Chapter 1

Preliminaries

Introduction
What are the key themes of microeconomics? What is a market? What is the difference between real and nominal prices? Why study microeconomics?

2005 Pearson Education, Inc.

Chapter 1

Themes of Microeconomics
Microeconomics deals with limits
Limited budgets Limited time Limited ability to produce

How do we make the most of limits? How do we allocate scarce resources?

2005 Pearson Education, Inc.

Chapter 1

Themes of Microeconomics
Workers, firms and consumers must make trade-offs
Do I work or go on vacation? Do I purchase a new car or save my money? Do we hire more workers or buy new machinery?

How are these trade-offs best made?

2005 Pearson Education, Inc.

Chapter 1

Themes of Microeconomics
Consumers
Limited incomes Consumer theory describes how consumers maximize their well-being, using their preferences, to make decisions about trade-offs How do consumers make decisions about consumption and savings?

2005 Pearson Education, Inc.

Chapter 1

Themes of Microeconomics
Workers
Individuals decide when and if to enter the workforce
Trade-offs

of working now or obtaining more education/training

What choices do individuals make in terms of jobs or workplaces? How many hours do individuals choose to work?
Trade-off

of labor and leisure

2005 Pearson Education, Inc.

Chapter 1

Themes of Microeconomics
Firms
What types of products do firms produce?
Constraints

on production capacity and financial resources create needs for trade-offs

Theory of the Firm describes how these trade-offs are best made

2005 Pearson Education, Inc.

Chapter 1

Themes of Microeconomics
Prices
Trade-offs are often based on prices faced by consumers and producers Workers make decisions based on prices for labor wages Firms make decisions based on wages and prices for inputs and on prices for the goods they produce

2005 Pearson Education, Inc.

Chapter 1

Themes of Microeconomics
Prices
How are prices determined?
planned economies governments control prices Market economies prices determined by interaction of market participants
Centrally

Markets collection of buyers and sellers whose interaction determines the prices of goods

2005 Pearson Education, Inc.

Chapter 1

Theories and Models

Economics is concerned with explanation of observed phenomena
Theories are used to explain observed phenomena in terms of a set of basic rules and assumptions:
The

Theory of the Firm The Theory of Consumer Behavior

2005 Pearson Education, Inc.

Chapter 1

10

Theories and Models

Theories are used to make predictions
Economic models are created from theories Models are mathematical representations used to make quantitative predictions

2005 Pearson Education, Inc.

Chapter 1

11

Theories and Models

Validating a Theory
The validity of a theory is determined by the quality of its prediction, given the assumptions Theories must be tested and refined Theories are invariably imperfect but gives much insight into observed phenomena

2005 Pearson Education, Inc.

Chapter 1

12

Positive & Normative Analysis

Positive Analysis statements that describe the relationship of cause and effect
Questions that deal with explanation and prediction
What

will be the impact of an import quota on foreign cars? What will be the impact of an increase in the gasoline excise tax?

2005 Pearson Education, Inc.

Chapter 1

13

Positive & Normative Analysis

Normative Analysis analysis examining questions of what ought to be
Often supplemented by value judgments
Should

the government impose a larger gasoline tax? Should the government decrease the tariffs on imported cars?

2005 Pearson Education, Inc.

Chapter 1

14

What is a Market?
Markets
Collection of buyers and sellers, through their actual or potential interaction, determine the prices of products
Buyers:

consumers purchase goods, companies purchase labor and inputs Sellers: consumers sell labor, resource owners sell inputs, firms sell goods

2005 Pearson Education, Inc.

Chapter 1

15

What is a Market?
Market Definition
Determination of the buyers, sellers, and range of products that should be included in a particular market

Arbitrage
The practice of buying a product at a low price in one location and selling it for more in another location

2005 Pearson Education, Inc.

Chapter 1

16

What is a Market?
Defining the Market
Many of the most interesting questions in economics concern the functioning of markets
Why

are there a lot of firms in some markets and not in others? Are consumers better off with many firms? Should the government intervene in markets?

