Economics is the science that deals with the allocation of limited resources to satiisfy

unlimited human wants. economics is often described as the science of constrained choice.

Broadly speaking, economics is composed of two branches, microeconomics and

macroeconomics. The prefix micro is derived from the Greek word mikros, which means
“small.” Microeconomics therefore studies the economic behavior of individual economic
decision makers, such as a consumer, a worker, a firm, or a manager. It also analyzes the
behavior of individual households, industries, markets, labor unions, or trade associations. By
contrast, the prefix macro comes from the Greek word makros, which means “large.”
Macroeconomics thus analyzes how an entire national economy performs.

Regardless of its market system, every society must answer these questions:

• What goods and services will be produced, and in what quantities?

• Who will produce the goods and services, and how?

• Who will receive the goods and services?

Microeconomic analysis attempts to answer these questions by studying the behavior of

individual economic units. By answering questions about how consumers and producers
behave, microeconomics helps us understand the pieces that collectively make up a model of
an entire economy. Microeconomic analysis also provides the foundation for examining the
role of the government in the economy and the effects of government actions.

Any model, whether it is used to study chemistry, physics, or economics, must specify what
variables will be taken as given in the analysis and what variables are to be determined by
the model. This brings us to the important distinction between exogenous and endogenous
variables. An exogenous variable is one whose value is taken as given in a model. In other
words, the value of an exogenous variable is determined by some process outside the model
being examined. An endogenous variable is a variable whose value is determined within the
model being studied.

Nearly all microeconomic models rely on just three key analytical tools:

• Constrained optimization

• Equilibrium analysis

• Comparative statics

The tool of constrained optimization is used when a decision maker seeks to make the best
(optimal) choice, taking into account any possible limitations or restrictions on the choices.
We can therefore think about constrained optimization problems as having two parts, an
objective function and a set of constraints. An objective function is the relationship that the
decision maker seeks to “optimize,” that is, either maximize or minimize. For example, a
consumer may want to purchase goods to maximize her satisfaction. Decision makers must
also recognize that there are often restrictions on the choices they may actually select. These
restrictions reflect the fact that resources are scarce, or that for some other reason only
certain choices can be made. The constraints in a constrained optimization problem
represent restrictions or limits that are imposed on the decision maker.

Problem 1: Constrained Optimization: The Farmer’s Fence

Suppose a farmer plans to build a rectangular fence as a pen for his sheep. He has F feet of
fence and cannot afford to purchase more. However, he can choose the dimensions of the
pen, which will have a length of L feet and a width of W feet. He wants to choose the
dimensions L and W that will maximize the area of the pen. He must also make sure that the
total amount of fencing he uses (the perimeter of the pen) does not exceed F feet.

Problem

What is the objective function for this problem?

(a) What is the constraint?

(b) Which of the variables in this model (L, W, and F) are exogenous? Which are
endogenous? Explain.

Solution

(a) The objective function is the relationship that the farmer is trying to maximize—in this
case, the area LW. In other words, the farmer will choose L and W to maximize the objective
function LW.

(b) The constraint will describe the restriction imposed on the farmer. We are told that the
farmer has only F feet of fence available for the rectangular pen. The constraint will describe
the restriction that the perimeter of the pen 2L + 2W must not exceed the amount of fence
available, F. Therefore, the constraint can be written as 2L + 2W ≤ F.

(c) The farmer is given only F feet of fence to work with. Thus, the perimeter F is an
exogenous variable, since it is taken as given in the analysis. The endogenous variables are L
and W, since their values can be chosen by the farmer (determined within the model).
The term marginal in microeconomics tells us how a dependent variable changes as a result
of adding one unit of an independent variable.

Marginal cost measures the incremental impact of the last unit of the independent variable
(output) on the dependent variable (total cost). Equivalently, marginal cost can be thought of
as a rate of change of the dependent variable (again, total cost) as the independent variable
(output) changes.

Problem 2: Constrained Optimization: Consumer Choice

Suppose a consumer purchases only two types of goods, food and clothing. The consumer has
to decide how many units of each good to purchase each month. Let F be the number of
units of food that she purchases each month, and C the number of units of clothing. She
wants to maximize her satisfaction with the two goods. Suppose the consumer’s level of
satisfaction when she purchases F units of food and C units of clothing is measured by the
product FC, but she can purchase only limited amounts of goods per month because she must
live within her budget. Goods cost money, and the consumer has a limited income. To keep
the example simple, suppose the consumer has a fixed monthly income I, and she must not
spend more than I during the month. Each unit of food costs PF and each unit of clothing
costs PC.

Problem

(a) What is the objective function for this problem?

(b) What is the constraint?

(c) Which variables (PF, F, PC, C, and I) are exogenous? Which are endogenous? Explain.

(d) Write a statement of the constrained optimization problem.

Solution

(a) The objective function is the relationship that the consumer seeks to maximize. In this
example, she will choose the amount of food and clothing to maximize her satisfaction,
measured by FC. Thus, the objective function is FC.

(b) The constraint represents the amounts of food and clothing that she may choose while
living within her income. If she buys F units of food at a price of P F per unit, her total
expenditure on food will be (PF)(F). If she buys C units of clothing at a price of PC per unit,
her total expenditure on clothing will be (PC)(C). Therefore, her total expenditure will be
(PF)(F) + (PC)(C). Since her total expenditure must not exceed her total income I, the
constraint is (PF)(F) + (PC)(C) ≤ I.

