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Figure 1
A variable is something that can take on different values. For example, in economics, price is a variable
that can take on many values. When variables are related to one another, they are usually classified as
being either a dependent variable or an independent variable. The value of a dependent variable
depends upon the value of the independent variable (or of a set of independent variables). For example,
a persons weight (dependent variable) depends on many things (independent variables) like caloric
intake, height, activity level, etc. When variables are related, a function can be used to describe the
relationship between the variables. A function is a mathematical rule (equation) that relates one set of
variables to another set of variables and assigns one unique value of the dependent variable to each
value of the independent variable. Discrete variables take on specific values, for example whole
numbers, 1, 2, 3, etc... within a range of numbers. Continuous variables can take on any value within a
range, for example, 1, 1.1, 1.11, 1.111, 1.111, etc. Most variables used in this class are assumed to be
continuous and can therefore be represented by a continuous function. When a continuous function is
graphed, there will be no gaps in the graph.
Functional relationships with two variables (one dependent, usually Y, and one independent, usually X)
can be easily graphed on the Cartesian coordinate system. For example, the line through points C and B
is the graph of the function, Y= aX - 2. This equation, or function, defines a positive (or direct), linear
relationship between the variables X and Y, as the value of X increases (decreases) the value of Y
increases (decreases). The line through points I and A is the graph of the function, Y=-X+1. This
function defines a negative (or inverse), linear relationship between the variables X and Y, as the value
of X increases (decreases) the value of Y decreases (increases). The curve through points D, E, F, G,
Figure 2
A society has the opportunity to produce any combination of goods in its production opportunity set
but, because of the "more is better" assumption mentioned above, we assume that a society not will
purposely choose to produce at a point below its PPF. To produce at a point below the PPF is to say that
a society is either not using all of its resources, or it is not using its best (most efficient) technology. If
more really is better, a society will seek to produce as much with its resources as possible. That is, it
will choose to produce one of the combinations of X and Y on its PPF. The PPF shows all of the
various combinations of two goods that can be produced assuming that society is using all its resources
and its most efficient technology (thus the concept captures the concept of efficiency).
Once a society is producing at a point on its PPF it cannot increase the output of one good without
decreasing the output of the other good. Thus, this model also captures the concept of opportunity costs.
The opportunity cost of good X is the amount of good Y that must be given up to produce one more X.
The opportunity cost of good Y is the amount of good X that must be given up to produce one more Y.
The absolute value of the slope of the PPF at the point of production is the opportunity cost of good X in
terms of good Y. For example, if society was producing at a point on the PPF where the slope was -2,
this would indicate that society must give up two units of Y to get one more unit of X. The reciprocal of
the absolute value of the slope of the PPF gives the opportunity cost of Y in terms of X. In this
example, society would have to give up 1/2 unit of X to get one more unit of Y.
We can talk of opportunity costs in three ways.
Constant Opportunity Costs - The opportunity cost of producing one more of good X (or good
Y) is the same regardless of how much is already being produced (constant returns to scale).
When there are constant opportunity costs the PPF will be linear (straight).
Increasing Opportunity Costs (shown in Figure 2) - The opportunity cost of producing a good
increases as more and more of the good is produced (decreasing returns to scale). When there
are increasing opportunity costs the PPF will be concave to the origin of the graph (bowed out)
Remember, this is a very simple model. Notice that there is no government, financial,
or external (international) sector. The purpose here is to gain an appreciation of how prices are
generated and their role as economic signals.
Households are economic decision making units. They may contain a single person, family, or other
group. The key is that they operate as a unit when making economic decisions. Households have two
basic decisions to make (a third will be discussed in class). Household members own resources and
must decide what quantity of resources they are willing to provide to firms (hours of labor, etc...). They
must also decide what goods and services they are willing to consume and in what quantities they will
consume them. Households make supply decisions in the resource market and demand decisions in the
product market.
Production takes place in firms. Entrepreneurs in firms have two basic economic decisions to make.
They must decide what quantity (and what mix) of resources they are willing to buy. They must also
decide what goods and services they are willing to produce and in what quantities to produce them.
