Introduction to Economics Barbulean

Instructional Method Suggestions for the study of economics Read the book before coming to class Recopy lectures and reread the book within several hours of class Identify what you don’t understand Ask questions in class Use the online study guide Visit the professor during office hours

Definition of Economics Mankiw’s definition How Society manages its scarce resources Hedrick’s definition How society chooses to allocate its scarce resources among competing demands to best satisfy human wants Alternative definitions Economics is the study of choice. Economics is what economist do. Wikipedia's perspective

Scarcity and the Fundamental Questions of Economics Scarcity : Unlimited wants versus limited resources Choices and tradeoffs Opportunity Costs All societies must answer these questions What is to be produced? How is to be produced? For whom will it be produced?

Economics as a Science The Scientific Method Observation →Hypothesis →Testing Observation: identifying and measuring important variables – orderly loss of information Hypothesis: educated guesses about cause and effect with the variables Theories Models: realism or usefulness Testing: theories can’t be proven and are supported by repeated failed attempts to disprove them. Microeconomics vs. Macroeconomics The Assumption of Rational Behavior Boxes Example People respond to incentives Limits to the use of rational behavior (e.g. axe murders)

Greg Mankiw’s Ten Principles of Economic Thinking http://gregmankiw.blogspot.com/

Categories of Basic Principles of Economics How people make decisions? How people interact? How does the economy work overall?

How People Make Decisions Principle #1 - People face tradeoffs Time allocation – an example of tradeoffs Production Possibilities Frontier Efficiency versus equity

How People Make Decisions Principle #2 - The cost of something is what you have to give up to get it Opportunity costs come from Von Weiser, a German economist late 1800s Opportunity costs are independent of monetary units TINSTAAFL The real costs of going to college

How People Make Decisions Principle #3 - Rational people think at the margin Rational or irrational decision-making Marginal benefits and costs versus total benefits and costs Weighing marginal costs and benefits leads to maximizing net benefits (total welfare)

How People Make Decisions Principle #4 –People respond to incentives Reactions to changes in marginal benefits and costs Increases (decreases) in marginal benefits mean more (less) of an activity Increases (decreases) in marginal costs mean less (more) of an activity Example of seat belts leading to increased speeds Example of SUV (with child car seat) in Issaquah

How People Interact Principle #5 - Trade can make everybody Society better off Adam Smith author of the “An Inquiry into the Causes and Consequences of the Wealth of Nations” 1776 Gains from the division of labor and specialization Mercantilists perspectives Example of why Ellensburgians should trade with others

How People Interact Principle #6 - Markets are usually a good way of organizing economic activity Feudal times and haciendas in the new world The power of trade: cooperation versus conflict Markets: prices and quantities traded, typical and abstract

How People Interact Principle #6 - Markets are usually a good way of organizing economic activity creativity and productivity and resource allocation “Failure” of centrally planned economies “set it and forget it” becomes “compete or be obsolete”

How People Interact Principle #7 Governments can sometimes improve market outcomes Market signals can fail to allocate resources efficiently or equitably Public goods, the exclusion principle, the free- rider problem and non-rival consumption External costs and benefits Examples: vaccines, education, pollution

How People Interact Principle #7 Governments can sometimes improve market outcomes Equitable or fair distribution of resources Efficiency and equity: the pie analogy Government Failure: is government intervention always the proper solution?

How the Economy works as a Whole Principle # 8 – A country’s standard of living depends upon its ability to produce goods and services Adam Smith’s “An Inquiry into the Nature and the Consequences of the Wealth of Nations” Materialism – more toys mean more welfare wealth: a necessary or sufficient condition for happiness (are rich people happier, children with lots of toys)

How the Economy works as a Whole Principle # 8 – A country’s standard of living depends upon its ability to produce goods and services leisure time and productivity the factors of production: land or natural resources, labor, capital, entrepreneurship technology and productivity the Rule of 72 and growth rates

How the Economy works as a Whole Principle #9 – The general level of prices rises when the government prints and distributes too much money Definition of money, and economic language

How the Economy works as a Whole Principle #9 – The general level of prices rises when the government prints and distributes too much money Examples: “Not worth a continental” and Argentina Establish of the Federal Reserve and the introduction of sustained inflation in the US

How the Economy works as a Whole Principle #10 – Society faces a short-run tradeoff between inflation and unemployment Short-run and the long-run Demand and supply shocks Short-run increases (decreases) in output above (below) long-run potential output lead to adjustments

