Principles of Economics

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Economists think that markets will always lead to efficiency. What happens when market does not lead to efficiency? How could this concept of market efficiency be applied to the market of “COVID-19 immunity”? 

Provide an example of a real-life situation in which the budget, the price, and the preference (or utility) have played a role. This example should be related to a choice that you recently made.

PRINCIPLES OF

ECONOMICS 2e

Chapter 2 Choice in a World of Scarcity

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COLLEGE PHYSICS

Chapter # Chapter Title

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CH.2 OUTLINE

2.1: How Individuals Make Choices Based on

Their Budget Constraint

2.2: The Production Possibilities Frontier and

Social Choices

2.3: Confronting Objections to the Economic

Approach

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Choices and Tradeoffs

In general, the higher the degree, the higher the salary. So why aren’t more people pursuing higher degrees? The short answer: choices and tradeoffs.

(Credit: modification of work by “Jim, the Photographer”/Flickr Creative Commons)

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2.1 How Individuals Make Choices Based

on Their Budget Constraint

Budget constraint – all possible consumption combinations of goods that someone can afford, given the prices of goods, when all income is spent; the boundary of the opportunity set.

Opportunity set – all possible combinations of consumption that someone can afford given the prices of goods and the individual’s income (all income does not need to be spent).

Given the price of the two goods and a budget amount, a budget constraint can be illustrated graphically.

With a limited amount of income to spend on things, consumers must choose what they need and want.

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The Budget Constraint: Alphonso’s Consumption Choice

Each point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to Alphonso’s budget of $10.

The slope of the budget constraint is determined by the relative price of burgers and bus tickets.

Giving up one burger means gaining four bus tickets.

The opportunity set – every point on (or inside) the constraint which shows a combination of burgers and bus tickets that Alphonso can afford.

Any point outside the constraint is not affordable, because it would cost more money than Alphonso has in his budget.

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The Concept of Opportunity Cost

Opportunity cost indicates what one must give up to obtain what he or she desires.

The cost of one item is the lost opportunity to do or consume something else.

The opportunity cost is the value of the next best alternative.

A fundamental principle of economics is that every choice has an opportunity cost.

For Alphonso, the opportunity cost of a burger is the four bus tickets he would have to give up.

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Identifying Opportunity Cost

In many cases, it is reasonable to refer to the opportunity cost as the price.

Example: If your cousin buys a new bicycle for $300, then $300 measures the amount of “other consumption” that he has forsaken.

Sometimes the price as measured in dollars may not accurately capture the true opportunity cost, such as when costs of time are involved.

Example: Attending college

The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses.

Additionally, during the hours you are attending class and studying, it is impossible to work at a paying job.

So, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.

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Opportunity Cost Examples

Discussion Question: What are the opportunity costs of…

Buying vs. leasing a car

Investing in different ways (i.e. savings accounts, certificates of deposit, mutual funds, stocks, etc.)

Going out to eat vs. preparing food at home

Walking or taking public transportation

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Marginal Decision-Making and Diminishing Marginal Utility

Marginal analysis – examining the benefits and costs of choosing a little more or a little less of a good.

Utility – satisfaction, usefulness, or value one obtains from consuming goods and services.

Law of diminishing marginal utility – as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines.

Example – the first slice of pizza eaten brings more satisfaction than the sixth.

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Sunk Costs

Sunk costs – costs that were incurred in the past and cannot be recovered.

For people and firms alike, dealing with sunk costs can be frustrating.

Example – A firm finds it hard to give up on a new product that is doing poorly because much money was spent in creating and launching the product.

The lesson of sunk costs is to ignore the past errors and make decisions based on what will happen in the future.

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2.2 The Production Possibilities Frontier

and Social Choices

Production possibilities frontier (PPF) – a diagram that shows the productively efficient combinations of two products that an economy can produce given the resources it has available.

The slope of the production possibilities frontier shows the opportunity cost.

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Healthcare vs. Education Production Possibilities Frontier

This production possibilities frontier shows a tradeoff between devoting social resources to healthcare and devoting them to education.

At A all resources go to healthcare and at B, most go to healthcare.

