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ECON 500 Week 1
ECON 500 –Microeconomic Theory
Week 1
Preliminaries
ECON 500 Week 1
Microeconomic
Theory
In economics, explanation and prediction are based on theories. Theories
are developed to explain observed phenomena in terms of a set of basic
rules and assumptions.
Economics uses theory to explain actions and predict future actions.
A model is a mathematical representation, based on economic theory, of a
firm, a market, or some other entity.
Theory does not work well all the time. The market test of theory is how
well it does in comparison to another theory. A theory must have the
possibility to being proved wrong.
ECON 500 Week 1
economic Theory
Micro
Economics:
οἰκονομία
οἶκος (oikos, "house")
νόμος (nomos, "custom" or "law")
ECON 500 Week 1
economic Theory
Micro
Economics:
The social science concerned with:
How to allocate scarce resource, with alternative uses
between unlimited and competing wants
ECON 500 Week 1
economic Theory
Micro
"Economics is the science of choice. It began with Aristotle but got mixed up with ethics in the
Middle Ages. Adam Smith separated it from ethics, and Walrus mathematized it. Alfred Marshall
tried to narrow it, and Keynes made is fashionable. Robbins widened it, and Samuelson dynamized
it, but modern science made it statistical and tried to confine it again.
But the science won't stay put. It keeps cropping up all over the place. There is an economics of
money and trade, of production and consumption, of distribution and development. There is also an
economics of welfare, manners, language, industry, music, and art. There is an economics of war
and an economics of power. There is even an economics of love.
Economics seems to apply to every nook and cranny of human experience. It is an aspect of all
conscious action. Whenever decisions are made, the law of economy is called into play. Whenever
alternatives exist, life takes on an economic aspect. It has always been so. But how can it be?
It can be because economics is more than just the most developed of the sciences of control. It is a
way of looking at things, an ordering principle, a complete part of everything. It is a system of
thought, a life game, an element of pure knowledge.
ECON 500 Week 1
economic Theory
Micro
The fundamental economic problem: Scarcity
Seemingly unlimited human needs and wants, need to be satisfied in a
world of limited resources.
Society has insufficient productive resources to fulfill all human wants and
needs, therefore not all of society's goals can be pursued at the same time;
trade-offs are made of one good against others.
Opportunity Cost:
The maximum benefit forgone by using scarce resources for a particular
purpose. It is the benefit provided by the next best use of that resource.
ECON 500 Week 1
Microeconomic Theory
microeconomics
Branch of economics that deals with the behavior of individual economic
units—mainly, consumers and firms—as well as the markets that these
units comprise and the interactions therein.
ECON 500 Week 1
AGENDA
Economic Lens
Theories and Models
Marginal Thinking
Demand and Supply
Consumer Theory
Utility Maximization
Preferences and Budget
Firm Theory
Profit Maximization
Productivity and Costs
Market Structures
Competition and Welfare
Imperfect Competition and Market Power
Input Demand, Capital and Time
Market Failures
ECON 500 Week 1
A model is a mathematical representation, based on economic theory, of a
firm, a market, or some other entity.
Models inevitably make heroic abstractions (arguably more so than other
sciences) from the complexities of the real world, but they still provide aid
in understanding economic behavior.
Theories and models do not work well all the time. Another important
purpose of science is to separate good ones from the bad.
ECON 500 Week 1
Two general methods used to verify economic models:
Direct approach
Tries to establishes the validity of the model’s assumptions
Indirect approach
Tries to show that the model correctly predicts real-world events
ECON 500 Week 1
An Example: Profit Maximization Model
Assumes that profits are the only relevant goal of the firm.
Other possibilities such as power, prestige, revenue, stock price,
shareholder satisfaction are treated as unimportant.
Assumes that the firm has sufficient information
about the cost and market conditions.
Direct Approach
Can we validate the assumptions?
Inconclusive
Indirect Approach
Can we find testable predictions?
Yes. In accord with reality
ECON 500 Week 1
An Example: Profit Maximization Model
A firm can sell all the output that it wishes at a price of p per unit
Total costs of production, C, depend on the amount produced, q
Profits = π = pq – C(q)
The profit-maximization output level, q* is determined by
First-order condition:
Output level for which price is equal to marginal cost, C’(q)
Second-order condition:
Marginal cost must be increasing at q*
ECON 500 Week 1
Deriving a testable prediction:


