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

2. 2 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

3. 3 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)

4. 4 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

5. 5 Amount of food per week 4 10 A B Amount of clothing per week 0 312 FIGURE 1.1: Production Possibility Frontier

6. 6 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

7. 7 Opportunity Cost The cost of a good or service as measured by the alternative uses that are foregone by producing the good or service

8. 8 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

9. 9 Amount of food per week 4 9.5 10 A B Opportunity cost of clothing = ½ pound of food Opportunity cost of clothing = 2 pounds of food 2 Amount of clothing per week 0 341213 FIGURE 1.1: Production Possibility Frontier

10. 10 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

11. 11 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

12. 12 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.

13. 13 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.

14. 14 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.

15. 15 Price P* Quantity per week FIGURE 1.2(a): Smith’s Model

16. 16 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

17. 17 Price P1P1 Quantity per weekQ1Q1 FIGURE 1.2(b): Ricardo’s Model

18. 18 Price P2P2 P1P1 Quantity per week Q1Q1 Q2Q2 FIGURE 1.2(b): Ricardo’s Model

19. 19 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

20. 20 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

21. 21 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

22. 22 Price Demand Supply Quantity per week 0 FIGURE 1.3: The Marshall Supply- Demand Cross

23. 23 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

24. 24 Price Demand Supply Equilibrium point P* Quantity per week 0 Q* FIGURE 1.3: The Marshall Supply- Demand Cross.

25. 25 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*

26. 26 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**

27. 27 Price D D’ S P* P** Quantity per week 0 Q*Q** FIGURE 1.4: An increase in Demand Alters Equilibrium Price and Quantity

28. 28 Price D S’ S P* P** Quantity per week 0 Q**Q* FIGURE 1.5: A shift in Supply Alters Equilibrium Price and Quantity

29. 29 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

30. 30 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

31. 31 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

32. 32 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

33. 33 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

34. 34 TABLE 1: Percentage of Economists Agreeing with Various Propositions in Three Nations