The Economic Way of Thinking

Chapter 1: The Economic Way of Thinking KEY CONCEPT Scarcity is the situation that exists because wants are unlimited and resources are limited. WHY THE CONCEPT MATTERS The concept of scarcity is an issue you confront in everyday life. Suppose you have $20 to cover the cost of lunches for the week. How would you use the money to cover your wants Monday through Friday? How would buying a late afternoon snack for $1 on two of the days affect your lunch choices?

Scarcity: The Basic Economic Problem What Is Scarcity? KEY CONCEPTS Wants — desires that can be met by consuming products Needs — things necessary for survival Scarcity — lack of resources available to meet all human wants not a temporary shortage Economics — study of how people use resources to satisfy wants examines how individuals and societies choose to use resources organizes, analyzes, interprets data about economic behaviors develops theories, economic laws to explain economy, predict future

What Is Scarcity? Principle 1: People Have Wants People make choices about all their needs and wants Wants are unlimited, ever changing

What Is Scarcity? Principle 2: Scarcity Affects Everyone Scarcity affects which goods and services are provided Goods — physical objects that can be bought Services — work one person does for another for pay Consumer — person who buys good or service for personal use Producer — person who makes a good or provides a service

Scarcity Leads to Three Economic Questions KEY CONCEPTS Scarcity affects society and producers as well as individuals Society must answer three basic economic questions: what will be produced? how will it be produced? for whom will it be produced?

Scarcity Leads to Three Economic Questions Question 1: What Will Be Produced? Societies must decide on mix of goods to produce depends in part on their natural resources Some countries allow producers and consumers to decide In other countries, governments decide Must also decide how much to produce; choice depends on societies’ wants

Scarcity Leads to Three Economic Questions Question 2: How Will It Be Produced? Decisions on production methods involve using resources efficiently decisions influenced by a society’s natural resources Societies adopt different approaches with unskilled labor force, might use labor-intensive methods with skilled labor force, might use capital-intensive methods

Scarcity Leads to Three Economic Questions Question 3: For Whom Will It Be Produced? How goods and services are distributed involves two questions how should each person’s share be determined? how will goods and services be delivered to people?

The Factors of Production KEY CONCEPTS Factors of production — resources needed to produce goods and services include land, labor, capital, entrepreneurship supply is limited

The Factors of Production Factor 1: Land Land means all natural resources on or under the ground includes water, forests, wildlife, mineral deposits

The Factors of Production Factor 2: Labor Labor is all the human time, effort, talent used to make products physical and mental effort used to make a good or provide a service

The Factors of Production Factor 3: Capital Capital is a producer’s physical resources includes tools, machines, offices, stores, roads, vehicles sometimes called physical capital or real capital Workers invest in human capital — knowledge and skills workers with more human capital are more productive

The Factors of Production Factor 4: Entrepreneurship Entrepreneurship — vision, skill, ingenuity, willingness to take risks Entrepreneurs anticipate consumer wants, satisfy these in new ways develop new products, methods of production, marketing or distributing risk time, energy, creativity, money to make a profit

Reviewing Key Concepts Explain the relationship between the terms in each of these pairs: wants and scarcity consumer and producer factors of production and entrepreneurship

Economic Choice Today: Opportunity Cost Making Choices KEY CONCEPTS Economic choices shaped by Incentives — benefits that encourage people to act in certain ways Utility — benefit or satisfaction gained from using a good or service To make choices, people economize: make decisions according to best combination of costs and benefits

Making Choices Factor 1: Motivations for Choice People motivated by incentives, expected utility, desire to economize They weigh costs against benefits to make purposeful choices motivated by self-interest: look for ways to maximize utility

Making Choices Factor 2: No Free Lunch All choices have a cost choosing one thing means giving up another, or paying a cost cost can take form of money, time, other thing of value

Trade-Offs and Opportunity Cost KEY CONCEPTS Trade-off is alternative people give up when they make a choice usually means giving up some, not all, of a thing to get more of another

Trade-Offs and Opportunity Cost Example 1: Making Trade-Offs Shanti wants to earn college credit over summer semester-long university course offers more credits six-week high school course leaves time for vacation

Trade-Offs and Opportunity Cost Example 2: Counting the Opportunity Cost Opportunity cost is value of next-best alternative a person gives up not the value of all possible alternatives Dan chooses to work for six months so he can travel for six months opportunity cost: six months of salary

Analyzing Choices KEY CONCEPTS Cost-benefit analysis — examination of costs, expected benefits of choices one of most useful tools for evaluating relative worth of economic choices

Analyzing Choices Example: Max’s Decision-Making Grid Decision-making grid shows what one gets, gives up with each choice Max’s grid shows all possible choices for his free hours each week lists choices, benefits and opportunity cost of each choice With time, costs and benefits change; also goals and circumstances Changes influence decisions, make people alter original choices

Analyzing Choices Example: Marginal Costs and Benefits Marginal cost additional cost of using one more unit of a good or service Marginal benefit additional benefit of using one more unit of a good or service

