Microeconomics: A Very Short Introduction, Schemes and Mind Maps of Microeconomics

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Microeconomics:

A Very Short Introduction

Avinash Dixit

Princeton University

PREFACE

Non-­‐economists think economics is about unemployment, inflation, growth, competitiveness of nations, and other matters pertaining to the economy as a whole, or in economists' jargon, about macroeconomics. They rarely mention, and perhaps are not even aware of, the whole nexus of choices and transactions behind the larger picture: people’s choices of where to live and work, how much to save, what to buy, and so on, firms' decisions about location, investment, hiring, firing, advertising, and many other dimensions of business, and government policies with regard to infrastructure, regulation of industries, structure and rates of taxes on goods and services, and so on. Citizens' relative ignorance and neglect of these fine-­‐level, or microeconomic, issues is partly explained by the fact that things often work pretty well at that level, and when they don't work so well, each failure seems small in the larger scheme of things. But many such small failures can add up to a large economic cost. They can have large ramifications at the macroeconomic level, too. Therefore it is important to understand why things work pretty well in the microeconomy much of the time, when and why they fail in little and big ways, and what to do to guard against and cope with such failures. In this essay I attempt to present this way of thinking about economics, and some of the conclusions it yields. I hope to convince non-­‐specialist readers that microeconomics is important, and connects as closely with their daily life as unemployment and inflation. I hope to give them some aha moments: "I have often seen this; now I understand why." For more lasting value, I hope to equip them with some basic concepts and tools of microeconomic analysis for use in their own thinking and actions, and leave them eager to do the further reading that I recommend. Three caveats before you begin. First, in this Very Short Introduction you should not look for anything like a comprehensive treatment of the subject. I had to leave out many topics, ideas and methods, not because they are unimportant, but because in my opinion others had a stronger claim in a brief introduction. If you are a microeconomist and your favorite topic is missing, blame my tastes.

TABLE OF CONTENTS

• PREFACE
• CHAPTER 1: WHAT AND WHY OF MICROECONOMICS
  • A wake-­‐up call
  • Information and incentives
• CHAPTER 2: CONSUMERS
  • Substitution
  • Complements
  • Demand curves
  • Consumers as workers and savers
  • Statistical estimation
  • Cost-­‐of-­‐living indexes
  • The babysitter effect
  • Time, and other budgets
  • Opportunity cost
  • Risk
  • Are consumers rational?
• CHAPTER 3: PRODUCERS
  • Costs
  • Small firms: Supply curves
  • Pricing strategies
  • Rivalry among large firms
  • Supply chains
  • Firms as organizations
• CHAPTER 4: MARKETS
  • Supply and demand
  • Efficiency
  • Shift of equilibrium
  • Taxes
  • Cycles of booms and busts
  • Price floors and ceilings
• CHAPTER 5: MARKET FAILURES AND POLICY FAILURES
  • Monopoly and oligopoly
  • Externalities, negative and positive
  • Information asymmetries
  • Moral hazard and adverse selection
  • Profit externalities between firms
  • A difficult tradeoff
  • Collective goods
  • Political economy of policy
  • The financial crisis
• CHAPTER 6: INSTITUTIONS AND ORGANIZATIONS
  • Property rights and contract enforcement
  • State and non-­‐state institutions of governance
  • Market design
  • Matching markets
  • Auctions
• CHAPTER 7: WHAT WORKS?
• FURTHER READING

scone or some other carb fix instead). But some failures are more drastic, like the gasoline shortages in the 1970s and the housing bubble and its collapse in the 2000s. Therefore it behooves all intelligent people to get some basic understanding of microeconomics: when and how transactions go well, when and why they fail, and what can be done when they do fail or threaten to fail.

Information and incentives

In most societies, consumers and producers interact in markets – not necessarily traditional bazaars and marketplaces, but shops, restaurants, other venues like bargaining-­‐tables and auctions, and increasingly the internet. In a market, buyers pay a price to sellers for the good or service. This price serves a twofold purpose. First, if something is scarce, its price rises; thus a high price conveys information about scarcity. Secondly, when a price is high, a supplier of that good or service can profit by producing more of it, and buyers will buy less or switch to something else; thus a high price also provides a natural incentive for actions that alleviate the scarcity. Information and incentive mechanisms to coordinate transactions between producers and consumers, and specifically whether and how prices work in this dual capacity, are the main subject matter of microeconomics. The focus on information and incentives also tells us when and why the price mechanism can fail: it may convey inadequate or wrong information or incentives, or responses to these signals may not occur. The most frequent failure of this kind arises when one person’s actions have spillover effects on others. Every car driver contributes to air pollution, which increases the scarcity of clean air. But there is no market or price for clean air, so no one gets a signal of that scarcity and no one has a profit incentive to alleviate it. The price mechanism can also fail if responses to its signals are suppressed. Price controls suppress them. So do barriers to entry of new producers: whether natural barriers, strategic ones erected by entrenched producers, or by government policies that favor them. Then existing producers can conspire to preserve some

scarcity so as to drive up the price for their own greater profit. In socialist countries where production and supply are in the hands of the state, its functionaries get little personal gain by satisfying consumers and suffer few penalties by neglecting them. Without markets the functionaries even lack good information about scarcity. That is why those systems have chronic shortages and poor quality. More subtly, the price mechanism may fail by conveying information about matters besides scarcity. Suppose you know that used 2010 Toyota Camrys are listed for around $15,000, but don't know the quality of the particular car you are contemplating buying. You infer that the car can't be worth much more than $15,000; otherwise the previous owner, who has had plenty of opportunity to observe its quality, wouldn't be selling it. But it could be worth less, much less. That depresses your willingness to pay. When all buyers think this and hold back, the lower demand leads to a lower price, driving even more owner-­‐sellers out of the market. In the worst-­‐case scenario, the whole market can collapse. Of course sellers of good cars and buyers who want good cars can both benefit by enabling credible communication of information about quality. The signals they use for this purpose are also subjects for microeconomic analysis. A different kind of market failure arises from a moral or ethical perspective. The signals and incentives of the price mechanism are ineffective if would-­‐be buyers don't have the purchasing power to back up their desire. The Pieman said to Simple Simon: "Show me first your penny," and Simon had to reply: "Indeed I have not any." This is a trivial example, but we may legitimately regard some wants such as health and education as meritorious, or basic human rights, regardless of a person's private ability to pay for them. Deciding and implementing policies to fulfill such wants becomes an issue in political economy. Prices and payments don't have to be in conventional money. One thing may be exchanged for another; payment may be deferred either as a loan or as a general favor owed. Depending on the context one form of "currency" may be more appropriate and effective than another. Money is crass and inappropriate in many social situations; informal arrangements of reciprocity and favor exchanges prevail among families and friends. Elaborate algorithms and organizations have evolved