Review of the Principles of Microeconomics

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Macroeconomics: an Introduction Supplement to Chapter 1

Review of the Principles of Microeconomics
Internet Edition as of Apr. 7, 2006 Copyright © 2006 by Charles R. Nelson All rights reserved. ********

S.1 What is Microeconomics All About?
Microeconomics is the study of how decisions are made by consumers and suppliers, how these decisions determine the allocation of scarce resources in the marketplace, and how public policy can influence market outcomes for better or worse. A basic understanding of microeconomics is essential to the study of macroeconomics because “micro” provides the foundations upon which “macro” is built. It is pointless to try to explain, for example, the demand for money and how it affects interest rates in the economy without a grasp of how suppliers and buyers interact in a market. The objective of this supplement to MACROECONOMICS: An Introduction, Third Edition is to provide a relatively compact overview of microeconomics for use in a course where micro is not a prerequisite for macro, and for students who want to brush up on their micro. Economists think of there being two sides to a market, the demand side and the supply side. The demand side consists of economic agents, households and sometimes firms, who come to the market to buy a specific good or service. The supply side consists of the suppliers of the good or service, generally firms that produce the item. In markets for final goods, which are ready for consumption, the demanders are usually the consumers in the household sector; for example, someone buying a croissant. However, in the case of capital goods, it is a firm that is the buyer of the final good; for example, a bakery buying a new automated oven. There are also markets for intermediate goods where the buyers are firms purchasing a good or 1

service used in the production of another good or service, for example bakeries purchasing flour from millers, or millers purchasing wheat from farmers. We study the demand and supply sides of a markets separately, because each involves a different groups of agents. Within each group there is a common goal but the two groups have very distinct goals. Buyers all come to the market with the same goal of getting as much satisfaction, or what economists call utility, as they can from their limited budget. Suppliers are maximizing profit by using the factors of production - land, labor, capital, and entrepreneurship, - as effectively as possible, given the costs of those factors and the price at which they can sell their product. Let us start by studying the behavior of consumers in a market familiar to most of us, the market for audio compact discs (CDs).

S.2 The Law of Demand
Think for a moment about your plans to buy audio CDs over the next year. Do you expect to buy about 1 per month? or 2? or 5? What would cause you to change the number you plan to buy? Certainly, a change in the price of CDs or a change in your income would cause you to reconsider the number you buy. Think first about your response to price. Suppose that CDs sell for $12 each, and you currently buy about 2 per month, on average. How many would you buy if the price were $20 instead? Certainly fewer, perhaps only 1. On the other hand, if the price fell to $4 each, you would surely buy more, maybe as many as 3 per month. In each case we assume that your income has not changed. We can summarize this information in a table as follows: One Person’s Demand for CDs One Person’s Demand for CDs Price of a CD Number of CDs you would buy per month at that price $4 3 $12 2 $20 1 We have taken a one person marketing survey here to see how the quantity of the CDs you would buy, which economists call the quantity demanded, varies as a function of price, holding income and all other variables that might affect your decision constant. If we could ask this question of all CD buyers we could add up the quantity demanded by each and get the quantity demanded in the CD market by...
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