Transcript Chapter One - Villanova University

Part I: Introduction
Chapter 1:
Ten Principles of
Economics
Objectives
1. Understand the concept of scarcity and
how it necessitates allocative decisions
2. Recognize that tradeoffs are a part of
every decision
3. Learn the meaning of opportunity cost
4. Understand what decision making at the
margin means
5. Recognize that incentives are an
important part of the decision making
process
Objectives
6. Understand that specialization and
exchange usually benefit all market
participants
7. Begin to see how markets are an efficient
way to organize production and allocate
resources
8. Learn about the relationship among
inflation, output and employment for
the economy as a whole
What is Economics?
Economics is the science that
studies the administration of
scarce resources and the
determinants of employment
and income.
Scarcity
Human
Wants
Economic
System
Scarce
Resources
Allocation
of
WHAT?
HOW?
Distribution
FOR
WHOM?
Scarcity

When wants exceed the resources
available to satisfy them, there is
scarcity.

People have unlimited wants.

Resources to satisfy those wants are
limited.
Scarcity & Poverty

Scarcity is not poverty.

The poor and the rich alike face
scarcity.

Faced with scarcity, people must make
choices.

“I cried because I had no premium
channels until I met a man who had no
cable.”
The Central Economic Problem
• Scarcity and how to overcome it
• Scarcity refers to economic resources
(factors of production)
• any economic system must solve this
central problem of economics
Central Economic Problem
Imposes certain basic questions
• With the resources available what should be
produced?
• Given a certain socially acceptable output
objective, how should the society’s output
be produced?
• After producing its output, who should
receive what shares of the goods?
Answers to the 3 basic
questions by a Market Economy
• What?
• In the long run only profitable goods and
services should be produced.
• How?
• Goods and services must be produced at the
lowest production cost.
Answers to the 3 basic
questions by a Market Economy
• How?
• To reduce the cost of production of a good
or service requires
– a. the specialization and division of labor to
increase efficiency
– b. the introduction of capital goods to reduce
labor costs and raise output
Answers to the 3 basic
questions by a Market Economy
• For whom?
• The factors of production will divide the
share of goods or services depending on
their contributions to the producing of these
goods.
• The value of each factors contribution will
be found in the factor markets.
Factors of Production
 Land is not just physical ground space, but
the totality of the raw materials of the earth.
2 Labor is the human physical exertion
performed in the production of a good or
service.
3 Capital (physical) the tools, buildings, and
machines used by labor to fashion goods
and services from raw materials.
Factors of Production
4 Entrepreneur is the human resource which
has the following attributes:
- organizes and directs the other factors of
production.
- Accepts the responsibility for all final decisions
in the production process.
- Accepts the risks for the firm in the dynamic
and changing market situations.
Returns to the factors of
production
•
•
•
•
Land --rent
Labor -- wages
Capital -- interest
Entrepreneur --profits
Choice

Economics is the study of the choices
people make to cope with scarcity.

Economics is sometimes called the
science of choice - the science that
explains the choices that people make
and predicts how choices change as
circumstances change.
1. People face tradeoffs.
“There is no such thing as a
free lunch!”
1. People face tradeoffs.
To get one thing, we usually have
to give up another thing.
 Guns v. butter
 Food v. clothing
 Leisure time v. work
 Efficiency v. equity
Making decisions requires trading
off one goal against another.
Tradeoff
1.) Efficiency is the property of society
getting the most it can from its scarce
resources.
2.) Equity is the property of distributing
economic prosperity fairly among all
members of society.
Rational Behavior

Economics is based on the assumption
of rational self-interest.

Individuals make rational decisions to
achieve maximum fulfillment of their
goals.

Adam Smith and the “Invisible Hand”.
Choice and Opportunity
Cost

Choosing more of one thing means
having less of something else.

There is no such thing as a free lunch.
Every choice involves an opportunity
cost.
Opportunity Cost
Opportunity Cost of some decision is the
value of the next best alternative which
you have to give up because of the
decision.
Marginal Analysis

Economic analysis uses marginal
analysis to study choices made by
people, businesses and governments.

Choices are made in small steps at the margin.
3. Rational people think at
the margin.
Marginal changes are small, incremental
adjustments to an existing plan of
action.
People make decisions by
comparing costs and benefits at the
margin.
Marginal Cost and
Marginal Benefit

The cost of a small increase in an
activity is called marginal cost.

The benefit that arises from a small
increase in an activity is called
marginal benefit.
Substitution and
Incentives

A central principle of economics - the
principle of substitution - is that when
the opportunity cost of an activity
increases, people substitute other
activities which have lower
opportunity costs.

Every activity has a substitute.
Incentives

An incentive is an inducement to
take a particular action.

Substituting away from more costly
activities toward less costly ones is
responding to incentives.
Incentives and
Economic Analysis

Whenever some event disrupts the
normal state of affairs, the economist
always asks: How will opportunity
costs change and what substitutions
will arise from the changed incentives?
Ten Principles of Economics
How People Make Decisions
1.) People face tradeoffs
2.) The cost of something is what you
give up to get it
3.) Rational people think at the margin
4.) People respond to incentives
Ten Principles of Economics
How People Make Decisions
1.) People face tradeoffs
2.) The cost of something is what you
give up to get it
3.) Rational people think at the margin
4.) People respond to incentives
Tradeoff
1.) Efficiency is the property of society
getting the most it can from its scarce
resources.
2.) Equity is the property of distributing
economic prosperity fairly among all
members of society.
Rational Behavior

Economics is based on the assumption
of rational self-interest.

Individuals make rational decisions to
achieve maximum fulfillment of their
goals.

