The Five Foundations

of Economics

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Big Questions1. What is economics?

2. What are the fundamental concepts underlying economic models?

3. How do we model/predict economic behavior?

And does it work?

Key TermsCommon understanding of key terms

Use them as shorthand for the concept; but have a precise/exact meaning

Scarcity There are not enough resources to produce and

consume all of the goods and services we desireOpportunity costs

What must be given up (next best alternative use of time/money) as a result of a decision or choice

“No such thing as a free lunch” (Milton Friedman)Cost-benefit analysis

Every decision/action has tradeoffsi.e., every decision has an opportunity cost

What is Economics2 major fields of inquiry

Microeconomics Study of individual markets and factors that affect market

price, quantity supplied two principal actors: consumers/households and

firms/producers Macroeconomics

Study of a system of (national) markets focusing on national income (gross national product), price levels (inflation), employment/unemployment and international trade

Focuses on the role of government (Congress and budgets, Federal Reserve Bank), regulation (and regulatory agencies, business cycles and their effect on the economy

Ten Principles of Economics

Micro-economists study:How people and firms make decisions and what

factors affect their decisionsHow people and firms interact with one

another in the marketplace

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Scarcity The Key Economic ProblemScarcity means limited resources

The limited nature of society’s resources (e.g. raw materials) means that we have to choose which goods get produced with scarce resources and how they are allocated/distributed to the consumer

EconomicsStudies of how people(consumers) and

firms(producers) make these decisions when constrained by scarcity

Determine what are the key factors affecting their decisions and modelling their decision making process

Big QuestionsEconomics is the study of how people allocate

their limited resources (income and time) to satisfy nearly unlimited wants and how firms use limited resources (raw materials) to meet consumer demand

The fundamental concepts on which economic models (decision-making) are based:

1. Incentives

2. Trade-offs

3. Opportunity cost

4. Marginal thinking

5. Trade creates value

Foundations underlying the ModelThe five underlying concepts of economic models:

1. Incentives – people respond to incentives Price is an incentive - lower price -> buy more

Lowering tuition costs

2. Trade-offs – buy one good -> can’t buy others Compare value/price of alternative use of income/time

3. Opportunity cost – what is given up Value of “best” alternative not chosen

4. Marginal thinking compare “additional” value of 1 more unit to its price when

making purchase decision (not total value/cost of all units)

5. Trade creates value Why people voluntarily enter into market transactions

How People Make DecisionsPrinciple 1: People face trade-offsMaking decisions

Trade off one goal against another Student – time (sleeping versus studying) Parents – income (consume or save) National defense vs. consumer goods Clean environment vs. high level of income Efficiency vs. equality

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Modelling Tradeoffs – Individual’s Choices Between 2 goodsIn microeconomic theory, an indifference

curve is a graph showing different bundles of goods between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for one bundle over another.

Production Possibilities Frontier- Choice between producing 2 goods

Production possibilities frontierCombinations of outputs that a society can

produce if all of its resources are being used efficiently

Assumptions of this modelTechnology fixedResources fixedSimplified two-good analysis

Production Possibilities Frontier

How People Make DecisionsPrinciple 2: The cost of something is what you

give up to get it - each decision has an opportunity cost

Because people face trade-offs when making choices – you have to give something up to get something Benefit/Cost Analysis to make decisions

Compare cost with benefits of alternatives Implies opportunity cost (of what is not chosen) is

incurred Whatever most be given up to obtain one item

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How People Make DecisionsPrinciple 3: Rational people think at the marginRational people

Systematically & purposefully do the best they can to achieve their objectives

Rational decision maker – take action only ifMarginal benefits > Marginal costs

Marginal Benefits – change (or increase) in total benefits from choice

Marginal Costs – change/increase in costs from choice (opportunity costs of “not chosen”)

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3. Optimal decisions are made at the “margin”

What do we mean?When making an economic decision, e.g. to

purchase 1 more unit of a good, we compare the marginal (or incremental) benefits against the marginal costs

For exampleWhen studying for an exam

Given you’ve already studied 8 hours, when deciding whether or not to study 1 more hour, you compare the expected benefits (a “marginal” improvement in your

grade Versus the next best (highest valued) use of your time

E.g., sleeping, eating, time with friends

Marginal DecisionsBack to the First Law of Demand

How much of a good do you buy? If the marginal/incremental value of the next unit is

less than what it costs, are you willing to buy it?

MV < priceDon’t buy!

MV < priceDo buy!

How People Make DecisionsPrinciple 4: People respond to incentivesIncentive

Something that induces a person to actIn economics – which incentives affect market

behavior and how important is each Higher price

Buyers - consume less Sellers - produce more

Public policy Change costs or benefits Change people’s behavior

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Incentives at work

An example: the First Law of DemandAs the price per unit of the good declines, a

consumer (all other things held constant, e.g. their income) will choose to buy more of the good over the same time period

How People Make DecisionsPrinciple 4: People respond to incentives

Gasoline tax Car size & fuel efficiency; carpool; public transportation

State will raise gasoline tax in July Reduced single-occupancy cars; less essential trips Increased demand for mass transit, car-pooling

Highway 520 bridge tolls Revenues used to finance new construction

Unintended consequences Policymakers fail to consider how their policies affect

incentives Will toll increase increase/decrease revenues?

(Elasticity)19

Will Women Have More Babies if the Government Pays Them To?

Makingthe

Connection

Learning Objective 1.1

The Estonian government is encouraged by the results of providing economic incentives and is looking for ways to provide additional incentives to raise thebirthrate further.

How People InteractPrinciple 5: Trade can make everyone better off Trade

Specialization Allows each person/country to specialize in the

activities he/she does bestPeople/countries can buy a greater variety of

goods and services at lower cost

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Gain from Trade - Specialization

Key Assumptions About Individual Economic Behavior

Alchian and Allen

1. For each person, some goods are scarce -> choices2. Each person desires many goods and goals ->

tradeoffs3. Each person is willing to give up some of one

economic good to get more of another economic good -> basis for trade

4. The more one has of a good, the lower is its personal marginal value -> diminishing marginal value

5. Not all people have identical tastes and preferences6. People are innovative and rational

An Example of a Model Built on These Assumptions

A Model of Consumer Demand

What is Economics?Economics

Analyzes the production and distribution/allocation of goods and services – i.e. how the market place works Or how “stuff” is made and bought, and how its

market price is determined. who gets what how/who makes it

Models how individuals and firms make decisions about: What to purchase (choosing how to allocate income

among various goods, services and savings/future consumption)

What goods are produced (and not) What technologies to use How goods get allocated to which consumers in the

marketplace26

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