Introduction to

Microeconomics

Study Guide

CONTENTS

Introduction

1 Introduction to Economics

2 The Market Mechanism

3 Elasticity

4 Costs of Production

5 Price Takers – Perfect competition

6 Price Makers – Monopoly

7 Imperfect competition

8 Labour Market

9 Market Failure – The Case for Government Intervention

10 Privatisation versus Nationalisation

AIMS

· To teach students the basic principles of elementary microeconomics

· To develop student understanding of the relevance of these principles in analyzing real world situations.

· To introduce and develop essay writing skills.

1 INTRODUCTION TO ECONOMICS

1.1 THE ECONOMIC PROBLEM

What Is The Economic Problem ?

The scarcity of resources in relation to the calls made upon them imposes a choice on society as to the range of wants it wishes to satisfy. A decision to satisfy one set of wants necessarily means sacrificing some other set: this is what economists refer to as the opportunity cost of satisfying wants.

The basic economic problem is that of allocating scarce resources among the competing and virtually limitless wants of individuals in a society.

The three basic questions that all nations have to decide in some way are what goods and services to produce, how to produce them and for whom to produce them. In order to do this choices are made by households, firms and governments and these choices are coordinated through markets for both goods and services and factors of production.

The Distinction Between Micro and Macro Economics

Microeconomics is concerned with the behaviour of individual forms, industries, markets and consumers (or households). This branch deals with the problems of resource allocation, considers problems of income distribution and is chiefly interested in the determination of relative prices of goods and services.

Macroeconomics concerns itself with large aggregates, particularly for the economy as a whole. It deals with factors such as the determination of output and employment, the general price level, spending and saving, total imports and export, the demand and supply of money.

This course maintains the tradition and in the first semester we will look at aspects of microeconomics, whilst the second semester will be concerned with looking at the macro economy. It should be pointed out that these two branches can never been completely separated from each other as there are many linkages and overlaps between them. The analysis of unemployment, for example, draws on both micro and macro analysis.

Economic Methodology

Economic science seeks to understand the principles which determine the behaviour of households and firms and governments when they take decisions in the economy. It is made up of two components 1) careful and systematic observation and measurement 2) The development of a body of theory to direct and interpret observations. Thus an economic theory is a reliable generalization that enables up to predict the economic choices that people make and the economic effects of their choices. The term methodology refer to the way in which economists go about the study of the subject matter. There are broadly two approaches:

Positive economics is objective in that the validity of positive statements such as what is, was or will be can be tested by reference to facts.

Normative economics is concerned with making suggestions about the ways in which society is goal might be more efficiently realized. This involves economists in such ethical questions as what should or ought to be.

For many years after the second world war economics was dominated by the positive approach to the subject, but there is a growing opposition to positivism and the hypo deductive methodology. There is an increasing recognition that economics is a value laden subject.

Economists try to find economic principles by building models. The predictions of the models form the basis of economic theories.

One of the simplest ways of constructing an economic model is the use of production possibility frontiers. What follows are examples of how these can be used to illustrate different economic situations.

Production possibility frontier - diminishing returns

A production possibility frontier will normally tend to be concave to the origin because of diminishing returns to factors of production. In other words switching resources from one use to another will lead to progressively smaller increases in output of the other good.

Production possibility frontier – growth (both goods)

An increase in the level of resources (or the efficiency of the resources) will shift the production possibility frontier outwards.

Production possibility frontier – unemployment

Any point inside the production possibility frontier indicates that there is unemployment or under-employment of some resources. Points on the PPF indicate that resources are being fully used and that an increase in the production of one good is only possible by decreasing production of another.

Production possibility frontier - growth (one good)

An increase in the level of resources (or the efficiency of the resources) for the production of just one good will lead to the production possibility frontier shifting at just one end.

Production possibility frontier - growth (both goods)

An increase in the level of resources (or the efficiency of the resources) will shift the production possibility frontier outwards.

1.2 RESOLVING THE ECONOMIC PROBLEM

The basic economic problem can be resolved through a number of different economic systems. We will examine the extreme cases of the free market and command economies. In the real world, however, most economies are mixed to one degree or another.

A Free Market Economy

A free market economy is an economy where all economic decisions are taken by individual households and firms.

Assumptions

· Firms seek to maximize profits and households aim to maximize utility

· Workers seek to maximize their wages relative to the human costs of working in a particular job.

The Price Mechanism (Adam Smith’s Invisible Hand)

The system in a market economy whereby changes in price in response to changes in demand and supply have the effect that demand equals supply.

Goods Market

· Demand for a good rises creating a shortage

·