Econ 300

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Econ 300 Intermediate Microeconomics University
of Illinois at Urbana Champaign Giovanni
Facchini Lecture 1 Analyzing Economic
Problems
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Outline
1. Defining Microeconomics
2. Who Should Study Microeconomics?

• 3. Microeconomic Modeling
• Elements of models
• Solving the models

4. The Limits of Microeconomic Analysis
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Defining Microeconomics
Microeconomics is the study of how individual
decision-makers such as consumers, workers, firms
or managers make themselves as well off as
possible in a world of scarcity. This study
involves both the behavior of these economic
agents on their own and their interaction in
larger units such as markets.
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Who Should Study Microeconomics?
Example The Railroad Industry in the US
74.9 of all freight, 1929 39.8 of all
freight, 1970 1970s poor profits,
bankruptcies, inability to invest 1980s
loosened regulation and union rules
improved profitability
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• Answer to this question
• Policy Makers
• Managers
• Union Leaders
• Lendersand beyond!

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Microeconomic Modeling

• 1. Models are simplificationslike maps
• Resemble reality
• Understandable
• Appropriate scale
• Allow to make predictions (e.g. government,
  private firms)

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Example World-wide market for unprocessed
coffee beans, December, 1997
Price per pound
Supply (P,W)
Quantity, pounds
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Example World-wide market for unprocessed
coffee beans, December, 1997
Price per pound
Supply (P,W)
Demand (P,I)
Quantity, pounds
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• 2. Elements of Models
• Specifying the Choices/Alternatives

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The Objective Function

• Definition The Objective Function
• specifies what the agent cares about
• Example Does manager care about raising profits
  or increasing power?
• Note The opportunity cost depends on how the
  objective function is specified

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The Constraint(s)

• Definition Whatever limits is placed on
• the resources available to the agent
• Example Our managers budget is 100
• Agents behavior can be modeled as optimizing the
  objective function, subject to his various
  constraints.

Constrained Optimization
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Example Managers Investment Choice Facilities
( F ) N budget/30 RD ( R ) N
budget/100 Max N (F,R) subject to budget lt
100 where N is the number of workers
Facilities workers cost 30 (per
unit time) RD workers cost 100 (per
unit time)
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Example Consumer purchases Food (F),
Clothing ( C ), Income (I) Price of food
(pf), price of clothing (pc) Satisfaction
from purchases S (FC)1/2 Max S
(F,C) subject to pfF pcC lt I Note "as if
modeling"
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F
Example Consumer Purchases
PFF PCC I
0
C
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F
Example Consumer Purchases
PFF PCC I
(FC)1/2 S0
0
C
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F
Example Consumer Purchases
PFF PCC I
(FC)1/2 S1
(FC)1/2 S0
0
C
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F
Example Consumer Purchases
PFF PCC I
S2 gt S1 gt S0
(FC)1/2 S2
(FC)1/2 S1
(FC)1/2 S0
0
C
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Exogenous and Endogenous Variables

• Definition Variables that have values that are
  taken as given in the analysis are exogenous
  variables. Variables that have values that are
  determined as a result of the workings of the
  model are endogenous variables.

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Example How would a manager hire the most
possible workers on a budget of 100?
vs. How would a manager minimize
the cost of hiring three workers? How
much food and clothing should the consumer
purchase in order to maximize satisfaction on a
budget of I? vs. What
is the minimum level of expenditure that the
consumer must undertake in order to be able to
survive?
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3. Solving the Models
Definition Equilibrium analysis is an analysis
of a system in a state that will continue
indefinitely as long as the exogenous factors
remain unchanged.
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Price per pound
Example The Market for Coffee Beans
Supply (P,W)
Q
Quantity, pounds
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Price per pound
Example The Market for Coffee Beans
Supply (P,W)

Demand (P,I)
Q
Quantity, pounds
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Price per pound
Example The Market for Coffee Beans
Supply (P,W)

P
Demand (P,I)
Q
Quantity, pounds
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Equilibrium is defined as the point where demand
just equals supply in this market (i.e., the
point where the demand and supply curves cross)
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Definition analysis compares the
equilibrium state of a system before a change in
the exogenous variables to the equilibrium state
after the change.
A comparative statics
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Example Coffee Beans, revisited
Price per pound
Supply (P,W)

Quantity, pounds
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Example Coffee Beans, revisited
Price per pound
Supply (P,W)

Demand (P,I)
Quantity, pounds
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Example Coffee Beans, revisited
Price per pound
Supply (P,W)
New Supply (P,W)


Demand (P,I)
Quantity, pounds
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Example Coffee Beans, revisited
Price per pound
Supply (P,W)
New Supply (P,W)

P

P
Demand (P,I)
Quantity, pounds
Q
Q
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Example Consumer choice, revisited
F
PFF PCC I0
0
C
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Example Consumer choice, revisited
F
PFF PCC I0
(FC)1/2 S0

0
C C
C
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Example Consumer choice, revisited
F
PFF PCC I0
(FC)1/2 S0


PFF PCC I1
0
C
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Example Consumer choice, revisited
F
PFF PCC I0
(FC)1/2 S0


(FC)1/2 S1
PFF PCC I1
0
C
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F
Example Consumer choice, revisited
PFF PCC I0
S0 gt S1
I0 gt I1
(FC)1/2 S0

F

F
(FC)1/2 S1
PFF PCC I1
0
C C
C
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Definition of a
change in the exogenous variable is the
incremental impact of the last unit of the
exogenous variable on the endogenous variable.
The marginal impact
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Budget 1m to allocate between TV ( T ) and
radio ( R ) Problem Max B(T,R)
(T,R) subject to T R lt
1m where B is "barrels"
Example Advertising Spots
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The Limits of Microeconomic Analysis
Definition can explain what has
happened due to an economic policy or it can
predict what might happen due to an economic
policy. Definition is an analysis of what
should be done
Positive analysis
Normative analysis
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Example Should we increase income equality
rather than focus on economic efficiency? Exampl
e Should we impose a progressive income tax or
a sales tax to increase income equality? Example
Will a progressive income tax reduce aggregate
hours worked?
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• 1. We have reviewed the basic elements of
• Microeconomic modeling.
• 2. The rest of the course will provide
• examples of such models
• 3. The rest of the course will also deepen
• many of the concepts we have discussed today
  (such as opportunity cost)
• 4. Finally, where possible, we will study
• back of the envelope techniques to make the
  concepts operational.

Summary