Principles of Microeconomics – Chapter 1 Quick Notes

Course Perspective

• Emphasis on clear narrative; graphs/models are aids, not ends, serving only to illustrate economic relationships and data more effectively.

• Ability to explain complex economic concepts in plain, accessible language is a core learning goal, fostering real-world application and understanding beyond technical jargon.

Key Economic Terms

• Economics: The social science that studies how individuals, businesses, and governments allocate scarce resources (such as land, labor, capital, and entrepreneurship) to satisfy unlimited human wants and needs. It addresses the fundamental problem of scarcity.

• Microeconomics: Focuses on the economic decisions and behaviors of individual economic agents, such as consumers, households, and firms. Policy analysis in microeconomics often examines specific market outcomes, including prices, quantities, and efficiency within individual industries or sectors.

• Macroeconomics: Deals with the aggregate performance and structure of the economy as a whole. It addresses broad economic issues such as national employment levels, inflation rates, economic growth (measured by GDP), and the effects of government policies like fiscal and monetary policy.

Positive vs Normative Analysis

• Positive analysis: Describes, explains, or predicts what is or what will be based on factual evidence and cause-and-effect relationships. These statements are empirically testable and can be proven or disproven by data. For example, the statement: "An increase in the money supply ( M ) will lead to an increase in the general price level (inflation) in the long run" is a positive statement.

• Normative analysis: Prescribes what ought to be or what should be, based on value judgments, opinions, and ethical considerations. These statements are subjective and cannot be tested empirically. Words like "should," "better," "fair," or "ought to" often indicate normative statements.

• Economics can inform policy debates by providing positive analysis of potential outcomes, but it cannot intrinsically resolve moral or ethical disputes because these involve subjective values.

Scarcity & Opportunity Cost

• Scarcity: The fundamental economic problem resulting from the mismatch between unlimited human wants and limited resources (natural resources, human capital, physical capital, and technology) available to satisfy those wants. This necessitates choices.

• Opportunity cost: The value of the next best alternative that must be forgone when a choice is made. It is the cost of choosing one option over another. For example, if you choose to study instead of work, the opportunity cost is the wages you could have earned.

• In modern, developed economies, scarcity often refers to trade-offs among non-life-threatening wants (e.g., choosing between a new car and a vacation) rather than basic survival needs.

Value Theories & Voluntary Exchange

• Subjective value: A theory asserting that the value of a good or service is determined by the utility or satisfaction an individual consumer derives from it. This perspective supports market freedom and decentralized decision-making, as individuals make choices based on their personal preferences.

• Objective value: A theory suggesting that the value of a good or service is inherent in the good itself, often based on its production cost or labor input. This view often underpins centralized planning and socialist regulation, where planners determine what is valuable and how resources should be allocated.

Markets & Exchange

• Market: Any arrangement that facilitates the interaction between willing buyers and sellers to exchange goods, services, or resources. This can include physical locations, online platforms, or informal networks.

• Defining feature: Voluntary exchange: Transactions occur only when both the buyer and seller willingly agree to the terms, implying that both parties expect to benefit from the exchange, without coercion.

• If both sides agree to a transaction and the costs imposed on third parties (externalities) are negligible, the transaction is generally presumed to be mutually beneficial for the immediate parties involved, leading to an increase in overall welfare.

• Recognized exceptions: Situations where voluntary exchange may not lead to mutually beneficial or socially desirable outcomes, warranting intervention. These exceptions include transactions involving minors, force or fraud, goods related to addiction, illegal activities, significant negative externalities (e.g., pollution), or information asymmetry.

Production Possibility Curve (PPC)

• Illustrates: The PPC (also known as the Production Possibilities Frontier or PPF) is a graphical model that demonstrates the concepts of scarcity, choice, and opportunity cost by showing the maximum possible combinations of two goods (e.g., butter vs. tractors) that an economy can produce, given its fixed resources and technology, and assuming full and efficient utilization of those resources.