At D most resources go to education, and at F, all go to education.

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Healthcare vs. Education Production Possibilities Frontier

A society could choose to produce any combination of healthcare and education on the production possibilities frontier.

It does not have enough resources to produce outside the PPF.

Because the PPF is downward sloping from left to right, the only way society can obtain more education is by giving up some healthcare.

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The Shape of the PPF and the Law of Diminishing Returns

Law of diminishing returns – as additional increments of resources to producing a good or service are added, the marginal benefit from those additional increments will decline.

The law of diminishing marginal utility is a more specific case of the law of diminishing returns.

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Healthcare vs. Education Production Possibilities Frontier, Continued

The curvature of the PPF shows that as we add more resources to education, moving from left to right along the horizontal axis, the original gains are fairly large, but gradually diminish.

By contrast, as we add more resources to healthcare, moving from bottom to top on the vertical axis, the original gains are fairly large, but again gradually diminish.

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Differences – Budget Constraint and PPF

Two major differences between a budget constraint and a PPF:

1) The budget constraint is a straight line.

Slope is given by the relative prices of the two goods, which are fixed, so slope doesn’t change.

PPF has a curved shape because of the law of diminishing returns, so slope is different at various points on the PPF.

2) The absence of specific numbers on the axes of the PPF.

The exact amount of resources an imaginary economy has is not known.

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Similarities – Budget Constraint and PPF

Both the budget constraint and the social production possibilities frontier (PPF) show the constraints under which individual consumers and society as a whole operate.

Both diagrams show the tradeoff in choosing more of one good at the cost of less of the other.

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Productive Efficiency and Allocative

Efficiency

Productive efficiency -when it is impossible to produce more of one good (or service) without decreasing the quantity produced of another good (or service)

Any choice inside the PPF is productively inefficient because it is possible to produce more of one good, the other good, or some combination of both goods.

Allocative efficiency – when the mix of goods produced represents the mix that society most desires

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Healthcare vs. Education Production Possibilities Frontier, Continued

Productive efficiency –

All choices along a given PPF like B, C, and D display productive efficiency.

R does not, because it is inside the PPF curve, and thus not all resources are being used.

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The PPF and Comparative Advantage

How much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country.

Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology, or skills.

Comparative advantage – when a country can produce a good at a lower opportunity cost than another country.

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The PPF and Comparative Advantage

The U.S. PPF is flatter than the Brazil PPF implying that the opportunity cost of wheat in terms of sugar cane is lower in the U.S. than in Brazil.

Conversely, the opportunity cost of sugar cane is lower in Brazil.

The U.S. has comparative advantage in wheat and Brazil has comparative advantage in sugar cane.

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2.3 Confronting Objections to the

Economic Approach

Objections in understanding the economic approach to decision-making:

1) People, firms, and society do not act in a way that fits the economic way of thinking.

However, it is reasonable, as a first approximation, to analyze them with the tools of economic analysis.

Will be addressed in a later chapter on consumer choices.

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Confronting Objections to the Economic Approach

Objections in understanding the economic approach to decision-making:

2) People, firms, and society should not act this way.

The economics approach:

Portrays people as self-interested, but economics is not a form of moral instruction.

Seeks to describe economic behavior as it actually exists.

Uses, positive statements, which describe the world as it is. These are factual.

Tries to avoid normative statements, which describe how the world should be. These statements are subjective questions of opinion.

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Confronting Objections to the Economic Approach

Invisible hand – concept that individuals’ self-interested behavior can lead to positive social outcomes

Identified in Adam Smith’s The Wealth of Nations.

Consumers will encourage businesses to offer goods and services that meet their needs.

It is possible that broader social good can emerge from selfish individual actions.

Self-interest in economics does not not imply self-interest in all aspects of life.

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Lecture notes

ECON-5003

College of Business

Prairie View A&M University

Chapter 1: Welcome to Economics

Economics is probably not what you think. It is not primarily about money or finance. It is not

primarily about business. It is not mathematics. What is it then? It is both a subject area and a way

of viewing the world.

What is Economics and why is it important?

