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 among alternative methods of production o Models describe the basic features of markets o Scarcity exists because there are not enough productive resources available to satisfy all human wants Few basic principles o 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 quantity of 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 good necessarily involves producing less of something else Opportunity costs are increasing: expanding the output of one particular good will usually involve increasing opportunity costs as diminishing returns set in The opportunity cost of an economic action is not constant but varies with the circumstances Incentives matter: People consider opportunity costs when making decisions. 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 its production possibility frontier is preforming inefficiently Whether markets work well is important: if markets work well, they can enhance everyones well-being When markets perform poorly, they can impose real costs on the economy o Cause the economy to operate inside its PPF Basic supply-demand model

o Market behavior can usually be explained by the relationship between preferences 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 are most valuable Prices play the crucial role of telling both consumers and firms what goods 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 associated with 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 of the 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 to purchase is equal to the quantity that suppliers are willing to produce No one has incentive to alter behavior at this point o Nonequilibrium outcomes When price is set above P*, demanders would wish to buy less than Q*, whereas suppliers would produce more than Q*

 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 based o Intuition do 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 events o 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 simplifying assumptions 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 be o positive economics: analyzes how and why resources are actually allocated in the economy o normative economics: analyzes whether or not resources are allocated correctly o some argue that economic models invariably have normative consequences and should be recognized normative, how the world should be