Chapter1

Introduction
Chapter Summary
Thepurposeofthischapterandoftheentiretextbookistoteachyoutothinklikeaneconomist.Economists
areuniqueinthewaythattheyviewtheworldandapproachproblems.Thekeyassumptionofeconomics
(especiallymicroeconomics)isthatindividualsallocatetheirscarceresourcessoastomakethemselves
aswelloffaspossible.Thisassumptioniscentraltoeconomics;thereisaneconomicwayofthinking
thatisdifferentanddistinctfromthemethodsofothersocialsciences.
Microeconomicsisthestudyoftheallocationofscarceresourceshowindividualconsumersandfirms
(producers)makedecisionsandhowthesemanydecisionsinteract.Economicresourcesarethefactorsof
productionavailableforproducinggoods.Scarcityexistswhenpeoplewantmorethantheycangetwith
theirlimitedresources.Scarcityimpliesthatsocietymustmaketradeoffsthatwemustgiveupsomething
togetmoreofanotherthing.Forexample,ifIwanttospendanhoursleeping,Icannotgetitwithoutgiving
upsomethingelse,suchasanhourofstudying.
Societyfacesthreekeytradeoffs:whatgoodsandservicestoproduce,howtoproducethem,andwhogets
thegoodsandservices.Amarketisanexchangemechanism(suchasaphysicalstructureoracomputer
network)thatallowsbuyerstotradewithsellers.Inamarketeconomythethreeallocationoutcomes
(what,how,andwho)reflecttheinteractionsofindependentdecisionsmadebymillionsofindividual
consumersandfirms.Priceslinkandcoordinatethethreesetsofdecisions.Pricesinfluencethedecisions
ofindividualconsumersandfirms,andtheinteractionsofthesedecisionsbyconsumers,firms,andthe
governmentinturndetermineprices.Mostofthetextbookisconcernedwithhowpricesaredetermined
withinamarketandtheconditions(numberofbuyersandsellers,amountofinformationavailable)that
determinewhetherpriceisequaltothecostofproduction.
Amodelisadescriptionoftherelationshipbetweentwoormorevariables.Economicmodelsbeginwith
simplifyingassumptionsandthendeducetheimplicationsoftheseassumptions.Economictheoryisthe
developmentanduseofamodeltotesthypotheses,whicharepredictionsaboutcauseandeffect.Economists
testtheoriesbycheckingwhetherthepredictionsofmodelsarecorrect.Agoodtheoryisrelativelysimple
touseandmakesclear,testablepredictionsthatarenotrefutedbyevidence.Ifamodelistoosimple,its
predictionsmaybeincorrect.Ifamodelistoocomplex,allofitspredictionswillbeambiguousand
thereforeuntestable.
Akeyassumptioninalmosteverymicroeconomicmodelisthatindividualsallocatetheirscarceresources
soastomakethemselvesaswelloffaspossible.Thisassumptionofmaximizingsubjecttoconstraints
impliesthatconsumerspickthebundlesofgoodsthatgivethemthegreatestpossibleenjoyment,andthat
firmstrytomaximizetheirprofitsgivenlimitedresourcesandexistingtechnology.

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Individuals,firms,andgovernmentsusemicroeconomicmodelsandpredictionstomakedecisions.A
scientificpredictioniscalledapositivestatement:atestablehypothesisaboutcauseandeffect.Positive
doesnotmeanthatwearecertainaboutthetruthofthestatementitonlyindicatesthatwecantestthe
statementstruth.Anormativestatementisavaluejudgmentaconclusionaboutwhethersomethingis
goodorbad.Inmakingeconomicpolicies,economistsusepositiveeconomicstopredictwhatwillhappen
ifcertainpoliciesareadopted,andthenusetheirbeliefsandjudgmenttoselectwhichofthepoliciesyields
thebestoutcome.Economistsareusuallycarefultoseparatetheirpredictionsfromtheirjudgmentsofright
andwrong.Thisoftenrequirescarefuluseoflanguage,suchaswhentheeconomistpointsoutthatwhat
manypeoplecallneedsareactuallyonlywants.

