Learning Unit 1

Introduction to Economics

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By the end of this chapter, students
should understand:
 that economics is about the allocation of scarce
resources.
 that individuals face trade-offs.
 the meaning of opportunity cost.
 how to use marginal reasoning when making decisions.
 how incentives affect people’s behavior.
 why trade among people or nations can be good for
everyone.
 why markets are a good, but not perfect, way to
allocate resources.
 what determines some trends in the overall economy.

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By the end of this chapter, students
should understand:

 how economists apply the methods of science.

 how assumptions and models can shed light on the
world.
 two simple models—the circular flow and the
production possibilities frontier.
 the difference between microeconomics and
macroeconomics.
 the difference between positive and normative
statements.
 the role of economists in making policy.
 why economists sometimes disagree with one another.

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4
 Economy. . .

. . . The word economy comes

from a Greek word for “one who
manages a household.”

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 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
 Society and Scarce Resources:
• The management of society’s resources is
important because resources are scarce.
• Scarcity. . . means that society has limited
resources and therefore cannot produce all the
goods and services people wish to have.

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TEN PRINCIPLES OF ECONOMICS

Economics is the study of how society manages its

scarce resources.

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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. Squash
 World
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. 21
 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.
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.

© 2007 Thomson South-Western

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.

© 2007 Thomson South-Western

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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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

© 2007 Thomson South-Western

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.

© 2011 Cengage
© 2007 ThomsonSouth-Western
South-Western
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

© 2007 Thomson South-Western

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

© 2007 Thomson South-Western

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

© 2007 Thomson South-Western

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

© 2007 Thomson South-Western

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.

© 2007 Thomson South-Western

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
© 2007 Thomson South-Western
Our Second Model: The Production
Possibilities Frontier
• Concepts illustrated by the production
possibilities frontier
• Efficiency
• Trade-offs
• Opportunity cost
• Economic growth

© 2007 Thomson South-Western

 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

© 2007 Thomson South-Western

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

© 2007 Thomson South-Western

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
? ?
© 2007 Thomson South-Western
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
?
© 2007 Thomson South-Western
Economists in Malaysian Government

• . . . serve as advisers in the policymaking

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

© 2007 Thomson South-Western

Consider your typical day:
• You wake up to an alarm clock made in China.
• You pour yourself orange juice made from Florida
oranges and coffee from beans grown in Brazil.
• You put on some clothes made of cotton grown in
India and sewn in factories in Thailand.
• You watch the morning news broadcast from Hong
Kong on your TV made in Japan.
• You drive to class in a car made of parts
manufactured in a half-dozen different countries.
. . . and you haven’t been up for more than two hours yet!

© 2011 Cengage
© 2007 ThomsonSouth-Western
South-Western
Interdependence and the Gains from
Trade

Remember, economics is the study of how

societies produce and distribute goods in an
attempt to satisfy the wants and needs of their
members.

© 2007 Thomson South-Western

Interdependence and the Gains from
Trade

• Individuals and nations rely on specialized

production and exchange as a way to address
problems caused by scarcity.
• But this gives rise to two questions:
• Why is interdependence the norm?
• What determines production and trade?

© 2007 Thomson South-Western

Interdependence and the Gains from
Trade

• Why is interdependence the norm?

• Interdependence occurs because people are better
off when they specialize and trade with others.
• What determines the pattern of production and
trade?
• Patterns of production and trade are based upon
differences in opportunity costs.

© 2007 Thomson South-Western

A PARABLE FOR THE MODERN
ECONOMY
Imagine an economic system with only two
goods, potatoes and chicken and only two people,

a potato farmer and a chicken breeder

• What should each person produce?
• Why should these people trade?

© 2007 Thomson South-Western

 Minutes Needed to Amount Produced in
Make 1 Kilogram of: 8 Hours
Chicken Potatoes Chicken Potatoes
Farmer 60 15 8 kg 32 kg Breeder
min/kg min/kg
Breeder 20 10 24 kg 48 kg
min/kg min/kg

© 2007 Thomson South-Western

Production Possibilities

• Suppose the farmer and breeder decide not to

engage in trade:
• Each consumes only what he or she can produce
alone.
• The production possibilities frontier is also the
consumption possibilities frontier.
• Without trade, economic gains are diminished.

© 2007 Thomson South-Western

Figure 1 The Production Possibilities
Frontier
(a) The Farmer’ s Production Possibilities Frontier

Chicken (kg)

If there is no trade,
the farmer chooses
8 this production and
consumption.

4 A

0 16 32 Potatoes (kg)

© 2007 Thomson South-Western

Figure 1 The Production Possibilities
Curve
(b) The Production Possibilities Frontier
Breeder’s
Chicken (kg)

24

If there is no trade,
the breeder chooses
this production and
consumption.

12 B

0 24 48
Potatoes (kg)

© 2007 Thomson South-Western

Production and Consumption Without
Trade

Farmer Breeder

Chicken Potatoes Chicken Potatoes

Without Trade:
Production & 4 kg 16 kg 12 kg 24 kg
Consumption

© 2007 Thomson South-Western

Specialization and Trade

• Suppose instead the farmer and the breeder

decide to specialize and trade…
• Both would be better off if they specialize in
producing the product they are more suited to
produce, and then trade with each other.

The farmer should produce potatoes.

The rancher should produce meat.

© 2007 Thomson South-Western

Figure 2 How Trade Expands the Set of
Consumption Opportunities
(a) The Farmer’ s Production and Consumption

Chicken (kg)

Farmer's
consumption
with trade
8 Farmer's
production and
consumption
5 A* without trade
4
A Farmer's
production
with trade

0 32 Potatoes (kg)
16 17

© 2007 Thomson South-Western

Figure 2 How Trade Expands the Set of
Consumption Opportunities
(b) The Breeder ’s Production and Consumption

Chicken (kg)

24 Breeder's
production
with trade
Breeder's
consumption
18 with trade

13
B* Breeder's
production and
B
12 consumption
without trade

0 12 24 27 48
Potatoes (kg)

© 2007 Thomson South-Western

Gains from Trade

Farmer Breeder
Chicken Potatoes Chicken Potatoes
With Trade:
Production 0 kg 32 kg 18 kg 12 kg
Trade Gets 5 kg Gives 15 Gives 5 kg Gets 15 kg
kg
Consumption 5 kg 17 kg 13 kg 27 kg
GAINS FROM TRADE:
Increase in Consumption +1 kg +1 kg +1 kg +3 kg

© 2007 Thomson South-Western

Copyright © 2004 South-Western/Thomson Learning