1.2 Microeconomics and Macroeconomics

Economics is all about understanding how people and businesses make decisions with limited resources. Microeconomics zooms in on individual choices, while macroeconomics looks at the big picture of entire economies.

When it comes to steering the economy, governments have two main tools: monetary policy and fiscal policy. Monetary policy tweaks interest rates and money supply, while fiscal policy uses taxes and spending to influence economic activity.

Foundations of Economics

Key concepts of microeconomics

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• Focuses on decision-making processes of individual economic agents
  • Consumers make choices to maximize utility (satisfaction) within budget constraints (income and prices)
  • Firms aim to maximize profits by minimizing costs and optimizing production
  • Markets determine prices and quantities through the interaction of supply and demand, reaching equilibrium when quantity supplied equals quantity demanded
• Scarcity arises from limited resources and requires individuals to make trade-offs, incurring opportunity costs (the next best alternative foregone)
• Marginal analysis examines incremental changes in costs and benefits to make optimal decisions (marginal revenue vs marginal cost)
• Incentives, such as prices and taxes, influence the decision-making of consumers and firms
• Elasticity measures the responsiveness of supply and demand to changes in price (elastic demand: quantity demanded changes more than price, inelastic demand: quantity demanded changes less than price)
• Comparative advantage explains how countries can benefit from specialization and trade based on their relative efficiency in producing goods

Focus of macroeconomics

• Examines the economy as a whole, focusing on aggregate economic variables
  • Gross Domestic Product (GDP) measures the total value of goods and services produced within a country's borders over a specific period (usually a year)
  • Inflation refers to a sustained increase in the general price level, eroding the purchasing power of money (measured by Consumer Price Index or CPI)
  • Unemployment rate represents the percentage of the labor force actively seeking work but unable to find employment
  • Economic growth is the increase in an economy's productive capacity over time, often measured by the growth rate of real GDP (adjusted for inflation)
• Analyzes relationships between variables and factors influencing them
  • Aggregate demand represents the total demand for goods and services in an economy, determined by consumption, investment, government spending, and net exports (AD = C + I + G + NX)
  • Aggregate supply is the total supply of goods and services in an economy, influenced by factors such as technology, labor, and capital
  • Business cycles are fluctuations in economic activity over time, characterized by periods of expansion (growth) and contraction (recession)

Economic Policies

Monetary vs fiscal policies

• Monetary policy is controlled by the central bank (Federal Reserve) and uses tools to influence money supply and interest rates
  1. Interest rates: Raising rates to combat inflation by making borrowing more expensive, or lowering rates to stimulate borrowing and investment
  2. Open market operations: Buying government securities to increase money supply or selling securities to decrease money supply
  • Short-term effects on borrowing, spending, and investment
  • Indirectly influences employment and economic growth
• Fiscal policy is controlled by the government (executive and legislative branches) and uses taxation and spending to influence the economy
  1. Government spending: Increasing spending to stimulate demand (infrastructure projects) or decreasing spending to reduce budget deficits
  2. Taxation: Lowering taxes to increase disposable income and stimulate spending (tax cuts) or raising taxes to reduce budget deficits or fund government programs
  • Directly influences aggregate demand
  • Long-term effects on economic growth and income distribution (progressive vs regressive taxation)

Market Imperfections and Economic Theory

• Market failure occurs when the free market fails to allocate resources efficiently (economic efficiency)
• Externalities are costs or benefits that affect third parties not involved in the economic transaction
• Public goods are non-excludable and non-rivalrous, often requiring government intervention for provision
• Game theory analyzes strategic decision-making in competitive situations, applicable to various economic scenarios