8/29/2020

LECTURE 1. Economic theory: the

subject of studying and
methodology
Microeconomics

WHAT IS ECONOMICS
• The word economy comes from a Greek word for “one who
manages a household.”
• 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?

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The Economic Problem

•Economics is the study of how society manages its scarce
resources.
•The big questions are:
• What goods and services should be produced?
• How should it be produced?
• Who should get the goods and services produced?

Scarcity and Choice

• 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.
• Economics is the study of how society manages its
scarce resources.

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HOW PEOPLE MAKE DECISIONS

‘The economy’ refers to all the production and
exchange activities that take place every day - all
the buying and selling.
The economy exists at different scales
• Local
• National e.g. the UK
• International e.g. EU

ECONOMICS AND THE MARKET

ECONOMY
• An economy is a system for coordinating society’s productive
activities.
• Economics is the social science that studies the production,
distribution, and consumption of goods and services.
• A market economy is an economy in which decisions about
production and consumption are made by individual producers
and consumers.

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MICROECONOMICS AND MARKET

FAILURE
• Microeconomics is the branch of economics that studies how
people make decisions and how these decisions interact.
• Market failure is when the individual pursuit of self-interest
actually makes society worse off.

● microeconomics Branch of economics that deals

with the behavior of individual economic units—
consumers, firms, workers, and investors—as well as
the markets that these units comprise.

● macroeconomics Branch of economics that

deals with aggregate economic variables, such as
the level and growth rate of national output,
interest rates, unemployment, and inflation.

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MODELS IN ECONOMICS
• Model: a simplified representation of a real situation that is
used to better understand real-life situations.
• Other things equal assumption: all other relevant factors
remain unchanged.
• We try to treat economics as close to a laboratory science as
possible—with only one variable allowed to change at a time.

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TRADEOFFS: THE PRODUCTION

POSSIBILITIES FRONTIER MODEL
The PPF is a model that shows the combinations of two goods
that are possible for a society to produce at full employment.

We can use the PPF model to answer questions like:

• How much can we produce?
• What will it cost us to change our mix of production?
• Does it make sense to import the good from somewhere else?

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TRADE-OFFS: THE PPF

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EFFICIENCY IN PRODUCTION: THE

PPF
An economy is efficient if there are
no missed opportunities—there is no
way to make some people better off
without making other people worse
off.
Points A and B are both efficient in
production.
If the economy could produce more
of some things without producing less
of others (it could produce more of
everything) then it is inefficient in
production.
Point C is inefficient in production

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EFFICIENCY IN ALLOCATION: THE PPF

Efficiency in production is only
part of what’s required for the
economy as a whole to be
efficient.
Efficiency also requires that the
economy allocate its resources
so that consumers are as well
off as possible. This is called
being efficient in allocation.
It’s unclear whether A or B is
more efficient in allocation
without knowing consumer
preferences.

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OPPORTUNITY COST: THE PPF

Opportunity Cost: what must be given up in order to get a
good.
If Boeing decides to change its production from point A to
point B, it will produce 8 more small jets but 6 fewer
Dreamliners: each small jet has an opportunity cost of 6 / 8
= 3 / 4 of a Dreamliner.

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LEARN BY DOING: PRACTICE QUESTION 1

Suppose you are stranded on an island. Luckily, this island is

rich in clams and mangos. If you devote all of your time to
harvesting clams, you can get 100 clams in a week. If you
us all of your time to collect mangos, you can find 200
mangos in a week.
Assume it is possible to collect fractional amounts of both
goods and draw a sketch of your production possibility
frontier for a week. (Place mangos on the x-axis and clams
on the y-axis.)
Calculate the opportunity cost of each good.

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INCREASING OPPORTUNITY COST: THE

PPF

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ECONOMIC GROWTH: THE PPF

Economic growth results in an outward shift of the PPF because production
possibilities are expanded. The economy can now produce more of
everything.

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WHAT CAUSES ECONOMIC GROWTH?

Two possibilities:
1. An increase in factors of production: resources used to produce
goods and services.
2. Better technology: the technical means for producing goods and
services.

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FACTORS OF PRODUCTION: LAND

1. Land includes natural resources, such as mineral deposits,
oil, natural gas, water, and actual land acreage.

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FACTORS OF PRODUCTION: LABOR

2. Labor is the mental and physical abilities of the workforce.

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FACTORS OF PRODUCTION: PHYSICAL

CAPITAL
3. Physical capital is manufactured items used to produce
other goods and services.

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FACTORS OF PRODUCTION: HUMAN

CAPITAL
4. Human capital is the educational achievements and skills of
the labor force (which increase labor productivity).