Economics is the study of how humans make decisions in the face of scarcity. These can be

individual decisions, family decisions, business decisions or societal decisions. We could also

define as the social science that studies the production, distribution, and consumption of goods and

services.

The distribution of goods and services takes place between economic agents: The producers

(firms), the consumers (households), and the regulator (the government).

The formal study of economics began when Adam Smith (1723–1790) published his famous book

The Wealth of Nations in 1776. Many authors had written on economics in the centuries before

Smith, but he was the first to address the subject in a comprehensive way. In the first chapter,

Smith introduces the concept of division of labor, which means that the way one produces a good

or service is divided into a number of tasks that different workers perform, instead of all the tasks

being done by the same person.

Division of labor can lead to increased production because of three reasons:

➢ First, specialization in a particular small job allows workers to focus on the parts of the

production process where they have an advantage.

➢ Second, workers who specialize in certain tasks often learn to produce more quickly and

with higher quality.

➢ Third, specialization allows businesses to take advantage of economies of scale, which

means that for many goods, as the level of production increases, the average cost of

producing each individual unit declines.

An economy is a system for coordinating society’s productive activities.

A market economy is an economy in which decisions about production and consumption are

made by individual producers and consumers.

The invisible hand refers to the way in which the individual pursuit of self-interest can lead to

good results for society.

1

When the individual pursuit of self-interest leads to bad results for society as a whole, there

is market failure.

The two main branches of Economics are Microeconomics and Macroeconomics.

Microeconomics is the branch of economics that studies how people make decisions and how

these decisions interact. Macroeconomics is the branch of economics that is concerned with

overall ups and downs in the economy. It focuses on broad issues such as growth of production,

the number of unemployed people, the inflationary increase in prices, government deficits, and

levels of exports and imports. Microeconomics and macroeconomics are not separate subjects, but

rather complementary

perspectives on the overall subject of the economy.

There are two types of statements in Economics: Positive and Normative. Positive statements

describe the world as it is, and normative statements describe how the world should be.

There exist many other sub-branches of economics that combine Microeconomics and

Macroeconomics principles. They include, but are not limited to, International Economics,

Monetary Economics, health economics, production economics, and development economics.

Regardless of the existence of numerous branches and sub-branches in economics, economists use

similar principles. The use of similar principles allowing economists to communicate and

understand each other, despite their divergences.

Some principles help understanding choices made by individuals, some principles allow

understanding interactions between economic agents, and other principles allow understanding

economy-wide interactions. Individual choice is the decision by an individual of what to do,

which necessarily involves a decision of what not to do. Interaction of choices is a feature of most

economic situations reflecting the fact that one person’s choices affect other persons’ choices.

Principles for understanding choices made by individuals include:

➢ People must make choices because resources are scarce.

➢ The opportunity cost of an item—what you must give up in order to get it—is its true cost.

➢ “How much” decisions require making trade-offs at the margin: comparing the costs and

benefits of doing a little bit more of an activity versus doing a little bit less (marginal

decisions).

➢ People usually respond to incentives, exploiting opportunities to make themselves better

off.

A resource is anything that can be used to produce something else. Resources are scarce—not

enough of the resources are available to satisfy all the various ways a society wants to use them.

You make a trade-off when you compare the costs with the benefits of doing something.

Decisions about whether to do a bit more or a bit less of an activity are marginal decisions. The

study of such decisions is known as marginal analysis. An incentive is anything that offers

rewards to people to change their behavior.

Principles for understanding interactions between economic agents include:

2

➢ There are gains from trade. There are gains from trade: people can get more of what they

want through trade than they could if they tried to be self-sufficient.

➢ Because people respond to incentives, markets move toward equilibrium. With the

equilibrium being defined as the situation when no individual would be better off doing

something different.

➢ Resources should be used as efficiently as possible to achieve society’s goals.
➢ Because people usually exploit gains from trade, markets usually lead to efficiency. An

economy is efficient if it takes all opportunities to make some people better off without

making other people worse off.

➢ When markets don’t achieve efficiency, government intervention can improve society’s

welfare.

