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CHAPTER

Economics: Foundations and Models

 Learning Objectives
1. Explain three key economic ideas

2. Discuss how society answers three key economic questions

3. Understand what economic models are and aren’t, and why they are a good idea

4. Distinguish between microeconomics and macroeconomics, Positive and

Normative Economics

5. Review the use of graphs and formulas.

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 Economics in Your Life

You versus Caffeine

• Something as simple as your morning cup of coffee is actually the result of

hundreds of individual choices made by people you have never met.

• Plant, picked, brought to a port, loaded it onto a ship, sailed the ship, unloaded,
transported to a roaster, roasted and ground, packaged, arrived at your local
coffee shop, brewed for you

• This interconnectedness of people’s choices can have major implications for you.

• Heavy rains in 2011 in Colombia caused higher price per cup in Canada.
 Economics in Your Life
How Much Will You Pay for a Cup of Coffee?
There was a time not long ago when a cup of coffee cost less than a dollar.

Suppose you are waiting in line to buy the cup of coffee you count on to keep you
awake during class.

➢ Is the price likely to be higher than it was last week?

➢ We all complain when the price of something we buy regularly goes up, but
what determines that price?

➢ Consider what might change if the price of coffee doubled over the next six
months.

➢ As you read this chapter, see if you can answer this question.
 Introduction

Scarcity: A situation in which unlimited wants exceed the limited resources

available to fulfill those wants.

Example: Firefighters, freshwater in a desert region

Economics: The study of the choices people make to attain their goals,
given their scarce resources.

Example: What to consume? What to produce?

 Introduction
As we study how people make choices and interact in markets, we will return to three important ideas:

1. People are rational. Economists assume that consumers and firms use all available information as
they act to achieve their goals, weighing the benefits and costs of each action (Marginal analysis),
and choosing an action only if the benefits outweigh the costs— even if it is not always the “best”
decision.

Example. Two or more cups of coffee per day. Driving to school or taking the bus, producing more apples
or not, etc.

2. People respond to economic incentives. Women in Quebec have more children than the Canadian
average.

Example: Landmark cinema ticket on Tuesday.

3. Optimal decisions are made at the margin. Most decisions in life involve doing a little more or a
little less. Economists reason that the optimal decision is to continue any activity up to the point
where the marginal benefit equals the marginal cost, MB = MC.

Example. Taking 4 or 5 courses in a term

 Introduction

Trade-off: The idea that because of scarcity, producing more of one good
or service means producing less of another good or service.

Example. Better health care vs. weaker defense sector.

Taking more courses vs. fewer recreation trips.

Opportunity cost: The highest-valued alternative that must be given up to

engage in an activity.

Example. - Gave up sleeping for the 8:00 class.

- Less spending for the summer trip.

 The Economic Problem That All Societies Must Solve
Scarcity forces society to make choices when answering the following three fundamental
questions:

1. What goods and services will be produced? Determined by the choices made by
consumers, firms, and governments. Consumers, firms, and the government face the
problem of scarcity by trading off one good or service for another. Each choice made
comes with an opportunity cost, measured by the value of the best alternative given up.

2. How will the goods and services be produced? With the most efficient, least-costly
methods. Firms choose how to produce the goods and services they sell, often facing a
trade-off between using more workers or using more machines.

3. Who will receive the goods and services produced? Those with the greatest
willingness and ability to pay. In Canada, who receives the goods and services produced
depends largely on how income is distributed. There is disagreement over whether the
current attempts to redistribute income are sufficient or whether there should be more or
less redistribution.
 Centrally Planned Economies versus Market Economies
Centrally planned economy: An economy in which the government decides how economic
resources will be allocated. The government directly answers all three questions. Ex.
Venezuela, Cuba, North Korea.
Market economy: Answers to three basic questions are provided by everyone. An economy
that relies on private ownership of resources in which the decisions of households and firms
interact in markets to allocate economic resources.

Two distinguishing features: (1) markets reward people’s hard work (2) decision-making is
shared by everyone in the market

The Modern “Mixed” Economy

All modern economies are “ mixed economies ” that use elements of both centrally planned
and market economies.

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.
 Efficiency and Equity
Productive efficiency: A situation in which a good or service is produced at the lowest
possible cost.

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.

