Chapter 01 - Introduction

Part I. Preliminaries

Chapter 1: Introduction
Main Concepts and Learning Objectives This chapter provides an overview of the purpose of this textbook: to help students develop a solid understanding of microeconomics, including both the content of microeconomics and the tools needed to undertake microeconomic analyses. Understanding the content of microeconomics will equip students to understand: • the major resource allocation questions that must be addressed by every society (what to produce, how to produce these goods and services, and who should enjoy these goods and services), • two primary strategies for addressing these questions (markets and government policies), and the interplay between these two strategies, and • the critical difference between fact-based positive analysis and value-based normative analysis. Microeconomic analyses are employed in businesses (customer analysis, sales forecasting, financial planning), finance (analysis of factors that influence corporate profits and, therefore, stock prices), and public policy design and evaluation. Students may, in the future, undertake their own microeconomic analyses, or they may be “consumers” who will base important decisions on forecasts or analyses prepared by others. In either event, understanding the tools needed to conduct microeconomic analyses will strengthen the quality of their decisions. These tools include: • implementing the scientific method, • constructing, employing and assessing the quality of mathematical models, and • locating and using data, in conjunction with sound econometric techniques to test models. This textbook will provide examples in which economists have used the first and third skills. It will focus on helping students to develop the second skill. Students may, initially, believe that this tool is completely new. However, we all use models to structure our decision-making processes – probably on a daily basis. Several examples are provided in this chapter. Specifically, students who master the material presented in this chapter will be able to provide examples of: 1. policy issues that involve resource allocation questions (What, How, Who). 2. policy controversies that focus on choices between centralized and decentralized decision-making 3. well-defined markets, and issues that complicate market definitions 4. positive and normative statements

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models used in everyday decision-making 1-2 .Chapter 01 .Introduction 5.

c. reflects positive economic decision because this policy would be more fair than our current policy. All of the above 4. as defined by economists. Designed experiments to test the impacts of the proposed rules on decisions to buy and sell. Figure 1. c. Vendors at this flea market sell a variety of goods that are not substitutes. Economists are naturally inquisitive. Economic analysis can help predict the impact of technological innovations such as the internet on social trends. Some politicians advocate a universal government-operated health insurance system. d. d. b. both (a) and (b) d.Introduction Multiple Choice Quiz (10 questions) covering main points: 1. Marriage patterns have important implications for society because they impact the transmission of wealth from one generation to another. The FCC staff was concerned that the new design was untested. Canada and the United Kingdom 2. France and Germany b. because: a. c.1 provides information about the percent of GDP that is allocated to government consumption. d. Marriage and dating patterns are important subjects for economic investigation because: a. b. The San Jose flea market is not a market. Which two countries are less decentralized than the United States? a. Replacing our current system of employer-provided insurance with a governmentoperated insurance system: a. Economists proposed a set of rules to structure a new auction market for “the airwaves”. Lobbied to create political pressure to implement the new system.Chapter 01 . Sweden and France d. b. none of the above 3. c. none of the above 1-3 . Collected survey data to assess the public opinion. would represent increased decentralization of decision-making. would represent a change in our society’s method for allocating healthcare resources. Economists therefore: a. Adjusted their estimates of the benefits of the new system 5. Ireland and South Korea c. Many of the goods sold at this flea market can also be purchased in nearby stores. b.

a decentralized decision that will impact What is produced d. Internet sales blur the geographic boundaries. a normative statement 8.S. address all aspects of the situation d. produce predictions that are 100% accurate c. The market for textbooks used to be well-defined at many universities: textbooks were bought and sold in the university book store. Some internet sites have developed rules that create a framework for orderly buying and selling (to prevent sellers from simply cashing checks without mailing any books). Models are an essential component of economic analysis. a decentralized decision that will impact How transportation is produced 9.Introduction 6. a centralized decision that is designed to change How transportation is produced c. a positive statement b. None of the above 7. b. d.Chapter 01 . c. The statement that “self-interest is an important motivation for decision-making” is a. The Internet increases interactions among potential buyers and potential sellers of used textbooks. The recent U. All of the above 10. To be useful. a model must: a. Internet sales are complicating the definition of this market because: a. policy mandating the use of ethanol fuel is: a. none of the above 1-4 . legal rules that specify ownership rights for any type of asset. The term “property rights” refers to: a. c. rules for buying and selling land. have realistic assumptions b. b. a centralized decision that will reduce the cost of transportation b.

