CHAPTER I

INTRODUCTION

CHAPTER 1: INTRODUCTION

Learning objectives
By the end of this chapter you should be able to:
 Understand the nature of the economic problem.
 Understand the principles of how people make decisions.
 Understand the principles of how people interact.
 Understand the methodology of economics.
 Understand economic models: Circular-Flow Diagram, Production Possibilities Frontier

Reading materials
Chapter 1 and Chapter 2; Principles of Economics (2021), N.Gregory Mankiw; South
Western Cengage Learning, 9th dition
 THE ECONOMIC PROBLEM OF SCARCITY AND
1 CHOICE

CHAPTER
2 HOW PEOPLE MAKE DECISIONS

OUTLINE
3 HOW PEOPLE INTERACT

4 THE METHODOLOGY OF ECONOMICS

1. THE ECONOMIC PROBLEM OF SCARCITY AND CHOICE

The problem of SCARCITY

SCARCITY is the excess of human wants over what can

actually be produced.
Human wants are unlimited
YET
The world can only produce a limited amount of goods and services
BECAUSE
Resources used to produce these goods
and services are limited
 Resources (factors of production) are the basic categories
of inputs used to produce goods and services.

Labor Capital Land

(Human resource) (natural resource)

FACTOR OF PRODUCTION

Labor Capital Land

Definition: Labor is the mental and physical capacity

of workers to produce goods and services.

Measured by: * the number of people available for work

* the skills or quality of workers

Entrepreneurship is a special type of labor.

 FACTOR OF PRODUCTION

Labor Capital Land

Definition: Capital is the physical

plants, machinery, and equipment
used to produce other goods.

Capital goods do not directly The term capital can be confusing

satisfy human wants
Capital means physical assets,
not financial assets

FACTOR OF PRODUCTION

Labor Capital Land

Definition: Land is any natural resource

provided by nature

Renewable resources

Classification
Nonrenewable resources
 Would your scarcity problem disappear if you were rich?

The condition of scarcity means all individuals, whether rich or

poor, want more than they can have.

All of us face scarcity. So, what should we do?

We have to make choices because we face trade-offs

In fact, virtually every time we do something, we are making a choice
between alternatives.

EFFICIENCY EQUALITY

the property of society getting the property of distributing

the maximum benefits from economic prosperity uniformly
its scarce resources. among the members of society.

The cost of increased equality is a reduction in the efficient use of resources.

Example: tax dollars paid by wealthy Americans and then distributed to those less fortunate may
improve equality but lower the return to hard work and therefore reduce the level of output produced
by available resources.
 PRINCIPLE 1: PEOPLE FACE TRADE-OFFS

11

2. HOW PEOPLE MAKE DECISIONS

Opportunity cost is the cost of doing something measured in

terms of the best alternative forgone.

Minh Trang is considering going to a movie with a ticket price of $35. She estimates that the
cost of driving to the cinema and parking there will total an additional $20. In order to
attend the cinema, Minh Trang will have to take time off from her part-time job or forgo
studying for an exam scheduled for the next morning. She estimates that she will lose 5
hours at work, at a wage of $6 per hour, or 5 hours of study time. If Minh Trang considers
working as the best alternative use of her time, find her opportunity cost of going to the
cinema?
OC of (going to the cinema) = value of (doing a part-time job)
 How much does go to a movie cost?

ticket price

The opportunity cost of going to a movie is the value of the best

alternative you could have done with the same money and time.

Decisions often involve sacrifice of both goods and time.

Bảo Khuê is considering to travel from Hanoi to Bangkok. The trip takes 1 hour by
plane OR 5 hours by bus. Airfare is $90 and the bus fare is $30.
When she is not traveling, she can work and earn $30/hour. Suppose working is her
best alternative of travelling.

