MICROECONOMICS
Lecture (Sept 3, 2020)
Part 1
Basic Concept of Economics:
• Economics is an inquiry into the nature and causes of the wealth of nations. -
Adam Smith
• Economics as the study of man in the ordinary business of life. It is a study of
wealth and study of mankind. It is not a natural science like physics and
chemistry but rather a social science. - Alfred Marshall
• Economics is the science which studies human behavior as a relationship
between ends and scarce means which have alternative uses. - Lionel Robbins
• Economics is the study of the use of scarce resources to satisfy unlimited human
wants. - Richard Lipsey
• Modern Definition of Economics: Economics is the study of how people and
society choose, with or without use of money, to employ scarce productive
resources which could have alternative uses, to produce various commodities
overtime and distribute them for consumption now and in the future among
various persons and groups of society. - Paul Samuelson (20th century
economist)
Definition of ECONOMICS
• ECONOMICS – is the study of how humans make decisions in the face of
scarcity. These can be individual decisions, family decisions, business decisions
or societal decisions.
• SCARCITY- means that human wants for goods, services and resources exceed
what is available. Resources such as labor, tools, land and raw materials are
necessary to produce the goods and services we want but they exist in limited
supply.
•
• Schools of Economic Theory
There are also schools of economic thought.
Two of the most common are monetarist and keynesian.
Monetarists (Classical) have generally favorable views on free markets as the
best way to allocate resources and argue that stable monetary policy is the best
course for managing the economy.
In contrast, the Keynesian approach believes that markets often don’t work well
at allocating resources on their own and favors fiscal policy by an activist
government in order to manage irrational market swings and recessions.
• Economic analysis often progresses through deductive processes, including
mathematical logic, where the implications of specific human activities are
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considered in a "means-ends" framework. Some branches of economic thought
emphasize empiricism, rather than formal logic—specifically, macroeconomics
or Marshallian microeconomics, which attempt to use the procedural
observations and falsifiable tests associated with the natural sciences.
• Since true experiments cannot be created in economics, empirical economists
rely on simplifying assumptions and retroactive data analysis. However, some
economists argue economics is not well suited to empirical testing, and that such
methods often generate incorrect or inconsistent answers.
The Economics of Labor, Trade, and Human Behavior
The building blocks of economics are the studies of labor and trade. Since there are
many possible applications of human labor and many different ways to acquire
resources, it is difficult to determine which methods yield the best results.
Economics demonstrates, for example, that it is more efficient for individuals or
companies to specialize in specific types of labor and then trade for their other needs or
wants, rather than trying to produce everything they need or want on their own. It also
demonstrates trade is most efficient when coordinated through a medium of exchange,
or money.
Economics focuses on the actions of human beings. Most economic models are based
on assumptions that humans act with rational behavior, seeking the most optimal level
of benefit or utility. But of course, human behavior can be unpredictable or inconsistent,
and based on personal, subjective values (another reason why economic theories often
are not well suited to empirical testing). This means that some economic models may
be unattainable or impossible, or just not work in real life.
Still, they do provide key insights for understanding the behavior of financial markets,
governments, economies—and human decisions behind these entities. As it is,
economic laws tend to be very general, and formulated by studying human incentives:
economics can say profits incentivize new competitors to enter a market, for example,
or that taxes disincentivize spending.
Microeconomics vs. Macroeconomics: An Overview
Economics is divided into two different categories: microeconomics and
macroeconomics. Microeconomics is the study of individuals and business decisions,
while macroeconomics looks at the decisions of countries and governments.
While these two branches of economics appear to be different, they are actually
interdependent and complement one another. Many overlapping issues exist between
the two fields.
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Microeconomics
• MICROECONOMICS – deals with the behavior of individual units. These units
include consumers, workers, investors, owners of land, business firms in fact,
any individual or entity that plays a role in the functioning of our economy.
Microeconomics is the study of decisions made by people and businesses regarding the
allocation of resources and prices of goods and services. It also takes into account
taxes, regulations, and government legislation.
Microeconomics focuses on supply and demand and other forces that determine the
price levels in the economy. It takes what is referred to as a bottom-up approach to
analyzing the economy. In other words, microeconomics tries to understand human
choices, decisions, and the allocation of resources.
Having said that, microeconomics does not try to answer or explain what forces should
take place in a market. Rather, it tries to explain what happens when there are changes
in certain conditions.
For example, microeconomics examines how a company could maximize its production
and capacity so that it could lower prices and better compete in its industry. A lot of
microeconomic information can be gleaned from the financial statements.
Microeconomics involves several key principles including (but not limited to):
• Demand, Supply, and Equilibrium: Prices are determined by the theory of
supply and demand. Under this theory, suppliers offer the same price
demanded by consumers in a perfectly competitive market. This creates
economic equilibrium.