Principles for understanding economy-wide interactions include:

➢ One person’s spending is another person’s income.
➢ Overall spending sometimes gets out of line with the economy’s productive capacity.

➢ Government policies can change spending.

Why to study economics?

➢ Virtually every major problem facing the world today, from the COVID-19 pandemic and

other infectious diseases, global warming, to world poverty, to the conflicts in Syria,

Afghanistan, and Somalia, has an economic dimension. If you are going to be part of

solving those problems, you need to be able to understand them. Economics is crucial.

➢ It is hard to overstate the importance of economics to good citizenship. You need to be able

to vote

intelligently on budgets, regulations, and laws in general. When the U.S. government came

close to a standstill at the end of 2012 due to the “fiscal cliff,” what were the issues? Did
you know? What are the repercussions of the recent trade war between the United States

and China? What is the impact of COVID-19 on local economies?

➢ A basic understanding of economics makes you a well-rounded thinker. When you read

articles about economic issues, you will understand and be able to evaluate the writer’s

argument. When you hear classmates, co-workers, or political candidates talking about

economics, you will be able to distinguish between common sense and nonsense. You will

find new ways of thinking about current events and about personal and business decisions,

as well as current events and politics. Watch presidential debates and follow presidential

candidates to realize how much they use economic concepts.

3

How Economists use Theories and Models to understand Economic issues1

To better understand complex real-life situations, economists use theories and models. A theory

is a simplified representation of how two or more variables interact with each other. The purpose

of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done

well, this enables the analyst to understand the issue and any problems around it. A good theory is

simple enough to understand, while complex enough to capture the key features of the object or

situation you are studying.

Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more

abstract

representation, while a model is a more applied or empirical representation. We use models to test

theories, but for this course we will use the terms interchangeably.

Examples of economic models include, but are not limited to, the Circular Flow Diagram, the

supply and demand, the production possibility Frontier, the comparative advantage model.

Circular Flow Model

The following circular flow diagram shows how households and firms interact in the goods and

services market, and in the labor market. The direction of the arrows shows that in the goods and

services market, households receive goods and services and pay firms for them. In the labor

market, households provide labor and receive payment from firms through wages, salaries, and

benefits.

1 John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that

economics is not just a subject area but also a way of thinking. Keynes famously wrote in the introduction to a

fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of
thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to
think, not what to think.

4

A more representative circular flow diagram, capable of reflecting all transactions taking place in

the economy, could be represented as follow:

• Consumer spending (C) is household spending on goods and services.

• Government purchases of goods and services (G) are total expenditures on goods and

services by federal, state, and local governments.

• Investment spending (I) is spending on productive physical capital (such as machinery

and construction of buildings) and on changes to inventories.

• Goods and services sold to other countries are exports (X). Goods and services purchased

from other countries are imports (M).

5

• Gross domestic product (GDP): the market value of all final goods and services

produced within a country in a year. This is represented in the above diagram by income

from sales.

The circular flow diagram can be used to understand and analyze transactions between economic

agents, across different markets. The following papers elaborate of the circular flow diagram and

provide examples of how this model can be used be understand a real-life situation.

The circular flow diagram uses one of the famous economic principles – “One person’s spending

is another person’s income”. Therefore,

∑ = ∑

This identity should hold for all the economic agents (e.g. Government, households, firms, and

rest of world) and in all the markets (e.g. market for goods and services, factor markets, and

financial markets.) represented in the circular flow diagram.

Applying the above identity to markets for goods and services, we can end up with the following

formula:

∑ = ∑ => + + + = +

We can rearrange the terms and obtain GDP=C+I+G+X-M.

Remember that when we import, income goes to other countries, but when we export income

comes to our country.

Daraban, B. (2010). Introducing the Circular Flow Diagram to Business Students. Journal of Education for

Business, 85(5), 274–279

Production Possibilities Frontier

The production possibility frontier illustrates the trade-offs facing an economy that produces

only two goods. It shows the maximum quantity of one good that can be produced for any given

quantity produced of the other.

6

The Production Possibility Frontier (PPF) illustrates the trade-offs Boeing faces in producing

Dreamliners and small jets. It shows the maximum quantity of one good that can be produced

given the quantity of the other good produced. Here, the maximum quantity of Dreamliners

manufactured per year depends on the quantity of small jets manufactured that year, and vice versa.

