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Chapter 1

Chapter 1. Economics: the Study of Opportunity Cost. Definition of Economics. According to Guell : Economics : the study of the allocation and use of scarce resources to satisfy unlimited human wants Opportunity Cost The forgone alternative of the choice made Or

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Chapter 1

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  1. Chapter 1 Economics: the Study of Opportunity Cost

  2. Definition of Economics According to Guell: • Economics: the study of the allocation and use of scarce resources to satisfy unlimited human wants • Opportunity Cost • The forgone alternative of the choice made Or • What you would have done had you not done what you did.

  3. Opportunity Costs • Point of both of these is that if you want to get more of one thing you typically have to give up something of another We see these things all the time: • In order to buy food I need to give up money • In order to get money I have to give up some free time and work more • If I want to eat more potato chips I have to spend less on bananas • I spend time in school today to make money in the future

  4. The opportunity cost can be different over time When you study you give up time when you could be doing something else. The opportunity cost of your time probably is different: On a Monday Evening On a Saturday Night During the Super Bowl On thanksgiving On the day you get married

  5. Production Possibilities Frontier • We are going to start with a simple model to learn how economists formalize these things • This is called a production possibilities frontier • Just a fancy way of describing the the way in which we are limited in what we can get

  6. Production Possibilities Frontier Imagine you are in charge of a small tribe on an island. You have 2 workers and you want to allocate them between two different tasks: Hunting or Fishing You know how good the workers are at each skill:

  7. Workers How do you assign them? There are 4 different possibilities that would lead to the following outcomes:

  8. Fish and Deer Deer Inefficient Fish

  9. Now suppose we add a Few More People This gives us quite a few more options

  10. Possibilities Now Deer Fish

  11. With a Lot of People Now it is going to look something like this: We are going to end up somewhere on the red line Attainable (and efficient) Not Attainable Deer Attainable (but not efficient) Fish

  12. What will I Choose? I know that I will be somewhere on the red line But where? It depends how much I like venison as opposed to seafood There is a tradeoff between fish and deer: The more deer I get the fewer fish I can get Economics is fundamentally about making these kinds of tradeoffs

  13. Increasing Opportunity Costs When things are bowed out like this there are increasing opportunity costs Suppose the PPF looks like what is on the next slide Think about the opportunity cost of a Deer when • I have no Deer • I already have 4 Deer

  14. Increasing Opportunity Cost If I already have 4 Deer, the opportunity cost of another is 5 fish Deer If I have no Deer, the opportunity cost of a deer is 1 fish Fish

  15. Homogeneous Workers Now suppose all workers are the same

  16. PPF with Workers Same Here the opportunity cost is constant The opportunity cost of 2 more deer is 20 fish regardless of how many deer I already have Deer Fish

  17. Budget constraint This is also very similar to another really important concept: the budget constraint • Suppose you have $100 to spend on Deer and Fish • The price of a fish is $1.00 • The price of a deer is $10.00 • This will look exactly the same

  18. The Big Picture Circular Flow Model: A model that shows the interactions of all economic actors • Markets are where the interactions take place (rectangles) • Actors are the entities interacting (ovals)

  19. Markets in a Circular Flow Diagram • Market: Any mechanism by which buyers and sellers negotiate an exchange • Factor Market: A mechanism by which buyers and sellers of labor and financial capital negotiate an exchange. • Goods and Services Market: A mechanism by which buyers and sellers of goods and services negotiate an exchange. • Foreign Exchange Market:A mechanism by which buyers and sellers of the currencies of various countries negotiate an exchange.

  20. Actors in a Circular Flow Diagram • Households • Firms • Government

  21. Thinking Economically: Marginal Analysis • Optimization Assumption: an assumption that suggests that the person in question is trying to maximize some objective • We usually assume people are maximizing utility or happiness • Firms maximize profits

  22. Marginal Costs and Benefits • Marginal Benefit: the increase in the benefit that results from an action • Marginal Cost: the increase in the cost that results from an action Generally we do things until the marginal cost=marginal benefit • If the marginal cost of fish I give up is greater than the marginal benefit I get from more deer, then I have too many deer • If the marginal cost of fish is less than the marginal benefit then I want more deer

  23. Positive and Normative Analysis • Positive Analysis: a form of analysis that seeks to understand the way things are and why they are that way • Normative Analysis: a form of analysis that seeks to understand the ways things should be

  24. Economic Incentives • Incentive: something that influences the decisions we make Examples: • Hourly wage influences how many hours you work • My grade scale influences how hard you study • Price of gas influences how much gas you buy • Taxes on pineapples influence how many pineapples you eat • Paying teachers based on students test scores influences how they teach

  25. Unintended Consequences Thinking about policy the most important thing economics has to offer is that policies often affect incentives and these incentives can have unintended consequences Examples: • Taxes • Teacher Cheating • Welfare(and other social programs) • Insurance • Safety Regulations

  26. Correlation and Causation If I was still teaching econometrics I would make a really big deal of this Often what we learn in economics depends on data and how we think about data is important Causation just means that one thing causes another

  27. Correlation means that they are related in the data (tend to move together) Things that are positively correlated: Height/Weight Wife’s Education/Husband’s education GDP/Food Consumption Things that are negatively correlated: Unemployment/GDP Growth Family Income/Family Size Things that are not correlated have no relationship Temperature here/weight of Vice President Result of first die/result of second die

  28. Just because two things are correlated does not mean that one causes the other • Possibilities: • A causes B • A causes B and B causes A at the same time • Z causes both A and B • These are not mutually exclusive • This is not a minor problem-it makes empirical work in economics very difficult • As we will see in this course theory is not enough-we need to combine models with evidence to really say anything strong about policy

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