NEXT The Economic Way of Thinking. NEXT Chapter 1: The Economic Way of Thinking KEY CONCEPT Scarcity...

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The Economic Way of Thinking

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Chapter 1: The Economic Way of Thinking

KEY CONCEPT• Scarcity is the situation that exists because wants are unlimited and

resources are limited.

WHY THE CONCEPT MATTERS• The concept of scarcity is an issue you confront in everyday life.

Suppose you have $20 to cover the cost of lunches for the week. How would you use the money to cover your wants Monday through Friday? How would buying a late afternoon snack for $1 on two of the days affect your lunch choices?

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What Is Scarcity?

KEY CONCEPTS• Wants — desires that can be met by consuming products• Needs — things necessary for survival• Scarcity — lack of resources available to meet all human wants

– not a temporary shortage• Economics — study of how people use resources to satisfy wants

– examines how individuals and societies choose to use resources– organizes, analyzes, interprets data about economic behaviors– develops theories, economic laws to explain economy, predict

future

Scarcity: The Basic Economic Problem

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What Is Scarcity?

Principle 1: People Have Wants • People make choices about all their needs and wants• Wants are unlimited, ever changing

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What Is Scarcity?

Principle 2: Scarcity Affects Everyone • Scarcity affects which goods and services are provided• Goods — physical objects that can be bought• Services — work one person does for another for pay• Consumer — person who buys good or service for personal use• Producer — person who makes a good or provides a service

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Scarcity Leads to Three Economic Questions

KEY CONCEPTS • Scarcity affects society and producers as well as individuals• Society must answer three basic economic questions:

– what will be produced?– how will it be produced?– for whom will it be produced?

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Question 1: What Will Be Produced?• Societies must decide on mix of goods to produce

– depends in part on their natural resources• Some countries allow producers and consumers to decide• In other countries, governments decide• Must also decide how much to produce; choice depends on societies’

wants

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Question 2: How Will It Be Produced?• Decisions on production methods involve using resources efficiently

– decisions influenced by a society’s natural resources• Societies adopt different approaches

– with unskilled labor force, might use labor-intensive methods– with skilled labor force, might use capital-intensive methods

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Question 3: For Whom Will It Be Produced?• How goods and services are distributed involves two questions

– how should each person’s share be determined?– how will goods and services be delivered to people?

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The Factors of Production

KEY CONCEPTS• Factors of production — resources needed to produce goods and

services – include land, labor, capital, entrepreneurship– supply is limited

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Factor 1: Land• Land means all natural resources on or under the ground

– includes water, forests, wildlife, mineral deposits

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Factor 2: Labor• Labor is all the human time, effort, talent used to make products

– physical and mental effort used to make a good or provide a service

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Factor 3: Capital• Capital is a producer’s physical resources

– includes tools, machines, offices, stores, roads, vehicles– sometimes called physical capital or real capital

• Workers invest in human capital — knowledge and skills– workers with more human capital are more productive

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Factor 4: Entrepreneurship• Entrepreneurship — vision, skill, ingenuity, willingness to take risks• Entrepreneurs anticipate consumer wants, satisfy these in new ways

– develop new products, methods of production, marketing or distributing

– risk time, energy, creativity, money to make a profit

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Reviewing Key Concepts

Explain the relationship between the terms in each of these pairs:

• wants and scarcity• consumer and producer• factors of production and entrepreneurship

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Making Choices

KEY CONCEPTS• Economic choices shaped by

– Incentives — benefits that encourage people to act in certain ways

– Utility — benefit or satisfaction gained from using a good or service

• To make choices, people economize:– make decisions according to best combination of costs and

benefits

Economic Choice Today: Opportunity Cost

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Making Choices

Factor 1: Motivations for Choice • People motivated by incentives, expected utility, desire to economize• They weigh costs against benefits to make purposeful choices

– motivated by self-interest: look for ways to maximize utility

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Making Choices

Factor 2: No Free Lunch • All choices have a cost

– choosing one thing means giving up another, or paying a cost– cost can take form of money, time, other thing of value

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Trade-Offs and Opportunity Cost

KEY CONCEPTS • Trade-off is alternative people give up when they make a choice

– usually means giving up some, not all, of a thing to get more of another

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Example 1: Making Trade-Offs• Shanti wants to earn college credit over summer

– semester-long university course offers more credits– six-week high school course leaves time for vacation

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Example 2: Counting the Opportunity Cost• Opportunity cost is value of next-best alternative a person gives up

– not the value of all possible alternatives • Dan chooses to work for six months so he can travel for six months

– opportunity cost: six months of salary

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Analyzing Choices

KEY CONCEPTS• Cost-benefit analysis — examination of costs, expected benefits of

choices– one of most useful tools for evaluating relative worth of economic

choices

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Analyzing Choices

Example: Max’s Decision-Making Grid• Decision-making grid shows what one gets, gives up with each

choice• Max’s grid shows all possible choices for his free hours each week

– lists choices, benefits and opportunity cost of each choice• With time, costs and benefits change; also goals and circumstances

– Changes influence decisions, make people alter original choices

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Analyzing Choices

Example: Marginal Costs and Benefits• Marginal cost

– additional cost of using one more unit of a good or service• Marginal benefit

– additional benefit of using one more unit of a good or service

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Explain the relationship between the terms in each of these pairs:

• incentive and utility• trade-off and opportunity cost• marginal cost and marginal benefit

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Graphing the Possibilities

KEY CONCEPTS• Economic models — simplified representations of economic forces• Production possibilities curve (PPC) is one model

– maximum goods or services that can be produced from limited resources

– also called production possibilities frontier

Analyzing Production Possibilities

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KEY CONCEPTS• PPC based on assumptions that simplify economic interactions

– resources are fixed– all resources are fully employed– only two things can be produced– technology is fixed

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Production Possibilities Curve • PPC runs between extremes of producing only one item or the other• Data is plotted on a graph; lines joining points is PPC

– shows maximum number of one item relative to other item• PPC shows opportunity cost of each choice

– more of one product means less of the other

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What We Learn from PPCs

KEY CONCEPTS• Concepts revealed by PPC:

– Efficiency — producing the maximum amount of goods and services possible

– Underutilization — producing fewer goods and services than possible

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Example: Efficiency and Underutilization• Each point on PPC represents efficiency

– points inside curve mean underutilization; outside curve cannot be met

• Law of increasing opportunity costs– as production switches from one product to another, more

resources needed to increase production of second product

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Example: Increasing Opportunity Costs• Increase in opportunity cost — each new unit costs more than last

one• Reasons for increasing cost of making more of one product

– need new resources, machines, factories– must retrain workers

• Costs paid by making less and less of other product

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Changing Production Possibilities

Example: A Shift in the PPC• A country’s supply of resources changes over time

– Example: U.S. in 1800s grew, gained resources, workers, new technology

– new resources mean new production possibilities beyond frontier• Increased production shown on PPC as shift of curve outward• Increase in total output called economic growth

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Explain how each term is illustrated by the production possibilities curve:

• underutilization• efficiency

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Working with Data

KEY CONCEPTS• Statistics — numerical data or information

– show patterns of human behavior• Economic models help organize and interpret data

The Economists Toolbox

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Working with Data

Using Economic Models • Economic models focus on a limited number of variables

– thus based on assumptions and use simplification– expressed in words, graphs, equations

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Working with Data

Using Charts and Tables • Economists look for statistical relationships, trends, connections • Charts and tables display data in rows and columns

– can reveal patterns by showing numbers in relation to other numbers

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Working with Data

Using Graphs• Graphs use two sets of variables: along horizontal, vertical axes• Line graphs useful for showing changes over time

– in economics, line referred to as a curve, even if straight• Bar graphs good for showing comparisons• Pie graph (or pie chart, circle graph) shows numbers in relation to

whole

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Microeconomics and Macroeconomics

KEY CONCEPTS• Microeconomics — studies behavior of individual players in an

economy– includes individuals, families, businesses

• Macroeconomics — studies behavior of economy as a whole– topics include inflation, unemployment, aggregate demand and

aggregate supply

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Microeconomics• Microeconomics examines specific, individual elements in an

economy– prices, costs, profits, competition, consumer and producer

behavior• Some Topics of Interest: business organization, labor markets,

environmental issues

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Macroeconomics• Macroeconomics studies sectors — combination of all individual units

– Includes consumer, business, public or government sectors• Macroeconomics studies national or global topics:

– monetary system, business cycle, tax policies, international trade

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Positive Economics and Normative EconomicsKEY CONCEPTS

• Positive economics describes and explains economic behavior as it is– uses verifiable facts; does not make judgments

• Normative economics studies what economic behavior should be– makes value judgments to recommend future actions

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Positive Economics and Normative EconomicsPositive Economics

• Positive economics uses scientific method– observe data, hypothesize, test, refine, continue testing

• Statements tested against real-world data – proved (or strongly supported) or disproved (or strongly

questioned)

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Positive Economics and Normative EconomicsNormative Economics

• Normative economics studies facts, asks if course of action is good• Recommendations differ because values they are based on also

differ

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Adam Smith: Founder of Modern Economics

Seeing the Invisible• An Inquiry into the Nature and Causes of the Wealth of Nations, 1776

– challenged mercantilism; argued for free trade• Invisible hand guides free marketplace, benefits sellers and buyers

– people pursue own economic self-interest– producers sell at prices that satisfy them and that consumers will

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Explain the differences between the terms in each of these pairs:

• statistics and economic model• macroeconomics and microeconomics• positive economics and normative economics

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Case Study: The Real Cost of Expanding O’Hare AirportBackground

• Chicago’s O’Hare Airport is one of the busiest airports in the United States.

• Delays at O’Hare are commonplace.• Considerable debate over the best solution to improve efficiency.

What’s the Issue• What are the real costs involved in airport expansion? Study these

sources to determine the costs tied to the expansion of O’Hare airport.

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Case Study: The Real Cost of Expanding O’Hare Airport {continued}

Thinking Economically1. Explain the real cost of expanding O’Hare Airport. Use information

presented in the documents to support your answer.2. Who are the most likely winners and losers as a result of the O’Hare

expansion? Explain your answer.3. How might supporters of expansion use a production possibilities

model to strengthen their case?

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