1. 1 Topic 1 - What is Economics Topic 1: What is Economics

2. 2 What is this class about? People make choices as they try to attain their goals. Choices are necessary because we live in a world of scarcity. Scarcity: A situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economics is the study of the choices people make to attain their goals, given their scarce resources. Economists study these choices using economic models, simplified versions of reality used to analyze real-world economic applications.

3. 3 Some typical “economics” questions We will learn how to answer questions like these: o How are the prices of goods and services determined? o How does pollution affect the economy, and how should government policy deal with these effects? o Why do firms engage in international trade, and how do government policies affect international trade?

4. 4 What do Economists do? Economists influence most economic policies concerning taxes, interest rate, etc. Economists study how people make decisions: how much households and firms work, what they buy, how much they save and how the y invest their savings. Economists also study how people interact with one another and how the government interacts with each other. Economists may be asked to explain the causes of economic events, or to recommend policies to improve economic outcomes.

5. 5 Three Key Economic Ideas We interact with one another in markets. Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. In analyzing markets, we generally assume: 1.People are rational 2.People respond to economic incentives 3.Optimal decisions are made at the margin

6. 6 1. People are rational Economists generally assume that people are rational. Rational: Using all available information to achieve your goals. Rational consumers and firms weigh the benefits and costs of each action, and try to make the best decision possible. Example: Apple doesn’t randomly choose the price of its smartwatches; it chooses the price(s) that it thinks will be most profitable.

7. 7 2. People respond to economic incentives As incentives change, so do the actions that people will take. Example: People go to university to get better educated to get better jobs to make more income to consume more good.

8. 8 3. Optimal decisions are made at the margin While some decisions are all-or-nothing, most decisions involve doing a little more or a little less of something. Example: Should you watch an extra hour of TV, or study instead? Economists think about decisions like this in terms of the marginal cost and benefit (MC and MB): the additional cost or benefit associated with a small amount extra of some action. Comparing MC and MB is known as marginal analysis.

9. 9 The Economic Problem That Every Society Must Solve 9 Discuss how an economy answers these questions: o What goods and services will be produced? o How will the goods and services be produced? o Who will receive the goods and services produced? In a world of scarcity, we have limited economic resources to satisfy our desires. Trade-off: The idea that, because of scarcity, producing more of one good or service means producing less of another good or service.

10. 10 We Must Understand Resource Categories Resources are divided into 4 main categories (payment are listed in brackets). o Land: all natural resources. (RENT) o Labour: Requires a fundamentally scarce resource (WAGES) o Capital: (INTEREST) Physical Capital: buildings, machinery tools, etc. Human capital: knowledge & skills that people develop o Enterprise or entrepreneurial ability (PROFIT)

11. 11 1. What goods and services will be produced? Individuals, firms, and governments must decide on the goods and services that should be produced. An increase in the production of one good requires the reduction in the production of some other good. This is a trade-off, resulting from the scarcity of productive resources. 11

12. 12 2. How will the goods be produced? A firm might have several different methods for producing its goods and services. Example #1: A music producer can make a song sound good by o hiring a great singer, and using standard production techniques; o Hiring a mediocre singer, and using Auto-Tune to correct the inaccuracies. Example #2: As the cost of manufacturing labor changes, a firm might respond by hanging its production technique to one that employs more machines and fewer workers Firm could also move to new location

13. 13 3. Who will receive the goods and services produced? In most countries, people with higher incomes obtain more goods and services. Changes in tax and welfare policies change the distribution of income; though people often disagree about the extent to which this “redistribution” is desirable.

14. 14 Types of economies Centrally planned economy: The government decides how economic resources will be allocated. Market economy: The decisions of households and firms interacting in markets allocate economic resources. Mixed economy: Most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources.

15. 15 Economic Models Economists develop economic models to analyze real-world issues. Building an economic model often follows these steps: 1.Decide on the assumptions to use 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 the economic data well. 5.Retain the revised model to help answer similar economic questions in the future.

