inter micro -- chapter 1

2/29/2016

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Walter NicholsonAmherst CollegeChristopher SnyderDartmouth College

PowerPoint Slide Presentation | Philip Heap, James Madison University©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2

EconomicModels

CHAPTER1

What is Economics?

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Ch. 1 • 3

• “Economics is the study of the allocation of scarce resources among alternative uses.”• Microeconomics is the study of the economic choices individuals and firms make and how these choices create markets.• Examples of economic choices.

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.

The PPF


• Suppose an economy produces food and clothingAmount of food per week

Amount of clothing per week

• We can show how much food and clothing can be made on a production possibilities frontier diagram.

PPF

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


10

3 12

4Or 4 food and 12 clothing

We can produce 10 food and 12 clothing

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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



• Principle 1: Scarce ResourcesAmount of food per week


10

3 12

4

Points outside the frontier are unattainable since we don’t have enough resources to produce them.

We can make 4 food and 12 clothing.But not 4 food and 14 clothing.

14



• Principle 1: How does the PPF illustrate scarcity?Amount of food per week


10

3 12

We can make 10 food and 3 clothing.

But not 12 food and 3 clothing.



• Principle 2: Scarcity involves opportunity cost.• Opportunity cost is the cost of a 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.



Principle 2: Scarcity involves opportunity costs Amount of food per week


10

3 12

4

4

9.5

What is the opportunity cost of increasing clothing production from 3 to 4 units?



• 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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Principle 3: Opportunity costs are increasing. Amount of food per week


10

3 12

4

4

9.5

Now to produce one more unit of clothing you give up 2 units of food

13

2

Here the opportunity cost of one more unit of clothing was ½ food



• 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.



• Principle 5: Inefficiencies involve real costsAmount of food per week


10

3 12

4

Why are points inside the frontier inefficient?Because we could produce more clothing withoutgiving up any food.

Or more food without giving up clothingOr make more of both goods

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).

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.

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• So any number of units of clothing can be produce for two units of food.

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• Adam Smith’s ModelPrices of goods depend on the relative value of labor used to produce the goods.


Price

Quantity per week

2

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.


• David Ricardo’s ModelDiminishing returns – the cost of producing one more unit of a good rises as more of that good is produced.


Price

Quantity per week

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.


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.


Price

Quantity

Adam Smith’s ModelDemand: As price falls, consumers are willing to buy more: this reflects decreasing marginal value.

Demand


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Price

Quantity


Demand


Supply: As price rises, firms are able to produce more: this reflects increasing marginal costs.

Supply

Price

Quantity


Demand


Market Equilibrium: The equilibrium price is the price at which the quantity demanded is equal to the quantity supplied.Supply

P*

QD=QS=Q*

On 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?


Price

Quantity per period

What happens if demand increases?

D

Supply

P*

Q*D’

P**

Q**

A Change in Demand

Demand shifts to the right. Price and quantity increase.


Price

Quantity per period

What happens if supply decreases?

D

S

P*

Q*

S’

P**

Q**

A Change in Supply

Supply shifts to the left. Price increases and quantity decreases.


• If demand increases (shifts right) P* will __ and Q* will ___.• If demand decreases (shifts left), P* will __ and Q* will ___.• If supply increases (shifts right) P* will __ and Q* will ___.• If supply decreases (shifts left) P* will __ and Q* will ___.

Changes in Market Equilibrium


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• 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





• 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.

• 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.

How Economists Verify Models


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?


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.

inter micro -- chapter 1

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