The scope and method of economics

why study economics = the study of how individuals & societies choose to use the scarce
economic resources that nature and previous generations have provided
s o to learn a way of thinking
 opportunity cost = the best alternative that we give up when we
make a decision
 marginalism = the process of analyzing the additional
(incremental) costs or benefits arising from a choice/decision
 efficient market = a market in which profit opportunities are
eliminated almost instantaneously
o to understand society
o to be an informed citizen
the scope o microeconomics = the branch of economics that examines the functioning
of of individual industries and the behavior of individual decision-making
economic units (i.e., firms and households)
s it sees and examines the “trees”
o macroeconomics = the branch of economics that examines the economic
behavior of aggregates (income, employment, output, etc.) on a national
scale
it sees and examines the “forest”
o economics is a broad and diverse discipline with many special fields of
inquiry (e.g., behavioral economics, economic history, environmental
economics, finance, law and economics, urban and regional economics)
the o economics asks and attempts to answer two kinds of questions
method of 1. positive economics – seeks to understand behavior and the
economic operation of systems without making judgements; it describes
s what exists and how it works
2. normative (policy) economics – analyzes outcomes of economic
behavior, evaluates them as good or bad, and may prescribe course
of action
o model = a formal (usually mathematical) statement of a presumed
relationships between 2 or more variables
 variable = a measure that can change from time to time or from
observation to observation
 Ockham’s razor = the principle that irrelevant detail should be cut
away
o ceteris paribus = all else equal = a device used to analyze the relationship
between 2 variables while the values of other variables don’t change
o models and theories can be expressed in many ways; the most common
ways are in words, in graphs, and in equations
o figuring out causality is often difficult in economics
 post hoc, ergo propter hoc – a common error made in thinking
about causation: if A happens before B, it’s not necessarily true
that A caused B
o empirical economics = the collection and use of data to test economic
 theories
o economic policy formulation is based on
 efficiency = the condition in which the economy is producing what
people want at the least possible cost
 equity
 growth
 stability
The economic problem: scarcity and choice
overview o economics = the study of the process through which societies transform
resources into a useful form + outcomes of this process
 what gets produced?
 how is it produced? (producers)
 who gets what is produced? (households)
o resources
 natural: minerals, timber, etc.
 products of past generations: buildings, factories etc.
 time and talent of people
o production = the process that transforms scarce resources (inputs) into
useful goods and services (outputs)
 producers: private firms, households, governments
o factors of production = the basic resources available to a society
land
labor
capital
o when a society consists of more than 1 person  questions of distribution,
cooperation, and specialization
opportunity = the best alternative that we give up when we make a decision
cost o unlimited human wants + limited resources  using resources to produce a
certain good/service implies not using them to produce another
good/service
o resources  capital  future benefits, no present benefits
o consumer goods = goods produced for present consumption
vs
o capital = goods produced to be used as inputs to produce other goods and
services (e.g., buildings, equipment, software, roads)
o investment (in econ) = the creation of capital
comparative o David Ricardo: specialization + free trade will benefit all trading parties,
advantage even those that may have an absolute advantage (more goods with fewer
resources)
o same amount of resources  goods produced at a lower opportunity cost
o trade is mutually beneficial
o formula: quantity of good A for country X / quantity of good B for country
X
production = a graph that shows all the combinations of goods and services that can be
possibility produced if all of society’s resources are used efficiently
frontier  scarcity
(ppf)  inefficiency
 increasing opportunity cost
 economic growth

o slope – negative  a society’s choices are constrained by available

resources & existing technology
value of the slope = marginal rate of transformation (MRT)
o opportunity cost of additional capital is the forgone production of
consumer goods
o law of increasing opportunity cost = as we increase the production of one
good, we sacrifice progressively more of the other  the concave shape of
the ppf
economic = increase in total output through
