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Econ ch 1 economic models

What is microeconomics?o Microeconomics: the study of all the choices and how well the resulting

market outcomes meet basic human needs

These choices affect the allocation of scarce resources amongalternative methods of production

o Models describe the basic features of marketso Scarcity exists because there are not enough productive resources

available to satisfy all human wants

Few basic principleso Production possibility frontier: shows various amounts of 2 goods that an

economy can produce during some period from a scarce amount of

resources

Slopes downward reflecting the opportunity cost of each good Illustrates how much of one good must be sacrificed to produce

another

o Shows the opportunity cost of producing more of one good as the quantityof the other good that cannot be produced

o PPF has 6 principles Resources are scarce: some combinations are impossible to make

given resources available

Scarcity involves opportunity costs: producing more of one goodnecessarily involves producing less of something else

Opportunity costs are increasing: expanding the output of oneparticular good will usually involve increasing opportunity costs asdiminishing returns set in

The opportunity cost of an economic action is not constantbut varies with the circumstances

Incentives matter: People consider opportunity costs when makingdecisions. only when the extra benefits from an action exceed the

extra opportunity costs will they take the action being considered

Inefficiency involves real costs: an economy operating inside itsproduction possibility frontier is preforming inefficiently

Whether markets work well is important: if markets work well, theycan enhance everyones well-being When markets perform poorly, they can impose real costs on

the economyo Cause the economy to operate inside its PPF

Basic supply-demand model

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o Market behavior can usually be explained by the relationship betweenpreferences for a good (demand) and the costs involved in producing that

good(supply)

o Adam Smith and the invisible hand The pattern of market determined prices provided a powerful

invisible hand to direct resources into activities where they aremost valuable

Prices play the crucial role of telling both consumers and firms whatgoods are worth and thereby prompt these actors to make efficient

choices about how to use them

Smith argued that a goods cost of production determines its price. Ricardo recognized that Smiths view of price determination was

incomplete

o David Ricardo and Diminishing returns: He believed that labor and other costs would tend to rise as the

level of production of a particular good expanded

Law of diminishing returns: hypothesis that the cost associatedwith producing one more unit of a good rises as more of that good is

produced

Supply curve slopes upward as quantity produced expands His explanation did not explain how prices are determined Ricardo and smith only considering production

o Marginalism and Marshalls model of supply and demand Alfred Marshall showed how the forces of demand and supply

simultaneously determine price The negative slope of the demand curve reflects the marginalist

principle: because people are willing to pay less and less for the last

unit purchased, they will buy more only at a lower price

Supply curve shows the increasing cost of making one more unit ofthe good as the total amount produced increases

Upward slope of the supply curve reflects increasing marginal costs Downward slope of the demand curve reflects decreasing marginal

value

o Market equilibrium Equilibrium price: the price that the quantity that people want topurchase is equal to the quantity that suppliers are willing to

produce

No one has incentive to alter behavior at this pointo Nonequilibrium outcomes

When price is set above P*, demanders would wish to buy less thanQ*, whereas suppliers would produce more than Q*

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Would lead to a surplus Regulation that holds price below P* would result in a

shortage

o Change in market equilibrium Equilibrium can persist as long as nothing happens to alter demand

or supply relationships The ultimate result of a shift in supply depends on the shape of both

the demand curve and the supply curve

How economists verify theoretical models

Testing assumptions: looks at the assumptions upon which model is basedo Intuitiondo assumptions seem reasonable?o Empirical evidence

Results are often difficult to interpret Testing predictions: uses the model to see if it can correctly predict real

world eventso the real test of any economic model is whether it is consistent with

events in the economy itself

direct test of the models assumptions tries to judge how closely simplifyingassumptions conform to reality

positive-normative distinction:o positive-normative distinction: distinction between theories that seek

to explain the world as it is and theories that postulate how the world

should beo positive economics: analyzes how and why resources are actually

allocated in the economy

o normative economics: analyzes whether or not resources are allocatedcorrectly

o some argue that economic models invariably have normativeconsequences and should be recognized

normative, how the world should be