Principles of Economics

Twelfth Edition

PART I
INTRODUCTION TO
ECONOMICS

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Principles of Economics
Twelfth Edition(2 of 2)

Chapter 1
The Scope and
Method of Economics

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Chapter Outline and Learning Objectives
(1 of 2)

1.1 Why Study Economics?

• Identify three key reasons to study economics. Think of an example
from your life in which understanding opportunity costs or the
principle of efficient markets could make a difference in your decision
making.

1.2 The Scope of Economics

• Describe microeconomics, macroeconomics, and the diverse fields of
economics.

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Chapter Outline and Learning Objectives
(2 of 2)

1.3 The Method of Economics

• Think about an example of bad causal inference leading to erroneous
decision making. Identify the four main goals of economic policy.

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Chapter 1 The Scope and Method of
Economics
• economics The study of how individuals and societies
choose to use the scarce resources that nature and
previous generations have provided.
• The key word in the definition is choose.
• Economics is a behavioral, or social, science.
• Economics is the study of how people make choices.

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Why Study Economics?
To Learn a Way of Thinking
• Economics has three fundamental concepts:
– Opportunity cost
– Marginalism
– Efficient markets

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To Learn a Way of Thinking (1 of 3)
Opportunity Cost
• opportunity cost The best alternative that we forgo, or
give up, when we make a choice or decision.
• scarce Limited.

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To Learn a Way of Thinking (2 of 3)
Marginalism
• marginalism The process of analyzing the additional or
incremental costs or benefits arising from a choice or
decision.

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To Learn a Way of Thinking (3 of 3)
Efficient Markets—No Free Lunch
• efficient market A market in which profit opportunities are
eliminated almost instantaneously.
• The study of economics teaches us a way of thinking and
helps us make decisions.

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To Understand Society
• Industrial Revolution The period in England during the
late eighteenth and early nineteenth centuries in which
new manufacturing technologies and improved
transportation gave rise to the modern factory system and
a massive movement of the population from the
countryside to the cities.
• The study of economics is an essential part of the study of
society.

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To Be an Informed Citizen
• To be an informed citizen requires a basic understanding
of economics.

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The Scope of Economics (1 of 2)
Microeconomics and Macroeconomics
• microeconomics The branch of economics that
examines the functioning of individual industries and the
behavior of individual decision-making units—that is, firms
and households.
• macroeconomics The branch of economics that
examines the economic behavior of aggregates—income,
employment, output, and so on—on a national scale.

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The Scope of Economics (2 of 2)
Microeconomics and Macroeconomics
• Microeconomics looks at the individual unit—the
household, the firm, the industry. It sees and examines the
“trees.”
• Macroeconomics looks at the whole, the aggregate. It sees
and analyzes the “forest.”

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TABLE 1.1 Examples of Microeconomic and Macroeconomic
Concerns

Division
of Economics Production Prices Income Employment
Microeconomics Production/output Prices of individual Distribution of Employment by
in individual goods and services income and individual
industries and Price of medical care wealth businesses and
businesses Price of gasoline Wages in the industries
How much steel Food prices auto industry Jobs in the steel
How much office Apartment rents Minimum wage industry
space Executive Number of
How many cars salaries employees in a firm
Poverty Number of
accountants

Macroeconomics National Aggregate price level National income Employment and

production/output Consumer prices Total wages and unemployment in
Total industrial Producer prices salaries the economy
output Rate of inflation Total corporate Total number of jobs
Gross domestic profits Unemployment rate
product
Growth of output

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TABLE 1.2 The Fields of Economics ( 1 of 3)

Behavioral economics Do aggregate household savings increase when we

automatically enroll people in savings programs and let
them opt out as opposed to requiring them to sign up?

Comparative economic systems How does the resource allocation process differ in
market versus command and control systems?
Econometrics What inferences can we make based on conditional
moment inequalities?

Economic development Does increasing employment opportunities for girls in

developing nations increase their educational
achievements?

Economic history How did the growth of railroads and improvement in

transportation more generally change the U.S. banking
systems in the nineteenth century?

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TABLE 1.2 The Fields of Economics (cont’d 2 of 3)

Environmental economics What effect would a tax on carbon have on emissions?

Is a tax better or worse than rules?

Finance Is high frequency trading socially beneficial?

Health economics Do co-pays by patients change the choice and use of

medicines by insured patients?

The history of economic thought How did Aristotle think about just prices?

Industrial organization How do we explain price wars in the airline industry

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TABLE 1.2 The Fields of Economics (cont’d 3 of 3)

International economics What are the benefits and costs of free trade? Does
concern about the environment change our views of free
trade?

Labor economics Will increasing the minimum wage decrease employment

opportunities?

Law and economics Does the current U.S. patent law increase or decrease
the rate of innovation?

Public economics Why is corruption more widespread in some countries

than in others?

