Principles of Economics

Economics, Scarcity, and

Choice
Economics
Study of choice under conditions of scarcity
Study of how society manages its scarce
resources

Scarcity
The means available to society (its labour force,
its capital stock, its natural resources, its
technology) are insufficient to meet all the wants
(or the desired goods and services) of the people
making up that society.

 There are an unlimited variety of

scarcities, however they are all based on
two basic limitations
Scarce time
Scarce spending power

Limitations force each of us to make

choices
Economists study choices we make as
individuals, and consequences of those
choices
Economists also study more subtle and

 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

Factors of production (or factors) The inputs into the

process of production. Another term for resources.

As a society our resourcesland, labor, and capitalare

insufficient to produce all the goods and services we might
desire
In other words, society faces a scarcity of resources

 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 that future even 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 bonds.
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.
Choices they make
Interaction in specific markets

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).
Study of how economy works
Accuracy of positive statements can be
tested by looking at the facts
Ex: The decline in home prices during 20082009 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
Based on values

Normative statements cannot be proved or

disproved by the facts 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 help prepare for other careers

Discover a wide range of careers deal with
economic issues on many levels

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 wellconstructed 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.

 Guiding principle of economic model

building
Should be as simple as possible to
accomplish its purpose

Level of detail that would be just

right for one purpose will usually be
too much or too little for another
Even complex models are built
around a simple framework

Assumptions and
Conclusions
Types of assumptions in an economic
model
Simplifying assumptions
Way of making a model simpler without
affecting any of its important conclusions

Critical assumptions
Affect conclusions of a model in important
ways
If critical assumptions are wrong model will
be wrong

All economic models have one or

more critical assumptions

 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 Modeling
Assumptions
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.

First 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
The first fundamental assumption seems to imply that
we are all engaged in a relentless, conscious pursuit of
narrow goals

Second Fundamental
Assumption
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
Economists always begin with the same three
questions
Who are the individual decision makers?
What are they maximizing?
What constraints do they face?

Economic Measurement
Stock variables.
Not measured with respect to time. e.g.
price, wealth, inventories.

Flow variables.
Measured per some unit of time. e.g.
production, consumption, income.

Two additional flow variables:

EXPENDITURE = PRICE CONSUMPTION.
REVENUE = PRICE PRODUCTION.

Prices
Nominal price
The absolute or current dollar price of a
good or service when it is sold.

Real price
The price relative to an aggregate
measure of prices or constant dollar
price. It also measures prices relative to
others. Price after adjustment for
inflation.

 Formula of real price:

Real price = Nominal price (current year)/
Inflation rate (base year to current year)

The production possibility frontier

(PPF)
The production possibility frontier shows all the
combinations of goods that can be produced if the means of
production (resources, technology etc.) are fully employed.
The PPF is a boundary. It demonstrates scarcity in that any
point beyond the frontier is unattainable. Society cannot
produce combinations that lie outside the PPF because
there are insufficient resources to do so.
Points above and to the right of the origin are seen as better
than points closer to the origin. If society produces at a
point on the frontier rather than inside it, society will be
better off.

 All points below and to the left of the curve

(the shaded area) represent combinations
of capital and consumer goods that are
possible for the society given the resources
available and existing technology.
Points above and to the right of the curve,
such as point G, represent combinations
that cannot be reached.
If an economy were to end up at point A on
the graph, it would be producing no
consumer goods at all; all resources would
be used for the production of capital. If an
economy were to end up at point B, it
would produce only consumer goods.

 Although an economy may be

operating with full employment
of its land, labor, and capital
resources, it may still be
operating inside its ppf, at a
point such as D. The economy
could be using those resources
inefficiently.
Periods of unemployment also
correspond to points inside the
ppf, such as point D.
Moving onto the frontier from a
point such as D means
achieving full employment of
resources.

Productive inefficiency
Empty seats on an airline flight
represents productive inefficiency.
Since the plane is making the trip
anyway, filling the empty seat would
enable the airline to serve more
people with the flight without using
any additional resources. Therefore,
more people could fly without
sacrificing any other good or service.

 The PPF and efficiency: Points on the PPF

are productive efficient, while points within
the curve are inefficient.
An efficient allocation of means of
production is one which yields a
combination of outputs where it is not
possible to increase the output of one good
without reducing the output of the other.
Societies must also choose not just any
point on the PPF but a specific point.

 The opportunity cost

of producing more
capital goods is fewer
consumer goods.
Moving from E to F,
the number of capital
goods increases from
550 to 800, but the
number of consumer
goods decreases from
1,300 to 1,100.

Economic growth
PPF changes when we produce more of
everything.
An increase in the total output of an economy. It
occurs when a society acquires new resources
or when it learns to produce more using existing
resources.
Two main causes of economic growth is increase
in resources and technological change.

The shape of the PPF and marginal

analysis
Marginal simply means extra or additional and marginal
analysis has to do with decision making at the margin.
Economists often analyse the effects of a one unit change in
something
Example: how much better off will a consumer be if they can purchase one
additional unit of a good? How much extra profit will a company earn by
producing one additional unit of a good? How much more can a company
produce if they hire one additional worker?

Asking such questions helps to find the optimal level of (for

example) consumption and production,
The fact that the extra output each additional input can produce
diminishes is one reason why the PPF is concave toward the origin.

 Absolute advantage: A producer has an

absolute advantage over another in the
production of a good or service if he or she can
produce that product using fewer resources.
Comparative advantage: A producer has a
comparative advantage over another in the
production of a good or service if he or she can
produce that product at a lower opportunity
cost.