Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

CHAPTER 1
Introduction
1.1 THE PURPOSE OF THEORY
The purpose of theory is to predict and explain. A theory is a hypothesis that has been successfully tested. A
hypothesis is tested not by the realism of its assumption(s) but by its ability to predict accurately and explain,
and also by showing that the outcome follows logically and directly from the assumptions.
EXAMPLE 1. From talking to friends and neighbors, from observations in the butcher shop, and from our own behavior,
we observe that when the price of a particular cut of meat rises, we buy less of it. From this casual real-world observation, we
could construct the following general hypothesis: “If the price of a commodity rises, then the quantity demanded of the
commodity declines.” In order to test this hypothesis and arrive at a theory of demand, we must go back to the real
world to see whether this hypothesis is indeed true for various commodities, for various people, and at different points
in time. Since these outcomes would follow logically and directly from the assumptions (i.e., consumers would want to
substitute cheaper for more expensive commodities) we would accept the hypothesis as a theory.
1.2 THE PROBLEM OF SCARCITY
The word scarce is closely associated with the word limited or economic as opposed to unlimited or free.
Scarcity is the central fact of every society.
EXAMPLE 2. Economic resources are the various types of labor, capital, land, and entrepreneurship used in producing
goods and services. Since the resources of every society are limited or scarce, the ability of every society to produce goods
and services is also limited. Because of this scarcity, all societies face the problems of what to produce, how to produce, for
whom to produce, how to ration the commodity over time, and how to provide for the maintenance and growth of the system.
In a free-enterprise economy (i.e., one in which the government does not control economic activity), all these problems are
solved by the price mechanism (see Problems 1.5 to 1.9).
1.3 THE FUNCTION OF MICROECONOMIC THEORY
Microeconomic theory,orprice theory, studies the economic behavior of individual decision-making units
such as consumers, resource owners, and business firms in a free-enterprise economy.
EXAMPLE 3. During the course of business activity, firms purchase or hire economic resources supplied by households
in order to produce the goods and services demanded by households. Households then use the income received from the sale
of resources (or their services) to business firms to purchase the goods and services supplied by business firms. The “circular
flow” of economic activity is now complete (see Problem 1.11). Thus, microeconomic theory, or price theory, studies
the flow of goods and services from business firms to households, the composition of such a flow, and how the prices of
goods and services in the flow are determined. It also studies the flow of the services of economic resources from resource
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