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How Economists Think

Rational behavior: making decisions logically weighing personal benefits and costs
of available actions, then selecting the most attractive option the consumer wants
Economic problem: unlimited wants but limited resources (scarcity)
Economic resources: basic items used in all types of production, including natural,
capital, and human resources.
Natural Resources
Capital Resources
Human Resources
- From nature used in
- Processed
- Labour is human
production including
effort employed
land, raw materials,
equipment, and
directly into
and natural
buildings used in
- Entrepreneurship
- (land, minerals,
- Real assets
: initiative, risk- (printing plant +
forest, sunlight,
taking, and
water power)
Resource Income: natural resource = owner receives a rent, capital resource =
income in the form of interest, labour = wages
Economics: the study of how to distribute scarce resources to make choices (micro
and macroeconomics)
Microeconomics: economics that focuses on the behavior of individual participants
in various markets
Macroeconomics: takes a wide-ranging view of the economy, studying the behavior
of economic sectors
Economic models: Simplifications of economic reality like laws, principles, and

Cause and effect: variables are connected by a casual relationship

o Variables: factors that have measurable value
o Independent variable: causes change to another variable
o Dependent variable: affected by another variable
Inverse and direct relationship
o Inverse: independent causes opposite change in dependent
o Direct: independent causes change in the same direction as the
Assumptions: to simplify the real world
o Ceteris Paribus: the assumption that all other things remain the same
Positive and normative economics: descriptive and policy economics
o Positive: objective and fact based, may not be correct but must be
proven (study of economic facts and why the economy operates as it


Normative: subject and value based, opinion so they cannot be proved

(study of how the economy ought to operate)

Economic Choice

Economic thinking and decision-making involves 2 major factors: utility and cost
Utility: the satisfaction gained from any action
Self-interest motive: assumption that people act to maximize their own welfare
Opportunity cost: utility that could have been gained by choosing and actions best

The Production Possibilities Model

ASSUMPTIONS: only two items are produced, resources and technology are fixed,
economic resources are employed to their full potential

Resources can be moved from the production of one good to another

Production Possibilities Schedule: table that shows the possible output combinations
for an economy
Production Possibilities Curve: graph that illustrates the possible output
combinations for an economy

A choice is necessary because producing more of one item means making do

with less of the other

Role of Society

The curve is the boundary of all the output combinations reachable in an

economy. Anything inside is feasible and anything outside is not.
Anything inside, the resources are not being used for full potential, on the
curve is full potential

Increasing Opportunity Costs: the concept that as more of one item is produced by
an economy, the opportunity cost of additional units of that product rises
Economic Growth: an increase in an economys total output of goods and services

May increase due to rise in amount of available resources or an improvement

in technology (outward shift of the production possibilities curve)

Economic Contraction: production possibilities curve shifts inward or when the

economy moves from the curve itself to within the area bounded by the curve.


Economic Systems

BASIC ECONOMIC QUESTIONS: what to produce, how to produce, whom to produce

What to produce: must decide how much of each possible goods and services are to
be supplied. Should it be made base on past practice, individual choices of
consumers, or government planning.
How to produce: must decide how the items are to be produced. Which resources
should be employed and in what combinations (should farmers use plows or
Whom to produce: determine how its total output of goods and services will be
Economic system: the organization of an economy, which represents a countrys
distinct set of social customs, political institutions, and economic practices

Traditional, market, command economy

Theoretical systems
Most are mixed and all have different views of what a societys primary aims
should be

Traditional Economy

An economic system in which economic decisions are made on the basis of

Relatively unchanged from generation to generation
Religion and culture are important
Based on tight social constraints and are resistant to change
Offer the advantage of stability
Restrains human potential and they have no freedom

Market Economy

An economic system based on private ownership and the use of markets in

economic decision-making
Individuals are free to pursue their own self interest
Households use income earned from their economic resources by saving
some and spending the rest on consumer products
Businesses buy resources from households and employ these resources to
provide the consumer products demanded by households
Government role is upholding the legal system and public security

Market: a set of arrangements between buyers and sellers of a certain item

Product markets: markets in which consumer products are traded

Resource market: market in which economic resources are traded (natural,

capital, human)

In product market, households are buyers of consumer products

(food/clothing) while businesses are the sellers. In a resource market,
households sell resources (labor) that businesses produce so that they can
produce goods and services

Benefits of a Market Economy



Consumer sovereignty: the effect of consumer needs and wants on
production decisions
o Decisions on what to produce is based on the needs and the wants of
o Prices (dollar) play a role
Innovation: incentive to make profits encourages innovation

Drawbacks of a Market Economy



Income distribution: Distribution of income can create inequities without the
intervention of the Government. Might not earn enough to provide for their
basic needs
Market Problems: Private markets not do operate that will benefit society as a
whole (pollution, monopoly)
Instability: Display instabilities in performance from year to year which can
harm the economy because the variations in prices or employment levels

Command Economy

An economic system based on public ownership and central planning

Opposite of a market economy
All productive property (natural resources and capital) are in the hands of the
Government and markets are replaced by central planning.
Planners decide how production should be carried out and how the output
should be distributed
Planners determine the split of how much to consume and how much to save
based on their judgement of the future needs of the entire economy

Benefits of a Command Economy



Income distribution: choose to distribute income on the basis of
considerations other than purely economic ones so income would be
distributed more fairly.

