What is economics?

The word economy comes from the Greek word for “one who manages a household”

A HH faces many decisions

        Who cooks dinner

        Who does laundry

        Who gets extra dessert at dinner

 

What is economics?

A society faces many decisions too, what jobs will be done and who will do them

        Some people should grow food        Some make clothing        Others computer software

Management of society’s resources is important because resources are scarce.

• Scarcity means that society has less to offer than people wish to have.

• Economics is the study of how society manages its scarce resources.

A choice is a tradeoff -- to get something we have to give up something else

Think of a student allocating her must valuable resource – time

• She can spend all her time studying economics• She can spend all her time studying mathematics• Or divide her time between the two.• For every hour she studies econ., she gives up an

hour she could have used studying math.• For every hour she spends studying, she gives up an

hour she could have spent sleeping, bike riding, watching TV.

Society’s tradeoff

• National defense versus increased production

• Clean environment versus cheaper goods

Another tradeoffEfficiency versus equity

• Efficiency: getting the most from your resources

• Equity: distributing economic prosperity fairly among members

Opportunity Cost

• Opportunity cost is that which we give up or forgo, when we make a decision or a choice.

Opportunity Cost

The cost of something is what you give up to get it: Consider the decision to go to university.

Intellectual enrichment and better job opportunities.

What is the cost:• Tuition• Books• Room and board

Opportunity Cost

• But even if you quit school you still need a place to stay.

•  • Wages given up should be considered as

part of the cost of going to university.• • the highest valued alternative we give up is

the opportunity cost of the activity chosen

We make choices in small steps, or at

the margin • suppose your cousin asks you whether he should

go to school one more year.• What is the benefit he gets if goes to school for

one more year? Marginal benefit MB• What is the cost associated with going to school

for one more year? Marginal cost MC• If MB>MC he should go to school for another

year• If MB<MC he should not go to school for another

year.

Microeconomics vs. Macroeconomics

Microeconomics is:• the study of the choices of individuals• the study of decisions made by enterprises, such

as businesses firms• and the interaction of those choices and decisions

in social frameworks, such as markets. Macroeconomics is the study of the national

economy and the global economy as a whole.

Examples of microeconomic and macroeconomic concernsProduction Prices Income Employment

Microeconomics Production/Output in Individual Industries and Businesses How much steelHow many officesHow many cars

Price of Individual Goods and Services Price of medical carePrice of gasolineFood pricesApartment rents

Distribution of Income and Wealth Wages in the auto industryMinimum wagesExecutive salariesPoverty

Employment by Individual Businesses & IndustriesJobs in the steel industryNumber of employees in a firm

Macroeconomics National Production/Output Total Industrial OutputGross Domestic ProductGrowth of Output

Aggregate Price Level Consumer pricesProducer PricesRate of Inflation

National IncomeTotal wages and salaries  

Total corporate profits

Employment and Unemployment in the Economy Total number of jobsUnemployment rate

Positive vs normative statements

• Positive statements: claims that attempt to describe the world as it is

• Normative statements: claims that attempt to prescribe how the world should be

Positive vs normative statements

• Ahmet- minimum wage laws cause unemployment• Mustafa- the govt should raise the minimum wage.

Difference between positive and normative statement• Positive: can test their validity• Normative: value judgment

Economic Models

Economists use economic models to understand the world 

A model is a formal statement of a theory. Models are descriptions of the relationship between two or more variables

First model: circular flow diagram

Millions of people buying, selling, working, hiring 

Economy has two types of decisionmakers

• Firms: produce G&S using FoP (factors of production)

• HHs: own FoP and consume

Factors of Production

• The basic resources that are available to a society are factors of production:– Land– Labor– Capital

• Production is the process that transforms scarce resources into useful goods and services.

• Resources or factors of production are the inputs into the process of production; goods and services of value to households are the outputs of the process of production.

