LU 1: Introduction

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Understanding Economics and Scarcity

• Scarcity means that there are never enough

resources to satisfy all human wants.
• Every society, at every level, must make choices
about how to use its resources.
• Economics is the study of the trade-offs and
choices that we make, given the fact of scarcity.
• Opportunity cost is what we give up when we
choose one thing over another.

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Goods and Resources

• Economic Goods: goods or services a consumer

must pay to obtain; also called scarce goods.
• Free Goods: goods or services that a consumer can
obtain for free because they are abundant relative
to the demand.
• Productive Resources: the inputs used in the
production of goods and services to make a profit:
land, economic capital, labor, and
entrepreneurship; also called “factors of
production”
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Productive Resources

Four productive resources also called factors

of production:
• Land: any natural resource, including
actual land, but also trees, plants,
livestock, wind, sun, water, etc.
• Economic capital: anything that’s
manufactured in order to be used in the
production of goods and services. Note • Labor: any human service—physical
the distinction between financial capital or intellectual. Also referred to
as human capital.
(which is not productive) and economic
capital (which is). While money isn’t • Entrepreneurship: the ability of
directly productive, the tools and someone (an entrepreneur)
machinery that it buys can be. to recognize a profit opportunity,
organize the other factors of
production, and accept risk.

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Concept of Opportunity Cost

Opportunity Cost: the value of the next best

alternative.
• Individual Decisions: In some cases,
recognizing the opportunity cost can alter personal
behavior.
• Societal Decisions: Opportunity cost comes into
play with societal decisions. Universal health care
would be nice, but the opportunity cost of such a
decision would be less housing, environmental
protection, or national defense. These trade-offs
also arise with government policies. 

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Microeconomics and Macroeconomics

Micro vs. Macro

•Macroeconomics: the branch of economics that
focuses on broad issues such as growth,
unemployment, inflation, and trade balance.
•Microeconomics: the branch of economics that
focuses on actions of particular agents within the
economy, like households, workers, and
businesses. We learn about the theory of
consumer behavior and the theory of the firm.

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 Understanding Microeconomics

Questions to Ask with Microeconomics

• What determines how • How do people decide

whether to work, and if
households and individuals so, whether to work
spend their budgets? full time or part time? 
• What combination of goods • How do people decide
and services will best fit their how much to save for
the future, or whether
needs and wants, given the they should borrow to
budget they have to spend? spend beyond their
current means?
 Understanding Microeconomics (cont.)

More Microeconomics Questions

• What determines the • What determines how

products, and how many of many workers it will
each, a firm will produce hire?
and sell?
• What determines what • How will a firm finance
prices a firm will charge? its business?
• What determines how a
firm will produce its • When will a firm
products? decide to expand,
downsize, or even
close?
TEN PRINCIPLES OF ECONOMICS
A household and an economy face many decisions:
 Who will work?
 What goods and how many of them should be
produced?
 What resources should be used in production?
 At what price should the goods be sold?

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TEN PRINCIPLES OF ECONOMICS
Economics is the study of how society manages
its scarce resources.

. . . The word economy comes from a Greek

word for “one who manages a household.”

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HOW PEOPLE MAKE DECISIONS
• People face trade-offs.
• The cost of something is what you give up to
get it.
• Rational people think at the margin.
• People respond to incentives.

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Principle #1: People Face Trade-offs.

• “There is no such thing as a free lunch!”

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Principle #1: People Face Trade-offs.

• To get one thing, we usually have to give up

another thing.
• Bicycle v. butter
• Food v. clothing
• Leisure time v. work
• Efficiency v. equity
Making decisions requires trading
off one goal against another.

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Principle #1: People Face Trade-offs

• Efficiency v. Equity
• Efficiency means society gets the most that it can
from its scarce resources.
• Equity means the benefits of those resources are
distributed fairly among the members of society.

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Principle #2: The Cost of Something Is
What You Give Up to Get It.
• Decisions require comparing costs and benefits
of alternatives.
• Whether to go to college or to work?
• Whether to study or go out on a date?
• Whether to go to class or sleep in?

• The opportunity cost of an item is what you

give up to obtain that item.

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Principle #2: The Cost of Something Is What You Give
Up to Get It.

• World Squash
Champion Nicol David
understands opportunity
costs and incentives.
She decided to put on
hold her academic
interests to concentrate
on squash where she
earns hundreds of
thousands of ringgit.

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Principle #3: Rational People Think at the
Margin.
• Marginal changes are small, incremental
adjustments to an existing plan of action.

People make decisions by comparing

costs and benefits at the margin.

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Principle #4: People Respond to
Incentives.
• Marginal changes in costs or benefits motivate
people to respond.

• The decision to choose one alternative over

another occurs when that alternative’s marginal
benefits exceed its marginal costs!

