Nicholson Chapter 1

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Intermediate Microeconomics andIts Application

9th Editionby

Walter Nicholson, Amherst CollegeWalter Nicholson, Amherst College

Slide Presentationby

Mark KarscigCentral Missouri

State Uniersity© 2004 Thomson Learning/South-Western



Chapter !

"conomic

Models

© 2004 Thomson Learning/South-Western



3

What is Microeconomics#

Economics

– The study of the allocation of scarce resourcesamong alternative uses

Microeconomics – The study of the economic choices individuals and

firms make and how those choices create markets



4

"conomic Models

Simple theoretical descriptions that capture the

essentials of how the economy works – Used because the “real world” is too complicated todescribe in detail

– Models tend to be “unrealistic” but useful

hile they fail to show every detail !such as houses on amap" they provide enough structure to solve the problem!such as how a map provides you with a way to solve howto drive to a new location"



5

$he Production Possibility %rontier

# graph showing all possible combinations of

goods that can be produced with a fi$edamount of resources

%igure &'& shows a production possibilityfrontier where the good goods are food and

clothing produced per week – #t point #( &) units of food and * units of clothing

can be produced



6

Amountof food

per week

4

10 A

B

Amount

of clothingper week

0

3 12

%I&U'" !(!) Production Possibility

%rontier


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$he Production Possibility %rontier

– #t point +( , units of food can be produced and &-units of clothing

ithout more resources( points outside thefrontier are unattainable – This demonstrates a basic fact that resources are

scarce



*pportunity Cost

The cost of a good or service as measured bythe alternative uses that are foregone byproducing the good or service



*pportunity Cost "+ample

#s shown in %igure &'&( if the economy

produces one more unit of clothing beyond the&) that it produces at point #( the amount offood produced decreases by &.- from &) to /'0 – Thus( the opportunity cost of one unit of clothing is

&.- unit of food at point #



Amountof food

per week

9.510 A

Opportunity cost of clothing ! pound of food

Amount

of clothingper week

0

3 4


%rontier



*pportunity Cost "+ample

%igure &'& also shows that the opportunity cost

of clothing is much higher at point + !& unit ofclothing costs - units of food" – The increasing opportunity costs of producing even

more clothing is consistent with 1icardo2s and

Marshall2s ideas of increasing marginal cost



Amountof food

per week

4 B

Opportunity cost of clothing 2 poundsof food

2

Amount

of clothingper week

0

1213


%rontier



Amountof food

per week

4

9.510 A

B

Opportunity cost of clothing ! pound of food

Opportunity cost of clothing 2 poundsof food

2

Amount

of clothingper week

0

3 4 1213


%rontier



APPICA$I*N !(!) -o Animals

Understand "conomics#

3ature provides e$amples of where animals

have scarcity affect their choices – +irds of prey recogni4e a trade5off betweenspending time and energy in one area and movingto another location

–

To avoid using too much energy( animals will leavean area before the food supply is e$hausted



Uses o. Microeconomics

hile the uses of microeconomics are varied(one useful way to categori4e is by types ofusers – 6ndividuals making decisions regarding 7obs(

purchases( and finances

–

+usinesses making decisions regarding thedemand for their product or their costs

– 8overnments making policy decisions regardinglaws and regulations



APPICA$I*N !(/) Is It Worth 0our

$ime to 1e 2ere#

9 The typical U'S' college student pays about

:&;())) per year in tuition( fees( and roomand board charges' <ne might concludethen( that the “cost” of , years of college isabout :=-()))'

5 # number of studies have suggested that collegegraduates earn more than those without such aneducation'



APPICA$I*N !(3) Saing

1lockbuster

The largest video rental company incurred a

huge financial loss primarily because of thehigh price of first5run movies

# large part of the “price” of the movie to thecustomer was not finding the movie in stock'

+lockbuster reached an agreement toguarantee availability and reverse its losses'



APPICA$I*N !(4) Microso.t and

Antitrust

The central issue of this case is whether or not

Microsoft is illegally “monopoli4ing” varioussegments of the software industry in violationof the Sherman #ntitrust #ct'