16. 16 Positive and normative analysis Economists try to mimic natural scientists by using the scientific method. But economics is a social science; studying the behavior of people is often tricky. When analyzing human behavior, we can perform: Positive analysis: analysis concerned with what is Normative analysis: analysis concerned with what ought to be Economists mostly perform positive analysis.

17. 17 Efficiency of economies Market economies tend to be more efficient than centrally- planned economies. Market economies promote: Productive efficiency, where goods or services are produced at the lowest possible cost; and Allocative efficiency, where production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it.

18. 18 Sources of economic efficiency Productive efficiency comes about because of competition. Allocative efficiency arises due to voluntary exchange. Voluntary exchange: A situation that occurs in markets when both the buyer and the seller of a product are made better off by the transaction. Each transaction that takes place improves the well-being of the buyer and seller; transactions continue until no further improvement can take place.

19. 19 Caveats about market economies Markets may not result in fully efficient outcomes. For example: People might not immediately do things in the most efficient way Governments might interfere with market outcomes Market outcomes might ignore the desires of people who are not involved in transactions – ex: pollution Economically efficient outcomes may not be the most desirable. Markets result in high inequality; some people prefer more equity, i.e. fairer distribution of economic benefits. We can talk about efficiency versus equity

20. 20 Microeconomics and Macroeconomics Microeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

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22. 22 Preview of Important Economic Terms Like all fields of study, economics uses terms or jargon with specific, precise meanings. Sometimes these terms will be used in ways that differ even from closely related disciplines. Examples: Technology: the processes a firm uses to produce goods and services Capital: manufactured goods that are used to produce other goods and services CETERIS PARIBUS (assumption) - Translated from the Latin as all other things being equal or holding everything else constant. Pay close attention to terms defined in class and in the textbook!

23. 23 Scarcity and trade-offs CETERIS PARIBUS (assumption) - Translated from the Latin as all other things being equal or holding everything else constant. Scarcity: a situation in which unlimited wants exceed the limited resources available to fulfill those wants. Scarcity requires trade-offs. Economics teaches us tools to help make good trade-offs.

24. 24 Opportunity Cost The highest-valued alternative given up in order to engage in some activity is known as the opportunity cost. Example: the opportunity cost of increased funding for space exploration might be giving up the opportunity to fund cancer research.

25. 25 Production Possibilities Frontiers and Opportunity Costs A production possibilities frontier (PPF) is a curve showing the maximum attainable combinations of two goods that can be produced with available resources and technology. Question: Is the PPF a positive or normative tool? Answer: Positive; it shows “what is”, not “what should be”.

26. 26 http://image.slidesharecdn.com/productionpossibilityfrontier-150509220414-lva1-app6892/95/production-possibility-frontier-revision- presentation-9-638.jpg?cb=1431209111

27. 27 Economic growth Shifts in the production possibilities frontier represent economic growth. Economic growth: the ability of the economy to increase the production of goods and services.

28. 28 Making the Connection: A PPF for exam grades Suppose you have a limited amount of time to study for two exams, Economics and Accounting. What would the production possibilities curve for the exam grades look like? 1.A straight line, like the PPF for sedans and SUVs, or 2.A bowed-outward curve, like the PPF for tanks and automobiles? Answer: 2, the first hour spent studying economics is much more valuable (and has a lower opportunity cost) than the last hour.

29. 29 The Market System Two key groups participate in the modern economy: Households consist of individuals who provide the factors of production: labor, capital, natural resources, and entrepreneurial ability. Households receive payments for these factors by selling them to firms in factor markets. Firms supply goods and services to product markets; households buy these products from the firms.

30. 30 Circular Flow Model

31. 31 Brief Introduction to trade Absolute advantage: The ability of an individual, firm or country to produce more of a good or service than competitors using the same amount of resources. – Comparative advantage: The ability of an individual, firm or country to produce a good or service at a lower opportunity cost than other producers. Refer to Handout: Absolute and Comparative Advantage

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