Introduction: What Is Economics? 1 C H A P T E R 1 © 2001 Prentice Hall Business...

Introduction:What Is

Economics?

1

C

H A

P T

E R

1

© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

IntroductionIntroduction

slide 2

ECONOMICS IS ABOUT DECIDING

Economists do not restrict themselves to considering only decision problems involving money and markets, though that is a big part of economics.


slide 3

EXAMPLES OF SOME DECISIONS ECONOMISTS HAVE ANALYZED

Whether to buy a car this week. Whether to have pizza for dinner tonight, or

something else. How hard to study for this course. Whether to go to college, and if so, which

one. Whether to buy a lottery ticket.

Individual Choice: Summing It Up

We have just seen that there are 3 basic principles:

Resources are scarce. It is always necessary to make choices.

The real cost of something is what you must give up to get it. All costs are opportunity costs.

People usually exploit opportunities to make themselves better off. As a result, people will respond to incentives.



So, What Is Economics?

Economics is the study of the choices made by people who are faced with scarcity.

Scarcity is a situation in which resources are limited and can be used in different ways.

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What Is Economics?

Because our resources are limited, we must sacrifice one thing for another.

Economists are always reminding us that there is scarcity—that there are tradeoffs in everything we do.


Society’s Choices

Having a limited amount of resources means that we must sacrifice one thing in order to obtain another.

The decisions of producers, consumers and government determine how an economic system answers three fundamental questions:


Society’s Choices

What goods and services do we produce? If we devote more resources to the

production of one good, we have fewer resources for the production of another.


Society’s Choices

How do we produce these goods and services? How do we organize production and

what methods and techniques should we use?


Society’s Choices

For whom do we produce the output? How should we distribute the output

produced among members of society?


Factors of Production

Natural resources Labor Physical capital Human capital Entrepreneurship

Factors of production, or productive inputs, are the resources we use to produce goods and services:



Natural resources: The things created by acts of nature

such as land, water, mineral, oil and gas deposits; renewable and nonrenewable resources.



Labor: The human effort, physical and

mental, used by workers in the production of goods and services.



Physical capital. All the machines, buildings,

equipment, roads and other objects made by human beings to produce goods and services.



Human capital: The knowledge and skills acquired

by a worker through education and experience.



Entrepreneurship: The effort to coordinate the

production and sale of goods and services. Entrepreneurs take risk and commit time and money to a business without any guarantee of profits.

»FIN


Fields: Microeconomics

Microeconomics focuses on the analysis of individual economic units.

Microeconomics is the study of the choices made by consumers, firms, and government, and how these decisions affect the market for a particular good.


Microeconomics

Microeconomics gives you the tools to analyze the impact of: Environmental regulations, taxes, imports,

gender discrimination, labor unions, competition, patterns of production and consumption, and other decisions made by individual economic units.


Microeconomics

Understand how markets work and predict changes.

Make personal or managerial decisions. Evaluate the merits of public policies.

Microeconomic analysis can be used to:


Macroeconomics

Macroeconomic analysis can be used to: Understand how a national economy

works. Understand the grand debates over

economic policy. Make informed business decisions.

Macroeconomics is the study of the nation’s economy as a whole.


Macroeconomics

Macroeconomic analysis can be used to understand important everyday economic issues such as: Unemployment, inflation, interest rates,

exchange rates, the standard of living, the federal budget, consumption, and saving patterns.

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In Short: Microeconomics

Microeconomics is the study of the choices made by households, firms, and government, and of how these choices affect the markets for goods or services.

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In short Microeconomics

We can use microeconomic analysis to:

1. Understand how markets work and predict changes.

2. Make personal and managerial decisions.

3. Evaluate public policies.

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In short: Macroeconomics

Macroeconomics is the study of the nation’s economy as a whole.

