Slide Presentation by Mark Karscig Central Missouri State University Intermediate Microeconomics and Its Application 9th Edition by Walter Nicholson, Amherst College Slide Presentation by Mark Karscig Central Missouri State University © 2004 Thomson Learning/South-Western

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

What is Microeconomics? 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

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)

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

FIGURE 1.1: Production Possibility Frontier Amount of food per week A 10 B 4 Amount of clothing per week 3 12

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

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

Opportunity Cost Example As shown in Figure 1.1, if the economy produces one more unit of clothing beyond the 10 that it produces at point A, the amount of food produced decreases by 1/2 from 10 to 9.5 Thus, the opportunity cost of one unit of clothing is 1/2 unit of food at point A

FIGURE 1.1: Production Possibility Frontier Amount of food per week Opportunity cost of clothing = ½ pound of food A 10 9.5 Amount of clothing per week 3 4

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

FIGURE 1.1: Production Possibility Frontier Amount of food per week Opportunity cost of clothing = 2 pounds of food B 4 2 Amount of clothing per week 12 13

FIGURE 1.1: Production Possibility Frontier Amount of food per week Opportunity cost of clothing = ½ pound of food A 10 9.5 Opportunity cost of clothing = 2 pounds of food B 4 2 Amount of clothing per week 3 4 12 13

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

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

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.

APPLICATION 1.3: Saving Blockbuster The largest video rental company incurred a huge financial loss primarily because of the high price of first-run movies A large part of the “price” of the movie to the customer was not finding the movie in stock. Blockbuster reached an agreement to guarantee availability and reverse its losses.

APPLICATION 1.4: Microsoft and Antitrust The central issue of this case is whether or not Microsoft is illegally “monopolizing” various segments of the software industry in violation of the Sherman Antitrust Act. MIT professor Franklin Fisher suggests that the real danger is allowing Microsoft to dominate the internet browser market which would eliminate competition.

APPLICATION 1.4: Microsoft and Antitrust MIT professor Richard Schmalensee argues that Microsoft has not acted like a monopoly in the pricing of the Windows operating system The judge’s decision will have to try to strike a balance between the operating system monopoly and the ability of Microsoft to be innovative

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.

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.

Adam Smith and the Invisible Hand Since labor was the primary resource used, this led Smith to embrace a labor-based theory of prices. If catching deer took twice as long as catching a beaver, one deer should trade for two beaver (the relative price of a deer is two beaver’s). In Figure 1.1(a), the horizontal line at P* shows that any number of deer can be produced without affecting the relative cost

FIGURE 1.2(a): Smith’s Model Price P* Quantity per week

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

David Ricardo and Diminishing Returns The relative price of a good could be practically any amount, depending upon how much was produced The level of production represented the quantity the country needed to survive In Figure 1.2(b), as the needs of the country increase from Q1 to Q2 prices increase from P1 to P2

FIGURE 1.2(b): Ricardo’s Model Price P1 Q1 Quantity per week

FIGURE 1.2(b): Ricardo’s Model Price P2 P1 Q1 Q2 Quantity per week

FIGURE 1.2: Early Views of Price Determination Quantity per week Q1 Q2 Quantity per week (a) Smith model ’ (b) Ricardo model ’

Marginalism and Marshall’s Model of Supply and Demand Ricardo’s model was unable to explain the fall in the relative prices of good during the nineteenth century so a more general model was needed Economists argued the willingness of people to pay for a good will decline as they have more of it

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

Marginalism and Marshall’s Model of Supply and Demand In Figure 1.3, the amount of a good purchased per period is shown on the horizontal axis and the price of the good is shown on the vertical axis The demand curve shows the amount people want to buy at each price and is negatively sloped reflecting the marginalism principle

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

FIGURE 1.3: The Marshall Supply-Demand Cross Price Supply Demand Quantity per week

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

FIGURE 1.3: The Marshall Supply-Demand Cross Price Demand Supply . P* Equilibrium point Quantity per week Q*

Market Equilibrium Both demanders and suppliers are satisfied at this price, so there is no incentive for either to alter their behavior unless something else happens Marshall compared the roles of supply and demand in establishing market equilibrium to the two blades of a pair of scissors working together in order to make a cut

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*

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**

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

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

Change in Market Equilibrium: decrease in Supply In Figure 1.5 the supply curve has shifted leftward reflecting a decrease in supply brought about because of an increase in supplier costs (say an increase in wages) At the new equilibrium price P** consumers respond by reducing quantity demanded along the Demand curve D

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

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

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

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

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

Models of Many Markets Marshall's model of supply and demand is a partial equilibrium model: An economic model of a single market To show the effects of a change in one market on others requires a general equilibrium model: An economic model of a complete system of markets

APPLICATION 1.5: Economics According to Bono The Spring 2002 trip to Africa by the Irish rock star Bono and U.S. Treasury Secretary Paul O’Neill sparked much interesting dialogue about economics Bono claimed that recently enacted agricultural subsidies in the U.S. were harming struggling farmers in Africa

APPLICATION 1.5: Economics According to Bono In Figure 1 U.S. farm subsidies reduce the world price of this crop from P* to P**. Exports from this African country fall from QS – QD to Q’S – Q’D

Figure 1: U.S. Subsidies Reduce African Exports QD Q’D Q’S QS Q

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

APPLICATION 1.6: 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

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