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Welcome to Session 1 of ECO201, in this session deals with:

• Defining Microeconomics and macroeconomics• Briefly outlining the key themes of microeconomics• Explaining what is a market• Explaining the difference between real and nominal prices• Briefly explaining the theoretical and practical importance of microeconomics.

Every society must allocate its scarce resources among alternative uses to solve the economic problems of production, distribution and growth.

Thus economics has been frequently defined as the study of the allocation of scarce resources among competing ends.

Since the mid 1930’s the subject matter of economics has been divided into two subfields – macroeconomics and microeconomics.

Macroeconomics which is the child of the Great Depression of the 1930’s is primarily concerned with the study of fluctuations in the levels of employment, aggregate income, and the general price level, and the ways to prevent such fluctuations.

Microeconomics, deals primarily with the determination of relative prices and allocation of resources among competing ends under full-employment conditions. Microeconomics deals with the study of the manner in which consumers allocate their limited income among various goods and services, the ways in which business firms seek desired prices and output rates, the procedures by which business firms hire their resources and provide income to various resource owners, and the way in which activities of consumers, producers and resource owners fit together to solve the economic problems.

In a sense, it is unfortunate that economics is somewhat arbitrarily subdivided into macro and microeconomics. After all, students of economics must learn both branches of economics well, because it is not possible to understand many economic problems without the knowledge of both branches of economics.

For instance one cannot study the problems of inflation and unemployment, without examining such macro and micro issues as aggregate levels of expenditures, pricing practices of large corporations, and behaviour of labour unions.

Clearly, micro and macroeconomics complement each other.

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The key problem is trying to reconcile the conflict between virtually limitless desire or demand for goods and services and the scarcity of resources available to produce these goods and services.

Microeconomics deals with limited resources, such as income, time and production techniques, and how best to employ the scarce resources to produce the goods and services that society demands.

Consumers are constrained or limited by their income and by the prices of goods of services.

A consumer has a given amount of income to spend and he or she has to decide how best to spend the limited income among the goods and services so as to maximise utility or satisfaction.

The consumer theory, the subject matter of later sessions, attempts to explain how consumers maximise their utility or satisfaction, and the approaches consumers adopt to achieve their objective.

We will also see how consumers decide how much of their incomes to save, thereby trading off current consumption for future consumption.

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Workers also face constraints and make trade offs. First, people must decide whether an when to enter the workforce. Because the kinds of jobs, and pay scales available to a worker depend in part on educational attainment and skills, one must trade off working now for continued education.

Workers also face trade offs in their choice of employment and also the amount of hours they wish to work.

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A firm is an institution that hires productive resources and organises those resources to produce and sell goods and services.

Australia has more than 2 million firms that differ in size and in the scope of what they do. But they all perform the same basic economic functions.

A firm’s fundamental goal is to maximise profit. A firm that does not maximise profit will eventually go out of business or be bought by another firm.

Just like the consumer, a firm also faces constraints. The constraints faced by a firm are financial, technology and market.

Given the limited resources the firm has to decide how to utilise its limited resources so as to minimise cost and maximise profit. The theory of the firm, a subject matter of later sessions describes how firms utilise their resources, make trade offs, and maximise profit.

One of the important themes of microeconomics is the role of prices. All of the trade offs described so far are based on the prices faced by consumers, workers or firms. For example, a consumer trades off beef for chicken based partly on his or her preferences for each one, but also on their prices.

A firm decides whether to hire more labour (workers) or purchase more capital equipment (machines) based in part on wage rates and price of capital.

Every economy, be it the market economy or centrally planned economy, faces a problem of scarcity that requires the economic system to organise some mechanism by which choices can be made.

A centrally planned economy is characterised by public ownership of the means of production and distribution. In a centrally planned economy, prices are set by the government or by a central authority.

Market economy is an economic system in which each individual in his capacity as a consumer, producer and resource owner is engaged in economic activity with a large measure of economic freedom.

