Nauman Ejaz

Objectives of this course

 To understand the key ideas of microeconomics.

 To acquire the ‘economic way of thinking’.

 To analyse problems from an economic perspective.

What is economics?
 Economics is a decision-science
 It analyses how people & firms make consumption & production
decisions & consequences of these decisions.

Examples:

 How do consumers choose what goods to buy?

 How do firms decide what to produce & how to produce?

 How do firms decide to price the goods they sell?

Decision makers in economics?

 A household is the basic unit in the economy

 it buys goods & services in markets & supplies inputs
(e.g. labour) used by

 firms – the other basic unit

 it sells goods & services in markets & use inputs (e.g.
labour) supplied by households
Economic decisions are important
 Resources are scarce
 consumers cannot buy everything &
 firms are constrained in their choices by technology &
prices.

 Similarly, society has limited resources & therefore

cannot produce all the goods & services people want.

 Economics is the study of how society manages its

scarce resources.
There are 7 key lessons learned
from economics in this unit.
Lesson 1: People face trade-offs

 To get one thing, we usually have to give up something.

 clothing v. holidays
 leisure time v. university study (& income)
 clean environment v. income
 (for governments) ‘spending on defence’ v. ‘spending on
education’
An important trade-off
 Effficiency v. equity.
 Efficiency means society gets most from its scarce
resources. Most output gets produced.
 Equity means that resources are distributed equally.
The rich don’t get it all.

 People often work hard (advance efficiency) only if they

are offered extra rewards (reduces equity).
 For example an employer might offer extra wages (which
increase inequality of wages)
 to motivate people to work harder (and thereby increase
output).
Lesson 2: The cost of something is what
you give up to get it
 Decisions require comparing costs & benefits of
alternatives.
 Whether to go to the class at the university or go
swimming?

 The opportunity cost of an item is what you give

up to obtain that item.
 Alternatively, opportunity cost is benefit foregone
by giving up the best alternative.
Example: Cost of attending university
 Example – whether to come to class or go swimming.
 Benefits you would get by going swimming.
 Benefits from coming to class.

 That you are attending (today) suggests you believe

that this maximises your benefits.

 For example
 The benefits of going swimming might be $30
 Cost of getting to a pool (say $5)
 So the net benefit is $25.
Example: Cost of attending university
 The benefits of coming to class today might be $45
 Cost of getting to university (say $10)
 So the net benefit is $35.
 Since the net benefits of coming to class today are larger
than the net benefits of going swimming
 You should choose to come to class
 i.e., You choose the item with maximum net benefits.

 Alternatively
 The opportunity cost of swimming is $35 &
 that of coming to class $25.
 You choose the item with minimum opportunity costs
Lesson 3: Rational people think at margin
 Marginal changes are small incremental adjustments to a
plan.

 Rational people make decisions by comparing costs &

benefits at the margin.

 Firms decide how many workers to hire by adding them

incrementally &
 seeing whether their cost (the wage paid) exceeds the value of the
extra production they provide.

 Consumers decide how many glasses of juice to drink by

focusing on whether drinking an additional glass will
provide benefits that exceed costs.
Parable: How can a blind person climb to
mountain top?
 By taking one step at a time &
 retracting the step if it does not move them uphill.

 If the mountain has one peak they will get to its top.

 Think about ‘getting to the peak’ as ‘doing the best you

can’ for yourself.

 This involves ‘marginal’ reasoning.

Lesson 4: People respond to incentives
 Marginal changes in costs or benefits motivate people to
respond.

 Choice of one alternative over another occurs when

 that alternative’s marginal benefits exceed its marginal costs.

 A worker might put in more effort if paid more.

 A car driver might drive less safely if they wear a seatbelt

 An illicit drug user might use less drugs if they fear health
or imprisonment risks.
Lesson 5: Trade can make everyone
better off

 People gain from trade with one another because

they get more choices.

 Competition increases choices & results in gains

from trading.

 Trade allows people to specialize in what they do

best.
Example – trade is mutually beneficial

 Suppose I have a second hand car that I value less than

house.

 If you have that house but prefer my car

 We can trade these goods & both of us will end up

better-off.
Lesson 6: Markets are often a good way
to organize economic activity
 Market economies allocate resources through the
decentralised decisions of firms & households
interacting in markets.

 Households decide what to buy and who to work

for.

 Firms decide who to hire & what to produce.

 There is no central planning as under socialism.

Adam Smith (1723-90)
 Observed that households & firms interact in
markets act as if guided by an ‘invisible hand’.

 Because households & firms look at prices

when deciding what to buy & sell, they
unknowingly take into account the social costs of
their actions.

 As a result, prices guide decision makers to

reach outcomes maximising society’s welfare.
Adam Smith
 "It is not from the
benevolence of the
butcher, the brewer, or the
baker, that we expect our
dinner, but from their
regard to their own self-
interest. We address
ourselves, not to their
humanity but to their self-
love, and never talk to
them of our own
necessities but of their
advantages."
 Adam Smith remains a key figure in economics.

 After more than 2 centuries his books:

 Wealth of the Nations
 Theory of Moral Sentiments
remain insightful discussions of economics, philosophy
& psychology.
Lesson 7: Governments can sometimes
improve market outcomes

 Market failures occur when markets fail to allocate

resources efficiently or equitably.

 When the market fails (breaks down) government

can intervene to promote efficiency and equity.
 Market failure may be caused by:
 an externality - the impact of one person or firm’s
actions on the wellbeing of a bystander .
 e.g. pollution & traffic congestion.
 Governments can tax these activities to force better
outcomes.

 Market power - the ability of a single person or firm

to have a substantial influence on market prices.
 Monopoly power.
 Governments can act to limit the formation of
monopolies or encourage competition.
Summary
 When individuals make decisions, they face trade-offs.

 The cost of any action is measured in terms of foregone

opportunities – opportunity costs. This is perhaps the most
crucial idea in economics.

 Rational people make decisions by comparing marginal

costs & marginal benefits – use marginal analysis.

 People change behavior in response to incentives.

Summary
 Trade can be mutually beneficial.

 Markets are often a good way of coordinating trade

among people.

 Government can sometimes improve market outcomes

if there is market failure or if the market outcome is
inequitable.