Micro-Economics

1. Defining Economics
Economics is the social science that studies the choices that individuals, businesses,
governments, and entire societies make as they cope with scarcity and the incentives that
influence and reconcile those choices.

2. Microeconomics vs. Macroeconomics

Microeconomics: The study of the choices that individuals and businesses make, the way
these choices interact in markets, and the influence of governments.
Macroeconomics: The study of the performance of the national economy and the global
economy.

3. Economic Systems and Central Questions

An economic system is a way of organizing the production, distribution, and consumption of
goods and services. The two central questions in any economy are:

1. How do choices end up determining what, how, and for whom goods and services are
produced?
What: Refers to which goods and services producers should be producing. Goods are
tangible items, while services are intangible tasks.
How:
Refers to the manner in which these goods and services are produced, utilizing the four
factors of production:
Land: Natural resources (minerals, oil, gas, coal).
Labour: Human capital, the work time and effort devoted to production.
Capital: Tools, instruments, machines, and buildings used in production. Financial
capital is important for acquiring capital but is not a factor of production itself.
Entrepreneurship: The human resource that organizes land, labour, and capital.

For whom:
Refers to the individuals consuming the goods and services. Individuals earn income by
selling the services of the factors of production they own:
Land earns rent.
Labour earns wages.
Capital earns interest.
Entrepreneurship earns profit.

2. When do the choices made in the pursuit of self-interest also promote the social interest?
Self-interest: A choice made for the best possible outcome for the individual.
The material suggests that often, choices made in self-interest can lead to outcomes that
are also in the social interest, making everyone better off without any losers.
4. The World's Basic Economic Problem: Scarcity
The economic problem is the fundamental challenge that faces society: how to satisfy unlimited
wants and needs with limited resources.

Scarcity:
The inability to satisfy our unlimited wants and needs due to the lack of resources required to
fulfill them. Resources are limited or finite.
Scarcity affects consumers due to a limited amount of goods and services on the market.
Scarcity affects producers due to a limited amount of factors of production, impacting
their ability to produce.

Wants: The desire for goods and services, which are unlimited.
Needs: Necessities essential for survival (food, water, shelter, clothing).
Demand: The intent to buy a good or service, provided the consumer is willing and able to do
so.

5. Scarcity, Choice, and Opportunity Costs

Scarcity and Choice: Because of unlimited human wants and scarce resources, we must
make choices. When we make a choice, we select from available alternatives.
Opportunity Cost:
The highest-valued alternative that is given up in order to receive a desired benefit. It is the
value of the best forgone opportunity.
There is always a cost involved when acquiring scarce natural resources.
Consumers must pay for goods and services, incurring a cost.

Trade-off: An exchange where giving up one thing is necessary to obtain another.

6. The Economic Way of Thinking

There are six key ideas that define economic thinking:

1. A choice is a trade-off: Due to scarcity, individuals, groups, companies, and countries must
make choices, which involve giving up one thing to obtain another.
2. Making a rational choice: Economists view choices as rational when the costs and benefits
are compared, aiming to achieve the greatest benefit for the cost incurred.
3. Benefit: What you gain: A benefit is something gained from a rational choice, determined by
the decision-maker's preferences.
4. Cost: What you must give up: Economists see costs as opportunity costs – the value of the
best forgone opportunity.
5. How much? Choosing at the margin:
Marginal Benefit: The benefit that occurs from an increase in an activity.
Marginal Cost: An increase in the opportunity cost.

6. Choices respond to incentives: Individuals make choices in an effort to pursue their own self-
 interest. Incentives are rewards that encourage an action or penalties that discourage one.

7. Economics as a Social Science

Economics is a social science because it studies the behavior of human beings, both individually
and in groups. It involves a systematic attempt to discover regular patterns of behavior to explain
events and predict future outcomes, guiding policymakers.

8. Positive vs. Normative Statements

Positive Statement: An objective statement of fact.
Normative Statement: A statement that involves an opinion or value judgment.

9. Graphs in Economics
Graphs are significant in economics for establishing relationships between variables.

Axes:
x-axis: The horizontal line.
y-axis: The vertical line.
Origin: The point where the x and y axes meet (zero point).

Reading a Graph: Start by reading the axis labels to understand what is being measured.
Scatter Diagram: A graph that plots the value of one variable against the value of another
variable.

Types of Relationships Between Variables:

1. Positive Relationship (Direct Relationship): Variables move in the same direction. A line that
slopes upward shows this.
2. Negative Relationship (Inverse Relationship): Variables move in opposite directions. A line
that slopes downward shows this.
3. Maximum or Minimum: Some relationships have a peak or a trough.
4. Unrelated Variables: Changes in one variable do not affect the other.
Curve: Any line on a graph, straight or curved.

Linear Relationship: A relationship shown by a straight line.

Ceteris Paribus: Latin for "if all other relevant things remain the same." Economists use this to
isolate the relationship between two variables by holding all other factors constant.

10. The Production Possibilities Frontier (PPF)

The Production Possibilities Frontier (PPF) is the boundary between the different combinations
of goods and services that can be produced and those that cannot, given the available resources
and technology.

