ECO - 101

Microeconomics
By Umema A. Siddiqi
Is Facebook Free?
Is Facebook free?
 Facebook doesn’t charge you a penny, so it’s tempting to say, “it’s free!”
 Here’s another way to think about it: what do you give up when you use
Facebook?
 In your view, what is the best alternative use of your Facebook time? That’s
the economic way of thinking about the cost of Facebook.
What Is Economics, and Why Is It
Important?
 Economics is the study of how humans make decisions in the face of scarcity. It is the study of choice.
 An Economic agent is an individual or a group that makes choices.
 Understanding people's choices is practically useful for two key reasons. Economic analysis
 1. describes what people actually do (positive economics)
 2. recommends what people, including society, ought to do (normative economics)
 Positive economics is analysis that generates objective descriptions or predictions which can be verified
with data.
 Normative economics is analysis that recommends what an individual or society ought to do.
Positive & Normative Economics
 Positive economics is the empirical study of what is happening in the world. It
examines, for example, why some countries are getting richer, why certain families are
getting poorer, and what is likely to happen to them in the future. It avoids making any
value judgements about whether certain phenomena ought to occur, being concerned
simply with the scientific study of why they do.
 Normative economics, on the other hand, engages with what is happening in the world
and attempts to sketch out how the economy could be improved. As such it involves
making value judgements about particular phenomena.
 Take, for example, the following statement: ‘A billion of the world’s population live on
less than $1 a day. This sum is below what any human should be expected to live on,
and ought to be increased through aid and assistance from governments – particularly
rich ones.’ The first sentence is a positive economic statement; the latter is normative.
What Is Economics, and Why Is It
Important?
 Scarcity means that human wants for goods, services and resources exceed what is available.
Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and
services we want but they exist in limited supply.
 The Division of and Specialization of Labor: Adam Smith (1723–1790) published his famous
book The Wealth of Nations in 1776.
 Division of labor: the way one produces a good or service is divided into a number of
tasks that different workers perform, instead of all the tasks being done by the same person.
What Is Economics, and Why Is It
Important?
 Why division of labor increases production?
 First, specialization in a particular small job allows workers to focus on the parts of the
production process where they have an advantage.
 Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality.
 Third, specialization allows businesses to take advantage of economies of scale, which means that for
many goods, as the level of production increases, the average cost of producing each individual unit declines.
 Specialization only makes sense, though, if workers can use the pay they receive for doing their jobs to
purchase the other goods and services that they need. In short, specialization requires trade.
Micro vs Macro
 Microeconomics focuses on the actions of individual agents within the economy, like households,
workers, and businesses.
 Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of
production, the number of unemployed people, the inflationary increase in prices, government deficits, and
levels of exports and imports.
 Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on
the overall subject of the economy.
How Economists Use Theories and
Models to Understand Economic Issues
 A theory is a simplified representation of how two or more variables interact with each other. The
purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials.
 Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical
representation.
Circular Flow
Diagram
 It pictures the economy as consisting
of two groups—households and firms
—that interact in two markets: the
goods and services market
in which firms sell and households buy
and the labor market in which
households sell labor to business firms
or other employees.
How To Organize Economies: An
Overview of Economic Systems
 Think about what a complex system a modern economy is. It includes all production of goods and services,
all buying and selling, all employment. The economic life of every individual is interrelated, at least to a
small extent, with the economic lives of thousands or even millions of other individuals.
 Who organizes and coordinates this system? Who insures that, for example, the number of televisions a
society provides is the same as the amount it needs and wants?
 Who ensures that the right number of employees work in the electronics industry? Who assures that
televisions are produced in the best way possible? How does it all get done?
 Economic systems answer three basic questions: what will be produced, how will it be
produced, and for whom it will be produced?
How To Organize Economies: An
Overview of Economic Systems
 1. Traditional economies organize their economic affairs the way they have always done (i.e., tradition).
[Example: parts of Asia, Africa, and South America.]
 2. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling
class. [Example: Ancient Egypt. China and Russia]
 3. In a market economy, decision-making is decentralized. Market economies are based on private
enterprise: the private individuals or groups of private individuals own and operate the means of
production (resources and businesses). [Example: European and Latin American countries]
 4. Most economies in the real world are mixed. They combine elements of command and market (and even
traditional) systems. The U.S. economy is positioned toward the market-oriented end of the spectrum
 The question of how to organize economic institutions is typically not a black-or-white choice between all
market or all government, but instead involves a balancing act over the appropriate combination of market
freedom and government rules.
Characteristics of a
Traditional Economic
System
 There is no involvement by the
government, so people are largely left
to conduct economic activities without
influence.
 Economic advances such as
technology, property rights, and
capital investment are largely
absent.
 Bartering is commonplace and
the use of cash as a medium of
exchange is almost non-existent.
