1. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 1 Economics: Foundations and Models

2. 2 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. What Happens When U.S. High-Technology Firms Move to China? 1.1Explain these three key economic ideas: People are rational. People respond to incentives. Optimal decisions are made at the margin. 1.2Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services? 1.3Understand the role of models in economic analysis. 1.4Distinguish between microeconomics and macroeconomics. 1.5Become familiar with important economic terms. APPENDIX Review the use of graphs and formulas. Learning Objectives Many U.S., Japanese, and European firms have been moving the production of goods and services outside their home country …

3. Chapter 1: Economics: Foundations and Models 3 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Economics: Foundations and Models In this book, we use economics to answer questions such as the following: How are the prices of goods and services determined? How does pollution affect the economy, and how should government policy deal with these effects? Why do firms engage in international trade, and how do government policies affect international trade? Why does government control the prices of some goods and services, and what are the effects of those controls?

4. Chapter 1: Economics: Foundations and Models 4 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Scarcity The situation in which unlimited wants exceed the limited resources available to fulfill those wants. Economics The study of the choices people make to attain their goals, given their scarce resources. Economic model A simplified version of reality used to analyze real-world economic situations. 4.1 Economics: Foundations and Models

5. Chapter 1: Economics: Foundations and Models 5 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Market A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. 4.1 Three Key Economic Ideas Learning Objective 1.1 Throughout this book, as we study how people make choices and interact in markets, we will return to three important ideas: 1People are rational. 2People respond to economic incentives. 3Optimal decisions are made at the margin. Marginal analysis Analysis that involves comparing marginal benefits and marginal costs.

6. Chapter 1: Economics: Foundations and Models 6 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. RATIONALITY: SELF INTEREST Assume two things happen to you today: 1.You hear of an earthquake in China that has killed over 200,000 people. 2.You cut off your pinkie finger while cooking (or something). You go to the hospital where they are unable to reattach it, but dress the wound and tell you that you’re in no mortal danger, that it will heal, and you’ll be fine (minus a little finger). Fortunately, you do not plan on making a living with that finger. Your mother calls you tonight and asks “What’s new?” You know she never pays any attention to the news and would know of neither event. What do you tell her about the day’s activities?

7. Chapter 1: Economics: Foundations and Models 7 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Will Women Have More Babies if the Government Pays Them To? Making the Connection Learning Objective 1.1

8. Chapter 1: Economics: Foundations and Models 8 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Incentives & Unintended Consequences: To increase fairness, LD students are given extra time to take tests. UI?? Hospitals are forced by gov’t to offer emergency room treatment free to poor people. UI?? To reduce its population, China forbids women to have a child if they’ve already given birth. UI?? A nation increases its border security to reduce illegal immigration. UI?? To prevent discrimination, the gov’t makes is difficult to fire elderly workers. UI?? To give bad kids a second chance, gov’t imposes light sentences on juvenile offenders. UI?? Colleges give more financial aid to students with less money. UI??

9. Chapter 1: Economics: Foundations and Models 9 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Solved Problem 1-1 Apple Computer Makes a Decision at the Margin Learning Objective 1.1 Should Apple produce an additional 300,000 iPods? In solving the problem, consider the following: Optimal decisions are made at the margin. An activity should be continued to the point where the marginal benefit is equal to the marginal cost. In this case, the correct decision requires information about additional revenue and additional cost.

10. Chapter 1: Economics: Foundations and Models 10 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Trade-off The idea that because of scarcity, producing more of one good or service means producing less of another good or service. Trade-offs force society to make choices, particularly when answering the following three fundamental questions: 1What goods and services will be produced? 2How will the goods and services be produced? 3Who will receive the goods and services produced? The Economic Problem That Every Society Must Solve Learning Objective 1.2 Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

11. Chapter 1: Economics: Foundations and Models 11 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Centrally planned economy An economy in which the government decides how economic resources will be allocated. The Economic Problem That Every Society Must Solve Learning Objective 1.2 Market economy An economy in which the decisions of households and firms interacting in markets allocate economic resources. Centrally Planned Economies versus Market Economies

12. Chapter 1: Economics: Foundations and Models 12 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Mixed economy An economy in which most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources. The Economic Problem That Every Society Must Solve Learning Objective 1.2 The Modern “Mixed” Economy

13. Chapter 1: Economics: Foundations and Models 13 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Productive efficiency The situation in which a good or service is produced at the lowest possible cost. The Economic Problem That Every Society Must Solve Learning Objective 1.2 Efficiency and Equity Allocative efficiency A state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it.

14. Chapter 1: Economics: Foundations and Models 14 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Voluntary exchange The situation that occurs in markets when both the buyer and seller of a product are made better off by the transaction. The Economic Problem That Every Society Must Solve Learning Objective 1.2 Efficiency and Equity Equity The fair distribution of economic benefits.

