ho macro ch01

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© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed.

c h a p t e r

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Prepared by: Fernando & Yvonn Quijano

Economics:Foundations and Models




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After studying thischapter, you should beable to:

Discuss these three importanteconomic ideas: People arerational. People respond toincentives. Optimal decisionsare made at the margin.

Discuss how an economyanswers these questions:What goods and services willbe produced? How will thegoods and services beproduced? Who will receivethe goods and services?

Understand the role of

models in economic analysis.

Distinguish betweenmicroeconomics andmacroeconomics.

Become familiar withimportant economic terms.

What Happens When U.S. FirmsMove to China?

L E A R N

I N G O

B J E C

T I V E S

1

2

3

4

5

Many U.S., Japanese, andEuropean firms have beenmoving the production ofgoods and services toother countries.




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Economics: Foundations and Models

In this book, we use economics to answer questions such as the following:

• “How are the prices of goods and services

determined?”

• “How does pollution affect the economy, and

how should government policy deal with theseeffects?”

• “Why do firms engage in international trade,

and how do government policies affectinternational trade?”

• “Why does government control the prices of

some goods and services, and what are theeffects of those controls?”




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Economics: Foundations and Models

Scarcity The situation in which unlimited wantsexceed the limited resources available to fulfillthose wants.

Economics The study of the choices peoplemake to attain their goals, given their scarceresources.

Economic model Simplified version of realityused to analyze real-world economic situations.




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Building a Foundation: Economics and Individual Decisions

LEARNING OBJECTIVE1

Market A group of buyers and sellers of a goodor service and the institution or arrangement by

which they come together to trade.

Marginal analysis Analysis that involves

comparing marginal benefits and marginal costs.

Three important ideas: People are rational

People respond to economic incentives

Optimal decisions are made at the margin




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Apple Computer Makes a Decision at the Margin

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LEARNING OBJECTIVE1

Should Apple produce an additional 300,000 iPods?

In solving the problem, consider the following:• Optimal decisions are made at the margin.

• An activity should be continued to the point

where the marginal benefit is equal to the

marginal cost.• In this case, the correct decision requires

information about additional revenue and

additional cost.


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The Economic Problem That Every Society Must Solve

LEARNING OBJECTIVE2

Trade-off The idea that because of scarcity,

producing more of one good or service means

producing less of another good or service.

Three fundamental questions:

What goods and services will be produced?

How will the goods and services be produced?

Who will receive the goods and servicesproduced?



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The Economic Problem That Every Society Must Solve

Centrally planned economy An economy in

which the government decides how economic

resources will be allocated.

Market economy An economy in which thedecisions of households and firms interacting inmarkets allocate economic resources.

Centrally Planned Economies versus Market Economies



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The Modern “Mixed” Economy

Mixed economy An economy in which

most economic decisions result from the

interaction of buyers and sellers in

markets, but in which the governmentplays a significant role in the allocation of

resources.



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The Modern “Mixed” Economy

Productive efficiency The situation in which a good or

service is produced at the lowest possible cost.

Allocative efficiency A state of the economy in which

production reflects consumer preferences; in particular,

every good or service is produced up to the point where the

last unit provides a marginal benefit to consumers equal to

the marginal cost of producing it.

Voluntary exchange The situation that occurs in marketswhen both the buyer and seller of a product are made better

off by the transaction.

Equity The fair distribution of economic benefits.

Efficiency and Equity



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Economic Models

LEARNING OBJECTIVE3

To develop a model, economists generally followthese steps:

1. Decide on the assumptions to be used in

developing the model.

2. Formulate a testable hypothesis.

3. Use economic data to test the hypothesis.

4. Revise the model if it fails to explain well the

economic data.

5. Retain the revised model to help answer

similar economic questions in the future.



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Economic Models

LEARNING OBJECTIVE3

The Role of Assumptions in Economic Models

Economic models make behavioral assumptions about the motivesof consumers and firms.

Forming and Testing Hypotheses in Economic Models

Economic variable Something measurable thatcan have different values, such as the wages of

software programmers.



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Economic Models

Positive analysis Analysis concerned withwhat is.

Normative analysis Analysis concerned with

what ought to be.

Normative and Positive Analysis

Don’t Confuse Positive Analysis with Normative Analysis

Does outsourcing by U.S. firmsraise or lower incomes in theUnited States?

When Economists Disagree: A Debate Over Outsourcing

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Microeconomics and Macroeconomics

LEARNING OBJECTIVE4

Microeconomics The study of howhouseholds and firms make choices, howthey interact in markets, and how thegovernment attempts to influence theirchoices.

Macroeconomics The study of theeconomy as a whole, including topics such as

inflation, unemployment, and economicgrowth.

LEARNING OBJECTIVE5



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A Preview of Important Economic Terms

LEARNING OBJECTIVE5

Entrepreneur

Innovation

Technology

Firm, company, or business

Goods

Services

Revenue

Opportunity cost

Profit

Household

Factors of production or

economic resources

Capital

Human capital



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Figure 1: Many countries, including the United States, have

experienced rapidly increasing exports to China.

The Halo Effect



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Allocative efficiency

Centrally planned economy

Economic model

Economic variable

Economics

Equity

MacroeconomicsMarginal analysis

Market

Market economy

Microeconomics

Mixed economy

Normative analysis

Positive analysis

Productive efficiency

ScarcityTrade-off

Voluntary exchange



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Appendix 1A: Using Graphs and Formulas

A graph is like a street map —

it is a simplified version of reality



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Graphs of One Variable 1A - 1

Bar Graphs and Pie Charts



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1A - 2

Time-Series Graphs

Graphs of One Variable



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Graphs of Two Variables

1A - 3Plotting Price and QuantityPoints in a Graph



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1A - 4Calculating the Slope of a Line

Graphs of Two Variables Slopes of Lines

Run

Rise

x

y

tal axishe horizonvalue on t Change in

l axishe verticavalue on t Change inSlope

Δ

Δ

2.0

10

2

)5565(

)14$12($

Δ

Δ

of pizzaQuantity

pizzaof Price Slope

A di A



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Graphs of Two Variables Taking Into Account More Than Two Variables on a Graph

1A - 5Showing Three Variableson a Graph

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Graphs of Two Variables Positive and Negative Relationships

1A - 6Graphing the Direct Relationshipbetween Income and Consumption

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Graphs of Two Variables

Slopes of Nonlinear Curves 1A - 7

The Slope of a Nonlinear Curve

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Formulas Formula for a Percentage Change

100xGDP

GDPGDP

2003

20032004

100x)periodfirsttheinValue

periodfirsttheinValue-periodsecondtheinValue(changePercentage

Using the growth of Gross Domestic Product(GDP) as an example:

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Formulas Formulas for the Areas of a Rectangle and a Triangle

1A - 8Showing a Firm’s Total Revenue on a Graph

heightxbaserectangleaof Area

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Formulas Formulas for the Areas of a Rectangle and a Triangle

1A - 9The Area of a Triangle

heightxbasextriangleaof Area 1/2

Appendi 1A



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Formulas Summary of Using Formulas

Whenever you must use a formula, you should follow these

steps:

1. Make sure you understand the economic concept

that the formula represents.

2. Make sure that you are using the correct formula

for the problem you are solving.

3. Make sure that the number you calculate using theformula is economically reasonable. For example,

if you are using a formula to calculate a firm’s

revenue and your answer is a negative number, you

know you made a mistake somewhere.

ho macro ch01

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