Individual economic actions conform to the existing legal and institutional framework of the society which is governed by the institution of private property, profit motive, freedom of enterprise, and consumer’s sovereignty. All factors of production are privately owned and managed by individuals

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Economics is a science which like any other science depends on an organised body of theoretical knowledge. Economic theory provides us with the tools of economic analysis and helps in interpreting and explaining economic phenomena of the real world.

By the process of abstraction, it chooses relevant facts, classifies and interprets them in the light of the previous or existing knowledge, establishes casual relationships among different variables in order to establish the validity of an economic problem.

For instance, to find out the causes of unemployment, data or facts are collected, enumerated, analysed and classified. Then they are interpreted in the light of our knowledge of the nature of unemployment. Ultimately, a relationship is established among the probable factors responsible for unemployment in order to arrive at the causes.

In economics, a model is a theoretical construct that represents economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is simplified framework designed to illustrate complex processes, often but not always using mathematical techniques. Economic models can be described with words, numerical tables, graphs and algebra.

Thus models do not describe the true economic world since by nature they are constructed as abstractions from the ‘truth’. However, abstraction does not imply unrealism, but a simplification of reality. It is the beginning of understanding a great complexity of the real economic world.

Economic theory aims at the construction of models which describe the economic behaviour of individual units (consumers, firms, government agencies) and their interactions which create the economic system of a region or a country.

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There are two main purposes for which a model is constructed – analysis and prediction. Analysis implies the explanation of the behaviour of economic units, consumers and producers.

From the assumptions we derive certain ‘laws’ which describe and explain with an adequate degree of generality the behaviour consumers and producers.

Prediction implies the possibility of forecasting the effects of changes in some magnitudes in the economy. For example, a model of supply might be used to predict the effects of imposition of a tax on the sales of firms.

The validity of a model may be judged on several criteria. Its predictive power, the consistency and realism of its assumptions, the extent of information it provides, its generality (that is, the range of cases to which it applies) and its simplicity.

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Microeconomics is concerned with both positive and normative questions.

Positive economics is concerned with explaining what is, that is, it describes theories and laws to explain to explain observed economic phenomena. It strives to formulate economic models with explanatory and predictive value. At least in principle, it is devoid of value or ethical judgement; that is , it describes and relates observable facts without saying whether they are good or bad. Positive statements can be proved either true of false.

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Normative economics is concerned with what should be or what ought to be. Normative economics is an analysis based on value judgements.

Normative statements express an individual or collective opinion on a subject that cannot be proved by facts to be true or false. Normative analysis is important for managers of firms and those making public policy. Normative analysis is valuable when considering a new tax on petrol, the size of the tax and whether the tax is in the public interest.

The objective of positive science is the establishment of uniformities; of a normative science the determination of the ideals.

There is increasing opinion among economists that economics cannot be disassociated from ethics and therefore, economics can be looked upon as both a positive and normative science.

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In economics, markets are a central focus of analysis, so economists try to be clear as possible about what they mean when they refer to a market.

A market is any arrangement that enables buyers and sellers to get information and to do business with each other.

A market may be a town square where people go to trade food and clothing. Another example is the world oil market which, is not a place. It is the network of oil producers, oil users, wholesalers and brokers who buy and sell oil.

Markets have evolved because they facilitate trade. Without organised markets, we would miss out on a substantial part of the potential gains from trade.

But markets can work only when property rights exist and when money is used as a medium for transaction.

Property rights is the social arrangements that govern the ownership, use and disposal of anything that people value.

Property includes real property (land, buildings and durable goods); financial property (stocks and bonds, and money in the bank) and intellectual property (books, music, computer programmes and inventions).

In summary, markets can be classified:a) On the basis of area as local, national and world markets.b) On the basis of time, as market price on any particular day, short period price, long

period price or secular markets covering a generation; andc) On the basis of nature of competition – perfects market and imperfect markets.

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Economists are often concerned with market definition – that is which buyers and sellers should be included in a particular market. When defining a market, potential interactions of buyers and sellers can be just as important as actual ones.

Significant differences in the price of a commodity create a potential for arbitrage: buying at a low price in one location and selling at a higher price in another location. The possibility of arbitrage prevents prices of commodities from differing significantly and creates a world market for commodities.

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Markets are at the centre of economic activity and many of the most interesting issues in economics concern the functioning of markets. For example, why do only a few firms compete with one another in some markets, while in others a great many firms compete? Are consumers necessarily better off if there are many firms? If so, should the government intervene in markets with only a few firms? These questions and many others will be discussed in later sessions.

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The types of markets depends on the degree of competition prevailing in the market.

Broadly speaking, there are two types of market: perfectly competitive markets and non-competitive markets (imperfect competition).

A market is said to be perfect when all the numerous potential sellers and buyers are promptly aware of the prices at which transactions take place and all the offers made by other sellers and buyers and when any buyer can purchase from any seller and conversely.

Under such a condition the price of a commodity will tend to be the same all over the market. Also no individual buyer or seller can influence the price.

Thus the prevalence of the same price for the same commodity at the same time is the essential characteristic of a perfect market.

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Most real-world markets are competitive, but firms possess some market power to set their prices. Markets in which competing firms have power to set their prices are called imperfect markets. Non-competitive markets can take many forms (such as cartels, dominant firm, price leadership) and where individual producers can influence the price.

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Markets make possible transactions between buyers and sellers. Quantities of a good are sold at specific prices. In a perfectly competitive market a single price – will the market price – will usually prevail (price of gold in Sydney). In markets that are not perfectly competitive, different firms might charge different prices for the same product. This might happen for many reason, but as an example, a firm trying to win customers from its competitors.

The market prices of most goods will fluctuate over time, and for many goods the fluctuations can be rapid. The stock market, for example, is highly competitive because there are many buyers and seller for any one stock.

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As we saw, market definition identifies which buyers and sellers should be included in a given market. However, to determine which buyers and sellers to include, we must first determine the extent of a market – its boundaries, both geographically and in terms of the range of products to be included in it.

Market definition is important for two reasons.

• A company must understand who its actual and potential competitors are for the various products that it sells or might sell in the future.

• It is important for public policy decisions. Should the government allow a merger or acquisition involving companies that produce similar products or should it challenge it?

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We often want to compare the price of a good today with what it was in the pass or is likely to be in the future. To make such a comparison meaningful, we need to measure prices relative to an overall price level. This means measuring prices in real rather than nominal terms.

The nominal price of a good (sometimes called its ‘current dollar’ price) is its absolute price. The real price of a good (expressed in constant dollars) is the price relative to an aggregate measure of prices. In other words, it is the price adjusted for inflation.

The term ‘real price’ tends to be used to make comparisons of one good to a group or bundle of other goods across different time periods, such as one year to the next.

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The Consumer Price Index (CPI) is compiled and published on a quarterly basis by the Australian Bureau of Statistics (ABS).

The CPI is a measure of changes over time, in retail prices of a constant basket of goods and services representative of consumption expenditure by resident households in Australian metropolitan areas. The simplest way of thinking about the CPI is to imagine a basket of goods and services comprising items typically acquired by Australian households. As prices vary, the total price of this basket will also vary. The CPI is simply a measure of the changes in the price (excluding changes in quality or quantity of goods and services) of this basket as the prices of items in it change.

The CPI is an important economic indicator for many years and actions related to movements in it have had direct or indirect effects on all Australians. It now provides a general measure of price inflation for the household sector as a whole and is used by the Reserve Bank of Australia (RBA) as the official measure of inflation for evaluating monetary policy.

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The above equation shows how the real price is calculated using the CPI. Students should refer to the next 3 slides (example 1.3) to see how the real price is calculated and also example 1.4 in your text.

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Microeconomics occupies a vital place in economics and it has both theoretical and practical importance. It is highly helpful in the formulation of economic policies that will promote the welfare of the people.

Microeconomic theory has many uses, the greatest of these is depth in understanding of how a free enterprise economy operates. Further, it tells us how the goods and services are produces are distributed among the various people for consumption, through price or market mechanism.

The importance of microeconomics is readily demonstrated by the following list of economic issues, for the solution of which the tools of microeconomics is indispensable: pollution control, equal pay for equal work, income versus excise tax, monopoly versus competition, minimum wage, energy crisis, wage and price control. This list is by no means exhaustive.