1. The Five Foundations of Economics1

2. Big Questions What is economics?
What are the fundamental concepts underlying economic models?
How do we model/predict economic behavior?
And does it work?

3. Key Terms Common understanding of key terms Scarcity Opportunity costs
Use them as shorthand for the concept; but have a precise/exact meaning
Scarcity
There are not enough resources to produce and consume all of the goods and services we desire
Opportunity costs
What must be given up (next best alternative use of time/money) as a result of a decision or choice
“No such thing as a free lunch” (Milton Friedman)
Cost-benefit analysis
Every decision/action has tradeoffs
i.e., every decision has an opportunity cost

4. What is Economics 2 major fields of inquiry Microeconomics
Study of individual markets and factors that affect market price, quantity supplied
two principal actors: consumers/households and firms/producers
Macroeconomics
Study of a system of (national) markets focusing on national income (gross national product), price levels (inflation), employment/unemployment and international trade
Focuses on the role of government (Congress and budgets, Federal Reserve Bank), regulation (and regulatory agencies, business cycles and their effect on the economy

5. Ten Principles of Economics
Micro-economists study:
How people and firms make decisions and what factors affect their decisions
How people and firms interact with one another in the marketplace
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6. Scarcity The Key Economic Problem
Scarcity means limited resources
The limited nature of society’s resources (e.g. raw materials) means that we have to choose which goods get produced with scarce resources and how they are allocated/distributed to the consumer
Economics
Studies of how people(consumers) and firms(producers) make these decisions when constrained by scarcity
Determine what are the key factors affecting their decisions and modelling their decision making process
Lecture notes:
“Scarcity” is often considered the most basic concept in economics. If scarcity didn’t exist, we wouldn’t have to study economics at all!
You may have to ask the students what “allocate” means.
Allocate: to distribute. How do I distribute my income? What do I buy? I can’t buy everything I want.
How does the last bullet of making decisions make sense? We’ll talk about opportunity cost in a bit, but for now, you can think of it this way: If I have limited time, money, what do I do with it? I have to make a choice. If a society has limited land, labor, capital, timber, water, oil What do we do with those resources? We have to make a choice!

7. Big Questions
Economics is the study of how people allocate their limited resources (income and time) to satisfy nearly unlimited wants and how firms use limited resources (raw materials) to meet consumer demand
The fundamental concepts on which economic models (decision-making) are based:
Incentives
Trade-offs
Opportunity cost
Marginal thinking
Trade creates value

8. Foundations underlying the Model
The five underlying concepts of economic models:
Incentives – people respond to incentives
Price is an incentive - lower price -> buy more
Lowering tuition costs
Trade-offs – buy one good -> can’t buy others
Compare value/price of alternative use of income/time
Opportunity cost – what is given up
Value of “best” alternative not chosen
Marginal thinking
compare “additional” value of 1 more unit to its price when making purchase decision (not total value/cost of all units)
Trade creates value
Why people voluntarily enter into market transactions

9. How People Make Decisions
Principle 1: People face trade-offs
Making decisions
Trade off one goal against another
Student – time (sleeping versus studying)
Parents – income (consume or save)
National defense vs. consumer goods
Clean environment vs. high level of income
Efficiency vs. equality

10. Modelling Tradeoffs – Individual’s Choices Between 2 goods
In microeconomic theory, an indifference curve is a graph showing different bundles of goods between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another.

11. Production Possibilities Frontier - Choice between producing 2 goods
Combinations of outputs that a society can produce if all of its resources are being used efficiently
Assumptions of this model
Technology fixed
Resources fixed
Simplified two-good analysis
Lecture notes:
The assumptions of the model help preserve ceteris paribus.
Our two goods are pizzas and wings.

12. Production Possibilities Frontier
Image: Animated Figure 2.1
Lecture notes:
Let’s begin by imagining a society that produces only two goods—pizzas and wings. This may not seem very realistic, since the entire economy is comprised of millions of different goods and services, but the benefit of this approach is that it allows us to understand the trade-offs in the production process without making the analysis too complicated.
The figure shows the production possibilities frontier for our two-product society. It is important to remember that the number of people and the total resources of this two-product society are fixed. If the economy uses all of its resources to produce pizzas, it can produce 100 pizzas and zero wings. If it uses all of its resources to produce wings, it can make 300 wings and zero pizzas. These outcomes can be found by locating points A and B on the production possibilities frontier. It is unlikely that the society will choose either of these extreme outcomes because it is human nature to enjoy variety.
At any combination of wings and pizzas along the production possibilities frontier, the society is using all its resources to be productive. These points are considered efficient because society is producing the largest possible output from its resources. But what about point F, and all the other points located in the purple shaded region? These points represent an outcome inside the production possibilities frontier and are, therefore, inefficient.
Whenever society is producing along the production possibilities frontier, the only way to get more of one good is to accept less of the other

