Chapter 01

Walter
Nicholson
Amherst College
Christopher
Snyder
Dartmouth College
PowerPoint Slide Presentation | Philip Heap, James Madison
University
2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
1
website, in whole or in part.
CHAPTER
Economic
Models
2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
2
whole or in part.
What is Economics?
Economics is the study of the allocation of scarce
resources among alternative uses.
Microeconomics is the study of the economic
choices individuals and firms make and how these
choices create markets.
Examples of economic choices.
2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
Ch.in1whole
3or in part.
Economic Models
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.
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4or in part.
The PPF
Suppose an economy produces food and clothing
We can show how much food and clothing can be
made on a production possibilities frontier
Amount
diagram.
of food
per week
PPF
Amount of clothing
per week
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The PPF
A PPF shows the possible combination of two goods
an economy can produce with a fixed amount of
Amount
resources.
of food
per week
We can produce 10 food and 12 clothing

10
Or 4 food and 12 clothing
12
Amount of clothing
per week
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6or in part.
The PPF and Five Basic

Principles
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
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Principles
Principle 1: Scarce Resources
Amount
of food
per week
Points outside the frontier are unattainable since

we dont have enough resources to produce them.
We can make 4 food and 12 clothing.
10
But not 4 food and 14 clothing.
12
14
Amount of clothing
per week
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8or in part.

Principles
Principle 1: How does the PPF illustrate scarcity?

Amount
of food
per week
But not 12 food and 3 clothing.

We can make 10 food and 3 clothing.
10
12
Amount of clothing
per week
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9or in part.

Principles
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.
or in part.
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Principles
Principle 2: Scarcity involves opportunity costs

Amount
of food
per week
What is the opportunity cost of increasing

clothing production from 3 to 4 units?
10
9.5
12
Amount of clothing
per week
or in part.
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Principles
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.
or in part.
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Principles
Principle 3: Opportunity costs are increasing.

Amount
of food
per week
Here the opportunity cost of one

more unit of clothing was food
10
9.5
Now to produce one more

unit of clothing you give up
2 units of food
4
2
12 13
Amount of clothing
per week
or in part.
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Principles
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.
or in part.
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Principles
Principle 5: Inefficiencies involve real costs

Why are points inside the frontier inefficient?
Amount
of food
per week
Because we could produce more clothing without

giving up any food.
10
Or more food without giving up

clothing
Or make more of both goods
12
Amount of
clothing per week
or in part.
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Basic Supply-Demand Model

A Supply-Demand Model is a model that describes
how a goods 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).
or in part.
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Adam Smith and the Invisible

Hand
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.
or in part.
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Adam Smiths Model

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.
or in part.
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Adam Smiths Model

Prices of goods depend on the relative value of labor
used to produce the goods.
Price
Quantity per week
or in part.
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David Ricardos Model

Do you see a problem with Adam Smiths 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.
or in part.
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David Ricardos Model
Diminishing returns the cost of producing one

more unit of a good rises as more of that good is
produced.
Price
Quantity per week
or in part.
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Marshalls Model of Supply

and Demand
What are the problems with Smiths and Ricardos

models?
Smiths model ignores rising opportunity costs.
Ricardos model is inconsistent with the falling
prices that occurred during the 19th century.
Neither model truly considered the demand side
of the market.
or in part.
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Marshalls Model of Supply

and Demand
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
Marshalls model shows how prices are
simultaneously determined by demand and supply.
or in part.
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Adam Smiths Model

Demand: As price falls, consumers are willing to
buy more: this reflects decreasing marginal
value.
Price
Demand
Quantity
or in part.
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Adam Smiths Model

Supply: As price rises, firms are able to
produce more: this reflects increasing marginal
costs.
Price
Supply
Demand
Quantity
or in part.
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Adam Smiths Model

Market Equilibrium: The equilibrium price is the
price at which the quantity demanded is equal to
the quantity supplied.
Price
Supply
P*
Demand
QD=QS=Q*
Quantity
or in part.
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On Market Equilibrium
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?
or in part.
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A Change in Demand
What happens if demand increases?
Price
Supply
P**
Demand shifts to the right.

Price and quantity increase.
P*
D
Q* Q**
D
Quantity per period
or in part.
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A Change in Supply
What happens if supply decreases?
S
Price
P**
Supply shifts to the left.

Price increases and
quantity decreases.
P*
D
Q**
Q*
Quantity per period
or in part.
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Changes in Market
Equilibrium
If demand increases (shifts right) P* will __ and Q*

will ___.
If demand decreases (shifts left), P* will __ and Q*
will ___.
If supply increases (shifts right) P* will __ and Q* will
___.
If supply decreases (shifts left) P* will __ and Q* will
___.
or in part.
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Changes in Market
Equilibrium
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
Ch. 1 31
___.
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.
Changes in Market
Equilibrium
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.
or in part.
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How Economists Verify

Models
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.
or in part.
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Positive-Normative
Distinction
Whats 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?
or in part.
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Summ
ary
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.
or in part.
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Walter

We can produce 10 food and 12 clothing

Or 4 food and 12 clothing

The PPF and Five Basic

We want to use this model to illustrate five basic

The PPF and Five Basic

Points outside the frontier are unattainable since

But not 4 food and 14 clothing.

The PPF and Five Basic

Principle 1: How does the PPF illustrate scarcity?

But not 12 food and 3 clothing.

The PPF and Five Basic

Principle 2: Scarcity involves opportunity cost.

If I am on the PPF the opportunity cost of more

The PPF and Five Basic

Principle 2: Scarcity involves opportunity costs

What is the opportunity cost of increasing

The PPF and Five Basic

Principle 3: Opportunity costs are increasing.

The PPF and Five Basic

Principle 3: Opportunity costs are increasing.

Here the opportunity cost of one

Now to produce one more

The PPF and Five Basic

People will make decisions based on opportunity

The PPF and Five Basic

Principle 5: Inefficiencies involve real costs

Because we could produce more clothing without

Or more food without giving up

Basic Supply-Demand Model

Adam Smith and the Invisible

The invisible hand directed resources to where they

Adam Smiths Model

Adam Smiths Model

Quantity per week

David Ricardos Model

David Ricardos Model

Diminishing returns the cost of producing one

Quantity per week

Marshalls Model of Supply

What are the problems with Smiths and Ricardos

Marshalls Model of Supply

What matters is the value of the last or marginal

Adam Smiths Model

Adam Smiths Model

Adam Smiths Model

What would happen if the price was set above or

What would cause the equilibrium price to rise or

Demand shifts to the right.

Supply shifts to the left.

Quantity per period

If demand increases (shifts right) P* will __ and Q*

If demand increases (shifts right) P* will __ and Q*

What happens to P* and Q* when both demand and

How Economists Verify

Testing Assumptions: Verifying economic

Whats the difference between the following two

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