15. Chapter 1: Economics: Foundations and Models 15 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. To develop a model, economists generally follow these steps: 1Decide on the assumptions to be used in developing the model. 2Formulate a testable hypothesis. 3Use economic data to test the hypothesis. 4Revise the model if it fails to explain well the economic data. 5Retain the revised model to help answer similar economic questions in the future. Economic Models Learning Objective 1.3

16. Chapter 1: Economics: Foundations and Models 16 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Economic models make behavioral assumptions about the motives of consumers and firms. Economic Models Learning Objective 1.3 The Role of Assumptions in Economic Models Economic variable Something measurable that can have different values, such as the wages of software programmers. Forming and Testing Hypotheses in Economic Models

17. Chapter 1: Economics: Foundations and Models 17 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. When Economists Disagree: A Debate over Outsourcing Making the Connection Learning Objective 1.3 Does outsourcing by U.S. firms raise or lower incomes in the United States?

18. Chapter 1: Economics: Foundations and Models 18 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Positive analysis Analysis concerned with what is. Economic Models Learning Objective 1.3 Normative and Positive Analysis Normative analysis Analysis concerned with what ought to be. Don’t Let This Happen to YOU! Don’t Confuse Positive Analysis with Normative Analysis

19. Chapter 1: Economics: Foundations and Models 19 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Microeconomics The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Microeconomics and Macroeconomics Learning Objective 1.4 Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

20. Chapter 1: Economics: Foundations and Models 20 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. A Preview of Important Economic Terms Learning Objective 1.5 Entrepreneur Innovation Technology Firm, company, or business Goods Services Revenue Profit Household Factors of production or economic resources Capital Human capital

21. Chapter 1: Economics: Foundations and Models 21 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. An Inside LOOK Should the United States Worry about High- Tech Competition from India and China? Nightmare Scenarios

22. Chapter 1: Economics: Foundations and Models 22 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Allocative efficiency Centrally planned economy Economic model Economic variable Economics Equity Macroeconomics Marginal analysis Market Market economy Microeconomics Mixed economy Normative analysis Opportunity cost Positive analysis Productive efficiency Scarcity Trade-off Voluntary exchange K e y T e r m s

23. Chapter 1: Economics: Foundations and Models 23 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Using Graphs and Formulas Appendix A graph is like a street map—it is a simplified version of reality.

24. Chapter 1: Economics: Foundations and Models 24 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix FIGURE 1A-1 Bar Graphs and Pie Charts Graphs of One Variable

25. Chapter 1: Economics: Foundations and Models 25 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix FIGURE 1A-2 Time-Series Graphs Graphs of One Variable

26. Chapter 1: Economics: Foundations and Models 26 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix FIGURE 1A-3 Plotting Price and Quantity Points in a Graph Graphs of Two Variables

27. Chapter 1: Economics: Foundations and Models 27 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix FIGURE 1A-4 Calculating the Slope of a Line Graphs of Two Variables Slopes of Lines

28. Chapter 1: Economics: Foundations and Models 28 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix FIGURE 1A-5 Showing Three Variables on a Graph Graphs of Two Variables Taking into Account More Than Two Variables on a Graph

29. Chapter 1: Economics: Foundations and Models 29 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix FIGURE 1A-6 Graphing the Positive Relationship between Income and Consumption Graphs of Two Variables Positive and Negative Relationships

30. Chapter 1: Economics: Foundations and Models 30 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix FIGURE 1A-7 Determining Cause and Effect Graphs of Two Variables Determining Cause and Effect

31. Chapter 1: Economics: Foundations and Models 31 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix Graphs of Two Variables Are Graphs of Economic Relationships Always Straight Lines? The graphs of relationships between two economic variables that we have drawn so far have been straight lines. The relationship between two variables is linear when it can be represented by a straight line. Few economic relationships are actually linear.

32. Chapter 1: Economics: Foundations and Models 32 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix Graphs of Two Variables Slopes of Nonlinear Curves FIGURE 1A-8 The Slope of a Nonlinear Curve

33. Chapter 1: Economics: Foundations and Models 33 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix Formulas Formulas for a Percentage Change One important formula is the percentage change. The percentage change is the change in some economic variable, usually from one period to the next, expressed as a percentage.

34. Chapter 1: Economics: Foundations and Models 34 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix Formulas Formulas for the Areas of a Rectangle and a Triangle FIGURE 1A-9 Showing a Firm’s Total Revenue on a Graph

35. Chapter 1: Economics: Foundations and Models 35 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix Formulas Formulas for the Areas of a Rectangle and a Triangle FIGURE 1A-10 The Area of a Triangle

36. Chapter 1: Economics: Foundations and Models 36 of 34 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Appendix Formulas Summary of Using Formulas 1Make sure you understand the economic concept that the formula represents. 2Make sure you are using the correct formula for the problem you are solving. 3Make sure that the number you calculate using the formula is economically reasonable. For example, if you are using a formula to calculate a firm’s revenue and your answer is a negative number, you know you made a mistake somewhere. Whenever you must use a formula, you should follow these steps: