Mirco Soffritti

Microeconomics
The content of Topic 2

Factors, systems Models

and agents The way to simplify a
complex reality
Two key ingredients of any
economic environment

Positive vs normative
The underlying separation between
two breanches of economics
 Factors, systems,
01 and agents
Economic agents
An economic agent is any institution that needs to solve an economic
problem (i.e. allocation of some scarce resources to satisfy potentially
unlimited needs).

Economic agents are:

Private: households* and private firms
Public: government and public firms

*A household is family that is about to solve an economic problem

Economic system
• An economic system is a framework that a society uses to produce,
distribute, and allocate goods and services among its population.
• It includes the institutions, laws, policies, and customs that
influence and regulate economic activity within a country or region.
• Economic systems determine how resources such as labor, capital,
and natural resources are utilized.
• They define the methods by which economic decisions are made.
 Economic system
Roughly speaking, we distinguish between:

Traditional economy Market economy

Rural or agricultural communities Tr Ma Economic decisions are made by individuals
where barter and trade are common and firm based on supply and demand

Planned economy Mixed economy

Government controls the allocation of Pl Mi It combines elements of both market and
resources, production, and pricing. planned economies.
Traditional economy
• A traditional economy often exists in rural or agricultural communities where
barter and trade are common. It relies on customs, history, and beliefs.
• Economic decisions are based on societal norms and cultural values. The
methods of production and distribution are typically passed down through
generations.

Examples:
▪ The Amish community in the United States:
They rely on traditional farming techniques
and community-based trade.
Market economy
• In a market economy, economic decisions are made by individuals and
businesses based on supply and demand. There is little to no government
intervention.
• Prices and the distribution of goods are determined by competition in a free
market. This system encourages innovation and efficiency but can lead to
inequality and market failures
Examples:
The United States:
While it is not a pure market economy, it is heavily
market-oriented with minimal government
intervention.
Planned economy
• Also known as a command economy, is one where the government makes all
economic decisions. The government controls all major aspects of the
economy, including the allocation of resources, production targets, and pricing.
• This system aims to eliminate inequality and provide for all citizens, but it often
leads to inefficiency and lack of innovation.

Examples:
North Korea: The government controls
almost all aspects of the economy, with
little to no input from private enterprises.
Mixed economy
• A mixed economy combines elements of both market and planned economies.
• The government intervenes to correct market failures, provide public goods,
and ensure economic stability, while still allowing private enterprise and
market forces to operate. This system aims to balance efficiency with social
welfare.

Examples:
France/Germany/Italy/…: The economy
has both significant government involvement
and a thriving private sector
Economic factors
A factor of production is an essential input used in the production of goods and
services in an economy. They are classified into four main categories:
• Land: Natural resource, such as minerals, forests, water, and arable land and
land. They t cannot be produced by humans but are necessary for production.
• Labor: Human effort, both physical and mental, that is used in the production
process. Labor is a critical component because it transforms raw materials
into finished products through work and expertise.
• Capital: In economics, capital refers to the tools, machinery, equipment, and
buildings used to make goods and services. They help increase efficiency.
• Entrepreneurship: This is the initiative and risk-taking ability of individuals to
combine the other factors of production to create goods and services.
Entrepreneurs organize resources, innovate, and drive economic growth.
Economic factors
Land, capital, and entrepreneurship are often treated together as ‘capital’ (often
classified as either physical vs intellectual/human capital)
A firm or a country are often treated as black box that converts factor such as
labor (L) and capital (K) into production/output (Y)

