Section 1

PRINCIPLES OF ECONOMICS
Economics defined
The circular flows
Production possibilities
Economic growth

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 Economics
Scarcity
Scarcity is the condition that arises because wants
exceed the ability of resources to satisfy them.

Choices

Facing scarcity, we must make choices—we must

choose among the available alternatives.
The choices we make depend on the incentives we face.

2
 Economics
▪ Factors of production are the productive resources
used to produce goods and services.
• Land: natural resources
• Labor
• Simple labor: man-day
• Human capital
• Capital
• Entrepreneurship

3
 Economics

▪ Choices – three basic economic questions

• What goods and services get produced and in
what quantities?
• How are goods and services produced?
• For Whom are the various goods and services
produced?

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 Economics
▪ Economics is the social science that studies the choices
that individuals, businesses, governments, and entire
societies make as they cope with scarcity, the incentives
that influence those choices, and the arrangements that
coordinate them.

▪ The subject has two parts:

• Microeconomics is the study of the choices that
individuals and businesses make, the way these choices
interact in markets, and the influence of governments

• Macroeconomics is the study of the performance of the

national economy and the global economy

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 Economics
▪ Microeconomics ▪ Macroeconomics
• How markets work • Indicators
• Supply and demand • Output, Inflation,
Unemployment...
• Household choices
• Relationship across indicators
• Consumer theories
• Growth models
• Firms’ choices
• IS-LM models
• Producer theories
• AD-AS models
• Market structures
• Government intervention
• Government intervention
• Monetary policy
• Market failures
• Fiscal policy

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 Economics
▪ Microeconomics ▪ Macroeconomics
• Price of apples • Price of all goods: CPI

• Output of a firm • National output: GDP

• Household income • National income: GNI

• Demand and Supply • Aggregate demand and

demand of a good aggregate supply

• Demand and Supply of • Total unemployment

labor

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 Economics
• The economist as a scientist
• Methods
o Observation
o Building models
o Models
o The role of assumption
o Ceteris paribus
o Testing models
o Testing assumption
o Testing prediction

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 Economics
▪ The economist as a policy adviser
• Positive statements: What is
o Attempt to describe the world as it is
o Confirm or refute by examining evidence:
“Minimum-wage laws cause unemployment”
• Normative statements: What ought to be
o Attempt to prescribe how the world should be:
“The government should raise the minimum wage”

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 Opportunity cost
▪ Cost - What You Must Give Up
• Opportunity cost is the best thing that you must give
up to get something—the highest-valued alternative
forgone.
– Going to college for a year - Opportunity cost is tuition, books,
and fees PLUS foregone wages.
– Going to the movies - Opportunity cost is the price of the
movie ticket PLUS the value of the time you spend in the
theater.
• Sunk cost is a previously incurred and irreversible
cost. A sunk cost is not part of the opportunity cost of a
current choice.
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 Opportunity cost
▪ Comparative advantages is the ability of a person to
perform an activity or produce a good or service at a
lower opportunity cost than someone else.
▪ People will specialize in producing the good in which
they have a comparative advantage and exchange it
with others.
▪ Markets are usually a good way to organize economic
activities
▪ Governments can sometimes improve market
outcomes.
▪ Absolute advantages is a situation in which one
person is more productive than another person in
several or even all activities. 11
 Rational Choice
▪ Rational Choice
• Rational people systematically and purposefully do the
best they can to achieve their objectives
• A rational choice is a choice that uses the available
resources to best achieve the objective of the person
making the choice.
• We make rational choices by comparing costs and
benefits.

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 Rational Choice
▪ Benefit: Gain Measured by What You Are Willing
to Give Up
• Benefit is the gain or pleasure that something
brings
▪ On the Margin
• A choice made on the margin is a choice
made by comparing all the relevant
alternatives systematically and incrementally

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 Rational Choice
▪ Marginal Analysis
• Marginal cost is the cost of a one-unit increase in
an activity.
• Marginal benefit is the what you gain when you
get one more unit of something

▪ Making a Rational Choice

• When we take those actions for which marginal
benefit exceeds or equals marginal cost.

