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Chapter 1Economics and the

Economy

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill Education, 2005

PowerPoint presentation by Alex Tackie and Damian Ward

C H

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© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair

The Scope andMethod of Economics

Appendix: How to Read and Understand Graphs

Prepared by: Fernando Quijano and Yvonn Quijano

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The Study of Economics• Economics is the study

of how individuals and societies choose to use the scarce resources that nature and previous generations have provided.

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Why Study Economics?• An important reason for

studying economics is to learn a way of thinking.

• Three fundamental concepts:– Opportunity cost– Marginalism, and– Efficient markets

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Opportunity Cost• Opportunity cost is

the best alternative that we forgo, or give up, when we make a choice or a decision.

• Nearly all decisions involve trade-offs.

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Marginalism• In weighing the costs

and benefits of a decision, it is important to weigh only the costs and benefits that arise from the decision.

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Marginalism• For example, when a firm

decides whether to produce additional output, it considers only the additional (or marginal cost), not the sunk cost.– Sunk costs are costs that

cannot be avoided, regardless of what is done in the future, because they have already been incurred.

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Efficient Markets• An efficient market is one

in which profit opportunities are eliminated almost instantaneously.

• There is no free lunch! Profit opportunities are rare because, at any one time, there are many people searching for them.

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More Reasons to Study Economics

• The study of economics is an essential part of the study of society.

• Economic decisions often have enormous consequences.– During the Industrial

Revolution, new manufacturing technologies and improved transportation gave rise to the modern factory system.

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More Reasons to Study Economics

• An understanding of economics is essential to an understanding of global affairs.

• Voting decisions also require a basic understanding of economics.

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The Scope of Economics• Microeconomics is the branch of

economics that examines the behavior of individual decision-making units—that is, business firms and households.

• Footballers’ wages and the price of oil, for example, are both microeconomic issues

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The Scope of Economics• Macroeconomics is the branch of

economics that examines the behavior of economic aggregates— income, output, employment, and so on—on a national scale.

• Gross domestic product, the aggregate price level and unemployment, for example, are all macroeconomic issues

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The Scope of EconomicsExamples of microeconomic and macroeconomic concerns

Production Prices Income EmploymentMicroeconomics Production/Output

in Individual Industries and Businesses How much steelHow many officesHow many cars

Price of Individual Goods and Services Price of medical carePrice of gasolineFood pricesApartment rents

Distribution of Income and Wealth Wages in the auto industryMinimum wagesExecutive salariesPoverty

Employment by Individual Businesses & IndustriesJobs in the steel industryNumber of employees in a firm

Macroeconomics National Production/Output Total Industrial OutputGross Domestic ProductGrowth of Output

Aggregate Price Level Consumer pricesProducer PricesRate of Inflation

National IncomeTotal wages and salaries  

Total corporate profits

Employment and Unemployment in the Economy Total number of jobsUnemployment rate

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Market orientation

Commandeconomy

Freemarketeconomy

Cuba

China

Hungary

Sweden

UK

USA

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What is Economics?• ECONOMICS ...• is the study of how society

decides:

– What– For whom– How

to produce...

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The price of oil

0

10

20

30

40

50

60

1965

1970

1975

1980

1985

1990

1995

2000

US$

per

bar

rel

Tripled in 1973-74, and doubled again in 1979-80 … and affected people all over the world.

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An increase in the price of oil affects

• What to produce– less oil-intensive products

• How to produce– less oil-intensive techniques

• For whom to produce– oil producers have more buying

power, importers have less

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The distribution of world population and GNP, 2003

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Population GNP

LIC MIC HIC

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The production possibility frontier (1)

• For each level of the output of one good, the production possibility frontier shows the maximum amount of the other good that can be produced.

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The production possibility frontier (2)

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Film output (G)

Food

out

put (

F)

Production possibility frontier

G = 8

F= 4

A

B10

14

6 14

F/G = opportunity cost (=1/2)

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The operation of markets• Market• a shorthand expression for the

process by which … – households’ decisions about

consumption of alternative goods– firms’ decisions about what and

how to produce– and workers’ decisions about how

much and for whom to work• … are all reconciled by

adjustment of prices

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Resource allocation• Resource allocation is crucial

for a society• and is handled in different

ways in different societies, e.g.:–Command economy–Mixed economy–Free market

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Normative and Positive Economics

• Positive economics deals with objective explanation– e.g. if a tax is imposed on a good its

price will tend to rise• Normative economics offers

prescriptions based on value judgements– e.g. a tax should be imposed on

tobacco to discourage smoking