CHAPTER
1
Principles
of Economics
Prepared by: Jamal Husein
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What Is Economics?

Economics is the study of the choices
made by people who are faced with
scarcity.

Scarcity is a situation in which resources
are limited and can be used in different
ways.
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Society’s Choices

Having a limited amount of
resources means that we must
sacrifice one thing in order to obtain
another.

The decisions of producers,
consumers and government
determine how an economic system
answers three fundamental
questions:
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Society’s Choices
 What
goods and services do
we produce?

If we devote more resources to
the production of one good, we
have fewer resources for the
production of another.
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Society’s Choices
 How
do we produce these
goods and services?

How do we organize
production and what methods
and techniques should we use?
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Society’s Choices

For whom do we produce the
output?

How should we distribute the output
produced among members of society?
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Factors of Production
Factors of production, or
productive inputs, are the resources
we use to produce goods and
services:

Natural resources

Labor

Physical capital

Human capital

Entrepreneurship
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Factors of Production

Natural resources:

The things created by acts of
nature such as land, water,
mineral, oil and gas deposits;
renewable and nonrenewable
resources.
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Factors of Production

Labor:

The human effort, physical and
mental, used by workers in the
production of goods and services.
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Factors of Production

Physical capital.

All the machines, buildings,
equipment, roads and other
objects made by human beings to
produce goods and services.
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Factors of Production

Human capital:

The knowledge and skills
acquired by a worker through
education and experience.
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Factors of Production

Entrepreneurship:

The effort to coordinate the
production and sale of goods and
services. Entrepreneurs take risk
and commit time and money to a
business without any guarantee of
profit.
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The Production Possibilities Curve (PPC)

The PPC curve is a graphical
illustration of fundamental economic
problems related to our ability to
produce goods and services.

The PPC curve shows the possible
combinations of goods and services
available to an economy, when
resources are fully and efficiently
employed.
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The Production Possibilities Curve

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When the
economy is at
point i, resources
are not fully
employed and/or
they are not used
efficiently.
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The Production Possibilities Curve

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Point h is desirable
because it yields
more of both
goods, but not
attainable given
the amount and
quality of
resources
available.
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The Production Possibilities Curve

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Point e is one of
the possible
combinations of
goods produced
when resources are
fully and
efficiently
employed.
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Tons of factory goods per year
The Production Possibilities Curve

At point d in this
example, resources are
devoted to the
production of 400 tons
of factory goods and 50
tons of farm goods.

To increase the number
of farm goods by 1 ton,
10 tons of factory goods
will have to be
sacrificed.
d
400
e
300
50
60
Tons of farm goods per year
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Tons of factory goods per year
The Production Possibilities Curve

New
g
600
d
h
400

50
70
Tons of farm goods per year
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To increase the
production of one good
without decreasing the
production of the other,
the PPC curve must
shift outward.
From point d, an
additional 20 tons of
farm goods (h) or 200
more tons of factory
goods (g) per year.
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The Production Possibilities Curve
Tons of factory goods per year

700
650

b
c
e
400
f
120
10
Resources are not
perfectly adaptable.
20
60 70
Tons of farm goods per year
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The PPC curve has a
concave shape because
resources are not
perfectly adaptable in
production. As we
increase the production
of one good, we sacrifice
progressively more of the
other (compare the
movement from b to c
with the movement from
e to f ).
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The Economic Way of Thinking

How do Economists think about problems
& decision making?
The economic way of thinking is best
summarized by the thinking of Keynes:
“The theory of Economics does not furnish a
body of settled conclusions immediately
applicable to policy. It is a method rather than a
doctrine, an apparatus of the mind, a technique
of thinking which helps its possessor to draw
correct conclusions”
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Positive and Normative Economics

Positive Economics: Analysis that answers
the questions, what is or what will be.


How will an increase in the price of
internet access affect the number of
subscribers?
Normative Economics: Analysis that answers
the question, what ought to be?

