Chapter 1Chapter 1

Economic Models

© 2006 Thomson Learning/South-Western

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Economics

Economics How societies allocate scarce resources

among alternative uses—three questions:What to produceHow much to produceWho gets the physical and monetary

proceeds

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MICROECONOMICS

How individuals and firms make economic choices among scarce resources

How these choices create markets

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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 At point A, society can produce 10 units of

food and 3 units of clothing

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Amount of food

per week—lbs.

4

10A

B

Amount of clothingper week—articles of

clothing

0 3 12

FIGURE 1-1: Production Possibility Frontier

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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 Resources are scarce; we must choose

among what we have to work with.

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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

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.

10

Amount of food per week (lbs.)

9.510

A

Opportunity cost ofclothing = ½ pound of food

Amount of clothing per week (articles)

0 3 4

FIGURE 1-1: Production Possibility Frontier

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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

12

Amountof food

per week

4

9.510

A

B

Opportunity cost ofclothing = ½ pound of food

Opportunity cost ofclothing = 2 poundsof food

2

Amountof clothing

per week0 3 4 1213

FIGURE 1-1: Production Possibility Frontier

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Uses of Microeconomics

Uses of microeconomic analysis vary. One useful way to categorize: by user type: 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.

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Basic Supply-Demand Model

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).

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Adam Smith--The Invisible Hand

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.

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David Ricardo--Diminishing Returns

David Ricardo (1772-1823) believed that labor and other costs would rise with production level 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

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Price

P*

Quantity per week

(a) Smith model’ (b) Ricardo model’

Price

P2

P1

Quantity per weekQ1 Q2

FIGURE 1-2: Early Views of Price Determination

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Marshall’s Model of Supply and Demand

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.

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Marshall, Supply and Demand, and the Margin

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.

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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

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.

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Price

Demand

Supply

Quantity per week0

FIGURE 1-3: The Marshall Supply-Demand Cross

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Market Equilibrium

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

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Price Demand Supply

Equilibrium pointP*

Quantity per week0

Q*

FIGURE 1-3: The Marshall Supply-Demand Cross

.

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Market Equilibrium

Both buyers and sellers are satisfied at this price--no incentive for either to alter their behavior unless something else changes

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Non-equilibrium Outcomes

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*.

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Change in Market Equilibrium: Increased Demand

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**

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PriceD S

P*

Quantityper week0 Q*

FIGURE 1-4: An increase in Demand Alters Equilibrium Price and Quantity

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PriceD

D’S

P*P**

Quantityper week0 Q* Q**

FIGURE 1-4: An increase in Demand Alters Equilibrium Price and Quantity

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Change in Market Equilibrium: decrease in Supply

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

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Price

D

S

P*

Quantityper week

0 Q*

FIGURE 1-5: A shift in Supply Alters Equilibrium Price and Quantity

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Price

D

S’S

P*P**

Quantityper week0 Q**Q*

FIGURE 1-5: Shift in Supply Alters Equilibrium Price and Quantity