Chapter 1 Economic Models © 2004 Thomson Learning/South-Western.

Chapter 1

Economic Models

© 2004 Thomson Learning/South-Western

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What is Microeconomics?

Economics– The study of the allocation of scarce resources

among alternative uses

Microeconomics– The study of the economic choices individuals and

firms make and how those choices create markets

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Economic Models

Simple theoretical descriptions that capture the essentials of how the economy works– Used because the “real world” is too complicated to

describe in detail– Models tend to be “unrealistic” but useful

While they fail to show every detail (such as houses on a map) they provide enough structure to solve the problem (such as how a map provides you with a way to solve how to drive to a new location)

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The Production Possibility Frontier

A graph showing all possible combinations of goods that can be produced with a fixed amount of resources

Figure 1.1 shows a production possibility frontier where the good goods are food and clothing produced per week– At point A, 10 units of food and 3 units of clothing

can be produced

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Amountof food

per week

4

10A

B

Amountof clothing

per week

0 3 12

FIGURE 1.1: Production Possibility Frontier

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The Production Possibility Frontier

– At point B, 4 units of food can be produced and 12 units of clothing

Without more resources, points outside the frontier are unattainable– This demonstrates a basic fact that resources are

scarce

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Opportunity Cost

The cost of a good or service as measured by the alternative uses that are foregone by producing the good or service

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Opportunity Cost Example

Figure 1.1 also shows that the opportunity cost of clothing is much higher at point B (1 unit of clothing costs 2 units of food)– The increasing opportunity costs of producing even

more clothing is consistent with Ricardo’s and Marshall’s ideas of increasing marginal cost

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Amountof food

per week

4

9.510

A

B

Opportunity cost ofclothing = ½ pound of food

Opportunity cost ofclothing = 2 poundsof food

2

Amountof clothing

per week

0 3 4 1213

FIGURE 1.1: Production Possibility Frontier

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APPLICATION 1.1: Do Animals Understand Economics?

Nature provides examples of where animals have scarcity affect their choices– Birds of prey recognize a trade-off between

spending time and energy in one area and moving to another location

– To avoid using too much energy, animals will leave an area before the food supply is exhausted

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Uses of Microeconomics

While the uses of microeconomics are varied, one useful way to categorize is by types of users– Individuals making decisions regarding jobs,

purchases, and finances– Businesses making decisions regarding the

demand for their product or their costs– Governments making policy decisions regarding

laws and regulations

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APPLICATION 1.2: Is It Worth Your Time to Be Here?

• The typical U.S. college student pays about $18,000 per year in tuition, fees, and room and board charges. One might conclude then, that the “cost” of 4 years of college is about $72,000.

- A number of studies have suggested that college graduates earn more than those without such an education.

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The Basic Supply-Demand Model

A model describing how a good’s price is determined by the behavior of the individual’s who buy the good and the firms that sell it.– Economists argue that market behavior can

generally be explained by this model that captures the relationship between consumers’ preferences and firms’ costs.

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Adam Smith and the Invisible Hand

Adam Smith (1723-1790) saw prices as the force that directed resources into activities where they were most valuable

Prices told both consumers and firms the “worth” of the good.

Smith’s somewhat incomplete explanation for prices was that they were determined by the costs to produce the goods.

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Price

P*

Quantity per week

FIGURE 1.2(a): Smith’s Model

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David Ricardo and Diminishing Returns

David Ricardo (1772-1823) believed that labor and other costs would rise with the level of production– for example, as new less fertile land was cultivated,

it would require more labor

This increasing cost argument is now referred to as the law of diminishing returns

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Price

P1

Quantity per weekQ1

FIGURE 1.2(b): Ricardo’s Model

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Price

P2

P1

Quantity per weekQ1 Q2

FIGURE 1.2(b): Ricardo’s Model

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Price

P*

Quantity per week

(a) Smith model’ (b) Ricardo model’

Price

P2

P1

Quantity per weekQ1 Q2

FIGURE 1.2: Early Views of Price Determination

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Marginalism and Marshall’s Model of Supply and Demand

People will be willing to consume more of a good only if the price is lower

The focus of the model was on the value of the last, or marginal, unit purchased

Alfred Marshall (1842-1924) showed how the forces of demand and supply simultaneously determined price

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Marginalism and Marshall’s Model of Supply and Demand

The upward sloping supply curve reflects the idea of increasing cost of making one more unit of a good as total production increases

Supply reflects increasing marginal costs and demand reflects decreasing marginal usefulness

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Price

Demand

Supply

Quantity per week

0

FIGURE 1.3: The Marshall Supply-Demand Cross

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Market Equilibrium

In Figure 1.3, the demand and supply curve intersect at the market equilibrium point P*, Q*

P* is the equilibrium price: The price at which the quantity demanded by buyers of a good is equal to the quantity supplied by sellers of the good

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Price Demand Supply

Equilibrium pointP*

Quantity per week

0Q*

FIGURE 1.3: The Marshall Supply-Demand Cross

.

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Nonequilibrium Outcomes

If something causes the price to be set above P*, demanders would wish to buy less than Q* while suppliers would produce more than Q*

If something causes the price to be set below P*, demanders would wish to buy more than Q* while suppliers would produce less than Q*

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Change in Market Equilibrium: Increased Demand

Figure 1.4 shows the case where people’s demand for the good increases as represented by the shift of the demand curve from D to D’

A new equilibrium is established where the equilibrium price has increased to P**

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PriceD

D’S

P*P**

Quantityper week

0 Q* Q**

FIGURE 1.4: An increase in Demand Alters Equilibrium Price and Quantity

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Price

D

S’S

P*P**

Quantityper week

0 Q**Q*

FIGURE 1.5: A shift in Supply Alters Equilibrium Price and Quantity

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How Economists Verify Theoretical Models

Two methods are used– Testing Assumptions: Verifying economic models by

examining validity of the assumptions on which they are based

– Testing Predictions: Verifying economic models by asking if they can accurately predict real-world events

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Testing Assumptions

One approach would be to determine if the assumptions are reasonable– The obvious problem is that people have differing

opinion regarding reasonable

Empirical evidence can also be used– Results of such methods have had problems similar

to those found in opinion polls

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Testing Predictions

Economists, such as Milton Friedman argue that all theories require unrealistic assumptions

The theory is only useful if it can be used to predict real-world events– Even if firms state they don’t maximize profits, if

their behavior can be predicted by using this assumption, the theory is useful

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The Positive-Normative Distinction

Distinction between theories that seek to explain the world as it is and theories that postulate the way the world should be– To many economists, the correct role for theory is to

explain the way the world is (positive) rather than the way it should be (normative)

– Positive economics is the primary approach of the text

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APPLICATION 1.5: Do Economists Ever Agree?

Many jokes and popular opinion suggest that economists do not agree on many issues

This belief arises primarily because people fail to distinguish between positive and normative issues

As Table 1 shows, there is much agreement regarding positive issues but much less agreement with normative issues

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TABLE 1: Percentage of Economists Agreeing with Various Propositions in Three Nations

Proposition U.S.A.Switzer-land Germany

Tariffs reduce economicwelfare 95 87 94

Flexible exchange rates areeffective for internationaltransactions

94 91 92

Rent controls reduce thequality of housing 96 79 94

Government shouldredistribute income 68 51 55

Government should hire thejobless 51 52 35