Chapter 1 Economic Models © 2006 Thomson Learning/South-Western

2 Economics How societies allocate scarce resources among alternative uses—three questions: What to produce How much to produce Who gets the physical and monetary proceeds

3 MICROECONOMICS How individuals and firms make economic choices among scarce resources How these choices create markets

4 Production Possibility Frontier Graph showing all possible combinations of goods produced with fixed resources Figure 1-1 shows production possibility frontier--food and clothing produced per week At point A, society can produce 10 units of food and 3 units of clothing

5 Amount of food per week— lbs A B Amount of clothing per week—articles of clothing FIGURE 1-1: Production Possibility Frontier

6 Production Possibility Frontier At B, society can choose to produce 4 lbs. of food and 12 articles of clothing. Without more resources, points outside production possibilities frontier are unattainable Resources are scarce; we must choose among what we have to work with.

7 Production Possibility Frontier Simple model illustrates five principles common to microeconomic situations:  Scarce Resources  Scarcity expressed as Opportunity costs  Rising Opportunity Costs  Importance of Incentives  Inefficiency costs real resources

8 Scarcity And Opportunity Costs Opportunity cost: Cost of a good as measured by goods or services that could have been produced using those scarce resources

9 Opportunity Cost Example Figure 1-1: if economy produces one more article of clothing beyond 10 at point A, economy can only produce 9.5 lbs. of food, given scarce resources. Tradeoff (or OPPORTUNITY COST) at pt. A: ½ lb food for each article of clothing.

10 Amount of food per week (lbs.) A Opportunity cost of clothing = ½ pound of food Amount of clothing per week (articles) 0 34 FIGURE 1-1: Production Possibility Frontier

11 Rising Opportunity Costs Fig.1-1 also shows that opportunity cost of clothing rises so that it is much higher at point B (1 unit of clothing costs 2 lbs. of food). Opportunity costs of economic action not constant, but vary along PPF

12 Amount of food per week A B Opportunity cost of clothing = ½ pound of food Opportunity cost of clothing = 2 pounds of food 2 Amount of clothing per week FIGURE 1-1: Production Possibility Frontier

13 Uses of Microeconomics Uses of microeconomic analysis vary. One useful way to categorize: by user type: Individuals making decisions regarding jobs, purchases, and finances; Businesses making decisions regarding product demand or production costs, or Governments making policy decisions about economic effects of various proposed or existing laws and regulations.

14 Basic Supply-Demand Model Model describes how sellers’ and buyers’ behavior determines good’s price Economists hold that market behavior generally explained by relationship between buyers’ preferences for a good (demand) and firms’ costs involved in bringing that good to market (supply).

15 Adam Smith--The Invisible Hand Adam Smith ( ) saw prices as force that directed resources into activities where resources were most valuable. Prices told both consumers and firms the “worth” of goods.

16 David Ricardo--Diminishing Returns David Ricardo ( ) believed that labor and other costs would rise with production level As new, less fertile, land was cultivated, farming would require more labor for same yield Increasing cost argument: now referred to as the Law of Diminishing Returns

17 Price P* Quantity per week (a) Smith model’(b) Ricardo model ’ Price P2P2 P1P1 Quantity per weekQ1Q1 Q2Q2 FIGURE 1-2: Early Views of Price Determination

18 Marshall’s Model of Supply and Demand Ricardo’s model could not explain fall in relative good prices during nineteenth century (industrialization), so economists needed a more general model. Economists argued that people’s willingness to pay for a good will decline as they have more of that good—the beginnings of thinking at the margin.

19 Marshall, Supply and Demand, and the Margin People willing to consume more of good only if price drops. Focus of model: on value of last, or marginal, unit purchased Alfred Marshall ( ) showed how forces of demand and supply simultaneously determined price.

20 Marshall, Supply and Demand, and the Margin Figure 1-3: amount of good purchased per period shown on the horizontal axis; price of good appears on vertical axis. Demand curve shows amount of good people want to buy at each price. Negative slope reflects marginalist principle.

21 Marshall, Supply and Demand, and the Margin Upward-sloping supply curve reflects increasing cost of making one more unit of a good as total amount produced increases. Supply reflects increasing marginal costs and demand reflects decreasing marginal utility.

22 Price Demand Supply Quantity per week 0 FIGURE 1-3: The Marshall Supply-Demand Cross

23 Market Equilibrium Figure 1-3: demand and supply curves intersect at the market equilibrium point P*, Q* P* is equilibrium price: price at which the quantity demanded by a good’s buyers precisely equals quantity of that good supplied by sellers

24 Price Demand Supply Equilibrium point P* Quantity per week 0 Q* FIGURE 1-3: The Marshall Supply-Demand Cross.

25 Market Equilibrium Both buyers and sellers are satisfied at this price--no incentive for either to alter their behavior unless something else changes

26 Non-equilibrium Outcomes If an event 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*.

27 Change in Market Equilibrium: Increased Demand Figure 1-4 people’s demand for good increases, as represented by shift of demand curve from D to D’ New equilibrium established where equilibrium price increases to P**

28 Price D S P* Quantity per week 0 Q* FIGURE 1-4: An increase in Demand Alters Equilibrium Price and Quantity

29 Price D D’ S P* P** Quantity per week 0 Q*Q** FIGURE 1-4: An increase in Demand Alters Equilibrium Price and Quantity

30 Change in Market Equilibrium: decrease in Supply Figure 1-5: supply curve shifts leftward (towards origin)--reflects decrease in supply because of increased supplier costs (increase in fuel costs) At new equilibrium price P**, consumers respond by reducing quantity demanded along Demand curve D

31 Price D S P* Quantity per week 0 Q* FIGURE 1-5: A shift in Supply Alters Equilibrium Price and Quantity

32 Price D S’ S P* P** Quantity per week 0 Q**Q* FIGURE 1-5: Shift in Supply Alters Equilibrium Price and Quantity