Lesson 1.

Economics and Microeconomics 1

Lesson 1
Economics and Microeconomics

2010
c
Roberto Serrano and Allan M. Feldman
All rights reserved
Version B

Economics is the social science that studies the economic problem. The nature of the economic
problem, however, has changed over time. For the classical school of economists (including Adam
Smith (1723-1790), David Ricardo (1772-1823), Karl Marx (1818-1883), and John Stuart Mill
(1806-1873), people who wrote at the end of the 18th century and in the first half of the 19th
century), the economic problem was to discover the laws which governed the production of goods,
and the distribution of goods among the different social classes: land owners, capitalists, workers.
These laws were thought to be like natural laws or physical laws, similar to Newton’s law of
gravitational attraction. Forces of history, and phenomena like the industrial revolution, produce
“universal constants” which govern the production of goods and the distribution of wealth.
Towards the end of the 19th century, however, there was a major change in the orientation
of economics, associated with the neoclassical school of economists. This group includes William
Stanley Jevons (1835-1882), Leon Walras (1834-1910), Francis Ysidro Edgeworth 1845-1926),
Vilfredo Pareto (1848-1923), and Alfred Marshall (1842-1924). The neoclassical revolution was
a shift in the emphasis of the discipline, away from a search for natural laws of production and
distribution, and toward the analysis of decision making by individuals.
Modern microeconomics as described in this book mostly follows the neoclassical path. For us,
and for the majority of contemporary microeconomists, the “economic problem” is the problem
of the “economic agent.” Her problem is to live in a world of scarcity, with limited resources but
with unlimited needs. Economics focuses on the fact that resources are limited or constrained,
for a man, for a woman, for a household, for a firm, for a government, even for humanity. On
the other hand, our needs are for all practical purposes unlimited. We want more and better
material things, for ourselves, our families, our children, our friends. Even if we are not greedy
materialists, we want better education, better culture, better health, longer lives. Economics is
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about how decision makers chose among all the things that they want, given that they cannot
have everything. The “economic world” is the world of limited resources and unlimited needs.
The key assumption in microeconomics, which could be taken as our slogan, our credo, our
faith, is this: Economic agents are rational. This means that they will choose the best alterna-
tives, given what’s available, given the constraints. Of course we know that some people behave
irrationally sometimes. But we think rationality is a reasonable assumption, especially when
important goods and services, and money, are at stake.
Economics applies the scientific method to the investigation and understanding of the eco-
nomic problem. As with the natural sciences like biology, chemistry or physics, economics has
theory, and it has empirical analysis. Modern economic theory usually involves the construction
of abstract, often mathematical models, which are intended to help us understand some aspect
of the economic world. A useful model makes simplifying assumptions about the world. (A com-
pletely realistic economic model would usually be too complicated to be useful.) The assumptions
incorporated in a useful model should be plausible or reasonable, and not absurd on their face.
For instance, it is reasonable to assume that firms want to maximize profits, even though some
firms may not be concerned with profits in some circumstances. It is reasonable to assume that
a typical consumer wants to eat some food, wear some clothing and live in a house or apartment.
It would be unreasonable to assume that a typical consumer wants to spend all her income on
housing, and eat no food. Once a model has assumptions, the economic analyst applies deductive
reasoning and logic to it, in order to derive conclusions. This is where the use of mathematics is
important.
Correct logical and mathematical arguments clarify the structure of a model and help us avoid
mistaken conclusions. If the argument is especially formal we might call it a proposition or a
theorem. (The latter term is usually reserved for an argument that is mathematically impressive,
with an especially interesting conclusion.) The aim is to have a model which sheds some light
on the economic world. For example, we might have a logical result like this: If we assume A, B
and C, then D holds, where D = “when the price of ice cream rises, the consumer will eat less of
it.” If A, B and C are very reasonable assumptions, then we feel confidant that D will be true.
On the other hand, if we do some empirical work and see that D is in fact false, then we are led
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to the conclusion that either A, B or C must also be false for that consumer. Either way, the
logical proposition “A, B and C together imply D” gives us insight into the way the economic
world works.
Economists do believe in the scientific method. Therefore if economic theorists provide a
mathematical proof of the proposition “A, B and C together imply D”, and if empirical economists
show that D is wrong, all will (eventually) come to the conclusion that A or B or C must be also
wrong. The final goal is always to better understand the economic world.
Economic theory is divided between microeconomics and macroeconomics. Macroeconomics
studies the economy from above, as if seen from space. It studies aggregate magnitudes, the big
things like booms and busts, gross national product, rates of employment and unemployment,
money supply and inflation. In contrast, microeconomics takes the “close-up view” approach to
understand the workings of the economy. It begins by looking at how individuals, households
and firms make decisions, and how those decisions interact in markets. The individual decisions
result in market variables, quantities demanded by buyers and supplied by sellers, and market
prices.
When people, households, firms and other economic agents make economic decisions, they
alter the allocation of resources. For example, if many people suddenly want to buy some good
in large quantities, they may drive up the prices of those goods, they may drive up employment
and wages of the workers who make those goods, they may drive up the profits of the firms that
sell them, and they may drive down the wages of people making other goods and the profits
of firms that supply the competing goods. When an economist analyzes a market in isolation,
assuming that no effects are taking place in other markets, the economist is doing what is called
partial equilibrium analysis. Partial equilibrium analysis focuses on the market for one good, and
assumes prices and quantities of other goods are fixed. General equilibrium analysis assumes that
what goes on in one market does affect prices and quantities in other markets. All markets in
the economy interact, and all prices and quantities are determined more-or-less simultaneously.
Obviously general equilibrium analysis is more difficult and complex than partial equilibrium
analysis. Both types of analysis, however, are part of microeconomics, and we will do both
in this book. Doing general equilibrium analysis allows the people who do microeconomics to
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connect to the aggregates of the economy, to see the “big picture.” This creates a link between
microeconomics and macroeconomics.