Chapter 1

Dr. Ebenge UsipPowerPoint SlidesTo AccompanyEconomicsbyHubbard &O’BrienChapter 1Economics: Foundations &Models©2006 Pearson/Prentice HallPurpose of this chapterTo show how scarcity ofresources forces individuals dvdu and the whole society to makehard but rational choices.First, “What is Economics?”Meaning of EconomicsA social science concerned with the studyof choices that people make to attain theirgoals given their scarce resources.Notes● Unlike other disciplines in the Social Sciences,economists use quantitative tools extensively todevelop and apply economic concepts.● Given the unlimited ends/goals of the economicagents (govts., individuals like Bill Gate, & firms)resource scarcity forces us to make hard choices.What is the Meaning ofScarcity?A situation in which the amount ofsomething available is insufficient tosatisfy the desire for it.For example:Individuals – face scarcity oftime & buying power.Society – faces scarcity ofproductive resources.What Are Resources?A society’s resources include:Labor: Time that humans spend to produce Goods& ServicesCapital- Physical & Human: Long-lastingtools used for productionLand: Physical Space on which production takes place,and the Natural Resources on and underneath it.Entrepreneurship: The ability & willingnessto combine other resources – labor, capital, andnatural resources – into a productive enterprise orfirm. Doing so involves risk-taking & innovation.

Examples of Physical Capital &Natural ResourcesPhysical Capital:● Buildings● Machinery● EquipmentNatural resources:● Oil (underneath the Land)● Iron ( same )● Coal ( same )● Timber (on the Land)Is the Marker/Chalk that aTeacher Uses ConsideredCapital?NO! NO!! NO!!!Reason: It is not long lasting. Itwould be considered a rawmaterial because it is used upduring lecture: the process ofproducing knowledge (output).Building a Foundation: Economicsand Individual DecisionsAll economic agents (decision makers):● Are market participants- b/c they have certainobjectives to fulfill● Are rational - b/c they face resource constraints● Respond to economic incentives■buy more at a lower price ■sell more at higher price■take a job that pays more ■invest in high-yield bond● Make optimal decisions at the margin due toinsufficient resources or incomes.Implication: Economists use of the principle of marginalanalysis to explain how economic agent seek to maximizetheir objectives in a market subject to some constraints.What is a Market?What is marginal Analysis?Market: A group of buyers and sellers of a goodor service and the institution orarrangement by which they cometogether to trade (voluntary exchange).Marginal analysis:Analysis that involves comparing marginalbenefits (MBs) and marginal costs (MCs).Application of Marginal Analysis: AppleComputer (Steve Job) Problem.Question: Should Apple produce an additional 300,000 iPods?Solution: To make a rational decision, Apple computer mustemploy the marginal analysis as follows:• Determine additional revenue of selling 300,000 ipods as ameasure MBDetermine additional cost of producing the 300,000 ipods asa measure of MC• Produce the if:1. MB = MC and earn zero economic profit2. MB > MC and earn positive economic profit• Do not produce if MB < MCThe Economic Problem that Every SocietyMust Solve by Allocating its ScarceResourcesKey idea: Trade-off ! Trade-off !! Trade-off !!!Producing more of one good or service meansproducing less of another good or service becauseof resource scarcity.This raises three fundamental questions:‣ What goods and services will the society produce?‣ How will the goods and services be produced?‣ Who will receive the goods and services produced?

