CHAPTER 1

WHAT IS?

• Economics: Economics is the study of the allocation of scarce resources among alternative uses

• Microeconomics: The study of the economic choices individuals and firms make and how these choices create markets

• Micro theory: Provides the tool box to understand how decisions are made and resources are allocated by individuals and firms

AN ECONOMIC MODEL

• A model is a simple theoretical description that captures the essentials of how the economy works

• An abstraction• Makes assumptions

AN EXAMPLE OF A MODEL: THE PPF

• Suppose an economy produces food and clothing

Amount of food per week

Amount of clothing per week

PPF

Scarce resources opportunity costs Opportunity costs increase Incentives matter Inefficiency has real costs

TO BUILD A MODEL

• Start with an economic problem• Identify the decision makers• Identify their objectives• Identify the relevant choices• State assumptions• Solve for the equilibrium• Discuss the equilibrium

HOW ECONOMISTS VERIFY THEORETICAL MODELS

• Testing Assumptions: Verifying economic models by examining validity of assumptions upon which models are based• Is it reasonable to assume that people are

rational, that firms maximize profits etc.

• Testing Predictions: Verifying economic models by asking whether models can accurately predict real-world events• If the model predicts events well, then the theory

is useful even if the assumption may not appear to be valid.