Introducing Economics

Introducing Economics

What do
Economists Study?
 WHAT DO ECONOMISTS STUDY?

• Scarcity: the central economic problem

– defining scarcity
– use of resources (factors of production)
• labour
• land and raw materials
• Capital

• Choice, Tradeoff and Opportunity cost.

• MB and MC.
• The production possibilities frontier(PPF).
• Economic Growth.
• Circular flow of goods and incomes.
 Definition of economics
Economics and the world of Business

Scarcity
• All economic questions arise because
we are unable to satisfy all our wants—
because we face scarcity.

• Economics is the social science that

studies the choices that individuals,
businesses, governments, and societies
make as they cope with scarcity.
 Definition of economics
The Business Environment

• Microeconomics environment:

This includes all the economic factors that are

specific to a particular firm operating in its
own particular market.
Microeconomics is the study of choices made
by individuals and businesses, and the
influence of government on those choices.
 Definition of economics
The Business Environment

• Macroeconomics environment
Macroeconomics is the study of the effects on
the national and global economy of the choices
that individuals, businesses, and governments
make.

Macroeconomic issues

- Growth, unemployment, inflation,

balance of payments problems, cyclical
fluctuations…
 Three Big Microeconomic Questions
Economics and the world of Business

Microeconomics seeks to understand what

determines:
• What goods and services are produced
• How goods and services are produced
• For whom goods and services are produced
Goods and services are the objects that people
value and produce to satisfy wants.
Three Big Microeconomic Questions

What Goods and

Services are Produced?

This Figure shows the

major items produced in
the U.S. economy today.
It emphasizes the
dominant place of
services in our economy.
 Classifying production
the Business environment and Business economy

Three broad categories:

Primary production: the production and
extraction of naturel resources such as minerals and
sources of energy. It also includes output from
agriculture.
Secondary production: this refers to the output
the manufacturing and construction sectors of the
economy.
Tertiary production: the production from the
services sector of the economy (retailing and transport,
the leisure industry, finance...).
Three Big Microeconomic Questions
Economics and the world of Business

This Figure shows the

trends in what the U.S.
economy has
produced over the
past 60 years.

It shows the decline of

agriculture, mining,
construction, and
manufacturing, and
the expansion of
services.
Three Big Microeconomic Questions
Economics and the world of Business

The facts about what

we produce raise the
deeper question: What
determines the
quantities of realtor
services, new homes,
DVD players, and corn
that we produce?
Microeconomics
provides some
answers to these
questions.
Three Big Microeconomic Questions

How are Goods and Services Produced?

Factors of production are the resources that
businesses use to produce goods and
services.
They are grouped into four categories:
 Land
 Labor
 Capital
 Entrepreneurship
Three Big Microeconomic Questions

 The" gifts of nature” that we use to produce

goods and services are land.

 The work time and effort that people devote to

producing goods and services is labor.

 The quality of labor depends on human

capital, which is the knowledge and skill that
people obtain from education, on-the-job
training, and work experience.
Three Big Microeconomic Questions

 The tools, instruments, machines,

buildings, and other constructions that
are used to produce goods and services
are capital.

 The human resource that organizes land,

labor, and capital is entrepreneurship.
Three Big Microeconomic Questions

For Whom are Goods and Services

Produced?
Who gets the goods and services
depends on the incomes that people earn.
 Land earns rent.
 Labor earns wages.
 Capital earns interest.
 Entrepreneurship earns profit.
 The Economic Way of Thinking

Choices and Tradeoffs

The economic way of thinking places

scarcity and its implication, choice, at
center stage.

You can think about every choice as a

tradeoff—an exchange—giving up one
thing to get something else.
 The Economic Way of Thinking

Microeconomic Tradeoffs
The three microeconomic questions become
sharper when we think in terms of tradeoffs.

“What?” Tradeoffs arise when people

choose how to spend their incomes, when
governments choose how to spend their tax
revenues, and when businesses choose
what to produce.
 The Economic Way of Thinking

Microeconomic Tradeoffs
“How?” Tradeoffs arise when businesses
choose among alternative production
technologies.

