Economics 1

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People need resources to fulfill their desires.

Desires can be infinite. Resources are scarce.


So people have to make choices.
Economists study these choices.
“Economics is the study of the use of scarce resources that have alternative uses.”
People’s wants are numerous and varied. Biologically, people need only air, water, food, clothing, and
shelter. But in modern society people also desire goods and services that provide a more comfortable or
affluent standard of living.
Fortunately, society possesses productive resources, such as labor and managerial talent, tools and
machinery, and land and mineral deposits. These resources, employed in the economy, help us produce
goods and services that satisfy many of our economic wants.
But the reality is that our economic wants far exceed the productive capacity of our scarce (limited)
resources. We are forced to make choices.
Scarcity restricts options and demands choices.
Economics is the social science that examines how individuals, institutions, and society make optimal
choices under conditions of scarcity.

Opportunity cost
Central to economics is the idea of opportunity cost: the value of the good, service, or time forgone to
obtain something else / the value of the best thing we give up to get something.
E.g. We have bought an apple for one dollar. Now we cannot buy an orange for the same dollar. The
orange was the opportunity cost of that apple.
E.g. Fast food line: Economists believe that what is true for the behavior of customers at fast-food
restaurants is true for economic behavior in general. Faced with an array of choices, consumers, workers,
and businesses rationally compare marginal (extra) costs and marginal benefits in making decisions.

Theories, Principles, and Models


Economics relies on the scientific method. That procedure consists of several elements:
- Observing real-world behavior and outcomes.
- Based on those observations, formulating a possible explanation of cause and effect (hypothesis).
- Testing this explanation by comparing the outcomes of specific events to the outcome predicted
by the hypothesis.
-Accepting, rejecting, and modifying the hypothesis, based on these comparisons.
-Continuing to test the hypothesis against the facts. As favorable results accumulate, the hypothesis
evolves into a theory.
-A very well-tested and widely accepted theory is referred to as an economic law or an economic
principle—a statement about economic behavior or the economy that enables prediction of the probable
effects of certain actions. Combinations of such laws or principles are incorporated into models which are
simplified representations of how something works, such as a market or segment of the economy.
- Economists develop theories of the behavior of individuals (consumers, workers) and institutions
(businesses, governments) engaged in the production, exchange, and consumption of goods and
services.
- Theories, principles, and models are “purposeful simplifications.” The full scope of economic reality itself
is too complex and confusing to be understood as a whole. In developing theories, principles, and models
economists remove the clutter and simplify.
- Economic principles and models are highly useful in analyzing economic behavior and understanding
how the economy operates. They are the tools for ascertaining cause and effect (or action and outcome)
within the economic system.
- Good theories do a good job of explaining and predicting. They are supported by facts concerning how
individuals and institutions actually behave in producing, exchanging, and consuming goods and services.
Generalizations: Economic principles are generalizations relating to economic behavior or to the economy
itself. Economic principles are expressed as the tendencies of typical or average consumers, workers, or
business firms. For example, economists say that consumers buy more of a particular product when its
price falls. Economists recognize that some consumers may increase their purchases by a large amount,
others by a small amount, and a few not at all. This “price-quantity” principle, however, holds for the typical
consumer and for consumers as a group.
Other-Things-Equal Assumption: In constructing their theories, economists use the ceteris paribus or other-
things-equal assumption—the assumption that factors other than those being considered do not change.
They assume that all variables except those under immediate consideration are held constant for a
particular analysis. For example, consider the relationship between the price of Pepsi and the amount of it
purchased. Assume that of all the factors that might influence the amount of Pepsi purchased (for example,
the price of Pepsi, the price of Coca-Cola, and consumer incomes and preferences), only the price of Pepsi
varies. This is helpful because the economist can then focus on the relationship between the price of Pepsi
and purchases of Pepsi in isolation without being confused by changes in other variables.
Graphical Expression: Many economic models are expressed graphically.

Microeconomics and Macroeconomics


Economists develop economic principles and models at two levels:
1) Microeconomics
- Microeconomics examines the decision making of specific economic units or institutions.
- Microeconomics is the part of economics concerned with individual units such as a person, a household, a
firm, or an industry. At this level of analysis, the economist observes the details of an economic unit, or very
small segment of the economy, under a figurative micro-scope.
- In microeconomics we look at decision making by individual customers, workers, households, and
business firms.
- We measure the price of a specific product, the number of workers employed by a single firm, the revenue
or income of a particular firm or household, or the expenditures of a specific firm, government entity, or
family.
- In microeconomics, we examine the sand, rock, and shells, not the beach.

