"Microeconomics is the study of how individuals and firms make themselves as well off as possible in a world of scarcity."

The core of economics is opportunity cost. Every choice involves giving up the next best alternative.

Definition

The study of how individuals and firms make themselves as well off as possible in a world of scarcity.

Core Concept: Constrained Optimization

• Microeconomics is fundamentally about trade-offs
• Given that "you can't have it all," how do you best use limited resources?

Opportunity Cost ⭐

Definition of a Model

A description of the relationship between two or more variables.

Economics vs. Natural Sciences

Natural Sciences	Economics
Scientific laws and constants exist	No laws or constants
"Real science"	Social science
Universally applicable	Requires simplifying assumptions

Purpose of Simplifying Assumptions

• Goal 1: Explain as much as possible
• Goal 2: Keep models parsimonious (easy to teach and solve)

Example: In reality, there are many goods, but a 2-good model provides sufficient intuition with simpler math.

"All models are wrong, but some are useful." — George Box

Three Levels of Understanding Economics

• Mathematical
• Graphical
• Intuitive

Adam Smith's Diamond-Water Paradox (1776)

From The Wealth of Nations:

Good	Essential for Life?	Price
Water	Essential	Nearly free
Diamonds	Not essential	Very high

Definition of a Market

Market: A place where buyers and sellers come together to transact.

Rose Market Example

Demand Curve

Supply Curve

Equilibrium

Type	Definition	Question Type
Positive Economics	Study of how things are	"Why did this happen?"
Normative Economics	Study of how things should be	"Should this be allowed?"

eBay Kidney Auction Case

Positive Question: Why did the price get so high?

→ Demand for kidneys is very high (survival issue), supply is extremely low → high price

Normative Question: Should we be allowed to sell body parts?

Two Reasons for Market Intervention

Reason	Explanation	Examples
Market Failures	When the market doesn't work properly	Information asymmetry, coerced transactions, criminal activity
Equity	Unfair outcomes	Is it fair that only the rich can buy organs?

Note: This course is 90% about efficiency. Equity is covered later in the semester.

Capitalism

Pure Capitalism (Laissez-faire)

• Individuals decide production and consumption without government interference
• Has never actually existed

Constrained Capitalism (e.g., USA)

• Market-driven + government/social constraints
• Example: GM decides car production, but emissions/safety regulations exist

Command Economy

• Government makes all production and allocation decisions
• Typically associated with communism (Soviet Union)
• Also possible under fascism (Nazi Germany)

Theoretical Advantage (Karl Marx): Government maximizes social welfare; right goods go to right people.

Why It Failed:

Problem	Explanation	Example
Decision Overload	Government can't make billions of decisions	East Germany: too much bread, not enough cars — fed bread to pigs
Inevitable Corruption	Those in power allocate to themselves first	Structurally inevitable

The Invisible Hand

Adam Smith: Markets automatically determine production and allocation without central control.

Capitalism: Pros and Cons

Pros	Cons
USA is the richest nation Rapid growth for centuries	Enormous inequality Top 1% controls 25% of income

Misconception About Socialism

• Misconception: European countries are socialist
• Reality: More constrained capitalism (higher taxes, more government intervention, more equal)
• True Socialism: Government owns and controls industries

Sequence	Content
Next few lectures	Where the demand curve comes from (consumer preferences)
Following 5 lectures	Where the supply curve comes from (firm decisions)
Supply + Demand combined	Understanding equilibrium
Normative economics	Why market equilibrium is the best outcome
Second half	When standard models break down - Monopoly (e.g., Google) - International trade - Savings and labor decisions - Investment and climate change

#	Concept	Key Point
1	Microeconomics	Optimal decision-making under scarcity
2	Opportunity Cost	Every choice means giving up the next best alternative
3	Supply-Demand Model	Most fundamental economic model; explained by opportunity cost
4	Positive vs. Normative	"How it works" vs. "How it should be"
5	Reasons for Intervention	Market failure or equity concerns
6	Capitalism vs. Command	Trade-off between efficiency and equity

Term	Definition
Scarcity	Resources are limited
Opportunity Cost	Value of the next best alternative foregone
Constrained Optimization	Making the best choice under constraints
Equilibrium	State where supply equals demand
Positive Economics	Analysis of how the world works
Normative Economics	Judgments about how the world should be
Market Failure	When markets fail to achieve efficient outcomes
Equity	Fairness of distribution
Invisible Hand	Market mechanism that achieves efficient allocation

Last updated: 2025-01-02

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