Why Study Microeconomics?

We think that after reading this book you will have no doubt about the impor- tance and broad applicability of microeconomics. In fact, one of our major goals is to show you how to apply microeconomic principles to actual decision-making problems. Nonetheless, some extra motivation early on never hurts. Here are two examples that not only show the use of microeconomics in practice, but also provide a preview of this book.

1. Corporate Decision Making: The Toyota Prius

In 1997, Toyota Motor Corporation introduced the Prius in Japan, and started selling it worldwide in 2001. The Prius, the first hybrid car to be sold in the United States, can run off both a gasoline engine and a battery, and the momen- tum of the car charges the battery. Hybrid cars are more energy efficient than cars with just a gasoline engine; the Prius, for example, can get 45 to 55 miles per gallon. The Prius was a big success, and within a few years other manufacturers began introducing hybrid versions of some of their cars.

The design and efficient production of the Prius involved not only some impressive engineering, but a lot of economics as well. First, Toyota had to think carefully about how the public would react to the design and performance of this new product. How strong would demand be initially, and how fast would it grow? How would demand depend on the prices that Toyota charged? Understanding consumer preferences and trade-offs and predicting demand and its responsive- ness to price are essential to Toyota and every other automobile manufacturer. (We discuss consumer preferences and demand in Chapters 3, 4, and 5.)

Next, Toyota had to be concerned with the cost of manufacturing these cars — whether produced in Japan or, starting in 2010, in the United States. How high would production costs be? How would the cost of each car depend on the total number of cars produced each year? How would the cost of labor and the prices of steel and other raw materials affect costs? How much and how fast would costs decline as managers and workers gained experience with the production process? And to maximize profits, how many of these cars should Toyota plan to produce each year? (We discuss production and cost in Chapters 6 and 7, and the profit-maximizing choice of output in Chapters 8 and 10.)

Toyota also had to design a pricing strategy and consider how competitors would react to it. Although the Prius was the first hybrid car, Toyota knew that it would compete with other small fuel-efficient cars, and that soon other manufacturers would introduce their own hybrid cars. Should Toyota charge a relatively low price for a basic stripped-down version of the Prius and high prices for individual options like leather seats? Or would it be more profitable to make these options “standard” items and charge a higher price for the whole package? Whatever pricing strategy Toyota chose, how were competitors likely to react? Would Ford or Nissan try to undercut by lowering the prices of its smaller cars, or rush to bring out their own hybrid cars at lower prices? Might Toyota be able to deter Ford and Nissan from lowering prices by threatening to respond with its own price cuts? (We discuss pricing in Chapters 10 and 11, and competitive strategy in Chapters 12 and 13.)

Manufacturing the Prius required large investments in new capital equipment, so Toyota had to consider both the risks and possible outcomes of its decisions. Some of this risk was due to uncertainty over the future price of oil and thus the price of gasoline (lower gasoline prices would reduce the demand for small fuel- efficient cars). Some of the risk was due to uncertainty over the wages that Toyota would have to pay its workers at its plants in Japan and in the United States. (Oil and other commodity markets are discussed in Chapters 2 and 9. Labor markets and the impact of unions are discussed in Chapter 14. Investment decisions and the implications of uncertainty are discussed in Chapters 5 and 15.)

Toyota also had to worry about organizational problems. Toyota is an inte- grated firm in which separate divisions produce engines and parts and then assemble finished cars. How should the managers of different divisions be rewarded? What price should the assembly division be charged for the engines it receives from another division? (We discuss internal pricing and organiza- tional incentives for the integrated firm in Chapters 11 and 17.)

Finally, Toyota had to think about its relationship to the government and the effects of regulatory policies. For example, all of its cars sold in the United States must meet federal emissions standards, and U.S. production-line operations must comply with health and safety regulations. How might those regulations and standards change over time? How would they affect costs and profits? (We discuss the role of government in limiting pollution and promoting health and safety in Chapter 18.)

2. Public Policy Design: Fuel Efficiency Standards for the Twenty–First Century

In 1975, the U.S. government imposed regulations designed to improve the average fuel economy of domestically-sold cars and light trucks (including vans and sport utility vehicles). The CAFE (Corporate Average Fuel Economy) standards have become increasingly stringent over the years. In 2007, President George W. Bush signed into law the Energy Independence and Security Act, which required automakers to boost fleet wide gas mileage to 35 miles per gallon (mpg) by 2020. In 2011, the Obama administration pushed the 35 mpg target forward to 2016, and (with the agreement of 13 auto companies) set a standard of 55 mpg for 2020. While the program’s primary goal is to increase gas emissions.

A number of important decisions have to be made when designing a fuel efficiency program, and most of those decisions involve economics. First, the government must evaluate the monetary impact of the program on consumers. Higher fuel economy standards will increase the cost of purchasing a car (the cost of achieving higher fuel economy will be borne in part by consumers), but will lower the cost of operating it (gas mileage will be higher). Analyzing the ulti-mate impact on consumers means analyzing consumer preferences and demand. For example, would consumers drive less and spend more of their income on other goods? If so, would they be nearly as well off? (Consumer preferences and demand are discussed in Chapters 3 and 4).

Before imposing CAFE standards, it is important to estimate the likely impact those standards will have on the cost of producing cars and light trucks. Might automobile companies minimize cost increases by using new light-weight materials or by changing the footprint of new model cars? (Production and cost are discussed in Chapters 6 and 7.) Then the government needs to know how changes in production costs will affect the production levels and prices of new automobiles and light trucks. Are the additional costs likely to be absorbed by manufacturers or passed on to consumers in the form of higher prices? (Output determination is discussed in Chapter 8 and pricing in Chapters 10 through 13.)

The government must also ask why problems related to oil consumption are not solved by our market-oriented economy. One answer is that oil prices are determined in part by a cartel (OPEC) that is able to push the price of oil above competitive levels. (Pricing in markets in which firms have the power to control prices are discussed in Chapters 10 through 12.) Finally, the high U.S. demand for oil has led to a substantial outflow of dollars to the oil-producing countries, which in turn has created political and security issues that go beyond the con-fines of economics. What economics can do, however, is help us evaluate how best to reduce our dependence on foreign oil. Are standards like those of the CAFE program preferred to fees on oil consumption? What are the environ-mental implications of increasingly stringent standards? (These problems are discussed in Chapter 18.)

These are just two examples of how microeconomics can be applied in the arenas of private and public-policy decision making. You will discover many more applications as you read this book.

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