We can use macroeconomic analysis to:

1. Understand why economies grow.

2. Understand economic fluctuations.

3. Make informed business decisions.


slide 25

Methodology: Positive vs. Normative Economics Positive econ. -- Studies the way the world is.

How much will a new gasoline tax raise the price of gasoline?

Will an increase in the minimum wage increase unemployment?

Why is the price of corn $4.20 per bushel? How much will a drought in the corn belt raise the

price of corn? Of wheat? What will be the effect on Byron Brown’s pizza

consumption if we take $1000 away from Tom Izzo and give it to Brown?


slide 26

Normative econ. -- Studies the way the world should be.

Should there be a new tax on gasoline? Should there be an increase in the minimum

wage? Should $1000 be taken from M. Peter McPherson

and given to Byron Brown? What should the price of corn be?

Methodology: Positive vs. Normative Economics

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Positive and Normative Analysis: Resume Normative economics answers the

question, What ought to be? Normative questions lie at the heart of policy debates.

Positive economics predicts the consequences of alternative actions, answering the questions, “What is?” or “What will be?”

FIN

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The Economic Way of Thinking

Three elements of the economic way of thinking:

1. Use assumptions to simplify

Eliminate irrelevant details and focus on what really matters. Keep in mind that simplifying assumptions do not have to be realistic.

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2. Isolate variables—Ceteris Paribus

Economists are interested in exploring relationships between two variables. A variable is a measure of something that can take on different values.

The expression ceteris paribus means that the effect of other tendencies is neglected for a time.

• Three elements of the economic way of thinking:

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3. Think at the margin

A small, one-unit change in value is called a marginal change.

Economists use the answer to a marginal question as the first step in deciding whether to do more or less of something.

• Three elements of the economic way of thinking:

3131 of 16 of 16


A key assumption of most economic analysis is that people act rationally, meaning that they act in their own self-interest.

Rational people respond to incentives.



Simplifying assumptions do not have to be realistic. We use maps, for example, to get us from point A to point B knowing that the map is not an accurate description of the road ahead, but only an abstraction of reality.

REMEMBER

Economists use simplifying assumptions to eliminate irrelevant details and focus on what really matters. Assumptions are an aid to the analytical process.



“Ceteris paribus” is Latin for “all else the same.” To study the relationship between two variables, we assume that other variables do not change.

The “ceteris paribus” assumption is used to explore the relationship between two variables. A variable is a measure of something that

can take on different values.

Understanding Graphs

Graph

Picture showing how variables relate and conveys information in a compact and efficient way

Functional relation exists between two variables when the value of one variable depends on another

The value of the dependent variable depends on the value of the independent variable

Basics of a Graph

The value of variable x is measured along the horizontal axis and increases as you move to the right of the origin.

The value of the variable y is measured along the vertical axis and increases as you move upward.

Any point on a graph represents a combination of particular values of two variables.

For example, point a represents the combination of 5 units of variable x and 15 units of variable y, while point b represents 10 units of x and 5 units of y.

y

20

15

10

5

0

Ver

tica

l axi

s

O rigin 5 10 15 20 x

a

b

Horizontal axis

Relating Distance Traveled to Hours Driven

1 2 3 4 5Hours driven per day

Dis

tan

ce t

rave

led

per

day

(m

iles)

250

200

150

100

50

0

a

b

c

d

e

Slopes of Straight Lines

Indicates how much the vertical variable changes for a given change in the horizontal variable

Vertical Change divided by the horizontal Change

Slope = Change in the vertical distance (Y) / change in the horizontal distance (X).

m= Δ(Y) / Δ(X)

Exhibit: Alternative Slopes for Straight Lines

y

20

15

10

010 20 x

5

10

Slope 0.5= =5 10

Positive relation


y

20

10

3

0 10

–7

10 20 x

Slope – – 0.7= =7 10

Negative relation


10 20 x

y

20

10

0

Slope 0= =0

10

10

No relation: zero slope


10 x

y

20

10

0

10 0

10

Slope = =

No relation: infinite slope

Slope and Marginal Analysis

Economic analysis usually involves marginal analysis

The slope is a convenient device for measuring marginal effects because it reflects the change in one variable – the effect – compared to the change in some other variable – the cause

Slope of straight line is the same everywhere along the line

Curves with Both Positive and Negative Ranges

y

x

b

a

The hill-shaped curve begins with a positive slope to the left of point a, a slope of 0 at point a, and a negative slope to the right of point a.

