Principles of Economics

Economics, Scarcity, and Choice

Economics
Study of choice under conditions of scarcity
Study of how society manages its scarce resources to
produce goods and services
distribute them among different individuals

There are unlimited variety of scarcities, however they are all

based on two basic limitations
Scarce time
Scarce spending power
 The problem for society is a scarcity of resources
Scarcity of Labor: Time human beings spend producing
goods and services.

Scarcity of Capital: Something produced that is long-

lasting, and used to make other things that we value.
Human capital
Capital stock

Scarcity of Land: Physical space on which production

occurs, and the natural resources that come with it.
 The scarcity of resourcesand the choices it forces us to
makeis the source of all of the problems studied in
economics
Households allocate limited income among goods and services
Business firms choices of what to produce and how much are limited
by costs of production
Government agencies work with limited budgets and must carefully
choose which goals to pursue

Economists study these decisions to

Explain how our economic system works
Forecast the future of our economy
Suggest ways to make future better
 Opportunity Cost

Opportunity cost is a direct implication of scarcity. The

opportunity cost of an action is what you must give up
when you make that choice.
The best alternative that we give up, or forgo, when we
make a choice or decision.
It is the value of the next best opportunity.
Opportunity cost includes both explicit and implicit
costs.
Explicit costs are costs that require a money payment
(Electricity Bill, wages)
Implicit costs are costs that do not require a money
payment (time and effort)
 The nominal interest rate is the opportunity cost of holding
money: it is what you give up by holding money rather than
bond.

Ex: Josephine Csun, who starts a business with $100,000 she inherited from
her rich uncle. The opportunity cost of this capital is what Josephine could
have earned if she had taken the money and invested it elsewhere. If the
rate of return on her best alternative investment opportunity is 10%, the
implicit cost of capital is $10,000. This would be added to her other
explicit costs of doing business to compute the opportunity cost.
 Macroeconomics
Macroeconomics
Study of the economy as a whole
Focuses on big picture and ignores fine details
 Microeconomics
Microeconomics
Studies how individuals and firms make decisions to
allocate limited resources, typically in markets where
goods or services are being bought and sold.
Focuses on individual parts of an economy, rather
than the whole
 Positive Economics
Study the relationship of cause and effect (questions
that deal with explanation and prediction).
Accuracy of positive statements can be tested by
analysis and empirical evidences

Ex: The decline in home prices during 2008-2009 was

a major cause of the recent recession.
 Normative Economics
Study of what should be
Used to make value judgments, identify problems, and
prescribe solutions
Statements that suggest what we should do about
economic facts, are normative statements
Can be resolved by political debate and decisions not by
economic analysis alone
Ex: We should cut total government spending.
 Why Study Economics
To understand the world better
to understand the cause of many of the things
that affect your life
(War, famines, epidemics, recessions, etc.)
To gain self-confidence
 To achieve social change
to understand origins of social problems and design more
effective solutions (unemployment, hunger, poverty,
disease, climate change etc.)
To become an economist
to develop a body of knowledge that could lead you to
become an economist in the future
 The Methods of Economics
Economics relies heavily on modeling
Economic theories must have a well-constructed model
While most models are physical constructs
Economists use words, diagrams, and mathematical
statements
What is a model?
Abstract representation of reality
 The exogenous variables are those that come
from outside the model.
The endogenous variables are those that the
model explains.
The model shows how changes in the exogenous
variables affect the endogenous variables.
 Two basic postulates
Rational Choice: Each person tries to choose the best
alternative available to him or her.
(In economics, people are assumed to act rationally, using
all available information to maximise their satisfaction. )

Equilibrium: Market price adjusts until quantity demanded

equals quantity supplied.
 Fundamental Assumption
Every economic decision maker tries to make the best out of
any situation
Typically, making the best out of a situation means maximizing some
quantity
Any economic model should begin with the assumption that someone
is maximizing something

Every economic decision maker faces constraints

Societys overall scarcity of resources constrains each of us individually
 Together, the two fundamental assumptions help define the
approach economists take in answering questions about the
world
Every society must have a way of determining
what commodities are produced,
how these goods are made, and
For whom they are produced.
Decision makers in the economy
The decision makers in the economy are divided into three broad groups:
Households
Business
Government agencies
In Microeconomic models
Individual households
firms
Government agencies
In Macroeconomic models
Household sector
Business sector
Government sector
Foreign sector
 Economic Measurement
Stock variables.
Measured at a point in time
amount of money, price, wealth, inventories.
Flow variables.
Measured per unit of time (for example, per
quarter or per year).
production, consumption, income.