What is Economics ? (Why does economics exist?)

Problem 1. Human Beings have unlimited wants for goods and services.

Problem 2. Resources (which are used to produce goods and services) are Limited

Example: You have a limited income (your resources), but could always want more goods & services than you do now.

The Economic problem is Scarcity…• Scarcity is the imbalance between: the unlimited wants of humans and

the limited means to satisfy those wants

Individual choice: The core of Economics• An Economy is: a mechanism through which

the use of land, labor, and capital are organized...

...in an attempt to satisfy the unlimited wants of it's members.

• Economics is...

1. the study of how individuals, groups, and countries use their limited resources in an attempt to satisfy their unlimited wants.

2. Economics is the study of how individuals, groups, and countries make choices in attempting to satisfy their unlimited wants.

Why make choices?• You can never get everything you desire because of

limited resources (i.e. income, wealth, time, etc.). This means that one must choose among many different possible alternatives

• This means that we could have done something elsesomething else with our time or with our income.– In other words we must always give up some other we must always give up some other

alternativealternative to get something else.• This is called: Opportunity cost, Opportunity cost, ((the cost of making a

choice) it is measured as the sacrifice of the next best alternative given up by a person, group, or nation.– It could be the amount of money you give up to get a good

or service but opportunity cost can be in terms of time or other measure.

– It is also, for the most part, subjective. That is it is measured by the person making the choice.

– “ There is no such thing as a free lunch”

Decision Making: Marginal AnalysisHow can individuals, business firms, and nations use our

resources and capabilities to make us as well off as possible?

Fact: People & Businesses usually exploit opportunities to make themselves better off.

Economists use the concept of opportunity cost as a way to visualize these decisions:

1. There is an opportunity cost to everything we do2. Therefore, a benefitbenefit (the opposite of cost) to

everything we do must exist and this is measured by what we are willing to give up.at we are willing to give up.

Since decisions are rarely all or nothing, this comparison of benefits and costs determine how much of something we choose to have.

This is referred to as a trade-off.

Decision Making: Marginal Analysis• Moreover, you will only be concerned with the additional

benefits and additional costs from your current situation.– Because there is nothing you can do about past costs and

benefits (called sunk costs).• The decision rule is simple: pursue an action where the

additional benefits are greater or equal toare greater or equal to the additional costs of an action.– It is called marginal analysis because this is the name

economists give to the words: additional, next, extra, small change.

– In fact you will choose an action or alternative until the marginal benefit = marginal cost (this will fully exploit the opportunity presented to you).

• Example: The choice of going to college.– All of you decided the marginal benefit of going to

college was higher than the marginal cost of going to college.

• Example: How many classes do you plan to take in the Fall?– The marginal cost of a class is tuition, books, time.– The marginal benefit for each class is more knowledge

gained and closer to graduation.• You are probably taking more than 1 class but less than 6. • At some point the marginal benefit of taking another class

diminishes while the marginal cost is constant.• Eventually, taking that 3rd, 4th, 5th, or 6th class is “no

longer worth it” compared to the cost.• At the point where marginal benefit = marginal cost for you

what determines the amount of classes you will take. • Much of the material covered in Microeconomics is based

on comparing marginal benefits & marginal costs

Decision Making: Marginal Analysis

• It shows how the market-capitalist system answers the following three fundamental questions: (which every economy faces these because of Scarcity)

Microeconomics takes a close look at how individuals and firms make choices

What to Produce?

How to Produce?

For Whom to Produce?

Interaction: How Economies work• Interaction of choices: My choices affect your choices

and vice versa. Results are often different from intentions.

5 Principles underlying interaction of individual choice

1. There are gains from trade

2. Markets move toward equilibrium

3. Resources should be used as efficiently as possible to achieve individual, group, or a countries goals

4. Markets usually lead to efficiency

5. If markets don’t achieve efficiency, government intervention may improve the well being of participants in the economy (called the welfare of society)

Interaction: How Economies work• There are gains from trade

– by providing goods to others and receiving goods from others, all can be made better off.

