Introduction: What Is Economics? 1 C H A P T E R 1 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin

Introduction slide 2 ECONOMICS IS ABOUT DECIDING  Economists do not restrict themselves to considering only decision problems involving money and markets, though that is a big part of economics.

Introduction slide 3 EXAMPLES OF SOME DECISIONS ECONOMISTS HAVE ANALYZED  Whether to buy a car this week.  Whether to have pizza for dinner tonight, or something else.  How hard to study for this course.  Whether to go to college, and if so, which one.  Whether to buy a lottery ticket.

Individual Choice: Summing It Up We have just seen that there are 3 basic principles:  Resources are scarce. It is always necessary to make choices.  The real cost of something is what you must give up to get it. All costs are opportunity costs.  People usually exploit opportunities to make themselves better off. As a result, people will respond to incentives. © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin

So, What Is Economics?  Economics is the study of the choices made by people who are faced with scarcity.  Scarcity is a situation in which resources are limited and can be used in different ways.

6 of 16 What Is Economics?  Because our resources are limited, we must sacrifice one thing for another.  Economists are always reminding us that there is scarcity—that there are tradeoffs in everything we do.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Society’s Choices  Having a limited amount of resources means that we must sacrifice one thing in order to obtain another.  The decisions of producers, consumers and government determine how an economic system answers three fundamental questions:

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Society’s Choices  What goods and services do we produce? If we devote more resources to the production of one good, we have fewer resources for the production of another.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Society’s Choices  How do we produce these goods and services? How do we organize production and what methods and techniques should we use?

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Society’s Choices  For whom do we produce the output? How should we distribute the output produced among members of society?

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Factors of Production  Natural resources  Labor  Physical capital  Human capital  Entrepreneurship Factors of production, or productive inputs, are the resources we use to produce goods and services:

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Factors of Production  Natural resources: The things created by acts of nature such as land, water, mineral, oil and gas deposits; renewable and nonrenewable resources.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Factors of Production  Labor: The human effort, physical and mental, used by workers in the production of goods and services.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Factors of Production  Physical capital. All the machines, buildings, equipment, roads and other objects made by human beings to produce goods and services.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Factors of Production  Human capital: The knowledge and skills acquired by a worker through education and experience.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Factors of Production  Entrepreneurship: The effort to coordinate the production and sale of goods and services. Entrepreneurs take risk and commit time and money to a business without any guarantee of profits. »FIN

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Fields: Microeconomics  Microeconomics focuses on the analysis of individual economic units.  Microeconomics is the study of the choices made by consumers, firms, and government, and how these decisions affect the market for a particular good.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Microeconomics  Microeconomics gives you the tools to analyze the impact of: Environmental regulations, taxes, imports, gender discrimination, labor unions, competition, patterns of production and consumption, and other decisions made by individual economic units.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Microeconomics  Understand how markets work and predict changes.  Make personal or managerial decisions.  Evaluate the merits of public policies. Microeconomic analysis can be used to:

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Macroeconomics Macroeconomic analysis can be used to:  Understand how a national economy works.  Understand the grand debates over economic policy.  Make informed business decisions. Macroeconomics is the study of the nation’s economy as a whole.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Macroeconomics  Macroeconomic analysis can be used to understand important everyday economic issues such as: Unemployment, inflation, interest rates, exchange rates, the standard of living, the federal budget, consumption, and saving patterns.

22 of 16 In Short: Microeconomics  Microeconomics is the study of the choices made by households, firms, and government, and of how these choices affect the markets for goods or services.

23 of 16 In short Microeconomics  We can use microeconomic analysis to: 1. Understand how markets work and predict changes. 2. Make personal and managerial decisions. 3. Evaluate public policies.

24 of 16 In short: Macroeconomics  Macroeconomics is the study of the nation’s economy as a whole.  We can use macroeconomic analysis to: 1. Understand why economies grow. 2. Understand economic fluctuations. 3. Make informed business decisions.

