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Chapter 1
Preliminaries
Introduction
 Review basic terminologies,
methodologies, and key assumptions
imposed in microeconomic theory.
 What is economics?
 What is microeconomics?
 What are theories and models?
 What is positive and normative analysis?
 What is the difference between real and
nominal prices
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Themes of Economics
 Economics studies economic phenomena and
the economic behavior of individual agents --consumers, workers, firms, government, and
other economic units as well as how they make
choices so that limited resources are allocated
among competing uses.
 A fundamental assumption on individual
behavior is that an individual is rational (i.e.,
self-interested).
 Because resources are limited, but people's
desires are unlimited, we need economics to
study this fundamental conflict.
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Four Basic Questions to be
Answered by Any Institution:
 What goods and services should be
produced and in what quantity?
 How should the product be produced?
 For whom should it be produced and
how should it be distributed?
 Who makes the decision?
 The answers depend on economic
institutions.
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Two basic economic institutions
used in the real world:
 Market economic institution:
Most decisions on economic activities are
made by individuals, it is mainly a
decentralized decision system.
 Planning economic institution:
Most decisions on economic activities are
made by government, it is mainly a
centralized decision system.
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Themes of Modern Economics
 The market economy has been proved to be
only economic institution so far that can keep an
economy with sustainable development and
growth.
 It is the most important economic institution
discovered for reaching cooperation and solving
the conflicts among individuals.
 Modern economics studies various economic
phenomena and behavior under market
economic environment by using an analytical
approach such the demand and supply model.
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Themes of Microeconomics
 Microeconomics: Branch of economics
that deals with the behavior of individuals
-- workers, firms and consumers– as well
as how markets are organized
 It deals with limits:Limited budgets;
Limited time; Limited ability to produce
 How do we allocate these limited
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?
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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?
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Themes of Microeconomics
 Workers
Individuals decide when and if to enter the
work-force
 Trade-offs
of working now or obtaining more
education/training
What choices do individuals make in terms of
jobs or work places?
How many hours do individuals choose to
work?
 Trade-off
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of labor and leisure
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Themes of Microeconomics
 Firms
What types of products do firms produce?
 Constraints
on production capacity & financial
resources create needs for trade-offs.
Theory of the Firm – describes how these
trade-offs are best made
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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.
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Theories and Models
 Economic theories are used to explain
observed economic phenomena in terms of a
set of basic rules and assumptions.
 The Theory of the Firm
 The Theory of Consumer Behavior
 The Theory of Markets
 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.
Theories must be tested and refined
Theories are invariably imperfect – but gives
much insight into observed phenomena
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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?
 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
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Types of Markets
 Noncompetitive Markets
Markets where individual producers can
influence the price.
– groups of producers who act
collectively
 Example: OPEC dominates with world oil
market
 Cartel
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Real Versus Nominal Prices
 Comparing prices across time required
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) 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 
baseyear100
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CPIbase y ear
CPIcurrent y ear
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x Nominal Pricecurrent y ear
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Real Price of College
Year
Nom.
Price
CPI
1970
$2,530
38.8
Real Price

1990 $12,018 130.7
2002 $18,273 181.0
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38.8
* $2,530  $2,530
38.8

38.8
* $12,018  $3,569
130.7

38.8
* $18,273  $3,917
181.0
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Real Price of Wages
 Observations
The minimum wage has been increasing in
nominal terms since 1940.
 From
1930 at $0.25 to 2003 at $5.15
The 1999 real minimum wage was no higher
in 1999 than 1950.
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The Minimum Wage: Figure 1.1
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Why Study Microeconomics?
 Microeconomic concepts can be used to
assist everyone in making choices as
consumers and producers.
 Examples show the numerous levels of
microeconomic questions necessary in
many decisions
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Ford SUV’s
 Built Ford Explorer in 1991, Ford
Expedition in 1997 and the Ford
Excursion in 1999
 In each of these cases, Ford had to
consider many aspects of the economy
to ensure their introduction was a sound
investment
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Ford SUV’s
 Questions
 How strong in demand and how quickly will it grow?
 Must understand consumer preferences and tradeoffs
 What are the costs of manufacturing
 Given all costs of production, how many should be
produced each year?
 Risk analysis
 Uncertainty of future prices: gas, wages
 Ford had to develop pricing strategy and determine
competitors reactions?
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Emission Standards
 1970 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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