Introduction: Key Methodological Concepts

Question 1

What are the two “three-legged stools” of economics?

Answer 1

1) concepts, techniques, connections 2) graphs, math, intuition

Question 2

Explain concepts, techniques, and connections using the law of supply and demand

Answer 2

Use techniques to explore concepts which connect to a larger picture

1) concept of demand (increase in price leads to a decrease in QD); concept of supply (increase in price leads to an increase in QS)
2) use this to determine equilibrium price and quantity – technique
3) connection = understanding the purpose/importance of equilibrium –> markets are capable of allocating scarce resources, and the “right” allocation of resources leads to efficiency

Question 3

Explain graphs, math, and intuition using the law of supply and demand

Answer 3

1) draw a graph of supply and demand 2) use math to set two linear equations equal to each other, and solve the point where they intersect = equilibrium 3) give an explanation (intuition) of equilibrium – e.g. equilibrium is the only price (P*) and quantity (Q*) where the market will be clear, i.e. QD = QS

Question 4

How do the two three-legged stools align?

Answer 4

concept~graph technique~math connection~intuition

Question 5

Why is the existence of equilibrium just the beginning of the story?

Answer 5

Not all markets are in equilibrium, but they are moving toward it Existence of equilibrium = useful concept from which we look at shifts in supply and/or demand –> change in price –> quantity adjusts –> move from one equilibrium to another ==> the importance of markets is that it can shift from one equilibrium to another, i.e. it can adjust to outside (exogenous) events

Question 6

Talk about equilibrium in the context of models

Answer 6

Equilibrium is a useful deduction that stems from the logic of the model (an abstraction, not a real world constant outcome)

Question 7

Explain comparative static analysis

Answer 7

–> Obtaining predictions by comparing an initial equilibrium to a subsequent equilibrium followed by a change in a relevant parameter of an economic model, i.e. compare one static equilibrium to another static equilibrium ==> not looking at “adjustment path” but rather two distinct points

Question 8

What are parameters?

Answer 8

Parameters capture the exogenous factors. They describe the function and are always fixed. For example, consider y = mx + b –> x and y are variables –> m and b are parameters, i.e. constants

Question 9

Explain the importance of ceteris paribus

Answer 9

all other things are captured in the parameter

Question 10

What is the relationship between P and Q?

Answer 10

endogenous

Question 11

What is the goal of constrained optimization?

Answer 11

Maximize (or minimize) an objective subject to a constraint; for example, maximize happiness subject to limited income, minimize the cost of an output level subject to input prices, etc.

Question 12

Why is the “marginal” perspective for optimal-decision making especially important when considering constrained optimization?

Answer 12

-rational economic decisions are not typically “all or nothing” -for example, the article about HOT lanes –> people make decisions at the margin (such as walking to work instead of driving) = INCREMENTAL adjustment -calculus is used to analyze these increments -in the case of nonlinear functions, the only way to optimize is to use calculus

Question 13

What is model building?

Answer 13

reasoning how variables are related

Question 14

What are the steps in building a model?

Answer 14

1) assumptions of what it means to be rational 2) abstraction 3) variables

Question 15

Explain the first step in building a model: assumptions of what it means to be rational

Answer 15

-rational household = maximize utility -rational firm = maximize profit ==> when building a model, assume that all actors are acting rationally

Question 16

Explain the second step in building a model: abstraction

Answer 16

Only include essential pieces, and suppress/SIMPLIFY unimportant details

Question 17

Explain the third step in building a model: variables

Answer 17

Using the example of the demand curve: -variables can be ENDOGENOUS, e.g. price affects quantity demanded -variables can be EXOGENOUS, e.g. tastes and preferences -note “ceteris paribus” –> all other conditions remain the same

Question 18

Endogenous

Answer 18

casual relationship, e.g. price affects quantity demanded

Question 19

Exogenous

Answer 19

factors outside the theory, e.g. tastes and preferences are outside the theory of demand

Question 20

What is a prediction?

Answer 20

A testable statement that follows from assumptions and logical deduction; takes the form of an “if… then” proposition

Question 21

How are models useful?

Answer 21

Models are useful in their ability to PREDICT BEHAVIOR For example, “if price increases then quantity demanded decreases”

Question 22

What is testing?

Answer 22

compare prediction with group behavior (this is essentially just the scientific method) –> “appeal to the data”

Question 23

Summary of models

Answer 23

The merit of an economic model is judged on its ability to PREDICT OUTCOMES of the MARKET process and policy actions. We do NOT focus on an actual description of the process that occurs, NOR do we attempt to predict any particular individual’s behavior. We focus only on WHAT happens to a market quantity when a price changes. We are NOT concerned with a detailed account of how it actually occurred.

Question 24

What are the broad reaches of microeconomic theory?

Answer 24

• develop MODELS of optimal decision-making by individual households and firms given the constraint of scarce resources, e.g. try to find out how people will respond to prices
• provides an understanding of how a MARKET economy deals with scarcity, i.e. determine equilibrium prices and quantities
• provides a framework for assessing how WELL a market economy functions
• provides a framework for identifying sources of MARKET FAILURE that lead to “allocative inefficiency”
• provides a framework for designing and evaluating public policy

Question 25

Explain the idea that microeconomic theory provides a framework for assessing how well a market economy functions

Answer 25

Are the market’s equilibrium quantity’s “allocatively efficient”? Allocative efficiency = the “right amount” of output

Question 26

Explain the idea that microeconomic theory provides a framework for designing and evaluating public policy

Answer 26

This can be in the form of designing corrections for market failure that improve efficiency (e.g. an excise tax to alter output) or measuring the efficiency loss of policies advocated on grounds of “fairness” (e.g. progressive income tax, minimum wage laws, etc.)

Question 27

Don’t miss the forest for the trees!

Answer 27

-Don’t be a woodpecker (their face is always right in the tree) -keep things in perspective -leaves vs twigs vs limbs vs branches…