Introduction To Microeconomic Analysis Lecture Notes PDF

INTRODUCTION TO MICROECONOMIC ANALYSIS Dr Janesh Sami (Ph.D., Australia) School of Accounting, Finance and Economics Email: [email protected] Lecture Objectives The Economic Way of Thinking Pitfalls to Avoid in Economic Thinking Establishing Causality Positive A...

INTRODUCTION TO MICROECONOMIC ANALYSIS Dr Janesh Sami (Ph.D., Australia) School of Accounting, Finance and Economics Email: [email protected] Lecture Objectives The Economic Way of Thinking Pitfalls to Avoid in Economic Thinking Establishing Causality Positive Analysis vs Normative Analysis Microeconomic Models Usefulness of Microeconomic Analysis 1. The Economic Way of Thinking The economic way of thinking involves the following guidelines: – Resources are scarce so trade-off is a must. – Individuals/firms choose purposefully given their constraints. – Incentives matter and can influence choice that economic agents make. – Individuals make decisions at margin. – Information is costly. More information helps make better choices. – Economic (policy) actions generates direct and indirect effects. – Value of a good or service is subjective. – Test of a theory is its ability to predict. 2. Pitfalls to Avoid in Economic Thinking Violation of the Ceteris Paribus Condition can lead one to draw the wrong conclusion. Good intentions do not guarantee desirable outcomes. Correlation /association is not causation. Statistical correlation/ association between two variables does not imply presence of cause and effect relationship between them. The fallacy of composition: What’s true for one might not be true for all. It’s important to consider both the micro and macro view. 3. Establishing causality Most economists work with observational data that comes from primary or secondary source. With observational data – time series analysis or cross-sectional analysis (use of regression technique) can be undertaken. However, concluding causality with observational data is very difficult. Use of randomized trials : a type of experiment designed to test causality where a group of individuals is randomly divided into a treatment group, which receives the treatment of interest, and a control group, which does not. Use of quasi-experiments : changes in economic environment (such as a policy change) that create nearly identical treatment and control group for studying the effect of that policy change. 4. Positive vs Normative Analysis Microeconomics analysis is useful for both positive and normative questions. Positive analysis : – Asks explanatory or predictive questions. – Focuses on how an economic system functions or predict how it will change over time. – It involves questions such as : What is happening ? What has happened ? What will happen if the exogenous variable changes? Normative Analysis: – Focuses mostly on issues of social welfare, involve value judgments and examine what will enhance or distract from the common good.  Positive analysis will be useful for understanding : – Why some markets are in equilibrium while others are not ? – Why changes in weather conditions results higher commodity prices? Applying microeconomic principles for predictive purposes is important for consumers and business managers. Positive analysis is also important for public policy. It helps understand the impact of taxes, government subsidies, tariffs or quota and government budget on consumers and producers.  Normative analysis will examine how to achieve a goal through alternative policy instruments that some people consider socially desirable. For example: – Affordable housing – family housing vouchers vs rent control – Reduced pollution – taxes on emissions vs limit on emissions – Reduced road accidents – fines for drinking and driving vs compulsory seat belts. It is important to do positive analysis before normative analysis. For instance, in case of affordable housing, the policy makers needs to understand both the implications of family housing vouchers and rent control. Positive analysis will help the policy makers better understand who is affected by the policies. 5. Economic (Microeconomic) Models Economic theory is basically development and use of a model to test economic hypotheses, which are predicting about cause and effect. Economists test theories by checking whether predictions are correct or not. If a prediction does not come true, economists are likely to reject the theory. Economic models describes relationship between two or more economic variables. Exogenous variable vs Endogenous variable Explains how individuals make choices? ; How firms allocate resources? ; How market prices are determined. Much of economics uses a framework based on the principle of optimization (people try to choose the best patterns of consumption that they can afford) and principle of equilibrium (prices adjust until quantity demanded and supplied are same).  Economic models are also useful for predicting effects of changes in some variable. For instance, if the price rises, the quantity demanded falls. Models are basically implications of reality. No economic model can exactly describe reality. They are based on certain assumptions but are still useful for describing, understanding behavior of individuals, firms and predicting effects of changes in some variable. Most microeconomic models are based on the utility maximization and profit maximization.  There are atleast four major essential components of a microeconomic model. a) The economic actors/agents – the economic decision making unit b) Motivation (utility maximization or profit maximization, welfare maximization, etc.) c) The economic environment d) Assumptions and axioms – helps develop the follow of an argument and focus on what’s important. The use of ceteris paribus. Validity of an economic model depends upon its ability to predict and explain real- world economic events. The ultimate test of an economic model comes when it is confronted with real-world economic data. 6. Usefulness of Microeconomic Analysis Microeconomic models helps explain why economic decisions are made and enables us to make predictions. This can be very useful for business firms and government organizations. Individuals can use microeconomics to make purchasing and other decisions. Consumers who are able do microeconomic analysis are well positioned to understand and comment on economic issues and vote responsibly. Economist are likely to disagree on economic issues. Use of empirical evidence in economic debate is important.  Microeconomic analysis is very useful for firms. – Use of production methods to minimize cost and maximize profit. – Use of pricing scheme to raise profits. – Use of strategies to maximize profits when there are other firms in the market. – Negotiate contract with other firms in the industry. – Understand the behavior of the rival firms.  Microeconomic analysis is also important for government. – Predict and understand the impact of tax policy changes on the consumers, labour supply, savings, investment and tax revenue. – Predict and understand the impact of price control, tariffs and quota on trade. – Predict and understand the impact of economic regulation of a monopoly. There has been recently increased emphasis on economic analysis in the policy arena. Microeconomic analysis can help policy makers understand and compare the effects of alternative policies on consumers and firms. This will help formulate and implement better policies and improve social welfare. References Besanko, D. A., Braeutigam, R. R., & Gibbs, M. (2011). Microeconomics (4th ed.). Hoboken, NJ: John Wiley. Perloff, J. M. (2012). Microeconomics (6th ed.). Harlow, Essex: Pearson. Varian, H. R. (2006). Intermediate Microeconomics: A Modern Approach (7th ed.). New York: Norton. Cowell, F. A. (2018). Microeconomics: Principles and analysis (2nd ed.). Oxford: Oxford University Press. Nicholson, W., & Snyder, C. M. (2008). Microeconomic theory: Basic principles and extensions (10th ed.). Mason, OH: Thomson South-Western. Gwartney, J. D., Macpherson, D. A., Sobel, R. S., & Stroup, R. L. (2003). Microeconomics: Private and Public Choice (10th ed.). Mason, OH: Thomson South-Western. Gruber, J. (2011). Public Finance and Public Policy (3rd ed.). New York: Worth.