Microeconomics

a brief introduction:

Microeconomics is one of the 2 branches of economics (or political economy) whose object is to study

economic systems = the way by which for ex. a country organizes its production, consumption and

distribution of goods, basically the way by which we live.

We live in a market economy = the main element that characterize our economy is what we call the market.

There are other types of economic systems that used to exist, for example a centralized economy in what

was the Soviet Union.

Of course, there is more than the market in an economic system, and sometimes this has problems, it may



not be efficient or not be functioning as well as it should we have to possibilities of intervention.

We said that economics has two branches:

- Microeconomics – related to the individual agents that are in the economy, so the individual decision

made inside of the economy, for ex. a firm deciding what to produce or how much to produce, or a

household deciding how much to spend, an individual deciding how much to consume or how much

to save –> we relate to the process by which any individual unit will take a decision.

- Macroeconomics – related to the study of large/big economic aggregates = we are talking about the

economic system as a whole, ex. The government’s expenditure, inflation, employment, GDP, rates

of growth of the economy, how to spend a recovery fund etc.

So, we need to talk about individual units and how they make choices, choices are based on some import

elements:

• scarcity

• opportunity cost

• trade-offs

• marginal analysis

We also have to take into consideration that while we have single individual taking choices, we also have the

interaction between them, therefore choices are not made by an individual only for itself, but they are related

to the fact that we have interaction between individuals, for ex. a firm will produce goods that will then be

purchased by consumers (= interaction between producers and consumers).

So, when we talk about the exchange, meaning the possibility of trading goods and services, we can see that

this brings to benefits = it is good to have an exchange

We will talk about the existence of an equilibrium –> the market equilibrium

we also have to consider what is the relation between what we call efficiency and what we called equity

Representation of the market Important because it means that everything that will be

Q = quantity put inside the graph will connect quantity and price

P = price

D = demand –> result of decision made by individual consumers,

people need to buy something

S = supply –> result of the decision

made by producers or producing

units

In this case there are 2 different interests, the one in producing (by the firms) and the one in buying (by

consumers) –> there is an interaction which is beneficial because what is produced by the firms will be

1

purchased by the consumers and in the end, we look at an equilibrium, we want both sides to be in

equilibrium with each other.

Individual choice: a decision of a single decision unit (a consumers, a household, a firm, etc.) on what to do

(ex. what to buy in order to consume etc.)

The basic principles on choices are:

1. Scarcity –> resources are scarce (resources are everything that can be used to produce something

else) = when we look at the possibilities that an individual has in choosing, we will see that there are

some limits in the range of choices, we can’t do whatever we like, there are limits because, for what

regard economy, things are not unlimited ex. there are not enough money to buy everything / not

enough raw material to produce everything

2. Real cost of something –> opportunity cost = important to understand that we are talking about real

cost which is different from monetary cost. Opportunity cost must be expressed in things that you

have to give up in order to do something, it is the value associated with what you can’t do because

you are doing something else ex. real cost of going to class is the value associated with the things we

are losing to go to class like sleep. Every time you do something you are giving up something else.

3. How much to produce, how much to consume –> what is the level of our choice, when we decide

what to do we’ll see that the decision is taken in the margin = marginal analysis => every time we

take a decision we are talking about the fact that we want to buy one unit more or less, it is not

important what you have done up until that point but it is important whether you decide to increase

or decrease your consumption, ex. you have decided to consume 30 apples, the marginal decision

would be to decide if you want to consume an additional one or one less. This approach it typical

neoclassical approach to economics.

4. People will use any possible opportunity to improve their condition –> the idea is that when people

are trying to decide what to do, they are trying to get the best out of their decision

Interaction: how economy works

Individuals take decision but they also interact with each other –> this will imply that there is a sort of

mutual influence (ex. producers take decision on producing, consumers will take decision on consuming and

they then interact because we consume what they produce)

The possibility of exchange and interaction between individuals is called mutual influence.

The basic principles related to this idea are:

5. Exchange between individuals produces benefits –> taking the same example again (producers and

consumers) if we exchange goods and services with different sectors and markets we can do better

than if we just decide on our own, basically if we leave it to other people to produce goods and

services or at least some and then we just buy them afterwards we’ll be better off than if we tried to

do everything by ourself = self-sufficiency non very good but interaction among people is beneficial,

produces benefits – this will lead to the fact that in economy there are people that specialize in doing

something and others in doing something else, not everybody does everything.

6. Markets and the economy tend to be in equilibrium (= situation in which no one has an incentive to

move away from that situation, there is no opportunity for anybody to change, decide to do

something else, there is no opportunity to be exploited, in this situation there is no way to move away

from it without making some people worse off). Everything that happens in the equilibrium will

bring a new equilibrium, it is not forever but it depends on external/other condition

7. Resources should be used in the most efficient way –> we want to use resources and take decision

that are efficient, this concept is quite objective, there are elements that are able to tell us that we are

2 doing something efficiently but the idea is that it is the market system that is giving the right signal

to people to behave efficiently ex. let’s take the market price, if this is increasing the signal that it is

given is that there is some sort of scarcity of something = price goes up. The price increases because

you are trying to find the person that will pay the highest price for that specific good

8. Markets are important but efficiency is not everything, we also have to talk about equity, is the

economic system doing things in the right way? Concept of equity is subjective = different people

have different concepts of fairness therefore to put together efficiency and equity it’s not realistic

because there is not one single solution but it depends on our concept of equity, ex. if we have a

disabled parking slot in a very congested area some may thing this is fair because it allows people

with disabilities to find a parking spot and it makes it easier for them to reach the destination, on the

contrary others could argue that this is not fair because in a moment when there are no disabled

people coming to the place that is a waste of parking spots because they will stay empty.

9. Markets can be very efficient and usually are but not always, when they are not = market failure –>

there is something that the market is not able to do, this happens for ex. when people are only

looking at their benefits and not the bigger picture an ex. is pollution, there is the need of an

intervention, you need the law to say that you can’t pollute or there is no way of reducing it. There

are a lot of situation in which we have market failure in this case addressing the market equilibrium

can be good, in order to fix the problem ex. sugar tax on coca cola, no sense in an economic point of

view because there would be a distortion on the market working but from other point of views it may

be justified by other objectives

Consumer theory

talking about decisions made by consumers, meaning decision about how much to

consume

consumer theory = to study how much will the consumer decide to consume, it is the

basis of the construction of the definition of market demand.

each consumer will have its own individual demands, if we put them all together we

get the market demand

we will consider choices by taking into account 3 elements

1) EACH CONSUMER will have “CONSTRAINTS” –> to limit the possibility of

choice

2) CONSUMPTION of GOODS will five us “PLEASURE” –> I’ll buy my 10 Ferrari

th

because I want one more

3) a RULE of CHOICE –> how to decide what to do = choosing what gives us

more pleasure

1- CONTRAINTS

• object of choice of consumer = consumption bundle = group of goods

(tangible)/services (non) x

n goods = = quantity of each

i

good ( )

x , x , … , x

1 2 n

Supposing n=2 ( ) )

A 2,3 ≡(x , x

The consumption bundle –> there are 2 units of

1 2

good 1 and 3 units of good 2

3 ( ) )

B 4,1 ≡( x , x –> there are 4 units of good 1

1 2

and 1 unit of good 2

We only use this quadrant because we have

positive numbers Any combination of numbers (point) is a

consumption bundle

Which one is better? A or B? To decide I use a constraint

– 1 is the amount of money I have = budget –>

st m

(P )

, P , … , P

– 2 is the prices of the goods I want –>

nd 1 2 n

P x

If combined, we have the expenditure –> = expenditure on

1 1

x 1 P x x

= expenditure on

2 2 2

+

P x P x x x

= total expenditure on and

1 1 2 2 1 2

the expenditure can’t exceed = we can’t spend more than

m

that we have

any bundle that respects this quality will be a possibility, those that

¿

are won’t

m Bundle A is

( )+(3∗5)

tot.expenditure –

( ) ( ) 8∗2

A x ; x ≡ 2; 3

1 2 AFFORDABLE

> ( ) ( )

+

16 15

( ) ( )

P ; P ≡ 8; 5

1 2 31 < 50

31

m=50 ( )+(5∗6)

tot.expenditure – 8∗2 Bundle C is NOT

( ) ( )

C x ; x ≡ 5 ; 6

1 2 > ( )+ ( )

40 30 AFFORDABLE

( ) ( )

P ; P ≡ 8; 5 70

1 2 70 > 50

m=50

There needs to be a distinction between affordable and non-affordable bundles –

> the infinity of possible bundles can be divides into

affordable and non

+

P x P x ≤ m

Affordable bundle Not affordable bundle

1 1 2 2

+ >m

P x P x

1 1 2 2

The set of all affordable bundles is called CONSUMPTION CHOICE SET = set of all

bundles x so that the expenditure is not greater

than the

budget

The idea behind the consumer theory is that consumers/individuals can’t do anything

about prices (they are set, given by somebody else) or about the income

4 {x / + }

P x P x ≤ m

We want to represent the consumption choice set ≡ 1 1 2 2

To do this we use the budget line = limit of consumption set –> it allows us to divide

affordable and non affordable bundles + =m

P x P x

introduces just affordable bundles –> 1 1 2 2

x

by explicating I’m able to find the equation for the

2

budget line =m−P

P x x

2 2 1 1 remember in the

P

m 1

= −

x x equation of a line

2 1

P P

2 2 y=a+bx

= the intercept

a = slope

b

the intercept = point in which the line intercepts the y axes

meaning = the quantity of good 2 that I can buy if I only

buy that good ( )

m

0 ;

the coordinates will be –> this would be a just

P 2

affordable bundle point in which the line intercepts the x axes

it has the same meaning = the quantity of good 1 that I

can buy if I only buy that good

( )

m ; 0

the coordinates will be –> this would be a just

P 1

affordable bundle

these two are extreme consumption bundles and if we connect them, we

get the budget line –– is the budget line

bundle A is affordable

bundle B is just affordable

bundle C is not affordable

the CONSUMPTION CHOICE SET is the area below the

budget line

the slope = it’s a downward line = there is an inverse relation

x x

between and

1 2 if you want to buy more of good 2 you are going to have to

buy less of good 1 the ratio between them is important

5 it’s the derivative

suppose we want to increase the consumption of good 1

by 1 unit, we would have to give up some quantity of good 2, in order

to be able to x

afford 1 more unit of I need $8, where do I find

1

them? I give up 1 unit of good 2 I get $5 (not enough) –> I have to give up

more. I have to 8

x

give up the opportunity cost of which is

1 5

The opportunity cost of good 2 in terms of units of good

5

1 is 8

Comparative statics

We are going to consider what is going to change if any of the given variables

changes –> exogenous variables

(income and

'

P , P , m P , P , m

1 2

budget) 1 2

8, 5, 50 8,5,60

change in income –> increasing the

––––––––>

income is good for ' >

m m us but how does it affect

the budget line?

−P

1 situation

st 1 x

• same slope

P 1

m P

budget line –>

1

= −

x x 2

2 1

P P m

2 2 • different intercept: 1 = /

st

2 situation

nd P 2

was not affordable before it is

now this means that the budget line will move

in a parallel way, having the same slope

but moving the budget line means that

the opportunity cost between the goods

is NOT changing but the is an expansion

of the possibilities

more money = more choice

• consumption choice set 1 and 2

st nd

' '

• if income decreases = fewer

<m

m

choices

change in price –> there are various possibilities

P , P , m

1 2

'

P , P , m

1 2

6 8, 5, 50 10,5,50

––––––––>

'

<

P P

1 1

1. one price changes this is bad for us

1 situation

st m

• same intercept: –

P

m P

budget line –>

1

= −

x x 2

2 1

P P −P

2 2 1

• different slope: 1 = / 2

st nd

2 situation

nd P 2

'

−P 1

= P 2

could afford before can’t this means that things that we could

anymore afford before are now not affordable –>

this is the area called REDUCTION OF

PURCHASING POWER

• the consumer choice set decreases

''

• if price decreases = more

<

P P

1 1

choices

Why do prices and income change?

–> one example could be taxes – they are a clear instrument by which we

can change the price

there are two types of taxes:

1) quantity tax (specific tax) –> it is a fixed amount of money charged on

the price, it depends in the n° of units, it is called fixed

because the amount of tax per unit is fixed. ex. plastic or

sugar tax 0.10€/kg

sugar tax is 10% if the price is 5€ the tax would be 5€ * 0.10 =

0.50 €/kg if the price changes 6€ tax would be 6€ * 0.10

= 0.60€/kg

the idea is that the price is given by price + tax –> tax will increase

the price meaning that the budget line will

rotate

2) ad-valorem tax –> it is a percentage on the price, an example is IVA

(imposta valore

aggiunto), in this case tax per unit is not a fixed amount,

only tax rate is.

if for example tax rate = = 25%



if the initial price is P by adding will have the new price of P



+ (*P)

7 = 25% = 0.25 P = 100 –> 100 + (100 * 0.25) = 100



(1 + 0,25)

The EFFECT of a UNIFORM TAX-RATE ()

suppose we introduce an ad-valorem tax and it’s affecting

everything –> NEGATIVE EFFECT

1+¿

P

m 1 ¿

= −

x x

before 2 1

P P

P , P , m 1+¿

before tax – after tax –

2 2

1 2

budget line ¿ ¿

P

¿

1+ 1

¿ ¿

1+

¿ P = when we change 2 prices

1

• same slope: –

¿

1+ with the same tax rate price

P

¿ 2

after = the ratio between the goods

−m

¿

P

• different intercept: 1 = / 2 =

st nd

2 does not change, as a

P

¿

P 2 consequence also the

1 ¿

P opportunity cost (p.2) stays

2 m What happens is that

the same.

=

x ¿ increasing both prices we

2 can afford less of both

goods

This is the same thing that happened when we had a change in

income –> increasing the prices, we reduce the choice of consumers

As a matter of fact, if we consider the new budget line

1+¿

¿

1+¿

¿ ¿

P 1

if we dived both sides per alpha, we see that

it reduces budget this is why

1+¿

¿ it has the same effect

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