Chapter 1: Introduction to Economics

Intended Learning Outcomes

At the end of this Chapter, students will be able to:

• Identify the kinds of questions an economics face

• Discuss the principles of how people make decisions

• Discuss the principles of how people interact

• Discuss the principles of how the economy as a whole works

What is Economics?

• Study of how society manages its scarce resources

• Therefore, basic economic concept is Scarcity

• Scarcity: the limited nature of society’s resources

• Economics: the study of how society manages its scarce resources, e.g.

• how people decide what to buy,

how much to work, save, and spend

• how firms decide how much to produce,

how many workers to hire

• how society decides how to divide its resources between national defense, consumer
goods,

The principles of HOW PEOPLE MAKE DECISIONS

Principle No.1
People Face Trade-offs

-There Is No Such Thing As A Free Lunch

- What in life is truly free?

All decisions involve tradeoffs. Examples:

• Going to a party the night before your midterm leaves less time for studying.
 • Having more money to buy stuff requires working longer hours, which leaves less time for
leisure.

• Protecting the environment requires resources

that could otherwise be used to produce
consumer goods.

Cont….

• Making decisions requires trading one goal for another

• Efficiency vs. Equity: Maximum benefits to society vs. “fairness”

• Efficiency: when society gets the most from its scarce resources

• Equality: when prosperity is distributed uniformly among society’s members

• Tradeoff: To achieve greater equality,

could redistribute income from wealthy to poor.
But this reduces incentive to work and produce, shrinks the size of the economic “pie.”

Principle No.2
The Cost of Something is What You Give Up to Get It

• Making decisions causes people to consider the costs & benefits of an action

• Opportunity Cost: Whatever must be given up in order to obtain some item

• It is the relevant cost for decision making.

Examples:
The opportunity cost of…

Do you go to college?

…going to college for a year is not just the tuition, books, and fees, but also the foregone wages.

…seeing a movie is not just the price of the ticket,

but the value of the time you spend in the theater.

Principle No.3
Rational People Think at the Margin

• Are people rational?

Rational people

• systematically and purposefully do the best they can to achieve their objectives.
 • HUGE CONCEPT:

• make decisions by evaluating costs and benefits of marginal changes – incremental

adjustments to an existing plan.

Marginal Benefit vs. Marginal Cost

- up to and including

MB=MC

Examples:

• When a student considers whether to go to college for an additional year, he compares the fees
& foregone wages to the extra income
he could earn with the extra year of education.

• When a manager considers whether to increase output, he compares the cost of the needed
labor and materials to the extra revenue.

Principle No. 4
People Respond to Incentives

• Incentives change people’s behavior

• Incentive: something that induces a person to act, i.e. the prospect of a reward or punishment.

• Must look at direct & indirect effects of incentives/policies (unintended consequences)

• Rational people respond to incentives.

• Change incentives/change behavior

-Ex: Incentive effects of Gas Prices Rising

When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs.

When cigarette taxes increase, teen smoking falls.

ACTIVE LEARNING 1
Applying the principles

You are selling your 1996 Mustang. You have already spent $1000 on repairs.

At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car “as is.”

In each of the following scenarios, should you have the transmission repaired? Explain.

A. Blue book value is $6500 if transmission works, $5700 if it doesn’t

B. Blue book value is $6000 if transmission works, $5500 if it doesn’t

The principles of
HOW PEOPLE
INTERACT

Is Trade Good for Sri Lanka?

• Should Sri Lanka trade more or less than we do? Why?

Principle No.5
Trade Can Make Everyone Better Off

• Trade doesn’t have to result in winners & losers – both can win!

• Trade allows for specialization in what you do best

Rather than being self-sufficient, people can specialize in producing one good or service and exchange it
for other goods.

• Countries also benefit from trade & specialization:

• Get a better price abroad for goods they produce

• Buy other goods more cheaply from abroad than could be produced at home

Principle No.6
Markets Are Usually a Good Way to Organize Economic Activity

• Many countries have abandoned centrally planned economies to develop markets

Market: a group of buyers and sellers (need not be in a single location)

• Market economy: an economy that allocates resources through decisions of many firms and
households

• “Organize economic activity” means determining

• what goods to produce

• how to produce them

• how much of each to produce

• who gets them

Count….
 • A market economy allocates resources through the decentralized decisions of many households
and firms as they interact in markets.

• Famous insight by Adam Smith in

The Wealth of Nations (1776):

Each of these households and firms acts as if “led by an invisible hand”

to promote general economic well-being.

Invisible Hand guides the economy when everyone does what is best for them

• The invisible hand works through the price system:

• The interaction of buyers and sellers determines prices.

• Each price reflects the good’s value to buyers and the cost of producing the good.

• Prices guide self-interested households and firms to make decisions that, in many cases,
maximize society’s economic well-being.

Good Government, Bad Government

• How much/how little should the government get involved in the economy?

• In what situations does it help to have government intervention?

Principle No.7
Governments Can Sometimes Improve Market Outcomes

• Important role for government: enforce property rights (with police, courts)

• People are less inclined to work, produce, invest, or purchase if large risk of their property being
stolen.

• Biggest Reasons for Intervention:

Efficiency & Equality

• Most useful when there is Market Failure

Market failure: when the market fails to allocate society’s resources efficiently

Causes:

Externalities, when the production or consumption of a good affects bystanders (e.g.

pollution)

Market power, a single buyer or seller has substantial influence on market price (e.g.
monopoly)
Cont…

• In such cases, public policy may promote efficiency.

• Government may alter market outcome to promote equity

• If the market’s distribution of economic well-being is not desirable, tax or welfare policies can
change how the economic “pie” is divided.

ACTIVE LEARNING 2
Discussion Questions

In each of the following situations, what is the government’s role? Does the government’s intervention
improve the outcome?

a. Public schools for K-12

b. Workplace safety regulations

c. Public highways

d. Patent laws, which allow drug companies to charge high prices for life-saving drugs

The principles of
HOW THE ECONOMY
AS A WHOLE WORKS

Principle No.8
A Country’s Standard of Living Depends on Its Ability to Produce Goods & Services

• Huge differences in living standards around the world

• Average income in rich countries is more than ten times average income in poor
countries.

• The U.S. standard of living today is about

eight times larger than 100 years ago.

• Explained by differences in productivity

• The most important determinant of living standards: productivity, the amount of goods and
services produced per unit of labor.

• Productivity depends on the equipment, skills, and technology available to workers.

• Other factors (e.g., labor unions, competition from abroad) have far less impact on living
standards.
 • Cont….

• Broken window fallacy?

• a man's son breaks a pane of glass

• man will have to pay to replace it.

• Some consider the boy has actually done the community a service because ….?

• his father will have to pay the repair man

• Who will then presumably spend the extra money on something else……

• jump-starting the local economy.

• Why is this wrong?

Cont…

• the man's son has reduced his father's disposable income,

• his father will not be able purchase new shoes or some other luxury good.

• Thus, the broken window might help the repair man, but at the same time,

• it robs other industries and reduces the amount being spent on other goods.

• Moreover, replacing something that has already been purchased is a maintenance cost, rather
than a purchase of truly new goods, and maintenance doesn't stimulate production.

Cont….

 broken window fallacy is often used to discredit the idea that going to war stimulates a country's
economy.

 This fallacy forgets about the missing third party (such as the shoe maker).

• In this sense, the fallacy comes from making a decision by looking only at the parties directly
involved in the short term,

• rather than looking at all parties (directly and indirectly) involved in the short and long term.

Principle No.9
Prices Rise When the Government Prints Too Much Money

• Inflation – increase in overall level of prices in the economy

 • In the long run, inflation is almost always caused by excessive growth in the quantity of money,
which causes the value of money to fall.

• The faster the government creates money, the greater the inflation rate.

• Examples?

Principle No.10
Society Faces a Short-Run Trade-off Between Inflation & Unemployment

• In the short-run (1 – 2 years), many economic policies push inflation and unemployment in
opposite directions- increase in $ leads to lower unemployment but higher prices

• In short run, Trade-off leads to discussions of business cycles, fiscal & monetary policy. These
other factors can make this tradeoff more or less favorable, but the tradeoff is always present.

CHAPTER SUMMARY

The principles of decision making are:

• People face tradeoffs.

• The cost of any action is measured in terms of foregone opportunities.

• Rational people make decisions by comparing marginal costs and marginal benefits.

• People respond to incentives.

The principles of interactions among people are:

• Trade can be mutually beneficial.

• Markets are usually a good way of coordinating trade.

• Government can potentially improve market outcomes if there is a market failure or if the
market outcome is inequitable.

The principles of the economy as a whole are:

• Productivity is the ultimate source of living standards.

• Money growth is the ultimate source of inflation.

• Society faces a short-run tradeoff between inflation and unemployment.

Reference

• Mankiw N G. (2009), “Principles of Microeconomics” South-Western, a part of Cengage

Learning. <http://academic.cengage.com/economics/mankiw>