• Points ON the curve: Represent production combinations where all available resources are fully and efficiently employed. These points are considered efficient.

• Points INSIDE the curve: Indicate that the economy is producing below its potential. Resources are either unemployed or inefficiently utilized, meaning more of both goods could be produced.

• Points OUTSIDE the curve: Represent production combinations that are currently unattainable with the given resources and technology. Reaching these points would require economic growth.

• Moving along the curve: Reflects the trade-off inherent in scarcity. To gain more of one good, a certain amount of the other good must be forgone, representing the opportunity cost of that choice.

Growth & Capital vs Consumer Goods

• Capital goods: Goods that are used to produce other goods and services (e.g., machinery, factories, infrastructure). They are not consumed directly but contribute to future production.

• Consumer goods: Goods and services that are purchased by households for immediate consumption (e.g., food, clothing, entertainment).

• Trade-off: A current choice biased toward the production of more capital goods (at the expense of present consumer goods) will lead to a larger outward shift of the future PPC. This highlights the inter-temporal trade-off between current consumption satisfaction and the potential for greater future economic growth and consumption capacity.

Entrepreneurship

• Most critical input: Entrepreneurship is the crucial factor that organizes and combines the other factors of production (land, labor, and capital) with technology to create and manage productive ventures. Entrepreneurs identify opportunities, take risks, and innovate.

• Distinct from invention: While invention is the creation of a new idea or product, entrepreneurship is the economic process of turning inventions into commercially viable innovations, bringing them to market, and scaling their production and distribution.

• Rewards: In market economies, significant rewards (profits) accrue to successful entrepreneurs because they bear risk, drive innovation, create jobs, and efficiently allocate resources, rather than solely to inventors who may not commercialize their ideas.

Firm Boundaries & Market Relationships

• Horizontal scope: Refers to the size of a firm relative to its competitors within a single stage of production or a specific market (e.g., its market share). It dictates how many different products or brands a firm offers within the same industry.

• Vertical scope: Determines how many successive stages of a product's value chain the firm performs internally (make) versus buying from external suppliers or selling to external distributors (buy). This ranges from fully integrated (performing all stages) to purely specialized (performing only one stage).

• Two vertical boundaries: The points where a firm interacts with external markets for its inputs (where it buys from upstream suppliers) and its outputs (where it sells to downstream customers).

Vertical, Horizontal & Conglomerate Concepts

• Vertical integration/expansion: The process of adding an adjacent stage of production to a firm's internal operations, moving either upstream (closer to raw materials, e.g., a car manufacturer buying a steel mill) or downstream (closer to the final consumer, e.g., a car manufacturer buying dealerships). The motivation is often to gain control over the supply chain, reduce transaction costs, or ensure quality.

• Horizontal merger: The combination of two or more competing firms operating at the same stage of production within the same industry. Common motivations include achieving economies of scale, increasing market share, reducing competition, or diversifying product lines within a core business area.

• Conglomerate merger: The combination of firms engaged in unrelated business activities. These mergers are often undertaken for risk diversification, efficient capital allocation across different industries, or potential synergies from shared management capabilities, and typically face less antitrust scrutiny.

• Takeover vs hostile takeover: A takeover is the acquisition of one company by another. A hostile takeover occurs when the target company's management or board of directors opposes the acquisition, often leading to complex legal and financial maneuvers.

• Spin-off/divestiture: The voluntary or forced shedding of an activity or a business unit. A spin-off typically creates a new, independent company whose shares are distributed to existing shareholders, while a divestiture is the outright sale of a business unit. Reasons include focusing on core competencies, raising capital, or complying with regulatory demands.

Make vs Buy Decisions

• Decisions to determine whether a firm should produce a good or service internally (make) or purchase it from an external supplier (buy).

• These decisions are critical for a firm's vertical scope and are driven by efforts to minimize transaction costs, manage risks, maximize efficiency, and leverage specialized capabilities.