• Production Theory: This principle is the study of how goods and services are
created or manufactured.
• Costs of Production: According to this theory, the price of goods or services is
determined by the cost of the resources used during production.
• Labor Economics: This principle looks at workers and employers, and tries to
understand the pattern of wages, employment, and income.
The rules in microeconomics flow from a set of compatible laws and theorems, rather
than beginning with empirical study.
Macroeconomics
Macroeconomics, on the other hand, studies the behavior of a country and how its
policies affect the economy as a whole. It analyzes entire industries and economies,
rather than individuals or specific companies, which is why it's a top-down approach. It
tries to answer questions like "What should the rate of inflation be?" or "What stimulates
economic growth?"
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• MACROECONOMICS – deals with aggregate economic quantities, such as level
and growth rate of national output, interest rates, unemployment, and inflation.
(Microeconomics 7th Edition by Pindyck & Rubinfeld, p. 3)
It is the study of the economy as a whole. It focuses on broad issues such as
growth of production, number of unemployed.
Macroeconomics examines economy-wide phenomena such as gross domestic product
(GDP) and how it is affected by changes in unemployment, national income, rate of
growth, and price levels.
Macroeconomics analyzes how an increase or decrease in net exports affects a nation's
capital account, or how GDP would be affected by the unemployment rate.
Macroeconomics focuses on aggregates and econometric correlations, which is why it
is used by governments and their agencies to construct economic and fiscal policy.
Investors of mutual funds or interest-rate-sensitive securities should keep an eye on
monetary and fiscal policy. Outside of a few meaningful and measurable impacts,
macroeconomics doesn't offer much for specific investments.
John Maynard Keynes is often credited as the founder of macroeconomics, as he
initiated the use of monetary aggregates to study broad phenomena. Some
economists dispute his theory, while many of those who use it disagree on how to
interpret it.
What Is Opportunity Cost?
Opportunity costs represent the potential benefits an individual, investor, or
business misses out on when choosing one alternative over another. The idea of
opportunity costs is a major concept in economics.
Because by definition they are unseen, opportunity costs can be easily overlooked if
one is not careful. Understanding the potential missed opportunities foregone by
choosing one investment over another allows for better decision-making.
While financial reports do not show opportunity costs, business owners often use the
concept to make educated decisions when they have multiple options before
them. Bottlenecks, for instance, are often a result of opportunity costs.
Opportunity cost is the forgone benefit that would have been derived by an option
not chosen.
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To properly evaluate opportunity costs, the costs and benefits of every option
available must be considered and weighed against the others.
Considering the value of opportunity costs can guide individuals and
organizations to more profitable decision-making.
• Opportunity Cost = FO – CO
Where: FO = return on best Foregone Option
CO = return on Chosen Option
The formula for calculating an opportunity cost is simply the difference between
the expected returns of each option.
FACTORS OF PRODUCTION
What Are Factors of Production?
Factors of production are the inputs needed for the creation of a good or service. The
factors of production include land, labor, entrepreneurship, and capital.
The Basics of Factors of Production
The modern definition of factors of production is primarily derived from a neoclassical
view of economics. It amalgamates past approaches to economic theory, such as the
concept of labor as a factor of production from socialism, into a single definition.
Land, labor, and capital as factors of production were originally identified by the early
political economists such as Adam Smith, David Ricardo, and Karl Marx. Today, capital
and labor remain the two primary inputs for the productive processes and the
generation of profits by a business. Production, such as in manufacturing, can be
tracked by certain indexes, including the ISM Manufacturing Index.
Land as a Factor
Land has a broad definition as a factor of production and can take on various forms,
from agricultural land to commercial real estate to the resources available from a
particular piece of land. Natural resources, such as oil and gold, can be extracted and
refined for human consumption from the land. Cultivation of crops on land by farmers
increases its value and utility. For a group of early French economists called the
physiocrats who pre-dated the classical political economists, the land was responsible
for generating economic value.
While the land is an essential component of most ventures, its importance can diminish
or increase based on industry. For example, a technology company can easily begin
operations with zero investment in land. On the other hand, the land is the most
significant investment for a real estate venture.
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Labor as a Factor
Labor refers to the effort expended by an individual to bring a product or service to the
market. Again, it can take on various forms. For example, the construction worker at a
hotel site is part of labor as is the waiter who serves guests or the receptionist who
enrolls them into the hotel.
Within the software industry, labor refers to the work done by project managers and
developers in building the final product. Even an artist involved in making art, whether it
is a painting or a symphony, is considered labor.
For the early political economists, labor was the primary driver of economic value.
