Chapter 1Overview of Economics – Getting Started

A. General Overview of Concepts

1. Economics – The study of choices under conditions of scarcity. Economics is far more than businesses and profits. It attempts to find out how people individually or in groups make decisions when resources are limited and how to best use those limited resources.

a. scarcity – when there is a larger demand for something relative to supply. This is how we know that it is scarce.

b. trade-offs- what must be given up because a society must choose to produce some items and not others or engage in certain activities and not others.

c. 3 questions that are determined by society about Goods & Services

Goods (G) and Services (S): the objects and actions that people value and produce to satisfy human wants.

(i) What G/S will be produced?

(ii) How will the G/S be produced?

(iii) Who will receive the G/S?

-the most commonly dealt with items by individuals is time and spending power (income)

-our choices as a society help to shape our economy

d. Self-Interest vs. Social Interest – self interested decisions are decisions aimed at optimizing one individual. Social interested decisions are aimed at optimizing a group’soverall well-being. Social decisions have the parameters of efficiency and equity.

Efficiency – how to make the well-being the greatest

Equity – How to divide up the well-being (i.e. the Goods and Services) in the ‘fairest’ way possible.

2. Economic Resources of Society– these are the things that are used to produce goods (G) and services (S). See chapter 2.

main resources of a society:

a. Labor – (L) - The time we spend on production of G/S.

-entrepreneurship is a characteristic of labor and is also a resource under the heading of labor. It is the ability of a person to seek and bear risk and the degree of creativity they have for production.

b. Capital – (K) – These are the tools or machinery that labor uses to be more productive when producing G/S.

note: can be classified as physical such as machinery, equipment, buildings, etc…. or can be human capital (HC) such as skills, training, education, etc…

c. Land – Space on which production takes place. This also includes the natural resources found on or under it.

Note: These resources are used in the production of what society wants. Most of what is produced is determined via a market mechanism (i.e. supply and demand). Not everything that we want can be produced however, due to the scarcity of resources mentioned above. It is sometimes said that we as a society have unlimited wants compared to our limited resources. Clearly we don’t have unlimited wants, but we have far fewer resources relative to what we desire as a society and individuals.

3. Differences between Macro and Micro

a. Microeconomics – this is the study of the behavior of individuals, firms, and governments. It essentially looks at how each of these entities makes choices and what role they play in the market and how they use the scarce resources that are allocated to them.

b. Macroeconomics – this is the study of business cycle theory. It looks at how nations grow and prosper primarily in terms of their national income. There is a large interplay between the public and private markets, government and the private sector, as well as international relations and how they affect a nation’s well-being.

4. Positive vs. Normative Economics

a. Positive – The study of how things are; these statements strive to deal with just factual statements

b. Normative – The study of how things should be. This requires value judgments and essentially is where much of the discussion takes place between economists.

5. Market – the way in which buyers and sellers come together to engage in voluntary transactions. A market can be very formal such as the markets that we see in the US or other developing nations, or it can be very informal such as a farmers market or flea market.

6. Assumptions about People’s Behavior in Markets

a. rationality – use of all available information to accomplish some economic goal

b. market agents respond to economic incentives. Incentives are anything of value or importance that influences a decision.

c. optimal decisions are made at margins  so decisions are made on a smaller scale and incrementally. So we see how things change when we adjust items a little bit at a time.

Example: Before you jump into a pool you dip your foot in. Then slowly but surely you continue to make sure the water is bearable as you ease your way into the water.

note: marginal analysis – compares marginal benefit vs. marginal costs

i. marginal benefit – what benefit you receive when you add one more unit of something

i.e.: if you study one more hour how much more you learn

ii. marginal cost – the additional cost you receive by adding one more unit of something.

i.e.: how much more tired you feel by studying that additional hour.

B. Economic Models

1. Model - Economic models are devices that are used to help us explain relationships that we believe exist in our economy. They are useful in helping us understand how changing one element or variable in our economy will affect other variables. They are not considered to be an exact portrait of reality, merely an abstraction of it which helps us understand the real world.

2. Simplifying Assumption - The use of simplifying assumptions in these models is pivotal in making them easier to deal with and allowing for economists to get at the heart of the relationship between different economic factors.

Note: The variables that are included in the models are the ones that economists believe have the greatest influence and significance in explaining or affecting other variables.

Ex: A very simple example is our use of supply and demand. In demand we know in general that price has the greatest affect on quantity demanded, but incomes, population, price of related goods, as well as other variables are also useful at explaining it.

3. Steps in Developing a Model

a. Step 1 - Decide on Assumptions to be used in the model

b. Step 2 - Formulate testable hypothesis

c. Step 3 - Use economic data to test the hypothesis

d. Step 4 – Revise the model if it fails to explain the data

e. Step 5 – Retain the model and use it to answer future questions, make predictions, and compare predictions with reality

4. Economic Variable – Something that measures economic phenomenon that can take on a range of values.

Example: A good example is income. Income fluctuates across people and it is a main variable of interest in many economic studies.

C. Economic Terms and Problems a Society Faces – Optional

1. Types of Economies

a. Centrally Planned Economy – When some central authority determines how to answer the 3 questions mentioned above about economies. A good example is communism

b. Market Economy – This is when the market determines how to divide up resources.

c. Mixed Economy – When decisions by buyers, sellers, and government determine how resources are used.

Note: Most economies are neither purely centrally planned or market economies  most are considered mixed, with different variations of how planned or market based they are.

2. Types of Efficiency

a. allocative – when production reflects consumer preferences

b. productive – when G/S are produced at the lowest cost implying that the process is efficient.

3. Voluntary Exchange – when the buyer and seller agree to engage in a market transaction. Both are assumed to benefit otherwise they would not engage in the transaction

4. Equity – ‘fair’ distribution of economic benefit.

5. Innovation – development of new G/S or process to make one. First there is an invention, but innovation is its practical application. In economics we are more concerned with the latter case because it serves to increase the production of G/S.

6. Technology – process used to create G/S.