Lecture notes on Microeconomics pdf

lecture notes advanced microeconomics and lecture notes in microeconomic theory solutions. how microeconomics is different from macroeconomics pdf free download
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INTRODUCTION TO MICROECONOMICS E201 Dr. David A. Dilts Department of Economics, School of Business and Management Sciences Indiana - Purdue University - Fort Wayne May 10, 1995 First Revision July 14, 1995 Second Revision May 5, 1996 Third Revision August 16, 1996 Fourth Revision May 15, 2003 Fifth Revision March 31, 2004 Sixth Revision July 7, 2004 1. Introduction to Course and Economics Lecture Notes 1. Economics Defined - Economics is the study of the ALLOCATION of SCARCE resources to meet UNLIMITED human wants. a. Microeconomics - is concerned with decision-making by individual economic agents such as firms and consumers. (Subject matter of this course) b. Macroeconomics - is concerned with the aggregate performance of the entire economic system. (Subject matter of the following course) c. Empirical economics - relies upon facts to present a description of economic activity. d. Economic theory - relies upon principles to analyze behavior of economic agents. e. Inductive logic - creates principles from observation. f. Deductive logic - hypothesis is formulated and tested. 2. Usefulness of economics - economics provides an objective mode of analysis, with rigorous models that are predictive of human behavior. a. Scientific approach b. Rational choice 2 3. Assumptions in Economics - economic models of human behavior are built upon assumptions; or simplifications that permit rigorous analysis of real world events, without irrelevant complications. a. model building - models are abstractions from reality - the best model is the one that best describes reality and is the simplest B Occam=s Razor. b. simplifications: 1. ceteris paribus - means all other things equal. 2. There are problems with abstractions, based on assumptions. Too often, the models built are inconsistent with observed reality - therefore they are faulty and require modification. When a model is so complex that it cannot be easily communicated or its implications easily understood - it is less useful. 4. Goals and their Relations - a. POSITIVE economics is concerned with what is; b. NORMATIVE economics is concerned with what should be. 1. Economic goals are value statements, hence normative. c. Economics is not value free, there are judgments made concerning what is important: 1. Individual utility maximization versus social betterment 2. Efficiency versus fairness 3. More is preferred to less 3 d. Most societies have one or more of the following goals, depending on historical context, public opinion, and socially accepted values : 1. Economic efficiency, 2. Economic growth, 3. Economic freedom, 4. Economic security, 5. Equitable distribution of income, 6. Full employment, 7. Price level stability, and 8. Reasonable balance of trade. 5. Goals are subject to: a. interpretation - precise meanings and measurements will often become the subject of different points of view, often caused by politics. b. goals that are complementary are consistent and can often be accomplished together. c. conflicting - where one goal precludes, or is inconsistent with another. d. priorities - rank ordering from most important to least important; again involving value judgments. 6. The Formulation of Public and Private Policy - Policy is the creation of guidelines, regulations or law designed to affect the accomplishment of specific economic goals. 4 a. Steps in formulating policy: 1. stating goals - must be measurable with specific stated objectives to be accomplished. 2. options - identify the various actions that will accomplish the stated goals & select one, and 3. evaluation - gathers and analyzes evidence to determine whether policy was effective in accomplishing goal, if not re-examine options and select option most likely to be effective. 7. Objective Thinking: a. bias - most people bring many misconceptions and biases to economics. 1. Because of political beliefs and other value system components rational, objective thinking concerning various issues requires the shedding of these preconceptions and biases. b. fallacy of composition - is simply the mistaken belief that what is true for the individual, must be true for the group. c. cause and effect - post hoc, ergo propter hoc - Aafter this, because of this B fallacy. 1. correlation - statistical association of two or more variables. 2. causation - where one variable actually causes another. a. Granger causality states that the thing that causes another must occur first, that the explainer must add to the correlation, and must be sensible. 5 d. cost-benefit or economic perspective - marginal decision-making - if benefits of an action will reap more benefits than costs it is rational to do that thing. 1. Focus on the addition to benefit, and the addition to cost as the basis for decision-making. a. Sunk costs have nothing to do with rational decision-making. 6 2. Economic Problems Lecture Notes 1. The economizing problem involves the allocation of resources among competing wants. There is an economizing problem because there are: d. unlimited wants e. limited resources 2. Resources and factor payments: d. land - includes space (i.e., location), natural resources, and what is commonly thought of as land. 1. land is paid rent e. capital - are the physical assets used in production - i.e., plant and equipment. 2. capital is paid interest f. labor - is the skills, abilities, knowledge (called human capital) and the effort exerted by people in production. 3. labor is paid wages d. entrepreneurial talent - (risk taker) the economic agent who creates the enterprise. 4. entrepreneurial talent is paid profits 3. Full employment includes the natural rate of unemployment and down time for normal maintenance (both capital & labor). However, full production or 100% capacity utilization cannot be maintained for a prolonged period without labor and capital breaking-down: 7 a. underemployment - utilization of a resource in a manner, which is less than what is consistent with full employment - using an M.D. as a practical nurse. 