Introduction slide 25 Methodology: Positive vs. Normative Economics  Positive econ. -- Studies the way the world is. How much will a new gasoline tax raise the price of gasoline? Will an increase in the minimum wage increase unemployment? Why is the price of corn $4.20 per bushel? How much will a drought in the corn belt raise the price of corn? Of wheat? What will be the effect on Byron Brown’s pizza consumption if we take $1000 away from Tom Izzo and give it to Brown?

Introduction slide 26  Normative econ. -- Studies the way the world should be. Should there be a new tax on gasoline? Should there be an increase in the minimum wage? Should $1000 be taken from M. Peter McPherson and given to Byron Brown? What should the price of corn be? Methodology: Positive vs. Normative Economics

27 of 16 Positive and Normative Analysis: Resume  Normative economics answers the question, What ought to be? Normative questions lie at the heart of policy debates.  Positive economics predicts the consequences of alternative actions, answering the questions, “What is?” or “What will be?”  FIN

28 of 16 The Economic Way of Thinking  Three elements of the economic way of thinking: 1. Use assumptions to simplify  Eliminate irrelevant details and focus on what really matters. Keep in mind that simplifying assumptions do not have to be realistic.

29 of 16 The Economic Way of Thinking 2. Isolate variables—Ceteris Paribus  Economists are interested in exploring relationships between two variables. A variable is a measure of something that can take on different values.  The expression ceteris paribus means that the effect of other tendencies is neglected for a time. Three elements of the economic way of thinking:

30 of 16 The Economic Way of Thinking 3. Think at the margin  A small, one-unit change in value is called a marginal change.  Economists use the answer to a marginal question as the first step in deciding whether to do more or less of something. Three elements of the economic way of thinking:

31 of 16 The Economic Way of Thinking  A key assumption of most economic analysis is that people act rationally, meaning that they act in their own self-interest.  Rational people respond to incentives.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Economic Way of Thinking  Simplifying assumptions do not have to be realistic. We use maps, for example, to get us from point A to point B knowing that the map is not an accurate description of the road ahead, but only an abstraction of reality. REMEMBER  Economists use simplifying assumptions to eliminate irrelevant details and focus on what really matters. Assumptions are an aid to the analytical process.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Economic Way of Thinking  “Ceteris paribus” is Latin for “all else the same.” To study the relationship between two variables, we assume that other variables do not change.  The “ceteris paribus” assumption is used to explore the relationship between two variables. A variable is a measure of something that can take on different values.

Understanding Graphs

Graph  Picture showing how variables relate and conveys information in a compact and efficient way  Functional relation exists between two variables when the value of one variable depends on another  The value of the dependent variable depends on the value of the independent variable

Basics of a Graph The value of variable x is measured along the horizontal axis and increases as you move to the right of the origin. The value of the variable y is measured along the vertical axis and increases as you move upward. Any point on a graph represents a combination of particular values of two variables. For example, point a represents the combination of 5 units of variable x and 15 units of variable y, while point b represents 10 units of x and 5 units of y.

Relating Distance Traveled to Hours Driven

Slopes of Straight Lines  Indicates how much the vertical variable changes for a given change in the horizontal variable  Vertical Change divided by the horizontal Change  Slope = Change in the vertical distance (Y) / change in the horizontal distance (X). m= Δ(Y) / Δ(X)

Exhibit: Alternative Slopes for Straight Lines Positive relation

Exhibit: Alternative Slopes for Straight Lines Negative relation

Exhibit: Alternative Slopes for Straight Lines No relation: zero slope

Exhibit: Alternative Slopes for Straight Lines No relation: infinite slope

Slope and Marginal Analysis  Economic analysis usually involves marginal analysis  The slope is a convenient device for measuring marginal effects because it reflects the change in one variable – the effect – compared to the change in some other variable – the cause  Slope of straight line is the same everywhere along the line

Curves with Both Positive and Negative Ranges y x b a The hill- shaped curve begins with a positive slope to the left of point a, a slope of 0 at point a, and a negative slope to the right of point a. The U- shaped curve begins with a negative slope, has a slope of 0 at point b, and a positive slope after point b.

