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2.1 Four Examples of Microeconomics

Learning Objectives

  1. What are two ways that you make economic choices all the time?
  2. How do economists think about the way people react to a change in a rule?
  3. What is the role of markets in an economy?

Here are four short and diverse illustrations of microeconomics you might encounter: deciding what to do with your time and money, buying or selling on eBay, visiting a large city, and reading about a soccer game. After you have finished your study of microeconomics, you will see these concepts very differently from the way you see them now. You may not know it, but your everyday life is filled with microeconomics in action.

Your Time and Money

Wouldn’t you rather be doing something else with your time right now, instead of reading an economics textbook? You could be surfing on the Internet, reading blogs, or updating your Facebook profile. You could be reading a novel or watching television. You could be out with friends. But you aren’t. You have made a choice—a decision—to spend time reading this chapter.

Your choice is an economic one. Economics studies how we cope with competing demands for our time, money, and other resources. You have only 24 hours each day, so your time is limited. Each day you have to divide up this time among the things you like or need to do: sleeping, eating, working, studying, reading, playing video games, hanging out in your local coffee shop, and so on. Every time you decide to do one thing instead of another, you have made an economic decision. As you study economics, you will learn about how you and other people make such choices, and you will also learn how to do a better job when making these decisions.

Money is also a limited resource. You undoubtedly have many things you would like to buy if money were no object. Instead you must choose among all the different things you like because your money—or, more precisely, your income—is a limited resource. Every time you buy something, be it a T-shirt, a breakfast bagel, or a new computer, you are choosing to forgo something else you could have bought instead. Again, these are economic decisions. Economics is about how you make choices. Whenever there is a limited resource—be it your time, the amount of oil reserves in the world, or tickets to the Super Bowl—and decisions to be made about how to use that resource, then economics is there to help. Indeed, the fundamental definition of economics is that it is the study of how we, as individuals and as a society, allocate our limited resources among possible alternative uses.

eBay and craigslist

Suppose you want to buy an MP3 player. There are many ways you can do this. You can go to a local store. You can look for stores on the Internet. You can also visit sites such as eBay (http://www.ebay.com) or craigslist (http://www.craigslist.org). eBay is an online auction site, meaning that you can look for an MP3 player and then bid against other potential buyers. The site craigslist is like an online version of the classified advertisements in a newspaper, so you can look to see if someone in your town or city is selling the player you want to buy. You can also use these sites if you want to sell something. Maybe you have some old baseball cards you want to sell. Perhaps you have a particular skill (for example, web design), and you want to sell your services. Then you can use sites such as eBay or craigslist as a seller instead of as a buyer.

We have said that economics is about deciding how to use your limited resources. It is also about how we interact with one another, and, more precisely, how we trade with one another. Adam Smith, the founder of modern economics, observed that humans are the only animal that makes bargains: “Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog.”Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Library, 1994 [1776]), 14. Barter or trade—the exchange of goods and services and money—is central to the world we live in today.

Economists often talk about trade taking place in markets. Some exchanges do literally take place in markets—such as a farmers’ market where local growers bring produce to sell. Economists use the term more generally, though: a market is any institution that allows us to exchange one thing for another. Sites such as eBay and craigslist create markets in which we can transact. Normally, we exchange goods or services for money. Sometimes we exchange one good or service for another. Sometimes we exchange one type of money for another.

Most of the time, nobody forces you to buy anything, so when you give up some money in return for an MP3 player, you are presumably happier after the transaction than before. (There are some exceptions, of course. Can you think of any cases where you are forced to engage in an economic transaction?) Most of the time, nobody forces you to sell anything, so when you give up your time in return for some money, you are presumably happier after the transaction than before. Leaving aside the occasional mistake or the occasional regret, nearly every voluntary transaction makes both participants better off. Markets matter because they are a means for people to become happier.

Breathing the Air

Welcome to Mexico City! It is a wonderful place in many respects. But not in every way: from the picture you can see that Mexico City has some of the most polluted skies in the world.“Researchers to Scrutinize Megacity Pollution during Mexico City Field Campaign,” University Corporation for Atmospheric Research, last modified March 2, 2006, accessed January 22, 2011, http://www.ucar.edu/news/releases/2006/mirage.shtml.

