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?

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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?

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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?

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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?

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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

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of labor and leisure

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

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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

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Chapter 1

Themes of Microeconomics
Prices

How are prices determined?

Centrally

planned economies governments

control prices
Market economies prices determined by
interaction of market participants

Markets collection of buyers and sellers

whose interaction determines the prices of
goods

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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

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Theories and Models

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

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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

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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?

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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?

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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

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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

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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?

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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

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Types of Markets
Noncompetitive Markets

Markets where individual producers can

influence the price
Cartels

groups of producers who act

collectively
Example: OPEC dominates with world oil
market

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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

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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

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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?

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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

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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

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Real Versus Nominal Prices

Calculating Real Prices

RealPrice
baseyear

CPIbase year
CPIcurrent year

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x Nominal Pricecurrent year

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Real Price of College

Year

Nom.
Price

CPI

1970

$2,530

38.8

Real Price

1990 $12,018 130.7

2002 $18,273 181.0

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38.8
* $2,530 $2,530
38.8

38.8
* $12,018 $3,569
130.7

38.8
* $18,273 $3,917
181.0

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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

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The Minimum Wage: Figure 1.1

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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

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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

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Ford SUVs
Questions

How strong is demand and how quickly will it

grow?
Must

understand consumer preferences and

trade-offs

What are the costs of manufacturing?

Given

all costs of production, how many should

be produced each year?

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

Uncertainty

Organizational decisions
Integration

of future prices: gas, wages

of all divisions of production

Government regulation
Emissions

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standards

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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?

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