2) Macroeconomics
- Macroeconomics examines either the economy as a whole or its basic subdivisions or aggregates, such
as the government, household, and business sectors.
- Macroeconomics is the study of the behavior of economic aggregates, such as GDP which tries to
measure the value of stuff produced, inflation which is a measure how prices go up over time and
unemployment which measures how many people are not employed.
- Figuratively, macroeconomics looks at the beach, not the pieces of sand, the rocks, and the shells.

The micro–macro distinction does not mean that economics is so highly compartmentalized that every topic
can be readily labeled as either micro or macro; many topics and subdivisions of economics are rooted in
both.
Example: While the problem of unemployment is usually treated as a macroeconomic topic (because
unemployment relates to aggregate production), economists recognize that the decisions made by
individual workers on how long to search for jobs and the way specific labor markets encourage or impede
hiring are also critical in determining the unemployment rate.
Positive and Normative Economics
All economic questions fall into one of two categories:
Positive Normative
Positive economics analysis deals with facts. Normative economics reflects value judgments.
What is? What ought to be?
Why do people use money? Should people use money?
No value judgments Value judgments

Both microeconomics and macroeconomics contain elements of positive economics and normative
economics.
Positive economics focuses on facts and cause-and-effect relationships. It includes description, theory
development, and theory testing (theoretical economics).
Positive economics avoids value judgments, tries to establish scientific statements about economic
behavior, and deals with what the economy is actually like. Such scientific-based analysis is critical to good
policy analysis.

Economic policy, on the other hand, involves normative economics, which incorporates value judgments
about what the economy should be like or what particular policy actions should be recommended to
achieve a desirable goal (policy economics). Normative economics looks at the desirability of certain
aspects of the economy. It underlies expressions of support for particular economic policies.

Positive economics concerns what is, whereas normative economics embodies subjective feelings
about what ought to be.
Examples:
Positive statement: “The unemployment rate in France is higher than that in the United States.”
Normative statement: “France ought to undertake policies to make its labor market more flexible to reduce
unemployment rates.” Whenever words such as “ought” or “should” appear in a sentence, you are very
likely encountering a normative statement.
Most of the disagreement among economists involves normative, value-based policy questions. Of course,
economists sometime disagree about which theories or models best represent the economy and its parts,
but they agree on a full range of economic principles. Most economic controversy thus reflects differing
opinions or value judgments about what society should be like.
Individuals’ Economizing Problem
Individuals face an economizing problem. Because their wants exceed their incomes, they must decide
what to purchase and what to forgo.

Limited income - We all have a finite amount of income, even the wealthiest among us. Our income comes
to us in the form of wages, interest, rent, and profit, although we may also receive money from government
programs or family members. The average income of Americans in 2006 was $44,970. In the poorest
nations, it was less than $500.

Unlimited wants - Our wants extend over a wide range of products, from necessities (for example, food,
shelter, and clothing) to luxuries (for example, perfumes, yachts, and sports cars).

A budget line (budget constraint) shows the various combinations of two goods that a consumer can
purchase with a specific money income.
-Attainable and Unattainable Combinations
-Trade-Offs and Opportunity Costs
-Choice
-Income changes

Scarce resources

Resource categories

A consumer’s budget line.


The budget line (or budget constraint) shows all the combinations of any two products that can be
purchased, given the prices of the products and the consumer’s money income.

