ECON 202: Principles of Microeconomics. Chapter 1 Economics: Foundations and Models

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1 ECON 202: Principles of Microeconomics Chapter 1 Economics: Foundations and Models

2 Economics: Foundations and Models 1. Introduction. 2. Three key economic ideas. 3. The economic problem that every society must solve. 4. Economic Models. 5. Microeconomics and Macroeconomics. Economics: Foundations and Models 2

3 1. Introduction What is economics? What type of questions economists study? What is the effect of gasoline taxes on gasoline consumption, miles travelled and pollution? Should urban transit subsidies be reduced? How are the prices of paintings sold at art auctions determined? How many hours more will people work if salaries increase? What happens when US high-technology firms move to China? Economics: Foundations and Models 3

4 1. Introduction All they involve people making choices as they try to attain their goals. Choices imply sacrifice something, because resources are (almost) always scarce. Scarcity: when unlimited wants exceed the limited resources available to fulfill those wants. Are there resources that are not scarce? Economics is the study of these decisions. The study of the choices people make to attain their goals, given their scarce resources. Economics: Foundations and Models 4

5 2. Three Key Economic Ideas People are rational Consumers and firms take their best decision, given the available information. Do not imply that consumers and firms know everything. Rational individuals weigh the benefits and costs of each action and choose when benefits exceeds cost. Example: Where to invest $1M? Economics: Foundations and Models 5

6 2. Three Key Economic Ideas People respond to economic incentives Consumer and firms consistently respond to economic incentives. Example: Effect of dying untaxed diesel fuel. Diesel fuel used for on-road purposes is taxed. Other uses are untaxed. Economics: Foundations and Models 6

7 Economics: Foundations and Models 7

8 2. Three Key Economic Ideas Optimal decisions are made at the margin Most decisions involve doing a little more or a little less. Marginal means an extra or additional benefit or cost of a decision. Marginal benefit (MB) Marginal cost (MC) Economists reason that the optimal decision is to continue any activity up to the point where MB = MC. Examples: watch more TV? Economics: Foundations and Models 8

9 3. The Economic Problem That Every Society Must Solve Every society has only a limited amount of resources. Workers Machines Raw Materials Yet, every society must decide: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? Economics: Foundations and Models 9

10 3. The Economic Problem That Every Society Must Solve Centrally planned economies Soviet Union. ( ) Government decides what to produce, how to produce them and who would receive them. Not successful in producing low-cost, high-quality goods and services. Economics: Foundations and Models 10

11 3. The Economic Problem That Every Society Must Solve Market economies US, Canada, Western Europe, Japan. Privately owned firms decide what to produce and how to produce it. Consumers decide to buy according to their wants. Exchanges are produced in the market. A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Does not imply a physical location. Economics: Foundations and Models 11

12 3. The Economic Problem That Every Society Must Solve Ultimately, consumers decide what goods and services will be produced. Firms produce according to consumer wants Who receive the goods and services produced? The most willing and able to buy them. How is income of an individual determined? By the payments of what he has to sell. (work) But, can we really talk about pure market economies? Mixed economies. Economics: Foundations and Models 12

13 3. The Economic Problem That Every Society Must Solve Markets tend to be more efficient that centrally planned economies. Productive efficiency: goods or services produced at the lowest cost. Achieved through firms competition in the market. Allocative efficiency: production is in accordance with consumer preferences. Achieved when combination of competition and voluntary exchange results in firms producing the mix of goods and services that consumers prefer the most. Economics: Foundations and Models 13

14 3. The Economic Problem That Every Society Must Solve Markets do not guarantee efficiency. Process in time. Interventions. (quotas, pollution control) Efficiency implies fairness? Equity: fair distribution of economic benefits. Government can intervene to promote equity. (income and saving taxes) Interventions can decrease efficiency. (trade-off) Market not always work well Public goods, externalities. Asymmetric information. Few producers, few consumers. Economics: Foundations and Models 14

15 4. Economic Models A simplification of the real world with explanatory power. It captures the most important aspects considered to make a decision, in order to explain it. Example: How many hours more will people work if salaries increase? People are happy with more spare time and more money People have a fixed amount of time per week People make money working Hypothesis: Direct relation between salary and hours worked Economics: Foundations and Models 15

16 4. Economic Models How to develop a model? Decide on the assumptions to be used in developing the model. Formulate a testable hypothesis. Use economic data to test the hypothesis. 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. Economics: Foundations and Models 16

17 4. Economic Models Assumptions are acceptable when real- world data supports predictions of the model Hypothesis is a statement that may be either correct or incorrect An economic hypothesis is usually about a causal relationship. Correlation does not imply causation Process of developing models, testing hypothesis and revising models is known as scientific method. Economics is a social science. Economics: Foundations and Models 17

18 4. Economic Models Positive and Normative analysis Positive analysis What is? Normative analysis What ought to be? Example: Federal Minimum Wage PA: Impact on employment, profits, income of workers NA: Is it a good idea? Economics: Foundations and Models 18

19 5. Micro and Macroeconomics Microeconomics is the study of How households and firms make choices How they interact in the market How the government attempts to influence their choices Macroeconomics is the study of the economy as a whole Inflation, unemployment, economic growth (aggregate variables) Many economic questions have a micro and a macro aspect. Firms investment and economic growth Economics: Foundations and Models 19

20 Slope of a curve Slope is how much we have to move vertically to be back over the curve after a one unit horizontal increment Slope can be positive or negative (or zero) For straight lines, the slope is the same along all the line For non-linear curves, the slope changes depending on where we are. To measure slope we use a straight line Economics: Foundations and Models 20

21 Slopes of Nonlinear Curves Economics: Foundations and Models 21

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