CHAPTER 1

ANALYZING ECONOMIC

PROBLEMS

1

Microeconomics Defined

Microeconomics

The study of how individual economic decision-makers such as consumers, workers, firms or

managers allocate scarce resources among

alternate uses

This study involves both the behaviour of these economic agents on their own and the way their

behaviour interacts to form larger units, such as

markets

2

Who should study microeconomics?

Policy maker

Produce more goods for national defence, but it would have to produce fewer civilian goods

Consumer

Allocate more time to work, but have less time available for leisure activities

Manager

Spend more of a firms resources on advertising, but have less resources for research and

development 3

Key Societal Questions

Societies must answer these questions that relate to microeconomics:

What goods and services will be produced and in what quantities?

Who will produces these services and how will they produce them?

Who will receive these goods and services and how will they get them?

4

Microeconomic Modeling

Economic model is like a roadmap

Is an abstract model that serves a particular purpose

Using visual methods, they simply the process and facilitate understanding of complex concepts

Shows us where we are and how we can get where we want to go

Microeconomic model need to:

Resemble Reality

Be Understandable

Be an Appropriate Scale

5

Exogenous & Endogenous Variables

Exogenous variable

Variable whose value is taken as given in the analysis of an economic system

Determined by some process outside the model being examined

E.g. wage

Endogenous variable

Variable whose value is determined within the economic system being studied

E.g. number of workers

6

Three Key Analytical Tools

Constrained optimization

Equilibrium analysis

Comparative statics

7

Constrained Optimization

Constrained optimisation

Making the best (optimal) choice, taking into account any possible restrictions on the choice

Objective function

The relationship that a decision maker seeks to maximise or minimise

E.g. maximise utility, minimise cost

Constraints

The restrictions or limits imposed on a decision maker in a constrained optimisation problem

E.g. time, budget, other resources 8

Constrained Optimization (cont.)

9

Constrained Optimization (cont.)

10

Constrained Optimization (cont.)

Example:

Consumer purchases

Food (F), Clothing ( C ), Income (I)

Price of food (pf), price of clothing (pc)

Satisfaction from purchases: S = (FC)1/2

Max S(F,C) - subject to: pf.F + pc.C I

11

12

PFF + PCC = I

F

C 0

(FC)1/2 = S0

(FC)1/2 = S1

(FC)1/2 = S2

S2 > S1 > S0

Constrained Optimization (cont.)

Marginal Reasoning

13

Equilibrium

An analysis of a system in a state that will continue indefinitely

As long as the no outside factor upsets the equilibrium

The point where demand just equals supply in this market

The point where the demand and supply curves cross

14

Equilibrium (cont.)

15

Comparative Statistics

Examine how a change in some exogenous variable will affect the level of some

endogenous variable in an economic system

Can be applied to constrained optimisation problems and equilibrium analyses

Comparing two snapshots of an economic model

Levels of the endogenous variables given a set of exogenous variables

How endogenous variables change in response to an exogenous shock

16

Comparative Statistics (cont.)

17

Comparative Statistics (cont.)

18

Comparative Statistics (cont.)

19

Comparative Statistics (cont.)

20

Comparative Statistics (cont.)

21

Microeconomic Analysis

Positive analysis

To explain how an economic system works or to predict how it will change over time

What has happened?

What is happening?

Normative analysis

Focuses on issues of social welfare, examining what will enhance or detract from the common

good

What should be done?

22

Microeconomic Analysis (cont.)

Example:

Should we increase income equality rather than focus on economic efficiency?

Should we impose a progressive income tax or a sales tax to increase income equality?

Will a progressive income tax reduce aggregate hours worked?

23