Lecture Notes – Introduction

Definitions
Scarcity: most resources are limited, human wants are unlimited
Example: water is a ‘scarce’ good, but gravity is not scarce.

Economics: study of managing scarce resources

Alternative definition: study of choice by people facing scarcity
No scarcity, no need to choose!

Choices are everywhere, so Economics is everywhere.

Examples of choices:
1. High-school student choosing between working after graduation vs. going to college
2. Firm choosing between hiring a worker vs. not
3. Consumer choosing between Tylenol and generic at CVS
4. Govt. choosing between cutting taxes vs. not

Microeconomics: study of individual ‘agents’ within the economy such as households and firms
Example: study of impact of increase in price of burgers on the quantity demanded of fries
Macroeconomics: study of issues pertaining to the whole economy such as unemployment and inflation
Example: study of impact of increase in minimum wage on unemployment

Fundamental questions that Economics attempts to answer:

1. what to produce
2. how to produce
3. for whom to produce

Who answers these questions depend on the type of economy:

1. free market – buyers and sellers
2. planned – central planner (usually the govt.)
3. mixed – combination of buyers and sellers and govt.

Principles of Economics
People face tradeoffs
“There’s no such thing as a free lunch.”
Example: you have exam tomorrow; if you study 1 more hour, you will get 1 less hour of sleep
Opportunity cost: next best alternative that is sacrificed
Example: 1 hour of sleep is the opportunity cost of 1 hour of study time
Opportunity cost is not the sum of all alternatives that are sacrificed
Example: you could have played video games for 1 more hour instead of studying for the exam. If you
value 1 more hour of sleep more than 1 more hour of playing video games, then the opportunity cost of
staying up late to study one more hour is the sleep, not playing video games.

People think at the margin

Marginal Benefit: the extra utility you get from increasing the quantity of a choice variable
Marginal Cost: the extra cost you bear from increasing the quantity of a choice variable
Example:
Walmart pays $8 per hour to a cashier.
During holiday season, opening up one more register allows more customers to be served and generates
$10 per hour of additional sales.
Marginal Benefit = $10 > $8 = Marginal Cost. Decision: open one more register

Sunk cost: cost that cannot be recovered

Example:
Walmart paid for the cash register when they first opened the store.
It cannot return it to the manufacturer.
The cost of the cash register is ‘sunk’.
Sunk costs play no role in decision-making.

People respond to incentives

Incentive: a desire to gain reward or avoid punishment.
Example: airlines imposed fees on checked baggage. Passengers now use much larger and multiple
carry-ons. They have the incentive to save on the checked baggage fee.
Example: at some condo complexes, the water bill is included in the condo fee and is fixed. Individual
owners do not have the incentive to minimize water usage. Billing by usage would create that incentive
to conserve.

There are often second order effects of actions

First order effect: direct impact of some action
Second order effect: indirect impact of some action
Example: first order effect: enactment of seat-belt laws causes fewer injuries and deaths to people
inside the vehicle
Second order effect: drivers feel safer and drive more aggressively; more accidents occur, and more
pedestrians get injured or die.
“Law of unintended consequences”

Methodology
Economist as a Scientist
Natural science: studies natural phenomena, like gravity and energy (physics) and life forms (biology)
Social science: studies human behavior, like why people form groups (sociology) and why people trade
(economics)
Just like in natural sciences, economists use the scientific method to explain the world
Steps in scientific method:
1. Make observations
2. Think of interesting questions
3. Formulate hypotheses
4. Gather data to test predictions
5. Refine, alter, expand or reject hypotheses
6. Develop general theories
Example:
1. Some countries are rich, some poor
2. Why the disparity in income?
 3. It may be due to differences in natural resource endowment.
4. Collect data on each country’s natural resources.
5. Japan has little resources but yet is very rich; Nigeria has a lot of oil but still poor.
Reject Initial hypothesis. New hypothesis: geography (climate, access to sea etc.) matters.
Go back to Step 4.
6. General theory: combination of multiple factors contribute to why some countries are rich

One problem in social sciences is the relative difficulty in conducting lab experiments.
So, often economists rely on ‘natural experiments’.
Example: Mariel Boatlift
Question: Does influx of low-skilled workers reduce wages or increase unemployment of local low-
skilled workers?
Economists cannot simply increase number of emigrant workers in an area on their own.
In just over 6 months in 1980, 125,000 Cubans immigrated to Miami by boat.
Economists used this opportunity to answer their question.

Models: simplification of reality to focus on important aspects

Examples of models:
1. Map
2. Anatomical model
3. Graph
4. Equation

To simplify reality, Economists make assumptions when modeling.

Example:
1. Two countries, two goods in a model of trade
2. People are rational
Assumptions can be benign or harmful.
Behavioral economics: people are often not rational. This affects the conclusions we derive using our
models.

Factors of production: any resource used to produce something

1. Natural resources. Example: land, oil, trees
2. Labor
a. Physical labor. Example: construction worker
b. Human capital. Example: engineer
3. Capital. Example: hammer, delivery truck
4. Entrepreneur. Example: owner, shareholders

Another example of a model:

Recall: people (or firms or countries) face tradeoffs.
Production Possibilities Frontier: shows the various combinations of output that a country can produce
Mama Jane’s Pizza offers pizzas and cheesecake for dessert.
Assume it uses only one factor of production, labor.
There are 4 workers, each of whom work 10 hours a day.
Also assume one worker can work on one item at a time only.
Making 1 pizza requires 30 minutes (0.5 hours) of labor.
Making 1 cheesecake requires 1 hour of labor.
 Employment of labor hours Production
Pizzas Cheesecakes Pizzas Cheesecakes
A 40 0 80 0
B 30 10 60 10
C 20 20 40 20
D 10 30 20 30
E 0 40 0 40

The slope of the PPF is the opportunity cost.

Economist as Policy Advisor

Economists as policy advisors try to improve the world.
Positive statement: statements that predict what is likely to happen or not happen due to some event
or action
Example: increasing taxes on cigarettes by 5% will lead to a decrease in smoking by 10%
Normative statement: statements that suggest what should happen
Example: taxes on cigarettes should be increased by 5%.