Econ 101 The Economic Problem

Java Python Econ 101

Module 1: The Economic Problem

Definition of Economics

Let’s begin by discussing what we mean by economics. Really, no definition can fully articulate what economics entails. However, definitions can provide us with key concepts that apply to economics, and these key concepts can help us better understand what economics is all about.

Economics is pervasive in our everyday lives from a personal, local, provincial, national, and even global perspective; we’re often just not conscious of it. Below is a well-established definition of economics:

Economics is the social science that studies choices that individuals, businesses, government, and entire societies make as they cope with scarcity and incentives that influence and reconcile these   choices.

This definition contains several key components that are critical to understanding economics, so let’s decompose it.

Let’s begin by looking at the term “scarcity.” People, businesses, and governments all desire various things; we will refer to these as “wants.”

For example, I want a new Can-Am Spyder, a new pair of Converse All-Stars, and a Toronto Maple Leafs playoff ticket.

Businesses may want more customers, increased margins, and more Internet sales.

Governments want lower national unemployment, low inflation, and increases in secondary school attainment rates.

In reality, all of our wants are unlimited in nature. No one can really ever satisfy all of their wants.    Unfortunately, we do not have unlimited resources to meet those unlimited wants. Our resources are scarce in relation of our wants.

For example, individual wants are limited by time, income, wealth, and prices. Business profits are limited by suppliers, customer demand, and government regulations. Governments are limited by    budgets, the tax base, and population demographics. Scarcity is all relative to wants.

Our inability to satisfy our unlimited wants is what defines scarcity. Now let’s see how scarcity

relates to choices and incentives. Faced with scarce resources against unlimited wants, we must

choose among alternatives, so choice becomes imminent. Since we cannot have all that we want, we need to make decisions; we need to make choices. However, when we make choices, our decisions are influenced by incentives, incentives being something, maybe a reward or a punishment, which  induces rational individuals to act in a certain way.

For example, if we have the choice of entrance into two university programs, where one program is offering large scholarship funding and the other program is offering no scholarship funding, the

positive funding incentive will influence which university program is selected, assuming a rational decision-making process.

What about a form. of negative incentive. Recall, that I mentioned that I want a Can-Am Spyder …    however, I am married to a wonderful woman (who does not want me to crash a motorcycle and hurt myself) that has provided me with a choice between purchasing a Can-Am Spyder and receiving

several negative consequences compared with not purchasing a Can-Am Spyder and not receiving

the negative consequences.  A penalty exists if I purchase the bike. So as a rational decision maker, I  will not buy the bike if I believe the penalty will outweigh the benefits of the purchase. Incentives are very important to understanding how markets operate, since rational individuals will respond to

incentives. Rational individuals will more than likely select choices that favor positive incentives and avoid choices that involve negative incentives.

In summary, the definition of economics has thus far taught us three key concepts that apply to

economics: scarcity, choice, and incentives. Some economists believe that scarcity is the cornerstone of economics, while other economists believe that choice is considered the root cause of economics.  Either way, scarcity, choice, and incentives are key concepts that apply to economics and economic   thought.

There is one more key concept that we also need to highlight in the definition of economics, that is the fact that economics is a social science. Economics is a social science that studies human

behaviour in the face of scarcity. Individuals often think of economics in terms of money. Individuals often believe that economics is always about making money, but such is not the case at all.

Economics has a very strong social component. Economics can help us better manage our natural

resources and how to best deal with the effects of global warming. Economics can help clarify why an ill patient may opt for one medication versus another. Economics can also explain why society

holistically benefits from higher levels of education attainment. We should never lose sight of the fact that economics is a social science.

As a social science, economics distinguishes between positive and normative statements, positive statements being about “what is.” These statements are testable, and positive statements are ones that economists usually agree on. For example, raising taxes on cigarettes will raise the price of cigarettes, which will lead more individuals to reduce smoking and in turn reduce health care costs. Normative statements are about “what ought to be.” These statements are more of an opinion and not necessarily testable. Normative statements are ones that economists do not necessarily agree upon. For example, taxes on cigarettes should be raised.

To test positive statements, economists create and test economic models to explain how the economy works. Economic models focus on what is important for the task at hand and are abstract depictions of the real world. Models are judged by their ability to predict outcomes. If a model appears very realistic, it can be considered as a failure if the model does not predict well what is actually happening. On the other hand, if a model appears very unrealistic, yet the model predicts well, it can be very useful. Be very cautious in economics to not judge models that appear highly unrealistic without assessing the model’s capacity to predict successfully.

To test economic models, economists sometimes employ natural experiments, which is a situation that arises in ordinary life, such as stagflation of the 1970s.  We also use statistical investigation, such as a regression analysis to help better understand the correlation between multiple variables.

Economic experiments are also conducted, where individuals are placed in decision-making situations, while varying factors of interest, in order to measure a response.

Before leaving the definition of economics, it is important to note that the discipline of economics is broken into two branches of study: microeconomics and macroeconomics. The course focuses on the study of microeconomics, which focuses on individual economic market components like consumers, firms, and specific market activity. Microeconomics really focuses on the consumer and firm behaviour, while the study of macroeconomics, focuses on the economy from a much broader level of activity that discusses larger market sectors and the relationship among market sectors.