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HOW PEOPLE INTERACT
• Trade can make everyone better off.
• Markets are usually a good way to organize
economic activity.
• Governments can sometimes improve
economic outcomes.

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Principle #5: Trade Can Make Everyone
Better Off.
• People gain from their ability to trade with one
another.
• Competition results in gains from trading.
• Trade allows people to specialize in what they
do best.

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Principle #6: Markets Are Usually a Good
Way to Organize Economic Activity.
• A market economy is an economy that allocates
resources through the decentralized decisions of
many firms and households as they interact in
markets for goods and services.
• Households decide what to buy and who to work
for.
• Firms decide who to hire and what to produce.

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Principle #6: Markets Are Usually a Good
Way to Organize Economic Activity.
• Adam Smith made the observation that
households and firms interacting in markets act
as if guided by an “invisible hand.”
• Because households and firms look at prices when
deciding what to buy and sell, they unknowingly
take into account the social costs of their actions.
• As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of
society as a whole.

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Principle #7: Governments Can
Sometimes Improve Market Outcomes.
• Markets work only if property rights are
enforced.
• Property rights are the ability of an individual to
own and exercise control over a scarce resource
• Market failure occurs when the market fails to
allocate resources efficiently.
• When the market fails (breaks down)
government can intervene to promote efficiency
and equity.

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Principle #7: Governments Can
Sometimes Improve Market Outcomes.
• Market failure may be caused by:
• an externality, which is the impact of one person or
firm’s actions on the well-being of a bystander.
• market power, which is the ability of a single person
or firm to unduly influence market prices.

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HOW THE ECONOMY AS A
WHOLE WORKS
• A country’s standard of living depends on its
ability to produce goods and services.
• Prices rise when the government prints too
much money.
• Society faces a short-run trade-off between
inflation and unemployment.

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Principle #8: A Country’s Standard of Living
Depends on Its Ability to Produce Goods and
Services.
• Standard of living may be measured in different
ways:
• By comparing personal incomes.
• By comparing the total market value of a nation’s
production.

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Principle #8: A Country’s Standard of Living
Depends on Its Ability to Produce Goods and
Services.
• Almost all variations in living standards are
explained by differences in countries’
productivities.
• Productivity is the amount of goods and
services produced from each hour of a worker’s
time.

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Principle #8: A Country’s Standard of Living
Depends on Its Ability to Produce Goods and
Services.
• Standard of living may be measured in different
ways:
• By comparing personal incomes.
• By comparing the total market value of a nation’s
production.

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Principle #9: Prices Rise When the
Government Prints Too Much Money.
• Inflation is an increase in the overall level of
prices in the economy.
• One cause of inflation is the growth in the
quantity of money.
• When the government creates large quantities
of money, the value of the money falls.

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Principle #10: Society Faces a Short-run Trade-
off between Inflation and Unemployment.

• The Phillips Curve illustrates the trade-off

between inflation and unemployment:
• Inflation or Unemployment
• It’s a short-run trade-off!
• The trade-off plays a key role in the analysis of the
business cycle—fluctuations in economic activity,
such as employment and production

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 Thinking Like an Economist

Economics trains you to. . . .

 Think in terms of alternatives.
 Evaluate the cost of individual and social choices.
 Examine and understand how certain events and
issues are related.

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THE ECONOMIST AS A SCIENTIST

The economic way of thinking . . .

 Involves thinking analytically and objectively.
 Makes use of the scientific method.
 Uses abstract models to help explain how a
complex, real world operates.
 Develops theories, collects and analyzes data to
evaluate the theories.

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The Scientific Method: Observation, Theory,
and More Observation
• Uses abstract models to help explain how a
complex, real world operates.
• Develops theories, collects and analyzes data
to evaluate the theories.

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 The Role of Assumptions

• Economists make assumptions in order to

make the world easier to understand.
• The art in scientific thinking is deciding
which assumptions to make.
• Economists use different assumptions to
answer different questions.

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Using Economic Models

Economic Model: a simplified version of reality

that allows us to observe, understand, and make
predictions about economic behavior.
Economic Models and Math
•Economic models can be represented using
words or using mathematics. 
•Algebra and graphs are utilized to explain
economic models.

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 Economic Models

• Economists use models to simplify reality in

order to improve our understanding of the
world.
• Two of the most basic economic models are:
• The Circular Flow Diagram
• The Production Possibilities Frontier

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Our First Model: The Circular-Flow
Diagram
• The circular-flow diagram is a visual model of
the economy that shows how dollars flow
through markets among households and firms.

