Economics: Foundations and Models - Comprehensive Notes

Three Key Economic Ideas

  • People are rational: Individuals use available information to make decisions that achieve their goals.
    • Rational consumers and firms weigh costs and benefits to make optimal decisions.
    • Example: Apple sets iPhone prices to maximize profit, not randomly.
  • People respond to economic incentives: Actions change in response to changes in incentives.
    • Example: Requiring convicted felons to submit DNA samples reduced repeat violent convictions by 17%.
  • Optimal decisions are made at the margin: Most decisions involve doing a little more or less of something.
    • Marginal cost (MC) and marginal benefit (MB) are considered for small changes in actions.
    • Marginal analysis involves comparing MB and MC.

The Economic Problem That Every Society Must Solve

  • Scarcity leads to choices and trade-offs.
    • Scarcity: Unlimited wants exceed limited resources.
    • Economics: Study of choices to attain goals with scarce resources.
    • Trade-off: Producing more of one good means producing less of another.
    • Opportunity cost: Highest-valued alternative given up for an activity.
      • Example: Funding space exploration might mean less funding for cancer research.
  • Three fundamental questions:
    1. What goods and services will be produced?
      • Individuals, firms, and governments decide.
    2. How will the goods and services be produced?
      • Firms choose production methods.
        • Example #1: Music production using a great singer vs. Auto-Tune with a mediocre singer.
        • Example #2: Firms may use more machines and fewer workers or move to cheaper labor locations as labor costs change.
    3. Who will receive the goods and services produced?
      • In the U.S., those with higher incomes typically obtain more goods and services.
      • Tax and welfare policies can alter income distribution.
  • Centrally Planned Economies vs. Market Economies
    • Centrally planned economy: Government controls resource allocation.
    • Market economy: Decisions of households and firms in markets determine resource allocation.
    • Mixed economy: Combination of market-driven decisions and government intervention.
      • The U.S. economy is best described as a mixed economy due to government interventions like Social Security and minimum wage regulations.
  • Efficiency of Market Economies
    • Market economies tend to be more efficient than centrally planned economies.
      • Productive efficiency: Goods/services produced at the lowest possible cost.
      • Allocative efficiency: Production aligns with consumer preferences; marginal benefit equals marginal cost.
    • Source of Economic Efficiency
      • Productive efficiency arises from competition.
      • Allocative efficiency arises from voluntary exchange.
        • Voluntary exchange: Transactions in which both buyer and seller are better off.
  • Equity
    • Economically efficient outcomes are not always desirable; equity (fair distribution of economic benefits) is also important.
    • Governments face a trade-off between efficiency and equity.
      • Example: Taxing income can fund programs for the poor, but might reduce work effort/business creation.

Economic Models

  • Economists use models to analyze economic events and policies.
  • Steps in building an economic model:
    1. Decide on assumptions.
    2. Formulate a testable hypothesis.
    3. Use economic data to test the hypothesis.
    4. Revise the model if it fails.
    5. Retain the revised model for similar questions.
  • The Role of Assumptions in Economic Models
    • Models require assumptions and simplifications.
    • Behavioral assumptions:
      • Consumers maximize well-being.
      • Firms maximize profits.
  • Forming and Testing Hypotheses in Economic Models
    • Hypothesis: A statement about an economic variable that may be correct or incorrect.
      • Economic variable: Measurable quantity with different values (e.g., employment in manufacturing).
      • Example: Increased use of robots in factories has resulted in a decline in manufacturing employment.
  • Testing Hypotheses in Economic Models
    • Economists use statistical methods to evaluate hypotheses with relevant data.
    • Causation is difficult to establish.
    • Models are accepted if they lead to confirmed hypotheses.
  • Positive and Normative Analysis
    • Positive analysis: Concerned with what is.
    • Normative analysis: Concerned with what ought to be.
    • Economists mostly perform positive analysis but it's usually not enough to decide what to do.

Economics as a Social Science

  • Economics is a social science that studies individual actions.
  • Emphasis on:
    1. How individual actions affect outcomes like prices.
    2. How changes in conditions and policies affect outcomes.
  • Economic analysis informs government policymakers.

Microeconomics and Macroeconomics

  • Microeconomics: Study of individual choices, interactions in markets, and government influence.
  • Macroeconomics: Study of the economy as a whole (inflation, unemployment, economic growth).

Economic Skills and Economics as a Career

  • Economists describe choices, explain consequences, and advise on better decisions.
  • Economics provides skills for better business decisions.
  • Many CEOs of large corporations majored in economics.
  • Economics majors tend to have higher salaries, but self-selection might play a role.
    • Median Wage, Early Career (people aged 22 to 27)
      • Economics majors: 60,00060,000
      • All majors: 45,00045,000
    • Median Wage, Midcareer (people aged 35-45)
      • Economics majors: 91,00091,000
      • All majors: 72,00072,000

A Preview of Important Economic Terms

  • Economics uses specific terminology.
    • Technology: Processes a firm uses to produce goods and services.
    • Capital: Manufactured goods used to produce other goods and services.

Appendix: Using Graphs and Formulas

  • Graphs and formulas help analyze economic situations.
  • Graphs
    • Bar graphs and pie charts represent data.
    • Time-series graphs show data over time; truncated scales can exaggerate fluctuations.
    • Plotting price and quantity points in a graph helps illustrate relationships.
  • Calculating the Slope of a Line
    • Slope is the change in the y-axis variable divided by the change in the x-axis variable.
    • slope=ΔyΔxslope = \frac{\Delta y}{\Delta x}
  • Showing Three Variables on a Graph
    • Demand curves show the relationship between price and quantity demanded, holding other factors constant.
  • Positive and Negative Relationships
    • Positive relationship: As one variable increases, the other increases.
    • Negative relationship: As one variable increases, the other decreases.
  • Determining Cause and Effect
    • Graphs can be misleading about cause and effect.
  • Linear vs. Nonlinear Relationships
    • Linear relationships are represented by straight lines.
    • Nonlinear relationships have varying slopes.
  • The Slope of a Nonlinear Curve
    • The slope can be approximated over a section or measured using a tangent line.
  • Formula for a Percentage Change
    • Percentage  Change=Value  in  the  second  period−Value  in  the  first  periodValue  in  the  first  period×100Percentage\; Change = \frac{Value\; in\; the\; second\; period - Value\; in\; the\; first\; period}{Value\; in\; the\; first\; period} \times 100
    • Example: U.S. real GDP increased from 19,61019,610 billion in 2021 to 20,01820,018 billion in 2022, a 2.1% increase.
  • Showing Total Revenue on a Graph
    • Total revenue equals quantity multiplied by price.
  • The Area of a Triangle
    • Area=12×base×heightArea = \frac{1}{2} \times base \times height
  • Summary of Using Formulas
    1. Understand the economic concept.
    2. Use the correct formula.
    3. Ensure the calculated number is economically reasonable.