Reviewing Key Concepts Explain the relationship between the terms in each of these pairs: incentive and utility trade-off and opportunity cost marginal cost and marginal benefit

Graphing the Possibilities Analyzing Production Possibilities Graphing the Possibilities KEY CONCEPTS Economic models — simplified representations of economic forces Production possibilities curve (PPC) is one model maximum goods or services that can be produced from limited resources also called production possibilities frontier

Graphing the Possibilities KEY CONCEPTS PPC based on assumptions that simplify economic interactions resources are fixed all resources are fully employed only two things can be produced technology is fixed

Graphing the Possibilities Production Possibilities Curve PPC runs between extremes of producing only one item or the other Data is plotted on a graph; lines joining points is PPC shows maximum number of one item relative to other item PPC shows opportunity cost of each choice more of one product means less of the other

What We Learn from PPCs KEY CONCEPTS Concepts revealed by PPC: Efficiency — producing the maximum amount of goods and services possible Underutilization — producing fewer goods and services than possible

What We Learn from PPCs Example: Efficiency and Underutilization Each point on PPC represents efficiency points inside curve mean underutilization; outside curve cannot be met Law of increasing opportunity costs as production switches from one product to another, more resources needed to increase production of second product

What We Learn from PPCs Example: Increasing Opportunity Costs Increase in opportunity cost — each new unit costs more than last one Reasons for increasing cost of making more of one product need new resources, machines, factories must retrain workers Costs paid by making less and less of other product

Changing Production Possibilities Example: A Shift in the PPC A country’s supply of resources changes over time Example: U.S. in 1800s grew, gained resources, workers, new technology new resources mean new production possibilities beyond frontier Increased production shown on PPC as shift of curve outward Increase in total output called economic growth

Reviewing Key Concepts Explain how each term is illustrated by the production possibilities curve: underutilization efficiency

The Economists Toolbox Working with Data KEY CONCEPTS Statistics — numerical data or information show patterns of human behavior Economic models help organize and interpret data

Working with Data Using Economic Models Economic models focus on a limited number of variables thus based on assumptions and use simplification expressed in words, graphs, equations

Working with Data Using Charts and Tables Economists look for statistical relationships, trends, connections Charts and tables display data in rows and columns can reveal patterns by showing numbers in relation to other numbers

Working with Data Using Graphs Graphs use two sets of variables: along horizontal, vertical axes Line graphs useful for showing changes over time in economics, line referred to as a curve, even if straight Bar graphs good for showing comparisons Pie graph (or pie chart, circle graph) shows numbers in relation to whole

Microeconomics and Macroeconomics KEY CONCEPTS Microeconomics — studies behavior of individual players in an economy includes individuals, families, businesses Macroeconomics — studies behavior of economy as a whole topics include inflation, unemployment, aggregate demand and aggregate supply

Microeconomics and Macroeconomics Microeconomics examines specific, individual elements in an economy prices, costs, profits, competition, consumer and producer behavior Some Topics of Interest: business organization, labor markets, environmental issues

Microeconomics and Macroeconomics Macroeconomics studies sectors — combination of all individual units Includes consumer, business, public or government sectors Macroeconomics studies national or global topics: monetary system, business cycle, tax policies, international trade

Positive Economics and Normative Economics KEY CONCEPTS Positive economics describes and explains economic behavior as it is uses verifiable facts; does not make judgments Normative economics studies what economic behavior should be makes value judgments to recommend future actions

Positive Economics and Normative Economics Positive economics uses scientific method observe data, hypothesize, test, refine, continue testing Statements tested against real-world data proved (or strongly supported) or disproved (or strongly questioned)

Positive Economics and Normative Economics Normative economics studies facts, asks if course of action is good Recommendations differ because values they are based on also differ

Adam Smith: Founder of Modern Economics Seeing the Invisible An Inquiry into the Nature and Causes of the Wealth of Nations, 1776 challenged mercantilism; argued for free trade Invisible hand guides free marketplace, benefits sellers and buyers people pursue own economic self-interest producers sell at prices that satisfy them and that consumers will pay

Reviewing Key Concepts Explain the differences between the terms in each of these pairs: statistics and economic model macroeconomics and microeconomics positive economics and normative economics

Case Study: The Real Cost of Expanding O’Hare Airport Background Chicago’s O’Hare Airport is one of the busiest airports in the United States. Delays at O’Hare are commonplace. Considerable debate over the best solution to improve efficiency. What’s the Issue What are the real costs involved in airport expansion? Study these sources to determine the costs tied to the expansion of O’Hare airport.

Case Study: The Real Cost of Expanding O’Hare Airport {continued} Thinking Economically Explain the real cost of expanding O’Hare Airport. Use information presented in the documents to support your answer. Who are the most likely winners and losers as a result of the O’Hare expansion? Explain your answer. How might supporters of expansion use a production possibilities model to strengthen their case?