Basic Concepts of Economics Managerial Economics - Lecture 1 Dr. Abdullah Alharbi Introduction: Basic Concepts of Economics

Definition of Economics All economic questions arise because we want more than we can get. Our inability to satisfy all our wants is called scarcity. Because we face scarcity, we must make choices. The choices we make depend on the incentives we face. An incentive is a reward that encourages an action or a penalty that discourages an action.

Definition of Economics Economics is the social science that studies how people & societies make decisions to get the most out of their limited resources. Economics divides in to main parts: Microeconomics Macroeconomics

Definition of Economics Microeconomics Microeconomics is the study of the behavior & decision making of individuals and businesses to allocate their limited resources. Macroeconomics Macroeconomics is the study of the behavior & performance of the entire economy.

Two Big Economic Questions Two big questions summarize the scope of economics: 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?

Two Big Economic Questions What, How, and For Whom? Goods and services are the objects that people value and produce to satisfy human wants. What? Agriculture accounts for less than 1 percent of total U.S. production, manufactured goods for 20 percent, and services for 80 percent. In China, agriculture accounts for 10 percent of total production, manufactured goods for 50 percent, and services for 40 percent.

Two Big Economic Questions Figure 1.1 shows these numbers for the United States and China. It also shows the numbers for Brazil. What determines these patterns of production? How do choices end up determining the quantity of each item produced in the United States and around the world?

Two Big Economic Questions How? Goods and services are produced by using productive resources that economists call factors of production. Factors of production are grouped into four categories: Land Labor Capital Entrepreneurship

Two Big Economic Questions The “gifts of nature” that we use to produce goods and services are land. The work time and work effort that people devote to producing goods and services is labor. The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, on-the-job training, and work experience. The tools, instruments, machines, buildings, and other constructions that businesses use to produce goods and services are capital. The human resource that organizes land, labor, and capital is entrepreneurship.

Two Big Economic Questions Figure 1.2 shows a measure of the growth of human capital in the United States over the last century—the percentage of the population that has completed different levels of education. Economics explains these trends.

Two Big Economic Questions For Whom? Who gets the goods and services depends on the incomes that people earn. Land earns rent. Labor earns wages. Capital earns interest. Entrepreneurship earns profit.

Two Big Economic Questions When is the Pursuit of Self-Interest in the Social Interest? Every day, 304 million Americans and 6.7 billion people in other countries make economic choices that result in What, How, and For Whom goods and services are produced. Do we produce the right things in the right quantities? Do we use our factors of production in the best way? Do the goods and services go to those who benefit most from them?

Two Big Economic Questions You make choices that are in your self-interest—choices that you think are best for you. Choices that are best for society as a whole are said to be in the social interest. An outcome is in the social interest if it uses resources efficiently and distributes goods and services fairly. The Big Question Is it possible that when each one of us makes choices that are in our self-interest, it also turns out that these choices are also in the social interest?

Two Big Economic Questions Self-Interest in the Social Interest Five topics that generate discussion and that illustrate tension between self-interest and social interest are Globalization The information-age economy Global warming Natural resource depletion Economic instability

The Economic Way of Thinking Choices and Tradeoffs The economic way of thinking places scarcity and its implication, choice, at center stage. You can think about every choice as a tradeoff—an exchange—giving up one thing to get something else. The classic tradeoff is “guns versus butter.” “Guns” and “butter” stand for any two objects of value.

The Economic Way of Thinking What, How, and For Whom Tradeoffs The questions what, how, and for whom become sharper when we think in terms of tradeoffs. What Tradeoffs arise when people choose how to spend their incomes, when governments choose how to spend their tax revenues, and when businesses choose what to produce.

The Economic Way of Thinking How Tradeoffs arise when businesses choose among alternative production technologies. For Whom Tradeoffs arise when choices change the distribution of buying power across individuals. Government redistribution of income from the rich to the poor creates the big tradeoff—the tradeoff between equality and efficiency.

The Economic Way of Thinking Choices Bring Change What, how, and for whom goods and services get produced changes over time and the quality of our economic lives improve. But the quality of our economic lives and the rate at which they improve depends on choices that involve tradeoffs. We face three tradeoffs between enjoying current consumption and leisure time and increasing future production, consumption, and leisure time.

The Economic Way of Thinking If we save more, we can buy more capital and increase our production. If we take less leisure time, we can educate and train ourselves to become more productive. If businesses produce less and devote resources to research and developing new technologies, they can produce more in the future. The choices we make in the face of these tradeoffs determine the pace at which our economic condition improves.

The Economic Way of Thinking Opportunity Cost Thinking about a choice as a tradeoff emphasizes cost as an opportunity forgone. The highest-valued alternative that we give up to get something is the opportunity cost of the activity chosen. Example: You own a land that can be: (1) Rented as warehouse for $500 ( 2) Rented to a factory for $550 But you decided to invest it as a parking lot ! A part of your counted cost should include the opportunity cost of ($550)

The Economic Way of Thinking Choosing at the Margin People make choices at the margin, which means that they evaluate the consequences of making incremental changes in the use of their resources. The benefit from pursuing an incremental increase in an activity is its marginal benefit. The opportunity cost of pursuing an incremental increase in an activity is its marginal cost.

