Chapter # 1

Introduction to Economics and Economy

Economics:
Economics is a social science concerned with the production, distribution, and
consumption of goods and services. It studies how individuals, businesses, governments,
and nations make choices on allocating resources to satisfy their wants and needs, trying
to determine how these groups should organize and coordinate efforts to achieve
maximum output.

Types of Economics:

1. Micro Economics:
Microeconomics is a branch of economics that studies the behavior of individuals
and firms in making decisions regarding the allocation of scarce resources and the
interactions among these individuals and firms.

2. Macro Economics:
Macroeconomics is a branch of economics dealing with the performance, structure,
behavior, and decision-making of an economy as a whole. This includes regional,
national, and global economies.

Economic Perspective:

Purposeful Behavior:
Economics assumes that human behavior reflects “rational self-interest.” Individuals look
for and pursue opportunities to increase their utility the pleasure, happiness, or
satisfaction obtained from consuming a good or service. Costs and benefits is necessary
part of economic decisions. They allocate their time, energy, and money to maximize
their satisfaction. Consumers are purposeful in deciding what goods and services to buy.
Business firms are purposeful in deciding what products to produce and how to produce
them. Government entities are purposeful in deciding what public services to provide and
how to finance them. “Purposeful behavior” does not assume that people and institutions
are immune from faulty logic. They sometimes make mistakes. Nor does it mean that
people’s decisions are unaffected by emotion or the decisions of those around them.
“Purposeful behavior” simply means that people make decisions with some desired
outcome in mind. Rational self-interest is not the same as selfishness.

Marginal Analysis: Benefits and Costs:

Marginal analysis is an examination of the additional benefits of an activity compared to
the additional costs incurred by that same activity. Marginal refers to the focus on the
cost or benefit of the next unit or individual, for example, the cost to produce one more
widget or the profit earned by adding one more worker.

Theories, Principles, and Models:

A. Economists use the scientific method to establish theories, laws, and principles.

1. The scientific method consists of:

a. The observation of facts (real data).
b. The formulations of explanations of cause and effect relationships (hypotheses)
based upon the facts.
c. The testing of the hypotheses.
d. The acceptance, rejection, or modification of the hypotheses.
e. The continued testing with an eye toward determination of a theory, law, principle,
or model.

2. Theories, principles, and models are “purposeful simplifications.”

Concept Illustration – Abstractions and Models

3. Principles are used to explain and/or predict the behavior of individuals and
institutions.

4. Terminology: Principles, laws, theories, and models are all terms that refer to
generalizations about economic behavior. They are used synonymously in the text, with
custom or convenience governing the choice in each particular case.

B. Generalizations: Economic principles are expressed as the tendencies of the typical

or average consumer, worker, or business firm.
C. “Other things equal” or ceteris paribus assumption: In order to judge the effect
one variable has upon another it is necessary to hold other contributing factors constant.
Natural scientists can test with much greater precision than can economists. They have
the advantage of controlled laboratory experiment. Economists must test their theories
using the real world as their laboratory.

D. Graphical Expression: Many economic relationships are quantitative, and are

demonstrated efficiently with graphs. The “key graphs” are the most important
Economics Principles:

Positive and Normative Economics:

Both macroeconomics and microeconomics contain elements of positive economics and

normative economics.

Positive economics focuses on facts and cause-and-effect relationships. It includes

description, theory development, and theory testing (theoretical economics). Positive
economics avoids value judgments, tries to establish scientific statements about economic
behavior, and deals with what the economy is actually like. Such scientific-based analysis
is critical to good policy analysis.

Normative economics, which incorporates value judgments about what the economy,
should be like or what particular policy actions should be recommended to achieve a
desirable goal (policy economics). E.g. Rich people should pay more taxes

Individual’s Economizing Problem:

A. Individuals are confronted with the need to make choices because their wants
exceed their means to satisfy them.

B. Limited income – everyone, even the most wealthy, has a finite amount of money to
spend.

C. Unlimited wants – people’s wants are virtually unlimited.

a. Wants include both necessities and luxuries (although many economists don’t
worry about this distinction).
 b. Wants change, especially as new products are introduced.
c. Both goods and services satisfy wants.
d. Even the wealthiest have wants that extend beyond their means (e.g. Bill Gates’
charitable efforts).

D. The combination of limited income and unlimited wants force us to choose those
goods and services that will maximize our utility.

