Chapter 1 | Scarcity, Opportunity Cost, Trade, Models SCARCITY AND CHOICE Because you can never satisfy all of your wants, making the most out of your life requires smart choices about what to go after, and what to give up. The problem of scarcity arises because of limited money, time, and energy scarcity prohibits you from spending and saving the same dollar. Economics is how individuals, businesses, and governments make the best possible choices to get what they want, and how those choices interact in markets “Economy is the art of making the most out of life.” George Bernard Shaw OPPORTUNITY COST Opportunity cost is the single most important concept both in economics and for making smart choices in life. Because of scarcity, every choice involves a trade-off — you have to give up something to get something else The true cost of any choice is the opportunity cost — the cost of the best alternative given up Opportunity cost is more important than money cost; may be greater, equal to, or less than, the money cost. For a smart choice, the value of what you get must be greater than value of what you give up Smart choices change as costs and benefits change; Incentives - rewards and penalties for choices You are more likely to choose actions with rewards (positive incentives), and avoid actions with penalties (negative incentives) GAINS FROM TRADE Opportunity cost and comparative advantage are key to understanding why specializing and trading make us all better off. With voluntary trade, each person feels that what they get is of greater value than what they give up o Absolute advantage the ability to produce a product or service at a lower absolute cost than another producer; more productive than others o Comparative advantage the ability to produce a product or service at a lower opportunity cost than another producer Opportunity cost Comparative advantage key to mutually beneficial gains from trade Trade makes individuals better off when each o Specializes in producing a product or service with comparative advantage (lower opportunity cost) o Trades for the other product or service o Without anymore working harder or technology advance. Production possibilities frontier (PPF) graph showing maximum combinations of products or services that can be produced with existing inputs Specialization according to comparative advantage and trade allows each trader to consume outside her PPF, an impossible combination without trade o All arguments you will ever hear for freer trade are based on comparative advantage Even if one individual has absolute advantage in producing everything at lower cost, differences in comparative advantage allow mutually beneficial gains from specializing and trading THINKING LIKE AN ECONOMIST The circular-flow model, like all economic models, focuses attention on what’s important for understanding and shows how smart choices by households, businesses, and governments interact in markets. An economic model is a simplified representation of the real world, focusing attention on what’s important for understanding Circular flow model of economic life reduces complexity of the Canadian economy to three sets of players who interact in markets — households, businesses, and governments o In input markets, households are sellers, businesses are buyers o In output markets, households are buyers, businesses are sellers Inputs are productive resources — labour, natural resources, capital equipment, and entrepreneurial ability — used to produce products and services Governments set rules of the game and can choose to interact in any aspect of the economy • The Three Keys Model summarizes the core of microeconomics, providing the basis for smart choices in all areas of your life. • Key 1: To make a smart choice, when you weigh benefits against costs, additional benefits must be greater than additional opportunity costs. +money cost+ time • Key 2 as “Count only marginal benefits — additional benefits from your next choice — and marginal opportunity costs — additional opportunity costs from your next choice.” • Key 3: Implicit Costs and Externalities Count - implicit costs to describe the opportunity costs of investing your own money or time. o negative externalities are costs that affect others who are external to a choice or trade, don’t pay for directly ; air pollution o positive externalities, benefits that affect others who are external to a choice or trade. If you plant a beautiful garden in your front lawn, you certainly benefit, but so do all of your neighbours who take in the colours and smells. o Unintended consequences: offering money for blood donation • Good models exclude unnecessary information to focus on what is most important for understanding o Microeconomics analyzes choices that individuals in households, individual businesses, and governments make, and how those choices interact in markets o Macroeconomics analyzes performance of the whole Canadian economy and global economy, the combined outcomes of all individual microeconomic choices • Differences o Trees (micro) versus forest (macro) o Smart choices for you (micro) versus all (macro) ? IS ECONOMICS A SCIENCE ? • Science is a systematic enterprise that builds and organizes knowledge in the form of testable explanations and predictions about the universe • Economics uses quantitative expression in mathematics and concise statement of its models in axioms and derived “theorems,” so it looks a lot like the models of science from physics • “Nobel Prize” in Economics (but see Controversies-Criticisms in Wikipedia entry) X what to think ->How to think like an economist Inputs are the productive resources — labour, natural resources, capital equipment, and entrepreneurial ability — used to produce products and services. Economic models, which assume all other things not in the model are unchanged, are the mental equivalent of controlled experiments in a laboratory. A good economic model: o leaves out unnecessary information. o is difficult to test. o assumes that "other things are unchanged.” o is the mental equivalent of controlled experiments in a laboratory. Positive statements o about what is o can be evaluated as true or false by checking the facts. Normative statements o about what you believe should be; involve value judgments.
