Microeconomics

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Microeconomics is the branch of Economics that studies the behavior of units called "economic agents". Microeconomic models investigate assumptions about "economic agents" activities and about interactions between these agents. An "economic agent" is the basic unit operating in the model. Most often, we do have in mind that the "economic agent" is an individual, a person with one head, one heart, two eyes, and two ears. However, in some economic models, an economic agent is taken to be a nation, a family, or a parliament. At other times, the "individual" is broken down into a collection of economic agents, each operating in distinct circumstances and each regarded as an economic agent. When we construct a model with a particular economic scenario in mind, we might have some "degree of freedom" regarding whom we take to be the "economic agents".

Those economic models are instruments or "tools" which help economists better understand the economic reality. As reality is too complex, and has infinite variables - that cannot be analysed simultaneoulsy - those models make simplifying assumptions about real life. We could compare economic models to geographical maps: the models create a "map" of the economic reality the same way a map creates a conventional representation of a country. As with maps, no information will come out of an economic model unless it had been previously incorporated in the model by the researcher; this information will only be presented in a more comprehensive manner. It is important to fully understand all the "assumptions" which lie behind any economic model in order to rationally understand their results.

The basic models of microeconomics

Production Possibilities Curves

The production possibility curve is a hypothetical representation of the amount of two different goods that can be obtained by shifting resources from the production of one good to the production of the other. It is "strictly hypothetical" and "static" in nature. The curve is used to represent a society’s choice between two different goods. A society can use up all its potential resources producing a lot of butter and no guns at all. Or can use most of its resources producing guns and no butter. Between those to extremes there are infinite combinations of possibilities for production of guns and butter that can be choosed by society. See graphs at the links

Any two different goods could be chosen arbitrarily. This is one of the "assumptions" for this economic model. The curve, (plotted on a X-Y axis) shows graphically, during a specific period of time (another assumption), which combined quantities of both goods could be produced, "if all resources are fully employed" (another assumption), while "technology and institutions do not change" (yet another assumption). Given those "hypotetical" conditions, society's "output potential" for those two goods combined is realized anywhere on the curve (which is called the "production possibility curve’s frontier"). Any point on the "production curve" represents the maximum output possible for both commodities. (mathematically all points in the curve represent the "locus" of the maximum possible combination of output for both goods simultaneoulsy). See graphs at the links

Any "unemployed" resources by society, such as labor, capital, or physical resources would cause society to remain in an "inefficient production level". This would be shown in the graph as a point to the left, (or inside) the curve. (So, when some people are unable to find a job, society is not reaching its "most efficient level of production" and the whole of society pays a price for that unemployment). By definition all point to the right (or outside) of the production possibility curve (frontier) are impossible to be attained, given the limits of existing resources and technology (another assumprion).

Assumptions used for the construction of this economic model

• Any two different goods could be chosen arbitrarily;
• Production takes place during a specific period of time;
• All resources are fully employed;
• Technology and institutions do not change, and
• All points to the right (or outside) of the "production possibility curve" (frontier) are impossible to be attained.

We will never find all of those conditions in real life. However they represent a "reasonable scenario" which allows economists to reduce the number of variables in the problem and better analyse the phenemenon.

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Demand Functions and Demand Curves

The demand for any good is the amount consumers want to buy and are able to buy in a particular period of time. The basic model of demand says that the amount demanded of any good depends on the good's own price, consumer income, the prices of substitutes and complements, consumer preferences, and perhaps other factors (assumptions for this model).

A most basic example

Imagine that a fruit merchant, Mr. Wilson, used to mark down how many oranges his client, Mrs Smith, buys at his shop every week. He noticed that as the price of oranges varies during the year, Mrs. Smith buys more or less oranges from him.

• If oranges cost 5 cents each > Mrs Smith buys 10 oranges
• If oranges cost 4 cents each > Mrs Smith buys 17 oranges
• If oranges cost 3 cents each > Mrs Smith buys 26 oranges
• If oranges cost 2 cents each > Mrs Smith buys 38 oranges
• If oranges cost 1 cents each > Mrs Smith buys 53 oranges

By drawing an x-y graph and ploting those results into the graph, we will have a "demand curve for oranges" showing Mrs. Smith's preference schedule. (By convention the demand curve displays quantity (oranges) as the independent variable (the x axis - horizontal ) and price (cents) as the dependent variable (the y axis- vertical). This curve is a "portrait" that represents the "demand" for oranges (by Mrs. Smith, at Mr. Wilson shop). <See graph at the link>

From this simple schedule the fruit dealer drew an important conclusion: "the demand for oranges increases as its price drops, and drops as its price increases". He might not have been aware of one fact, however: to draw this conclusion he made a very important "assumption": "all other factors remaining constant". If, for instance, Mrs, Smith was giving a party the day she bought 53 oranges at 1 cent each, (and that particular day would have bought 53 oranges even if the price was at 5 cents) the conclusions of Mr. Smith "demand function" would be worthless. Mr Smith also noticed some other things that puzzle him: his client Mr. Bernstein never buys any orange, no matter how cheap they get. And Mr. Gates, his millionaire customer, always takes home two dozen oranges, doesn't matter if they are cheap or very expensive. Why is that so? Mr. Smith keeps asking himself those questions, without finding an answer.

Assumptions used by Mr. Smith (implicitly) in this economic model

• ALL other factors remain equal
• This demand function reflects the "consumer preference" of a single customer, Mrs Smith's.

A more realistic scenario

For example, one could build an schedule showing a hypothetical demand curve for spaghetti in San Francisco, measured in plates per day. Demand depends on the price of spaghetti, average annual money income of consumers, the price of tacos, and the price of wine (assumptions). You may build your own spreadsheet, place all those variables on it as "parameters" and see how demand varies. (Or you may use this link to an already built spreadsheet; all of the prices and income and the spaghetti demand will be updated. The graph of the demand curve wil be redrawn to show the effects of your changes.) <See live graph at the link>

Economists make a distinction between the effects on the amount demanded of changing a "good's own price", and the effects on the amount demanded when one of the other determinants of demand varies, such as "income". When a good's own price changes, consumers "move along" a particular demand curve. When any other determinant changes, the "demand curve shifts", as can be seen on the live graph when "income" is changed. <See live graph at the link> Changes in a good's own price are said to cause a "change in quantity demanded", while changes in other factors are said to cause a "change in demand".

Assumptions used in this model

• The amount demanded of any good depends on the good's own price, consumer income, the prices of substitutes and complements, consumer preferences, and perhaps other factors such as weather;
• The consumer is absolutely rational and has an almost infinite desire for the good considered; in this case he likes spaghetti a lot. So, if the price of spaguetti keeps falling, he will always eat more and more spaguetti.

See also

• Economics
• Macroeconomics
• Economic Theory

External Links

• ECONOMICS 100 ONLINE. Department of Economics at the University of Toronto<copyright K.J. Rea, 2000-2003 all rights reserved>. (A great "primer" to understanding the basic principles of Economics)

• MICROECONOMICS: Most important concepts explained in detail. Text and workable problems. WARNING: Internet Explorer will not work! Get "Firefox" or "Netscape". Requires "Adobe Acrobat Reader" as a helper to your web browser. You will need "Excel 97" or higher running on your computer to use the spreadsheets.

• World Wide Web Resources in Economics. Center for Innovative Education, Helsinki School of Economics, Finland. (An excellent sorce of links to the various Economics subdisciplines)