• Factors influencing the decision include:

  • Production costs: Comparing the cost of internal production (labor, materials, overhead) versus the purchase price from an external vendor.

  • Transaction costs: Costs associated with buying from external markets, such as search costs, contracting costs, monitoring costs, and enforcement costs.

  • Asset specificity: The degree to which an asset is tailored to a specific transaction or relationship. High asset specificity often favors internal production to reduce reliance on external parties.

  • Quality control: The ability to maintain desired quality standards. Internal production may offer greater control.

  • Strategic importance: Activities core to a firm's competitive advantage are often kept in-house.

  • Flexibility: The ability to adapt to changes in demand or technology. Outsourcing can offer flexibility, but also introduces dependence.

  • Proprietary information: The risk of sensitive information being compromised when dealing with external suppliers.

  • Capacity utilization: If a firm has excess capacity, it may be more cost-effective to produce internally.

• These decisions often involve a trade-off between control (favors make) and flexibility/cost savings (favors buy).

GM and GMAC: Conglomerate Expansion of a Complement

• General Motors (GM) created General Motors Acceptance Corporation (GMAC) in 1919 to offer financing for car purchases.

• This expansion capitalized on the complementary relationship between automobile demand and the availability/price of financing, which was previously unavailable from traditional banks.

• Similarly, auto dealers entered the used car business and offered trade-ins to support new car sales, especially as the market shifted to replacement demand.

The Advantages of Conglomerate Expansion: Diversification and Risk Management

• Conglomerate mergers involve expanding into unrelated business areas, providing opportunities for diversification.

• Diversification can manage risk by allowing one business line to compensate for poor performance in another.

• However, diversification does not protect against all risks (e.g., broad economic downturns affect multiple diversified sectors, unlike industry-specific events).

Coca-Cola and Minute Maid Orange Juice: Reaping the Benefits of Core Technologies and Synergies

• Coca-Cola acquired Minute Maid Orange Juice in a conglomerate merger, leveraging its marketing and distribution expertise for beverages.

• The acquisition also created synergies by utilizing the same distribution network for both soft drinks and orange juice, which proved successful for Coke.

• Despite this success, extending core technologies or achieving synergies through conglomerate mergers is often challenging, as illustrated by Intel's struggles to enter the DSP chip market.

Squeegee – Ensuring Quality through In-house Production

• Squeegee, a premier window-washing tool company, maintained high quality through precise cutting of rubber blades.

• The company purchased rubber blanks from an external supplier but opted to keep the critical blade-cutting process in-house.

• This decision was driven by the need for stringent quality control, as the "perfect edge" of the blades was essential to Squeegee's reputation and product performance.

• Quality control was performed by skilled employees who could accurately gauge the edges by touch, highlighting the importance of specialized internal expertise.

James Duke creates The American Tobacco Company - Vertical integration to integrate Mass Distribution and Mass Production

• James Duke utilized the high-capacity Bonsack cigarette-making machine, which could produce 100,000-120,000 cigarettes daily, vastly exceeding existing demand.

• His key entrepreneurial insight was developing mass-marketing strategies to match this unprecedented production volume.

• Duke innovated modern advertising by packing cigarettes, creating brand names, and using extensive promotions via print, billboards, and sporting event sponsorships (including baseball cards).

• To sustain mass production, Duke vertically expanded: downstream into mass distribution to sell the large output, and upstream to secure a consistent tobacco supply by forming a wholesale firm.

Ericsson and Flextronics - Using the Market to Better Focus the Firm

• Ericsson, a cell phone company, redrew its vertical boundaries by divesting its manufacturing operations.

• It outsourced the production of its cell phones to Flextronics, a contract manufacturer.

• This strategic move allowed Ericsson to better focus its resources and efforts on its core competencies: design and marketing of innovative products.

• The aim was to enhance competitiveness against rivals like Nokia, Samsung, and Motorola by avoiding distractions from production issues.

