Module 1: The Economic Problem

Learning Outcomes

After successful completion of this module, you will be able to

 Identify the four parts or themes of ECON 101 and their

interrelatedness
 Define economics and its place in social science
 Explain the broad scope of economics using the two big
questions
 Explain how choice is related to tradeoffs, change,
opportunity cost, margins, and incentives using an
economic way of thinking
 Illustrate how an economic system works using the circular
flow model and the production possibility frontier model
 Define comparative and absolute advantage
 Explain how nations that specialize in their comparative
advantage can possibly gain from trade
 1.1 The Definition of Economics

Definition of Economics

Let’s begin by discussing what we mean by economics. Really,

no definition can fully articulate what economics entails.
However, definitions can provide us with key concepts that
apply to economics, and these key concepts can help us better
understand what economics is all about.

Economics is pervasive in our everyday lives from a personal,

local, provincial, national, and even global perspective; we’re
often just not conscious of it. Below is a well-established
definition of economics:

Economics is the social science that studies choices that

individuals, businesses, government, and entire societies make
as they cope with scarcity and incentives that influence and
reconcile these choices.

This definition really does contain several key components that

are critical to understanding economics, so let’s decompose this
definition.
Let’s begin by looking at the term “scarcity.” People,
businesses, and governments all have various things that they
desire; we will refer to these as “wants.”

For example, I want a new Can-Am Spyder, a new pair of

Converse All-Stars, and a Toronto Maple Leafs playoff ticket.

Businesses may want more customers, increased margins, and

more Internet sales.

Governments want lower national unemployment, low inflation,

and increases in secondary school attainment rates.

In reality, all of our wants are unlimited in nature. No one can

really ever satisfy all of their wants. Unfortunately, we do not
have unlimited resources to meet those unlimited wants. Our
resources are scarce in relation of our wants.

For example, individual wants are limited by time, income,

wealth, and prices. Business profits are limited by suppliers,
customer demand, and government regulations. Governments
are limited by budgets, the tax base, and population
demographics. Scarcity is all relative to wants.
Our inability to satisfy our unlimited wants is what defines
scarcity. Now let’s see how scarcity relates to choices and
incentives. Faced with scarce resources against unlimited wants,
we must choose among alternatives, so choice becomes
imminent. Since we cannot have all that we want, we need to
make decisions; we need to make choices. However, when we
make choices, our decisions are influenced by incentives,
incentives being something, maybe a reward or a punishment,
which induces rational individuals to act in a certain way.

For example, if we have the choice of entrance into two

university programs, where one program is offering large
scholarship funding and the other program is offering no
scholarship funding, the positive funding incentive will
influence which university program is selected, assuming a
rational decision-making process.

What about a form of negative incentive. Recall, that I

mentioned that I want a Can-Am Spyder … however, I am
married to a wonderful woman (who does not want me to crash
a motorcycle and hurt myself) that has provided me with a
choice between purchasing a Can-Am Spyder and receiving
several negative consequences compared with not purchasing a
Can-Am Spyder and not receiving the negative consequences. 
A penalty exists if I purchase the bike. So as a rational decision
maker, I will not buy the bike if I believe the penalty will
outweigh the benefits of the purchase. Incentives are very
important to understanding how markets operate, since rational
individuals will respond to incentives. Rational individuals will
more than likely select choices that favor positive incentives and
avoid choices that involve negative incentives.

In summary, the definition of economics has thus far taught us

three key concepts that apply to economics: scarcity, choice, and
incentives. Some economists believe that scarcity is the
cornerstone of economics, while other economists believe that
choice is considered the root cause of economics. Either way,
scarcity, choice, and incentives are key concepts that apply to
economics and economic thought.

There is one more key concept that we also need to highlight in

the definition of economics, that is the fact that economics is a
social science. Economics is a social science that studies human
behaviour in the face of scarcity. Individuals often think of
economics in terms of money. Individuals often believe that
economics is always about making money, but such is not the
case at all. Economics has a very strong social component.
Economics can help us better manage our natural resources and
how to best deal with the effects of global warming. Economics
can help clarify why an ill patient may opt for one medication
versus another. Economics can also explain why society
holistically benefits from higher levels of education attainment.
We should never lose sight of the fact that economics is a social
science.

