Choice & Economics
Plan for today:
1. Class organization- Introduction
2. Chapter 1 introduction
3. Math review
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"the purpose of studying
economics is not to acquire a
set of ready-made answers
to economic questions, but
to learn how to avoid being
deceived by economists."
Joan Robinson
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Economics
Study of the choices people make to attain
their goals given their scarce resources.
1.
What do economists study?
•
gasoline prices, inflation, housing markets, international trade, income
inequality, sports, families, smoking, health care, happiness
•
decision-making or choices
2.
How do they do it?
•
by using theories and models
•
theories are based on assumptions
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Resources
What is a Resource?
Resources are anything that can be
used to produce stuff!
Land
Labor
Capital
Human Capital
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Individual Choices
Basic Principles Behind Individual Choices:
1. Resources are scarce.
2. The real cost of something is what you
must give up to get it.
3. “How much?” is a decision at the margin.
4. People usually take advantage of
opportunities to make themselves better off.
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1. Scarcity
• Recall that goods only have
economic value if they are scarce.
• Without scarcity you wouldn’t have
to make a choice. i.e. no costs
• Individual decisions vs. “societal
decisions”
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2. Opportunity Costs
• Because of scarcity all choices
involve trade-offs
• The real cost of something is what
you must give up to get it.
• “The most valuable forgone
alternative…” i.e. get a job or go to
college?
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3. Decisions at the Margin
• “How Much” is a decision at the
margin.
Study Time vs. Xbox
Eating Donuts
• Marginal Analysis: Comparing the
costs and benefits of doing a little bit
more of less of something
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Economics
Scarcity
When the price is zero there
is not enough for everyone
Unlimited
wants
Choices
People behave as if
they are comparing the
costs and benefits
Benefits
Limited
availability
Costs
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Economics
Scarcity
Everything has alternative uses
Tradeoffs
Opportunity cost
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Economics
Choices
People are rational when they behave
as if they were comparing costs and
benefits
People respond to incentives
Decisions are made on the margin
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4. Exploit Opportunities
• Everyone wants to be better off!
• Incentives: What motivates people
to act or change their actions
Change Behavior
Change Incentives
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Making Choices
• Because of higher gas prices, people
in Europe drive smaller cars.
Opportunity to make themselves better-off
• You are weighing the advantages of
working more hours this month.
Decision at the Margin
Scarce Resources of Time
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Making Choices
• Mothers (Fathers) of young children
must weigh returning to work or
staying at home with their kids.
People face trade-offs
• You decide four classes is enough
for this semester and not five.
Make a Decision at the Margin
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Example
• Should Apple produce an additional 300,000
iPods?
• In solving this problem note
• Optimal Decisions are made at the margin
• An activity should be continued until the
marginal benefit is equal to the marginal cost.
• Decisions require perfect information about
additional revenue and additional costs.
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Exercise for Chapter 1
• Dell Laptops
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Microeconomics vs. Macroeconomics
• Economic models can be used to analyze decision
making in many areas whether it is micro or macro
oriented.
• Microeconomics- study of how households and
firms make choices, how they interact in markets,
and how the government attempts to influence
their choices.
• Macroeconomics- study of the economy as a
whole
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The Economic Problem That Every
Society Must Solve
Trade-offs force society to make choices, particularly when
answering the following three fundamental questions:
1 What goods and services will be produced?
2 How will the goods and services be produced?
3 Who will receive the goods and services produced?
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The Economic Problem That Every
Society Must Solve
• Policy Makers face: Normative and Positive Analysis
Positive analysis: Analysis
concerned with what is.
Normative analysis: Analysis
concerned with what ought to
be.
Don’t Let This Happen to YOU!
Don’t Confuse Positive Analysis with Normative Analysis
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The Economic Problem That Every Society
Must Solve
• Centrally Planned Economies versus Market Economies
Centrally planned economy An economy
in which the government decides how
economic resources will be allocated.
