Chapter 1
Economics and Life
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
What will you learn in this chapter? •  How to explain the concepts of:
–  Scarcity.
–  Opportunity cost and marginal decision making.
–  IncenBves.
–  Efficiency.
•  How to disBnguish between:
–  CorrelaBon and causaBon.
–  PosiBve and normaBve analysis.
•  What the characterisBcs of good economic modeling are.
1-2
What is economics? •  Economics is the study of how people manage resources.
•  Decisions made by individuals and also by groups.
•  Resources are both physical objects and intangibles such as Bme.
•  Economics is divided into two broad fields:
–  Microeconomics: Study of individuals and firms.
–  Macroeconomics: Study of the economy on a regional, naBonal, or internaBonal scale.
1-3
Choices and ra6onal behavior •  Economists assume that people
–  Compare all available choices.
–  Purposefully behave in the way that will best achieve their goals, called ra.onal behavior.
•  Peoples’ decisions can be studied using four main quesBons:
1. What are their wants and constraints?
2. What are their trade-­‐offs?
3. How will others respond?
4. Why isn’t everyone doing it?
1-4
Scarcity •  People make decisions aimed at geUng the things they want.
•  People want a lot of things, but they are constrained by limited resources.
•  Scarcity is the condiBon of peoples’ wants being greater than available resources.
–  Individuals’ resources: Bme and money.
–  SocieBes’ resources: factors of producBon, such as labor and technology.
1-5
Opportunity cost •  Every decision in life involves weighing the trade-­‐off between costs and benefits.
–  RaBonal behavior dictates that when people choose between two things, the one with the greatest net benefit (benefits minus costs) is chosen.
•  The benefits are oYen easily calculated.
•  The costs include both the direct cost and opportunity cost.
–  The direct cost includes all associated costs.
–  The opportunity cost includes the value of the next best alternaBve.
–  Opportunity cost is based on people’s valuaBon of the best alternaBve.
1-6
Ac6ve Learning: Opportunity cost Suppose that you are studying for your economics final and you are confronted with the choice to go to the movies with your friends.
•  What is the opportunity cost of going to the movies?
–  How does this change if you are borderline failing?
•  What is the opportunity cost of studying economics?
–  How does this change depending on the movie?
•  What is the rule of thumb in deciding which acBvity to chose?
1-7
Ac6ve Learning: Opportunity cost •  What is the opportunity cost of going to the movies?
–  The opportunity cost of going to the movies is the value placed on studying. This could be valued at the change in grade from study or forgone future earnings.
•  How does this change if you are borderline failing?
–  The costs of possibly retaking the class are now considered.
1-8
Ac6ve Learning: Opportunity cost •  What is the opportunity cost of studying economics?
–  The opportunity cost of studying economics is the value of going to see the movie. It could be valued at the Bcket price.
•  How does this change depending on the movie?
–  If the individual has a big desire to see the movie, this will increase the opportunity cost.
•  What is the rule of thumb in deciding which acBvity to choose?
–  Choose the acBvity with the lowest opportunity cost.
1-9
Opportunity cost •  RaBonal behavior suggests that people compare the addiBonal benefits of a choice against the addiBonal costs.
–  Referred to as marginal decision making.
–  No consideraBon of past benefits or costs, both referred to as sunk.
•  Opportunity cost helps understand adages such as “the mechanic’s car is the worst one on the block.”
1-10
Incen6ves •  RaBonal behavior suggests that people respond to incen.ves.
•  An incenBve is something that causes a change in the tradeoffs that people face.
–  PosiBve incenBve: Makes people more likely to do something by lowering their opportunity cost.
–  NegaBve incenBve (disincenBve): Makes people less likely to do something by raising their opportunity cost.
•  When an incenBve is provided on a large scale, the consequences can be extremely large.
1-11
Ac6ve Learning: Incen6ves •  Suppose your higher educaBon insBtuBon permits your final exam score to replace a midterm exam score in a course.
–  How does this affect your opportunity cost of going to the movies?
1-12
Ac6ve Learning: Incen6ves •  Suppose your higher educaBon insBtuBon permits your final exam score to replace a midterm exam score in a course.
–  How does this affect your opportunity cost of going to the movies?
The opportunity cost of going to the movies increases. The insBtuBon has given students a disincenBve to engage in non-­‐school related acBviBes.
1-13
Efficiency •  RaBonal behavior suggests that people seek opportuniBes to get what they want.
–  Given this behavior, individuals and firms will act to provide the things people want.