The Economic Problem Why does food cost much more today than it did a few years ago? One reason is that we now use part of our corn crop to produce ethanol, a clean biofuel substitute for gasoline. Another reason is that drought in some parts of the world has decreased global grain production. We use an economic model—the production possibilities frontier—to learn why ethanol production and drought have increased the cost of producing food. We also use this model to study how we can expand our production possibilities; how we gain by trading with others; and why the social institutions have evolved.

Production Possibilities and Opportunity Cost The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot. To illustrate the PPF, we focus on two goods at a time and hold the quantities of all other goods and services constant. That is, we look at a model economy in which everything remains the same (ceteris paribus) except the two goods we’re considering.

Production Possibilities and Opportunity Cost Production Possibilities Frontier Figure 2.1 shows the PPF for two goods: cola and pizza. Any point on the frontier such as E and any point inside the PPF such as Z are attainable. Points outside the PPF are unattainable.

Production Possibilities and Opportunity Cost Production Efficiency We achieve production efficiency if we cannot produce more of one good without producing less of some other good. Points on the frontier are efficient.

Production Possibilities and Opportunity Cost Any point inside the frontier, such as Z, is inefficient. At such a point, it is possible to produce more of one good without producing less of the other good. At Z, resources are either unemployed or misallocated.

Production Possibilities and Opportunity Cost Tradeoff Along the PPF Every choice along the PPF involves a tradeoff. On this PPF, we must give up some cola to get more pizzas or give up some pizzas to get more cola.

Production Possibilities and Opportunity Cost As we move down along the PPF, we produce more pizzas, but the quantity of cola we can produce decreases. The opportunity cost of a pizza is the cola forgone.

Production Possibilities and Opportunity Cost In moving from E to F, the quantity of pizzas increases by 1 million. The quantity of cola decreases by 5 million cans. The opportunity cost of the fifth 1 million pizzas is 5 million cans of cola. One of these pizzas costs 5 cans of cola.

Production Possibilities and Opportunity Cost In moving from F to E, the quantity of cola produced increases by 5 million. The quantity of pizzas decreases by 1 million. The opportunity cost of the first 5 million cans of cola is 1 million pizzas. One of these cans of cola costs 1/5 of a pizza.

Production Possibilities and Opportunity Cost Note that the opportunity cost of a can of cola is the inverse of the opportunity cost of a pizza. One pizza costs 5 cans of cola. One can of cola costs 1/5 of a pizza.

Production Possibilities and Opportunity Cost Because resources are not equally productive in all activities, the PPF bows outward—is concave. The outward bow of the PPF means that as the quantity produced of each good increases, so does its opportunity cost.

Using Resources Efficiently All the points along the PPF are efficient. To determine which of the alternative efficient quantities to produce, we compare costs and benefits. The PPF and Marginal Cost The PPF determines opportunity cost. The marginal cost of a good or service is the opportunity cost of producing one more unit of it.

Using Resources Efficiently Figure 2.2 illustrates the marginal cost of pizza. As we move along the PPF in part (a), the opportunity cost of a pizza increases. The opportunity cost of producing one more pizza is the marginal cost of a pizza.

Using Resources Efficiently In part (b) of Fig. 2.2, the bars illustrate the increasing opportunity cost of pizza. The black dots and the line MC show the marginal cost of pizza. The MC curve passes through the center of each bar.

Using Resources Efficiently Preferences and Marginal Benefit Preferences are a description of a person’s likes and dislikes. To describe preferences, economists use the concepts of marginal benefit and the marginal benefit curve. The marginal benefit of a good or service is the benefit received from consuming one more unit of it. We measure marginal benefit by the amount that a person is willing to pay for an additional unit of a good or service.

Using Resources Efficiently It is a general principle that the more we have of any good, the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it. We call this general principle the principle of decreasing marginal benefit. The marginal benefit curve shows the relationship between the marginal benefit of a good and the quantity of that good consumed.

Using Resources Efficiently Figure 2.3 shows a marginal benefit curve. The curve slopes downward to reflect the principle of decreasing marginal benefit. At point A, with pizza production at 0.5 million, people are willing to pay 5 cans of cola for a pizza.

Using Resources Efficiently At point B, with pizza production at 1.5 million, people are willing to pay 4 cans of cola for a pizza. At point E, with pizza production at 4.5 million, people are willing to pay 1 can of cola for a pizza.

Using Resources Efficiently Allocative Efficiency When we cannot produce more of any one good without giving up some other good, we have achieved production efficiency. We are producing at a point on the PPF. When we cannot produce more of any one good without giving up some other good that we value more highly, we have achieved allocative efficiency. We are producing at the point on the PPF that we prefer above all other points.

Using Resources Efficiently Figure 2.4 illustrates allocative efficiency. The point of allocative efficiency is the point on the PPF at which marginal benefit equals marginal cost. This point is determined by the quantity at which the marginal benefit curve intersects the marginal cost curve.

Using Resources Efficiently If we produce fewer than 2.5 million pizzas, marginal benefit exceeds marginal cost. We get more value from our resources by producing more pizzas. On the PPF at point A, we are producing too much cola, and we are better off moving along the PPF to produce more pizzas.

Using Resources Efficiently If we produce more than 2.5 million pizzas, marginal cost exceeds marginal benefit. We get more value from our resources by producing fewer pizzas. On the PPF at point C, we are producing too many pizzas, and we are better off moving along the PPF to produce fewer pizzas.

Using Resources Efficiently If we produce exactly 2.5 million pizzas, marginal cost equals marginal benefit. We cannot get more value from our resources. On the PPF at point B, we are producing the efficient quantities of cola and pizzas.