Economics is the social science concerned with how individuals, institutions, and society make optimal (best) choices under conditions of scarcity.

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Frederick Byrd
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1 Chapter 1: Limits, Alternatives, and Choices Learning objectives: List the ten key concepts to retain for a lifetime. Define economics and the features of the economic way of thinking. Describe the role of economic theory in economics. Distinguish microeconomics from macroeconomics, and positive economics from normative economics. Explain the individual s economic problem and how trade-offs, opportunity costs, and attainable combinations can be illustrated with budget lines. List the categories of scarce resources and delineate the economic problem. Apply the concepts of production possibilities analysis, increasing opportunity costs, and economic growth. Explain how economic growth and international trade increase consumption possibilities. Economics is the social science concerned with how individuals, institutions, and society make optimal (best) choices under conditions of scarcity. Ten key concepts to retain for a lifetime Concepts pertaining to the individual: 1. Facing trade-offs: scarcity means that you have to make choices. 2. Opportunity costs: what you give up when you make a choice is the opportunity cost of the choice. 3. Choosing a little more or less: most decisions are made at the margin. 4. The influence of incentives: choices are affected by incentives. Concepts that explain the interaction among individuals: 5. Specialization and trade: specialization and trade make people and countries better off. 6. The effectiveness of markets: markets usually do a better job of organizing trade than governments. 7. The role of governments: governments sometimes improve the functioning of markets. Concepts that deal with the economy as a whole and the standard of living: 8. Production and the standard of living: the standard of living describes how production is divided among people in a country. 9. Money and inflation: if money is printed that isn t backed up by production, the result is inflation. 10. Inflation-unemployment trade-off: there is a trade-off in the short run, but not in the long run, between inflation and unemployment. The economic way of thinking An economic perspective is a viewpoint that envisions individuals and institutions making rational decisions by comparing the marginal benefits and marginal costs associated with their actions.

2 Because our wants generally exceed our resources, we have to make choices. There is no free lunch ; even if there is no dollar cost, there is an opportunity cost of your time. Opportunity costs are the amounts of other products that must be forgone or sacrificed to produce a unit of a product. Individuals buy goods and services to increase their utility. Utility is the satisfaction, pleasure, or happiness a person gets from consuming a good or service. Consumers, firms, and governments are purposeful in choosing which items to buy, produce, or provide. Such rational behaviour is not selfish and is not necessarily perfect. Most decisions are marginal decisions, i.e., decisions about consuming one more unit or producing one more unit of a good or service. Marginal analysis refers to the comparison of marginal ( extra or additional ) benefits and marginal costs, usually for decision making. Will you spend one more hour studying, working, or hanging out with friends? Will you spend your entertainment budget on going to a concert or going to a movie? Will a firm hire more workers or buy more machines? Will the government spend more on health care or on education? Theories, principles, and models Economics relies on the scientific method to arrive at economic laws or principles. The scientific method is the systematic pursuit of knowledge through formulating a problem, collecting data, and formulating and testing hypotheses to obtain theories, principles, and laws. An economic principle is a statement about economic behaviour or the economy that enables prediction of the probably effects of certain actions. The scientific method: Observe the world. Formulate hypotheses. Test by comparing actual outcomes to the hypothesized predictions. Accept, reject, or modify hypotheses as required. Continue testing against the facts. Economic theories about the behaviour of households, firms, workers, and governments engaged in the production and consumption of goods and services involve simplifications, since the real world is so complex. Economic principles are generalizations, statements of the nature of the relation between two or more sets of facts. For example, when the price of a good rises, we believe that consumers

3 purchase less of it. But some consumers may consume a little less and some may consume a lot less. Economists assume that we can hold everything else constant except the factors being considered. This is called the other-things-equal assumption; in Latin, it is ceteris paribus or holding all else constant. An economic model is a simplified picture of economic reality; an abstract generalization. Some models are expressed in words, some in equations, and some in graphs. Microeconomics versus macroeconomics Microeconomics is the part of economics concerned with such individual units as industries, firms, and households. Microeconomics allows us to determine how much output a firm will produce in order to maximize its profit, or how much of which goods and services a household will buy in order to maximize its utility. Macroeconomics is the part of economics concerned with the economy as a whole. Macroeconomics allows us to understand what will happen to production when the economy goes into recession, or how actions by the Bank of Canada will affect interest rates. To look at the whole economy, we must aggregate all households together to look at overall household spending, or aggregate all firms together to look at overall production. An aggregate is a collection of specific economic units treated as if they were one unit. Positive economics is the analysis of facts to establish cause-and-effect relationships. An example of a positive economic question is what would happen if the government raises the minimum wage? Normative economics is the part of economics involving value judgments about what the economy should be like. An example of a normative economic question is should the government raise the minimum wage? The individual s economic problem The economic problem is the need to make choices because society s material wants for goods and services are unlimited but the resources available to satisfy these wants are limited (scarce). For an individual, we can show the economic problem on a graph using a budget line or budget constraint, a schedule or curve that shows various combinations of two products a consumer can purchase with a specific money income. Suppose you have $100 income to spend on your dining out per month, and lunches cost $10 while dinners cost $20.