Urban and regional economics Do enterprise zones improve employment opportunities

in central cities?

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The Method of Economics
• Economics deals with two kinds of questions: positive and
normative.
• positive economics An approach to economics that
seeks to understand behavior and the operation of
systems without making judgments. It describes what
exists and how it works.
• normative economics An approach to economics that
analyzes outcomes of economic behavior, evaluates them
as good or bad, and may prescribe courses of action. Also
called policy economics.
Descriptive Economics and Economic Theory

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Theories and Models (1 of 5)
• model A formal statement of a theory, usually a
mathematical statement of a presumed relationship
between two or more variables.
• variable A measure that can change from time to time or
from observation to observation.
• Ockham’s razor The principle that irrelevant detail should
be cut away.

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Theories and Models ( 2 of 5)
All Else Equal
• ceteris paribus, or all else equal A device used to
analyze the relationship between two variables while the
values of other variables are held unchanged.
• Using the device of ceteris paribus is one part of the
process of abstraction.
• In formulating economic theory, the concept helps us
simplify reality to focus on the relationships that interest us.

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Theories and Models (3 of 5)
Expressing Models in Words, Graphs, and Equations
• Graphs and equations capture the quantitative side of
economic observations and predictions.

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Theories and Models (4 of 5)
Cautions and Pitfalls
• Economists are interested in cause and effect, but sorting
out causality from correlation is not always easy.
• post hoc, ergo propter hoc Literally, “after this (in time),
therefore because of this.” A common error made in
thinking about causation: If Event A happens before Event
B, it is not necessarily true that A caused B.
• Fallacy of Composition: the erroneous belief that what is
true for a part is necessarily true for the whole

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Theories and Models (5 of 5)
Testing Theories and Models: Empirical Economics
• empirical economics The collection and use of data to
test economic theories.

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Economic Policy ( 1 of 3)
• Four criteria are important in judging economic outcomes:
1. Efficiency
2. Equity
3. Growth
4. Stability

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Economic Policy (2 of 3)
Efficiency
• efficiency In economics, allocative efficiency. An efficient
economy is one that produces what people want at the
least possible cost.
Equity
• equity Fairness.

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Economic Policy ( 3 of 3)
Growth
• economic growth An increase in the total output of an
economy.
Stability
• stability A condition in which national output is growing
steadily, with low inflation and full employment of
resources.

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Principles of Economics
Twelfth Edition

Chapter 2
The Economic
Problem: Scarcity and
Choice

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Chapter 2 The Economic Problem:
Scarcity and Choice ( 1 of 2)
• On the surface, economic issues seem quite different from
one another.
• But the fundamental concern is choice in a world of
scarcity.
• Individuals’ choices determine three key features of
society:
– What gets produced?
– How is it produced?
– Who gets what is produced?

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Chapter 2 The Economic Problem:
Scarcity and Choice ( 2 of 2)
• capital Things that are produced and then used in the
production of other goods and services.
• factors of production (or factors) The inputs into the
process of production. Another term for resources.
• production The process that transforms scarce resources
into useful goods and services.
• inputs or resources Anything provided by nature or
previous generations that can be used directly or indirectly
to satisfy human wants.
• outputs Goods and services of value to households.

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 FIGURE 2.1 The Three Basic Questions

Every society has some system or process that transforms its scarce resources into useful
goods and services.

In doing so, it must decide what gets produced, how it is produced, and to whom it is
distributed.

The primary resources that must be allocated are land, labor, and capital.

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Scarcity, Choice, and Opportunity Cost
Scarcity and Choice in a One-Person Economy
• Nearly all the same basic decisions that characterize
complex economies must also be made in a simple
economy.
• A person must decide what to produce and how and when
to produce it.

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Scarcity and Choice in a One-Person
Economy
Opportunity Cost
• The concepts of constrained choice and scarcity are
central to the discipline of economics.
• opportunity cost The best alternative that we give up, or
forgo, when we make a choice or decision.

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Scarcity and Choice in an Economy of
Two or More (1 of 2)
Specialization, Exchange, and Comparative Advantage
• theory of comparative advantage Ricardo’s theory that
specialization and free trade will benefit all trading parties,
even those that may be “absolutely” more efficient producers.
• absolute advantage A producer has an absolute advantage
over another in the production of a good or service if he or
she can produce that product using fewer resources (a lower
absolute cost per unit).
• comparative advantage A producer has a comparative
advantage over another in the production of a good or service
if he or she can produce that product at a lower opportunity
cost.

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Scarcity and Choice in an Economy of
Two or More (2 of 2)
Weighing Present and Expected Future Costs and
Benefits
• We trade off present and future benefits in small ways all
the time.
Capital Goods and Consumer Goods
• consumer goods Goods produced for present
consumption.
• investment The process of using resources to produce
new capital.

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The Production Possibility Frontier (1 of 7)
• production possibility frontier (ppf) A graph that shows
all the combinations of goods and services that can be
produced if all of society’s resources are used efficiently.