This shift occurred as an explicit response to the shortage of live donor kidneys. the book. c 3. d 10. • • 2. a 8. Marginal Analysis and Empirical Research (American Economic Review 1946) provides a good discussion of the value of modeling behavior even if individuals do not actually do the math that is hypothesized in the model. The AMA reversed its previous opposition to any payment for live donor kidneys. 3.Chapter 01 . Markets include substitute products. judgment allocation). b 9. b 6.) Economic models are used generating predictions. This topic could generate discussion to cover the following points: • • • Each of the two systems for distributing kidneys has advantages and disadvantages (markets vs. Two strategies are used to test the models: data analysis and lab experiments. While lengthy. normative analysis. Live donor kidneys may not be needed in the future due to new technology. and introduction of a new substitute can radically alter markets. The Russians. 1-5 . (Live donor kidneys were not widely used in the prior to the development of effective anti-rejection drugs.Introduction Answers to Multiple Choice Quiz 1. d 4. b 7. Positive vs. offers numerous examples of the difficulties created by centralized resource allocation decisions. The American Medical Association (AMA) recently shifted its position on the appropriate role of market forces in the allocation of transplant (live donor) kidneys. Government regulatory infrastructure and legal property rights definitions structure market interactions. and now endorses payment of small amounts of money. d Additional examples 1. b 2. Machlup's paper. a 5.

) 1-6 . (see Worksheet 1. etc.) • inputs that can be used to produce electricity (natural gas. The ethanol mandate provides a good example to discuss introductory ideas presented in this chapter. Resource allocation implications: o Production of corn & substitute crops o Food prices o Income of corn producers o Food for pigs o Driving habits o Housing density in urban and suburban areas o Support for mass transit • What would we like to see? o Impact on global warming o Impact on Middle East politics o Impact on food prices Potential student learning issues 1. steel mills. Students may not have concrete ideas about productive resources and potential substitutions among productive resources.Introduction 4. It might be helpful to distinguish between two types of questions: • What will happen? Corn price will increase. coal. electricity. Clear grasp of introductory microeconomics concepts is essential for success in this class. coal. insulation or sweaters) 2.) • strategies to produce comfortable room temperatures (natural gas. It may be helpful to list: • resources that are needed to produce goods include railroads.Chapter 01 . (Description of the input/output table employed by Soviet planners could help clarify these ideas. etc. wind. An early just-in-time training-style homework assignment can help students remember these ideas (from their introductory classes) and alert students that the intermediate class will require problem-solving and algebra skills.

Show the impact of news that potassium (found in bananas) prevents heart attacks. label the x-axis (horizontal) • label the y-axis • draw S • draw D • If this part is wrong. p 28. they would want (_________)(more or fewer ??) bananas ???? So. 1-7 . Remembering how to show the impacts of changes on supply and demand: Redraw the demand for bananas from I. Use the following steps: Put a dot on your demand line Draw a price-line and a quantity line for this point Think to yourself: if people just learned that bananas prevent heart attacks. all is lost. 2. • Draw the equilibrium price • Draw the equilibrium quantity • Note the order of events: First you drew S&D. Draw a new demand line through this point. Verify by comparing with the S and D lines in your book. Then you looked at the intersection to find P&Q.Chapter 01 . Definitions supply describes the views of ___________ (who?) demand describes the views of ___________ Draw supply and demand for bananas & find equilibrium P & Q. keep the price constant and mark a point at which people buy ________ bananas. Supply and Demand: Remembering to find the equilibrium price and quantity by looking at the intersection of S and D.Introduction Worksheet 1: Supply and Demand 1.