General Motors and Fischer Body: Vertical Acquisition as a Solution to the “Hold-up Problem”

• In the early 1920s, General Motors (GM) relied on independent suppliers for car bodies, which were highly customized and required specific assets.

• This created a "hold-up problem," where either GM or the supplier (Fischer Body) could exploit the other due to the specialized nature of the assets involved.

• To mitigate this risk and ensure a reliable supply without coercion, GM acquired Fischer Body through an upstream vertical acquisition.

• This internalization of production eliminated the potential for a hold-up problem by bringing the critical car body manufacturing in-house.

Case Study: The Pet Rock, Voluntary Exchange, and Subjective versus Objective Value

• The Pet Rock Concept and Success:

  • Conceived by Gary Dahl in 1975 as a low-maintenance, amusing pet.

  • Packaged in a straw-filled box with care instructions and priced at $4.95 resulting in widespread popularity and making Dahl a millionaire.

• Conflicting Economic Perspectives:

  • Soviet Economists (Objective Value): Condemned the Pet Rock as wasteful decadence, arguing it did not meet their objective criteria for what society needed.

  • Western Economists (Subjective Value/Voluntary Exchange): Defended it as a perfect example of voluntary exchange, asserting that if both parties willingly engaged in the transaction, they perceived mutual benefit, thus increasing overall welfare (assuming no harm to third parties).

  • The question of whether the Pet Rock was a "good" or "bad" product is a normative one, reliant on subjective value judgments.

• Soviet Automobile Production Example:

  • The Soviet Union severely restricted consumer automobile production, despite available technology, resources, and consumer interest.

  • Soviet planners, applying an objective value criterion, decided automobiles were detrimental to the economy (except for Party officials), illustrating central planning's belief in planners knowing "what is best" for citizens.

• Hayek's "Fatal Conceit":

  • Nobel laureate Friedrich Hayek criticized this socialist planning approach as the "Fatal Conceit."

  • This term highlights the arrogance, conceit, and inherent lack of freedom stemming from the belief that central planners can objectively determine what is best for everyone.

Entrepreneurial Mini Cases

• Henry Ford (Automobile Industry)

  • Correctly read extreme elasticity of demand, envisioning low-priced, quality autos.

  • Introduced Model T at 850850 (1908), a risky bet that proved wildly successful.

  • Production soared, reaching 12 million by 1925 due to cost reductions and lower prices.

  • Adopted moving assembly line in 1913, 5 years after Model T's initial success.

  • Created the auto industry by achieving over 60% U.S. market share.

• James Bonsack vs. James Duke (Cigarettes)

  • Bonsack invented cigarette machine (1882), producing over 100,000 daily; challenged by lack of demand.

  • Duke's genius: mass-marketing cigarettes to match machine output.

  • Pioneered modern advertising: packed cigarettes, created brands, linked ads to sports (baseball cards).

  • Transformed cigarette market through mass marketing, not invention.

• Henry Crowell (Rolled Oats)

  • Founded Quaker Oats (1882) to mass-produce rolled oats using new steel roller technology.

  • Challenge: oats were considered animal feed outside Scotland/Ireland.

  • Solution: extensive advertising campaign highlighting health benefits.

  • Packaged distinctively; pioneered in-package coupons.

  • Successfully established oats as human food, exploiting mass production.

• Isaac Singer (Sewing Machines)

  • Success from high-volume sales, not invention of the sewing machine.

  • First complex machine for mechanically unskilled customers (housewives).

  • Sales lagged due to fears of servicing/repair issues.

  • Overcame reluctance by building vast network of dealers and repair stations.

  • Addressed customer concerns, enabling volume sales, mass production, and market expansion.

• Elisha Otis (Elevators)

  • Modern elevator industry hindered by public fear of falling.

  • Otis invented elevator brake (1853) to address this fear.

  • Famously demonstrated brake by cutting cables while in elevator.

  • Crucial entrepreneurial role: recognized and overcame psychological barrier more than the technical invention itself.

  • Made elevators commercially viable, transforming urban landscapes.