Intermediate Microeconomics and Its Application

1. Walter Nicholson
1
Amherst College
Christopher Snyder
Dartmouth College
PowerPoint Slide Presentation | Philip Heap, James Madison University
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2. ©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.
Economic
Models
2
CHAPTER
1

3. What is Economics?
Ch. 1 • 3
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• “Economics is the study of the allocation of scarce resources
among alternative uses.”
• “Economics is the study of mankind in the ordinary business of
life.” Alfred Marshall
• “Economics never tells a man how he should act; it merely shows
how a man must act if he wants to attain definite ends.” Ludwig
von Mises

4. What is Microeconomics?
Ch. 1 • 4
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• Microeconomics is the study of the economic choices individuals
and firms make and how these choices create markets.
• Examples of economic choices.

5. Economic Models
Ch. 1 • 5
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• A model is a simple theoretical description that captures the
essentials of how the economy works.
– Simple since it does not capture every detail.
– But lets you see the overall picture and answer the relevant
question.

6. The PPF
• S
W
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h
n
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b
g
emade on a
production possibilities frontier diagram.
Amount
of food
per week
Amount of clothing
per week
PPF
Ch. 1 • 6
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7. The PPF
We can produce 10 food and 12
Or 4 food
• A PPF shows the possible combination of two goods an economy
can produce with a fixed amount of resources.
Amount
of food
per week
clothing
10
Ch. 1 • 7
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Amount of clothing
per week
3 12
4
and 12 clothing

8. The PPFand Five Basic Principles
Ch. 1 • 8
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• We want to use this model to illustrate five basic principles.
– Scarce resources
– Scarcity involves opportunity costs
– Increasing opportunity costs
– Incentives matter
– Inefficiency has real costs

9. The PPFand Five Basic Principles
• Principle 1: Scarce Resources
Amount
of food
per week
10
Amount of clothing
per week
3 12 14
4
Points outside the frontier are unattainable since
es to produce them.
we don’t have enough resourc
We can make 4
But not
food and 12 clothing.
4 food and 14 clothing.
Ch. 1 • 9
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10. The PPFand Five Basic Principles
• Principle 1: How does the PPF illustrate scarcity?
Amount
of food
per week
Amount of clothing
per week
10
3 12
We can make 10 food and 3 clothing.
But not 12 food and 3 clothing.
Ch. 1 • 10
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11. The PPFand Five Basic Principles
Ch. 1 • 11
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• Principle 2: Scarcity involves opportunity cost.
• 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.

12. The PPFand Five Basic Principles
Principle 2: Scarcity involves opportunity costs
Amount
of food
per week
Ch. 1 • 12
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Amount of clothing
per week
10
9.5
3 12
4
4
What is the opportunity cost of increasing
clothing production from 3 to 4 units?

13. The PPFand Five Basic Principles
Ch. 1 • 13
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• Principle 3: Opportunity costs are increasing.
• 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.

14. The PPFand Five Basic Principles
Principle 3: Opportunity costs are increasing.
Amount
of food
per week
Amount of clothing
per week
10
9.5
3 12 13
4
4
Now to produce one more
unit of clothing you give up
2 units of food
2
Ch. 1 • 14
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Here the opportunity cost of one
more unit of clothing was ½ food

15. The PPFand Five Basic Principles
Ch. 1 • 15
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• 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.

16. The PPFand Five Basic Principles
• Principle 5: Inefficiencies involve real costs
Amount
of food
per week
Amount of
clothing per week
10
3 12
4
Why are points inside the frontier inefficient?
Because we could produce more clothing without
giving up any food.
Or more food without giving up
clothing
Or make more of both goods
Ch. 1 • 16
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17. Basic Supply-Demand Model
Ch. 1 • 17
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• A Supply-Demand Model is a model that describes how a good’s
price is determined by the behavior of the people who buy the
good and of the firms that sell the good.
• The model relates buyers’ preferences (demand) to production
costs (supply).

18. Adam Smith and the Invisible Hand
Ch. 1 • 18
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• What did Smith mean by the “invisible hand”?
• 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.

19. Adam Smith’sModel
Ch. 1 • 19
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• 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.

20. Adam Smith’sModel
Price
Ch. 1 • 20
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Quantity per week
2

21. David Ricardo’sModel
Ch. 1 • 21
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• Do you see a problem with Adam Smith’s model of price given our
discussion of the PPF?
• 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.

22. David Ricardo’sModel
Pric
e
Ch. 1 • 22
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Quantity per
week

23. Marshall’s Model of Supply and Demand
Ch. 1 • 23
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• What are the problems with Smith’s and Ricardo’s models?
– Smith’s model ignores rising opportunity costs.
– Ricardo’s model is inconsistent with the falling prices that
occurred during the 19th century.
– Neither model truly considered the demand side of the
market.

24. Marshall’s Model of Supply and Demand
Ch. 1 • 24
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• What matters is the value of the last or marginal unit produced or
consumed.
• 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
• Marshall’s model shows how prices are simultaneously
determined by demand and supply.

25. Demand: As price falls, consumers are willing to buy more:
this reflects decreasing marginal value.
Price
Adam Smith’sModel
Demand
Quantity
Ch. 1 • 25
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26. Demand
Quantity
Adam Smith’sModel
Supply: As price rises, firms are able to produce more: this
reflects increasing marginal costs.
Price
Supply
Ch. 1 • 26
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27. Quantity
Adam Smith’sModel
Demand
Market Equilibrium: The equilibrium price is the price at which
the quantity demanded is equal to the quantity supplied.
Price
Supply
P*
Ch. 1 • 27
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QD=QS=Q*

28. On Market Equilibrium
Ch. 1 • 28
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• What does it mean to be at equilibrium?
• What would happen if the price was set above or below the
equilibrium price?
• What would cause the equilibrium price to rise or fall?

29. Price
Quantity per period
What happens if demand increases?
D
Supply
P**
P*
Ch. 1 • 29
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Q* Q**
D’
A Change in Demand
Demand shifts to the right.
Price and quantity increase.

30. Quantity per period
D
What happens if supply decreases?
S’
Price
S
P*
Q** Q*
P**
A Change in Supply
Ch. 1 • 30
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Supply shifts to the left.
Price increases and
quantity decreases.

31. • If demand increases (shifts right) P* will and Q* will .
– rise; rise
• If demand decreases (shifts left), P* will and Q* will .
– fall; fall
• If supply increases (shifts right) P* will and Q* will .
– fall; rise
• If supply decreases (shifts left) P* will and Q* will .
– rise; fall
Ch. 1 • 31
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Changes in Market Equilibrium

32. Changes in Market Equilibrium
Ch. 1 • 32
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• What happens to P* and Q* when both demand and supply
change?
• Suppose demand and supply increase:
– We know that Q* rises, but P* may rise or fall.
• Suppose demand increases but supply decreases:
– We know P* rises, but Q* may rise or fall.

33. • 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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How Economists Verify Models

34. Positive-Normative Distinction
Ch. 1 • 34
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• What’s 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.
• The first is a positive statement: it looks at “what is”.
• The second is a normative statement: it looks at “what should be”.
• Is Economics a positive or normative science?

35. Summary
Ch. 1 • 35
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• Since resources are scarce, we must make choices about how we
use them.
• We can use the PPF model to illustrate important concepts such
as opportunity cost and efficiency.
• The supply and demand model shows how prices are determined,
and how changes in demand and/or supply influence the price.
• Judge the validity of economic models by how well they explain
actual economic events.