Introduction to Microeconomics

The Rolling Stones once said: “You can’t always get what you want.” This is true. For most people (even Mick Jagger), that there are limits to what you can have or do is a simple fact of life learned in early childhood. For economists, however, it can be an obsession.

Much of microeconomics is about limits—the limited incomes that consumers can spend on goods and services, the limited budgets and technical know-how that firms can use to produce things, and the limited number of hours in a week that workers can allocate to labor or leisure. But microeconomics is also about ways to make the most of these limits. More precisely, it is about the allocation of scarce resources. For example, microeconomics explains how consumers can best allocate their limited incomes to the various goods and services available for purchase. It explains how workers can best allocate their time to labor instead of leisure, or to one job instead of another. And it explains how firms can best allocate limited financial resources to hiring additional workers versus buying new machinery, and to producing one set of products versus another.

In a planned economy such as that of Cuba, North Korea, or the former Soviet Union, these allocation decisions are made mostly by the government. Firms are told what and how much to produce, and how to produce it; workers have little flexibility in choice of jobs, hours worked, or even where they live; and consum- ers typically have a very limited set of goods to choose from. As a result, many of the tools and concepts of microeconomics are of limited relevance in those countries.

1. TradeOffs

In modern market economies, consumers, workers, and firms have much more flexibility and choice when it comes to allocating scarce resources. Microeconomics describes the trade-offs that consumers, workers, and firms face, and shows how these trade-offs are best made.

The idea of making optimal trade-offs is an important theme in micro- economics—one that you will encounter throughout this book. Let’s look at it in more detail.

CONSUMERS Consumers have limited incomes, which can be spent on a wide variety of goods and services, or saved for the future. Consumer theory, the sub- ject matter of Chapters 3, 4, and 5 of this book, describes how consumers, based on their preferences, maximize their well-being by trading off the purchase of more of some goods for the purchase of less of others. We will also see how con- sumers decide how much of their incomes to save, thereby trading off current consumption for future consumption.

WORKERS Workers also face constraints and make trade-offs. First, people must decide whether and when to enter the workforce. Because the kinds of jobs—and corresponding pay scales—available to a worker depend in part on educational attainment and accumulated skills, one must trade off work- ing now (and earning an immediate income) for continued education (and the hope of earning a higher future income). Second, workers face trade-offs in their choice of employment. For example, while some people choose to work for large corporations that offer job security but limited potential for advancement, others prefer to work for small companies where there is more opportunity for advancement but less security. Finally, workers must sometimes decide how many hours per week they wish to work, thereby trading off labor for leisure.

FIRMS Firms also face limits in terms of the kinds of products that they can pro- duce, and the resources available to produce them. General Motors, for exam- ple, is very good at producing cars and trucks, but it does not have the ability to produce airplanes, computers, or pharmaceuticals. It is also constrained in terms of financial resources and the current production capacity of its factories. Given these constraints, GM must decide how many of each type of vehicle to produce. If it wants to produce a larger total number of cars and trucks next year or the year after, it must decide whether to hire more workers, build new factories, or do both. The theory of the firm, the subject matter of Chapters 6 and 7, describes how these trade-offs can best be made.

2. Prices and Markets

A second important theme of microeconomics is the role of prices. All of the trade-offs described above are based on the prices faced by consumers, workers, or firms. For example, a consumer trades off beef for chicken based partly on his or her preferences for each one, but also on their prices. Likewise, workers trade off labor for leisure based in part on the “price” that they can get for their labor—i.e., the wage. And firms decide whether to hire more workers or pur- chase more machines based in part on wage rates and machine prices.

Microeconomics also describes how prices are determined. In a centrally planned economy, prices are set by the government. In a market economy, prices are determined by the interactions of consumers, workers, and firms. These interactions occur in markets—collections of buyers and sellers that together determine the price of a good. In the automobile market, for example, car prices are affected by competition among Ford, General Motors, Toyota, and other manufacturers, and also by the demands of consumers. The central role of markets is the third important theme of microeconomics. We will say more about the nature and operation of markets shortly.

3. Theories and Models

Like any science, economics is concerned with the explanations of observed phenomena. Why, for example, do firms tend to hire or lay off workers when the prices of their raw materials change? How many workers are likely to be hired or laid off by a firm or an industry if the price of raw materials increases by, say,10 percent?

In economics, as in other sciences, explanation and prediction are based on theories. Theories are developed to explain observed phenomena in terms of a set of basic rules and assumptions. The theory of the firm, for example, begins with a simple assumption—firms try to maximize their profits. The theory uses this assumption to explain how firms choose the amounts of labor, capital, and raw materials that they use for production and the amount of output they produce.