Market economy An economy in which
the decisions of households and firms
interacting in markets allocate economic
resources “Invisible hand.”
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The Economic Problem That Every Society
Must Solve
• The Modern “Mixed” Economy
Mixed economy An economy in which
most economic decisions result from the
interaction of buyers and sellers in
markets but in which the government
plays a significant role in the allocation of
resources.
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The Link : “Value” Prices
Individual preferences, and thus individual
choices, are manifest in a market economy
through the relative prices of goods and
services.
Prices and profits signal information about
what consumers DEMAND so that
producers know what they should SUPPLY.
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Leaky Roof
An old economics example comes from
Soviet Russia which had many command
economy elements:
Observed houses with no roofs because
the incentives for producers did not lead
them to make small roofing nails, only big
ones. Needed markets and prices!
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Invisible Hand: Say What?
• Adam Smith (1776): “[H]e intends
only his own gain, and he is in this, as
in many other cases, led by an
invisible hand to promote an end
which was no part of his intention.”
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Was Adam Smith Right?
• How could people making individual
decisions possibly allocate resources
and production?
• Answer: In a market economy
PRICES are the primary and almost
magical tool for coordinating the
economy.
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Conditions for Economic Value:
1. “They are useful in satisfying
human wants, and are therefore
desired.”
2. “They are SCARCE. Any goods that
are in unlimited supply would have
no value.
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What Determines Value
Price: $1.25
Legal Tender: $1
Silver Price: $16.50/oz
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What is “Value”
• We will use the word “VALUE” to
mean the exchange value or the
price of a good or service.
• Exchange value or prices are
SYMBOLIC of something more
fundamental.
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Interaction of Choices
Principles of Interaction Between Choices:
1. There are gains from trade.
2. Markets move toward equilibrium.
3. Resources should be used as efficiently
as possible to achieve society’s goals.
4. Markets usually lead to efficiency.
5.When markets don’t achieve efficiency,
government intervention can improve
society’s welfare.
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1. Gains from Trade
• In a market, people engage in
mutually beneficial trades of goods
and services.
• Money is the medium of exchange.
• In order for a trade to be mutually
beneficial, there must be NO
DECEPTION or COERCION involved!
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Gains from Trade: Specialization
• Why do people specialize?
• People can get more of everything
through specialization and trading
rather than trying to be selfsufficient!
• The entire economy is better off.
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2. Markets Move To Equilibrium
• Equilibrium just means that no
individual would be better off by
doing something else.
• Question: Are equilibriums a fixed
state or are they a dynamic state?
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3. Resources Used Efficiently
• An economy is efficient if it takes all
opportunities to make some people
better off without making other
people worse off.
• Maximum gains from given resources
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Efficiency: Some Questions
• Should economic policy strive for
efficiency?
• Using the definition of efficiency, is
taxing rich people and redistributing
their wealth to poor people efficient?
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Beyond Efficiency
• What criteria other than efficiency
should be used in making policy?
• Equity: everyone gets his or her
“fair” share.
• Why is deciding what is “fair” so
challenging?
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4: Markets Usually Yield Efficiency
• “Invisible Hand”
• If each individual choice makes the
person better off – then by definition
the economy as a whole should be
operating efficiently.
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Difficult Choices
A society that has 500 children is
threatened by a disease that strikes only
children. A company has made a pill that
reduces the risk of getting the disease from
90% chance to only a 10% chance. The
company can only produce 500 pills at the
present time. Getting more than one pill
greatly reduces the risk of a child dying.
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Difficult Choices: Questions
How do you allocate the 500 pills between the
500 children?
Equity: All children should get antidote.
Efficiency: Encourage profit-oriented firms to
innovate.
How do we as a society preserve incentives for
the company to innovate and take the risks of
developing new drugs?
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These principles will also improve your
understanding of how decisions are made in
business and government, even if you aren’t an
econ major!
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