1. Walter Nicholson Christopher Snyder
Amherst College
Christopher Snyder
Dartmouth College
PowerPoint Slide Presentation | Philip Heap, James Madison University
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2. 1 Economic Models CHAPTER
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3. What is Economics?
“Economics is the study of the allocation of scarce resources among alternative uses.”
“Economics is the study of mankind in the ordinary business of life.” Alfred Marshall
“Economics never tells a man how he should act; it merely shows how a man must act if he wants to attain definite ends.” Ludwig von Mises
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4. What is Microeconomics?
Microeconomics is the study of the economic choices individuals and firms make and how these choices create markets.
Examples of economic choices.
Repair a bicycle or buy a new one
Study for one more hour or go to the movies
Invest in stocks or in bonds or both
Go for a Master’s program or start working after graduating
Add another dish to the restaurant’s menu
Cheap and low quality versus expensive and high quality
What do these choices have in common? TRADEOFFS
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5. Economic Models
A model is a simple theoretical description that captures the essentials of how the economy works.
Simple since it does not capture every detail.
But lets you see the overall picture and answer the relevant question.
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6. The PPF Suppose an economy produces food and clothing
We can show how much food and clothing can be made on a production possibilities frontier diagram.
Amount of food per week
PPF
Amount of clothing per week
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7. The PPF
A PPF shows the possible combination of two goods an economy can produce with a fixed amount of resources.
Amount of food per week
We can produce 10 food and 3 clothing 10
Or 4 food and 12 clothing 4
Amount of clothing per week 3 12
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8. The PPF and Five Basic Principles
We want to use this model to illustrate five basic principles.
Scarce resources
Scarcity involves opportunity costs
Increasing opportunity costs
Incentives matter
Inefficiency has real costs
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9. The PPF and Five Basic Principles
Principle 1: Scarce Resources
Amount of food per week
Points outside the frontier are unattainable since we don’t have enough resources to produce them.
We can make 4 food and 12 clothing. 10
But not 4 food and 14 clothing. 4
Amount of clothing per week 3 12 14
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10. The PPF and Five Basic Principles
Principle 1: How does the PPF illustrate scarcity?
Amount of food per week
But not 12 food and 3 clothing.
We can make 10 food and 3 clothing. 10
Amount of clothing per week 3 12
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11. The PPF and Five Basic Principles
Principle 2: Scarcity involves opportunity cost.
Opportunity cost is the cost of producing a good measured by the alternative uses that are foregone producing it.
If I am on the PPF the opportunity cost of more clothing is less food.
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12. The PPF and Five Basic Principles
Principle 2: Scarcity involves opportunity costs
Amount of food per week
What is the opportunity cost of increasing clothing production from 3 to 4 units? 10
9.5 4
Amount of clothing per week 3 4 12
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13. The PPF and Five Basic Principles
Principle 3: Opportunity costs are increasing.
As you produce more and more of one good, its opportunity cost in terms of the other good foregone increases.
To produce more and more clothing you would have to give up increasing amounts of food.
The law of diminishing marginal returns.
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14. The PPF and Five Basic Principles
Principle 3: Opportunity costs are increasing.
Amount of food per week
Here the opportunity cost of one more unit of clothing was ½ food 10
9.5
Now to produce one more unit of clothing you give up 2 units of food 4 2
Amount of clothing per week 3 4 12 13
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15. The PPF and Five Basic Principles
Principle 4: Incentives Matter
People will make decisions based on opportunity costs.
When the opportunity cost of some activity increases, people are more likely to engage in that activity.
Sometimes it is difficult to see the true opportunity costs of the activity.
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16. The PPF and Five Basic Principles
Principle 5: Inefficiencies involve real costs
Why are points inside the frontier inefficient?
Amount of food per week
Because we could produce more clothing without giving up any food. 10
Or more food without giving up clothing
Or make more of both goods 4
Amount of clothing per week 3 12
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17. Opportunity Costs of College Education
A typical US student pays $20000 in tuition fees
Is the cost of 4 years of college equal to $80000?
Room and board are likely to be paid for anyway
Foregone wages and salaries
$20000 today are worth more compared to $20000 four years later
Room and board are $7000 annually, which brings “pure” tuition down to $13000
A regular job would get you $20000 a year, but as a student you could make $2000, so $18000 is what you “lose” by not working because of studying
Tuition + Foregone Job = $ $18000 = $31000
Adjusting for time (see Chapter 16), the total cost of your education is less than 4x$31000 and is estimated to be about $114000

