Pindyck, Rubinfeld, Mehta: Microeconomics, Seventh edition.

Chapter 1 Preliminaries

Introduction
 What are the key themes of microeconomics?  What is a market?  What is the difference between real and nominal prices?  Why study microeconomics?

Themes of Microeconomics
 Microeconomics vrs macroeconomics Microeconomics: Decision making by firms and households, interactions amongst them, effects of policy changes  Decision making is in the face of limits
Limited budgets Limited time Limited ability to produce

 How do we make the most of limits?  How do we allocate scarce resources?

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Themes of Microeconomics
 Workers, firms and consumers must make trade-offs
Do I work or go on vacation? Do I purchase a new car or save my money? Do we hire more workers or buy new machinery?

 How are these trade-offs best made?optimal decision making.

Themes of Microeconomics
 Consumers
Limited incomes Consumer theory describes how consumers maximize their well-being, using their preferences, to make decisions about trade-offs How do consumers make decisions about consumption and savings?

Themes of Microeconomics
 Workers
Individuals decide when and if to enter the workforce
 Trade-offs

of working now or obtaining more education/training

What choices do individuals make in terms of jobs or workplaces? How many hours do individuals choose to work?
 Trade-off

of labor and leisure

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Themes of Microeconomics
 Firms
What types of products do firms produce?
 Constraints

on technology, production capacity, and financial resources create needs for tradeoffs

Theory of the Firm describes how these trade-offs are best made

Themes of Microeconomics
 Prices
Trade-offs are often based on prices faced by consumers and producers Workers make decisions based on prices for labor wages Firms make decisions based on wages and prices for inputs and on prices for the goods they produce

Themes of Microeconomics
 Prices
How are prices determined?
 Centrally

planned economies governments control prices  Market economies prices determined by interaction of market participants

Markets collection of buyers and sellers whose interaction determines the prices of goods (more than an industry which reflects the supply side)
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Theories and Models

 Economics is concerned with explanation of observed phenomena
Theories are used to explain observed phenomena in terms of a set of basic rules and assumptions:
 The

Theory of the Firm  The Theory of Consumer Behavior

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Theories and Models

 Theories are used to make predictions
Economic models are created from theories Models are mathematical representations used to make quantitative predictions

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Theories and Models

 Validating a Theory
The validity of a theory is determined by the quality of its prediction, given the assumptions (explanatory power with respect to observed phenomenon) Theories must be tested and refined Theories are invariably imperfect but gives much insight into observed phenomena

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Rationale and Objective of the firm

 Rationale of the firm
o Minimize transaction costs by internalizing production. o Limit to size of the firm diminishing returns to management (Penrose effect) overcome somewhat through working of profit centers.

Objective of the firm

o Profit maximizing versus Satisficing (revenue maximizing) o Principal agent problem
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Positive & Normative Analysis

 Positive Analysis statements that describe the relationship of cause and effect
Questions that deal with explanation and prediction
will be the impact of an import quota on foreign cars?  What will be the impact of an increase in the gasoline excise tax?
 What

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Positive & Normative Analysis

 Normative Analysis analysis examining questions of what ought to be
Often supplemented by value judgments
 Should

the government impose a larger gasoline tax?  Should the government decrease the tariffs on imported cars?

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What is a Market?
 Markets
Collection of buyers and sellers, through their actual or potential interaction, determine the prices of products
 Buyers:

consumers purchase goods, companies purchase labor and inputs  Sellers: consumers sell labor, resource owners sell inputs, firms sell goods

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What is a Market?
 Market Definition
Determination of the buyers, sellers, and range of products that should be included in a particular market

 Arbitrage
The practice of buying a product at a low price in one location and selling it for more in another location

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What is a Market?
 Defining the Market
Many of the most interesting questions in economics concern the functioning of markets
 Why are

there a lot of firms in some markets and not in others?  Are consumers better off with many firms?  Should the government intervene in markets?

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Types of Markets
 Perfectly competitive markets
Because of the large number of buyers and sellers, no individual buyer or seller can influence the price
 Example:

Most agricultural markets

Fierce competition among firms can create a competitive market (Airlines industry in India).

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Types of Markets
 Noncompetitive Markets
Markets where individual producers can influence the price
 Cartels

groups of producers who act collectively  Example: OPEC dominates with world oil market

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Market Price
 Transactions between buyers and sellers are exchanges of goods for a certain price
Market price price prevailing in a competitive market
 Some

markets have one price: price of gold  Some markets have more than one price: price of Nirma and Surf washing powder

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Market Definition
 Market Definition
Which buyers and sellers should be included in a given market? This depends on the extent of the market boundaries, geographical and by range of products, to be included in it
 Market

for housing in New Delhi or Chennai (not much movement across cities by households)  Market for all cameras or digital cameras

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Market Definition
 Importance of market definition
In order to set price, make budgeting decisions, etc., companies must know
 Their

competitors  Product-characteristic and geographic boundaries of the market

Important for public policy decisions

 Should

government allow a merger between companies in same market?

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Real Versus Nominal Prices

 Comparing prices across time requires measuring prices relative to some overall price level
Nominal price is the absolute or current dollar price of a good or service when it is sold Real price is the price relative to an aggregate measure of prices or constant dollar price

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Real Versus Nominal Prices

 Consumer Price Index (CPI) is often used as a measure of aggregate prices
Records the prices of a large market basket of goods purchased by a typical consumer over time Percent changes in CPI measure the rate of inflation

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Real Versus Nominal Prices

 Calculating Real Prices

RealPrice !
baseyear

CPIbase year CPIcurrent year

x Nominal Price current year

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Real Price of College

Year Nom. Price Rs2,530 CPI Real Price

1971 1991 2010

38.8
!

38.8 * Rs2, 30 ! Rs2, 30 38.8

Rs12,018 130.7 Rs18,273 181.0

38.8 ! * Rs12,018 ! Rs3,569 130.7

!

38.8 * Rs18,273 ! Rs3,917 181.0

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Real Price of Wages

 Observations
Wage of industrial workers has been increasing in nominal terms since 1991 Real wage also has been increasing but to a lower extent than the nominal wage because of inflation.

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Why Study Microeconomics?

 Microeconomic concepts are used by everyone to assist them in making choices as consumers and producers  Examples show the numerous levels of microeconomic questions necessary in many decisions

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Tata Motors cars

 Building Nano car or introducing Jaguar vehicles into the Indian market.  Tata Motors has to consider many aspects of the economy to ensure their introduction is a sound investment

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Tata Motors cars

 Questions
How strong is demand and how quickly will it grow?
 Must

understand consumer preferences and trade-offs all costs of production, how many should be produced each year?

What are the costs of manufacturing?

 Given

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Tata Motors cars

 Questions (cont.)
Tata Motors has to develop pricing strategy and determine competitors reactions Risk analysis
 Uncertainty

of future prices: gas, wages

Organizational decisions
 Integration

of all divisions of production standards

Government regulation
 Emissions

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Emission Standards
 Clean Air Act imposed emissions standards and have become increasingly stringent
Questions:
are the impacts on consumers?  What are the impacts on producers?  How should the standards be enforced?  What are the benefits and costs?
 What

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The End

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