Modern Microeconomics: A Comprehensive Guide
1. What is Economics?
Economics is the social science that deals with the production, distribution, and consumption of goods and services and with the theory and management of economics or economic systems. It can also be divided into two major fields:
a. Microeconomics
Explains how the interplay of demand and supply in competitive markets creates a multitude of individual prices, wage rates, profit margins, and rental changes.
b. Macroeconomics
Deals with the explanation of national income and employment.
2. Is Economics a Science?
Economics as a science differs from other sciences. For example, Physics and Biology both have a succession of theories. Economics, however, hardly has one, as Alexander Gray said in his book The Development of Economic Doctrine (1931, p. 13): “There is no ruthless tracking down of truth which, once unbarred, shall be truth to all times to the complete confusion of any contrary doctrine.”
3. Economics (Oeconomy) vs. Political Economy
Political economy was the original term for the study of production, the acts of buying and selling, and their relationship to law, customs, and government. Also considered a branch of the science of a statesman or legislator with two distinct objects:
a. Political Economy
- To supply a plentiful revenue or product for the people, or more properly, to enable them to provide such a revenue or subsistence for themselves.
- To supply the state or commonwealth with revenue sufficient for public services. It proposes to enrich both the people and the sovereign.
b. Oeconomy
Oeconomy is the art of providing for all the wants of a family. What oeconomy is in a family, political economy is in the state—with these essential differences, however: that in a state, there are no servants, all are children; that a family may be formed when and how a man pleases, and he may establish what plan of oeconomy he thinks fit; but states are found formed, and the Oeconomy of these depends upon a thousand circumstances. The principal objective of this science is to secure a certain fund of subsistence for all the inhabitants, to obviate every circumstance which may render it precarious, to provide everything necessary for supplying the wants of a society.
4. The Magic Year: 1776
- Publication of The Wealth of Nations by Adam Smith – the bible of modern economics.
- July 4, 1776 – Declaration of Independence.
- Publication of The Decline and Fall of the Roman Empire by Edward Gibbon (devastating effect of high taxes, trade barriers, and bureaucratic burden on the development of ancient Rome).
5. Economics as a Profession (Who Was the First Professor of Political Economy?)
William Nassau Senior (1790-1864) was nominated in 1825 as the first professor of political economy (Adam Smith was a “natural philosopher”).
6. Economics in One Lesson (Henry Hazlitt and Frederic Bastiat)
a. Henry Hazlitt
Economics in One Lesson
“Economics is haunted by more fallacies than any other study known to man.”
The Bad Economist
The bad economist: immediately strikes the eye; only sees the direct consequences; focuses on the effect a particular policy has had or will have on one particular group.
The Good Economist
The good economist looks beyond; looks also at the longer and indirect consequences; considers the effect of the policy on all groups.
The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy: it consists in tracing the consequences of that policy not merely for one group but for all groups.
b. Frederic Bastiat (1850)
The department of economy gives birth to a series of effects: the first one is immediate (it is seen), while the others unfold in succession (they are not seen).
Between a good and bad economist, this constitutes the whole difference – the one takes account of the visible effect, the other takes account of both the effects which are seen, and also those which are necessary to foresee.
The bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come – at the risk of a small present evil.
7. Positive vs. Normative Economics
a. Positive Economics
Positive economics is the branch of economics that concerns the description and explanation of economic phenomena. It focuses on facts and cause-and-effect relationships and includes the development and testing of economic theories.
b. Normative Economics
Normative economics is the branch of economics that incorporates value judgments about what the economy should be like or what particular policy actions should be recommended to achieve a desirable goal. It looks at the desirability of certain aspects of the economy. It underlines expressions of support for particular economic policies.
It is common to distinguish normative economics (what ought to be) from positive economics (what is).
8. Difficulties of Economic Analysis
Complex influences: Endogenous (within economic processes) and Exogenous (demographic, cultural, psychological, sociological).
9. Model and Reality: Why Do We Construct Models?
A model of real phenomena is always a simplified, idealized, and approximate representation of the process. There are four basic reasons for model construction and analysis:
a. Understanding and Explanation
Understanding and explanation of a given phenomenon.
b. Forecasting
Forecasting (predictions of future and development) or retro prognosis.
c. Decision Making
Supporting decision-making to achieve well-defined goals.
d. Optimal System Design
Design for optimal performance of a system.
10. Opinion of Alfred Marshall on Using Maths in Economic Analysis
Alfred Marshall once said that nature’s action is complex, and that therefore the use of mathematics in economic questions seemed to be helping a person to write down quickly, shortly, and exactly. And by using mathematics, he came up with some rules:
- Use maths as a shorthand language rather than as an engine of inquiry.
- Keep these till you have done.
- Translate into English.
- Illustrate by examples that are important in real life.
- Burn the maths.
- If you can’t succeed in (d), burn (c).