Introduction Redraw the supply for bananas from I. Show the current price (just draw a horizontal line in the middle of your diagram. 1-8 . Show the impact of a drop in average income (assuming bananas are a normal good).) Show the impact of an increase in the price.Chapter 01 . Show the impact on your diagram of entry of a large group of new growers. Don't make it difficult. Redraw the demand for bananas from I. Redraw the supply of bananas from I. Redraw the supply of bananas from I. Show the impact on your diagram of an increase in the cost of insecticide needed to produce bananas. This is really really easy.

Include S&D and the equilibrium P&Q.Introduction Redraw the demand for bananas from I. Include S&D and the equilibrium P&Q. Redraw the market for bananas from I.Chapter 01 .) Show the impact of an increase in the price. Remembering how to think about the impacts of these changes on price and quantity Secrets to success: • Start by drawing the initial equilibrium. Show the impact on P&Q of the news that potassium prevents heart attacks. Show the current price (just draw a horizontal line in the middle of your diagram. show the new equilibrium P & Q. When do you shift the line? Is this a change in demand or a change in quantity demanded? When do you move along the line? Is this a change in demand or a change in quantity demanded? 3. Show the impact on P&Q of a drop in average income 1-9 . • After steps 1 & 2. • Then show how the change affects S and D. Redraw the market for bananas from I.

What would happened to this price (that you just drew) if the per-unit production cost increased by $2/item? 5. the entire supply line will shift __________. 6. Show the impact on P&Q of an increase in the price of an insecticide needed to grow bananas Redraw the market for bananas from I. Label the upward-sloping line 3. Show this shift. Draw a horizontal line to show the amount that is needed per-item to induce sellers to sell this quantity. Look at the vertical quantity line. Include S&D and the equilibrium P&Q. This would happen at every possible quantity. 4. Include S&D and the equilibrium P&Q. 4. Show the impact on P&Q of an increase in the number of banana producers Redraw the market for bananas from I.Chapter 01 . The vertical distance between the old supply line and the new line is equal to ____________ 1-10 . Show the impact on P&Q of a new government regulation requiring that bananas be sold at a price that is higher than the old equilibrium price.Introduction Redraw the market for bananas from I. Include S&D and the equilibrium P&Q. Label the axes 2. Therefore. Get ready to think about the impact of quality on supply and demand 1.

The vertical distance between the old demand line and the new line is equal to ____________ 5. Show this shift. Therefore. Draw a horizontal line to show the amount that is needed per-item to induce sellers to sell this quantity. Draw a basic S&D diagram for the gasoline market: 1-11 . What would happened to this price (that you just drew) if consumer willingness to pay for this good decreases by $2 per item? 5. I’ll help you draw a graph to illustrate the impact of gasoline price caps. the entire demand line will shift __________. 4. Equilibrium Price. Price Ceilings and Price Floors Some states considered imposing gasoline price caps when the price shot up last summer.Chapter 01 . Label the upward-sloping line 3. Label the axes 2. Look at the vertical quantity line.Introduction 1. 6. This would happen at every possible quantity.

Look at the place where your price cap line intersects Demand. Put your pencil on that point. What do we have? ________________ 1-12 . Compare two quantities. Now show quantity supplied. Now look at your graph. so now you know that the goal of instituting a price cap is to force the price to be ___________ (above or below ?) the equilibrium price.) OK. This is the quantity demanded. Show this price cap on your graph above. Draw a line straight down until it intersects the horizontal axis.Chapter 01 . People want price caps because they think the equilibrium market price is too __________ (high ??? Or low ??? Fill in the right one. Now think about a price cap.Introduction Show the equilibrium price on this graph.

3. Label the price as P2. 2. Is the new line more elastic or less elastic than the old line? Apply this thinking: Suppose a university has two types of students: • students who have high grades and high test scores and could obtain scholarships at numerous other universities = very price sensitive • students who could not earn scholarships at other universities = not price sensitive Use the diagram to show the impact of a tuition increase on the mix of students. Is the quantity change bigger or smaller than before? 5. Now: draw a new flatter line through point A. Draw a horizontal line from Point A to the Y-axis. because this line goes through point A. Draw a new LOWER price. 2. Draw a vertical line down to the X-axis to show the new quantity. 4.Introduction 6. Label the new point on the SAME demand as point B. 1. Label the new quantity as Q2. 3. Draw the vertical line for the new Q2. 1-13 . Q1 is the same as before. Extend your P2 line to meet the new line. Your new line will go through point A. Label everything. 4. elasticity: P *A Demand Q First: show the impact of a price change on quantity. Follow the steps below to be sure you are correct. It will be more flat (less steep) than the old line. Label this P1. 1. Label this Q1. Draw a vertical line from Point A down to the X-axis.Chapter 01 .

