CHAPTER 1

ANALYZING ECONOMIC
PROBLEMS

Microeconomics Defined
Microeconomics
The study of how individual economic decisionmakers 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?

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

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.)

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

Constrained Optimization (cont.)

F

PFF + PCC = I
S2 > S 1 > S 0
(FC)1/2 = S2
(FC)1/2 = S1

(FC)1/2 = S0
0

C
12

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