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Some definitions of economics
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• “Economics is a study of mankind in the
ordinary business of life”
•Alfred Marshall
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• "the purpose of studying economics is not to acquire a set
of ready-made answers to economic questions, but to learn how to avoid being deceived by
economists."
• Joan Robinson
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• “Economics is what economists do”
• Jacob Viner
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Economics (1)
• Study of the choices people make to attain their goals given their scarce resources.
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Economics: Foundations and Models1. What do economists study?
• gasoline prices, inflation, housing markets, international trade, income inequality, sports, families, smoking, health care, happiness
• decision-making or choices
2. How do they do it?
• by using theories and models
• theories are based on assumptions
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What makes a good theory or a model?
• Models are not judged by their realism but by their usefulness
• What is the most useless map in the world?To be useful a model has to be refutable
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Why study theory?
• “I don’t know how it is in theory but here is what I know from my 20 years of experience will happen “
• Laura, Executive MBA student
• Theory saves time!
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•When Economists Disagree: A Debate over Outsourcing
Makingthe
Connection
Learning Objective 1.3
Does outsourcing by U.S. firms raise or lower incomes in
the United States?
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Economics (2)
• Study of the choices people make to attain their goals given their scarce resources.
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Economics
When the price is zero there is not enough for
everyone
People behave as if they are comparing
the costs and benefits
Scarcity Choices
Benefits
Costs
Unlimited wants
Limited availabilit
y
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Economics
Everything has alternative uses
Scarcity
Tradeoffs
Opportunity cost
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Economics
People are rational when they behave as if they were comparing
costs and benefits
Choices
People respond to incentives
Decisions are made on the margin
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14
as if• Does a pool player need to know the
laws of trigonometry and physics to win?
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as if• “…getting out of bed in the
morning and making breakfast involves more complex decisions than the average game of chess. (Will that fries egg kill me in twenty-eight years?)”
• Charles Wheelan
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Economics (3)
• Study of the choices people make to attain their goals given their scarce resources.
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Trade-offs force society to make choices, particularly when answering the following three fundamental questions:
1 What goods and services will be produced?
2 How will the goods and services be produced?
3 Who will receive the goods and services produced?
The Economic Problem That Every Society Must Solve
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Centrally planned economy An economy in which the government
decides how economic resources will be allocated.
The Economic Problem That Every Society Must Solve
Market economy An economy in which the decisions of households and firms
interacting in markets allocate economic resources.
• Centrally Planned Economies versus Market Economies
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Mixed economy An economy in which most economic decisions result from
the interaction of buyers and sellers in markets but in which the government
plays a significant role in the allocation of resources.
The Economic Problem That Every Society Must Solve
• The Modern “Mixed” Economy
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Positive analysis Analysis concerned with what is.
Economic Models• Normative and Positive Analysis
Normative analysis Analysis concerned with what ought to
be.
Don’t Let This Happen to YOU!Don’t Confuse Positive Analysis with Normative Analysis
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The Market The Market System and System and the Circular the Circular
FlowFlow2C H A P T E R
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PROPERTY RESOURCESPROPERTY RESOURCES1. LAND1. LAND
2. CAPITAL2. CAPITAL
HUMAN RESOURCESHUMAN RESOURCES3. LABOR3. LABOR4. ENTREPRENEURIAL ABILITY4. ENTREPRENEURIAL ABILITY
SCARCE RESOURCESSCARCE RESOURCESECONOMIC RESOURCESECONOMIC RESOURCES
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Resource payments: correspond to resource Resource payments: correspond to resource categoriescategories
RENTALRENTALINCOMEINCOME
INTERESTINTERESTINCOMEINCOME
WAGESWAGESPROFIT &PROFIT &
LOSSLOSS
PROPERTY RESOURCESPROPERTY RESOURCES
LANDLAND
CAPITALCAPITALHUMAN RESOURCESHUMAN RESOURCES
LABORLABOR
ENTREPRENEURENTREPRENEUR
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Macroeconomics Starts Here
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Economic Systems
• Definition: A particular set of institutional arrangements and a coordinating mechanism to respond to the economizing problem.
