Microeconomics

Answers to Textbook Questions

and Problems

Questions for Review

1. Microeconomics is the study of how individual firms and households make decisions,

and how they interact with one another. Microeconomic models of firms and households

are based on principles of optimization—firms and households do the best they can

given the constraints they face. For example, households choose which goods to purchase

in order to maximize their utility, whereas firms decide how much to produce in

order to maximize profits. In contrast, macroeconomics is the study of the economy as a

whole; it focuses on issues such as how total output, total employment, and the overall

price level are determined. These economy-wide variables are based on the interaction

of many households and many firms; therefore, microeconomics forms the basis for

macroeconomics.

2. Economists build models as a means of summarizing the relationships among economic

variables. Models are useful because they abstract from the many details in the economy

and allow one to focus on the most important economic connections.

3. A market-clearing model is one in which prices adjust to equilibrate supply and

demand. Market-clearing models are useful in situations where prices are flexible. Yet

in many situations, flexible prices may not be a realistic assumption. For example,

labor contracts often set wages for up to three years. Or, firms such as magazine publishers

change their prices only every three to four years. Most macroeconomists

believe that price flexibility is a reasonable assumption for studying long-run issues.

Over the long run, prices respond to changes in demand or supply, even though in the

short run they may be slow to adjust.

Problems and Applications

1. The many recent macroeconomic issues that have been in the news lately (early 2002)

include the recession that began in March 2001, sharp reductions in the Federal

Reserve's target interest rate (the so-called Federal Funds rate) in 2001, whether the

government should implement tax cuts or spending increases to stimulate the economy,

and a financial crisis in Argentina.

2. Many philosophers of science believe that the defining characteristic of a science is the

use of the scientific method of inquiry to establish stable relationships. Scientists examine

data, often provided by controlled experiments, to support or disprove a hypothesis.

Economists are more limited in their use of experiments. They cannot conduct controlled

experiments on the economy; they must rely on the natural course of developments

in the economy to collect data. To the extent that economists use the scientific