Chapter 1 Economics Foundations and Models.ppt

Macro Economics

1. Economics
6
thedition
Chapter1
Economics:
Foundationsand
Models
1
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2. ChapterOutline
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1.ThreeKeyEconomicIdeas
2.TheEconomicProblemThatEverySocietyMustSolve
3.EconomicModels
4.MicroeconomicsandMacroeconomics
5.APreviewofImportantEconomicTerms
AppendixUsingGraphsandFormulas
2

3. Whatisthisclassabout?
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Peoplemakechoicesastheytrytoattaintheirgoals.Choices
arenecessarybecauseweliveinaworldofscarcity.
Scarcity:Asituationinwhichunlimitedwantsexceedthelimited
resourcesavailabletofulfillthosewants.
Economicsisthestudyofthechoicespeoplemaketoattain
theirgoals,giventheirscarceresources.
Economistsstudythesechoicesusingeconomic models,
simplifiedversionsofrealityusedtoanalyzereal-worldeconomic
applications.
3

4. Some typical “economics”questions
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Wewilllearnhowtoanswerquestionslikethese:
–Howarethepricesofgoodsandservicesdetermined?
–Howdoespollutionaffecttheeconomy,andhowshould
governmentpolicydealwiththeseeffects?
–Whydofirmsengageininternationaltrade,andhowdo
governmentpoliciesaffectinternationaltrade?
–Whydoesgovernmentcontrolthepricesofsomegoodsand
services,andwhataretheeffectsofthosecontrols?
4

5. 1.1ThreeKeyEconomicIdeas
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Explainthesethreekeyeconomicideas:Peoplearerational;peoplerespondtoeconomic
incentives;andoptimaldecisionsaremadeatthemargin
Weinteractwithoneanotherinmarkets.
Market:Agroupofbuyersandsellersofagoodorserviceandthe
institutionorarrangementbywhichtheycometogethertotrade.
Inanalyzingmarkets,wegenerallyassume:
1.Peoplearerational
2.Peoplerespondtoeconomicincentives
3.Optimaldecisionsaremadeatthemargin
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6. 1.Peoplearerational
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Economistsgenerallyassumethatpeoplearerational.
Rational:Usingallavailableinformationtoachieveyourgoals.
Rationalconsumersandfirmsweighthebenefitsandcostsofeach
action,andtrytomakethebestdecisionpossible.
Example:Apple doesn’t randomly choosethepriceofits
smartwatches;itchoosestheprice(s)thatitthinkswillbemost
profitable.
6

7. 2.Peoplerespondtoeconomic
incentives
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Asincentiveschange,sodotheactionsthatpeoplewilltake.
Example:Changesinseveralfactorshaveresultedinincreased
obesityinAmericansoverthelastcoupleofdecades,including:
•Decreasesinthepriceoffastfoodrelativetohealthfulfood
•Improvednon-activeentertainmentoptions
•Increasedavailabilityofhealthcareandinsurance,protecting
peopleagainsttheconsequencesoftheiractions
7

8. 3.Optimaldecisionsaremadeatthe
margin
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Whilesomedecisionsareall-or-nothing,mostdecisionsinvolve
doingalittlemoreoralittlelessofsomething.
Example:ShouldyouwatchanextrahourofTV,orstudyinstead?
Economiststhinkaboutdecisionslikethisintermsofthemarginal
costandbenefit(MCandMB):theadditionalcostorbenefit
associatedwithasmallamountextraofsomeaction.
ComparingMCandMBisknownasmarginal analysis.
8

9. MakingtheConnection:Health
insuranceandobesity(1of2)
ObesityisrisinginAmerica,forvariousreasons.
•Isoneofthosereasonshealthinsurance?
9
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10. MakingtheConnection:Health
insuranceandobesity(2of2)
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Peoplewithhealthinsurancehavelessincentivetostayhealthy
thanpeoplewithouthealthinsurance.
Holdingconstantotherfactorslikeage,gender,andincome,
researchshowspeoplewithhealthinsurancearemorelikelytobe
obese.
•Theyarerespondingtoeconomicincentives.
10

11. 1.2TheEconomicProblemThatEvery
SocietyMustSolve
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Discusshowaneconomyanswersthesequestions:Whatgoodsandserviceswillbeproduced?How
willthegoodsandservicesbeproduced?Whowillreceivethegoodsandservicesproduced?
Inaworldofscarcity,wehavelimitedeconomicresourcesto
satisfyourdesires.
•Thereforewefacetrade-offs.
Trade-off:Theideathat,becauseofscarcity,producingmoreof
onegoodorservicemeansproducinglessofanothergoodor
service.
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12. 1.Whatgoodsandserviceswillbe
produced?
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Individuals,firms,andgovernmentsmustdecideonthegoodsand
servicesthatshouldbeproduced.
Anincreaseintheproductionofonegoodrequiresthereductionin
theproductionofsomeothergood.Thisisatrade-off,resulting
fromthescarcityofproductiveresources.
Thehighest-valuedalternativegivenupinordertoengageinsome
activityisknownastheopportunitycost.
Example:theopportunitycostofincreasedfundingforspace
explorationmightbegivinguptheopportunitytofundcancer
research.
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13. 2.Howwillthegoodsbeproduced?
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Afirmmighthaveseveraldifferentmethodsforproducingits
goodsandservices.
Example#1:Amusicproducercanmakeasongsoundgoodby
•Hiringagreatsinger,andusingstandardproductiontechniques;
•Hiringamediocresinger,andusingAuto-Tunetocorrectthe
inaccuracies.
Example#2:Asthecostofmanufacturinglaborchanges,afirm
mightrespondby
•Changingitsproductiontechniquetoonethatemploysmore
machinesandfewerworkers
•Movingitsfactorytoalocationwithcheaperlabor
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14. 3.Whowillreceivethegoodsand
servicesproduced?
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ThewaywearemostfamiliarwithintheUnitedStatesisthat
peoplewithhigherincomesobtainmoregoodsandservices.
Changesintaxandwelfarepolicieschangethedistributionof
income;thoughpeopleoftendisagreeabouttheextenttowhich
this “redistribution” is desirable.
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15. Typesofeconomies
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Centrally planned economy:Aneconomyinwhichthe
governmentdecideshoweconomicresourceswillbeallocated.
Market economy:Aneconomyinwhichthedecisionsof
householdsandfirmsinteractinginmarketsallocateeconomic
resources.
Mixed economy:Aneconomyinwhichmosteconomicdecisions
resultfromtheinteractionofbuyersandsellersinmarketsbutin
whichthegovernmentplaysasignificantroleintheallocationof
resources.
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16. Efficiencyofeconomies
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Marketeconomiestendtobemoreefficientthancentrally-planned
economies.
Marketeconomiespromote:
•Productive efficiency,wheregoodsorservicesareproduced
atthelowestpossiblecost;and
•Allocative efficiency,whereproductionisinaccordancewith
consumerpreferences;inparticular,everygoodorserviceis
produceduptothepointwherethelastunitprovidesamarginal
benefittosocietyequaltothemarginalcostofproducingit.
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17. Sourceofeconomicefficiency
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Productiveefficiencycomesaboutbecauseofcompetition.
Allocativeefficiencyarisesduetovoluntaryexchange.
Voluntary exchange:Asituationthatoccursinmarketswhen
boththebuyerandthesellerofaproductaremadebetteroffby
thetransaction.
•Eachtransactionthattakesplaceimprovesthewell-beingofthe
buyerandseller;transactionscontinueuntilnofurther
improvementcantakeplace.
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18. Caveatsaboutmarketeconomies
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Marketsmaynotresultinfullyefficientoutcomes.Forexample:
•Peoplemightnotimmediatelydothingsinthemostefficientway
•Governmentsmightinterferewithmarketoutcomes
•Marketoutcomesmightignorethedesiresofpeoplewhoare
notinvolvedintransactions–ex:pollution
Economicallyefficientoutcomesmaynotbethemostdesirable.
Marketsresultinhighinequality;somepeopleprefermoreequity,
i.e.fairerdistributionofeconomicbenefits.
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19. Marketeconomiesandequity
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Economicallyefficientoutcomesarenotnecessarilydesirable.
•Lessefficientoutcomesmaybemorefairorequitable.
Equity:Thefairdistributionofeconomicbenefits.
Animportanttrade-offforagovernmentisthatbetweenefficiency
andequity.
Example:Ifwetaxincome,peoplemightworklessoropenfewer
businesses;butthosetaxreceiptscanfundprogramsthataidthe
poor.
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20. 1.3EconomicModels
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Describetheroleofmodelsineconomicanalysis
Economistsdevelopeconomicmodelstoanalyzereal-world
issues.
Buildinganeconomicmodeloftenfollowsthesesteps:
1.Decideontheassumptionstouseindevelopingthe
model.
2.Formulateatestablehypothesis.
3.Useeconomicdatatotestthehypothesis.
4.Revisethemodelifitfailstoexplaintheeconomicdata
well.
5.Retaintherevisedmodeltohelpanswersimilareconomic
questionsinthefuture.
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21. Importantfeaturesofeconomicmodels
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•Assumptionsandsimplifications:everymodelneedsthemin
ordertobeuseful.
•Testability:goodmodelsgeneratetestablepredictions,which
canbeverifiedordisprovenusingdata.
•Economic variables:somethingmeasurablethatcanhave
differentvalues,suchastheincomesofdoctors.
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22. Positiveandnormativeanalysis
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Economiststrytomimicnaturalscientistsbyusingthescientific
method.Buteconomicsisasocialscience;studyingthebehavior
ofpeopleisoftentricky.
Whenanalyzinghumanbehavior,wecanperform:
•Positive analysis:analysisconcernedwithwhatis
•Normative analysis:analysisconcernedwithwhatoughttobe
Economistsmostlyperformpositiveanalysis.
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23. MakingtheConnection:Shouldmedical
schoolbefree?
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Forecastsindicateasignificantshortageofdoctors,especially
primarycarephysicians,by2020.
Highcostsofmedicalschoolmay:
•Preventsomepeoplefrombecomingdoctors
•Leadpeopletopursuelucrativespecialtiesinsteadofprimary
care
Wouldmorepeoplebecomeprimarycarephysiciansifmedical
schoolwerefree?Andifso,woulditbeworththecost?
•Economicmodelscanfindanswerstothepositiveaspectsof
thisdebate.
23

24. 1.4Microeconomicsand
Macroeconomics
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Distinguishbetweenmicroeconomicsandmacroeconomics
Microeconomicsisthestudyof
•howhouseholdsandfirmsmakechoices,
•howtheyinteractinmarkets,and
•howthegovernmentattemptstoinfluencetheirchoices.
Macroeconomicsisthestudyoftheeconomyasawhole,
includingtopicssuchasinflation,unemployment,andeconomic
growth.
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25. Table1.1IssuesinMicroeconomicsandMacroeconomics
25
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26. 1.5APreviewofImportantEconomic
Terms
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Defineimportanteconomicterms
Likeallfieldsofstudy,economicsusestermsorjargonwith
specific,precisemeanings.
Sometimesthesetermswillbeusedinwaysthatdifferevenfrom
closelyrelateddisciplines.
Examples:
•Technology:theprocessesafirmusestoproducegoodsand
services
•Capital:manufacturedgoodsthatareusedtoproduceother
goodsandservices
Paycloseattentiontotermsdefinedinclassandinthetextbook!
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27. Appendix:UsingGraphsandFormulas
Usegraphsandformulastoanalyze
economicsituations
Amapisasimplifiedmodel
ofreality,showingessential
detailsonly.
Economicmodels,with
featureslikegraphsand
formulas,canhelpus
understandeconomic
situationsjustlikeamap
helpsustounderstandthe
geographiclayoutofacity.
27
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28. Figure1A.1BarGraphsandPieCharts
Panel(a)showsabargraphofmarketsharedatafortheU.S.
automobileindustry;marketshareisrepresentedbytheheightofthebar.
Panel(b)showsapiechartofthesamedata;marketshareis
representedbythesizeofthe “slice of the pie”.
28
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29. Figure1A.2Time-SeriesGraphs
Bothpanelspresenttime-series graphs of Ford Motor Company’s
worldwidesalesduringeachyearfrom2001to2010.
•Panel(a)hasatruncatedscaleontheverticalaxis,andpanel(b)does
not.
•As a result, the fluctuations in Ford’s sales appear smaller in panel (b)
thaninpanel(a).
29
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30. Figure1A.3PlottingPriceandQuantityPointsinaGraph
Thefigureshowsatwo-
dimensionalgridonwhichwe
measurethepriceofpizza
alongtheverticalaxis(ory-
axis)andthequantityofpizza
soldperweekalongthe
horizontalaxis(orx-axis).
Eachpointonthegrid
representsoneoftheprice
andquantitycombinations
listedinthetable.
Byconnectingthepointswith
aline,wecanbetterillustrate
therelationshipbetweenthe
twovariables.
30
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31. Figure1A.4CalculatingtheSlopeofaLine(1of2)
Wecancalculatethe
slopeofalineasthe
changeinthevalueof
thevariableonthey-axis
dividedbythechangein
thevalueofthevariable
onthex-axis.
Becausetheslopeofa
straightlineisconstant,
wecanuseanytwo
pointsinthefigureto
calculatetheslopeofthe
line.
31
xRun
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Slope
Changeinvalueontheverticalaxis

y

Rise
Changeinvalueonthehorizontal axis

32. Figure1A.4CalculatingtheSlopeofaLine(2of2)
Forexample,
whenthepriceof
pizzadecreases
from$14to$12,
thequantityof
pizzademanded
increasesfrom55
perweekto65
perweek.
So,theslopeof
thislineequals–
2dividedby10,
or–0.2.
32
xRun
Slope
Changeinvalueontheverticalaxis

y

Rise
Changeinvalueonthehorizontal axis
0.2Slope
Priceofpizza

($12$14)