Resource Allocation: What is it?●A method by which a society uses itsavailable resources to determine:▪What goods & services should beproduced.▪How they should be produced.▪Who should get them.●Known methods that have been used inthe history of mankind are:♦Traditional Economy♦Command or Centrally planned Economy♦Market Economy.Traditional Economy: HowDoes it the work?●An economic system in whichresources are allocated according tolong-lived practices.●How it Works:Elders confer to determine whatoutputs to produce, how to produce,and who receives the outputs.▪Still used in tribal societies and villagesCommand Economy: How Doesit Work?●An economic system where resourcesare allocated according to explicitinstructions from a central authority(e.g., Former USSR, China!!!).●How It Works:▪What outputs to produce? As ordered▪How to produce? As told▪Who gets them? Distribute as directedMarket Economy: How Does itWork?●An economic system in which resources areallocated through individual decisionmaking.●How it Works:▪What outputs to produce?As directed/dictated by prices▪How to produce?As dictated by prices▪Who gets them? As directed by prices(with limited govt. regulation).What’s a Market? What’s a Price?●Market: A group of buyers & sellers and theinstitution or arrangement by which theycome together to trade with eachvoluntarily.●Price: The amount of money that abuyer must pay to a seller toobtain a good or service.●Note:▪Prices are stated in the units of the economy’snational currency: U.S $, ₤ in U.K.; € in Europe▪The price for goods/services is Not the same asthe price for resources (e.g., wage rate for Labor)Prices: Why So Important?●Prices (or price signals) direct the actions of :▪Producers/sellers when choosing whichgoods/services to produce and how toproduce.▪Buyers when choosing which goods/services tobuy & how much (Rationing role of prices).▪Gov’t. when choosing the regulation to enforce.●Conclusion: Markets via prices allocate theavailable resources of the society in the mostorderly & efficiently manner.

What Kind of Economy Do WeHave in the U.S.?●Mostly a Market Economy with someaspects of▪tradition (decisions within families), &▪command d (through h governmentinterventions).●Thus, the U.S. economy is betterdescribed as a Mixed Market Economyor a Mixed Capitalism.●The Modern Mixed Economy:An economy in which most economicdecisions result from the interaction ofbuyers and sellers in markets, but inwhich the government plays a significantrole in the allocation of resources.●Key Features:■Efficiency (productive & allocative)■Equity in the distribution of economicbenefitsKey ConceptsProductive efficiency :The situation in which a good or service is produced at the lowestpossible cost.Allocative efficiency:A state of the economy in which production reflects consumerpreferences; in particular, every good or service is produced up to thepoint where the last unit provides a marginal benefit to consumersequal to the marginal cost of producing it.Voluntary exchange:The situation that occurs in markets when both the buyer and sellerof a product are made better off by the transaction.Equity:The fair distribution of economic benefits.Resource Ownership: What is it?●The manner in which the availableresources in the society are ownedand appropriated for income.▪Labor owner – wages as income▪Land owner – rent as income▪Capital owner – return as income▪Human Capital – Salary as incomeThe World of Economics: What arethe Major Parts/Branches?Microeconomics: The study of thebehavior of individual households,firms, and governments; the choicesthey make, and their interaction inspecific markets.Macroeconomics: The study of thebehavior of the whole economy.Note: This distinction has to do with thelevel of detail in analyzing economicproblems.What kind of Questions areasked in Microeconomics?• How many jobs will open up in thefast-food industry?• What will happen to the price of fuelover the next five years?• How will U.S. phone companies beaffected by a U.S. tax increase onimported cell phones?

What kind of Questions areasked in Macroeconomics?● Why do interest rates rise & fall?● Why does the aggregateunemployment rate rise & fall?● What is money? What is money stockHow does changes in the price levelaffect money stock?Note: Econ 2630 will cover these topics.What are the Other Methods ofAnalysis ?● Positive Analysis● Normative AnalysisNote: This distinction has to do withthe purpose (not the level ofdetail) in analyzing economicproblems.What is Positive Analysis?Analysis concerned with what is – involves theuse of economic models to explain how theeconomy actually worksE.g: 2005 Minimum wage ($5.15) LawPositive analysis goes as follow:● GDP may decline if unemployment orgrows if otherwise.●Production costs may rise causing profits tofall since Profit = TR-TCQuestion: Is the law bad or good for economy?Answers come from Normative AnalysisWhat is Normative Analysis?Analysis concerned with what should or ought to be -involves the use of value judgments to identify problemsand prescribe solutions, albeit in a way that may reflect theeconomist’s personal bias.Normative Analysis of the minimum wage Law is basedon how people assess the trade-off between marginalbenefits and marginal costs of the policy.Some may argue that:● It benefits existing workers: higher income/welfare● It hurts unemployed workers:● It hurts producers – shrinking profits, hence low R&D.Conclusion: Individuals use personal judgment todetermine whether the gains/benefits outweigh the losses.Why Do Economists Disagree?Two economists may disagree or expressdifferent views on a specific problem:● sometimes: simply because they haveimperfect knowledge of theeconomy even when both usepositive economic analysis● usually: due perhaps to differences intheir political affiliation or beliefso they use normative economicanalysis to draw their conclusions.Note: An economist can be a progressiveor a conservative (Econ &Politics).Why Study Economics?• To become an economistof the Fed, Bernarke (Greenspan, outgoing)• To gain self confidence (by understandinge.g., Chairmanthe cause-and-effect and effect in global economic events)• To understand the world better• To achieve social changeareas of hunger, poverty, and employment equity, etc.)• To help prepare for other careers(in the