As a social science, economics distinguishes between positive

and normative statements, positive statements being about “what
is.” These statements are testable, and positive statements are
ones that economists usually agree on. For example, raising
taxes on cigarettes will raise the price of cigarettes, which will
lead more individuals to reduce smoking and in turn reduce
health care costs. Normative statements are about “what ought to
be.” These statements are more of an opinion and not
necessarily testable. Normative statements are ones that
economists do not necessarily agree upon. For example, taxes on
cigarettes should be raised.

To test positive statements, economists create and test economic

models to explain how the economy works. Economic models
focus on what is important for the task at hand and are abstract
depictions of the real world. Models are judged by their ability
to predict outcomes. If a model appears very realistic, it can be
considered as a failure if the model does not predict well what is
actually happening. On the other hand, if a model appears very
unrealistic, yet the model predicts well, it can be very useful. Be
very cautious in economics to not judge models that appear
highly unrealistic without assessing the model’s capacity to
predict successfully.

To test economic models, economists sometimes employ natural

experiments, which is a situation that arises in ordinary life, such
as stagflation of the 1970s.  We also use statistical investigation,
such as a regression analysis to help better understand the
correlation between multiple variables.  Economic experiments
are also conducted, where individuals are placed in decision-
making situations, while varying factors of interest, in order to
measure a response.

Before leaving the definition of economics, it is important to

note that the discipline of economics is broken into two branches
of study: microeconomics and macroeconomics. The course
focuses on the study of microeconomics, which focuses on
individual economic market components like consumers, firms,
and specific market activity. Microeconomics really focuses on
the consumer and firm behaviour, while the study of
macroeconomics, focuses on the economy from a much broader
level of activity that discusses larger market sectors and the
relationship among market sectors.
Concept Checks:
 1.2 Economic Questions

Economic Questions

Now that we have established a definition of economics that

helped us define several key concepts that apply to economics,
those being scarcity, choice, and incentives, and the fact that
economics is a social science, we will move on to the two big
economic questions. These questions will help us better
understand the scope of economics.
 1. How do choices end up determining what, how,
and for whom goods and services are produced? Now
let’s look at this question in more detail.

Remember that as a society, we have unlimited wants. Goods

and services comprise the things that individuals obtain to help
satisfy some of those unlimited wants. This equates to the
“what” in our first question.

Goods or services are then produced through the use of

resources, which are called the factors of production,
specifically land, labour, capital, and entrepreneurship. Land
refers to natural resources. Labour refers to time and effort
workers put towards work. Capital refers to physical capital such
as machinery, plants, and human capital such as knowledge,
skills, and education level of workers. This equates to the “how”
of our first question.

Of course, each of these factors of production has a rental price.

Land earns rent, labour earns wages, capital earns interest, and
entrepreneurs earn profit. This equates to the “who” in our first
question. Please note that the “who” in this case can also be
considered as the recipient of the good or service.

As an economist, you will always be asking yourself the “what,

how, and for whom” question.

Now we will turn our attention to the second question in more

detail.

2. How can choices made in the pursuit of self-interest also

promote the social interest?

Choices are made in the pursuit of self-interest or social interest

or potentially both. Self- and social interests are often at conflict
with each other. However, economics asks the question, “Could
it be possible that when each of us makes choices in our self-
interest, can these choices also be of a social interest?” For
example, if I am making a self-interest choice of pursuing higher
education, as I believe I can earn more money over my lifetime
with higher education, can this choice also promote social
interest? The answer in this case is a clear “yes.” My increased
level of education actually does promote social interest.

From a societal perspective, if I am earning more money over

my lifetime, I will be able to support society better by increasing
output and by providing a stronger tax base. In fact, it has been
shown in various studies that if I am more educated, I will more
likely treat the environment with increased respect, my health
will be better, and I will be a better democratic citizen. As noted
earlier in this lecture, we must never lose sight of the fact that
economics is a social science. As an economist, you will always
be asking yourself “How does self-interested choice help
promote the social interest?”
Concept Checks:
 1.3 The Economic Way of Thinking

2 The Economic Way of Thinking

3 Now that we have established the two big questions that we

are constantly asking ourselves as economists, we move on
to learning how economists actually answer these questions,
and it is through economic thought. The economic way of
thinking really revolves around choice in some way. Key
components within the economic way of thinking include
choice and trade-offs, choice and change, choice and
opportunity cost, choice and the margin, and choice and
incentives.
4 Choice and trade-offs: when we think of choice we really
mean that we are making some type of trade-off. We are
making a decision to consume one item over another item.
We are in fact, making a trade-off. Everyone faces a trade-
off when they make a choice. The answers to our
 “what,” “who,” and “how” questions all involve some form
of trade-off. Let’s look at a few examples.
5 Let’s consider consumption and savings. When you save
your money in a financial institution, such as a bank, you
can no longer use those funds for current consumption.
However, your savings will in turn be funneled through
financial institutions to finance new business capital
projects, for example, which will spark future growth and
consumption. So we make a trade-off. We traded current
consumption for economic growth and higher future
consumption.
6
Now let’s look at the big trade-off: efficiency versus equity.
Efficiency relates to society obtaining the most it can from
scarce resources. An analogy often made to help illustrate
efficiency is the size of a pie. Equity relates to distributing
prosperity freely among all members of society. Coming back to
the pie analogy, equity would equate to how the pie is being
divided. When governments redistribute income, they answer
the “for who” question, but income distribution does have a
trade-off. Taxing workers and transferring those tax dollars to
lower income individuals in society, for some, is considered a
deterrent to working more hours, which means that less goods
and services will be produced. So we reduced the size of the pie,
but we shared the pie more equally. We have made a trade-off.
Choice and change: choices over time. This component within
the economic way of thinking simply illustrates the fact that
choices evolve over time. Our choice evolves for many reasons.
For example, we no longer have a desire to consume media on
videotape or DVD, we now consume media using streaming
services. As our lives progress, our circumstances and society
changes. As a result, our preferences change and our choices
change with those preferences.

Choice and opportunity cost: opportunity cost is a very

important economic way of thinking, so be sure to fully
understand this concept before moving on. By
definition, opportunity cost equals the highest value alternative
that we must give up in order to get. What does this mean?
Choices have associated opportunity costs; nothing is for free.
There are many alternatives that we each consider when we
make a choice. Each of the alternatives that we did not choose
has an associated form of cost. And the alternative that we did
not choose that has the highest associated cost is considered the
opportunity cost. The key concept is that nothing is for free. Or
as an economist would say, there is no such thing as a free
lunch.

Let’s look at an example to help us illustrate the concept. Let’s

look at the opportunity cost of going to university. Yes, there are
obvious monetary costs such as tuition, books, and fees, but
opportunity cost is not always about an immediate outlay of
cash. Students attending university full-time have chosen to go
to school full-time versus work full-time. As such, students are
losing potential income they could have earned if they were
working full-time instead of going to school full-time. Not only
that, students are losing a lot of leisure time, and leisure time
also carries a cost. So, forgone income and forgone leisure time
are considered opportunity costs. Fortunately, university rates of
return are high. That is, the benefits outweigh the costs. So, the
decision to attend university is normally a smart one.

Choice and the margin: when we make a choice, we want to

make the choice such that what we gain is greater than what we
give up. Now when we choose, we are making trade-offs, and
those choices are actually being made in small steps and being
influenced by incentives. What do we mean by small steps in
economic terms? We mean at the margin. At the margin, we are
comparing marginal benefits to marginal costs. From an
economic standpoint, when we make choices, we are looking at
the additional benefits, that is, the marginal benefit, of an
increase in activity versus the additional cost, that is, the
marginal cost, of an increase in activity. We strive for choices
where marginal benefit is greater than marginal cost. That is, a
rational decision maker will choose when marginal benefit is
greater than marginal cost. Working at the margin is another
very important economic way of thinking, so be sure to fully
understand this concept before moving on.

