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 FIRST PRINCIPLES
Why study macroeconomics?
• Why are there ups and downs in the economy?
• How all the households together might react to higher prices?
• How a change in interest rates affects the investment decisions of the business sector
as a group?
• How are imports and exports affected by exchange rates?
• How government policy can hurt or help the economy, considering three goals:
• Low unemployment, low inflation, economic growth
• Evaluate politicians.
• Because you need to pass this course to graduate.
• Economics is extremely useful as a form of employment for economists. (John Kenneth
Galbraith)
WHAT YOU WILL LEARN

• How does the invisible hand govern modern economies?

• How can the individual pursuit of self-interest lead to market failures?

• Main principles that guide the choices made by individuals and how individual
choices interact?
Command economy vs Market economy

▪ Command economy: government officials decide about what factories would

produce and what goods would be delivered to households
▪ China before 1980, the Soviet Union before 1991, North Korea and Cuba currently
▪ Production issues due to no access to raw materials, not enough demand for their
products
▪ Consumers were often unable to find necessities
▪ Enormous economic hardship and causing millions of unnecessary deaths.
Command economy vs Market economy

▪ Market economy: No (or minimal) centralized decision making about consumption

or production.
▪ Each individual producer makes what they think will be most profitable; each
consumer buys what they choose.
▪ Might sound chaotic but historically proven to be more orderly than the planning of a
command economy
▪ Individuals, in pursuing their own interests, often end up serving the interests of
society as a whole:
▪ The invisible hand refers to the way in which the individual pursuit of self-interest can
lead to good results for society as a whole.
 THE INVISIBLE HAND
• The invisible hand refers to the way in which the individual pursuit of self-
interest can lead to good results for society as a whole.
• “[H]e intends only his own gain, and he is in this, as in many other cases, led
by an invisible hand to promote an end which was no part of his intention.”
 - Adam Smith, The Wealth of Nations, 1776 (this book created the foundation for modern economic thinking)

• unintended social benefits resulting from individual self-interested actions, which

work like an invisible hand leading economy to its best
• The Great Depression changed all that…

• Before the 1930s, economists tended to regard the economy as self-

regulating.
MARKET FAILURE

 Market failure is when the individual pursuit of self-interest actually makes

society worse off.
• The good news: economic analysis can be used to diagnose cases of market failure.
And devise solutions for the problem.
• More in microeconomics
A digression on Adam Smith

• When people think about Adam Smith, they think about The Wealth of Nations and
the most well-known phrase in the book, the “invisible hand”
• This phrase appears in the book only once, treated cautions by Smith:
• By pursuing personal profits, the typical businessman is “led by an invisible hand to
promote an end which was no part of his intention. Nor is it always the worse for
the society that it was no part of it.”
• Note the guarded language of the second sentence
• “Nor it is always the worse for society” is hardly the same thing as a claim for
optimality.
 INDIVIDUAL CHOICE: THE
PRINCIPLES PRINCIPLE #1
 PRINCIPLE #1: Choices are necessary because
resources are scarce.
 Resource: anything that can be used to produce
something else.
 Scarce: in short supply; a resource is scarce when
there is not enough of the resource available to
satisfy all the various ways a society wants to use it.
Trust me, I’m an economist

https://www.youtube.com/watch?v=awvdZslaVzM
INDIVIDUAL CHOICE: THE PRINCIPLES: PRINCIPLE #2

 PRINCIPLE #2: The true cost of something is its opportunity cost.

Opportunity cost: what you must give up in order to get something.

In other words, it is what you forgo by not choosing your next-best alternative.
Opportunity cost
• What was the cost of going to college for Bill Gates?
• Tuition, fees are the same as for other Harvard students
• But what's really different is what he could have earned if he could work more on his
computer software company that went on to become Microsoft ($$$$)

• Bill Gates Harvard Commencement Address 2007 by Harvard University Youtube channel:
https://youtu.be/zPx5N6Lh3sw
Bill Gates Harvard Commencement Address 2007
by Harvard University Youtube channel

• https://youtu.be/zPx5N6Lh3sw (4:40)
• Bill Gates at commencement at Harvard
“I’m a bad influence. That’s why I was
invited to speak at your graduation. If I
had spoken at your orientation, fewer of
you might be here today”.
Opportunity cost

• Bill Gate’s opportunity cost was very high relative to the benefit of
attending college.
• For most of us, the trade-off is quite different. For many people, benefits of
college exceed the costs of college because our opportunity cost is much
lower than the boost in earnings from attending college
Active Learning

 The local Taco Hut charges the same price for everything on its menu: $3 will buy a
taco, a burrito, or nachos. You buy the taco and think that if you had not purchased
the taco, you would have purchased the burrito. The opportunity cost of the taco is:
a) the $3.
b) the $3 and your enjoyment of the burrito.
c) your enjoyment of the burrito.
d) the $3, your enjoyment of the burrito, and your enjoyment of the nachos.

