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Chapter 1
What is economics?

Economics is the study of choice under conditions of scarcity

Economics is a social science

The study of how individuals and societies use limited resources to satisfy
unlimited wants.
1.
Fundamental economic problem:

Scarcity.

Individuals and societies must choose among available alternatives

“As individuals we face a scarcity of time and spending power. Given
more of either, we could have more of the goods and services that we
desire.”
2. Scarcity and Social Choice
“Resources are the land, labor, and capital that are used to produce goods and services.”

Land: natural resources: nature, resources, forests, farms, oil, etc. “The
physical space on which production occurs, and the natural resources that
comes with it.”

Labor: the contribution of human beings: workers, managers. “The time
human beings spend producing goods and services.”

Capital: plant and equipment; (real capital/physical capital) tools, equipments,
buildings, computers. “Long lasting tools used in producing goods and
services.”
o this differs from “financial capital”
o entrepreneurial ability
 Real vs. nominal assets
The word economy comes from the Greek word meaning “one who manages a
household.” This makes sense because in an economy, we are faced with many decisions
(just as a household is)
3. Scarcity and Economics:
The First Fundamental Problem: Scarcity
Tradeoffs: Making decisions requires trading one goal for another, to make
rational financial decisions.
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a) Efficiency means that society is getting the most for its scarce resources.
b) Equity means that the benefits of those resources are distributed fairly
among society’s members.
Microeconomics and Macroeconomics:

Microeconomics is the study of the economic behavior of decision makers

Macroeconomics is the study of the behavior of entire economies
Microeconomics: The study of how households and firms make
decisions (profits, production, etc.) and how they interact in the specific
markets. Microeconomics includes topics such as monopoly, perfectly
competitive.
Macroeconomics: The study of economy-wide phenomena. A
macroeconomist might study unemployment, or the effect of rent control
on housing in New York City, or the impact of foreign competition on the
U.S. auto industry, or even the effects of compulsory school attendance on
workers’ earnings. Basically, though, macroeconomics is the study of
economy-wide phenomena, including inflation, unemployment, and
economic growth.
What is the Difference between Positive and Normative?
Positive is objective and describes how the world really is, with facts. For
example, it is positive that unemployment was 5% during Clinton’s
presidency.
 Relies on testable hypotheses
Normative is subjective and is how one believes the world “should be.”

It is your opinion, like stating that 5% is too high.

Relies on value judgments to evaluate or recommend alternative
policies.
The Use of Models in Economics
 “A model is an abstract representation of reality”
 “A model should be as simple as possible to accomplish its
purpose.”
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 Assumptions make the world easier to
understand.
 Most assumptions will be somewhat
unrealistic but will have small effects on the
actual outcome of the model.
 “A simplifying assumption is any assumption that makes a model
simpler without affecting any of its important conclusions.”
 “A critical assumption is any assumption that affects the conclusions
of a model in an important way.”
 Example: International trade: once we understand trade between two
countries we can extend the analysis to a greater number of countries and
goods.
Q: What is an unrealistic assumption in trade theory?
A: The preceding two trades/ two country example.
 (However assumptions provide:) a road map:
Economists follow the scientific method: “a four step process…”
1. Observation and develop a theory (
2. Hypothesis (as price goes up people buy less)
3. Data can be collected to evaluate the hypothesis (statistic)
4. Accept or Reject Hypothesis
a) If you accept, then theory confirmed
b) If you reject, theory has to be modified (This causes one to start back
at step one)
In economics controlled experiments are very difficult.
Chapter 2: Scarcity, Choice and Economic System
Outline:
1. The concept of opportunity cost

Opportunity cost for individuals

Opportunity cost and society

Production possibilities frontiers
2. Economic Systems
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Opportunity Cost
The relevant cost of any decision is its opportunity cost - the value of the next-best
alternative that is given up.
By making choices in how we use our time and spend our money we give something up.
Instead attending class at SMC, what else could you be doing? Your best alternatives
may involve sports, leisure, work, entertainment, and more. Thus, the concept of
opportunity cost is your best alternative to the choice that is made. If you choose to go to
a restaurant this evening, the money that you spend on dinner will not be available for
other uses, even saving.
Businesses and governments also deal with opportunity costs. As noted, by choosing to
maintain large deficits today, the federal government may reduce future economic
growth. Or laws that protect wilderness areas and endangered species will ensure a better
environment tomorrow at the opportunity cost of reduced access to resources today.
Businesses must choose what type of goods to produce and the quantity. Given limited
funds, the opportunity cost of producing one type of good will arise from not being able
to produce another.
 The opportunity cost of college attendance includes:
$ The cost of tuition, books, and supplies,
$ Foregone income (this is usually the largest cost associated with college
attendance), and
Opportunity cost of attending a movie?
A date with your girlfriend/boyfriend…
The Production Possibilities Frontier (PPF): The production possibilities frontier
is used to illustrate the economic circumstances of scarcity, choice, and opportunity cost.

“The direct money cost concept: the direct money cost of a choice may
only be a part of the opportunity cost of that choice

All production carries an opportunity cost: to produce more of one thing,
society must shift resources away from producing something else”
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
According to the law of increasing opportunity cost, the more of
something we produce, the greater the opportunity cost of producing even
more of it.

The law of increasing opportunity cost causes the PPF to have a concave
shape.

A firm, an industry, or an entire economy is productively inefficient if it
could produce more of at least one good without pulling resources from
the production of another good.
Economic Systems:
1. Market system/economy
2. Command economy
3. Mixed economy (all economies are mixed to some degree)
Chapter 3
Markets:
A market is a group of buyers and sellers
Aggregation: combining a group of distinct things into a single whole
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“How broadly or narrowly we define a good or service is one of the choices that
distinguish macroeconomists from macroeconomists. In macroeconomics, goods and
services are aggregated to the highest levels.”
For example:
 Dishwashers, cell phones, blue jeans, are placed into one
category: “consumer goods,” they are thus traded in a single,
broadly defined market, “the market for consumption goods.”
 And, instead of recognizing different markets for shovels,
bulldozers, computers, and factory, and factory buildings,
macro models analyze the market for “capital goods.”
 “Defining goods in this very broad way allows
macroeconomists to take an overall view of the
economy without getting bogged down in the
details.”
Buyers and Sellers: “A market is composed of the buyers and sellers that trade in it”
Competition in Markets: (general)



In imperfectly competitive markets, individual buyers and sellers have some
influence over the price of the product.
In imperfectly competitive markets (or just competitive markets), each buyer and
seller takes the market price as given.
The supply and demand model is designed to explain how prices are determined
in perfectly competitive markets.
Demand:
 The demand for a good or service is defined to be the relationship that
exists between the price of the good and the quantity demanded in a given
time period, ceteris paribus. One way of representing demand is through a
demand schedule such as the one appearing below:
Note that the demand for the good is the entire relationship that is summarized by
this table. This demand relationship may also be represented by a demand curve (as
illustrated).
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Both the demand schedule and the demand curve indicate that, for this good, an inverse
relationship exists between the price and the quantity demanded when other factors are
held constant. This inverse relationship between price and quantity demanded is so
common that economists have called it the law of demand:
 An inverse relationship exists between the price of a good and the quantity
demanded in a given time period, ceteris paribus.
 As noted above, demand is the entire relationship between price
and quantity, as represented by a demand schedule or a demand
curve. A change in the price of the good results in a change in the
quantity demanded, but does not change the demand for the good.
As the diagram below indicates, an increase in the price from $2 to
$3 reduces the quantity of this good demanded from 80 to 60, but
does not reduce demand.


An individual’s quantity demanded of any good is the total amount that
individual would choose to buy at a particular price.
The market quantity demanded of any good is the total amount that all buyers in
the market would decide to buy at a particular price.
Change in demand vs. change in quantity demanded
A change in demand occurs only when the relationship between price and quantity
demanded changes. The position of the demand curve changes when demand
changes. If the demand curve becomes steeper or flatter or shifts to the right or the
left, we can say that demand has changed. The diagram below illustrates a shift in the
demand for a good (from D to D'). Notice that a rightward shift in the position of the
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demand curve is said to be an increase in demand since a larger quantity is demanded
at each price.
The Law of Demand: states that when the price of a good rises and everything else
remains the same, the quantity of the good demanded will fall.
The Demand Schedule and the Demand Curve


The demand schedule is a list showing the quantities of a good that consumers
would choose to purchase at different prices, with all other variables held
constant.
The market demand curve (or just the demand curve) shows the relationship
between the price of a good and the quantity demanded, holding all other
variables that affect demand. Each point on the curve shows the total quantity
that buyers would choose to buy a specific price.
Market demand
The market demand consists of the total quantity demanded by each individual in the
market. Conceptually, the market demand curve is formed by computing the
horizontal summation of the individual demand curves for all consumers. The
diagram below illustrates this process. This diagram illustrates a simple case in which
there are only two consumers, Person A and Person B. Notice that the total quanity
demanded in the market is just the sum of the quantities demanded by each
individual. In this diagram, Person A wished to buy 10 of this commodity and person
B wishes to buy 15 units when the price is $3. Thus, at a price of $3, the total quantity
demanded in the market is 25 (=10+15) units of this commodity.
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
A change
in a good’s
price
causes us
to move along the demand curve. We call this a change in quantity demanded.
A rise in price causes a leftward movement along the demand curve—a decrease
in quantity demanded. A fall in price causes a rightward movement along the
demand curve—an increase in quantity demanded.
 A change in demand is a shift of a demand curve in response to a change in some
other variable other than price.
 The demand for most goods (normal goods) is positively related to income or
wealth. A rise in either income or wealth will increase demand for these goods
and shift the demand curve to the right.
 Income is the amount that a person or firm earns over a particular period
 Wealth is the total value of everything a person or firm owns, at a point in time,
minus the total value of everything owed.
 A normal good is a good that people demand more of as their income increases.
 An inferior good is a good that people demand less of as their income rises.
 A substitute (good) is a god that can be used in place of some other good and that
fulfills more or less the same purpose.
“When the price of a substitute rises, the demand for a good will increase, shifting the
demand curve to the right.”
 A complement is a good that is used together with some other good. A rise in the
price of a complement decreases the demand for a good, shifting the demand
curve to the left.
 A firm’s technology is the set of methods a firm can use to turn inputs into
outputs. [A firm’s production technology (or just technology) is the set of
methods it can use to turn inputs (resources and raw materials) into outputs
(goods and services)].
 When a competitive firm comes to a market as a seller, it wants to make the
highest possible profit. The firm can choose the level of output it wants to
produce, but it faces three constraints: (1) its production technology, (2) the
prices it must pay for its inputs, and (3) the market price of its output.
Determinants of demand
Let's examine some factors that might be expected to change demand for most goods and
services. These factors include:
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
Tastes and preferences,

The prices of related goods,

Income,

The number of consumers, and

Expectations of future prices and income.

