Chapter 1
Economic Models
Nicholson and Snyder, Copyright ©2008 by Thomson South-Western. All rights reserved.
Outline of Microeconomics
•
•
•
Microeconomics: The Allocation of Scarce
Resources
Models
Uses of Microeconomic Models
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
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.
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.
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
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?
Features of Economic Models
• Ceteris Paribus assumption
• Optimization assumption
• Distinction between positive and normative
analysis
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
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
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.
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.
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.
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.
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”
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
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
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
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
Supply-Demand Equilibrium
The supply curve has
a positive slope
because marginal
cost rises as quantity
increases
Price
Equilibrium
QD = Q s
S
P*
D
Q*
The demand curve has
a negative slope
because the marginal
value falls as quantity
increases
Quantity per period
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
Supply-Demand Equilibrium
Price
An increase in demand...
S
…leads to a rise in the
equilibrium price and
quantity.
7
5
D’
D
500 750
Quantity per period
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
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
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
3
4
12 13
Quantity of clothing
(per week)
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
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:
lx + ly < 200
Opportunity Cost
• Suppose that the production possibility frontier
can be represented by
x 2  0.25y 2  200
• 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
y  800  4 x 2
• If we differentiate, we get
dy
 4x
2 0.5
 0.5(800  4 x ) ( 8 x ) 
dx
y
Concavity of A PPF
dy
 4x
2 0.5
 0.5(800  4 x ) ( 8 x ) 
dx
y
• 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
Inefficiency
• Now the PPF becomes:
• X2 + 0.25Y2 = 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.