ECONOMICS

Economics is the study of how society manages its scarce resources.

CONT…

• Resources such as natural resources, fertile land, labor etc are limited.

• Therefore not everyone can have everything they want. That is what we mean by scarcity.

• Microeconomics is the study of how individuals and firms can make themselves as well off as possible in a world of scarcity, and the consequences of those individual decisions for markets and the entire economy

TEN PRINCIPLES OF ECONOMICS

A household and an economy face many decisions:

Who will work?

What goods and how many of them should be produced?

What resources should be used in production?

At what price should the goods be sold?

TEN PRINCIPLES OF ECONOMICS

• Society and Scarce Resources:

• The management of society’s resources is important because resources are scarce.

• Scarcity. . . means that society has limited resources and therefore cannot produce all the goods and services people wish to have.

HOW PEOPLE MAKE DECISIONS

• People face trade-offs.

• The cost of something is what you give up to get it.

• Rational people think at the margin.

• People respond to incentives.

PRINCIPLE #1: PEOPLE FACE TRADE-OFFS.

• “There is no such thing as a free lunch!”

Making decisions requires trading off one goal against another.

PRINCIPLE #1: PEOPLE FACE TRADE-OFFS.

• To get one thing, we usually have to give up another thing.

• Food v. clothing

• Leisure time v. work

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.

PRINCIPLE #2: THE COST OF SOMETHING IS WHAT YOU GIVE UP TO GET IT.

• Basketball star LeBron James understands opportunity costs and incentives. He chose to skip college and go straight from high school to the pros where he earns millions of dollars.

PRINCIPLE #3: RATIONAL PEOPLE THINK AT THE MARGIN.

• Marginal changes are small, incremental adjustments to an existing plan of action.

People make decisions by comparing costs and benefits at the margin.

PRINCIPLE #4: PEOPLE RESPOND TO INCENTIVES.

• Marginal changes in costs or benefits motivate people to respond.

• The decision to choose one alternative over another occurs when that alternative’s marginal benefits exceed its marginal costs!

HOW PEOPLE INTERACT

• Trade can make everyone better off.

• Markets are usually a good way to organize economic activity.

• Governments can sometimes improve economic outcomes.

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.

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.

CONT…

• Principle #7: Governments Can Sometimes Improve Market Outcomes.

• Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services.

• Principle #9: Prices Rise When the Government Prints Too Much Money.

• Principle #10: Society Faces a Short-run Trade-off between Inflation and Unemployment.

ECONOMIC THEORY IN PRACTICE POSITIVE VERSUS NORMATIVE ECONOMICS

INTRODUCTION TO MACROECONOMICS

• Positive Economics An approach to economics that seeks to understand behavior and the operation of systems without making judgments. It explains what will happen under certain conditions.

• Normative Economics An approach to economics that analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. Also called policy economics. It explains what should happen

THINKING LIKE AN ECONOMIST

• Economics trains you to. . . .

• Think in terms of alternatives.

• Evaluate the cost of individual and social choices.

• Examine and understand how certain events and issues are related.

THE ROLE OF ASSUMPTIONS

• Economists make assumptions in order to make the world easier to understand.

• 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 FIRST MODEL: THE CIRCULAR-FLOW DIAGRAM

• The circular-flow diagram is a visual model of the economy that shows how rupees flow through markets among households and firms.

FIGURE 1 THE CIRCULAR FLOW

Copyright © 2004 South-Western

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

OUR SECOND MODEL: THE PRODUCTION POSSIBILITIES FRONTIER

• 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.

OUR SECOND MODEL: THE PRODUCTION POSSIBILITIES FRONTIER

• Concepts Illustrated by the Production Possibilities Frontier

• Efficiency

• Tradeoffs

• Opportunity Cost

• Economic Growth

CONT…

• Every decision has an opportunity cost – the cost in foregone opportunities.

• A production possibility curve is used to illustrate opportunity cost.

• A production possibility curve measures the maximum combination of outputs that can be achieved from a given number of inputs.

• It slopes downward from left to right.

EFFICIENCY AND INEFFICIENCYFo

od

10

8

6

4

2

0 2 4 6 8 10

Clothes

C D

A

B

Efficientpoints

Inefficientpoint

Unattainable point, given available technology, resources and labor force

Neutral Technological Change

Food

A

B Clothes0

SHIFTS IN THE PRODUCTION POSSIBILITY CURVE

C

D

Biased Technological Change

SHIFTS IN THE PRODUCTION POSSIBILITY CURVE

0

B

A

Food

Clothes

C

SHIFTS IN THE PRODUCTION POSSIBILITY CURVE

• Test your understanding:

• A natural disaster destroys half the earth’s natural resources.

• Technology is perfected that lowers the cost of manufactured goods.

A new technology is discovered that doubles the speed at which all goods can be produced.

Global warming increases the cost of producing agricultural goods.