BASIC

MICROECONOMICS

Learning Module 3
(MICROECONOMIC RESOURCES: Scarcity and
Utility)

Prepared by:

Ethyl Vilgrace Oliveros Pacaldo

Faculty, Institute of Arts and Sciences

 MICROECONOMIC RESOURCES: Scarcity and Utility Resources

Individuals and firms allocate their limited resources to make

themselves as well off as possible. Consumers pick the mix of goods and
services that makes them as happy as possible given their limited wealth.
Firms decide which goods to produce, where to produce them, how much
to produce to maximize their profits, and how to produce those levels of
output at the lowest cost by using more or less of various inputs such as
labor, capital, materials, and energy. The owners of a depletable natural
resource such as oil decide when to use it. Government decision makers
decide which goods and services the government will produce and whether
to subsidize, tax, or regulate industries and consumers so as to benefit
consumers, firms, or government employees.

TRADE-OFFS

People make trade-offs because they can’t have everything. A society faces
three key trade-offs:

 Which goods and services to produce: If a society produces more

cars, it must pro- duce fewer of other goods and services, because
there are only so many resources— workers, raw materials, capital,
and energy—available to produce goods.
 How to produce: To produce a given level of output, a firm must use
more of one input if it uses less of another input. Cracker and cookie
manufacturers switch between palm oil and coconut oil depending
on which is less expensive.
 Who gets the goods and services: The more of society’s goods and
services you get, the less someone else gets.
 WHO MAKES THE DECISIONS

These three allocation decisions may be made explicitly by the

government, or they may reflect the interaction of independent
decisions by many individual consumers and firms. In the former
Soviet Union, the government told manufacturers how many cars of
each type to make and which inputs to use to make them. The
government also decided which consumers would get cars.

In most other countries, how many cars of each type are produced
and who gets them are determined by how much it costs to make
cars of a particular quality in the least expensive way and how much
consumers are willing to pay for them. More consumers would own a
handcrafted Rolls-Royce and fewer would buy a mass-produced Ford
Taurus if a Rolls were not 21 times more expensive than a Taurus.

HOW PRICES DETERMINE ALLOCATION

Prices link the decisions about which goods and services to produce,
how to produce them, and who gets them. Prices influence the decisions of
individual consumers and firms, and the interactions of these decisions by
consumers, firms, and the government determine price.

Interactions between consumers and firms take place in a market, which is

an exchange mechanism that allows buyers to trade with sellers. A market
may be a town square where people go to trade food and clothing, or it may
be an international telecommunications network over which people buy
and sell financial securities. Typically, when we talk about a single market,
we are referring to trade in a single good or a group of goods that are
closely related, such as soft drinks, movies, novels, or auto- mobiles.

To explain how individuals and firms allocate resources and how market
prices are determined, economists use a model: a description of the
relationship between two or more economic variables. Economists also use
models to predict how a change in one variable will affect another variable.

SIMPLIFICATIONS BY ASSUMPTION

We stated the income threshold model verbally, but we could have

presented it using graphs or mathematics. Regardless of how the model is
described, an economic model is a simplification of reality that contains
only reality’s most important features. Without simplifications, it is difficult
to make predictions because the real world is too complex to analyze fully.

By analogy, if the owner’s manual accompanying your new DVD recorder

had a dia- gram showing the relationships among all the parts in the DVD,
the diagram would be overwhelming and useless. But a diagram that
includes a photo of the buttons on the front of the machine, with labels
describing the purpose of each, is useful and informative.

Economists make many assumptions to simplify their models. When using

the income threshold model to explain car-purchasing behavior in
Malaysia, we assume that factors other than income, such as the color of
cars, are irrelevant to the decision to buy cars. Therefore, we ignore the
color of cars that are sold in Malaysia when we describe the relationship
between average income and the number of cars that con- sumers want. If
this assumption is correct, by ignoring color we make our analysis of the
auto market simpler without losing important details. If we’re wrong and
these ignored issues are important, our predictions may be inaccurate.