Figure 2.1 The Skies of Mexico City

Mexico City was not always so polluted. Sadly, economic growth and population growth, together with the peculiarities of geography and climate, have combined to make its air quality among the worst you will encounter anywhere. Other cities around the world, from Beijing to Los Angeles, also experience significant air pollution, reducing the quality of life and bringing with it health risks and other costs.

It is hard to understand economists talking about the beauty and power of markets when you cannot breathe the air. So what is going wrong in Mexico City? Is it not full of people carrying out trades that make them better off? The problem is that transactions sometimes affect other people besides the buyer and the seller. Mexico City is full of gas stations. The owners of the gas stations are happy to sell gasoline because every transaction makes them better off. The owners of cars are happy to buy gasoline because every transaction makes them better off. But a side effect of all these transactions is that the air becomes more and more polluted.

Economics studies these kinds of problems as well. Economists seek to understand where and when markets work and where and when they don’t work. In those situations where markets let us down, economists search for ways in which economic policies can help.

Changing the Rules

We have explained that microeconomics studies choices and the benefits and problems that arise from trade. Perhaps most fundamentally, microeconomics studies how people respond to incentives. To illustrate the importance of incentives, here is an example of what can happen when they go wrong.

In February 1994, an extraordinary scene took place during a soccer match in the Caribbean. Grenada was playing Barbados, and with five minutes remaining in the match, Barbados was leading by two goals to one. As the seconds ticked away, it seemed clear that Barbados was going to win the match. Then, three minutes from the end of the game, the Barbados team did a remarkable thing. It intentionally scored an own goal, tying the game at two goals apiece.

After Grenada kicked off again, pandemonium ensued. The Grenada team tried not only to score against Barbados but also to score an own goal. Barbados desperately defended both its own goal and its opponents’ goal. The spectacle on the field had very little to do with soccer as it is usually played.

To explain this remarkable sight, we must describe the tournament in which the two teams were playing. There were two groups of teams, with the winner of each group progressing to the final. The match between Barbados and Grenada was the last group game and would determine which two teams would be in the final. The results of the previous matches were such that Barbados needed to win by two goals to go to the final. If Barbados won by only one goal, then Grenada would qualify instead. But the tournament organizers had introduced an unusual rule. The organizers decided that if a game were tied, the game would go to “golden goal” overtime, meaning that the first team to score would win the game, and they had also decided that the winning team would then be awarded a two-goal victory.

As the game was drawing to a close, Barbados realized it was unlikely to get the two-goal win that it needed. The team reasoned that a tie was a better result than a one-goal victory because it gave them roughly a fifty-fifty chance of winning in extra time. So Barbados scored the deliberate own goal. Grenada, once it realized what had happened, would have been happy either winning or losing by one, so it tried to score in either goal. Barbados’ strategy paid off. The game finished in a tie; Barbados scored in overtime and went on win the final.

The organizers should have consulted an economist before instituting the rules of the tournament. Economics has many lessons to teach, and among the most important is this: people respond to incentives. The change in the rules changed the incentives that the two teams faced. Because the tournament organizers had not realized that their rules could lead to a situation in which a team preferred a tie to a win, they failed to foresee the bizarre scene on the field.“Football Follies,” Snopes.com, last modified July 6, 2008, accessed January 22, 2011, http://www.snopes.com/sports/soccer/barbados.asp.

Key Takeaways

  • You make economic decisions on the allocation of time by deciding how to spend each minute of the day. You make economic decisions on the allocation of your income by deciding how much to buy of various goods and services and how much to save.
  • Economists study how changes in rules lead individual and firms to change their behavior. This is part of the theme in economics that incentives matter.
  • Markets are one of the central ways in which individuals interact with each other. Market interactions provide a basis for the trade that occurs in an economy.

Checking Your Understanding

  1. When you are choosing how much time to allocate to studying, what incentives affect your decision? Does the decision depend on how much money you have? Does the decision depend on whether you have a quiz or an exam coming up in the course? If your instructor changed the rules of the course—for example, by canceling the final exam—would your choice change?
  2. Instead of writing about air pollution in Mexico City, we could have written about water pollution from the 2010 oil spill in the Gulf of Mexico. Would that also be a good example of markets failing?