Chapter 1: Overview

of Microeconomics
Content
1.1. What is Economics?
1.2. Ten Principles of Economics
1.3. Economic Models
1.4. Microeconomics and Macroeconomics
1.5. Positive versus Normative Analysis

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 1.1. What is Economics?
• Scarcity: the limited nature of society’s resources
• Economics: the study of how society manages its scarce resources,
e.g.
– how people decide what to buy, how much to work, save, and spend
– how firms decide how much to produce, how many workers to hire
– how society decides how to divide its resources between national
defense, consumer goods, protecting the environment, and other needs

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1.2. Ten Principles of Economics
How people make decisions
Principle #1: People Face Tradeoffs
All decisions involve tradeoffs. Examples:
• Going to a party the night before your midterm leaves less time for
studying.
• Having more money to buy stuff requires working longer hours, which
leaves less time for leisure.
• Protecting the environment requires resources that could otherwise be
used to produce consumer goods.

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 How people make decisions
Principle #1: People Face Tradeoffs
• Society faces an important tradeoff: efficiency vs. equality
• Efficiency: when society gets the most from its scarce resources
• Equality: when prosperity is distributed uniformly among society’s
members
• Tradeoff: To achieve greater equality, could redistribute income from
wealthy to poor. But this reduces incentive to work and produce, shrinks
the size of the economic “pie”.

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 How people make decisions
Principle #2: The Cost of Something Is
What You Give Up to Get It

• Making decisions requires comparing the costs and benefits

of alternative choices.
• The opportunity cost of any item is whatever must be given
up to obtain it.
• It is the relevant cost for decision making.

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 How people make decisions
Principle #2: The Cost of Something Is
What You Give Up to Get It

Examples:
The opportunity cost of…
…going to college for a year is not just the tuition, books, and fees,
but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.

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How people make decisions Example
You have the ticket to the concert of Min (it’s free and you cannot
resell). The concert of Erik, your idol, is taken place at the same
time of Min’s concert. The price of the ticket is 200,000vnd. Your
willingness to pay for the ticket is 300,000vnd.
What is the opportunity cost of Min’s concert?
What is your decision?

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 How people make decisions
Principle #3: Rational People Think at the Margin

Rational people
– systematically and purposefully do the best they can to achieve
their objectives.
– make decisions by evaluating costs and benefits of marginal
changes – incremental adjustments to an existing plan.

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 How people make decisions
Principle #3: Rational People Think at the Margin

Examples:
• When a student considers whether to go to college for an additional
year, he compares the fees & foregone wages to the extra income he
could earn with the extra year of education.
• When a manager considers whether to increase output, she
compares the cost of the needed labor and materials to the extra
revenue.

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 How people make decisions
Principle #4: People Respond to Incentives
• Incentive: something that induces a person to act, i.e. the prospect
of a reward or punishment.
• Rational people respond to incentives.
Examples:
– When gas prices rise, consumers buy more hybrid cars and fewer
gas guzzling SUVs.
– When cigarette taxes increase, teen smoking falls.

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 ACTIVE LEARNING 1
Applying the principles
You are selling your 1996 Mustang. You have already
spent $1000 on repairs.
At the last minute, the transmission dies. You can pay
$600 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you have the
transmission repaired? Explain.
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t

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 ACTIVE LEARNING 1
Answers
Observations:
• The $1000 you previously spent on repairs is irrelevant.
What matters is the cost and benefit
of the marginal repair (the transmission).
• The change in incentives from scenario A
to scenario B caused your decision to change.

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 1.2. Ten Principles of Economics
How people interact
Principle #5: Trade Can Make Everyone Better Off

• Rather than being self-sufficient, people can specialize in

producing one good or service and exchange it for other goods.
• Countries also benefit from trade & specialization:
– Get a better price abroad for goods they produce
– Buy other goods more cheaply from abroad than could be produced
at home

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 How people interact
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
• Market: a group of buyers and sellers (need not be in a single
location)
• “Organize economic activity” means determining
– what goods to produce
– how to produce them
– how much of each to produce
– who gets them

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 How people interact
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity

• A market economy allocates resources through the

decentralized decisions of many households and firms as they
interact in markets.

