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 societys 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!

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
Making decisions requires trading
off one goal against another.

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 alternatives 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 Countrys 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 Tradeoff between Inflation and Unemployment.

ECONOMIC THEORY IN PRACTICE

POSITIVE VERSUS NORMATIVE ECONOMICS
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

INTRODUCTION TO MACROECONOMICS

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

MARKETS
FOR
GOODS AND SERVICES
Firms sell
Goods
Households buy
and services
sold
Revenue

Wages, rent,
and profit

Goods and
services
bought

HOUSEHOLDS
Buy and consume
goods and services
Own and sell factors
of production

FIRMS
Produce and sell
goods and services
Hire and use factors
of production

Factors of
production

Spending

MARKETS
FOR
FACTORS OF PRODUCTION
Households sell
Firms buy

Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars

Copyright 2004 South-Western

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 INEFFICIENCY

Unattainable point,
given available technology,
resources and labor force

10

Food

8
6
4
2
0

Efficient
points

B
A

Inefficient
point
2

6
Clothes

10

SHIFTS IN THE PRODUCTION POSSIBILITY CURVE

Neutral Technological Change

Food
C
A

Clothes

SHIFTS IN THE PRODUCTION POSSIBILITY CURVE

Biased Technological Change

Food
C
B

Clothes

SHIFTS IN THE PRODUCTION POSSIBILITY CURVE

Test your understanding:
A natural disaster destroys half the earths
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.