Pindyck, Rubinfeld, Mehta: Microeconomics, Seventh

edition.

Chapter 1
Preliminaries

Introduction
What are the key themes of
microeconomics?
What is a market?
What is the difference between real and
nominal prices?
Why study microeconomics?

Themes of Microeconomics
Microeconomics vrs macroeconomics
Microeconomics: Decision making by firms and
households,
interactions amongst them,
effects of policy changes
Decision making is in the face of limits
Limited budgets
Limited time
Limited ability to produce

How do we make the most of limits?

How do we allocate scarce resources?
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Themes of Microeconomics
Workers, firms and consumers must
make trade-offs
Do I work or go on vacation?
Do I purchase a new car or save my money?
Do we hire more workers or buy new
machinery?

How are these trade-offs best made?optimal decision making.

Themes of Microeconomics
Consumers
Limited incomes
Consumer theory describes how
consumers maximize their well-being, using
their preferences, to make decisions about
trade-offs
How do consumers make decisions about
consumption and savings?

Themes of Microeconomics
Workers
Individuals decide when and if to enter the
workforce
Trade-offs

of working now or obtaining more

education/training

What choices do individuals make in terms of

jobs or workplaces?
How many hours do individuals choose to
work?
Trade-off

of labor and leisure

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Themes of Microeconomics
Firms
What types of products do firms produce?
Constraints

on technology, production capacity,

and financial resources create needs for tradeoffs

Theory of the Firm describes how these

trade-offs are best made

Themes of Microeconomics
Prices
Trade-offs are often based on prices faced
by consumers and producers
Workers make decisions based on prices for
labor wages
Firms make decisions based on wages and
prices for inputs and on prices for the goods
they produce

Themes of Microeconomics
Prices
How are prices determined?
Centrally

planned economies governments

control prices
Market economies prices determined by
interaction of market participants

Markets collection of buyers and sellers

whose interaction determines the prices of
goods (more than an industry which reflects
the supply side)
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Theories and Models

Economics is concerned with explanation
of observed phenomena
Theories are used to explain observed
phenomena in terms of a set of basic rules
and assumptions:
The

Theory of the Firm

The Theory of Consumer Behavior

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Theories and Models

Theories are used to make predictions
Economic models are created from theories
Models are mathematical representations
used to make quantitative predictions

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Theories and Models

Validating a Theory
The validity of a theory is determined by the
quality of its prediction, given the
assumptions (explanatory power with respect
to observed phenomenon)
Theories must be tested and refined
Theories are invariably imperfect but gives
much insight into observed phenomena

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Rationale and Objective of the firm

Rationale of the firm
o Minimize transaction costs by internalizing production.
o Limit to size of the firm diminishing returns to
management (Penrose effect) overcome somewhat
through working of profit centers.

Objective of the firm

o Profit maximizing versus Satisficing (revenue maximizing)
o Principal agent problem
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Positive & Normative Analysis

Positive Analysis statements that
describe the relationship of cause and
effect
Questions that deal with explanation and
prediction
What

will be the impact of an import quota on

foreign cars?
What will be the impact of an increase in the
gasoline excise tax?

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Positive & Normative Analysis

Normative Analysis analysis examining
questions of what ought to be
Often supplemented by value judgments
Should

the government impose a larger

gasoline tax?
Should the government decrease the tariffs on
imported cars?

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What is a Market?
Markets
Collection of buyers and sellers, through their
actual or potential interaction, determine the
prices of products
Buyers:

consumers purchase goods, companies

purchase labor and inputs
Sellers: consumers sell labor, resource owners
sell inputs, firms sell goods

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What is a Market?
Market Definition
Determination of the buyers, sellers, and
range of products that should be included in
a particular market

Arbitrage
The practice of buying a product at a low
price in one location and selling it for more in
another location

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What is a Market?
Defining the Market
Many of the most interesting questions in
economics concern the functioning of
markets
Why

are there a lot of firms in some markets

and not in others?
Are consumers better off with many firms?
Should the government intervene in markets?

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Types of Markets
Perfectly competitive markets
Because of the large number of buyers and
sellers, no individual buyer or seller can
influence the price
Example:

Most agricultural markets

Fierce competition among firms can create a

competitive market (Airlines industry in
India).

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Types of Markets
Noncompetitive Markets
Markets where individual producers can
influence the price
Cartels

groups of producers who act

collectively
Example: OPEC dominates with world oil
market

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Market Price
Transactions between buyers and sellers
are exchanges of goods for a certain
price
Market price price prevailing in a
competitive market
Some

markets have one price: price of gold

Some markets have more than one price: price
of Nirma and Surf washing powder

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Market Definition
Market Definition
Which buyers and sellers should be included
in a given market?
This depends on the extent of the market
boundaries, geographical and by range of
products, to be included in it
Market

for housing in New Delhi or Chennai (not

much movement across cities by households)
Market for all cameras or digital cameras

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Market Definition
Importance of market definition
In order to set price, make budgeting
decisions, etc., companies must know
Their

competitors
Product-characteristic and geographic
boundaries of the market

Important for public policy decisions

Should

government allow a merger between

companies in same market?

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Real Versus Nominal Prices

Comparing prices across time requires
measuring prices relative to some overall
price level
Nominal price is the absolute or current
dollar price of a good or service when it is
sold
Real price is the price relative to an
aggregate measure of prices or constant
dollar price

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Real Versus Nominal Prices

Consumer Price Index (CPI) is often
used as a measure of aggregate prices
Records the prices of a large market basket
of goods purchased by a typical consumer
over time
Percent changes in CPI measure the rate of
inflation

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Real Versus Nominal Prices

Calculating Real Prices

RealPrice

CPI base year

CPI current year

x Nominal Price current year

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Real Price of College

Year

Nom.
Price

CPI

1971

Rs2,530

38.8

Real Price

1991

Rs12,018 130.7

2010

Rs18,273 181.0

38.8
*Rs2,530 Rs2,530
38.8

38.8
*Rs12,018
Rs3,569
130.7

38.8
*Rs18,273
Rs3,917
181.0

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Real Price of Wages

Observations
Wage of industrial workers has been
increasing in nominal terms since 1991
Real wage also has been increasing but to a
lower extent than the nominal wage because
of inflation.

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Why Study Microeconomics?

Microeconomic concepts are used by
everyone to assist them in making
choices as consumers and producers
Examples show the numerous levels of
microeconomic questions necessary in
many decisions

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Tata Motors cars

Building Nano car or introducing Jaguar
vehicles into the Indian market.
Tata Motors has to consider many
aspects of the economy to ensure their
introduction is a sound investment

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Tata Motors cars

Questions
How strong is demand and how quickly will it
grow?
Must

understand consumer preferences and

trade-offs

What are the costs of manufacturing?

Given

all costs of production, how many should

be produced each year?

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Tata Motors cars

Questions (cont.)
Tata Motors has to develop pricing strategy
and determine competitors reactions
Risk analysis
Uncertainty

of future prices: gas, wages

Organizational decisions
Integration

of all divisions of production

Government regulation
Emissions

standards

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Emission Standards
Clean Air Act imposed emissions
standards and have become increasingly
stringent
Questions:
What

are the impacts on consumers?

What are the impacts on producers?
How should the standards be enforced?
What are the benefits and costs?

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The End

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