1

Big Questions 1. What is economics? 2. What are the fundamental concepts underlying economic models?

Big Questions Economics is the study of how people allocate their limited resources to satisfy nearly unlimited wants. The fundamental concepts on which economic models are based: 1. Incentives 2. Trade-offs 3. Opportunity cost 4. Marginal thinking 5. Trade creates value

Scarcity The Key Economic Problem Scarcity means limited resources The limited nature of society’s resources Nothing is infinite in nature—not even air and water! So can’t always get all that you want Economics The study of how people allocate their limited resources to satisfy their nearly unlimited wants The study of how people make decisions

What is Economics? Economics The social science that analyzes production, distribution of goods and service Studies how individuals and firms make decisions about: What to purchase (choosing how to allocate income among various goods, services and savings) How to allocate their time (leisure/work/school) What goods to produce What technologies to use How goods get allocated in the marketplace 5 © 2011, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Ten Principles of Economics Economists study: How people make decisions How people interact with one another Analyze forces and trends that affect the economy as a whole 6 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What is Economics? Alchian and Allen Discovery and analysis of the different ways in which individual goals and activities can be coordinated without central planning (i.e., by the invisible hand – or marketplace) The unit of analysis is the individual Economic analysis is scientific, not normative Formulates hypothesis about behavior, subjects these hypotheses to tests/analysis with data, accepts/rejects the model based on the results It helps explains what conditions lead to what consequences

What is Economics 2 major fields of inquiry Microeconomics Study of individual markets and factors that affect market price, quantity supplied two principal actors: consumers/households and firms/producers Macroeconomics Study of a system of (national) markets focusing on national income (gross national product), price levels (inflation), employment/unemployment and international trade Focuses on the role of government (Congress and budgets, Federal Reserve Bank), regulation (and regulatory agencies, business cycles and their effect on the economy

Key Assumptions About Individual Economic Behavior Alchian and Allen 1. For each person, some goods are scarce -> choices 2. Each person desires many goods and goals -> tradeoffs 3. Each person is willing to give up some of one economic good to get more of another economic good -> basis for trade 4. The more one has of a good, the lower is its personal marginal value -> diminishing marginal value 5. Not all people have identical tastes and preferences 6. People are innovative and rational

An Example of a Model Built on These Assumptions A Model of Consumer Demand

Foundations underlying the Model The five underlying concepts of economic models: 1. Incentives – people respond to incentives Lower the price -> buy more 2. Trade-offs – buying one good -> can’t buy others Marginal value of consumption vs cost (price) 3. Opportunity cost – what is given up Foregone alternative 4. Marginal thinking – value of last good = cost (price) Diminishing marginal value 5. Trade creates value Voluntarily purchase the goods as value is higher than cost