Inter Micro - Chapter 1

2/29/2016
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.
Walter Nicholson
Amherst College
But lets you see the overall picture and answer the relevant
question.
Christopher Snyder
Dartmouth 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.
Ch. 1 4
The PPF
CHAPTER
Suppose an economy produces food and clothing

We can show how much food and clothing can be made on a
production possibilities frontier diagram.
Economic
Models
Amount
of food
per week
PPF
Amount of clothing
per week
What is Economics?
The PPF
Economics is the study of the allocation of scarce resources

among alternative uses.
A PPF shows the possible combination of two goods an economy

can produce with a fixed amount of resources.
Microeconomics is the study of the economic choices individuals

and firms make and how these choices create markets.
Amount
of food
per week
10
We can produce 10 food and 12 clothing
Examples of economic choices.
Or 4 food and 12 clothing
Ch. 1 5
Ch. 1 3
12
Amount of clothing
per week
Ch. 1 6
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The PPF and Five Basic Principles
We want to use this model to illustrate five basic principles.
Principle 2: Scarcity involves opportunity cost.
Scarce resources
Scarcity involves opportunity costs
Increasing opportunity costs
Incentives matter
Inefficiency has real costs
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.
Ch. 1 7
Principle 2: Scarcity involves opportunity costs
Points outside the frontier are unattainable since

we dont have enough resources to produce them.
We can make 4 food and 12 clothing.
10
But not 4 food and 14 clothing.
Amount
of food
per week
What is the opportunity cost of increasing

clothing production from 3 to 4 units?
10
9.5
12
14
Amount of clothing
per week
Ch. 1 8
12
Amount of clothing
per week
Ch. 1 11
Principle 3: Opportunity costs are increasing.
But not 12 food and 3 clothing.

We can make 10 food and 3 clothing.
10
Principle 1: How does the PPF illustrate scarcity?

Amount
of food
per week
Ch. 1 10
Principle 1: Scarce Resources

Amount
of food
per week
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.
12
Amount of clothing
per week
Ch. 1 9
Ch. 1 12
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Basic Supply-Demand Model
Principle 3: Opportunity costs are increasing.

Amount
of food
per week
A Supply-Demand Model is a model that describes how a goods

price is determined by the behavior of the people who buy the
good and of the firms that sell the good.
Here the opportunity cost of one

more unit of clothing was food
10
9.5
The model relates buyers preferences (demand) to production

costs (supply).
Now to produce one more

unit of clothing you give up
2 units of food
4
2
12 13
Amount of clothing
per week
Ch. 1 13
Adam Smith and the Invisible Hand

What did Smith mean by the invisible hand?
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.
Ch. 1 14
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.

Why are points inside the frontier inefficient?
Because we could produce more clothing without

giving up any food.
10
Or more food without giving up

clothing
Or make more of both goods
12
Amount of
clothing per week
Ch. 1 17
Adam Smiths Model
Principle 5: Inefficiencies involve real costs

Amount
of food
per week
Ch. 1 16
Ch. 1 15
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.
Ch. 1 18
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Adam Smiths Model
Marshalls Model of Supply and Demand
Prices of goods depend on the relative value of labor used to

produce the goods.
What are the problems with Smiths and Ricardos models?
Price
Smiths model ignores rising opportunity costs.

Ricardos model is inconsistent with the falling prices that
occurred during the 19th century.
Neither model truly considered the demand side of the

market.
Quantity per week
Ch. 1 19
Ch. 1 22
David Ricardos Model
Marshalls Model of Supply and Demand
Do you see a problem with Adam Smiths model of price given our
discussion of the PPF?
What matters is the value of the last or marginal unit produced or

consumed.
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.
Ch. 1 20
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
Marshalls model shows how prices are simultaneously
determined by demand and supply.
David Ricardos Model
Diminishing returns the cost of producing one more unit of a

good rises as more of that good is produced.
Price
Ch. 1 23
Adam Smiths Model

Demand: As price falls, consumers are willing to buy more:
this reflects decreasing marginal value.
Price
Quantity per week
Ch. 1 21
Demand
Quantity
Ch. 1 24
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Adam Smiths Model
A Change in Demand
Supply: As price rises, firms are able to produce more: this

reflects increasing marginal costs.
Price
What happens if demand increases?

Price
Supply
Supply
P**
Demand shifts to the right.

Price and quantity increase.
P*
Demand
Quantity
Q* Q**
Ch. 1 25
Adam Smiths Model
What happens if supply decreases?

S
Price
Supply
P**
P*
Supply shifts to the left.

Price increases and
quantity decreases.
P*
Demand
QD=QS=Q*
Quantity
Q**
Ch. 1 26
On Market Equilibrium
Q*
Quantity per period
Ch. 1 29
Changes in Market Equilibrium
What does it mean to be at equilibrium?
If demand increases (shifts right) P* will __ and Q* will ___.

If demand decreases (shifts left), P* will __ and Q* will ___.
What would happen if the price was set above or below the
equilibrium price?
If supply increases (shifts right) P* will __ and Q* will ___.

If supply decreases (shifts left) P* will __ and Q* will ___.
What would cause the equilibrium price to rise or fall?
Ch. 1 28
A Change in Supply
Market Equilibrium: The equilibrium price is the price at which

the quantity demanded is equal to the quantity supplied.
Price
Quantity per period
Ch. 1 27
Ch. 1 30
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Positive-Normative Distinction
If demand increases (shifts right) P* will __ and Q* will ___.

rise; rise
Whats 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.
If demand decreases (shifts left), P* will __ and Q* will ___.

fall; fall
The first is a positive statement: it looks at what is.
If supply increases (shifts right) P* will __ and Q* will ___.

fall; rise
The second is a normative statement: it looks at what should be.
If supply decreases (shifts left) P* will __ and Q* will ___.

rise; fall
Is Economics a positive or normative science?

Ch. 1 31
Ch. 1 34
Summary
What happens to P* and Q* when both demand and supply

change?
Since resources are scarce, we must make choices about how we

use them.
Suppose demand and supply increase:
We can use the PPF model to illustrate important concepts such

as opportunity cost and efficiency.
We know that Q* rises, but P* may rise or fall.
The supply and demand model shows how prices are determined,
and how changes in demand and/or supply influence the price.
Suppose demand increases but supply decreases:

We know P* rises, but Q* may rise or fall.
Judge the validity of economic models by how well they explain

actual economic events.
Ch. 1 32
Ch. 1 35
How Economists Verify Models

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.
Ch. 1 33

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2/29/2016

PowerPoint Slide Presentation | Philip Heap, James Madison University

Suppose an economy produces food and clothing

Economics is the study of the allocation of scarce resources

A PPF shows the possible combination of two goods an economy

Microeconomics is the study of the economic choices individuals

We can produce 10 food and 12 clothing

Examples of economic choices.

Or 4 food and 12 clothing

The PPF and Five Basic Principles

The PPF and Five Basic Principles

We want to use this model to illustrate five basic principles.

Principle 2: Scarcity involves opportunity cost.

Opportunity cost is the cost of a producing a good measured by

If I am on the PPF the opportunity cost of more clothing is less

The PPF and Five Basic Principles

Principle 2: Scarcity involves opportunity costs

Points outside the frontier are unattainable since

We can make 4 food and 12 clothing.

But not 4 food and 14 clothing.

What is the opportunity cost of increasing

The PPF and Five Basic Principles

Principle 3: Opportunity costs are increasing.

But not 12 food and 3 clothing.

The PPF and Five Basic Principles

Principle 1: How does the PPF illustrate scarcity?

The PPF and Five Basic Principles

Principle 1: Scarce Resources

The PPF and Five Basic Principles

Basic Supply-Demand Model

Principle 3: Opportunity costs are increasing.

A Supply-Demand Model is a model that describes how a goods

Here the opportunity cost of one

The model relates buyers preferences (demand) to production

Now to produce one more

The PPF and Five Basic Principles

Adam Smith and the Invisible Hand

Principle 4: Incentives Matter

The invisible hand directed resources to where they would be

The PPF and Five Basic Principles

Because we could produce more clothing without

Or more food without giving up

Adam Smiths Model

Principle 5: Inefficiencies involve real costs

Prices of goods depend on the relative value of labor used to

Adam Smiths Model

Marshalls Model of Supply and Demand

Prices of goods depend on the relative value of labor used to

What are the problems with Smiths and Ricardos models?

Smiths model ignores rising opportunity costs.

Neither model truly considered the demand side of the

Quantity per week

David Ricardos Model

Marshalls Model of Supply and Demand

What matters is the value of the last or marginal unit produced or

Diminishing returns the cost of producing one more unit of a

David Ricardos Model

Diminishing returns the cost of producing one more unit of a

Adam Smiths Model

Quantity per week

Adam Smiths Model

Supply: As price rises, firms are able to produce more: this

What happens if demand increases?

If demand increases (shifts right) P* will and Q* will _.

If supply increases (shifts right) P* will and Q* will _.

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 _.