INTRODUCTION TO ECONOMICS

Barbulean

INSTRUCTIONAL METHOD Suggestions for the study of economics

Read the book before coming to classRecopy lectures and reread the book within

several hours of class Identify what you don’t understand

Ask questions in class Use the online study guide Visit the professor during office hours

DEFINITION OF ECONOMICS Mankiw’s definition

How Society manages its scarce resources Hedrick’s definition

How society chooses to allocate its scarce resources among competing demands to best satisfy human wants

Alternative definitionsEconomics is the study of choice.Economics is what economist do.Wikipedia's perspective

SCARCITY AND THE FUNDAMENTAL QUESTIONS OF ECONOMICS

Scarcity : Unlimited wants versus limited resources

Choices and tradeoffs Opportunity Costs All societies must answer these

questionsWhat is to be produced?How is to be produced?For whom will it be produced?

ECONOMICS AS A SCIENCE

The Scientific Method Observation →Hypothesis →Testing Observation: identifying and measuring important variables –

orderly loss of information Hypothesis: educated guesses about cause and effect with the

variables Theories Models: realism or usefulness

Testing: theories can’t be proven and are supported by repeated failed attempts to disprove them.

Microeconomics vs. Macroeconomics The Assumption of Rational Behavior

Boxes Example People respond to incentives Limits to the use of rational behavior (e.g. axe murders)

GREG MANKIW’S TEN PRINCIPLES OF

ECONOMIC THINKINGhttp://gregmankiw.blogspot.com/

CATEGORIES OF BASIC PRINCIPLES OF ECONOMICS How people make decisions? How people interact? How does the economy work overall?

HOW PEOPLE MAKE DECISIONS Principle #1 - People face tradeoffs

Time allocation – an example of tradeoffsProduction Possibilities FrontierEfficiency versus equity

HOW PEOPLE MAKE DECISIONS Principle #2 - The cost of something is

what you have to give up to get itOpportunity costs come from Von Weiser, a

German economist late 1800sOpportunity costs are independent of

monetary unitsTINSTAAFLThe real costs of going to college

HOW PEOPLE MAKE DECISIONS Principle #3 - Rational people think at

the marginRational or irrational decision-makingMarginal benefits and costs versus total

benefits and costsWeighing marginal costs and benefits leads

to maximizing net benefits (total welfare)

HOW PEOPLE MAKE DECISIONS Principle #4 –People respond to

incentivesReactions to changes in marginal benefits

and costs Increases (decreases) in marginal benefits

mean more (less) of an activity Increases (decreases) in marginal costs mean

less (more) of an activityExample of seat belts leading to increased

speedsExample of SUV (with child car seat) in

Issaquah

HOW PEOPLE INTERACT Principle #5 - Trade can make everybody

Society better offAdam Smith author of the “An Inquiry into the

Causes and Consequences of the Wealth of Nations” 1776

Gains from the division of labor and specialization

Mercantilists perspectivesExample of why Ellensburgians should trade

with others

HOW PEOPLE INTERACT Principle #6 - Markets are usually a good

way of organizing economic activityFeudal times and haciendas in the new worldThe power of trade: cooperation versus conflictMarkets: prices and quantities traded, typical

and abstract

HOW PEOPLE INTERACT Principle #6 - Markets are usually a

good way of organizing economic activity creativity and productivity and resource allocation“Failure” of centrally planned economies “set it and forget it” becomes “compete or

be obsolete”

HOW PEOPLE INTERACT Principle #7 Governments can

sometimes improve market outcomesMarket signals can fail to allocate resources

efficiently or equitablyPublic goods, the exclusion principle, the

free-rider problem and non-rival consumption

External costs and benefitsExamples: vaccines, education, pollution

HOW PEOPLE INTERACT Principle #7 Governments can

sometimes improve market outcomesEquitable or fair distribution of resources Efficiency and equity: the pie analogyGovernment Failure: is government

intervention always the proper solution?