E. Budget line

a. Definition: A schedule or curve that shows the various combinations of two

products a consumer can purchase with a specific money income.
b. The model assumes two goods, but the analysis generalizes to all goods available
to consumers.
c. The location of a budget line depends on a consumer’s money income, and the
prices of the two products under analysis.
d. The slope of the graphed budget line is the ratio of the price of the good measured
on the horizontal axis (Pb in the text) to the price of the good measured on the
vertical axis (Pdvd). A change in the price of one of the goods will change the
slope of the budget line and change the purchasing power of the consumer.
e. The budget line illustrates a number of important ideas:

i. Points on or inside the budget line represent points that are unattainable
given the relevant income and prices. Points outside (up and to the right)
the budget line are unattainable.
ii. Tradeoffs and opportunity costs – the negative slope of the budget line
represents that consumers must make tradeoffs in their consumption
decisions; the value of the slope measures precisely the opportunity cost of
one more unit of a good under analysis.
iii. Limited income and positive prices force people to choose. Note that the
budget line does not indicate what a consumer will choose, only what they
can choose.
iv. Income changes will shift the budget line. Greater income will shift the
line out and to the right, allowing consumers to purchase more of both
goods. Increasing income lessens scarcity, but does not eliminate it.

F. Consider This … Did Gates, Winfrey, and Rodriguez Make Bad Choices?
 a. The college decision requires weighing future benefits, including projected
lifetime earnings, against present costs, including direct costs (tuition) and indirect
costs (forgone wages).
b. Despite the success of celebrities such as Bill Gates, Oprah Winfrey, and Alex
Rodriguez, in general those attending and completing college will earn greater
lifetime earnings (about 50% more) than those holding only high school diplomas.
c. For Gates, Winfrey, Rodriguez, and others like them, the opportunity cost of
college was extremely high, and it would be hard to argue that they made a wrong
decision.

Society’s Economizing Problem:

A. Scarce resources:
a. Economic resources are limited relative to wants.
b. Economic resources are sometimes called factors of production and include all
natural, human, and manufactured resources used to produce goods and services.

B. Resource categories:
a. Land or natural resources (“gifts of nature).
b. Labor or human resources, which include physical and mental abilities used in
production.
b. Capital or investment goods, which are all manufactured aids to production like
tools, equipment, factories, transportation, etc.
c. Entrepreneurial ability, a special kind of human resource that provides four
important functions:

i. Combines resources needed for production.

ii. Makes basic business policy decisions.
iii. Is an innovator for new products, production techniques, and organizational
forms?
iv. Bears the risk of time, effort, and funds.

Production Possibilities Model:

Society uses its scarce resources to produce goods and services. The alternatives and
choices it faces can best be understood through a macroeconomic model of production
possibilities. To keep things simple, let’s initially assume:

i. Full employment: The economy is employing all its available resources.

ii. Fixed resources: The quantity and quality of the factors of production are fixed.
iii. Fixed technology: The state of technology (the methods used to produce output)
is constant.
iv. Two goods: The economy is producing only two goods: pizzas and industrial
robots. Pizzas symbolize consumer goods, products that satisfy our wants directly;
industrial robots (for example, the kind used to weld automobile frames)
symbolize capital goods, products that satisfy our wants indirectly by making
possible more efficient production of consumer goods.
 Chapter # 2

Market System & Circular Flow

Command Economy:
The command system is also known as socialism or communism. Command economy,
economic system in which the means of production are publicly owned and economic
activity is controlled by a central authority that assigns quantitative production goals and
allots raw materials to productive enterprises.

Market Economy:
The polar alternative to the command system is the market system, or capitalism. A
market economy is an economic system in which the decisions regarding investment,
production and distribution are guided by the price signals created by the forces of supply
and demand.

Mixed Economy:
A mixed economy is a system that combines characteristics of market, command and
traditional economies. As such, there is no single definition of a mixed economy. One
definition is about a mixture of markets with state interventionism, referring specifically
to capitalist market economies with strong regulatory oversight and extensive
interventions into markets. The other definition is apolitical in nature, strictly referring to
an economy containing a mixture of private enterprise with public enterprise.

Characteristics of Market System:

1. Private Property:
 The right of private persons and firms to obtain, own, control, employ, dispose of,
and bequeath land, capital, and other property.
 Property rights encourage people to cooperate by helping to ensure that only
manually agreeable economic transactions take place.
 Property rights extend to intellectual property through patents, copyrights, and
trademarks.
2. Freedom of Enterprise and Choice:

i. Freedom of Enterprise:
 Businesses can buy and sell as they choose.

ii. Freedom of Choice:

 Owners can use or sell property as they choose.
 Workers can work where they like.
 Consumers can buy what they want.

3. Self-Interest:
 Self Interest is the motivation force of economic units.
 Entrepreneurs try to maxims profits or minimize loss.
 Property owners try to get the highest price for the sale or rent of their resources
 Workers try to maximize their utility (satisfaction) by finding jobs that offer the
best combination of wages, hours, fringe benefits, and working conditions.
 Consumers try to obtain the products they want at the lowest possible price and
apportion their expenditures to maximize their utility.

4. Competition:
i. Independently acting sellers and buyers operating in a particular product or factor
market.
 No single buy or seller is able to dictate the price of the product or factor.
ii. Freedom of sellers and buyers to enter or leave markets, on the basis of their
economic self-interest.
 Help the economy to remain efficient over time.
 Enable the economy to adjust to changes in consumer tastes, technology, and
factor availability.

