CHAPTER 1

What
Economics
is About

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 INTHISCHAPTER
► A Definition of Economics
► Key Concepts in Economics
► The Market and Government
► Ceteris Paribus and Theory
► Economic Categories

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 A Definition of Economics

Resources are scarce

● Scarcity: the limited nature of society’s resources
• Society has limited resources and cannot produce all
the goods and services people wish to have.

● Economics
• The study of how society manages its scarce resources
• the word “economics” comes from Greek “oikonomos” =
“one who manages a household.”

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 Three Fundamental Questions

● What to Produce?
● How to Produce?
● For Whom to Produce?

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 Goods and Bads

• Good: Anything from which individuals receive

utility or satisfaction

• Utility: The satisfaction one receives from a good

• Bad: Anything from which individuals receive

disutility or dissatisfaction

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 Resources
• Land: All natural resources, such as minerals,
forests, water, and unimproved land
• Labor: The work brought about by the physical and
mental talents that people contribute
• Capital: Produced goods, such as factories,
machinery, tools, computers, and buildings, that can
be used as inputs for further production
• Entrepreneurship: The talent that some people
have for organizing the resources of land, labor, and
capital to produce goods, seek new business
opportunities, and develop new ways of doing things

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 The Counterintuitive in Economics
• Scarcity can exist with either poverty or wealth
• Comparing the U.S. (wealthy) and Cuba (poor)
– Prices are determined by:
• U.S: the market; Cuba: the government
• The incentive to produce:
– U.S.: firms produce what they want; Cuba: the
government says what should be produced
• Scarcity is a fact of life; it is how we deal with it
that matters
• Documentary : Poverty in America
• https://www.youtube.com/watch?v=JHDkALRz5Rk
(42 minutes)

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 Those Three Questions
► Economists study:
• How people decide how much they work, what they
buy, how much they save, and how they invest
their savings
• How firms decide how much to produce and how
many workers to hire
• How society decides how to divide its resources
between national defense, consumer goods,
protecting the environment, and other needs

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 People Face Trade-Offs

►To get something that we like, we have to

give up something else that we also like.
• Going to a party the night before an exam
• Less time for studying
• Having more money to buy stuff
• Working longer hours, less time for leisure
• Protecting the environment
• Resources could be used to produce consumer goods.

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 Society faces trade-offs

►The more it spends on national defense (guns)

to protect from foreign aggressors
• The less it can spend on consumer goods (butter) to
raise its standard of living
►Pollution regulations: cleaner environment
and improved health
• But at the cost of reducing the well-being of the firms’
owners, workers, and customers

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 Society faces trade-offs
Efficiency: Society gets the maximum benefits from its
scarce resources.

Equality: Prosperity is distributed uniformly among

society’s members.

►Trade-off:
• To achieve greater equality, we could redistribute
income from wealthy to poor.
• But this reduces incentive to work and produce,
shrinking the size of economic “pie”.

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 The Cost of Something Is What You Give Up to
Get It

► Making decisions:
• Compare costs with benefits of alternatives
• Need to include opportunity costs
► Opportunity cost
• Whatever must be given up to obtain some item
• The value of the forgone alternative action
► Opportunity Cost and Behavior
• Economists believe that a change in opportunity cost can
change a person’s behavior
• The higher the opportunity cost of doing something, the
less likely it is that it will be done

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 Opportunity Cost
►What is the opportunity cost of going to the
movies?
• The price of the movie ticket
• PLUS the value of the time you spend in the
theater

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 Rational People Think at the Margin

► Rational people
• Systematically and purposefully do the best they can
to achieve their objectives given the available
opportunities
• Make decisions by evaluating costs and benefits of
marginal changes
• Small incremental adjustments to a plan of action

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 Active Learning 1: Thinking at the margin
A. As the manager at the local Shwapno store, you are
thinking of hiring one more cashier that would
increase sales revenues by Tk. 3000 per week. The new
cashier would earn Tk. 2500 per week. Should you hire
the new cashier? Why?

B. You pay $12/month for access to Netflix, regardless of

how many movies or TV shows you watch in a month.
Should you watch one more movie (or episode)? Why?

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 Active Learning 1: Answers, A

A. Manager at the local Shwapno:

• Marginal benefit of hiring one more cashier:
• Sales would increase by Tk. 3000 per week.
• Marginal cost of hiring one more cashier:
• The new cashier would earn Tk. 2500.
• Decision: Because the marginal benefit exceeds the
marginal cost, the manager should hire the additional
cashier

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 Active Learning 1: Answers B
B. Netflix:
• Marginal benefit of watching one more movie:
• The enjoyment you get from watching the
movie
• Marginal cost of watching one more movie :
• Monetary cost = $ 0
• Opportunity cost of time
• Decision: If the marginal benefit exceeds the marginal
cost, watch the movie.

