Nature, Scope and Methodology of

Microeconomics

• Micro Vs Macro
• Methods

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Recap
• Before we look at the methodology of economics, we are
going to will have a short recap on what economics is:
– We defined economics as a social science that tries to
understand how human being use available resources to
create commodities to satisfy their wants or increase
welfare.
– We indicated that the basic economic problem is that:
– Resources are scarce while wants are infinite
– Thus we have to make choices and incur opportunity costs.
We demonstrated the economic problem using the
production possibility curve which is presented below:

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 Example of PPF
1. Society can produce any combination
of food and clothes
Cloths e* 2. Maximum output is only attained when
0, 12
society produces on the PPF.
12 a 3. All points on the PPF are said to be
4, 11
11 points of efficiency

10 5, 10 4. Any points below the PPF

like C means either not all
resources are being used or
b
not best technology is being
C* used or both
4
5. All points beyond the PPF
Are unattainable (unachievable)
2
They are outside the capability of
society
10, 0

4 10
Food
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 Example of PPF
Note: the slope of the PPF is called the
Marginal rate of transformation (MRT)– the
Cloths e* rate at which we transform one product
0, 12 (clothes), Into another (say food)
12 a This is the movement along the PPF curve
4, 11
11

10 5, 10 How do we calculate the MRTS

As the slope of the PPF at that
b point say “a”, to find the MRT,
C* we simply compute the slope at
4 that point.
MRT = slope of the PPF
2

10, 0

4 10
Food
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 How do we calculate the MRT?
So the MRT is the slope of the PPF at that point
The slope = rise/run
• At q = slope is: 11/4 = 2.75
Cloths
• At q, 4 food transforms into 1 unit of cloth
0, 12 • v = 2/10 = 0.2
12
4, 11 Note: Any change from one point to
11 q another on the PPF implies MRT and
10 5, 10 also opportunity cost.
When making choices
among alternatives,
individuals have to
C*
compare benefits and
4
costs. If the benefits
2, 10 outweigh the costs
2 v you go for it
10, 0

4 10
Food
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6

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 Nature and Methodology
• Economics – divided into 2 main sub-fields of Micro
and Macroeconomics
• Microeconomics is the study of how individual
consumers or households and firms make decisions and
how they interact in specific markets for goods and
services
– It looks at individual markets—for corn, records, books,
and so forth—that operate within the broad national
economy
• Focuses on human behavior of wealth creation at
analytically disaggregated levels
• Key questions:

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 Nature and Methodology
• What determines the price of particular goods and
services?
• What determines the output of particular firms and
industries?
• What determines the wages workers receive? The interest
rates lenders receive?
• The profits businesses receive?
• How do government policies—such as minimum wage
laws, price controls, tariffs, and excise taxes—affect the
price and output levels of individual markets?
• Why do incentives matter inside firms and how can
economic theory be used to properly structure a firm’s
incentives to increase worker productivity and firm
profitability?
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 Nature and Methodology
• Macroeconomics the study of economy-wide phenomena,
that is human economic behaviours in terms of the whole
economy and its interaction with other economies
– It deals with the “big picture,” not the details, of the nation’s
economic activity
• Examples: total output in the economy, general price level -
inflation, unemployment, and economic growth
• Typical macroeconomic questions include:
• What determines the general price level? The rate of inflation?
• What determines national income and production levels?
• What determines national employment and unemployment
levels?
• What effects do government monetary and budgetary policies
have on the general price, income, production, employment, and
unemployment levels?

