Chapter 1 Section 2

Economic Theory

Economic Theory

Economic model Is a simplification of economic reality

that is used to make predictions about the real world.

Ex. What happens to the consumption of Pepsi when its price increases.

Simplify the ProblemCaptures the important elements of the

problem under study.One way to strip down reality is by

using simplifying assumptions.

Simplifying Assumptions The idea is to identify the variables of interest

and then focus exclusively on the relations among them, assuming that nothing else of importance changes- that other things remain constant.

Isolate the relationship b/w these two variables Price and quantity purchased- model no other changes in other variables.

Ex. Pepsi ( consumer income, Price of Coke, and average outdoor temperature. No changes to these variables.)

Economist –assumptions what motives people-how they behave.Behavioral Assumption-how people

behave.

Basic behavioral assumptions is that people make choices based on their own self-interest.

Rational Self InterestEconomists mean that you try to make

the best choices you can, given the information available.

Rational In general, rational self interest means

that you try to maximize the expected benefit achieved with a given cost or to minimize the expected cost of achieving a given benefit.

Continued The assumption of rational self interest does

not rule out concern for others. It simply means that concern for others is influenced to some extent by the same economic forces that affect other economic choices.

Ex. The lower your personal cost of helping others, the more help you will offer.

Every body uses theoriesVending machineEconomists tell stories about how they

think the economy works.

Normative Versus Positive Statements Economists sometimes concern themselves

not with how the economy does work but how it should work.

Ex.Unemployment rate is 5.8%. The U.S. unemployment rate should be lower.

Positive economic statement, b/c it is a statement about economic reality that can be supported or rejected by reference to the facts.

Normative economic statement It reflects someone’s opinion.

MarginalMeans incremental, additional, extra, or

one more.Marginal refers to a change in an

economic variable, a change in status quo.

Status quo means the existing state of affairs.

ContinuedA rational decision maker will change

the status quo as long as the expected marginal benefit from the change exceeds the expected marginal cost.

ExampleCompare the marginal benefit you

expect from eating dessert (added satisfaction)With its marginal cost (the added dollar, cost, time, and

calories).

ExampleAmazon.com compares the marginal

benefit expected from adding a new products.

(the added sales revenue)With the marginal cost (the added cost of resources required)

Jack n the box 2 tacos for 99 cents You normally order 6 tacos, but of the 6 eat

only 5. Marginal benefit would be to eat food, taste,

satisfaction Marginal cost – money, time, that the value of

the 6th taco is not worth 49 cents it would cost.

Food and money would be wasted.

Market economics Aka Microeconomics-your economic behavior

and the economic behavior of others who make choices involving what to buy and what to sell, how much to work and how much to play, how much to borrow and how much to save.

Ex. The factors that influence individual economic choices and how markets coordinate the choices of various decision makers. Ex. cereal

National economicsAka Macroeconomics focuses on the

performance of the economy as a whole, especially the national economy.

Ex. Takes a look at all the pieces of the economy as a whole.

HouseholdsPeopleAs consumers, households demand the

goods and services produced.As resource owners, households supply

the resources used to produce goods and service.

Reminder Human resources, Natural resources, Capital Goods

Firms, governments, and the rest of the worldDemand the resource that households

supply, and then use these resources to supply the goods and services that households demand.

MarketsAre the means by which buyers and

sellers carry out exchange.Brings to together supply and demand.Supply- a relation showing the

quantities of a good producers are willing and able to sell at various prices during a given period, or other things constant.

continuedDemand – A relation showing the

quantities of a good that consumers are willing and able to buy at various prices per period, other things constant. (shopper)

PriceQuantity purchased

Continued Income-salary or wage for human resources. Expenditure-the amount of money that people

spend on product or good and services. Resources payments - companies have to

pay for their resources. (human resources-labor, natural resource, capital resources-building.)

Revenue -