Principles of Economics

Principles of
economics
What Economics Is All

About
Scarcity: the limited nature of
societys resources
Economics: the study of how
society manages its scarce
resources, e.g.
o how people decide what to buy,
how much to work, save, and spend
o how firms decide how much to produce,
how many workers to hire
o how society decides how to divide its resources
between national defense, consumer goods,
protecting the environment, and other needs
What is
Economics?
o Study of choice under conditions of scarcity
o its the study of scarcity, the study of how
people use resources
o Economics is the study of how societies use
scarce resources to produce valuable
commodities and distribute them among
different people
Given unlimited wants, it is important that an

economy make the best use of its limited
resources.
Efficiency denotes the most effective use of a
societys resources in satisfying peoples wants
and needs.
Inefficiency leads to under development.
In economics, we say that an economy is
producing efficiently when it cannot make
anyone economically better off without
making someone else worse off.
Why Study Economics

To understand the world better
o Youll begin to understand the cause of many
of the things that affect your life
To achieve social change

o Youll gain tools to understand origins of social
problems and design more effective solutions
To gain self-confidence
o Youll lose that feeling that mysterious,
inexplicable forces are shaping your life for
you
5
Economics
Microeconomics
Macroeconomics
Micro Economics
Micro Economics studies how the individual parts
of the economy make decisions to allocate limited
resources
Microeconomics studies:
how individuals use limited resources to meet
unlimited needs
the consequences of their decisions
the behaviour of individual components like
industries, firms and households.
how individual prices are set
7
Macro Economics
Macroeconomics studies about the functioning of

the economy as a whole
It examines the economy through wide-lens.
Macroeconomics studies about
the total output of a nation
the way the nation allocates its limited
resources of land, labor and capital
the ways to maximize production levels
the techniques to promote trade
Some Basic Principles of Economics
PRINCIPLE #1:
People Face Tradeoffs

All decisions involve tradeoffs. Examples:
Going to a party the night before your midterm
leaves less time for studying.
Having more money to buy stuff requires working
longer hours, which leaves less time
for leisure.
Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.
PRINCIPLE #1:
People Face Tradeoffs

Society faces an important tradeoff:
efficiency vs. equality
Efficiency: when society gets the most from its
scarce resources
Equality: when prosperity is distributed
uniformly among societys members
Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic pie.
PRINCIPLE #2:
The Cost of Something Is

What You Give Up to Get It
Making decisions requires comparing the
costs and benefits of alternative choices.
The opportunity cost of any item is
whatever must be given up to obtain it.
It is the relevant cost for decision making.
PRINCIPLE #2:
The Cost of Something Is

What You Give Up to Get It
Examples:
The opportunity cost of
going to college for a year is not just the tuition,
books, and fees, but also the foregone wages.
seeing a movie is not just the price of the ticket,
but the value of the time you spend in the
theater.
PRINCIPLE #3:
Rational People Think at the Margin

Rational people
o systematically and purposefully do the best they
can to achieve their objectives.
o make decisions by evaluating costs and benefits
of marginal changes, incremental adjustments
to an existing plan.
Examples:
When a manager considers whether to increase
output, she compares the cost of the needed
labor and materials to the extra revenue.
PRINCIPLE #4:
People Respond to Incentives

Incentive: something that induces a
person to act, i.e. the prospect of a reward
or punishment.
Rational people respond to incentives.
Examples:
o When gas prices rise, consumers buy more hybrid cars
and fewer gas guzzling SUVs.
o When cigarette taxes increase,
teen smoking falls.
PRINCIPLE #5:
Trade Can Make Everyone Better Off

Rather than being self-sufficient,
people can specialize in producing one good
or service and exchange it for other goods.
Countries also benefit from trade and
specialization:
o Get a better price abroad for goods they produce
o Buy other goods more cheaply from abroad than
could be produced at home
Applying the principles

You are selling your 1996 Mustang. You have
already spent $1000 on repairs.
At the last minute, the transmission dies. You can
pay $600 to have it repaired, or sell the car as
is.
In each of the following scenarios, should you
have the transmission repaired? Explain.
A. Blue book value (what you could get for the
car) is $6500 if transmission works, $5700 if it
doesnt
B. Blue book value is $6000 if transmission works,
$5500 if it doesnt
Answers
Cost of fixing transmission = $600
A.
Blue book value is $6500 if transmission works,

