The Economic Way of Thinking An Introduction to Economics

Objectives Define economics and explain the questions that economists try to answer. Explain the core ideas that define the economic way of thinking.

Economics Defined Economics: The study of how people use resources to satisfy wants. Key economic questions include: How do choices end up determining what, how, and for whom goods and services get produced? When do choices made in the pursuit of self-interest also promote the social interest?

The Economic Problem What goods and services should an economy produce? – should the emphasis be on agriculture, manufacturing, or services, or should it be on sport and leisure or housing? How should goods and services be produced? – labor intensive, land intensive, capital intensive? Efficiency? Who should get the goods and services produced? – even distribution? more for the rich? for those who work hard? This is the traditional three key questions any economic system has to answer. Many students would have difficulty defining what an ‘economy’ actually is! It is useful at this stage to clear this up – a system for the production and exchange of goods and services to satisfy the wants and needs of the population. This is open ended enough to be able to incorporate all manner of economic systems from a barter system that still exists in remote parts of the world to sophisticated economic systems such as the UK and US! The questions and the examples raised can be used for discussion – get the students to express their views at this stage and be as controversial as possible to stimulate discussion and involvement!

The Economic Problem Scarcity having seemingly unlimited human needs and wants, in a world of limited resources. Why does it exist? It exists because wants are unlimited and resources are limited

Economic Thinking People Choose Most situations involve making choices (tradeoffs). People evaluate the costs and benefits of different alternatives and choose the alternative that seems best to them.

Efficiency vs. Equality Examples… Going to a movie the night before your midterm leaves less time for studying. Having more money to buy stuff requires working longer hours, which leaves less time for leisure. Protecting the environment requires resources that could otherwise be used to produce consumer goods. Society faces an important tradeoff – Efficiency vs. Equality Should society get the most from its scarce resources, or should prosperity be distributed evenly among society’s members?

Economic Thinking People’s Choices Involve Costs Costs do not necessarily involve money. The most important type of cost is opportunity cost: The next best alternative that people give up when they make a choice.

Examples… The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages. If a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead. Seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater. But what about the statement “the best things in life are free?”

Economic Thinking People Respond to Incentives in Predictable Ways Incentives are actions or rewards that encourage people to act in a certain way. Incentives can be either positive or negative. When incentives change, people’s behavior changes in predictable ways.

Economic Thinking People Create Economic Systems that Influence Individual Choices and Incentives How people cooperate is governed by written and unwritten rules. As the rules change, incentives – and consequently people’s behaviors – change.

Economic Thinking People Gain when they Trade Voluntarily People can produce goods and services at lower opportunity costs when they specialize in what they do best. Then they can trade what they produce for goods or services that would be more costly for them to produce. In this way both sides win.

Economic Thinking People’s Choices have Consequences that Lie in the Future The important costs and benefits in economic decision making are those that will appear in the future. The study of economics stresses the importance of making decisions about the future because we can influence only the future; we cannot influence things that happened in the past.

Economic Thinking Choices are Made on the Margin Margin = “edge” A choice on the margin is a choice made comparing all alternatives systematically and incrementally Marginal cost is the opportunity cost that arises from a one-unit increase in an activity. Marginal benefit is the benefit that arises from a one-unit increase in an activity.

Examples… When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education. When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue.

Question You are selling your 1996 Mustang. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car “as is.” In each of the following scenarios, should you have the transmission repaired? Explain. Blue book value (what you could get for the car) is $6500 if transmission works, $5700 if it doesn’t Blue book value is $6000 if transmission works, $5500 if it doesn’t

Answer Cost of fixing transmission = $600 A. Blue book value is $6500 if transmission works, $5700 if it doesn’t Benefit of fixing transmission = $800 ($6500 – 5700). Get the transmission fixed. B. Blue book value is $6000 if transmission works, $5500 if it doesn’t Benefit of fixing the transmission is only $500. Do not pay $600 to fix it.

Terms Goods: physical objects that can be bought. Services: work one person does for another. Consumer: Person who buys goods or services for personal use. Producer: person who makes a good or provides a service. Wants: unfulfilled desire (something you’d like to have). Needs: things necessary for survival (something you have to have). Scarcity: the basic economic problem that arises because people have unlimited wants but resources are limited. Incentives: positive or negative, used to influence people’s decision-making. Margin: A choice that is made by comparing all of the relevant alternatives systematically and incrementally. Opportunity Cost: the value of the next-best alternative.

Factors of Production Resources needed to produce goods and services Land Labor Capital Entrepreneurship

Factors of Production Land Includes all natural resources on or under the ground Water Forests Mineral deposits

Factors of Production Labor Includes all the time, effort, and talent used to produce goods or services Human capital: the knowledge and skill that people obtain from education, on-the-job training, and work experience

Factors of Production Capital Durable goods used in the production of goods or services Tools Machines Buildings

Factors of Production Entrepreneurship The human resource – one with the skill, vision, ingenuity, and willingness to take risks

Making Economic Choices Two factors affect economic decisions: Incentives – a reward or penalty that encourages people to act in certain ways Utility – the benefit or satisfaction gained from using a good or service Choices vary from individual to individual based on what each thinks is best for them

Making Economic Choices Factor #1 People are motivated by incentives, expected utility, desire to economize They weigh costs against benefits to make purposeful choices Motivated by self-interest

Making Economic Choices Factor #2 “There’s no such thing as a free lunch” All choices have a cost Choosing one thing means giving up another Cost can take the form of money, time, or anything of value

Analyzing Production Possibilities Every decision has an opportunity cost – the cost in foregone opportunities. A production possibilities frontier is a model used to illustrate opportunity cost, showing the trade-offs of the choices we make. The PPF shows the combination of outputs that a business or society can produce if all of its resources are being used efficiently. Ceteris paribus – “other things being equal” Economists examine change in one variable while holding everything else constant

Production Possibilities Frontier PPF runs between extremes of producing only one item or the other Data is plotted on a graph; lines joining points is PPF shows maximum number of one item relative to other item PPC shows opportunity cost of each choice more of one product means less of the other

Production Possibilities Frontier Efficiency: producing the maximum number of goods or services possible Any point along the line Inefficiency: (or underutilization) is any point inside the curve Producing fewer goods or services than possible

Production Possibilities Frontier Increasing opportunity cost Constant opportunity cost Decreasing opportunity cost Resources are not usually perfectly adaptable, and production doesn’t usually change at a constant rate.

Changing Production Possibilities Economic growth allows a society to produce more output in the future Based on changes in: Technology Management Factors of production