Boeing’s feasible production is shown by the area inside or on the curve. Production at point C is

feasible but not efficient. Points A and B are feasible and efficient in production, but point D is not

feasible.

The downward sloping line is called the PPF curve. Its slope (-3/4) represents the opportunity cost

of increasing the production of small jets, in terms of Dreamliner. A slope of -3/4 means that you

need to give away ¾ units of Dreamliner to increase the production of small jets by 1 unit.

This concept of opportunity costs will later be used to determine which company or country has a

comparative advantage. The country or company with lower opportunity costs will have

comparative advantage in producing a given good.

7

Another graphical model put together the supply and the demand curves to replicate economic

markets, with the supply curve (S) mimicking the behavior of suppliers, while the demand curve

(D) mimic behaviors of consumers in a market.

Prices

S

D

0 Quantities

How to organize economies: An overview of Economic Systems

Economies can be organized in three different ways: traditional economies, command economies,

and market economies.

The first is the traditional economy, which is the oldest economic system and is used in parts of

Asia, Africa, and South America. Traditional economies organize their economic affairs the way

they have always done (i.e., tradition). Occupations stay in the family. Most families are farmers

who grow the crops using traditional methods. What you produce is what you consume. Because

tradition drives the way of life, there is little economic progress or development.

In a command economy, economic effort is devoted to goals passed down from a ruler or ruling

class. In a command economy, the government decides what goods and services will be produced

and what prices it will charge for them. The government decides what methods of production to

use and sets wages for workers. The government provides many necessities like healthcare and

education for free.

A market is an institution that brings together buyers and sellers of goods or services, who may

be either individuals or businesses. In a market economy, decision-making is decentralized.

Market economies are based on private enterprise: the private individuals or groups of private

individuals own and operate the means of production (resources and businesses). Businesses

supply goods and services based on demand.

Most economies in the real world are mixed.

Discussion 1: Economists think that markets will always lead to efficiency. What happens

when market does not lead to efficiency? How could this concept of market efficiency be

applied to the market of “COVID-19 immunity”? 10 pts.

References:

Principles of Economics (2e) from OpenStax, ISBN: 978-1-947172-37-1

8

Daraban, B. (2010). Introducing the Circular Flow Diagram to Business Students. Journal of

Education for Business, 85(5), 274–279

Kitenge, Erick, COVID-19: A Virus for the Rich and the Poor (September 01, 2020). Available

at SSRN: https://ssrn.com/abstract=3693543

Chapter 2: Choice in a World of Scarcity

“Choices are necessary because resources are scarce”.

How Individuals Make Choices Based on Their Budget Constraint

Because you had either limited time or limited resources, you had to choose between ECON 5003

and another course. Or, because the university had limited resources, they had to decide whether

to offer ECON 5003 during the first 8 weeks or during the last 8 weeks of the semester. Moreover,

when you go to Wal Mart, you buy a limited quantity of goods because your budget is limited.

Even if your budget was not limited, your car would not have enough space to contain all the goods

from the store. Therefore, you have to make choices because you have limited resources. In this

sub-section, we will focus on how the budget constraint can affect your choices.

Three main elements or factors determine your choices of goods in each market: the budget, prices,

and the preference.

The Budget

The budget represents the limited amount of money to spend on a given basket of goods and

services. Let us assume you have the amount of $50 to spend on either Oranges or Apples. If one

bag of apples costs $5 and the one of oranges costs $4, your budget constraint can be represented

by the following equation:

$50 = ∗ + ∗

This can also be written as:

= ∗ + ∗ (1)

With M, Pa,Qa,Po, and Qo being the income (or budget), the price of apples, the quantity of

apples, the price of oranges, and the quantity of oranges, respectively.

Equation (1) could be transformed into:

= − ∗

9

The related graph is shown below:

Apples

The Budget Constraint curve => |slope|=

Affordable bundles

0 Oranges

The budget constraint curve above shows how many bags of apples and/or oranges that can be

afforded. If the consumer decides to buy only Apples he or she will be able to afford bags, but

if he decides to buy only Oranges, he or she will be able to afford only . All the affordable

bundles are in the triangle

, ,

. Any bundle outside of that triangle is not affordable.