Market: A group of buyers and sellers of a good or service and the institution or
arrangement by which they come together to trade

Voluntary exchange: A situation that occurs in markets when both the buyer and seller of a
product are made better off by the transaction. Promote competition which in turn promotes
both productive and allocative efficiency.

Equity: The fair distribution of economic benefits.

There is often a trade-off between efficiency and equity. More tax and more
government expenditure???
 Economic Models

• Economic model: A simplified version of reality used to analyze real-

world economic situations.

• To develop a model, economists generally follow these steps:

1. Decide on the assumptions to use in developing the model.

2. Formulate a testable hypothesis

3. Use economic data to test the hypothesis

4. Revise the model if it fails to explain the economic data well.

5. Retain the revised model to help answer similar economic questions in

the future.
 Economic Models
The Role of Assumptions in Economic Models

Economic models make behavioral assumptions about the motives of

consumers and firms.

Economic variable: Something measurable that can have different values,

such as the incomes of farmers, household expenditure

Economics as a Social Science

• The process of developing models, testing hypotheses, and revising models is often
referred to as the scientific method, which economics applies to the study of the
interactions among individuals.

• Because economics studies the actions of individuals, it is a social science. As a social

science, economics considers human behavior—particularly decision-making behavior.
 Normative and Positive Analysis

Positive analysis - Analysis concerned with what is. Analysis of facts to

establish cause and effect relationship.

Example: Lower interest rate in Canada caused higher inflation

Normative analysis - Analysis concerned with what ought to be. Involving

value judgments about what the economy should be like. Based upon subjective
beliefs.

Example: Canada should take policy to lower the inflation rate.

 Making Should the Government of British Columbia Increase
the
Its Minimum Wage?
Connection
The minimum wage in BC was $10.85 per hour, despite the fact that Vancouver is one of the
most expensive places to live in Canada. Should BC increase the minimum wage? Like most
questions about economic policy, the answer is, it depends. There are costs and benefits to
increasing the minimum wage.
• An increase in the minimum wage tends to reduce the number of entry-level jobs.

• Higher labor costs are also difficult for some firms to deal with.

• Increasing the minimum wage also offers important benefits. Those who can find or keep
their jobs get bigger pay cheques.

➢ Whether BC should increase its minimum wage rate is a normative question.

➢ The answer to that question will be based on how the people of BC feel the costs and
benefits compare.
 Microeconomics and Macroeconomics
Microeconomics: The study of how households and firms make
choices, how they interact in markets, and how the government attempts
to influence their choices.

Example: price of specific product, number of employed labour by

individual firm, income of individual firm, household

Macroeconomics: The study of the economy as a whole, including topics

such as inflation, unemployment, and economic growth.

Example: price level, unemployment rate, gross national product

Appendix A Using Graphs and Formulas

Review the use of

graphs and formulas.

A graph is like a
street map—it is
a simplified
version of reality.
Graphs of One Variable

Figure 1A.1 Bar Graphs and Pie Charts

Values for an economic variable are often displayed as a bar graph or as a pie chart.
In this case, panel (a) shows market share data for the U.S. automobile industry as a
bar graph, where the market share of each group of firms is represented by the height
of its bar.
Panel (b) displays the same information as a pie chart, with the market share of each
group of firms represented by the size of its slice of the pie.
Figure 1A.2 Time-Series Graphs

Both panels present time-series graphs of Ford Motor Company’s worldwide sales
during each year from 2001 to 2010.
Panel (a) has a truncated scale on the vertical axis, and panel (b) does not.
As a result, the fluctuations in Ford’s sales appear smaller in panel (b) than in panel (a).
Graphs of Two Variables
Figure 1A.3
Plotting Price and Quantity
Points in a Graph
The figure shows a two-
dimensional grid on which
we measure the price of
pizza along the vertical
axis (or y-axis) and the
quantity of pizza sold per
week along the horizontal
axis (or x-axis).
Each point on the grid
represents one of the price
and quantity combinations
listed in the table.
By connecting the points
with a line, we can better
illustrate the relationship
between the two variables.
Slopes of Lines
Figure 1A.4
Calculating the Slope of
a Line
For example, when
the price of pizza
decreases from $14 to
$12, the quantity of
pizza demanded
increases from 55 per
week to 65 per week.
So, the slope of this
line equals –2 divided
by 10, or –0.2.
Change in value on the vertical axis y Rise
Slope = = =
Change in value on the horizontal axis x Run