SUPPLY:
Supply is the relationship that exists between the price of a good and the quantity
supplied in a given time period, ceteris paribus. The supply relationship may be
represented by a supply curve:
or a supply schedule:
 Just as there is a "law of demand" there is also a "law of supply." The law
of supply states that:
 A direct relationship exists between the price of a good and the quantity
supplied in a given time period, ceteris paribus.
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 To understand the law of supply, it's helpful to remember the law
of increasing cost. Since the marginal opportunity cost of
supplying a good rises as more is produced, a higher price is
required to induce the seller to sell more of the good or service.
 The law of supply indicates that supply curves will be
upward sloping (as in the diagram below
Change in quantity supplied vs. change in supply
 As in the case of demand, it is important to distinguish between a change in supply
and a change in quantity supplied. A change in the price of a good results in a change
in the quantity supplied. A change in the price changes the quantity supplied, as noted
in the diagram below.
o A change in supply occurs when the supply curve shifts, as in the diagram below.
Note that a rightward shift in the supply curve indicates an increase in supply since
the quantity supplied at each price increases when the supply curve shifts to the right.
When supply decreases, the supply curve shifts to the left.
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Determinants of supply
The factors that can cause the supply curve to shift include:

the prices of resources,

technology and productivity,

the expectations of producers,

the number of producers, and

the prices of related goods and services.

A firm’s quantity supplied of any good is the amount it would choose to produce
and sell at a particular price.
 The market quantity supplied of any good is the amount that all firms in the
market would like to produce and sell at a particular price, given the prices they
must pay for their inputs, and given any other influences on their selling
decisions.
The Law of Supply: states that when the price of a good rises, and everything else
remains the same, the quantity of the good supplied will rise.

The supply schedule is a list showing the quantities of a good or service that
firms would choose to produce and sell at different prices, with all other variables
held constant.
Changes in Quantity Supplied







A change in a good’s price causes us to move along the supply curve. We call
this a change in quantity supplied. A rise in price causes a rightward movement
along the supply curve—an increase in quantity supplied. A fall in price causes a
leftward movement along the supply curve—a decrease in quantity supplied.
A change in any influence on supply—except for the good’s price—causes the
supply curve to shift. We call this a change in supply. When sellers choose to
sell more at any price, the supply curve shifts rightward—an increase in supply.
When sellers chose to sell less at any price, the supply curve shifts leftward—a
decrease in supply.
Prices of inputs: A rise in the price of an input causes a decrease in supply,
shifting the supply curve to the left. A fall in the price of an input causes an
increase in supply, shifting the supply curve to the right.
Profitability of alternate goods: When an alternate good becomes more
profitable to produce—because its price rises, or the cost of producing it falls—
the supply curve for the good in question will shift leftward.
An alternate good: “other goods that a firm could produce, using some of the
same types of inputs as the good in question.”
Technology: a cost saving technological change advances increase the supply of
a good, shifting the supply curve to the right.
Productive Capacity: an increase in seller’s productive capacity—caused by, say,
good weather or am increase in the number of firms—shifts the supply curve
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


rightward. A decrease in sellers’ productive capacity shifts the supply curve
leftward.
Expectations of future prices: a rise in the expected price of a good will increase
supply, shifting the supply curve leftward.
An equilibrium: is a situation that, once achieved, will not change unless there is
a change in something we have been assuming to be constant.
Excess supply: at a given price, the excess of quantity supplied over quantity
demanded.
Equilibrium
Let's combine the market demand and supply curves on one diagram:

It can be seen that the market demand and supply curves intersect at a price of $3
and a quantity of 60. This combination of price and quantity represents
equilibrium since the quantity demanded equals the quantity supplied. At this
price, each buyer is able to buy all that he or she desires and each firm is able to
sell all that it desires to sell. Once this price is achieved, there is no reason for the
price to either rise or fall (as long as neither the demand nor the supply curve
shifts).

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 If the price is above the equilibrium, a surplus
occurs (since quantity supplied exceeds quantity
demanded). This situation is illustrated in the
diagram below. The presence of a surplus would
be expected to cause firms to lower prices until
the surplus disappears (this occurs at the
equilibrium price of $3).

If the price is below the equilibrium, a shortage occurs (since quantity demanded
exceeds quantity supplied). This possibility is illustrated in the diagram below.
When a shortage occurs, producers will be expected to increase the price. The
price will continue to rise until the shortage is eliminated when the price reaches
the equilibrium price of $3.
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Shifts in demand and supply
 Let's examine what happens if demand or supply changes. First, let's consider the
effect of an increase in demand. As the diagram below indicates, an increase in
demand results in an increase in the equilibrium levels of both price and quantity.