$5700 if it doesnt
Benefit of fixing the transmission = $800
($6500 5700).
Its worthwhile to have the transmission fixed.
B.
Blue book value is $6000 if transmission works,

$5500 if it doesnt
Benefit of fixing the transmission is only $500.
Paying $600 to fix transmission is not worthwhile.
Observations
The $1000 you previously spent on repairs is
irrelevant. What matters is the cost and benefit
of the marginal repair (the transmission).
The change in incentives from scenario A
to scenario B caused your decision to change.
Our First Model:
The Circular-Flow Diagram
The Circular-Flow Diagram: a visual model of

the economy, shows how dollars flow through
markets among households and firms
Two types of actors:
o households
o firms
Two markets:
o the market for goods and services
o the market for factors of production
Factors of Production
Factors of production: the resources the
economy uses to produce goods & services,
including
o labor
o land
o capital (buildings & machines used in
production)
FIGURE 1: The Circular-Flow Diagram

Households:
Own the factors of production,
sell/rent them to firms for income
Buy and consume goods & services
Firms
Firms:
Buy/hire factors of production,
use them to produce goods and
services
Sell goods & services
Households
FIGURE 1: The Circular-Flow Diagram
Revenue
G&S
sold
Markets for
Goods &
Services
Firms
Factors of
production
Wages, rent,
profit
Spending
G&S
bought
Households
Markets for
Factors of
Production
Labor, land,
capital
Income
23
Our Second Model:
The Production Possibilities Frontier
The Production Possibilities Frontier (PPF):

a graph that shows the combinations of
two goods the economy can possibly produce given the
available resources and the available technology
The production possibility frontier (PPF) is a curve
depicting all maximum output possibilities for two goods,
given a set of inputs. The PPF assumes that all inputs are
used efficiently.
Example:
o Two goods: computers and wheat
o One resource: labor (measured in hours)
o Economy has 50,000 labor hours per month available for
production.
PPF Example
Producing one computer requires 100 hours labor.
Producing one ton of wheat requires 10 hours labor.
Employment of
labor hours
Production
Computers
Wheat
Computers
Wheat
50,000
500
40,000
10,000
400
1,000
25,000
25,000
250
2,500
10,000
40,000
100
4,000
50,000
5,000
PPF Example
Production
Point
on
Comgraph puters Wheat
A
500
400
1,000
250
2,500
100
4,000
5,000
E
D
C
B
A
26
Point F:
100 computers,
3000 tons wheat
Point F requires
40,000 hours
of labor.
Possible but
not efficient:
could get more
of either good
w/o sacrificing
any of the other.
2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Point G:
300 computers,
3500 tons wheat
Point G requires
65,000 hours
of labor.
Not possible
because
economy
only has
50,000 hours.
The PPF: What We Know

So Far
Points on the PPF (like A E)
o possible
o efficient: all resources are fully utilized
Points under the PPF (like F)

o possible
o not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
Points above the PPF (like G)

o not possible
The PPF and Opportunity

Cost
Recall: The opportunity cost of an item
is what must be given up to obtain that item.
Moving along a PPF involves shifting resources
(e.g., labor) from the production of one good to
the other.
Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
The slope of the PPF tells you the opportunity cost
of one good in terms of the other.
The PPF and Opportunity Cost

slope =
1000
= 10
100
The slope of a line

equals the
rise over the
run, the amount
the line rises when
you move to the
right by one unit.
Here, the
opportunity cost of
a computer is
10 tons of wheat.
PPF and Opportunity Cost

In which country is the opportunity cost of cloth lower?
FRANCE
ENGLAND
Answers
England, because its PPF is not as steep as Frances.
FRANCE
ENGLAND
Economic Growth and the PPF

With additional
resources or an
improvement in
technology,
the economy can
produce more
computers,
more wheat,
or any combination
in between.
Economic
growth shifts
the PPF
outward.
The Shape of the PPF

The PPF could be a straight line or bowshaped
Depends on what happens to opportunity
cost
as economy shifts resources from one
industry
to the other.
o If opp. cost remains constant, PPF is a straight line.
(In the previous example, opp. cost of a computer was
always 10 tons of wheat.)
o If opp. cost of a good rises as the economy produces
more of the good, PPF is bow-shaped.
As the economy
shifts resources
from beer to
mountain bikes:
Beer
Why the PPF Might Be

Bow-Shaped
PPF becomes
steeper
opp. cost of
mountain bikes
increases
Mountain
Bikes
At point A,
most workers are
producing beer,
even those who
are better suited
to building bikes.
So, do not have
to
give up much
beer
to get more bikes.
Beer
Why the PPF Might Be Bow-Shaped

