• Chapter 1: Limit, Alternatives, and Choices

• Chapter 2: The Market System and the

CircularFlow

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 OBLECTIVES:
What will you learn in this chapter?
• How to explain the concepts of:
– Scarcity.
– Opportunity cost and marginal decision making.
– Incentives.
– Efficiency.
• What the characteristics of good economic
modeling are.

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 What is economics?
• Economics is the study of how people manage
resources. (or the study of how people make
choices/decisions)
• Decisions made by individuals and also by groups.
• Resources are both physical objects and intangibles
such as time.
• Economics is divided into two broad fields:
– Microeconomics: Study of individuals and firms.
– Macroeconomics: Study of the economy on a
regional, national, or international scale.

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 Choices and rational behavior
• Economists assume that people
– Compare all available choices.
– Purposefully behave in the way that will best
achieve their goals, called rational behavior.
• Peoples’ decisions can be studied using four
main questions:
1. What are their wants and constraints?
2. What are their trade-offs?
3. How will others respond?
4. Why isn’t everyone doing it?

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 Scarcity
• People make decisions aimed at getting the
things they want.
• People want a lot of things, but they are
constrained by limited resources.
• Scarcity is the condition of peoples’ wants
being greater than available resources.
– Individuals’ resources: time and money.
– Societies’ resources: factors of production, such as
labor and technology.

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 Opportunity cost
• Every decision in life involves weighing the trade-
off between costs and benefits.
– Rational behavior dictates that when people choose
between two things, the one with the greatest net
benefit (benefits minus costs) is chosen.
• The benefits are often easily calculated.
• The costs include both the direct cost and
opportunity cost.
– The direct cost includes all associated costs.
– The opportunity cost includes the value of the next
best alternative.
– Opportunity cost is based on people’s valuation of the
best alternative.

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 Active Learning: Opportunity cost
Suppose that you are studying for your economics
final and you are confronted with the choice to go to
the movies with your friends.
• What is the opportunity cost of going to the
movies?
– How does this change if you are borderline failing?
• What is the opportunity cost of studying
economics?
– How does this change depending on the movie?
• What is the rule of thumb in deciding which
activity to chose?

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 Active Learning: Opportunity cost
• What is the opportunity cost of going to the
movies?
– The opportunity cost of going to the movies is the
value placed on studying. This could be valued at
the change in grade from study or forgone future
earnings.
• How does this change if you are borderline
failing?
– The costs of possibly retaking the class are now
considered.

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 Active Learning: Opportunity cost
• What is the opportunity cost of studying
economics?
– The opportunity cost of studying economics is the
value of going to see the movie. It could be valued at
the ticket price.
• How does this change depending on the movie?
– If the individual has a big desire to see the movie, this
will increase the opportunity cost.
• What is the rule of thumb in deciding which
activity to choose?
– Choose the activity with the lowest opportunity cost.

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• When your alarm went off, or your
mother called you, what choice did you
face this morning?

• Why did you have to make this choice?

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• You have been invited to a birthday party, to
see a movie with your friend and to spend the
night at your grandparents. Unfortunately, the
three events are on the same day and at the
same time. Of course, you cannot do all three.
You have to make a decision.

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 Opportunity cost
• Rational behavior suggests that people
compare the additional benefits of a choice
against the additional costs.
– Referred to as marginal decision making.
– No consideration of past benefits or costs, both
referred to as sunk.
• Opportunity cost helps understand adages
such as “the mechanic’s car is the worst one
on the block.”

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1. Decisions about how to allocate resources are made by:
A. individuals.
B. businesses.
C. governments.
D. Resource allocation decisions are made by all of these.

2. Which of the following could be considered

microeconomic issue?
A. The local university decides to raise tuition for online
course offerings.
B. Zimbabwe has experienced a decline in inflation.
C. The economic growth rate was reported at 2.4
percent in the first quarter of 2013 for the United States.
D. The unemployment rate in Greece is 22.8 percent.

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3. A rational choice is one that:
A. allows individuals to reach their goals.
B. involves the use of strategic decision making in an
effort to reach a goal.
C. does not involve self-interested behavior.
D. is usually optimized when decision makers are
poorly informed about alternatives.

