Economics is the study how individuals and societies choose to use scarce resources

that nature and or previous generations have provided.

In order to understand the above definition we first must learn a few new concepts.

The definition talks about individuals and societies – reference to microeconomics and
macroeconomics

Scarce resources mean limited resources, for example limited income

That nature and or previous generations have provided – resources could be many
different things such as natural resources, oil and rivers, or buildings or time.

Microeconomics and Macroeconomics

1. Economics is studied on various levels.

a. Definition of microeconomics: the study of how households and firms

make decisions and how they interact in markets.

b. Definition of macroeconomics: the study of economy-wide phenomena,

including inflation, unemployment, and economic growth and
government.

 Microeconomics and macroeconomics are closely intertwined because

changes in the overall economy arise from the decisions of individual
households and firms.

 Because microeconomics and macroeconomics address different

questions, each field has its own set of models which are often taught in
separate courses.

Why do we learn economics? There are many possible reasons:

1. To learn a new way of thinking
2. to learn about global affairs
3. to understand society
4. to be an informed voter

While I am sure you understand the bottom three, I would like to focus on the first one: to
learn a new way of thinking. A great example is the concept of opportunity cost.

One of the main concepts in economics that we can relate to is COST. How much does a
product cost? But in economics not only we talk about cost, but opportunity cost.

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Opportunity costs – is the best alternative that we forgo (or give up) when we make
a decision.

For example, you go to a store with $100 in your wallet, and you want to buy a dress for
$80 and a sweater for $40. Can you buy both items? No. Why? Because you only have
$100. In other words, you have limited resources.

In the end you decide to buy the dress for $80. How much does the dress cost? $80. What
is the opportunity cost of buying that dress? The answer is the sweater for $40 that you
gave up in order to buy the dress. Opportunity cost is simply what you give up.
On a daily basis we give up certain things to buy other things. But resources is not only
money. As a matter of fact MONEY is not considered a resource. In our example the
$100 in the wallet is part of the income that the households have. Income is one of the
main resources of households. Because income is limited, household have to make
decisions how to spend it.

Another example: If a friend invites you for dinner and a movie, but you only have two
hours available. You have to make a decision, if you go to the movies, you give up
having dinner with your friend. In other words, the opportunity cost of going to the
movies is the dinner with your friend. Why do you have to make a decision? Because you
only have two hours. In this example time is the resource.

Why do we have to make decisions (forgo certain things). Because resources are limited.
Resources in example 1 was income and in example 2 was time.

Example 3- What is the cost associated with going to college?

1. Tuition
2. Room and board
3. Textbooks
4. Transportation

What is the opportunity cost of going to college? For everyone is different,

because opportunity cost is subjective. For one person is the salary they gave up if
they did not attend college and went to work instead. For another person the
opportunity cost of attending college is perhaps giving up the opportunity to travel
for a year.

Opportunity costs – is the best alternative that we forgo (or give up) when we make
a choice or a decision.

Resources are anything that helps in the production of something else. Also known as
factors of production.

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Resources can mean a lot of different things. First natural resources, such as land, energy
timber, mountains with aluminum, rivers to create energy and electricity. It also means,
buildings and machinery usually known as physical capital, and something like a building
is a resource that was built by a different generation. Labor and skills are also known as
human capital also known as resource.

In any economy we will take resources available and transform into products and this is
the process of production. For example, a firm needs, labor, skilled labor, a building
machines and a natural product such as bauxite to transform into aluminum.

Money is NOT a resource. The reason is that with money you can pay for workers and
buy raw materials and pay rent and buy machinery- all this items are resources that will
help you produce something else. Therefore, money is NOT a resources, but raw
materials, labor and machinery are.

Example: what resources are needed to produce shoes?

1. Leather
2. Workers (labor)
3. Factory (building)
4. Machinery (physical capital)

The 4 items above are resources, the final product is the shoe.

Scarcity, choice and opportunity cost

Scarcity means limited resources. While resources are natural or time or income, they are
always limited.
Because of limited resources, we need to make decisions. Economics study such
decisions.

One Person Economy –Bill survived a plane crash and is alone in an island must make
decisions. What is he going to do? Bill has to decide about how to allocate resources,
what to produce and how to produce it. This is constrained choice (limited cannot do
everything he wants to).

One man on an island – what are the main necessities of a person? - food and shelter

Bill has to decide how to divide his time before the sun sets. Bill is considering:
Laid down in the sun OR
Get food (hunt or look for fruits) OR
Looking for seeds to plant (capital) OR
Look for logs of wood (house)

Limited resources - time (8 hours of sun per day) and physical ability

After a long time, Bill decided most important is look for food and shelter. Every hour
that Bills look for food is an hour that he is not looking for shelter. If Bill (= man alone in

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the island) decides to look for food the whole day, his opportunity cost is logs of wood to
build a shelter

It is easier to understand the concept of opportunity cost on the individual level, in other
words on the micro-level. How about society as a whole. Can you think of an example of
opportunity cost on the macro level? Safety streets vs. school system

The textbook bring us 10 principles of economics (Read Chapter 1). Here there is a
summary. At this point, the most important one to know are principles one and 2.

How People Make Decisions

A. Principle #1: People Face Trade-offs

1. “There is no such thing as a free lunch.” Making decisions requires trading

one goal for another.

2. Examples include how students spend their time, how a family decides to
spend its income, how the U.S. government spends tax dollars, and how
regulations may protect the environment at a cost to firm owners.

3. An important trade-off that society faces is the trade-off between efficiency

and equality.

a. Definition of efficiency: the property of society getting the most it can

from its scarce resources.

b. Definition of equality: the property of distributing economic

prosperity uniformly among the members of society.

c. For example, tax dollars paid by wealthy Americans and then distributed
to those less fortunate may improve equality but lower the return to hard
work and therefore reduce the level of output produced by our resources.

d. This implies that the cost of this increased equality is a reduction in the
efficient use of our resources.

4. Recognizing that trade-offs exist does not indicate what decisions should or
will be made.

B. Principle #2: The Cost of Something Is What You Give Up to Get It

1. Making decisions requires individuals to consider the benefits and costs of

some action.

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 2. What are the costs of going to college?

a. We should not count room and board (unless they are more expensive at
college than elsewhere) because the student would have to pay for food
and shelter even if she were not in school.

b. We should count the value of the student’s time because she could be
working for pay instead of attending classes and studying.

3. Definition of opportunity cost: whatever must be given up in order to

obtain some item.

C. Principle #3: Rational People Think at the Margin

1. Economists generally assume that people are rational.

a. Definition of rational people: people who systematically and

purposefully do the best they can to achieve their objectives.

b. Consumers want to purchase the goods and services that allow them the
greatest level of satisfaction given their incomes and the prices they face.

c. Firm managers want to produce the level of output that maximizes the
profits the firms earn.

2. Many decisions in life involve incremental decisions: Should I remain in

school this semester? Should I take another course this semester? Should I
study another hour for tomorrow’s exam?

a. Definition of marginal change: a small incremental adjustment to a

plan of action.

b. Example: Suppose that you are considering calling a friend on your cell
phone and the marginal benefit of the 10 minute call is $7.00. Your cell
phone costs you $40 per month plus an additional $0.50 per minute. You
typically talk for $100 minutes and have a monthly bill of $90. If you
consider the average cost of a call, you would decide that the benefit of
this 10 minute call does not exceed its cost ($9.00). However, the
marginal cost of the call is only $5.00 so the marginal benefit of the call
does outweigh its marginal cost. Cell phone users who have unlimited
minutes (free at the margin) often make long and frivolous phone calls.

c. Suppose that flying a 200-seat plane across the country costs the airline
$100,000, which means that the average cost of each seat is $500. Suppose

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 that the plane is minutes from departure and a passenger is willing to pay
$300 for a seat. Should the airline sell the seat for $300? In this case, the
marginal cost of an additional passenger is very small.

d. Another example: Why is water so cheap while diamonds are expensive?

The marginal benefit of a good depends on how many units a person
already has. Because water is plentiful, the marginal benefit of an
additional cup is small. Because diamonds are rare, the marginal benefit
of an extra diamond is high.

3. A rational decision maker takes an action if and only if the marginal benefit is
at least as large as the marginal cost.

D. Principle #4: People Respond to Incentives

1. Definition of incentive: something that induces a person to act.

2. Because rational people make decisions by weighing costs and benefits, their
decisions may change in response to incentives.

a. When the price of a good rises, consumers will buy less of it because its
cost has risen.

b. When the price of a good rises, producers will allocate more resources to
the production of the good because the benefit from producing the good
has risen.

3. Many public policies change the costs and benefits that people face.
Sometimes policymakers fail to understand how policies alter incentives and
behavior and a policy may lead to unintended consequences.

4. Example: Seat belt laws increase the use of seat belts but lower the incentives
of individuals to drive safely. This leads to an increase in the number of car
accidents. This also leads to an increased risk for pedestrians.

III. How People Interact

A. Principle #5: Trade Can Make Everyone Better Off

1. Trade is not like a sports contest, where one side gains and the other side
loses.

2. Consider trade that takes place inside your home. Your family is likely to be
involved in trade with other families on a daily basis. Most families do not
build their own homes, make their own clothes, or grow their own food.

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 3. Countries benefit from trading with one another as well.

4. Trade allows for specialization in products that countries (or families) can do
best.

B. Principle #6: Markets Are Usually a Good Way to Organize Economic Activity

1. Many countries that once had centrally planned economies have abandoned
this system and are trying to develop market economies.

2. Definition of market economy: an economy that allocates resources

through the decentralized decisions of many firms and households as they
interact in markets for goods and services.

3. Market prices reflect both the value of a product to consumers and the cost of
the resources used to produce it.

4. When a government interferes in a market and prevents price from adjusting,

household and firm decisions become distorted.

5. Centrally planned economies failed because they did not allow the market to
work.

6. FYI: Adam Smith and the Invisible Hand

a. Adam Smith’s 1776 work suggested that although individuals are

motivated by self-interest, an invisible hand guides this self-interest into
promoting society’s economic well-being.

b. Smith’s insights are at the center of modern economics and will be

analyzed more fully in the chapters to come.

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

1. The invisible hand will only work if the government enforces property rights.

a. Definition of property rights: the ability of an individual to own and

exercise control over scarce resources.

2. There are two broad reasons for the government to interfere with the
economy: the promotion of efficiency and equality.

3. Government policy can improve efficiency when there is market failure.

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 a. Definition of market failure: a situation in which a market left on its
own fails to allocate resources efficiently.

4. Examples of Market Failure

a. Definition of externality: the impact of one person’s actions on the

well-being of a bystander.

b. Definition of market power: the ability of a single economic actor (or

small group of actors) to have a substantial influence on market
prices.

c. Because a market economy rewards people for their ability to produce

things that other people are willing to pay for, there will be an unequal
distribution of economic well-being.

5. Note that the principle states that the government can improve market
outcomes. This is not saying that the government always does improve market
outcomes.

IV. How the Economy as a Whole Works

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

Goods and Services

1. Differences in living standards from one country to another are quite large.

2. Changes in living standards over time are also great.

3. The explanation for differences in living standards lies in differences in

productivity.

4. Definition of productivity: the quantity of goods and services produced by

each unit of labor input.

5. High productivity implies a high standard of living.

6. Thus, policymakers must understand the impact of any policy on our ability to
produce goods and services.

7. In the News: Why You Should Study Economics

a. Training in economics helps us to understand fallacies and to anticipate

unintended consequences.

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 b. This is an excerpt from a commencement address by Robert D. McTeer,
Jr., the former President of the Federal Reserve Bank of Dallas and
describes why students should study economics.

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

1. Definition of inflation: an increase in the overall level of prices in the

economy.

2. When the government creates a large amount of money, the value of money
falls, leading to price increases.

3. Examples: Germany after World War I (in the early 1920s) and the United
States in the 1970s.

C. Principle #10: Society Faces a Short-Run Trade-off between Inflation and

Unemployment

1. Most economists believe that the short-run effect of a monetary injection is

lower unemployment and higher prices.

a. An increase in the amount of money in the economy stimulates spending

and increases the quantity of goods and services sold in the economy. The
increase in the quantity of goods and services sold will cause firms to hire
additional workers.

b. An increase in the demand for goods and services leads to higher prices
over time.

2. The short-run trade-off between inflation and unemployment plays a key role
in the analysis of the business cycle.

3. Definition of business cycle: fluctuations in economic activity, such as

employment and production.

4. Policymakers can exploit this trade-off by using various policy instruments,

but the extent and desirability of these interventions is a subject of continuing
debate.

5. This debate heated up during the early years of Obama’s presidency. The
severe downturn in the economy led policymakers to try to stimulate demand,
but some feared that the end result would be inflation.

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