Chapter 01 - Introduction

Part I. Preliminaries

Chapter 1: Introduction
Main Concepts and Learning Objectives This chapter provides an overview of the purpose of this textbook: to help students develop a solid understanding of microeconomics, including both the content of microeconomics and the tools needed to undertake microeconomic analyses. Understanding the content of microeconomics will equip students to understand: the major resource allocation questions that must be addressed by every society (what to produce, how to produce these goods and services, and who should enjoy these goods and services), two primary strategies for addressing these questions (markets and government policies), and the interplay between these two strategies, and the critical difference between fact-based positive analysis and value-based normative analysis. Microeconomic analyses are employed in businesses (customer analysis, sales forecasting, financial planning), finance (analysis of factors that influence corporate profits and, therefore, stock prices), and public policy design and evaluation. Students may, in the future, undertake their own microeconomic analyses, or they may be consumers who will base important decisions on forecasts or analyses prepared by others. In either event, understanding the tools needed to conduct microeconomic analyses will strengthen the quality of their decisions. These tools include: implementing the scientific method, constructing, employing and assessing the quality of mathematical models, and locating and using data, in conjunction with sound econometric techniques to test models. This textbook will provide examples in which economists have used the first and third skills. It will focus on helping students to develop the second skill. Students may, initially, believe that this tool is completely new. However, we all use models to structure our decision-making processes probably on a daily basis. Several examples are provided in this chapter. Specifically, students who master the material presented in this chapter will be able to provide examples of: 1. policy issues that involve resource allocation questions (What, How, Who). 2. policy controversies that focus on choices between centralized and decentralized decision-making 3. well-defined markets, and issues that complicate market definitions 4. positive and normative statements

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5. models used in everyday decision-making

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Multiple Choice Quiz (10 questions) covering main points: 1. Figure 1.1 provides information about the percent of GDP that is allocated to government consumption. Which two countries are less decentralized than the United States? a. France and Germany b. Ireland and South Korea c. Sweden and France d. Canada and the United Kingdom 2. The San Jose flea market is not a market, as defined by economists, because: a. Vendors at this flea market sell a variety of goods that are not substitutes. b. Many of the goods sold at this flea market can also be purchased in nearby stores. c. both (a) and (b) d. none of the above 3. Marriage and dating patterns are important subjects for economic investigation because: a. Economists are naturally inquisitive. b. Economic analysis can help predict the impact of technological innovations such as the internet on social trends. c. Marriage patterns have important implications for society because they impact the transmission of wealth from one generation to another. d. All of the above 4. Economists proposed a set of rules to structure a new auction market for the airwaves. The FCC staff was concerned that the new design was untested. Economists therefore: a. Designed experiments to test the impacts of the proposed rules on decisions to buy and sell. b. Collected survey data to assess the public opinion. c. Lobbied to create political pressure to implement the new system. d. Adjusted their estimates of the benefits of the new system 5. Some politicians advocate a universal government-operated health insurance system. Replacing our current system of employer-provided insurance with a governmentoperated insurance system: a. would represent increased decentralization of decision-making. b. would represent a change in our societys method for allocating healthcare resources. c. reflects positive economic decision because this policy would be more fair than our current policy. d. none of the above

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6. The term property rights refers to: a. rules for buying and selling land. b. legal rules that specify ownership rights for any type of asset. c. None of the above 7. The statement that self-interest is an important motivation for decision-making is a. a positive statement b. a normative statement 8. The recent U.S. policy mandating the use of ethanol fuel is: a. a centralized decision that will reduce the cost of transportation b. a centralized decision that is designed to change How transportation is produced c. a decentralized decision that will impact What is produced d. a decentralized decision that will impact How transportation is produced 9. The market for textbooks used to be well-defined at many universities: textbooks were bought and sold in the university book store. Internet sales are complicating the definition of this market because: a. Internet sales blur the geographic boundaries. b. The Internet increases interactions among potential buyers and potential sellers of used textbooks. c. Some internet sites have developed rules that create a framework for orderly buying and selling (to prevent sellers from simply cashing checks without mailing any books). d. All of the above 10. Models are an essential component of economic analysis. To be useful, a model must: a. have realistic assumptions b. produce predictions that are 100% accurate c. address all aspects of the situation d. none of the above

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Answers to Multiple Choice Quiz 1. b 2. c 3. d 4. a 5. b 6. b 7. a 8. b 9. d 10. d Additional examples 1. The American Medical Association (AMA) recently shifted its position on the appropriate role of market forces in the allocation of transplant (live donor) kidneys. The AMA reversed its previous opposition to any payment for live donor kidneys, and now endorses payment of small amounts of money. This shift occurred as an explicit response to the shortage of live donor kidneys. This topic could generate discussion to cover the following points: Each of the two systems for distributing kidneys has advantages and disadvantages (markets vs. judgment allocation). Government regulatory infrastructure and legal property rights definitions structure market interactions. Markets include substitute products, and introduction of a new substitute can radically alter markets. (Live donor kidneys were not widely used in the prior to the development of effective anti-rejection drugs. Live donor kidneys may not be needed in the future due to new technology.) Economic models are used generating predictions. Two strategies are used to test the models: data analysis and lab experiments. Positive vs. normative analysis.

2. While lengthy, the book, The Russians, offers numerous examples of the difficulties created by centralized resource allocation decisions. 3. Machlup's paper, Marginal Analysis and Empirical Research (American Economic Review 1946) provides a good discussion of the value of modeling behavior even if individuals do not actually do the math that is hypothesized in the model.

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4. The ethanol mandate provides a good example to discuss introductory ideas presented in this chapter. It might be helpful to distinguish between two types of questions: What will happen? Corn price will increase. Resource allocation implications: o Production of corn & substitute crops o Food prices o Income of corn producers o Food for pigs o Driving habits o Housing density in urban and suburban areas o Support for mass transit What would we like to see? o Impact on global warming o Impact on Middle East politics o Impact on food prices Potential student learning issues 1. Students may not have concrete ideas about productive resources and potential substitutions among productive resources. It may be helpful to list: resources that are needed to produce goods include railroads, steel mills, etc. (Description of the input/output table employed by Soviet planners could help clarify these ideas.) inputs that can be used to produce electricity (natural gas, coal, wind, etc.) strategies to produce comfortable room temperatures (natural gas, electricity, coal, insulation or sweaters) 2. Clear grasp of introductory microeconomics concepts is essential for success in this class. An early just-in-time training-style homework assignment can help students remember these ideas (from their introductory classes) and alert students that the intermediate class will require problem-solving and algebra skills. (see Worksheet 1.)

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Worksheet 1: Supply and Demand

1. Supply and Demand: Remembering to find the equilibrium price and quantity by looking at the intersection of S and D. Definitions supply describes the views of ___________ (who?) demand describes the views of ___________ Draw supply and demand for bananas & find equilibrium P & Q. label the x-axis (horizontal) label the y-axis draw S draw D If this part is wrong, all is lost. Verify by comparing with the S and D lines in your book, p 28. Draw the equilibrium price Draw the equilibrium quantity Note the order of events: First you drew S&D. Then you looked at the intersection to find P&Q. 2. Remembering how to show the impacts of changes on supply and demand: Redraw the demand for bananas from I.

Show the impact of news that potassium (found in bananas) prevents heart attacks. Use the following steps: Put a dot on your demand line Draw a price-line and a quantity line for this point Think to yourself: if people just learned that bananas prevent heart attacks, they would want (_________)(more or fewer ??) bananas ???? So, keep the price constant and mark a point at which people buy ________ bananas. Draw a new demand line through this point.

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Redraw the supply for bananas from I.

Show the impact on your diagram of an increase in the cost of insecticide needed to produce bananas. Redraw the demand for bananas from I.