growth 1) acquiring more resources (capital)
2) discovering & applying new, more efficient techniques of production
o for low-income countries, capital is essential, BUT taking resources out of
the production of consumer goods is difficult
o in some LICs, wealthy people decide to invest in foreign economies
because of the domestic political turmoil
Economic Systems and the Role of Government
command o central government (in)directly sets output targets, incomes, and prices
economy o government control  budget and allocation of resources 
prioritization  no competition  authority
o e.g., former Soviet Union, China
laissez-faire laissez-faire (fr.) = allow [them] to do
economy o the less government involvement, the better
o central institution: the market (= the institution through which buyers
 and sellers interact and engage in exchange)
o behavior of buyers (consumer sovereignty) and sellers determined what
gets produced, how it is produced, and who gets it
o the system is left to operate on its own, with no outside interference 
production decisions are made by private organizations acting in their
own interest
o basic coordinating mechanism: the price
these economies don’t exist in their pure forms, but rather in mixed systems
Demand, supply and market equilibrium
firms and o firm = an organization that comes into being when a person/group of
households people decides to produce a good/service to meet a perceived demand –
the producing unit
 firms make decisions to maximize profits (difference between
revenues and costs)
o entrepreneur = a person who organizes, manages, and assumes the risks
of a firm, taking a new idea or a new product and turning it into a
successful business
o households – the consuming units
 they buy what they want and can afford
 constrained by the availability of jobs, current wages, their own
abilities, and their accumulated and inherited (lack of) wealth
the circular o input (factor) markets – resources used to produce goods and services
flow are exchanged
o output (product) markets – goods and services are exchanged

input markets
o labor market – households supply work for wages / to firms that demand
labor
o capital market – households supply their savings for interest/claims to
future profits / to firms that demand funds to buy capital goods
o land market – households supply land/other real property in exchange
for rent
demand in o determinants of demand
output  price of the product
markets  income (the sum of all a household’s wages, salaries, profits,
interest payments, rents, and other forms of earnings in a given
period of time) available to the household
 household’s amount of accumulated wealth (net worth) = total
value of what a household owns minus what it owes
 normal goods = goods for which there is a positive
relationship between income and demand
 inferior goods = goods for which there is a negative
relationship between income and demand
 prices of other products available to the household
 substitutes = goods that can serve as replacements for one
another; when the price of one increases, demand for the
other increases
perfect substitutes = identical products
 complements = goods that “go together”; a decrease in
the price of one results in an increase in demand for the
other and vice versa (e.g., cars & gasoline, bacon & eggs)
 household’s tastes and preferences
 volatile
 specific to individuals
 household’s expectations about future income, wealth, and prices
o quantity demanded = the amount of a product that a household would
buy in a given period if it could buy all it wanted at the current market
price
o changes in price (all else equal) affect the quantity demanded, while all
other factors affect demand
o demand curve = a graph illustrating how much of a given product a
household would be willing to buy at different prices
 has a negative slope
 intersects the quantity axis because of time limitations and
diminishing marginal utility
 intersects the price axis because of limited income and wealth
 price changes  quantity demanded changes  movement along
the demand curve
 any other factor changes  demand changes  shift of the
demand curve (e.g., to the left for inferior goods, to the right for
normal goods; to the left for complements, to the right for
substitutes)
o law of demand: there is an inverse (negative) relationship between
quantity demanded and price  demand curve slopes downward
o law of diminishing marginal utility: all else equal, as consumption
increases, the marginal utility derived from each additional unit declines
o market demand = the sum of all the quantities of a good/service
 demanded per period by all the households buying in the market for that
good/service
 total demand – the sum of the demands of all the households
shopping in a particular market
supply in o determinants of supply
output  price of output
markets  cost of production
 price of required inputs (labor, capital, land, etc.)