M6T professor %ranklin %isher suggests that the

real danger is allowing Microsoft to dominatethe internet browser market which wouldeliminate competition'



19

APPICA$I*N !(4) Microso.t and

Antitrust

M6T professor 1ichard Schmalensee argues

that Microsoft has not acted like a monopoly inthe pricing of the indows operating system

The 7udge2s decision will have to try to strike abalance between the operating system

monopoly and the ability of Microsoft to beinnovative



20

$he 1asic Supply5-emand Model

# model describing how a good2s price is

determined by the behavior of the individual2swho buy the good and the firms that sell it' – Economists argue that market behavior can

generally be e$plained by this model that captures

the relationship between consumers2 preferencesand firms2 costs'



21

Adam Smith and the Inisible 2and

#dam Smith !&=-*5&=/)" saw prices as the

force that directed resources into activitieswhere they were most valuable

>rices told both consumers and firms the“worth” of the good'

Smith2s somewhat incomplete e$planation forprices was that they were determined by thecosts to produce the goods'



22

Adam Smith and the Inisible 2and

Since labor was the primary resource used( this

led Smith to embrace a labor5based theory ofprices' – 6f catching deer took twice as long as catching a

beaver( one deer should trade for two beaver !therelative price of a deer is two beaver2s"'

– 6n %igure &'&!a"( the hori4ontal line at >? shows thatany number of deer can be produced withoutaffecting the relative cost



23

"rice

"#

$u%ntity per week

%I&U'" !(/6a7) Smith8s Model



24

-aid 'icardo and -iminishing

'eturns

@avid 1icardo !&==-5&;-*" believed that labor

and other costs would rise with the level ofproduction – for e$ample( as new less fertile land was cultivated(

it would reAuire more labor

This increasing cost argument is now referredto as the law of diminishing returns



25

-aid 'icardo and -iminishing

'eturns

The relative price of a good could be practically

any amount( depending upon how much wasproduced

The level of production represented the Auantitythe country needed to survive

6n %igure &'-!b"( as the needs of the countryincrease from B& to B- prices increase from >&

to >-



26

"rice

"1

$u%ntity per week $1

%I&U'" !(/6b7) 'icardo8s Model



27

"rice

"2

"1

$u%ntity per week $1 $2

%I&U'" !(/6b7) 'icardo8s Model



28

"rice

"#

$u%ntity per week

&%' (mith model) &*' +ic%rdo model)

"rice

"2

"1

$u%ntity per week $1 $2

%I&U'" !(/) "arly 9ie:s o. Price

-etermination



29

Marginalism and Marshall8s Model

o. Supply and -emand

1icardo2s model was unable to e$plain the fall

in the relative prices of good during thenineteenth century so a more general modelwas needed

Economists argued the willingness of people to

pay for a good will decline as they have moreof it



30



>eople will be willing to consume more of a

good only if the price is lower The focus of the model was on the value of the

last( or marginal ( unit purchased

#lfred Marshall !&;,-5&/-," showed how the

forces of demand and supply simultaneously determined price



31



6n %igure &'*( the amount of a good purchased

per period is shown on the hori4ontal a$is andthe price of the good is shown on the verticala$is

The demand curve shows the amount people

want to buy at each price and is negativelysloped reflecting the marginalism principle



32



The upward sloping supply curve reflects theidea of increasing cost of making one more unitof a good as total production increases

Supply reflects increasing marginal costs anddemand reflects decreasing marginal

usefulness



33

"rice

,em%nd

(upply

$u%ntity per week

0

%I&U'" !(3) $he Marshall Supply5

-emand Cross



34

Market ";uilibrium

6n %igure &'*( the demand and supply curve

intersect at the market eAuilibrium point >?(B?

>? is the eAuilibrium priceC The price at whichthe Auantity demanded by buyers of a good is

eAual to the Auantity supplied by sellers of thegood



35

"rice ,em%nd (upply

-uili*rium point"#

$u%ntity per week

0$#

%I&U'" !(3) $he Marshall Supply5

-emand Cross

.



