1. Chapter 1
Economic Models

2. Outline of Microeconomics
Microeconomics: The Allocation of Scarce Resources
Models
Uses of Microeconomic Models

3. Microeconomics: The Allocation of Scarce Resources
Scarcity implies trade-offs
Resources (workers, raw materials, capital, and energy) are available in limited supply.
Which goods and services should be produced?
How should we produce those goods and services?
Who gets to consume those goods and services?
Decision-makers
Individuals (consumers)
Firms
Government

4. The Themes of Microeconomics
Trade-Offs
CONSUMERS
Consumers have limited incomes, which can be spent on a wide variety of goods and services, or saved for the future.
WORKERS
Workers also face constraints and make trade-offs.
People must decide whether and when to enter the workforce.
Workers face trade-offs in their choice of employment.
Workers must sometimes decide how many hours per week they wish to work, thereby trading off labor for leisure.
FIRMS
Firms also face limits in terms of the kinds of products that they can produce, and the resources available to produce them.

5. Microeconomics: The Allocation of Scarce Resources
Prices determine resource allocation
Which goods? How to produce? Who gets them?
Prices answer these important questions by influencing decision-makers.
Markets
A market is where interactions between consumers, firms, and the government occur.
Prices of goods and services are determined in a market.

6. Microeconomic Models
Economists use models to describe economic activities
A model is a description of the relationship between two or more economic variables.
Understanding this relationship allows economists to predict how a change in one variable will affect another variable.
Economic models:
have assumptions that simplify things relative to the real world
make theoretical predictions that we can test empirically
involve maximizing something (e.g. consumer satisfaction, firm profits) subject to resource constraints

7. Uses of Microeconomic Models
Predicting individual decisions
Does it pay financially to go to college?
Should a homeowner purchase a insurance?
Predicting firm decisions
Should a movie theater charge lower prices for matinee show?
Should Coca-Cola advertise more if Pepsi does?
How does a mining company’s extraction decision depend on interest rates?
Predicting government decisions
What is the impact of a new tax on tax revenues raised?
How can pollution taxes reduce global warming?

8. Features of Economic Models
Ceteris Paribus assumption
Optimization assumption
Distinction between positive and normative analysis

9. Ceteris Paribus Assumption
Ceteris Paribus means “other things the same”
Economic models explain simple relationships
focus on only a few forces at a time
other variables are assumed to be unchanged

10. Optimization Assumptions
Many models assume that economic actors are rationally pursuing some goal
consumers seek to maximize utility
firms seek to maximize profits (or minimize costs)
government regulators seek to maximize public welfare

11. Positive-Normative Distinction
Positive economic theories seek to explain the economic phenomena that are observed
The truth of a positive statement can be tested.
Normative economic theories focus on what “should” be
A normative statement contains a value judgment that can’t be tested.

12. Disagreement: Normative versus Positive
Economists sometimes disagree about assumptions and models and also about what policy to use.
Some disagreements can be settled by appealing to further facts, but others cannot.
Disagreements that can’t be settled by facts are normative statements — statements about what ought to be.
Disagreements that can be settled by facts are positive statements—statements about what is.
Students sometimes have difficulty sorting out economic facts from economic opinions. One way to cure this problem is to have them cut out articles from a newspaper (possibly The Wall Street Journal, or the New York Times) or copy sections of articles from reliable sources from the Internet. Ask the students to label the headlines as either positive or normative economic statements. Tell them to distinguish the headlines is by asking whether a statement is testable. If it can’t be tested, then it’s normative (a value judgment). Explain that some of the common buzzwords that are tip-offs to a normative statement are: should, must, or ought.
The value of models. Help the students to appreciate the power of models as tools for understanding reality. The analogy of a model as a map is easy and convincing. Jim Peach, a fine economics teacher at the University of New Mexico, gets his students to make paper airplanes on the first day of class. After flying their paper planes around the classroom (and picking up the debris!) he gets them to talk about what they can learn about real airplanes from experimenting with paper (and other model) planes.

