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Published by: gagan585 on Aug 07, 2008
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Chapter 1 notesDefinition of EconomicsThe first thing that we should discuss is the definition of "economics." Economists generally defineeconomics as the study of how individuals and societies use limited resources to satisfy unlimited wants.To see how this concept works, think about your own situation. Do you have enough time available foreverything that you wish to do? Can you afford every item that you would like to own? Economistsargue that virtually everyone wants more of something. Even the wealthiest individuals in society do notseem to be exempt from this phenomenon.This problem of limited resources and unlimited wants also applies to society as a whole. Can you think of any societies in which all wants are satisfied? Most societies would prefer to have better health care,higher quality education, less poverty, a cleaner environment, etc. Unfortunately, there are not enoughresources available to satisfy all of these goals.Thus, economists argue that the fundamental economic problem is scarcity. Since there are not enoughresources available to satisfy everyone’s wants, individuals and societies have to choose amongavailable alternatives. An alternative, and equivalent, definition of economics is that economics is thestudy of how such choices are made.Economic Goods, Free Goods, and Economic BadsA good is said to be an economic good (also known as a scarce good) if the quantity of the gooddemanded exceeds the quantity supplied at a zero price. In other words, a good is an economic good if people want more of it than would be available if the good were available for free.A good is said to be a free good if the quantity of the good supplied exceeds the quantity demanded at azero price. In other words, a good is a free good if there is more than enough available for everyone evenwhen the good is free. Economists argue that there are relatively few, if any, free goods.An item is said to be an economic bad if people are willing to pay to avoid the item. Examples of economic bads include things like garbage, pollution, and illness.Goods that are used to produce other goods or services are called economic resources (and are alsoknown as inputs or factors of production). These resources are often categorized into the followinggroups:Land,Labor,Capital, andEntrepreneurial ability.The category of "land" includes all natural resources. These natural resources include the land itself, aswell as any minerals, oil deposits, timber, or water that exists on or below the ground. This category issometimes described as including only the "free gifts of nature," those resources that exist independentof human action.The labor input consists of the physical and intellectual services provided by human beings. Theresource called "capital" consists of the machinery and equipment used to produce output. Note that theuse of the term "capital" differs from the everyday use of this term. Stocks, bonds, and other financialassets are not capital under this definition of the term.Entrepreneurial ability refers to the ability to organize production and bear risks. Your text does not listthis as a separate resource, but instead considers it as a type of labor input. Most other introductory texts,though, list this as a separate resource. (No, your text is not wrong, it just uses a different way of classifying resources. I think it's better, though, to stick with the somewhat more standard classificationin this course.)The resource payment associated with each resource is listed in the table below:Economic Resource Resource PaymentLand RentLabor wagesCapital interest
entrepreneurial ability profitRational Self-interestAs noted above, scarcity results in the need to choose among competing alternatives. Economists arguethat individuals pursue their rational self-interest when making choices. This means that individuals areassumed to select the alternative(s) that they believe will make them happiest, given the information thatthey possess at the time of the decision.Note that the term "self-interest" means something quite different than "selfish." Self-interested peoplemay donate their time to charitable organizations, give gifts to loved ones, contribute to charities andengage in other similarly altruistic activities. Economists assume, though, that altruistic people selectthese actions because they find these activities more enjoyable than available alternative activities.Economic MethodologyEconomic discussions may involve both positive and normative analysis. Positive analysis involvesattempts to describe how the economy functions. Normative economics relies on value judgments toevaluate or recommend alternative policies.As a social science, economics attempts to rely on the scientific method. The scientific method consistsof the following steps:Observe a phenomenon,Make simplifying assumptions and develop a model (a set of one or more hypotheses),Make predictions, andTest the model.If the model is rejected in step 4, formulate a new model. If the test fails to reject the model, conductadditional tests.Note that tests of a model can never prove that a model is true. A single test, however, may be used toestablish that a model is incorrect.Economists rely on the ceteris paribus assumption in constructing models. This assumption, translatedroughly as "other things constant," allows economists to simplify reality so that it may be more readilyunderstood.Logical fallaciesThe fallacy of composition occurs when one incorrectly attempts to generalize from a relationship that istrue for each individual, but is not true for the whole group. As an example of this, note that any personcan get a better view at a concert by standing (regardless of the actions of those in from of him or her). Itis incorrect, though, to state that everyone can get a better view if everyone stands.Similarly, one would commit the fallacy of composition if one were to claim that, since anyone couldincrease his or her wealth by stealing from his or her neighbors (assuming no detection), that everyonecan become wealthier if everyone steals from their neighbors.The association as causation fallacy, also known less technically as the post hoc, ergo propter hocfallacy, occurs if one incorrectly assumes that one event is the cause of another simply because itprecedes the other event. The Super Bowl example discussed in your text is a good example of thislogical fallacy.Microeconomics vs. MacroeconomicsMicroeconomics involves the study of individual economic agents and individual markets.Macroeconomics involves the study of economic aggregates.Alegbra and Graphical Analysis in Economics(This is a summary of some of the most important material in the appendix to Chapter 1.) Graphs areextensively used in economic analysis to represent the relationships that exist among economicvariables. Two simple types of relationships that may exist are direct and inverse relationships.A direct relationship is said to exist between two variables X and Y if an increase in X is alwaysassociated with an increase in Y and a decrease in X is associated with a decrease in Y. A graph of sucha relationship will be upward sloping, as in the diagram below.
A direct relationship may be linear (as in the diagram above), or it may be nonlinear (as in the diagramsbelow).An inverse relationship is said to exist between the variables X and Y if an increase in X is alwaysassociated with a decrease in Y and a decrease in X is associated with an increase in Y. A graph of aninverse relationship will be downward sloping.An inverse relationship may also be either linear or nonlinear (as illustrated below).

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