 technologies that can be used to produce the product
 prices of related products
o supply curve = a graph illustrating how much of a product a firm will
sell at different prices
 price changes  quantity supplied changes  movement along
the supply curve
 any other factor changes  supply changes  shift of the supply
curve
o law of supply: there is a proportional (positive) relationship between
quantity supplied and market price  supply curve slopes upward
there is an inverse relationship between supply
and price when demand is unchanged
o market supply = the sum of all that is supplied each period by all
producers of a single product
market = the condition that exists when quantity supplied and quantity demanded are
equilibrium equal; no incentive for price to change
o excess demand (shortage) = quantity demanded > quantity supplied at
the current price
 price rationing: price rises  quantity demanded falls + quantity
supplied rises  equilibrium point
o excess supply (surplus) = quantity supplied > quantity demanded at the
current price
 price rationing: price falls  quantity demanded increases +
quantity supplied decreases  equilibrium point
o equations (a – the price at which quantity demanded is 0, b – the slope of
the demand curve, c – the price at which quantity supplied is 0, d – the
slope of the supply curve)
 Price = a – b*Quantity demanded
 Quantity demanded = a/b – (1/b)*Price
 Price = c + D*Quantity supplied
 Quantity supplied = –c/d + (1/d)*Price
Demand and supply applications
overview 2 main functions of the market
1) price rationing
2) allocation of resources + determining final mix of output
price = the process by which the market system allocates goods and services to
rationing consumers when Qd>Qs
 o whenever there is a need to ration a good (when shortage exists) in a
free market, the price of the good will rise until Qs=Qd (until the
market clears – market equilibrium)
e.g., fires in Russia – summer 2010  supply of wheat
decreased by 25 million of metric tons  price increased from
$160 to $247 per metric ton  demand fell & supply increased
 new equilibrium point
o if the product is in strictly scarce supply (e.g., single famous painting)
its price is demand-determined (the highest bidder)
case: in 1973 – 1974, OPEC (Organization of the Petroleum Exporting
Counties) imposed an embargo on shipments of crude oil to the US
o  price ceiling (a maximum price that sellers may charge for a good,
usually set by the government)  price system wasn’t allowed to
function  shortage  alternative rationing mechanisms? fairness?
 queuing (first-come-first-served)
 favored customers = those who receive special treatment from
dealers during situations of excess demand
 ration coupons = tickets / coupons that entitle individuals to
purchase a certain amount of a given product per month (if
trading them is not prohibited, the result is the same as with
price rationing)
 black markets = a market in which illegal trading takes place at
market-determined prices (e.g., human / organs / drug
trafficking)
o price ceiling – must be set below the competitive equilibrium price
o price floor = a minimum price below which exchange is not permitted
(e.g., minimum wage)
 must be set above the competitive equilibrium price
prices & the o shifts of demand in output markets  price changes  profits rise
allocation of (attracting capital) or fall (leading to disinvestment)
resources o higher wages attract labor and encourage workers to acquire skills
o supply, demand, and prices determine the allocation of resources and
the final combination of goods and services produced
e.g., an oil import tax will reduce quantity of oil demanded,
increase domestic production, and generate revenues for the
government
market o consumer surplus = the difference between the maximum amount a
efficiency person is willing to pay for a good and its current market price
o producer surplus = the difference between the current market price and
the cost of production for the firm
o deadweight loss = the loss of economic efficiency when the optimal
level of supply and demand are not achieved (under/overproduction)
o total producer and consumer surplus is greatest where supply and
demand curves intersect at equilibrium
possible exam topics: graphs with consumer surplus, producer surplus &
 deadweight loss
Externalities, public goods and common resources
Environmental Problems
externalities = actions of one party impose costs or benefits on a second party (spillovers,
neighborhood effects)
o ideal scenario: the costs and benefits of production fully impact the
consuming society
 marginal (private) cost = (P2-P1)/(Q2-Q1)
o real life: production imposes costs and benefits on society as a whole,
even those not directly engaged in the economic activity (e.g., detergent
producing firm dumps wastewater into local river and affects the quality
of water for the local community, all industries produce carbon
emissions that contribute to global warming and air pollution)
 marginal social cost (MSC) = the change in society's total cost
