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CHAPTER 1: What is Economics? (Pg. 2-4 and 9-13)
Definition of Economics (Pg. 2)
The study of how choices (consumption and production) are made under scarcity of resources.
Traditional Dichotomy: Microeconomics and Macroeconomics
Microeconomics Questions (Pg. 3-4)
What (to produce), How (to produce it), and For Whom (who gets it)?
The Economic Way of Thinking (Pg. 9-11)
Choices and Tradeoffs (Pg. 9)
Opportunity Cost (Pg. 10)
The opportunity cost of an action is the highest benefit forgone from an alternative action.
Choosing at the Margin (Pg. 11)
Choices are made where marginal benefit equals marginal cost.
Responding to Incentives (Pg. 11)
Economics as a Social Science (Pg. 12-14)
Positive (what is) and Normative (what ought to be) Statements (Pg. 12)
Model Building (Pg. 12)
Definition of Variables: Independent and Dependent Variables
Assumptions about the Behaviour of Variables
Predictions
Qualitative (direction of change of variable) and Quantitative (magnitude of change of variable) Predictions
Testing Models (Pg. 12)
Use data to evaluate predictions of the model
The Ceteris Paribus Assumption (Pg. 13)
Look at the effect of a change in one variable, while holding all other variables constant.
Chapter Key Ideas
Economics helps us understand our ever-changing world
A. Economics is the science of choice. It gives us valuable insight into how we can best deal with the challenges and opportunities that we all face.
1. Our global economy allows technological changes to bring affordable, innovative products and services to consumers around the world.
2. Our global economy also allows the repercussions from a single terrorist act or the poor economic policies of a single nation to spread economic hardship worldwide.
B. This makes for a life that is rich with problems to be tackled and choices to be understood. A course in economics can help students to understand the powerful forces that shape and change our world.
Outline
I. Definition of Economics
A. Economic questions arise because we face scarcity - we all want more than we can get.
1. Because we are unable to satisfy all of our wants, we must make choices.
2. Incentives are the rewards that encourage us, or the penalties that discourage us, from taking an action. The incentives that we face will influence the choices that we make when dealing with scarcity.
B. Economics is the social science that studies the choices that individuals, businesses, governments, and societies make as they cope with scarcity. It can be divided into two areas of study:
1. Microeconomics is the study of the choices individuals and businesses make, the way those choices interact in the markets, and the influence of governments.
2. Macroeconomics is the study of the performance of the national economy and the global economy.
II. Two Big Economics Questions
A. The first big question is “How do choices end up determining what, how and for whom are goods and services produced?
1. What goods and services are produced in our economy?
a. Goods and services are the objects that people value and produce to satisfy human wants.
b. Figure 1.1 shows the trends in what the U.S. economy has produced over the past 60 years. It shows the decline of agriculture, mining, construction, and manufacturing goods, and the expansion of services.
2. How are goods and services produced?
a. Factors of production are the productive resources used to produce goods and services. These include land (natural resources), labour (the work time and work effort of people), capital (tools, instruments, and machines that are used to produce goods and services), and entrepreneurship (the human resource that organizes land, labour, and capital).
b. The quality of labour depends on human capital, which is the knowledge and skill that people obtain from education, work experience, and on-the-job training.
3. For whom are goods and services produced?
a. Who gets to consume the goods and services that are produced depends on the incomes that people earn.
b. Owners of the factors of production earn income, which is a monetary return for using the resources for production: Land earns rent, labour earns wages, capital earns interest, and entrepreneurship earns profit.
c. In the United States, labour earns the largest share of all income (70 percent), but this income is not distributed equally across the population.
B. The second big question is “When is the pursuit of self-interest also in the social interest?”
1. People make choices in their own self-interest - they make choices they think are best for their own well-being.
a. The incentives surrounding an individual’s choice amongst available alternatives influence the tradeoffs involved in making that choice.
b. The choice made by one individual changes the incentives surrounding the tradeoffs facing other individuals, which influences their choices.
c. In this way, many self-interested individuals making choices in society will bring about change to the incentive surrounding all decisions to be made by individuals in the economy.
