Chapter 1: The Economic Way of Thinking

The Economic Problem Production Possibilities Economic Analysis

Got stuff?

Who made it? How was it made? How did you get it?

I. The Economic Problem

the basic economic problem is

scarcity: -- wants are unlimited, but resources are limited so with scarcity, we must make choices, and with choices, come costs

 Cost is the opportunity cost

-- what you give up when you make a choice -- theres no such thing as a free lunch

Cost of going to college -- what you can buy with tuition & fees -- what you could earn by working -- what you could do with the free time

 you are willing to give up

-- tuition -- wages -- leisure time to go to college -- b/c you expect higher income or more rewarding career

economics is the study of choices

of how to allocate scarce resources choices made by

-- consumers -- businesses -- governments

What are resources?

use resources to produce goods and

services factors of production -- land -- labor -- capital -- entrepreneurship

Land

all natural resources

-- land -- minerals -- water -- wildlife

Labor

size of labor force (quantity) skills of labor force (quality)

-- human capital the value of time

Capital

physical capital
-- goods used to make other goods -- factories -- machines -- infrastructure

 NOT financial capital

-- stocks, bonds, bank loans financial capital facilitates building of physical capital

entrepreneurship

human resource ideas

-- doing things better
-- e-commerce

-- new products

Three Questions to answer:

1. What to produce? 2. How to produce the stuff in #1? 3. For whom to produce? (who gets the stuff in #1?)

Example: A Lexus

1. What to produce?

Toyota designs a luxury car with buyers in mind Toyota decides how much to produce give the price and their costs Buyers decide how many to buy, based on price, their income, tastes, etc.

2. How to produce?

Toyota designs factory, uses

machinery, & trains workers to minimize cost BUT retain a certain quality

U.S. government restricts this decision:

Pollution laws safety laws labor laws

3. Who gets the Lexus?

Those who are willing and able to

pay $50,000 for one. (this is why I drive a Dodge) With markets, price rations a scarce resource

Who answers #1-3?

pure capitalism

when buyers and sellers interact to answer these questions

markets unrestricted private property prices coordinate #1-3

the U.S. is a mixed market economy, since government plays a role

enforces property rights
regulates markets taxes to provide goods & services

command system the government answers questions 1-3 former U.S.S.R., N. Korea reduced incentives for efficiency coordination failures

Specialization

How do we get the most out of our

resources? We specialize in what we do best and trade that for what we need

 I teach. I get paid for it. I use the money to buy

food oil changes clothes

 If I
grew my own food made my own clothes fixed my own car

I would not consume as much Specialization produces gains!

I can consume more than what I could make on my own

Who specializes in what?

Comparative advantage
if you produce a good at a lower opportunity cost then you should specialize in it

Example: married couple

Husband: Wife:

surgeon

$250,000 /year

5th grade teacher

$50,000 /year

who should run the household?

Who has lower opportunity cost?

The wife.

with specialization,

division of labor
different people specialize in different things people become very good at their task efficiency gains -- get more out of same resources

specialization is everywhere

doctors
neurosurgeon, obstetrics, pediatrics,

lawyers
divorce, real estate, patent law, personal injury...

The bottom line:

Scarcity & opportunity cost are

unavoidable. BUT efficiency & specialization make the most of scarce resources

II. Production Possibilities Frontier (PPF)

model of scarcity, choice, &

opportunity cost choice between 2 goods PPF shows maximum possible output combos of 2 goods, given current resources

PPF example

2 goods:

-- CDs -- bottled water use land, labor, capital to make these goods

Suppose these are 6 possible pairs:

CDs
(millions per yr.)

Bottled Water
(millions per yr.)

A B C D E F

15 14 12 9 5 0

0 1 2 3 4 5

We can graph the table & get the PPF:

CDs
15

bottled water

Using the PPF

points on or inside the PPF are

possible
CDs

points INSIDE the PPF are inefficient

-- do not use all resources

9 6

points ON the PPF are efficient

-- use all resources bottled water

2 3

Using the PPF

points outside the PPF are NOT

possible at this time
CDs 15 9

cannot produce 15 CDs AND 6 bottles of water

bottled water

scarcity & tradeoffs

the PPF shows limits to production so must choose between bottled

water & CD combinations -- give up water to get more CDs -- give up CDs to get more water -- TRADEOFF

Opportunity Cost

on PPF there are tradeoffs

-- how much is given up? = opportunity cost

opportunity cost of 1 bottle of Bottled water:

A to B

= 1 CD B to C = 2 CDs C to D = 3 CDs
A B C D E F

CDs
(millions per yr.)

Water
(millions per yr.)

15 14 12 9 5 0

0 1 2 3 4 5

CDs
(millions per yr.)

Opp. cost of 1 bottle Bottled of water (in Water terms of (millions per yr.) CDs)

A B C D E F

15 14 12 9 5 0

0 1 2 3 4 5

1 2 3 4 5

opportunity costs are increasing

cost (in CDs) increases

as water production increases PPF is concave (bowed out) why? -- harder to switch resources between CDs and water

 At first when making more water

switch the best resources from CD production But as we make more water resources switched are less and less suitable for water production

Shifts in the PPF

if we get more resources OR if technology improves then the PPF will shift out
produce more CDs and more water economic growth!

With economic growth,

CDs

15
9

the unattainable becomes attainable

bottled water

II. Economic analysis

models positive vs. normative fallacies

Microeconomics

studies choices of consumers, firms,

and how government affects these choices studies parts of the economy or a particular market

Macroeconomics

studies whole economy -- inflation

-- unemployment -- recessions

Building economic models

ask a question simplify reality make assumptions make prediction test the prediction

 Models may be described with

-- words -- math -- pictures (graphs)

example
Model consumer behavior in buying pizza how does a change in price of pizza impact the amount of pizza bought?

 assume only price changes, and

other factors remain constant -- ceteris paribus other things being equal

 make a prediction:
Words: when the price of pizza rises, people buy less pizza Math:
quantity of pizza = 10 - .2(price of pizza)

 graph
price

demand Quantity of pizza

Testing models

Do model predictions match

the data? Do people buy less pizza when its price rises? must distinguish cause and effect in the real world other factors are not held constant

Positive statements

statements about what is may be right or wrong testable

Normative statements

statements about what ought to be based on opinions and values not testable

Example 1
Employer-provided daycare reduces costs due to employee sick days and lost productivity positive -- statement of fact (but it may be wrong) -- testable

Example 2
Firms should provide on-site daycare for their employees. normative -- opinion -- cannot test what firms should do, only the result of what they do

Economists

discover, collect positive statements

about how economy works. predict AVERAGE behavior use positive statements as support for normative statements.

Faulty economic analysis

correlation vs. causation post hoc, ergo propter hoc fallacy of composition ignoring secondary effects

correlation vs. causation

if a rises when b rises,

positively correlated NOT necessarily true that a causes b b could cause a OR third factor causes both a and b

Example

assault and ice cream sales are

positively correlated Does ice cream make people want to hit someone? Do bullies go out for ice cream after a good fight? No, both increase due to warmer weather

post hoc, ergo propter hoc

if A happened right before B, then A

must have caused B. what about
coincidence? a third unrelated causal factor?

example

nutrasweet and brain tumors

increase in tumors in 1980s due to nutrasweet approval in 1981 [Link] [Link]

But Duran Duran became a band in

[Link]?

fallacy of composition

what is true for one part is true for

the whole example: Paradox of thrift
should you save more $? what if everybody did?

secondary effects

policies have unintended

consequences especially when they alter incentives example: rent control intended to keep rents down leads to shortage and run-down apts.