Chapter 1. Introductory economics
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1st. Session
Scarcity = escasez
Resources = recursos
Tradeoff = disyuntiva
Goal = objetivo
Trade = intercambio comercio
Household = economía doméstica
Welfare = bienestar
Allocate = asignar
Income = renta
Short run = corto plazo
Feasible = realizable
Ceteris paribus = todo lo demás constante
Chapter 1. Introductory economics
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Lesson 1. Basic Ideas
Economics is the study of how society manages
its scarce resources.
Economists study:
 Principles concerning the way people make
decisions.
 Principles concerning the interaction
between agents.
 Principles related to the workings of the
whole economy.
 Principles concerning the way
people make decisions
1. People face trade offs
A trade off is an alternative between different
courses of action. A trade off exists because
there is scarcity. If resources are scarce and I
have two objectives, then the more I have of
one, the less I will have of the other.
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2. The true cost of something is what you
give up to get it
Because people face trade offs, making
decisions requires the comparison of costs and
benefits of alternative courses of action.
Example: Costs and benefits of going to
university.
Opportunity cost of doing something: the cost of
what you have to give up to get or to do
something.
3. Correct economic decisions are arrived
at by using marginal thinking
We think at the margin when we put ourselves
at the border, at the margin of our present
situation, and think of the consequences (costs
and benefits) of going beyond this border, of
doing something additional to this present
situation.
4. People respond to incentives
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People make decisions comparing benefits and
costs. If these benefits or these costs change,
the decisions also change.
In other words: people respond to relative
prices. If something becomes more expensive, I
buy less of it; if something becomes cheaper, I
buy more of it.
 Principles concerning the
interaction between agents
5. Trade can make everyone better off.
6. Markets are usually a good way to
organize economic activity
*Market economy: an economy that allocate
resources through the decentralized
decisions of many firms and households as
they interact in markets for goods and
services.
*Planners decide everything: what goods,
how much, who, etc.
*Firms and households interact in the market,
where prices and self-interest guide their
decisions. They promote overall economic
Chapter 1. Introductory economics
well-being (A. smith 1776 “An Inquiry into the
nature and causes of the wealth of nations”)
guided by an invisible hand that leads them.
How this invisible hand works its magic?
Answer in the course.
*Prices are the instrument with which the
invisible hand directs economic activity.
*Prices reflect both the value of a good to
society and the cost to society of making the
good.
*Prices guide these individual decision
makers to reach outcomes that, in many
cases, maximize the welfare of society as a
whole.
Corollary from the invisible hand: when the
Gov. prevent prices from adjusting naturally to
supply and demand it impedes the invisible
hand’s ability to coordinate.
• That explains why taxes adversely affect
the allocation of resources.
• Taxes distort prices and thus the
decisions of households and firms.
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• Also the harm caused by policies that
directly control prices.
7. Governments can sometimes improve
market outcomes
*Markets work only if property rights are
enforced.
*Although markets are a good way to organize
economic activity, there are some important
exceptions: two reasons
1. To promote efficiency, to promote equity:
size of the pie, to enlarge it, to change it.
2. Market failure: the market fails to allocate
de resources efficiently.
Externality: is one cause of market
failure e.g. pollution.
Externality is the impact of one person’s
actions on the wellbeing of a bystander.
Market power: the ability of a single
economic actor to have a substantial
influence on market prices. E.g. only
one well.
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Another failure: to ensure that
economic activity is distributed
equitably. E.g. chess and basket.
 Principles related to the workings
of the whole economy
8. A country’s standard of living depends
on its ability to produce goods and
services.
9. Prices rise when the government prints
too much money.
10. Society faces a short-run trade off
between inflation and unemployment.
1.4 Micro and macroeconomics: positive
and normative economics
Economics is studied at various levels: that is,
the field of economics is divided into two broad
fields:
1. Microeconomics; Is the study of how
individuals make decisions and how they
interact in specific markets.