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Figure 1 The Circular Flow
MARKETS
Revenue FOR Spending
GOODS AND SERVICES
•Firms sell Goods and
Goods
•Households buy services
and services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars

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Our First Model: The Circular-Flow
Diagram
• Firms
• Produce and sell goods and services
• Hire and use factors of production
• Households
• Buy and consume goods and services
• Own and sell factors of production

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Our First Model: The Circular-Flow
Diagram
• Markets for Goods and Services
• Firms sell
• Households buy
• Markets for Factors of Production
• Households sell
• Firms buy

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Our First Model: The Circular-Flow
Diagram
• Factors of Production
• Inputs used to produce goods and services
• Land, labor, and capital

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Our Second Model: The Production
Possibilities Frontier
• The production possibilities frontier is a graph
that shows the combinations of output that the
economy can possibly produce given the
available factors of production and the
available production technology.

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Figure 2 The Production Possibilities Frontier
Quantity of
Computers
Produced

3,000 C

A
2,200
2,000 B
Production
possibilities
frontier
1,000 D

0 300 600 700 1,000 Quantity of

Cars Produced
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Our Second Model: The Production
Possibilities Frontier
• Concepts illustrated by the production
possibilities frontier
• Efficiency
• Trade-offs
• Opportunity cost
• Economic growth

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 Figure 3 A Shift in the Production Possibilities
Frontier
Quantity of
Computers
Produced

4,000

3,000

2,300 G
2,200
A

0 600 650 1,000 CarsQuantity

Produced
of
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 Purpose of Functions

• Function: a relationship or expression involving

one or more variables.
• In economics, functions frequently describe cause and
effect.
• The variable on the left-hand side is what is being
explained (“the effect”). 
• On the right-hand side is what’s doing the explaining
(“the causes”).
• Economic models tend to express relationships
using economic variables, such as:
• Budget = money spent on econ books + money spent on
music

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 Solving Simple Equations

Order of Operations Understanding Variables

•When you solve an equation it’s important to do
each operation in the following order:
•values
Variable: a quantity that can assume a range of
represented by a letter or a symbol.
• Simplify inside parentheses and brackets.
• For example: y=9+3x
• Simplify the exponent.
• Multiply and divide from left to right. Working with Variables
• Add and subtract from left to right.
•more
When you’re trying to solve an equation with one or
Lines variables, you need to isolate the variable.
•In this course the most common equation you
will see is for a line in graphs: y = b+mx •What does x equal if y=12?
 Creating and Interpreting Graphs

• intercept: the point on a graph where a line crosses the

vertical axis or horizontal axis.
• slope: the change in the vertical axis divided by the change
in the horizontal axis.
• variable: a quantity that can assume a range of values.
• x-axis: the horizontal line on a graph, commonly represents
quantity (q) on graphs in economics.
• y-axis: the vertical line on a graph, commonly represents
price (p) on graphs in economics.
 Creating and Interpreting Graphs (cont.)

Equation for a Line: y = mx + b

•In any equation for a line, m is the slope and b is the y-intercept.
Interpreting Graphs in Economics
•It is rare for real-world data points to arrange themselves as a perfectly straight line.
•It often turns out that a straight line can offer a reasonable approximation of actual data.
Interpreting Slope

What the Slope Means: the change in the vertical axis

divided by the change in the horizontal axis.
• positive slope indicates that two variables are
positively related; when one variable increases, so does
the other, and when one variable decreases, the other
also decreases.
Interpreting Slope: Negative Slope

What the Slope Means: the change in the

vertical axis divided by the change in the
horizontal axis.
• negative slope indicates that two variables are
negatively related; when one variable increases,
the other decreases, and when one variable
decreases, the other increases.
Interpreting Slope: Slope of Zero

What the Slope Means: the change in the

vertical axis divided by the change in the
horizontal axis.
•Slope of zero indicates that there is a
constant relationship between two variables:
when one variable changes, the other does not
change. 
Interpreting Slope: Calculating Slope

Calculating Slope
• The slope of a straight line between two points can be
calculated in numerical terms.
• To calculate slope, begin by designating one point as the
“starting point” and the other point as the “end point” and
then calculating the rise over run between these two points.
 Interpreting Slope: Calculating Slope
(cont.)
Calculating Slope
•Graphs of economic relationships are not always straight lines but often nonlinear (curved) lines.
• Can interpret nonlinear relationships similarly to the way we interpret linear relationships.
• Their slopes can be positive or negative. We can calculate the slopes similarly also, looking at the rise over
the run of a segment of a curve.
Interpreting Slope: Nonlinear Relationships

Nonlinear relationships can be interpreted similar to

linear relationships.
• Their slopes can be positive (as in Figure 5) or
negative.
• We can calculate the slopes similarly also, looking at
the rise over the run of a segment of a curve.
• A higher positive slope means a steeper upward tilt
to the curve, which you can see at higher output
levels.
• A negative slope that is larger in absolute value (that
is, more negative) means a steeper downward tilt to
the line.
Interpreting Slope: Nonlinear Relationships (cont.)