11. Interpolation, Extrapolation, and Trends in Economic Analysis
a. Interpolation
Interpolation – estimation of an unknown quantity between two known quantities (historical data), or drawing conclusions about missing information from available information.
b. Extrapolation
Extrapolation – statistical technique of inferring the unknown from the known. It attempts to predict future data by relying on historical data, such as estimating the size of a population a few years from now on the basis of current population size and its rate of growth. Extrapolation may be valid where the present circumstances do not indicate any interruption in the long-established past trends.
c. Trends
Trends – patterns of movements or changes in economic factors such as consumer, households, or firms’ income, savings, debt, and expenditure.
12. Definition of Index: What is a Consumer Price Index?
a. Index
Index – value of some characteristic at time t relative to the value of the same characteristic at base year t0.
b. Consumer Price Index (CPI)
Consumer Price Index (CPI) – a measure of changes in the purchasing power of a currency and the rate of inflation. The CPI expresses the current prices of a basket of goods and services in terms of the prices during the same period in a previous year, to show the effects of inflation on purchasing power.
13. Nominal and Real Values – Differences
a. Nominal Values
Nominal values – expressed in current prices (e.g., nominal costs of living).
b. Real Values
Real values – nominal values adjusted to the CPI (inflation) (relative costs).
14. Nicolas Kaldor and His Idea of “Stylised Facts”
a. Stylised Facts
Definition – observations repeated in so many contexts that they are commonly accepted as empirical truths and set boundaries to which all new hypotheses must conform.
b. Nicolas Kaldor
“The theorist, in choosing a particular theoretical approach, ought to start off with a summary of facts which he regards as relevant to his problem. Since facts, as recorded by statisticians, are always subject to numerous snags and qualifications, and for that reason are incapable of being accurately summarized, the theorist, in his view, should be free to start off with a ‘stylized’ view of facts.”
15. The Most Popular Sub-Criteria of Models’ Evaluation
- Correctness – consequences of the model ought to be very close to the results of experiments and/or observations.
- Consistency – the model ought to be consistent not only internally but also with other commonly accepted theories used to describe similar or related phenomena.
- Universality – consequences of the model ought not to be confined to individual cases, as intended at the initial stages of the model development.
- Simplicity – the model ought to create order in the formally isolated phenomena; some evaluations based on individual feelings of harmony and beauty are also taken into account in this partial evaluation.
- Fecundity – the model ought to throw new light on well-known phenomena; it ought to be the generator of new discoveries.
- Usefulness – this practical criterion dominates frequently in sciences, being very close to engineering and industry.
16. Analytical Models vs. Simulation Models – Advantages and Disadvantages
a. Advantages
i. Analytical Models
- Generality of results
- Optimal solutions
ii. Simulation Models
- Imitative realism
- Study of non-existing systems
- Time passing control
- Criterion of elasticity
- Controllability and repeatability of experiments
- Limited mathematical results
- Relatively low costs
- Use of expert knowledge
b. Disadvantages
i. Analytical Models
- For reaching simplifications
- Sophisticated mathematics
ii. Simulation Models
- Lack of generality of results
- Large number of experiments required
- Optimization problems
- Long duration of simulation studies
- Simulation misusing
17. Convergence in Economic Development of Nations
The idea of convergence in economics is the hypothesis that poorer economies’ per capita incomes will tend to grow at faster rates than richer economies. Developing countries have the potential to grow faster than developed countries because diminishing returns are not as strong as in capital-rich countries.
18. What is Capitalism?
Capitalism is the system in which people are free to use their private property without outside interference. It is an economic system in which trade, industry, and the means of production are controlled by private owners with the goal of making profits in a market economy.
19. Economic (Scarce) Good – Definition and Opinion of Carl Menger
a. Economic Good
Definition – A consumable item that is useful to people but scarce in relation to its demand, so that human effort is required to obtain it.
Scarce Good – for a price equal to zero, the demand for it exceeds its supply.
b. Carl Menger
For him, for anything to become a good, it had to present four prerequisites:
- A human need.
- Such properties as render the thing capable of being brought into a causal connection with the satisfaction of this need.
- Human knowledge of this causal connection.
- Command of the thing sufficient to direct it to the satisfaction of the need.
20. How Prices are Set: Opinion of Pierre de Jean Olivi. What is a Just Price?
a. How Prices are Set
Prices are set by scarcity, usefulness, and desirability.
b. Just Price
Just price – equivalent to the common market price determined by the needs. Both parties exchange the benefit – “when a horse is sold for money, both the buyer and the seller gain from the transaction since the buyer demonstrates that he needs the horse more than the money, while the seller prefers the money to the horse.”
21. Price System and Three Functions of Prices
Prices are expressed in many terms. The price system enables the exchange of goods without the interference of any central institution. The great value of the price system:
- Impersonal interchange of goods.