Illustrating a PPF: Typically focuses on two goods at a time, holding the quantities of all other
goods constant.
Factors to Consider:
Quantities of goods and services are limited by available resources and technology.
To increase production of one good, production of another must decrease (a trade-off).
The PPF illustrates scarcity because points outside the frontier are unattainable.

Production Efficiency: Achieved when goods and services are produced at the lowest
possible cost, which occurs when producing along the PPF boundary. Production is inefficient
if it's inside the PPF.
Trade-off Along the PPF: Every choice along the PPF involves a trade-off due to limited
factors of production.
Opportunity Cost and Opportunity Cost Ratios:
The opportunity cost of an action is the highest-valued alternative forgone.
The opportunity cost ratio is the decrease in the quantity produced of one good divided by
the increase in the quantity produced of another good as we move along the PPF.

Example: PPF and Opportunity Cost

Consider a simplified economy that can produce only hamburgers and cooldrinks.

Possibility Hamburgers Cooldrinks (millions of Marginal Cost of 1 Hamburger (in

(millions) cans) Cooldrinks)
A 0 15 -
B 1 14 1
C 2 12 2
D 3 9 3
E 4 5 4
F 5 0 5

Graph:

Imagine a graph with "Hamburgers (millions)" on the x-axis and "Cooldrinks (millions of cans)" on
the y-axis. The points A through F would plot out a curve.

Point A (0, 15): All resources are used to produce cooldrinks.

Point F (5, 0): All resources are used to produce hamburgers.
Moving from A to B: To produce the first million hamburgers, we give up 1 million cooldrinks.
The opportunity cost of the first hamburger is 1 cooldrink.
Moving from C to D: To produce the third million hamburgers, we give up 3 million cooldrinks.
 The opportunity cost of the third hamburger is 3 cooldrinks.

Explanation: As we move along the PPF, producing more hamburgers requires giving up
increasingly larger amounts of cooldrinks. This demonstrates increasing opportunity cost. The
PPF shows the trade-offs: to get more of one good, you must accept less of the other. The slope
of the PPF at any point represents the marginal cost of producing one more unit of the good on
the horizontal axis.

Marginal Benefit and Preferences

Marginal Benefit: The benefit that arises from consuming one more unit of a good or service.
Preferences: Represented by the willingness to pay for a good. As the quantity of a good
increases, the willingness to pay for an additional unit typically falls (decreasing marginal
benefit).
Efficient Allocation: Occurs where marginal benefit equals marginal cost.

11. Gains from Trade

Comparative Advantage: A person has a comparative advantage in producing a good if their
opportunity cost of producing that good is lower than another person's.
Gains from Trade: Occur when individuals or countries specialize in producing goods where
they have a comparative advantage and then trade with others. This allows them to consume
beyond their individual PPF.

Example: Joe and Liz's Smoothie Bar

Joe:
Can produce 1 smoothie in 10 minutes or 1 salad in 2 minutes.
Opportunity cost of 1 smoothie = 5 salads.
Opportunity cost of 1 salad = 1/5 smoothie.
Joe's PPF allows for (e.g.) 6 smoothies or 30 salads per hour.

Liz:
Can produce 1 smoothie in 2 minutes or 1 salad in 2 minutes.
Opportunity cost of 1 smoothie = 1 salad.
Opportunity cost of 1 salad = 1 smoothie.
Liz's PPF allows for 30 smoothies or 30 salads per hour.

Comparative Advantage:

Joe has a comparative advantage in producing salads (opportunity cost of 1/5 smoothie vs.
Liz's 1 smoothie).
Liz has a comparative advantage in producing smoothies (opportunity cost of 1 salad vs.
Joe's 5 salads).

Specialization and Trade:

If Joe specializes in salads (produces 30/hour) and Liz in smoothies (produces 30/hour).
They can trade. For example, Liz offers to trade 10 smoothies for 20 salads.
 For Liz: Buying a salad for 1/2 smoothie (10 smoothies / 20 salads) is cheaper than her
opportunity cost of 1 smoothie.
For Joe: Selling a salad for 1/2 smoothie is better than his opportunity cost of 1/5
smoothie. Buying a smoothie for 2 salads is cheaper than his opportunity cost of 5
salads.

Result: Both Joe and Liz can consume more smoothies and salads than they could produce
on their own, moving outside their individual PPFs.

12. Economic Coordination

Challenge: Coordinating the specialized choices of billions of people.
Systems:
Central Economic Planning: Works poorly because planners lack information about
production possibilities and preferences.
Markets:
Decentralized coordination that works best, supported by four institutions:
1. Firms: Organize factors of production to produce goods and services.
2. Markets: Bring together buyers and sellers.
3. Property Rights: Define ownership and use of resources.
4. Money: A medium of exchange.

Circular Flows Through Markets

Households: Provide labor, land, capital, and entrepreneurship to factor markets. They use
their income (wages, rent, interest, profits) to purchase goods and services from goods
markets.
Firms: Hire factors of production from factor markets and use them to produce goods and
services. They sell these goods and services in goods markets, earning revenue to pay for
factors of production.
Factor Markets: Where factors of production are bought and sold.
Goods Markets: Where goods and services are bought and sold.
Real Flows: The flow of factors of production (households to firms) and goods/services
(firms to households).
Monetary Flows: The flow of income (firms to households) and expenditure (households to
firms).