Firms make demand decisions in the resource market and supply decisions in the product market.
The prices of resources (wages, interest, etc...)are determined when buyers and sellers interact in
resource markets. The prices of goods and services (PX and PY) are determined when buyers and sellers
interact in the product market. In turn, prices provide information to market participants that help them
make production and consumption decisions.
Refer to the circular flow diagram above. Households sell their resources in the resource market to earn
incomes with which they buy the goods and services they wish to consume. When they pay for the
goods and services, firms receive revenue which they use to pay for the resources used when they
produced the goods and services which they sell to the households. This is an example of economic
interdependence. There is a basic conflict here in that both households and firms behave in a self
interested way. Utility maximizing households want high incomes (resource prices) and low prices for
goods and services. Profit maximizing firms want low costs (resource prices) and high revenues (prices
of goods and services). This conflict is what makes markets work.
Figure 4
Notice that demand is downward sloping indicating a negative (inverse) functional relationship between
the price of X and the quantity demanded of X (as the price of X goes down, consumers are willing and
able to buy more of X, and vice versa). This is because of the income effect and the substitution effect.
The income effect is part of the reason for the inverse relationship between price and quantity
demanded. As a price goes down (other things staying the same) consumers real incomes (the
amount of goods and services that can be purchased from ones money income) increase. This
increase in income causes consumers to buy more of the good X because now they can afford
to.2
For example, suppose you have an income of $250 per week and you have been spending it all on
consumption. If you are buying 10 gallons of gasoline every week and the price of gasoline drops by
$.25 (everything else stays the same price) you will be able buy everything you bought before the price
change and have $2.50 left to spend, part of which you may spend on more gasoline.
The substitution effect is another part of the reason for the inverse relationship between price and
quantity demanded. As the price goes down (other things equal) the good becomes cheaper not
only in the dollar amount paid but it also becomes cheaper relative to (compared to) other goods.
Because of this, consumers may buy more of the now relatively cheaper good and buy less of
some substitute for the good. For example, if the price of hamburgers increases (decreases) you
This assumes that X is a normal good. For normal goods, an increase (decrease) in
income will cause the consumer to buy more (less) of the good. For inferior goods, an increase
(decrease) in income will cause the consumer to buy less (more) of the good. For many people,
shrimp or steak might be normal goods while Ramen noodles or frozen burritos might be inferior
goods.
Figure 5
(See Figure 5) At price P2 we find a surplus (excess supply) of X in the market because, at this price,
quantity supplied is greater than quantity demanded. At P2, sellers are willing and able to sell more of
X than buyers are willing and able to buy. As the surplus becomes evident to producers, they will begin
to offer X for sale at a lower price and, at the same time, bring less to market (reduction in quantity
supplied). As the price drops, consumers who were not willing and able to pay price P2 begin to buy X
as the price drops (increase in quantity demanded). This adjustment will continue as long as there is a
surplus of X in the market. The adjustment will stop when the market price has dropped to P1, the
equilibrium price.
Figure 6
(See Figure 6) At price P2 we find a shortage (excess demand) of Y in the market because, at this price,
quantity supplied is less than quantity demanded. At P2, sellers are willing and able to sell less of Y
than buyers are willing and able to buy. As the shortage becomes evident to producers, they will begin
to ask a higher price for Y and, at the same time, bring more to market (increase in quantity supplied).
As the price increases, consumers who were willing and able to pay price P3, but not a higher price, stop
buying Y as the price increases (decrease in quantity demanded). This adjustment will continue as long
as there is a shortage of Y in the market. The adjustment will stop when the market price has increased
to P1, the equilibrium price.
IMPORTANT P1 will only be the equilibrium price for the case shown in the graph. If one of the non
price determinants of supply or demand change (shifting the supply or demand curve) there will be a
new equilibrium price. For example, if demand increases (demand curve shifts right) because of a
change in tastes and preferences, the equilibrium price will increase. As the price of X adjusts upward
toward the new equilibrium, producers increase their quantity supplied. The price increase sent a signal
to producers that consumers wanted more Y.
