1. 1 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models CBEB 1108 Managerial Economics II Instructor: Dr. Shahnaz BBA (Ohio), MBA (Malaya), PhD (Nottingham) Textbook: Macroeconomics, Hubbard & O’Brien (2010)

2. 2 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models CHAPTER 1 Foundations and Models Bill Gates, chairman of Microsoft, testified before Congress in 2008 that limiting the number of foreign technical workers allowed into the United States was resulting in a “critical shortage of scientific talent.” CBEB1108: Managerial Economics

3. 3 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models 1.1Three Key Economic Ideas Explain these three key economic ideas: People are rational. People respond to incentives. Optimal decisions are made at the margin. 1.2The Economic Problem That Every Society Must Solve Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? 1.3Economic Models Understand the role of models in economic analysis. 1.4Microeconomics and Macroeconomics Distinguish between microeconomics and macroeconomics. 1.5A Preview of Important Economic Terms Become familiar with important economic terms. APPENDIX: Using Graphs and Formulas Review the use of graphs and formulas. Chapter Outline and Learning Objectives Economics: Foundations and Models CHAPTER 1

4. 4 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models 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 these effects? Why do firms engage in international trade, and how do government policies affect international trade? Why does government control the prices of some goods and services, and what are the effects of those controls?

5. 5 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Scarcity A situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economics The study of the choices people make to attain their goals, given their scarce resources. Economic model A simplified version of reality used to analyze real-world economic situations. 4.1 Economics: Foundations and Models

6. 6 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Market A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Three Key Economic Ideas Throughout this book, as we study how people make choices and interact in markets, we will return to three important ideas: 1.People are rational. 2.People respond to economic incentives. 3.Optimal decisions are made at the margin. Marginal analysis Analysis that involves comparing marginal benefits and marginal costs. Explain these three key economic ideas: People are rational. People respond to incentives. Optimal decisions are made at the margin. 1.1 LEARNING OBJECTIVE

7. 7 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Will Women Have More Babies if the Government Pays Them To? Making the Connection More than 45 countries in Europe and Asia have taken steps to try to raise their birthrates. These policies suggest that people may respond to economic incentives even when making the very personal decision of how many children to have. YOUR TURN: Test your understanding by doing related problem 1.7 at the end of this chapter. Explain these three key economic ideas: People are rational. People respond to incentives. Optimal decisions are made at the margin. 1.1 LEARNING OBJECTIVE

8. 8 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Solved Problem 1-1 Apple Computer Makes a Decision at the Margin Should Apple produce an additional 1 million iPhones? 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. YOUR TURN: For more practice, do related problems 1.4, 1.5, and 1.6 at the end of this chapter. Explain these three key economic ideas: People are rational. People respond to incentives. Optimal decisions are made at the margin. 1.1 LEARNING OBJECTIVE

9. 9 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Trade-off The idea that because of scarcity, producing more of one good or service means producing less of another good or service. Trade-offs force society to make choices when answering the following three fundamental questions: 1.What goods and services will be produced? 2.How will the goods and services be produced? 3.Who will receive the goods and services produced? The Economic Problem That Every Society Must Solve Opportunity cost The highest-valued alternative that must be given up to engage in an activity. Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? 1.2 LEARNING OBJECTIVE

10. 10 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Centrally planned economy An economy in which the government decides how economic resources will be allocated. The Economic Problem That Every Society Must Solve Market economy An economy in which the decisions of households and firms interacting in markets allocate economic resources. Centrally Planned Economies versus Market Economies Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? 1.2 LEARNING OBJECTIVE

11. 11 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Mixed economy An economy in which 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. The Economic Problem That Every Society Must Solve The Modern “Mixed” Economy Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? 1.2 LEARNING OBJECTIVE

12. 12 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Productive efficiency A situation in which a good or service is produced at the lowest possible cost. The Economic Problem That Every Society Must Solve Efficiency and Equity Allocative efficiency A state of the economy in which 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. Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? 1.2 LEARNING OBJECTIVE

13. 13 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Voluntary exchange A situation that occurs in markets when both the buyer and seller of a product are made better off by the transaction. The Economic Problem That Every Society Must Solve Efficiency and Equity Equity The fair distribution of economic benefits. Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? 1.2 LEARNING OBJECTIVE

14. 14 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models To develop a model, economists generally follow 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 well the economic data. 5.Retain the revised model to help answer similar economic questions in the future. Economic Models Understand the role of models in economic analysis. 1.3 LEARNING OBJECTIVE

15. 15 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Economic models make behavioral assumptions about the motives of consumers and firms. Economic Models The Role of Assumptions in Economic Models Economic variable Something measurable that can have different values, such as the wages of software programmers. Forming and Testing Hypotheses in Economic Models Understand the role of models in economic analysis. 1.3 LEARNING OBJECTIVE

16. 16 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Positive analysis Analysis concerned with what is. Economic Models Normative and Positive Analysis Normative analysis Analysis concerned with what ought to be. Don’t Let This Happen to YOU! Don’t Confuse Positive Analysis with Normative Analysis YOUR TURN: Test your understanding by doing related problem 3.9 at the end of this chapter. Understand the role of models in economic analysis. 1.3 LEARNING OBJECTIVE