5. Markets and Prices:

i. A market is an institution or mechanism that brings buyers (demanders) and sellers
(suppliers) into contact.
ii. The coordinating mechanism of capitalism is a system of markets and prices.
 Through this mechanism society decides what the economy should produce, how
production can b organized efficiently, and how the productions are to be
distributed among the various economic units.
6. Technology and Capital Goods:
i. In the market system, competition, freedom of choice, self-interest, and personal
reward provide the opportunity and motivation for technological advance
ii. Extensive use of technologically advanced capital goods helps market economies
achieve greater efficiency in production
 What drives firms to greater efficiency?
 Greater profit? Yes
 Competition for consumers? Yes, consumers always look for lower prices.

7. Specialization:
 Use of economic resources to produce a few goods and services instead of many,
to achieve higher efficiency, thus lower prices.

i. Division of Labor:
 Ability differences
 Learning by doing
 Saving time, avoid switching tasks

ii. Geographic Specialization:

 I.e. certain crops are better suited to some areas compared to others.

8. Use of Money:
 Acts as medium of exchanges.
 Barter requires double coincidence of want.

9. Active but Limited Government:

Market Failures:
 Government can increase the overall efficiency of the economic system if there are
market failures (over production of goods with social costs — i.e. pollution).
 -The central government, along with the central bank, needs to take action a
market economy is experiencing recession or inflation.

Five Fundamental Equations:

Five Fundamental Questions

1. What Will Be Produced?

 The goods and services that can be produced at a continuing profit (TR > TC).
  Businesses must respond to consumers’ (individuals, other businesses, and the
government) wants and if it desires to make profits.
 Consumer sovereignty determines the types and quantities.
 A dollar votes by consumers drive what is to be produced.

2. How Will the Goods and Services Be Produced?

 Minimize the cost per unit by using the most efficient techniques-The right mix of
labor and capital-Optimal location of production facilities.
 Use appropriate technology.
 Seek the lowest prices for the necessary factors input.
 The market system encourages and rewards those producers who are…

3. Who Will Get the Output?

 Consumers with the ability and willingness to pay will get the product.
 Ability to pay depends on income
 Income depends on:
a. Property and human resources.
b. Resources in the factor market-Those factors with the highest demand get
highest rewards.
 Resources in the factor market-Those factors with the highest demand get highest
rewards.
 Willingness to purchase a product or service depends on preference.

4. How Will the System Accommodate Change?

 By responding to:
a. Price & profit signals.
b. Changes in consumer tastes.
c. Changes in technology.
d. Changes in factor (resource) prices.
 The direction or guiding function of prices and profits is a core element of the
market system.

5. How Will the System Promote Progress?

 Technological advance:
a. Innovation in product (income increasing)•Innovation in process (cost
reducing).
 b. Creative destruction occurs when new products and production methods
destroy the market positions of firms that are not able or willing to adjust.

Capital accumulation:
 Entrepreneurs and business owners use part of profit to purchase capital goods or
engage in R&D to receive higher profit in the future.

Competition and the “Invisible Hand”:

A. Competition is the mechanism of control for the market system. It not only
guarantees that industry responds to consumer wants, but it also forces firms to adopt
the most efficient production techniques.

B. Adam Smith talked of the “invisible hand” which promotes public interest through a
market system where the primary motivation is self-interest. By attempting to
maximize profits, firms will also be producing the goods and services most wanted
by society.

C. Of the many merits of the market system, three stand out:

 Market systems promote efficiency in the allocation of resources.
 Market systems provide incentives for people to be productive through work effort
and acquiring skills.
 Market systems provide a lot of personal freedom in making economic decisions.

The Circular Flow Model:

Households:
 One or more persons occupying a housing unit
 Buy the good and services provided by businesses in the product market
 Obtain the income needed to buy the products by selling resources in the factor
market
1. Wages, rents, interest, and profit flows to households for their labor, land,
capital, and entrepreneurial ability.

Businesses:
 Economic entities that purchase factors of production in the resource market and
sell goods and services in the product market.
 1. Sole Proprietorship: an incorporated business owned and operated by a
single person.
2. Partnership: two or more individuals pool their financial resources and
business skills to operate the business and share the profits/losses.
3. Corporation: an independent legal entity that can acquire resources, own
assets, produce, sell, incur debts, extend credit, etc.

Product Market:
 Where the goods and services produced by businesses are bought and sold.
 Households use the income they receive from the sale of resources to buy goods
and services.
 The money spent on goods and services flows to businesses as revenue.

Factor Market:
 Where households sell resources to businesses.
1. Households sell resources to generate income.
2. Businesses buy resources to produce goods and services.
 Productive resources flow from household to businesses.
 The money flows from businesses to household wages, rents, interest, and profits.
 Limitations of the model:
1. Does not depict transaction between households and between businesses.
2. Ignores government and the “rest of the world” in the decision-making
process.