4 If you used all of your income on lunches, you could have lunches out. If you used all of your income on dinners, you could have dinners out. If you want to eat one more dinner out, you would have to give up the opportunity to eat lunches. We can show this information graphically on the budget line below. The dinners intercept is the maximum number of dinners out you can consume if you use all of your dining income on dinners; the lunches intercept is the maximum number of lunches you can consume if you use all of your dining out budget on lunches instead. lunches dinners Of course, you can choose to use your dining out budget to buy some of each good. The combinations that you can afford with your income are called attainable points, and the combinations that are unaffordable are called unattainable points. All combinations of lunches and dinners on or inside the budget line are attainable, but combinations outside the budget line are unattainable. The budget line shows us that, with limited income, trade-offs exist. A trade-off is the sacrifice of some or all of one economic goal, good, or service to achieve some other goal, good, or service. In this example, you can trade off one dinner for two lunches. This trade-off is constant, so this budget line shows a constant opportunity cost, an opportunity cost that remains the same for each additional unit as a consumer (or society) shifts purchases (production) from one product to another along a straight-line budget line (production possibilities curve). The budget line shows us what you can choose to consume, but it doesn t tell us what you will consume, since that depends what will make you happiest. If your income rises, the whole budget line will shift up, and choices that were previously unattainable will become attainable. Society s economic problem Society also faces the economic problem of making choices under conditions of scarcity. As a society, our economic resources (the land, labour, capital, and entrepreneurial ability that are used in the production of goods and services) are scarce or limited.

5 Economic resources: Land Labour Capital Entrepreneurial ability Land refers to natural resources used to produce goods and services. Labour refers to the physical and mental talents of individuals used in producing goods and services. Capital refers to the human-made resources (buildings, machinery, and equipment) used to produce goods and services. Capital does not mean money! Consumer goods are products and services that satisfy human wants directly, while capital goods are goods that satisfy human wants indirectly by aiding the production of consumer goods. For example, the coffee maker at Tim Hortons is a capital good, while the double-double you bought this morning is a consumer good that was produced using the capital good. Investment is spending for the production and accumulation of capital. Again, investment does not refer to money or the purchase of financial assets. Entrepreneurial ability refers to the human talents that combine the other resources to produce a product, make non-routine decisions, innovate, and bear risks. Land, labour, capital, and entrepreneurial ability are used together to produce goods and services, so they are called factors of production or inputs. Production possibilities model The production possibilities model is like a budget line for a society, showing the alternative combinations of goods that we can produce with our existing factors of production. We will assume full employment, fixed resources, fixed technology, and two goods. A production possibilities table is a table showing the different combinations of two products that can be produced with a specific set of resources in a full-employment, full-production economy.

6 For example, suppose that Canada produces only two goods, blueberries and tractors, and that our production alternatives are as follows: A B C D E F Blueberries (millions of kg) Tractors (thousands) Notice that, to produce more blueberries, we must forgo some tractors, and vice versa. We can show the same information on a production possibilities curve (PPC), a curve showing the different combinations of goods or services that can be produced in a full-employment, fullproduction economy where the available supplies of resources and technology are fixed. Tractors Blueberries The points on or inside the PPC are attainable, whereas the points outside the PPC are unattainable. Notice that producing more blueberries means giving up some production of tractors; there is a trade-off between producing blueberries and producing tractors. But it is not a constant trade-off; the more blueberries we produce, the more tractors we have to give up. This is called the law of increasing opportunity costs: as the production of a good increases, the opportunity cost of producing an additional unit rises. This is because economic resources are not completely adaptable to alternative uses. The PPC is not a straight line but is a curve that is concave to the origin, or bowed out from the origin. This reflects the increasing trade-off: as more blueberries are produced, we must give up increasing amounts of tractors to get more blueberries. This shape indicates the law of increasing opportunity costs.

7 Since the cost of producing blueberries increases as we produce more, firms will have to charge higher prices to produce more blueberries. The extra, or marginal, cost of producing blueberries therefore rises as we produce more. But the marginal benefit of consuming blueberries falls as we produce more. Comparing marginal benefit and marginal cost helps us to go from what society can produce to what society will produce. The optimal amount of production is found where marginal benefit equals marginal cost. MB, MC Unemployment, growth, and the future Quantity of blueberries We have assumed full employment, but we can drop that assumption. Unemployment is shown as a point inside the PPC, in which we are not using all of our resources. Notice that we have the resources to produce more of either good or more of both goods. Tractors Blueberries We can also drop the assumptions that resources and technology are fixed. Economic growth is an outward shift in the production possibilities curve that results from an increase in factor supplies or quality, or an improvement in technology. We could see an increase in our labour force over time due to immigration, for example, or an increase in our stock of capital due to investment. We could also see technological change that allows for greater production.

8 A B C D E F Blueberries (millions of kg) Tractors (thousands) Tractors Blueberries Notice that points that were previously unattainable are now attainable. One way to achieve economic growth is to forgo consumption goods today in favour of capital goods, which can be used to produce more output in the future. So the choices we make today will affect our ability to produce tomorrow. The opportunity cost of higher growth in the future is fewer consumer goods today. International specialization and trade allow a country to consume outside its production possibilities curve. Pitfalls to avoid: Fallacy of composition: the assumption that what is true for one individual or part of a whole is necessarily true for a group of individuals or the whole. Post hoc fallacy: incorrectly reasoning that when one event precedes another, the first event must have caused the second event. Spurious correlation: a case in which two variables move together but are otherwise unrelated.

Ch. 1 LECTURE NOTES Learning objectives II. Definition of Economics III. The Economic Perspective CONSIDER THIS Free for All?

Ch. 1 LECTURE NOTES Learning objectives II. Definition of Economics III. The Economic Perspective CONSIDER THIS Free for All? Ch. 1 LECTURE NOTES I. Learning objectives In this chapter students will learn: A. The definitions of economics and the features of the economic perspective. B. The role of economic theory in economics.