A decrease in demand results in a decrease in the equilibrium levels of price
and quantity.

An increase in supply results in a higher equilibrium quantity and a lower
equilibrium price. Equilibrium quantity will fall and equilibrium price will
rise if supply falls.
Chapter 4
Macroeconomic concerns




High employment
Employment and the business cycle
Business cycles
Fluctuations in real GDP around its long-term growth trend.
Expansion : A period of increasing real GDP .
Peak: The point at which real GDP reaches its highest level during an expansion.
Recession: A period of declining or abnormally low real GDP .
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Trough: The point at which real GDP reaches its lowest level during a recession.
Depression: An unusually severe recession.
“Economists—and society at large—agree on three important macroeconomic goals:
rapid economic growth, full employment, and stable prices.”

What is responsible for these dramatic changes in economic well being?

Rapid economic growth….In the United States—as in most developing
economies—our output of goods and services has risen faster than the population.
As a result, the average person can consume much more today—more food,
clothing, housing, medical care, entertainment, and travel—than in the year 1900.

Topic of discussion: real GDP.

Facts presented in book: real GDP has increased dramatically over the greater
part of the century—part of the reason is an increase in population: more workers
can produce more goods and services, but Real GDP has actually risen faster
than population. During this period, while the US population did not quite triple,
the quantity of goods and services produced each year has increased more than
tenfold. Hence, the remarkable rise in the average American’s living standard.

Although output has grown, the rate of growth has varied over long periods
of time:
o 1959-1973: real GDP growth by 4.2% each year
o 1973-1991: real GDP growth slowed to 2.7% per year
o 1991-2000: growth picked up again, averaging 3.7% per year

These may seem like slight differences. But over long periods of
time, such small differences in growth rates can cause huge
differences in living standards.

Economists and government officials are very concerned when
economic growth slows down.

Growth does not benefit everyone.

Living standards will always rise more rapidly for some groups
than others. For example, since the late 1980’s, economic growth
has improved the living standards of the highly skilled, while less
skilled workers have actually become worse off. Partly, this is due
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to improvements in technology that have lowered the earnings of
workers whose roles can be taken by computers and machines.

Will everyone benefit from growth, in the long run?* Some see a
role for the government in taxing successful people an providing
benefits to those left behind by growth.
High Employment

High employment—or consistently low employment—is an important
macroeconomic goal.
o Unemployment rate: percentage of the population who would like to work,
but cannot find jobs.

Unemployment rate is never zero
Employment and the Business Cycle:

When firms produce more output, they hire more workers,
when they produce less output, they tend to lay off workers.

We would thus expect real GDP and employment to be
closely related, and indeed they are. In recent years, each
1 percent drop in output has been associated with the loss
of about half a million jobs. Consistently high
employment, then, requires a high, stable level of output.

The periodic fluctuations in GDP are called the business
cycle.
 When output rises, we are in the expansion phase,
which continues until we reach a peak.
 Then, as output falls, we enter a recession—a
period of declining output.
 When output hits bottom, we are in the trough of
the recession.
 When a recession is particularly severe or
long lasting, it is called a depression.
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Stable Prices: With very few exceptions, the inflation rate has been positive from 19222001.
o With very few exceptions, the inflation rate has been positive, on
average, the prices have risen each of those years.
o However, during 1979 and 1980, we had double digit inflation—
prices rose by more than 12% in both years.

During the 1990’s, the inflation rate averaged less than 3%
per year, and it has stayed low through the end of 2001.
Aggregation in Macroeconomics:
Aggregation: the process of combining different things into a single category.
Because we want to consider the entire economy at once, and yet keep our model as
simple as possible, we must aggregate all markets into the broadest possible categories.
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