TESTING THEORIES

Economic theory is the development and use of a model to test

hypotheses, which are predictions about cause and effect. We are interested
in models that make clear, testable predictions, such as “If the price rises,
the quantity demanded falls.” A theory saying that “People’s behavior
depends on their tastes, and their tastes change randomly at random
intervals” is not very useful because it does not lead to testable predictions.

Economists test theories by checking whether predictions are correct. If a

prediction does not come true, economists may reject the theory.
Economists use a model until it is refuted by evidence or until a better
model is developed.

A good model makes sharp, clear predictions that are consistent with
reality. Some very simple models make sharp predictions that are
incorrect, and other, more com- plex models make ambiguous predictions
—in which any outcome is possible—that are untestable. The skill in model
building is to chart a middle ground.

An economist, an engineer, and a physicist are stranded on a deserted

island with a can of beans but no can opener. How should they open the
can? The engineer proposes hitting the can with a rock. The physicist
suggests building a fire under it to build up pressure and burst the can
open. The economist thinks for a while and then says, “Assume that we have
a can opener. . . .”
We can use evidence of whether a theory’s predictions are correct to refute
the theory but not to prove it. If a model’s prediction is inconsistent with
what actually happened, the model must be wrong, so we reject it. Even if
the model’s prediction is consistent with reality, however, the model’s
prediction may be correct for the wrong reason. Hence we cannot prove
that the model is correct—we can only fail to reject it.

MAXIMIZING SUBJECT TO CONSTRAINTS

Although one economist’s model may differ from another’s, a key

assumption in most microeconomic models is that individuals allocate their
scarce resources so as to make themselves as well off as possible. Of all the
affordable combinations of goods, consumers pick the bundle of goods that
gives them the most possible enjoyment. Firms try to maximize their
profits given limited resources and existing technology. That resources are
limited plays a crucial role in these models. Were it not for scarcity, people
could consume unlimited amounts of goods and services, and sellers could
become rich beyond limit.

As we show throughout this book, the maximizing behavior of individuals

and firms determines society’s three main allocation decisions: which
goods are produced, how they are produced, and who gets them. For
example, diamond-studded pocket combs will be sold only if firms find it
profitable to sell them. The firms will make and sell these combs only if
consumers value the combs at least as much as it costs the firm to produce
them. Consumers will buy the combs only if they get more pleasure from
the combs than they would from the other goods they could buy with the
same resources.
Thus many of the models that we examine are based on maximizing an
objective that is subject to a constraint. Consumers maximize their well-
being subject to a bud- get constraint, which says that their resources limit
how many goods they can buy. Firms maximize profits subject to
technological and other constraints. Governments may try to maximize the
welfare of consumers or firms subject to constraints imposed by limited
resources and the behavior of consumers and firms. We cover the formal
economic analysis of maximizing behavior in the following chapters and
review the underlying mathematics in the appendix at the end of the book.

POSITIVE VERSUS NORMATIVE

The use of models of maximizing behavior sometimes leads to

predictions that seem harsh or heartless. For instance, a World Bank
economist predicted that if an African government used price controls to
keep the price of food low during a drought, food shortages would occur
and people would starve. The predicted outcome is awful, but the
economist was not heartless. The economist was only making a scientific
prediction about the relationship between cause and effect: Price controls
(cause) lead to food shortages and starvation (effect).

Such a scientific prediction is known as a positive statement: a testable

hypothesis about cause and effect. “Positive” does not mean that we are
certain about the truth of our statement—it indicates only that we can test
the truth of our statement.

If the World Bank economist is correct, should the government control

prices? If government policymakers believe the economist’s predictions,
they’ll know that the low prices will help consumers who are lucky enough
to be able to buy as much food as they want but hurt both the firms that sell
food and the people who cannot buy as much food as they want, some of
whom may die. As a result, the government’s decision of whether to use
price controls turns on whether the government cares more about the
winners or the losers. In other words, to decide on its policy, the
government makes a value judgment.

Instead of first making a prediction and testing it and then making a value
judgement to decide whether to use price controls, government
policymakers could make a value judgment directly. The value judgment
could be based on the belief that “because people should have prepared for
the drought, the government should not try to help them by keeping food
prices low.” Alternatively, the judgment could be based on the view that
“people should be protected against price gouging during a drought, so the
government should use price controls.”

These two statements are not scientific predictions. Each is a value

judgment or normative statement: a conclusion as to whether something
is good or bad. A normative statement cannot be tested because a value
judgment cannot be refuted by evidence. It is a prescription rather than a
prediction. A normative statement concerns what somebody believes
should happen; a positive statement concerns what will happen.

Although a normative conclusion can be drawn without first conducting a

positive analysis, a policy debate will be more informed if positive analyses
are conducted first. Suppose your normative belief is that the government
should help the poor. Should you vote for a candidate who advocates a
higher minimum wage (a law that requires firms to pay wages at or above a
specified level); a European-style welfare system (guaranteeing health
care, housing, and other basic goods and services); an end to our cur- rent
welfare system; a negative income tax (in which the less income a person
has, the more the government gives that person); or job training programs?
Positive economic analysis can be used to predict whether these programs
will benefit poor people but not whether these programs are good or bad.
Using these predictions and your value judgment, you decide for whom to
vote.

Economists’ emphasis on positive analysis has implications for what they

study and even their use of language. For example, many economists stress
that they study people’s wants rather than their needs. Although people
need certain minimum levels of food, shelter, and clothing to survive, most
people in developed economies have enough money to buy goods well in
excess of the minimum levels necessary to maintain life. Consequently,
calling something a “need” in a wealthy country is often a value judgment.
You almost certainly have been told by some elder that “you need a college
education.” That person was probably making a value judgment—“you
should go to college”—rather than a scientific prediction that you will suffer
terrible economic deprivation if you do not go to college. We can’t test such
value judgments, but we can test a hypothesis such as “One-third of the
college-age population wants to go to college at current prices.”

Some economists draw the normative conclusion that, as social scientists,

we economists should restrict ourselves to positive analyses. Others argue
that we shouldn’t give up our right to make value judgments just like the
next person (who happens to be biased, prejudiced, and pigheaded, unlike
us).

Because microeconomic models explain why economic decisions are made

and allow us to make predictions, they can be very useful for individuals,
governments, and firms in making decisions. Throughout this book, we
consider examples of how microeconomics aids in actual decision making.
Here we briefly look at some uses by individuals and governments.

Individuals use microeconomics to make purchasing and other decisions.

For example, we examine how inflation and adjustments for inflation affect
individuals. I How to invest in stocks, bonds, and other financial
instruments, and whether to buy insurance is covered. Individuals have to
decide whether a used car is a lemon or worth buying. Whether potential
employers regard your college degree as proof of your abilities depends on
the fraction of people who have advanced degrees and whether education
provides useful training. Whether you should hire a lawyer by the hour or
offer the lawyer a percentage of any winnings depends on the type of case.
Whether you should accept deferred payments can also be analyzed using
economics. Another use of microeconomics is to help citizens make voting
decisions on the basis of candidates’ views on economic issues.

Your government’s elected and appointed officials use (or could use)
economic models in many ways. Recent administrations have placed
increased emphasis on economic analysis. Today, economic and
environmental impact studies are required before many projects can
commence. The President’s Council of Economic Advisers and other federal
economists analyze and advise national government agencies on the likely
economic effects of all major policies.

Indeed, a major use of microeconomic models by governments is to predict

the probable impact of a policy.

Decisions by firms reflect microeconomic analysis. Firms price discriminate

or bundle goods to increase their profits. How American and United
Airlines compete on the Chicago-Los Angeles route is predictable using
economic analysis. Indeed, many strategic decisions concerning pricing,
setting quantities, advertising, or entry into a market are based on game
theory. When the phone company should replace telephone poles or a
mining company should extract depends on interest rates. Firms decide
whether to offer employees deferred payments to ensure hard work.

Assessment/Activities:

1. In your own opinion, how will you properly allocate the limited
resources that we have.

2. Why do people make trade-offs? Explain!

3. Are Microeconomics models important? Why? Why not? And give the

uses of these microeconomic models.