sss/Principles of Microeconomics

Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part I

The Ten Prin iples of E onomi s

E onomi s is the study of human behavior. All resour es are s ar e and limited. Resour es ome from nature (oil,

gas, stone, et .), human produ tion (steel, labor, apital), and human behavior (time, money, wealth). The ore

of E onomi s involves studying how humans onfront the problem of s ar ity. There are many key questions that

dire tly relate to the problem of s ar ity:

� How should s ar e resour es be allo ated in an e onomy?

� Who determines how these resour es are ultimately distributed?

� What should be distributed at all?

� Is there a way to allo ate resour es fairly? Should resour es be allo ated equitably or e� iently?

� What distin tion is there between equity and e� ien y?

E onomi s plays a key role in answering these questions and provides an in-depth framework to analyze human

behavior. If resour es were limitless, this type of analysis would be unne essary. However, no resour e is unlimited

and this is why E onomi s is an important subje t. It allows for analysis of real life problems utilizing a set number

of rules and assumptions. The following assumptions will generally hold true for all future e onomi analysis and

we group them into three broad ategories:

How People Make De isions:

1. People fa e trade-o�s

� Every de ision involves giving up something in ex hange for something else. There are no �free lun hes� due

to the s ar ity of resour es.

� So iety often fa es a trade-o� between equality and e� ien y.

2. The ost of something is what you give up to get it

� Nothing an be gained for free

� Expli it osts: What is dire tly given up. (Ex: Tuition money, rent, bus ti ket)

� Opportunity osts are impli it osts that represent foregone alternatives. For instan e, the opportunity ost

for attending a year of s hool is the foregone wages that ould be attained working at a job instead.

3. Rational people think at the margin

� A rational person a ts in a purposeful and systemati manner. E onomists assume that most people a t

rationally. This assumption allows e onomists to analyze the spe trum of human behavior in a broad way.

� Marginal hanges represent in remental hanges. Analyzing at the margin allows for fa ile analysis.

4. People respond to in entives

� In entives represent the foundation of the analysis of human behavior. E onomists an glean valuable infor-

mation from how humans respond to a variety of in entives.

How People Intera t:

5. Trade an make everyone better o�

� Countries and individuals usually have an advantage in ertain areas (produ tion, labor, et .)

6. Markets are usually a good way to organize e onomi a tivity

� A market onsists of households and �rms making de entralized de isions and intera ting in markets.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� Despite self-interested entities, markets generally allo ate resour es e� iently (as seen in Adam Smith's book

The Wealth of Nations). However...

7. Governments an sometimes improve market out omes

� When property rights require prote tion, governments an improve the state of an e onomy.

� Property rights allow an owner to own and utilize ertain s ar e resour es.

� Government an also prote t an e onomi system from an entity that has market power. Market power

o urs when one individual or group has substantial power/in�uen e on market pri es.

� Though government an provide improvement in an e onomi system, this is not the universal ase. Govern-

ment interferen e in markets often leads to undesirable out omes.

How the E onomy as a Whole Works:

8. A ountry's standard of living depends on its ability to produ e goods and servi es

� In ome inequality throughout the world is growing in reasingly large.

� One of the driving for es of this trend is produ tivity. Produ tivity is the quantity of goods and servi es

that a single unit of labor produ es.

� A ountry that is more produ tive and is able to produ e more has a mu h higher han e of improving the

standard of living for its itizens and in reasing overall wealth

9. Pri es rise when the government prints too mu h money

� In�ation is an overall rise in pri es in an e onomy. In other words, when a government prints too mu h money

the pri e level in reases.

10. So iety fa es a short-run trade-o� between in�ation and unemployment

� When a government prints too mu h money, the short run e�e t is usually an in rease in demand and

improvement in the e onomy

� One of the results of this intera tion is that �rms have more �nan ial resour es and are willing to hire more

workers

� Thus, unemployment drops signi� antly. The business y le demonstrates the �up and down� nature of an

e onomy and an tra k the health of an e onomy as well.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part II

Thinking Like an E onomist

E onomist use the s ienti� method to develop and test theories. One inherent problem in e onomi s is the inability

to produ e true experiments. Unlike in a laboratory or other ontrolled situations, e onomists study problems in

the real world. These real world problems are riddled with problems and in onsisten ies regarding a ontrolled

situation. E onomists often use situations that o ur in the real world as proxies for experiments:

The Role of Assumptions:

� Assumptions play a key role in e onomi analysis.

� One of the ore problems is whi h assumptions should be used.

� Many real world problems are in redibly intri ate � assumptions are required to distill ompli ated situations

into manageable models.