Answer the following questions

a.What is the opportunity cost (OC) of traveling by

bus?

b.What is the OC of traveling by plane?

c. Which mode of travel has lower OC?

d. How would the answers be different for Minh

Trang who can work and earn $6/hour when she is
not traveling?
PRINCIPLE 2: THE COST OF SOMETHING IS WHAT
YOU GIVE UP TO GET IT

Which of the following statements best represents the principle represented by the adage,
"There is no such thing as a free lunch"?
a) Khuê must decide between going to Đà Nẵng or Đà Lạt for spring break.
b) Khuê can attend the concert only if she takes her sister with her.
c) Bảo is hungry and homeless.
d) Bảo must repair the tire on his bike before he can ride it to class.

Trang decides to spend two hours taking a nap rather than attending her classes (her best
alternative). Her opportunity cost of napping is
a) the $24 she could have earned if she had worked at her job for those two hours.
b) the value of the knowledge she would have received had she attended class.
c) the value of her nap less the value of attending class.
d) nothing, since she valued sleep more than attendance at class.

When calculating the cost of college, which of the following should you probably not include?
a) the cost of tuition
b) the cost of books required for college classes
c) the cost of meals
d) the income you would have earned had you not gone to college
 2. HOW PEOPLE MAKE DECISIONS
MARGINAL analysis

MARGINAL BENEFITS (MB) MARGINAL COSTS (MC)

Incremental benefit of producing one Incremental cost of producing one

more unit of a good or service more unit of a good or service

The RATIONAL choice

If MC exceeds MB, If MB exceeds MC,

it is rational not to do the activity it is rational to do the activity
(or to do less of it). (or to do more of it).

A music label is considering making an album for a young artist.

The total investment of making album is $300,000.
After the completion of making music album, the music label
will decide the quantities of CDs launched to the market. Each
CD costs $2.
 In the first 3 months, the music label plans to produce
10,000 CDs at the price $10/each CD.
 In the next 3 months, the music label plans to produce
5,000 CDs at the price $5/each CD.
 In the 3 months after next, the music label plans to produce
2,000 CDs at the price $1/each CD.

Analyze the music label’s decision.

To produce a typical CD, the music label spend approximately
$300,000 on making the album.

When the music label decide whether to produce a CD for

an artist, the $300,000 investment is important.

But once an artist is signed and the investment is made, every new copy
costs only $2.

As long as companies can sell that copy for more than $2, or the marginal
benefit bigger than the marginal cost, it is better off making the copy.

The original investment made to create the music is irrelevant —

. Sunk costs are costs that cannot be avoided because they have
already been incurred.

CHECK POINT

Consider an airline deciding how much to charge passengers

who fly standby. Suppose that flying a 200-seat plane from Hanoi
to HCMC costs the airline $100,000. Imagine that a plane is about
to take off with ten empty seats, and a standby passenger waiting
at the gate will pay $300 for a seat. Should the airline sell the
ticket?
 Option 1 Option 2
MB: $30 MB: $40
MC: $15 MC: $20

Option 3 Option 4
MB: $35 MB: $50
MC: $20 MC: $25

Rational decision making involves choosing those items that

give you the best value for money – i.e. the greatest benefit
relative to cost.

PRINCIPLE 3:
RATIONAL PEOPLE THINK AT THE MARGIN

22
Suppose the cost of operating a 100 room hotel for a night is $10,000 and there are 5 empty rooms for
tonight. If the marginal cost of operating one room for one night is $30 and a customer is willing to pay
$60 for the night, the hotel manager should
a) rent the room because the marginal benefit exceeds the marginal cost.
b) rent the room because the marginal benefit exceeds the average cost.
c) not rent the room because the marginal benefit is less than the marginal cost.
d) not rent the room because the marginal benefit is less than the average cost.

Ms Thu, your lecturer loves her work, teaching economics. She has been offered other positions in the
movie industry, but she has decided to continue working as a lecturer. Her decision would not change
unless the marginal
a) benefit of teaching increased.
b) cost of teaching increased.
c) cost of a corporate job increased.
d) benefit of a corporate job decreased.

