Chapter 1 Section 2 Economic Theory

Economic Theory Economic model Is a simplification of economic reality that is used to make predictions about the real world. Ex. What happens to the consumption of Pepsi when its price increases.

Simplify the Problem Captures the important elements of the problem under study. One way to strip down reality is by using simplifying assumptions.

Simplifying Assumptions The idea is to identify the variables of interest and then focus exclusively on the relations among them, assuming that nothing else of importance changes- that other things remain constant. Isolate the relationship b/w these two variables Price and quantity purchased- model no other changes in other variables. Ex. Pepsi ( consumer income, Price of Coke, and average outdoor temperature. No changes to these variables.)

Economist –assumptions what motives people-how they behave. Behavioral Assumption-how people behave. Basic behavioral assumptions is that people make choices based on their own self-interest.

Rational Self Interest Economists mean that you try to make the best choices you can, given the information available.

Rational In general, rational self interest means that you try to maximize the expected benefit achieved with a given cost or to minimize the expected cost of achieving a given benefit.

Continued The assumption of rational self interest does not rule out concern for others. It simply means that concern for others is influenced to some extent by the same economic forces that affect other economic choices. Ex. The lower your personal cost of helping others, the more help you will offer.

Every body uses theories Vending machine Economists tell stories about how they think the economy works.

Normative Versus Positive Statements Economists sometimes concern themselves not with how the economy does work but how it should work. Ex.Unemployment rate is 5.8%. The U.S. unemployment rate should be lower. Positive economic statement, b/c it is a statement about economic reality that can be supported or rejected by reference to the facts.

Normative economic statement It reflects someone’s opinion.

Marginal Means incremental, additional, extra, or one more. Marginal refers to a change in an economic variable, a change in status quo. Status quo means the existing state of affairs.

Continued A rational decision maker will change the status quo as long as the expected marginal benefit from the change exceeds the expected marginal cost.

Example Compare the marginal benefit you expect from eating dessert (added satisfaction) With its marginal cost (the added dollar, cost, time, and calories).

Example Amazon.com compares the marginal benefit expected from adding a new products. (the added sales revenue) With the marginal cost (the added cost of resources required)

Jack n the box 2 tacos for 99 cents You normally order 6 tacos, but of the 6 eat only 5. Marginal benefit would be to eat food, taste, satisfaction Marginal cost – money, time, that the value of the 6th taco is not worth 49 cents it would cost. Food and money would be wasted.

Market economics Aka Microeconomics-your economic behavior and the economic behavior of others who make choices involving what to buy and what to sell, how much to work and how much to play, how much to borrow and how much to save. Ex. The factors that influence individual economic choices and how markets coordinate the choices of various decision makers. Ex. cereal

National economics Aka Macroeconomics focuses on the performance of the economy as a whole, especially the national economy. Ex. Takes a look at all the pieces of the economy as a whole.

Households People As consumers, households demand the goods and services produced. As resource owners, households supply the resources used to produce goods and service. Reminder Human resources, Natural resources, Capital Goods

Firms, governments, and the rest of the world Demand the resource that households supply, and then use these resources to supply the goods and services that households demand.

Markets Are the means by which buyers and sellers carry out exchange. Brings to together supply and demand. Supply- a relation showing the quantities of a good producers are willing and able to sell at various prices during a given period, or other things constant.

continued Demand – A relation showing the quantities of a good that consumers are willing and able to buy at various prices per period, other things constant. (shopper) Price Quantity purchased

Continued Income-salary or wage for human resources. Expenditure-the amount of money that people spend on product or good and services. Resources payments - companies have to pay for their resources. (human resources-labor, natural resource, capital resources-building.) Revenue -