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Chapter 1 ©2010  Worth Publishers First Principles Slides created by Dr. Amy Scott.

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1 Chapter 1 ©2010  Worth Publishers First Principles Slides created by Dr. Amy Scott

2 One must choose To understand how an economy works, you need to understand more than how individuals make choices. Common Ground Through the study of economics, we will discover common principles about individual choice and interaction.

3 1.What is Economics? 2.Three Principles A.Individual Choice A set of principles for understanding the economics of how individuals make choices B.Choice Interaction A set of principles for understanding how individual choices interact C.Economy-wide Interaction A set of principles for understanding economy-wide interactions Chapter Objectives

4 What is Economics?  Economics: social science that studies the production, distribution and consumption of goods and services from the Greek oikonomia meaning administration or management of a household  Economy: system for coordinating society’s productive activities  Market economy: an economy in which decisions about production and consumption are made by individual producers and consumers

5 Learning the Language of Economics: Definitions  Microeconomics: branch of economics concerned with how people make decisions and how these decisions interact  Macroeconomics: branch of economics concerned with the overall economy  Market failure: when individual pursuits of self-interest lead to bad results for society

6 Learning the Language of Economics: More Definitions  Invisible hand: Refers to the idea that individual pursuit of self-interest can lead to good results for society as a whole  Adam Smith 1776 An Inquiry into the Nature and Causes of the Wealth of Nations “ It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”  Recession: a downturn in the economy  Economic growth: growing ability of the economy to produce goods and services

7 1. The pursuit of one’s own self-interest sometimes results in market failure. 2. The invisible hand harnesses the power of self-interest for the good of society 3. A central authority makes decisions about production and consumption. 4. Growth in a market economy is steady and without fluctuations. Which of the following statements describe features of a market economy?

8 Three Principles: Principle #1: Individual Choice  Individual choice is the decision by an individual of what to do, which necessarily involves a decision of what not to do  Basic principles behind the individual choices: A.Resources are scarce. B.The real cost of something is what you must give up to get it. C.“How much?” is a decision at the margin. D.People take advantage of opportunities to make themselves better off.

9 Basic Principles of Individual Choice Resources  A resource is anything that can be used to produce something else.  Ex.: Land, labor (time of workers), capital (machines)  Resources are scarce – the quantity available is not large enough to satisfy all productive uses.  Ex.: Petroleum, lumber, intelligence

10 Basic Principles of Individual Choice: Opportunity Cost  The real cost of an item is its opportunity cost: what you must give up in order to get it.  Also defined as the value of the next best alternative.  Opportunity cost is crucial to understanding individual choice: Ex.: The cost of attending the economics class is what you must give up to be in the classroom during the lecture. Sleep? Watching TV? Rock climbing? Work? All costs are ultimately opportunity costs. LeBron James understood the concept of opportunity cost.

11 Basic Principles of Individual Choice Opportunity Cost (Continued)  Opportunity cost is about what you have to forgo to obtain your choice.  The bumper stickers that say “I would rather be … (fishing, golfing, swimming, etc…)” are referring to the “opportunity cost.”  The opportunity cost of attending college is high: it’s the cost of tuition and housing plus the forgone salary you could have earned. I WOULD RATHER BE SURFING THE INTERNET

12  At many cash registers there is a little basket full of pennies. People are encouraged to use the basket to round their purchases up or down.  If it’s too small a sum to worry about, why calculate prices that exactly? Why do we have pennies?  Sixty years ago, a penny was equivalent to 30 seconds worth of work—it was worth saving a penny if doing so took less than 30 seconds. But wages have risen along with overall prices. Today a penny is therefore equivalent to just over 2 seconds of work—and so it’s not worth the opportunity cost of the time it takes to worry about a penny more or less.  The rising opportunity cost of time in terms of money has turned a penny from a useful coin into a nuisance. Got a Penny?

13 Basic Principles of Individual Choice Marginal Analysis  You make a trade-off when you compare the costs with the benefits of doing something.  Many decisions are not “either-or” but instead “how much.”  Some of you may decided not to study for the economics exam but many of you will decide to study. The question is how much: five hours, eight hours or seventeen hours?  Decisions about whether to do a bit more or a bit less of an activity are marginal decisions.

14 Basic Principles of Individual Choice Marginal Analysis (continued)  Making trade-offs at the margin: comparing the costs and benefits of doing a little bit more of an activity versus doing a little bit less.  Ex.: Studying one more hour, eating one more cookie, buying one more CD, etc.  The study of such decisions is known as marginal analysis.

