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Chapter 1 Economic Models © 2004 Thomson Learning/South-Western What is Microeconomics? Economics – Microeconomics – 2 The study of the allocation of scarce resources among alternative uses The study of the economic choices individuals and firms make and how those choices create markets 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 3 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) 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 – 4 At point A, 10 units of food and 3 units of clothing can be produced FIGURE 1.1: Production Possibility Frontier Amount of food per week 10 A B 4 0 5 3 12 Amount of clothing per week The Production Possibility Frontier – Without more resources, points outside the frontier are unattainable – 6 At point B, 4 units of food can be produced and 12 units of clothing This demonstrates a basic fact that resources are scarce Opportunity Cost 7 The cost of a good or service as measured by the alternative uses that are foregone by producing the good or service 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) – 8 The increasing opportunity costs of producing even more clothing is consistent with Ricardo’s and Marshall’s ideas of increasing marginal cost FIGURE 1.1: Production Possibility Frontier Amount of food per week 10 9.5 Opportunity cost of clothing = ½ pound of food A Opportunity cost of clothing = 2 pounds of food B 4 2 0 9 3 4 1213 Amount of clothing per week APPLICATION 1.1: Do Animals Understand Economics? Nature provides examples of where animals have scarcity affect their choices – – 10 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 Uses of Microeconomics While the uses of microeconomics are varied, one useful way to categorize is by types of users – – – 11 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 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. 12 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. – 13 Economists argue that market behavior can generally be explained by this model that captures the relationship between consumers’ preferences and firms’ costs. Adam Smith and the Invisible Hand 14 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. FIGURE 1.2(a): Smith’s Model Price P* Quantity per week 15 David Ricardo and Diminishing Returns David Ricardo (1772-1823) believed that labor and other costs would rise with the level of production – 16 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 FIGURE 1.2(b): Ricardo’s Model Price P1 Q1 17 Quantity per week FIGURE 1.2(b): Ricardo’s Model Price P2 P1 Q1 18 Q2 Quantity per week FIGURE 1.2: Early Views of Price Determination Price Price P2 P* P1 Quantity per week (a) Smith ’ model 19 Q1 Q2 Quantity per week (b) Ricardo model ’ Marginalism and Marshall’s Model of Supply and Demand 20 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 Marginalism and Marshall’s Model of Supply and Demand 21 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 FIGURE 1.3: The Marshall SupplyDemand Cross Price Supply Demand 0 22 Quantity per week Market Equilibrium 23 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 FIGURE 1.3: The Marshall SupplyDemand Cross Price Demand . P* 0 24 Supply Q* Equilibrium point Quantity per week Nonequilibrium Outcomes 25 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* Change in Market Equilibrium: Increased Demand 26 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** FIGURE 1.4: An increase in Demand Alters Equilibrium Price and Quantity D’ Price S D P** P* 0 27 Q* Q** Quantity per week FIGURE 1.5: A shift in Supply Alters Equilibrium Price and Quantity S’ Price S P** P* D 0 28 Q** Q* Quantity per week How Economists Verify Theoretical Models Two methods are used – – 29 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 Testing Assumptions One approach would be to determine if the assumptions are reasonable – Empirical evidence can also be used – 30 The obvious problem is that people have differing opinion regarding reasonable Results of such methods have had problems similar to those found in opinion polls 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 – 31 Even if firms state they don’t maximize profits, if their behavior can be predicted by using this assumption, the theory is useful 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 – – 32 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 APPLICATION 1.5: Do Economists Ever Agree? 33 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 TABLE 1: Percentage of Economists Agreeing with Various Propositions in Three Nations Proposition Tariffs reduce economic welfare 95 87 94 94 91 92 96 79 94 Government should redistribute income 68 51 55 Government should hire the jobless 51 52 35 Flexible exchange rates are effective for international transactions Rent controls reduce the quality of housing 34 SwitzerU.S.A. land Germany