2005 Pearson Education, Inc.

Chapter 1

17

Types of Markets
Perfectly competitive markets
Because of the large number of buyers and sellers, no individual buyer or seller can influence the price
Example:

Most agricultural markets

Fierce competition among firms can create a competitive market

2005 Pearson Education, Inc.

Chapter 1

18

Types of Markets
Noncompetitive Markets
Markets where individual producers can influence the price
groups of producers who act collectively Example: OPEC dominates with world oil market
Cartels

2005 Pearson Education, Inc.

Chapter 1

19

Market Price
Transactions between buyers and sellers are exchanges of goods for a certain price
Market price price prevailing in a competitive market
Some

markets have one price: price of gold Some markets have more than one price: price of Tide versus Wisk

2005 Pearson Education, Inc.

Chapter 1

20

Market Definition
Market Definition
Which buyers and sellers should be included in a given market? This depends on the extent of the market boundaries, geographical and by range of products, to be included in it
Market

for housing in New York or Indianapolis Market for all cameras or digital cameras

2005 Pearson Education, Inc.

Chapter 1

21

Market Definition
Importance of market definition
In order to set price, make budgeting decisions, etc., companies must know
Their

competitors Product-characteristic and geographic boundaries of the market

Important for public policy decisions

Should

government allow a merger between companies in same market?

2005 Pearson Education, Inc.

Chapter 1

22

Real Versus Nominal Prices

Comparing prices across time requires measuring prices relative to some overall price level
Nominal price is the absolute or current dollar price of a good or service when it is sold Real price is the price relative to an aggregate measure of prices or constant dollar price

2005 Pearson Education, Inc.

Chapter 1

23

Real Versus Nominal Prices

Consumer Price Index (CPI) is often used as a measure of aggregate prices
Records the prices of a large market basket of goods purchased by a typical consumer over time Percent changes in CPI measure the rate of inflation

2005 Pearson Education, Inc.

Chapter 1

24

Real Versus Nominal Prices

Calculating Real Prices

RealPrice
baseyear

CPIbase year CPIcurrent year

x Nominal Pricecurrent year

2005 Pearson Education, Inc.

Chapter 1

25

Real Price of College

Year Nom. Price $2,530 CPI Real Price

1970

38.8

38.8 * $2,530 $2,530 38.8

1990 $12,018 130.7 2002 $18,273 181.0

38.8 * $12,018 $3,569 130.7 38.8 * $18,273 $3,917 181.0

2005 Pearson Education, Inc.

Chapter 1

26

Real Price of Wages

Observations
The minimum wage has been increasing in nominal terms since 1940
From

1930 at $0.25 to 2003 at $5.15

The 1999 real minimum wage was no higher in 1999 than 1950

2005 Pearson Education, Inc.

Chapter 1

27

The Minimum Wage: Figure 1.1

2005 Pearson Education, Inc.

Chapter 1

28

Why Study Microeconomics?

Microeconomic concepts are used by everyone to assist them in making choices as consumers and producers Examples show the numerous levels of microeconomic questions necessary in many decisions

2005 Pearson Education, Inc.

Chapter 1

29

Ford SUVs
Built Ford Explorer in 1991, Ford Expedition in 1997 and Ford Excursion in 1999 In each of these cases, Ford had to consider many aspects of the economy to ensure their introduction was a sound investment

2005 Pearson Education, Inc.

Chapter 1

30

Ford SUVs
Questions
How strong is demand and how quickly will it grow?
Must

understand consumer preferences and trade-offs all costs of production, how many should be produced each year?

What are the costs of manufacturing?

Given

2005 Pearson Education, Inc.

Chapter 1

31

Ford SUVs
Questions (cont.)
Ford had to develop pricing strategy and determine competitors reactions Risk analysis
Uncertainty

of future prices: gas, wages

Organizational decisions
Integration

of all divisions of production

Government regulation
Emissions

standards

2005 Pearson Education, Inc.

Chapter 1

32

Emission Standards
1970 Clean Air Act imposed emissions standards and have become increasingly stringent
Questions:
What

are the impacts on consumers? What are the impacts on producers? How should the standards be enforced? What are the benefits and costs?

2005 Pearson Education, Inc.

Chapter 1

33