Foundations of

Micro Economics
Big Questions
1. What is economics?
2. What are the fundamental concepts
underlying economic models?
3. How do we model/predict economic
behavior?
 And does it work?
Key Terms
Common understanding of key terms
Use them as shorthand for the concept; but have a
precise/exact meaning
Scarcity
 There are not enough resources to produce and consume all
of the goods and services we desire
Opportunity costs
What must be given up (next best alternative use of
time/money) as a result of a decision or choice
“No such thing as a free lunch” (Milton Friedman)
Cost-benefit analysis
Every decision/action has tradeoffs
i.e., every decision has an opportunity cost
 What is Economics
2 major fields of inquiry
 Microeconomics
 Study of individual markets and factors that affect market price,

quantity supplied
 two principal actors: consumers/households and

firms/producers
 Macroeconomics
 Study of a system of (national) markets focusing on national

income (gross national product), price levels (inflation),

employment/unemployment and international trade
 Focuses on the role of government (Congress and budgets,

Federal Reserve Bank), regulation (and regulatory agencies,

business cycles and their effect on the economy
 Ten Principles of Economics

Micro-economists study:
How people and firms make decisions (choices) and
what factors (incentives) affect their decisions
How people and firms interact with one another in the
marketplace
It’s all about the incentives!
What factors/incentive drive consumer/supplier
behavior
How do we model what they are reacting to, and why?

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 Scarcity
The Key Economic Problem
Scarcity means limited resources
The limited nature of society’s resources (e.g. raw
materials) means that we have to choose which goods
get produced with scarce resources and how they are
allocated/distributed to the consumer
Economics
Studies of how people(consumers) and
firms(producers) make these decisions when
constrained by scarcity
Determine what are the key factors affecting their
decisions and modelling their decision making process
Big Questions
Economics is the study of how people allocate their
limited resources (income and time) to satisfy nearly
unlimited wants and how firms use limited resources
(raw materials) to meet consumer demand
The fundamental concepts on which economic
models (decision-making) are based:
1. Incentives
2. Trade-offs
3. Opportunity cost
4. Marginal thinking
5. Trade creates value
Foundations underlying the Model
The five underlying concepts of economic models:
1. Incentives – people respond to incentives
 Price is an incentive - lower price -> buy more
 Lowering tuition costs
2. Trade-offs – buy one good -> can’t buy others
 Compare value/price of alternative use of income/time

3. Opportunity cost – what is given up

 Value of “best” alternative not chosen

4. Marginal thinking
 compare “additional” value of 1 more unit to its price when

making purchase decision (not total value/cost of all units)

5. Trade creates value
 Why people voluntarily enter into market transactions
How People Make Decisions
Principle 1: People face trade-offs
Making decisions
Trade off one goal against another
 Student – time (sleeping versus studying)
 Consumers – income (consume or save)

 Clean environment vs. high level of income

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Modelling Tradeoffs – Individual’s Choices
Between 2 goods
In microeconomic theory, an indifference curve is a
graph showing different bundles of goods between
which a consumer is indifferent. That is, at each point
on the curve, the consumer has no preference for one
bundle over another.
Production Possibilities Frontier
- Choice between producing 2 goods
Production possibilities frontier
Combinations of outputs that a society can
produce if all of its resources are being used
efficiently
Assumptions of this model
Technology fixed
Resources fixed
Simplified two-good analysis
Production Possibilities Frontier
Pizzas Chicken W Cost of +1 CW Cost of +1 Pizza
100 0 -3
70 90 -0.33 -3
50 150 -0.33 -3
0 300 -0.33

Can’t Produce
Technology
Constraint

Economically
Inefficient
How People Make Decisions
Principle 2: The cost of something is what you give up to
get it - each decision has an opportunity cost
Because people face trade-offs when making choices –
you have to give something up to get something
Benefit/Cost Analysis to make decisions
 Compare cost with benefits of alternatives
 Implies opportunity cost (of what is not chosen) is incurred
 Whatever most be given up to obtain one item