Market for Goods andServices

Revenue

Market for Factors ofProduction

Firms Households

Wage, rent,and profit

Income

SpendingGoods andservices sold

Goods andservices bought

Labor, landand capital

Inputs forproduction

The Circular-Flow Diagram

Production Possibilities Frontier

• The production possibilities frontier (ppf) is a graph that shows all of the combinations of goods and services that can be produced if all of society’s resources are used efficiently

The Production Possibilities Frontier

3,000

Quantity ofCars Produced

0 1,000

Quantity ofComputers

Produced

Y

If we look at productionof both computers and cars,the straight line joining Xand Y shows the combinationsassuming that there is only a single factor of production =>constant trade off between goods

X

The Production Possibilities Frontier

3,000

2,0002,100

A

Quantity ofCars Produced

700 7500 1,000

Quantity ofComputers

Produced4,000

If we look at productionof both computers and cars,the concave line joining Xand Y shows the combinationsassuming that there is more than one factor of production=> changing trade-off.

The Production Possibilities Frontier

3,000

1,000

2,000

2,200

Productionpossibilitiesfrontier

A

B

C

Quantity ofCars Produced

7006003000 1,000

Quantity ofComputers

Produced

D

Note: changing slope => changing trade-off.

The Production Possibilities Frontier: Growth

3,000

2,0002,100

A

Quantity ofCars Produced

700 7500 1,000

Quantity ofComputers

Produced4,000

Change means that more computers can be producedrelative to cars

Scarcity and Choicein an Economy of Two or More

• A producer has an absolute advantage over another in the production of a good or service if it can produce that product using fewer resources.

Scarcity and Choicein an Economy of Two or More

• A producer has a comparative advantage in the production of a good or service over another if it can produce that product at a lower opportunity cost.

Comparative Advantageand the Gains From Trade

• Mary has an absolute advantage in the production of both wood and food because she can produce more of both goods using fewer resources than Bill.

Daily ProductionWood(logs)

Food(bushels)

Mary 10 10

Bill 4 8

Comparative Advantageand the Gains From Trade

• In terms of wood:

– For Bill, the opportunity cost of 8 bushels of food is 4 logs.

– For Mary, the opportunity cost of 8 bushels of food is 8 logs.

• In terms of food:

– For Mary, the opportunity cost of 10 logs is 10 bushels of food.

– For Bill, the opportunity cost of 10 logs is 20 bushels of food.

Daily ProductionWood(logs)

Food(bushels)

Mary 10 10

Bill 4 8

Comparative Advantageand the Gains From Trade

• Suppose that Mary and Bill each wanted equal numbers of logs and bushels of food. In a 30-day month they (each separately) could produce:

Daily Production

Wood(logs)

Food(bushels)

Mary 10 10

Bill 4 8

Monthly Production with

No Trade

Wood(logs)

Food(bushels)

Mary 150 150

Bill 80 80

Total 230 230

A.B.

Comparative Advantageand the Gains From Trade

• By specializing on the basis of comparative advantage, Mary and Bill can produce more of both goods.

Monthly Production after Specialization

Wood(logs)

Food(bushels)

Mary 270 30

Bill 0 240

Total 270 270C.

Monthly Production with

No Trade

Wood(logs)

Food(bushels)

Mary 150 150

Bill 80 80

Total 230 230B.

Comparative Advantageand the Gains From Trade

• To end up with equal amounts of wood and food after trade, Mary could trade 100 logs for 140 bushels of food. Then:

Monthly Production after Specialization

Wood(logs)

Food(bushels)

Mary 270 30

Bill 0 240

Total 270 270D.

Monthly Use After Trade

Wood(logs)

Food(bushels)

Mary 170 170

Bill 100 100

Total 270 270C.

Specialization, Exchangeand Comparative Advantage

• According to the theory of competitive advantage, specialization and free trade will benefit all trading parties, even those that may be absolutely more efficient producers.