Introduction

Microeconomics is the field of economics that studies the decision-making behavior of

consumers and firms when their choices are constrained by scarcity. Scarcity results from the
fact the goods that consumers desire and the resources used to produce them are limited in
quantity. The principle of constrained decision-making is the major building block of modern
economics and is the central concept around which this course is built.

The course is divided into four parts: In part 1, you’ll gain an understanding of how consumers
make decisions on the types and quantities of goods to purchase. In part 2, you’ll learn how
managers decide how much to produce, the price to set for their products, and the amounts and
types of inputs to buy. In part 3, the focus will be on the interaction between consumers and
producers and the concepts of equilibrium and efficiency. The final part of this course focuses
on market distortions that are introduced by governments, such as taxes and tariffs, or those
that result from the nature of the products produced or consumed.

In this section we will discuss the general principles we will use in order to develop parts 1 and 2
of our course.

Part 1 - Consumer Theory

Take the case of Celeste, who we will follow throughout part 1 of this course. Celeste likes
apples and buys them at her local grocery store. She has a special inclination towards
honeycrisp apples because, as the name suggest, they are crispy, yet smooth and sweet like
honey. But, just like the rest of us, she adjusts her consumption of apples depending on how
much the store is charging her for every apple that she buys. Let’s assume that in the back of
her mind, and as she enters the store she has an idea of how many apples she will purchase,
depending on how expensive apples are that day. The following table, labeled Table 1A.1.1
summarizes her thought-process for five different possible prices:

Table 1A.1.1:
Price per apple Number of apples bought

$0.50 30

$0.75 20

$1.00 15

$1.25 12

$1.50 10

We can get an even better idea of her thought process by creating a graph that has on its
vertical axis the price per apple and on its horizontal axis the number of apples that she buys.
The following graph, labeled Figure 1A.1.2 is consistent with Table 1A.1.1 and has the
advantage of showing what would happen for many more possible prices (lower, like $0.30,
higher, like $2 or in-between prices like $0.60 or $1.20):

Figure 1A.1.2:

The correct way to read this particular graph is to first identify a price on the vertical axis and
then use the curve from the graph to determine the number of apples that Celeste will purchase
at that price. So, for example, if the price is $1 per apple then Celeste buys $15 apples,
according to the graph. The graph is consistent with Table 1A.1.1 because all the entries of
that table can be identified as points along the curve. The graph is more informative than the
table because it allows us to assess other possible prices and their effect on Celeste’s
consumption of apples. Because the curve shows how many apples Celeste demands for the
different possible price of apples she will encounter at the store, we label it Celeste’s Demand
Curve for apples.

We don’t know the details of the thought process that Celeste follows, but we know that there is
a very good chance that it is a reasoned or rational thought process that guides the possible
choices expressed by her demand curve. We know this because we are familiar with this type
of reasoning, as we face it in our daily lives as well. Assuming that Celeste’s behavior is the
result of rational decision-making also gives us a chance to assess how she would react to
other possible scenarios she could face when entering the store: Would she still consider
buying 15 honeycrisp apples if the price was $1 per apple, but there was a special discount for
Gala apples, reducing their price to just $0.25 each? What would happen to her willingness to
buy apples if she got a raise at her job?

We have a chance at answering these questions if we develop an understanding of the main

factors that drive both her preference for honeycrisp apples and her means to afford them.
Of course, we could also take a much more skeptical route and simply say that since we don’t
know her personally, we have no reason to believe she was being rational. And while it is
certainly possible that Celeste was not being rational (in other words, that she is crazy), taking
this approach would leave us unable to predict any future behavior, regardless of the scenario
that is presented. As economists, we are interested in making predictions on future behavior
and in order to do so we must rely on individuals that behave rationally. This doesn’t mean we
believe that irrational behavior does not exist; it simply means that we can only concentrate on
those people for which a decision-making process can be understood through logical reasoning.
Fortunately for us, the vast majority of decisions in a marketplace are the result of rational
thought and the market outcomes are not meaningfully affected by the very few decisions that
were not guided by reason.

There are two essential elements that play a role in the decision-making process of a consumer
like Celeste. The first one is scarcity, a defining component in all of economics. For Celeste,
scarcity presents itself as the combination of two pretty trivial facts: First, the store does not just
give away honeycrisp apples for free and second, Celeste is not infinitely rich. These two facts
mean that there is a limited amount apples that Celeste can afford. And given that this limit
imposed by her income applies to all other goods as well, this means that Celeste will face
trade-offs between consuming more of certain goods while having to consume less of others in
order to afford paying for all of them. These trade-offs are imposed by market prices of the
goods considered for purchase.

The second essential element of Celeste’s decision-making process is given by her own
personal preferences, not just for consuming honeycrisp apples, but for any other goods as
well. Of course, there would be no reason for Celeste to buy honeycrisps if she didn’t like them,
so her preferences should favor consuming honeycrisps over not consuming them at all. But
equally important is her preferences for honeycrisps relative to other possible goods like, for
example, gala apples. This results in a different type of trade-off. A personal trade-off between
two goods (in this case between gala and honeycrisp apples) that she is willing to accept in
order to stay as happy one way or the other. So, if she is comfortable replacing honeycrisps with
gala apples then a sudden change in the price of gala apples will most surely affect her demand
for honeycrisps. And even a change in the price of seemingly unrelated goods like a three-day
trip to a ski-resort, might result in her modifying her demand for honeycrisp apples (for example
she could buy the ski-trip and then cut back on more expensive food, including honeycrisps, in
favor of cheaper alternatives to help pay for it). It is the existence of both a preference for
consumption (of various goods) and a scarcity constraint (imposed by having limited resources
in order to pay for them) which results in a rational consumer’s decision to consume different
amounts of a good depending on that good’s market price.