HOW THE ECONOMY WORKS AS A WHOLE

Principle # 8 – A country’s standard of living depends upon its ability to produce goods and services Adam Smith’s “An Inquiry into the Nature and

the Consequences of the Wealth of Nations”Materialism – more toys mean more welfarewealth: a necessary or sufficient condition for

happiness (are rich people happier, children with lots of toys)

HOW THE ECONOMY WORKS AS A WHOLE Principle # 8 – A country’s standard of

living depends upon its ability to produce goods and services leisure time and productivity the factors of production: land or natural

resources, labor, capital, entrepreneurship technology and productivity the Rule of 72 and growth rates

HOW THE ECONOMY WORKS AS A WHOLE Principle #9 – The general level of prices

rises when the government prints and distributes too much moneyDefinition of money, and economic

language

HOW THE ECONOMY WORKS AS A WHOLE Principle #9 – The general level of prices

rises when the government prints and distributes too much moneyExamples: “Not worth a continental” and

ArgentinaEstablish of the Federal Reserve and the

introduction of sustained inflation in the US

HOW THE ECONOMY WORKS AS A WHOLE Principle #10 – Society faces a short-run

tradeoff between inflation and unemploymentShort-run and the long-runDemand and supply shocksShort-run increases (decreases) in output

above (below) long-run potential output lead to adjustments

THE CONCEPT OF OPPORTUNITY COST Opportunity cost of any choice

What we forego when we make that choice

Most accurate and complete concept of cost

Direct money cost of a choice may only be a part of opportunity cost of that choice

Opportunity cost of a choice includes both explicit costs and implicit costs

Explicit cost—dollars actually paid out for a choice

Implicit cost—value of something sacrificed when no direct payment is made

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OPPORTUNITY COST AND SOCIETY

All production carries an opportunity costTo produce more of one thing

Must shift resources away from producing something else

The Principle of Opportunity CostThe concept of opportunity cost sheds light

on virtually every problem that economists study, whether it be explaining the behavior of consumers or business firms or understanding important social problems like problems like poverty or racial discrimination

Basic Principle #2: Opportunity CostAll economic decisions made by individuals

or society are costlyThe correct way to measure the cost of a

choice is its opportunity cost—that which is given up to make the choice

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FIGURE 1: THE PRODUCTION POSSIBILITIES FRONTIER

24

Number of Lives Saved per Period

Quantity of All Other Goods

per Period

100,000 200,000 300,000 400,000 500,000

1,000,000950,000850,000

700,000

500,000400,000

BA

C

D

E

F

W

At point A, all resources are used for "other goods."

Moving from point A to point B requires shifting resources out of other goods and into health care.

At point F. all resources are used for health care.

INCREASING OPPORTUNITY COST According to law of increasing opportunity costThe more of something we produce

The greater the opportunity cost of producing even more of it

This principle applies to all of society’s production choices

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RECESSIONS A slowdown in overall economic activity

when resources are idle Widespread unemployment Factories shut down

Land and capital are not being used An end to the recession would move

the economy from a point inside its PPF to a point on its PPF

Using idle resources to produce more goods and services without sacrificing anything

Can help us understand an otherwise confusing episode in U.S. economic history

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RECESSIONS During early 1940s, standard of living in U.S.

did not decline as we might have expected but actually improved slightly. Why?

U.S. entered World War II and began using massive amounts of resources to produce military goods and services

Instead of pitting “health care” against “all other goods,” we look at society’s choice between military goods and civilian goods

U.S. was still suffering from the Great Depression when it entered WWII

Joining war effort helped end the Depression and moved economy from a point like A, inside the PPF, to a point like B, on the frontier

Military production increased, but so did the production of civilian goods

Although there were shortages of some consumer goods Overall result was a rise in the material well-being of the

average U.S. citizen War is only one factor that can reverse a downturn No rational nation would ever choose war as an economic policy

designed to cure a recession Alternative policies that virtually everyone would find

preferable 27

FIGURE 2: PRODUCTION AND UNEMPLOYMENT

28

A

B

Civilian Goods per Period

Military Goods per Period

2. then moved to the PPF during the war. Both military and civilian production increased.