4. Scarcity can best be defined as a situation in

which:
A. consumers looking for bargains.
B. producers are selfish with resources.
C. people respond to incentives.
D. all wants cannot be satisfied due to resource
constraints.
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5. Scarcity is:
A. a fact of life.
B. not a problem for Bill Gates because he is a
billionaire.
C. can be eliminated by rational decision making.
D. is a problem studied in microeconomics but is
not a macroeconomic concern.
6. People choose to do something:
A. when they believe the benefits outweigh the
costs of the decision.
B. when they believe the costs outweigh the
benefits of the decision.
C. when they believe equilibrium will be reached.
D. when they believe it won't harm anyone and
will better themselves.
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7. You decide to drive your car on a long road trip of
1,500 miles. The opportunity cost of driving your car:
A. is the amount of money spent on gas.
B. is zero because the car is paid for.
C. includes lost wages that you could have
earned instead of driving.
D. None of these.

8. The extra cost associated with producing or

consuming the next unit is called the:
A. variable cost.
B. marginal cost.
C. utility cost.
D. sunk cost.

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• In 1787, the British government had hired sea
captains to ship convicted felons to Australia.
Conditions on board the ships were terrible. On
one voyage, more than one-third of the men died
and the rest arrived beaten, starved, and sick.
• The British public and legislators started to ask
the captains to provide better food, water, light
and air on the ship but the death rate was still very
high.
• Then an economist suggested something new.
When this new idea was implemented, the
survival rate was up to 99%. Can you guess what
the economist suggested?
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• Instead of paying the captains for each
prisoner placed on board ship in Great
Britain, the economist suggested paying
for each prisoner that walked off the ship
in Australia.
==== > Incentives

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 Incentives
• Rational behavior suggests that people respond to
incentives.
• An incentive is something that causes a change in
the tradeoffs that people face.
– Positive incentive: Makes people more likely to do
something by lowering their opportunity cost.
– Negative incentive (disincentive): Makes people less
likely to do something by raising their opportunity cost.
• When an incentive is provided on a large scale,
the consequences can be extremely large.

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 Active Learning: Incentives
• Suppose your higher education institution permits
your final exam score to replace a midterm exam
score in a course.
– How does this affect your opportunity cost of going to
the movies?

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 Active Learning: Incentives
• Suppose your higher education institution
permits your final exam score to replace a
midterm exam score in a course.
– How does this affect your opportunity cost of
going to the movies?

The opportunity cost of going to the movies

increases. The institution has given students a
disincentive to engage in non-school related
activities.

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• Think about an item you recently bought.
What factors influence you to buy it?

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• Make a list of three things you do each day
because of a positive incentive and three things
you do not do because of a negative incentive.
Discuss their choices

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 Efficiency
• Rational behavior suggests that people seek
opportunities to get what they want.
– Given this behavior, individuals and firms will act to
provide the things people want.
• If a profit-making opportunity exists, someone will
provide the good or service.
• This leads to efficiency: resources are used to
produce goods and services with the greatest
economic value.

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 Efficiency
Sometimes economies do not operate efficiently.
• Innovation: Yet to be discovered innovations/ideas
increase efficiency.
• Market failure: People and firms may be
prevented from capturing the benefits of the
opportunity or incur additional costs.
• Intervention: Interventions in the economy cause
transactions to not take place.
– Most often government policies.
• Goals other than profit: Individuals and
governments have goals other than profit.

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 Models
Economic models show how people, firms, and
governments make decisions about managing
resources, and how their decisions interact.
• Models are a simplification of complex problems.
• Models include:
– Groups of individuals and their choices.
– Markets to study.
• What makes a model useful?
– Makes clear assumptions.
– Describes the real world accurately.
– Predicts cause and effect.

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 The circular flow diagram
The circular flow model represents a basic economy.

Goods and
Land, labor, Households
services
and capital
bought
Income Spending

Market for the Market for goods

factors of production and services

Wages, rent,
Revenue
and profit
Purchased Goods and
land, labor services to
and capital Firms be sold

Flow of dollars Flows of goods

and services

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 Summary
• Four concepts of economics are discussed
– Scarcity: Constraints on obtaining everything wanted.
– Opportunity cost: Given scarcity, people face trade-
offs.
– Incentives: Economic agents can alter people’s trade-
offs by providing incentives/disincentives.
– Efficiency: Markets typically provide the highest value
of goods/services.
• The differences between correlation and
causation are analyzed.
• Economists utilize models to understand decision
making.

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