1. Introduction to Economics & Choices in Production

Economics: The Study of Choice ¹

• Ultimately, economics is the study of choice. Because choices range over every imaginable aspect of human experience, so does economics.
• Economics: A social science that examines how people choose among the alternatives available to them.
• Scarcity implies that we must give up one alternative in selecting another. A good that is not scarce is a free good.
• The three fundamental economic questions are: What should be produced? How should goods and services be produced? For whom should goods and services be produced?
• Every choice has an opportunity cost and opportunity costs affect the choices people make. The opportunity cost of any choice is the value of the best alternative that had to be forgone in making that choice.

The Economic Way of Thinking

• The core of economic thinking:
  1. Economists give special emphasis to the role of opportunity costs in their analysis of choices.
  2. Economists assume that individuals make choices that seek to maximize the value of some objective, and that they define their objectives in terms of their own self-interest.
  3. Individuals maximize by deciding whether to do a little more or a little less of something. Economists argue that individuals pay attention to the consequences of small changes in the levels of the activities they pursue.
• Margin is the current level of an activity. Think of it as the edge from which a choice is to be made.
• A choice at the margin is a decision to do a little more or a little less of something.

Microeconomics and Macroeconomics

• Microeconomics is the branch of economics that focuses on the choices made by individual decision-making units in the economy -typically consumers and firms- and the impacts those choices have on individual markets.
• Macroeconomics is the branch of economics that focuses on the impact of choices on the total, or aggregate, level of economic activity.
• Microeconomics answers questions such:
  • Why do tickets to the best concerts cost so much?
  • How does the threat of global warming affect real estate prices in coastal areas?
  • Why do women end up doing most of the housework?
  • Why do senior citizens get discounts on public transit systems?
• Macroeconomics answers questions such as:
  • Is the total level of economic activity rising or falling?
  • Is the rate of inflation increasing or decreasing?
  • What is happening to the unemployment rate?

Economics Career

• Economists work in three types of organizations. About 58% of economists work for government agencies. The remainder work for business firms or in colleges and universities.
• Jobs:
  • Economists working for business firms and government agencies sometimes forecast economic activity to assist their employers in planning.
  • They also apply economic analysis to the activities of the firms or agencies for which they work or consult.
  • Economists employed at colleges and universities teach and conduct research.

Economist Toolkit

• A hypothesis is an assertion of a relationship between two or more variables that could be proven to be false.
• A statement is not a hypothesis if no conceivable test could show it to be false.
• A theory is a hypothesis that has not been rejected after widespread testing and that wins general acceptance.
• A law is a theory that has been subjected to even more testing and that has won virtually universal acceptance.
• Even a hypothesis that has achieved the status of a law cannot be proven true. There is always a possibility that someone may find a case that invalidates the hypothesis. That possibility means that nothing in economics, or in any other social science, or in any science, can ever be proven true. We can have great confidence in a particular proposition, but it is always a mistake to assert that it is “proven.”
• A model is a set of simplifying assumptions about some aspect of the real world.
  • Models are always based on assumed conditions that are simpler than those of the real world, assumptions that are necessarily false.
  • A model of the real world cannot be the real world.
• The All-Other-Things-Unchanged Problem:
  • Ceteris paribus is a Latin phrase that means “all other things unchanged.”
  • It is important to isolate the effects of the change in one variable while testing a hypothesis, and all other variables must be held constant.
  • Ignoring this principle makes it difficult to examine the effects of the test variable vs other variables.
  • Controlled experiments are luxury in economics, as it is hard to control all the social and economic variables.
• The Fallacy of False Cause:
  • Hypotheses in economics typically specify a relationship in which a change in one variable causes another to change. We call the variable that responds to the change the dependent variable; and the one that causes the change the independent variable.
  • Sometimes the fact that two variables move together can suggest the false conclusion that one of the variables has acted as an independent variable that has caused the change we observe in the dependent variable.
  • Reaching the incorrect conclusion that one event causes another because the two events tend to occur together is called the fallacy of false cause.
• Normative and Positive Statements:
  • A positive statement is a statement of fact or a hypothesis that can be proven true.
  • A normative statement is one that makes a value judgment. Such a judgment is the opinion of the speaker; no one can “prove” that the statement is or is not correct. It can not be proven false.