Economic Questions

Now that we have established a definition of economics that helped us define several key concepts that apply to economics, those being scarcity, choice, and incentives, and the fact that economics is a social science, we will move on to the two big economic questions. These questions will help us better understand the scope of economics.

1. How do choices end up determining what, how, and for whom goods and services are produced?

Now let’s look at this question in more detail.

Remember that as a society, we have unlimited wants. Goods and services comprise the things that individuals obtain to help satisfy some of those unlimited wants. This equates to the “what” in our  first question.

Goods or services are then produced through the use of resources, which are called the factors of

production, specifically land, labour, capital, and entrepreneurship. Land refers to natural resources.   Labour refers to time and effort workers put towards work. Capital refers to physical capital such as   machinery, plants, and human capital such as knowledge, skills, and education level of workers. This equates to the “how” of our first question.

Of course, each of these factors ofproduction has a rental price. Land earns rent, labour earns wages, capital earns interest, and entrepreneurs earn profit. This equates to the “who” in our first question.

Please note that the “who” in this case can also be considered as the recipient of the good or service. As an economist, you will always be asking yourself the “what, how, and for whom” question.

Now we will turn our attention to the second question in more detail.

2. How can choices made in the pursuit of self-interest also promote the social interest?

Choices are made in the pursuit of self-interest or social interest or potentially both. Self- and social  interests are often at conflict with each other. However, economics asks the question, “Could it be     possible that when each of us makes choices in our self-interest, can these choices also be of a social interest?” For example, if I am making a self-interest choice ofpursuing higher education, as I

believe I can earn more money over my lifetime with higher education, can this choice also promote social interest? The answer in this case is a clear “yes.” My increased level of education actually does promote social interest.

From a societal perspective, if I am earning more money over my lifetime, I will be able to support    society better by increasing output and by providing a stronger tax base. In fact, it has been shown in various studies that if I am more educated, I will more likely treat the environment with increased

respect, my health will be better, and I will be a better democratic citizen. As noted earlier in this

lecture, we must never lose sight of the fact that economics is a social science. As an economist, you will always be asking yourself “How does self-interested choice help promote the social interest?”

The Economic Way of Thinking

Now that we have established the two big questions that we are constantly asking ourselves as

economists, we move on to learning how economists actually answer these questions, and it is

through economic thought. The economic way of thinking really revolves around choice in some

way. Key components within the economic way of thinking include choice and trade-offs, choice and change, choice and opportunity cost, choice and the margin, and choice and incentives.

Choice and trade-offs: when we think of choice we really mean that we are making some type of

trade-off. We are making a decision to consume one item over another item. We are in fact, making a trade-off. Everyone faces a trade-off when they make a choice. The answers to our “what,” “who,”    and “how” questions all involve some form. of trade-off. Let’s look at a few examples.

Let’s consider consumption and savings. When you save your money in a financial institution, such   as a bank, you can no longer use those funds for current consumption. However, your savings will in turn be funneled through financial institutions to finance new business capital projects, for example,  which will spark future growth and consumption. So we make a trade-off. We traded current

consumption for economic growth and higher future consumption.

Now let’s look at the big trade-off: efficiency versus equity. Efficiency relates to society obtaining the most it can from scarce resources. An analogy often made to help illustrate efficiency is the size of a   pie. Equity relates to distributing prosperity freely among all members of society. Coming back to the pie analogy, equity would eq Econ 101 The Economic Problem uate to how the pie is being divided. When governments redistribute

income, they answer the “for who” question, but income distribution does have a trade-off. Taxing workers and transferring those tax dollars to lower income individuals in society, for some, is

considered a deterrent to working more hours, which means that less goods and services will be   produced. So we reduced the size of the pie, but we shared the pie more equally. We have made a trade-off.

Choice and change: choices over time. This component within the economic way of thinking simply illustrates the fact that choices evolve over time. Our choice evolves for many reasons. For example, we no longer have a desire to consume media on videotape or DVD, we now consume media using streaming services. As our lives progress, our circumstances and society changes. As a result, our preferences change and our choices change with those preferences.

Choice and opportunity cost: opportunity cost is a very important economic way of thinking, so be    sure to fully understand this concept before moving on. By definition, opportunity cost equals the   highest value alternative that we must give up in order to get. What does this mean? Choices have     associated opportunity costs; nothing is for free. There are many alternatives that we each consider   when we make a choice. Each of the alternatives that we did not choose has an associated form. of     cost. And the alternative that we did not choose that has the highest associated cost is considered the opportunity cost. The key concept is that nothing is for free. Or as an economist would say, there is   no such thing as a free lunch.

Let’s look at an example to help us illustrate the concept. Let’s look at the opportunity cost of going  to university. Yes, there are obvious monetary costs such as tuition, books, and fees, but opportunity cost is not always about an immediate outlay of cash. Students attending university full-time have     chosen to go to school full-time versus work full-time. As such, students are losing potential income they could have earned if they were working full-time instead of going to school full-time. Not only  that, students are losing a lot of leisure time, and leisure time also carries a cost. So, forgone income and forgone leisure time are considered opportunity costs. Fortunately, university rates of return are

high. That is, the benefits outweigh the costs. So, the decision to attend university is normally a smart one.