15 Basic Principles of Individual Choice Exploiting Opportunities  People usually take advantage of opportunities to make themselves better off.  People respond to incentives.  Ex.: If the price of parking in Manhattan rises, commuters who can find alternative ways to get to their job will save money.  Incentives: anything that offers rewards to people who change their behavior.

16  A few years ago, some Florida schools offered actual cash bonuses to students who scored high on the state’s standardized exams.  Why?  To motivate the students to take the exams as seriously as the school administrators did (Florida introduced a pay-for-performance scheme for schools: schools whose students earned high marks on the state exams received extra state funds).  Did it work?  Yes. Some Florida schools that have introduced rewards for good grades on state exams report substantial improvements in student performance. Pay for Grades?

17  In 1900, only 6 percent of married women worked for pay outside the home.  By 2005, the number was about 60 percent. This change is in part due to changing attitudes, invention, and the growing availability of home appliances, especially washing machines.  In pre-appliance days, the opportunity cost of working outside the home was very high: it was something women typically did only in the face of dire financial necessity.  With modern appliances, the opportunities available to women changed—and the rest is history. A Woman’s Work

18 Which of the four principles of individual choice do the following situations illustrate?  You are on your third trip to a restaurant’s All You Can Eat dessert buffet and are feeling very full. Although it would cost you no additional money, you forgo a slice of coconut cream pie but have a slice of chocolate cake. 1.opportunity cost 2.resources are scarce 3.people usually exploit opportunities to make themselves better off 4.marginal analysis

19 Which of the four principles of individual choice do the following situations illustrate?  Even if there were more resources in the world, there would still be scarcity. 1.opportunity cost 2.resources are scarce 3.people usually exploit opportunities to make themselves better off 4.marginal analysis

20 Which of the four principles of individual choice do the following situations illustrate?  Different teaching assistants teach several Economics 101 tutorials. Those taught by the teaching assistants with the best reputations fill up quickly, with spaces left unfilled in the ones taught by assistants with poor reputations. 1.opportunity cost 2.resources are scarce 3.people usually exploit opportunities to make themselves better off 4.marginal analysis

21 Which of the four principles of individual choice do the following situations illustrate?  To decide how many hours per week to exercise, you compare the health benefits of one more hour of exercise to the effect on your grades of one less hour spent studying. 1.opportunity cost 2.resources are scarce 3.people usually exploit opportunities to make themselves better off 4.marginal analysis

22 You make $45,000 per year at your current job with Whiz Kids Consultants. You are considering a job offer from Brainiacs, Inc., which will pay you $50,000 per year.  The increased time spent commuting to your new job is an opportunity cost of accepting the new job. 1.True 2.False

23 You make $45,000 per year at your current job with Whiz Kids Consultants. You are considering a job offer from Brainiacs, Inc., which will pay you $50,000 per year.  The $45,000 salary from your old job is an opportunity cost of accepting the new job. 1.True 2.False

24 You make $45,000 per year at your current job with Whiz Kids Consultants. You are considering a job offer from Brainiacs, Inc., which will pay you $50,000 per year.  The more spacious office at your new job is an opportunity cost of accepting the new job. 1.True 2.False

25 Principle #2: Choice Interaction Interaction of choices—my choices affect your choices, and vice versa—is a feature of most economic situations. Principles that underlie the interaction of individual choices: A. There are gains from trade. B.Markets move toward equilibrium. C.Resources should be used as efficiently as possible to achieve society’s goals. D.Markets usually lead to efficiency. E.When markets don’t achieve efficiency, government intervention can improve society’s welfare.

26 Basic Principles of Choice Interaction Gains from Trade  In a market economy, individuals engage in trade: Trade: individuals provide goods and services to others and receive goods and services in return.  There are gains from trade: people can get more of what they want through trade than they could if they tried to be self-sufficient.  Specialization: when each person specializes in the task that he or she is good at performing.

27 This increase in output is due to specialization: each person specializes in the task that he or she is good at performing. © The New Yorker Collection 1991 Ed Frascino from cartoonbank.com.All Rights Reserved. The economy, as a whole, can produce more when each person specializes in a task and trades with others. There Are Gains From Trade “I hunt and she gathers – otherwise we couldn’t make ends meet.”