2. When people make self-interested choices that are the best for society, they make choices that are considered in the social interest.
a. In 1776 Adam Smith published The Wealth of Nations describing how a market based system can theoretically motivate self-interested individuals to make choices that promote the social interest.
b. Economists try to identify those characteristics of a market system that successfully promote self-interested individuals to make choices that coincide with the social interest.
IV. The Economic Way of Thinking: Choices and Tradeoffs
A. Because we all face scarcity, we all must make choices between available alternatives - which creates a tradeoff.
1. A tradeoff is an exchange - giving up one thing to get something else.
2. “Guns versus Butter” is a classic tradeoff that every country faces when deciding how much of its factors of production should go towards producing national security versus goods and services like food and shelter.
B. What, How, and For Whom Tradeoffs
1. “What?” Tradeoffs arise when people choose how to spend their incomes, when governments choose how to spend their tax revenues, and when businesses choose what to produce with their factors of production.
2. “How?” Tradeoffs arise when businesses and governments choose among alternative production technologies. For example: businesses might switch to using robotics rather than labour in assembly lines, thereby effectively trading off labour for capital.
3. “For Whom?” Tradeoffs arise when choices change the distribution of goods and services produced across individuals. Government redistribution of income from the rich to the poor changes the incentives facing owners of productive resources, creating the Big Tradeoff: the tradeoff between efficiency and equity.
C. The results arising from all the choices made in society will influence the incentives surrounding the future choices by other people, businesses, and governments. For example:
1. Consumers’ decisions to consume less and save more increases the funds that are available for businesses to borrow and invest, increasing future output.
2. Workers’ decision to decrease leisure time to acquire human capital increases their income as well as government income tax revenues, increasing how much public services the government chooses to offer.
3. Businesses’ decisions to increase research and development for innovative products rather than to increase current production improves investor’s expectations, increasing the level of income people invest (save).
D. Thinking about a choice as a tradeoff emphasizes how cost is an opportunity forgone.
1. Opportunity cost is the highest-valued alternative that we give up to get something.
2. The opportunity cost of attending college includes not only the money cost of books, tuition and (perhaps) room and board, but also the money income forgone from not being able to work full time, as well as the leisure time lost from studying nights and weekends.
E. People make choices at the margin. Making choices at the margin means people look at tradeoffs that arise from making small changes in an activity.
1. The benefit that arises from an increase in an activity is its marginal benefit.
2. The opportunity cost of an increase in an activity is its marginal cost.
3. Marginal benefit and marginal cost act as an incentive influencing people’s choices.
a. If the marginal benefit of an alternative exceeds the marginal cost, people have an incentive to do more of that activity.
b. If the marginal cost of an alternative exceeds the marginal benefit, people have an incentive to do less of that activity.
F. A change in the incentives people face changes the choices they make.
1. Economists can predict how people will choose based on understanding the incentives they face.
a. When the incentives facing the individual are in the social interest, their choices will promote the social interest.
b. When people make choices that are not in the social interest, they do so because they face the wrong incentives.
V. Economics is a Social Science
A. Economists distinguish between two types of statements about the world:
1. Positive statements make a claim about “what is” and can be tested to determine whether they are valid.
2. Normative statements make a claim of “what ought to be.” Such a statement is an opinion and cannot be tested for validity.
B. Economists build models
1. Economists observe and measure economic activity, build economic models, and test their models.
2. An economic model is a description of some aspect of the economic world that includes only those features of the world that are needed for the purpose at hand.
C. Economists test their models
1. An economic theory is a generalization that summarizes what we think we understand about the economic choices that people make and the performance of industries and entire economies.
D. Obstacles and Pitfalls in Economics
1. Ceteris Paribus means “other things being equal.” Economists try to isolate cause-and-effect relationship by changing only one variable at a time, and hold all other relevant factors unchanged.