What are the areas ofSpecialization in Economics?• Public Finance/Economics• Monetary Economics• Labor Economics• International Economics• Comparative Economics• Development Economics• Energy Economics• Quantitative Economics• Business EconomicsWhat are the EightFundamental Principles?• Maximization Subject toConstraints• Opportunity Cost (of an action)• Specialization and Trade• Markets and Equilibrium• Short-run vs. Long-run• Marginal Decision Making• Policy Trade-offs• The Importance of Real ValueWhat Methods DoEconomists Use to Explainthe Real World?Economists make heavy use of:● Models (words, graphs, or equations)● Assumptions (simplifying andcritical)● Basic Mathematics(Math 1501 or higher on the mathplacement test - Course prerequisite)What is an Economic Model?An abstract representation of reality.The word “abstract” suggests that:● A model is not an exact representationof the real world being explained;unnecessary details about the realworld are left out during model building.● Assumptions (simplifying and critical)are used to eliminate the unnecessarydetails. A good model should containonly the necessary details.Simplifying BehavioralAssumption?Any assumption that makes a model simpler tounderstand without affecting any of itsimportant conclusions.Example: A typical consumer buys only twogoods – when stating the rule for explaininghis/her Utility Maximization behavior.● Key conclusions are unaffected byconsidering a basket with many items:She still seeks to maximize utility.Critical Behavioral Assumption?Any assumption that affects theconclusions of a model in an importantway (if it is relaxed or changed).Examples:■A A firm’s goal lis to maximize i profit.■A consumer’s goal is maximize utilityRemoving these assumptions will nullifythe conclusions from the models aboutthe consumer’s behaviors in the market.

Key Considerations whenBuilding & Testing Hypotheses inEconomic Models● Keep the Model Simple:A simple model is more likely toaccomplish its stated purpose.● Avoid Complexity (UnnecessaryDetails): A complex model will failto predict/explain the real worldcorrectly.Economic Models: How AreThey Represented?By using:● Words e.g. Law of Demand● Graphs e.g. Demand Curve● Mathematical equationse.g. Q d = a – bPwhere ‘a’, ‘b’ are parameters.Note:Economic models, when represented with graphs& equations, provide better insights/understandingof how the real world actually works.How much Math, Jargon, OtherConcerns in Learning Economics?● Math: basic concepts of Graphs,Equations, and Slope● Jargon: Special vocabularye.g. demand, supply, etc.● Concerns: Shift of a curveversus a movement along it.What Should Beginners KnowAbout Graphs & Equations?How to:● Draw a GRAPH from a TABLEof raw data and from an EQUATION.● Interpret LINEAR & NON-LINEARgraphs and their SLOPES● Shift a Line/Curve in contrast to a Movementalong it (p. 19).● Solve Equations (p. 20).Using Graphs & Formulas• Graphs of One Variable: Bar, Pie, & Time-series GraphsUsing Graphs and Formulas:Graphs of One Variable1A – 1, p. 22:Market Shares in the U.S.Automobile MarketBar Graph & Pie ChartTime-Series Graphs1A – 2, p. 23