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 Nature and Methodology
• Methodology –refers to the way in which economists go
about the study of their subject matter. There are two
broad approaches in microeconomics:
a. Positive Microeconomics –this investigates how
different economic agents in society seek to improve their
welfare using wealth.
- Positive economics is that branch of economic inquiry
that is concerned with the world as it is rather than as
it should be
- It is very factual and is concerned with what is, what
was, what will be
- It is objective and can be replicated by others

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 Nature and Methodology
• Normative economics is that branch of economic
inquiry that deals with value judgments—with what
prices, production levels, incomes, and government
policies ought to be
– It involves suggesting what should be or ought to be the
situation or outcome
– It involves making value judgements and sometimes taking
strong moral positions
– It can involve professional subjectivity

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 Methodology

▪ The Economist as a Scientist/Positive economics

– Involves thinking analytically and objectively.
– Makes use of the scientific method
– Uses Economic Models to help explain how a complex,
real world operates.
– An economic model is a simplified representation of a
particular feature of the world that we want to understand.
• models are used to simplify reality in order to improve
our understanding of the world
- All models are expected to have the following elements

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 Methodology
a. Description - of the individuals and economic variables of
interest to us
b. Assumptions -economists make assumptions in order to
make the world easier to understand . The art in scientific
thinking is deciding which assumptions are more realistic to
make. Assumptions are aid at simplifying the model.
Different assumptions will be made for different models
Includes developing abstract models from theories and the
analysis of the models
– Example the PPF we looked above we assumed two products
– Using the ceteris paribus, or all else being equal, assumption,
economists study the relationship between variables while the
values of other variables are held unchanged or constant.
– The ceteris paribus device is part of the process of abstraction
used to focus only on key relationships

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 Methodology
c. Outcomes – these are the predictions of the model that
follow logically from the assumptions. The outcome
maybe refer to the equilibrium of the model.
• Overall, a model is a formal statement of a theory. Models
are descriptions of the relationship between two or more
variables. They can be graphs mathematical etc.
• Example of a mathematical model:
– Think about this: you want to buy a new car from Toyota
Zambia. Your demand for the new car (say Dc) and ability to
buy it will likely be influenced by the price of the new car (pC)
and your income (how much your earn) levels (say Y). and
maybe before buy, you may also consider the price of second
hand cars (Ps), price of fuel (Pf) and any other factor say (Z)

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• The relationships among the above factors can be
written as follows:
– Dc =f(pC, Y, Ps , Ps , Pf , Z)
• This models simply says that –the demand (Dc) for the
car depends on or is dependent on or is a function of the
explanatory variables listed in the brackets.
• The models give us the framework to organize how we
think about a problem, data is required to quantify the
observed relationship in our theoretical model
• A theory or model that has been tested several times
and proved true over time is called a behavioral law.

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 Methodology
• So a behavioral law is a sensible theoretical relationship
not rejected by evidence over a long period
• To test the model, we need to have information or data of
the variables.
– Economic data refer to pieces of evidence about economic
behavior –example total amount of cars sold per month in the
country, the average monthly price of new cars and used cars,
the average price of fuel etc. It can refer to total output,
– Data can be presented in many different ways. These include:
a. Time series data - this is a sequence taken at successive
equally spaced points in time. For example, we can collect
the price of the same book like Begg et al. every month.for
the whole year. The seris of prices make what we call time
series data

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 Methodology
• Example of time series data: the Zambia statistics Agency
compiles the volumes of copper every year. This data is
presented in the figure below.
1400000 Copper Export Volumes (mt)

1200000 1023859.131
1146315.366
1000000 1022096.51
976305.6942

800000 829749.68

674096.91 937984.9077
600000 587124.69
832144.1675
400000 882095.0871
490940.1416
200000

0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

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 Methodology
b) Cross sectional data - is a type of data collected by
observing many subjects (such as individuals, firms,
countries, or regions) at the one point or period of time,
– For example, we can ask each one of our class members
present today to give us their gender, phone ownership
are (if they have a phone or not), income ( how rich they)
etc.
– This information is only collected for today and we do not
collect it again. We have get what we call a cross-
sectional data
c) Panel Data – this is a mix of time series and cross
section. For example, we can get the information in b)
above every month from the same people. We make a
panel.