Show the impact of a drop in average income (assuming bananas are a normal good).

Redraw the supply of bananas from I.

Show the impact on your diagram of entry of a large group of new growers. Redraw the supply of bananas from I.

Show the current price (just draw a horizontal line in the middle of your diagram.) Show the impact of an increase in the price. This is really really easy. Don't make it difficult.

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Redraw the demand for bananas from I.

Show the current price (just draw a horizontal line in the middle of your diagram.) Show the impact of an increase in the price. When do you shift the line? Is this a change in demand or a change in quantity demanded? When do you move along the line? Is this a change in demand or a change in quantity demanded? 3. Remembering how to think about the impacts of these changes on price and quantity Secrets to success: Start by drawing the initial equilibrium. Then show how the change affects S and D. After steps 1 & 2, show the new equilibrium P & Q. Redraw the market for bananas from I. Include S&D and the equilibrium P&Q. Show the impact on P&Q of the news that potassium prevents heart attacks.

Redraw the market for bananas from I. Include S&D and the equilibrium P&Q. Show the impact on P&Q of a drop in average income

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Redraw the market for bananas from I. Include S&D and the equilibrium P&Q. Show the impact on P&Q of an increase in the price of an insecticide needed to grow bananas

Redraw the market for bananas from I. Include S&D and the equilibrium P&Q. Show the impact on P&Q of an increase in the number of banana producers

Redraw the market for bananas from I. Include S&D and the equilibrium P&Q. Show the impact on P&Q of a new government regulation requiring that bananas be sold at a price that is higher than the old equilibrium price. 4. Get ready to think about the impact of quality on supply and demand

1. Label the axes 2. Label the upward-sloping line 3. Look at the vertical quantity line. Draw a horizontal line to show the amount that is needed per-item to induce sellers to sell this quantity. 4. What would happened to this price (that you just drew) if the per-unit production cost increased by $2/item? 5. This would happen at every possible quantity. Therefore, the entire supply line will shift __________. Show this shift. 6. The vertical distance between the old supply line and the new line is equal to ____________

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1. Label the axes 2. Label the upward-sloping line 3. Look at the vertical quantity line. Draw a horizontal line to show the amount that is needed per-item to induce sellers to sell this quantity. 4. What would happened to this price (that you just drew) if consumer willingness to pay for this good decreases by $2 per item? 5. This would happen at every possible quantity. Therefore, the entire demand line will shift __________. Show this shift. 6. The vertical distance between the old demand line and the new line is equal to ____________

5.

Equilibrium Price, Price Ceilings and Price Floors

Some states considered imposing gasoline price caps when the price shot up last summer. Ill help you draw a graph to illustrate the impact of gasoline price caps. Draw a basic S&D diagram for the gasoline market:

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Show the equilibrium price on this graph. Now think about a price cap. People want price caps because they think the equilibrium market price is too __________ (high ??? Or low ??? Fill in the right one.) OK, so now you know that the goal of instituting a price cap is to force the price to be ___________ (above or below ?) the equilibrium price. Show this price cap on your graph above. Now look at your graph. Look at the place where your price cap line intersects Demand. Put your pencil on that point. Draw a line straight down until it intersects the horizontal axis. This is the quantity demanded. Now show quantity supplied. Compare two quantities. What do we have? ________________

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Chapter 01 - Introduction 6. elasticity:

*A

Demand Q First: show the impact of a price change on quantity. 1. Draw a vertical line from Point A down to the X-axis. Label this Q1. 2. Draw a horizontal line from Point A to the Y-axis. Label this P1. 3. Draw a new LOWER price. Label the new point on the SAME demand as point B. Label the price as P2. 4. Draw a vertical line down to the X-axis to show the new quantity. Label the new quantity as Q2. Now: draw a new flatter line through point A. Follow the steps below to be sure you are correct. 1. Your new line will go through point A. It will be more flat (less steep) than the old line. 2. Q1 is the same as before, because this line goes through point A. 3. Extend your P2 line to meet the new line. Draw the vertical line for the new Q2. 4. Is the quantity change bigger or smaller than before? 5. Is the new line more elastic or less elastic than the old line?

