INTRODUCTION

TO ECONOMICS
WHY STUDY ECONOMICS

• To achieve social change

– You’ll gain tools to understand origins of social problems and design more effective
solutions
• To help prepare for other careers
– You’ll discover that a wide range of careers deal with economic issues on many levels
• To become an economist
– You’ll begin to develop a body of knowledge that could lead you to become an economist
in the future
MAKING DECISIONS

To post or not to post?

Every day we are faced with a myriad of decisions, from what to have for breakfast, to which
route to take to class, to the more complex—“Should I double major and add possibly another
semester of study to my education?”
Our response to these choices depends on the information we have available at any given
moment;
Despite the lack of perfect information, we still make hundreds of decisions a day.
This leads us to the topic of this chapter, an introduction to the world of making decisions,
processing information, and understanding behavior in markets —the world of economics.
WHAT IS ECONOMICS?

Economics is probably not what you think. It is not primarily about money or finance. It is not
primarily about business. It is not mathematics.

What is it then?
It is both a subject area and a way of viewing the world.
Making choices is at the heart of what economists study.
 WHAT IS ECONOMICS
• Economics – the study of how individuals and societies make decisions about
ways to use scarce resources to fulfill wants and needs.
ECONOMICS

– The word Economics has come from a Greek work ‘Okinomous’ meaning ‘one who
manages a household’.
– Economics is the study of how society manages its scarce resources.
– According to Adam Smith- “Economics is the social science that studies the production,
distribution and consumption of goods and services”.
– Adam Smith is considered as the ‘ Father of Economics’. His revolutionary work is the
book- The Nature and Causes of the Wealth of Nation (1776).
– According to Oxford English Dictionary,” Economics is the Branch of knowledge
concerned with the Production, Consumption, and Transfer of wealth”.
WHAT IS BUSINESS ECONOMICS?

• Business economics is a field of applied economics that studies the financial, organizational,
market-related, and environmental issues faced by corporations.
• Business economics assesses certain factors impacting corporations—business organization,
management, expansion, and strategy—using economic theory and quantitative methods.
Research topics in the field of business economics might include how and why corporations
expand, the impact of entrepreneurs, interactions among corporations, and the role of
governments in regulation.
BUT, THERE’S A
FUNDAMENTAL
PROBLEM:

• Unlimited wants and needs but

limited resources.
• SCARCITY: Situation in which the
amount of something available is
insufficient to satisfy the desire for it
SCARCITY AND INDIVIDUAL CHOICE

• There are an unlimited variety of scarcities, however they are all

based on two basic limitations
– Scarce time
– Scarce spending power
• Limitations force each of us to make choices
• Economists study choices we make as individuals, and
consequences of those choices
SCARCITY AND SOCIAL CHOICE
• The problem for society is a scarcity of resources
– Scarcity of Labor
• Time human beings spend producing goods and services
– Scarcity of Capital
• Something produced that is long-lasting, and used to make other things that we value
– Human capital
– Capital stock
– Scarcity of land
• Physical space on which production occurs, and the natural resources that come with it
– Scarcity of entrepreneurship
• Ability and willingness to combine the other resources into a productive enterprise
• As a society our resources—land, labor, and capital—are insufficient to
produce all the goods and services we might desire
– In other words, society faces a scarcity of resources
SCARCITY AND ECONOMICS
• The scarcity of resources—and the choices it forces us to make—is
the source of all of the problems studied in economics
– Households allocate limited income among goods and services
– Business firms choices of what to produce and how much are limited by
costs of production
– Government agencies work with limited budgets and must carefully choose
which goals to pursue
• Economists study these decisions to
– Explain how our economic system works
– Forecast the future of our economy
– Suggest ways to make that future even better
CHOICES, CHOICES

• Because ALL resources, goods, and services are

limited –
• WE MUST MAKE CHOICES!!!!
• We make choices about how we spend our money,
time, and energy so we can fulfill our NEEDS and
WANTS.
WANTS AND NEEDS &
TRADE-OFFS
• NEEDS – “stuff” we must have to survive, generally: food, shelter, clothing .
• WANTS – “stuff” we would really like to have (Fancy food, shelter, clothing, big screen
TVs, jewelry, conveniences . . .Also known as LUXURIES.
• You can’t have it all (SCARCITY – remember) so you have to choose how to spend
your money, time, and energy. These decisions involve picking one thing over all the
other possibilities – a TRADE-OFF
Needs Vs.Wants
• Needs: items for survival, water, food, shelter.
• Wants: luxuries, fancy cars, vacations.
 TEN PRINCIPLES OF ECONOMICS
P 03: Rational people think at the margin
– A rational decision maker takes action if and only if the marginal benefit of the action exceeds the
marginal cost.
– Example: if you buy a used car, and plan to spend $10000 but the car is only priced at $ 6000; would you
still buy it if it needed $5000 in repair? Of course not; because-
a. You are a rational thinker; and
b. You would end up spending more than you planned to.
P 04: People respond to incentives
– Incentives: something that persuades a person to act.
– It may be punishment or reward. People responds to incentive because people make decision by
comparing costs and benefits.
– Incentives are crucial to analyzing how market work.
– Example: when gas prices rise, consumers buy more hybrid cars and fewer gas consuming cars. Or when
Cigarette taxes increase, teen smoking fall.
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 TEN PRINCIPLES OF ECONOMICS
P 05: Trade can make everyone better off.
– Trade allows each person to specialize in the activities he or she does best.
– By trading with others, people can buy a greater variety of goods or services.

P 06: Markets are usually a good way to recognize economic activity.

– An economy that allocates resources through the decentralized decisions of many firms and households as they
interact in markets for goods and services.
– Market economy:
a. Allocates resources, through
b. Decentralized decisions, of
c. Firms and households as they interact.
– Households decide what to buy and who to work for
– Firms decide to hire and what to produce.

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 TEN PRINCIPLES OF ECONOMICS
P 07 Governments can sometimes improve market outcomes.
– When a markets fails to allocate resources efficiently, the government can change the outcome though
public policy.
– Examples are regulations against monopolies and pollution.
– Example: a dry cleaning factory can cause water pollution when they dispose off used chemicals.
Government has a task of regulating, auditing and monitoring the activities of the market. Thus they can
introduce regulating policies to protect the environment.
P 08: The standard of living depends on a Country’s production.
– Countries whose workers produce a large quantities of goods and services per unit of time enjoy a high
standard of living. Similarly , as a nation’s productivity grows, so does its average income.
– Standard of living may be measured
- By comparing personal incomes
- By comparing the total market value of a nation’s production.

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 TEN PRINCIPLES OF ECONOMICS
P 09: Prices rise when the government prints too much money
– When a government creates large quantities of the nation’s money, the value of the money falls. As a
result prices increase requiring more of the same money to buy goods and services.
– Example: when there is a lot of money in circulation in the economy, then the income of the consumer
rises and this will push up the demand for goods and services. If purchasing power increases it leads to
excess demand the producer will not be able to fulfill the demand, and since excess doesn’t exist in the
market, the producer will increase the price. This will lead to inflation.

P 10: Society faces a short- run tradeoff between inflation and unemployment
– Phillips curve: show short run tradeoff between inflation and unemployment.
– Lower unemployment-higher inflation or higher unemployment- lower inflation. That shows a negative
relationship.

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 THE ECONOMIST AS SCIENTIST
• Economists play two roles:
1. Scientists: try to explain the world

2. Policy advisors: try to improve it

• In the first, economists employ the

scientific method,
the dispassionate development and testing of theories about how the world
works.

THINKING LIKE AN ECONOMIST 18

ASSUMPTIONS & MODELS
• Assumptions simplify the complex world,
make it easier to understand.
• Example: To study international trade,
assume two countries and two goods.
Unrealistic, but simple to learn and
gives useful insights about the real world.
• Model: a highly simplified representation of
a more complicated reality.
Economists use models to study economic issues.