The Paradox of Choice ²

• The Paradox of Choice: The more choices we have, the less happy we are.
• Too many choices can lead to paralysis and dissatisfaction as it requires more time and effort to make a decision.

What is Economics? ³

• Economics studies the allocation of scarce resources among people – examining what goods and services wind up in the hands of which people.
• Markets are an important means of allocating resources, so economists study markets. Markets include stock markets like the New York Stock Exchange, commodities markets like the Chicago Mercantile, but also farmer’s markets, auction markets like Christie’s or Sotheby’s, or eBay.
• Price – exchange of goods and services for money – is an important allocation means, but price is hardly the only factor even in market exchanges. Other terms, such as convenience, credit terms, reliability, and trustworthiness are also valuable to the participants in a transaction.
• Economic analysis was used by experts in the antitrust suit brought by the U.S. Department of Justice both to understand Microsoft’s incentive to foreclose (eliminate from the market) rival Netscape and consumer behavior in the face of alleged foreclosure.
• Stock market analysts use economic models to forecast the profits of companies in order to predict the price of their stocks.
• When the government forecasts the budget deficit or considers a change in environmental regulations, it uses a variety of economic models.
• Cost-benefit analysis weighs the gains and losses to different individuals and suggests carrying out changes that provide greater benefits than harm. It is a normative analysis.
• Welfare analysis provides another approach to evaluating government intervention into markets. It involves performing a cost-benefit analysis taking account not just of the overall gains and losses, but also weighting those gains and losses by their effects on other social goals such as helping the poor or protecting the environment. It is also a normative analysis.
• Willingness to pay is a measure of the value of a good to a person: how much they would be willing to pay for it.
• Monetizing opportunity costs is clearly valuable, because it gives a means of comparison.
• Risk management: the science of hedging or minimizing risk.
• Certainty equivalent: An amount of money that provides equal value to a person as a given gamble.
• Risk Premium: The difference between the expected value of a gamble and the certainty equivalent.
• Hedonic pricing: Estimating the value of something by summing the value of parts.

Confronting Scarcity: Choices in Production ⁴

• Production possibilities model shows the goods and services that an economy is capable of producing -its possibilities- given the factors of production and the technology it has available.
• An economic system is the set of rules that define how an economy’s resources are to be owned and how decisions about their use are to be made.

Factors Of Production

• Factors of production are the resources available to the economy for the production of goods and services.
• Utility: The value, or satisfaction, that people derive from the goods and services they consume and the activities they pursue.
• Labor: The human effort that can be applied to the production of goods and services.
• Capital: A factor of production that has been produced for use in the production of other goods and services.
• Natural resources: The resources of nature that can be used for the production of goods and services.
• Human capital: The skills a worker has as a result of education, training, or experience that can be used in production.
• Who benefits from technological progress?
  • Consumers gain from lower prices and better service.
  • Workers gain: Their greater ability to produce goods and services translates into higher wages.
  • Firms gain: Lower production costs mean higher profits.
  • Of course, some people lose as technology advances. Some jobs are eliminated, and some firms find their services are no longer needed.

Production Possibilities Curve

• Production possibilities curve: A graphical representation of the alternative combinations of goods and services an economy can produce.
• The curve is a downward-sloping straight line, indicating that there is a linear, negative relationship between the production of the two goods.
• The negative slope of the production possibilities curve reflects the scarcity of the plant’s capital and labor.
• The absolute value of the slope of any production possibilities curve equals the opportunity cost of an additional unit of the good on the horizontal axis.
• It is the amount of the good on the vertical axis that must be given up in order to free up the resources required to produce one more unit of the good on the horizontal axis.
• The greater the absolute value of the slope of the production possibilities curve, the greater the opportunity cost will be.
• Comparative advantage: In producing a good or service, the situation that occurs if the opportunity cost of producing that good or service is lower for that economy than for any other.
• Law of increasing opportunity cost: As an economy moves along its production possibilities curve in the direction of producing more of a particular good, the opportunity cost of additional units of that good will increase.
• The law of increasing opportunity cost implies that the curve will be bowed out, or concave, in shape.
• Two things could leave an economy operating at a point inside its production possibilities curve:
  • First, the economy might fail to use fully the resources available to it.
  • Second, it might not allocate resources on the basis of comparative advantage.
• Full employment: Situation in which all the factors of production that are available for use under current market conditions are being utilized.
• Efficient production: When an economy is operating on its production possibilities curve.
• Inefficient production: Situation in which the economy is using the same quantities of factors of production but is operating inside its production possibilities curve.
• Specialization: Situation in which an economy is producing the goods and services in which it has a comparative advantage.