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The Themes of Microeconomics

Trade-Offs
CONSUMERS

Consumers have limited incomes, which can be spent on a wide variety of

goods and services, or saved for the future.

WORKERS
Workers also face constraints and make trade-offs. First, people must decide
whether and when to enter the workforce. Second, workers face trade-offs
in their choice of employment. Finally, workers must sometimes decide how
many hours per week they wish to work, thereby trading off labor for leisure.

FIRMS
Firms also face limits in terms of the kinds of products that they can
produce, and the resources available to produce them.

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Prices and Markets

Microeconomics describes how prices are determined.

In a centrally planned economy, prices are set by the

government.

In a market economy, prices are determined by the

interactions of consumers, workers, and firms. These
interactions occur in markets—collections of buyers and
sellers that together determine the price of a good.

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Theories and Models

In economics, explanation and prediction are based on theories.
Theories are developed to explain observed phenomena in terms of a
set of basic rules and assumptions.

A model is a mathematical representation, based on economic theory,

of a firm, a market, or some other entity.

Positive versus Normative Analysis

● positive analysis Analysis describing relationships of
cause and effect.
● normative analysis Analysis examining questions of
what ought to be.

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USING MODELS: POSITIVE VERSUS

NORMATIVE ECONOMICS
Positive economics is the branch of economic analysis that
describes the way the economy actually works.
Normative economics makes prescriptions about the way
the economy should work.
Positive economics is about description; normative
economics is about prescription.
A forecast is a simple prediction of the future.

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LEARN BY DOING: PRACTICE QUESTION 2

Label each of the following statements as normative (a) or
positive (b):
1. More than 60% of women are in the labor market.
2. Rent control laws should be implemented because they help to
achieve equity or fairness in housing.
3. Society should take measures to end gun violence.
4. People who smoke pass on increased medical costs to the
whole society.
5. Single mothers are more than twice as likely as married mothers
to be in poverty.

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1.2 What Is a Market?

● market Collection of buyers and sellers that, through
their actual or potential interactions, determine the price
of a product or set of products.

● market definition Determination of the buyers, sellers,

and range of products that should be included in a
particular market.

● arbitrage Practice of buying at a low price at one

location and selling at a higher price in another.

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Competitive versus Noncompetitive Markets

● perfectly competitive market Market with many buyers and sellers, so

that no single buyer or seller has a significant impact on price.

Many other markets are competitive enough to be treated as if they were

perfectly competitive.

Other markets containing a small number of producers may still be treated

as competitive for purposes of analysis.

Finally, some markets contain many producers but are noncompetitive;

that is, individual firms can jointly affect the price.

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Market Price
● market price Price prevailing in a competitive market.

In markets that are not perfectly competitive, different firms

might charge different prices for the same product. This might
happen because one firm is trying to win customers from its
competitors, or because customers have brand loyalties that
allow some firms to charge higher prices than others.

The market prices of most goods will fluctuate over time, and for
many goods the fluctuations can be rapid. This is particularly
true for goods sold in competitive markets.

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Market Definition—The Extent of a Market

● extent of a market Boundaries of a market, both geographical and in

terms of range of products produced and sold within it.
For some goods, it makes sense to talk about a market only in terms of very
restrictive geographic boundaries.

We must also think carefully about the range of products to include in a

market.
Market definition is important for two reasons:

A company must understand who its actual and potential competitors are for
the various products that it sells or might sell in the future.

Market definition can be important for public policy decisions.

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TRANSACTIONS: THE CIRCULAR-FLOW

DIAGRAM
Trade takes the form of barter when people directly
exchange goods or services that they have for goods or
services that they want.
The circular-flow diagram represents the transactions in an
economy by flows around a circle.
A household is a person or a group of people that share
their income.
A firm is an organization that produces goods and services
for sale.

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THE CIRCULAR-FLOW DIAGRAM

ILLUSTRATED

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FIRMS, MARKETS AND INCOME DISTRIBUTION:

THE CIRCULAR-FLOW DIAGRAM
Firms sell goods and services that they
produce to households in markets for goods
and services.
Firms buy the resources they need to produce
goods and services in factor markets.
An economy’s income distribution is the way
in which total income is divided among the
owners of the various factors of production.

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USING MODELS: WHEN AND WHY

ECONOMISTS DISAGREE
• Media coverage tends to exaggerate the real differences
in views among economists.
• Economics is often tied up in politics.
– Powerful interest groups find and promote economists who profess
supportive opinions.
• Diverse people have diverse values.
– Reasonable people can come to different conclusions because of
their values.
• Economic modeling requires simplifying assumptions.
– Two economists can legitimately disagree about which
simplifications are appropriate.

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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.

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Ten Propositions about Which Most Economists Agree

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