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OUR FIRST MODEL:
THE CIRCULAR-FLOW DIAGRAM
• The Circular-Flow Diagram: a visual model of the economy, shows how
dollars flow through markets among households and firms
• Two types of “actors”:
– households
– firms
• Two markets:
– the market for goods and services
– the market for “factors of production”

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 FACTORS OF PRODUCTION
• Factors of production: the resources the economy uses to produce
goods & services, including
– labor
– land
– capital (buildings & machines used in production)

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FIGURE 1: THE CIRCULAR-FLOW DIAGRAM

Households:
 Own the factors of production,
sell/rent them to firms for income
 Buy and consume goods & services

Firms Households

Firms:
 Buy/hire factors of production,
use them to produce goods and
services
 Sell goods & services
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FIGURE 1: THE CIRCULAR-FLOW DIAGRAM

Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
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 OUR SECOND MODEL:
THE PRODUCTION POSSIBILITIES FRONTIER
• The Production Possibilities Frontier (PPF):
a graph that shows the combinations of
two goods the economy can possibly produce given the available resources
and the available technology
• Example:
– Two goods: computers and wheat
– One resource: labor (measured in hours)
– Economy has 50,000 labor hours per month
available for production.

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PPF EXAMPLE
• Producing one computer requires 100 hours labor.
• Producing one ton of wheat requires 10 hours labor.
Employment of
Production
labor hours
Computers Wheat Computers Wheat
A 50,000 0 500 0
B 40,000 10,000 400 1,000
C 25,000 25,000 250 2,500
D 10,000 40,000 100 4,000
E 0 50,000 0 5,000
 PPF EXAMPLE
Production Wheat
Point
(tons)
on Com- 6,000
graph puters Wheat E
5,000
A 500 0 D
4,000
B 400 1,000
3,000 C
C 250 2,500
2,000
D 100 4,000 B
1,000
E 0 5,000 A
0
0 100 200 300 400 500 600
Computers
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A C T I V E L E A R N I N G 1
POINTS OFF THE PPF
A. On the graph, find the point that represents
(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce this
combination of the two goods?
Why or why not?
B. Next, find the point that represents
(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce this
combination of the two goods?

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 A C T I V E L E A R N I N G 1
ANSWERS
Wheat
 Point F: (tons)
100 computers, 6,000
3000 tons wheat 5,000
 Point F requires 4,000
40,000 hours
3,000
of labor. F
Possible but 2,000
not efficient: could 1,000
get more 0
of either good 0 100 200 300 400 500 600
w/o sacrificing any Computers
of the other.
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A C T I V E L E A R N I N G 1
ANSWERS
Wheat
 Point G: (tons)
300 computers, 6,000
3500 tons wheat 5,000

 Point G requires 4,000 G

65,000 hours 3,000
of labor.
2,000
Not possible
because 1,000

economy 0
only has 0 100 200 300 400 500 600
50,000 hours. Computers

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 THE PPF: WHAT WE KNOW SO FAR

Points on the PPF (like A – E)

– possible
– efficient: all resources are fully utilized
Points under the PPF (like F)
– possible
– not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
Points above the PPF (like G)
– not possible

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THE PPF AND OPPORTUNITY COST
• Recall: The opportunity cost of an item
is what must be given up to obtain that item.

 Moving along a PPF involves shifting resources (e.g.,

labor) from the production of one good to the other.
 Society faces a tradeoff: Getting more of one good
requires sacrificing some of the other.
 The slope of the PPF tells you the opportunity cost
of one good in terms of the other.

