The Economic Fundamentals

What Is Economics?Economics is the study of how people make

choices to satisfy their wantsFor example: --You must choose how to spend

your timeBusinesses must choose how many people to hire Adam Smith- father of Economics – introduced a

way of thinking about economic ideas in his book “The Wealth of Nations” 1776

Economic Enigmas- puzzles or riddles that might be explained through an economic analysis

What is Economics……Microeconomics- economic decision making

by individuals, households and businessesMacroeconomics- workings of the economy

as a wholePositive economics- statement that describes

how things areNormative Economics- statement of how

things ought to be

7 Principles Of EconomicsPrinciple 1: Scarcity Forces Tradeoffs Scarcity- there will never be enough of everything to

satisfy everyone completely Tradeoff- choosing one thing over another“there is no such thing as a free lunch”- no-free-lunch- principle:

even that of accepting a free lunch involves tradeoffs. Principle 2: Costs Versus Benefits Costs- what you spend in time, money, and other sacrificesBenefits- what you gain from something in terms of money,

time, experience, or improvementsCost benefit analysis- listing of costs vs benefits to make a

choice

7 Principles Of EconomicsPrinciple 3: Thinking at the MarginMargin- border or outer edge of something “most decisions

we make each day involve choices about a little less or a little more of something”

Marginal Cost- what you give up to add one unit to an activity

Marginal Benefit- what you gain by adding one more unit Principle 4: Incentives Matter Incentives- something that motivates a person to take

a particular course of action Principle 5: Trade makes people better off

7 Principles Of EconomicsPrinciple 6: Markets Coordinate TradeMarket- an arrangement that brings buyers and

sellers together to do business with each otherInvisible hand- Adam Smith’s theory that supply

will meet demand which is guided by an invisible hand

 Principle 7: Future Consequences CountLaw of Unintended Consequences- the actions of

people and governments always have effects that are not expected or that are “unintended”

Scientific Method

- Posing a question- researching the question- developing a hypothesis- conducting studies and collecting

information- analyzing information-evaluating the hypothesis

Economic GraphsGraph: Two dimensional

representation of a three dimensional world

Graph- visual representation of the relationship between two given sets of data

Variable- quantity that can vary

Curve- any line representing data points plotted on a graph

Economic ModelsEconomic Model- Simplified representation

of reality that allows economists to focus on the effects of one change at a time

Rational Behavior model- tool for understanding the mystery of human behavior

Chapter 2: Economic Decision Making

Why Is What We Want Scarce?We can’t get everything we want because

there is a limited amount of resources to fulfill our wants.

All goods (physical objects) and services (activities provided by others) are scarce because the resources needed to produce them are scarce.

Scarcity and shortage are not the same. A shortage is a temporary condition that occurs when there is less of a good or service available than people want at the current price.

How Do We Satisfy Economic Wants?The productive resources that go into producing goods

and services are called factors of production. These inputs make up the production equation:

land + labor + capital = goods and servicesLand resources are gifts of nature such as air, soil,

minerals, water, and plants.Labor resources include the physical and mental

activities that go into producing goods and services.Capital resources include the tools, machines,

buildings, and technologies that are used in the production of goods and services.

Entrepreneurs combine land, labor, and capital to produce goods and services.

They often supply vision, take risks, and provide the drive needed to turn ideas into realities.

What Do We Give Up When We Make a Choice?

People seek to maximize their utility (satisfaction or benefit) when making decisions.This requires them to consider tradeoffs, or alternatives among

choices.Businesses and societies also face tradeoffs when making

decisions.An opportunity cost of a decision is the value (in time,

money, etc.) of the next best alternative. In other words, it is the cost of a decision.

People tend to make decisions based on their marginal utility, or the extra satisfaction they gain from one additional unit of a good or service.

Most goods and services have diminishing marginal utility because as we get more of something, the pleasure we derive from it tends to decrease.

How Can We Measure What We Gain and Lose When Making Choices?A production possibilities

frontier (PPF) is a graph that shows how an economy might use its resources to produce two goods.

A PPF is used to calculate the opportunity cost of moving production from one point to another.

Every point on a PPF represents an efficient use of resources. The area under the curve represents an attainable but inefficient use of resources.

Increases in productivity, a measure of the output of a system, can shift the PPF outward.

Chapter 3 Economic Systems

Who Gets What? How Do Societies Decide?

