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Unit 1: Intro to Economics
Economics
• The word economy comes from a Greek word
for “one who manages a household.”
• What are we managing?
– Our unlimited wants and
needs, but how do we
know they are unlimited?
BASIC PRINCIPLES OF ECONOMICS
Society and Scarce Resources:
– We use resources to meet wants and needs.
Unfortunately, these resources are limited.
• Factors Of Production
– Land, Labor, Capital, Ideas/Entrepreneurs
– Scarcity. . . means that society has limited
resources and therefore cannot produce all the
goods and services people wish to have.
ECONOMICS IS THE STUDY OF SCARCITY
Principle #1: People Face Tradeoffs.
“There is no such thing as a free lunch!”
Principle #1: People Face Tradeoffs.
To get one thing, we usually have to give up
another thing.
– Guns v. butter
– Food v. clothing
– Leisure time v. work
– Efficiency v. equity
Making decisions requires trading
off one goal against another.
Principle #1: People Face Tradeoffs
•
•
Goals of a society
Economic Efficiency
– Refers to how well scarce productive resources are allocated to produce the goods and
services people want and how well inputs are used in the production process to keep
production costs as low as possible.
•
•
Allocative VS Productive
Economic Equity
– Means what is “fair.” Economic actions and policies have to be evaluated in terms of
what people think is right or wrong. This usually deals with questions of income and
wealth. Equal outcomes VS equal opportunities.
•
Economic Freedom
– Refers to things such as the freedom for consumers to decide how to spend and save
their incomes, the freedom of workers to change jobs and join unions, and the freedom
of individuals to establish new businesses and close old ones.
•
Economic Growth
– Refers to increasing the production of goods and services over time.
•
Economic Security
– Refers to protecting consumers, producers, and resource owners from risks that exist in
society. Each society must decide from which uncertainties individuals can and should be
protected and whether individuals, employers, or the government should pay for this
protection.
Principle #1: People Face Tradeoffs
• The Three Economic Questions
– What to produce?
• Goods VS Services
• Capital Goods VS Consumer Goods
• Durable Goods VS Non-durable Goods
– How to produce?
– For whom to produce?
Principle #2: The Cost of Something Is What You
Give Up to Get It.
• Decisions require comparing costs and benefits
of alternatives.
– Whether to go to college or to work?
– Whether to study or go out on a date?
– Whether to go to class or sleep in?
• The opportunity cost of an item is what you
give up to obtain that item.
– Implicit VS Explicit
• Economics measures both of these
Principle #2: The Cost of Something Is What You
Give Up to Get It.
• The production possibilities frontier is a graph that
shows the combinations of output that the
economy can possibly produce given the
available factors of production and the
available production technology.
The Production Possibilities Frontier
Quantity of
Computers
Produced
3,000
D
C
2,200
2,000
A
Production
possibilities
frontier
B
1,000
0
300
600 700
1,000
Quantity of
Cars
Produced
Copyright©2003 Southwestern/Thomson Learning
Principle #2: The Cost of Something Is What You
Give Up to Get It.
• Concave shape of curve illustrates the concept
of increasing opportunity costs
– Not all resources are easily transferable
Principle #2: The Cost of Something Is What You
Give Up to Get It.
• Concepts Illustrated by the Production
Possibilities Frontier
– Efficiency
– Scarcity and Tradeoffs
– Opportunity Cost
– Economic Growth
• Increasing standards of living
• Human capital investments
A Shift in the Production Possibilities Frontier
Quantity of
Computers
Produced
4,000
3,000
2,100
2,000
0
E
A
700 750
1,000
Quantity of
Cars Produced
Copyright © 2004 South-Western
Principle #3: Rational People Think at the
Margin.
• Marginal = The Extra
• Marginal changes are small, incremental
adjustments to an existing plan of action.
• Marginal Benefit or Utility
– The extra benefit of one more unit
– Benefit will correlate with the value that we place on the product
• Paradox of Value
– The contradiction between the high value nonessentials and low value of essentials
– Law of Diminishing Marginal Returns/Utility/Benefit
• Shape on a graph?
• Marginal Cost
– The extra cost of one more unit
– Increasing Marginal Costs
• Due to convex PPC
• Shape on a graph?
Principle #4: People Respond to Incentives.
• Individuals have an INCENTIVE to profit from a
transaction.
– Hope of reward or fear of punishment that encourages
people to behave in a certain way.
• Marginal changes in costs or benefits motivate
people to respond.
• We only choose to do something (make a
rational decision) when it maximizes total
profit.
Principle #5: Trade Can Make Everyone Better
Off.
• People gain from their ability to trade with
one another.
• Competition results in gains from trading.
• Trade allows people to specialize in what they
do best.
Interdependence and the Gains from
Trade
• Why aren’t your parents farmers?
• How do we satisfy our wants and needs in a
global economy?
– We can be economically
self-sufficient.
– We can specialize and trade
with others, leading to
economic interdependence.
• Leads to increases in
allocative and productive
efficiency and creates a
division of labor.
Interdependence and the Gains from
Trade
• Individuals and nations rely on specialized
production and exchange as a way to address
problems caused by scarcity.
• But this gives rise to two questions:
– Why is interdependence the norm?
• We are better off because of it.
– What determines production and trade?
• Differences in opportunity costs
A PARABLE FOR THE MODERN
ECONOMY
• Imagine . . .
– only two goods: potatoes and meat
• only two people: a potato farmer and a cattle rancher
• What should each produce?
• Why should they trade?
The Production Opportunities of the Farmer and
Rancher
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Absolute VS Comparative Advantage
• Absolute
– Make more stuff
• Comparative
– Compares producers of a good according to their
opportunity cost.
Comparative Advantage and Trade
• Comparative advantage and differences in
opportunity costs are the basis for specialized
production and trade.
• Whenever potential trading parties have
differences in opportunity costs, they can each
benefit from trade.
The Gains from Trade: A Summary
Who has the absolute advantage?
Who has the comparative advantage?
Copyright © 2004 South-Western
Principle #6: Markets Are Usually a Good Way to
Organize Economic Activity.
• A market economy is an economy that
allocates resources through the decentralized
decisions of many firms and households as
they interact in markets for goods and
services.
– Households decide what to buy and who to work
for.
– Firms decide who to hire and what to produce.
Principle #6: Markets Are Usually a Good Way to
Organize Economic Activity.
• Adam Smith made the observation that
households and firms interacting in markets act
as if guided by an “invisible hand.”
– Because households and firms look at prices when
deciding what to buy and sell, they unknowingly
take into account the social costs of their actions.
– As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of
society as a whole.
– “Laissez Faire”
Principle #6: Markets Are Usually a Good Way to
Organize Economic Activity.
• Characteristics of Market Economies
– Economic Freedom
– Voluntary Exchange
– Private Property
• Forces individuals to care for and preserve property in
order to make a profit. Helps us avoid the Tragedy of
the Commons.
– Profit Motive
– Capitalism
– Competition
Principle #6: Markets Are Usually a Good Way to
Organize Economic Activity.
• Roles in the system
– Consumer
• Consumer sovereignty
– Entrepreneur
– Government
• Other ways to organize an economy
– Traditional
– Command
– Mixed
Principle #7: Governments Can Sometimes
Improve Market Outcomes.
• Market failure occurs when the market fails to
allocate resources efficiently.
• When the market fails (breaks down)
government can intervene to promote
efficiency and equity.
Principle #8: The Standard of Living Depends on
a Country’s Production.
• Almost all variations in living standards are
explained by differences in countries’
productivities.
• Productivity is the amount of goods and
services produced from each hour of a worker’s
time.
• Increases in productivity lead to economic
growth.
Principle #9: Prices Rise When the Government
Prints Too Much Money.
• Inflation is an increase in the overall level of
prices in the economy.
• One cause of inflation is the growth in the
quantity of money.
• When the government creates large quantities
of money, the value of the money falls.
Principle #10: Society Faces a Short-run Tradeoff
Between Inflation and Unemployment.
• The Phillips Curve illustrates the tradeoff
between inflation and unemployment:
Inflation  Unemployment
It’s a short-run tradeoff!
The Role of Assumptions
• Economists make assumptions in order to
make the world easier to understand.
– Ceteris Paribus
• The art in scientific thinking is deciding which
assumptions to make.
• Economists use different assumptions to
answer different questions.
Economic Models
• Economists use models to simplify reality in
order to improve our understanding of the
world
• Two of the most basic economic models
include:
– The Circular Flow Diagram
– The Production Possibilities Frontier
Our Second Model: The Circular-Flow Diagram
• The circular-flow diagram is a visual model of the
economy that shows how dollars flow through
markets among households and firms.
The Circular Flow
Revenue
Goods
and services
sold
MARKETS
FOR
GOODS AND SERVICES
•Firms sell
•Households buy
Wages, rent,
and profit
Goods and
services
bought
HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
Factors of
production
Spending
MARKETS
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars
Copyright © 2004 South-Western
Microeconomics and Macroeconomics
• Microeconomics focuses on the individual parts
of the economy.
– How households and firms make decisions and
how they interact in specific markets
• Macroeconomics looks at the economy as a
whole.
– Economy-wide phenomena, including inflation,
unemployment, and economic growth
POSITIVE VERSUS NORMATIVE ANALYSIS
• Positive statements are statements that attempt
to describe the world as it is.
– Called descriptive analysis
• Normative statements are statements about how
the world should be.
– Called prescriptive analysis
POSITIVE VERSUS NORMATIVE
ANALYSIS
• Positive or Normative Statements?
?
– An increase in the minimum wage will cause a
decrease in employment among the least-skilled.
POSITIVE
?
– Higher federal budget deficits will cause interest
rates to increase.
POSITIVE
?
POSITIVE VERSUS NORMATIVE
ANALYSIS
• Positive or Normative Statements?
?
?
– The income gains from a higher minimum wage
are worth more than any slight reductions in
employment.
NORMATIVE
– State governments should be allowed to collect
from tobacco companies the costs of treating
smoking-related illnesses among the poor.
NORMATIVE
?
WHY ECONOMISTS DISAGREE
• They may disagree about the validity of
alternative positive theories about how the
world works.
• They may have different values and, therefore,
different normative views about what policy
should try to accomplish.
Ten Propositions about Which Most Economists Agree
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