36

Market ";uilibrium

+oth demanders and suppliers are satisfied atthis price( so there is no incentive for either toalter their behavior unless something elsehappens

Marshall compared the roles of supply and

demand in establishing market eAuilibrium tothe two blades of a pair of scissors workingtogether in order to make a cut



37

None;uilibrium *utcomes

6f something causes the price to be set above>?( demanders would wish to buy less than B?while suppliers would produce more than B?

6f something causes the price to be set below>?( demanders would wish to buy more than

B? while suppliers would produce less than B?



38

Change in Market ";uilibrium)

Increased -emand

%igure &', shows the case where people2s

demand for the good increases as representedby the shift of the demand curve from @ to @2

# new eAuilibrium is established where theeAuilibrium price has increased to >??



39

"rice, (

"#

$u%ntityper week

0 $#

%I&U'" !(4) An increase in -emand Alters

";uilibrium Price and <uantity



40

"rice,

,)(

"#

"##

$u%ntityper week

0 $# $##

%I&U'" !(4) An increase in -emand Alters




41

Change in Market ";uilibrium)

decrease in Supply

6n %igure &'0 the supply curve has shiftedleftward reflecting a decrease in supply broughtabout because of an increase in supplier costs!say an increase in wages"

#t the new eAuilibrium price >?? consumers

respond by reducing Auantity demanded alongthe @emand curve @



42

"rice

,

(

"#

$u%ntityper week

0 $#

%I&U'" !(=) A shi.t in Supply Alters




43

"rice

,

()

(

"#

"##

$u%ntityper week

0 $##$#

%I&U'" !(=) A shi.t in Supply Alters




44

2o: "conomists 9eri.y $heoretical

Models

Two methods are used – Testing #ssumptionsC Derifying economic models by

e$amining validity of the assumptions on which theyare based

– Testing >redictionsC Derifying economic models byasking if they can accurately predict real5worldevents



45

$esting Assumptions

<ne approach would be to determine if theassumptions are reasonable – The obvious problem is that people have differing

opinion regarding reasonable

Empirical evidence can also be used

– 1esults of such methods have had problems similarto those found in opinion polls



46

$esting Predictions

Economists( such as Milton %riedman arguethat all theories reAuire unrealistic assumptions

The theory is only useful if it can be used topredict real5world events – Even if firms state they don2t ma$imi4e profits( if

their behavior can be predicted by using thisassumption( the theory is useful



47

Models o. Many Markets

Marshalls model of supply and demand is apartial eAuilibrium modelC #n economic modelof a single market

To show the effects of a change in one marketon others reAuires a general eAuilibrium modelC

#n economic model of a complete system ofmarkets



48

APPICA$I*N !(=) "conomics

According to 1ono

The Spring -))- trip to #frica by the 6rish rockstar +ono and U'S' Treasury Secretary >aul<23eill sparked much interesting dialogueabout economics

+ono claimed that recently enacted agricultural

subsidies in the U'S' were harming strugglingfarmers in #frica



49

APPICA$I*N !(=) "conomics

According to 1ono

6n %igure & U'S' farm subsidies reduce the

world price of this crop from >? to >??' E$ports from this #frican country fall from

BS – B@ to B2S – B2@



50

"

%igure !) U(S( Subsidies 'educe

A.rican "+ports

(

,

$$, $), $)( $(

"#

"##



51

$he Positie5Normatie -istinction

@istinction between theories that seek toe$plain the world as it is and theories thatpostulate the way the world should be – To many economists( the correct role for theory is to

e$plain the way the world is !positive" rather thanthe way it should be !normative"

– >ositive economics is the primary approach of thete$t



52

APPICA$I*N !(>) -o "conomists

"er Agree#

Many 7okes and popular opinion suggest thateconomists do not agree on many issues

This belief arises primarily because people failto distinguish between positive and normativeissues

#s Table & shows( there is much agreementregarding positive issues but much lessagreement with normative issues



$A1" !) Percentage o. "conomists Agreeing :ith 9arious

Propositions in $hree Nations

Proposition U.S.A.

Switzer-

land GermanyTariffs reduce economic

welfare 95 87 94

Flexible exchange rates are

effective for international

transactions94 91 92

Rent controls reduce the

quality of housing 96 79 94

Government should

redistribute income 68 51 55

Government should hire the

jobless 51 52 35

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