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A C T I V E L E A R N I N G 2
PPF AND OPPORTUNITY COST
In which country is the opportunity cost of cloth lower?
FRANCE ENGLAND
Wine Wine
600 600

500 500

400 400

300 300

200 200

100 100

0 0
0 100 200 300 400 0 100 200 300 400
Cloth Cloth32
A C T I V E L E A R N I N G 2
ANSWERS
England, because its PPF is not as steep as France’s.
FRANCE ENGLAND
Wine Wine
600 600

500 500

400 400

300 300

200 200

100 100

0 0
0 100 200 300 400 0 100 200 300 400
Cloth Cloth33
 ECONOMIC GROWTH AND THE PPF
With additional Wheat
Economic
resources or an (tons)
6,000 growth shifts
improvement in the PPF
technology, 5,000 outward.
the economy can 4,000
produce more 3,000
computers,
2,000
more wheat,
or any combination in 1,000
between. 0
0 100 200 300 400 500 600
Computers

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 THE SHAPE OF THE PPF
• The PPF could be a straight line, or bow-shaped
• Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
– If opp. cost remains constant,
PPF is a straight line.
(In the previous example, opp. cost of a computer was always 10 tons of wheat.)
– If opp. cost of a good rises as the economy produces more of the good, PPF is
bow-shaped.

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WHY THE PPF MIGHT BE BOW-SHAPED

As the economy shifts

Beer
resources
from beer to
mountain bikes:
 PPF becomes
steeper
 opp. cost of
mountain bikes
increases
Mountain
Bikes
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WHY THE PPF MIGHT BE BOW-SHAPED
• So, PPF is bow-shaped when different workers have different skills,
different opportunity costs of producing one good in terms of the other.
• The PPF would also be bow-shaped when there is some other resource,
or mix of resources with varying opportunity costs
(E.g., different types of land suited for
different uses).

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 THE PPF: A SUMMARY
• The PPF shows all combinations of two goods that an economy can possibly
produce,
given its resources and technology.

 The PPF illustrates the concepts of

tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.

 A bow-shaped PPF illustrates the concept of

increasing opportunity cost.

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 MICROECONOMICS AND MACROECONOMICS

• Microeconomics is the study of how households and firms make decisions and how they
interact in markets.
• Macroeconomics is the study of economy-wide phenomena, including inflation,
unemployment, and economic growth.
• These two branches of economics are closely intertwined, yet distinct – they address different
questions.

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POSITIVE ECONOMICS & NORMATIVE
ECONOMICS
Positive Economics
• Study of how economy works
• Statements about how the economy works are positive statements, whether they are true or not
• Accuracy of positive statements can be tested by looking at the facts—and just the facts.
Normative Economics
• Study of what should be
– Used to make value judgments, identify problems, and prescribe solutions
– Statements that suggest what we should do about economic facts, are normative statements
• Based on values
– Normative statements cannot be proved or disproved by the facts alone
A C T I V E L E A R N I N G 3
IDENTIFYING POSITIVE VS. NORMATIVE
Which of these statements are “positive” and which are
“normative”? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.

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A C T I V E L E A R N I N G 3
ANSWERS
a. Prices rise when the government increases the
quantity of money.
Positive – describes a relationship, could use data to
confirm or refute.
b. The government should print less money.
Normative – this is a value judgment, cannot be confirmed
or refuted.

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A C T I V E L E A R N I N G 3
ANSWERS
c. A tax cut is needed to stimulate the economy.
Normative – another value judgment.
d. An increase in the price of burritos will cause an
increase in consumer demand for video rentals.
Positive – describes a relationship.
Note that a statement need not be true to be positive.

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WHY ECONOMISTS DISAGREE

• Economists often give conflicting policy advice.

• They sometimes disagree about the validity of alternative positive theories about the world.
• They may have different values and, therefore, different normative views about what policy
should try to accomplish.
• Yet, there are many propositions about which most economists agree.

THINKING LIKE AN ECONOMIST 44

WHY STUDY ECONOMICS

• To understand the world better

–You’ll begin to understand the cause of many of the
things that affect your life
• To gain self-confidence
–You’ll lose that feeling that mysterious, inexplicable
forces are shaping your life for you