Characteristics of a
Command Economic
System
 Under this structure, power is centralized
either to the government or a sole ruler. In
turn, they decide the rules of the game and
command how economic interactions take
place.
 Economic decisions such as what goods to
produce, how much to produce, and its
price are decided upon by central powers.
 Examples include North Korea, Cuba, and
the former Soviet Union.
Characteristics of
Capitalist Economic
System
 When consumers demand goods, it
sends a signal to businesses for
them to produce more. Equally,
when demand for goods falls, it
sends a signal to businesses to
produce less.
 Many individuals can amass great
economic power and wealth. Not
only does this create social
discontent, but can also lead to
unscrupulous business practices
Characteristics of a
Mixed Economic System
 A mixed economy extends beyond just
mixed control of the means of production,
but also governments involvement
through regulation and other forms of
intervention. Subsidies, tariffs, and quotas
are just some interventionist tools than
many mixed economy nations such.
 In a mixed economy, some industries are
controlled by the government, whilst
others are privately owned.
Differences
between
Capitalist,
Socialist, and
Mixed
Economies
The Rise of
Globalization
 Recent decades have seen a trend toward
globalization, which is the expanding cultural,
political, and economic connections between people
around the world.
 Reasons for globalization:
 Improvements in shipping and air cargo have driven down
transportation costs.
 Innovations in computing and telecommunications have
made it easier and cheaper to manage long-distance
economic connections of production and sales.
 Finally, international agreements and treaties between
countries have encouraged greater trade.
 Benefits & Risks
of Globalization
 Globalization refers to the increasingly integrated nature of
economies around the world.
 FDI can help to boost technology transfer, industrial
restructuring, and the growth of global companies.
 Increased competition helps inspire new technology
development.
 Interdependence between nations can cause local or global
instability.
 Some see the rise of nation-states, global firms, and other
international organizations as a threat to sovereignty.
 The pros of globalization can be unfairly skewed toward rich
nations or individuals, creating greater economic inequalities.
 Three Principles of Economics
 Economists emphasize three key concepts:
 1. Optimization: Picking the best feasible option, given (whatever) limited information, knowledge,
experience, and training the economic agent has.
 2. Equilibrium: is the special situation in which everyone is simultaneously optimizing, so nobody would
benefit personally by changing his/her own behavior, given the choices of others.
 3. Empiricism: is analysis that uses data – evidence-based analysis. Economists use data to develop
theories, to evaluate the success of different government policies, and to determine what is causing things
to happen in the world.
Introduction to Choice in a World of
Scarcity
 In 1968, the Rolling Stones recorded “You Can’t Always Get What You Want.” Economists chuckled,
because they had been singing a similar tune for decades.
 Because people live in a world of scarcity, they cannot have all the time, money, possessions, and
experiences they wish. Neither can society.
How Individuals Make Choices Based
on Their Budget Constraint
 Suppose Alphonso has $10 in spending money each week
that he can allocate between bus tickets for getting to work
and the burgers that he eats for lunch. Burgers cost $2
each, and bus tickets are 50 cents each. We can see
Alphonso's budget problem (or budget constraint) on the
right.
 The relative price of burgers and bus tickets
determines the slope of the budget constraint. All
along the budget set, giving up one burger means
gaining four bus tickets.
 Solving for the budget constraint:
 Budget = (P1*Q1) + (P2*Q2)
The Concept of Opportunity Cost
‘The cost of something is what you give up to get it.’
- Greg Mankiw, Harvard economics professor
 Economists use the term opportunity cost to indicate what one must give up to obtain what he or she
desires. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or
consume something else.
 In short, opportunity cost is the value of the next best alternative.
 A fundamental principle of economics is that every choice has an opportunity cost.
 If you sleep through your economics class, the opportunity cost is the learning you miss from not attending
class!
Opportunity Cost – A bigger picture
 “Every gun that is made, every warship launched, every rocket fired
signifies, in the final sense, a theft from those who hunger and are not fed,
those who are cold and are not clothed. This world in arms is not spending
money alone. It is spending the sweat of its laborers, the genius of its
scientists, the hopes of its children. The cost of one modern heavy bomber is
this: a modern brick school in more than 30 cities .It is 2 electric power
plants, each serving a town of 60,000 population. It is two fine, fully
equipped hospitals. It is some 50 miles of concrete pavement. We pay for a
single fighter plane with a half million bushels of wheat. We pay for single
destroyer with new homes that could have housed more than 8000 people.”
- Dwight D. Eisenhower
Opportunity Costs: Example
 Every hour of our time has a value. For every hour we work at one job we could quite easily
be doing another, or be sleeping or watching a film. Each of these options has a different
opportunity cost – namely, what they cost us in missed opportunities.
 Say you intend to watch a football match but the tickets are expensive and it will take you a
couple of hours to get to and from the stadium. Why not, you might reason, watch the game
from home and use the leftover money and time (the time you’d have spent in pre- and post-
match traffic) to have dinner with friends? This – the alternative use of your cash and time –
is the opportunity cost.