brought about by the production of an additional unit of a good
or service (marginal private cost + marginal external cost)
 marginal social benefit = the change in benefits associated with
the consumption of an additional unit of a good or service (even
pollution has this, so the best solution might not actually be
getting to zero-emissions)
o external costs aren’t considered  provision of activities/products that
aren’t “worth it” (overproduction)
o external benefits aren’t considered  failure to provide
activities/products that are “worth it” (underproduction)
o negative externalities: pollution, traffic congestion, second-hand smoke
o positive externalities: health precautions, vaccination, public education
alternative a) private bargaining and negotiations
mechanisms o Coase theorem: under certain conditions, when externalities are
(aka present, private parties can arrive at the efficient solution
internalizing without involving the government
externalities o basic rights must be understood by all parties
) o people must be able to bargain without impediments/additional
costs
o small number of parties involved
o legal instruments
 injunction = a court order forbidding the continuation of
behavior that leads to damage
 liability rules = laws that require A to compensate B for
damages that A imposed on B (generates powerful
incentives to be careful)
o free-rider problem
b) environmental standards
o direct regulation of externalities takes place at federal, state, and
local level
o impose costs
 o specifying what firms should do often yields suboptimal results
by imposing higher costs
o difficult to find the right standards to set for everyone
c) government-imposed taxes and subsidies
o per-unit tax should be imposed (proportionality)
o firms experience the externality cost as a financial cost  their
marginal costs become marginal social costs
o difficult to translate social costs into monetary costs (especially
when health issues or loss of life is involved)
o activities that provide external social benefits may be subsidized
(directly – specific expenditure programs, indirectly – tax
exemptions) to give decision makers an incentive to consider
doing them
d) sale or auctioning the rights to impose externalities
o the right to impose environmental externalities is beneficial to
the parties causing the external costs
o e.g., plants are issued permits allowing them to emit only up to a
certain level  trade between firms with low costs of cutting
emission and those with high costs
o European Union Emissions Trading System
Public (Social) Goods
overview o nonrivalrous
o nonexcludable
o goods are public/private by virtue of their characteristics, not because
they are provided by the public/private sector
o difficult for the private sector to produce profitably
o problems
 free-riding = people can enjoy the benefits of public goods
regardless of whether or not they pay, so they are usually
unwilling to pay
 drop-in-the-bucket = the good/service is so costly that its
provision generally doesn’t depend on whether any single
person pays, so people simply don’t pay
 large number prisoner’s dilemma
public o often based on private production (profits?)
provision o frequently leads to public dissatisfaction (it’s easy to be angry when
something is nonrivalrous and nonexcludable)
o theoretically, an optimal level of provision does exist; to discover such
a level, we would need to know the preferences of each individual
citizen
o Samuelson-Musgrave Theory (assumes we know said preferences –
could never happen in practice; solutions: dictators decide for the
people, representative political bodies speak for the people, people vote
directly)
 market demand for private goods: the sum of quantities that
 each household decides to buy at each price (horizontal sum)
 market demand for public goods – the other way around: the
sum that individual households are willing to pay for each
potential level of output (vertical sum)
 optimal level of production: society’s total willingness to pay
per unit = the marginal cost of production
o Tiebout hypothesis: an efficient mix of public goods is produced when
local prices (in the form of taxes or higher housing costs) reflect
consumer preferences just as they do in the market for private goods
Common Resources Management
overview o rivalrous
o nonexcludable
o e.g., open sea, common pastures
overuse o central problem
o 1 owner: enjoys the benefits, suffers the costs vs multiple owners: one
can enjoy all the benefits, everyone suffers the costs
o policy instruments
 standards
 taxes
 privatization
Uncertainty and asymmetric information
tools o expected value = the sum of the payoffs associated with each possible
outcome of a situation weighted by its probability of occurring
 payoff = the amount that comes from a possible outcome of a
situation (can be positive or negative)
 fair bet = fair game = zero-sum game
o expected utility = the sum of the utilities coming from all possible
