
• Hire and use factors of production
• Households
• Buy and consume goods and services
• Own and sell factors of production
Our First Model: The Circular-Flow Diagram

• Markets for Goods and Services

• Firms sell
• Households buy
• Markets for Factors of Production
• Households sell
• Firms buy
Our First Model: The Circular-Flow Diagram

• Factors of Production
• Inputs used to produce goods and services
• Land, labor, and capital
Our Second Model: The Production
Possibilities Frontier
• The production possibilities frontier is a graph that
shows the combinations of output that the
economy can possibly produce given the
available factors of production and the
available production technology.
 Figure 2 The Production Possibilities Frontier
Quantity of
Computers
Produced

3,000 D

C
2,200
2,000 A
Production
possibilities
frontier
1,000 B

0 300 600 700 1,000 Quantity of

Cars Produced
Copyright©2003 Southwestern/Thomson Learning
Our Second Model: The Production
Possibilities Frontier
• Concepts Illustrated by the Production
Possibilities Frontier
• Efficiency
• Tradeoffs
• Opportunity Cost
• Economic Growth
 Figure 3 A Shift in the Production Possibilities Frontier

Quantity of
Computers
Produced

4,000

3,000

2,100 E
2,000
A

0 700 750 1,000 Quantity of

Cars Produced
Copyright © 2004 South-Western
Microeconomics and Macroeconomics

• Microeconomics focuses on the individual parts

of the economy.
• How households and firms make decisions and how
they interact in specific markets
• Macroeconomics looks at the economy as a
whole.
• Economy-wide phenomena, including inflation,
unemployment, and economic growth
 THE ECONOMIST AS POLICY
ADVISOR
• When economists are trying to explain the
world, they are scientists.
• When economists are trying to change the
world, they are policy advisor.
POSITIVE VERSUS NORMATIVE
ANALYSIS
• Positive statements are statements that attempt to
describe the world as it is.
• Called descriptive analysis
• Normative statements are statements about how
the world should be.
• Called prescriptive analysis
 POSITIVE VERSUS NORMATIVE
ANALYSIS
• Positive or Normative Statements?
• An increase in the minimum wage will cause a
?
decrease in employment among the least-skilled.
POSITIVE

? • Higher federal budget deficits will cause interest

rates to increase.
POSITIVE
?
 POSITIVE VERSUS NORMATIVE
ANALYSIS
• Positive or Normative Statements?
?
• The income gains from a higher minimum wage are
worth more than any slight reductions in
employment.

?
NORMATIVE

• State governments should be allowed to collect

?
from tobacco companies the costs of treating
smoking-related illnesses among the poor.
NORMATIVE
 WHY ECONOMISTS DISAGREE
• They may disagree about the validity of
alternative positive theories about how the
world works.

• They may have different values and, therefore,

different normative views about what policy
should try to accomplish.
 Summary
• Economists try to address their subjects with a
scientist’s objectivity.
• They make appropriate assumptions and build
simplified models in order to understand the world
around them.
• Two simple economic models are the circular-flow
diagram and the production possibilities frontier.
 Summary
• Economics is divided into two subfields:
• Microeconomists study decisionmaking by
households and firms in the marketplace.
• Macroeconomists study the forces and trends that
affect the economy as a whole
 Summary
• A positive statement is an assertion about how
the world is.
• A normative statement is an assertion about
how the world ought to be.
• When economists make normative statements,
they are acting more as policy advisors than
scientists.
 Summary
• Economists who advise policymakers offer
conflicting advice either because of differences
in scientific judgments or because of
differences in values.
• At other times, economists are united in the
advice they offer, but policymakers may choose
to ignore it.
 Summary
• When individuals make decisions, they face
tradeoffs among alternative goals.
• The cost of any action is measured in terms of
foregone opportunities.
• Rational people make decisions by comparing
marginal costs and marginal benefits.
• People change their behavior in response to the
incentives they face.
 Summary
• Trade can be mutually beneficial.
• Markets are usually a good way of coordinating
trade among people.
• Government can potentially improve market
outcomes if there is some market failure or if
the market outcome is inequitable.
 Summary
• Productivity is the ultimate source of living
standards.
• Money growth is the ultimate source of
inflation.
• Society faces a short-run tradeoff between
inflation and unemployment.