Chapter 1 Notes — Economics: Foundations and Models

Scarcity

  • Scarcity: a situation in which unlimited wants exceed the limited resources available to fulfill those wants.
  • Relates to different economic agents:
    • Individuals: time and money are scarce
    • Firms: production inputs are scarce
    • Governments: revenue is scarce

Economics: Foundations and Models

  • Economics: the study of the choices people make to attain their goals, given scarce resources.
  • Economic model: a simplified version of reality used to analyze real-world economic situations.

Market

  • Market: a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

Three Key Economic Ideas (recurrent throughout the book)

  • People are rational.
  • People respond to economic incentives.
  • Optimal decisions are made at the margin.
  • Marginal analysis: analysis that involves comparing marginal benefits and marginal costs.

Marginal Analysis and Marginal Benefits/Costs

  • Marginal benefits (MB): the additional benefit received from consuming or producing one more unit.
  • Marginal costs (MC): the additional cost of consuming or producing one more unit.
  • Practical use: compare MB and MC to decide whether to undertake an additional unit of an activity.

Illustrative Marginal-Benefit/Marginal-Cost Examples

  • Action: College athlete leaving school early for pros
    • MB: extMoney,Fame,Fortuneext{Money, Fame, Fortune}
    • MC: extHaltingeducation,LeavingFriends,Injuryext{Halting education, Leaving Friends, Injury}
  • Action: Halting education / leaving education early
    • MB: (not explicitly listed in the excerpt; the decision is implied in the example above)
    • MC: (not explicitly listed in the excerpt; the decision is implied in the example above)
  • Action: Halting or delaying education (continuation of the same idea)
    • MB: (as above)
    • MC: (as above)
  • Action: Super-sizing a value meal
    • MB: extMorefoodext{More food}
    • MC: extMonetaryCost,Caloriesext{Monetary Cost, Calories}
  • Action: A firm hiring a new employee
    • MB: extLargerworkforce,Newideasext{Larger workforce, New ideas}
    • MC: extSalaryandbenefitsext{Salary and benefits}
  • Action: Local government paving a road
    • MB: extSaferdrivingsystem,attractsbusiness,lesscomplainingext{Safer driving system, attracts business, less complaining}
    • MC: extCouldhaveusedthatmoneytofund:education,safety,etc.ext{Could have used that money to fund: education, safety, etc.}

Trade-offs and The Economic Problem

  • Trade-off: due to scarcity, producing more of one good or service means producing less of another.
  • The three fundamental questions society must answer (in the face of trade-offs):
    1. What goods and services will be produced?
    2. How will the goods and services be produced?
    3. Who will receive the goods and services produced?
  • Opportunity Cost: the highest-valued alternative that must be given up to engage in an activity.
    • Expressed as: OC=exthighest−valuedalternativeforgoneOC = ext{highest-valued alternative forgone}

Economies: The Economic Problem Solved by Different Systems

  • Centrally planned economy: an economy in which the government decides how economic resources will be allocated.
  • Market economy: an economy in which the decisions of households and firms interacting in markets allocate economic resources.
  • Mixed economy: an economy in which most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources.
  • The Modern “Mixed” Economy: blend of market-driven decisions with government involvement.

Voluntary Exchange

  • Voluntary exchange: a situation in markets when both the buyer and seller of a product are made better off by the transaction.

Efficiency and Equity

  • Efficiency: the economy’s ability to maximize total benefits from scarce resources.
  • Productive efficiency: producing a good or service at the lowest possible cost.
  • Allocative efficiency: a state of the economy in which production is in accordance with consumer preferences; every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it.
  • Equity: the fair distribution of economic benefits.
  • Relationship: efficiency and equity are often key objectives in evaluating economic performance.

The Role of Assumptions in Economic Models

  • Economic models make behavioral assumptions about the motives of consumers and firms.
  • The Role of Assumptions in Economic Models
    1) Generalizations: use two goods to represent the tendencies of the typical consumer.
    2) Ceteris Paribus (Latin): “other things equal”; when analyzing one variable, hold other factors constant.
    3) Graphical Expression: many economic relationships are quantitative and are effectively demonstrated with graphs.
  • Economics as a social science: considers human behavior and decision-making in many contexts, not just business.

Positive and Normative Analysis

  • Positive analysis: analysis concerned with what is; descriptive; testable.
  • Normative analysis: analysis concerned with what ought to be; prescriptive; opinion.

Identifying Positive vs. Normative Statements

  • Example statements (identification exercise):
    a. Prices rise when the government increases the quantity of money.
    b. The government should print less money.
    c. A tax cut is needed to stimulate the economy.
    d. An increase in the price of burritos will cause an increase in consumer demand for video rentals.

Answers to Positive vs. Normative Exercise

  • a. Positive – describes a relationship and could be tested with data.
  • b. Normative – a value judgment; cannot be confirmed or refuted.
  • c. Normative – another value judgment.
  • d. Positive – describes a relationship; note that a statement need not be true to be positive.

Economics: A Social Science

  • Economics studies the actions of individuals, so it is a social science.
  • It is similar to psychology, political science, and sociology.
  • It considers human behavior—particularly decision-making behavior—in every context, not just in business contexts.

Microeconomics and Macroeconomics

  • Microeconomics: the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.
  • Macroeconomics: the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.