Chapter 1 Principles and Practice of Economics PDF

Chapter 1 The Principles and Practice of Economics © 2015 Pearson Education, Inc. 1 The Principles and Practice of Economics Chapter Outcomes Understand the meaning of economics and how economic factors effect individual choices and how all these ch...

Chapter 1 The Principles and Practice of Economics © 2015 Pearson Education, Inc. 1 The Principles and Practice of Economics Chapter Outcomes Understand the meaning of economics and how economic factors effect individual choices and how all these choices come together to shape the economic systems. Discuss difference between goods and services Explain the factors of production Discuss the simple circular flow of income The Scope of Economics Three Principles of Economics The First Principle of Economics: Optimization The Second Principle of Economics: Equilibrium The Third Principle of Economics: Empiricism © 2015 Pearson Education, Inc.  It is a social science which deals how individuals, societies, firms and government make their optimal economic decisions based on scarce resources. It is a science of choice. It is a social science which deals on how individuals and economic units can use limited resources ( scarce) to satisfy unlimited wants. Main economic problem: how to satisfy people’ unlimited wants with the use of limited (scarce) resources. Since resources are scarce while human wants are unlimited, we must make choice & choices involve sacrifice which is called opportunity cost. Opportunity cost is the cost of the best alternative forego. It addresses the basic questions of what to produce, how to produce and for whom to produce? © 2015 Pearson Education, Inc.  The Economic Problem Basic economic problem is that wants are unlimited while the resources available to satisfy these wants are scarce/limited. Resource are scarce when they are not freely available, that means, when its price exceeds zero Economics is a social science that examines the issue of how people use their scarce resources to satisfy their unlimited wants. © 2015 Pearson Education, Inc. 1.1 The Scope of Economics What does it mean if something is “scarce”? Scarcity is the situation of having unlimited wants in a world of limited resources. © 2015 Pearson Education, Inc.  Resources Resources : Inputs, or factors of production, used to produce the goods and services Thus, goods and services are scarce because resources are scarce Four general categories of resources o Labor o Capital o Land/natural resources o Entrepreneurial Ability © 2015 Pearson Education, Inc.  Labor Labor is defined in broad sense It can be defined as the mental and physical effort required to do a job. This include both skilled & unskilled labor. Labor comes from a more fundamental resources and that is time. Labor is scarce because the time that can be allocated to various tasks is scarce or limited. © 2015 Pearson Education, Inc.  Capital Capital means human creations used to produce goods and services. Two types of capital o Physical capital: It means factories, machines, tools, buildings, airports, highways and other manufactured items employed to produce goods and services o Human capital: consists of the knowledge and skill people acquire to enhance their labor productivity © 2015 Pearson Education, Inc.  Land &Entrepreneurial Ability Land Land or Natural resources can be defined as all the gifts of nature used to produce goods and services o Includes not only land in the conventional sense but also all other natural resources o Gifts of nature including bodies of water, trees, oil reserves, etc. o Renewable and exhaustible resources o Examples: Renewable: forest, water, o Exhaustible resources: oil and gas Entrepreneurial Ability o It is a special kind of human skill o It is a talent required to dream up a new product or find a better way to produce an existing one o Examples: Wallmart, Lulu, etc © 2015 Pearson Education, Inc.  Payments for Resources Wages  payment for use of labor( salaries) Interest  payment for the use of capital Rent  payment for use of land Profit  reward for entrepreneur’s reward o Revenue from sales minus cost of resources employed o Claims what is left over after paying for other resources o Resources payments have time dimension such as $10/hour © 2015 Pearson Education, Inc.  Goods and Services Resources can be combined in a variety of ways to produce goods and services Goods o Are tangible items o They require scarce resources o They satisfy human wants o Examples: Give five examples of goods Services o They are intangible items o They require scarce resources o They satisfy human wants o Provide: Five examples of services o Question: understand the difference between G and S. © 2015 Pearson Education, Inc.  Economic Decision Makers Four types of decision-makers in the economy o Households: the most important; drivers As consumers, households demand the goods and services produced As resource owners they supply labor, capital, land, and entrepreneurial ability o Firms, governments, and the rest of the world Demand the resources Supply the goods and services Rest of the world  foreign households, firms and governments © 2015 Pearson Education, Inc.  Markets What is a market? Means by which buyers and sellers carry out exchanges o A market is a group of economic agents who are trading a good or service. Sellers meet with buyers. Product markets o Markets in which goods and services are bought and sold Example: Carrefour, Lulu, RAWASCO Resource Markets o Markets in which the resources are exchanged o Labor, or job, market is the most important of the resource markets © 2015 Pearson Education, Inc.  