2. Macroeconomics; Is the study of economy
wide phenomena.
Chapter 1. Introductory economics
Micro and macroeconomics are closely related,
it is impossible to understand macroeconomic
developments without considering the
associated microeconomics decisions.
Example: analyse the effect of an income cut
tax on the overall production of goods and
services, but the first question is, how the tax
cut affect the decisions of household? In fact,
the two fields are distinct.
The economist as policy adviser
We are often asked to explain the causes of
economic events.
When economists are trying to explain the
world, they are scientists.
When they are trying to help improve it, they
are policy makers
Positive vs. normative analysis
Scientists and policy makers have different
goals.
Positive statements are descriptive, how the
words is, how it works.
Normative statements are prescriptive, how the
world ought to be, according to my personal
point of view.
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Why economists disagree?
Policies cannot be judged on scientific grounds
alone. Economists give conflicting advice,
sometimes because they have different values,
additionally political thinking lead to different
consideration of the problems.
1.5 Economic methodology: models and
empirical applications
Economy is a science because it applies the
scientific method, that means: development and
testing of theories about how the world works.
The scientific method: observation, theory
and more observation.
1. Observation from reality
2. testing with data
3. If results agree with theory, the economist
will be more confident with the theory.
Chapter 1. Introductory economics
Experiments are difficult in economics, so pay
close attention to the natural experiments
offered by history.
The role of assumptions
Assumptions simplify the complex world and
make it easier to understand. E.g. two
countries, two goods.
The issue: which assumptions to make?
With short-run policies we may assume that
prices do not change.
Economic models, we do use models, all
models are built with assumptions.
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 Two examples of models
1. The circular flow diagram
Assumptions:
a) The economy has two types of agents:
households and firms.
Households consume goods and own factors of
production that they hire to firms.
Firms produce goods and use (hire) factors of
production (labour, land machines, etc.)
b) Households and firms interact in two types
of markets:
- market for goods and services (in this
market households buy and firms sell).
- market for factors of production (in this
market households sell and firms buy).
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Spending
Revenue
Market
for´Goods
and Services
Goods and
services bought
Goods and
services sold
Firms
Households
Labour,
land,
capital sold
Factors for
production
bought
Market for
factors of
production
Wages, profits and rents
Income
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2. The production possibilities
frontier (PPF)
Assumptions:
a) The economy produces only two goods: cars
and houses.
b) All factors of production are employed in the
production of these two goods.
c) Technological data:
CARS
3500
3250
2750
2000
1000
0
HOUSES
0
100
200
300
350
375
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Cars / year
4.000
A
3.000
F
2.000
D
C
E
1.000
B
100
200
300
400 Houses / year
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Characteristics of the PPF
-If all resources are used, we are at the frontier.
For example, point C (2000 cars; 300 houses).
-If some of the resources are not used, we are
inside the frontier. For example, point D
(2000;200).
-Point C is called an efficient point. At C the
economy can only produce more of one good
by producing less of another. This is the
definition of efficiency.
-Point D is an inefficient point.
-The slope of the PPF shows the opportunity
cost of producing these two goods.
 cars
1000
CE

 20
 houses
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At C, each additional house costs 20 cars. The
opportunity costs o a house is 20 cars.
-The opportunity cost is not constant along the
PPF. For example, at F (going from F to C), the
opportunity cost of a house is 7.5 cars. Why?
-More resources, or better technology, will shift
the PPF outwards.
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 Opportunity cost depends on one’s
particular situation.
 Growing
opportunity
cost
for
concavity. The slope is bigger when
going downwards and to the right.
 Absolute value of the slope is the
opportunity cost of producing one
more unit.
 Resources are scarce and more
adequate for producing some certain
goods than others, so, the more of
one thing is being produced, the
highest will be the opportunity cost of
producing one more unit.
 Any production has an opportunity
cost, to produce more of one good,
society must pass resources from the
production of others goods.