Introduction to microeconomics

Economics is often defined as something along the lines of “the study of how society manages its scarce resources.” The starting point of most such studies is that individuals allocate their resources such that they themselves will get the highest possible level of utility.

An individual has an idea of what the consequences of different actions will be, and she chooses that action she believes will produce the best result for her. She is, in other words, selfish and rational.

Note that she is also forward-looking. She acts so that she in the future will get the highest possible level of utility, independently of what she has already done. That she is selfish does not have to mean that she is an egoist. However, it does mean that she will only voluntarily share with others if she believes that she thereby will maximize her own utility. We often call this simplification of human beings Homo Economicus.

The resources that we are talking about here could be labor, capital (such as machines), and raw materials. That they are scarce means there are not enough resources to produce everything we want. That, in turn, means that one has to weight different things against each other. To get more of one thing, one has to give up something else. If you, e.g., want to sleep an extra hour, it is impossible to do so without giving up something else, such as an hour of studying.

There is, consequently, a sort of a hidden cost to sleeping longer. This type of cost is called opportunity cost (or alternative cost). A classical saying in economics is that “there is no such thing as a free lunch.” This means that, even if you do not actually pay for the lunch, you always have to give up at least the time when you could have done something else. That is, you always have to pay the opportunity cost.

When we study microeconomics, it is primarily individual human beings and individual firms, agents, that we study. This is in contrast to macroeconomics, where one studies whole economies and questions such as unemployment and inflation.

Roughly speaking, there are three types of decisions that need to be made in an economy: Which goods and services to produce, how to produce them, and who should get them. Often in economic models, the prices of goods (or services, labor, capital, etc.) automatically coordinate these decisions in a market.

A market is any mechanism where buyers and sellers meet. That could be, for example, a market square, a stock exchange, or a computer network where one can buy and sell things.

Microeconomics is often based on models. We try to describe a real phenomenon as simply as possible by only highlighting a few central features. Many economic models can be used for predictions and can therefore be tested against reality. Such models are called positive.

The opposite kind of models, models that are about values, is called normative. For example, to decide about an economic policy one would first use positive economics to make assessments about the consequences of different alternatives. Then one would use one’s opinions about what is desirable and what is not to choose between the different alternatives. That is then a normative decision.

Plan

Before we begin, it is probably wise to make it clear where we are trying to go. We want to develop a number of models that together can describe how an economy works. They should be able to produce clear and testable predictions and be as simple as possible.

In a market, products and/or services are being bought and sold (or traded). We begin by looking at consumers and producers, and their respective demand and supply in a market. That way, we will see an example of how the market price of a good is determined.

Consumers and producers, however, have difficult problems to solve before they arrive at their respective demand and supply. First, we look at a consumer’s problem in a very simple case: She has to choose between two different goods for which she has different preferences. We show how it is possible to go from her preferences and income to her demand for one of the goods. Then we show how one can derive the demand for the whole market.

Then we change perspectives and study a producer’s problem. We will then discover that the model looks very similar to that of the consumer. The producer has to produce the good with the help of labor and capital, and different combinations of the two will lead to different quantities of the good. She also has to think about the fact that, different combinations will have different costs. The results will help us to show how the market supply is determined.

There are usually quite many consumers but substantially fewer producers. This has a large impact on how the market operates, and we, therefore, continue to study different market forms. We will differentiate between cases where there are one, two, some, and many producers. We also study the welfare effects of different market forms.

The producers have a demand for labor and the workers supply it. The labor market has some odd features that we will treat separately.

Equilibrium is a central concept in economics. We show how consumer and producer markets, as well as the market for goods, simultaneously reach equilibrium in a simple and stylized economy.

Lastly, we relax some of the assumptions we have made so far. We show how undesirable results can arise because of so-called market failures, e.g. because different agents have different amounts of information about a good, or because it is difficult to keep out users who do not pay.