Microeconomic Theory Basic Principles and Extensions, 9eByWALTER NICHOLSONSlides prepared byLinda Ghent (Eastern Illinois University)Modified byHuihua NIE (Renmin Unversity of China)1
Chapter 1ECONOMIC MODELS2
Theoretical Models• Economists use models to describe economic activities, as a map for road• While all economic models are abstractions from reality, they provide aid in understanding behavior of individuals, firms and governments3
Verification of Economic Models• There are two general methods used to verify economic models:– direct approach• establishes the validity of the model’s assumptions– indirect approach• shows that the model correctly predicts real- world events4
Verification of Economic Models• We can use the profit-maximization model to examine these approaches– do firms really seek to maximize profits? Yes and No by questionnaires.– can the model predict the behavior of real-world firms? An example of printer. Empirical analysis matters!– what firms can survive in competitive market?5
Features of Economic Models• Ceteris Paribus assumption• Optimization assumption• Distinction between positive and normative analysis6
Ceteris Paribus Assumption• Ceteris Paribus means “other things the same”– focus on the effects of only a few forces at a time, because we usually can’t control conditions– apply statistical methods, as econometrics– scientific arguments must be verifiable, as the relationship between income and
Optimization Assumptions• Many economic models begin with the assumption that economic actors are rationally pursuing some goal– consumers seek to maximize their utility– firms seek to maximize profits (or minimize costs)– government regulators seek to maximize public
Optimization Assumptions• Optimization assumptions generate precise, solvable and predictable models, but satisfaction does not• Optimization models appear to be perform fairly well in explaining
Positive-Normative Distinction• Positive economic theories seek to explain the economic phenomena that is observed• Normative economic theories focus on what “should” be done• We should not say that econometrics is positive
The Economic Theory of Value• Early Economic Thought– “value” was considered to be synonymous with “importance”– since prices were determined by humans, it was possible for the price of an item to differ from its value– prices > value were judged to be “unjust”– the paradox of diamond v.
The Economic Theory of Value• The Founding of Modern Economics– the publication of Adam Smith’s The Wealth of Nations is considered the beginning of modern economics– distinguishing between “value” and “price” continued (illustrated by the diamond-water paradox)• the value of an item meant its “value in use”• the price of an item meant its “value in exchange”
The Economic Theory of Value• Labor Theory of Exchange Value– the exchange values of goods are determined by what it costs to produce them• these costs of production were primarily affected by labor costs• therefore, the exchange values of goods were determined by the quantities of labor used to produce them– producing diamonds requires more labor than producing water (supply side)
The Economic Theory of Value• The Marginalist Revolution– the exchange value of an item is not determined by the total usefulness of the item, but rather the usefulness of the last unit consumed• because water is plentiful, consuming an additional unit has a relatively low value to individuals• demand side, actually supply side
The Economic Theory of Value• Marshallian Supply-Demand Synthesis– Alfred Marshall showed that supply and demand simultaneously operate to determine price– prices reflect both the marginal evaluation that consumers place on goods and the marginal costs of producing the goods• water has a low marginal value and a low marginal cost of production Low price • diamonds have a high marginal value and a high marginal cost of production High
Supply-Demand EquilibriumPriceEquilibriumSThe supply curve has a positiveQ= QD sslope because marginal costrises as quantity increasesP*The demand curve has a negative slope because the marginal value falls as Dquantity increasesQuantity per periodQ*
Supply-Demand Equilibriumq= 1000 - 100pD q= -125 + 125p (why -)S Equilibrium q= qD S1000 - 100p = -125 + 125p225p = 1125p* = 5q* =
Supply-Demand Equilibrium• A more general model isq= a + bpD q= c + dpS Equilibrium q= qD Sa + bp = c + dpacp*d
Supply-Demand EquilibriumA shift in demand will lead to a new equilibrium:Q’= 1450 - 100PD Q’= 1450 - 100P = Q= -125 + 125PD S 225P = 1575P* = 7Q* =
Supply-Demand EquilibriumAn increase in demand...PriceS…leads to a rise in theequilibrium price and ’DQuantity per
The Economic Theory of Value• General Equilibrium Models– the Marshallian model is a partial equilibrium model• focuses only on one market at a time– to answer more general questions, we need a model of the entire economy• Walras’s simultaneous
The Economic Theory of Value• The production possibilities frontier can be used as a basic building block for general equilibrium models• A production possibilities frontier shows the combinations of two outputs that can be produced with an economy’s
A Production Possibility FrontierQuantity of foodOpportunity cost of(weekly)clothing = 1/2 pound of cost of4clothing = 2 pounds of food2Quantity of clothing341213(weekly)
A Production Possibility Frontier• The production possibility frontier reminds us that resources are scarce• Scarcity means that we must make choices– each choice has opportunity costs– the opportunity costs depend on how much of each good is produced– OC is the slope of PPF in
A Production Possibility Frontier• Suppose that the production possibility frontier can be represented by222xy225• what type?• To find the slope, we can solve for Y2y225
A Production Possibility Frontierdy14x2x21/2(2252x)(4x)dx22yy• when x=5, y=, the slope= -2(5)/= • when x=10, y=5, the slope= -2(10)/5= -4what can we know? MRTSxy=dy/dx=MPy/
The Economic Theory of Value• Welfare Economics– tools used in general equilibrium analysis have been used for normative analysis concerning the desirability of various economic outcomes• economists Francis Edgeworth and Vilfredo Pareto helped to provide a precise definition of economic efficiency and demonstrated the conditions under which markets can attain that goal (invisible hand)27
Modern Tools• Mathematical foundations (Samuelson,1947)• Game theory (Nash, 1950)• uncertainty and imperfect information (information economics and finance)• Econometrics and experimental economics28
Important Points to Note:• Economics is the study of how scarce resources are allocated among alternative uses– economists use simple models to understand the process– the difference between economists and engineers29
Important Points to Note:• The most commonly used economic model is the supply-demand model– shows how prices serve to balance production costs and the willingness of buyers to pay for these costs – what’s the difference between neoclassic economics and labor theory of value?30
Important Points to Note:• Testing the validity of a model is a difficult task– are the model’s assumptions reasonable?– does the model explain real-world events?31
Important Points to Note:• The supply-demand model is only a partial-equilibrium model– a general equilibrium model is needed to look at many markets together32