Apply this thinking: Suppose a university has two types of students: students who have high grades and high test scores and could obtain scholarships at numerous other universities = very price sensitive students who could not earn scholarships at other universities = not price sensitive Use the diagram to show the impact of a tuition increase on the mix of students. Label everything.

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Chapter 01 - Introduction 7. Demand function: You are responsible for production and inventory planning for a firm that bottles salad dressing. Your firm is considering changing the price. You must forecast the impact of a price change on the quantity people will buy. You have data on salad dressing prices and quantities. The main exogenous factor that impacts salad dressing sales is the price of lettuce. (When lettuce is expensive, people eat less salad.) Suppose you estimated a regression equation and obtained the following result: salad dressing sales = 20 - 7* Price Salad Dressing -4*Price lettuce. According to this regression equation when the salad dressing price increases $1, the number of items sold decreases by _________ when the price of lettuce decreases $1, the number of items sold increases by _________ Q = 20-7 * P 4 * L L = price lettuce.

We could rewrite the equation using symbols: Q = salad dressing sales

P = price salad dressing

The coefficient of P is 7. This is important for us. a) which is correct? 7 = change in Q / change in P ? OR 7 = change in P / change in Q ? b) Draw a graph of the line: Q = 20 7*P. LABEL THE AXES CAREFULLY This is NOT the usual demand curve that economists usually draw. What is different?

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Answers to End-of-Chapter Questions 1.1 a. These responses should include things typically only available from government: public safety provision (police force, fire department, coast guard, etc.), certain licenses (for hunting, driving, selling liquor, etc.), and certain social services. b. Almost all consumer goods fall into this category; clothing, entertainment, furniture, and food items are all good examples. c. Anything that can be received from government or purchased in the marketplace would be an acceptable answer: education, environmental protection, charitable programs, adjudication/arbitration, etc. d. There are many examples of goods not distributed in response to a price mechanism and not distributed by government. One example would be a lottery for a place in line to buy the hottest new toy (note that the student should understand that the place in line is the good, not the toy). Also, licenses, accreditations or memberships that are not granted by the government are good examples. 1.2 a. Normative. This statement is prescriptive in nature. Words like should or ought are good indicators of a normative statement. b. Positive. This is a testable hypothesis; one could scientifically investigate the relationship between time worked and the existence of an income tax. c. Normative. Positive statements can be confirmed or denied without having to rely on a set of values. Confirming or denying this statement would require establishing what improves well-being, which undoubtedly requires an appeal to a set of values. d. Positive. This statement represents a testable hypothesis. Although one might typically hear this sort of statement from someone who endorses exercise, this statement itself does not. e. Normative. This statement is clearly stating a value judgment. What one believes to be good or bad depends on ones values. f. Positive. This statement is a testable hypothesis. It makes a claim about what is, was, or will be true. g. Normative. This statement is stating a value judgment; we could not test this statement without first agreeing on what it means to be better off.
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Answers to the following questions will vary but should be well supported.

