 “We hold these truths to be self evident: that all men are created equal; that they are endowed by their Creator with certain inalienable rights: that among these are life, liberty, and the pursuit of happiness.” - Thomas Jefferson

 Two sources of human happiness: ◦ Spiritual ◦ Material

 Material happiness is derived from satisfaction of material wants.  Material wants are unlimited.

 Production of what people want requires resources: land, labor, capital, entrepreneurship But these resources are limited.

 Limited resources and unlimited wants create the economic problem of SCARCITY. Scarcity is a situation in which unlimited wants exceed the limited resources available to fulfill those wants. What is scarce and what is not scarce in the U.S.?

 One test of a scarce thing is that people have to sacrifice (pay) something else to get it.  A limited amount of resources can produce a limited amount of goods and services.  With a given amount of resources and given technology, more of one good can be produced only with less of the other goods.

 The cost of producing (getting) more of one good is the value of what must be given up (sacrificed) to produce it.  Opportunity Cost is the value of what must be given up or sacrificed to produce or get something.  All the economic goods have opportunity cost associated with them.

 With the given amount of economic resources and technology, getting more of one good implies getting less of the other.  Scarcity imposes this type of trade-offs on individuals as well as societies.

 What goods and services will be produced?  How will the goods and services be produced?  Who will receive the goods and services produced?

 Economists use models—simplified versions of reality—to analyze real-world issues.  Economists accept a model if it leads to hypotheses that are confirmed by statistical analysis.  Economists use both inductive method and deductive method in building models.

 Models are based on certain assumptions.  Four key assumptions of economic models are: 1. People are self-interested. 2. People are rational. 3. People respond to incentives. 4. Optimal decisions are made at the margin.

 Rationality assumption: This assumption does not mean that economists believe everyone knows everything or always makes the “best” decision. Rational individuals weigh the benefits and costs of each action and choose an action if the benefits outweigh the costs.

 People respond to incentives (positive and negative): Economists emphasize that consumers and firms consistently respond to economic incentives (positive and negative).

 Optimal Decisions Are Made at the Margin:  Economists use the word marginal to mean an extra or additional benefit or cost of a decision. The optimal decision is to continue any activity to the point where the marginal benefit equals the marginal cost. Marginal analysis involves comparing marginal benefits and marginal costs.

# of Labor Hours Total OutputMarginal OutputAverage Output kites 236 kites21kites18 kites 348 kites12 kites16 kites 456 kites8 kites14 kites 560 kites4 kites12 kites Problem: Allocation of scarce resource - how many hours of labor should be used for the production of kites?

# of Labor Hours Total CostMarginal CostAverage Cost 0$ $ Allocation Problem: how many labor hours should be hired?

# of Labor Hours Hired Marginal Benefit at Price =$10 per kite Marginal CostNet Benefit 0-- 1$150$80$ IF MB>MC, hire more IF MB<MC, hire less IF MB = MC, stay put – don’t hire more or less MB = MC  Optimality  Allocative Efficiency

# of Pizza Slices Consumed Total Satisfaction (Utility) Marginal Satisfaction (Utility) Average Satisfaction (Utility) utils 224 utils14 utils12 utils 333 utils9 utils11 utils 440 utils7 utils10 utils 545 utils5 utils9 utils How many slices of pizza should be purchased by a rational consumer for allocative efficiency, if the price of each slice of pizza is 9 cents and each util of satisfaction is worth 1 cent?

 Allocative efficiency is a state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it.

 Markets promote efficiency but don’t guarantee it. Inefficiency arises from various sources. Sometimes governments may reduce efficiency by interfering with voluntary exchanges in markets. The production of some goods may damage the environment when firms ignore the costs of environmental damage. In this case, government intervention can increase efficiency.

 A market is a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.  Voluntary exchange is a situation that occurs in markets when both the buyer and seller of a product are made better off by the transaction.  Allocative Efficiency

 Allocative efficiency is a state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it.  Productive efficiency is the situation in which a good or service is produced at the lowest possible cost.  An allocatively efficient situation may or may not be productively efficient.

 Allocative efficiency is a state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it.

 Society may not find efficient economic outcomes to be desirable. Many people prefer economic outcomes that they consider fair or equitable even if these outcomes are less efficient.  Equity is the fair distribution of economic benefits. Equity is harder to define than efficiency. Programs designed to increase equity may reduce efficiency.

 Positive analysis: Analysis concerned with what is.  Normative analysis: Analysis concerned with what ought to be.

 Centrally planned economy: An economy in which the government decides how economic resources will be allocated.  Market economy: An economy in which the decisions of households and firms interacting in markets allocate resources.  Mixed economy: An economy in which most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources.

 There is wide spectrum of mixed economies ranging between the U.S. and China