1 Section 1 Basic Economic Principles

2 Overview What is Economics? What is Economics? Basic terms and definitions Basic terms and definitions The ten key elements of economics The ten key elements of economics Four pitfalls to avoid when engaging in sound economic reasoning Four pitfalls to avoid when engaging in sound economic reasoning

3 Is Life Getting Better or Worse? “the first 10 years of this century will very likely go down as the most dispiriting and disillusioning decade Americans have lived through in the post WWII era” – Times Magazine, from article End of the 2000’s: Goodbye to the Decade from Hell

4 Is Life Getting Better or Worse? NBC/Wallstreet Journal Poll: Rate this last decade: Awful: 36% Not Good: 31% Fair: 18% Good: 10% Great: 5% Was this decade the worst in recent history? Was this decade the worst in recent history? Is life getting worse? Is life getting worse?

5 Is Life Getting Better or Worse? What objective measures should we analyze?..... Life Expectancy HealthIncomeEducationEntertainment

6 Is Life Getting Better or Worse?

7 Who’s got the better mustache?

8 Just look at the changes in…. Our transportation Our transportation Is Life Getting Better or Worse?

9 Just look at the changes in…. Our technology Our technology

10 Is Life Getting Better or Worse? our medicine our medicine our entertainment our entertainment

11 Is Life Getting Better or Worse?

12 The Study of Economics Economics is the science of how individuals make choices under scarcity Science: developing and testing objective theories Science: developing and testing objective theories Individuals: a person or group of people Individuals: a person or group of people Choice: The act of selecting among alternatives Choice: The act of selecting among alternatives

13 The Study of Economics Scarcity: The concept that there is less of something freely available from nature than people would like. Scarcity: The concept that there is less of something freely available from nature than people would like. ex. time, money, cars, etc. ex. time, money, cars, etc.

14 Scarcity 1. Scarcity is not the same thing as poverty

15 Scarcity 2. Scarcity necessitates rationing a. Rationing – Allocating scarce goods a. Rationing – Allocating scarce goods to those who want them. to those who want them. b. In a market economy, price is used b. In a market economy, price is used to ration goods to ration goods

16 Scarcity 3. Scarcity leads to competitive behavior… …. And competition is good!

17 What do we do in the face of scarcity? When will the world run out of oil?

18 Resources Resources: An input used to produce an economic good 1. Human resources (human capital) 2. Physical resources (physical capital) 3. Natural resources Capital: Human-made resources used to produce other goods and services.

19 Example of Human Capital

20 Ten Key Elements of Economics Using the Economic way of thinking, things are not always as they appear:

21 #1 Incentives Matter Incentives matter: choice is influenced in a predictable way by changing incentives Incentives matter: choice is influenced in a predictable way by changing incentives ex. Money Game ex. Killer Seatbelts ex. 5 th grade spelling tests ex. Prices

22 #1 Incentives Matter

23 #1 Incentives Matter This economic principle influences all people Students Students Politicians Politicians Altruists Altruists Criminals Criminals

24 #1 Incentives Matter Individuals are rational: they try to get the most from their limited resources. “greatest benefit at least possible cost” “greatest benefit at least possible cost” Note: What is rational for one person may not be rational for everyone

25 #1 Incentives Matter Utility: The subjective benefit or satisfaction a person expects from a choice or course of action.

26 #2 There is No Such Thing as a Free Lunch Because resources are scarce, trade-offs must be made. Even if it is free to you, it is not free to society!

27 #2 There is No Such Thing as a Free Lunch Opportunity Cost: The highest valued alternative that must be sacrificed when choosing an option ex. An hour of your time ex. An hour of your time ex. how you spend your next $15 ex. how you spend your next $15 ex. Airbags vs. AIDS research ex. Airbags vs. AIDS research

28 #2 There is No Such Thing as a Free Lunch Opportunity Cost: “With every choice you risk the life you would have had; with every decision, you lose it.” – Richard Bach

29 #2 There is No Such Thing as a Free Lunch What is usually the biggest cost of getting your college degree? Foregone Earnings!

30 #2 There is No Such Thing as a Free Lunch Failure to understand this principle is one of the biggest mistakes made in economic reasoning. Ex. Government bailout and stimulus package Ex. Some Recycling Programs

31 #3 Decisions Are Made at the Margin Marginal: Describes the effect of a change in the current situation. Marginal = Change or Additional ex. Ponderosa Buffet ex. Ponderosa Buffet ex. Supersizing your extra value meal ex. Supersizing your extra value meal ex. Drive or Fly ex. Drive or Fly

32 #3 Decisions Are Made at the Margin The Diamond-Water Paradox: Don’t confuse total value with marginal value!

33 #3 Decisions Are Made at the Margin Law of Diminishing Marginal Utility: as consumption increases, the marginal utility derived from additional consumption will eventually decline Banana Eating Contest Results:

34 #3 Decisions Are Made at the Margin This helps us answer questions about our world: 1. Why do top pro-wrestlers and actors typically make more than top nurses and teachers? >

35 #3 Decisions Are Made at the Margin 2. Why do people cheat on their spouses?

36 #3 Decisions Are Made at the Margin Marginal thinking may also be why a stepwise criminal justice punishment system might be more effective than a capital punishment system

37 #3 Decisions Are Made at the Margin *Cost-benefit analysis: when making a decision one compares the marginal benefits and the marginal costs* To be economically efficient: 1. All actions generating more benefits then costs should be undertaken 2. No actions generating more costs then benefits should be undertaken

38 #3 Decisions Are Made at the Margin

39 #3 Decisions Are Made at the Margin This is why people will rationally choose to not be fully informed when making decisions. ex. New car vs. New pencil

40 #4 Voluntary Trade Promotes Economic Progress Voluntary vs. Coerced Coercion: Someone will devote resources to make you worse off if you don’t comply

41 #4 Voluntary Trade Promotes Economic Progress A. Because the value of a good or service is subjective, voluntary trade moves goods from people who value them less to people who value them more Ex. The Candy Game

42 #4 Voluntary Trade Promotes Economic Progress B. Trade makes larger output and consumption levels possible because it allows us to specialize in what we do best How much of what you have or use everyday do you make yourself?

43 #4 Voluntary Trade Promotes Economic Progress The Law of Comparative Advantage: individuals, economies, and nations should produce that which they can make at a lower opportunity cost and trade for everything else. ex. Should LeBron James clean his own house? house? ex. Who should mow the lawn

44 #4 Voluntary Trade Promotes Economic Progress C. Voluntary Exchange makes it possible for firms to achieve lower per-unit costs by adopting mass production methods.

45 #5 Transaction Costs Are an Obstacle to Trade Transaction Costs: The time, effort, and other resources needed to search out and complete an exchange.

46 #5 Transaction Costs Are an Obstacle to Trade Leaves a role for middleman.... Middleman: A person who buys and sells goods or services or arranges trades. A middleman reduces transaction costs.

47 #6 Profits direct businesses toward activities that increase wealth Profit: An excess of sales revenue relative to the opportunity cost of production. A profit occurs only when the value of the good produced is greater than the value of the resources used for its production.

48 #6 Profits direct businesses toward activities that increase wealth Loss: A deficit of sales revenue relative to the opportunity cost of production Losses are penalties imposed on those who produce goods that are valued less than the resources required for their production

49 #6 Profits direct businesses toward activities that increase wealth Are profits a bad thing? Are losses a bad thing?

50 #6 Profits direct businesses toward activities that increase wealth

51 #6 Profits direct businesses toward activities that increase wealth The economic philosophy of business failure: “The mark of your ignorance is the depth of your belief in injustice and tragedy. What the caterpillar calls the end of the world, the master calls a butterfly” – Richard Bach

52 #7 People Earn Income by Helping Others The process by which some people become rich will make everybody richer. Ex. Bill Gates WrongRight!

53 #7 People Earn Income by Helping Others

54 #8 Economic progress comes primarily through trade, investment, better ways of doing things, and sound economic institutions 1. Investments in productive assets and in the skills of workers enhance our ability to produce goods and services

55 #8 Economic progress comes primarily through trade, investment, better ways of doing things, and sound economic institutions However, investment requires us to give up consumption VS.

56 #8 Economic progress comes primarily through trade, investment, better ways of doing things, and sound economic institutions

57 #8 Economic progress comes primarily through trade, investment, better ways of doing things, and sound economic institutions 2. Improvements in technology spur economic progress. As a student can you do more with: Computer, printer, internet or paper, pencil, and books

58 #8 Economic progress comes primarily through trade, investment, better ways of doing things, and sound economic institutions Creative Destruction: The replacement of old products and production methods by innovative new ones that consumers judge to be superior.

59 #8 Economic progress comes primarily through trade, investment, better ways of doing things, and sound economic institutions 3. Improvements in economic organization can promote growth Growth comes from a legal system that promotes: Private property rights Private property rights Competition Competition Personal and economic freedom Personal and economic freedom

60 #9 The invisible hand directs people toward activities that promote the general welfare The Invisible Hand Principle: The tendency for people, while pursuing their own interests, to promote the economic well-being of society. Ex. Lines at Walmart

61 #9 The invisible hand directs people toward activities that promote the general welfare Prices and market order: 1. Prices communicate information to decision makers 2. Prices coordinate the actions of market participants 3. Prices motivate economic players

62 #9 The invisible hand directs people toward activities that promote the general welfare

63 #10 Long-term consequences, or the secondary effects, of an action are often ignored A person “…must trace not merely the immediate results but the results in the long run, not merely the primary consequences but the secondary consequences, and not merely the effects on some special group but the effects on everyone” - Henry Hazlitt, 1979 Economics in One Lesson

64 #10 Long-term consequences, or the secondary effects, of an action are often ignored Secondary effect: the indirect impact of an event or policy that may not be easily and immediately observable. ex. Yacht tax ex. Trade restrictions

65 4 Pitfalls to avoid in economic thinking Don’t make these mistakes when trying to engage in correct economic thinking

66 4 Pitfalls to avoid in economic thinking 1. Violation of ceteris paribus principle ceteris paribus: other things constant ex. Buying Roses

67 4 Pitfalls to avoid in economic thinking 2. The belief that good intentions guarantee desirable outcomes ex. Endangered species act ex. Endangered species act ex. Anti-depressant medication ex. Anti-depressant medication

68 4 Pitfalls to avoid in economic thinking 3. Fallacy of composition: belief that what is true for one might be true for all ex. Standing at a football game

69 4 Pitfalls to avoid in economic thinking 3. The belief that association is causation ex. Initials and performance ex. Initials and performance ex. Superstitions

70 The Economic Way of Thinking

71 Review Know what is meant by the term scarcity Know what is meant by the term scarcity 10 key elements of economics 10 key elements of economics 1. Incentives matter 2. No such thing as a free lunch (opp. cost) 3. Decisions are made at the margin 4. Trade promotes economic progress 5. Transaction costs and middlemen 6. The economic role of profits and losses 7. Productive activity creates wealth 8. Growth comes from investment, technology, and good institutions 9. The invisible hand and the role of prices 10. Secondary effects.

72 Review Know the 4 pitfalls to avoid in economic thinking: Know the 4 pitfalls to avoid in economic thinking: 1. violation of the ceteris paribus principle 2. The belief that good intentions guarantee good outcomes 3. The fallacy of composition 4. The belief that association = causation