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

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

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

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. 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:
Resources are scarce.
The real cost of something is what you must give up to get it.
“How much?” is a decision at the margin.
People take advantage of opportunities to make themselves better off.

8. 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

9. 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.
LeBron James
understood the concept of opportunity cost.
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.

10. Basic Principles of Individual Choice Opportunity Cost (Continued)
I WOULD RATHER BE SURFING THE INTERNET
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.

11. Got a Penny?
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.

12. 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.

13. 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.

14. 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.

15. Pay for Grades?
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.

16. 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:
There are gains from trade.
Markets move toward equilibrium.
Resources should be used as efficiently as possible to achieve society’s goals.
Markets usually lead to efficiency.
When markets don’t achieve efficiency, government intervention can improve society’s welfare.

17. 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.

18. 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?

19. 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?

20. Basic Principles of Choice Interaction Efficiency vs
Basic Principles of Choice Interaction Efficiency vs. Equity (Continued)
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?

21. 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.

22. 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

23. 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.

24. Terms and Definitions Scarcity
Whatever is given up to get something else
Economics
means that everyone gets his or
her fair share.
Opportunity cost
A situation in which the market fails to allocate
resources efficiently
Marginal changes
Limited resources and unlimited wants
Invisible hand
Study of how society manages its scarce resources
Market failure
each person does in the task that he or she is
good at performing.
Specialisation
The principle that self-interested market
participants may unknowingly maximize the
welfare of society as a whole
Market economy
An economic system where interaction of
households and firms in markets determines the allocation of resources
Equity
Incremental adjustments to an existing plan

25. True/False Questions
When the government redistributes income with taxes and welfare, the economy becomes more efficient. (…)
When economists say, "There ain't no such thing as a free lunch;' they mean that an economic decisions involve trade-offs. (…)
The United States will benefit economically if we eliminate trade with Asian countries because we will be forced to produce more of our own cars and clothes.

26. Multiple Questions
1) Which of the following is not a ‘factor of production’?
Labor
Land
Capital
Firm

27. Multiple Questions
2) ……………. is the study of how society manages its scarce resources.
Economic System
Scarcity
Demand
Economics

28. Multiple Questions 3) A rational person does not act unless
the action makes money for the person
the action is ethical
the action produces marginal costs that exceed marginal benefits
the action produces marginal benefits that exceed marginal costs