Chapter 1 The Central Idea TheCentralIdea

Tiger Woods Economics major at Stanford in 1996 before he chose to become a golf professional Sportsman of the Year 1996 Winner of 54 tournaments by the end of 2006 –Includes 12 major championships –$65 million in prize money –Over $500 million in endorsement income

Tiger Woods had to make a choice: continue his college education or become a PGA Tour professional. Tiger’s story illustrates the idea at the center of economics: that people make purposeful choices with scarce resources and interact with others when they make these choices. The Central Idea

Economics - the study of how people deal with scarcity Scarcity - the situation in which the quantity of resources is insufficient to meet all wants.

Economic Interactions - exchanges of goods and services between people. Market – an arrangement by which economic exchanges between people take place. The Central Idea

PART I Scarcity and Choice for Individuals

Two Fundamental Individual Choices: 1.What to Consume (Consumer Decisions) 2.What to Produce (Producer Decisions) I - Scarcity and Choice for Individuals

Budget Constraint: a scarce amount of funds that limits an individual’s spending. Opportunity Cost (of a choice): the value of the best alternative that was not chosen because something else was chosen. I - Scarcity and Choice for Individuals

II - Opportunity Cost, an example: What is the opportunity cost of attending an 8 a.m. economics class? To answer this question, think of all the other activities you could do at this exact time, and rank these choices (from most preferred to least preferred).

At 8 a.m., you could sleep a bit more, have a longer breakfast, take more time to walk to school, watch the early morning news, etc. Since you made a choice to come to your 8 a.m. economics class, then the best alternative that you DID NOT choose is your opportunity cost. If you value sleep the most, then sleeping is your opportunity cost. II - Opportunity Cost, an example:

Note: Since you cannot do all of the other activities at the same time, it is incorrect to state that all of those activities are your opportunity cost of attending your 8 a.m. economics class. The opportunity cost of attending class at 8 a.m., or of any activity differs across individuals. My opportunity cost of attending class at 8 a.m. may be eating breakfast, while for you, it may be taking a longer shower. II - Opportunity Cost, an example:

Gains from Trade: improvements in income, production or satisfaction owing to the exchange of goods and services. Example: Suppose Maria has 2 pairs of sunglasses and Adam has two hats. If both Maria and Adam would prefer to have one pair of sunglasses and one hat each, then Maria and Adam can improve their situation through trade. Maria can trade one of her sunglasses to Adam for one of Adam’s hats. III - Gains from Trade

Before Trade After Trade Figure 1: Gains from Trade Through a Better Allocation of Goods

IV - Producer Decisions Now, consider a situation with two producers: Emily the poet and Johann the Printer. Below is a summary of the choices for Emily and Johann face because of scarcity.

PART II Scarcity and Choice for the Economy as a Whole

Specialization: Specialization: concentration of production effort into a single specific task. Division of Labor: Division of Labor: the division of production into various parts where some workers specialize in one task, while other specialize in another task. IV - Producer Decisions

Comparative Advantage: a situation in which a person or group can produce one good at a lower opportunity cost than another group. IV - Producer Decisions

V - International Trade International Trade: the exchange of goods and services between people and firms in different countries. Note: Gains from international trade are essentially the same as gains from trade within a country.

VI - Production Possibilities Production Possibilities: alternative combinations of production of various goods that are possible, given the economy’s resources.

Increasing Opportunity Costs: a situation in which producing more of one good requires giving up an increasing amount of production of another good. Why do opportunity costs increase? Some resources are more suited in producing one good than another. VI - Production Possibilities

VII -Production Possibilities Curve Production Possibilities Curve: a curve showing the maximum combinations of production of two goods that are possible, given the economy’s resources and technology.

Figure 2: The Production Possibilities Curve

Notes: In Figure 2, the labels on the x and y- axis of the graph are two goods or outputs. Inputs in the production of the two goods are important, but are not depicted on the labels of the graphs. VII -Production Possibilities Curve

Notes: In Figure 2, points A, B, C, D, E, and F are points on the production possibilities curve, and represent production combinations that are efficient. A production combination is efficient if more of either movies or computers CANNOT be produced without decreasing the production of the other good. VII -Production Possibilities Curve

Notes: In Figure 2, point I is a point inside the production possibilities curve, and represents a production combination that is inefficient. A production combination is inefficient if more of either movies or computers can be produced without decreasing the production of the other good. VII -Production Possibilities Curve

Notes: In Figure 2, point J is a point outside the production possibilities curve, and represents a production combination that is unattainable or impossible to produce, given the current amount of resources and technology. VII -Production Possibilities Curve

VII - Shifts in the Production Possibilities Curve The Production Possibilities Curve can shift out as a result of:  More workers  More capital (e.g. more cameras, more studios)  Technological innovations (faster movie editing machines)

Figure 3: Shifts in the Production Possibilities Curve

How far the production possibilities curve will shift will depend on how much resources are consume now vs. how much is invested for the future. Investing less for the future implies less growth. Investing more for the future implies more growth. Shifts in the Production Possibilities Curve

Figure 4: Shifts in the Production Possibilities Curve Depend on Choices Choosing to allocate a few resources for investment in the future will result in a low growth.

Figure 4: Shifts in the Production Possibilities Curve Depend on Choices Choosing to allocate a lot of resources for investment in the future will result in a high growth.

PART III Market Economies and the Price System

VIII- Market Economies and the Price System The Three Fundamental Economic Questions:The Three Fundamental Economic Questions: 1.WHAT is to be produced? 2.HOW are these goods to be produced? 3.FOR WHOM are the goods to be produced?

Two Alternative Approaches to Answering the Three Fundamental Questions: 1)Market Economy: 1)Market Economy: an economy where most decisions of how, what and for whom to produce are made by individual firms, consumers and governments interacting in markets. In this economy, production and prices are determined in markets. VIII- Market Economies and the Price System

2)Command Economy: 2)Command Economy: an economy where most decisions of how, what and for whom to produce are made by a select group of individuals and firms that control the government. In this economy, production and prices are determined by the government. VIII- Market Economies and the Price System

Key Elements of a Market Economy Freely Determined Price:Freely Determined Price: a price that is determined by the interaction of individuals and firms in the market. Property Rights:Property Rights: rights over the use, sale and proceeds from a good or a resource. Incentive:Incentive: a device that motivates people to take action, usually so as to increase economic efficiency.

A Role for the Government Market failure:Market failure: any situation in which the market does not lead to an efficient economic outcome. Government failure:Government failure: a situation in which the government makes things worse than the market, even though there may be market failure.

The Price System The Uses of the Price System in a Market Economy 1.Signals: 1.Signals: the price of a good sends a signal to producers to increase or decrease production. 2.Incentives: 2.Incentives: higher (lower) prices of goods will increase (decrease) the incentives for firms to produce those goods. 3.Distribution: 3.Distribution: higher or lower worker income resulting from a higher or lower price of the goods or the services they make will affect the distribution of goods and services in the economy.

Figure 5: From One Central Idea, Many Powerful Ideas Follow