� E onomi models allow for in-depth analysis due to build-in assumptions

Cir ular Flow Model:

The ir ular �ow model is a visual representation of the �ow of dollars through a market. The model is inhabited

by households and �rms and intera t in two markets: the market for goods and servi es and the market for

fa tors of produ tion. In the market for goods and servi es, �rms are the sellers and households are the buyers

while the opposite situation is true in the market for the fa tors of produ tion. There are three primary fa tors of

produ tion: land, labor, & apital. E onomists often in lude entrepreneurship as well. In this model, households

are the sole owner and seller of the fa tors of produ tion. This assumption represents a key element in the

model:

Fa tors of produ tion are utilized by �rms to produ e goods and servi es. When a member of a household

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

pur hases a good or servi e, the �ow of dollars will be transferred to the �rm. The �rm will utilize the �ow in the

fa tor of produ tion market to buy the fa tors required for produ tion. Flows move in opposite dire tions as money

is ex hanged for tangible elements when the parties intera t in the two markets.

This version of the ir ular �ow model is simpli�ed. Simplifying assumptions allow for straightforward analysis

and a brief introdu tion to a model. Often these assumptions will be in pla e when a model is �rst introdu ed.

However, there are almost always more layers that need to be in luded in the model � the roles of entral government

and international trade should eventually be added to the ir ular �ow model.

Produ tion Possibility Frontier:

The PPF is a graph that demonstrates the output ombinations an e onomy an produ e given a set amount

of fa tors of produ tion. Core assumptions for the PPF in lude the e onomy produ ing only two goods and all

resour es are utilized in produ tion of only the two goods. This graph demonstrates an e onomy that produ es

only ars and omputers.

As demonstrated above, the PPF indi ates di�erent levels of the two goods that an be produ ed. When a point

on the PPF is on one of the axis, only one good is produ ed. Any point along the urve in between represents a

ombination of the two goods in produ tion. An e onomy produ es e� iently when resour es are fully utilized. This

o urs when produ tion o urs on the urve. Any point within the urve will be feasible. These points represent

feasibly but ine� ient allo ations. These allo ations are ine� ient be ause some produ tion resor es are being

unterutilized or not used at all. Any point beyond the urve represent produ tion ombinations that require more

fa tors of produ tion then are available. Thus, it is impossible to produ e in this region.

The PPF is an ex ellent example of the 1st prin iples of e onomi s. To move along the PPF urve, produ tion of

one good has to be traded to produ e more of the other. Another way to interpret this trade-o� is using opportunity

ost. The opportunity ost of produ ing one more ar is how many omputers have to be given up.

The shape of the PPF is indi ative of the produ tion relationship between the two goods. When most

produ tion resour es are utilized to produ e one good (su h as omputers), then workers that are

skilled at produ ing automobiles are produ ing omputers as well. Thus, when these workers shift

to produ ing ars, the opportunity ost is small and the urve is relatively �at. A movement along the urve

demonstrates how the opportunity ost of produ ing ars will in rease (and the PPF be omes steeper). This is

be ause as workers skilled at omputer produ tion shift to produ ing automobiles, the opportunity ost in omputer

produ tion will in rease.

The PPF is not �xed. Improvements in te hnology or other advan ements in produ tion an result in a shift

of the urve. This is due to the ability of the e onomy to produ e at a higher level given a �xed level of fa tors or

produ tion and resour es.:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

The distin tion between Mi roe onomi s and Ma roe onomi s:

� Mi roe onomi s is the study of how households and �rms make de isions and intera t in spe i� markets. In

other words, mi roe onomi s fo uses on analysis at the individual or �rm level.

� An example of a mi roe onomi s problem is how a �rm's pri ing de isions a�e ts onsumer behavior.

� Ma roe onomi s is the study of e onomy wide phenomena. Ma roe onomi s fo uses on study at the aggre-

gate/overall levels in an e onomy.

� An example of a ma roe onomi s is how the unemployment rate �u tuates in an e onomy.

� Both topi s are losely intertwined as the a tions of individuals has an impa t on the overall state of the

e onomy and vi e versa. However, analysis of the two subje ts di�ers due to the distin t nature of the subje t

matter.

Positive vs. Normative Analysis:

-A positive statement is des riptive in nature and explains how the world is.

-A normative statement is pres riptive and des ribes how the world should be.

-It is signi� antly more di� ult to determine the validity of a normative statement � There is no eviden e or

previous experien e

The Re ommendation of E onomists:

1. E onomists utilize their knowledge to make poli y re ommendations to politi ians and governments.

2. Certain theories (su h as the Keynesian theory of e onomi s) have an impa t and are strongly debated.

3. E onomists and those that rely on their advi e often disagree on the orre t ourse of a tion. The following

are ommon reasons why:

(a) Di�eren es in s ienti� judgments

(b) Di�eren es in values

( ) Per eption vs. reality

There are ertain poli ies that nearly all e onomist agree on. These in lude the negative impa t of rent ontrol and

tari�s/import quotas. These poli ies undermine the free market and reate ine� ien ies. However, these poli ies

are still in pla e today. The politi al pro ess ombined with a la k of e onomi initiative likely is at the root of

these problems.

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