Should the government increase the
minimum wage?
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Use Assumptions to Simplify


Economists use simplifying assumptions
to eliminate irrelevant details and focus
on what really matters. Assumptions are
an aid to the analytical process.
Simplifying assumptions do not have to
be realistic. We use maps, for example,
to get us from point A to point B
knowing that the map is not an accurate
description of the road ahead, but only
an abstraction of reality.
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Use Assumptions to Simplify

Most of the economic analysis (in this
book) is based on two assumptions
 Self
interest: the assumption that
people act in their own self interest,
without considering the impacts of
their actions on other people; and
 Informed decisions: the assumption
that people (consumers and producers
make informed decisions
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Explore the Relationship Between Two
Variables

The “ceteris paribus” assumption is
used to explore the relationship
between two variables.


A variable is a measure of something
that can take on different values.
“Ceteris paribus” is Latin for “other
things being equal.” To study the
relationship between two variables, we
assume that other variables do not change.
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The Marginal Principle
Marginal PRINCIPLE
Increase the level of an activity if its
marginal benefit exceeds its marginal cost,
but reduce the level if the marginal cost
exceeds the marginal benefit. If possible,
pick the level at which the marginal benefit
equals the marginal cost.
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Marginal Benefit and Marginal Cost
 Marginal
benefit: the extra
benefit resulting from a small
increase in some activity.
 Marginal cost: the additional
cost resulting from a small
increase in some activity.
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Using the Marginal Principle
Benefit to cost ($ per hour)

To illustrate the marginal principle, consider an
# 2 If pedaling is required and the discomfort of
experiment
where
a child must
pedal
pedaling is $0.85/hour,
the marginal
costaofstationary
TV time is
bicycle to turn
a TV
set, will
watch less
TV,is and
$1.2 (i.e.,
$.35+$.85),
and he
the marginal
principle
satisfied less?.
at point m, with only 3 hours of TV time per
if so, how much
week.
1.30
m
1.20
Marginal Cost
with Pedaling
0.35
# 1 If the opportunity
Cost of TV time is
$0.35 per hour and
pedaling is not
Marginal Cost
required For TV time,
without Pedaling the marginal principle
Marginal benefit is satisfied at point n,
and the child will
watch 20 hours/week.
n
1
3
20
Hours of TV time per week
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PRINCIPLE of Opportunity Cost
PRINCIPLE of Opportunity Cost
The opportunity cost of something is
what you sacrifice to get it.

What you sacrifice is the next best
choice. To determine opportunity cost
we consider only the best of the possible
alternatives.
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PRINCIPLE of Opportunity Cost

As long as resources are scarce, an
increase in the production of a good,
which necessarily results in a decrease in
the production of other goods, means
that the production of a good is subject
to increasing opportunity cost.

Prices are a measure of opportunity cost
because they provide information about
the value of one good relative to another.
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Microeconomics
Microeconomics
is the study of
the choices made by consumers,
firms, and government, and how
these decisions affect the market for
a particular good.
 Microeconomics
focuses on the
analysis of individual economic
units.
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Microeconomics
Microeconomic analysis can be used to:
 Understand
how markets work and
predict changes.
 Make
personal or managerial
decisions.
 Evaluate
the merits of public
policies.
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Macroeconomics
Macroeconomics is the study of the
nation’s economy as a whole.
Macroeconomic analysis can be used to:
 Understand
how a national economy
works.
 Understand
the grand debates over
economic policy.
 Make
informed business decisions.
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PRINCIPLE of Diminishing Returns
PRINCIPLE of Diminishing Returns
Suppose that output is produced with two
or more inputs and that we increase one
input while holding the other inputs fixed.
Beyond some point—called the point of
diminishing returns—output will increase
at a decreasing rate.
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Number of Piazza per hour
PRINCIPLE of Diminishing Returns
22
21
Total
Product
Curve
Total Product Curve: A
curve showing the
relationship between the
quantity of Labor and the
quantity of output
Marginal
Product
Curve
Marginal Product Curve:
A curve showing the
relationship between the
quantity of Labor and the
quantity of output
18
12
1
2
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Number
of workers
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Spillover PRINCIPLE
Spillover PRINCIPLE
For some goods, the costs or benefits
associated with the good are not confined to
the person or organization that decides how
much of the good to produce or consume.
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Spillover PRINCIPLE

A spillover occurs when the people
who are external to a decision are
affected by the decision.