people eat less salad. a) which is correct? • 7 = change in Q / change in P ? OR • 7 = change in P / change in Q ? b) Draw a graph of the line: Q = 20 – 7*P. • LABEL THE AXES CAREFULLY • This is NOT the usual demand curve that economists usually draw. the number of items sold decreases by _________ when the price of lettuce decreases $1. Your firm is considering changing the price. the number of items sold increases by _________ Q = 20-7 * P – 4 * L L = price lettuce.Introduction 7. You must forecast the impact of a price change on the quantity people will buy.7* Price Salad Dressing -4*Price lettuce.) Suppose you estimated a regression equation and obtained the following result: salad dressing sales = 20 .Chapter 01 . The main exogenous factor that impacts salad dressing sales is the price of lettuce. We could rewrite the equation using symbols: Q = salad dressing sales P = price salad dressing The coefficient of P is 7. (When lettuce is expensive. Demand function: You are responsible for production and inventory planning for a firm that bottles salad dressing. According to this regression equation • • when the salad dressing price increases $1. You have data on salad dressing prices and quantities. What is different? 1-14 . This is important for us.

was. and food items are all good examples. environmental protection. licenses. These responses should include things typically only available from government: public safety provision (police force. Normative. What one believes to be good or bad depends on one’s values.2 a. This is a testable hypothesis. This statement is clearly stating a value judgment. f. selling liquor. this statement itself does not.). This statement is a testable hypothesis. It makes a claim about what is. etc. Almost all consumer goods fall into this category. or will be true. d. clothing. charitable programs. Positive. and certain social services. one could scientifically investigate the relationship between time worked and the existence of an income tax. This statement represents a testable hypothesis. adjudication/arbitration. furniture. Anything that can be received from government or purchased in the marketplace would be an acceptable answer: education. Positive. Normative. Words like “should” or “ought” are good indicators of a normative statement. There are many examples of goods not distributed in response to a price mechanism and not distributed by government. etc. certain licenses (for hunting. d. e. This statement is stating a value judgment. Confirming or denying this statement would require establishing what improves well-being. c. 1.Introduction Answers to End-of-Chapter Questions 1. accreditations or memberships that are not granted by the government are good examples. fire department. we could not test this statement without first agreeing on what it means to be better off. entertainment. Normative. b. coast guard. b. g. Positive statements can be confirmed or denied without having to rely on a set of values. This statement is prescriptive in nature. 1-15 . driving. Positive. One example would be a lottery for a place in line to buy the hottest new toy (note that the student should understand that the place in line is the good. not the toy). Normative.1 a.). etc. Also. c.Chapter 01 . which undoubtedly requires an appeal to a set of values. Although one might typically hear this sort of statement from someone who endorses exercise.

1-16 .Chapter 01 .Introduction Answers to the following questions will vary but should be well supported.