Price of pizza ($12 − $14) − 2

Slope = = = = −0.2
Quantity of pizza (65 − 55) 10
 Taking into Account More than Two Variables
on a Graph
Figure 1A.5
Showing Three Variables on a
Graph

The demand curve for pizza

shows the relationship
between the price of pizzas
and the quantity of pizzas
demanded, holding
constant other factors that
might affect the willingness
of consumers to buy pizza.
 Taking into Account More than Two Variables
on a Graph
Figure 1A.5
Showing Three Variables on a
Graph

If the price of pizza is $14

(point A), an increase in the
price of hamburgers from
$1.50 to $2.00 increases
the quantity of pizzas
demanded from 55 to 60
per week (point B) and
shifts us to Demand curve2.
 Taking into Account More than Two Variables on a Graph

Figure 1A.5
Showing Three Variables on a
Graph

Or, if we start on Demand

curve1 and the price of
pizza is $12 (point C), a
decrease in the price of
hamburgers from $1.50 to
$1.00 decreases the
quantity of pizza demanded
from 65 to 60 per week
(point D) and shifts us to
Demand curve3.
 Positive and Negative Relationships

Figure 1A.6
Graphing the Positive
Relationship between Income
and Consumption
In a positive relationship
between two economic
variables, as one variable
increases, the other
variable also increases.
This figure shows the
positive relationship
between personal
disposable income and
consumption spending. As
personal disposable
income in Canada has
increased, so has
consumption spending.
 Are Graphs of Economic Relationships Always
Straight Lines?

The relationship between two variables is linear when it can be represented by

a straight line.

Few economic relationships are actually linear. If we carefully plot data on the
price of a product and the quantity demanded at each price, holding constant
other variables that affect the quantity demanded, we will usually find a
curved—or nonlinear—relationship.

In practice, it is often useful to approximate a nonlinear relationship with a

linear relationship. If the relationship is reasonably close to being linear, the
analysis is not significantly affected.
Figure 1A.8a The Slope of a Nonlinear Curve

The relationship between the quantity of

iPhones produced and the total cost of
production is curved rather than linear.

• In moving from point A to point B, the

quantity produced increases by 1 million
iPhones, while the total cost of production
increases by $50 million.

Farther up the curve,

• as we move from point C to point D, the
change in quantity is the same—1 million
iPhones—but the change in the total cost
of production is now much larger: $250
million.

• Because the change in the y variable has

increased, while the change in the x
variable has remained the same, we know
that the slope has increased.
Figure 1A.8b The Slope of a Nonlinear Curve

Here we measure the slope of the curve at

a particular point by the slope of the
tangent line.
The slope of the tangent line at point B is
75, and the slope of the tangent line at
point C is 150.

Cost 75
= = 75
Quantity 1

Cost 150
= = 150
Quantity 1
 Formulas

Formula for a Percentage Change

One important formula is the percentage change, which is the change in some
economic variable, usually from one period to the next, expressed as a
percentage.

Value in the second period − Value in the first period

Percentage change =  100
Value in the first period

Example: An important macroeconomic measure is the real gross

domestic product (GDP). GDP is the value of all the final goods and
services produced in a country during a year.

GDP - GDP
2010 2009 X 100
GDP 2009
Formulas for the Areas of a Rectangle and a Triangle

Area of a rectangle = Base  Height

Figure 1A.9
Showing a Firm’s Total
Revenue on a Graph
The area of a rectangle is
equal to its base multiplied
by its height. Total revenue
is equal to quantity
multiplied by price. Here,
total revenue is equal to the
quantity of 125,000 bottles
times the price of $2.00 per
bottle, or $250,000. The
area of the green-shaded
rectangle shows the firm’s
total revenue.
 1
Area of a triangle =  Base  Height
2

Figure 1A.10
The Area of a Triangle
The area of a triangle is
equal to 1⁄2 multiplied by
its base multiplied by its
height.
The area of the blue-
shaded triangle has a
base equal to 150,000 –
125,000, or 25,000, and a
height equal to $2.00 –
$1.50, or $0.50.
Therefore, its area equals
1/2 × 25,000 × $0.50, or
$6,250.