Economic growth: Central planners can promote economic growth by

devoting more resources to capital goods than would be the case in a market

Drawbacks of a Command Economy



Planning difficulties: planning an entire economy is difficult and requires
tremendous amounts of information that may not be accessible by the
planner. Incorrect estimates of the future are too easy to make leading to
over and underproduction
Inefficiencies: Government ownership can lead to waste and inefficiencies
since they do not depend on the lure of pure profit to promote efficient use of
resources. Corruption of government officials is common without the control
of individual self-interest. Planners emphasize quantity so quality will suffer
Lack of freedom: People have limited economic choices because central
planners make all economic decisions.

Mixed Economies

Modern mixed economy

o An economic system that combines aspects of a market economy and
a command economy; production decisions are made both in private
markets and by government
Traditional mixed economy
o Economic systems in which a traditional sector coexists with modern

Conflicts and opportunities


Emerging economies: economies that have recently exhibited high rates of

economic growth and rising average incomes
o Countrys communist regime outlawed private ownership of land,
forcing farmers to work in large collectives
o Rural reforms meant farmers were able to rent land and keep the
proceeds to themselves
o Rise of agricultural output once stated owned producers in other
sectors were allowed to keep a portion of their profits
o Embrace of the private markets caused an economic growth
o Government reforms freed private business to operate in key areas of
the economy
o Global sales from service industries benefited from their widespread
knowledge of English and later to manufacturing

Market reforms allowed their supply of oil, minerals, and fresh water

Economic Goals

Issue of normative economics based on value judgements

Income equity, price stability, full employment, viable balance of payments,
economic growth, economic efficiency, environmental sustainability
Income equity
o Countrys total output is distributed fairly
Price stability
o Government policy makers try to decrease the amount of inflation
o Peoples income may not rise, but the average price of items increase
Full employment
o Government tries to minimize involuntary unemployment in the labour
o Unemployment rate: the percentage of a labour force that is
involuntary unemployed
o Being without work is a waste of personal potential and can bring
economic hardship to the person and family
o Higher unemployment means lower total output (economic activity
takes place inside the production possibilities curve)
Viable balance of payments
o Balance of payments accounts: a summary of all transactions between
Canadian and foreigners that involve exchanging Canadian dollars for
other currencies
o Financial flows in and out of the country need to be more or less evenly
Economic growth
o Helps raise the average standard of living for Canadians
Economic efficiency
o Economic efficiency: employing scarce resources in such a way as to
derive the highest benefit
Environmental sustainability
o Quality of our physical environment can be sustained without
significant harm
o Our worlds air, water, and land resources have deteriorated a lot (an
irreversible change)
o Climate change
Kyoto Protocol

Complementary goals

Success in reaching one economic goal makes another goal easier to achieve
(full employment and economic growth)

Conflicting goals

Some goals are bound to conflict so that attaining one goal makes another
goal more difficult to achieve
(price stability and the full employment)
One must set priorities and that one goal is achieved at the cost of another

Adam Smith The Founder of Modern Economics


Adam Smith (1723-1790) is known as the father of modern-day economics

and has employed ideas from earlier thinkers. His greatest talent was
combining innovative ideas into theories that influence economic thinking to
this day.
Industrial Revolution
o Technological innovations started a new manufacturing sector based
on labour saving machinery, producing a social and economic impact
The Division of Labour
o The job of each worker is a specialized task is a significant single cause
of economic progress
o Greatest improvement in the production power of labour is the division
of labour
The Invisible Hand
o Economic progress is spurred by the self-interest motive
o Self-interest motive: the desire individuals have to increase their own
o If people are free to pursue their own private interests, they act in a
way that aids the economy as a whole because of competition
o The forces of individual self-interest and competition ensure that
resources are used in ways that promote economic growth and
national prosperity.
The Principle of Laissez Faire (let things be)
o When competition is lacking, which is called a monopoly, a single
producer controls an entire market
o The business selfish motive causes prices to be driven to the highest
market value meaning that consumers will suffer
o Often, government causes monopoly because they offer privileges to
firms and impede private markets through laws
Relevance for Today
o Suggest that Smiths invisible hand only operates in an economy of
many small businesses
o Markets todays are made up of huge corporations who are able to
control their prices
o Private competition is preferred over government intervention as
shown through the examples of emerging economies throughout the