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 How people interact
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
• Famous insight by Adam Smith in The Wealth of Nations (1776):
Each of these households and firms acts as if “led by an invisible
hand” to promote general economic well-being.

“It is not from the benevolence of the butcher, the brewer, or the
baker that we expect our dinner, but from their regard to their own
interest”

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 How people interact
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
• The invisible hand works through the price system:
– The interaction of buyers and sellers determines prices.
– Each price reflects the good’s value to buyers and the cost of
producing the good.
– Prices guide self-interested households and firms to make decisions
that, in many cases, maximize society’s economic well-being.

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 How people interact
Principle #7: Governments Can Sometimes
Improve Market Outcomes

• Important role for govt: enforce property rights

(with police, courts)
• People are less inclined to work, produce, invest, or purchase if
large risk of their property being stolen.

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 How people interact
Principle #7: Governments Can Sometimes
Improve Market Outcomes
• Market failure: when the market fails to allocate society’s
resources efficiently
• Causes:
– Externalities, when the production or consumption
of a good affects bystanders (e.g. pollution)
– Market power, a single buyer or seller has substantial
influence on market price (e.g. monopoly)
• In such cases, public policy may promote efficiency.

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 How people interact
Principle #7: Governments Can Sometimes
Improve Market Outcomes

• Govt may alter market outcome to promote equity

• If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can change how the
economic “pie” is divided.

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1.2. Ten Principles of Economics
How the economy as a whole works
• Principle 8: A country’s standard of living depends on its ability to
produce goods and services
• Principle 9: Prices rise when the government prints too much
money
• Principle 10: Society faces a short-run trade-off between inflation
and unemployment

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 1.3. Economic Models
The Circular-Flow Diagram
• The Circular-Flow Diagram: a visual model of the economy,
shows how dollars flow through markets among households and
firms
• Two types of “actors”:
– households
– firms
• Two markets:
– the market for goods and services
– the market for “factors of production”
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 The Circular-Flow Diagram
Factors of Production
• Factors of production: the resources the economy
uses to produce goods & services, including
– labor (L)
– capital (buildings & machines used in production) (K)
– Technology (T)
– Resource (R)

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 The Circular-Flow Diagram
Households:
 Own the factors of production,
sell/rent them to firms for income
 Buy and consume goods & services

Firms
Households
Firms:
 Buy/hire factors of production,
use them to produce goods and
services
 Sell goods & services
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 The Circular-Flow Diagram
Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
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 1.3. Economic Models
The Production Possibilities Frontier
• The Production Possibilities Frontier (PPF):
a graph that shows the combinations of
two goods the economy can possibly produce given the
available resources and the available technology
• Example:
– Two goods: computers and wheat
– One resource: labor (measured in hours)
– Economy has 50,000 labor hours per month available for
production.

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 PPF Example
• Producing one computer requires 100 hours labor.
• Producing one ton of wheat requires 10 hours labor.
Employment of
Production
labor hours
Computers Wheat Computers Wheat
A 50,000 0 500 0
B 40,000 10,000 400 1,000
C 25,000 25,000 250 2,500
D 10,000 40,000 100 4,000
E 0 50,000 0 5,000
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 PPF Example
Production Wheat
Point
(tons)
on Com- 6,000
graph puters Wheat E
5,000
A 500 0 D
4,000
B 400 1,000
3,000 C
C 250 2,500
2,000
D 100 4,000 B
1,000
E 0 5,000 A
0
0 100 200 300 400 500 600
Computers
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 ACTIVE LEARNING 1
Points off the PPF
A. On the graph, find the point that represents
(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce
this combination of the two goods?
Why or why not?
B. Next, find the point that represents
(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce
this combination of the two goods?

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The PPF: What We Know So Far
Points on the PPF (like A – E)
– possible
– efficient: all resources are fully utilized
Points under the PPF (like F)
– possible
– not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
Points above the PPF (like G)
– not possible
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 The PPF and Opportunity Cost
• Recall: The opportunity cost of an item is what must be given
up to obtain that item.
• Moving along a PPF involves shifting resources (e.g., labor) from
the production of one good to the other.
• Society faces a tradeoff: Getting more of one good requires
sacrificing some of the other.
• The slope of the PPF tells you the opportunity cost of one good in
terms of the other.

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 The PPF and Opportunity Cost
Wheat The slope of a line equals
(tons) the “rise over the run” the
–1000 amount the line rises when
6,000 slope = = –10
100 you move to the right by
5,000 one unit.
4,000
3,000
2,000 Here, the
1,000 opportunity cost of
a computer is
0
10 tons of wheat.
0 100 200 300 400 500 600
Computers

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 ACTIVE LEARNING 2
PPF and Opportunity Cost
In which country is the opportunity cost of cloth lower?
FRANCE ENGLAND
Wine Wine
600 600

500 500

400 400

300 300

200 200

100 100

0 0
0 100 200 300 400 0 100 200 300 400
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Economic Growth and the PPF
Wheat
(tons)
With additional resources or 6,000 Economic
an improvement in 5,000 growth shifts
technology, the economy the PPF
4,000 outward.
can produce more
computers, more wheat, or 3,000
any combination in between. 2,000
1,000
0
0 100 200 300 400 500 600
Computers
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 The Shape of the PPF
• The PPF could be a straight line, or bow-shaped
• Depends on what happens to opportunity cost as economy
shifts resources from one industry to the other.
– If opp. cost remains constant, PPF is a straight line.
(In the previous example, opp. cost of a computer was always
10 tons of wheat.)
– If opp. cost of a good rises as the economy produces more of
the good, PPF is bow-shaped.

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 Why the PPF Might Be Bow-Shaped
As the economy shifts

Beer
resources
from beer to mountain
bikes:
• PPF becomes
steeper
• opp. cost of
mountain bikes
increases
Mountain
Bikes
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 Why the PPF Might Be Bow-Shaped
At point A, At A, opp. cost of

Beer
A mtn bikes is low.
most workers are
producing beer,
even those that
are better suited
to building bikes.
So, do not have to
give up much beer
to get more bikes.

Mountain
Bikes
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 Why the PPF Might Be Bow-Shaped
At B, most workers

Beer
At B, opp. cost
are producing bikes.
of mtn bikes
The few left in beer
is high.
are the best brewers.
Producing more B
bikes would require
shifting some of the
best brewers away
from beer
production,
would cause a big
Mountain
drop in beer output.
Bikes
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 Why the PPF Might Be Bow-Shaped

• So, PPF is bow-shaped when different workers have different

skills, different opportunity costs of producing one good in terms
of the other.
• The PPF would also be bow-shaped when there is some other
resource, or mix of resources with varying opportunity costs
(E.g., different types of land suited for different uses).

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 The PPF A Summary

• The PPF shows all combinations of two goods that an economy

can possibly produce, given its resources and technology.
• The PPF illustrates the concepts of tradeoff and opportunity cost,
efficiency and inefficiency, unemployment, and economic growth.
• A bow-shaped PPF illustrates the concept of increasing
opportunity cost.

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1.4. Microeconomics and Macroeconomics
• Microeconomics is the study of how households and firms make
decisions and how they interact in markets.
• Macroeconomics is the study of economy-wide phenomena,
including inflation, unemployment, and economic growth.
• These two branches of economics are closely intertwined, yet
distinct – they address different questions.

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1.5. Positive versus Normative Analysis
• As scientists, economists make positive statements,
which attempt to describe the world as it is.
• As policy advisors, economists make normative statements,
which attempt to prescribe how the world should be.
• Positive statements can be confirmed or refuted, normative
statements cannot.
• Govt employs many economists for policy advice. E.g., the U.S.
President has a Council of Economic Advisors, which the author of
this textbook chaired from 2003 to 2005.

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 ACTIVE LEARNING 3
Identifying positive vs. normative
Which of these statements are “positive” and which are
“normative”? How can you tell the difference?
a. Prices rise when the government increases the quantity
of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of burritos will cause an increase
in consumer demand for video rentals.

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1. Suppose that country A produce
only 2 products: Clothes and Food.
Possibility Food Clothes
The possibilities of producing these
two good is as follow:
A 300 0
a. Plot the PPF curve of country A.
B 200 50
b. Determine the opportunity cost of
producing food and clothes at different
quantity given in the table. C 100 100

c. How does the opportunity cost D 0 150

change in the table?

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