“For Whom?” Tradeoffs arise when

choices change the distribution of buying
power across individuals. Government
redistribution of income from the rich to
the poor creates the big tradeoff—the
tradeoff between equality and efficiency.
 The Economic Way of Thinking

Opportunity Cost

Thinking about a choice as a tradeoff

emphasizes cost as an opportunity
forgone.

The highest-valued alternative that we give

up to get something is the opportunity cost
of the activity chosen.
 The Economic Way of Thinking

Margins and Incentives

People make choices at the margin, which
means that they evaluate the consequences
of making incremental changes in the use of
their resources.

 The benefit from pursuing an incremental

increase in an activity is its marginal
benefit.

 The opportunity cost of pursuing an

incremental increase in an activity is its
marginal cost.
 The Economic Way of Thinking

Margins and Incentives:

Rational economic decision making
Marginal benefit and marginal cost act as an incentive—an
inducement to take a particular action.

 MB > MC  do more

For any activity, if marginal benefit exceeds marginal cost, people

have an incentive to do more of that activity.

 MC > MB  do less
If marginal cost exceeds marginal benefit, people have an incentive
to do less of that activity.
Economists seek to predict choices by looking at changes in
incentives.
 Economics: A Social Science

Economics is a social science.

Economists distinguish between two types
of statements:
What is—positive statements
What ought to be—normative
statements
A positive statement can be tested by
checking it against facts
A normative statement cannot be tested.
 Economics: A Social Science

The task of economic science is to discover

positive statements that are consistent with
what we observe in the world and that
enable us to understand how the economic
world works.

This task is large and breaks into three

steps:
 Observation and measurement
Model building
Testing models
 Economics: A Social Science

Observation and Measurement

Economists observe and measure
economic activity, keeping track of such
things as:
Quantities of resources
Wages and work hours
Prices and quantities of goods and
services produced
Taxes and government spending
Quantities of goods and services
bought from and sold to other countries
 Economics: A Social Science

Model Building

An economic model is a description of some

aspect of the economic world that includes
only those features of the world that are
needed for the purpose at hand.
 Economics: A Social Science

Testing Models
An economic theory is a generalization that
summarizes what we think we understand
about the economic choices that people
make and the performance of industries and
entire economics.

A theory is a bridge between a model and

reality. It is a proposition about which model
works.
 Good, Better, Best!

For many people, life is good and getting

better.
But we all face costs and must choose what
we think is best for us.
This section sharpens the concepts of
scarcity and opportunity cost.
It introduces the idea of economic efficiency.
It also explains how we can expand
production by accumulating capital and
specializing and trading with each other.
Production Possibilities and Opportunity Cost

The production possibilities frontier (PPF) is

the boundary between those combinations of
goods and services that can be produced and
those that cannot.

To illustrate the PPF, we focus on two goods at

a time and hold the quantities of all other
goods and services constant.
That is, we look at a model economy in which
everything remains the same except the two
goods we’re considering.
 Production Possibilities and Opportunity Cost

Production Possibilities
Frontier
This Figure shows the
PPF for “guns” and
“butter,” which stand
for any pair of goods
and services.
Production Possibilities and Opportunity Cost

Points inside and on

the frontier, such as
points A, B, C, D, E, F,
and Z are attainable.

Points outside the

frontier are
unattainable.
 Production Possibilities and Opportunity Cost

Production Efficiency

We achieve production
efficiency if we cannot
produce more of one
good without
producing less of
some other good.
Points on the frontier
are efficient.
 Production Possibilities and Opportunity Cost

Any point inside the

frontier, such as point
Z, is inefficient.

At such a point it is
possible to produce
more of one good
without producing less
of the other good.