Production workers are paid for their time and effort in wages that depend on their skill
and training. Labor by an uneducated and untrained worker is typically paid at low
prices. Skilled and trained workers are referred to as human capital and are paid higher
wages because they bring more than their physical capacity to the task. For example,
an accountant’s job requires synthesis and analysis of financial data for a company.
Countries that are rich in human capital experience increased productivity and
efficiency.
The difference in skill levels and terminology also helps companies and entrepreneurs
arbitrage corresponding disparities in pay scales. This can result in a transformation of
factors of production for entire industries. An example of this is the change in production
processes in the Information Technology (IT) industry after jobs were outsourced to
countries with a trained workforce and significantly lower salaries.
Capital as a Factor
In economics, capital typically refers to money. But money is not a factor of production
because it is not directly involved in producing a good or service. Instead, it facilitates
the processes used in production by enabling entrepreneurs and company owners to
purchase capital goods or land or pay wages. For modern mainstream (neoclassical)
economists, capital is the primary driver of value.
As a factor of production, capital refers to the purchase of goods made with money in
production. For example, a tractor purchased for farming is capital. Along the same
lines, desks and chairs use d in an office are also capital.
It is important to distinguish personal and private capital in factors of production. A
personal vehicle used to transport family is not considered a capital good. But a
commercial vehicle that is expressly used for official purposes is considered a capital
good. During an economic contraction or when they suffer losses, companies cut back
on capital expenditure to ensure profits. During periods of economic expansion,
however, they invest in new machinery and equipment to bring new products to market.
An illustration of the above is the difference in markets for robots in China versus the
United States after the financial crisis. China experienced a multiyear growth cycle after
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the crisis and its manufacturers invested in robots to improve productivity at their
facilities and meet growing market demands. As a result, the country became the
biggest market for robots. Manufacturers within the United States, which had been in
the throes of an economic recession after the financial crisis, cut back on their
investments related to production due to tepid demand.
Entrepreneurship as a Factor
Entrepreneurship is the secret sauce that combines all the other factors of production
into a product or service for the consumer market. An example of entrepreneurship is
the evolution of social media behemoth Facebook Inc. (FB). Mark Zuckerberg assumed
the risk for the success or failure of his social media network when he began allocating
time from his daily schedule towards that activity. At the time that he coded the
minimum viable product himself, Zuckerberg’s labor was the only factor of production.
After Facebook became popular and spread across campuses, Zuckerberg realized that
he needed help to build the product and, along with co-founder Eduardo Saverin,
recruited additional employees. He hired two people, an engineer (Dustin Moskovitz)
and a spokesperson (Chris Hughes), who both allocated hours to the project, meaning
that their invested time became a factor of production. The continued popularity of the
product meant that Zuckerberg also had to scale technology and operations. He raised
venture capital money to rent office space, hire more employees, and purchase
additional server space for development.
At first, there was no need for land. However, as business continued to grow, Facebook
built its own office space and data centers. Each of these requires significant real estate
and capital investments.
Another example of entrepreneurship is Starbucks Corporation (SBUX). The retail
coffee chain needs all four factors of production: land (prime real estate in big cities for
its coffee chain), capital (large machinery to produce and dispense coffee), and labor
(employees at its retail outposts for service). The company’s founder Howard Schulz
was the first person to realize that a market for such a chain existed and figured out the
connections between the other three factors of production.
While large companies make for excellent examples, a majority of companies within the
United States are small businesses started by entrepreneurs. Because entrepreneurs
are vital for economic growth, countries are creating the necessary framework and
policies in order to make it easier for them to start companies.
Ownership of Factors of Production
The definition of factors of production in economic systems presumes that ownership
lies with households, who lend or lease them to entrepreneurs and organizations. But
that is a theoretical construct and is rarely the case in practice. With the exception of
labor, ownership for factors of production varies based on industry and economic
system.
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For example, a firm operating in the real estate industry typically owns significant
parcels of land. But retail corporations or shops lease land for extended periods of time.
Capital also follows a similar model in that it can be owned or leased from another party.
Under no circumstances, however, is labor owned by firms. Labor’s transaction with
firms is based on wages.
Ownership of the factors of production also differs based on the economic system. For
example, private enterprise and individuals own most of the factors of production in
capitalism. However, collective good is the predominating principle in socialism. As
such, factors of production, such as land and capital, is owned and regulated by the
community as a whole.
PRODUCTION FUNCTION
Production function relates physical output of a production process to physical inputs
or factors of production. It is a mathematical function that relates the maximum
amount of output that can be obtained from a given number of inputs – generally capital
and labor.
The production function is expressed in the formula: Q = f(K, L, P, H), where the
quantity produced is a function of the combined input amounts of each factor. ...
The formula for this form is: Q = f(L, K), in which labor and capital are the two factors
of production with the greatest impact on the quantity of output.
END OF LECTURE