4. Economic Efficiency consists of the following three components: a. allocative efficiency - is measured using a concept known as Pareto Superiority (or Optimality) 1. Pareto Optimal - is that allocation where no person could be made better off without inflicting harm on another. 2. Pareto Superior - is that allocation where the benefit received by one person is more than the harm inflicted on another. cost - benefit approach b. technical efficiency - for a given level of output, you minimize cost or (alternatively) for a given level of cost you maximize output. c. full employment - for a system to be economically efficient then full employment is also required. 5. Allocations of resources imply that decisions must be made, which in turn involves choice. Every choice is costly; there is always the lost alternative the opportunity cost: a. opportunity cost - the next best alternative that must be foregone as a result of a particular decision. 6. The production possibilities curve is a simple model that can be used to show choices: a. assumptions necessary to represent production possibilities in a simple production possibilities curve model: 8 1. efficiency 2. fixed resources 3. fixed technology 4. two products Beer Pizza 7. Law of Increasing Opportunity Costs is illustrated in the above production possibilities curve. Notice - as we obtain more pizza (shift to the right along the pizza axis) we have to give up large amounts of beer (downward shift along beer axis). 8. Inefficiency, unemployment and underemployment are illustrated by a point inside the production possibilities curve, as shown above. (identified by this symbol): a. Inefficiency is a violation of the assumptions behind the model, but do not change the potential output of the system. 9. Economic Growth can also be illustrated with a production possibilities curve. The dashed line in the above model shows a shift to the right of the of the curve which is called economic growth. 9 a. The only way this can happen is for there to be more resources or better technology. b. Growth will change the potential output of the economy, hence the shift of the entire curve. 10. Economic Systems rarely exist in a pure form. The following classification of systems is based on the dominant characteristics of those systems: a. pure capitalism - private ownership of productive capacity, very limited government, and motivated by self-interest. 1. laissez faire - government hands-off; markets relied-upon to perform allocations. 2. costs of freedom - poverty, inequity and several social ills are associated with the lack of protection afforded by government. b. command - government makes the decisions - with force of law (and sometimes martial force) 1. Often associated with dictatorships c. traditional - based on social mores or ethics or other non-market, non- legislative bases 1. Christmas gift giving is tradition d. socialism - maximizes individual welfare based on perceived needs, not contributions; generally concerned more with perceived equity than efficiency. e. communism - everyone shares equally in the output of society (according to their needs), generally no private holdings of productive resources 1. The former Soviet Union espoused communism, but also was mostly 10 command 2. Utopian movement in the U.S. f. mixed system - contains elements of more than one system - U.S. economy is a mixed system (capitalism, command, and socialism are the major elements, with some communism and tradition) 1. All of the high income, industrialized economies are mixed economies e. Even with mixed systems there are substantial variations in the amounts of socialism, capitalism, tradition, and command exist in each example. 11 3. Interdependence and the Global Economy Lecture Notes 1. The modern economic system is no longer the closed (i.e., U.S. only) system upon which the debates surrounding isolationalism occurred prior to World War II. a. Imports and Exports are increasingly important b. Foreign investment versus U.S. investment abroad 1. Outsourcing 2. Technological transfers c. Balance of trade issues. 1. Current accounts (import v. exports) 2. Capital accounts (foreign investment) 2. Capitalist Ideology - The characteristics of a capitalist economy and the ideology that has developed concerning this paradigm are not necessarily the same thing. The elements of a capitalist ideology are: a. freedom of enterprise b. self-interest c. competition d. markets and prices 12 e. a very limited role for government f. different countries with different views of these matters B i.e., equity v. efficiency again. 3. Market System Characteristics - the following characteristics are typical of a system that relies substantially on markets for allocation of resources. These characteristics are: a. division of labor & specialization b. capital goods c. comparative advantage - is concerned with cost advantages. 1. Comparative advantage is the motivation for trade among nations and persons. 2. Terms of trade are those upon which the parties may agree and depends on the respective cost advantages and bargaining power. 4. Trade among nations a. the reliance upon comparative advantage to motivate trade B assuming barter: Belgium Holland Tulips 400 4000 Wine 4000 400 The data above show what each country could produce if all of their resources were put into each commodity. For example, if Holland put all 13 their resources in tulip production they could produce 4000 tons of tulips but no wine. Assuming the data give the rate at which the commodities can be substituted, if both countries equally divided their resources between the two commodities, Belgium can produce 200 tons of tulips and 2000 barrels of wine and Holland can produce 200 barrels of wine and 2000 tons of tulips (for a total of 2200 units of each commodity produced by the two countries by splitting their resources among the two commodities). If Belgium produced nothing but wine it would produce 4000, and if Holland produced nothing but tulips it would produce 4000 tons). If the countries traded on terms where one barrel of wine was worth one ton of tulips then both countries would have 2000 units of each commodity and obviously benefit from specialization and trade. b. absolute advantage for one trading partner results in no advantage to trade. 