MICROECONOMICS

Lecturer:
Pham Thu Hang
CHAPTER

1
INTRODUCTION
 CONTENTS

I. Ten Principles of Economics

II. Thinking Like an Economist

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 N. Gregory Mankiw

I. Ten Principles of Economics

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 In this part,
look for the answers to these questions:
• What kinds of questions does economics
address?
• What are the principles of how people make
decisions?
• What are the principles of how people interact?
• What are the principles of how the economy as
a whole works?

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 What Economics Is All About
 Scarcity: the limited nature of society’s
resources
 Economics: the study of how society manages
its scarce resources, e.g.
 how people decide what to buy,
how much to work, save, and spend
 how firms decide how much to produce,
how many workers to hire
 how society decides how to divide its resources
between national defense, consumer goods,
protecting the environment, and other needs
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The principles of
HOW PEOPLE
MAKE DECISIONS
 PRINCIPLE #1:
People Face Tradeoffs
All decisions involve tradeoffs. Examples:
 Going to a party the night before your midterm
leaves less time for studying.
 Having more money to buy stuff requires
working longer hours, which leaves less time
for leisure.
 Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.

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 PRINCIPLE #1:
People Face Tradeoffs
 Society faces an important tradeoff:
efficiency vs. equality
 Efficiency: when society gets the most from its
scarce resources
 Equality: when prosperity is distributed
uniformly among society’s members
 Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic ―pie.‖
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 PRINCIPLE #2:
The Cost of Something Is
What You Give Up to Get It
 Making decisions requires comparing the costs
and benefits of alternative choices.
 The opportunity cost of any item is
whatever must be given up to obtain it.
 It is the relevant cost for decision making.

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 PRINCIPLE #2:
The Cost of Something Is
What You Give Up to Get It
Examples:
The opportunity cost of…
…going to college for a year is not just the tuition,
books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.

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 PRINCIPLE #3:
Rational People Think at the Margin
Rational people
 systematically and purposefully do the best they
can to achieve their objectives.
 make decisions by evaluating costs and benefits
of marginal changes, incremental adjustments
to an existing plan.

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 PRINCIPLE #3:
Rational People Think at the Margin
Examples:
 When a student considers whether to go to
college for an additional year, he compares the
fees & foregone wages to the extra income
he could earn with the extra year of education.
 When a manager considers whether to increase
output, she compares the cost of the needed
labor and materials to the extra revenue.

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 PRINCIPLE #4:
People Respond to Incentives
 Incentive: something that induces a person to
act, i.e. the prospect of a reward or punishment.
 Rational people respond to incentives.
Examples:
 When gas prices rise, consumers buy more
hybrid cars and fewer gas guzzling SUVs.
 When cigarette taxes increase,
teen smoking falls.

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The principles of
HOW PEOPLE
INTERACT
 PRINCIPLE #5:
Trade Can Make Everyone Better Off
 Rather than being self-sufficient,
people can specialize in producing one good or
service and exchange it for other goods.
 Countries also benefit from trade and
specialization:
 Get a better price abroad for goods they
produce
 Buy other goods more cheaply from abroad
than could be produced at home

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 PRINCIPLE #6:
Markets Are Usually A Good Way to
Organize Economic Activity
 Market: a group of buyers and sellers
(need not be in a single location)
 ―Organize economic activity‖ means determining
 what goods to produce
 how to produce them
 how much of each to produce
 who gets them

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 PRINCIPLE #6:
Markets Are Usually A Good Way to
Organize Economic Activity
 A market economy allocates resources through
the decentralized decisions of many households
and firms as they interact in markets.
 Famous insight by Adam Smith in
The Wealth of Nations (1776):
Each of these households and firms
acts as if ―led by an invisible hand‖
to promote general economic well-being.

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 PRINCIPLE #6:
Markets Are Usually A Good Way to
Organize Economic Activity
 The invisible hand works through the price
system:
 The interaction of buyers and sellers
determines prices.
 Each price reflects the good’s value to buyers
and the cost of producing the good.
 Prices guide self-interested households and
firms to make decisions that, in many cases,
maximize society’s economic well-being.
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 PRINCIPLE #7:
Governments Can Sometimes
Improve Market Outcomes
 Important role for govt: enforce property rights
(with police, courts)
 People are less inclined to work, produce,
invest, or purchase if large risk of their property
being stolen.