Graphically, a budget line (or budget constraint) illustrates the economizing problem for individuals. The line
shows the various combinations of two products that a consumer can purchase with a specific money
income, given the prices of the two products.
Resource Categories
Economists classify economic resources into four general categories.
1) Land - Land means much more to the economist than it does to most people. To the economist land
includes all natural resources (“gifts of nature”) used in the production process, such as arable land,
forests, mineral and oil deposits, and water resources.
2) Labor - The resource labor consists of the physical and mental talents of individuals used in producing
goods and services. The services of a logger, retail clerk, machinist, teacher, professional football player,
and nuclear physicist all fall under the general heading “labor.”
3) Capital - For economists, capital (or capital goods) includes all manufactured aids used in producing
consumer goods and services. Included are all factory, storage, transportation, and distribution facilities, as
well as tools and machinery.
Economists refer to the purchase of capital goods as investment.
Capital goods differ from consumer goods because consumer goods satisfy wants directly, whereas capital
goods do so indirectly by aiding the production of consumer goods. Note that the term “capital” as used by
economists refers not to money but to tools, machinery, and other productive equipment. Because money
produces nothing, economists do not include it as an economic resource. Money (or money capital or
financial capital) is simply a means for purchasing capital goods.
4) Entrepreneurial Ability - Finally, there is the special human resource, distinct from labor, called
entrepreneurial ability. The entrepreneur performs several functions:
The entrepreneur takes the initiative in combining the resources of land, labor, and capital to produce a
good or a service. Both a sparkplug and a catalyst, the entrepreneur is the driving force behind production
and the agent who combines the other resources in what is hoped will be a successful business venture.
The entrepreneur makes the strategic business decisions that set the course of an enterprise.
The entrepreneur is an innovator. He or she commercializes new products, new production techniques, or
even new forms of business organization.
The entrepreneur is a risk bearer. The entrepreneur has no guarantee of profit. The reward for the
entrepreneur’s time, efforts, and abilities may be profits or losses. The entrepreneur risks not only his or her
invested funds but those of associates and stockholders as well.
Because land, labor, capital, and entrepreneurial ability are combined to produce goods and services, they
are called the factors of production, or simply “inputs.”

Production Possibilities Analysis


Economists illustrate society’s economizing problem through production possibilities analysis.
Production possibilities tables and curves show the different combinations of goods and services that can
be produced in a fully employed economy, assuming that resource quantity, resource quality, and
technology are fixed.
An economy that is fully employed and thus operating on its production possibilities curve must sacrifice the
output of some types of goods and services to increase the production of others. The gain of one type of
good or service is always accompanied by an opportunity cost in the form of the loss of some of the other
type.
Because resources are not equally productive in all possible uses, shifting resources from one use to
another creates increasing opportunity costs. The production of additional units of one product requires the
sacrifice of increasing amounts of the other product.
The optimal (best) point on the production possibilities curve represents the most desirable mix of goods
and is determined by expanding the production of each good until its marginal benefit (MB) equals its
marginal cost (MC).
Production Possibilities Model
Society uses its scarce resources to produce goods and services. The alternatives and choices it faces can
best be understood through a macroeconomic model of production possibilities. To keep things simple, let’s
initially assume:
Full employment The economy is employing all its available resources.
Fixed resources The quantity and quality of the factors of production are fixed.
Fixed technology The state of technology (the methods used to produce output) is constant.
Two goods The economy is producing only two goods: pizzas and industrial robots. Pizzas symbolize
consumer goods, products that satisfy our wants directly; industrial robots (for example, the kind used to
weld automobile frames) symbolize capital goods, products that satisfy our wants indirectly by making
possible more efficient production of consumer goods.

Production Possibilities Table


A production possibilities table lists the different combinations of two products that can be produced with a
specific set of resources, assuming full employment.
This Table presents a simple, hypothetical economy that is producing pizzas and industrial robots. At
alternative A, this economy would be devoting all its available resources to the production of industrial
robots (capital goods); at alternative E, all resources would go to pizza production (consumer goods).
Those alternatives are unrealistic extremes; an economy typically produces both capital goods and
consumer goods, as in B, C, and D. As we move from alternative A to E, we increase the production of
pizzas at the expense of the production of industrial robots.

Generalization: At any point in time, a fully employed economy must sacrifice some of one good to obtain
more of another good.
Scarce resources prohibit such an economy from having more of both goods.
Society must choose among alternatives.
There is no such thing as a free pizza, or a free industrial robot. Having more of one thing means having
less of something else.

Production Possibilities Curve


The data presented in a production possibilities table are shown graphically as a production possibilities
curve.
Each point on the production possibilities curve represents some maximum combination of two products
that can be produced if resources are fully employed. When an economy is operating on the curve, more
industrial robots means fewer pizzas, and vice versa.
Limited resources and a fixed technology make any combination of industrial robots and pizzas lying
outside the curve (such as W) unattainable. Points inside the curve are attainable, but they indicate that full
employment is not being realized.
Overtime, technological advances and increases in the quantity and quality of resources enable the
economy to produce more of all goods and services, that is, to experience economic growth.
Society’s choice as to the mix of consumer goods and capital goods in current output is a major
determinant of the future location of the production possibilities curve and thus of the extent of economic
growth.
International trade enables nations to obtain more goods from their limited resources than their production
possibilities curve indicates.

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