– This occurs because specialization improves productivity (each person does what he is best at) and we exchange our surplus

• Markets move toward equilibrium− equilibrium means at rest or no tendency to change− people & businesses will exploit opportunities until they can’t be made any better off. This will be an equilibrium.

“I hunt and she gathers – otherwise we couldn’t make ends meet.”

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Interaction: How Economies work• Resources should be used as efficiently as possible to

achieve individual, group, or a countries goals.– they are used to fully exploit all opportunities to make

everyone better off.– this means that if we are operating efficiently it will be

impossible to make one better off unless we make someone worse off.

– Other measurement of well being – equity. This is very difficult to measure, but to gain equity we usually must sacrifice some efficiency.

• Markets usually lead to efficiency– voluntary trade is done for mutual gain, as long as gains

exist people will exploit them• If markets don’t achieve efficiency, government

intervention may improve the well being of participants in the economy (called the welfare of society)

• The study of how choices of households, businesses, and governments affect the aggregate (total) economy.

• Three large issues of Macroeconomics:

1. Standard of Living - level of consumption of goods and services people enjoy. (Issue of: Full (Issue of: Full Employment)Employment)

Relationship between: Economic growthEconomic growth and Unemployment.

Productivity : Total Production / Number employed

2. The cost of Living - number of dollars it takes to buy goods and services for a given standardgiven standard of living.

Inflation and Price StabilityPrice Stability : Quantity of Money

3. Economic Fluctuations - the periodic rise and fall of total production in the economy, called the business cycle

Recessions and Expansions affecting Unemployment & Inflation:

Macroeconomics

Economy wide InteractionsPrinciples that underlie Economy wide transactions1. One person’s spending is another person’s income

When spending on a particular good or type of good increases, the income of resources producing that good increases.

2. Overall spending sometimes gets out of line with the economy’s productive capacityFluctuations in spending in the economy leads to the

business cycle with periodic recessions (a lack of spending compared to the ability to produce goods & services) and inflations (too much spending compared to the ability to produced goods & services)

3. Government policies can change spendingActions of the President, Congress, and the Federal

Reserve can influence spending.Macroeconomic policymaking

An Introduction in reading and using Graphs

Graphs• Graphs are pictures that show the

relationship between two variables

• A variable is something that can take on more than one value.

• There are two ways that variables can be related:

1) Positive relationship: variables move in the same direction

2) Negative relationship: variables move in the opposite direction

Example: Positive or Direct relationship

Miles driven in a car and the total amount of gasoline used

As you drive more you will use up more gasoline.

Miles Driven Gasoline used (gallons)

200 10 400 20 600 30 800 40

Miles Driven

200

400

600

800

0 Gallons of gasoline used10 20 30 40

A graph always starts with labeling the verticaland horizontal axis with the variables(numbering is usually optional)

Miles Gasoline used Driven (gallons) 200 10 400 20 600 30 800 40

Next, we plot the points from our table...

Then we connect the dots to represent other possible observations and to describe the relationship

The graph is read by moving to the right on the horizontal axis.....

...and then moving vertically until you hit the relationship line.

Miles Driven

Gallons of gasoline used

200

400

600

800

0 10 20 30 40

Miles Gasoline used Driven (gallons) 200 10 400 20 600 30 800 40

If we want more detailed information about this relationship we can calculate the slope of the line

Slope = Change in vertical distanceChange in horizontal distance

= Rise Run

= 200 miles

10 gallons

= 20 miles gallon

200 miles

10 gallons

This relationship line is constructed “all things equal”

• Are there other variables could affect the amount of gasoline a car would use for the same amount of miles driven?

Tire inflation Weather conditions a well tuned engine amount of weight in car or towing• If a car is driven is cold weather it will use more

gas for same miles driven• How will this affect the relationship line we have

drawn?

