Microeconomics

Chapter 1
How Economics Work: The Scope and Method of Economics

Case & Fair: chapter 1

 Outline
• The Scope and Methods of Economics
• Why Do We Study Economics?
• Fundamental Concepts in Economics
• Methods in Economics
• Appendix

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 The Scope And Method Of Economics
 Economics is the study of how individuals and societies
choose to use the scarce resources that nature and
previous generations have provided;

 Economics is about choices;

 Economics is a behavioral, or social, science. In large

measure it is the study of how people make choices. The
choices that people make, when added up, translate into
societal choices.

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 Why Do We Study Economics?
 The study of economics teaches us a way of thinking and helps us make
decisions.

 The study of economics is an essential part of the study of society.

 An understanding of economics is essential to an understanding of global

affairs.

 To be and informed citizen. When we participate in the political process,

we are voting on issues that require a basic understanding of economics.

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 Fundamental Concepts in Economics
Probably the most important reason for studying economics is to learn a way of thinking;

Economics has three fundamental concepts that, once absorbed, can change the way you look
at everyday choices: Opportunity Cost, Marginalism, and the working of Efficient markets.

Fundamental Concepts in Economics:

•Trade-Offs (Opportunity Costs)

•Incentives (Marginalism)
•Exchange (Market Efficiency)
•Distribution
•Information

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 Trade-Offs and Opportunity Cost

Trade-offs (Balance between two desirable but incompatible features)

Nearly all decisions involve trade-offs . Deciding to spend more on one thing
leaves less to spend on something else.

Opportunity cost A key concept that occurs in analyzing the decision- making process is
the notion of opportunity cost.
The full “cost” of making a specific choice includes what we give up by not
making the alternative choice.
The best alternative that we forgo, or give up, when we make a choice or a
decision is called the opportunity cost of that decision.

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 Incentives and Marginalism
 Incentives In making choices, individuals respond to
incentives.

 Marginalism The process of analyzing the additional or

incremental costs or benefits arising from a choice or
decision.

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 Exchange and Efficient Market
Exchange When we exchange with others, our range of choices becomes
larger.

Efficient market A market in which profit opportunities are eliminated almost

immediately

There are clearly times when profit opportunities exist.

Someone has to be first to get the news, and some people have
quicker insights than others.
Nevertheless, news travels fast, and there are thousands of
people with quick insights. The general view that large profit
opportunities are rare is close to the mark.

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 Major Changes that Affect Choices
Industrial Revolution The period in England during the late eighteenth and early
nineteenth centuries in which new manufacturing technologies and improved
transportation gave rise to the modern factory system and a massive movement of the
population from the countryside to the cities.

Information Revolution The period of the late twentieth century and early twenty first
century related to the new technological advances

These changes affect what we produce and consume, how products are
produced and consumed, where these products are produced and consumed.

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 The Scope of Economics
Microeconomics and Macroeconomics

 Microeconomics The branch of economics that examines the functioning of

individual industries and the behavior of individual decision-making units—
that is, business firms and households.

 Macroeconomics The branch of economics that examines the economic

behavior of aggregates—income, employment, output, and so on—on a
national and international scale.

Microeconomics looks at the individual unit—the household, the firm, the

industry. It sees and examines the “trees.” Macroeconomics looks at the
whole, the aggregate. It sees and analyzes the “forest.”

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 Methods in Economics:
Positive and Normative Economics

 Positive economics An approach to economics that seeks to understand

behavior and the operation of systems without making judgments. It
describes what exists and how it works.

 Normative economics An approach to economics that analyzes outcomes of

economic behavior, evaluates them as good or bad, and may prescribe courses
of action. Also called policy economics.

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 Methods in Economics
Descriptive Economics, Economic Theory, and Empirical Economics are all related.
They are mainly important in research.
Positive economics is often divided into descriptive economics and economic theory.

 Descriptive economics The compilation of data that describe phenomena and

facts.

 Economic theory A statement or set of related statements about cause and

effect, action and reaction.

One of the first theories you will encounter her is the law of demand, which was
most clearly stated by Alfred Marshall in 1890:
When the price of a product rises, people tend to buy less of it; when the price of a
product falls, people tend to buy more.

 Empirical economics The collection and use of data to test economic theories.

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 Methods in Economics:
The Model

 Model A formal statement of a theory, usually a mathematical statement of a

presumed relationship between two or more variables.

 Variable A measure that can change from time to time or from observation to
observation.

 Ockham’s razor The principle that irrelevant detail (or not connected) should be
cut away.

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 Methods in Economics:
Ceteris Paribus
All Else Equal: Ceteris Paribus

 Ceteris paribus, or all else equal A device used to analyze the relationship between two
variables while the values of other variables are held unchanged.

We ask, “What is the impact of a change in gasoline price on driving behavior, ceteris
paribus, or assuming that nothing else changes?” If gasoline prices rise by 10 percent, how
much less driving will there be, assuming no simultaneous change in anything else—that is,
assuming that income, number of children, population, laws, and so on, all remain constant?
Using the device of ceteris paribus is one part of the process of abstraction. In formulating
economic theory, the concept helps us simplify reality to focus on the relationships that
interest us.

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 Methods in Economics:
How to Express Economic Relationships?

Expressing Models in Words, Graphs, and Equations

The most common method of expressing the quantitative relationship between two
variables is graphing that relationship on a two-dimensional plane.

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Methods in Economics: Economic Policy

What are the Criteria for judging economic policy outcomes?

1. Efficiency
2. Equity
3. Growth
4. Stability

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 Methods in Economics: Economic Policy

1. Efficiency

In economics, it means allocative efficiency. An efficient economy is one that produces

what people want at the least possible cost.

2.Equity

Equivalent to Fairness.
Implies a more equal distribution of income and wealth. For others, fairness involves
giving people what they earn.

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 Methods in Economics: Economic Policy

3.Growth

Economic growth: An increase in the total output of an economy.

4.Stability

A condition in which national output is growing in a regular way, with low inflation and
full employment of resources.
The causes of instability and the ways in which governments have attempted to stabilize
the economy are the subject matter of macroeconomics.

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 APPENDIX
HOW TO READ AND UNDERSTAND GRAPHS

A graph is a two-dimensional representation of a set of numbers, or data.

TIME SERIES GRAPHS

A time series graph shows how a single variable changes over time.

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 TIME SERIES GRAPHS
TABLE 1A.1 Total Disposable FIGURE 1A.1 Total Disposable Personal
Personal Income in the United Income in the United States: 1975–2014 (in
States, 1975–2014 (in Billions of
Billions of Dollars)
Dollars)
Total Total
Disposable Disposable
Personal Personal
Year Income Year Income
1975 1,219 1995 5,533
1976 1,326 1996 5,830
1977 1,457 1997 6,149
1978 1,630 1998 6,561
1979 1,809 1999 6,876
1980 2,018 2000 7,401
1981 2,251 2001 7,752
1982 2,425 2002 8,099
1983 2,617 2003 8,466
1984 2,904 2004 9,002
1985 3,099 2005 9,401
1986 3,288 2006 10,037
1987 3,466 2007 10,507
1988 3,770 2008 10,994
1989 4,052 2009 10,943
1990 4,312 2010 11,238
1991 4,485 2011 11,801
1992 4,800 2012 12,384
1993 5,000 2013 12,508
1994 5,244 2014 12,981

Source: U.S. Department of Commerce, Bureau of Economic Analysis . Source: See Table 1A.1.

Copyright © 2017 Pearson Education, Inc. 1-20

 Graphing Two Variables

• X-axis The horizontal line against which a variable is plotted.

• Y-axis The vertical line against which a variable is plotted.
• origin The point at which the horizontal and vertical axes intersect.
• Y-intercept The point at which a graph intersects the
Y-axis.
• X-intercept The point at which a graph intersects the
X-axis.
Plotting Income and Consumption Data for
Households

 Positive relationship: A relationship between two

variables, X and Y, in which a decrease in X is
associated with a decrease in Y and an increase in X
is associated with an increase in Y.
 Negative relationship: A relationship between two
variables, X and Y, in which a decrease in X is
associated with an increase in Y and an increase in X
is associated with a decrease in Y.
FIGURE 1A.2 Household
Consumption and Income
TABLE 1A.2 Consumption
Expenditures and Income, 2012
Average Average
Income Consumption
Before Taxes Expenditures
Bottom fifth $ 9,988 $ 22,154
2nd fifth 27,585 32,632
3rd fifth 47,265 43,004
4th fifth 75,952 59,980
Top fifth 167,010 99,368

Source: Consumer Expenditures in 2012, U.S. Bureau

of Labor Statistics.

Source: See Table 1A.2.

A graph is a simple two-dimensional geometric representation of data. The graph in Figure 1A.2 displays the data from Table
1A.2.

Along the horizontal scale (X-axis), we measure household income. Along the vertical scale (Y-axis), we measure household
consumption.

Note: At point A, consumption equals $22,154 and income equals $9,988. At point B, consumption equals $32,632 and income
equals $27,585.

Copyright © 2017 Pearson Education, Inc. 1-23

 APPENDIX
HOW TO READ AND UNDERSTAND GRAPHS
SLOPE: A measurement that indicates whether the relationship between variables is positive or
negative and how much of a response there is in Y (the variable on the vertical axis) when X (the
variable on the horizontal axis) changes.
Y Y Y
 2 1
X X 2  X 1
FIGURE 1A.4 A Curve with (a) Positive Slope and (b) Negative Slope

A positive slope indicates that increases A negative slope indicates the opposite
in X are associated with increases in Y —when X increases, Y decreases and
and that decreases in X are associated when X decreases, Y increases.
with decreases in Y.
 APPENDIX
HOW TO READ AND UNDERSTAND GRAPHS

FIGURE 1A.5 Changing Slopes Along Curves