Introduction slide 45 Models and theories  Model -- a hypothesis about the relationships among variables.  Everyone uses models.  Because a model abstracts from reality it makes mistakes.  Models can contain two kinds of errors or mistakes: the wrong explanatory variables may be included. the functional form may be incorrect.

Introduction slide 46 Contents of models  List of variables, especially a clear statement of what is to be explained Dependent v. independent variables  Hypothesized relationships among the variables.  Using tables of values, graphs, or equations.

Introduction slide 47 MODEL SUMMARY  Three ways to describe models Graphs Tables of values Mathematical functions (equations)  Important concepts Dependent and independent variables Linear function, intercept and slope

Introduction slide 48 AN ECONOMIC MODEL The Production Possibility Curve  Purposes of model Show scarcity constraint Illustrate economic efficiency Introduce opportunity cost concept  Variables Quantities of goods that may be produced  Givens Total amounts of inputs available Technology of production

Introduction slide 49 PPF DEFINED  The Production Possibility Curve (or frontier) shows the maximum amount of a good you can produce given the amounts of other goods produced, and given the total amounts of inputs available, and given the technology of production.

Introduction slide 50 PPC EXAMPLE  Assumptions: There are only two goods, pizza and spaghetti. There are limited inputs and given technology of production.  Definition: The PPC shows the maximum amount of pizza you can produce, given the amount of spaghetti to be produced.

Introduction slide 51 PRODUCTION POSSIBILITY CURVE SPAGHETTI PIZZA Which points are attainable and which points are unattainable? Which points are attainable and which points are unattainable? Go to hidden slide

Introduction slide 52 PRODUCTION POSSIBILITY CURVE SPAGHETTI PIZZA attainable unattainable

Introduction slide 53 PRODUCTION POSSIBILITY CURVE SPAGHETTI PIZZA What’s the effect of an improvement in the technology for producing spaghetti? What’s the effect of an improvement in the technology for producing spaghetti? Go to hidden slide

Introduction slide 54 SPAGHETTI PIZZA An improvement in spaghetti technology

Introduction slide 55 PRODUCTION POSSIBILITY CURVE SPAGHETTI PIZZA What’s the effect of an increase in total resources (inputs)? What’s the effect of an increase in total resources (inputs)? Go to hidden slide

Introduction slide 56 Effect of an increase in resources. SPAGHETTI PIZZA

Introduction slide 57  Points “inside” the PPC are inefficient.  For any point “inside” there corresponds some point that represents more production of both goods.  Note that while points on the PPC are efficient, we cannot say at this time whether some are better for society than others.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Production Possibilities Frontier (PPF) Curve 2  The PPF curve shows the possible combinations of goods and services available to an economy, when resources are fully and efficiently employed.  The PPF curve is a graphical illustration of fundamental economic problems related to our ability to produce goods and services.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Production Possibilities Frontier (PPF) Curve  When the economy is at point i, resources are not fully employed and/or they are not used efficiently.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Production Possibilities Frontier (PPF) Curve  Point h is desirable because it yields more of both goods, but not attainable given the amount of resources available.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Production Possibilities Frontier (PPF) Curve  Point e is one of the possible combinations of goods produced when resources are fully and efficiently employed.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Production Possibilities Frontier (PPF) Curve  At point e in this example, resources are devoted to the production of four space missions and 380 thousand computers.  To increase the number of space missions by one, 80 thousand computers will have to be sacrificed.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Production Possibilities Frontier (PPF) Curve  To increase the production of one good without decreasing the production of the other, the PPF curve must shift outward.  From point f, an additional 150 thousand computers or two more space missions are now possible.