2
Quantityofpizza (6555)10
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33. Figure1A.5ShowingThreeVariablesonaGraph(1of3)
Thedemandcurve
forpizzashowsthe
relationshipbetween
thepriceofpizzas
andthequantityof
pizzasdemanded,
holdingconstant
otherfactorsthat
mightaffectthe
willingnessof
consumerstobuy
pizza.
33
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34. Figure1A.5ShowingThreeVariablesonaGraph(2of3)
Ifthepriceofpizza
is$14(pointA),an
increaseinthe
priceof
hamburgersfrom
$1.50to$2.00
increasesthe
quantityofpizzas
demandedfrom55
to60perweek
(pointB)andshifts
ustoDemand
curve
2.
34
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35. Figure1A.5ShowingThreeVariablesonaGraph(3of3)
Or,ifwestarton
Demandcurve
1and
thepriceofpizzais
$12(pointC),a
decreaseinthe
priceofhamburgers
from$1.50to$1.00
decreasesthe
quantityofpizza
demandedfrom65
to60perweek
(pointD)andshifts
ustoDemand
curve
3.
35
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36. Figure1A.6GraphingthePositiveRelationshipbetween
IncomeandConsumption
Inapositiverelationship
betweentwoeconomic
variables,asonevariable
increases,theother
variablealsoincreases.
Inanegativerelationship,
asonevariableincreases,
theotherdecreases.
Thisfigureshowsthe
positiverelationship
betweendisposable
personalincomeand
consumptionspending.
36
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37. Figure1A.7DeterminingCauseandEffect
Usinggraphstodrawconclusionsaboutcauseandeffectis
dangerous.
Forexample,inpanel(a),asthenumberoffiresinfireplaces
increases, the number of leaves on trees falls; but the fires don’t
causetheleavestofall.
Inpanel(b),asthenumberoflawnmowersbeingusedincreases,
sodoestherateatwhichgrassgrows.
37
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38. Aregraphsofeconomicrelationships
alwaysstraightlines?
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Therelationshipbetweentwovariablesislinearwhenitcanbe
representedbyastraightline.
Feweconomicrelationshipsareactuallylinear.Howeverlinear
approximations are simpler to use, and are often “good enough” in
modeling.
38

39. Figure1A.8TheSlopeofaNonlinearCurve(panel(a))
Anon-linearcurvehasdifferent
slopesatdifferentpoints.This
curveshowsthetotalcostof
productionforvariousquantities
ofAppleWatches.
Wecanapproximateitsslope
overasectionbymeasuringthe
slopeasifthatsectionwere
linear.
BetweenCandD,theslopeis
greaterthanbetweenAandB;so
wesaythecurveissteeper
betweenCandDthanbetweenA
andB.
39
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40. Figure1A.8TheSlopeofaNonlinearCurve(panel(b))
Anotherwaytomeasurethe
slopeofanon-linearcurveisto
measuretheslopeofatangent
linetothecurve,atthepointwe
wanttoknowtheslope.
Cost

75
75
40
Quantity1
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41. Formulaforapercentagechange
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Oneimportantformulaisthepercentagechange,whichisthe
changeinsomeeconomicvariable,usuallyfromoneperiodtothe
next,expressedasapercentage.
Percentage change 
Value in the second period Value in the first period
100
Value in the first period
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42. Figure1A.9ShowingaFirm’sTotalRevenueona Graph
Theareaofarectangle
isequaltoitsbase
multipliedbyitsheight;
totalrevenueisequalto
quantitymultipliedby
price.
Here,totalrevenueis
equaltothequantityof
125,000bottlestimes
thepriceof$2.00per
bottle,or$250,000.
Theareaofthegreen-
shadedrectangleshows
the firm’s total revenue.
42
AreaofarectangleBaseHeight
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43. Figure1A.10TheAreaofaTriangle
Theareaofatriangleis
equalto½multipliedby
itsbasemultipliedbyits
height.
Theareaoftheblue-
shadedtrianglehasa
baseequalto150,000
–125,000,or
25,000,andaheight
equalto$2.00–$1.50,
or$0.50.
Therefore,itsarea
equals½×25,000×
$0.50,or$6,250.
43
Areaofatriangle
1
BaseHeight
2
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44. Summaryofusingformulas
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Wheneveryoumustuseaformula,youshouldfollowthesesteps:
1.Makesureyouunderstandtheeconomicconcepttheformula
represents.
2.Makesureyouareusingthecorrectformulafortheproblem
youaresolving.
3.Makesurethenumberyoucalculateusingtheformulais
economicallyreasonable.Forexample,ifyouareusingaformula
to calculate a firm’s revenue and your answer is a negative
number,youknowyoumadeamistakesomewhere.
44