• how is the marginal cost of watching a movie tonight

changes if tomorrow you have an exam?
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 Efficiency
► Efficiency : Exists when marginal benefits equal
marginal costs
• Question: What is the right amount of time to study?
• The marginal (MB) curve of studying is downward
sloping because we have assumed that the benefits
of studying for the 1st hour are greater than the
benefits of studying for the 2nd hour, and so on
• The marginal cost (MC) curve of studying is upward
sloping because we have assumed that studying the
2nd hour costs a person more (in terms of goods
forfeited) than studying the 1st hour, studying the
3rd hour costs more than the 2nd, and so on
• Exhibit 2 shows that 3 hours is the efficient length
of time to study

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 EXHIBIT 2
EFFICIENCY

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 Efficiency
► Efficiency (cont)
• Maximizing Net Benefits: If you had stopped
studying after the 1st hour, you would have given up
the net benefits of studying longer
• Efficiency is consistent with MB = MC, and also
consistent with maximizing net benefits
► Economics is About Incentives
• Incentive: Something that encourages or motivates a
person to undertake an action

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 Externality and Exchange
► Unintended Effects (Externality)
• Economists think in terms of unintended effects
• If a minimum wage law is passed, might some lose
their jobs?
• Do mandatory seat belt laws cause more accidents
because people feel safer?
► Exchange
• Exchange (trade): The giving up of one thing for
something else
• People enter into exchanges to make themselves
better off
• Think of the trade in terms of utility or satisfaction
• After a trade, you expect that your utility rate has
risen
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 Markets Are Usually a Good Way to Organize
Economic Activity – 1

► Market
• A group of buyers and sellers (need not be in a single
location)
► “Organize economic activity” means determining
• What goods and services to produce
• How to produce these goods and services
• How to allocate them to their final user

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 Markets Are Usually a Good Way to Organize
Economic Activity – 2

► Market economy
• Allocates resources through the decentralized
decisions of many firms and households as they
interact in markets
• Proven remarkably successful in organizing economic
activity to promote overall prosperity

Milton Friedman (winner of the 1976 Nobel Memorial Prize in

Economic Sciences) introduces these concepts using a very famous,
simple, effective story.
See it here: http://www.youtube.com/watch?v=4ERbC7JyCfU
(Lesson: the pencil; 10 minutes)

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 Markets Are Usually a Good Way to Organize
Economic Activity – 3

► Prices:
• Determined by the interaction of buyers and sellers
• Reflect the good’s value to buyers
• Reflect the cost of producing the good
► Adam Smith’s “invisible hand”:
• Prices guide self-interested households and firms to
make decisions that maximize society’s economic well-
being.
• Example: The case of UBER

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 Governments Can Sometimes Improve
Market Outcomes – 1

► Government: enforce property rights

• Enforce rules and maintain institutions that are key
to a market economy
• People are less inclined to work, produce, invest, or
purchase if there is a large risk of their property
being stolen.
• We rely on government-provided police and courts
to enforce our rights over the things we produce.

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 Governments Can Sometimes Improve
Market Outcomes – 2

► Government: promote efficiency

• Avoid market failures: Market left on its own fails to
allocate resources efficiently.
• Externality – source of market failure
• Production or consumption of a good affects
bystanders (e.g. pollution).
• Market power – source of market failure
• A single buyer or seller has substantial influence on
market price (e.g., monopoly).

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 Governments Can Sometimes Improve
Market Outcomes – 3

► Government: promote equality

• Avoid disparities in economic well-being
• Use tax or welfare policies to change how the
economic “pie” is divided.
► To say that the government can improve market
outcomes
• Does not mean that it always will

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 Ceteris Paribus and Theory

► Ceteris Paribus Thinking

• Ceteris Paribus: A Latin term meaning, “all other
things constant” or “nothing else changes”
• Economists specify ceteris paribus because they want
to clearly define what they believe to be real-world
relationship between two variables
► What is a Theory?
• Theory (model): An abstract representation of the
real world designed with the intent to better
understand it

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 Ceteris Paribus and Theory (2 of 2)

► What is a Theory? (cont)

• Abstraction: The process (used in building a
theory) of focusing on a limited number of variables
to explain or predict an event
• People build theories when they do not know the
answer to a question
• A theory emphasizes only the variables that the
theorist believes are the main or critical ones that
explain an activity or event
• What to ask a Theorist:
• If your theory is correct, what do you predict we
will see in the world?

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 Economic Categories (1 of 3)

There are four common economic categories

► Positive Economics & Normative Economics
• Positive Economics: The study of “what is” in
economics
• Normative Economics: The study of “what
should be” in economics
► Microeconomics and Macroeconomics
• Microeconomics: The branch of economics that
deals with human behavior and choices as they
relate to relatively small units: an induvial, a firm,
an industry, a single market
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 Economic Categories (2 of 3)

► Microeconomics and Macroeconomics (cont)

• Macroeconomics: The branch of economics that
deals with human behavior and choices as they relate
to highly aggregate markets (e.g., the market for
goods and services) or the entire economy
• Microeconomists and Macroeconomists ask different
questions:
• A Microeconomist might ask:
– How does a market work?
– What level of output does a firm produce?
– What price does a firm charge for the good it produces?

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 Economic Categories (3 of 3)

► Microeconomics and Macroeconomics (cont)

• Microeconomists … ask different questions: (cont)
• A Macroeconomist might ask:
– How does the economy work?
– Why is the unemployment rate sometimes high
and sometimes low?
– What causes inflation?

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