Principles of

Economics

Copyright 2004 South-Western/Thomson Learning

Definition of Economics
Economics is the study of how society
individuals, nations, the worldmanages its
scarce resources by making choices.

An economy can be big or smallyour own

budget, or the global marketplacebut an
economy captures the action as people deal
with scarcity
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Underlying Economic Reality of

Society
Society and Scarce Resources:

Resources are scarce

Scarcity. . . means that society has limited
resources and therefore cannot produce all the
goods and services people want to have
And people have UNLIMITED wants
Formula:
Scarcity=Wants which are >limited Resources
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The Basic Questions in an Economy

Because Goods are Scarce, society has to decide:

What to produce?
How to produce it?
How much to produce?
Who gets the goods of production?

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MAJOR PRINCIPLES OF
ECONOMICS
The first 3 principles deal with how people make
decisions.
1. People face tradeoffs.
2. Rational people think at the margin marginal
analysisand respond to incentives
3. The cost of something is what you give up
to get it opportunity cost

Copyright 2004 South-Western/Thomson Learning

Principle #1:
People Face Tradeoffs.
To get one thing, we usually have to give up
another thing.
Theres no such thing as a free lunch!
Food v. clothing
Leisure time v. work
Efficiency v. equity
Guns v. Butter
Making decisions requires trading off one goal
against another. It may involve trading off
between many options. We use cost/benefit and
marginal analysis.
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Principle #2:
Rational People Think at the Marginand
respond to incentives
People make decisions by comparing
costs and benefits at the marginby
doing marginal analysis.
Marginal changes are small, incremental
adjustments to an existing plan of action.
Marginal means looking at that one additional
unit, or a little bit moreAND how it affects
ones measure of satisfaction
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When you hear the word marginal

in Economics, think of
the next one
the additional one
the next increment

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Principle #2:
Rational People Think at the Margin
Marginal changes in costs or benefits motivate
people to respond.
The decision to choose one alternative over
another occurs when that alternatives marginal
benefits exceed its marginal costs
Formula: When the Marginal Benefit

> Marginal Cost, you will choose that

alternative . . .

MB > MC
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Principle #3:
The Cost of Something Is What You Give Up
to Get It.
The opportunity cost of an item is what you
give up to obtain that itemthe value of the
next best alternative
Opportunity Cost = Opportunity Lost
Choosing is refusing
Subjectivity of opportunity costs:
Sometimes a $ amount
Oftenmaybe alwaysa cost in time
Sometimes more subjective
Copyright 2004 South-Western/Thomson Learning

Re-visiting Opportunity Cost

Examples

Wild Kingdom
Friday night
Prom
College
Chauffeurs
Celebrities

An AP caveat about Opp Cost!

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The Road Not Taken

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MAJOR PRINCIPLES OF
ECONOMICS
The next 3 principles deal with how people
interact with each other.
4. Trade can make everyone better off.
5. Markets are usually a good way to organize
economic activity.
6. Governments can sometimes improve economic
outcomes.

Copyright 2004 South-Western/Thomson Learning

Principle #4:
Trade Can Make Everyone Better Off.
Voluntary Trade creates wealth
People only trade if both parties feel they benefit
from the exchange

By trade, we mean exchange of goods and

services
MM Simulationan example of voluntary
trade

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Debriefing the MM Simulation

Examine the data
Discuss the Principles
Opportunity Cost
As measured in satisfaction points

Incomplete Information
Voluntary Trade
A Market economy

Copyright 2004 South-Western/Thomson Learning

Principle #5:
Markets Are Usually a Good Way to
Organize Economic Activity.
Remember the Basic Questions in an Economy?
We said:
Because Goods are Scarce, society has to decide:

What to produce?
How to produce it?
How much to produce?
Who gets the goods of production?

Markets are providing the answer to these

questions in a particular way.
Copyright 2004 South-Western/Thomson Learning

Principle #5:
Markets Are Usually a Good Way to
Organize Economic Activity.
A market economy is an economy that
allocates resources through the decentralized
decisions of many firms and households as they
interact in markets for goods and services.
Households decide what to buy and who to work
for.
Firms decide who to hire and what to produce.

Copyright 2004 South-Western/Thomson Learning

A new Question:
Could we allocate goods in a different way?
Markets are a way to allocate goods
Could we organize the rationing or
allocation process differently?

YES!
Demonstration

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A new Question:
Could we organize economies as a whole in
another way?
The free market system is a way we organize
our economy.
Could we organize our economycould we
solve our scarcity issuesdifferently?

YES!
Traditional Economy
Command Economy
Market Economy
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Traditional vs Command vs Market

Economies
Traditional
Economy

Command
Economy

Market Economy

Decisions based on
past, earlier
practice, custom,
etc.

Decisions made by
an authority, central
planner,
government, etc.

Decisions made by
individuals and
firms through
interchange of trade

Family business
How its always been
done
Passing on a family
tradition

Central Planning
5-year plan
Nationalized industries
From each according to
his ability; to each
according to his needs

Private property
invisible hand
Supply and demand
Profit motive

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Principle #5:
Markets Are Usually a Good Way to
Organize Economic Activity.
Adam Smith (Father of Modern Economics)
Economics
Writer of The Wealth of Nations (1776)
Observed that households and firms interacting
in markets act as if guided by an invisible
hand

Copyright 2004 South-Western/Thomson Learning

Principle #6:
Governments Can Sometimes Improve
Market Outcomes.
Even though we believe in the efficiency of
markets, we see that sometimes they can fail
Market failure occurs when the market fails to
allocate resources efficiently.
Market failures might be happening whether
you notice it or not
When the market fails (breaks down),
government can intervene to promote efficiency
and equity.
Copyright 2004 South-Western/Thomson Learning

Two Divisions of Economics Study

MICROECONOMICS
Examines the factors
that influence INDIVIDUAL economic choices
Examines how markets coordinate the choices of
various decision-makers
Studies the individual pieces of the economic
puzzle
MACROECONOMICS
Studies the performance
of the economy AS A WHOLE
Focuses on the big picture
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Thinking Like an Economist

Every field of study has its own terminology
Economics
supply opportunity cost incentives elasticity
consumer surplus demand comparative
advantage deadweight loss
and MANY more!!!

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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. . .
All of these skills are framed within the content of
evaluating how to deal with scarcity of productive
resources

Copyright 2004 South-Western/Thomson Learning

THE ECONOMIST AS A
SCIENTIST
The economic way of thinking . . .
Involves thinking analytically and objectively.
Makes use of the scientific method, which:
Posits hypotheses and develops theories
Uses simulations/models/demonstrations/historical data
as lab experiments
Collects, and analyzes data to evaluate the theories.
Develops abstract models to help explain how a complex,
real world operates.

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Roles for an Economist

When economists are trying to explain the
world, they are Social Scientists. The Scientific
role of economists is called descriptive
analysis, which involves making positive
statements, which describe the world as it is.
When economists are trying to change the
world, they are Policy Advisors. The Policy
Advising role of economists is called
prescriptive analysis, which involves making
normative statements, about how the world
should be.
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The Difference between

P & N Statements
Positive economic statement
An assertion about economic reality that can be
supported or rejected by reference to the facts

Normative economic statement

Reflects an opinion
Cannot be shown to be true or false by reference
to the facts
Most of the disagreements in economics involve
normative debates
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POSITIVE VERSUS NORMATIVE

ANALYSIS

Positive or Normative StatementsWhich is it?

1. State governments should be allowed to collect

from tobacco companies the costs of treating
smoking-related illnesses among the poor.
2. An increase in the minimum wage will cause a
decrease in employment among the least-skilled.
3. Higher federal budget deficits will cause interest
rates to increase.
4. The income gains from a higher minimum wage
are worth more than any slight reductions in
employment.

Copyright 2004 South-Western/Thomson Learning

Jobs for Economists

Industry &/or Businesshome or abroad
FORECAST consumer demand and sales of a firms
products.
ANALYZE competitors growth and market share and
ADVISE their company on how to handle the
competition.
MONITOR legislation passed by Congress, and
ASSESS its impact on their business.
MONITOR the economic situations in countries
where they do business, and ASSESS risks of
expanding into a country
Copyright 2004 South-Western/Thomson Learning

Jobs for Economists

in Federal, State or Local Governments. . .
Serve as scientists or advisors in government.
Work for agencies like:

Department of Commerce
Bureau of Labor Statistics
Congressional Budget Office
Federal Reserve Board
State Department
White House
And similar state/local agencies
Copyright 2004 South-Western/Thomson Learning