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The Economic Approach

Chapter 1

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Identify the critical components of economics and learn how to use the guideposts of economic thinking.

Define opportunity cost.

Chapter 1 Objectives

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1776 The Wealth of Nations Wealth

◦ Not about gold or silver◦ About productivity

Self-interest leads to helping others!

Adam Smith: Father of Econ

Who’s your daddy?

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The study of how individuals make choices and use scarce resources

We all have unlimited wants but limited resources

Economics

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Scarcity – there is less of a good freely available from nature than people would like

If it has a price, it’s scarce!

Choices – always involve trade-offs

Economics is About

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Resources – ingredients (inputs) used to produce goods and services◦ Human resources◦ Physical (capital) resources◦ Natural resources

Economics is About

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Poverty ◦ Is subjective◦ We may one day eliminate

“poverty”◦ 2014 FPL: $19,790 family

of 3 Scarcity

◦ Is objective◦ Will always be present◦ We have limited resources

and unlimited wants

Scarcity ≠ Poverty

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Life in 1750◦ Life is “solitary, poor, nasty, brutish, and short” –

Thomas Hobbes ◦ Work 70+ hr/wk to survive◦ Life expectancy: 37 years

Contrast this with life today

Scarcity ≠ Poverty

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Rationing – allocating a limited supply of a good or resource among people who would like to have more of it

Competition for scarce goods always present

Method of rationing influences the nature of competition◦ Price◦ Government◦ First-come, first-served

Scarcity Necessitates Rationing

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1. The use of scarce resources is costly, so decision makers must make trade-offs

◦ There’s no such thing as a free lunch◦ Opportunity cost – what is given up to get

something

Eight Guideposts to Economic Thinking

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1. The use of scarce resources is costly, so decision makers must make trade-offs

◦ Public elementary school, not free Admission is $0 Costs are higher taxes, less medical care

Eight Guideposts to Economic Thinking

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2. Individuals choose purposefully – they try to get the most from their limited resources

◦ Economizing behavior – choosing the option that offers the greatest benefit at the least possible cost

◦ Utility – The subjective benefit or satisfaction a person expects from a choice or course of action

Eight Guideposts to Economic Thinking

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2. Individuals choose purposefully – they try to get the most from their limited resources

◦ People behave rationally◦ Rational is not the same as

Ethical Safe Healthy

Eight Guideposts to Economic Thinking

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3. Incentives matter – choice is influenced in a predictable way by changes in incentives

◦ ALL ECONOMICS IS BASED ON THIS STATEMENT!◦ Incentive – a threat of a reward or punishment◦ Responses to incentives vary

Eight Guideposts to Economic Thinking

3. Incentives matter – choice is influenced in a predictable way by changes in incentives

◦ Altering incentives alters people’s behavior! The Peltzman Effect, 1975

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Eight Guideposts to Economic Thinking

4. Individuals make decisions at the margin

◦ Marginal – used to describe the effects of a change in the current situation

◦ “marginal” = “additional” ◦ Decisions aren’t all or nothing

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Eight Guideposts to Economic Thinking

4. Individuals make decisions at the margin

◦ Diamond water paradox◦ Total benefit ≠ marginal benefit

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Eight Guideposts to Economic Thinking

4. Individuals make decisions at the margin

◦ Marginal ≠ average◦ Average cost = total cost / total produced◦ Marginal cost = cost of producing an additional

unit of a product

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Eight Guideposts to Economic Thinking

4. Individuals make decisions at the margin

◦ Marginal thinking allows us to answer questions like How many times should you visit that buffet? Should you buy that third burger?

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Eight Guideposts to Economic Thinking

4. Individuals make decisions at the margin

While waiting in line to buy two burgers at $1.00 each, and a drink for $1.50, Renegade notices that the restaurant has a value meal containing three burgers and a drink all for $4.25. For Renegade, the marginal cost of the third burger would be…?

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Eight Guideposts to Economic Thinking

4. Individuals make decisions at the margin

Jordin wants to buy some beer. She can buy five beers for $2 each or she can purchase a six pack for $10.50. What’s the marginal cost of the 6th beer?

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Eight Guideposts to Economic Thinking

5. Although information can help us make better choices, its acquisition is costly

◦ Gathering information isn’t free◦ Limited knowledge and uncertainty are common◦ The bigger the decision, the more resources you’ll

use gathering information and “shopping”

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Eight Guideposts to Economic Thinking

6. Beware of the secondary effects: economic actions often generate indirect as well as direct effects

◦ Secondary effect – the indirect impact of an event or policy that may not be easily and immediately observable

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Eight Guideposts to Economic Thinking

6. Beware of the secondary effects: economic actions often generate indirect as well as direct effects

◦ Changes in government policy often alter incentives and have unintended consequences

◦ Example: mortgage lending, payday loans

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Eight Guideposts to Economic Thinking

6. Beware of the secondary effects: economic actions often generate indirect as well as direct effects

◦ Government spending does not create jobs!◦ Where does the money come from?

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Eight Guideposts to Economic Thinking

7. The value of a good or service is subjective

◦ Preferences differ among individuals◦ Circumstances can change value

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Eight Guideposts to Economic Thinking

7. The value of a good or service is subjective

◦ Moving goods to those who value them most is a source of economic progress

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Eight Guideposts to Economic Thinking

8. The test of a theory is its ability to predict

◦ Scientific thinking – developing a theory from basic principles and testing it against real world events

◦ Average outcomes instead of anecdotal outcomes

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Eight Guideposts to Economic Thinking

Positive Economics◦ What is◦ Can be proven true or false

Normative Economics◦ What ought to be◦ Cannot be proven true or false

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Positive and Normative Economics

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1. Violation of ceteris paribus principle ceteris paribus: other things constant

◦ When the price of ice cream falls, quantity demanded will rise. Ceteris paribus!

◦ Outcomes change when we dont hold all else constant.

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Pitfalls to Avoid in Economic Thinking

2. The belief that good intentions guarantee desirable outcomes

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Pitfalls to Avoid in Economic Thinking

3. Thinking association (correlation) is causation

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Pitfalls to Avoid in Economic Thinking

4. Fallacy of composition: belief that what is true for one is true for all

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Pitfalls to Avoid in Economic Thinking