A
At A, opp. cost of
mtn bikes is low.
Mountain
Bikes
At B, most workers
are producing bikes.
The few left in beer
are the best brewers.
Producing more
bikes would require
shifting some of the
best brewers away
from beer
production,
causing a big drop in
beer output.
Beer

At B, opp. cost
of mtn bikes
is high.
B
Mountain
Bikes

So, PPF is bow-shaped when different workers
have different skills, different opportunity costs of
producing one good in terms of the other.
The PPF would also be bow-shaped when there is
some other resource, or mix of resources with
varying opportunity costs
(E.g., different types of land suited for
different uses).
The PPF: A Summary

The PPF shows all combinations of two goods that an
economy can possibly produce,
given its resources and technology.
The PPF illustrates the concepts of tradeoff and
opportunity cost,
efficiency and inefficiency, unemployment, and
economic growth.
A bow-shaped PPF illustrates the concept of
increasing opportunity cost.
Interdependence and
the Gains from Trade
Suppose that the farmer and the rancher each
work 8 hours per day and can devote this time to
growing potatoes, raising cattle, or a combination of
the two.
The Farmers Production Possibilities

Frontier
The Ranchers Production Possibilities

Frontier
After several years of eating combination B, the rancher gets an

idea and goes to talk to the farmer:
Rancher: Farmer, my friend, have I got a deal for you! I know how
to improve life for both of us. I think you should stop producing
meat altogether and devote all your time to growing potatoes.
According to my calculations, if you work 8 hours a day growing
potatoes, youll produce 32 ounces of potatoes. If you give me 15
of those 32 ounces,
The Farmers Production and Consumption
Ill give you 5 ounces of meat
in return. In the end, youll get
to eat 17 ounces of potatoes
and 5 ounces of meat every
day, instead of the 16 ounces
of potatoes and 4 ounces of
meat you now get. If you go
along with my plan, youll
have more of both foods.
Farmer: (sounding skeptical) That seems like a good deal for

me. But I dont understand why you are offering it. If the deal is
so good for me, it cant be good for you too.
Rancher: Oh, but it is! Suppose I spend 6 hours a day raising
cattle and 2 hours growing potatoes. Then I can produce 18
ounces of meat and 12 ounces of potatoes.
After I give you 5 ounces of my meat in exchange for 15 ounces
of your potatoes, Ill end up with 13 ounces of meat and 27
ounces of potatoes, instead of the 12 ounces of meat and 24
ounces of potatoes that I now get. So I will also consume more
of both foods than I do now.
Farmer: I dont know. . .
This sounds too good to be true
The Gains from Trade
If the rancher is better at both raising cattle and

growing potatoes, how can the farmer ever
specialize in doing what he does best?
The farmer doesnt seem to do anything best. To
solve this puzzle, we need to look at the
principle of comparative advantage.
Absolute Advantage
Economists use the term absolute advantage
when comparing the productivity of one person,
firm, or nation to that of another.
The producer that requires a smaller quantity of
inputs to produce a good is said to have an
absolute advantage in producing that good.
The rancher has an absolute advantage both in
producing meat and in producing potatoes
because she requires less time than the farmer to
produce a unit of either good
Opportunity Cost and

Comparative Advantage
Rather than comparing inputs required, we can
compare the opportunity costs
Opportunity cost of some item is what we give
up to get that item.
When reallocating time between the two goods,
the rancher and farmer give up units of one good
to produce units of the other, thereby moving
along the production possibilities frontier.
The opportunity cost measures the trade-off
between the two goods that each producer faces.
Rancher: producing 1 ounce of potatoes takes 10

minutes of work.
When the rancher spends those 10 minutes
producing potatoes, she spends 10 minutes less
producing meat.
Because the rancher needs 20 minutes to
produce1 ounce of meat, 10 minutes of work
would yield ounce of meat.
Hence, the ranchers opportunity cost of
producing 1 ounce of potatoes is ounce of
meat.
Economists use the term comparative advantage

when describing the opportunity cost of two
producers.
The producer who gives up less of other goods to
produce Good X has the smaller opportunity cost of
producing Good X and is said to have a
comparative advantage in producing it.
The farmer has a lower opportunity cost of
producing potatoes than the rancher:
An ounce of potatoes costs the farmer only 1/4
ounce of meat, but it costs the rancher 1/2 ounce of
meat.
The rancher has a lower opportunity cost of