You have drunk two cups of bubble tea. You consider drinking a third. As a rational consumer you
should make your choice by comparing
a) the benefits from drinking all three cups to how much three cups costs.
b) the benefits from drinking all three cups to how much one more cup costs.
c) the benefits from drinking one more cup to how much one more cup costs.
d) the benefits from drinking one more cup to how much three cups costs.

Because rational people make decisions by weighing costs and benefits,

their decisions may change in response to incentives.

incentive: something that induces a person to act,

i.e. the prospect of a reward or punishment.

Many public policies change the costs and benefits that people face.
Sometimes policymakers fail to understand how policies alter incentives
and behavior and a policy may lead to unintended consequences.
Example: Seat belt laws increase the use of seat belts but lower the incentives of individuals to drive safely.
This leads to an increase in the number of car accidents.
This also leads to an increased risk for pedestrians.
 CHECK POINT:

A 1996 bill reforming the federal government’s

antipoverty programs limited many welfare recipients
to only two years of benefits.
a. How does this change affect the incentives for
working?
b. How might this change represent a trade-off
between equality and efficiency?

25

PRINCIPLE 4:
PEOPLE RESPOND TO INCENTIVES

26
3. HOW PEOPLE INTERACT
FUNDAMENTAL ECONOMIC QUESTION

which goods and services are to be

WHAT TO PRODUCE
produced and in what quantities?

PRINCIPLE 5: TRADE CAN MAKE EVERYONE BETTER OFF

Trade allows countries to specialize in what they do best and to

enjoy a greater variety of goods and services.

FUNDAMENTAL ECONOMIC QUESTION

HOW TO PRODUCE which techniques are to be adopted?

selection of the category of people

FOR WHOM TO PRODUCE
who will consume the goods

FUNDAMENTAL ECONOMIC QUESTION

ECONOMIC SYSTEMS
For every society the answers to the three basic questions depend on what kind of economic system it
uses. The term economic system refers to the way in which a society organizes the production
and distribution of good and services.

allocates resources allocates resources contains features of

through the
decentralized decisions
of many firms and
households as they
interact in markets for
goods and services.
through administrative
decisions. All the
economic decisions are
taken by the
government.
both the market and
planned economic
systems, with the
government intervening
in various ways to
influence market prices.

market planned / mixed

command
economy economy economy

PRINCIPLE 6: MARKETS ARE USUALLY A GOOD

WAY TO ORGANIZE ECONOMIC ACTIVITY

Adam Smith’s invisible hand:

Although individuals are
motivated by self-interest, an
invisible hand guides this self-
interest into promoting society’s
economic well-being.
Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
“Man has almost constant occasion for the help of
his brethren, and it is vain for him to expect it from
their benevolence only.
He will be more likely to prevail if he can interest
their self-love in his favor, and show them that it is
for their own advantage to do for him what he
requires of them…
It is not from the benevolence of the butcher, the
brewer, or the baker that we expect our dinner, but
Adam Smith, from their regard to their own interest….
1723-1790

Adam Smith and the Invisible Hand

Passages from The Wealth of Nations, 1776
“Every individual…neither intends to promote the
public interest, nor knows how much he is promoting
it….
He 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.
Nor is it always the worse for the society that it was no
part of it. By pursuing his own interest he frequently
promotes that of the society more effectually than
Adam Smith, when he really intends to promote it.”
1723-1790
 PRINCIPLE 6: MARKETS ARE USUALLY A GOOD WAY
TO ORGANIZE ECONOMIC ACTIVITY

Adam Smith’s invisible hand:

 prices are the instrument with which the invisible hand directs
economic activity.

 As a result of the decisions that buyers and sellers make, market prices
reflect both the value of a good to society and the cost to society of
making the good.

 Smith’s great insight was that prices adjust to guide these individual
buyers and sellers to reach outcomes that, in many cases, maximize the
well-being of society as a whole.

