Micro Economics Part I Unit 2 Slide 1 Created: by Jim Luke. The desire for food is limited in every man by the narrow capacity of the human stomach; but the desire for the conveniences and ornaments of building, dress, equipage, and household furniture, seem to have no limit or boundary. Adam Smith, 1776

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 2 The Economic Problem Unlimited Wants but Scarce Resources

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 3 Key Definitions* Goods  Anything that satisfies a human want Resources  Land, Labor, Capital Consumption  Use Goods to satisfy wants Production  Combine resources to create goods

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 4 Nine Principles 4 Principles of Individual Choice 4 Principles of Individual Choice 5 Principles of Markets 5 Principles of Markets

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 5 Individual Choice Principle: Scarcity Result of Economic Problem Both Resources & Time are Scarce

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 6 Individual Choice Principle: Opportunity Cost Measured by value of best alternative given-up Measured by value of best alternative given-up What could have been if this choice were not made What could have been if this choice were not made

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 7 Individual Choice Principle: Marginal Decisions Marginal: the next unit, or the incremental unit Quantities are chosen marginally by comparing marginal benefits vs. marginal costs

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 8 Individual Choice Principle: Rational Decisions “Self-Interest” Individuals try to maximize the expected benefit, given constraints  Assumed Rationality  Voluntary, not Coerced

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 9 Market Principle: Trade is Win-Win Diversity creates opportunities for “gains from trade” Voluntary trade ONLY occurs if both parties gain

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 10 Market Principle: Equilibrium Given conditions, everybody is doing the best they can No incentive to change more precise definition later

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 11 Market Principle: Social Goal: Efficiency Making the most of limited resources Economic Efficiency  “Pareto Optimal”  “Allocation” efficiency Efficient Production  Max Output, Given Current Resources  What about Equity?

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 12 Market Principle: Markets are Efficient Competitive markets achieve greatest efficiency Exceptions: monopoly monopoly externalities externalities public goods public goods

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 13 Market Principle: Government Role Sets the “rules” Enforce Contracts Public goods Correct market “failures”

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 14 Question: Bastiat’s Fallacy of the Window: A child throws a brick though a window. The owner pays a glazier to replace the window.  Who gains?  Who loses?  Was there economic “growth” and production?  Examples of the fallacy?

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 15 Methodology: How Do Economists Think? “What is often called sound economics is very often what mirrors the needs of the respectably affluent”. J.K. Galbraith ( Money, 1975)

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 16 Economic Theories: Models Simplied Simplied “If…..then….” “If…..then….” Predict Behavior Predict Behavior Key Factors Only Key Factors Only Too Many Details  Unwieldy Too Many Details  Unwieldy Aim to Explain Aim to Explain  Stories, Graphs, Data, Math

Micro Economics Part I Unit 2 Slide 17 Economic Activities & Interactions Economic Agents:  Households  Firms Where they interact:  Markets for goods and services  Markets for factors of production

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 18 Positive vs. Normative Economics Theory & Positive Economics  Evidence Supports/Denies  Conditional Forecasts  “ceteris paribus”  How things work/ What “is” Policy & Normative Economics  Change Rules  What to do / What “should”

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 19 Economic “Systems” How to answer 4 questions?  What to produce?  How much to produce?  How to produce?  Who gets to consume?

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 20 Questions for our 1 st model: What to produce? How much to produce? What’s possible? What’s a fantasy? What’s most we can make?

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 21 PPF: Production Possibilities Frontier Model of Economic Problem & Choice  Max. Production Quantities Possible of 2 Goods  All Resources Used Efficiently Assumptions  Two Goods  Fixed Time Period  Resources available:  Fixed Quantity  Fixed Quality  Technology does not change

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 22 Factors Affecting PPF Shift curve (right/out or left/in)  Changes in Resource Quantity / Quality  Increase Capital Stock  Technological Change Shape curve  Comparative Advantage & Trade  Law of Increasing Costs

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 23 Example Homer & Ned Stranded on Two Islands

Created: 2005-Aug-31 by Jim Luke. Micro Economics Part I Unit 2 Slide 24 PPF Model Illustrates Opportunity Costs Opportunity Costs Gains from Trade and Specialization Gains from Trade and Specialization

Micro Economics Part I Unit 2 Slide 25 Who makes what & who trades? Comparative advantage: opportunity cost of is lower than for other people. Determines trade patterns Absolute advantage: physical resource cost is least physical resource cost is least

Micro Economics Part I Unit 2 Slide 26 In the next unit: When trade happens….  How is price determined?  How is the quantity traded determined?