Miles Driven

Gallons of gasoline used

200

400

600

800

0 10 20 30 40

Miles Gasoline used Gasoline used Driven (gallons) (gallons) 200 10 12 400 20 24 600 30 36 800 40 48

Use more gas more same amount of miles driven...

Adding the variable driving in cold weather has caused the curve to Shift Position!

When a third(or more) variable is included in a model it causes the entire curve to shift.

This curve also shows a positive relationship, except it is a not a straight line.

The slope of a curved line changes at every point on that curve.

you should be able to tell how the slope of the line changes as we move away from the origin.

Dealing with curves

Production of Cars

Cost of Next car

Any time a line gets steeper, the slope is getting larger

Interpretation:As production gets larger the same increase in production leads to greater increases in costs than before.

Production of Autos

Amount of Workers

Here is a positive relationship where Y increases but at a smaller rate as X increases.

Interpretation:As more workers are added the same increase in workers leads to smaller increases in production.

Dealing with curves

The Difference Between a Line and a Curve

Equal increments in Equal increments in XX lead to diminished lead to diminished increases in increases in YY..

Equal increments in Equal increments in XX lead to constant lead to constant increases in increases in YY..

Negative or Inverse relationship

• Two Variables move in the opposite direction

• Example: Birthrate and Family income

• As Family income increases the Birthrate tends to decline

Birthrate(averageper family)

Family Income (average per family)0

A negative relationship shows a downward sloping line

A

B

c

d

e f

When we move to the right on the horizontal axis, the relationship line tells us we must move down the vertical axis.

Y

XHere is a case of a negative relationship that is not a straight line

Interpretation:As X gets larger the same increase in X leads to Y decreasing in greater amounts than when X was smaller

Dealing with curves

Y

X

…as X increases, Y does not changeThis means that Y is independent of X and vice versa.A straight horizontal or vertical line indicate no relationship between the two variables.

A Graph that shows no relationship between the two variables...

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This is a time series graph. It shows how a variable performs over time. This graph shows Mortgage rates 1976-2009

1. All economic analysis is based on a list of basic principles. These principles apply to three levels of economic understanding. First, we must understand how individuals make choices; second, we must understand how these choices interact; and third, we must understand how the economy functions overall.

2. Everyone has to make choices about what to do and what not to do. Individual choice is the basis of economics.

3. The reason choices must be made is that resources—anything that can be used to produce something else—are scarce.

4. Because you must choose among limited alternatives, the true cost of anything is what you must give up to get it— all costs are opportunity costs.

Summary

5. Many economic decisions involve questions not of “whether” but of “how much. Such decisions must be taken by performing a trade-off at the margin—by comparing the costs and benefits of doing a bit more or a bit less. Decisions of this type are called marginal decisions, and the study of them, marginal analysis, plays a central role in economics.

6. The study of how people should make decisions is also a good way to understand actual behavior. Individuals usually exploit opportunities to make themselves better off. If opportunities change, so does behavior: people respond to incentives.

7. Interaction—that my choices depend on your choices, and vice versa, adds another level to economic understanding.

Summary

8. The reason for interaction is that there are gains from trade: by engaging in the trade of goods and services with one another, the members of an economy can all be made better off. Underlying gains from trade are the advantages of specialization, of having individuals specialize in the tasks they are good at.

9. Economies normally move toward equilibrium—a situation in which no individual can make himself or herself better off by taking a different action.

10. An economy is efficient if all opportunities to make some people better off without making other people worse off are taken. Efficiency is not the sole way to evaluate an economy: equity, or fairness, is also desirable. There is often a trade-off between equity and efficiency.

Summary

11. Markets usually lead to efficiency, with some well-defined exceptions.

12. When markets fail and do not achieve efficiency government intervention can improve society’s welfare.

13. One person’s spending is another person’s income.

14. Overall spending in the economy can get out of line with the economy’s productive capacity, leading to recession or inflation.

15. Governments have the ability to strongly affect overall spending, an ability they use in an effort to steer the economy between recession and inflation.

Summary