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 PRINCIPLE #7:
Governments Can Sometimes
Improve Market Outcomes
 Market failure: when the market fails to allocate
society’s resources efficiently
 Causes of market failure:
 Externalities, when the production or consumption
of a good affects bystanders (e.g. pollution)
 Market power, a single buyer or seller has
substantial influence on market price
(e.g. monopoly)
 Public policy may promote efficiency.
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 PRINCIPLE #7:
Governments Can Sometimes
Improve Market Outcomes
 Govt may alter market outcome to
promote equity.
 If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can
change how the economic ―pie‖ is divided.

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The principles of
HOW THE
ECONOMY
AS A WHOLE
WORKS
 PRINCIPLE #8:
A Country’s Standard of Living Depends
on Its Ability to Produce Goods & Services
 Huge variation in living standards across
countries and over time:
 Average income in rich countries is more than
ten times average income in poor countries.
 The U.S. standard of living today is about
eight times larger than 100 years ago.

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 PRINCIPLE #8:
A Country’s Standard of Living Depends
on Its Ability to Produce Goods & Services
 The most important determinant of living
standards: productivity, the amount of goods
and services produced per unit of labor.
 Productivity depends on the equipment, skills,
and technology available to workers.
 Other factors (e.g., labor unions, competition from
abroad) have far less impact on living standards.

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 PRINCIPLE #9:
Prices Rise When the Government Prints
Too Much Money
 Inflation: increases in the general level of prices.
 In the long run, inflation is almost always caused
by excessive growth in the quantity of money,
which causes the value of money to fall.
 The faster the govt creates money,
the greater the inflation rate.

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 PRINCIPLE #10:
Society Faces a Short-run Tradeoff
Between Inflation and Unemployment
 In the short-run (1–2 years),
many economic policies push inflation and
unemployment in opposite directions.
 Other factors can make this tradeoff more or less
favorable, but the tradeoff is always present.

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 S U MMA RY

The principles of decision making are:

• People face tradeoffs.
• The cost of any action is measured in terms of
foregone opportunities.
• Rational people make decisions by comparing
marginal costs and marginal benefits.
• People respond to incentives.

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 S U MMA RY

The principles of interactions among people are:

• Trade can be mutually beneficial.
• Markets are usually a good way of coordinating
trade.
• Govt can potentially improve market outcomes if
there is a market failure or if the market outcome
is inequitable.

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 S U MMA RY

The principles of the economy as a whole are:

• Productivity is the ultimate source of living
standards.
• Money growth is the ultimate source of inflation.
• Society faces a short-run tradeoff between
inflation and unemployment.

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 N. Gregory Mankiw

II. Thinking Like an Economist

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 In this part,
look for the answers to these questions:
• What are economists’ two roles? How do they differ?
• What are models? How do economists use them?
• What are the elements of the Circular-Flow Diagram?
What concepts does the diagram illustrate?
• How is the Production Possibilities Frontier related
to opportunity cost? What other concepts does it
illustrate?
• What is the difference between microeconomics and
macroeconomics? Between positive and normative?
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 The Economist as Scientist
 Economists play two roles:
1. Scientists: try to explain the world
2. Policy advisors: try to improve it

 In the first, economists employ the

scientific method,
the dispassionate development and testing of
theories about how the world works.

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 Assumptions & Models
 Assumptions simplify the complex world,
make it easier to understand.
 Example: To study international trade,
assume two countries and two goods.
Unrealistic, but simple to learn and
gives useful insights about the real world.
 Model: a highly simplified representation of
a more complicated reality.
Economists use models to study economic
issues.
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 Our First Model:
The Circular-Flow Diagram
 The Circular-Flow Diagram: a visual model of
the economy, shows how dollars flow through
markets among households and firms
 Two types of ―actors‖:
 households
 firms
 Two markets:
 the market for goods and services
 the market for ―factors of production‖

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 Factors of Production
 Factors of production: the resources the
economy uses to produce goods & services,
including
 labor
 land
 capital (buildings & machines used in
production)

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 FIGURE 1: The Circular-Flow Diagram

Households:
 Own the factors of production,
sell/rent them to firms for income
 Buy and consume goods & services

Firms Households

Firms:
 Buy/hire factors of production,
use them to produce goods
and services
 Sell goods & services
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 FIGURE 1: The Circular-Flow Diagram

Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
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 Our Second Model:
The Production Possibilities Frontier
 The Production Possibilities Frontier (PPF):
a graph that shows the combinations of
two goods the economy can possibly produce
given the available resources and the available
technology
 Example:
 Two goods: computers and wheat
 One resource: labor (measured in hours)
 Economy has 50,000 labor hours per month
available for production.