•  If a profit-­‐making opportunity exists, someone will provide the good or service.
•  This leads to efficiency: resources are used to produce goods and services with the greatest economic value.
1-14
Efficiency SomeBmes economies do not operate efficiently.
•  InnovaBon: Yet to be discovered innovaBons/ideas increase efficiency.
•  Market failure: People and firms may be prevented from capturing the benefits of the opportunity or incur addiBonal costs.
•  IntervenBon: IntervenBons in the economy cause transacBons to not take place.
–  Most oYen government policies.
•  Goals other than profit: Individuals and governments have goals other than profit.
1-15
Problem-­‐solving toolbox •  Accurately spoUng the fundamental economic concepts at work in the world is someBmes difficult.
•  Economic analysis requires:
–  Theory to be combined with observaBons.
–  ScruBny of both theory and observaBons before drawing conclusions.
•  These analyses disBnguish between:
–  Posi.ve analysis: The way things are.
–  Norma.ve analysis: The way things should be.
1-16
Ac6ve Learning: Posi6ve and norma6ve statements For each of the following, categorize as either a posiBve or normaBve statement.
–  GDP fell by 0.5% during last quarter.
–  Given an inflaBon rate of 2%, no one should be concerned with higher costs of living.
–  The DOW rose above 15,000 on May 3, 2013.
1-17
Ac6ve Learning: Posi6ve and norma6ve statements For each of the following, categorize as either a posiBve or normaBve statement.
–  GDP fell by .5% during last quarter.
•  PosiBve statement.
–  Given an inflaBon rate of 2%, no one should be concerned with higher costs of living.
•  NormaBve statement.
–  The DOW rose above 15,000 on May 3, 2013.
•  PosiBve statement.
1-18
Correla6on and causa6on •  When two events occur together, there is a tendency to assume that one causes the other.
•  Economists differenBate between two relaBonships.
–  Correla.on: A consistently-­‐observed relaBonship between two events.
•  PosiBve correlaBon: Increase in A and B.
•  NegaBve correlaBon: Increase in A and a decrease in B.
–  Causa.on: A relaBonship between two events in which one brings about the other.
•  A causes B.
1-19
Correla6on and causa6on There are three reasons why an assumed causal relaBonship may be false:
•  CorrelaBon without causaBon: Two events may be extremely correlated, making it appear that a causal relaBonship exists.
•  Omiied variables: Two events may be extremely correlated due to a third event causing the two.
•  Reverse causaBon: SomeBmes it is unclear whether Event A causes Event B or if Event B causes Event A.
1-20
Ac6ve Learning: Correla6on and causa6on For each of the following statements, classify whether it is false due to correla.on without causa.on, an omiBed variable, or reverse causa.on.
•  EducaBon and future earnings is posiBvely correlated.
•  Shoe size and reading comprehension scores are posiBvely correlated.
•  Baby booms are caused by higher quality minivans.
1-21
Ac6ve Learning: Correla6on and causa6on For each of the following statements, classify whether it is false due to correla.on without causa.on, an omiBed variable, or reverse causa.on.
•  EducaBon and future earnings is posiBvely correlated.
–  Omiied variable bias: ability.
•  Shoe size and reading comprehension scores are posiBvely correlated.
–  CorrelaBon without causaBon.
•  Baby booms are caused by higher-­‐quality minivans.
–  Reverse causaBon.
1-22
Models Economic models show how people, firms, and governments make decisions about managing resources, and how their decisions interact.
•  Models are a simplificaBon of complex problems.
•  Models include:
–  Groups of individuals and their choices.
–  Markets to study.
•  What makes a model useful?
–  Makes clear assumpBons.
–  Describes the real world accurately.
–  Predicts cause and effect.
1-23
The circular flow diagram The circular flow model represents a basic economy. Land, labor,
and capital
Income
Spending
Market for the
factors of production
Purchased
land, labor
and capital
Goods and
services
bought
Households
Market for goods
and services
Wages, rent,
and profit
Revenue
Goods and
services to
be sold
Firms
Flow of dollars Flows of goods
and services
1-24
Summary •  Four concepts of economics are discussed
–  Scarcity: Constraints on obtaining everything wanted.
–  Opportunity cost: Given scarcity, people face trade-­‐offs.
–  IncenBves: Economic agents can alter people’s trade-­‐offs by providing incenBves/disincenBves.
–  Efficiency: Markets typically provide the highest value of goods/services.
•  The differences between correlaBon and causaBon are analyzed.
•  Economists uBlize models to understand decision making.
1-25