Lecture 2 - Economics PDF

Lecture 2 What is Economics? Slides by John F. Hall INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL CHAPTER 1 / WHAT IS ECONOMICS? ©2005, South-Western/Thomson Learning...

Lecture 2 What is Economics? Slides by John F. Hall INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL CHAPTER 1 / WHAT IS ECONOMICS? ©2005, South-Western/Thomson Learning Animations by Anthony Zambelli  Economics, Scarcity, and Choice A good definition of economics ▪ Study of choice under conditions of scarcity Scarcity ▪ Situation in which the amount of something available is insufficient to satisfy the desire for it Lieberman & Hall; Introduction to Economics, 2005 2  Scarcity and Individual Choice There are an unlimited variety of scarcities, however they are all based on two basic limitations ▪ Scarce time ▪ Scarce spending power Limitations force each of us to make choices Economists study choices we make as individuals, and consequences of those choices Economists also study more subtle and indirect effects of individual choice on our society Lieberman & Hall; Introduction to Economics, 2005 3  Scarcity and Social Choice The problem for society is a scarcity of resources ▪ Scarcity of Labor Time human beings spend producing goods and services ▪ Scarcity of Capital Something produced that is long-lasting, and used to make other things that we value ◻ Human capital ◻ Capital stock ▪ Scarcity of land Physical space on which production occurs, and the natural resources that come with it ▪ Scarcity of entrepreneurship Ability and willingness to combine the other resources into a productive enterprise As a society our resources—land, labor, and capital—are insufficient to produce all the goods and services we might desire ▪ & In Lieberman Hall; other Introductionwords, to Economics,society 2005 faces a scarcity of resources 4  Scarcity and Economics The scarcity of resources—and the choices it forces us to make—is the source of all of the problems studied in economics ▪ Households allocate limited income among goods and services ▪ Business firms choices of what to produce and how much are limited by costs of production ▪ Government agencies work with limited budgets and must carefully choose which goals to pursue Economists study these decisions to ▪ Explain how our economic system works ▪ Forecast the future of our economy ▪ Suggest ways to make that future even better Lieberman & Hall; Introduction to Economics, 2005 5  Microeconomics Micro ▪ Micro comes from Greek word mikros, meaning “small” Microeconomics ▪ Study of behavior of individual households, firms, and governments Choices they make Interaction in specific markets Focuses on individual parts of an economy, rather than the whole Lieberman & Hall; Introduction to Economics, 2005 6  Macroeconomics Macro ▪ Macro comes from Greek word, makros, meaning “large” Macroeconomics ▪ Study of the economy as a whole Focuses on big picture and ignores fine details Lieberman & Hall; Introduction to Economics, 2005 7  Positive Economics Study of how economy works Statements about how the economy works are positive statements, whether they are true or not Accuracy of positive statements can be tested by looking at the facts—and just the facts Lieberman & Hall; Introduction to Economics, 2005 8  Normative Economics Study of what should be ▪ Used to make value judgments, identify problems, and prescribe solutions ▪ Statements that suggest what we should do about economic facts, are normative statements Based on values ▪ Normative statements cannot be proved or disproved by the facts alone Lieberman & Hall; Introduction to Economics, 2005 9  Why Economists Disagree In some cases, the disagreement may be positive in nature because ▪ Our knowledge of the economy is imperfect ▪ Certain facts are in dispute In most cases, the disagreement is normative in nature because ▪ While the facts may not be in dispute Differing values of economists lead them to dissimilar conclusions about what should be done Lieberman & Hall; Introduction to Economics, 2005 10  Why Study Economics To understand the world better ▪ You’ll begin to understand the cause of many of the things that affect your life To gain self-confidence ▪ You’ll lose that feeling that mysterious, inexplicable forces are shaping your life for you Lieberman & Hall; Introduction to Economics, 2005 11  Why Study Economics To achieve social change ▪ You’ll gain tools to understand origins of social problems and design more effective solutions To help prepare for other careers ▪ You’ll discover that a wide range of careers deal with economic issues on many levels To become an economist ▪ You’ll begin to develop a body of knowledge that could lead you to become an economist in the future Lieberman & Hall; Introduction to Economics, 2005 12  Microeconomics Microeconomics: The study of how resources are allocated to various uses in society. Each society must answer the following three questions: Q1: What to produce? Q2: How to produce it? Q3: For whom do we produce it?  Economic Efficiency An economy, or economic process, is operating efficiently if it cannot make more of one good without making less of another.  Opportunity Cost The quantity of a good we must sacrifice to obtain one more unit of some other good.  