Chapter 1

Nature & Scope of

Economics
DEFINITION AND QUESTIONS

All economic questions and problems arise because human

wants exceed the resources available to satisfy them.
Scarcity
Scarcity is the condition that arises because wants
exceeds the ability of resources to satisfy them. It means
that the resources we use to produce goods and services
are limited.

Faced with scarcity, we must make choices—we must

choose among the available alternatives.

The choices we make depend on the incentives we face.

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 What is ECONOMICS?
Came from the Greek word “oikonomia” or
“oikonomos” w/c means “management of the
household;” the two basic facts are: (1) the
limited resources available to the household; (2)
unlimited needs of the members of the
household
Social science that studies the optimum
allocation, overtime of scarce human & non-
human resources among their alternative uses in
order to satisfy unlimited human wants & desires
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What is ECONOMICS?

Social science that studies the

choices that individuals, businesses,
governments, and entire societies
make as they cope with scarcity and
the incentives that influence and
reconcile our choices.
It is the study of choices when there is
scarcity.
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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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Economic Methodology

1) Theoretical economics is the gathering and

analysis of relevant facts to derive economic
principles. Economists use both inductive &
deductive reasoning to develop economic
principles.
➢ Induction creates principles from factual
observations or goes from the particular to the
general.
➢ Deduction formulates a hypothesis and then
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Economic Methodology

➢ tests it for validity or goes from the general to the

particular
❖Economic principles and theories are:
✓ Meaningful statements about economic behavior
in the economy
✓ They are also laws and models
✓ Each principle & theory is a generalization that
shows a tendency or average effect
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Economic Methodology

✓ the “other things equal” assumption is used to

limit the influence of other factors when making a
generalization
✓ These are abstractions from reality
✓ Many of these can be illustrated graphically
2) Policy economics is the use of economic
principles to develop a course of action to solve
economic problems.

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THE ECONOMIC WAY OF THINKING

Core Economic Ideas:

• Rational choice
• Cost
• Benefit
• Margin
• Incentives
• Trade off
• Efficient Markets

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THE ECONOMIC WAY OF THINKING

1) Rational Choice
–A rational choice is a choice that uses
the available resources to best achieve
the objective of the person making the
choice.
–We make rational choices by comparing
costs and benefits.

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THE ECONOMIC WAY OF THINKING

2) Cost: What You Must Give Up

Opportunity cost is the best thing that you must
give up to get something—the highest-valued
alternative forgone. The best alternative that we
forgo, or give up, when we make a choice or a
decision.
•Sunk cost is a previously incurred and
irreversible cost. A sunk cost is not part of the
opportunity cost of a current choice. Costs that
cannot be avoided, regardless of what is done in
the future, because they have already been
incurred.
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THE ECONOMIC WAY OF THINKING

PRINCIPLE OF OPPORTUNITY COST

The opportunity cost of something is what you sacrifice to get it.

• Opportunity cost
What you sacrifice to get something.

The Cost of College

Opportunity cost of money spent on tuition and books $ 40,000

Opportunity cost of college time (four years working for

$20,000 per year) 80,000

Economic cost or total opportunity cost $120,000

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THE PRINCIPLE OF OPPORTUNITY COST

Opportunity Cost and the

Production Possibilities Curve
Production possibilities curve
A curve that shows the possible
combinations of products that an economy
can produce, given that its productive
resources are fully employed and efficiently
used.

The production possibilities curve illustrates

the principle of opportunity cost for an entire
economy.
An economy has a fixed amount of
resources. If these resources are fully
employed, an increase in the production of
wheat comes at the expense of steel.

 12
 THE PRINCIPLE OF OPPORTUNITY COST

An increase in the quantity of

resources or technological
innovation in an economy shifts
the production possibilities
curve outward.

Starting from point f, a nation

could produce more steel (point
g), more wheat (point h), or
more of both goods (points
between g and h).

 13
 THE ECONOMIC WAY OF THINKING
3) Benefit: Gain Measured by What You Are Willing to
Give Up
–Benefit is the gain or pleasure that something brings.
4) On the Margin
Marginalism: The process of analyzing the additional or
incremental costs or benefits arising from a choice or
decision.
–A choice made on the margin is a choice made by
comparing all the relevant alternatives systematically and
incrementally.
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THE ECONOMIC WAY OF THINKING

 Marginal cost is the cost of a one-unit increase in an

activity.
 Marginal benefit is the what you gain when you get one
more unit of something.

MARGINAL PRINCIPLE
Increase the level of an activity as long as its marginal benefit
exceeds its marginal cost. Choose the level at which the marginal
benefit equals the marginal cost.
Making a Rational Choice
–When we take those actions for which marginal benefit
exceeds or equals marginal cost.

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THE MARGINAL PRINCIPLE
How Many Movie Sequels?
The marginal benefit of movies in a
series decreases because revenue falls
off with each additional movie, while the
marginal cost increases because actors
demand higher salaries.

The marginal benefit exceeds the

marginal cost for the first two movies,
so it is sensible to produce two, but not
three, movies.

 16
Example: Driving Speed and Safety
Consider the decision about how fast to drive on a highway. The marginal benefit of going
one mile per hour faster is the travel time you’ll save. On the cost side, an increase in speed
increases your chances of colliding with another car, and also increases the severity of
injuries suffered in a collision. A rational person will pick the speed at which the marginal
benefit of speed equals the marginal cost.

In the 1960s and 1970s, the government required automakers to include a number of safety
features, including seat belts and collapsible steering columns. These new regulations had
two puzzling effects. Although deaths from automobile collisions decreased, the reduction
was much lower than expected. In addition, more bicyclists were hit by cars and injured or
killed.

We can use the marginal principle to explain why seat belts and other safety features made
bicycling more hazardous. The mandated safety features decreased the marginal cost of
speed: People who wear seat belts suffer less severe injuries in a collision, so every
additional unit of speed is less costly. Drivers felt more secure because they were better
insulated from harm in the event of a collision, and so they drove faster. As a result, the
number of collisions between cars and bicycles increased, meaning that safer environment
for drivers led to a more hazardous environment for bicyclists.

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THE ECONOMIC WAY OF THINKING

5) An incentive is a reward or a penalty—a

“carrot” or a “stick”—that encourages or
discourages an action.
6) Trade-off
The idea that because of scarcity, producing
more of one good or service means
producing less of another good or service.

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THE ECONOMIC WAY OF THINKING

7) 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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Scope of Economics

1) Microeconomics
 The study of the choices that individuals and
businesses make and the way these choices
interact and are influenced by governments.
 The study of how households and firms
make choices, how they interact in markets,
and how the government attempts to
influence their choices.
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Scope of Economics

2) Macroeconomics
The study of the aggregate (or total) effects on
the national economy and the global economy
of the choices that individuals, businesses, and
governments make.
The study of the economy as a whole,
including topics such as inflation,
unemployment, and economic growth.

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Scope of Economics

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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 Scope of Economics

TABLE 1.1 Examples of Microeconomic and

Macroeconomic Concerns
Divisions
of Economics Production Prices Income Employment

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

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

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METHODS OF ECONOMICS

1) 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.
2) 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.
Economists distinguish between
• Positive statements: What is?
• Normative statements: What ought to be?
–The task of economic science:
–To test positive statements about how the economic world
works and to weed out those that are wrong. 27
Theories and Models

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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THE ECONOMIC WAY OF THINKING

–Unscrambling Cause and Effect

–The central idea that economists use to unscramble cause and effect is
ceteris paribus.
–Ceteris paribus means “other things being equal.”
–A device used to analyze the relationship between two variables while the
values of other variables are held unchanged.
–By changing one factor at a time and holding other relevant factors constant,
we are able to investigate the effects of the factor.
–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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Economic Policy

Four criteria are important in judging

economic outcomes:
1. Efficiency
2. Equity
3. Growth
4. Stability

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Economic Policy

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

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