© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 1: Economics and Economic Reasoning Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 What Economics Is Economics is the study of how individuals, firms, and governments make optimal choices from among a set of alternatives when facing scarce resources.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 What Economics Is Key words: choice alternative scarcity

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 What Economics Is Scarcity exists because individuals want more than available resources can produce. Wants are unlimited, but resources are limited.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 What Economics Is The degree of scarcity is constantly changing. The quantity of goods, services, and usable resources depends on technology and human action.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 What Economics Is Any economic system must solve three central coordination problems:  What, and how much, to produce.  How to produce it.  For whom to produce it.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 What Economics Is In this course you will learn:  Economic reasoning.  Economic terminology.  Economic insights economists have about issues, and theories that lead to those insights.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 What Economics Is To understand the economy, you need to learn:  Information about economic institutions.  Information about the economic policy options facing society today.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 A Guide to Economic Reasoning Economic reasoning is making decisions by comparing costs and benefits.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Marginal Costs and Marginal Benefits The relevant costs and benefits are the expected incremental, or additional, costs incurred and the expected incremental benefits of a decision.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Marginal Costs and Marginal Benefits Economist use the term marginal when referring to additional or incremental.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 Marginal Costs and Marginal Benefits Marginal cost – the additional cost to you over and above the costs you have already incurred. This means not counting sunk costs – costs that have already been incurred and cannot be recovered.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 Marginal Costs and Marginal Benefits Marginal benefit – the additional benefit above and beyond what you’ve already accrued.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Marginal Costs and Marginal Benefits According to the economics decision rule:  If the relevant benefits of doing something exceed the relevant costs, do it.  If the relevant costs of doing something exceed the relevant benefits, don’t do it.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Economics and Passion Economic reasoning is based on the premise that everything has a cost. It leads to a better society for the majority of people.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Opportunity Cost The Opportunity cost of the chosen activity is the value of the next-best alternative to the activity you have chosen. Opportunity cost is the basis of cost/benefit economic reasoning.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Opportunity Cost In economic reasoning, opportunity cost must be less than the benefit of what you have chosen.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 Economic and Market Forces The opportunity cost concept applies to all aspects of life. It is fundamental to understanding how society reacts to scarcity.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 Economic and Market Forces When goods are scarce, they must be rationed. Rationing is the mechanism for determining who gets what.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 Economic and Market Forces Economic reality is controlled by three forces:  Economic forces (the invisible hand).  Social and cultural forces.  Political and legal forces.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 Economic and Market Forces Economic forces are the necessary reactions to scarcity. A market force is an economic force that is given relatively free rein by society to work through the market.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Economic and Market Forces Market forces ration quantity by changing prices. When there is a shortage, the price goes up. When there is a surplus, the price goes down.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Economic and Market Forces The invisible hand is the price mechanism -- the rise and fall of prices -- that guides our actions in a market.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 Economic and Market Forces Political and social forces often work together against the invisible hand. What happens in society can be seen as a reaction to, and interaction of, the invisible hand, political and legal forces, and social and cultural forces.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Theories, Models and Assumptions General insights into how economies work are often based on generalizations called economic theories.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Theories, Models and Assumptions Economic theories are abstract. A theory is often embodied in an economic model or an economic principle.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 Theories, Models and Assumptions Economic model – a set of simple behavioural assumptions to explain decision making.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Theories, Models and Assumptions Economic principle – a commonly held insight stated as a law or general assumption.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 Theories, Models and Assumptions Economists cannot test their models with controlled experiments. It is impossible to hold “other things constant,” as is done in laboratory experiments.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 Theories, Models and Assumptions Theories, models, and principles must be combined with a knowledge of real-world economic institutions to arrive at a specific policy recommendation. In order to understand the theory you must understand the assumptions underlying the theory.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 The Invisible Hand Theory Economist have observed:  Price tends to fall when the quantity supplied is greater than the quantity demanded.  Price tends rise when the quantity demanded is greater than the quantity supplied.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 The Invisible Hand Theory According to the invisible hand theory, a market economy, through the price mechanism, will allocate resources efficiently. Efficiency means achieving a goal as cheaply as possible.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 Economic Theory and Stories Economic theory and its models are a shorthand means of telling a story. If you can’t translate a theory into a story, you don’t understand the theory.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Microeconomics and Macroeconomics Economics is divided into two parts: microeconomics and macroeconomics.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Microeconomics Microeconomics is the study of individual decision making. It considers household and business decisions, market allocations and pricing policies.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 Macroeconomics Macroeconomics is the study of the economy as a whole. It considers the problems of inflation, unemployment, business cycles, and economic growth.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 Economic Institutions In applying economic theory to reality, you must know about economic institutions. Economic institutions are the laws, common practices, and social, political, and religious organization, of a society.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 38 Economic Institutions Economic institutions differ significantly among nations. They sometimes seem to operate in ways quite different than economic theory predicts.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 39 Economic Policy Options Economic policies are actions taken by government to influence economic events.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 40 Economic Policy Options To carry out economic policy effectively, one must understand how the economic policy might change institutions.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 41 Objective Policy Analysis Objective policy analysis keeps the value judgments separate from the analysis. Subjective policy analysis is that which reflects the analyst’s view of how things should be.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 42 Objective Policy Analysis To make clear the distinction between objective and subjective analysis, economics is divided into three categories:  Positive economics  Normative economics  Science of economics

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 43 Objective Policy Analysis Positive economics – the study of what is, and how the economy works. Normative economics – the study of what the goals of the economy should be.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 44 Objective Policy Analysis Science of economics – the application of the knowledge learned in positive economics to achieve the goals determined in normative economics.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 45 Objective Policy Analysis It is hard to maintain objectivity in the science of economics. It embodies the problems of both positive and normative economics

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 46 Policy and Social and Political Forces The choice of policy options depends on more than economic theory. Political and social forces must be taken into account when applying economic theory to policy.

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.47 Economics and Economic Reasoning End of Chapter 1

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.48 The Language of Graphs Chapter 1 Appendix

© 2006 McGraw-Hill Ryerson Limited. All rights reserved A 0 4 Horizontal Number Line

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 50 B Vertical Number Line

© 2006 McGraw-Hill Ryerson Limited. All rights reserved B (1, 20) A (4, 5) Coordinate System

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 52 From Table to Graph Price of pens (in dollars) Quantity of pens bought $ C D E B A

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 53 Price (in dollars) Quantity $ Nonlinear Curve 40

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 54 Slopes of Curves Slope = 1 Run = 1 Rise = 1 Rise = -4 Rise = -1 Run = 2 Slope = -0.5 Slope = 4 Slope = -4 Rise = 4 Run = 1 A B a L d Slope = 1 Rise = Run = 1 E e c b e L

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 55 Inverse and Direct Relationships X Y X Y Inverse relationship: When X goes up, Y goes down When X goes down, Y goes up Direct relationship: When X goes up, Y goes up When X goes down, Y goes down

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 56 Maximum Point Maximum Slope = 0 A

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 57 Maximum and Minimum Points Slope = 0 Minimum B

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 58 Presenting Information Visually

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 59 Income (in dollars) $14,000 13,000 12,000 11,000 10, (a) Income over time (1) The Importance of Scales Income (in dollars) $18,000 16,000 14,000 12,000 10, (b) Income over time (2)

© 2006 McGraw-Hill Ryerson Limited. All rights reserved.60 The Language of Graphs End of Chapter 1 Appendix