𝑌 = 𝑓(𝐾, 𝐿)
02 Models
Scientific models
• A stripped-down version of something complex. It's like a map that helps us
understand, explain, and predict how things work in the real world.
• Scientists use models to focus on the most important parts of a system,
ignoring the less important details so they can better analyze and predict what
will happen under different conditions.
• These models can be made of a list of statements, and/or mathematical
equations, and/or diagrams, or even computer simulations.
Economic model
• An economic model is a model that economists use to understand and predict
how the economy works.
• By looking at the key parts and how they interact, economists can make
predictions about things like how prices will change, how much of a product
people will buy, or what might happen if the government changes its policies.
Some famous economics models
• The Circular Flow Diagram model * (eco)
• The PPF model * (eco)
• The Supply and Demand model * (micro)
• The IS-LM Model:
• The Solow Growth model:
• The Cobb-Douglas Production Function model * (micro)
• The Monopoly model * (micro)
• Etc
* Models we see in this course
What an economic model may look like
Circular Flow Diagram model
The CFD is a basic visual economic model that shows how money, goods, and
services move through an economy. At its basic, it involves two main players.
▪ Households provide resources like labor (basically, people working) to firms.
▪ Firms use these resources to produce goods and services.
In return, firms pay wages, rent, and profits to households.
Households then use this income to buy goods and services from the firms.
So, there's this continuous loop where money and resources flow back and forth.
Households supply resources and get paid. Then they spend that money on
products and services from firms.
The firms, in turn, use the money to pay for the resources they need.
Circular Flow Diagram model
To practice with the CFD model
In a simplified economy, the total amount of money spent by
households on goods and services is $500 million. Firms pay $350
million in wages, $50 million in rent, and $100 million in profits.
Calculate the total income earned by
households in this economy.
To practice with the CFD model
Assume the total household income in an economy is $600 million,
out of which households decide to save 10%. Calculate the amount
of money that will be spent on goods and services by households
after the savings.
To practice with the CFD model
What happens to the Circular Flow when households decide to save
more money?
A) The flow of goods decreases.
B) The flow of income increases.
C) The flow of money increases.
D) The government increases its spending
Production Possibility Frontier (PPF) model
• It illustrates the trade-offs and opportunity costs that a society faces
when allocating scarce resources between different goods and services.
• The PPF refers to a real economy (no money) and shows the max possible
output combinations of two goods that an economy can produce, given a
fixed amount of resources and a certain technological state.
• Imagine an economy that produces only two goods: let's say small jets and
Dreamliners. The PPF curve demonstrates the different combinations of
these two goods that can be produced if all resources (like labor, capital,
and raw materials) are used efficiently. The curve itself represents the
boundary of what is feasible—hence the term "frontier“.
Linear PPF
Linear PPF
Trade-offs: Along the PPF we see the trade-offs between two goods. As
resources are shifted from producing one good to the other, the economy
has to give up some quantity of one good to produce more of the other.
Opportunity Cost: The PPF helps illustrate the concept of opportunity
cost, which is the cost of forgoing the next best alternative when making a
decision. For example, if the economy moves from A to B, the opportunity
cost is the 6 Dreamliners that are no longer produced.
Efficiency and Inefficiency: Points along the PPF (like A and B) represent
efficient production levels, where all resources are fully utilized. Points
like C inside the PPF indicate inefficiency, where resources are
underutilized.
Non-linear PPF

•B
 To practice with non-linear PPF
i. What is the opportunity cost (OC) of increasing the number of Dreamlimers from
15 to 25 as shown from point B to A? Why?
ii. Along the PPF, what is the OC of increasing the number of small jets from 0 to
20? And the OC per small jet?
iii. Along the PPF, what is the OC of increasing the number of Dreamlimners from 0
to 30? And per Dreamliner? How are the two OC per unit (ii) and (iii). related?
iv. Along the PPF, what is the OC of increasing the number of small jets from 20 to
40? And the OC per small jet?
v. How is the two OC from 0 to 20 (ii) related to that from 20 to 40 (iv)?
The PPF is typically non-linear, decreasing and concave (umbrella shape). Why?
This is called the property of increasing opportunity costs (under efficiency).
Shifts of PPF
What could cause an outard shift of the PPF curve?
Shifts of PPF
An outward shift of the PPF in a two-good economy signifies that the economy is
now capable of producing more of both goods than it previously could. This can
occur due to several factors:
• Technological Advancements: Production processes become more efficient.
For example, if a new technology allows car manufacturers to produce goods
more quickly or with fewer resources. This increased efficiency leads to an
outward shift of the PPF.
• Increase in Resource Availability: If is an increase in the number of workers
available, perhaps due to population growth or immigration, the economy can
produce more of both goods.
• Discovery of New Resources: Finding new natural resources, like oil, minerals, or
fertile land, can enhance production capabilities. For example, discovering a new
oil field could provide the energy to increase production of both goods.
• Capital Accumulation: An increase in physical capital, such as more factories,
machines, or tools, allows the economy to produce more.
Why is the PPF concave?
• A Production Possibility Frontier (PPF) is concave because the
opportunity cost of production increases as production of a good (for
example small jets) increases.
• That is called the law of diminishing returns, and it exists everywhere
you look.
• If we give up a Dreamliner when we’re producing 10 jets, we increase the
production of jets by approximately 20/5= 4 jets. Instead, if we give up
one Dreamliner when we are already producing 30 jet, we increase the
production of jets by approximately 20/25= 4/5<4 jets.
• This is because when giving up the first Dreamliners, to maintain
efficient, we had to transfer to the production of jets the best (most
productive) of the best resources we had. An the more we do so, the less
productive are the resources we still are left to transfer.
Six concepts
The six economic concepts that the PPF helps us understand:

• Feasibility
• Efficiency
• Tradeoffs
• Opportunity Cost
• Decreasing returns to factors
• Economic Growth
Make sense of each of them. Write down their definition and how they do
relate to the PPF of a two-good country
To practice with the PPF model
Consider the PPF on left. Associate (in case
it exists) at least one point to the following
concepts:
• There is a trade off
• There is an opportunity cost
• All resources are used for food
• Infeasible production
• There is free lunch
• All resources are efficiently used
• The opportunity cost of producing
clothes is (approximately) ½ units of food
To practice with the PPF model
Plot the following events on the PPF or
change the PPF. Assume we currently
are at point C.
• 5 unemployed workers are hired to
build a small jet.
• 5 immigrants (good for both kinds of
planes) enter the country but
remain unemployed.
• 5 unemployed workers (good for
both kinds of planes) leave the
country.
• 5 employed workers for the
production of Dreamliners leave the
country.
To practice with the PPF model
Jason is lost on a desert island. Think
of his PPF about catching of fish vs
gathering coconuts. Assume Jason
operates efficiently.
An increase in the amount of
resources available to Tom for use in
producing coconuts (he discovers
more trees) does not change his
production possibility frontier.”

a) True
b) False
To practice with the PPF model
Jason is lost on a desert island. Think
of his PPF about catching of fish vs
gathering coconuts. Assume Jason
operates efficiently.
A technological change that allows
Tom to catch more fish for any amount
of coconuts he gathers results in a
change in his production possibility
frontier which now becomes upward
sloping.”
a) True
b) False
To practice with the PPF model
Jason is lost on a desert island. Think
of his PPF about catching of fish vs
gathering coconuts. Assume Jason
operates efficiently.
The PPF frontier is useful because it
illustrates how many coconuts Jason
must give up gathering to be able to
catch one more fish, a number that
does not depend on the number of fish
he already catched.
a) True
b) False
03 Normative vs positive
Positive vs normative economics
Positive Economics:
Deals with objective analysis and facts. It describes "what is"
without making value judgments.
Descriptive or objective economics.

Normative Economics:
Involves value judgments and opinions.
It focuses on "what ought to be.“
Prescriptive or subjective economics.
Positive vs normative economics
Classify the following three questions:
1. How much revenue will the tolls on the state turnpike yield
next year?
2. How much would that revenue increase if the toll were
raised from $1 to $1.50?
3. Should the toll be raised, bearing in mind that a toll
increase will reduce traffic and air pollution near the road
but will impose some financial hardship on frequent
commuters?
To practice with the positive/normative
1. The unemployment rate in the country increased by 2% last year.
2. The government should provide universal healthcare to ensure equal access
for all citizens.
3. A 10% increase in the minimum wage is expected to reduce employment by
1% in small businesses.
4. The price of oil has risen by 15% due to increased global demand.
5. We ought to reduce income taxes to boost consumer spending.
6. The central bank should focus more on controlling inflation than on reducing
unemployment.
7. The GDP growth rate of the economy slowed to 1.5% in the last quarter.
8. We should implement stricter regulations on financial institutions to
prevent another economic crisis.
To practice
In an economy represented by the Circular Flow Diagram model, firms pay $400
million in wages, $100 million in rent, and $200 million in profits. If the economy
shifts towards a planned economy where government taxes 25% of firms' income,
what will be the total income left for households after taxation?
a) $525 million
b) $550 million
c) $450 million
d) $600 million
To practice
The opportunity cost of increasing Dreamliner production from 10 to 20 units
is 15 small jets. If the production possibility curve is linear, what is the
opportunity cost of increasing Dreamliner production from 20 to 30 units?
a) 10 small jets
b) 15 small jets
c) 25 small jets
d) 30 small jets
To practice
In a non-linear PPF, the opportunity cost of moving from 0 to 10 Dreamliners
is 5 small jets, and from 10 to 20 Dreamliners, it is 10 small jets. What is the
(average) marginal opportunity cost of producing each additional Dreamliner
as the economy moves from 10 to 20 units?
a) 0.5 small jets
b) 1 small jet
c) 1.5 small jets
c) 2 small jets
To practice
If the PPF for an economy shows the production of two goods, cars and
computers, and the opportunity cost of producing cars increases as more
cars are produced, which of the following points on the PPF demonstrates
the highest opportunity cost per car?
a) Moving from 0 to 10 cars
b) Moving from 10 to 20 cars
c) Moving from 20 to 30 cars
d) Moving from 30 to 40 cars
To practice
In a two-good economy, if the current production level is inefficient (inside the PPF),
the labor force grows by 10%, and firms increase their capital investments by 15%.
What would be the expected impact on the economy’s position relative to its PPF?
a) Will be closer to the PPF but remain inside
b) Will shift outward beyond the current PPF
c) Will be more away from the PPF but remain inside
d) None of the above
To practice
Jason, stranded on a desert island, has a PPF for producing fish and coconuts. If
he gathers 10 coconuts, he can catch 5 fish, and if he gathers 20 coconuts, he
can only catch 1 fish. What is the opportunity cost of each additional coconut as
Jason moves from 10 to 20 coconuts?
a) 0.5 fish
b) 0.25 fish
c) 0.4 fish
d) 0.1 fish
To practice
The concept of opportunity cost is central to the PPF model. Which of the following
best captures the increasing opportunity costs depicted in a concave PPF?
a) The opportunity cost remains constant as production shifts between goods
b) The opportunity cost increases as more resources are allocated to one good
c) The opportunity cost decreases as the economy moves toward full employment
d) The opportunity cost only applies when resources are underutilized
To practice
Which of the following statements represents normative economics?
a) The government should increase taxes on high-income earners to reduce
inequality
b) The unemployment rate increased by 1.5% in the last quarter
c) Inflation is expected to rise by 2% next year due to supply chain disruptions
d) A decrease in interest rates is likely to boost consumer spending
To practice