(c) The exogenous variables are the ones the consumer takes as given when she makes her
purchasing decisions. Since her monthly income is fixed, I is exogenous. The prices of food P F
and clothing PC are also exogenous, since she cannot control these prices. The consumer’s
only choices are the amounts of food and clothing to buy; hence, F and C are the endogenous
variables.

(d) The statement of the constrained optimization problem is

max FC
(F ,C)

subject ¿:(P¿¿ F) ( F ) +( P¿ ¿C ) ( C ) ≤ I ¿ ¿

The first line shows that the consumer wants to maximize FC and that she can choose F and
C. The second line describes the constraint: total expenditure cannot exceed total income.

A second important tool in microeconomics is the analysis of equilibrium, a concept found in

many branches of science. An equilibrium in a system is a state or condition that will
continue indefinitely as long as exogenous factors remain unchanged—that is, as long as no
outside factor upsets the equilibrium.

In a competitive market, equilibrium is achieved at a price at which the market clears—that

is, at a price at which the quantity offered for sale just equals the quantity demanded by
consumers. Equilibrium occurs at the point where the demand curve and the supply curve
intersect.

Our third key analytical tool, comparative statics analysis, is used to examine how a change
in an exogenous variable will affect the level of an endogenous variable in an economic
model. Comparative statics analysis can be applied to constrained optimization problems or
to equilibrium analyses. Comparative statics allows us to do a “before-and-after” analysis by
comparing two snapshots of an economic model. The first snapshot tells us the levels of the
endogenous variables given a set of initial values of exogenous variables. The second snapshot
tells us how an endogenous variable we care about has changed in response to an exogenous
shock—that is, a change in the level of some exogenous variable.

Problem 3: Comparative Statics with Market Equilibrium in the U.S. Market for Corn

Suppose that in the United States, the quantity of corn demanded Qd

 depends on two things: the price of corn P and the level of income in the nation I. Assume
that the demand curve for corn is downward sloping, so that more corn will be demanded
when the price of corn is lower. Assume also that the demand curve shifts to the right if
income rises (i.e., higher income increases the demand for corn). The dependence of the
quantity of corn demanded on the price of corn and income is represented by the demand
function Qd(P, I).

Suppose the quantity of corn offered for sale, QS, also depends on two things: the price of
corn, P, and the amount of rain that falls during the growing season, r. The supply curve is
upward sloping, so that as the price of corn rises, more corn will be offered for sale. Assume
that the supply curve shifts to the right (more corn is produced) if there is more rain. The
relationship showing the quantity of corn supplied at any price and amount of rainfall is the
supply function QS(P, r).

In equilibrium, the price of corn will adjust so that the market will clear (Q d = QS). Let’s call
the equilibrium quantity exchanged Q* and the equilibrium price P*. We can assume that the
market for corn is only a small part of the U.S. economy, so that national income is not
noticeably affected by events in the market for corn.

Problem

(a) Suppose that income rises from I1 to I2. On a clearly labeled graph, illustrate how the
change in this exogenous variable affects each of the endogenous variables.

(b) Suppose that income remains at I1 but that the amount of rainfall increases from r1

to r2. On a second clearly labeled graph, illustrate how the change in this exogenous variable
affects each of the endogenous variables.

Solution
(a) As shown in
Figure 1.5, the
change in income
shifts the demand
curve to the right
(increases demand),
from D1 to D2. The
location of the
supply curve, S1, is
unaffected because
QS does not depend
on I. The
equilibrium price
therefore rises from
P1* to P2*. So the
change in income
leads to a change in
equilibrium price.
The equilibrium
quantity also
rises from
Q1* to Q2*.
So the
change in
income also
leads to a
change in
quantity.

(b) As
shown in
Figure 1.6,
the increase
in rainfall
shifts the
supply curve
to the right
(increases
supply), from S1 to S2. The location of the demand curve, D1, is unaffected because Qd does
not depend on r. The equilibrium price therefore falls from P 1* to P2*. So the change in
rainfall leads to a change in equilibrium price. The equilibrium quantity rises from Q 1* to Q2*.
So the change in rainfall also leads to a change in quantity.

Problem 4: Comparative Statics with Constrained Optimization

In the farmer’s fencing problem (Learning-By-Doing Exercise 1.1), the exogenous variable is

the perimeter of the fence F, and the endogenous variables are the length L and width W of
the pen. You may have solved a problem like this one before: The area is maximized when
the farmer builds a square pen. (You do not need to know how to arrive at that conclusion in
this exercise. Just trust that it is correct.)

Problem

If the farmer is given an extra length of fence ΔF (where Δ, the Greek letter delta, means “the
change in”), how will the dimensions of the pen change? In other words, how will a change
in the exogenous variable ΔF be reflected by changes in the endogenous variables ΔL and
ΔW?

Solution

Since the optimal configuration of the pen is a square, we know that the length and width of
the pen will each be one-fourth of the perimeter, so L = F/4 and W = F/4. Therefore, ΔL =
ΔF/4 and ΔW = ΔF/4. This comparative statics result tells us, for example, that if the farmer is
given an extra 4 feet of fence, the length and the width of the pen will each be increased by 1
foot.

Microeconomic analysis can be used to study both positive and normative questions. Positive
analysis attempts to explain how an economic system works or to predict how it will change
over time. Positive analysis asks explanatory questions such as “What has happened?” or
“What is happening?” It may also ask a predictive question: “What will happen if some
exogenous variable changes?” In contrast, normative analysis asks prescriptive questions,
such as “What should be done?” Normative studies typically focus on issues of social welfare,
examining what will enhance or detract from the common good. Normative studies
introduce value judgments into the analysis.