The U-shaped curve begins with a negative slope, has a slope of 0 at point b, and a positive slope after point b.


slide 45

Models and theories

Model -- a hypothesis about the relationships among variables.

Everyone uses models. Because a model abstracts from reality it makes

mistakes. Models can contain two kinds of errors or mistakes:

the wrong explanatory variables may be included. the functional form may be incorrect.


slide 46

Contents of models

List of variables, especially a clear statement of what is to be explained

Dependent v. independent variables

Hypothesized relationships among the variables.

Using tables of values, graphs, or equations.


slide 47

MODEL SUMMARY

Three ways to describe models Graphs Tables of values Mathematical functions (equations)

Important concepts Dependent and independent variables Linear function, intercept and slope


slide 48

AN ECONOMIC MODELThe Production Possibility Curve

Purposes of model Show scarcity constraint Illustrate economic efficiency Introduce opportunity cost concept

Variables Quantities of goods that may be produced

Givens Total amounts of inputs available Technology of production


slide 49

PPF DEFINED

The Production Possibility Curve (or frontier) shows the maximum amount of a good you can produce given the amounts of other goods produced, and given the total amounts of inputs available, and given the technology of production.


slide 50

PPC EXAMPLE

Assumptions: There are only two goods, pizza and spaghetti. There are limited inputs and given technology of

production.

Definition: The PPC shows the maximum amount of pizza

you can produce, given the amount of spaghetti to be produced.


slide 51

PRODUCTION POSSIBILITY CURVE

SPAGHETTI

PIZZA

Which points are attainable

and which points are unattainable?

Which points are attainable

and which points are unattainable?

0

100

200

300

400

0 10 20 30 40 50 60

Go to hidden slide


slide 53


SPAGHETTI

PIZZA

What’s the effect of an improvement

in the technology for producing spaghetti?

What’s the effect of an improvement

in the technology for producing spaghetti?

0

100

200

300

400

0 10 20 30 40 50 60

Go to hidden slide


slide 54

SPAGHETTI

PIZZA

An improvement in spaghetti technology

0

100

200

300

400

0 10 20 30 40 50 60


slide 55


SPAGHETTI

PIZZA

What’s the effect of an increase in

total resources (inputs)?

What’s the effect of an increase in

total resources (inputs)?

0

100

200

300

400

0 10 20 30 40 50 60

Go to hidden slide


slide 56

Effect of an increase in resources.

SPAGHETTI

PIZZA

0

100

200

300

400

0 10 20 30 40 50 60


slide 57

Points “inside” the PPC are inefficient. For any point “inside” there corresponds

some point that represents more production of both goods.

Note that while points on the PPC are efficient, we cannot say at this time whether some are better for society than others.


The Production Possibilities Frontier (PPF) Curve 2

The PPF curve shows the possible combinations of goods and services available to an economy, when resources are fully and efficiently employed.

The PPF curve is a graphical illustration of fundamental economic problems related to our ability to produce goods and services.


The Production Possibilities Frontier (PPF) Curve

When the economy is at point i, resources are not fully employed and/or they are not used efficiently.



Point h is desirable because it yields more of both goods, but not attainable given the amount of resources available.



Point e is one of the possible combinations of goods produced when resources are fully and efficiently employed.



At point e in this example, resources are devoted to the production of four space missions and 380 thousand computers.

To increase the number of space missions by one, 80 thousand computers will have to be sacrificed.



