Basic Economic Concepts

Professional Development Course in Knowledge Enrichment for Senior Secondary Economics Teachers
Outline of Lecture 1 Basic Economic Concepts Topics covered: Concept of cost II. Interest as the cost of earlier availability of resources III. Positive and normative statements IV. Brief introduction to methodology

I.

I.

Concept of cost

A. How People make decisions Teaching advice Begin by pointing out that economics is a subject that students must encounter in their everyday lives. Point out that they have already spent a great deal of their time thinking about economic issues: prices, buying decisions, use of their time, etc. Teacher may want to start the semester by explaining to students that we start learning economics by studying a number of new terminologies and definitions. Economists generally use very precise (and sometimes different) definitions. To avoid confusion, it will be helpful to students if teachers follow the definitions provided in the text as much as possible.

(i)

Principle 1 : People Face Tradeoffs Making decisions requires trading off one goal for another.

Examples include how a student spends her time, how a family decides to spend its income, how the H.K. government spends tax revenue, how regulations may protect the environment at a cost to firm owners.

A special example of a tradeoff is the tradeoff between efficiency and equity.

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For example, tax dollars paid by wealthy HK taxpayers and then distributed to those less fortunate may improve equity but lower the return to hard work. It therefore reduces the level of output produced by our resources.

This implies that the cost of increased equity is a reduction in the efficient use of our resources.

Recognizing that tradeoffs exist does not indicate what decisions should be made. Principle 2: The cost of something is what you give up to get it Making decisions requires individuals to consider the benefits and costs of some actions.

(ii)

B. Definition of cost: opportunity cost is the highest-valued option forgone. Teaching advice One of the hardest ideas for students to grasp is that free things are not truly free. Thus, teacher will need to provide students with numerous examples of such free things with implicit costs, especially the value of time. (i) Principle 3: Rational People Think at the Margin Definition of marginal changes: small incremental adjustments to a plan of actions.

(ii)

Principle 4: People Respond to Incentives Since people make decisions by weighing costs and benefits, their decisions may change in response to changes in costs and benefits. Teaching advice If you include any incentive-based criteria on your syllabus, discuss it now. For example, if you reward class attendance (or penalize students who do not attend class), explain to students how this change in marginal benefit of attending class can be expected to alter their behavior.

C. Concept of sunk cost, implicit cost, explicit cost and full cost
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Teaching advice Students rarely have trouble in understanding the concept of explicit costs. However, they do often have difficulty in understanding the nature of implicit costs. Definition of sunk cost: a cost that has been committed and cannot be recovered. Once a cost is sunk, it is no longer an opportunity cost.

Total opportunity costs include both implicit and explicit costs. Definition of explicit costs: input costs that require an outlay of money by the firm. Definition of implicit costs: input costs that do not require an outlay of money by the firm.

II.

Interest as the cost of earlier availability of resources Meaning of interest from the perspective of investor, borrower and lender Investors Interest is the return on capital Borrowers Interest is the price of earlier availability or the cost of borrowing c) Lenders Interest is a compensation for postponement of consumption, which is an extra value of entity owned today over the entity owned in future. Meaning of Time Preference If more people prefer current consumption to future consumption, more people will be borrowers and less will be lenders, and interest rate will increase. Discussion on the tradeoff in borrowing

a) b)

III. Positive and normative statements Teaching advice Use several examples to illustrate the differences between positive and normative statements and stimulate classroom discussion.

Possible examples include:

Minimum wage Budget deficits Tobacco taxes

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Legalization of marijuana Seat-belt laws. Ask students to bring in newspaper articles and ask them to form groups. Identify some statements in an editorial and ask students to state whether they are positive or normative statements. Discuss the difference between straight news stories and editorials and the analogy to economists as scientists and as policy advisers.

Distinction between positive statements and normative statements a) b) Definition of positive statements: claims that attempt to describe the world as it is. Definition of normative statements: claims that attempt to prescribe how the world should be.

Examples of positive statements Examples of normative statements

IV.

Brief introduction to methodology Teaching advice To illustrate to the class how simple but unrealistic models can be useful, bring a road map to class. Point out how unrealistic it is. For example, it does not show where all of the stop signs, gas stations, or restaurants are located. It assumes that the earth is flat and two-dimensional. But, despite these simplifications, a map usually helps travelers get from one place to another. Thus, it is a good model. Discussion on economic model, assumption of an economic model, the relationship among model, theory and reality. Discuss how theories are developed.

How theories are developed 4

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Economi c Model

Make assumptions Deduce implications Predictions are in conflict with facts

Economi c Theory

Make predictions

Test predictions

REALITY Facts: observations of economic phenomena to be explained

Discuss how economists apply the methods of science. Discuss how assumptions and models can shed light on the world.