Using Graphs and Formulas:Graphs of Two Variables1A – 3, p. 24Plotting Price and QuantityPoints in a GraphUsing Graphs Two Variables:Slope of a Linear RelationshipSlopes of Lines = Rise ÷ Run = -2÷ 10 = -0.21A – 4, p. 25• Can we learn to compute the areas of a triangle andrectangle from the above graph?Using Graphs of TwoVariables and a Shift FactorSales ($1,0001A – 5, p. 25Showing Three Variables on aGraphFinding the Slope of a Straight LineTheory: Sales depend positively on advertisingor Sales = a + bAd (linear relationship assumed)per Month76736158494640ABCDEF1 2 3 4 5 6 7 8 9 10 11 12Advertising ($1,000Slope at E (from D) = (Y 2 –Y 1 )÷(X 2 -X 1 )per Month)= (73 – 61)÷(11-7) = 12/4 = 3For every $1000 rise in Ad., Sales would rise by $3,000Finding the Slope a CurveTheory: Sales depend +ly on Ad nonlinearlyor Sales = F(Ad) (nonlinear relationship assumed)Sales($1,000 perMonth5453494643H404. sales increase from 43to 49 units (ΔY= 6). Sothe curve's slope atpoint B is = 6 / 3 = 2.1. The slope of thiscurve at point B . ..1ABCD2 3 4 5 6 7 8 92. is the slope of thestraight line tangent tothe curve at point B.3. Along the tangent line,when advertisingincreases from 0 to 3units (ΔX = 3)Advertising($1,000 per Month)Slope at B = (Y 2 –Y 1 )÷(X 2 -X 1 ) = (49 – 43)÷(3- 0) = 6/3 = 2For every $1000 rise in Ad., Sales would rise by $2,000YaStraight Lines with Different Slopes(a)b > 0 Y = a + bXPositive slopeb = 0 Y = aZero slopeb < 0 Y = a - bXNegative slope0 X

YStraight Lines with Different VerticalIntercepts (but same slope)a > 0(b)Positive Intercept relative tothe Origin (0,0)Y = a + bXY = bXShifts in the Graphs of Advertising & Sales ofIce creamTheory: Sales depend positively on advertisingSales($1,000 perMonth6458or Sales = a + bAd (linear relationship assumed)C'CC''July (HighTemp.)June (normalTemperature)September(Low Temp.)a = 0Origin (0,0)0 XNegative Intercept relativea < 0 to the Origin (0,0)Y = -a + bX6Advertising ($1,000per Month)Note: Let Z denote changes in temperature(previously held constant when relating Sales to Adv.)Fig. A.5a Shifts of Curved Lines p. 19Theory: Y depends positively on X but in a nonlinear manner)Y(a)An increase in Zcauses an increase inY at any value of XC'YShifts of Straight LinesTheory: Y depends negative on X but in a linear manner)(b)An increase in Z causesa decrease in Y at anyvalue of XCCC'XNote: Z has a positive effect on YNote: Z has a negative effect on YXSolving EquationsRecall: Sales(Y) depend directly on Advertising (X), cet. par)If the relationship is linear with “a” = 40; and “b” = 3then Y = 40 +3X is the specific form of the relationshipProblem: Find X given known value of Y?Suppose the firm plans to sale $64,000 worth of goods.How much should it spend on advertising?i Solution: Letting Y = 64 (in $000) implies that64 = 40 + 3Xor 64 – 40 = 3XThus, X = 24÷ 3 = 8 (in $000) or $8000Interpretation: To achieve sales of $64,000 the firmmust spend $8,000 on advertising.The END

Capital Stock: What is it?Input: What is it?●Capital Stock: The total amount of capital in anation that is productively usefulat a given point in time.●Input: Anything (including materials) used toproduce a goods or service.Examples: labor, capital, Chalk, oil, ... are inputsthat enterprises/firms use in theirproduction process.Primary Inputs: Labor, Capital & Land only.