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Chapter 1
Economic Models
© 2006 Thomson Learning/South-Western
Economics
Economics
 How societies allocate scarce resources
among alternative uses—three
questions:
 What to produce
 How much to produce
 Who gets the physical and monetary
proceeds
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MICROECONOMICS
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
How individuals and firms make
economic choices among scarce
resources

How these choices create markets
Production Possibility Frontier

Graph showing all possible combinations
of goods produced with fixed resources

Figure 1-1 shows production possibility
frontier--food and clothing produced per
week

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At point A, society can produce 10 units of
food and 3 units of clothing
FIGURE 1-1: Production
Possibility Frontier
Amount of
food
per week—
lbs.
10
A
B
4
0
5
3
Amount of clothing
12
per week—articles of clothing
Production Possibility Frontier


At B, society can choose to produce 4 lbs.
of food and 12 articles of clothing.
Without more resources, points outside
production possibilities frontier are
unattainable
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Resources are scarce; we must choose
among what we have to work with.
Production Possibility Frontier
Simple model illustrates five principles
common to microeconomic situations:
 Scarce Resources
 Scarcity expressed as Opportunity costs
 Rising Opportunity Costs
 Importance of Incentives
 Inefficiency costs real resources
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Scarcity And Opportunity Costs
Opportunity cost:
 Cost of a good as measured by
goods or services that could
have been produced using those
scarce resources
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Opportunity Cost Example
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
Figure 1-1: if economy produces one more
article of clothing beyond 10 at point A,
economy can only produce 9.5 lbs. of
food, given scarce resources.

Tradeoff (or OPPORTUNITY COST) at pt.
A: ½ lb food for each article of clothing.
FIGURE 1-1: Production Possibility Frontier
Amount of
food per
week (lbs.)
Opportunity cost of
clothing = ½ pound of food
10
9.5
0
10
A
3 4
Amount of clothing per
week (articles)
Rising Opportunity Costs

Fig.1-1 also shows that opportunity cost
of clothing rises so that it is much higher
at point B (1 unit of clothing costs 2 lbs.
of food).

Opportunity costs of economic action
not constant, but vary along PPF
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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
12
3 4
1213
Amount
of clothing
per week
Uses of Microeconomics

Uses of microeconomic analysis vary. One
useful way to categorize: by user type:



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Individuals making decisions regarding jobs,
purchases, and finances;
Businesses making decisions regarding product
demand or production costs, or
Governments making policy decisions about
economic effects of various proposed or existing
laws and regulations.
Basic Supply-Demand Model


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Model describes how sellers’ and buyers’
behavior determines good’s price
Economists hold that market behavior
generally explained by relationship
between buyers’ preferences for a good
(demand) and firms’ costs involved in
bringing that good to market (supply).
Adam Smith--The Invisible Hand

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Adam Smith (1723-1790) saw prices as
force that directed resources into activities
where resources were most valuable.
Prices told both consumers and firms the
“worth” of goods.
David Ricardo--Diminishing Returns

David Ricardo (1772-1823) believed that
labor and other costs would rise with
production level

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As new, less fertile, land was cultivated,
farming would require more labor for same
yield
Increasing cost argument: now referred to
as the Law of Diminishing Returns
FIGURE 1-2: Early Views of Price
Determination
Price
Price
P2
P*
P1
Quantity per week
(a) Smith
’
model
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Q1
Q2 Quantity per week
(b) Ricardo model
’
Marshall’s Model of Supply and Demand


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Ricardo’s model could not explain fall in
relative good prices during nineteenth
century (industrialization), so economists
needed a more general model.
Economists argued that people’s
willingness to pay for a good will decline
as they have more of that good—the
beginnings of thinking at the margin.
Marshall, Supply and Demand, and the Margin


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People willing to consume more of good
only if price drops.
Focus of model: on value of last, or
marginal, unit purchased
Alfred Marshall (1842-1924) showed how
forces of demand and supply
simultaneously determined price.
Marshall, Supply and Demand, and the Margin

Figure 1-3: amount of good purchased per
period shown on the horizontal axis; price
of good appears on vertical axis.

Demand curve shows amount of good
people want to buy at each price. Negative
slope reflects marginalist principle.
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Marshall, Supply and Demand, and the Margin

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Upward-sloping supply curve reflects
increasing cost of making one more unit of
a good as total amount produced
increases.
Supply reflects increasing marginal costs
and demand reflects decreasing marginal
utility.
FIGURE 1-3: The Marshall
Supply-Demand Cross
Price
Supply
Demand
0
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Quantity
per week
Market Equilibrium

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Figure 1-3: demand and supply curves
intersect at the market equilibrium point
P*, Q*
P* is equilibrium price: price at which
the quantity demanded by a good’s
buyers precisely equals quantity of that
good supplied by sellers
FIGURE 1-3: The Marshall
Supply-Demand Cross
Price
Demand
.
P*
0
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Supply
Q*
Equilibrium point
Quantity
per week
Market Equilibrium
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Both buyers and sellers are satisfied at
this price--no incentive for either to alter
their behavior unless something else
changes
Non-equilibrium Outcomes
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If an event 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

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Figure 1-4 people’s demand for good
increases, as represented by shift of
demand curve from D to D’
New equilibrium established where
equilibrium price increases to P**
FIGURE 1-4: An increase in Demand
Alters Equilibrium Price and Quantity
D
Price
S
P*
0
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Q*
Quantity
per week
FIGURE 1-4: An increase in Demand
Alters Equilibrium Price and Quantity
D’
Price
S
D
P**
P*
0
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Q* Q**
Quantity
per week
Change in Market Equilibrium:
decrease in Supply

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Figure 1-5: supply curve shifts leftward
(towards origin)--reflects decrease in
supply because of increased supplier
costs (increase in fuel costs)
At new equilibrium price P**, consumers
respond by reducing quantity demanded
along Demand curve D
FIGURE 1-5: A shift in Supply Alters
Equilibrium Price and Quantity
S
Price
P*
D
0
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Q*
Quantity
per week
FIGURE 1-5: Shift in Supply Alters
Equilibrium Price and Quantity
S’
Price
S
P**
P*
D
0
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Q** Q*
Quantity
per week