Intermediate Microeconomics and Its Application Walter Nicholson, Amherst College Christopher...

Intermediate Microeconomics Intermediate Microeconomics and Its Applicationand Its Application

10th Editionby

Walter Nicholson, Amherst CollegeWalter Nicholson, Amherst CollegeChristopher Snyder, Dartmouth CollegeChristopher Snyder, Dartmouth College

PowerPoint Slide Presentation

by

Mark Karscig

Central Missouri State University

© 2006 Thomson Learning/South-Western

Chapter 1Chapter 1

Economic Models

© 2004 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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Economic Models

Simple theoretical descriptions--capture essentials of how economies work Real economies too complex to describe in

useful detail Models are unrealistic, but useful

Maps unrealistic--do not show every house, parking lot, etc. Despite lack of “realism,” maps show overall picture; help us get where we want to go; form mental image

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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.

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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

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Amount of food per week (lbs.)

4 B

Opportunity cost ofclothing = 2 poundsof food

2

Amount of clothing per week (articles)

0 1213

FIGURE 1-1: Production Possibility Frontier

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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.

Smith’s somewhat incomplete explanation for prices: determined by the costs to produce the goods.

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Adam Smith--the Invisible Hand

In 18th century, labor was primary resource. Thus Smith embraced labor-based theory of prices:

If catching a deer took twice as long as catching a beaver, one deer should trade for two beaver (the relative price of a deer is two beavers).

Figure 1-2(a), horizontal line at P* shows that any number of deer can be produced without affecting relative cost

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Price(hrs)

P*

Quantity deer per week

FIGURE 1-2(a): Smith’s Model

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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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David Ricardo--Diminishing Returns

Relative price of good could be practically any amount, depending upon how much was produced.

Production level represented quantity the country needed to survive.

Figure 1-2(b): as country’s needs increase from Q1 to Q2, prices increase from P1 to P2

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Price

P1

Quantity per weekQ1

FIGURE 1-2(b): Ricardo’s Model

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Price

P2

P1

Quantity per weekQ1 Q2

FIGURE 1-2(b): Ricardo’s Model

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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

Marshall compared roles of supply and demand in establishing market equilibrium to two scissor blades working together in order to make a cut

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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

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How Economists Verify Theoretical Models

Two methods used:

Testing Assumptions: Verifying economic models by examining validity of assumptions upon which models are based

Testing Predictions: Verifying economic models by asking whether models can accurately predict real-world events

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Testing Assumptions

One approach: determine whether underlying assumptions are reasonable Obvious problem: people differ in opinion of

what is reasonable Empirical evidence

Results have problems similar to those found in opinion polls:interpretation

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Testing Predictions

Economists such as Milton Friedman argue that all theories require unrealistic assumptions.

Theory is only useful if it can be used to predict real-world events. Even if firms state they don’t maximize profits,

if their behavior can be predicted by using theory, it is useful.

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Models of Many Markets

Marshall's supply and demand model is partial equilibrium model: Economic model of a single market

To show effects of change in one market on others requires a general equilibrium model: An economic model of complete system of markets

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Positive-Normative Distinction

Distinguish between theories that seek to explain the world as it is and theories that postulate the way the world should be 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).

Text takes approach based on positive economics.