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Some definitions of economics

• “Economics is a study of mankind in the ordinary business of life” •Alfred Marshall

• "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

• do” “Economics is what economists • Jacob Viner

Economics (1) • Study of the choices people make to attain their goals given their scarce resources.

Economics: Foundations and Models

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

What makes a good theory or a model?

• Models are not judged by their realism but by their usefulness • What is the most useless map in the world?

To be useful a model has to be refutable

Why study theory?

• “I don’t know how it is in theory but here is what I know from my 20 years of experience will happen “ • Laura, Executive MBA student • Theory saves time!

Making the Connection

Learning Objective 1.3

When Economists Disagree: A Debate over Outsourcing

Does outsourcing by U.S. firms raise or lower incomes in the United States?

Economics (2) • Study of the choices people make to attain their goals given their scarce resources.

Economics Scarcity When the price is zero there is not enough for everyone Choices People behave as if they are comparing the costs and benefits Unlimite d wants Limited availabilit y Benefits Costs

Economics Scarcity Everything has alternative uses Tradeoffs Opportunity cost

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

as if

• Does a pool player need to know the laws of trigonometry and physics to win?

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as if

• “…getting out of bed in the morning and making breakfast involves more complex decisions than the average game of chess. (Will that fries egg kill me in twenty-eight years?)” • Charles Wheelan

Economics (3) • Study of the choices people make to attain their goals given their scarce resources.

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?

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.

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.

Economic Models

• 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

2 C H A P T E R

The Market System and the Circular Flow

SCARCE RESOURCES

ECONOMIC RESOURCES

PROPERTY RESOURCES

1. LAND 2. CAPITAL

HUMAN RESOURCES

3. LABOR 4. ENTREPRENEURIAL ABILITY

Resource payments: correspond to resource categories

PROPERTY RESOURCES

LAND

RENTAL INCOME

CAPITAL

HUMAN RESOURCES INTEREST INCOME

LABOR ENTREPRENEUR

WAGES PROFIT & LOSS

Macroeconomics Starts Here

Economic Systems

• Definition: A particular set of institutional arrangements and a coordinating mechanism to respond to the economizing problem.

• Economic systems differ as to: 1) who owns the factors of production 2) the method used to motivate, coordinate, and direct economic activity.

The Command System

• The government owns most property resources and economic decision making occur through a central economic plan.

• The central planning board determines production goals for each firm and resources to be allocated.

The Market System

• There is private ownership of resources.

• Markets and prices coordinate and direct economic activity.

• Each participant acts in its own self-interest.

• In pure capitalism the government plays a very limited role.

Characteristics of the Market System

• Private Property.

• Freedom of firms to choose.

• Self interest.

• Competition.

• Markets and prices.

• Technology and capital goods.

• Specialization.

• Use of money.

• Active, but limited government.

The Circular Flow Model

There are two groups of decision makers in the private economy: households (resource owners) and businesses (resource users)

The market system (resource markets and product markets) coordinates these decisions.

What happens in the resource markets? a. Households sell resources directly or indirectly (through ownership of corporations) to businesses.

b. Businesses buy resources in order to produce goods and services.

c. Interaction of these sellers and buyers determines the price of each resource , which in turn provides

income

for the owner of that resource.

d. Flow of payments from businesses for the resources constitutes business owners’ incomes .

costs

and resource

What happens in the product markets?

a. Households are on the buying side of these markets, purchasing goods and services.

b. Businesses are on the selling side of these markets, offering products for sale.

c. Interaction of these buyers and sellers determines the price of each product.

d. Flow of consumer expenditures constitutes sales receipts for businesses.

CIRCULAR FLOW MODEL

RESOURCE MARKET BUSINESSES HOUSEHOLDS PRODUCT MARKET

CIRCULAR FLOW MODEL

RESOURCES RESOURCE MARKET INPUTS BUSINESSES HOUSEHOLDS PRODUCT MARKET

CIRCULAR FLOW MODEL

$ INCOMES $ COSTS RESOURCES RESOURCE MARKET INPUTS BUSINESSES GOODS & SERVICES PRODUCT MARKET GOODS & SERVICES HOUSEHOLDS

CIRCULAR FLOW MODEL

$ INCOMES $ COSTS RESOURCES RESOURCE MARKET INPUTS BUSINESSES GOODS & SERVICES PRODUCT MARKET GOODS & SERVICES HOUSEHOLDS

CIRCULAR FLOW MODEL

$ INCOMES $ COSTS RESOURCES RESOURCE MARKET INPUTS BUSINESSES HOUSEHOLDS GOODS & SERVICES $ REVENUE PRODUCT MARKET GOODS & SERVICES $ CONSUMPTION

CIRCULAR FLOW MODEL

$ INCOMES $ COSTS RESOURCES RESOURCE MARKET INPUTS BUSINESSES HOUSEHOLDS GOODS & SERVICES $ REVENUE PRODUCT MARKET GOODS & SERVICES $ CONSUMPTION

More Realistic Circular Flow

Macroeconomic Policies

Limitations of the model:

1. Does not depict transactions between households and between businesses (inter businesses).

2. Ignores government and the “rest of the world” in the decision-making process (we will take care of them later on).

3. Does not explain how prices of products and resources are actually determined.

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