Atlantis is a small, isolated island in the South Atlantic. The inhabitants grow
potatoes and catch fish. The accompanying table shows the maximum annual output
combinations of potatoes and fish that can be produced. Obviously, given their
limited resources and available technology, as they use more of their resources for
potato production, there are fewer resources available for catching fish.
To practice

a) Draw a production possibility frontier (PPF) with potatoes on the horizontal

axis and fish on the vertical axis illustrating these options, showing points A–F.
b) Can Atlantis produce 500 pounds of fish and 800 pounds of potatoes? Explain.
Where would this point lie relative to the production possibility frontier?
To practice

c) What is the opportunity cost of increasing the annual output of potatoes

from 600 to 800 pounds?
d) What is the opportunity cost of increasing the annual output of potatoes
from 200 to 400 pounds?
e) Can you explain why the answers to parts c and d are not the same? What
does this imply about the slope of the PPF?
To practice (challenging)
Your dormitory roommate plays loud music most of the time; you, however, would
prefer more peace and quiet. You suggest that he buy some earphones. He
responds that although he would be happy to use earphones, that you should be in
charge of spending this money. You discuss this situation with a female friend who
is an economics major. The following exchange takes place:
She: “How much would it cost to buy earphones? “
You: «$15.»
She: “How much do you value having peace and quiet for the rest of the semester?”
You: «$30.»
She: “It is efficient for you to buy the earphones and give them to your roommate.
You gain more than you lose; the benefit exceeds the cost. You should do that!”
You: “It isn’t fair that I have to pay for the earphones when I’m not the one making
the noise!“
a) Which parts of this conversation contain positive statements and which parts
contain normative statements?
To practice (challenging)
• Construct an argument supporting your viewpoint that your roommate
should be the one to change her behavior.
• Similarly, construct an argument from the viewpoint of your roommate that
you should be the one to buy the earphones.
• If your dormitory has a policy that gives residents the unlimited right to play
music, whose argument is likely to win?
• If your dormitory has a rule that a person must stop
playing music whenever a roommate complains,
whose argument is likely to win?
To practice (challenging)
A representative of the American clothing industry recently made the following
statement: “Workers in Asia often work in sweatshop conditions earning only pennies
an hour. American workers are more productive and as a result earn higher wages. In
order to preserve the dignity of the American workplace, the government should
enact legislation banning imports of low-wage Asian clothing.”
a) Which parts of this quote are positive statements? Which parts are normative
statements?
b) Would such a policy make some Americans better off without
making any other Americans worse off? That is, would this
policy be efficient from the viewpoint of all Americans?
c) Would low-wage Asian workers benefit from or be hurt by
such a policy?
Summary of Topic 2
Economic Agents and Systems
Economic Agents:
• Private (households, private firms)
• Public (government, public firms)
Economic Systems:
• Traditional Economy: Based on customs and traditions (e.g., Amish community)
• Market Economy: Based on supply and demand, minimal government
intervention (e.g., USA)
• Planned Economy: Government controls production/prices (e.g., North Korea)
• Mixed Economy: Combines market and government control (e.g., France,
Germany)
Summary of Topic 2
Economic Factors and Models
Factors of Production:
• Land: Natural resources
• Labor: Human effort in production
• Capital: Tools, machinery, equipment
• Entrepreneurship: Risk-taking to combine resources and innovate
Scientific Models in Economics:
• Simplified versions of reality to explain and predict economic behavior
• Examples: Circular Flow Diagram, Production Possibility Frontier (PPF), Supply
and Demand model.
Summary of Topic 2
Production Possibility Frontier (PPF) and Normative vs Positive Economics
PPF Model:
• Illustrates trade-offs and opportunity costs
• Shows maximum output combinations of two goods given fixed resources
• Points on the PPF: Efficiency; inside PPF: inefficiency; outside: infeasible
Normative vs Positive Economics:
• Positive Economics: Objective, based on facts (e.g., "The unemployment rate
increased by 2% last year.")
• Normative Economics: Value-based, subjective (e.g., "We should reduce taxes
to boost spending.")