Tuesday, May 12, 2015

Microeconomics 01

The study of microeconomics involves constrained optimization in face of scarcity. We build models on how consumers and producers behave in order to study their relationships. However, unlike engineering models, these models are never precise, and can only capture the main insights and never the minute details.

The main constraint faced by consumers is their limited budget, which we will optimize through utility maximization. We want to maximize their utility subject to a budget constraint. Firms on the other hand focus on maximizing profits subject to both consumer demands and input costs.

In Microeconomics, prices play three fundamental roles:
1) What goods and services should be produced?
2) How do we produce these goods and services?
3) Who will make use of these goods and services?

The above three question can be summarized into the term "allocation". As consumers and firms interact in the marketplace, these questions will lead to a set of prices which best satisfies both the consumers and producers.

If we want to create a product, we need to analyze the consumer's reception towards it. Next, we will need to look at all the input costs to see if we will be able to set a price that allows us to profit, while making it affordable to the target market.

When dealing with economics, we have to face both the theoretical and empirical sides. Theoretical economics involves building models to explain the world, while empirical economics involves testing those models to judge its accuracy. That would mean that, of course, models built in theoretical economics should be testable.

Economics can also be positive or normative. Positive describes what the world are, and normative describes what the world should be.

We can almost model any kind of decision. An example model for a decision-making process for buying a new vs used product can be:
1) What are your personal preferences?
2) Are you risk-averse or risk-loving?
3) Is your budget limited or unlimited?

By comparing the price of the new and used product, we weigh that difference in price with the above questions to result in an optimization problem.

Even though we do not really go through these thought processes, but we behave AS IF we have solved these optimization problems. This is known as Milton Friedman's "As If" principle.

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