Adam Smith and the “Invisible Hand”.
Ten Principles of Economics
How People Make Decisions
1.) People face tradeoffs
2.) The cost of something is what you
give up to get it
3.) Rational people think at the margin
4.) People respond to incentives
Choice and Opportunity
Cost

Choosing more of one thing means
having less of something else.

There is no such thing as a free lunch.
Every choice involves an opportunity
cost.
Opportunity Cost
Opportunity Cost of some decision is the
value of the next best alternative which
you have to give up because of the
decision.
Kerry Kittles
Villanova University
Class of 1996
Tim Thomas
VU Freshman,
entered Fall, 1996
Alvin Williams
Villanova University
Class of 1997
Entered Villanova
University 1999
Left V.U. June of
2001
Ten Principles of Economics
How People Make Decisions
1.) People face tradeoffs
2.) The cost of something is what you
give up to get it
3.) Rational people think at the margin
4.) People respond to incentives
Marginal Analysis

Economic analysis uses marginal
analysis to study choices made by
people, businesses and governments.

Choices are made in small steps at the margin.
Marginal Cost and
Marginal Benefit

The cost of a small increase in an
activity is called marginal cost.

The benefit that arises from a small
increase in an activity is called
marginal benefit.
Ten Principles of Economics
How People Make Decisions
1.) People face tradeoffs
2.) The cost of something is what you
give up to get it
3.) Rational people think at the margin
4.) People respond to incentives
Substitution and
Incentives

A central principle of economics - the
principle of substitution - is that when
the opportunity cost of an activity
increases, people substitute other
activities which have lower
opportunity costs.

Every activity has a substitute.
Incentives

An incentive is an inducement to
take a particular action.

Substituting away for more costly
activities toward less costly ones is
responding to incentives.
Incentives and
Economic Analysis

Whenever some event disrupts the
normal state of affairs, the economist
always asks: How will opportunity
costs change and what substitutions
will arise from the changed incentives?
Ten Principles of Economics
How People Interact
5.) Trade can make everyone better off
6.) Markets are usually a good way to
organize economic activity
7.) Governments can sometimes improve
market outcomes
Ten Principles of Economics
How People Interact
5.) Trade can make everyone better off
6.) Markets are usually a good way to
organize economic activity
7.) Governments can sometimes improve
market outcomes
5. Trade can make everyone
better off.
People
gain from their ability to trade
with one another.
Competition results in gains from
trading.
Trade allows people to specialize in
what they do best.
Ten Principles of Economics
How People Interact
5.) Trade can make everyone better off
6.) Markets are usually a good way to
organize economic activity
7.) Governments can sometimes improve
market outcomes
Market Economy
“Invisible Hand” / Prices
Market economy - an economy that
allocates resources through the
decentralized decisions of many firms
and households as they interact in
markets for goods and services.
6. Markets are usually a
good way to organize
economic activity.
Adam Smith made the
observation that households and
firms interacting in markets act as
if guided by an “invisible hand.”
6. Markets are usually a
good way to organize
economic activity.
Because households and firms look at
prices when deciding what to buy and sell,
they unknowingly take into account the
social costs of their actions.
As a result, prices guide decision makers
to reach outcomes that tend to maximize
the welfare of society as a whole.
Ten Principles of Economics
How People Interact
5.) Trade can make everyone better off
6.) Markets are usually a good way to
organize economic activity
7.) Governments can sometimes improve
market outcomes
Government Intervention Why?
1.) Market Failure - a situation in which a
market left on its own fails to allocate
resources efficiently.
2.) Externality - the impact of one person’s
action on the well being of a bystander.
3.) Market Power - the ability of a single
economic ( or a small group of factors) to
have a substantial influence on market
prices.
Ten Principles of Economics
How the Economy as a Whole Works
8.) A country’s standard of living depends on
its ability to produce goods and services
9.) Prices rise when the government prints
too much money
10.) Society faces a short-run tradeoff
between Inflation and Unemployment
Ten Principles of Economics
How the Economy as a Whole Works
8.) A country’s standard of living
depends on its ability to produce
goods and services
9.) Prices rise when the government
prints too much money
10.) Society faces a short-run tradeoff
between Inflation and unemployment
8. The standard of living
depends on a country’s
production.
Standard of living may be measured in
different ways:
By comparing personal incomes.
By comparing the total market value of a
nation’s production.
8. The standard of living
depends on a country’s
production.
Almost all variations in living standards
are explained by differences in
countries’ productivities.
8. The standard of living
depends on a country’s
production.
Productivity is the amount of goods
and services produced from each hour
of a worker’s time.
Higher productivity  Higher standard of living
Productivity

Productivity is the amount of output
obtained from a given amount of inputs.

Labor Productivity is amount of output
per worker hour.
Ten Principles of Economics
How the Economy as a Whole Works
8.) A country’s standard of living
depends on its ability to produce
goods and services
9.) Prices rise when the government
prints too much money
10.) Society faces a short-run tradeoff
between Inflation and unemployment
Inflation

Inflation refers to a sustained increase
in the average price level.
Ten Principles of Economics
How the Economy as a Whole Works
8.) A country’s standard of living
depends on its ability to produce
goods and services
9.) Prices rise when the government
prints too much money
10.) Society faces a short-run tradeoff
between Inflation and unemployment
10. Society faces a short-run tradeoff
between inflation and unemployment.
The Phillips Curve illustrates the tradeoff
between inflation and unemployment:
Inflation  Unemployment
It’s a short-run tradeoff!
Summary
When
individuals make decisions, they
face tradeoffs.
Rational people make decisions by
comparing marginal costs and marginal
benefits.
Summary
People can benefit by trading with
each other.
Markets are usually a good way of
coordinating trades.
Government can potentially improve
market outcomes.
Summary
A country’s productivity determines
its living standards.
Society faces a short-run tradeoff
between inflation and unemployment.