What Economics Is All About 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 16 between national defense, consumer goods, TEN PRINCIPLES OF ECONOMICS  The principles of HOW PEOPLE MAKE DECISIONS  HOW PEOPLE MAKE DECISIONS Principle #1: People Face Tradeoffs 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. 18 TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE MAKE DECISIONS Principle #1: People Face Tradeoffs Society faces an important tradeoff: efficiency vs. equality 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.” 19 TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE MAKE DECISIONS Principle #2: The Cost of Something Is What You Give Up to Get It Making decisions requires comparing the costs and benefits of alternative choices. The opportunity cost of any item is whatever must be given up to obtain it. It is the relevant cost for decision making. 20 TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE MAKE DECISIONS Principle #2: The Cost of Something Is What You Give Up to Get It Examples: The opportunity cost of… …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. 21 TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE MAKE DECISIONS Principle #3: Rational People Think at the Margin Rational people ▪ systematically and purposefully do the best they can to achieve their objectives. ▪ make decisions by evaluating costs and benefits of marginal changes – incremental adjustments to an existing plan. 22 TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE MAKE DECISIONS Principle #3: Rational People Think at the Margin 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, she compares the cost of the needed labor and materials to the extra revenue. 23 TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE MAKE DECISIONS Principle #4: People Respond to Incentives Incentive: something that induces a person to act, i.e. the prospect of a reward or punishment. Rational people respond to incentives. Examples: ▪ When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs. ▪ When cigarette taxes increase, teen smoking falls. 24 TEN PRINCIPLES OF ECONOMICS The principles of HOW PEOPLE INTERACT  HOW PEOPLE INTERACT Principle #5: Trade Can Make Everyone Better Off 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 26 TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE INTERACT Principle #6: Markets Are Usually A Good Way to Organize Economic Activity Market: a group of buyers and sellers (need not be in a single location) “Organize economic activity” means determining ▪ what goods to produce ▪ how to produce them ▪ how much of each to produce 27 ▪ who gets them TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE INTERACT Principle #6: Markets Are Usually A Good Way to Organize Economic Activity 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” 28 to promote general economic well-being. TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE INTERACT Principle #6: Markets Are Usually A Good Way to Organize Economic Activity 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. 29 TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE INTERACT Principle #7: Governments Can Sometimes Improve Market Outcomes Important role for govt: enforce property rights (with police, courts) People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen. 30 TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE INTERACT Principle #7: Governments Can Sometimes Improve Market Outcomes 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) In such cases, public policy may promote 31 efficiency. TEN PRINCIPLES OF ECONOMICS  HOW PEOPLE INTERACT Principle #7: Governments Can Sometimes Improve Market Outcomes Govt 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. 32 TEN PRINCIPLES OF ECONOMICS The principles of HOW THE ECONOMY AS A WHOLE WORKS  HOW THE ECONOMY AS A WHOLE WORKS Principle #8: A country’s standard of living depends on its ability to produce goods & services. Huge variation in living standards across countries and over time: ▪ 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. 34 TEN PRINCIPLES OF ECONOMICS  HOW THE ECONOMY AS A WHOLE WORKS Principle #8: A country’s standard of living depends on its ability to produce goods & services. 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 35 abroad) have far TEN less impact on living standards. PRINCIPLES OF ECONOMICS  HOW THE ECONOMY AS A WHOLE WORKS Principle #9: Prices rise when the government prints too much money. Inflation: increases in the general level of prices. 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 govt creates money, the greater the inflation rate. 36 TEN PRINCIPLES OF ECONOMICS  HOW THE ECONOMY AS A WHOLE WORKS Principle #10: Society faces a short-run tradeoff between inflation and unemployment In the short-run (1 – 2 years), many economic policies push inflation and unemployment in opposite directions. Other factors can make this tradeoff more or less favorable, but the tradeoff is always present. 37 TEN PRINCIPLES OF ECONOMICS 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. 38 CHAPTER SUMMARY The principles of interactions among people are: Trade can be mutually beneficial. Markets are usually a good way of coordinating trade. Govt can potentially improve market outcomes if there is a market failure or if the market outcome is inequitable. 39 CHAPTER SUMMARY 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. 40