Dr.Mohammed Alwosabi Econ 140 – Ch.1 Notes on Chapter 1 FIRST INTRODUCTION TO ECONOMICS Economics is the social science that helps us understand how best individuals, firms and societies can deal with the challenges and opportunities they face as a result of the fundamental problem of scarcity. So, what is scarcity? Scarcity It is a fact of life that we cannot get everything we want. We all want more than we can get. Our inability to satisfy all our "unlimited wants" because of our "limited resources" is called scarcity. We live in a world of scarcity of resources relative to human wants. Scarcity means that unlimited wants always exceed the limited resources available to satisfy them. Scarcity does not imply poverty. Every individual, every firm, and every country- regardless of its economic system or the level of developmentexperiences scarcity. Scarcity applies to money and time, and confronts (experienced by) every one whether they are poor or rich. Scarcity cannot be eliminated so we have to learn how to cope with it. Choice The existence of scarcity forces us to make choices. A choice is a comparison of alternatives. The choices we make depend on the incentives we face. An incentive is a reward that encourages an action (or choice) or penalty that discourages an action (or a choice). The incentives that we face will influence the choices that we make when dealing with scarcity. 1 Dr. Mohammed Alwosabi Econ 140 – Ch.1 For example, if a price of a good falls, people have incentive to buy more of that good. Incentives are influenced by the changes in the marginal benefits and marginal costs and hence, lead to changes in our choices Making choices at the margin means looking at the trade-offs that arise from making small changes in an activity. People make choices at the margin by comparing the benefit from a small change in an activity (which is the marginal benefit) to the cost of making a small change in an activity (which is the marginal cost). Marginal benefit is the benefit from one more unit of an activity (a small change in an activity). Marginal cost is the opportunity cost of one additional activity(a small change in an activity). A change in a marginal benefit or in a marginal cost changes the incentives that we face and leads us to change our choices. If the marginal benefit of an alternative exceeds the marginal cost, people have an incentive to do more of that activity. If the marginal cost of an alternative exceeds the marginal benefit, people have an incentive to do less of that activity. The central idea of economics is that we can predict how choices will change by looking at changes in incentives To make your choice, you compare marginal benefit of that choice to its marginal cost and choose only the actions that will bring greater marginal benefits than marginal costs. That is called Optimization. Optimization is making the best use of the available resources given the available information and technology. Choices bring change. The quality of our lives depends on many choices made by individuals, firms, and governments. These choices involve tradeoffs. One choice is how to divide our incomes between consumption and saving. Another choice is how much efforts and resources to be devoted to education and 2 Dr. Mohammed Alwosabi Econ 140 – Ch.1 training. A third choice is how much efforts and resources to be devoted to research and development. Making choices at the margin means looking at the trade-offs that arise from making small changes in an activity. Trade off Every choice has its tradeoff—an exchange. To get more of one thing you have to get less of something else. A trade off is giving up one thing to get something else. The big tradeoff is the tradeoff between efficiency and equity at business level and at government level. Thinking about a choice as a tradeoff emphasizes cost as an opportunity forgone. What we give up is the cost of what we get. Economists call this cost the opportunity cost. Opportunity Cost: Every time we choose to use scarce resources in one way, we give up the opportunity to use them in other ways. Seeing choices as tradeoffs shows there is an opportunity cost of a choice. The opportunity cost of making a choice is the highest-valued thing we give up in order to get something else. The best thing you choose not to do is the opportunity cost of the thing that you choose to do. The forgone alternative or the next best alternative is the opportunity cost of the thing that you choose to do. The opportunity cost of an increase in one extra action is its marginal cost. In a world of scarcity, everything we do involves an opportunity cost. If there is no scarcity (resources are not limited), there will be no opportunity cost (i.e., opportunity cost is zero) 3 Dr. Mohammed Alwosabi Econ 140 – Ch.1 Example: Suppose on one Thursday night, you can do only one of three actions. You rank these three alternatives as follows: meet your friends, study for the econ 140 midterm or watch your favorite show on TV. What is the opportunity cost of meeting your friend? Answer: The opportunity cost of meeting your friends is not studying for the midterm exam. Why? Example: Suppose Ahmed is faced with two choices: either to work and get BD500 or study at the local university and pay BD200 tuition for the course and BD50 to buy the textbooks. If Ahmed decides to join the university, what is the opportunity cost of joining the university? Answer: OC = the 500 salary forgone + the best alternative use of the 250 = BD750 Exercise: Suppose you have a holiday for one week and you have 3 choices: to go to Mekka for Umrah, to go to Dubai, or to spend the week preparing for the midterm exams. If you decide to go for Umrah, what is the opportunity cost of the week? ECONOMICS: Economics is a social science that studies how best individuals, businesses, governments, and societies make their choices to cope with scarcity (to allocate scarce resources among competing uses). The study of economics is typically divided into two main branches: microeconomics and macroeconomics. Microeconomics deals with small, sometimes individual, economic choices faced within any society. It is the study of individual behavior in the economy. The focus of microeconomics is on the individual consumers, individual firms, 4 Dr. Mohammed Alwosabi Econ 140 – Ch.1 individual industries and individual markets. It studies supply and demand in individual markets, the prices and quantities of inputs and individual goods and services, production processes, cost structure for individual goods and services, and distribution of goods and services. Macroeconomics deals with the large, or aggregated, economic choices faced by the national economy or the global economy. It studies the total (aggregate) behavior and performance of an entire economy (country). It focuses on the total (aggregate) economic activity such as the total output, total employment, total income, inflation, and government policies such as government spending and taxation, and so forth. Macroeconomic policies such as fiscal policy and monetary policy focus on national goals such as achieving full employment, reducing inflation, smoothing business cycle, and increasing the economic growth of the country. The emphasis on the “aggregate” or “total” is the primary factor that distinguishes macroeconomics from microeconomics (forest vs. trees). ECONOMY An economy is simply a collection of all our production and consumption activities in a defined geographical area—Bahrain economy, German economy, Japanese economy, or the global economy. What people collectively produce is what the economy produces, what people collectively consume is the economy's consumption. An economic system can also be defined as a mechanism (a way) that is used by a society to allocate (decides how to use) its limited resources among the competing uses to satisfy the human wants. This mechanism answers the three questions of 1. what to produce, 2. how to produce, and 3. for whom to produce. 5 Dr. Mohammed Alwosabi Econ 140 – Ch.1 What goods and services to produce with our limited resources and in what quantities (types of gods and services). o Goods and services are the objects that people value and produce to satisfy human wants. o The list of what to produce differs from one society to another, and it differs from time to time in the same society according to the availability of resources, their quantity and quality, and according to how the economy is managed, and what are the objectives and priorities of the society. (e.g., the economy may decide to produce capital goods vs. consumer goods, war goods vs. peace goods, schools vs. highways, computers vs. TVs, etc.) How to produce the goods and services we select (production methods). o How to produce depends on the availability of factors of production and depends on technological advances that society has reached. o The most important focus for economists is on the issue of producing the output with the fewest resources or the lowest costs (efficiency). o The "how" question contains when to produce and where to produce the goods and services (e.g., domestic vs. foreign production). o The "how decision" is a question not just of efficiency but also of social values. For whom goods and services are produced. o Who should get these goods and services depends on the incomes that people earn. o Owners of the factors of production earn income, which is a monetary return for using the resources for production: Land earns rent. Labor earns wages. Capital earns interest. Entrepreneurship earns profit. o The distribution of economic benefits depends largely on the distribution of income and wealth. A large income enables a person to buy large quantities of goods and services. A small income leaves a person with few options and small quantities of goods and services. People earn their 6 Dr. Mohammed Alwosabi Econ 140 – Ch.1 incomes by selling the services of factors of production they own. (e.g., salaries of engineers, wages of workers building highway, compensation to unemployed) o Social values have an important role in answering the question of whom to produce. Every day, 6.7 billion people make economic choices that result in “What,” “How,” and “For Whom” goods and services get produced. o Do we produce the right things in the right quantities? o Do we use our factors of production in the best way? o Do the goods and services go to those who benefit most from them? Self-interest vs. Social-interest Everyone makes choices that are in his self interest- choices that he thinks are best for his well-being. In making our decisions we interact with a lot people as seller, buyers, intermediaries, etc. Those people make their own choices that they think is the best for each one of them. Self-interest action is not necessarily selfish action. When people make self-interested choices that are the best for society, they make choices that are considered in the social interest. Choices that are best for the society as whole are said to be in the socialinterest. Economists try to identify those characteristics of a market system that successfully promote self-interested individuals to make choices that coincide with the social interest. In the process of answering the three important questions of what, how and for whom, we must make sure that pursuing self- interest does not contradict promoting social interest and work out the trade off between efficiency and equity 7 Dr. Mohammed Alwosabi Econ 140 – Ch.1 FACTORS OF PRODUCTION The factors of production are the productive resources (also called inputs) used to produce goods and services. The four basic factors of production (the inputs) are: 1. Land: refers to all natural resources on the ground, above it, and beneath it such as water, air, oil, and minerals. Rent is the reward (return or income) for using land. 2. Labor: refers to the time and efforts that people devote to produce goods and services. Labor involves mental and physical skills and abilities of people to produce goods and services. Quantity and quality are included in the "labor" factor. The quality of labor depends on human capital. Human Capital refers to the knowledge and skills that people obtain from education, on-the-job training, and work experience. Wage is the income for labor. 