The slope of the budget constraint represents the opportunity cost of oranges in terms of apples. It

shows the how many bags of apples you should sacrifice to get one additional bag of oranges.

From the figures provided above, the opportunity cost of oranges is 4/5 or 0.8 bags of apples.

An increase in income will shift the budget curve to the right, while a decrease in income will shift

the budget curve to the left.

Everything remaining the same, an increase (decrease) in the price of Oranges will rotate, toward

the left (right), the curve around the y-intercept.

Preferences

Preferences represent the satisfaction or utility you get by consuming a given good or service. The

satisfaction you get from consuming the second slice of Pizza is lower than the satisfaction you

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got after consuming the first slice. The decrease in marginal utility reflects the diminishing

marginal utility. We will come back to this concept in another chapter.

PPF

Although I provided a linear PPF curve, the PPF curve will not be linear all the time. A concave

PPF curve will reflect the diminishing marginal returns. the law of diminishing returns, which

holds that as additional increments of resources are added to a certain purpose, the marginal benefit

from those additional increments will decline.

In the graph above, we have a concave PPF curve that shows production possibilities of two

services (Healthcare and Education). Efficient production possibilities (A, B, C, D, F) are on the

PPF curve, while the one in the area between the axes and the PPF curve are less efficient. In this

case the opportunity cost of producing education increases as the quantity of education increases.

This is shown by the increasing slope of the PPF curve as we move away from the origin.

Let us now assume that the United States and Canada can produce only Dreamliners and Small

Jets, and their related PPF curve are presented below:

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10 80

Dreamliners Dreamliners

50 Small Jets 120 Small

Jets

Canada United States

From the two PPF curve above, the United States has absolute advantage in production of both

Dreamliners and small jets. However, if you allow the two countries to trade, each country will

have to specialize only in producing the good in which it has comparative advantage. The

country has comparative advantage when its opportunity cost to produce a good is lower than for

other countries. From our two PPF curves, the opportunity costs for producing small jets are 1/5

for Canada and 2/3 for the United States. Therefore, Canada has comparative advantage in the

production of Small jets, while the United States has comparative advantage in the production of

Dreamliners.

There are numerous objection the approaches uses by economists such as, but not limited to:

– The economic approach to decision-making seems to require more information than most

individuals possess and more careful decision-making than most individuals actually

display.

– The economics approach portrays people as self-interested.

Discussion 2: Provide an example of a real-life situation in which the budget, the price, and the

preference (or utility) have played a role. This example should be related to a choice that you recently

made. 10 pts.

References:

Principles of Economics (2e) from OpenStax, ISBN: 978-1-947172-37-1

12

PRINCIPLES OF

ECONOMICS 2e

Chapter 1 Welcome to Economics!

PowerPoint Slideshow

COLLEGE PHYSICS

Chapter # Chapter Title

PowerPoint Image Slideshow

CH.1 OUTLINE

1.1: What is Economics, and Why Is It Important?

1.2: Microeconomics and Macroeconomics

1.3: How Economists Use Theories and Models

to Understand Economic Issues

1.4: How To Organize Economies: An Overview

of Economic Systems

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1.1 What is Economics, and Why Is It Important?

Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions.

Scarcity means that human wants for goods, services and resources exceed what is available.

The FRED website (
https://openstax.org/l/FRED/) includes data on nearly 400,000 domestic and international economic and social variables over time, which will be used often in this course.

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Economics in the social media age

Economics is greatly impacted by how well information travels through society. Today, social media giants Twitter, Facebook, and Instagram are major forces on the information superhighway.

(Credit: modification of work by Johan Larsson/Flickr Creative Commons)

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Scarcity

Homeless people are a stark reminder that scarcity of resources is real. (Credit: “daveynin”/Flickr Creative Commons)

Discussion Question: What are examples of critical goods and services?