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 Methodology
• Economic Experiments
– Data is used to identify and quantify cause and effect
relationships among economic variables as predicted by
models
– Best data in this regard is easy to get in natural sciences
like physics and biology where experiments in laboratory
are easy to conduct
– Economics is a social science – and we may not be able to
run experiments for some macroeconomic variables like
inflation
– However, experiments are feasible for some economic
issues in experimental economics

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 Methodology

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 Methodology

• Diagrams, line etc–are vastly used to show relations

among variables.
• They are often drawn on assumption that other variables
remain unchanged “ceteris paribus”
• Graphs can depict relationship between two variables
– For example the relationship between the amount your
dad earns and the amount he saves
– If you dad makes a lot of money, he is likely to save more
– We will have a positive relationship between the two
• Graphs can also depict some condition that is achieved
when two variables are combined. Example PPF?

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 THE CIRCULAR-FLOW DIAGRAM
• The circular flow of income diagram is an example of a
model.
• We all know that the economy consists of millions of
people engaged in many activities—buying, selling,
working, hiring, manufacturing, and so on.
• To understand how the economy works, we simplify our
thinking about all these activities using a model of how
the economy is organized and how participants in the
economy interact with one another.
• We use the circular-flow diagram - a visual model of the
economy that shows how money flow through markets
among households and firms

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THE CIRCULAR-FLOW DIAGRAM
Assumptions of the model

1. The economy has two

decision makers which are
households and firms

2. Firms produce goods

and services using inputs or
Factors of production (L, K, H)
3. Factors of production are
Owned by households
• Households and firms interact in
two types of markets.
a) In the markets for goods and
services, households are buyers and
firms are sellers
House holds buy goods and services
Or money

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 THE CIRCULAR-FLOW DIAGRAM
Assumptions of the model
b. Factor markets -households
are sellers and firms are buyers.
• Here households provide
firms the inputs that the firms
use to produce commodities
The inner loop represents the
flows of commodities between
households and firms.
he households sell the use of
their L, land, K to the firms in the
markets for the factors of
production.
The firms then use these factors
to produce goods and services,
which in turn are sold to
households in the commodities
markets

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 THE CIRCULAR-FLOW DIAGRAM
• The factors of production flow from households to firms,
and goods and services flow from firms to households.
• The outer loop represents the corresponding flow of
money dollars.
– Households spend money to buy goods and services from
the firms
– Firms in turn use some of the revenue from these sales to
pay for their inputs in form of rent, wages and profits (To
who??)
• The circular flow of income is one simple model of the
economy.
• The other example of a model is the PPF!!!

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 Methodology Easter Duflo

• Experimental economics is the application of

experimental methods to study economic questions.
Data collected in experiments are used to estimate effect
size, test the validity of economic theories, and illuminate
market mechanism
– Economic experiments usually use cash to motivate
subjects, in order to mimic real-world incentives.
Experiments are used to help understand how and why
markets and other exchange systems function as they do
– Duflo et al won the Nobel prize for their “experimental
approach to alleviating global poverty”
– The approach often gets a group of people and randomly
assigns them to two different groups – the treatment and
control group
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 Methodology
• The treatment group – can be given some incentive
towards achieving the set goal. The control group may
not be given any incentive.
– At the end of the experiment, we can test/observe and see
there will be differences in results among the two groups
– Based on the results, a policy conclusions can be made.

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 Methodology
• Positive Statements: • Normative Statements:
– Capable of being verified or – Contains a value judgement
refuted by resorting to fact or which cannot be verified by
further investigation resort to investigation or
▪ The Scientific Method research
– Collect Data (observation or • The "reality" – predicting the
experimentation) future is more art than science.
– Formulate Behavioral
• A lot has to do with our
hypotheses and models
assumptions and our
– Make Predictions (attention to experiential memories
role of uncertainty)
– Run experiments to
prove/disprove behavioral
hypotheses
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