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The Economic Approach
Chapter 1
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Identify the critical components of economics and learn how to use the guideposts of economic thinking.
Define opportunity cost.
Chapter 1 Objectives
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1776 The Wealth of Nations Wealth
◦ Not about gold or silver◦ About productivity
Self-interest leads to helping others!
Adam Smith: Father of Econ
Who’s your daddy?
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The study of how individuals make choices and use scarce resources
We all have unlimited wants but limited resources
Economics
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Scarcity – there is less of a good freely available from nature than people would like
If it has a price, it’s scarce!
Choices – always involve trade-offs
Economics is About
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Resources – ingredients (inputs) used to produce goods and services◦ Human resources◦ Physical (capital) resources◦ Natural resources
Economics is About
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Poverty ◦ Is subjective◦ We may one day eliminate
“poverty”◦ 2014 FPL: $19,790 family
of 3 Scarcity
◦ Is objective◦ Will always be present◦ We have limited resources
and unlimited wants
Scarcity ≠ Poverty
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Life in 1750◦ Life is “solitary, poor, nasty, brutish, and short” –
Thomas Hobbes ◦ Work 70+ hr/wk to survive◦ Life expectancy: 37 years
Contrast this with life today
Scarcity ≠ Poverty
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Rationing – allocating a limited supply of a good or resource among people who would like to have more of it
Competition for scarce goods always present
Method of rationing influences the nature of competition◦ Price◦ Government◦ First-come, first-served
Scarcity Necessitates Rationing
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1. The use of scarce resources is costly, so decision makers must make trade-offs
◦ There’s no such thing as a free lunch◦ Opportunity cost – what is given up to get
something
Eight Guideposts to Economic Thinking
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1. The use of scarce resources is costly, so decision makers must make trade-offs
◦ Public elementary school, not free Admission is $0 Costs are higher taxes, less medical care
Eight Guideposts to Economic Thinking
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2. Individuals choose purposefully – they try to get the most from their limited resources
◦ Economizing behavior – choosing the option that offers the greatest benefit at the least possible cost
◦ Utility – The subjective benefit or satisfaction a person expects from a choice or course of action
Eight Guideposts to Economic Thinking
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2. Individuals choose purposefully – they try to get the most from their limited resources
◦ People behave rationally◦ Rational is not the same as
Ethical Safe Healthy
Eight Guideposts to Economic Thinking
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3. Incentives matter – choice is influenced in a predictable way by changes in incentives
◦ ALL ECONOMICS IS BASED ON THIS STATEMENT!◦ Incentive – a threat of a reward or punishment◦ Responses to incentives vary
Eight Guideposts to Economic Thinking
3. Incentives matter – choice is influenced in a predictable way by changes in incentives
◦ Altering incentives alters people’s behavior! The Peltzman Effect, 1975
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Eight Guideposts to Economic Thinking
4. Individuals make decisions at the margin
◦ Marginal – used to describe the effects of a change in the current situation
◦ “marginal” = “additional” ◦ Decisions aren’t all or nothing
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Eight Guideposts to Economic Thinking
4. Individuals make decisions at the margin
◦ Diamond water paradox◦ Total benefit ≠ marginal benefit
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Eight Guideposts to Economic Thinking
4. Individuals make decisions at the margin
◦ Marginal ≠ average◦ Average cost = total cost / total produced◦ Marginal cost = cost of producing an additional
unit of a product
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Eight Guideposts to Economic Thinking
4. Individuals make decisions at the margin
◦ Marginal thinking allows us to answer questions like How many times should you visit that buffet? Should you buy that third burger?
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Eight Guideposts to Economic Thinking
4. Individuals make decisions at the margin
While waiting in line to buy two burgers at $1.00 each, and a drink for $1.50, Renegade notices that the restaurant has a value meal containing three burgers and a drink all for $4.25. For Renegade, the marginal cost of the third burger would be…?
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Eight Guideposts to Economic Thinking
4. Individuals make decisions at the margin
Jordin wants to buy some beer. She can buy five beers for $2 each or she can purchase a six pack for $10.50. What’s the marginal cost of the 6th beer?
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Eight Guideposts to Economic Thinking
5. Although information can help us make better choices, its acquisition is costly
◦ Gathering information isn’t free◦ Limited knowledge and uncertainty are common◦ The bigger the decision, the more resources you’ll
use gathering information and “shopping”
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Eight Guideposts to Economic Thinking
6. Beware of the secondary effects: economic actions often generate indirect as well as direct effects
◦ Secondary effect – the indirect impact of an event or policy that may not be easily and immediately observable
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Eight Guideposts to Economic Thinking
6. Beware of the secondary effects: economic actions often generate indirect as well as direct effects
◦ Changes in government policy often alter incentives and have unintended consequences
◦ Example: mortgage lending, payday loans
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Eight Guideposts to Economic Thinking
6. Beware of the secondary effects: economic actions often generate indirect as well as direct effects
◦ Government spending does not create jobs!◦ Where does the money come from?
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Eight Guideposts to Economic Thinking
7. The value of a good or service is subjective
◦ Preferences differ among individuals◦ Circumstances can change value
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Eight Guideposts to Economic Thinking
7. The value of a good or service is subjective
◦ Moving goods to those who value them most is a source of economic progress
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Eight Guideposts to Economic Thinking
8. The test of a theory is its ability to predict
◦ Scientific thinking – developing a theory from basic principles and testing it against real world events
◦ Average outcomes instead of anecdotal outcomes
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Eight Guideposts to Economic Thinking
Positive Economics◦ What is◦ Can be proven true or false
Normative Economics◦ What ought to be◦ Cannot be proven true or false
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Positive and Normative Economics
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1. Violation of ceteris paribus principle ceteris paribus: other things constant
◦ When the price of ice cream falls, quantity demanded will rise. Ceteris paribus!
◦ Outcomes change when we dont hold all else constant.
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Pitfalls to Avoid in Economic Thinking
2. The belief that good intentions guarantee desirable outcomes
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Pitfalls to Avoid in Economic Thinking
3. Thinking association (correlation) is causation
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Pitfalls to Avoid in Economic Thinking
4. Fallacy of composition: belief that what is true for one is true for all
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Pitfalls to Avoid in Economic Thinking