Econ 1000 Lecture 2 Chapter 1 + 2

13th September 2018

Topic: What is Economics and The Economic Problem

Two Big Economic Questions

When is the Pursuit of Self-Interest in the Social Interest?
You make choices that are in your self-interest—choices that you think are best for you.
Choices that are best for society as a whole are said to be in the social interest.
An outcome is in the social interest if it uses resources efficiently and distributes goods and
services fairly.
The Big Question
Is it possible that when each one of us makes choices that are in our self-interest, it also turns
out that these choices are also in the social interest?
Answer: Most of the times, economic agents acting purely out of their own self interest also
promote social interest.
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our
dinner, but from their regard to their own interest.” Adam Smith: The Wealth of Nations.”
Sometimes, a conflict/tension may occur between self interest and social interest.
Some examples that illustrate tension between self-interest and social interest are
 Environmental pollution and global warming

 Globalization and outsourcing of production processes

 Natural resource depletion

 Human Nature, Incentives, and Institutions

 If a conflict arises between self interest and social interest, how do we deal with it?

 Economists answer by emphasizing the role of institutions in creating incentives that

compel individuals to behave in the social interest.
 What are Institutions?

 Formal and informal rules and laws that define the incentive structure in the society and
govern the behaviour of individuals and the governments.
 Some ways to gauge the quality of institutions:

 Political Institutions: Democracy, accountability, human rights, freedoms (religious,

economic and political)

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  Economic Institutions: Enforcement of property rights and contracts, the conduct of
government’s monetary and fiscal policy
 Others: Control of Corruption, Rule of Law and Order

Economics is divided into two main parts:

 Microeconomics

 Macroeconomics

Microeconomics is the study of choices that individuals and businesses make, the
way those choices interact in markets, and the influence of governments.
Macroeconomics is the study of the performance of the national and global
economies.
Economics as Social Science
Economists distinguish between two types of statement:
 How things are (the statement of facts)—positive statements

 How things ought to be (involves judgements)—normative statements

A positive statement can be tested by checking it against facts.

A normative statement cannot be tested.
Studying relationships between economic variables
The key task of economic science is to understand how the economic world works.
Economists study relationships between different economic variables. Since many
economic variables interact with each other, it is challenging to unscramble the effect of
one variable from the other. To deal with this challenge, economists use economic
models.
An economic model is a description of some aspect of the economic world that
includes only those features that are needed for the purpose at hand.

Chapter 2
The Economic Problem
Production Possibilities Frontier as an Economic Model
 The production possibilities frontier (PPF) is a simple economic model that

• helps us understand how society allocates resources and decides what to

produce and how much?
• Illustrates the concepts of scarcity, opportunity cost, trade-offs and efficiency
 Assumptions:

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 • There are only two goods that the economy produces
• Resources along with technology and capital are fixed
 The production possibilities frontier (PPF) is the boundary between those
combinations of goods and services that can be produced within the given resources
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 (ceteris
paribus) except the two goods we’re considering.
 Production Possibilities Frontier

 Figure 2.1 shows the PPF for two goods: cola and pizza.

 Any point on the frontier such as E and any point inside the PPF such as Z are
attainable.
 Points outside the PPF are unattainable.

Production Possibilities and Opportunity Cost

– 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.

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 – Any point inside the frontier, such as 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.
– Tradeoff Along the PPF
– Every choice along the PPF involves a tradeoff.
– On this PPF, we must give up some cola to get more pizzas or give up some pizzas to
get cola.
Production Possibilities and Opportunity Cost
• Opportunity Cost
– As we move down along the PPF, we produce more pizzas, but the quantity of
cola we can produce decreases.
– The opportunity cost of a pizza is the cola forgone.

– In moving from E to F, the quantity of pizzas increases by 1 million.

– The quantity of cola decreases by 5 million cans.
– The opportunity cost of the fifth 1 million pizzas is 5 million cans of cola.

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 – One of these pizzas costs 5 cans of cola.
– In moving from F to E, the quantity of cola produced increases by 5 million.
– The quantity of pizzas decreases by 1 million.
– The opportunity cost of the first 5 million cans of cola is 1 million pizzas.
– One of these cans of cola costs 1/5 of a pizza.
– Note that the opportunity cost of a can of cola is the inverse of the opportunity cost of a
pizza.
– One pizza costs 5 cans of cola.
– One can of cola costs 1/5 of a pizza.

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