13. Competitive versus Noncompetitive Markets
● Perfectly competitive market
Market with many buyers and sellers, so that no single buyer or seller has a significant impact on price.
Other markets containing a small number of producers
Finally, some markets contain many producers but are noncompetitive; that is, individual firms can jointly affect the price.

14. Market Price ● Market price Price prevailing in a competitive market.
In markets that are not perfectly competitive, different firms might charge different prices for the same product.
This might happen because one firm is
Trying to win customers from its competitors,
Customers have brand loyalties that allow some firms to charge higher prices than others.
The market prices of most goods will fluctuate over time, and for many goods the fluctuations can be rapid.

15. The Economic Theory of Value
The founding of modern economics
The Wealth of Nations is considered the beginning of modern economics
Distinction between value and price
Value meant “value in use”
Price meant “value in exchange”

16. The Economic Theory of Value
Labor theory of exchange value
the exchange values of goods are determined by the costs of producing them
primarily affected by labor costs
diamond-water paradox
producing diamonds requires more labor than producing water

17. The Economic Theory of Value
The marginalist revolution
the exchange value of an item is determined by the usefulness of the last unit consumed
since water is plentiful, consuming an additional unit has a relatively low value

18. The Economic Theory of Value
Marshallian supply-demand synthesis
supply and demand simultaneously operate to determine price
prices reflect both the marginal valuation that consumers place on goods and the marginal costs of producing the goods

19. The Economic Theory of Value
Water
low marginal value
low marginal cost of production
low price
Diamonds
high marginal value
a high marginal cost of production
high price

20. Supply-Demand Equilibrium
The supply curve has a positive slope because marginal cost rises as quantity increases
Price
Equilibrium
QD = Qs D
The demand curve has a negative slope because the marginal value falls as quantity increases P* Q*
Quantity per period

21. Supply-Demand Equilibrium
What happens to the equilibrium price if either demand or supply shift?
A shift in demand will lead to a new equilibrium

22. Supply-Demand Equilibrium
An increase in demand...
Price D’ S
…leads to a rise in the
equilibrium price and
quantity. 7
750 5 D
Quantity per period
500

23. The Economic Theory of Value
General equilibrium models
the Marshallian model is a partial equilibrium model
focuses only on one market at a time
for more general questions, we need a model of the entire economy
must include the interrelationships between markets and economic agents

24. The Economic Theory of Value
Production possibilities frontier
can be used as a basic building block for general equilibrium models
shows the combinations of two outputs that can be produced with an economy’s resources

25. A Production Possibility Frontier
Quantity of food
(per week)
Opportunity cost of
clothing = 1/2 pound of food 10
9.5
Opportunity cost of
clothing = 2 pounds of food 4 2
Quantity of clothing
(per week) 3 4 12 13

26. A Production Possibility Frontier
Resources are scarce
Scarcity  we must make choices
each choice has opportunity costs
opportunity costs depend on how much of each good is produced

27. Production Possibility Frontier and Economic Efficiency
Suppose that an economy produces 2 goods: x and y,
Labor is the only input.
The production function for good x and y can be written:
Total labor available is constrained by
lx + ly < 200
Construction of the PPF in this economy is:

28. Opportunity Cost
Suppose that the production possibility frontier can be represented by
Assume that the economy is on the frontier, the opportunity cost of y in terms of good x can be derived by solving for y as
Solve for Y to find the slope
If we differentiate, we get

29. Concavity of A PPF
Suppose that labor is equally divided between x and y, the number of units of
When x = 10, y = 20, dy/dx = -4(10)/20 = -2
Suppose labor is allocated as 144 and 56, then outputs are
When x = 12, y  15, dy/dx = -4(12)/15 = -3.2
The slope rises as x rises

30. Inefficiency
Now the PPF becomes:
X Y2 = 180,
x = 10, then y output is now y = 17.9.
The loss of output 2.1 units of y is a measure of the labor market being inefficient.
Again, if equal allocation of labor is being done, then we would have, x= 9.5 and y = 19.