Intermediate Microeconomics
and Its Application
10th Edition
by
Walter Nicholson, Amherst College
Christopher Snyder, Dartmouth College
PowerPoint Slide Presentation
by
Mark Karscig
Central Missouri State University
© 2006 Thomson Learning/South-Western
Chapter 1
Economic Models
© 2004 Thomson Learning/South-Western
Economics
Economics
 How societies allocate scarce resources
among alternative uses—three
questions:
 What to produce
 How much to produce
 Who gets the physical and monetary
proceeds
3
MICROECONOMICS
4

How individuals and firms make
economic choices among scarce
resources

How these choices create markets
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

5
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
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

6
At point A, society can produce 10 units of
food and 3 units of clothing
FIGURE 1-1: Production
Possibility Frontier
Amount of
food
per week—
lbs.
10
A
B
4
0
7
3
Amount of clothing
12
per week—articles of clothing
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

8
Resources are scarce; we must choose
among what we have to work with.
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
9
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
10
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.
11
FIGURE 1-1: Production Possibility Frontier
Amount of
food per
week (lbs.)
Opportunity cost of
clothing = ½ pound of food
10
9.5
0
12
A
3 4
Amount of clothing per
week (articles)
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
13
FIGURE 1-1: Production Possibility Frontier
Amount of
food per week
(lbs.)
Opportunity cost of
clothing = 2 pounds
of food
4
B
2
0
14
1213
Amount of
clothing per
week (articles)
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
15
3 4
1213
Amount
of clothing
per week
Uses of Microeconomics

Uses of microeconomic analysis vary. One
useful way to categorize: by user type:



16
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.
Basic Supply-Demand Model


17
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).
Adam Smith--The Invisible Hand



18
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.
Adam Smith--the Invisible Hand

19
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
FIGURE 1-2(a): Smith’s Model
Price
(hrs)
P*
Quantity deer per week
20
David Ricardo--Diminishing Returns

David Ricardo (1772-1823) believed that
labor and other costs would rise with
production level


21
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
David Ricardo--Diminishing Returns



22
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
FIGURE 1-2(b): Ricardo’s Model
Price
P1
Q1
23
Quantity per week
FIGURE 1-2(b): Ricardo’s Model
Price
P2
P1
Q1
24
Q2
Quantity per week
FIGURE 1-2: Early Views of Price
Determination
Price
Price
P2
P*
P1
Quantity per week
(a) Smith
’
model
25
Q1
Q2 Quantity per week
(b) Ricardo model
’
Marshall’s Model of Supply and Demand


26
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.
Marshall, Supply and Demand, and the Margin



27
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.
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.
28
Marshall, Supply and Demand, and the Margin


29
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.
FIGURE 1-3: The Marshall
Supply-Demand Cross
Price
Supply
Demand
0
30
Quantity
per week
Market Equilibrium


31
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
FIGURE 1-3: The Marshall
Supply-Demand Cross
Price
Demand
.
P*
0
32
Supply
Q*
Equilibrium point
Quantity
per week
Market Equilibrium


33
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
Non-equilibrium Outcomes


34
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*.
Change in Market Equilibrium: Increased
Demand


35
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**
FIGURE 1-4: An increase in Demand
Alters Equilibrium Price and Quantity
D
Price
S
P*
0
36
Q*
Quantity
per week
FIGURE 1-4: An increase in Demand
Alters Equilibrium Price and Quantity
D’
Price
S
D
P**
P*
0
37
Q* Q**
Quantity
per week
Change in Market Equilibrium:
decrease in Supply


38
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
FIGURE 1-5: A shift in Supply Alters
Equilibrium Price and Quantity
S
Price
P*
D
0
39
Q*
Quantity
per week
FIGURE 1-5: Shift in Supply Alters
Equilibrium Price and Quantity
S’
Price
S
P**
P*
D
0
40
Q** Q*
Quantity
per week
How Economists Verify Theoretical Models
Two methods used:
41

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
Testing Assumptions
One approach: determine whether
underlying assumptions are reasonable


Empirical evidence

42
Obvious problem: people differ in opinion of
what is reasonable
Results have problems similar to those found
in opinion polls:interpretation
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.

43
Even if firms state they don’t maximize profits,
if their behavior can be predicted by using
theory, it is useful.
Models of Many Markets


44
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
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


45
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.