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Comprehensive study of economics

Adam Smith introduced the idea of dividing labor into discrete tasks, in his famous 1776 book, titled The Wealth of Nations.

(Credit: Wikimedia Commons)

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Division of labor – the way in which different workers divide required tasks to produce a good or service.

Workers on an assembly line are an example of the divisions of labor. (Credit: Nina Hale/Flickr Creative Commons)

The Division of and Specialization of Labor

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Why the Division of Labor Increases Production

Dividing and subdividing the tasks involved with producing a good or service, produces a greater quantity of output.

Specialization – when workers or firms focus on particular tasks for which they are well-suited within the overall production process.

Specialization allows businesses to take advantage of economies of scale, which means that for many goods,as the level of production increases, the average cost of producing each individual unit declines.

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1.2 Microeconomics and Macroeconomics

Economics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as those with high incomes and those with low incomes.

Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses.

Macroeconomics is the branch of economics that focuses on broad issues such as growth, unemployment, inflation, and trade balance.

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Other Economic Terms

Monetary policy – policy that involves altering the level of interest rates, the availability of credit in the economy, and the extent of borrowing.

Determined by a nation’s central bank

Fiscal policy – economic policies that involve government spending and taxes.

Determined by a nation’s legislative body

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One of the most influential economists in modern times was John Maynard Keynes. (Credit: Wikimedia Commons)

Keynes thought that economics teaches you how to think, not what to think.

1.3 How Economists Use Theories and

Models to Understand Economic Issues

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Economic Theories and Models

A theory is a simplified representation of how two or more variables interact with each other.

A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying.

Economists use models to test theories, but for this course we will use the terms model and theory interchangeably.

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Circular Flow Diagram

The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market.

The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them.

In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.

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1.4 How To Organize Economies: An

Overview of Economic Systems

There are at least three ways that societies organize an economy:

1) Traditional economy – typically an agricultural economy where things are done the same as they have always been done.

Oldest economic system

Used in parts of Asia, Africa, and South America

Occupations tend to stay in the family

What you produce is what you consume

Little economic progress or development

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An Overview of Economic Systems

2) Command economy – an economy where economic decisions are passed down from government authority and where the government owns the resources.

Government decides what goods and services will be produced and what prices it will charge for them.

The government decides what methods of production to use and sets wages for workers.

The government provides many necessities like healthcare and education for free.

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(Credit: Jay Bergesen/Flickr Creative Commons)

An Overview of Economic Systems

Examples of command economy:

Ancient Egypt

Medieval manor life

Communism

Currently, Cuba and North Korea

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An Overview of Economic Systems

3) Market economy – an economy where economic decisions are decentralized, private individuals own resources, and businesses supply goods and services based on demand.

Market – interaction between potential buyers and sellers; a combination of demand and supply.

Private enterprise – system where private individuals or groups of private individuals own and operate the means of production (resources and businesses).

Nothing says “market” more than The New York Stock Exchange. (Credit: Erik Drost/Flickr Creative Commons)

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Real World Economies

Most economies in the real world are mixed. They combine elements of command, traditional, and market systems.

The U.S. economy is positioned toward the market-oriented end of the spectrum.

Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than the U.S. economy.

China and Russia, while they have moved more in the direction of having a market-oriented system, remain closer to the command economy end of the spectrum.

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Regulations: The Rules of the Game

There is no such thing as an absolutely free market.

Regulations always define the “rules of the game” in the economy.

Economies that are primarily market-oriented have fewer regulations—ideally just enough to maintain an even playing field for participants.

Heavily regulated economies often have underground economies (or black markets), which are markets where the buyers and sellers make transactions without the government’s approval.

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The Rise of Globalization

Globalization – the trend in which buying and selling in markets have increasingly crossed national borders.

Exports – the goods and services that a nation produces domestically and sells abroad.

Imports – the goods and services that are produced abroad and then sold domestically.

Gross domestic product (GDP)- measures the size of total production in an economy.

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The Global Economy

Cargo ships are one mode of transportation for shipping goods in the global economy. (Credit: Raul Valdez/Flickr Creative Commons)

Discussion question: What are examples of products and services in the modern economy? How has this contributed to globalization?

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