Nonlinear relationships can be interpreted similar to linear

relationships.
• A slope of zero is a horizontal line.
• A vertical line has an infinite slope.
• If a line has a larger intercept, graphically, it would shift out (or
up) from the old origin, parallel to the old line.
• If a line has a smaller intercept, it would shift in (or down),
parallel to the old line.
 Types of Graphs: Line

Line Graphs: show a relationship between

two variables: one measured on the
horizontal axis and the other measured on
the vertical axis.
• Sometimes it’s useful to show more than
one set of data on the same axes.
• The data in the table, below, is displayed
in Figure 1, which shows the relationship
between two variables: length and median
weight for American baby boys and girls
during the first three years of life.
Types of Graphs: Line (cont.)

Line Graphs:
• The line graph measures length in inches on the
horizontal axis and weight in pounds on the vertical axis.
For example, point A on the figure shows that a boy who
is 28 inches long will have a median weight of about 19
pounds.
• One line on the graph shows the length-weight
relationship for boys, and the other line shows the
relationship for girls.
• This kind of graph is widely used by health-care
providers to check whether a child’s physical
development is roughly on track.
 Types of Graphs: Pie

Pie Graphs: (sometimes called a pie chart) is used to

show how an overall total is divided into parts. A circle
represents a group as a whole. The slices of this circular
“pie” show the relative sizes of subgroups.
• These pie graphs show how the U.S. population was
divided among children, working-age adults, and the
elderly in 1970, 2000, and what is projected for 2030.
• In a pie graph, each slice of the pie represents a share of
the total, or a percentage. For example, 50% would be half
of the pie and 20% would be one-fifth of the pie.
Types of Graphs: Pie (cont.)

Pie Graphs:
• The three pie graphs show that the share of the
U.S. population 65 and over is growing.
• The pie graphs allow you to get a feel for the
relative size of the different age groups from
1970 to 2000 to 2030, without requiring you to
slog through the specific numbers and
percentages in the table.
• Some common examples of how pie graphs are
used include dividing the population into groups
by age, income level, ethnicity, religion,
occupation; dividing different firms into
categories by size, industry, number of
employees; and dividing up government spending
or taxes into its main categories.
 Types of Graphs: Bar

Bar Graphs: uses the height of different bars to

compare quantities.
• Bar graphs can be subdivided in a way that
reveals information similar to that we can get from
pie charts.
• It is sometimes easier for a reader to run his or
her eyes across several bar graphs, comparing the
shaded areas, rather than trying to compare several
pie graphs.
Types of Graphs: Bar (cont.)

Bar Graphs: uses the height of different bars to compare

quantities.
• The three bar graphs are based on the information from
the chart about the U.S. age distribution in 1970, 2000,
and 2030.
• Graph (a) shows three bars for each year,
representing the total number of persons in each
age bracket for each year.
• Graph (b) shows just one bar for each year, but the
different age groups are now shaded inside the bar.
• Graph(c), still based on the same data, the vertical
axis measures percentages rather than the number
of persons.
 Types of Graphs: Comparison

How do you know which graph to use for your data?

• Bar graphs are especially useful when comparing • Pie graphs are often better than line
graphs at showing how an overall
quantities.
group is divided.
• For example, if you are studying the
populations of different countries, bar graphs • However, if a pie graph has too
can show the relationships between the many slices, it can become
population sizes of multiple countries. difficult to interpret.
• Not only can it show these relationships, but it
can also show breakdowns of different groups
within the population
Types of Graphs: Comparison (cont.)

How do you know which graph to use for your data?

• Line graphs are often the most effective format

for illustrating a relationship between two
variables that are both changing.
• For example, time-series graphs can show
patterns as time changes, like the
unemployment rate over time.
• Line graphs are widely used in economics to
present continuous data about prices, wages,
quantities bought and sold, the size of the
economy.
THE ECONOMIST AS POLICY
ADVISOR

• When economists are trying to explain the

world, they are scientists.
• When economists are trying to change the
world, they are policy advisors.

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Positive versus Normative Analysis

• Positive statements are statements that attempt

to describe the world as it is.
• Called descriptive analysis
• Normative statements are statements about how
the world should be.
• Called prescriptive analysis

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Positive Versus Normative Analysis

?
• Are the following positive or normative
statements?
• An increase in the minimum wage will cause a
decrease in employment among the least-skilled.
• POSITIVE

• Higher federal budget deficits will cause interest

rates to increase.
• POSITIVE ?
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Positive Versus Normative Analysis
• Are the following positive or normative
statements?
• The income gains from a higher minimum wage are worth
?
more than any slight reductions in employment.
• NORMATIVE

• Governments should be allowed to collect from tobacco

companies the costs of treating smoking-related illnesses
among the poor.
• NORMATIVE
?
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Economists in Malaysian Government

• . . . serve as advisers in the policymaking

process of the three branches of government:
• Legislative
• Executive
• Judicial

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