Adventures in Microeconomics 1

1.1 Microeconomics (and What It Can Teach Us about Rosa and Lauren)

Rosa and Lauren’s connection is the consequence of a large number of decisions and transactions that combine to make Rosa believe that growing coffee is worth her time and effort, and make Lauren feel that her skinny cappuccino is worth the money. This book investigates those many decisions and transactions, and how they interact in markets.

microeconomics

The branch of economics that studies the specific choices made by consumers and producers.

Before we delve deeper into this book’s topics, we need to be very clear about how we’re going to approach the study of markets. We will be looking at these decisions through the framework of microeconomics. Microeconomics is the branch of economics that studies the specific choices made by consumers (like Lauren) and producers (like Rosa). In contrast, macroeconomics looks at the world through a wider lens and is a description of the larger, complex system in which consumers and firms operate. Macroeconomics takes hundreds of millions of individual producers and consumers like Rosa and Lauren, and tries to describe and predict the behavior and outcome of the combined total of their individual decisions. In this book, we steer clear of the macroeconomic questions.

Although the basic outline and content of this course are similar to those of the principles of microeconomics course, there are some important differences. First, we incorporate mathematics into our models along with graphs. Remember that at its heart, economics is concerned with resource allocation, so we want to be able to create precise models that can be solved for optimal quantities. For example, we often want to know exactly how much of a good a consumer will want to consume to maximize her happiness (utility) given that she has limited income. We also want to model how a firm maximizes its profit when choosing its output level and the amounts of inputs it uses to make that quantity of output. Although graphs and verbal explanations are helpful, using math allows us to better quantify these economic agents’ decisions.1

1 For students who might need a review of basic mathematical tools, there is an appendix that provides such a review at the back of this text. Although we use only algebra throughout the chapters, several chapters have appendices that show you how the use of simple calculus skills (such as taking a first derivative) can greatly simplify the analysis.

Second, in intermediate microeconomics the level of analysis is deeper than in principles. We don’t take relationships such as the law of demand or the law of supply for granted.?We examine the details of why the relationships exist and when they don’t apply.

Finally, intermediate microeconomics has a greater policy focus than the principles of microeconomics course. Understanding the economic behavior of consumers and producers is the key to developing appropriate policies. We can also use this deeper knowledge to attempt to predict how various policies (proposed or in place) alter individuals’ and firms’ incentives and change their behaviors.

Learning the Tools of Microeconomics

Microeconomics does not address every question about the economy, but it does provide tools to answer a dazzling number of questions about the choices individuals and firms make. The set of tools microeconomics gives you can be used to solve almost any economic problem an individual person or firm faces.

theories and models

Explanations of how things work that help us understand and predict how and why economic entities behave as they do.

What sorts of tools will we learn to use as we explore the study of microeconomics? We always start with theories and models, explanations of how things work that help us understand and predict how and why economic entities (consumers, producers, industries, governments, etc.) behave as they do. To learn the intricacies of the theories and models, we use the tools of graphs and mathematics.

We then use the theories and models to look at how people and firms actually behave in real life (including some seemingly noneconomic situations). The interaction between microeconomic theory and the events, decisions, and empirical data from the real world lies at the heart of microeconomics. Each chapter includes the following sections that illustrate this interaction:

Application sections help us understand theory at work by showing how microeconomics can be used to inform economic decision making in a variety of interesting, real-world situations. Want to know how members of OPEC decide how much oil to produce? Or, how the NBA sets contracts for rookie players? Or, how and why consumers and producers act as they do in the markets for housing, movies, electricity generation, corn, satellite radio, music, and concrete? Applications delve into the specifics of how consumers and producers act in real life.

Some applications look at current microeconomic research to see how the data gathered by microeconomists inform and test the predictions of theory across a wide range of topics, such as golf tournaments, phone service, the use of gym memberships, the relationship between hospital input choices and Medicare, and patent length and cancer drug development.
Freakonomics essays reveal the surprising ways in which economic analysis provides a unique perspective for exploring a huge variety of phenomena in the world around us. These essays look at topics as diverse as a homemade toaster, White House photography, football stadiums, Indian fishermen’s cell phones, garbage taxes, Amazon.com and e-Book pricing, track cycling, and subway toll payment avoidance. Such stories give us a framework for thinking about the economic phenomena that surround us.

FREAKONOMICS

Thomas Thwaites’s Toaster

Thomas Thwaites must really like toast.

