1、Lecture NotesMicroeconomic TheoryGuoqiang TIANDepartment of EconomicsTexas A(2) Scarcity of Resources: Individuals confront scarce resources;(3) Economic freedom: voluntary cooperation and voluntary exchange;(4) Decentralized decision makings: One prefers to use the way of decentral-ized decision ma
2、king because most economic information is incomplete orasymmetric to the decision marker;(5) Incentive compatibility of parties: the system or economic mechanismshould solve the problem of interest conflicts between individuals or eco-nomic units;(6) Well-defined property rights;(7) Equity in opport
3、unity;(8) Allocative efficiency of resources;Relaxing any of these assumptions may result in different conclusions.31.1.3 The Basic Analytical Framework of Modern EconomicsThe basic analytical framework for an economic theory consists of five aspects or steps: (1)specifying economic environments, (2
4、) imposing behavioral assumptions, (3) presentingeconomic institutional arrangements, (4) choosing equilibria, and (5) making evaluations.The framework is used to study particular economic issues and questions that economistsare interested in. To have good training in modern economics, one needs to
5、master thesefive aspects. To understand various economic theories and arguments, it is also importantto understand these five aspects.Understanding this basic analytical framework can help people classify possible mis-understandings about modern economics, and can also help them use the basic econom
6、icprinciples or develop new economic theories to solve economic problems in various eco-nomic environments, with different human behavior and institutional arrangements.1. Specifying Economic EnvironmentThe first step for studying an economic issue is to specify the economic environment.The specific
7、ation on economic environment can be divided into two levels: 1) descriptionof the economic environment, and 2) characterization of the economic environment. Toperform these well, the description is a job of science, and the characterization is a jobof art. The more clear and accurate the descriptio
8、n of the economic environment is, thehigher the possibility is of the correctness of the theoretical conclusions. The more refinedthe characterization of the economic environment is, the simpler and easier the argumentsand conclusions will obtain.Modern economics provides various perspectives or ang
9、les to look at real world eco-nomic issues. An economic phenomenon or issue may be very complicated and be affectedby many factors. The approach of characterizing the economic environment can grasp themost essential factors of the issue and take our attention to the most key and core charac-teristic
10、s of an issue so that we can avoid unimportant details. An economic environmentusually consists of (1) a number of individuals, (2) the individuals characteristics, suchas preferences, technologies, endowments, etc. (3) informational structures, and (4) insti-tutional economic environments that incl
11、ude fundamental rules for establishing the basisfor production, exchange, and distribution.42. Imposing Behavior AssumptionsThe second step for studying an economic issue is to make assumptions on individualsbehavior. Making appropriate assumptions is of fundamental importance for obtaininga valuabl
12、e economic theory or assessment. A key assumption modern economics makesabout an individuals behavior is that an individual is self-interested. This is a main dif-ference between individuals and other subjects. The self-interested behavior assumptionis not only reasonable and realistic, but even whe
13、n the assumption is not correct; theassumption poses little threat to viability of the research. A rule of a game designed forself-interested individuals is likely also suitable for altruists, but the reverse is likely nottrue.3. Presenting Economic Institutional ArrangementsThe third step for study
14、ing an economic issue is to give or determine the economic institu-tional arrangements, which are also called economic mechanisms, which can be regardedas the rules of the game. Depending on the problem under consideration, an economicinstitutional arrangement could be exogenously given or endogenou
15、sly determined. Forinstance, when studying individuals decisions in the theories of consumers and produc-ers, one takes the market mechanism as given. However, when considering the choice ofeconomic institutions and arguing the optimality of the market mechanism, the marketinstitution is endogenousl
16、y determined. The alternative mechanisms that are designed tosolve the problem of market failure are also endogenously determined. Economic arrange-ments should be designed differently for different economic environments and behaviorassumptions.4. Choosing EquilibriaThe fourth step for studying an e
17、conomic issue is to make trade-off choices and determinethe ”best” one. Once given an economic environment, institutional arrangement, andother constraints, such as technical, resource, and budget constraints, individuals willreact, based on their incentives and own behavior, and choose an outcome f
