Transcript (b) Ricardo model

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



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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