Introduction to Microeconomics

Microeconomics vs Macroeconomics

  • Microeconomics: the study of individual economic agents and individual markets (e.g., the demand and supply of a particular good or market, such as cars or clothing).

  • Macroeconomics: the study of economic aggregates (an overview perspective of an economy) by examining variables such as inflation, exchange rate, unemployment, economic growth, and money supply.

Definition of Microeconomics

  • The study of how individuals and societies use limited resources to satisfy unlimited wants.

Fundamental problems

  • Scarcity: how individuals and firms make decisions given that we live in a world of scarcity.

  • Constrained optimization: given scarce resources, how individuals and firms trade off different alternatives to make themselves as well-off as possible.

  • All economic questions arise because we want more than we can get.

Two agents

  • Consumers

    • Constrained by their limited wealth.

    • Subject to that constraint, they choose the set of goods that makes them as well off as possible.

  • Producers

    • Maximize their profits.

    • Subject to: 1) consumers’ demands; 2) input cost.

Two Big Economic Questions – scope of economics

  • How do choices end up determining what, how, and for whom goods and services get produced?

  • When do choices made in pursuit of self-interest also promote the social interest?

Two Big Economic Questions (What, How, and For Whom?)

  • Goods and services are the objects that people value and produce to satisfy human wants.

  • What?

    • In Canada:

    • ext{Agriculture share}_{CAN} = 2\%

    • ext{Manufactured goods share}_{CAN} = 28\%

    • ext{Services share}_{CAN} = 70\%

    • In Ethiopia:

    • ext{Agriculture share}_{ETH} = 35\%

    • ext{Manufactured goods share}_{ETH} = 21\%

    • ext{Services share}_{ETH} = 44\%

  • How?

    • Goods and services are produced using productive resources called factors of production.

    • Factors of production are grouped into four categories:

    • Land

    • Labour

    • Capital

    • Entrepreneurship

  • For Whom?

    • Who gets the goods depends on incomes earned by resources:

    • Land earns rent

    • Labour earns wages

    • Capital earns interest

    • Entrepreneurship earns profit

  • Do these choices promote the social interest?

    • Everyday, 35.4 million Canadians and 7.2 billion people elsewhere make economic choices that determine What, How, and For Whom goods and services are produced.

    • Questions: Do we produce the right things in the right quantities? Do we use our factors of production in the best way? Do goods go to those who benefit most from them?

Do Choices in the Pursuit of Self-Interest also Promote the Social Interest?

  • Self-Interest: you make choices that are in your self-interest—choices you think are best for you.

  • Social Interest: choices that are best for society as a whole; two dimensions:

    • Efficiency

    • Equity

  • Efficiency and Social Interest:

    • Resource use is efficient if it is not possible to make someone better off without making someone else worse off.

    • Equity is fairness, but economists have a variety of views about what is fair.

  • Fair Shares and Social Interest:

    • The idea that the social interest requires “fair shares” is a deeply held one.

    • But what is fair?

The Economic Way of Thinking – Six key ideas

  • 1) A choice is a tradeoff.

  • 2) People make rational choices by comparing benefits and costs.

  • 3) Benefit is what you gain from something.

  • 4) Cost is what you must give up to get something.

  • 5) Most choices are “how-much” choices made at the margin.

  • 6) Choices respond to incentives.

The Economic Way of Thinking

  • A Choice Is a Tradeoff

    • Scarcity places choice at the center; every choice is an exchange—giving up one thing to get something else.

    • Example: On Saturday night, study or have fun; you can’t do both fully at the same time, so you must choose. Whatever you choose, you could have chosen something else.

Making a Rational Choice

  • A rational choice compares costs and benefits and achieves the greatest benefit over cost for the person making the choice.

  • Only the wants of the person making the choice are relevant to determine its rationality.

  • The answer to what goods and services will be produced and in what quantities: those that people rationally choose to buy.

How do people choose rationally?

  • The answers turn on benefits and costs.

  • Benefit: What you gain; determined by preferences.

    • Preferences are what a person likes and dislikes and the intensity of those feelings.

Cost: What you Must Give Up

  • The opportunity cost of something is the highest-valued alternative that must be given up to get it.

  • Opportunity cost has two components:

    • The things you can’t afford to buy if you purchase the AC/DC ticket.

    • The things you can’t do with your time if you go to the concert.

The Opportunity Cost of Your University Degree

  • Your university degree does not include only the out-of-pocket expenses on tuition and books.

  • What do you give up to attend university? e.g., working

Scarcity forces choice (for society, government, and the individual) and opportunity cost

  • Scarcity forces choice, and every choice involves an opportunity cost—the sacrificed benefit of the next best alternative.

The Economic Way of Thinking – How Much? Choosing at the Margin

  • To make a choice at the margin, evaluate the consequences of making incremental changes in the use of your resources.

  • Marginal Benefit (MB): the benefit from pursuing an incremental increase in an activity.

  • Marginal Cost (MC): the opportunity cost of pursuing an incremental increase in an activity.

  • If the marginal benefit from an incremental increase exceeds its marginal cost, your rational choice is to do more of that activity.

Choices Respond to Incentives

  • An incentive is a reward that encourages an action or a penalty that discourages an action.

  • A change in marginal cost or a change in marginal benefit changes the incentives that we face and leads us to change our choice.

  • The central idea of economics is that we can predict how choices will change by looking at changes in incentives.

  • Incentives are also the key to reconciling self-interest and the social interest.

Positive and normative analysis

  • Positive statements — what is; can be tested against facts; relies on testable hypotheses.

  • Normative statements — what ought to be; expresses an opinion and cannot be tested; relies on value judgments to evaluate.

  • Examples:

    • a. Canada should cut its imports.

    • b. China is Canada’s largest trading partner.

    • c. The federal government should increase the production of biofuels.