1. Before WWII the United States operated inside its PPF . . .

ECONOMIC GROWTH If economy is already operating on its PPF

Cannot exploit opportunity to have more of everything by moving to it

But what if the PPF itself were to change? Couldn’t we then produce more of everything? This happens when an economy’s productive capacity

grows Many factors contribute to economic growth, but

they can be divided into two categories Quantities of available resources—especially capital—can

increase An increase in physical capital enables economy to produce

more of everything that uses these tools More factories, office buildings, tractors, or high-tech medical

equipment Same is true for an increase in human capital

Skills of doctors, engineers, construction workers, software writers, etc.

Technological change enables us to produce more from a given quantity of resources

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ECONOMIC GROWTH Increases in capital and technological

change often go hand in hand For instance, PET body scanners will enable

us to save even more lives than our current set of resources Moving horizontal intercept of PPF rightward, from

F to F‘ Impact of PET scanners stretches PPF outward

along horizontal axis How can a technological change in

lifesaving enable us to produce more goods in other areas of the economy? Society can choose to use some of increased

lifesaving potential to shift other resources out of medical care and into production of other things Because of technological advance and new capital, we

can shift resources without sacrificing lives30

ECONOMIC GROWTH If we can produce more of the things

that we value, without having to produce less of anything else, have we escaped from paying an opportunity cost?Yes . . . and noFigure 3 tells only part of story

Leaves out steps needed to create this shift in the PPF

For example, technological innovation doesn’t just “happen”—resources must be used to create it Mostly by research and development (R&D)

departments of large corporations In order to produce more goods and

services in the future, we must shift resources toward R&D and capital productionAway from production of things we’d

enjoy right now31

FIGURE 3: THE EFFECT OF A NEW MEDICALTECHNOLOGY

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Number of Lives Saved per Period

Quantity of All Other Goods

per Period

300,000 500,000 600,000

1,000,000

700,000

A

J

D

H

F

1. A technological advance in saving lives increases this PPF's horizontal intercept . . .

4. or more lives saved and greater production of other goods.

3. The economy can end up with more lives saved and un-changed production of other goods . . .

2. But not its vertical intercept.

F'

EFFICIENCY In production, we’d like to have

productive efficiency – achieving as much output as possible from a given amount of inputs or resources.

Efficiency involves achieving a goal as cheaply as possible.

Efficiency has meaning only in relation to a specified goal.

EFFICIENCY Any point within (INSIDE) the production

possibility curve represents inefficiency.

Inefficiency – getting less output from inputs which, if devoted to some other activity, would produce more output.

Unattainable -Any point outside the production possibility curve represents something unattainable, given present resources and technology.

EFFICIENCY AND INEFFICIENCY

Gun

s

10

8

6

4

2

0 2 4 6 8 10

Butter

C D

A

B

Efficientpoints

Inefficientpoint

Unattainable point, given available technology, resources and labor force

TOM’S TRADE-OFFS: THE PRODUCTION POSSIBILITY FRONTIER

SHIFTS IN THE PRODUCTION POSSIBILITY CURVE Society can produce more output if:

Technology is improved.More resources are discovered.Economic institutions get better at fulfilling

our wants.

ECONOMIC GROWTHEconomic growth results in an outward shift of the PPF because production possibilities are expanded.

The economy can now produce more of everything.

Production is initially at point A (20 fish and 25 coconuts), it can move to point E (25 fish and 30 coconuts).