18、rom amongthe available or feasible outcomes. Such a state is called equilibrium and the outcome anequilibrium outcome. This is the most general definition an economic ”equilibrium”.55. Making EvaluationsThe fifth step in studying an economic issue is making evaluations and value judgmentsof the chos
19、en equilibrium outcome and economic mechanism based on certain criterion.The most important criterion adopted in modern economics is the notion of efficiencyor the ”first best”. If an outcome is not efficient, there is room for improvement. Theother criterions include equity, fairness, incentive-com
20、patibility, informational efficiency,and operation costs for running an economic mechanism.In other words, in studying an economic issue, one should start by specifying eco-nomic environments and then study how individuals interact under the self-interestedmotion of the individuals within an exogeno
21、usly given or endogenously determined mech-anism. Economists usually use “equilibrium,” “efficiency”, “information”, and “incentive-compatibility” as focal points, and investigate the effects of various economic mechanismson the behavior of agents and economic units., show how individuals reach equi
22、libria,and evaluate the status at equilibrium. Analyzing an economic problem using such abasic analytical framework has not only consistence in methodology, but also in gettingsurprising (but logically consistent) conclusions.1.1.4 Methodology for Studying Modern EconomicsAs discussed above, any eco
23、nomic theory usually consists of five aspects. Discussions onthese five steps will naturally amplify into how to combine these five aspects organically.To do so, economists usually integrate various studying methods into their analysis. Twomethods used in modern economics are providing various level
24、s and aspects studyingplanforms and establishing reference/benchmark systems.Studying PlanformA studying planform in modern economics consists of some basic economic theories orprinciples. It provides a basis for extending the existing theories and analyzing more deepeconomic issues. Examples of Stu
25、dying Planforms:(1) Consumer and producer theories provide a bedrock planform for studyingindividuals independent decision choices.6(2) The General Equilibrium Theory is based on the theories of consumers andproducers and is a higher level planform. It provides a basis for studyinginteractions of in
26、dividuals within a market institution and how the marketequilibrium is reached in each market.(3) The Mechanism design theory provides an even higher level of studyingplanform and can be used to study or design an economic institution. Itcan be used to compare various economic institutions or mechan
27、isms, aswell as to identify which one may be an “optima”.Reference Systems/BenchmarkModern economics provides various reference/benchmark systems. A reference systemis a standard economic model/theory that results in ideal results, such as efficiency/the”first best”. The importance of a reference sy
28、stem does not rely on whether or not itdescribes the real world correctly or precisely, but instead gives a criterion for under-standing the real world. It is a mirror that lets us see the distance between varioustheoretical models/realistic economic mechanisms and the one given by the reference sys
29、-tem. For instance, the general equilibrium theory we will study in these notes is sucha reference system. With this reference system, we can study and compare equilibriumoutcomes under various market structures with the ideal case of the perfectly competitivemechanism. Other examples include the Co
30、ase Theorem in property rights theory andeconomic law, and the Modigliani-Miller Theorem in corporate finance theory.Although those economic theories or economic models as reference systems may havemany unrealistic assumptions, they are very useful, and can be used to make furtheranalysis. They esta
31、blish criterions to evaluate various theoretical models or economicmechanisms used in the real world. A reference system is not required, in most cases it isactually not needed, to predicate the real world well, but it is used to provide a benchmarkto see how far a reality is from the ideal status g
32、iven by a reference system. The valueof a reference system is not that it can directly explain the world, but that it provides abenchmark for developing new theories to explain the world. In fact, the establishmentof a reference system is very important for any subject, including economics. Anyone c
33、antalk about an economic issue but the main difference is that a person with systematic7training in modern economics has a few reference systems in her mind while a personwithout training in modern economics does not so he cannot grasp essential parts of theissue and cannot provide deep analysis and