• Remember: Opportunity cost is what you forgo by not choosing your next-best
alternative.
 Active Learning
• Unfortunately, you only have a few hours after work to do whatever you want this weekend.
• You would enjoy hanging out with friends at a concert they want to see, but you aren't a fan
of the band. movies > study > concert

• You enjoy doing well in school, and so would rather study than go to the concert.
• There is a movie coming out this weekend that you would prefer to see instead of studying.
• What are the benefits and opportunity costs of these activities? Assume friends pay for
s

concert and movie tickets.

Activity Benefit Opportunity cost Better grades
Go to a concert Enjoyment of the activity Miss the movie Miss the concert
Go to a movie Enjoyment of the activity Better Grades Miss the movie
Study Better Grades Miss the movie Enjoyment of the activity
 Opportunity Cost

• Textbook definition of Opportunity Cost:

• Opportunity Cost of A = Direct cost of A – Direct cost of B + Benefit of B
A:Toyota, B:BMW
– where B is the next best alternative opp cost of toyota:
30,000 - 30,000 +
60,000 = 40,000
- The more attractive is the next best alternative, the higher the opportunity cost

Tuition+Fees+Textbooks - Direct cost of Cashier + Cashier Salary

future benefit - opp. cost = >, <

opp of Bill Gates : Tuition+Fees - 0 + benefit of microsoft.

-> Huge, so he didn’t attending the college.
INDIVIDUAL CHOICE: THE PRINCIPLES: PRINCIPLE #3

 PRINCIPLE #3: People usually respond to incentives, exploiting opportunities

to make themselves better off.
• The basis of all predictions by (classical) economists about individual behavior

 Incentive: anything that offers rewards to people who change their behavior.

In the United States, restaurant customers have the option of adding a tip to the
restaurant bill. In much of Europe a tip is added automatically.
Where would you expect waiters to be more attentive, Europe or the U.S.?
U.S.
Active Learning

 Which provision does not provide incentives for innovation?

a. patent systems
b. research and development tax credit
c. copyright laws
d. home buyers tax credit
Active Learning
 Assume the government of the country of Midian is extremely concerned about the
poor. Suppose that the government promises every family an income of $30,000. If a
family makes less than $30,000, the government will subsidize the difference. Under
these circumstances, what will likely occur?
opp cost of working: hours - 0 + Benefit of not working

a. People may choose to remain unemployed rather than take low-wage jobs because
they will make $30,000 regardless
b. People will devote more effort to leaving unemployment for low paying jobs so that
they can make more money.
c. People with high paying jobs will opt to leave their jobs and become unemployed.
INTERACTION AND INDIVIDUAL CHOICE: PRINCIPLE #4
 PRINCIPLE #4: Markets move toward equilibrium.

 Equilibrium: an economic situation in which no individual would be better off doing something
different.

• What a t-shirt vendor might do if his t-shirts are not selling?

• One strategy is to put the t-shirts on sale. This is a movement toward equilibrium.
INTERACTION AND INDIVIDUAL CHOICE: PRINCIPLE #4
• Does the situation below describe an equilibrium?

• At the intersection of Main and Broadway are two gas stations. One station charges $3.00 per
gallon for regular gas, and the other charges $2.85 per gallon. Customers can get service
immediately at the first station but must wait in a long line at the second.

• It’s an equilibrium

 How about this situation: Uber share charges less than Uber X

• It’s an equilibrium
Active Learning
 Does the situation describe an equilibrium?
 Every student enrolled in Economics 121 must also attend a weekly tutorial. This year two
sections are offered: section A and section B, which meet at the same time in adjoining
classrooms and are taught by equally competent instructors. Section A is overcrowded, with
people sitting on the floor and often unable to see what is written on the board at the front of
the room. Section B has many empty seats.

a. Equilibrium
more people move from A to B
b. Not an equilibrium
INTERACTION AND INDIVIDUAL CHOICE: PRINCIPLE #5
▪ PRINCIPLE #5: Resources should be used efficiently to achieve society’s
goals.
▪ Efficient: taking all opportunities to make some people better off without making
other people worse off.
▪ Should policy always strive to achieve economic efficiency?
▪ Equity: a condition in which everyone gets his or her “fair share.”

▪ Since people can disagree about what’s “fair,” equity isn’t as well-defined a concept
as efficiency.

▪ EQUITY AND EFFICIENCY ARE SOMETIMES AT ODDS.

Efficiency vs. Equity
• Example: disabled-designated parking spaces in a busy parking lot
not efficient, but fair

▪ A conflict between:
▪ equity, making life “fairer” for the disabled, and
▪ efficiency, making sure that all opportunities to make people
better off have been fully exploited by never letting parking spaces
go unused.
▪ How far should policy makers go in promoting equity over
efficiency?
Active Learning

• A low-skilled worker may work full time and still earn an income that falls
below the poverty line. Some economists consider this a failure related to
a) Inefficiency
b) Inequity
Active Learning

• On Friday night you can babysit and earn $40, or you can go to the movies with your
friend, which will cost you $20.
• What is the opportunity cost of going to the movies?
• Remember: Opportunity cost is what you forgo by not choosing your next-best
alternative.
• What do you forgo when you do not choose babysitting? iClicker Question
• Answer:
• You lose $40 and you pay $20 for ticket: $60
• The opportunity cost of going to the movies is $60.
Thank you!