Not content simply to buy a toaster to make his toast, in 2009 Thomas Thwaites set out on a mission to make a toaster from scratch. He started with the raw materials, gathering copper, mica, nickel, and oil (to make plastic), some of which he extracted himself from abandoned mines in the English countryside. He even built his own version of a microwave smelter in order to smelt the iron ores needed for the toaster’s grill and spring. In the end, his homemade contraption was indeed capable of making toast about as well as the cheapest toaster you can buy at Walmart for under $20. If you factor in time, effort, and money spent, Thwaites’s toaster cost thousands of times more to make than the store-bought version.

The Toaster Project, by Thomas Thwaites A very expensive custom-built toaster.

Thomas Thwaites

It should not have come as a surprise to Thwaites that making a toaster from scratch would be hard work, at least not if he knows anything about economics. Think about the goods and services you’ve consumed so far just today, and all the different materials, technology, workmanship, and coordination that went into making them. The modern economy is nothing short of miraculous. All of us—Thwaites included—have become completely dependent on the market’s amazing ability to deliver a nearly infinite variety of products to us at a tiny fraction of the cost and effort it would cost us to produce them ourselves.

Compared to other things we use as consumers, a toaster is fairly simple. Imagine trying to build a computer or an automobile completely from scratch, starting from the rawest materials. Even making your own dinner, if you had to grow the food, would be life-consuming.

No doubt Thomas Thwaites’s toaster experiment taught him—the hard way—about the modern economy. If his goal is to learn economics, we suggest a different approach the next time he gets a craving, say, for ice cream. Rather than raising cows, growing sugarcane, and hand harvesting vanilla beans, we suggest he visit his local convenience store and enjoy some store-bought ice cream while he finishes reading Chapter 2 of this book.

Using the Tools of Microeconomics

An old joke tells of a tourist looking for a famous concert venue in New York City, who asks a local, “How do you get to Carnegie Hall?” “Practice, practice, practice,” the New Yorker replies. So it is with microeconomics. Practice with using the tools of microeconomics is how you get good at it, and there’s plenty of help on this front as you progress through this book.

In each chapter, you will find several worked out problems titled Figure It Out. These problems are typical of the problems you will encounter in your homework sets, quizzes, and exams, and they appear throughout the chapters to illustrate how to translate your understanding of theory, graphs, and mathematics into successful problem-solving skills. Each Figure It Out shows you, step-by-step, how to understand what, exactly, a problem is asking you to do, and then how to solve it using the tools you’ve just learned.
At the end of each chapter, you will find a set of Problems to solve. The variety of problems will prepare you well for applying the tools you’ve learned to new situations, scenarios, and dilemmas. You should try to solve as many of these problems as you can, and for selected problems, you can check your answers with the solutions provided in the back of the text. If you get stuck on a problem, go back through the Figure It Out examples to review the steps you should take to solve for the correct answer.
In many chapters, you will find a Make the Grade box with hints and explanations about how to successfully navigate the sometimes confusing path through microeconomic theory and its application. Read these boxes carefully before exams and quizzes to help you avoid some common mistakes that students often make in the intermediate micro course.

make the grade

Holding the rest of the world constant

Things are not held constant between these two cones.

Bruno Crescia Photography Inc./First Light/Getty Images; wildarrow/iStockphoto

As you have probably seen in your previous economics courses, economists often use simplifying assumptions in their models to make the world an easier place to understand. One of the most important assumptions we use time and time again in this text is ceteris paribus—that is, “all else is equal.” For example, suppose you are contemplating your friend Max’s demand for an ice cream cone and considering how his demand is affected by an increase in the price of an ice cream cone. To see this impact, you need to hold constant everything else that may influence Max’s decision: the amount of money he has, the outside temperature, the prices of other things Max buys, even his preferences for ice cream itself. This “all else equal” assumption then allows you to focus on the factor that you are interested in, the price of an ice cream cone.

It is easy to get tripped up on this assumption when you’re asked to dissect an application or an example, so be careful! Don’t read more into a scenario than the facts you are given, and don’t drive yourself crazy by dragging into the problem all kinds of hypothetical situations beyond those provided in the problem you are analyzing (e.g., what if Max is lactose intolerant? what if it’s a cold, windy day? or what if Max just lost his job?).

It is also important to remember that the “all else equal” assumption applies, in addition, to the goods we are considering. When we talk about a particular good, we assume that all units of that good are the same; that is, we hold all the characteristics of the good constant. This means that when we talk about ice cream cones, we are talking about cones of a particular size and quality. Do not think that the price of an ice cream cone has risen if the ice cream inside it is now a premium brand, or if the same ice cream now comes in a chocolate-dipped waffle cone. By introducing either of those changes, you’re changing the nature of the good itself, not just its price. By allowing something other than the cone’s price to change, you would be violating the “all else equal” assumption.