The invisible hand will only work if the
government enforces property rights.
There are two broad reasons for the
government to interfere with the economy:
the promotion of efficiency and equality.
Government policy can improve efficiency
when there is market
failure, such as
externalities or market power.
property rights: the ability of an
individual to own and exercise control
over scarce resources.
market failure: a situation in which a
market left on its own fails to allocate
resources efficiently.
externalities: the impact of one
person’s actions on the well-being of a
bystander.

PRINCIPLE 7: GOVERNMENTS market power: the ability of a single

CAN SOMETIMES IMPROVE economic actor (or small group of
MARKET OUTCOMES actors) to have a substantial influence
on market prices.
 4. THE METHODOLOGY OF ECONOMICS
Economics definition

“Economics is ‘the science which studies human behaviour as a

relationship between ends and scarce means which have
alternative uses” – Lord Robbin (1932)

It studies anything to do
with the process of
satisfying human wants.
Means (resources) of
The resources can be put
producing ends (final
to alternative uses in
goods) are in limited supply,
order to meet certain
hence a society faces the
ends.
problem of scarcity.

The scope of economics

MICROECONOMICS
Microeconomics is the branch of economics
that studies economic decisions of a single
unit: individual, household, firm, industry, or
MACROECONOMICS
level of government. Macroeconomics is the branch of economics
that studies decision making for the economy
as a whole.

Concerns
individual income national income
individual product prices the overall price level
how many people will be hired (or fired) in a aggregate employment and unemployment
particular industry
 CHECK POINT

Which of the following is a microeconomic statement?

A. Unemployment was 6.8 percent of the labor force last year.
B. The price of personal computers declined last year.
C. The general price level increased by 4 percent last year.
D. Real domestic output increased by 2.5 percent last year.

Which of the following is a macroeconomic statement?

A. The gross profits of all U.S. businesses were $182 billion last
year.
B. The price of beef declined by 3 percent last year.
C. General Motors' profits increased last year.
D. The productivity of steelworkers increased by 1 percent last year.

The scope of economics

POSITIVE ECONOMICS NORMATIVE ECONOMICS

 A positive statement is  A normative statement is

descriptive (a statement of fact).
 Positive statements are claims about
how the world is.
 Accuracy is not the criterion for being a
positive statement BUT whether the
statement is testable.
prescriptive (a statement of value).
 Normative statements are claims about
how the world should be (statements
which include the words good, bad, need,
should or ought).
 There is no way of proving it correct or
incorrect.

Positive views about how the world works affect normative views about which
policies are desirable.
CHECK POINT: Are the following statement positive or normative economics?

1. A fall in incomes will lead to a rise in numbers of own-label supermarket foods purchased.

2. The government should increase the minimum wage to £7 per hour to reduce poverty.

3. If the government raises the tax on beer, this will lead to a fall in profits of the brewers.

4. Pollution is the most serious economic problem.

5. The government is right to introduce a ban on smoking in public places.

6. Resources are best allocated by allowing the market mechanism to work freely.

Economists play two roles:

SCIENTISTS POLICY ADVISOR

try to explain the world try to improve the economy

make positive statements make normative statements

As Scientist, economists employ the scientific method, the dispassionate
development and testing of theories about how the world works.

Observations help us to develop theory.

Data can be collected and analyzed to evaluate theories.

Using data to evaluate theories is more difficult in economics than in physical

science because economists are unable to generate their own data.
Thus, most common data for testing economic theories come from
historical episodes of economic change.

MODELING METHOD
Modeling method is a method of using simple models (usually composed of
equations and diagrams) to describe complex phenomena and economic
processes.
PURPOSE

Explanation. Models explain by showing how things are caused

Prediction. Models are sometimes used to make simple forecasts

The role of assumptions: simplify the complex world and make it

easier to understand.
IMPORTANT ASSUMPTION: CETERIS PARIBUS
Define the issue:
Why Vietnamese motorists cut back on gasoline consumption from 400 million gallons
per day in May to 300 million gallons per day in June?

changes in laws the household's income

the availability and quality of public transport

What is the impact of a change in gasoline price on
gasoline consumption, ceteris paribus, or
theassuming
location of shopping facilities
the price of gasoline
that nothing else changes?

