Microeconomics: Preliminaries Notes

1.1 The Themes of Microeconomics

• Microeconomics vs Macroeconomics

  • Microeconomics: branch of economics that deals with the behavior of individual economic units—consumers, firms, workers, and investors—and 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.

• Core ideas in microeconomics

  • Trade-offs: individuals and firms face choices that trade off one goal for another.

  • Consumers: trade off more of one good for less of another; trade-off between current consumption and future consumption.

  • Workers: trade-offs in their choice of employment; trade-off between labor and leisure.

  • Firms: trade-offs in what to produce; trade-offs in the resources to use in production.

• Prices and markets as the mechanism for trade-offs

  • In a centrally planned economy, prices are set by the government.

  • In a market economy, prices are determined by the interactions of buyers and sellers in markets (collections of buyers and sellers that together determine the price of a good).

• Theories and models in economics

  • Economics uses explanations of observed phenomena and predictions based on theories built from a set of assumptions.

  • A model is a mathematical representation (based on economic theory) of a firm, a market, or another entity.

  • Statistics and econometrics are used to measure the accuracy of predictions.

  • Theories are invariably imperfect and have limited success in making predictions.

• Positive vs Normative analysis

  • Positive analysis: deals with explanation and prediction; describes relationships between cause and effect; central to microeconomics.

  • Normative analysis: questions of what ought to be; often supplemented by value judgments.

  • When value judgments are involved, microeconomics cannot tell us what the best policy is, but it can clarify trade-offs, illuminate issues, and sharpen the debate.

1.2 What Is a Market?

• Market: a collection of buyers and sellers that, through their actual or potential interactions, determines 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.

• Competitive vs Noncompetitive markets

  • Perfectly competitive market: many buyers and sellers, so no single buyer or seller can have a significant impact on price.

  • Many markets are competitive enough to be treated as perfectly competitive for analysis.

  • Some markets have many producers but are noncompetitive; i.e., individual firms can jointly affect the price.

• 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.

  • Market prices of most goods fluctuate over time, and for many goods these fluctuations can be rapid, especially in competitive markets.

• Market definition: extent of a market

  • Boundaries of a market, geographically and in terms of the range of products produced and sold within it.

  • Some goods may be best analyzed with very restrictive geographic market definitions.

  • It is important to think about the range of products to include in a market.

  • Market definition matters for two reasons:

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

  • Market definition can be important for public policy decisions.

• Examples

  • EXAMPLE 1.1: THE MARKET FOR SWEETENERS

  • In 1990, Archer-Daniels-Midland (ADM) acquired Clinton Corn Processing Company (CCP).

  • The U.S. Department of Justice challenged the acquisition on grounds that it would lead to a dominant corn-syrup producer with power to push prices above competitive levels.

  • ADM fought the DOJ decision; case went to court.

  • Basic issue: whether corn syrup represents a distinct market. ADM argued sugar and corn syrup should be considered part of the same market because they are used interchangeably to sweeten a vast array of food products.

  • EXAMPLE 1.2: A BICYCLE IS A BICYCLE. OR IS IT?

  • Two different markets for bicycles identified by store type:

    • Mass Market Bicycles: sold by mass merchandisers (e.g., Target, Walmart, Kmart, Sears).

    • Examples and approximate prices:

      • Huffy: $90 ext{–}140$

      • Schwinn: $140 ext{–}240$

      • Mantis: $129 ext{–}140$

      • Mongoose: $120 ext{–}280$

    • Dealer Bicycles: sold by bicycle dealers that mostly sell bicycles and bicycle equipment.

    • Examples and approximate prices:

      • Trek: $400 ext{–}2500$

      • Cannondale: $500 ext{–}2000$

      • Giant: $500 ext{–}2500$

      • Gary Fisher: $600 ext{–}2000$

      • Mongoose: $700 ext{–}2000$

      • Ridley: $1300 ext{–}2500$

      • Scott: $1000 ext{–}3000$

      • Ibis: $2000 ext{ and up}$

1.3 Real versus Nominal Prices

• Key definitions

  • Nominal price: Absolute price of a good, unadjusted for inflation.

  • Real price: Price of a good relative to an aggregate measure of prices; price adjusted for inflation.

  • Consumer Price Index (CPI): Measure of the aggregate price level.

  • Producer Price Index (PPI): Measure of the aggregate price level for intermediate products and wholesale goods.

• Illustrative example: butter

  • Nominal price of a pound of butter: $0.87$ in $1970$ and $3.48$ in $2015$.

  • To compare across years, convert to the base-year dollars using CPI.

  • CPI values: $CPI<em>{1970} = 38.8, bsp; C P I</em>{2015} = 237.0$

  • Relative price change: nominal price ↑ by about 300 ext{%}, CPI ↑ by about 511 ext{%}.

  • Conclusion: relative to the aggregate price level, butter prices fell, i.e., real butter price decreased from 1970 to 2015.

  • This demonstrates why real prices matter for cross-year comparisons.

• Example 1.3: The price of eggs and the price of a college education

  • Table data (selected values):

  • CPI: $38.8, 82.4, 130.7, 172.2, 241.7$ for years $1970, 1980, 1990, 2000, 2016$ respectively.

  • Nominal eggs (Grade A Large Eggs): $0.61, 0.84, 1.01, 0.91, 2.47$ dollars.

  • Nominal college education: $1784, 3499, 7602, 12922, 25694$ dollars.

  • Real prices in 1970 dollars:

    • Eggs: $0.61, 0.40, 0.30, 0.21, 0.40$

    • College education: $1784, 1624, 2239, 2912, 4125$

  • Real prices (in base-year dollars) are computed to compare across years with a fixed price level.

• How to compute real prices (brief note)

  • General formula (base year b):
    $P^{real}<em>{t} = P^{nominal}</em>{t} imes rac{CPI<em>b}{CPI</em>t}$

  • This allows comparisons of prices in year t to the purchasing power of year b dollars.

  • Example applications: calculating real butter in 1970 dollars, real eggs in 1990 dollars, etc.

• EXAMPLE 1.4: The authors debate the minimum wage

  • In nominal terms, the minimum wage has increased steadily over the past $80$ years. However, in real terms its $2016$ level is below that of the $1970s$.

  • This highlights the importance of distinguishing between nominal and real measures when evaluating policy changes over time.

• EXAMPLE 1.5: Health care and college textbooks

  • Prices of health care and college textbooks have risen much faster than overall inflation.

  • College textbook prices have risen about three times as fast as the CPI.

1.4 Why Study Microeconomics? (1 of 4) Why study microeconomics

• Reasons:

  • To understand how the world works: economics aims to explain observed phenomena and answer why they occur.

  • The world becomes less mysterious when you know not only what happened, but why it possibly happened.

  • Interesting questions you may be able to answer by the end of the course include: price discrimination, social vs market norms, and the value of ownership.

1.4 Why Study Microeconomics? (2 of 4) How microeconomics helps decision making

• To make better decisions:

  • As an ordinary person: understanding how markets work helps with decisions about future jobs, major purchases (houses, cars), and financial decisions (retirement, insurance, investments). Understanding how to measure cost and benefit correctly relates to utility maximization (
    $ext{Utility Maximization}$).

  • As a corporate decision-maker: knowing how consumers and competitors will react to price and product design helps with investment decisions; economic tools help continuously adjust strategies to meet competition (
    $ext{Profit Maximization}$).

  • As a policymaker: knowing how consumers and firms react to a policy helps choose the best policy or policy mix; e.g., $ext{Minimum wage hurts less skilled workers; tariffs hurt consumers and benefit producers}$; balancing equity and economic efficiency.

• Foundational concepts mentioned:

  • Utility Maximization

  • Profit Maximization

  • Equity & Economic Efficiency

1.4 Why Study Microeconomics? (3 of 4) Corporate decision making: The Toyota Prius

• The Prius case (Toyota, 1997 in Japan; worldwide in 2001) illustrates how economics interacts with engineering.

• The design and production challenges of the Prius involve many economic considerations, not just engineering.

• Chapters referenced for related issues:

  • Consumer preferences and demand: Chapters $3, 4, 5$

  • Production and cost: Chapters $6, 7$

  • The profit-maximizing choice of output: Chapters $8, 10$

  • Pricing: Chapters $10, 11$

  • Competitive strategy: Chapters $12, 13$

  • Oil and other commodity markets: Chapters $2, 9$

1.4 Why Study Microeconomics? (4 of 4) Public policy design: Fuel Efficiency Standards (CAFÉ)

• CAFÉ standards were introduced in $1975$ to improve average fuel economy of domestically-sold cars and light trucks.

• CAFÉ standards have become increasingly stringent over the years.

• Important policy-design decisions involve economics: evaluating monetary impact on consumers, estimating the likely impact on the cost of producing cars and light trucks, and addressing why market mechanisms do not solve oil consumption problems alone.

• Key questions that policy design must consider:

  • What is the monetary impact on consumers?

  • How will the cost of production be affected?

  • Why aren’t market forces alone solving the problem of oil consumption?

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