At Z, resources are
either unemployed or
misallocated.
 Production Possibilities and Tradeoff

Tradeoff Along the PPF

Every choice along the
PPF involves a
tradeoff.
On this PPF, we must
give up some guns to
get more butter or give
up some butter to get
more guns.
 Production Possibilities and Opportunity Cost

Opportunity Cost
The PPF makes the
concept of opportunity
cost precise.
If we move along the
PPF from C to D the
opportunity cost of the
increase in butter is
the decrease in guns.
 Production Possibilities and Opportunity Cost

A move from C to D
increases butter
production by 1 ton.
Gun production
decreases from 12 units
to 9 units, a decrease of 3
units.
The opportunity cost of 1
ton of butter is 3 units of
guns.
One ton of butter costs 3
units of guns.
Production Possibilities and Opportunity Cost

A move from D to C
increases gun
production by 3 units.
Butter production
decreases by 1 ton.
The opportunity cost of 3
units of guns is 1 ton of
butter.
One unit of guns costs
1/3 of a ton of butter.
 Production Possibilities and Opportunity Cost

Note that the opportunity cost

of guns is the inverse of the
opportunity cost of butter.
One ton of butter costs 3 units
of guns.
One unit of guns costs 1/3 of a
ton of butter.
Production Possibilities and Opportunity Cost

Because resources are not all

equally productive in all activities,
the PPF bows outward—is concave.
The outward bow of the PPF means
that as the quantity produced of
each good increases, so does its
opportunity cost.
 A production possibility curve
8

6
Units of food (millions)

5 Units of food Units of clothing

(millions) (millions)

4 8m 0.0
7m 2.2m
6m 4.0m
3
5m 5.0m
4m 5.6m
2 3m 6.0m
2m 6.4m
1m 6.7m
1
0 7.0m

0
0 1 2 3 4 5 6 7 8
Units of clothing (millions)
 Economic Growth

The expansion of production possibilities—and

increase in the standard of living—is called
economic growth.
Two key factors influence economic growth:
 Technological change
 Capital accumulation
 Technological change is the development of
new goods and of better ways of producing
goods and services.
 Capital accumulation is the growth of capital
resources, which includes human capital.
 Growth in potential output
Food

Now

O
Clothing
 Growth in potential output

5 years’ time
Food

Now

O
Clothing
 Growth in potential and actual output
Food

O
Clothing
 Growth in potential and actual output

y
x
Food

O
Clothing
 Economic Growth

The Cost of Economic Growth

To use resources in research and
development and to produce new capital, we
must decrease our production of
consumption goods and services
 Economic Growth

 This Figure
illustrates the
tradeoff we face.
We can produce butter
or butter making
machines along PPF0.
 By using some
resources to produce
butter-making
machines, the PPF
shifts outward in the
future.
 Economic Growth

Economic Growth in
the United States and
Hong Kong
In 1960, Hong Kong’s
production
possibilities (per
person) were much
smaller than those in
the United States.
 Economic Growth

By 2000, Hong Kong’s

production
possibilities (per
person) were still
smaller than those in
the United States.
But Hong Kong grew faster
than the United States
grew by devoting more of
its resources to capital
accumulation.
 The Market Economy

Circular Flows in the Market Economy

A circular flow diagram, like this Figure,
illustrates how households and firms interact
in the market economy.
The Market Economy: the circular flow of goods and incomes

Goods and services

and factors of
production flow
in one direction.

And money flows in

the opposite
direction.
The circular flow of goods and incomes
The circular flow of goods and incomes
Goods and services
The circular flow of goods and incomes
Goods and services

£
Consumer
expenditure
The circular flow of goods and incomes
Goods and services

£
Consumer
expenditure

Services of factors of production (labour, etc)

The circular flow of goods and incomes
Goods and services

£
Consumer
expenditure

Wages, rent
dividends, etc.
£

Services of factors of production (labour, etc)

The circular flow of goods and incomes
Goods and services

£
Consumer
expenditure
GOODS MARKETS

FACTOR MARKETS
Wages, rent
dividends, etc.
£

Services of factors of production (labour, etc)