To increase the production of one good without decreasing the production of the other, the PPF curve must shift outward.

From point f, an additional 150 thousand computers or two more space missions are now possible.



Resources are not perfectly adaptable.

The PPF curve has a concave shape because resources are not perfectly adaptable in production. As we increase the production of one good, we sacrifice progressively more of the other.

To wrap up the PP curve

The production possibility curve what the curve shows

0

1

2

3

4

5

6

7

8

0 1 2 3 4 5 6 7 8Units of clothing (millions)

Un

its o

f foo

d (

mill

ion

s)

Units of food Units of clothing

(millions) (millions)

8m 0.0

7m 2.2m

6m 4.0m

5m 5.0m

4m 5.6m

3m 6.0m

2m 6.4m

1m 6.7m

0 7.0m

A production possibility curveA production possibility curve

0

1

2

3

4

5

6

7

8


Un

its o

f foo

d (

mill

ion

s)



a 8m 0.0

7m 2.2m

6m 4.0m

5m 5.0m

4m 5.6m

3m 6.0m

2m 6.4m

1m 6.7m

0 7.0m

a


0

1

2

3

4

5

6

7

8


Un

its o

f foo

d (

mill

ion

s)



8m 0.0

b 7m 2.2m

6m 4.0m

5m 5.0m

4m 5.6m

3m 6.0m

2m 6.4m

1m 6.7m

0 7.0m

b


0

1

2

3

4

5

6

7

8


Un

its o

f foo

d (

mill

ion

s)



8m 0.0

7m 2.2m

c 6m 4.0m

5m 5.0m

4m 5.6m

3m 6.0m

2m 6.4m

1m 6.7m

0 7.0m

c


The Economic Problem

The production possibility curve

what the curve shows

microeconomics and the p.p. curve:





choices and opportunity cost






increasing opportunity cost

Units of clothing (millions)

Un

its o

f foo

d (

mill

ion

s)Increasing opportunity costsIncreasing opportunity costs

x

y

0

1

2

3

4

5

6

7

8

0 1 2 3 4 5 6 7 8

1

1

z1

2







macroeconomics and the p.p. curve:








production within the curve

v

x

y

O

Making a fuller use of resourcesMaking a fuller use of resourcesF

oo

d

Clothing

Production inside

the production

possibility curve








production within the curve

shifts in the curve

O

Growth in potential outputGrowth in potential outputF

oo

d

Clothing

Now

O

Fo

od

Clothing

Now

Growth in potential outputGrowth in potential output

5 years’ time

O

Fo

od

Clothing

Growth in potential and actual outputGrowth in potential and actual output

O

Fo

od

Clothing

Growth in potential and actual outputGrowth in potential and actual output

x

y


slide 82

OPPORTUNITY COST DEFINED

The opportunity cost of doing something is what you must give up in order to do it.

The cost of a pizza is what you must give up to consume it, which in this case is easily computed in money.

The cost of a college education includes both money and other foregone alternatives. For example, the cost of a year at MSU includes not only tuition and books, but the income you could have earned working on a full time job.

The cost of attending a Lugnuts baseball game includes the value of the time you could have spent studying economics.


slide 83

The PPC can show opportunity cost

Suppose you are at some point on a PPC. Then suppose you want to consume one

more pizza. The opportunity cost of one more pizza is the

amount of spaghetti you must give up in order to get it.

Note that this opportunity cost is equal to minus the slope of the PPC.


slide 84


SPAGHETTI

PIZZA

More pizza means less spaghettiMore pizza means less spaghetti

0

100

200

300

400

0 10 20 30 40 50 60


slide 85

OPPORTUNITY COST INCREASES AS MORE OF A GOOD IS PRODUCED

Not only does more pizza mean less spaghetti, but each additional pizza costs more than the one before it.

This idea shows up as the PPC being concave to the origin. (The curve bows out.)

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