Fundamental Economic Concepts

I WON THE LOTTERY! I’ll give you anything you want other than money. What do you want? Would your list ever end? Why not? 2

What is Economics? - The study of mankind’s unlimited desires in a world of limited resources. - Economics is the science of scarcity -Since we are unable to have everything we desire, we must make CHOICES on how we will use our resources. In economics we study the choices of individuals, firms, and governments Microeconomics deals with individual decisions, Macroeconomics looks at the economy as a whole

Positive vs. Normative Positive Statements- Based on facts. Avoids value judgements (what is). Normative Statements- Includes value judgements (what ought to be). How is Economics used? Economists use the scientific method to make generalizations and abstractions to develop theories. This is called theoretical economics. These theories are then applied to fix problems or meet economic goals. This is called policy economics. Copyright ACDC Leadership

5 Key Economic Assumptions 1. Society has unlimited wants and limited resources (scarcity). 2. Due to scarcity, choices must be made. Every choice has a cost (a trade-off). 3. Everyone’s goal is to make choices that maximize their satisfaction. Everyone acts in their own “self-interest.” 4. Everyone makes decisions by comparing the marginal costs and marginal benefits of every choice. 5. Real-life situations can be explained and analyzed through simplified models and graphs. Copyright ACDC Leadership

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What is the Economy?

Why Do We Study It? 1. Description 2. Analysis 3. Explanation 4. Prediction What? or How Much? How? or Why? When? OR…

Why do we study Economics? So we don’t get screwed.

Book Auction What economic concepts were demonstrated by the book auction? ◦ Scarcity ◦ Value ◦ Choices ◦ Rationing ◦ Equity vs. Efficiency  Which was the sealed auction? ◦ Consumer surplus } Stay Tuned!

Scarcity Situation that occurs when wants are greater than available resources. Scarcity is the fundamental problem in economics.

In this classroom, is/are _________ scarce? Desks? Water? Books? Gasoline? Jolly Ranchers? … Good looking economics instructors? But not in the hallway… Wants are satisfied by available resources No want for it in classroom, but outside… yes Wants exceed available resources

Good looking economics instructors?

We always assume…. People make decisions based upon RATIONAL SELF-INTEREST

We must consider… Examples: Shelter is a need, a mansion is a want. Food is a need, a large pizza is a want.

Utility The satisfaction that consumption of a good or service provides

DIMINISHING MARGINAL UTILITY As you consume additional units of a good, at some point each additional unit will begin providing less utility than the one before it.

Cost – Benefit Analysis Question? : What do you want RIGHT NOW?

Cost – Benefit Analysis Follow up question? : Why don’t you go get it?

Cost – Benefit Analysis We all make decisions in our own self-interest All decisions come with certain trade-offs and alternatives THERE IS NO SUCH THING AS A FREE LUNCH!!! SeinfeldSeinfeld example Opportunity Cost: the next-best alternative given up when making a choice

Opportunity Cost VS.

Marginal Cost Marginal = Additional, next Additional cost vs. additional benefit We constantly engage in marginal analysis

Would you see the movie three times? Notice that the total benefit is more than the total cost but you would NOT watch the movie the 3 rd time. Thinking at the Margin # Times Watching Movie BenefitCost 1st$30$10 2nd$15$10 3rd$5$10 Total$50$30 Copyright ACDC Leadership

Marginal Analysis Marginal analysis (aka: thinking on the margin) making decisions based on increments Example: When you decide to go to the mall you consider the additional benefit and the additional cost (your opportunity cost). Once you get to the mall, you continue to use marginal analysis when you shop, buy food, and talk to friends. Since your marginal benefits and costs can quickly change your analyzing them every second. What if your ex-girlfriend shows up? The Point: You will continue to do something as long as the marginal benefit is greater than the marginal cost Copyright ACDC Leadership

Turn to a partner and share a recent example of marginal thinking in your life.

Economic Terminology Utility = Marginal = Satisfaction! Additional! Allocate =Distribute! 33 Copyright ACDC Leadership 2015

Paradox of Value Water vs. Diamonds Monetary Value ◦ Must be scarce ◦ Must give utility Are diamonds scarce? Do they give utility? Conspicuous consumption ◦ Examples?

Scarcity forces us to ask the following questions… WHAT to produce? HOW to produce? FOR WHOM to produce?

Imagine a scenario where… …we take an all-expenses- paid class trip to…

Australia!

Our plane is forced to make a “water landing,” and we are able to swim to an uncharted island. You are in charge. Prioritize 3-5 things we’ll have to do to survive and how (and with who) we should accomplish these tasks.

Specialization Allocating resources toward production for which they are best suited.

FACTORS OF PRODUCTION Land – all gifts of nature Labor – human efforts and abilities Capital – tools, equipment, space Entrepreneurship – risk taking, ideas –**The “spark” or driving force of the economy**

EXAMPLES: Durable vs. Nondurable goods Durable – lasts more than 3 years Nondurable – lasts less than 3 years

Adam Smith “Wealth of Nations” ◦ 1776 Invisible hand ◦ Meat ◦ Bread ◦ Candles ◦ How do we decide to provide these?

CIRCULAR FLOW

But Remember...

5 Key Economic Assumptions 1. Society has unlimited wants and limited resources (scarcity). 2. Due to scarcity, choices must be made. Every choice has a cost (a trade-off). 3. Everyone’s goal is to make choices that maximize their satisfaction. Everyone acts in their own “self-interest.” 4. Everyone makes decisions by comparing the marginal costs and marginal benefits of every choice. 5. Real-life situations can be explained and analyzed through simplified models and graphs. Copyright ACDC Leadership

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Production Possibilities Model Illustrate production choices Assumptions: ◦ Full employment ◦ Fixed resources ◦ Fixed technology ◦ Two goods 1-47

Production Possibilities Frontier Guns (thousands) Butter (tons) All possible combinations of two products that can be produced when employing 100% of available resources.

Production Possibilities Frontier

Type of Product Pizzas (in hundred thousands) Industrial Robots (in thousands) Production Alternatives ABCDE Plot Points to Create Graph… Production Possibilities Table 1-51

Production Possibilities Curve Pizzas Industrial Robots Attainable Unattainable A B C D E Economic Growth Now Attainable A’ B’ C’ D’ E’ 1-52

Production Possibilities Curve Pizzas Industrial Robots Attainable Unattainable A B C D E Law of Increasing Opportunity Cost A’ B’ C’ D’ E’ Shape of the Curve 1-53

Quick Quiz Why is the PPF bowed out from the origin? ◦ Law of increasing opportunity costs… ◦ …due to specialization of resources What is the marginal opportunity cost of the 2 nd unit of pizza? ◦ 2 thousand robots Which point(s) on the curve represent full employment of resources? ◦ All points ON the curve

The Future Economy Consequences of unemployment Economic growth ◦ More resources ◦ Better quality resources ◦ Technological advances 1-55

Future Possibilities Goods for the Present Goods for the Future Goods for the Present P F Current Curve Current Curve Future Curve Future Curve Presentville Futureville 1-56

Why do people trade? 1.Assume people didn’t trade. What things would you have to go without? Everything you don’t produce yourself! (Clothes, car, cell phone, bananas, heath care, etc) The Point: Everyone specializes in the production of goods and services and trades it to others 2. What would life be like if cities couldn’t trade with cities or states couldn’t trade with states? Limiting trade would reduce people’s choices and make people worse off. The Point: More access to trade means more choices and a higher standard of living. 57 Copyright ACDC Leadership 2015

Economic Basis for Trade Nations have different resource endowments Labor-intensive goods Land-intensive goods Capital-intensive goods LO2

Absolute and Comparative Advantage 59 Copyright ACDC Leadership 2015

Let’s Simplify… 60

Specialization benefits both sides Shift resources to export industry Achieve higher overall output and income Absolute advantage ◦ Higher output per worker for a good Comparative advantage ◦ Lower domestic opportunity cost for a good 5-61

Comparative Advantage ProductABCDE Avocados Soybeans **Optimal domestic production occurs at point C Mexico’s Production Possibilities Table (in Tons) Production Alternatives 5-62

Comparative Advantage Avocados Soybeans **Optimal domestic production occurs at point C ProductABCDE U.S.’s Production Possibilities Table (in Tons) Production Alternatives 5-63

Comparative Advantage ProductABCDE Avocados Soybeans **Optimal domestic production occurs at point C Mexico’s Production Possibilities Table (in Tons) Production Alternatives 5-64

Comparative Advantage Avocados Soybeans **Optimal domestic production occurs at point C ProductABCDE U.S.’s Production Possibilities Table (in Tons) Production Alternatives 5-65

Comparative Advantage Mexico will produce avocados U.S. will produce soybeans U.S. gives up 3 A for 1 S Mexico gives up 4 A for 1 S Terms of trade ◦ 3.5 A for 1 S ◦ Both countries benefit 5-66

Comparative Advantage Gains from trade Mexico starts at C (24 A and 9S) ◦ Move to E (60 A and 0 S) ◦ Trade 35 A for 10 S U.S. starts at T (33 A and 19 S) ◦ Move to R (0 A and 30 S) ◦ Trade 10 S for 35 A Overall gains? 5-67

Comparative Advantage (pg. 98) Terms of Trade – 1s : 3.5a Trade: 10 tons soybeans for 35 tons avocados