Microeconomics Essay, Research Paper


Outline Thesis Statement: Microeconomic mechanisms can predict future technology impacted economic outcomes. I. What is Economics? A. What do economics tell us? B. The science of economics 1. defining microeconomics 2. some terms and definitions II. Using Microeconomic models A. Theory 1. practical application 2. household choices III. Economic Growth A. The cost of economic growth B. Capital accumulation C. Technological change IV. Individual and Market Demand A. Household Consumption Choices 1. Constraints 2. Preferences 3. Marginal utility a. an analogy 4. Utility maximization V. Predictions Based on Marginal Utility Theory A. Price increases B. Increases of income VI. In Conclusion This paper will attempt to examine microeconomic structures in relation to technological advances. The impact of increasingly available technology is a major economic force. Prior to 1975, for example, viewing a first run movie at home was technically possible but economically infeasible. Only the wealthy chose to view moves at home. VCR’s became available in 1976, with a typical price tag of $2000.00 Even at such a high price, that invention slashed the price of home viewing. Today a VCR can be purchased for $200.00, a fraction of its’ initial cost. Videos can be rented for approximately a dollar or purchased for around $20.00. Home viewing has become common in a few short years, where formerly it had been available only to the very rich. In what other ways has technology changed the way of life and can microeconomic mechanisms accurately predict future economic outcomes? What is Economics? The simple answer to the question, “What is the economy?” is to state that the economy is the means by which resources are allocated. A more accurate portrayal of economic process is to view it as a machine that produces three distinctly different results:  First, the economy determines what goods and services will be produced and in what quantities.  Secondly, it indicates how various goods and services will be produced.  Thirdly, it resolves the question of distribution. Markets for goods and services, and markets for production of those goods and services – command mechanisms –directly correlate with the choices made by households, firms and governments. The US economy relies mainly on markets but to a degree on command mechanisms. The US economy is an open economy and has become highly integrated with the global economy. This is a fairly recent development, with foreign investment into US business outstripping US investments in foreign enterprises shifting the balance in the mid-1980s. Economists study these financial movements in order to determine the underlying principles driving the economy. This approach utilizes the same rigor and objectivity of natural scientists. Economic science, like natural science, is an attempt to discover a body of laws. All sciences use the same criteria in the investigative process: careful and systematic observation and measurement, and the development of a body of theory to direct and interpret observations. That theory is a general rule or principle that allows economists to understand and predict the economic choices that people make. Theories are derived from building and testing economic models. Economic models are built on four key premises. These basic assumptions are:  People have preferences  People have a fixed amount of resources and a technology that can transform resources into goods and services.  People choose how to use resources and technology to increase economic well-being.  People’s choices are coordinated – buyers choose what sellers offer and vice versa. The implications of such models are that the values of various prices and quantities result in “equilibrium”. That is, situations in which everyone has made the best possible choices, given their own preferences, information, resources, and technologies, and that those choices are coordinated and compatible with the choices of everyone else. Equilibrium is the solution or outcome of an economic model. Economic models fall into two categories: Microeconomics and macroeconomics. Microeconomics is the branch of economics that studies the choices of individual households and firms. Because it analyzes the behavior of economic units, microeconomics is a most important social science. Microeconomics theory is used to analyze various circumstances and outcomes from decision making. In addition, microeconomics provides foundations for scientists of other social disciplines. Microeconomics is a highly useful tool in business management, aiding in planning, finance, and marketing. However, microeconomics is not limited to business applications. Government administration, political science, history, social- behavior, and much more can be viewed through the lens of microeconomics. What do microeconomics tell us? Careful analysis using microeconomic models answer those questions dealing with technological change, production and consumption, wages and earnings. Economic concerns involving unemployment, inflation, and the differences in wealth among nations are macroeconomic. A major cog in the microeconomic machinery is the concept of “scarcity”. This is easily summed up as the universal state in which wants exceed resources. Scarcity fuels “production”, the conversion of land, labor, and capital into goods and services. Services are made up of intangible commodities such as haircuts, phone calls and cab rides. Goods are tangible – cars, socks, VCRs, and bread. Goods are classified as either capital goods, i.e., those goods with long term use such as buildings cars, computers, etc., or consumption goods. Consumption goods are items that can be used one time only, such as pickles and toothpaste. Finite resources and the available technologies limit what can be produced in terms of goods and services. The boundary between what can and cannot be produced is referred to as the production possibility frontier (PPF). Using Microeconomic Models Understanding the PPF as applied to real life is critically important. To make that concept easier to grasp a model economy can be devised that, while simpler than real life situations, provides enough accurate information to draw viable conclusions and make feasible predictions. To build this model, features essential to understanding the real economy must be incorporated, but copious details are eliminated. The model will be simplified by establishing three important criteria: 1. Everything in this model that is produced is also consumed, stabilizing capital resources so that they neither grow nor shrink. 2. There are only two goods rice and cloth. 3. There is a single individual involved with this economy, “Joe”. Joe’s setting is a deserted island, with no outside contact. Joe uses all the resources available to him to produce rice and cloth. It requires Joe to labor 10 hours a day. The amount of cloth and rice produced relies on how many hours are devoted to the activity. producing them. If Joe does no work, nothing is produced. To produce six pounds of rice in a month, Joe must work two hours a day. Devoting more hours to rice increases monthly output, but the return rate diminishes as Joe has to use increasingly unsuitable land in that production. Initially, Joe plants in fertile wet land. As the best quality land is put into production, remaining available land becomes drier and less productive. Eventually, all workable land is used and time and effort must now be devoted to reconditioning other types of land. To produce cloth, Joe gathers wool from sheep on the island. As he devotes more hours to gathering wool and weaving fiber, cloth output increases. If Joe devotes all his time to raising rice, he can produce twenty pounds of corn a month. He cannot, however, produce any cloth. Conversely, if Joe devotes all of his time to making cloth, he can produce five yards a month but will have no time for the rice crop. He can vote some of his time to rice and some to cloth but not more than ten hours total. Thus he can spend two hours a day producing rice and eight hours producing cloth, or any combination of hours equaling ten hours. This clearly illustrates the production possibility frontier as a boundary identifying what is obtainable and what is not. Calculate Joe’s PPF by using the information in Table 1. These calculations are summarized in Figure 1 and graphed as Joe’s PPF. To understand these calculations, first examine the data found in Figure 1. Possibility A shows an entire working day devoted solely to rice production. In this case 20 pounds of rice per month is the forecasted yield, while no cloth is produced. Possibility B demonstrates two hours daily in cloth production and eight hours producing rice, yielding a total of eighteen pounds of rice and one yard of cloth monthly. The pattern continues onto F, showing an entire working day devoted to cloth production. The work day is defined as two hour blocks of time in Table 1, however, any feasible allocation of a day hour work day will ________________________________________________________________________demonstrate the potential various combinations of rice and cloth along the line joining points A, B, C, D, E, and F. in Figure 1. This indicates the Production Possibility Frontier. Production can be maintained at any point on or within the attainable frontier – the area discerned as yellow inside Figure 1. Points outside that frontier are unattainable. To produce at points beyond the frontier, there would have to be more time allotted to the working day. A ten hour work day allows for various combinations of rice and cloth production at the PPF. A work day less than ten hours will allow for production only at a point inside the frontier. Table 1 Production Possibilities Hours Worked Rice Grown Cloth Produced (per day) ( lbs. per month) (yards per month) 0 either 0 or 0 2 either 6 or 1 4 either 11 or 2 6 either 15 or 3 8 either 18 or 4 10 either 20 or 5 ______________________________________________________________________________________________ If Joe performs no labor no rice or cloth are produced. If Joe labors for 2 hours daily and devotes all that time on corn production he will produce 6 pounds of rice per month. If that same time is used for cloth production, 1 yard of cloth is produced but no rice. The last four rows of the table indicate the amount of rice or cloth that can be produced per month as more hours are devoted to those activities. ______________________________________________________________________________________________ _____________________________________ Production Possibility Frontier Figure 1 Rice 20 A in lbs. 18 B per month 16 C Unattainable 14 12 Z D 10 8 6 E Attainable 4 Production possibility 2 frontier F 0 1 2 3 4 5 6 7 8 9 Cloth in yards per month Rice Cloth in in lbs. yards per per Possibility month month A 20 and 0 B 18 and 1 C 15 and 2 D 11 and 3 E 6 and 4 F 0 and 5 The graph lists six points on Joe’s production possibility Frontier. Row E tells us that if Joe produces 6 pounds of rice, the maximum cloth production that’s possible is 4 yards. These same points are graphed as A, B, C, D, E, and F in the figure. The line passing through these points is the production possibility frontier, which separates the attainable from the unattainable. The attainable area contains all the possible production points. Joe can produce anywhere inside the area or on the production possibility frontier. Points outside the frontier are unattainable. Models such as these provide a structure for understanding how production works and aids in decision making by demonstrating what opportunities exist and what is required to take advantage of those opportunities. But having more of one means having less of another. This is referred to as opportunity cost. Opportunity cost is measured by evaluating the PPF. How much cloth has to be given up to get more rice and vice versa are the questions requiring answers using the rice and cloth model. If all allotted monthly working hours are used to grow rice, there are twenty pounds of rice but no cloth. How much rice is given up to produce one yard of cloth? Figure 1 shows that a single yard of cloth will cost two pounds of rice to produce. If an additional yard of cloth is produced, the progression from point B to point C indicates that it will cost three pounds of rice to produce the second yard of cloth. The next yard of cloth costs six pounds of corn. It has been learned from the model that the opportunity cost of cloth increases as more cloth is produced. This is also true in reverse. The first six pounds of rice costs one yard of cloth to produce. The next five pounds of rice costs an additional yard of cloth, and so on. The opportunity cost of rice also increases. Contributing to this phenomenon is the factor of inequality; not all scarce resources are equally useful in all activities. For example, while some of the land on Joe’s hypothetical island is extremely suitable for high yield rice crops, the remaining landscape may be rocky and barren. The sheep on the island, however, prefer rocky and barren land. Obviously, the optimum use of this island resource is to use the most fertile, wet land to grow rice and the most rocky and barren land to raise sheep. Only if a larger rice yield is desired will it be necessary to attempt to cultivate the less desirable land. If all allocated time is devoted to cultivating rice then it becomes necessary to use unsuitable low yielding land. Devoting some of the time to making cloth and reducing some of the time spent growing rice produces a small drop in crop yield but a large increase in the output of cloth. Conversely, if all allocated time is used to make Seal Straugh cloth, a small reduction in woolgathering leads to a large increase in rice production. What has been learned from the model provides fundamental lessons in real world economy. The world has a fixed number of people endowed with a given amount of limited time and human capital. These limited resources can be utilized, using the available but limited technology to produce goods and services. But there is a limit to the goods and services that can be produced, a boundary between what’s attainable and unattainable. For example, the political candidate who offers better education and human services must simultaneously be prepared to increase taxes or reduce services in another sector such as road maintenance or fire protection. On a much smaller but equally important scale, each time an individual rents a video, that same individual must determine where to expend remaining cash resource, be it popcorn, soft-drinks or something else entirely. The cost of one more video is one less of something else. It is impossible to escape from scarcity and opportunity costs. Given the limited resources available to any individual, the more of one thing always means less than another and the more of anyone service or product, the higher its opportunity cost. Economic Growth The PPF defines a clear boundary between what is and is not attainable. However, that boundary is not static. It is constantly changing. At times the PPF moves inward, reducing production possibility. Other times, it moves outward. Using the “Joe’s Island” analogy for example, excellent growing and harvesting conditions would have the effect of pushing the production possibility frontier outward. Expansion of production possibilities is termed economic growth. Over the last 100 years, the PPF has expanded exponentially. The question at hand for the new millennium appears to be how far can the economic envelope be pushed? The cost incurred in economic growth involves two key factors: capital accumulation, the growth of capital resources; and technological progress, new and better methods of producing goods and services. As a result of these factors in the nation’s current economic profile, there are an enormous quantity of trains, planes, and automobiles, producing far more available transportation than was experienced when only horses and buggies were available as transport. Satellites make transcontinental communications possible on a scale much larger than what could have been predicted using cable technology. However, accumulating capital and developing new technology are costly. Economic growth wears a cloak of trade-off. If all resources are devoted to the production of food, clothing, houses, entertainment, and other consumer goods, and none to research, development, and accumulating capital, there will be no more capital and no better technologies in the future than exist at present. Production possibilities in the future will be exactly as they are today. Future economic expansion requires that fewer goods are produced for future consumption. Resources that are freed up today allow for the accumulation of capital. In turn, better technologies for the production of consumption goods can be developed in the future. The cut in output of consumer goods today is the opportunity cost of economic growth. Household Consumer Choices Individuals determine what goods and services they will consume. The total quantity of those desired goods and services is called market demand. The relationship between the quantity of a good or service by a single individual and its price is called individual demand. Market demand is the sum of all individual demands. These demands are better understood by examining the mechanism used by households in making consumer choices. Consumption choices made by households are determined by two factors: constraints and preferences. Consumer choices made by any household are limited by that household’s income and the price of the desired goods or services purchased. Marginal utility theory assumes that a household has a given income to spend and that it has no influence on the prices of goods or services it purchases. A representation of this theory follows: House A has a monthly income of $100.00 and is constrained by that limit. House A spends its dollar resources on only two items – books and beverages. Books cost $6.00 each. Beverages cost .50 each or $3.00 a six pack. House A can purchase as many as ten six packs a month or five books a month. There are many other purchase combinations conceivable. Consumption possibilities can be visualized similar to the PPF, and the structure of Figure 1 is an excellent representation of such a consumption possibilities model. House A must decide how to divide the monthly income between books and beverages. The likes and dislikes of the members of that household drive those purchasing decision. This is referred to as preference. Marginal utility theory uses the highly abstract concept of utility to describe those preferences. The concept of utility can best be explained with an analogy. Take, for example, the concept of temperature. It’s easy to understand the difference between feeling hot and cold, but hot and cold are not something observable. Water turns into steam when hot enough or ice when cold enough and those are observable phenomena. In order to predict when such changes will occur an instrument can be constructed. Such an instrument is called a thermometer. The scale on the thermometer is the essence of temperature. The units used to measure that temperature are arbitrary. That is, the weight and value assigned to those units are subject to the judgment of the designer of the scale. An accurate prediction of water turning to ice can be made when a thermometer using a Celsius scale reaches 0. But the units of measure themselves are meaningless because this same events takes place when a Fahrenheit thermometer shows a temperature of 32. The concept of utility allows for predictions about consumption choices in much the same way. It must be pointed out, however, that marginal utility theory is not as accurate as the theory that allows us to predict when water will turn to ice. Total utility refers to the total benefit, or pay out, derived from the consumption of goods or services. The level of consumption determines the quantity of total utility. This concept can be illustrated by using the consumption possibilities of House A. Table 2 shows House A’s total utility from consuming different quantities of books and beverages. If no books are purchased in a month, there is no utility from books. If one book is purchased monthly 50 units of utility are assigned. Total Utility from Books and Beverages Table 2 Books Beverages___ Monthly Quantity Total Utility Monthly Quantity Total Utility 0 0 0 0 1 50 1 75 2 88 2 117 3 121 3 153 4 150 4 181 5 175 5 206 6 196 6 225 7 214 7 243 8 229 8 260 9 241 9 276 10 250 10 291 As the number of book purchases increase, total utility increases. If ten books are purchased 250 units of utility are awarded. The other part of the table shows the total utility of beverage consumption. As beverages are consumed total utility rises. Marginal utility is that change in total utility resulting from a one-unit increase in the quantity of consumed goods or services. When consumption of books moves from four to five monthly, total utility from books increases from 150 to 175 units. Thus, for House A marginal utility of procuring a fifth book each month is 25 units. Marginal utility appears midway between the quantities consumed. The change in consumption from four to five is what produces the marginal utility of 25 units. The more books House A purchases a month the more total utility it gets. However the marginal utility decreases, with each purchase. For example, marginal utility from the first book is 50 units. The second book has a marginal utility of 38 units and the third, 33 units. This decrease in marginal utility as the consumption of a good increases is the principle of diminishing marginal utility. Marginal utility is positive but diminishes as consumption increases. These two features come about in this way: The members of House A enjoy reading so benefit from the purchase of books. That casts marginal utility in a positive light. Marginal utility diminishes as more books are purchased due in part to opportunity cost and in part to lessening benefit. Those readers still enjoy a good book but the 30th is not quite as satisfying as the first. Utility maximization is the attainment of the greatest possible utility. A household’s income and the prices that it faces limit the utility that it can obtain. The model in Table 3 is used to examine the allocation of spending to establish the maximum total utility. Assume that Household A has $30.00 per month book and beverage budget. When House A consumes two books and six beverages a month it receives 313 units of total utility. This is the best that can be done within the Any other combination of books and beverages generates less than 313 units of total utility. In maximizing total utility, that is, allocating income to achieve the most total utility units, consumer equilibrium is created. Books and Beverages Utility-Maximization Combinations Table 3 ________________________________________________________________________ Books Total Utility from Beverages Quantity Total Utility Books & Beverages Total Utility Beverages 0 0 291 291 10 1 50 310 260 8 2 88 313 225 6 3 121 302 181 4 4 150 267 117 2 5 175 175 0 0 _____________________________________________________________________________________ Predictions Based on Marginal Utility Theory This information allows for economic prediction. This is relevant because income and prices are not stagnant. What happens to House A’s consumption of books and beverages when their prices and House A’s income changes? Determining the effect of a change in price on consumption involves three steps: 1 Determine the combinations that can be purchased at new prices. 2 Calculate the new marginal utilities per dollar spent. 3 Determine the maximum utility resulting in consumer equilibrium. This process demonstrates that if, for example, the price of books falls but beverages remain constant in pricing, House A will most likely increase consumption of books and indulge in fewer beverages. If house A does not adjust it’s consumer habits it losses consumer equilibrium. A rise in income, however, brings about an increase in consumer goods. Should House A increase it’s books and beverages budget to $42.00 consumer equilibrium is reached when seven books and seven beverages are purchased monthly. Marginal utility theory is used by economists to answer a wide range of questions. An example of this can be found in it’s application in determining the fluctuations in popularity between wooden and aluminum baseball bats. Another example is the ability of the theory to answer questions about patterns of consumer spending. But as well as explaining consumption choices, it can be used to explain all household choices. The allocation of time as well as capital can be decided using marginal utility theory. And it’s often been stated that time equates to money. In Conclusion What does all this mean to the modern consumer? There becomes a point for consumers when all resources, intangible capital such as time as well as tangible dollars, goods and services, has to be factored into the cost/benefit analysis of consumption and production. Making intelligent consumer choices requires a clear understanding of the opportunity cost and an applied strategy for maximizing total utility. When that takes place a window for technological advancement is opened. New technologies enable producers to eliminate some of those factors that drive up production costs and therefore prices. For example, the development of new technology for the manufacture of tape by companies such as 3M has lowered the cost of producing tapes and increased the available supply. Technology advances in the area of sticky products is now available and affordable to the masses. However, that technology has also made obsolete other goods and services. Tape sales may be up due to market demand created by new tape technology, but the market for library paste is drying up. Makers of library paste may or may not be able to hold enough market share to continue production. But until it is no longer economically feasible to produce library paste, consumers have choices beyond tape when considering sticky products. Basically, consumers are faced with more choices than at any time ever before. In a spiraling effect, these consumer choices have created the opportunity for increasing technology. And that technology has changed every aspect of day to day life and all human transactions. We live in a style that previous generations could not have imagined. Goods such as home videos and microwave popcorn now appear on the average shopping list. Advances in medicine have cured previously fatal diseases. Homes are more spacious, people eat better, grow taller, and are even born larger than in past generations. Economic growth and technological change have made the current generation richer than the generations of our parents and grandparents. But we have not created Utopia. As a society we experience opportunity cost with each new technological advancement. The extent of that cost can be measured with the tools of microeconomics that have been examined in this paper. Possible production frontier graphs can be employed in the planning and decision making stage prior to production. Determining how an item is priced, and therefore its’ profitability, is a function of marginal utility theory. All of this helps industry to decide if and how to go about introducing new products and technology. That’s critically important simply because just because we can, it doesn’t always mean we should. Seal Straugh Notes


C. Menenger, Principles of Economics, (Grove City PA, Libertarian Press) 1994, 12 Michael Parkin, Microeconomics, 2nd Edition, (New York, Addison-Wesley Publishing Company) 1993, 12 Parkin, 18 Menenger, 33-36 Xiphaias, producer, Economics Alive! CD-ROM 1994 IBM William Baumol, and Alan Blinder, Economics Principles and Policy, 4th Edition, (New York University and Princeton University, Harcourt Brace Jovanovich, Publishers) 1988, 122 Baumol and Binder, 74 Danila Israel, “Review of Microeconomic Models and Valuation Methods Applied in the Natural Resources and Environmental Sector” Eastern Economic Journal, May, 1998 vol. 2, (Boston, Mass., Asset Publication) 144-157 Parkin, 53 Menenger, 112 Economics Alive! CD-ROM Parkin, 222 Israel, 123 Parkin, 359 Israel, 166 Economics Alive! CD-RO Parkin, 260 Israel, 166 Israel, 169 Eric N. Berg, “ Wood Makes Baseball Comeback,” New York Times, July 7, 1986 Bibliography Primary Sources Books Baumol, William & Blinder, Alan, Economics Principles and Policy, 4th Edition, New York University & Princeton University: Harcourt Brace-Javonovich, Publishers, 1988 Meneger, C., Principles of Economics, Grove City PA: Libertarian Press, 1994 Parkin, Michael, Microeconomics, 2nd Edition, New York: Addison-Wesely Publishing, 1993 Collected Documents Berg, Eric N., “Wood Makes Baseball Comeback”, New York Times, July 7, 1991 Israel, Danila, “Review of Microeconomic Models and Valuation Methods in the Natural Resources and Environment Sector”’ Eastern Economic Journal, May, Vol. 2, Boston: Asset Publication, 1998 Electronic References Xiphaias, Economics Alive! CD-ROM 1994 IBM

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