• Economic systems differ as to: 1) who owns the factors of production 2) the method used to motivate, coordinate, and
direct economic activity.
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The Command System
• The government owns most property resources and economic decision making occur through a central economic plan.
• The central planning board determines production goals for each firm and resources to be allocated.
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The Market System
• There is private ownership of resources.• Markets and prices coordinate and direct
economic activity.• Each participant acts in its own self-interest.• In pure capitalism the government plays a very
limited role.
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Characteristics of the Market System
• Private Property.• Freedom of firms to choose.• Self interest.• Competition.• Markets and prices.• Technology and capital goods.• Specialization.• Use of money.• Active, but limited government.
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The Circular Flow Model
• There are two groups of decision makers in There are two groups of decision makers in the private economy: households the private economy: households (resource (resource owners)owners) and businesses and businesses (resource users)(resource users)
• The market system The market system (resource markets and (resource markets and product markets)product markets) coordinates these decisions. coordinates these decisions.
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What happens in the resource markets? What happens in the resource markets? a.a. Households Households sellsell resources directly or resources directly or
indirectly (through ownership of corporations) to indirectly (through ownership of corporations) to businesses.businesses.
b. Businesses b. Businesses buybuy resources in order to produce resources in order to produce goods and services.goods and services.
c.c. Interaction of these sellers and buyers Interaction of these sellers and buyers determines the determines the price of each resourceprice of each resource, which in , which in turn provides turn provides incomeincome for the owner of that for the owner of that resource.resource.
d.d. Flow of payments from businesses for the Flow of payments from businesses for the resources constitutes business resources constitutes business costscosts and resource and resource owners’ owners’ incomesincomes..
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What happens in the product markets?What happens in the product markets?a. Households are on the a. Households are on the buyingbuying side of these side of these
markets, purchasing goods and services.markets, purchasing goods and services.
b.b. Businesses are on the Businesses are on the sellingselling side of these side of these markets, offering products for sale.markets, offering products for sale.
c.c. Interaction of these buyers and sellers determines Interaction of these buyers and sellers determines the price of each product.the price of each product.
d.d. Flow of consumer expenditures constitutes Flow of consumer expenditures constitutes sales receiptssales receipts for businesses. for businesses.
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CIRCULAR FLOW MODEL
BUSINESSES HOUSEHOLDS
RESOURCEMARKET
PRODUCTMARKET
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BUSINESSES HOUSEHOLDS
RESOURCEMARKET
RESOURCES INPUTS
PRODUCTMARKET
CIRCULAR FLOW MODEL
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BUSINESSES HOUSEHOLDS
RESOURCEMARKET
RESOURCES INPUTS
$ COSTS $ INCOMES
GOODS &GOODS &SERVICESSERVICES
GOODS &GOODS &SERVICESSERVICES
PRODUCTMARKET
CIRCULAR FLOW MODEL
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BUSINESSES HOUSEHOLDS
RESOURCEMARKET
RESOURCES INPUTS
$ COSTS $ INCOMES
PRODUCTMARKET
GOODS &SERVICES
GOODS &SERVICES
CIRCULAR FLOW MODEL
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BUSINESSES HOUSEHOLDS
RESOURCEMARKET
RESOURCES INPUTS
$ COSTS $ INCOMES
PRODUCTMARKET
GOODS &SERVICES
GOODS &SERVICES
$ CONSUMPTION$ REVENUE
CIRCULAR FLOW MODEL
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CIRCULAR FLOW MODEL
BUSINESSES HOUSEHOLDS
RESOURCEMARKET
RESOURCES INPUTS
$ COSTS $ INCOMES
PRODUCTMARKET
GOODS &SERVICES
GOODS &SERVICES
$ CONSUMPTION$ REVENUE
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More Realistic Circular Flow
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Macroeconomic Policies
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Limitations of the model:
1. Does not depict transactions between households and between businesses (inter-businesses).
2. Ignores government and the “rest of the world” in the decision-making process (we will take care of them later on).
3. Does not explain how prices of products and resources are actually determined.