18. Basic Supply-Demand Model
A Supply-Demand Model is a model that describes how a good’s price is determined by the behavior of the people who buy the good and of the firms that sell the good.
The model relates buyers’ preferences (demand) to production costs (supply).
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19. Adam Smith and the Invisible Hand
What did Smith mean by the “invisible hand”?
The invisible hand directed resources to where they would be most valuable.
Prices in the market tell buyers and sellers the relative value of goods: prices act as signals.
This enables them to make efficient choices.
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20. Adam Smith’s Model
Prices of goods depend on the relative value of labor used to produce the goods.
If it takes twice as long to make clothing as to grow food, one unit of clothing should trade for _______ units of food.
two
Labor is the only determinant of the cost of producing a good and hence its price
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21. Adam Smith’s Model Price 2 Quantity per week
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22. David Ricardo’s Model
Do you see a problem with Adam Smith’s model of price given our discussion of the PPF?
Diminishing returns – the cost of producing one more unit of a good rises as more of that good is produced.
Consistent with the idea of increasing opportunity costs.
As we produce more clothing, the price of clothing in terms of food should rise.
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23. David Ricardo’s Model Price Quantity per week
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24. The “Dismal Science” of Ricardo
Ricardo’s model was more realistic compared to Smith’s since it took account of scarcity of the production resources so prices would go up as more of anything is produced
Ricardo’s model, though, predicted that prices could be anything, and as population grew, infinite prices were a major fear, hence ‘dismal science’, see also Malthus.
However, in the 19th century prices did not increase significantly. In fact, many of them fell, consumption increased, and quality rose.
Subsistence no longer could explain the observed level of consumption.

25. Marshall’s Model of Supply and Demand
What are the problems with Smith’s and Ricardo’s models?
Smith’s model ignores rising opportunity costs.
Ricardo’s model is inconsistent with the falling prices that occurred during the 19th century.
Neither model truly considered the demand side of the market.
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26. Marshall’s Model of Supply and Demand
What matters is the value of the last or marginal unit produced or consumed.
On the demand side, the amount that people are willing to pay falls as they consume more.
Or, as the price falls, people are willing to buy more
Marshall’s model shows how prices are simultaneously determined by demand and supply.
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27. Law of Demand
Demand: As price falls, consumers are willing to buy more: this reflects decreasing marginal value.
Price
Demand
Quantity
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28. Law of Supply
Supply: As price rises, firms are able to produce more: this reflects increasing marginal costs.
Price
Supply
Demand
Quantity
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29. Equilibrium
Market Equilibrium: The equilibrium price is the price at which the quantity demanded is equal to the quantity supplied.
Price
Supply P*
Demand
Quantity
QD=QS=Q*
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30. Desirability of Market Equilibrium
Market equilibrium is desirable since
Consumers can buy exactly as many units as they want at the market price: no excess demand
Producers can sell exactly as many units as they want at the market price: no excess supply
Both consumers and producers satisfy their needs at the market price
Equilibrium is desirable in the economic sense, but it has nothing to do with fairness
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31. Stability of Market Equilibrium
What does it mean to be at equilibrium?
What would happen if the price was set above or below the equilibrium price?
What would cause the equilibrium price to rise or fall?
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32. 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*
Excess supply
Prices pushed down
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*
Excess demand
Prices pushed up
As a result, market equilibrium is a stable outcome.

33. A Change in Demand What happens if demand increases?
Price
Supply
P**
Demand shifts to the right. Price and quantity increase. P* D D’
Quantity per period Q*
Q**
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34. A Change in Supply What happens if supply decreases?
Price S
P**
Supply shifts to the left. Price increases and quantity decreases. P* D
Quantity per period
Q** Q*
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35. Changes in Market Equilibrium
If demand increases (shifts right) P* will __ and Q* will ___.
rise; rise
If demand decreases (shifts left), P* will __ and Q* will ___.
fall; fall
If supply increases (shifts right) P* will __ and Q* will ___.
fall; rise
If supply decreases (shifts left) P* will __ and Q* will ___.
rise; fall
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36. Changes in Market Equilibrium
What happens to P* and Q* when both demand and supply change?
Suppose demand and supply increase:
We know that Q* rises, but P* may rise or fall.
Suppose demand increases but supply decreases:
We know P* rises, but Q* may rise or fall.
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37. Bono against US Agricultural Subsidies
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
The Economist documents the event

38. U.S. Subsidies Reduce African Exports
African exports without US subsidies
African exports with
US subsidies P S P*
With subsidies, African exports drop, farmers’ incomes decline
However, subsidies increase welfare of African consumers
P** Pa D QD
Q’D
Q’S QS Q

39. How Economists Verify Models
Two methods:
Testing Assumptions: Verifying economic models by examining validity of assumptions upon which models are based
Is it reasonable to assume that people are rational, that firms maximize profits etc.
Testing Predictions: Verifying economic models by asking whether models can accurately predict real-world events
If the model predicts events well, then the theory is useful even if the assumption may not appear to be valid.
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40. Positive-Normative Distinction
What’s the difference between the following two statements?
An increase in the minimum wage leads to more unemployment.
We should increase the minimum wage to help low income workers.
The first is a positive statement: it looks at “what is”.
The second is a normative statement: it looks at “what should be”.
Is Economics a positive or normative science?
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41. Summary
Since resources are scarce, we must make choices about how we use them.
We can use the PPF model to illustrate important concepts such as opportunity cost and efficiency.
The supply and demand model shows how prices are determined, and how changes in demand and/or supply influence the price.
Judge the validity of economic models by how well they explain actual economic events.
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