Every society must answer three fundamental economic questions: what to produce, how, and for whom?

How societies answer these questions depends on their economic goals: freedom, efficiency, equity, growth, security, and stability.

Societies differ in the degree of importance they attach to each goal. Progress toward one goal can sometimes be achieved only at the expense of another.

Who Decides What in Different Economic Systems?

In answering the three economic questions, every society develops an economic system.A traditional economy relies on custom and

tradition to dictate production and consumption. The goals are economic security and stability.

In a command economy, decisions about production are made by a powerful ruler or central authority. The goals are equity and security.

In a market economy, individual producers and consumers coordinate economic activity. The goals are economic freedom and efficiency.

Nearly all countries have mixed economies, in which both the government and individuals play important roles in production and consumption.

The government’s role varies but usually involves: protection (such as establishing institutions that

enable markets to operate) regulation (such as stepping in when markets operate

in a way that society finds unacceptable)public benefits (such as providing certain goods and

services that markets do not always provide or do not provide enough of).

How do Mixed Economies Divide the Decision Making?

What are the Key Characteristics of the U.S. Economic System

In a free enterprise system, as in the United States, individuals own the factors of production and make decisions about how to use those factors within the framework of the law.

A free enterprise system has seven key characteristics: economic freedom, competition, equal opportunity, property rights, binding contracts, profit motive, and limited government.

Chapter 4 : Gains from Trade

How Does Specialization Lead to Economic Interdependence?

Specialization is the development of skills or knowledge in one aspect of a job or field of interest. It leads to greater productivity and a higher standard of living.

Societies that specialize are more productive than those that are self-sufficient.

Specialization encourages trade. Trade is a voluntary exchange that is usually facilitated with money.

Trade creates economic interdependence, in which people rely on others for most of the goods and services they want.

How Do People and Nations Gain from Specialization and Trade?An individual holds an absolute advantage

when he or she can produce a good or service using fewer resources than someone else.

An individual holds a comparative advantage when he or she can produce a good or service at a lower opportunity cost than someone else.

COMPARATIVE ADVANTAGECAMERAS(units)

TV SETS(units)

Japan 50 40

Australia 10 20

Which country has the absolute advantage in the production of Cameras? TV Sets?

What is the opportunity Cost of producing one camera for Japan? For Australia?

What is the opportunity cost of producing one TV Set for Japan? For Australia?

For which good does Australia have the Comparative Advantage?

For which good does Japan have the Comparative Advantage?

OPP. COST

1 CAMERA

1 TV SET

Japan .8 units of a TV set

1.25 units of a camera

Australia 2 units of a camera

.5 units of a cameras

COMPARATIVE ADVANTAGECAMERAS(units)

TV SETS(units)

Japan 50 40

Australia 10 20

Which country has the absolute advantage in the production of Cameras? TV Sets?

Japan for Both What is the opportunity Cost of

producing one camera for Japan? For Australia?

Japan- .8 units of a TV Set Australia- 2 units of a TV Set

What is the opportunity cost of producing one TV Set for Japan? For Australia?

Japan- 1.25 Units of a Camera Australia- .5 Units of a camera

For which good does Australia have the Comparative Advantage?

TV Sets because they are giving up less cameras

For which good does Japan have the Comparative Advantage?

Cameras because they are giving up less TV’s

OPP. COST

1 CAMERA

1 TV SET

Japan .8 units of a TV set

1.25 units of a camera

Australia 2 units of a TV set

.5 units of a camera

SpecializationSpecialization and trade based on comparative advantage

benefits both trading partners—whether individuals, societies, or nations. For example, Alexander Selkirk and Pirate Jack can both produce turnips and clams. Even though Pirate Jack holds an absolute advantage in the production of both goods, he and Selkirk both benefit when they specialize in producing the good for which they hold a comparative advantage and trade for the other good.

When the principle of comparative advantage guides who produces what, society usually benefits.

Some of the factors that give rise to comparative advantage are climate, natural resources, education, wage levels, and technology differences.

How Does Trade Make us Wealthier?Wealth is defined as our sense of well-being.

It is not just how much money we have, but how much we value what we have.

Trade makes us wealthier in three ways:• Trade moves goods to the people who value

them more.• Trade increases the quantity and variety of

goods available.• Trade lowers the cost of goods.