Neutral Technological Change

Butter

A

B Guns0

SHIFTS IN THE PRODUCTION POSSIBILITY CURVE

C

D

Biased Technological Change

SHIFTS IN THE PRODUCTION POSSIBILITY CURVE

0

B

A

Butter

Guns

C

SPECIALIZATION AND EXCHANGE

Specialization Method of production in which each person

concentrates on a limited number of activities Exchange

Practice of trading with others to obtain what we want

Allows for Greater production Higher living standards than otherwise possible

All economics exhibit high degrees of specialization and exchange

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FURTHER GAINS TO SPECIALIZATION Absolute Advantage: A Detour

Ability to produce a good or service using fewer resources than other producers use

Comparative Advantage If one can produce some good with a

smaller opportunity cost than others can Total production of every good or service

will be greatest when individuals specialize according to their comparative advantage

Another reason why specialization and exchange lead to higher living standards than self-sufficiency 42

RESOURCE ALLOCATION Problem of resource allocation

Which goods and services should be produced with society’s resources?

Where on the PPF should economy operate? How should they be produced?

No capital at all Small amount of capital More capital

Who should get them? How do we distribute these products among

the different groups and individuals in our society?

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THE THREE METHODS OF RESOURCES ALLOCATION Traditional Economy

Resources are allocated according to long-lived practices from the past

Command Economy (Centrally-Planned)Resources are allocated according to

explicit instructions from a central authority Market Economy

Resources are allocated through individual decision making

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THE NATURE OF MARKETS A market is a group of buyers and sellers with the potential to trade with each otherGlobal markets

Buyers and sellers spread across the globe

Local marketsBuyers and sellers within a

narrowly defined area

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THE IMPORTANCE OF PRICES A price is the amount of money that

must be paid to a seller to obtain a good or service

When people pay for resources allocated by the marketThey must consider opportunity cost to

society of their individual actions Markets can create a sensible allocation

of resources

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RESOURCE ALLOCATION IN THE UNITED STATES Numerous cases of resource

allocation outside the marketSuch as families

Various levels of government collect about one-third of our incomes as taxesEnables government to allocate resources

by command Government uses regulations of

various types to impose constraints on our individual choice

The market is the dominant method of resource allocation in United StatesHowever, it is not a pure market

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RESOURCE OWNERSHIP Communism

Most resources are owned in common

SocialismMost resources are owned by state

CapitalismMost resources are owned privately

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TYPES OF ECONOMIC SYSTEMS An economic system is composed of two featuresMechanism for allocating resourcesMarketCommand

Mode of resource ownershipPrivateState

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FIGURE 4: TYPES OF ECONOMIC SYSTEMS

50

Resource Allocation

Market Command

Private

State

Resource Ownership

Market Capitalism

Centrally Planned

Capitalism

Centrally Planned

Socialism

Market Socialism

TRANSACTIONS: THE CIRCULAR-FLOW DIAGRAMTrade takes the form of barter when people directly exchange goods or services that they have for goods or services that they want.

The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle.

CIRCULAR-FLOW OF ECONOMIC ACTIVITIESA household is a person or a group of people that share their income.

A firm is an organization that produces goods and services for sale.

Firms sell goods and services that they produce to households in markets for goods and services.

Firms buy the resources they need to produce—factors of production—in factor markets.

Factor Market- A market used to exchange the services of a factor of production: labor, capital, land , and entrepreneurship.

THE CIRCULAR-FLOW DIAGRAM

FACTOR MARKET Factor markets, also termed resource

markets, exchange the services of factors, NOT the factors themselves. For example, the labor services of workers are exchanged through factor markets NOT the actual workers. Buying and selling the actual workers is not only slavery (which is illegal) it's also the type of exchange that would take place through product markets, not factor markets. More realistically, capital and land are two resources than can be and are legally exchanged through product markets. The services of these resources, however, are exchanged through factor markets. The value of the services exchanged through factor markets each year is measured as national income.

THE CIRCULAR FLOW

Goods

Other countries

Financial markets

GovernmentFirms

(production)HouseholdTaxes

Factor services

SavingsImports

Government

Spending

Wages, rents, interest, profits

ExportsInvestment

Personal consumption

GROWTH IN THE U.S. ECONOMY FROM 1962…

…TO 1988