Basic Principles Behind Economic Models Chapter 1

Basic Principles Behind
Economic Models
Chapter 1
With Illustrations from Ch. 3 and 4
Ten Principles Underlying Economic Models
(Ch. 1)
How do We Model
How People Make Decisions
• The Basic Foundation
• Key assumptions
For each person, some goods are scarce
Each person desires many goods
Each person is willing to give up some of one economic
good to get more of another economic good
• Greg’s Second Principle
• Cost of something is what you have to give up
• “opportunity cost” – next best alternative/good given up when you chose a good
• Benefit of good A (chosen) versus benefit of good B
• Cost of good A includes the cost of not being able to purchase good B
• Key to modelling decisions will incorporate this tradeoff
A First Model of the Economy
Production Possibilities Frontier Curve
• DEFINITION of 'Production Possibility Frontier - PPF' A curve
depicting all maximum output possibilities for two or more goods given a
set of inputs (resources, labor, etc.). The PPF assumes that all inputs are used
• A production-possibility frontier is a budget constraint presented by the
limitation of available factors of production.
Production Possibilities Frontier
Production Possibilities Frontier
• Why is the PPF downward-sloping?
• Must give up one good to increase production of another
• Opportunity Costs
Why are we unable to produce certain combinations?
• Scarcity and limited resources
Efficient points
• Points ON the PPF (A, B, C, and D)
Inefficient points
• Points INSIDE the PPF (F)
• Workers goofing off, unused buildings
Unattainable (for now) points
• Points OUTSIDE the PPF (E)
PPF and Opportunity Cost
• Recall opportunity cost
– Highest-valued alternative
– What we give up as a result of an action
• Opportunity cost in this case is the slope of
the PPF
– Slope = rise over run
– ∆y/∆x = (y2-y1)/(x2-x1)
Production Possibilities Frontier
Linear PPF – Opp Costs are constant
No Specialization of Labor (or any input)
Principle 3: Rational decisions are made at the
• What do we mean?
• When making an economic decision, e.g. to purchase 1 more unit of a good, we compare
the marginal (or incremental) benefits against the marginal costs
• For example
• When studying for an exam
• Given you’ve already studied 8 hours, when deciding whether or not to study 1 more hour, you
• the expected benefits (a “marginal” improvement in your grade
• Versus the next best (highest valued) use of your time
• E.g., sleeping, eating, time with friends
Making Decisions at the Marginal
• Back to the First Law of Demand
• How much of a good do you buy?
• If the marginal/incremental value of the next unit is less than what it costs, are you willing
MV < price
Don’t buy!
to buy it?
MV < price
Do buy!
Totals versus Marginals
• When you make a “consumption” decision
• You may be comparing Total Value of consuming x amount of the good (TV(x)) to the
Total Cost (TC(x))
• But it’s really a step-wise comparison
• If TV(9) > TC(9)
• Buy at least 9
• then check at x =10
• If TV(10) < TC(10)
• Stop at 9
• MV(10th unit) less than MC(10th unit)
• Easier and faster (fewer calculations) to compare marginals than totals
Optimal Decisions
Made at the Margin
• For consumers
• If price > additional/incremental/marginal “use” value of the good -> don’t buy
• If price < MV -> buy
• For suppliers
• If P > marginal costs of producing that last unit -> supply it to the marketplace (sell it!)
• If P < MC then don’t produce it
Principle 4: People Respond (rationally)
to Economic Incentives
• An example (Hubbard and O’Brien)
• Average age of the populations of US, Japan and most Europeans countries are getting
• Declining birth rates (below replacement level)
• People living longer
• Post WWII baby boom (“mouse in the python”)
• Challenge for governments as
• Social security and medical care payments will increase as larger % of population retires
• Fewer younger folks replacing them in the workforce
-> tax payments are decreasing
An Interesting Solution
• Estonia
• UN estimated that population would decline by 0.7M by 2050 (from 1.4M to 0.7M)
• Starting in 2007
• Working women paid entire salary up to 15 months for having a child
• Non-working: $200 per month (avg income ~$650)
• Impact
• Birth rate increased from 1.6 to 2.1 children per woman
• 45 other european countries in the process of adopting a similar set of
Learning Objective 1.1
•Will Women Have More Babies if
the Government Pays Them To?
The Estonian government is
encouraged by the results of
providing economic
incentives and is looking for
ways to provide additional
incentives to raise the
birthrate further.