Just to emphasize the point, we will go through an example of

what it means to think at the margin. You are studying for an
exam. It’s been four hours, and you’re getting tired. The choice
you need to make is how much longer you will continue to
study. When you ask yourself this question, you’re asking
yourself, “How much extra benefit will I get from studying from
one more hour versus the extra cost that I incur by studying one
more hour?” Instead of studying, I could be eating, working on
another project, going to a part-time job, and all of these items
have associated costs. When you make your choice, you are
looking at what benefit you will receive from the next hour of
studying, not the total hours you have spent studying or the
average number of hours you have spent studying. You are
looking at how much extra benefit you will secure from studying
one more hour versus the cost of studying one more hour, with
the costs being the cost of the alternatives that you could have
been doing versus studying.

Choice and incentives: we have already discussed incentives, so

we will just quickly review this topic. Incentives influence your
decisions. Changes in marginal benefit and marginal cost will
influence decisions. In economics, we try to predict how choices
vary based on incentives. It has been proven many times that
incentives do work. Individuals will respond to rewards or
penalties when considering choice.
Concept Check:
 1.4 Economic Coordination

Economic Coordination

Now that we have an understanding of what economics means

and the economic way of thinking, let’s discuss how economic
systems are coordinated. How does the complex web of
economic activity and decisions all work together? How are all
these interrelated activities coordinated?

Historically, there are two major forms of economic coordinated

systems: central economic planning and decentralized economic
planning. Today, there are economic coordinated systems that
are actually a bit of both. They are partially centralized and
partially decentralized. For example, one could argue that
China’s economy is evolving in this manner.

In this course, we will focus on the decentralized economic

planning approach. We are focusing on this approach as it is the
predominant approach leveraged in the Western world,
including Canada. Economists answer the question of how
economic systems are coordinated through a decentralized
economic planning via a schematic model of an economy,
entitled the Circular Flow in the Market Economy. There is a lot
of activity and information within this model, so let’s break it
down.
First, let’s establish some common definitions for concepts
within the model. A firm is an economic unit that hires factors
of production and organizes those factors of production to
produce and sell goods or services. A market is any arrangement
that enables a buyer and a seller to get information and to do
business with each other. We have a goods market and a factors
market. The factors market refers to the factors of production,
specifically land, labour, capital, and entrepreneurship, which
we learned earlier in this module. A household will be defined
as an economic unit of one or more persons that provides the
economy with resources. A household will also aim to satisfy
some of their human wants by purchasing goods and services
with money.

As you can see by the model, each component within the model
is exchanging something with another component. For example,
households exchange quantities of land, labour, capital, and
entrepreneurship to firms for wages, rent, interest, and profit.
Exchanges are flowing from one component to another. Firms
and households are interacting with markets, and it is
determined through this interaction what will be produced, how
it will be produced, and who will get what is produced. Notice
our “what,” “how,” and “for whom” question appearing again.

So what is coordinating these decisions? Prices. Prices within

markets coordinate the firms’ and households’ decisions. For
example, dollars flow through markets between households and
firms.

Let’s analyze the model even further. Households and firms

participate in both markets, but on different sides of the model.
Households are supplying resources, and firms are demanding or
buying resources. Scarcity is really within each of the
exchanges. For example, households only have so many
resources to supply to a firm.

The model is a simplification. The model does not illustrate the

many transactions that occur within every component, for
example, the multitude of transactions that occur every day
within every firm. You will notice that there is no mention of
government in the model. Why? Because the picture is intended
at this stage to reflect a self-governing economy, a concept that
we will further discuss later in the course. And finally, the
model does not reflect how the rest of the world is incorporated,
that is, international markets. Again, this is another topic that we
will discuss further in the course.

Despite various weaknesses, the Circular Flow model does

provide us with an overall image of how a decentralized
economic system works at a very high level.
 1.5 Production Possibility Frontier

Video

Concept Checks:
 1.6 Specialization and Trade

Video

Concept Checks: