Economic TheoryChapter 1, Lesson 2

Do Now

• How do you define theory?• Using that definition, what is

“economic theory”?

Goal of Economic Theory• Economic theory: economic model; simplification of

economic reality used to make predictions about the real world• For example, what happens to consumption of Pepsi

when price increases?

Goal of Economic Theory• Economists make simplifying assumptions• Other-things-constant assumption: assume nothing else of importance changes – that other things remain constant• Example: want to see how change in price of Pepsi affects amount purchased• Isolate relationship between two variables

(price and amount purchased) by assuming there are no changes in other relevant variables like consumer income or price of Coca-Cola

Rational Self-Interest• Behavior assumption: how people make

choices based on self-interest• you select alternatives you perceive to be in your best interests• Rational self-interest means that you try to maximize the expected benefit achieved with a given cost or to minimize the expected cost of achieving a given benefit

Rational Self-Interest• Self-interest often includes welfare of family and

friends• Concern for others is influenced by your personal cost of

that concern• Example: You may volunteer to take the dog out before

you leave for school, but are less likely if you are asked to do so at 4 a.m.• The lower your personal cost of helping others, the

more help you will offer

• Rationality also implies each firm supplies products expected to maximize firm’s profit• Also behavioral assumptions because they specify how

economic decision makers are expected to behave

Think & Ink

• Your Turn: Give examples of choosing actions that are based on your rational self-interest, yet pose some sort of cost to you in the process

Jigsaw…ish• Four groups of six-to-seven• Each group will read on individual section of this article• Groups will summarize respective section using three bullet points minimum• Create summary of section using markers and poster board at front of room• Be creative, use pictures, and PROVIDE

APPLICABLE EXAMPLES!

Theories Explained• Everyone uses some sort of theory, although they

may not even realize it• Example: Pounding on vending machine so quarter will

go where it needs to, but not knowing the actual intricacies of how a vending machine actually works• Economists explain theories by telling how they think

the economy works based on case studies and personal experience, as well as supporting data

• Questions: Think of some theories you have • Write down three questions that would determine whether

or not others hold the same theories• If so, what is the theory on which you agree?• If not, why do you disagree?

Normative vs. Positive Statements• Normative: reflects someone’s opinion• “The U.S. unemployment rate should be lower”• Cannot be shown true or false by reference to facts

• Positive: statement about economic reality that can be supported or rejected by reference to facts• “The U.S. unemployment rate is 9%”• Need not be true, but can find out if they are or are not by

referring to facts• Most disagreements among economists center around

normative statements

Think, Ink, Pair, Share• Think about an argument you have had with your

siblings, parents, or friends• Write down the situation in your notebooks• Then share this argument with the person sitting

next to you• Your partner must identify whether the argument

was based on a normative statement or positive statement that can be supported by facts• BE PREPARED TO DISCUSS!

Closure• Fist of Five:

1. No idea2. Uncertain and shaky3. Comfortable4. Would test well and relatable 5. Can teach to someone else

Do Now

• What is a common element behind every decision you make?

Marginal Analysis• Economic choice involves some adjustment to

existing situation• Example: jeans on sale and you must decide whether to

buy another pair, or you have just finished dinner at a restaurant and decide whether to eat dessert• All economic choice is based on comparison of expected

marginal benefit and expected marginal cost of action under consideration

Marginal Cost and Marginal Benefit• Marginal: incremental, additional, extra• Change in the status quo• Rational decision-maker will change status quo as long as expected marginal benefit from change exceeds expected marginal cost

Think about it…• Pair & Share: What are the marginal benefits

and marginal costs of eating dessert?•What are larger marginal choices that you make that have a large impact on the economy?•What about for a corporation?• Draw examples of both that your classmates

must solve themselves through Pictionary• After you solve, then identify both the marginal

benefit and marginal cost of each decision• What is the better option, in your opinion?

Time and Information• Rational choice takes time and requires

information, yet both are scarce and, thus, valuable• Often willing to pay others to gather and digest information for you• Example: college guides, travel agents, real estate brokers…what are other examples?

• Rational decision-makers will continue to acquire information as long as the marginal benefit from that information exceeds the marginal cost of gathering it

Micro and Macro• How many of you have thought about your

economic behavior this in-depth before?

• Microeconomics: focuses on one’s economic behavior and behavior of other individuals and firms who make choices involving what to buy and what to sell, how much to work and how much to play, how much to borrow and how much to save

Micro and Macro

• Macroeconomics: focuses on performance and economy as a whole, especially the national economy

•Micro: individual pieces of economic puzzle•Macro: fits pieces together to look at big picture

Market Participants

• Four types of decision makers in economy:1. Households2. Firms3. Governments4. Rest of world• Interaction between all determine how

economy’s resources are allocated

Market Participants• Households play leading role in economy• Demand goods and services produced• Own resources, so therefore supply resources used to

produce goods and services

• Firms, governments, and rest of world demand resources that households supply• Use those resources to supply goods and services

households demand• Rest of world includes foreign households, foreign

firms, and foreign governments that supply resources and products to U.S. markets and demand resources and products from U.S. markets

Market Participants

• Markets: means by which buyers and sellers carry out exchange• Bring together two sides of exchange, demand and supply, means price and quantity are determined

• Think, Ink, Pair, Share: Where are marketplaces that you know of?•Why is this considered a marketplace?

Market Participants

• Goods and services bought and sold in product markets

• Resources are bought and sold in resource markets•Most important resource market is labor, or job, market

Circular-Flow Model

• Circular flow model: describes flow of resources, products, income, and revenue among economic decision makers• Depicts interaction among households and firms in a market economy• Households on left, firms on right

Circular-Flow Model

Households• Supply: human

resources, natural resources, and capital goods to firms through resource markets (lower portion of figure)

• Demand: goods and services from firms through products markets (upper portion of figure)

Firms• Supply: goods and

services to households through product markets

• Demand: human resources, natural resources, and capital goods from households through resources markets

Circular-Flow Model• Begin to sketch a circular flow model with a partner by

using an example of a firma and households working together

• You must include the following elements:

• Households• Firms• Resource Market• Product Market• Natural, Human, and Capital Resources• Goods and Services

• Keep room for yourselves, as you will be adding to this!

Circular-Flow Model• Flows of resources and products supported by flows

of income and expenditure – the flow of money

• Supply and demand for resources determine what firms pay for resources• Resource prices – wages, interest, rent, and profit – flow as

income to households

• Supply and demand for products determine what households pay for goods and services• Prices paid for goods and services flow as revenue to firms

Circular-Flow Model• Finish your own circular-flow model with a partner by

adding the following:

• Resource prices (include all)• Product prices

• Exit Ticket:• How are your everyday decisions “economic”

decisions?• Will you put more thought into the decisions you make

going forward?• If so, how?• If not, why not?