CHAPTER 1

ANALYZING ECONOMIC
PROBLEMS

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Microeconomics Defined
• Microeconomics
– Allocation of limited resources to satisfy unlimited
human wants
• Resources are scarce (limited supply)
– Study of how individual economic decision-
makers (consumers, workers, firms or managers)
allocate scarce resources among alternate uses
– Study involves both the behaviour of these
economic agents on their own and the way their
behaviour interacts to form larger units (markets)
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Who should study microeconomics?
• Policy maker
– Produce more goods for national defence, but it
would have to produce fewer civilian goods
• Consumer
– Allocate more time to work, but have less time
available for leisure activities
• Manager
– Spend more of a firm’s resources on advertising,
but have less resources for research and
development
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Key Societal Questions
• Societies must answer these questions that
relate to microeconomics:
– What goods and services will be produced and in
what quantities?
– Who will produces these services and how will
they produce them?
– Who will receive these goods and services and
how will they get them?

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Microeconomic Modeling
• Economic model is like a roadmap
– Is an abstract model that serves a particular
purpose
• Using visual methods, they simply the process and
facilitate understanding of complex concepts
• Shows us where we are and how we can get where we
want to go
– Microeconomic model need to:
• Resemble reality
• Be understandable
• Be an appropriate scale
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Exogenous & Endogenous Variables
• Exogenous variable
– Variable whose value is taken as given in the
analysis of an economic system
• Determined by some process outside the model being
examined
• E.g. wage
• Endogenous variable
– Variable whose value is determined within the
economic system being studied
• E.g. number of workers
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Three Key Analytical Tools

• Constrained optimization

• Equilibrium analysis

• Comparative statics

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Constrained Optimization
• Constrained optimisation
– Making the best (optimal) choice, taking into
account any possible restrictions on the choice
– Objective function
• Relationship that a decision maker seeks to maximise or
minimise
• E.g. maximise utility, minimise cost
– Constraints
• Restrictions or limits imposed on a decision maker in a
constrained optimisation problem
• E.g. time, budget, other resources
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Constrained Optimization (cont.)

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Constrained Optimization (cont.)

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Marginal Reasoning

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Marginal Reasoning (cont.)
• Marginal
– How a dependent variable changes as a result of
adding one unit of an independent variable
– Dependent variable – total cost
– Independent variable – volume of production
– Incremental impact
• Impact of the last unit of the independent variable
(output) on the dependent variable (total cost)
• E.g. costs an extra RM5 to increase production by one
unit

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Equilibrium
• An analysis of a system in a state that will
continue indefinitely
– As long as no outside factor upsets the equilibrium
• The point where demand just equals supply in
this market
– The point where the demand and supply curves
cross

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Equilibrium (cont.)
• Demand
– What quantity of a good would be purchased in the
market at any given price
• Supply
– What quantity of a good would be offered for sale
in the market at any given price
• Equilibrium
– In a competitive market
• At a price at which the quantity offered for sale equals
the quantity demanded by consumers
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Equilibrium (cont.)

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Comparative Statics
• Examine how a change in some exogenous
variable will affect the level of some
endogenous variable in an economic system
– Can be applied to constrained optimisation
problems and equilibrium analyses
– Comparing two snapshots of an economic model
• Levels of the endogenous variables given a set of
exogenous variables
• How endogenous variables change in response to an
exogenous shock
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Comparative Statics (cont.)

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Comparative Statics (cont.)

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Comparative Statics (cont.)

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Comparative Statics (cont.)

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Comparative Statics (cont.)

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Microeconomic Analysis
• Positive analysis
– To explain how an economic system works or to
predict how it will change over time
• What has happened?
• What is happening?
– Examples
• What dimensions of the sheep’s pen will the farmer
choose to maximise the area of the pen?
• How will the area of the pen change if the farmer
choose to maximise the area of the pen?

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Microeconomic Analysis (cont.)
• Normative analysis
– Focuses on issues of social welfare, examining
what will enhance or detract from the common
good
– Example:
• Should we increase income equality rather than focus
on economic efficiency?
• Should we impose a progressive income tax or a sales
tax to increase income equality?
• Will a progressive income tax reduce aggregate hours
worked?
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