The Concept of Opportunity Cost Opportunity cost of any choice What we forego when we make that choice Most accurate and complete concept of cost Direct money cost of a choice may only be a part of opportunity cost of that choice Opportunity cost of a choice includes both explicit costs and implicit costs Explicit cost—dollars actually paid out for a choice Implicit cost—value of something sacrificed when no direct payment is made

Opportunity Cost and Society All production carries an opportunity cost To produce more of one thing Must shift resources away from producing something else The Principle of Opportunity Cost The concept of opportunity cost sheds light on virtually every problem that economists study, whether it be explaining the behavior of consumers or business firms or understanding important social problems like problems like poverty or racial discrimination Basic Principle #2: Opportunity Cost All economic decisions made by individuals or society are costly The correct way to measure the cost of a choice is its opportunity cost—that which is given up to make the choice

Figure 1: The Production Possibilities Frontier Number of Lives Saved per Period Quantity of All Other Goods per Period 100,000 200,000 300,000 400,000 500,000 1,000,000 950,000 850,000 700,000 At point A, all resources are used for "other goods." A Moving from point A to point B requires shifting resources out of other goods and into health care. B C D At point F. all resources are used for health care. W E F

Increasing Opportunity Cost According to law of increasing opportunity cost The more of something we produce The greater the opportunity cost of producing even more of it This principle applies to all of society’s production choices

Recessions A slowdown in overall economic activity when resources are idle Widespread unemployment Factories shut down Land and capital are not being used An end to the recession would move the economy from a point inside its PPF to a point on its PPF Using idle resources to produce more goods and services without sacrificing anything Can help us understand an otherwise confusing episode in U.S. economic history

Recessions During early 1940s, standard of living in U.S. did not decline as we might have expected but actually improved slightly. Why? U.S. entered World War II and began using massive amounts of resources to produce military goods and services Instead of pitting “health care” against “all other goods,” we look at society’s choice between military goods and civilian goods U.S. was still suffering from the Great Depression when it entered WWII Joining war effort helped end the Depression and moved economy from a point like A, inside the PPF, to a point like B, on the frontier Military production increased, but so did the production of civilian goods Although there were shortages of some consumer goods Overall result was a rise in the material well-being of the average U.S. citizen War is only one factor that can reverse a downturn No rational nation would ever choose war as an economic policy designed to cure a recession Alternative policies that virtually everyone would find preferable

Figure 2: Production and Unemployment 1. Before WWII the United States operated inside its PPF . . . Civilian Goods per Period Military Goods per Period 2. then moved to the PPF during the war. Both military and civilian production increased. B A

Economic Growth If economy is already operating on its PPF Cannot exploit opportunity to have more of everything by moving to it But what if the PPF itself were to change? Couldn’t we then produce more of everything? This happens when an economy’s productive capacity grows Many factors contribute to economic growth, but they can be divided into two categories Quantities of available resources—especially capital—can increase An increase in physical capital enables economy to produce more of everything that uses these tools More factories, office buildings, tractors, or high-tech medical equipment Same is true for an increase in human capital Skills of doctors, engineers, construction workers, software writers, etc. Technological change enables us to produce more from a given quantity of resources

Economic Growth Increases in capital and technological change often go hand in hand For instance, PET body scanners will enable us to save even more lives than our current set of resources Moving horizontal intercept of PPF rightward, from F to F‘ Impact of PET scanners stretches PPF outward along horizontal axis How can a technological change in lifesaving enable us to produce more goods in other areas of the economy? Society can choose to use some of increased lifesaving potential to shift other resources out of medical care and into production of other things Because of technological advance and new capital, we can shift resources without sacrificing lives

Economic Growth If we can produce more of the things that we value, without having to produce less of anything else, have we escaped from paying an opportunity cost? Yes . . . and no Figure 3 tells only part of story Leaves out steps needed to create this shift in the PPF For example, technological innovation doesn’t just “happen”—resources must be used to create it Mostly by research and development (R&D) departments of large corporations In order to produce more goods and services in the future, we must shift resources toward R&D and capital production Away from production of things we’d enjoy right now

Figure 3: The Effect of a New Medical Technology Number of Lives Saved per Period Quantity of All Other Goods per Period 2. But not its vertical intercept. 4. or more lives saved and greater production of other goods. A 1,000,000 3. The economy can end up with more lives saved and un-changed production of other goods . . . J H 700,000 D 1. A technological advance in saving lives increases this PPF's horizontal intercept . . . F F' 300,000 500,000 600,000

Efficiency In production, we’d like to have productive efficiency – achieving as much output as possible from a given amount of inputs or resources. Efficiency involves achieving a goal as cheaply as possible. Efficiency has meaning only in relation to a specified goal.