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1.3 Anytime an individual makes any decision, he or she is trying to reach some goalmost often happiness. To choose A over B implies that the happiness that results from choosing A (its benefits minus the cost of choosing it) must exceed the happiness that results from choosing B. If choice B created more net happiness, then the individual would have chosen it. It is easily seen, therefore, that any human decision can be described in terms of costs and benefits. Sometimes, however, the costs and benefits are of a type that would be difficult to capture in a scientific way. For example, many costs and benefits are emotional in nature. Costs of some decisions may involve things like stress, anxiety, guilt, or anger; benefits may involve things like involve relief, comfort, relaxation, or love. So while all human decisions can be discussed in economic terms, many would, due to the nature of the costs and benefits involved, be difficult to analyze empirically. 1.4 Latanyas statements are not a theory but merely a set of assertions. In making these claims, it does not seem that Latanya is attempting to explain the nature or cause of an observed phenomenon. Her statements, as presented, cannot be scientifically verified or falsified because they do not apply to all human actions. No single observed action or set of observed actions would have to be consistent with Latanyas beliefs even if her beliefs were true. An observed rational decision, for example, does not necessarily cast doubt on her beliefs as stated, and an observed irrational decision does not necessarily strengthen the case for her beliefs. These beliefs may be helpful to Latanya if they help her sleep at night, but because her statements do not attempt to explain observed phenomena and cannot be supported by observed phenomena, her beliefs are not scientifically useful. 1.5 A model is a simplified representation of a how some part of the world works. Statement A is a model of weather at sea. Because statement C attempts to describe a simplification of a cause-and-effect relationship, it can be considered a model. Statement E likewise paints a picture of a simplified cause-and-effect relationship, making it a model. All three of these statements are of the type when one thing happens, another thing follows from it, which is similar to economic reasoning of this sort: when a goods price falls, consumers buy more of it. The other statements (B & D) do not make an attempt at representing how things work.

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1.6 It is always fair to say that people are motivated by self interest, as any action, even charitable actions, can be described in terms of a benefit to the individual. However, as in the example of charitable giving, our interests are not always material in nature. The decision to exercise or play video games has little to do with material gain (for most people, excluding professional athletes and game testers). The decision to spend time with family and friends also does not lead directly to material gain. However, when it comes to the decisions most often discussed in economics, this assumption is probably not too problematic. If an individual faced a choice between one sweater or two equal sweaters (for the same price), most often the consumer would choose to have two sweatersor more material goods. In other words, when it comes to material goods, people will more often prefer to have more rather than less. 1.7 Both of these experiments can be considered natural experiments in the sense that they occur outside of a laboratory. The experimental design in A is problematic; many variables that affect how much people drive (besides rain) are not controlled because Seattle and Los Angeles are very different cities. Further, individuals were not placed randomly in either of the two cities. People who like the rain (and presumably mind driving in it less) may choose to live in Seattle, whereas people who hate the rain might choose to live in Los Angeles. The experiment described in B would produce a more reliable conclusion. Because it focuses on only one city, many variables like average distance traveled, typical road conditions and driver preferences are naturally controlled. Both experiments rely on the questionable assumption that gasoline sales on a day accurately reflect the amount of driving that takes place on that day. 1.8 Student responses will vary, but the most common answers will involve the following costs of attending college: being in class takes up time, so one gives up the opportunities to earn money, relax, spend time with friends and family, etc.; books and tuition cost money, so one gives up the opportunity to consume more goods right now; living in a dorm can be uncomfortable and frustrating, so one gives up the comfort of living on ones own (or at ones parents house). These costs are endured in order to enjoy the benefits of a college education, which include things like increased future income, better ability to take care of ones health, better parenting skills, and a feeling of accomplishment.

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1.9 Most responses will be acceptable so long as they involve making incremental changes to a course of action. Marginal thinking works best when the margin is clearly understood when all costs and benefits of a decision are easily observable. Marginal thinking when this is not the case can lead to bad decisions. A good example of this would be a cigarette smoker who is trying to quit. He or she might think that, on the margin, smoking is not really all that bad for ones health. After all, what real damage, over the course of a lifetime, can one cigarette do? However, if each cigarette smoked makes the next cigarette harder to resist, then the true marginal cost of the next cigarette also includes part of the negative health effects of all future cigarettes. This true understanding of the cost of the next cigarette makes it less likely to be a good choice. 1.10 Some good examples include a person who bought a hybrid car because of generous tax rebates, a child who studied diligently because he was promised money for good grades or pulled on a loose tooth all day to get money from the Tooth Fairy, a veteran who received a college education because of GI Bill funding, or a person who recycles soda bottles and cans to receive a rebate (in states that offer rebates).

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