PUTTING THINGS TOGETHER
Refer again to Figure 4 above. The prices shown in this graph (P1, P2, P3) were generated in markets
by the interactions of households (consumers) and producers. As prices change, consumers and
producers both transmit and receive important signals. Increasing prices tell producers to produce more
and consumers to consume less. Decreasing prices tell them the opposite. Besides clearing markets,
changes in relative prices (Py/Px or Px/Py) signal the need to reallocate resources. For example,
suppose consumer tastes and preferences changed such that the demand for X increased (price increases)
and the demand for Y decreases (price decreases). The changing relative prices would tell producers to
reallocate resources from Y production and toward X production.
2.
3.
4.
5.
If the PPF were straight instead of concave to the origin of the graph, we would say that this economy
experiences ___________________ marginal opportunity costs. What does this mean?
6.
Which of the labeled points on the graph are included in the feasible production/consumption
opportunity set?
7.
Which of the labeled points are not included in the feasible production/consumption opportunity set?
8.
9.
Point G represents a combination of beans and franks that has both more beans and more franks than are
represented by point C. Suppose that, even though this is true society chooses to produce and consume
the combination represented by point C. If more is better, why would a society choose to do this?
Given the assumptions we talked about briefly in class, would a society ever voluntarily choose to
produce at point H? Why or why not?
11.
If the slope of the PPF is - at point B, what is the marginal opportunity cost of franks at this point?
What is the marginal opportunity cost of beans at this point?
12.
If the slope of the PPF is -2 at point D, what is the marginal opportunity cost of franks at this point?
13.
Suppose that a NMSU researcher develops, and makes public, a new method to raise cattle and hogs
which allows them to gain weight with less feed. Describe what will happen to the PPF in this case.
14.
Suppose that an NMSU researcher develops, and makes public, a new method for controlling the
weather. Describe what will happen to the PPF in this case.
15.
Suppose that this is the United States PPF and a large earthquake causes California to fall into the
ocean. Describe what will happen to the PPF in this case.
16.
Is it likely that a society would voluntarily choose to produce and consume at either of these points?
Why or why not?
17.
We discussed the economic problem in class. What is it and how does it relate to the PPF model?
Why is it called an equilibrium and what condition is met at the equilibrium price that is not met at any other
price?
What condition exists in the shoe polish market when the price is above equilibrium? Then what happens?
What is the difference between a change in demand and a change in quantity demanded?
What is the difference between a change in supply and a change in quantity supplied?
How would each of the following affect demand or supply and the equilibrium price and quantity? In each
case, identify which determinant of demand or supply has changed.
The price of leather shoes decreases (what kind of good is this?)
The price of canvas shoes decreases (what kind of good is this?)
Consumer incomes increase and shoe polish is a normal good (incomes decrease?)
Consumer incomes increase and shoe polish is an inferior good (incomes decrease?)
A famous and popular movie star says that men (or women) with shiny shoes drives him or her wild
Scientists at NMSU discover that shiny shoes cause skin cancer
The wage for factory workers increases (decreases?)
The price of tin decreases (increases?)
There is massive unemployment and many unemployed workers start shoe shine stands to make ends
meet.
A machine is invented that blends wax with dye faster and uses less energy to operate than the older
machines
The price of moustache wax increases substantially
Each number on the graph above indicates a sector, market, real flow, or monetary flow. If any two of
them have been identified, you should be able to identify the other 10. I have identified two of the
elements of the model below. Identify the others and note whether it is a sector, a market, a real flow, or
a monetary flow.
1.
____________________
______________________
2.
____________________
______________________
3.
____________________
______________________
4.
____________________
______________________
5.
____________________
______________________
6.
____________________
______________________
7.
_Households__________
____Sector_____________
8.
____________________
______________________
9.
____________________
______________________
10.
_Real Flow_____________
11.
____________________
______________________
12.
____________________
______________________
____________________
B.
____________________
C.
____________________
D.
____________________
E.
____________________
F.
____________________
G.
____________________
H.
____________________
III