Efficiency Any point within (INSIDE) the production possibility curve represents inefficiency. Inefficiency – getting less output from inputs which, if devoted to some other activity, would produce more output. Unattainable -Any point outside the production possibility curve represents something unattainable, given present resources and technology.

Efficiency and Inefficiency Guns 10 8 6 4 2 2 4 6 Butter C D A B Unattainable point, given available technology, resources and labor force Efficient points Inefficient point

Tom’s Trade-offs: The Production Possibility Frontier

Shifts in the Production Possibility Curve Society can produce more output if: Technology is improved. More resources are discovered. Economic institutions get better at fulfilling our wants.

Economic Growth Production is initially at point A (20 fish and 25 coconuts),  it can move to point E (25 fish and 30 coconuts). Economic growth results in an outward shift of the PPF because production possibilities are expanded. The economy can now produce more of everything.

Shifts in the Production Possibility Curve Neutral Technological Change Butter C D A B Guns

Shifts in the Production Possibility Curve Biased Technological Change Butter C B A Guns

Specialization and Exchange Method of production in which each person concentrates on a limited number of activities Exchange Practice of trading with others to obtain what we want Allows for Greater production Higher living standards than otherwise possible All economics exhibit high degrees of specialization and exchange

Further Gains to Specialization Absolute Advantage: A Detour Ability to produce a good or service using fewer resources than other producers use Comparative Advantage If one can produce some good with a smaller opportunity cost than others can Total production of every good or service will be greatest when individuals specialize according to their comparative advantage Another reason why specialization and exchange lead to higher living standards than self-sufficiency

Resource Allocation Problem of resource allocation Which goods and services should be produced with society’s resources? Where on the PPF should economy operate? How should they be produced? No capital at all Small amount of capital More capital Who should get them? How do we distribute these products among the different groups and individuals in our society?

The Three Methods of Resources Allocation Traditional Economy Resources are allocated according to long-lived practices from the past Command Economy (Centrally-Planned) Resources are allocated according to explicit instructions from a central authority Market Economy Resources are allocated through individual decision making

The Nature of Markets A market is a group of buyers and sellers with the potential to trade with each other Global markets Buyers and sellers spread across the globe Local markets Buyers and sellers within a narrowly defined area

The Importance of Prices A price is the amount of money that must be paid to a seller to obtain a good or service When people pay for resources allocated by the market They must consider opportunity cost to society of their individual actions Markets can create a sensible allocation of resources

Resource Allocation in the United States Numerous cases of resource allocation outside the market Such as families Various levels of government collect about one-third of our incomes as taxes Enables government to allocate resources by command Government uses regulations of various types to impose constraints on our individual choice The market is the dominant method of resource allocation in United States However, it is not a pure market

Resource Ownership Communism Socialism Capitalism Most resources are owned in common Socialism Most resources are owned by state Capitalism Most resources are owned privately

Types of Economic Systems An economic system is composed of two features Mechanism for allocating resources Market Command Mode of resource ownership Private State

Figure 4: Types of Economic Systems Resource Allocation Market Command Private State Resource Ownership Market Capitalism Centrally Planned Capitalism Centrally Planned Socialism Market Socialism

Transactions: The Circular-Flow Diagram Trade takes the form of barter when people directly exchange goods or services that they have for goods or services that they want. The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle.

Circular-Flow of Economic Activities A household is a person or a group of people that share their income. A firm is an organization that produces goods and services for sale. Firms sell goods and services that they produce to households in markets for goods and services. Firms buy the resources they need to produce—factors of production—in factor markets. Factor Market- A market used to exchange the services of a factor of production: labor, capital, land , and entrepreneurship.

The Circular-Flow Diagram

Factor Market Factor markets, also termed resource markets, exchange the services of factors, NOT the factors themselves. For example, the labor services of workers are exchanged through factor markets NOT the actual workers. Buying and selling the actual workers is not only slavery (which is illegal) it's also the type of exchange that would take place through product markets, not factor markets. More realistically, capital and land are two resources than can be and are legally exchanged through product markets. The services of these resources, however, are exchanged through factor markets. The value of the services exchanged through factor markets each year is measured as national income.

Wages, rents, interest, profits The Circular Flow Wages, rents, interest, profits Firms (production) Household Factor services Goods Government Spending Other countries Financial markets Government Taxes Savings Investment Personal consumption Exports Imports

Growth in the U.S. Economy from 1962…

…to 1988