3. Capital: final goods produced to be used in producing other goods and services, e.g., equipments, machines, tools, and structures. Interest is the reward for using capital. In everyday terms, we talk about money, stocks, and bonds as being capital. These items are financial capital. They play an important role in providing businesses and individuals with financial resources, but they are not used to produce goods and services. Because they are not productive resources, they are not part of capital in economic definition. 4. Entrepreneurship: refers to organizing and managing the resources to produce new or improved goods or services. An entrepreneur is an innovator who comes up with new ideas, brings resources together, organize them and manage them to produce new or improved products and technologies. An entrepreneur is a risk taker. He bears the risks that arise from his business decisions. The reward for entrepreneur is profit. 8 Dr. Mohammed Alwosabi Econ 140 – Ch.1 ECONOMICS AS A SOCIAL SCIENCE Economics is a social science. Like all other sciences, in order to discover how an economic world works, economists distinguish between two types of statements: positive statements and normative statements. Positive statements are statements about "what is". They describe how the world actually exists or behaves. They are objective statements. They may be right or wrong. We can test a positive statement by checking it against the facts. Examples of positive statements: o The high temperature today was 35 degrees. o Higher interest rates reduce the total amount of borrowing. o The UAE economy now has lower unemployment than Saudi's economy o The American stock market boomed in the 1990s Normative statements are statements about "what ought to be". They describe how the world should exist or behave. Normative statements are subjective and matters of opinions. They represent value judgment. You agree or disagree with them. They cannot be tested. Examples of normative statements: o o o o It was too hot today. Interest rates are too high. It is desirable to have a minimum wage law Every citizen must have a free health care The task of economics is to discover positive statements that are consistent with what we observe and that helps us to understand how the economic world works. This task can be divided into three steps: observation and measurement, model building, and testing models. Observation and Measurement Economic phenomena can be observed and measured. Understanding what makes things work requires the discovery of laws governing economic behavior. That is the main task of economists. 9 Dr. Mohammed Alwosabi Econ 140 – Ch.1 Model Building o The second step toward understanding how the economic world works is to build a model. o An economic model is an explanation and simple representation of some aspect of the economic world that includes only those features of the world that are needed for the purpose at hand. o Every economic model is based on a set of assumptions and results in some implications. o Economic model is a diagrammatic, mathematical, written or verbal representation of the economy. o Economic models are used to explain and predict economic behavior, and to design and evaluate economic policies. The success of a model is judged by its ability to predict. Testing Models o The third step is testing a model. A model's predictions might correspond to the facts or be in conflict with them. By comparing the model's predictions with the facts, we can test a model and develop an economic theory. o An economic theory is a general rule or principle that enables us to understand and predict the economic behavior and performance by people, firms and the entire economy. Economic theory explains the relationship between factors. It is a bridge between a model and reality. It is a proposition about which model works. o For example, demand is a relationship between price and quantity demanded. As price decreases consumer buy more quantities of the good. This is a theory and can be tested by observing reality. o The process of building and testing models create theories. 10 Dr. Mohammed Alwosabi Econ 140 – Ch.1 OBSTACLES AND PITFALLS There are several obstacles that can affect economic analysis. Ceteris Paribus Economists cannot easily do experiments and most economic behavior has many simultaneous causes. Confusion can result when too many things change and so it might not be possible to understand what caused what. So, in their models economists change one factor at a time, holding all other relevant factors unchanged, to isolate (unscramble) cause-and-effect relationship using the ceteris paribus assumption. Ceteris paribus is a Latin phrase that means “other things being equal”, (or constant), nothing else changing, or everything else remains the same, "Ceteris Paribus" assumption is necessary because of complexity of real economy. It makes it easier to formulate economic theory and policy, but it also increases the risk of error. The Fallacy of Composition is the (false) statement that what is true for the parts is true of the whole or that what is true for the whole is true of the parts. For example, one person can walk through the door into the class, so the entire 40-person class can simultaneously walk through the door. The Post Hoc Fallacy gets its name from the Latin term “Post hoc, ergo propter hoc,” which means “after this, therefore, because of this.” This fallacy is (false) claim that a first event causes a second event because the first occurred before the second. Agreement and Disagreement among Economists Economists tend to agree on positive statements, though they might disagree on normative statements. 11