outcomes of a deal weighted by the probability of each occurring
 payoffs are measured in utility terms
 diminishing marginal utility = the more of any one good
consumed in a given period, the less incremental satisfaction is
generated by consuming a marginal or incremental unit of the
same good  usually people don’t play large stakes fair games
o cost of risk
o attitudes towards risk
 risk-averse: certain payoff > uncertain payoff (same expected
value, diminishing marginal utility of income)
 most people in most situations
 why people buy insurances (insurance companies are risk-
neutral)
 risk-neutral: certain payoff = uncertain payoff (same expected
value, constant marginal utility of income)
 risk-loving: certain payoff < uncertain payoff (same expected
value)
 asymmetric = one of the parties to a transaction has information relevant to the transaction
information that the other party doesn’t have
o adverse selection – participants with key information might participate
selectively in trades at the expense of other parties who don’t have the
same information  market failure
 e.g., secondhand car dealer, insurance companies
 reducing adverse selection: signaling, screening, lemon law,
warranties
 market signaling = actions taken by buyers and sellers to
communicate quality in a world of uncertainty (e.g.,
warranties, reputation)
o moral hazard – an entity has an incentive to increase its exposure to risk
because it doesn’t bear the full costs of that risk (e.g., risk taking by
banks/firms & government bail-outs, risky behavior & insurances)
incentives o mechanism design = an area of economics that explores how
contract/transaction structures can overcome asymmetric information
problems
 correct incentive design  improve the selection mechanism and
reduce the moral hazard problem
o incentive contracts (e.g., compensation schemes & performance contracts
in the labor market, co-pays in the health insurance market)
Income distribution and poverty
sources of 1. wages and salaries
household  + wage supplements (i.e., health insurance, pensions, etc.)
income  received in exchange for labor
 for some people, wage and salary income represents all of their
personal income
2. income from property
 from the ownership of real property and financial holdings
 it takes the form of profits, interest, dividends, and rents
3. income from the government (transfer payments)
 people don’t supply goods, services, or labor in exchange
 includes Social Security benefits, veterans’ benefits, and
welfare payments
distribution o market income = wage and property income before transfers and taxes
of market (1 + 2)
income o before-tax income = market income plus transfers (1 + 2 + 3)
o after-tax/disposable income = before-tax income minus taxes
o Lorenz curve graph
 x axis: the percentage of households, in ascending order of
income
 y axis: the cumulative percentage of income
 if income were distributed equally, the angle formed by the
Lorenz curve and the x axis would measure 45o
  Gini coefficient = a measure of statistical dispersion intended to
represent the income/wealth inequality within a nation or a
social group
 range: 0 to 1
 Gini = A / (A+B)

causes of I. in wage income

inequality in o inborn skills
market o training & education
income  human capital = a form of intangible capital that
includes the skills and other knowledge that workers
have/acquire through education and training and that
yields valuable services to a firm over time
 also play a role in explaining the intergenerational
transfer of poverty (e.g., lower-quality schools are more
often located in poorer areas, college admissions and
completion)
o experience (seniority)
o technological change  unskilled labor replaced by machines
o differences in jobs (dangerous, exciting, glamorous, difficult)
 compensating differentials = differences in working
conditions  differences in wages; risky jobs usually
pay higher wages, while highly desirable jobs usually
pay lower wages
 dependent on place, i.e., higher wages compensate for a
higher cost of living
o discrimination (gender, racial)
 explained (attributed to differences in the human capital
investments) portion – not necessarily fair
  housing segregation  unequal public education
 early poverty  lack of access to education
 self-enforcing income inequality
 residual portion
o household composition (number of wage earners)
II. in property income
o property income is less equally distributed than wage income
o inheritance
 some of today’s assets were inherited from previous
generations (e.g., the Kennedys, the Rockefellers)
o differences in current and past saving rates
reducing arguments against
market- o the market is fair when left to operate on its own  rewards paid in the
income marked are linked to productivity, one is entitled to the fruits of one’s
inequality efforts
o principles of freedom of contract and protection of property rights (you
agree to sell your labor  you contract to receive payment, which
becomes your property)
o redistribution has negative effects on incentives to work, save, and
invest/take risks
arguments in favor
o social obligations to help the poorest households
 the elderly faced with unexpected medical problems and costs
 some people are born with mental/physical problems that
severely limit their productivity
 children born to poor parents may lack access to education 
result in low wages
o utilitarian justice
 “a dollar in the hand of a rich person is worth less than a dollar
in the hands of a poor person”
 the rich spend their marginal dollars on luxury goods, while the
poor spend their marginal dollars on necessities (i.e., food,
clothing, medical care)
we cannot make interpersonal comparisons of utility
 the marginal utility of income declines with additional income
 transferring income from the rich to the poor increases total
utility
o Rawlsian justice = a theory of distributional justice that concludes that
the social contract emerging from the original position would call for
an income distribution that would maximize the well-being of the
worst-off members of society (even if it involves some inequality)
 original position: all members in society agree to an
original social contract without knowledge of who they
are or who they will be in society
redistribution the US tax system
 of income o progressive income taxes
through taxes o the Earned Income Tax Credit (EITC)
and transfers the US transfer system
o the Social Security system
 the Old Age and Survivors Insurance program
 the Disability Insurance program
 the Health Insurance/Medicare program – provides health and
hospitalization benefits to the aged and their survivors and to
certain of the disabled
o Temporary Assistance for Needy Families
o unemployment compensation
o Medicaid – provides health and hospitalization benefits to people with
low incomes
o Supplemental Nutrition Assistance Program (formerly Food Stamp
Program)
o housing programs
poverty o official poverty line = the officially established income level that
distinguishes the poor from the non-poor (intl. poverty line is currently
set at $1.90 a day)
minimum = a price floor set for the price of labor
wage o New Zealand, 1894: first minimum wage law
o economists are divided on whether substantial increases in the
minimum wage can be instituted without affecting the employment
levels of these lower skilled workers
 against: minimum wage legislation interferes with the smooth
functioning of the labor market and creates unemployment
 in favor: minimum wage legislation has been successful in
raising the wages of the poorest workers and alleviating poverty
without creating much unemployment
Unemployment, inflation and long-run growth
unemploymen o types of unemployment
t  frictional = the portion of unemployment resulting from the
normal turnover in the labor market (i.e., job search takes
some time)
 structural = the portion of unemployment resulting from
changes in the structure of the economy, which result in a
significant loss of jobs in certain industries
natural rate of unemployment = the unemployment rate
that occurs as a normal part of the functioning of the
economy (frictional + structural)
 cyclical = unemployment that is above frictional plus
structural unemployment
o measuring unemployment
 labor force = employed + unemployed
 population = labor force + not in labor force
 not in labor force = a person is not looking for work
because he/she doesn’t want a job or has given up
looking (e.g., full-time students, retirees)
 unemployment rate = unemployed / labor force
 labor force participation rate = labor force / population (of
legal age of employment)
o factors
 different demographic groups
 discouraged-worker effect = the decline in the measured
unemployment rate that results when people who want to
work but cannot find work grow discouraged and stop
looking, therefore entering the “not in labor force” category
 duration of unemployment – the unemployment rate isn’t
longitudinal so it doesn’t tell us anything about how long the
average worker is out of work
o social consequences
inflation and = an increase/decrease in the overall price level
deflation o consumer price index = cost of market basket in current period / cost
of market basket in base period * 100
o producer price indexes = measures of prices that producers receive for
products at various stages in the production process (e.g., finished
goods, intermediate materials, crude materials)
o whether people gain or lose during a period of inflation depends on
whether their income rises faster or slower than the prices of the
things they buy
o inflation is likely to have a larger effect on the distribution of income
when it’s unanticipated
long-run o output growth = the growth rate of the entire economy – depends on
growth  the growth rate of the capital stock
 the growth rate of output per unit of the capital stock
 the growth rate of labor
 the growth rate of output per unit of labor
o per-capita output growth = the growth rate of output per person in the
economy
o productivity growth = the growth rate of output per worker