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 The circular flows
▪ Real Flows and Money Flows
In factor markets: In goods markets:
• Households supply • Firms supply goods
factors of production and services produced.
• Firms hire factors of • Households buy goods
production. and services.
Goods/ Services
market

Households Firms

Factor of production
market
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 The circular flows
▪ Real Flows and Money Flows
• Firms pay households incomes for the services of factors
of production.
• Households pay firms for the goods and services they buy.
• These dashed lines are the money flows.
Expenditure Revenue
Goods/ Services market

Households Firms

Factor of production
market
Income Costs
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 The circular flows
• Household income comes from the corresponding
factors of production that they provide
o Rent: Income paid for the use of land.
o Wages: Income paid for the services of labor.
o Interest: Income paid for the use of capital
o Profit: Income paid for the entrepreneurship

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 The circular flows
▪ Governments in the Circular Flow
• Households and firms pay taxes and receive transfers
• Governments buy goods and services from firms

Expenditure Revenue
Goods/ Services market

Transfers Transfers
Households Gov Firms
Taxes Taxes

Factor of production
market
Income Costs

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 Production possibilities
▪ Production Possibilities Frontier (PPF)
• The boundary between the combinations of goods and
services that can be produced and the combination of
those that cannot be produced, given the available factors
of production and the state of technology.
• The PPF is a valuable tool for illustrating the effects of
scarcity and its consequences.
• The PPF puts three features of production possibilities in
sharp focus:
o Attainable and unattainable combinations
o Efficient and inefficient production
o Tradeoffs and free lunches
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 Production possibilities
▪ We can produce at
any point inside the 16 A
B G
PPF or on the frontier. 14
C
▪ We cannot produce at 12

DVDs (millions per year)

10 D
any point outside the
8
PPF such as point G.
6 E
▪ The PPF separates 4
attainable 2
F
combinations from 0
unattainable 0 2 4 6
Cell phones (millions per year)
combinations.

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 Production possibilities
Production efficiency is a 16 A
situation in which we cannot 14
B

produce more of one good or C

DVDs (millions per year)

12
service without producing
10 D
less of something else.
8 Efficient
production
1. When production is on the 6 E
PPF, production is efficient. 4
H
2 Inefficient
2. If production were inside the production F
PPF, more could be 0
0 2 4 6
produced of both goods Cell phones (millions per year)
without forgoing either good.
Production is inefficient.
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 Production possibilities
▪ A tradeoff is an
exchange—giving up 16 A
B
one thing to get 14
C
something else. When 12
Trade

DVDs (millions per year)

off
production is on the 10 Free D
Efficient
PPF, we face a tradeoff 8
lunch
production
▪ A free lunch is a gift— 6 E
getting something
4 H
without giving up Inefficient
production
2
something else. If F
0
production were inside 0 2 4 6
the PPF, there would be Cell phones (millions per year)

a free lunch 22
 PPF and Opportunity Cost
▪ The Opportunity Cost
• The opportunity cost of a X is the decrease in
the quantity of Y.
▪ The law of increasing Opportunity Cost
• The opportunity cost of producing a good or
service increases as more of the good or
service are produced.
• Comparative advantages in producing any
good or service are dynamic.
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 Economic Growth
If we produce at point A,
16 A
we produce only tractors B
14
and no rice.

tractors (millions per year)

C
12

If we produce at point F, 10 D

we produce only rice and 8

6 E
no tractors.
4
At F, consumption 2
F
remains at 5 million kg of 0
0 2 4 6
rice every year. Rice (million kg per year)

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 Economic Growth
If we cut production of 16
rice to 3 million kg this
14
year, we can produce 9

Tractors (millions per year)

millions tractors at point H. 12

Then next year, our PPF 10 H’

H
shifts outward because we 8
have more capital. 6
We can consume at a 4
point outside our original 2
PPF, such as H'.
0
0 2 4 6 8
Rice (million kg per year)

Original PPF New PPF

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