ECON1002: Introduction to Economics II
Yulei Luo
SEF of HKU
January 16, 2012
Luo, Y. (SEF of HKU)
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Economics, Microeconomics and Macroeconomics
Economics: The study of the choices people (consumers, business
managers, and governments) make to attain their goals, given their
scarce resources.
Microeconomics: The study of how households and …rms make
choices, how they interact in markets, and how the government
attempts to in‡uence their choices.
Macroeconomics: The study of the economy as a whole, including
topics such as in‡ation, unemployment, economic growth, business
cycles, and the e¤ects of monetary and …scal policies.
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Economics: Foundations and Models
Scarcity: The situation in which unlimited wants exceed the limited
resources available to ful…ll those wants.
Economic model: Simpli…ed version of reality used to analyze
real-world economic situations.
Market: A group of buyers and sellers of a good or service and the
institution or arrangement by which they come together to trade.
Trade-o¤: The idea that because of scarcity, producing more of one
good or service means producing less of another good or service.
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Three important economic ideas
As we study how people make decisions and interact in markets, we will
use the following three ideas:
People are rational
It does not mean that everyone knows everything.
It means that consumers and …rms use all available information as they
make optimal decisions.
Note that not everyone behaves rationally all the time; most of the
choices that people make are rational.
People respond to economic incentives
Changes in bene…ts or costs
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(continued.)
Optimal decisions are made at the margin
Some decisions are just “all or nothing”: to be entrepreneur or worker;
to enter a graduate school or take a job.
Most decisions involve doing a little more or a little less.
Marginal: an extra or additional bene…t or cost of a decision
Marginal analysis: Analysis that involves comparing marginal bene…ts
(MB ) and marginal costs (MC ).
The optimal decision is to continue any activity up to the point where
the MB = MC . If MB > (<) MC , increases (decreases) inputs.
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The Economic Problem That Every Society Must Solve
Trade-o¤s force society to make choices, particularly when answering the
following three fundamental questions:
What goods and services will be produced?
The answer is determined by the choices made by consumers, …rms,
and the government.
They all face the problem of scarcity by trading o¤ one good for
another.
How will the goods and services be produced?
Firms choose how to produce the goods and services they sell. E.g.,
…rms face a trade-o¤ between using more workers or using more
machines.
Who will receive the goods and services produced?
In the U.S., IT depends largely on how income is distributed.
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Societies organize their economies in two main ways to answer the above
three questions:
Centrally planned economy: An economy in which the government
decides how economic resources will be allocated.
E.g., the pre Soviet Union (1917-1991), the government decided what
goods to produce, how to produce them, and who would receive them.
Government employees managed factories and stores; these managers
followed the orders from the government, not from the demands of
consumers in markets.
Market economy (ME): An economy in which the decisions of
households and …rms interacting in markets allocate economic
resources.
All high-income countries are ME. MEs rely primarily on privately
owned …rms to produce goods and services (G&S) and to decide how
to produce them.
Markets determine who receives the G&S produced.
Firms must produce G&S that meet the demands of consumers. That
is, consumers determine what G&S will be produced.
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(continued.)
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 signi…cant role in the allocation of resources.
The U.S. government has played an important role in a¤ecting the real
economy since the Great Depression of the 1930s.
Monetary and …scal policies are used to …ght recessions and high
in‡ation.
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Economic Models
To develop a model, economists generally follow these steps:
Decide on the assumptions to be used in developing the model.
Economic models make behavioral assumptions about the motives of
consumers and …rms.
Formulate a testable hypothesis.
An economic hypothesis is about a causal relationship. It is a statement
that may be either correct or incorrect about a economic variable.
Economic variable: Something measurable that can have di¤erent
values, such as the wages of workers.
Use economic data to test the hypothesis.
Before accepting a hypothesis, we must use data to test it.
Revise the model if it fails to explain well the economic data.
Retain the revised model to help answer similar economic questions in
the future.
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Economics as a Social Science
Because economics studies the actions of individuals, it is a social
science. Economics is therefore similar to other social science
disciplines, such as psychology, political science, and sociology.
As a social science, economics considers human behavior— particularly
decision-making behavior— in every context, not just in the context of
business.
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A Preview of Important Economic Terms
Goods: Goods are tangible merchandise, such as books, computers, or
MP4.
Services: Services are activities done for others, such as investment
advice or haircuts.
Entrepreneur: An entrepreneur is someone who runs a business. In a
market system entrepreneurs decide what goods and services to
produce and how to produce. In the U.S., about half of new
businesses close within four years. Economic progress would be
impossible in a market system without entreprenuers taking risks.
Firm, company, or business: A …rm is an organization that produces a
good or service for pro…t. Most …rms produces G&S to earn pro…ts,
but there are also non-pro…t …rms (e.g., some universities and
hospitals). Economists use these terms interchangeably.
Household: A household consists of all persons occupying a home.
HHs are suppliers of factors of production such as labor. HHs also
demand goods and services produced by …rms and governments.
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(continued.)
Technology: A …rm’s technology is the processes it uses to produces
goods and services.
Revenue: A …rm’s revenue is the total amount received for selling a
good or service: price per unit units sold.
Opportunity cost: it is the highest-valued alternative that must be
given up to engage in that activity. E.g., a professor gave up his
teaching job with a salary of $80, 000 and started a new business. In
this case, the OC of his entrepreneurial activity is $80, 000.
Pro…t: the di¤erence between its revenue and its costs.
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(continued.)
Factors of production or economic resources: Firms use factors of
production to produce goods and services. The main factors of
production are labor, capital, human capital, natural resources
including land, and entrepreneurial ability. Households earn income by
supplying the factors of production to …rms.
Capital: “capital” can refer to “…nancial capital” or to “physical
capital”.
Financial capital includes stocks and bonds issued by …rms, bank
accounts (savings or checking), and holdings of money.
In economics, capital refer to physical capital, which includes
manufactured goods that are used to produce other G&S. E.g.,
computers, factory buildings, machine tools, trucks, etc. The total
amount of physical capital available in a country is referred to as the
country’s capital stock.
Human capital: It refers to te accumulated training and skills that
workers possess. E.g., workers with higher deduction generally have
more skills and are more productive.
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