producing meat than the farmer:
An ounce of meat costs the rancher 2 ounces of
potatoes, but it costs the farmer 4 ounces of
potatoes.
Thus, the farmer has a comparative advantage in
growing potatoes, and the rancher has a
comparative advantage in producing meat
Although it is possible for one person to have an absolute

advantage in both goods (as the rancher does in our
example),
it is impossible for one person to have a comparative
advantage in both goods.
Because the opportunity cost of one good is the inverse of the
opportunity cost of the other,
if a persons opportunity cost of one good is relatively high,
the opportunity cost of the other good must be relatively low.
Unless two people have exactly the same opportunity
cost, one person will have a comparative advantage in
one good, and the other person will have a
comparative advantage in the other good.
The farmer gets 5 ounces of meat in exchange for 15

ounces of potatoes.
In other words, the farmer buys each ounce of meat for
a price of 3 ounces of potatoes.
This price of meat is lower than his opportunity cost for
an ounce of meat, which is 4 ounces of potatoes.
Thus, the farmer benefits from the deal because he
gets to buy meat at a good price.
The rancher buys 15 ounces of potatoes for a price of 5
ounces of meat. That is, the price of potatoes is 13
ounce of meat.
This price of potatoes is lower than her opportunity cost
of an ounce of potatoes, which is . ounce of meat. The
rancher benefits because she gets to buy potatoes at a
good price.
The moral of the story :

Trade can benefit everyone in society because it
allows people to specialize in activities in which they
have a comparative advantage.
For both parties to gain from trade, the price at which
they trade must lie between the two opportunity costs.
The farmer and rancher agreed to trade at a rate of 3
ounces of potatoes for each ounce of meat. This price
is between the ranchers opportunity cost (2 ounces of
potatoes per ounce of meat) and the farmers
opportunity cost (4 ounces of potatoes per ounce of
meat).
Production Possibilities in
the U.S.
The U.S. has 50,000 hours of labor
available for production, per month.
Producing one computer
requires 100 hours of labor.
Producing one ton of wheat
requires 10 hours of labor.
The U.S. PPF
Wheat
(tons)
The U.S. has enough labor

to produce 500 computers,
or 5000 tons of wheat,
or any combination along
the PPF.
5,000
4,000
3,000
2,000
1,000
0
100
200
300
400
500
Computers
55
The U.S. Without Trade
Wheat
(tons)
Suppose the U.S. uses half its labor to

produce each of the two goods.
Then it will produce and
consume
250 computers and
2500 tons of wheat.
5,000
4,000
3,000
2,000
1,000
0
100
200
300
400
500
Computers
56
Derive Japans PPF

Use the following information to draw Japans PPF.
o Japan has 30,000 hours of labor available for production, per month.
o Producing one computer requires 125 hours of labor.
o Producing one ton of wheat requires 25 hours of labor.
Your graph should measure computers on the

horizontal axis.
Japans PPF
Wheat
(tons)
Japan has enough labor to

produce 240 computers,
or 1200 tons of wheat,
or any combination
along the PPF.
2,000
1,000
100
200
300
Computers
58
Japan Without Trade

Wheat
(tons)
2,000
1,000
Suppose Japan uses half its labor to

produce each good.
Then it will produce and consume
120 computers and
600 tons of wheat.
100
200
300
Computers
59
Consumption With and Without Trade

Without trade,
o U.S. consumers get 250 computers
and 2500 tons wheat.
o Japanese consumers get 120 computers
and 600 tons wheat.
We will compare consumption without trade

to consumption with trade.
First, we need to see how much of each
good is produced and traded by the two
countries.
Production under trade

1. Suppose the U.S. produces 3400 tons of wheat.
How many computers would the U.S. be able to
produce with its remaining labor? Draw the
point representing this combination of computers
and wheat on the U.S. PPF.
2. Suppose Japan produces 240 computers.

How many tons of wheat would Japan be able to
produce with its remaining labor? Draw this
point on Japans PPF.
Wheat
(tons)
U.S. Production With Trade

Producing 3400 tons of wheat
requires 34,000 labor hours.
5,000
4,000
The remaining 16,000

labor hours are used to
produce 160 computers.
3,000
2,000
1,000
0
100
200
300
400
500
Computers
62
Japans Production With Trade

Wheat
(tons)
Producing 240 computers

requires all of Japans 30,000
labor hours.
2,000
So, Japan would produce

0 tons of wheat.
1,000
100
200
300
Computers
63
Exports & Imports

Exports:
goods produced domestically and sold abroad
To export means to sell domestically produced
goods abroad.
Imports:
goods produced abroad and sold domestically
To import means to purchase goods produced in
other countries.
ACTIVE LEARNING
Consumption under trade

Suppose the U.S. exports 700 tons of wheat to
Japan, and imports 110 computers from Japan.
(So, Japan imports 700 tons wheat and exports 110
computers.)
o How much of each good is consumed in

the U.S.? Plot this combination on the
U.S. PPF.
o How much of each good is consumed in
Japan? Plot this combination on Japans
PPF.
Wheat
(tons)
U.S. Consumption With Trade

produced
+
imported
exported
5,000
4,000
= amount
consumed
3,000
computers wheat
160
3400
110
0
0
700
270
2700
2,000
1,000
0
100
200
300
400
500
Computers
66
Japans Consumption With Trade

computers
produced
240
+ imported
0
exported
110
= amount
130
consumed
Wheat
(tons)
2,000
wheat
0
700
0
700
1,000
100
200
300
Computers
67
Trade Makes Both Countries Better Off

U.S.
consumption consumption gains from
without trade with trade
trade
computers
250
270
20
wheat
2500
2700
200
Japan
consumption consumption gains from
without trade with trade
trade
computers
120
130
10
wheat
600
700
100
68
SUMMARY
Interdependence and trade allow everyone

to enjoy a greater quantity and variety of
goods & services.
Comparative advantage means being able
to produce a good at a lower opportunity
cost. Absolute advantage means being able
to produce a good with fewer inputs.
When peopleor countriesspecialize in
the goods in which they have a comparative
advantage, the economic pie grows and
trade can make everyone better off.
Problem
England and Scotland both produce shirts and sweaters.
Suppose that an English worker can produce 50 shirts per hour
or 1 sweater per hour. Suppose that a Scottish worker can
produce 40 shirts per hour or 2 sweaters per hour.
a. Which country has the absolute advantage in the production
of each good? Which country has the comparative
advantage?
b. If England and Scotland decide to trade, which commodity
will Scotland trade to England? Explain.
c. If a Scottish worker could produce only 1 sweater per hour,
would Scotland still gain from trade? Would England still gain
from trade? Explain.

Principles of Economics

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Principles of Economics

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Principles of

What Economics Is All

Given unlimited wants, it is important that an

Why Study Economics

To achieve social change

Macroeconomics studies about the functioning of

Some Basic Principles of Economics

People Face Tradeoffs

People Face Tradeoffs

The Cost of Something Is

The Cost of Something Is

Rational People Think at the Margin

People Respond to Incentives

Trade Can Make Everyone Better Off

Applying the principles

Blue book value is $6500 if transmission works,

Blue book value is $6000 if transmission works,

Our First Model:

The Circular-Flow Diagram

The Circular-Flow Diagram: a visual model of

FIGURE 1: The Circular-Flow Diagram

FIGURE 1: The Circular-Flow Diagram

Our Second Model:

The Production Possibilities Frontier

The Production Possibilities Frontier (PPF):

The PPF: What We Know

Points under the PPF (like F)

Points above the PPF (like G)

The PPF and Opportunity

The PPF and Opportunity Cost

The slope of a line

PPF and Opportunity Cost

Economic Growth and the PPF

The Shape of the PPF

Why the PPF Might Be

Why the PPF Might Be Bow-Shaped

Why the PPF Might Be Bow-Shaped

Why the PPF Might Be Bow-Shaped

The PPF: A Summary

The Farmers Production Possibilities

The Ranchers Production Possibilities

After several years of eating combination B, the rancher gets an

Farmer: (sounding skeptical) That seems like a good deal for

The Gains from Trade

If the rancher is better at both raising cattle and

Opportunity Cost and

Rancher: producing 1 ounce of potatoes takes 10

Economists use the term comparative advantage

The rancher has a lower opportunity cost of

Although it is possible for one person to have an absolute

The farmer gets 5 ounces of meat in exchange for 15

The moral of the story :

The U.S. PPF

The U.S. has enough labor

The U.S. Without Trade

Suppose the U.S. uses half its labor to

Derive Japans PPF

Your graph should measure computers on the

Japan has enough labor to

Japan Without Trade

Suppose Japan uses half its labor to

Consumption With and Without Trade

We will compare consumption without trade

Production under trade