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How People Make Decisions
Principle 3: Rational people think at the margin
Rational people
Systematically & purposefully do the best they can to
achieve their objectives
Rational decision maker – take action only if
Marginal benefits > Marginal costs
 Marginal Benefits – change (or increase) in total benefits from
choice
 Marginal Costs – change/increase in costs from choice
(opportunity costs of “not chosen”)

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3. Optimal decisions are made at the “margin”

What do we mean?
When making an economic decision, e.g. to purchase 1
more unit of a good, we compare the marginal (or
incremental) benefits against the marginal costs (e.g.,
price)
For example
When studying for an exam
 Given you’ve already studied 8 hours, when deciding whether or not
to study 1 more hour, you compare
 the expected benefits (a “marginal” improvement in your grade
 Versus the next best (highest valued) use of your time

 E.g., sleeping, eating, time with friends

Marginal Decisions
Back to the First Law of Demand
How much of a good do you buy?
 If the marginal/incremental value of the next unit is less than
what it costs, are you willing to buy it?
MV < price
Don’t buy!

MV < price
Do buy!
How People Make Decisions
Principle 4: People respond to incentives
Incentive
Something that induces a person to act
In economics – which incentives affect market behavior
and how important is each
 Higher price
 Buyers - consume less

 Sellers - produce more

 Public policy
 Change costs or benefits

 Change people’s behavior

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An example: the First Law of Demand
As the price per unit of the good declines, a consumer
(all other things held constant, e.g. their income) will
choose to buy more of the good over the same time
period
How People Make Decisions
Principle 4: People respond to incentives
Gasoline tax
 Car size & fuel efficiency; carpool; public transportation
 State will raise gasoline tax in July

 Reduced single-occupancy cars; less essential trips

 Increased demand for mass transit, car-pooling

Highway 520 bridge tolls

 Revenues used to finance new construction
Unintended consequences
 Policymakers fail to consider how their policies affect incentives
 Will toll increase increase/decrease revenues? (Elasticity)

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Principle 4: People Respond (rationally)
to Economic Incentives
An example (Hubbard and O’Brien)
Average age of the populations of US, Japan and most
Europeans countries are getting older
 Declining birth rates (below replacement level)
 People living longer
 Post WWII baby boom (“mouse in the python”)

Challenge for governments as

Social security and medical care payments will increase
as larger % of population retires
Fewer younger folks replacing them in the workforce
 -> tax payments are decreasing
An Interesting Solution
Estonia
UN estimated that population would decline by 0.7M by
2050 (from 1.4M to 0.7M)
Starting in 2007
 Working women paid entire salary up to 15 months for having
a child
 Non-working: $200 per month (avg income ~$650)

Impact
 Birth rate increased from 1.6 to 2.1 children per woman
45 other european countries in the process of adopting
a similar set of incentives
 Learning Objective 1.1

Making Will Women Have More Babies if the

the Government Pays Them To?
Connection

Estonian Gov’t Increased Paid Time-Off for Mat

The Estonian government is
encouraged by the results of
providing economic
incentives and is looking for
ways to provide additional
incentives to raise the
birthrate further.
How People Interact
Principle 5: Trade can make everyone better off
Trade
Specialization
 Allows each person/country to specialize in the activities
he/she does best
People/countries can buy a greater variety of goods and
services at lower cost

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Gain from Trade -
Specialization
Key Assumptions About Individual Economic
Behavior
Alchian and Allen
1. For each person, some goods are scarce -> choices
2. Each person desires many goods and goals -> tradeoffs
3. Each person is willing to give up some of one economic good
to get more of another economic good -> basis for trade
4. The more one has of a good, the lower is its personal
marginal value -> diminishing marginal value
5. Not all people have identical tastes and preferences
6. People are innovative and rational
 An Example of a Model Built
on These Assumptions
A Model of Consumer Demand
 What is Economics?
Economics
Analyzes the production and distribution/allocation
of goods and services – i.e. how the market place
works
 Or how “stuff” is made and bought, and how its market
price is determined.
 who gets what

 how/who makes it

Models how individuals and firms make decisions

about:
 What to purchase (choosing how to allocate income among
various goods, services and savings/future consumption)
 What goods are produced (and not)

 What technologies to use

 How goods get allocated to which consumers in the

marketplace
© 2011, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website for classroom use. 28