1. Chapter 2 A Review of Microeconomic Theory

2. Overview Microeconomics is frequently defined as the study of how scare resources are allocated among competing ends. As an example, should you go play basketball with some friends or study some economics? It is your time, how will you allocate that time? In this chapter we will study some of the basic tools of microeconomic analysis. The rest of this section is devoted to some basic ideas about economic actors and actions.

3. Maximizing behavior In microeconomics we take as given the idea that economic actors maximize some objective, say utility or profit. Business organizations, for example, are assumed to operate with the intent of making the most profit that is possible to achieve. Most of the time economic actors are constrained in reaching their objectives. Taking businesses again as an example, costs are incurred and consumers do not want to buy an unlimited number of units of output. So the firm has to balance what price to charge with the cost of doing business.

4. Productive efficiency A production process is said to be productively efficient if either of two conditions hold: 1. It is not possible to produce the same amount of output using a lower-cost combination or inputs, or 2. It is not possible to produce more output using the same combination of inputs. Since there are usually many ways of skinning a cat, we look to productive efficiency as a way to judge some methods “better” than others.

5. Pareto efficiency A particular situation is Pareto efficient if when the situation is changed (by whatever means) person A is better off (in the mind of person A) and another person, person B, is worse off (in the mind of person B). The concept is really stronger than I have stated it. To be a Pareto efficient allocation all possible alternative allocations that make Person A better off, must leave Person B worse off. The book definition of this is presented on the next slide. I may be making too big a deal out of the textbook definition, but I have always had to concentrate when I read and think about the concept.

6. Pareto efficiency A particular situation is said to be Pareto efficient if it is impossible to change the situation so as to make one person better off (in the mind of this person) without making another person worse off (in the mind of this other person). Example: Say I am currently endowed with 2 cookies and 3 cokes. You have 3 cookies and 2 cokes. I want what you have and you want what I have. This situation is NOT Pareto efficient because we could trade (or the government could make us exchange) 1 cookie (cookies are large in this example) for one coke and we both would be better off.

7. Pareto efficiency Another example similar to the last one. We have the same endowments. Say I am currently endowed with 2 cookies and 3 cokes. You have 3 cookies and 2 cokes. I want what you have and you want exactly what you have (I am assuming this combination makes you the happiest within the realm of things you can afford). This situation is Pareto efficient because the only way I get what I want (and am made better) is to make you worse off.