d
 p  C '(q )  0 or p  C '(q ) 
dq


Second-order condition:


d 2
 C "(q )  0 or C"(q*)  0 
2
dq

d ( p  C '(q*)  0)
dq *
 1  C "(q*)
0
dp
dp
dq *
1


0
dp C "(q*)
First-order condition:
ECON 500 Week 1
General Features of Economic Models:
Ceteris Paribus assumption
“Other things the same”
Focus on only a few forces at a time
Other variables are assumed to be unchanged
ECON 500 Week 1
General Features of Economic Models:
Optimization assumption
Economic actors are assumed to be rationally pursuing some goal
Consumers: maximize utility
Firms: maximize profits (or minimize costs)
Government regulators: maximize public welfare
Generates precise, solvable models
Appear to perform fairly well in explaining reality
ECON 500 Week 1
General Features of Economic Models:
Positive-normative distinction
Positive economic theories
Seek to explain the economic phenomena that are observed
Normative economic theories
Focus on what “should” be done
ECON 500 Week 1
General Structure of Economic Models:
ECON 500 Week 1
Thinking at the Margin
Very small changes from status quo are essential in decision making
ECON 500 Week 1
Thinking at the Margin
Very small changes from status quo are essential in decision making
Idea goes back to:
…external goods have a limit, like any other instrument, and all things
useful are of such a nature that where there is too much of them they must
either do harm, or at any rate be of no use.
Aristotle Politics
ECON 500 Week 1
ECON 500 Week 1
Thinking at the Margin
Economic activity persists until benefits and costs are equal at the margin
Consumer context: Marginal Utility vs Marginal Cost
Producer context: Marginal Revenue vs Marginal Cost
Social Context: Social MB vs Social MC
ECON 500 Week 1
Theory of Value and the development of the Marginalist Revolution
The Marginalist Revolution
The exchange value of an item is determined by
Not the usefulness of the aggregate
But by the usefulness of the last unit consumed
Water is plentiful, therefore additional units has a low value in exchange
Diamond is scarce, therefore additional units have high value in exchange
ECON 500 Week 1
Theory of Value and the development of the Marginalist Revolution
The Marshallian Supply-Demand Analysis
Prices reflect both the marginal valuation that consumers place on goods
and the marginal costs of producing the goods
Supply and demand simultaneously operate to determine price
ECON 500 Week 1
ECON 500 Week 1
A more general model
qD = a + bp
qS = c + dp
Equilibrium  qD = qS
a + bp = c + dp
ac
p* 
d b
ECON 500 Week 1
Comparative Statics:
What happens to the equilibrium price if either demand or supply shift?
dp*
1

0
da d  b
dp*
1

0
dc d  b
An increase in demand (an increase in a) increases equilibrium price
An increase in supply (an increase in c) reduces price
ECON 500 Week 1
From Partial to General Equilibrium
The Marshallian model is a partial equilibrium model that focuses on price
determination in only one market at a time.
Prices are signals that communicate the relative scarcity of
goods across various markets.
For more general questions, we need a model of the entire economy that
includes the interrelationships between markets and economic agents
One Simple model that provides a few general equilibrium insights is the
production possibilities frontier model.
ECON 500 Week 1
ECON 500 Week 1
PPF Model highlights that the resources in an economy are scarce and the
economy is always faced with trade-offs and provides two insights that are
not clear in Mashallian partial equilibrium
Each choice has opportunity costs
Opportunity costs depend on how much of each good is produced in a
systematic way
ECON 500 Week 1