Foreword

This planet [Earth] has — or rather had — a problem, which was this: most of the people living on it were unhappy for pretty much of the time. Many solutions were suggested for this problem, but most of these were largely concerned with the movement of small green pieces of paper, which was odd because on the whole it wasn't the small green pieces of paper that were unhappy.

When most people think about economics, they’re thinking about money, or what they have come to know as “the law of supply and demand.” However, economic activity — producing, trading, and consuming goods — existed before there was ever either money or markets, and many important economic decisions have nothing to do with prices. Economic activity fundamentally consists of producing goods and services using scarce resources, with the end goal of providing utility or happiness for people. To the extent that we’re interested in markets, it’s because markets are an institution that coordinates these activities.

This book takes the approach of first analyzing the “real economy,” absent the existence of markets or other institutions. We’ll model this as what economists have long called a Robinson Crusoe economy; though to bring us into the 21st century, and to deal with a less problematic narrative, we’ll refer to the plot of the movie “Cast Away” rather than the original novel by Daniel Defoe. In that movie, a FedEx manager named Chuck, played by Tom Hanks, is stranded on a desert island, and in order to survive must produce anything he wants to consume. As both the only producer and the only consumer on the island, there are no markets or money involved — Chuck doesn’t pay himself for the coconuts he produces! — but Chuck’s core challenge is the same as any economy: given the available resources, and the technology available to transform those resources into goods, what allocation of resources would result in the most happiness?

In Part I of the book, we introduce the core building blocks of microeconomic analysis, production functions and utility functions. We derive Chuck’s production possibilities frontier from his resources and available technology, and solve Chuck’s problem of what to produce using the fundamental economic modeling tool of constrained optimization.

With this optimization problem as backdrop, we will then rigorously examine the role of the “little green pieces of paper” Douglas Adams refers to in quotation above. We’ll show how the specific institution of a competitive market economy — one potentially involving billions of people and millions of goods — goes about solving these same fundamental problems of what to produce and consume, given the available resources and technology. In Parts II and III we will analyze the problems faced by consumers and firms who take prices as given, and examine how their optimal choices are affected by market prices. In these sections, we will develop the tool of comparative statics and derive the economics “laws” of demand and supply from first principles. In Part IV, we will develop the tool of equilibrium analysis to see how the market “chooses” prices. What we’ll see by the end of Part IV is that prices play the role of a coordinating mechanism that sends signals from consumers to producers about what they value (what gives them utility), and also sends signals from producers to consumers about the opportunity cost of producing different goods.

Finally, in Part V, we will examine a different class of markets – markets where, instead of consumers buying things from firms, they start with an “endowment” of goods and then trade with each other. We will use this framework to examine a number of important applications, including how much people choose to work, how they borrow or save to shift consumption over time, and how they approach situations with uncertain outcomes. We conclude with my favorite economic model, the Edgeworth Box, which brings us back to thinking about the real economy – but instead of the goods consumed by a single person, we turn our thoughts to allocations of goods across people. We’ll use this model to analyze issues of allocations of goods across people, and reflect on how we can evaluate economic outcomes. Can we say that one allocation is “better” than another? Is there a tension between economic efficiency and equity?

Required Mathematical Background

This book will make extensive use of multivariable calculus. The key mathematical background is presented in the mathematical appendices:

• Many of the functions in this book, like Chuck’s production and utility functions, are multivariable functions. Appendix A: Multivariable Calculus reviews important topics such as level sets, partial derivatives, the chain rule, and the implicit function theorem. You should review this material before reading the book.
• Many of the problems in this book (utility maximization, cost minimization, profit maximization, welfare maximization) are optimization problems. Appendix B: Optimization reviews the mathematics of unconstrained and constrained optimization, both in functions of one variable and multivariable functions using the method of Lagrange multipliers. You should review this material before Chapter 5.
• Throughout our analysis of comparative statics in Parts II and III, we will use the concept of elasticity to measure the degree to which an endogenous (dependent) variable changes due to a change in an exogenous (independent) variable. Appendix C: Elasticity reviews the definition of elasticity and shows how calculus may be used to derive elasticity analytically from a functional relationship.

Use in coursework at Stanford University

This book is the text for the first 14 weeks of the intermediate micro sequence at Stanford University. The first 17 chapters, through the end of Part IV, are the entirety of the Econ 50 course; the remaining 7 chapters form the first four weeks of Econ 51. The last six weeks of Econ 51 continues the discussion of efficiency and interactions between agents in a game-theoretic context using Joel Watson’s excellent book, Strategy, which I highly recommend as a complement to this book.

To support this goal of maximizing intuition while minimizing math, I have incorporated interactive graphs throughout the text. I have developed these kinds of graphs over the past several years as part of econgraphs.org, and used them in lectures, especially to show how economic relationships change when their underlying parameters change. My hope is that as you read the book, you’ll play with the graphs to test your own intuition regarding the underlying models. I’ve also developed the open-source Javascript framework that powers the graphs; if you’re interested in how that works, or would like to create some graphs of your own, information may be found at kineticgraphs.org.

Finally, please note that this is very much a work in progress. I’ve developed and reworked the text each year since 2020, when I wrote it for the first time, and I expect to continue doing so. So please don’t expect the current book to remain unchanged or stable in any way for the next few years, and please do let me know if you have any suggestions or find any errors.