28 Basic Principles of Choice Interaction Equilibrium  An economic situation is in equilibrium when no individual would be better off doing something different.  Any time there is a change, the economy will move to a new equilibrium.  Ex.: What happens when a new checkout line opens at a busy supermarket?

29  Before there were formal traffic laws, there were informal “rules of the road.”  These rules included an understanding that people would normally keep to one side of the road.  Why would some places choose the right and others, the left? Dependent upon the dominant form of “traffic” in that particular area  Once established, the rule of the road would be self- enforcing—that is, it would be an equilibrium.  This rule even lends itself to pedestrians Most people in the US walk on the right while those in England and France tend to walk on the left Choosing Sides

30 Basic Principles of Choice Interaction Efficiency vs. Equity  An economy is efficient if it takes all opportunities to make some people better off without making other people worse off.  Equity means that everyone gets his or her fair share. Since people can disagree about what’s “fair,” equity isn’t as well-defined a concept as efficiency.  Ex.: Should economic policy makers always strive to achieve economic efficiency?  Ex.: Should the payment of taxes be efficient or equitable?

31  Ex.: Handicapped-designated parking spaces in a busy parking lot  A conflict between:  equity, making life “fairer” for handicapped people, and  efficiency, making sure that all opportunities to make people better off have been fully exploited by never letting parking spaces go unused.  How far should policy makers go in promoting equity over efficiency? Basic Principles of Choice Interaction Efficiency vs. Equity (Continued)

32 Basic Principles of Choice Interaction Markets Usually Lead to Efficiency  The incentives built into a market economy already ensure that resources are usually put to good use.  Opportunities to make people better off are not wasted.  Exceptions: market failure, the individual pursuit of self-interest found in markets makes society worse off  the market outcome is inefficient.

33 Basic Principles of Choice Interaction Government Intervention Can Improve Society’s Welfare  Why do markets fail?  Individual actions have side effects not taken into account by the market (externalities).  One party prevents mutually beneficial trades from occurring in the attempt to capture a greater share of resources for itself.  Some goods cannot be efficiently managed by markets. Ex.: Freeways in L.A. after earthquake in 1994

34  In 1994, a powerful earthquake struck the Los Angeles area, causing several freeway bridges to collapse, disrupting the normal commuting routes of hundreds of thousands of drivers.  In the immediate aftermath of the earthquake, there was great concern about the impact on traffic, since motorists would now have to crowd onto alternative routes or detour around the blockages by using city streets.  Public officials and news programs warned commuters to expect massive delays and urged them to avoid unnecessary travel, reschedule their work to commute before or after the rush, or to use mass transit.  These warnings were unexpectedly effective  a new equilibrium was reached. Restoring Equilibrium on the Freeways

35  In fact, in the first few days following the quake, those who maintained their regular commuting routine actually found the drive to and from work faster than before!!!  Of course, this situation could not last. As word spread that traffic was actually not bad at all, people abandoned their less convenient new commuting methods and reverted to their cars—and traffic got steadily worse.  Within a few weeks after the quake, serious traffic jams had appeared.  After a few more weeks, however, the situation stabilized: the reality of worse-than-usual congestion discouraged enough drivers to prevent the nightmare of citywide gridlock from materializing. Los Angeles traffic, in short, had settled into a new equilibrium, in which each commuter was making the best choice he or she could, given what everyone else was doing. Restoring Equilibrium on the Freeways (cont’d)

36 Directions: Which of the five principles of interaction is illustrated in the situations described?  Using the college Web site, any student who wants to sell a used textbook for at least $30 is able to sell it to another who is willing to pay $30. 1.gains from trade 2.Markets move toward equilibrium. 3.Resources should be used as efficiently as possible to achieve society’s goal. 4.Markets usually lead to efficiency. 5.When markets don’t achieve efficiency, government intervention can improve society’s welfare.

37 Directions: Which of the five principles of interaction is illustrated in the situations described?  At a college tutoring co-op, students can arrange to provide tutoring in subjects they are good in (like economics) in return for receiving tutoring in subjects they are poor in (like philosophy). 1.gains from trade 2.Markets move toward equilibrium. 3.Resources should be used as efficiently as possible to achieve society’s goal. 4.Markets usually lead to efficiency. 5.When markets don’t achieve efficiency, government intervention can improve society’s welfare.

38 Directions: Which of the five principles of interaction is illustrated in the situations described?  The local municipality imposes a law that requires bars and nightclubs near residential areas to keep their noise levels below a certain threshold. 1.gains from trade 2.Markets move toward equilibrium. 3.Resources should be used as efficiently as possible to achieve society’s goal. 4.Markets usually lead to efficiency. 5.When markets don’t achieve efficiency, government intervention can improve society’s welfare.

39 Directions: Which of the five principles of interaction is illustrated in the situations described?  To provide better care for low-income patients, the local municipality has decided to close some underutilized neighborhood clinics and shift funds to the main hospital. 1.gains from trade 2.Markets move toward equilibrium. 3.Resources should be used as efficiently as possible to achieve society’s goal. 4.Markets usually lead to efficiency. 5.When markets don’t achieve efficiency, government intervention can improve society’s welfare.

40 Directions: Which of the five principles of interaction is illustrated in the situations described?  On the college Web site, books of a given title with approximately the same level of wear and tear sell for about the same price. 1.gains from trade 2.Markets move toward equilibrium. 3.Resources should be used as efficiently as possible to achieve society’s goal. 4.Markets usually lead to efficiency. 5.When markets don’t achieve efficiency, government intervention can improve society’s welfare.

41 The Following Describes an Equilibrium Situation. True or False?  The restaurants across the street from the university dining hall serve better-tasting and cheaper meals than those served at the university dining hall. The vast majority of students continue to eat at the dining hall. 1.True 2.False

42 Which of the following describes an equilibrium situation? Which does not?  You currently take the subway to work. Although taking the bus is cheaper, the ride takes longer. So you are willing to pay the higher subway fare in order to save time. 1.True 2.False

43 Principle #3: Economy-Wide Interactions Three principles underlie economy-wide interactions: A. One person’s spending is another person’s income.  Economy is linked and changes in spending behaviors have repercussions throughout the economy B. Overall spending sometimes gets out of line with the economy’s productive capacity.  The amount of goods and services people want to buy sometimes does not match the amount of goods and services the economy can produce. c. Government policies can change spending.  Government uses three tools (government spending, taxes and quantity of money in circulation) that can have a large impact on the economy.

44 Explain how each of the following examples illustrates one of the three principles of economy-wide interactions.  The White House urged Congress to pass major tax cuts in the spring of 2001, when it became clear that the U.S. economy was experiencing a slump. 1.One person’s spending is another person’s income. 2.Overall spending doesn’t match the economy’s productive capacity. 3.Government policies can change spending.

45 Explain how each of the following examples illustrates one of the three principles of economy-wide interactions.  Oil companies are investing heavily in projects that will extract oil from the “oil sands” of Canada. In Edmonton, Alberta, near the projects, restaurants and other consumer businesses are booming. 1.One person’s spending is another person’s income. 2.Overall spending doesn’t match the economy’s productive capacity. 3.Government policies can change spending.

46 Explain how each of the following examples illustrates one of the three principles of economy-wide interactions.  In the mid-2000s, Spain, which was experiencing a big housing boom, also had the highest inflation rate in Europe. 1.One person’s spending is another person’s income. 2.Overall spending doesn’t match the economy’s productive capacity. 3.Government policies can change spending.

47 1. All economic analysis is based on a list of basic principles which apply to three levels of economic understanding. First: how individuals make choices Second: how these choices interact Third: how the economy functions overall 2. Individual choice is the basis of economics. Everyone has to make choices about what to do and what not to do. 3. Choices must be made because resources—anything that can be used to produce something else—are scarce. 4. Because people must choose from limited alternatives, the true cost of anything is what you must give up to get it— all costs are opportunity costs. 1 of 4 Summary

48 5. Many economic decisions involve questions not of “whether” but of “how much”. Decision makers perform a trade-off at the margin—by comparing the costs and benefits of doing a bit more or a bit less. These 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. 2 of 4 Summary

49 8. Interaction originates because there are gains from trade: by trading goods and services with one another, members of an economy can all be made better off. Gains from trade come from specialization, when individuals specialize in the tasks they are good at. 9. Economies normally move toward equilibrium—a situation where no individual can be made better off by taking a different action. 10. There is often a trade-off between equity and efficiency. An economy is efficient if all opportunities to make some people better off without making other people worse off are taken. Equity, or fairness, is also desirable. 3 of 4 Summary

50 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. 4 of 4 Summary

51 The End of Chapter 1 Coming attraction Chapter 2: Economic Models: Trade-offs and Trade


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