Applications Of The Production Possibilities Model

• Comparative Advantage and International Trade:
  • Efficient world production requires that each nation specialize in those activities in which it has a comparative advantage.
  • A failure to allocate resources in this way means that world production falls inside the production possibilities curve; more of each good could be produced by relying on comparative advantage.
  • Trade allows the production of more of all goods and services. Restrictions on trade thus reduce production of goods and services.
• Economic Growth:
  • It is the process through which an economy achieves an outward shift in its production possibilities curve.
  • The curve expands to include points that were previously unattainable.
• Comparison of Economic Systems:
  • In a market capitalist economy, resources are generally owned by private individuals who have the power to make decisions about their use. A market capitalist system is often referred to as a free enterprise economic system.
  • In a command socialist economy, the government is the primary owner of capital and natural resources and has broad power to allocate the use of factors of production.
  • Between these two categories lie mixed economies that combine elements of market capitalist and of command socialist economic systems.
  • The global shift toward market capitalist economic systems that occurred in the 1980s and 1990s waa due to:
    • First, the emphasis on individual ownership and decision-making power has generally yielded greater individual freedom than has been available under command socialist or some more heavily regulated mixed economic systems that lie toward the command socialist end of the spectrum.
    • Second, market economies are more likely than other systems to allocate resources on the basis of comparative advantage. They thus tend to generate higher levels of production and income than do other economic systems.
    • Third, market capitalist-type systems appear to be the most conducive to entrepreneurial activity.

Trade ⁵

Production Possibilities Frontier (PPF) ^{6 7}

• Four factors of production:
  • Land: or natural resources.
  • Labor: untrained labor; while educated labor is called human capital.
  • Capital: Tools and equipment that are used to produce goods and services.
  • Entrepreneurship: or technology. It means the knowledge that is used to connect the other three factors of production.
• Everything outside the PPF is impossible to produce, but everything inside the PPF is possible but inefficient.

References

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1. Rittenberg, L. & Tregarthen, T. (2009). Principles of Economics. Flat World Knowledge. Chapter 1. Economics: The Study of Choice. https://my.uopeople.edu/pluginfile.php/1894522/mod_book/chapter/527749/PrinciplesOfEconomicsChapter01.pdf ↩

2. FightMediocrity. (2015, June 15). The paradox of choice by Barry Schwartz - Animation [Video]. YouTube. https://youtu.be/F4QzhSlqmqg ↩

3. McAfee, R. P., Lewis, T. R., & Dale, D. D. (2014). Introduction to Economic Analysis. Chapter 1. What is Economics? ↩

4. Rittenberg, L. & Tregarthen, T. (2009). Principles of Economics. Flat World Knowledge. Chapter 2. Confronting Scarcity: Choices in Production. https://my.uopeople.edu/pluginfile.php/1894524/mod_book/chapter/527756/PrinciplesOfEconomicsChapter02.pdf ↩

5. McAfee, R. P., Lewis, T. R., & Dale, D. D. (2014). Introduction to Economic Analysis. P.84-91. Chapter 6. Trade. ↩

6. Khan Academy. (2011, December 29). Production possibilities frontier | Microeconomics | Khan Academy [Video]. YouTube. https://youtu.be/_7VHfuWV-Qg ↩

7. Khan Academy. (2019, February 12). Four factors of production | AP Microeconomics | Khan Academy [Video]. YouTube. https://youtu.be/-IvwoqPh1_I ↩