Another word for spillover is
externality. Some goods generate
spillover benefits (positive
externalities), and others generate
spillover costs (negative
externalities).
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Spillover PRINCIPLE


Externalities are an economic
problem because the decisions of
consumers and producers tend to be
based on their own costs or benefits,
not the costs or benefits for society as
a whole.
The amount of certain goods
produced or consumed by free
markets may not be the socially
optimal amount.
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Spillover Benefits
 A positive
externality
occurs when the production
or consumption of a good
generates benefits that are
not confined to the producer
or the consumer.
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Spillover Benefits
Examples of spillover benefits:

A flood control dam that benefits some people
who have not paid for it

A contribution to public television benefits
some who watch it but have not contributed
themselves

A new scientific discovery that treats a
common disease

More educated people become better workers
and better citizens who benefit those around
them
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Spillover Costs

A negative externality occurs
when the production or consumption
of a good generates costs that are not
confined to the producer or the
consumer. For example:
• Air pollution
• Water pollution
• Noise pollution
• Ozone depletion
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Reality PRINCIPLE
Reality PRINCIPLE
What matters to people is the real value or
purchasing power of money or income, not
its face value.

Nominal value: the face value of a
sum of money.

Real value: the value of a sum of
money in terms of the quantity of goods
the money can buy.
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Reality PRINCIPLE

The reality principle applies to a
variety of important economic
measures including:
• Real wages versus nominal wages
• Real GDP versus nominal GDP
• Real interest rates versus nominal interest
rates
• Real money supply versus nominal money
supply
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Appendix: Using Graphs and Formulas

Suppose that a student receives a weekly
income which consists of a $40 weekly
allowance from her parents, and $8 per
hour of work from her job.

There is a linear relationship between
hours worked and the student’s weekly
income which can be described by the
formula:
W = $40 + ($8 × hours worked)
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Appendix: Using Graphs and Formulas

The expression W = $20 + ($4 × hours worked)
can be illustrated as follows:
Hours
worked
Per week
Weekly
Income
0
40
10
120
22
216
30
280
Weekly Income ($)
There is a positive relationship
between the amount of work
time and real income.
d
280
c
216
120
b
40
10
22
30
Hours worked per week
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Negative Relationship
Consider a consumer with a monthly budget of $300
who buys CDs at a price of $20 per CD and tapes at a
price of $5 a tape.
There is a negative relationship between
Number of Number of
CDs
tapes
Purchased Purchased
0
30
5
20
10
10
15
0
Number of tapes
purchased per month

the number of CDs purchased and the
number of cassette tapes purchased
30
e
20
f
10
5
10
15
Number of CDs purchased per month
-10
vertical ddifference
= -2
=
slope =
5
horizontal difference
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Shifting the Curve

Weekly Income ($)

If the student’s allowance or hourly wage change, the
line’s intercept and slope will change, respectively.
For example, an increase in her weekly allowance to $35 per
week will shift the line upward by $15 for each previous
number of hours worked.
y
246
216
150
120
70
40
c
z
b
10
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Hours
worked per
week
46
Nonlinear Relationship

There is a positive,
nonlinear relationship
between study time
and grade on the
exam.



The second hour of study
increases the grade by four
points (from 6 to 10).
But the ninth hour of study
increases the grade by only
one point (from 24 to 25).
There are diminishing returns in study time. As
study time increases, the exam grade increases at
a decreasing rate.
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