Circular-Flow Model The interaction between these four decision makers can be conveyed by the circular flow model Describes the flow of resources, products, income, and revenue among decision makers Exhibit 1 © 2015 Pearson Education, Inc. Exhibit 1: Circular-Flow Model Households supply resources in the resource market and demand goods and services in the product market Firms supply goods and services in product market and demand resources in the resource market Money flows in resource market determine wages, interest, rents, and profits which flow as income to households Product markets determine the prices for goods and services which flow as revenue to firms © 2015 Pearson Education, Inc. 1.1 The Scope of Economics Economic Agent = Any group or individual that makes choices, such as consumers, firms, parents, politicians, etc. © 2015 Pearson Education, Inc. 1.1 The Scope of Economics Positive Economics Some people took more than one and not everyone got a piece Normative economics Each student should just take one so that everyone gets a piece © 2015 Pearson Education, Inc.  Positive & Normative Economics Economic analysis, statements and recommendations are either based on both facts, evidences or value judgements, opinion and feelings. Thus, Positive economics is an economic analysis that generates objective descriptions or predictions about the world that can be verified with data. Example, according to Oman ministry of Man Power, unemployment rate is 6 % & expected to fall to 4 % by the end of this year.  Normative Economics It is an economic analysis, statements & recommendations that are based on opinions, value judgments or personal feelings. It describe what an individual or society out to do.  Example : unemployment rate is high in Oman & government should create more jobs. Normative economics uses the words should be’,‘would be’, ‘ought to be’ or ‘could be’ in the statement or analysis © 2015 Pearson Education, Inc. 1.1 The Scope of Economics Microeconomics The study of individuals, firms, government Macroeconomics The study of the whole economy © 2015 Pearson Education, Inc. 1.2 Three Principles of Economics Three Principles of Economics: 1. Optimization = making the best choice possible with given information 2. Equilibrium = when everyone is optimizing; no one would be better off with a different choice 3. Empiricism = using data to figure out answers to interesting questions © 2015 Pearson Education, Inc. The First Principle of Economics: Optimization All choices are tied together by optimization. Here, people decide what to do by consciously or unconsciously weighing all of the known pros and cons of the different available options and trying to pick the best feasible option. In other words, people make choices that are motivated by calculations of benefits and costs. © 2015 Pearson Education, Inc. Trade- offs and Budget Constraints An economic agent faces a trade off when the agent needs to give up one thing to get something else. A Budget constraint shows the bundles of goods and services that a consumer can choose given her limited budget. When economists talk about the choice that an economic agent faces, the economist first specifies the budget constraint. Opportunity Cost It is the best alternative use of a resource. © 2015 Pearson Education, Inc. 1.4 The Second Principle of Economics: Equilibrium Equilibrium A situation in which no one benefits by changing his/her behavior © 2015 Pearson Education, Inc.  Equilibrium is a situation in which no one benefits by changing his/her behavior For e.g. if market is in equilibrium & a buyer decide not to buy, his decision will not affect market price, or one seller decide to increase its price, he/she decision will not change market price. One of the main problem with equilibrium analysis is a free rider problem. Free rider problem Exists when an individual or group is able to enjoy the benefits of a situation without incurring the costs. The problem exist because when market is in equilibrium & changes in behavior of few cannot affect the market conditions  Example : some people avoid paying taxes but want to enjoy services offered by government, a small number of people sneak onto pubic transportation without paying ticket  The problem is overlooked if it involves only small group of people with less effect on the market or business. © 2015 Pearson Education, Inc. 1.4 The Second Principle of Economics: Equilibrium The Free Rider Problem Exists when an individual or group is able to enjoy the benefits of a situation without incurring the costs © 2015 Pearson Education, Inc.  THE THIRD PRINCIPLE OF ECONOMICS Empiricism is evidence based analysis where economists use data to test idea, theories, and relationship between economic variables. § For instance, economists use data to determine whether theories about human behavior such as optimization and equilibrium match with actual human behavior. § Economists can also study what causes things & their effects ; such as whether there is relationship between crowded beach & hot temperature. Are hot days attracting many people to swim in the beach? Does going to college make people smart? © 2015 Pearson Education, Inc. 1.4 The Second Principle of Economics: Equilibrium Which one is experiencing equilibrium? © 2015 Pearson Education, Inc. 1 The Principles and Practice of Economics Key Ideas 1. Economics is the study of people’s choices. 2. The first principle of economics is that people try to optimize; they try to choose the best available option. 3. The second principle of economics is that economic systems tend to be in equilibrium, a situation in which nobody would benefit by changing his or her own behavior. 4. The third principle of economics is empiricism—analysis that uses data. Economists use data to test theories and to determine what is causing things to happen in the real world. © 2015 Pearson Education, Inc.