17. 17 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Should the Federal Government Have Increased Restrictions on the Immigration of Skilled Workers? Making the Connection Does restricting the immigration of skilled workers affect the employment opportunities of recent U.S. graduates? Like many other policy debates, the debate over the immigration of skilled workers has both positive and normative elements. The debate over the immigration of skilled workers demonstrates that economics is often at the center of important policy issues. YOUR TURN: Test your understanding by doing related problem 3.7 at the end of this chapter. Understand the role of models in economic analysis. 1.3 LEARNING OBJECTIVE

18. 18 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Economic Models Economics as a Social Science Because economics studies the actions of individuals, it is a social science. Economics is therefore similar to other social science disciplines, such as psychology, political science, and sociology. As a social science, economics considers human behavior— particularly decision-making behavior—in every context, not just in the context of business. Understand the role of models in economic analysis. 1.3 LEARNING OBJECTIVE

19. 19 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Microeconomics The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Microeconomics and Macroeconomics Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. Distinguish between microeconomics and macroeconomics. 1.4 LEARNING OBJECTIVE

20. 20 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models A Preview of Important Economic Terms Entrepreneur Innovation Technology Firm, company, or business Goods Services Revenue Profit Household Factors of production or economic resources Capital Human capital Become familiar with important economic terms. 1.5 LEARNING OBJECTIVE

21. 21 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Do Immigrants Displace or Complement Domestic Workers? AN INSIDE LOOK at Policy >> Figure 1 Foreign-Born Scientists and Engineers as a Percentage of All Scientists and Engineers in the United States Figure 2 Foreign Recipients of U.S. Science and Engineering Doctorates, 1985–2005

22. 22 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Appendix FIGURE 1A-1 Bar Graphs and Pie Charts Graphs of One Variable Values for an economic variable are often displayed as a bar graph or as a pie chart. In this case, panel (a) shows market share data for the U.S. automobile industry as a bar graph, where the market share of each group of firms is represented by the height of its bar. Panel (b) displays the same information as a pie chart, with the market share of each group of firms represented by the size of its slice of the pie. Review the use of graphs and formulas. LEARNING OBJECTIVE

23. 23 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Appendix FIGURE 1A-2 Time-Series Graphs Graphs of One Variable Both panels present time-series graphs of Ford Motor Company’s worldwide sales during each year from 2001 to 2008. Panel (a) has a truncated scale on the vertical axis, and panel (b) does not. As a result, the fluctuations in Ford’s sales appear smaller in panel (b) than in panel (a). Review the use of graphs and formulas. LEARNING OBJECTIVE

24. 24 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Appendix FIGURE 1A-3 Plotting Price and Quantity Points in a Graph Graphs of Two Variables The figure shows a two- dimensional grid on which we measure the price of pizza along the vertical axis (or y-axis) and the quantity of pizza sold per week along the horizontal axis (or x-axis). Each point on the grid represents one of the price and quantity combinations listed in the table. By connecting the points with a line, we can better illustrate the relationship between the two variables. Review the use of graphs and formulas. LEARNING OBJECTIVE

25. 25 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Appendix FIGURE 1A-4 Calculating the Slope of a Line Slopes of Lines We can calculate the slope of a line as the change in the value of the variable on the y-axis divided by the change in the value of the variable on the x-axis. Because the slope of a straight line is constant, we can use any two points in the figure to calculate the slope of the line. For example, when the price of pizza decreases from $14 to $12, the quantity of pizza demanded increases from 55 per week to 65 per week. So, the slope of this line equals –2 divided by 10, or –0.2. Graphs of Two Variables Review the use of graphs and formulas. LEARNING OBJECTIVE

26. 26 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Appendix FIGURE 1A-5 Showing Three Variables on a Graph Graphs of Two Variables Taking into Account More Than Two Variables on a Graph The demand curve for pizza shows the relationship between the price of pizzas and the quantity of pizzas demanded, holding constant other factors that might affect the willingness of consumers to buy pizza. If the price of pizza is $14 (point A), an increase in the price of hamburgers from $1.50 to $2.00 increases the quantity of pizzas demanded from 55 to 60 per week (point B) and shifts us to Demand curve 2. Or, if we start on Demand curve 1 and the price of pizza is $12 (point C), a decrease in the price of hamburgers from $1.50 to $1.00 decreases the quantity of pizza demanded from 65 to 60 per week (point D) and shifts us to Demand curve 3. Review the use of graphs and formulas. LEARNING OBJECTIVE

27. 27 of 38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 1: Economics: Foundations and Models Appendix FIGURE 1A-6 Graphing the Positive Relationship between Income and Consumption Graphs of Two Variables Positive and Negative Relationships In a positive relationship between two economic variables, as one variable increases, the other variable also increases. This figure shows the positive relationship between disposable personal income and consumption spending. As disposable personal income in the United States has increased, so has consumption spending. Review the use of graphs and formulas. LEARNING OBJECTIVE