Chapter 1 FUNDAMENTALS OF ECONOMICS

Economics is the study of how people allocate limited resources among unlimited wants.
Scarcity is the state of not having enough of something to satisfy everyone who wants. People use things to satisfy their wants, but the supply of things is limited. Therefore people allocate the things they own or can obtain to satisfy their most important wants first, leaving only their least important wants unsatisfied. Economic goods can be used to satisfy wants and are scarce. Free goods are either too plentiful to be scarce, or are of no use in satisfying wants. Economic bads are something you would not pay for, and would have to be paid to accept. Economics considers behavior in the context of rational self-interest.

limited resources + unlimited wants = scarcity 

1-4 deal with Individual Decision Making
5-7 deal with Interpersonal Interaction
8-10 deal with the Macroeconomy

#1 People face tradeoffs
Efficiency v. equity 

#2 The cost of something is what you give up to get it (opportunity cost) 

#3 Rational people think at the margin
Optimization occurs incrementally 

#4 People respond to incentives

#5 Trade can make everyone better off (division or specialization of labor)
Applies to trade among countries as well as trade among individuals 

#6 Markets are usually a good way to organize economic activity
The invisible hand serves the common interest 

#7 Government can sometimes improve market outcomes
Market failure, externalities, monopolies (market power)

#8 A country's standard of living depends on its ability to produce goods and services
Mercantilists v. Adam Smith 

#9 Prices rise when the government prints too much money (the quantity theory of money)
MV = PQ 

#10 Society faces a short-run tradeoff between inflation and unemployment (the Phillips curve)

Positive analysis deals with the way things are. Normative analysis deals with the way things should be. The scientific method in economics consists of five steps:
 

1. Recognition - describing the phenomenon to be explained.

2. Assumptions - stating the assumptions your model will be based on. Assumptions make theories simpler than reality.

3. Model building - using your assumptions and observed facts from step one to reach a testable hypothesis, which is a conclusion or prediction of your model or theory.

4. Stating a hypothesis - stating a prediction of your model, which can be compared to data from the real world to see how well your theory agrees with reality.

5. Hypothesis testing - the theoretical conclusion is compared to real world data.

Opportunity costs are the highest-valued alternative that must be given up when a choice is made. 

Marginal costs and benefits are examined to analyze economic choice. The marginal cost of an activity is the cost of the last increment. If the activity is eating candy bars, the marginal cost is the cost of the last one eaten. It may be the same as the cost of the first one eaten. It can be lower if you get a quantity discount, or it can be higher if you eat so many that you bid up the price! The marginal benefit is the enjoyment you get from eating the last candy bar. Normally, marginal benefit declines as more is consumed. Consumers increase an activity until marginal cost is greater than marginal benefit. The amount consumed is either the last unit where marginal benefit is still greater, or where marginal cost and marginal benefit are exactly equal. 

Specialization makes the PPF bowed outward instead of a straight line. Resources best for producing one good rather than the other are used first for producing that good, providing large increments in production of the first good, at the cost of very small amounts of the second good. Resources best for producing the other good are used last for producing the first good, providing very small increments in production of the first good, at the cost of very large amounts of the second good. 

Marginal opportunity cost is the amount of one good that must be given up to obtain one additional unit of another good. The marginal opportunity cost of A is the amount of B which must be given up to obtain one more unit of A. 

It is advantageous to allocate scarce resources to wherever the marginal opportunity cost is lowest. One country has a comparative advantage when they can do something with a lower opportunity cost than someone else. Countries specialize in producing goods for which they have a comparative advantage. 

Two economic agents: Households & Firms 

Counter-clockwise (outside): payments flows
Clockwise (inside): flows of goods and services 

Households:  purchase output of firms, provide resource service to firms
Firms: purchase resource services from households, provide goods and services to households 

Full model: add government, banks, & foreign countries 

Illustrates tradeoffs
Illustrates inefficient production, and impossible combinations
Can show growth, technological progress 

a.  Straight line PPF:
 

b.  Bowed outward PPF: