Chapter 1

Analyzing Economic
Problems
Chapter One Overview
1. Why Study Microeconomics
2. Three Key Analytical Tools
3. Positive and Normative Analysis

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Microeconomics Defined
• Broadly speaking, economics is composed of two
branches, microeconomics and macroeconomics
• Microeconomics is the study of how individual economic
decision-makers such as consumers, workers, firms or
managers allocate scarce resources among alternate uses.

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• This study involves both the behavior of these economic
agents on their own and the way their behavior interacts to
form larger units, such as markets.

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Who Should Study Microeconomics?
• Policy makers
• Managers
• Union leaders
• Lenders

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• Business owners
• Consumers

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Key Societal Questions that Relate to
Microeconomics
• What goods and services will be produced and in what
quantities?
• Who will produce these services and how will they
produce them?
• Who will receive these goods and services and how will

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they get them?

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Microeconomic Modeling
Choice vs. Alternatives
• Many microeconomic issues are studied using models
• Models are like maps – using visual methods, they simply
the process and facilitate understanding of complex
concepts
• Microeconomic models need to:

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– Resemble reality
– Be understandable
– Be an appropriate scale
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Exogenous & Endogenous Variables
• Variables that have values taken as given in the analysis
are exogenous variables
• Variables that have values determined as a result of the
model’s workings are endogenous variables

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Examples Using Exogenous and Endogenous
Variables
• “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

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order to maximize satisfaction on a budget of X?” vs
• “What is the minimum level of expenditure that the consumer
must receive in order to reach a subsistence level of
satisfaction?”
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Analytical Tools
• Nearly all microeconomic models rely on just three key
analytical tools
1. Constrained optimization
2. Equilibrium analysis
3. Comparative statics

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• You should learn to recognize them when we apply them
in later chapters

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Constrained Optimization
• An analytical tool for making the best (optimal) choice,
taking into account any possible limitations or restrictions
on the choice
• Constrained optimization problems have two parts
1. Objective function

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2. Constraints

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The Objective Function
• The Objective Function specifies what the agent cares
about
• Example: Does manager care more about raising profits
or increasing “power”?

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The Constraints
• Constraints are whatever limits is placed on the resources
available to the agent
• Examples:
– Time
– Budget

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– Other resources
– Technical capabilities
– The marketplace
– Rules, regulations, and law
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The Constraint Optimization
• Behavior can be modeled as optimizing the objective function,
subject to various constraints
• Example (manager’s investment choice):
– Facilities ( F ): N = budget / $30
– R&D ( R ): N = budget / $100

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– Max N
– (F,R)
– Subject to: expenditure < $100
– Where: N is the number of workers
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The Constraint Optimization (Example)
• Consumer purchases
• Food (F), Clothing ( C ), Income (I)
• Price of food (PF), price of clothing (PC)
• Satisfaction from purchases: S = (FC)1/2

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• Max S(F,C)
• Subject to: (PF)(F) + (PC)(C)  I

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The Constraint Optimization
Example – Consumer Purchases

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The Constraint Optimization
Example – Consumer Purchases

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The Constraint Optimization
Example – Consumer Purchases

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The Constraint Optimization
Example – Consumer Purchases

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Marginal Impact
• Marginal tells us how a dependent variable changes as a
result of adding one unit of an independent variable
• The marginal impact of a change in the exogenous
variable is the incremental impact of the last unit of the
exogenous variable on the endogenous variable

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Equilibrium
Example – Sale of Coffee Beans

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Equilibrium
• Equilibrium is defined as the point where demand just
equals supply in this market
– The point where the demand and supply curves cross
• Equilibrium analysis is an analysis of a system in a state
that will continue indefinitely as long as the exogenous

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factors remain unchanged

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Equilibrium
Example – Sale of Coffee Beans

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Equilibrium
Example – Sale of Coffee Beans

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Comparative Statics Analysis
A comparative statics analysis
compares the equilibrium state
of a system before a change in
the exogenous variables to the
equilibrium state after the
change

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Positive and Normative Analysis
• Microeconomic analysis can be used to study both
positive and normative questions
• Positive analysis:
– Is an analysis that attempts to explain how an economic system
works or to predict how it will change over time

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• Normative analysis:
– Is an analysis of what should be done

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Microeconomic Analysis
Some Examples
• “Should we increase income equality rather than focus on
economic efficiency?”
• “Should we impose a progressive income tax or a sales
tax to increase income equality?”
• “Will a progressive income tax reduce aggregate hours

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worked?”

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