34、 insights.Analytical ToolsModern economics also provides various powerful analytical tools that are usually givenby geometrical or mathematical models. Advantages of such tools can help us to analyzecomplicated economic behavior and phenomena through a simple diagram or mathemat-ical structure in a
35、model. Examples include (1) the demand-supply curve model, (2)Samuelsons overlapping generation model, (3) the principal-agent model, and (4) thegame theoretical model.1.1.5 Roles, Generality, and Limitation of Economic TheoryRoles of Economic TheoryAn economic theory has three possible roles: (1) I
36、t can be used to explain economicbehavior and economic phenomena in the real world. (2) It can make scientific predictionsor deductions about possible outcomes and consequences of adopted economic mechanismswhen economic environments and individuals behavior are approximated correctly. (3)It can be
37、used to refute faulty goals or projects before they are actually undertaken. If aconclusion is not possible in theory, then it is not possible in a real world setting, as longas the assumptions were approximated realistically.Generality of Economic TheoryAn economic theory is based on assumptions im
38、posed on economic environments, individ-uals behavior, and economic institutions. The more general these assumptions are, themore powerful, useful, or meaningful the theory that comes from them is. The generalequilibrium theory is considered such a theory.8Limitation of Economic TheoryWhen examining
39、 the generality of an economic theory, one should realize the boundary,limitation, and applicable range of economic theory. Thus, two common mistakes in theuse of an economic theory should be avoided. One mistake is to over-evaluate the role ofan economic theory. Every theory is based on some impose
40、d assumptions. Therefore, it isimportant to keep in mind that every theory is not universal, cannot explain everything,but has its limitation and boundary of suitability. When applying a theory to makean economic conclusion and discuss an economic problem, it is important to notice theboundary, limi
41、tation, and applicable range of the theory. It cannot be applied arbitrarily,or a wrong conclusion will be the result.The other mistake is to under-evaluate the role of an economic theory. Some peopleconsider an economic theory useless because they think assumptions imposed in the theoryare unrealis
42、tic. In fact, no theory, whether in economics, physics, or any other science,is perfectly correct. The validity of a theory depends on whether or not it succeeds inexplaining and predicting the set of phenomena that it is intended to explain and predict.Theories, therefore, are continually tested ag
43、ainst observations. As a result of this testing,they are often modified, refined, and even discarded.The process of testing and refining theories is central to the development of moderneconomics as a science. One example is the assumption of perfect competition. In reality,no competition is perfect.
44、 Real world markets seldom achieve this ideal. The question isthen not whether any particular market is perfectly competitive, almost no market is. Theappropriate question is to what degree models of perfect competition can generate insightsabout real-world markets. We think this assumption is appro
45、ximately correct in certainsituations. Just like frictionless models in physics, such as in free falling body movement(no air resistance), ideal gas (molecules do not collide), and ideal fluids, frictionless modelsof perfect competition generate useful insights in the economic world.It is often hear
46、d that someone is claiming they have toppled an existing theory orconclusion, or that it has been overthrown, when some condition or assumption behind itis criticized. This is usually needless claim, because any existing theory can be criticizedat anytime because no assumption can coincide fully wit
47、h reality or cover everything. So,as long as there are no logic errors or inconsistency in the theory, we cannot say that9the theory is wrong. We can only criticize it for being too limited or unrealistic. Whateconomists should do is to weaken or relax the assumptions, and obtain new theoriesbased o
48、n old theories. We cannot say though that the new theory topples the old one,but instead that the new theory extends the old theory to cover more general situationsand different economic environments.1.1.6 Roles of Mathematics in Modern EconomicsMathematics has become an important tool in modern eco
49、nomics. Almost every fieldin modern economics uses mathematics and statistics. The mathematical approach toeconomic analysis is used when economists make use of mathematical symbols in thestatement of a problem and also draw upon known mathematical theorems to aid inreasoning. It is not difficult to understand why the mathematical approach has becomea dominant approach since developing an analytical framework of a theory, establishingreference systems, and providing analytical tools all need mathematics.Some of the advantages of using mathematics are that (1)the “language” used and the
