Unit - 4

Introduction to Economics
 Economy. . .
. . . The word economy comes from a Greek
word for “one who manages a household.”
 What Economics Is
• Economics is the study of how human beings
coordinate their wants and desires, given the
decision-making mechanisms, social customs,
and political realities of the society.
Or in simple terms
How scarce resources are used to satisfy people’s
unlimited wants.
 What Economics Is
• Scarcity exists because individuals want more
than can be produced.

– Scarcity – the goods available are too few to

satisfy individuals’ desires.
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?
 What Economics Is
• The degree of scarcity is constantly changing.

• The quantity of goods, services, and usable

resources depends on technology and
human action.
 Problem of Scarcity

Scarcity: The condition in which human wants are

forever greater than the available supply of time,
goods, and resources.

3 Economic Questions

What will be Produced?

How will it be Produced?

For whom will it be produced?
 Scarce Economic Resources

Factors of Production (FOP): The resources used to create goods and services

Land: Any natural resource provided by nature.

Labor: The mental and physical capacity of workers to produce goods and
services.

Capital: Any physical man-made good used to

produce other goods.

Entrepreneurship: Vision, skills, and risk-taking

needed to create and run a business.
 Definition

Economics: The study of how society chooses to allocate its scarce resources in order
to satisfy unlimited wants

Microeconomics: Branch of economics that studies

decision-making by a single individual, household, firm, industry or
level of government.

Macroeconomics: Branch of economics that studies

decision-making for the economy as a whole
Microeconomics and Macroeconomics
• Microeconomics focuses on the individual
parts of the economy.
– How households and firms make decisions and
how they interact in specific markets
• Macroeconomics looks at the economy as a
whole.
– Economy-wide phenomena, including inflation,
unemployment, and economic growth
 Positive vs. Normative

Positive Economics: An analysis limited to

statements that are verifiable (objective approach,
relied on facts)

“Government-funded healthcare surges public

expenditures”

Normative Economics: An analysis based on

value judgment (ideological, perspective-based,
opinion-oriented statements)

“The government should make available

fundamental healthcare to every citizen”
 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.
 People Face Trade-offs.
• To get one thing, we usually have to give up
another thing.
– Guns v. butter
– Food v. clothing
– Leisure time v. work
– Efficiency v. equity

Decisions usually involve a value judgment

 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.
The Cost of Something Is What You
Give Up to Get It.
• Basketball star LeBron
James understands
opportunity costs and
incentives. He chose to
skip college and go
straight from high
school to the pros
where he earns
millions of dollars.
 Opportunity Cost
Definition – the cost expressed in terms of the next best
alternative sacrificed
Helps us view the true cost of decision making
Implies valuing different choices
Trade-off: Any alternative that could be chosen
Opportunity Cost: The best alternative sacrificed for a chosen
alternative
Adam Smith: Scottish Economist (1723-1790)

The Invisible Hand Theory

“It is not from the benevolence of the butcher, the brewer, or

the baker, that we can expect our dinner, but from their
regard to their own interest
 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.

Unfortunately, we are not rational all of

the time.
 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.
 FIGURE 1-3
Economic Theory and Models
 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.
 Data
– Department of Commerce
• http://www.commerce.gov
– Bureau of Labor Statistics
• http://www.bls.gov
– Congressional Budget Office
• http://www.cbo.gov
– Federal Reserve Board
• http://www.federalreserve.gov
 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
 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
 First Model: The Circular-Flow
Diagram
• Markets for Goods and Services
– Firms sell
– Households buy
• Markets for Factors of Production
– Households sell
– Firms buy
 First Model: The Circular-Flow
Diagram
• Factors of Production
– Inputs used to produce goods and services
– Land, labor, capital, and entrepreneurship
• Labor includes all human effort, both physical an
mental.
• Capital are the tools used to produce goods
• Land is the land itself and all of the raw materials that
originate in nature
• Entrepreneurship is the function of organizing the
factors together
 Microeconomics and
Macroeconomics
• Microeconomics focuses on the individual
parts of the economy.
– How households and firms make decisions and
how they interact in specific markets
• Macroeconomics looks at the economy as a
whole.
– Economy-wide phenomena, including inflation,
unemployment, and economic growth
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.
Our Second Model: The Production
Possibilities Frontier
• Concepts illustrated by the production
possibilities frontier
– Efficiency
– Trade-offs
– Opportunity cost
– Economic growth
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.
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
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.

– Higher federal budget deficits will cause interest

rates to increase.

? ?
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.

– State governments should be allowed to collect

from tobacco companies the costs of treating
smoking-related illnesses among the poor.
?