Preferences and scarcity are reflected in another key economic concept: Opportunity cost.
Generally, opportunity cost is the highest valued alternative forgone when a decision is made. If
Celeste chooses to purchase a honeycrisp apple at a price of $2, the opportunity cost of the
apple is the next-best use of the $2 she spent. The opportunity cost may be the satisfaction she
would receive from purchasing a gala apple, making a contribution to the ski-trip, or any other
possible use of the $2, whichever she values the most. Scarcity forces her to make choices and
the opportunity cost of her choices depends on her preferences. As Celeste considers buying a
second apple for $2, she weighs the benefit she would receive from the additional honeycrisp
apple, or marginal benefit, against the opportunity cost, or marginal cost.

The economic theory that describes consumer behavior through the lens of rational individuals
with preferences for consumption goods and constrained by a scarcity of resources is called
Consumer Theory and we will dedicate 2 weeks to develop it.

Part II - Producer Theory

Take the case of Mario, who we will follow through most of part 2 of this course. Mario is a
sugarcane producer in El Salvador. Mario will produce the sugarcane in order to sell it to the
sugar mills and make a profit. The sugarcane he produces is measured in metric tons (MT) and
Mario has a rough idea of how much he can get per MT from the sugar mills for his sugarcane.
Mario has decided to adjust his production of sugarcane depending on the price he is likely to
observe. The following table summarizes Mario’s thought process on how much sugarcane to
produce and sell for five different possible market prices:

Table 1A.1.3:
Price per MT MTs of sugarcane
of sugarcane produced

$10 4.2

$20 6.7

$30 9

$40 11.1

$50 13

Just like with Celeste, we can get an even better idea of Mario’s thought process by creating a
graph that has on its vertical axis the price per MT of sugarcane and on its horizontal axis the
number of MTs of sugarcane that he produces. The following graph, labeled Figure 1A.1.4 is
consistent with Table 1A.1.3 and also has the advantage of showing what would happen for
many more possible prices.
Figure 1A.1.4:

The correct way to read this particular graph is the same as that of the demand curve: First
identify a price on the vertical axis and then use the curve from the graph to determine the
amount of sugarcane that Mario will produce at that price. The graph is consistent with Table
1A.1.3 because all the entries of that table can be identified as points along the curve. The
graph is more informative than the table because it allows us to assess other possible prices
and their effect on Mario’s production amount. Because the curve shows how much sugarcane
Mario supplies to the market (by producing and selling) at the different possible market prices of
sugarcane, we label it Mario’s sugarcane Supply Curve.

To explain where Mario’s decision to supply at different possible prices comes from we must
also assume that Mario is behaving rationally. And just like with Celeste, this will allow us to
break-down Mario’s thought process into two categories: a motive that drives Mario to produce
and sell sugarcane and a set of constraints that he faces when doing so. Then, understanding
the motive and constraints will allow us to predict any future behavior under different possible
circumstances.

Start with the motive: We know that Mario sells the sugarcane for profit, so profit is his motive.
However, being a rational profit-driven producer means that Mario intends to produce not just
any amount that results in a profit, he wants to select the amount of sugarcane that makes him
the highest profit possible. We call this behavior profit-maximizing. Not all firms behave in this
way, but in this course we concentrate on those that do. The reason is that it is empirically
consistent with the behavior of the vast majority of firms and market outcomes are not
meaningfully impacted by those that do not behave this way.

Mario faces various constraints as well. Each of these can be traced back to or directly
interpreted as some form of scarcity. For example, if Mario wants to produce a certain amount
of sugarcane, he knows that there are multiple ways of producing it. He could rent a big plot of
land and let the sugarcane grow pretty much unattended or he could produce the same amount
by renting a smaller plot of land and using a watering system that also requires paying workers
to tend to it. He could harvest using expensive machinery that require less workers or send out
many workers with machetes to do the same job. The multiple known ways of producing the
sugarcane are what we call a technology and, in a way, it imposes a constraint on Mario. He
would like to produce sugarcane with as few workers, machinery and land as possible, but
technology imposes a limit on his ability to do so. In other words, knowledge of the many
possible ways of producing sugarcane is limited and a limited resource is a scarce resource.

Mario can’t produce the sugarcane for free because he must hire, rent and/or purchase inputs in
order to produce it. He does have the freedom to choose which inputs to use but does not have
the ability to decide the wage rate, rental rate or price he will have to pay for the inputs that he
uses. This results in costs and these costs will increase with the amount of sugarcane
produced. In his quest to maximize profit Mario must weigh the benefits of producing more, the
(added or) marginal revenue, to the costs of producing more, the (added or) marginal cost. We
thus say that Mario’s output decision is an on-the-margin type of decision, which is a
fundamental characteristic of the types of decisions made by (both consumers and) firms
interacting in a marketplace.

The economic theory that describes producer behavior through the lens of rational profit-
maximizing firms constrained by different forms of scarcity is called Producer Theory and we
will dedicate 2½ weeks to develop it.

In the next section we will discuss the general principles and definitions used to develop part 3
of this course with a brief overview of the market distortions that we will study in part 4 and their
consequences.