 Consider that most famous economic rule of all: there’s no such thing as a free lunch. Even if
someone offers to take you out to lunch for free, with no expectation that you will return the
favour or make conversation during the meal, the lunch is still not entirely free. The time you
will spend in the restaurant still costs you something in terms of forgone opportunities.
Marginal Decision-Making and
Diminishing Marginal Utility
 People desire goods and services for the satisfaction or utility those goods and services provide.
 Economists typically assume that the more of some good one consumes (for example, slices of pizza), the
more utility one obtains.
 At the same time, the utility a person receives from consuming the first unit of a good is typically more
than the utility received from consuming the fifth or the tenth unit of that same good.
 The law of diminishing marginal utility explains why people and societies rarely make all-or-nothing
choices. You would not say, “My favorite food is ice cream, so I will eat nothing but ice cream from now
on.”
 A rational consumer would only purchase additional units of some product as long as the marginal utility
exceeds the opportunity cost.
The Production Possibilities Frontier
(PPF) and Social Choices
 Because society has limited resources (e.g., labor,
land, capital, raw materials) at any point in time, there
is a limit to the quantities of goods and services it can
produce. Suppose a society desires two products,
healthcare and education..
 The PPF shows the tradeoff between healthcare and
education.
What’s the difference between a
budget constraint and a PPF?
 Budget constraint is a straight line, slope constant. PPF is curved, slope not
constant.
 On PPF, at point A, all available resources are devoted to healthcare and
none are left for education. This situation would be extreme and even
ridiculous. For example, children are seeing a doctor every day, whether they
are sick or not, but not attending school.
 A B: little reduction in health, as slope is relatively flat.
 D F: devoting all spending to education and none to healthcare. Showing
large drop in health for only a small gain in education. Slope is steep.
Productive Efficiency and Allocative
Efficiency

efficiency refers to lack of waste
 Productive efficiency occurs when a firm produces goods
or services at the lowest possible cost. This means utilizing
resources in such a way that the maximum output is
achieved with the given inputs. In this scenario, the firm
operates on its production possibility frontier (PPF), meaning
it cannot produce more of one good without sacrificing the
production of another.
 Allocative efficiency is achieved when resources are
distributed in a way that maximizes the overall benefit to society.
This occurs when the price of a good or service reflects the marginal
cost of producing it, meaning that resources are allocated to where
they are most valued. In a state of allocative efficiency, the quantity
of goods produced is exactly what consumers want, leading to an
optimal distribution of resources.
The PPF and Comparative
Advantage
 Often how much of a good a country decides to produce depends on how expensive it is to produce it
versus buying it from a different country.
 The curvature of a country’s PPF gives us information about the tradeoff between devoting resources to
producing one good versus another.
 In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in
terms of the other good (in the y-axis).
 When a country can produce a good at a lower opportunity cost than another country, we say that this
country has a comparative advantage in that good.
Comparative &
Absolute Advantage
 All countries only have a
certain amount of resources
available, so they always face
trade-offs between the
different goods. As we know,
these trade-offs are measured
in opportunity costs.
Example: Absolute & Comparative Advantage
 Absolute advantage occurs when a country or individual can produce more of a good or service
with the same resources than another country or individual.
 Example: Country A can produce 10 tons of wheat using the same amount of resources that Country B
uses to produce 5 tons of wheat. In this case, Country A has an absolute advantage in wheat
production because it can produce more with the same resources.
 Comparative advantage occurs when a country or individual can produce a good or service at a
lower opportunity cost than another country or individual.
 Example:
 Country A can produce either 10 tons of wheat or 5 tons of rice.
 Country B can produce either 6 tons of wheat or 4 tons of rice.
 In this scenario:
For Country A, the opportunity cost of producing 1 ton of wheat is 0.5 tons of rice.
For Country B, the opportunity cost of producing 1 ton of wheat is approximately 0.67 tons of
rice.
Since Country A has a lower opportunity cost for wheat, it has a comparative advantage in wheat
production. Conversely, Country B has a comparative advantage in rice production because its
opportunity cost for producing rice is lower than that of Country A.
Critical Thinking Questions
 During the Second World War, Germany’s factories were decimated. It also suffered many human
casualties, both soldiers and civilians. How did the war affect Germany’s production possibilities curve?
 Home Activity: Use this information to answer the following questions:
 Marie has a weekly budget of $24, which she likes to spend on magazines and pies.
 (i) If the price of a magazine is $4 each, what is the maximum number of magazines she could buy in a week?
 (ii) If the price of a pie is $12, what is the maximum number of pies she could buy in a week?
 (iii) Draw Marie’s budget constraint with pies on the horizontal axis and magazines on the vertical axis. What is the
slope of the budget constraint?