- Buyers are interested only in the value and properties of a given good.
a. Information Function
Transmit information (from the producer to the buyer, between producers, etc.).
b. Incentives Function
Provide an incentive to use efficient methods of production – least costly use of available resources for the most highly valued purposes.
c. Re-Distribution Function
Distribution of income – who gets how much of the product.
22. Production Possibility Frontier and Why the Possibility Production Frontier is Convex (Bowed Outward)
A curve that compares the trade-offs between two goods produced by an economy to demonstrate the efficient use of resources.
23. Opportunity Cost – General View
What you give up by having it. Something in terms of an opportunity, or the most valuable forgone alternative (or highest-valued option forgone) > opportunity cost is not the sum of the available alternatives, but rather the benefit of the best alternative of them. It does not need to be assessed in monetary terms but rather can be assessed in terms of anything which is of value to the person or persons doing the assessing (or those affected by the outcome).
24. Market – A Definition: Efficiency of Market (in the Context of the Pareto Principle)
a. Market
Definition – concordance of decisions of households and entrepreneurs on what and how to produce and for whom to work via the price mechanism.
b. Market Economy
Market economy – an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services.
c. Market
Market – institution supporting the function of buyers and sellers in the process of goods and services interchange.
d. Pareto Principle
Pareto Principle – also known as the 80-20 rule, the law of the vital few, and the principle of factor scarcity. It states that, for many events, 80% of the effects come from 20% of the causes.
25. What are the Main Features of a Market?
Private property, competition, supply-demand-price, division of labor, spontaneity of development, entrepreneur – entrepreneurship, free entry and exit.
26. Demand and Supply, Demand Function, Supply Function
a. Demand
Demand – willingness to buy vs. quantity of goods (or services) intended to buy.
b. Demand Function (Demand Curve)
Demand function (demand curve) – a quantity of good inclined to be bought by the consumers at a given price in an assumed unit of time (a month, a year) (ceteris paribus).
c. Supply
Supply – is a quantity of goods (services) which entrepreneurs (sellers) intend to offer for a given market price.
Supply of good A is equal to the quantity of that good offered in a unit of time (a month, a quarter, a year) offered by producers for a given market price (ceteris paribus).
27. Equilibrium Price: The Pope and the Price of Fish? Problems with the Concept of Equilibrium Price
a. Equilibrium Price
Equilibrium price – price for which the supply is equal to the demand.
b. The Pope and the Price of Fish
In 1996, the Pope repealed the rigorous law forbidding eating meat on Fridays.
c. Problems with a Concept of Equilibrium Price
- Homogenous goods.
- Diversity of market prices (even for the same goods).
- Technological changes.
- What is the process of shifting from one equilibrium to the ensured one? The orthodox economies remain silent or suggest that it is an instant process.
28. Price Elasticity of Demand (Inelastic and Elastic)
- Elasticity is a measure of how much buyers and sellers respond to changes in market conditions.
- The price elasticity of demand measures how much the quantity demanded responds to a change in price. Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the prices.
- The price elasticity of demand is the percentage change in the quantity demanded divided by the percentage change in the price.
29. Short and Long Term Development – A Concept
a. Short Term
Over short periods, firms cannot easily change the size of their factories to make more or less of a good. Thus, in the short run, the quantity supplied is not very responsive to the price.
b. Long Term
Over long periods, firms can build new factories or close old ones. In addition, new firms can enter a market, and old firms can shut down. Thus, in the long run, the quantity supplied can respond substantially to the price.
30. Cross-Price Elasticity of Demand – Substitute and Complementary Goods
Relation between the relative change of demand of good i (A) and the relative change of price of good j (B).
Cross-price elasticity of demand = % change in quantity demanded of good A / % change in price of good B.
Cij= dBi/Di // dpj/Pj
a. Substitutability
Car, railway, tube, bus, tram / cinema, TV, video / coffee, tea / beer, wine, vodka, whisky.
b. Complementarity
Petrol and gas for cars / tea and sugar / houses, refrigerators, and TV sets.
Cross-price elasticity can be positive (for substitutes) and negative (complementary goods).
31. Income Elasticity of Demand: Normal and Inferior Goods
Relative change of demand of good i to the relative change of consumers’ income y.
Income elasticity of demand = % change in quantity demanded / % change in income
Ey= dQi/ Qi // dy/ Y
a. Normal Good
A good where the quantity demanded rises when income rises (positive income elasticity of demand).
b. Inferior Good
A good where the quantity demanded declines as income increases (negative income elasticity of demand).
32. Revenue, Income, Costs, Profit, Normal Profit (Natural Profit), Extraordinary Profit – Definitions
a. Revenue (Income)
Revenue (income) quantity of money received from selling manufactured products (usually per year) (R – revenue).
R = pQ
b. Costs
Costs – all the firm’s expenses covered to manufacture the production Q.
c. Profit
Profit – surplus of the revenue over costs.
Profit = total revenue – total cost.