The Economic Approach;

Some Tools of the Economist;

Analyzing Economic Problems
and Microeconomics
• Gwartney, ch.1-2
• Besanko, ch.1

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 Microeconomics Defined
Microeconomics is the study of the economic
behavior of individual economic decision-
makers such as consumers, workers, firms or
managers. This study involves both the
behavior of these economic agents on their own
and the way their behavior reacts on
government policy-decisions or interacts to
form larger units, such as markets.

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Who Should Study Microeconomics?
Example: The Railroad Industry in the US

 74.9% of all freight, 1929

 39.8% of all freight, 1970

1970’s:
• Poor profits, bankruptcies, and an inability
to invest.

1980’s:
• Loosened regulation and union rules
improved profitability.

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Who Should Study Microeconomics?
Analysis of these issues requires Microeconomic
tools and the key players below need to know
something about Microeconomics:

 Policy Makers

 Managers

 Union Leaders

 Lenders

 Business Owners
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 Nearly all microeconomic models rely on
just three key analytical tools:
• 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;
• Equilibrium - i.e., the point where the demand and
supply curves cross;
• Comparative statics Analysis used to examine how a
change in some exogenous variable will affect the level
of some endogenous variable in an economic system.

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 Key Societal Questions:

1. What goods and services will be produced

and in what quantities;

2. Who will produces these services

and how will they produce them;

3. Who will receive these goods and services

and how will they get them.

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 Scarcity and Choice
• Scarcity and choice are the two essential
ingredients of an economic topic.
• Goods are scarce because desire for them
far outstrips their availability from nature.
• Scarcity forces us to choose among
available alternatives.

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Guideposts to Economic Thinking
• The use of scarce resources to produce a
good is always costly.
• Someone must give up something if we are
to have more of a scarce good.
• The highest valued alternative that must
be sacrificed is the opportunity cost of
the choice.
• Individuals choose purposefully; therefore
they will economize.
• Economizing:
gaining a specific benefit at the least
possible cost.

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Guideposts to Economic Thinking
• Incentives matter
• As personal benefits (costs) from choosing
an option increase, other things constant, a
person will be more (less) likely to choose
that option.
• Economic reasoning focuses on the impact
of marginal changes.
• Decisions will be based on marginal costs
and marginal benefits (utility).
• Since information is scarce, uncertainty is
a fact of life.

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Guideposts to Economic Thinking
• In addition to their initial impact, economic
events often generate secondary effects that
may be felt only with the passage of time.
• The value of a good is subjective and varies
with individual preferences.
• The test of an economic theory is its ability
to predict and explain events in the real
world.

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Four Pitfalls to Avoid in Economic Thinking:

• Violation of the ceteris paribus condition;

• Good intentions do not guarantee desirable
outcomes;
• Fallacy of composition (what is true for the
individual is not always true for the group)
• Association is not causation (Statistical
association alone cannot establish causation).

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 Property rights: The right to use, control, and
obtain benefits from a resource, good, or service.

Private ownership is a key to prosperity because

it provides people with a strong incentive to take
care of things and develop resources in ways that
are highly valued by others.
• Private property rights involve:
• the right to exclusive use.
• legal protection against invaders.
• the right to transfer to another.

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 Production Possibilities Curve
for Susan’s grades in English and Economics (10 hrs of study)
• Susan is a student who only has
10 Expected
hours of study to divide between grade in Production Possibilities
• Ifher
sheeconomics andof
spends most English
her time Economics 101 Curve ( PPC )
classes.
studying economics, she can earn
and a D in A
heranEnglish
A in economics
class. …
• If she splits her time between the B
two, she can earn a B in
economics
and a B in her English class. C
• If…she spends most of her time
studying English, she can earn a D
D in economics
and an A…in her
English class. Expected
• Mapping out all the possibilities F grade in
English 101
of F D C B A
how Susan can divide her time
(limited resources) between these
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 Production Possibilities Curve
for a nation’s economy (given limited resources)
• Consider an economy which has
limited resources to divide between Production Possibilities
Only clothing Curve ( PPC )
the production of clothing and is produced
• food.
If it allocates all of its resources Output
of clothing
toward the production of S
clothing, All output
A combinations
• then it can produce at point S.
If the it allocates all of its resources on the frontier
toward the production of food, then curve are
efficient.
B
• it can produce at point T.
Mapping out all the possibilities of D
how an economy can divide the
use
its resources gives us the - Inefficiency - C
• economy’s
Output combinations A, B, & C Only food
Production Possibilities Curve.
are is produced
all on the PPC and are, therefore, T
• efficient allocations of resources.
D is within the PPC and represents Output
of food
an inefficient resource allocation.
Combination B delivers more food
with the same output of clothing. Jump to first page
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Shifting the Production Possibilities Curve Outward

• An increase in the economy’s resource

base would expand our ability to produce
goods and services.
• Advancements in technology can expand
the economy’s production possibilities.
• An improvement in the rules (laws,
institutions, and policies) of the economy
can increase output.
• By working harder and giving up current
leisure, we could also increase our
production of goods and services.

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 Investment and Production
Possibilities in the Future
• The long-term benefits of Investment
goods
investment include greater
output in the future. Thus, PPC 2015 with A
decisions we make today
regarding how much to PPC 2005
save
(investment) and consume
determine the shape of the
• IfPPC 10 yearstofrom
we choose now.a
produce
mixture of consumption
and
investment goods which A
corresponds
then the future to bundle
PPC A…
might IA
move out to PPC 2015 with A
– due to the new buildings,
equipment, training, and
other forms of investment CA Consumption
goods
goods that IA represents.
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 Investment and Production
Possibilities in the Future
• If we choose to produce a Investment
goods PPC 2015 with B
mixture of consumption
and PPC 2015 with A
investment goods which
corresponds to bundle B, PPC 2005
with fewer consumption
goods (CB < CA) and more
then the future(IPPC
investment might
B > IA) …
move out to PPC 2015 with B
instead. B
• The level of investment IB
(savings) in an economy is A
only one determinant of IA
the movement outward (or
inward) of the production
possibilities curve.
CB CA Consumption
goods
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