For example. 1-17 . benefits may involve things like involve relief. many costs and benefits are emotional in nature. her beliefs are not scientifically useful. 1. An observed rational decision. These beliefs may be helpful to Latanya if they help her sleep at night. consumers buy more of it.” The other statements (B & D) do not make an attempt at representing how things work. it does not seem that Latanya is attempting to explain the nature or cause of an observed phenomenon. but because her statements do not attempt to explain observed phenomena and cannot be supported by observed phenomena. All three of these statements are of the type “when one thing happens. another thing follows from it. 1. Costs of some decisions may involve things like stress. Because statement C attempts to describe a simplification of a cause-and-effect relationship. as presented.4 Latanya’s statements are not a theory but merely a set of assertions. Statement E likewise paints a picture of a simplified cause-and-effect relationship.Chapter 01 . therefore. In making these claims. relaxation. be difficult to analyze empirically. cannot be scientifically verified or falsified because they do not apply to all human actions. or anger. does not necessarily cast doubt on her beliefs as stated.3 Anytime an individual makes any decision. then the individual would have chosen it.Introduction 1. anxiety. Her statements. No single observed action or set of observed actions would have to be consistent with Latanya’s beliefs even if her beliefs were true. Sometimes. the costs and benefits are of a type that would be difficult to capture in a scientific way. So while all human decisions can be discussed in economic terms. however. comfort.5 A model is a simplified representation of a how some part of the world works. If choice B created more net happiness. To choose A over B implies that the happiness that results from choosing A (its benefits minus the cost of choosing it) must exceed the happiness that results from choosing B. It is easily seen. making it a model. many would. or love.” which is similar to economic reasoning of this sort: “when a good’s price falls. guilt. that any human decision can be described in terms of costs and benefits. and an observed irrational decision does not necessarily strengthen the case for her beliefs. he or she is trying to reach some goal—most often happiness. due to the nature of the costs and benefits involved. for example. it can be considered a model. Statement A is a model of weather at sea.

books and tuition cost money. The experimental design in A is problematic. The decision to spend time with family and friends also does not lead directly to material gain. People who like the rain (and presumably mind driving in it less) may choose to live in Seattle. when it comes to the decisions most often discussed in economics. and a feeling of accomplishment.8 Student responses will vary. living in a dorm can be uncomfortable and frustrating. people will more often prefer to have more rather than less. relax. so one gives up the comfort of living on one’s own (or at one’s parents’ house). as any action. However. as in the example of charitable giving. can be described in terms of a benefit to the individual. The decision to exercise or play video games has little to do with material gain (for most people. many variables like average distance traveled. even charitable actions. typical road conditions and driver preferences are naturally controlled. better parenting skills. In other words. If an individual faced a choice between one sweater or two equal sweaters (for the same price). most often the consumer would choose to have two sweaters—or more material goods.6 It is always fair to say that people are motivated by self interest. However. etc. so one gives up the opportunities to earn money. when it comes to material goods.Introduction 1. this assumption is probably not too problematic.7 Both of these experiments can be considered natural experiments in the sense that they occur outside of a laboratory. our interests are not always material in nature. spend time with friends and family. which include things like increased future income. so one gives up the opportunity to consume more goods right now. excluding professional athletes and game testers). many variables that affect how much people drive (besides rain) are not controlled because Seattle and Los Angeles are very different cities..Chapter 01 . 1. 1. Because it focuses on only one city. Both experiments rely on the questionable assumption that gasoline sales on a day accurately reflect the amount of driving that takes place on that day. better ability to take care of one’s health. whereas people who hate the rain might choose to live in Los Angeles. Further. but the most common answers will involve the following costs of attending college: being in class takes up time. individuals were not placed randomly in either of the two cities. These costs are endured in order to enjoy the benefits of a college education. The experiment described in B would produce a more reliable conclusion. 1-18 .

He or she might think that. A good example of this would be a cigarette smoker who is trying to quit. over the course of a lifetime. or a person who recycles soda bottles and cans to receive a rebate (in states that offer rebates).Introduction 1.9 Most responses will be acceptable so long as they involve making incremental changes to a course of action. then the true marginal cost of the next cigarette also includes part of the negative health effects of all future cigarettes. Marginal thinking when this is not the case can lead to bad decisions.10 Some good examples include a person who bought a hybrid car because of generous tax rebates. 1.Chapter 01 . smoking is not really all that bad for one’s health. what real damage. a veteran who received a college education because of GI Bill funding. This true understanding of the cost of the next cigarette makes it less likely to be a good choice. on the margin. 1-19 . a child who studied diligently because he was promised money for good grades or pulled on a loose tooth all day to get money from the Tooth Fairy. can one cigarette do? However. After all. if each cigarette smoked makes the next cigarette harder to resist. Marginal thinking works best when the margin is clearly understood— when all costs and benefits of a decision are easily observable.

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