One way to simplify reality is to isolate or focus attention on only selected variables.
Ceteris paribus is a Latin phrase that means while certain variables change, “all other
things remain unchanged.” The ceteris paribus assumption allows us to isolate or
focus attention on selected variables.

CHECK POINT

Suppose an economist examines a model explaining the

relationship between the price and quantity
purchased of Coca-Cola. The theory is “If the price
increases, then the quantity of Coca-Cola purchased
decreases, ceteris paribus.”
Now assume you observe that the price of Coca-Cola
increased one summer and some people actually bought
more, not less. Based on this real-world
observation, can you declare the theory is
incorrect?
 Revenue Consumption
GOODS AND
SERVICES
G&S sold G&S bought
MARKET

FIRMS HOUSEHOLDS

Labour,
Factors of
capital, land
production FACTORS OF
PRODUCTION
MARKET
Wages, rents, Income
profits

MODEL 1: THE CIRCULAR FLOW DIAGRAM

Model 2: The production possibilities frontier (PPF)

The production possibilities frontier shows the maximum

combinations of two outputs that an economy can produce in a given
period of time with its available resources and technology.

Three basic assumptions:

1. Fixed Resources. The quantities and qualities of all resource inputs remain
unchanged during the time period.

2. Fully Employed Resources. The economy operates with all its factors of
production fully employed and producing the greatest output possible without waste
or mismanagement.

3. Technology Unchanged. Holding existing technology fixed creates constraints on

the amounts and types of goods an economy can produce.
 efficient points
meat

90 infeasible point
A
80
B F Output
Production possibilities
70 (billion units
per year)
60 A B C D
50
E C Meat 80 70 40 0
40

30
inefficient point
Potatoes 0 40 80 120
20
10
D
0 20 40 60 80 100 120
potatoes

Opportunity costs rise as the production of a good increases.

meat

90 Output
Production possibilities
A (billion units
80 per year)

70
B A B C D
60 Meat 80 70 40 0
50
C Potatoes 0 40 80 120
40

30

20 What happens if one of the

10 assumptions is violated?
D
0 20 40 60 80 100 120
potatoes
 1) In the simple circular-flow diagram, the participants in the 4) Unemployment would cause an economy to
economy are a) produce inside its production possibilities frontier.
a) households and firms. b) produce on its production possibilities frontier.
b) firms and government. c) produce outside its production possibilities frontier.
c) households and government. d) experience an inward shift of its production possibilities frontier.
d) households, firms, and government.

5) Which of the following is a correct statement about production

2) In the simple circular-flow diagram,
a) households own the factors of production.
b) households buy all the goods and services that firms produce.
c) land, labor, and capital flow from households to firms.
d) All are correct.
possibilities frontiers?
a) An economy can produce only on the PPF.
b) An economy can produce at any point inside or outside a PPF.
c) An economy can produce at any point on or inside the PPF, but
not outside the PPF.
d) An economy can produce at any point inside the PPF, but not on
or outside the PPF.

3) In the circular-flow diagram, which of the following items flows 6) Efficiency is illustrated by
from households to firms through the markets for the factors of a) both the production possibilities frontier and the circular-flow
production? diagram.
a) goods and services b) neither the production possibilities frontier nor the circular-flow
b) land, labor, and capital diagram.
c) dollars spent on goods and services c) the production possibilities frontier only.
d) wages, rent, and profit d) the circular-flow diagram only.

KEY POINTS:

⬩ The fundamental lessons about individual decision making:

 people face trade-offs among alternative goals,
 the cost of any action is measured in terms of forgone opportunities,
 rational people make decisions by comparing marginal costs and marginal benefits,
 people change their behavior in response to the incentives they face.

⬩ The fundamental lessons about interactions among people:

 trade and interdependence can be mutually beneficial,
 markets are usually a good way of coordinating economic activity among people,
 the government can potentially improve market outcomes by remeding a market failure or
by promoting greater economic equality.
50