Chapter 1 Microeconomics: A Working Methodology

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The economic environment poses many complex questions. The only way to understand economic behaviour is to find a method for setting out and then solving microeconomic problems. This methodology consists of a relatively small set of ideas that are applicable to a vast number of situations. Throughout this book you will be introduced to the ideas of economic analysis and shown how to use them to answer many economic questions.

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A Water Shortage Problem

An

imaginary island is sub-divided into the 100-home Estates. Water for these homes comes from a series of wells owned by the Estates Water District at a total cost of $50 000 per year. Every household pays a flat fee of $500 per year for water (nonmetered scheme).
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A Water Shortage problem

All

householders are identical and the typical household uses 80 000 litres of water over July and August. Water is sometime unavailable in August. The householder currently has an unbalanced water use profile consisting of 60 000 litres in July and 20 000 in August.
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A Water Shortage Problem

The

householder would actually prefer to consume 40 000 litres of water in each of July and August (the balanced water profile). However the householder cannot achieve the preferred water profile by his/her own effort, even though total water consumption under both profiles is the same.
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A Water Shortage problem

To see why suppose just one householder reduces personal water use from 60 000 to 40 000 litres in July, leaving 20 000 additional litres for August. In August this water conserving household would get only 1/100 (2 000 litres) of this additional water as all other household draw on the extra water supply. Figure 1.1 shows all the water use profiles the householder can personally achieve under the non-metered scheme.

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Figure 1.1 Attainable water use profiles

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From Figure 1.1

What

is the most preferred water profile along DCU? Because all 100 householders see the problem in the same way, they find an equilibrium at 60 000 litres in July and 20 000 litres in August. There is nothing an individual householder by themselves can do to attain a more preferred profile.
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From Figure 1.1

However, this equilibrium is unattractive. Even though total water usage is the same, every householder would prefer to consume the balanced profile of 40 000 litres in each July and August. Put differently, each householder could be better off if there were some way to induce everyone to save 20 000 litres in July for use in August.

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A Water Monitoring Scheme

A

metered water scheme, where the price was sufficient to reduce July consumption, could bring about the balanced water profile. If it costs nothing to monitor water consumption, all revenues raised by the per litre charge could be used to reduce the householders fixed yearly fee.
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A Water Monitoring Scheme

Monitoring

is not costless. The expense of collecting fees, must be compared with the benefits of balanced water use. Such a comparison will determine if the water monitoring scheme is preferable to the non-monitored scenario.
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Common Property Problems

The water shortage problem is referred to as a common property problem. In the non-metered scheme, the districts wells are common property and there is insufficient incentive to curb water usage. With the metered scheme, the wells become private property, the water is sold to users and the cost of usage provides incentives for conservation.

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Competitive Equilibrium

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Agricultural Price Supports

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Describing an Economy: Four Building Blocks

Resource

endowment consists of all resources available to an economy. Technology specifies how resources can be used to produce goods. Preferences of individuals determines what goods are produced in an economy. Institutions are the rules by which the economic game is played.
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The Equilibrium Method

An equilibrium consists of a set of choices for the individuals and a corresponding social state such that no individual can be better off by making some other choice. Comparative static analysis is the method of analyzing the impact of a change by comparing the equilibrium resulting from that change with the original equilibrium.

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Positive and Normative Economics

Positive economics is concerned with factual matters. The answers to positive economic questions can be settled by factual observation. Normative economics involves value judgements. The answers to normative economic questions are based on judgements (opinions) and cannot be settled by appealing to the facts

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The Pareto Criterion

In

comparing two social states (state I and J) - state I is Pareto preferred to state J if no one is worse off in state I then in state J, and if at least one person is better off in state I than in state J.

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Pareto Optimality
A

social state is Pareto-optimal if no other attainable social state is Pareto-preferred to it. Pareto-optimal is synonymous with economic efficiency.

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Cost-Benefit Analysis
Net social benefits equals gross social benefits minus gross social costs In the move from social state I to social state J, if net social benefit is positive, then the cost-benefit criterion ranks J as preferred to I. If net social benefit is negative, then the cost-benefit criterion ranks state I as preferred to state J.

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The Circular Flow of Economic Activity

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