HFIN 3103: MICROECONOMIC

ANALYSIS

Introduction to Economics
 Definition of Economics
Economics is the science that deals with the
allocation of limited resources to satisfy unlimited
human wants.
Mankiws definition
How Society manages its scarce resources
Hedricks definition
How society chooses to allocate its scarce resources
among competing demands to best satisfy human
wants
Alternative definitions
Economics is the study of choice.
Economics is what economist do.
Scarcity and the Fundamental
Questions of Economics
Scarcity : Unlimited wants versus limited
resources
Choices and tradeoffs
Opportunity Costs
All societies must answer the WHFW questions
What is to be produced?
How is to be produced?
For whom will it be produced?
 The Central Economic Problem
Although there are many specific economic problems
poverty, inflation, unemployment etc, the term economic
problem is used to refer to the overall problem of scarcity of
resources. Hence because they cannot have everything,
individuals and society have to choose carefully when trying
to make best use of scarce resources.
Paul Samuelson, the American Nobel Prize winner noted
that every economic society has to answer three
fundamental questions arising from the economic problem:
a. What? What goods are to be produced with the scarce
resources
b. How? How should we combine the scarce resources
c. For Whom? how to distribute the goods produced
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The Central Economic Problem
What goods and services should an economy
produce? should the emphasis be on
agriculture, manufacturing or services, should it
be on sport and leisure or housing?
How should goods and services be produced?
labour intensive, land intensive, capital intensive?
Efficiency?
Who should get the goods and services
produced? even distribution? more for the rich?
for those who work hard?
 Opportunity Cost
Underlying business decisions is the fact that
resources are scarce. This existence of scarcity
means that whenever a decision or choice is made
a cost is incurred.
Economists take a broader view of such cost than
that based purely on monetary factors as used by
accountants. In economists jargon such cost
include opportunity cost.
The opportunity cost of any activity is what we give
up when we make a choice. In other words it is the
loss of the opportunity to pursue the most attractive
alternative given the same time and resources.
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Opportunity Cost
Definition the cost expressed in terms of
the next best alternative sacrificed
Helps us view the true cost of decision
making
Implies valuing different choices
Economics as a Science
The Scientific Method
Observation Hypothesis Testing
Observation: identifying and measuring
important variables.
Hypothesis: educated guesses about cause and
effect with the variables.
Theories
Models: realism or usefulness
Testing: theories cant be proven and are
supported by repeated failed attempts to
disprove them.
The Assumption of Rational Behavior
 Hypothesis of rationality
The individual decision maker is assumed to make
rational decisions.
The individual decision maker should be able to set out
all the feasible or attainable alternatives and distinguish
them from the unattainable ones.
He should use all the available information to him or
worth collecting to assess the consequences of
choosing one of these feasible alternatives he has.
He ranks all of the feasible alternatives in order of
preference.
He chooses the alternative which is highest in his scale
of preference (in his ranking)
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Microeconomics versus Macroeconomics
Broadly speaking, economics is composed of two branches,
microeconomics and macroeconomics. The prefix micro is
derived from the Greek word mikros, which means small.
Microeconomics therefore studies the economic behavior
of individual economic decision makers, such as a
consumer, a worker, a firm, or a manager. It also analyzes
the behavior of individual households, industries, markets,
labor unions, or trade associations.
By contrast, the prefix macro comes from the Greek word
makros, which means large.
Macroeconomics thus analyzes how an entire national
economy performs. A course in macroeconomics would
examine aggregate levels of income and employment, the
levels of interest rates and prices, the rate of inflation, and
the nature of business cycles in a national economy.
 Normative vs. positive approaches
A brief history of economic thinking
The language of economics
MankiwsTen Principles
of Economic Thinking
Principles of Economics
by N. Gregory Mankiw
Categories of Basic Principles of
Economics

How people make decisions?

How people interact?
How does the economy work overall?
How People Make Decisions

Principle 1 - People face tradeoffs

Time allocation an example of tradeoffs
Production Possibilities Frontier
Efficiency versus equity
How People Make Decisions

Principle 2 - The cost of something is what you

have to give up to get it
Opportunity costs come from Von Weiser, a
German economist in late 1800s
Opportunity costs are independent of monetary
units
i.e. The real costs of going to college
How People Make Decisions

Principle 3 - Rational people think at the margin

Rational or irrational decision-making
Marginal benefits and costs versus total benefits
and costs
Weighing marginal costs and benefits leads to
maximizing net benefits (total welfare)
How People Make Decisions
Principle 4 People respond to incentives
Reactions to changes in marginal benefits
and costs
Increases (decreases) in marginal benefits
mean more (less) of an activity
Increases (decreases) in marginal costs
mean less (more) of an activity
Example of seat belts leading to increased
speeds
Example of SUV (with child car seat) in
Issaquah
How People Interact

Principle #5 - Trade can make everybody

better off
Adam Smith author of the An Inquiry into the
Causes and Consequences of the Wealth of
Nations 1776
Gains from the division of labor and
specialization
Mercantilists perspectives
Example of why Kenyans should trade with
others
How People Interact

Principle 6 - Markets are usually a good way of

organizing economic activity
Feudal times and haciendas in the new world
The power of trade: cooperation versus conflict
Markets: prices and quantities traded, typical
and abstract
How People Interact

Principle 6 - Markets are usually a good way of

organizing economic activity, creativity and
productivity and resource allocation
Failure of centrally planned economies
set it and forget it becomes compete or be
obsolete
How People Interact
Principle 7 Governments can sometimes improve
market outcomes
Market signals can fail to allocate resources
efficiently or equitably
Public goods, the exclusion principle, the free-rider
problem and non-rival consumption
External costs and benefits
Examples: vaccines, education, pollution
Equitable or fair distribution of resources
Efficiency and equity: the pie analogy
Government Failure: is government intervention
always the proper solution?
How the Economy works as a Whole
Principle 8 A countrys standard of living depends upon
its ability to produce goods and services
Adam Smiths An Inquiry into the Nature and the
Consequences of the Wealth of Nations
wealth: a necessary or sufficient condition for
happiness (are rich people happier, children with lots
of toys)
leisure time and productivity
the factors of production: land or natural resources,
labor, capital, entrepreneurship
technology and productivity
How the Economy works as a Whole

Principle 9 The general level of prices rises

when the government prints and distributes
too much money
Definition of money, and economic language
How the Economy works as a Whole

Principle 10 Society faces a short-run tradeoff

between inflation and unemployment
Short-run and the long-run
Demand and supply shocks
Short-run increases (decreases) in output above
(below) long-run potential output lead to
adjustments
How the Economy works as a Whole

Principle 10 Society faces a short-run tradeoff

between inflation and unemployment
Counter-cyclical stabilization versus pro-cyclical
destabilization
Political business cycles