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FIGURE 2.4 Production Possibility Frontier

The ppf illustrates a number of economic concepts. One of the most important is opportunity cost.

The opportunity cost of producing more capital goods is fewer consumer goods.

Moving from E to F, the number of capital goods increases from 550 to 800, but the number of consumer
goods decreases from 1,300 to 1,100.

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The Production Possibility Frontier (4 of 7)
Unemployment
• During economic downturns or recessions, industrial plants
run at less than their total capacity.
• When there is unemployment of labor, we are not
producing all that we can.

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The Production Possibility Frontier (5 of 7)
Inefficiency
• Waste and mismanagement are the results of a firm
operating below its potential.
• Sometimes inefficiency results from mismanagement of
the economy instead of mismanagement of individual
private firms.

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FIGURE 2.6 Inefficiency from Misallocation of Land in Farming

Inefficiency always results in a combination of production shown by a point inside the ppf, like point A.
Increasing efficiency will move production possibilities toward a point on the ppf, such as point B.

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The Production Possibility Frontier (6 of 7)
The Efficient Mix of Output
• To be efficient, an economy must produce what people
want.
• Output efficiency occurs when the economy is operating at
the “right” point on the ppf.

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The Production Possibility Frontier (7 of 7)
Economic Growth
• economic growth An increase in the total output of an
economy. Growth occurs when a society acquires new
resources or when it learns to produce more using existing
resources.
• Growth shifts the ppf up and to the right.

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The Economic Problem
• Recall the three basic questions facing all economic
systems:
– What gets produced?
– How is it produced?
– Who gets it?
• Given scarce resources, how do large, complex societies
go about answering the three basic economic questions?

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Economic Systems and the Role of
Government (1 of 7)
Command Economies
• command economy An economy in which a central
government either directly or indirectly sets output targets,
incomes, and prices.
Laissez-Faire Economies: The Free Market
• laissez-faire economy Literally from the French: “allow
[them] to do.” An economy in which individual people and
firms pursue their own self-interest without any central
direction or regulation.

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Economic Systems and the Role of
Government (2 of 7)
• market The institution through which buyers and sellers
interact and engage in exchange.
• Some markets are simple and others are complex, but
they all involve buyers and sellers engaging in exchange.
• The behavior of buyers and sellers in a laissez-faire
economy determines what gets produced, how it is
produced, and who gets it.

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Economic Systems and the Role of
Government (3 of 7)
Consumer Sovereignty
• consumer sovereignty The idea that consumers
ultimately dictate what will be produced (or not produced)
by choosing what to purchase (and what not to purchase).
• The mix of output is dictated by consumers who “vote” by
buying or not buying.

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Economic Systems and the Role of
Government (4 of 7)
Individual Production Decisions: Free Enterprise
• Under a free market system, individual producers must
determine how to organize and coordinate their production.
• In a free market economy, production decisions are made
by private organizations acting in their own interest.

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Economic Systems and the Role of
Government (5 of 7)
Distribution of Output
• A household’s income affects the amount of output it can
get.
• Income is the amount that a household earns each year. It
comes in a number of forms, such as wages, salaries, and
interest.
• You may be able to increase your income by getting more
education or training.

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Economic Systems and the Role of
Government (6 of 7)
Price Theory
• In a free market system, the basic economic questions are
answered without the help of a central government plan or
directives.
• This is what the “free” in free market means—the system is
left to operate on its own, with no outside interference.
Individuals pursuing their own self-interest will go into
business and produce the products and services that
people want.

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 Economic Systems and the Role of
Government (7 of 7)
Price Theory
• Other individuals will decide whether to acquire skills; whether
to work; and whether to buy, sell, invest, or save the income
that they earn.
• The basic coordinating mechanism is price.
• A price is the amount that a product sells for per unit, and it reflects what
society is willing to pay. Prices of inputs—labor, land, and capital—determine
how much it costs to produce a product. Prices of various kinds of labor, or
wage rates, determine the rewards for working in different jobs and
professions. Many of the independent decisions made in a market economy
involve the weighing of prices and costs, so it is not surprising that much of
economic theory focuses on the factors that influence and determine prices.
This is why microeconomic theory is often simply called price theory.
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Mixed Systems, Markets, and
Governments
• The differences between command economies and
laissez-faire economies in their pure forms are enormous.
• In fact, these pure forms do not exist in the world.
• All real systems are in some sense “mixed.”

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REVIEW TERMS AND CONCEPTS
• absolute advantage • laissez-faire economy

• capital • marginal rate of transformation (MRT)

• command economy • market

• comparative advantage • opportunity cost

• consumer goods • outputs

• consumer sovereignty • production

• economic growth • production possibility frontier (ppf)

• factors of production (or factors) • theory of comparative advantage

• inputs or resources

• investment

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