13. How People Make Decisions
Principle 2: The cost of something is what you give up to get it - each decision has an opportunity cost
Because people face trade-offs when making choices – you have to give something up to get something
Benefit/Cost Analysis to make decisions
Compare cost with benefits of alternatives
Implies opportunity cost (of what is not chosen) is incurred
Whatever most be given up to obtain one item

14. How People Make Decisions
Principle 3: Rational people think at the margin
Rational people
Systematically & purposefully do the best they can to achieve their objectives
Rational decision maker – take action only if
Marginal benefits > Marginal costs
Marginal Benefits – change (or increase) in total benefits from choice
Marginal Costs – change/increase in costs from choice (opportunity costs of “not chosen”)

15. 3. Optimal decisions are made at the “margin”
What do we mean?
When making an economic decision, e.g. to purchase 1 more unit of a good, we compare the marginal (or incremental) benefits against the marginal costs
For example
When studying for an exam
Given you’ve already studied 8 hours, when deciding whether or not to study 1 more hour, you compare
the expected benefits (a “marginal” improvement in your grade
Versus the next best (highest valued) use of your time
E.g., sleeping, eating, time with friends

16. Marginal Decisions Back to the First Law of Demand
How much of a good do you buy?
If the marginal/incremental value of the next unit is less than what it costs, are you willing to buy it?
MV < price
Don’t buy!
MV < price
Do buy!

17. How People Make Decisions
Principle 4: People respond to incentives
Incentive
Something that induces a person to act
In economics – which incentives affect market behavior and how important is each
Higher price
Buyers - consume less
Sellers - produce more
Public policy
Change costs or benefits
Change people’s behavior

18. Incentives at work An example: the First Law of Demand
As the price per unit of the good declines, a consumer (all other things held constant, e.g. their income) will choose to buy more of the good over the same time period

19. How People Make Decisions
Principle 4: People respond to incentives
Gasoline tax
Car size & fuel efficiency; carpool; public transportation
State will raise gasoline tax in July
Reduced single-occupancy cars; less essential trips
Increased demand for mass transit, car-pooling
Highway 520 bridge tolls
Revenues used to finance new construction
Unintended consequences
Policymakers fail to consider how their policies affect incentives
Will toll increase increase/decrease revenues? (Elasticity)

20. Will Women Have More Babies if the Government Pays Them To?
Learning Objective 1.1
Making the Connection
Will Women Have More Babies if the Government Pays Them To?
The Estonian government is encouraged by the results of providing economic incentives and is looking for ways to provide additional incentives to raise the
birthrate further.

21. How People Interact Principle 5: Trade can make everyone better off
Specialization
Allows each person/country to specialize in the activities he/she does best
People/countries can buy a greater variety of goods and services at lower cost

22. Gain from Trade - Specialization
Image: Animated Figure 2.4
Lecture notes:
Here, more resources allow to produce more of all goods. Additional resources could include more people, land, or natural resources.
From the text:
Because the additional resources make the production of more pizzas and wings possible at the same time, the curve moves from PPF1 to PPF2, expanding up along the y axis and out along the x axis. Like improvements in technology, additional resources expand the frontier and allow society to reach a point—in this case, H—that was not possible before.

23. What is Economics? Alchian and Allen
Discovery and analysis of the different ways in which individual goals and activities can be coordinated without central planning
The unit of analysis is the individual
Economic analysis is scientific, not normative
Formulates hypothesis about behavior, subjects these hypotheses to tests/analysis with data, accepts/rejects the model based on the results
It helps explains what conditions lead to what consequences

24. Key Assumptions About Individual Economic Behavior
Alchian and Allen
For each person, some goods are scarce -> choices
Each person desires many goods and goals -> tradeoffs
Each person is willing to give up some of one economic good to get more of another economic good -> basis for trade
The more one has of a good, the lower is its personal marginal value -> diminishing marginal value
Not all people have identical tastes and preferences
People are innovative and rational

25. An Example of a Model Built on These Assumptions
A Model of Consumer Demand

26. What is Economics? Economics
Analyzes the production and distribution/allocation of goods and services – i.e. how the market place works
Or how “stuff” is made and bought, and how its market price is determined.
who gets what
how/who makes it
Models how individuals and firms make decisions about:
What to purchase (choosing how to allocate income among various goods, services and savings/future consumption)
What goods are produced (and not)
What technologies to use
How goods get allocated to which consumers in the marketplace
© 2011, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.