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 PPF Example
• Producing one computer requires 100 hours labor.
• Producing one ton of wheat requires 10 hours labor.

Employment of
Production
labor hours
Computers Wheat Computers Wheat
A 50,000 0 500 0
B 40,000 10,000 400 1,000
C 25,000 25,000 250 2,500
D 10,000 40,000 100 4,000
E 0 50,000 0 5,000
 PPF Example

Wheat
Point Production
(tons)
on Com- 6,000
graph puters Wheat E
5,000
A 500 0 D
4,000
B 400 1,000
3,000 C
C 250 2,500
2,000
D 100 4,000 B
1,000
E 0 5,000 A
0
0 100 200 300 400 500 600
Computers
40
 The PPF and Opportunity Cost
 Recall: The opportunity cost of an item
is what must be given up to obtain that item.
 Moving along a PPF involves shifting resources
(e.g., labor) from the production of one good to
the other.
 Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
 The slope of the PPF tells you the opportunity
cost of one good in terms of the other.

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 The PPF and Opportunity Cost
Wheat The slope of a line
(tons) equals the
–1000
6,000 slope = = –10 ―rise over the run,‖
100
5,000 the amount the line
4,000
rises when you
move to the right by
3,000
one unit.
2,000
Here, the
1,000 opportunity cost of
0 a computer is
0 100 200 300 400 500 600 10 tons of wheat.
Computers

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 Economic Growth and the PPF
With additional Wheat
(tons) Economic
resources or an growth shifts
6,000
improvement in the PPF
technology, 5,000 outward.
the economy can 4,000
produce more
3,000
computers,
2,000
more wheat,
or any combination 1,000
in between. 0
0 100 200 300 400 500 600
Computers

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 The Shape of the PPF
 The PPF could be a straight line or bow-shaped
 Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
 If opp. cost remains constant,
PPF is a straight line.
(In the previous example, opp. cost of a
computer was always 10 tons of wheat.)
 If opp. cost of a good rises as the economy
produces more of the good, PPF is bow-shaped.

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 Why the PPF Might Be Bow-Shaped

Beer
As the economy
shifts resources
from beer to
mountain bikes:
 PPF becomes
steeper
 opp. cost of
mountain bikes
increases
Mountain
Bikes
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 Why the PPF Might Be Bow-Shaped
At A, opp. cost of

Beer
At point A, A mtn bikes is low.
most workers are
producing beer,
even those who
are better suited
to building bikes.
So, do not have to
give up much beer
to get more bikes.
Mountain
Bikes
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 Why the PPF Might Be Bow-Shaped
At B, most workers

Beer
At B, opp. cost
are producing bikes. of mtn bikes
The few left in beer is high.
are the best brewers.
Producing more B
bikes would require
shifting some of the
best brewers away
from beer production,
causing a big drop in Mountain
beer output. Bikes
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 Why the PPF Might Be Bow-Shaped
 So, PPF is bow-shaped when different workers
have different skills, different opportunity costs of
producing one good in terms of the other.
 The PPF would also be bow-shaped when there
is some other resource, or mix of resources with
varying opportunity costs
(E.g., different types of land suited for
different uses).

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 The PPF: A Summary
 The PPF shows all combinations of two goods
that an economy can possibly produce,
given its resources and technology.
 The PPF illustrates the concepts of
tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.
 A bow-shaped PPF illustrates the concept of
increasing opportunity cost.

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 Microeconomics and Macroeconomics
 Microeconomics is the study of how
households and firms make decisions and how
they interact in markets.
 Macroeconomics is the study of economy-wide
phenomena, including inflation, unemployment,
and economic growth.
 These two branches of economics are closely
intertwined, yet distinct—they address different
questions.

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 The Economist as Policy Advisor
 As scientists, economists make
positive statements,
which attempt to describe the world as it is.
 As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
 Positive statements can be confirmed or refuted,
normative statements cannot.
 Govt employs many economists for policy advice.
E.g., the U.S. President has a Council of Economic
Advisors, which the author of this textbook chaired
from 2003 to 2005.
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 S U MMA RY

• As scientists, economists try to explain the world

using models with appropriate assumptions.
• Two simple models are the Circular-Flow Diagram
and the Production Possibilities Frontier.
• Microeconomics studies the behavior of
consumers and firms, and their interactions in
markets. Macroeconomics studies the economy
as a whole.
• As policy advisers, economists offer advice on how
to improve the world.
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