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Lecture 1 Basic Economic Analysis The Economic Framework • For our purposes two basic sets of agents: – Consumers – Firms • Both consumers and firms live within an environment defined by certain economic characteristics • Faced with some environment, each agent makes decisions • Decisions lead to economic outcomes Economic Analysis • Analysis of decisions of individual agents operating within an economic environment • Make predictions on the observable outcomes of these decisions and how these observables are affected by the economic environment. • Observable outcomes: Prices, Quantities, Profits, Product specifications, Advertising, Contractual Arrangements, Technological Change Individual Decision Making The Basic Principles PRINCIPLE 1 Individuals are self interested. Among the feasible alternatives individuals choose whatever they most prefer. PRINCIPLE 2 Every choice results in foregone alternatives. The value of the foregone alternative represents the cost of the choice (OPPORTUNITY COST) PRINCIPLE 3 Individuals adjust consumption decisions in response to prices. The amount of a good that an individual wishes to purchase (quantity demanded) falls as its price increases. The amount an individual wishes to sell (quantity supplied) increases when price increases Competitive Equilibrium • Demand curve summarizes how the decisions of individuals wishing to purchase the good are affected by changes in the price of the good: As price falls, desired quantity purchased rises. • Supply curve summarizes how the decisions of individuals wishing to sell the good are affected by changes in the good’s price: As price rises, desired quantity sold rises. • How are these decisions coordinated to produce a market outcome? Equilibrium Cont’d • Price adjustments are the means by which individual purchaser’s decision and individual seller’s decision coordinated. • As price rises, quantity demanded falls and quantity supplied rises; as price falls, quantity demanded rises and quantity supplied falls • Equilibrium price is the one for which quantity demanded equals quantity supplied: the amount that buyers wish to purchase is just equal to the amount sellers wish to sell.