Key Concepts and Formulas

Microeconomics:thestudyoftheallocationofscarceresources.
Scarcity:thesituationthatariseswhenpeoplewantmorethantheycangetwiththeirlimited
resources.
Tradeoffsmeasurehowmuchofonethingmustbegivenuptogetmoreofanotherthing.
Market:anexchangemechanismthatallowsbuyerstotradewithsellers.
Pricesmeasurethetradeoffsavailableinthemarketplaceandcoordinatetheindependentdecisionsof
consumersandproducers.
Model: a description of the relationship between two or more economic variables.
Theory:thedevelopmentanduseofamodeltotesthypotheses,whicharepredictionsaboutcauseand
effect.
Economistsassumethatindividualsexhibitmaximizingbehaviorthattheyallocatetheirscarce
resourcessoastomakethemselvesaswelloffaspossible.
Positivestatement:atestablehypothesisaboutcauseandeffect.
Normativestatement:avaluejudgment.

Application: Agreement among Economists

Storiesabouteconomistsdisagreeingamongthemselvesarelegendary.Yeteconomistsinsistthatthereis
aneconomicwayofthinkingandspeakaboutkeyassumptionsthatalmostalleconomistshold.
Question: Doeconomistsagreewitheachotheronanyimportantissues?Ifso,whydotheyagreeon
someissuesanddisagreeonothers?
Answer:

Asshownbelow,recentsurveysshowthateconomistsactuallyagreeaboutalotofthings,but
thattherearemajordisagreementsonsomefundamentalissues.Theresultsshowthatthereis
oftenmoreagreementonthesubjectwearenowstudyingmicroeconomics.Thismaybe
becausemosteconomistsagreewiththecentralassumptionofmicroeconomics:thatalmost
allindividualsallocatetheirscarceresourcessoastomakethemselvesaswelloffaspossible.
Thisessentialpostulateleadstoanumberofclearpredictions.Aggregationtothemacroeconomic
levelinvolvesfeedbackeffectsandhardtounderstandcomplications.Thisisprobablywhat
explainsthelackofconsensusonmanykeymacroeconomicissues.Ingeneral,economistsare
morelikelytodisagreewhen(1)theydisagreeabouttheappropriatemodeltouse,(2)they
disagreeabouthowtointerpretdata,and(3)theydisagreeaboutnormativeissues(i.e.,what
shouldbedone).

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Chapter1Introduction3

Noteveryoneagreeswiththecentralassumptionsofmicroeconomics,however.Arecentsurvey
askedsocialscientistswhetherornotindividualsarerationalutilitymaximizers.Among
economists,70percentagreedandonly13percentdisagreed.However,amongpolitical
scientists,only33percentagreed,while43percentdisagreed.
MicroeconomicPropositions
1.

2.
3.
4.
5.
6.
7.

PercentAgreeing

Pollutiontaxesormarketablepollutionpermitsareamore
economicallyefficientapproachtopollutioncontrolthanemission
standards.
Tariffsandimportquotasusuallyreducegeneraleconomic
welfare.
Aceilingonrentsreducesthequantityandqualityofhousing
available.
Cashpaymentsincreasethewelfareofrecipientstoagreater
degreethandotransfersinkindofequaldollarvalue.
TheSocialSecuritypayrolltaxisbornealmostentirelyby
workers,nottheiremployers.
Aminimumwageincreasesunemploymentamongyoungand
unskilledworkers.
Economicevidencesuggeststhattherearetoomanyresourcesin
Americanagriculture.

MacroeconomicPropositions
1.

2.
3.
4.

AneconomyinshortrunequilibriumatarealGNPbelow
potentialGNPhasaselfcorrectingmechanismthatwill
eventuallyreturnittopotentialrealGNP.
Intheshortrun,areductioninunemploymentcausestheinflation
ratetoincrease.
TheFederalReserveshouldincreasethemoneysupplyata
fixedrate.
Themajorsourceofmacroeconomicdisturbancesissupplyside
shocks.

93

93
93
84
83
74
73
PercentAgreeing
60

48
44
40

Sources: RichardAlston,J.R.Kearl,andMichaelVaughan,IsThereConsensusamongEconomistsinthe1990s?
AmericanEconomicReview:PapersandProceedings,May1992;RobertWhaples,IsThereConsensus
amongAmericanLaborEconomists?JournalofLaborResearch,Fall1996;DanFullerandDorisGeide
Stevenson,ConsensusamongEconomists:Revisited,JournalofEconomicEducation,Fall2003;
RobertWhaplesandJacC.Heckelman,PublicChoiceEconomics:WhereIsThereConsensus?
AmericanEconomist,Spring2005.ArePublicChoiceScholarsDifferent?PS:PoliticalScience
andPolitics,forthcoming.
Note:

PercentAgreeingsumsthosewhogenerallyagreeandthosewhoagreewithprovisos.

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4PerloffMicroeconomicswithCalculus,SecondEdition

Practice Problems
Multiple-Choice
1. Askingwhetheranincreaseintheminimumwagewilldecreaseemploymentis
a. aquestionofpositiveeconomics.
b. aquestionofnormativeeconomics.
c. neitheranorb.
d. bothaandb.
2. Whichofthefollowingisapositivestatement?(Morethanonemaybecorrect.)
a. Intermediatemicroeconomicsshouldberequiredofalleconomicsmajorstobuildasolid
foundationineconomictheory.
b. Whenthepriceofagoodgoesup,peoplebuymoreofit.
c. Whenthepriceofagoodgoesdown,peoplebuymoreofit.
d. JeffreyPerloffwasthefirstPresidentoftheUnitedStates.

True-False-Ambiguous and Explain Why

3. Thegovernmentshouldspendmoremoneyonmannedspacemissions.
4. Marketpricesaredeterminedbylargecompanies.
5. Economistsmodelsgenerallypredictthatindividualsallocatetheirscarceresourcessoastomake
themselvesaswelloffaspossible.
6. Extremelywealthypeople,suchasBillGates,dontfacescarcity.

Short-Answer
7. Mosteconomicmodelsassumethatthegoalofallfirmsistomaximizetheirprofitsallthetime.This
assumption,however,isobviouslynotcorrect,sothetheoriesbasedonthesemodelsarenotvalid.
Howwouldaneconomistrespondtothislineofreasoning?
8. Dr.Mergatroidstheoryisthatthepriceofcompactdisksisdeterminedbytheworkingsofevil
spirits.Whentheevilspiritsareactive,thepriceofacompactdiskrises.Whentheevilspiritsare
atrest,thepriceofcompactdisksfalls.Isthisausefultheory?Whyorwhynot?
9. Youmayhaveheardpeopleusethetermthemarriagemarkettodescribetheprocessbywhichmen
andwomenfindmarriagepartners.Inwhatwaysisthemarriagemarketsimilartothemarketfora
servicesuchasahaircutordaycare?Howdoesitdiffer?
10. Howmanyeconomistsdoesittaketoscrewinalightbulb?

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Answers to Practice Problems

1. a. Positivestatementsareaboutcauseandeffect.Askingwhetheranincreaseintheminimumwage
willreduceemploymentisatestablehypothesisthatcan,inprinciple,bedemonstratedtobe
supportedbyempiricalevidence(ornotsupportedbyevidence).
2. b,c,anddarepositivestatementsthisis,testablehypotheses.Choiceaisavaluejudgment,hence
anormativestatement.
3. Ambiguous.Thisisanormative(should)questionwhoseanswerwilldependonthevaluesofthe
personansweringthequestion.Inanswering,youwillbeginbydiscussingthetradeoffsfacing
society.Resourcesarescarce,sospendingmoreonmannedspacemissionsmeansthatlesscanbe
spentonotherthings(includingunmannedspacemissions).Amaximizingindividualwillcompare
thebenefitsfromspendingmoreonmannedspacemissions(e.g.,thevalueofadditionalknowledge
gainedbythemissions)versusthecosts(e.g.,highertaxes,lostlives).PrincetonUniversityeconomist
PaulKrugmanweighedthesebenefitsandcostsintheNewYorkTimes(February4,2003)following
theexplosionoftheColumbiaspaceshuttle.Hepointedoutthattheadditionalcostsofputtinghumans
intospacearesubstantial.TheshuttleandInternationalSpaceStationcostabout$7billionperyear.
Thebenefits,heargues,arescant.Machinescancarryoutalmostanyresearchthathumanscandoin
spacescientificobservationandexperimentsorevenminingasteroidsandatamuchlowercost.
HeconcludedthatNASAshouldnotspendadditionalmoneyonmannedspacemissions.
4. False.Thepricesystemisadecentralizedmechanismbywhichthedecisionsofmillionsofconsumers
andmillionsofproducersarecoordinated.Inlaterchapters,theextenttowhichlargefirmsinfluence
priceswillbeconsidered,butinanycase,thedecisionsofconsumershaveasignificantimpactaswell.
5. False.Thisisthemostwidelyusedassumptionofeconomicmodels.Itisnotaprediction.
6. False.Scarcityisthesituationthatariseswhenpeoplewantmorethantheycangetwiththeirlimited
resources.Wantsgenerallyexceedresources,evenforverywealthypeople.Yourtimeisscarce
becauseyoudliketospendthenexthourstudyingforanexam,catchinguponyoursleep,hanging
outwithyourfriends,andplayingthataddictivenewvideogame,butyoucantspendthehourdoing
allfourofthesethingsinthenext60minutes.Becausewealthypeoplealsofacetimeconstraintsand
havelotsofthingstheydliketodo,theyfacescarcity,too.
7. Becausetheworldandtheeconomyaresocomplex,allmodelsmustsimplify.Thus,allmodelsare
subjecttothecriticismthattheirassumptionsdonotreflectreality.Butwecannotthrowoutall
models.Ifwedid,wewouldhavenowayoftestingtheoriesormakingpredictions.Ifwearetoact
sensiblyitiscrucialthatwepredicttheconsequencesofouractionsbeforewemakethem.Instead,
weacceptthefactthatassumptionsdonotperfectlyreflectreality,andfocusontheabilityofamodel
topredict.Ifamodelmakesbetterpredictionsthananyothermodel,thenitwillbeacceptedasvalid
(untilabettermodelcomesalong).Economistsgenerallyusetheassumptionofprofitmaximizing
firmsbecauseithasagreattrackrecordofmakingpredictionsthatmatchtherealworld.

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8. MosteconomistswouldrejectDr.Mergatroidstheory.Evenifthetheoryisanaccuratereflectionof
reality,ithasaninsurmountableproblem:Itisnottestable.Unlessthereisamethodofmeasuringthe
activitylevelofevilspirits,thereisnowaytomakepredictionsusingthistheoryandtoshowthatits
predictionsaregenerallycorrect.Inaddition,economistshavedevelopedanalternativetheorythe
theoryofsupplyanddemand.Iftherewereawaytomeasuretheactivityofevilspirits,thenwe
wouldneedtoseeifitmadebetterpredictionsthanthetheoryofsupplyanddemand.

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9. Amarketisanexchangemechanismthatallowsbuyerstotradewithsellers.Thereareallsortsof
places(colleges,bars,churchsocials)andinstitutions(networksoffriends,classifiedads,dating
services)thatallowmenandwomentogettogether.Inthissense,thereisamarriagemarket.Men
andwomenshoparound(asSmokeyRobinsonputitinhisclassicMotownsong)tryingtofindthe
bestbargaininaspouseexhibitingmaximizingbehavior.Themarriagemarketisdifferentfromthe
marketforanotherservicebecauseitislessclearwhoisbuyingandwhoisselling.Bothpartiesseem
tobebuyingandselling.Inaddition,thereisnotusuallyanexplicitpriceinthemarriagemarket.
However,therearecontemporarysocietiesandhistoricalcasesinwhichpricescanbeseenmore
clearlyforexample,whenoneofthefamiliespaystheotheradowry.
10. Howmanyeconomistsdoesittaketoscrewinalightbulb?
Economistsanswerstothisjokecanbeveryilluminating.
a. None.Ifthelightbulbneededtobescrewedin,themarketwouldhavealreadydoneit.(Inother
words,economistshavealotoffaithinthemarketsabilitytogetthingsdone.)
b. Itdependsonthewagerate.(Inotherwords,economiststhinkthatpriceswhichincludewages
areneededinjustaboutanyexplanationinvolvingpeople.)
c. Seven,plusorminusten(i.e.,sometimeseconomicmodelspredictionsareoverlyimprecise).
d. Eight:onetoscrewitinandtheotherstoholdeverythingelseconstant.
ThesejokeswereliftedfromTheWhartonJournal,February21,1994bySelenaMaranijan,whoalso
includesthiszinger:
Q: WhydidGodcreateeconomists?
A: Inordertomakeweatherforecasterslookgood.(Ouch!)

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