© 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Production Possibilities Frontier (PPF) Curve  Resources are not perfectly adaptable. The PPF curve has a concave shape because resources are not perfectly adaptable in production. As we increase the production of one good, we sacrifice progressively more of the other.

To wrap up the PP curve  The production possibility curve what the curve shows

Units of clothing (millions) Units of food (millions) Units of food Units of clothing (millions) (millions) 8m 0.0 7m 2.2m 6m 4.0m 5m 5.0m 4m 5.6m 3m 6.0m 2m 6.4m 1m 6.7m 0 7.0m A production possibility curve

Units of clothing (millions) Units of food (millions) Units of food Units of clothing (millions) (millions) a 8m 0.0 7m 2.2m 6m 4.0m 5m 5.0m 4m 5.6m 3m 6.0m 2m 6.4m 1m 6.7m 0 7.0m a A production possibility curve

Units of clothing (millions) Units of food (millions) Units of food Units of clothing (millions) (millions) 8m 0.0 b 7m 2.2m 6m 4.0m 5m 5.0m 4m 5.6m 3m 6.0m 2m 6.4m 1m 6.7m 0 7.0m b A production possibility curve

Units of clothing (millions) Units of food (millions) Units of food Units of clothing (millions) (millions) 8m 0.0 7m 2.2m c 6m 4.0m 5m 5.0m 4m 5.6m 3m 6.0m 2m 6.4m 1m 6.7m 0 7.0m c A production possibility curve

The Economic Problem  The production possibility curve what the curve shows microeconomics and the p.p. curve:

The Economic Problem  The production possibility curve what the curve shows microeconomics and the p.p. curve:  choices and opportunity cost

The Economic Problem  The production possibility curve what the curve shows microeconomics and the p.p. curve:  choices and opportunity cost  increasing opportunity cost

Units of clothing (millions) Units of food (millions) Increasing opportunity costs x y 1 1 z 1 2

The Economic Problem  The production possibility curve what the curve shows microeconomics and the p.p. curve:  choices and opportunity cost  increasing opportunity cost macroeconomics and the p.p. curve:

The Economic Problem  The production possibility curve what the curve shows microeconomics and the p.p. curve:  choices and opportunity cost  increasing opportunity cost macroeconomics and the p.p. curve:  production within the curve

v x y O Making a fuller use of resources Food Clothing Production inside the production possibility curve

The Economic Problem  The production possibility curve what the curve shows microeconomics and the p.p. curve:  choices and opportunity cost  increasing opportunity cost macroeconomics and the p.p. curve:  production within the curve  shifts in the curve

O Growth in potential output Food Clothing Now

O Food Clothing Now Growth in potential output 5 years’ time

O Food Clothing Growth in potential and actual output

O Food Clothing Growth in potential and actual output x y

Introduction slide 82 OPPORTUNITY COST DEFINED  The opportunity cost of doing something is what you must give up in order to do it. The cost of a pizza is what you must give up to consume it, which in this case is easily computed in money. The cost of a college education includes both money and other foregone alternatives. For example, the cost of a year at MSU includes not only tuition and books, but the income you could have earned working on a full time job. The cost of attending a Lugnuts baseball game includes the value of the time you could have spent studying economics.

Introduction slide 83 The PPC can show opportunity cost  Suppose you are at some point on a PPC.  Then suppose you want to consume one more pizza.  The opportunity cost of one more pizza is the amount of spaghetti you must give up in order to get it.  Note that this opportunity cost is equal to minus the slope of the PPC.

Introduction slide 84 PRODUCTION POSSIBILITY CURVE SPAGHETTI PIZZA More pizza means less spaghetti

Introduction slide 85 OPPORTUNITY COST INCREASES AS MORE OF A GOOD IS PRODUCED  Not only does more pizza mean less spaghetti, but each additional pizza costs more than the one before it.  This idea shows up as the PPC being concave to the origin. (The curve bows out.)