It also explains how these choices depend on the prices of inputs, such as labor, capital, and raw materials, and the prices that firms can receive for their outputs. Economic theories are also the basis for making predictions. Thus the theory of the firm tells us whether a firm’s output level will increase or decrease in response to an increase in wage rates or a decrease in the price of raw materi- als. With the application of statistical and econometric techniques, theories can be used to construct models from which quantitative predictions can be made.

A model is a mathematical representation, based on economic theory, of a firm, a market, or some other entity. For example, we might develop a model of a par- ticular firm and use it to predict by how much the firm’s output level will change as a result of, say, a 10-percent drop in the price of raw materials.

Statistics and econometrics also let us measure the accuracy of our predictions. For example, suppose we predict that a 10-percent drop in the price of raw materi- als will lead to a 5-percent increase in output. Are we sure that the increase in out- put will be exactly 5 percent, or might it be somewhere between 3 and 7 percent? Quantifying the accuracy of a prediction can be as important as the prediction itself.

No theory, whether in economics, physics, or any other science, is perfectly correct. The usefulness and validity of a theory depend on whether it succeeds in explaining and predicting the set of phenomena that it is intended to explain and predict. Theories, therefore, are continually tested against observation. As a result of this testing, they are often modified or refined and occasionally even discarded. The process of testing and refining theories is central to the develop- ment of economics as a science.

When evaluating a theory, it is important to keep in mind that it is invariably imperfect. This is the case in every branch of science. In physics, for example, Boyle’s law relates the volume, temperature, and pressure of a gas.2  The law is based on the assumption that individual molecules of a gas behave as though they were tiny, elastic billiard balls. Physicists today know that gas molecules do not, in fact, always behave like billiard balls, which is why Boyle’s law breaks down under extremes of pressure and temperature. Under most conditions, however, it does an excellent job of predicting how the temperature of a gas will change when the pressure and volume change, and it is therefore an essential tool for engineers and scientists.

The situation is much the same in economics. For example, because firms do not maximize their profits all the time, the theory of the firm has had only limited success in explaining certain aspects of firms’ behavior, such as the timing of capital investment decisions. Nonetheless, the theory does explain a broad range of phenomena regarding the behavior, growth, and evolution of firms and indus- tries, and has thus become an important tool for managers and policymakers.

4. Positive versus Normative Analysis

Microeconomics is concerned with both positive and normative questions. Positive questions deal with explanation and prediction, normative questions with what ought to be. Suppose the U.S. government imposes a quota on the import of foreign cars. What will happen to the price, production, and sales of cars? What impact will this policy change have on American consumers? On workers in the automobile industry? These questions belong to the realm of positive analysis: statements that describe relationships of cause and effect.

Positive analysis is central to microeconomics. As we explained above, theories are developed to explain phenomena, tested against observations, and used to construct models from which predictions are made. The use of eco- nomic theory for prediction is important both for the managers of firms and for public policy. Suppose the federal government is considering raising the tax on gasoline. The change would affect the price of gasoline, consumers’ purchasing 2Robert Boyle (1627–1691) was a British chemist and physicist who discovered experimentally that pressure (P), volume (V), and temperature (T) were related in the following way: PV = RT, where R is a constant. Later, physicists derived this relationship as a consequence of the kinetic theory of gases, which describes the movement of gas molecules in statistical terms. choices for small or large cars, the amount of driving that people do, and so on. To plan sensibly, oil companies, automobile companies, producers of auto- mobile parts, and firms in the tourist industry would all need to estimate the impact of the change. Government policymakers would also need quantitative estimates of the effects. They would want to determine the costs imposed on consumers (perhaps broken down by income categories); the effects on profits and employment in the oil, automobile, and tourist industries; and the amount of tax revenue likely to be collected each year.

Sometimes we want to go beyond explanation and prediction to ask such questions as “What is best?” This involves normative analysis, which is also important for both managers of firms and those making public policy. Again, consider a new tax on gasoline. Automobile companies would want to deter- mine the best (profit-maximizing) mix of large and small cars to produce once the tax is in place. Specifically, how much money should be invested to make cars more fuel-efficient? For policymakers, the primary issue is likely to be whether the tax is in the public interest. The same policy objectives (say, an increase in tax revenues and a decrease in dependence on imported oil) might be met more cheaply with a different kind of tax, such as a tariff on imported oil.

Normative analysis is not only concerned with alternative policy options; it also involves the design of particular policy choices. For example, suppose it has been decided that a gasoline tax is desirable. Balancing costs and benefits, we then ask what is the optimal size of the tax.

Normative analysis is often supplemented by value judgments. For example, a comparison between a gasoline tax and an oil import tariff might conclude that the gasoline tax will be easier to administer but will have a greater impact on lower-income consumers. At that point, society must make a value judgment, weighing equity against economic efficiency. When value judgments are involved, microeconomics cannot tell us what the best policy is. However, it can clarify the trade-offs and thereby help to illuminate the issues and sharpen the debate.

Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.

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