Chapter 1 Notes: Economics Foundations and Models

Introduction: What Economics Is About

  • Economics studies how people make choices to attain their goals in a world of scarcity.
  • Scarcity: A situation in which unlimited wants exceed the limited resources available to fulfill those wants. Time is always scarce.
  • Purpose: Understand the choices people make given scarce resources using simplified analytical tools called economic models.
  • Economic models: Simplified versions of reality used to analyze real-world economic situations.
  • Real-world example: Apple iPhone manufacturing
    • Apple designed the iPhone in the U.S., but most iPhones are assembled in China.
    • Discussion prompts: Why are many products manufactured overseas? Can we change this? Should we change this?
  • Typical questions economists seek to answer include:
    • How are the prices of goods and services determined?
    • Why do firms engage in international trade, and how do government policies (e.g., tariffs) affect trade?
    • Why does government control prices of some goods and services, and what are the effects of those controls?

1.1 Three Key Economic Ideas

  • Economic agents interact with one another in markets.
    • Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.
    • In markets, we generally assume:
    • People are rational.
    • People respond to economic incentives.
    • Optimal decisions are made at the margin.
  • 3 core ideas:
    • 1) People are rational
    • Economists assume people use all available information to pursue their goals.
    • Rationality means weighing benefits and costs to make the best decision for oneself, though not necessarily the best for society.
    • Example: Apple sets prices to maximize profitability, not arbitrarily.
    • Other examples: attending college, smoking, crime.
    • 2) People respond to economic incentives
    • Incentives change behavior; they influence decisions.
    • Example: DNA sampling for offenders reduced repeat convictions by 17% among serious violent offenders.
    • Other examples: kids’ allowances, tax credits for electric vehicles.
    • 3) Optimal decisions are made at the margin
    • Most decisions involve doing a little more or a little less of something.
    • Marginal cost (MC) and marginal benefit (MB): the additional cost or benefit of a small amount extra of an action.
    • Marginal analysis: comparison of MB and MC to guide decision-making.
    • Key idea: act as long as MB > MC; stop when MB = MC.

1.2 The Economic Problem That Every Society Must Solve

  • In a world of scarcity, resources are limited and desires are unlimited, creating trade-offs.
  • Trade-off: Producing more of one good means producing less of another.
  • Three fundamental questions every society faces:
    • 1) What goods and services will be produced?
    • Choosing to produce more of one good requires sacrificing others.
    • Opportunity cost (OC): the highest-valued alternative given up to engage in an activity.
    • Example: Increased funding for space exploration might require giving up funding for cancer research.
    • Other examples mentioned: coming to class, entering a draft.
    • 2) How will the goods and services be produced?
    • Firms may have multiple production methods.
    • Examples:
      • A music producer can achieve good sound by hiring a great singer using standard techniques or a mediocre singer with Auto-Tune.
      • If labor costs rise, a firm might adopt more machines and fewer workers, or relocate to cheaper locations.
    • 3) Who will receive the goods and services produced?
    • In the U.S., higher-income individuals typically obtain more goods and services.
    • Tax and welfare policies alter income distribution; there is debate about the desirability of redistribution.

1.3 Types of Economies and Efficiency

  • Types of economies:
    • Centrally planned economy: Government decides how resources are allocated.
    • Market economy: Households and firms interacting in markets allocate resources.
    • Mixed economy: Markets drive most decisions, but the government plays a significant role in allocation.
  • Efficiency in market economies:
    • Productive efficiency: Producing at the lowest possible cost.
    • Allocative efficiency: Production aligns with consumer preferences; MB = MC in particular for each good or service.
  • Source of economic efficiency:
    • Productive efficiency arises through competition.
    • Allocative efficiency arises through voluntary exchange.
    • Voluntary exchange: A transaction where both buyer and seller are better off; transactions continue until no further improvement is possible.
  • Caveats about market economies:
    • Markets may not be fully efficient due to:
    • People not always acting with perfect efficiency.
    • Government interference in markets.
    • Market outcomes may ignore the desires of nonparticipants (e.g., pollution).
  • Market economies and equity:
    • Economically efficient outcomes are not necessarily desirable (equity vs efficiency).
    • Equity: Fair distribution of economic benefits.
    • Important government trade-off: taxation can fund programs that aid the poor, but may reduce incentives to work or to start businesses.

1.3 Economic Models and the Process of Modeling

  • Economists develop economic models to analyze real-world issues.
  • Steps to build an economic model:
    • Decide on the assumptions to use.
    • Formulate a testable hypothesis.
    • Use economic data to test the hypothesis.
    • Revise the model if it fails to explain the data well.
    • Retain the revised model to answer similar questions in the future.
  • Role of assumptions:
    • All models rely on simplifying assumptions to be useful.
    • Behavioral assumptions in models:
    • Consumers maximize well-being.
    • Firms maximize profits.
    • Assumptions may be correct or incorrect; hypotheses are tested against data.
  • Forming hypotheses in economic models:
    • A hypothesis is a statement about an economic variable that may be correct or incorrect.
    • Economic variables: measurable quantities (e.g., number of people employed in manufacturing).
    • Examples: Increased use of industrial robots and information technology in U.S. factories has led to a decline in manufacturing employment.
    • Most hypotheses concern causal relationships.
  • Testing hypotheses in economic models:
    • After collecting data, economists use statistical methods to evaluate hypotheses.
    • Causality is difficult to establish; correlation does not prove causation (e.g., manufacturing employment decline and robot adoption may move together but not prove one caused the other).
    • A model is accepted if its hypotheses are confirmed or not rejected by statistical analysis; new information may overturn previous beliefs.

1.4 Positive vs Normative Analysis and the Scope of Economics

  • Economics uses the scientific method but is a social science, studying human behavior.
  • Positive analysis: What is (descriptive questions about how the economy works).
  • Normative analysis: What ought to be (prescriptive recommendations about what should be).
  • Economists predominantly perform positive analysis but often discuss normative implications when policy questions arise.

1.5 Microeconomics vs Macroeconomics

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