1. LDCs often have no comparative advantage and hence the developed countries, possessing absolute advantage have no incentive to trade (. 2. LDCB Less Developed Country - Low-income countries B 60 B (per capita GDP of 800), middle-income countries B 75 B (per capital GDP of 8000). 3. High income countries and developed countries (19 countries) 4. High income countries without economic development (Hong Kong, Israel, Kuwait, Singapore, and UAE) 5. Money facilitates market activities and is necessary in complex market systems: a. barter economy - is where commodities are directly traded without the use of money. 1. Direct trade requires a coincidence of wants. 2. Prices become complicated by not having a method to easily measure worth. 14 b. functions of money: 1. medium of exchange 2. store of value 3. measure of worth c. Fiat money th 1. European Gold & Silver smith receipts 15 century th 2. Genghis Kahn in the 12 century in Asia B paper money 6. Foreign exchange B value of one currency versus another a. Hard currency B U.S. dollar, British Pound, Canadian dollar, Japanese Yen, and the Euro B general acceptability of the currency and it being demanded as reserves by central banks 1. G-7 nations, hard currency nations; Euro predecessors France, Germany, Italy b. Exchange rates affect both imports and exports; and foreign investment here, U.S. investment abroad. 1. Dollar gains strength, Imports cheaper here, exports more expensive abroad 2. Dollar gains strength, foreign investment in U.S. more attractive 15 because dollar buys more foreigners= home currency when investment repatriated c. Strong dollar policy in exchange B based on interest rates, growth, and relative strength of economy and stability of political system etc. 1. Debt and supply of currency an important factor in economic development 7. The Circular Flow Diagram is used to show the interdependence that exists among sectors of the economy: a. sectors private-domestic 1. households 2. resource markets 3. businesses 4. product markets b. complications 1. government 2. foreign sector c. Model of interdependence: 16 ______________________________________________________________________ ____________________________________________________________________ FOREIGN SECTOR _____________________________________________________________________ _____________________________________________________________________ Product markets are where the domestic parties obtain and sell commodities inside the pyramid, and the factor markets shown with the dotted lines are where the domestic parties obtain and supply productive resources. The base reads AFOREIGN SECTOR, which indicates that the same buying and selling of commodities and resources is not limited to just domestic parties, but can include foreign businesses and resources as well. The circular flow diagram shows that each of the sectors relies on the others for resources and supplies the others commodities and resources. 17 4. Basics of Supply and Demand Lecture Notes 1. A market is nothing more or less than the locus of exchange; it is not necessarily a place, but simply buyers and sellers coming together for transactions. 2. The law of demand states that as price increases (decreases) consumers will purchase less (more) of the specific commodity. a. The demand schedule (demand curve) reflects the law of demand it is a downward sloping function and is a schedule of the quantity demanded at each and every price. As price falls from P1 to P2 the quantity demanded increases from Q1 to Q2. This is a negative relation between price and quantity, hence the negative slope of the demand schedule; as predicted by the law of demand. 1. utility (use, pleasure, jollies) from the consumption of commodities. 18 2. The change in utility derived from the consumption of one more unit of a commodity is called marginal utility. 3. Diminishing marginal utility is the fact that at some point further consumption of a commodity adds smaller and smaller increments to the total utility received from the consumption of that commodity. b. The income effect is the fact that as a person's income increases (or the price of item goes down which effectively increases command over goods more of everything will be demanded. c. The substitution effect is the fact that as the price of a commodity increases, consumers will buy less of it and more of other commodities. 3. Demand Curve a. Price and quantity - again the demand curve shows the negative relation between price and quantity. b. Individual versus market demand - a market demand curve is simply an aggregation of all individual demand curves for a particular commodity. c. Nonprice determinants of demand; and a shift to the left (right) of the demand curve is called a decrease (increase) in demand. The nonprice determinants of demand are: 1. tastes and preferences of consumers, 2. the number of consumers, 3. the money incomes of consumers, 4. the prices of related goods, and 5. consumers' expectations concerning future availability or prices of the commodity. 19 d. Changes in demand versus in quantity demanded An increase in demand is shown in the first panel, notice that at each price there is a greater quantity demanded along D2 (the dotted line) than was demanded with D1 (the solid line). The second panel shows a decrease in demand, notice that there is a lower quantity demanded at each price along D2 (the dotted line) than was demanded with D1 (the solid line). 20

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