Choice and the margin: when we make a choice, we want to make the choice such that what we gain is greater than what we give up. Now when we choose, we are making trade-offs, and those choices  are actually being made in small steps and being influenced by incentives. What do we mean by

small steps in economic terms? We mean at the margin. At the margin, we are comparing marginal  benefits to marginal costs. From an economic standpoint, when we make choices, we are looking at the additional benefits, that is, the marginal benefit, of an increase in activity versus the additional

cost, that is, the marginal cost, of an increase in activity. We strive for choices where marginal benefit is greater than marginal cost. That is, a rational decision maker will choose when marginal benefit is   greater than marginal cost. Working at the margin is another very important economic way of

thinking, so be sure to fully understand this concept before moving on.

Just to emphasize the point, we will go through an example of what it means to think at the margin. You are studying for an exam. It’s been four hours, and you’re getting tired. The choice you need to make is how much longer you will continue to study. When you ask yourself this question, you’re

asking yourself, “How much extra benefit will I get from studying from one more hour versus the

extra cost that I incur by studying one more hour?” Instead of studying, I could be eating, working on another project, going to a part-time job, and all of these items have associated costs. When you

make your choice, you are looking at what benefit you will receive from the next hour of studying,   not the total hours you have spent studying or the average number of hours you have spent studying. You are looking at how much extra benefit you will secure from studying one more hour versus the cost of studying one more hour, with the costs being the cost of the alternatives that you could have been doing versus studying.

Choice and incentives: we have already discussed incentives, so we will just quickly review this topic. Incentives influence your decisions. Changes in marginal benefit and marginal cost will

influence decisions. In economics, we try to predict how choices vary based on incentives. It has  been proven many times that incentives do work. Individuals will respond to rewards or penalties when considering choice.

Economic Coordination

Now that we have an understanding of what economics means and the economic way of thinking, let’s discuss how economic systems are coordinated. How does the complex web of economic

activity and decisions all work together? How are all these interrelated activities coordinated?

Historically, there are two major forms of economic coordinated systems: central economic planning and decentralized economic planning. Today, there are economic coordinated systems that are

actually a bit of both. They are partially centralized and partially decentralized. For example, one could argue that China’s economy is evolving in this manner.

In this course, we will focus on the decentralized economic planning approach. We are focusing on this approach as it is the predominant approach leveraged in the Western world, including Canada.  Economists answer the question of how economic systems are coordinated through a decentralized economic planning via a schematic model of an economy, entitled the Circular Flow in the Market  Economy. There is a lot of activity and information within this model, so let’s break it down.

First, let’s establish some common definitions for concepts within the model. A firm is an economic unit that hires factors ofproduction and organizes those factors ofproduction to produce and sell

goods or services. A market is any arrangement that enables a buyer and a seller to get information     and to do business with each other. We have a goods market and a factors market. The factors market refers to the factors ofproduction, specifically land, labour, capital, and entrepreneurship, which we   learned earlier in this module. A household will be defined as an economic unit of one or more

persons that provides the economy with resources. A household will also aim to satisfy some of their human wants by purchasing goods and services with money.

As you can see by the model, each component within the model is exchanging something with another component. For example, households exchange quantities of land, labour, capital, and

entrepreneurship to firms for wages, rent, interest, and profit. Exchanges are flowing from one     component to another. Firms and households are interacting with markets, and it is determined     through this interaction what will be produced, how it will be produced, and who will get what is produced. Notice our “what,” “how,” and “for whom” question appearing again.

So what is coordinating these decisions? Prices. Prices within markets coordinate the firms ’ and    households ’ decisions. For example, dollars flow through markets between households and firms.

Let’s analyze the model even further. Households and firms participate in both markets, but on

different sides of the model. Households are supplying resources, and firms are demanding or buying resources. Scarcity is really within each of the exchanges. For example, households only have so

many resources to supply to a firm.

The model is a simplification. The model does not illustrate the many transactions that occur within every component, for example, the multitude of transactions that occur every day within every firm. You will notice that there is no mention of government in the model. Why? Because the picture is

intended at this stage to reflect a self-governing economy, a concept that we will further discuss later  in the course. And finally, the model does not reflect how the rest of the world is incorporated, that is, international markets. Again, this is another topic that we will discuss further in the course.

Despite various weaknesses, the Circular Flow model does provide us with an overall image of how a decentralized economic system works at a very high level.

Production Possibility Protier & Specialization and Trade

Module 2: Demand and Supply

Basic Terms and Definitions

A few definitions are needed to lend context to the following sections regarding demand and supply.

A market is any arrangement that enables buyers and sellers to get information and do business with each other.

A competitive market is a market that has many buyers and many sellers so no single buyer or seller can influence the price.

The money price of a good is the amount of money needed to buy it.

The relative price of a good — the ratio of its money price to the money price of the next best alternative good — is its opportunity cost.

For now, let’s focus our attention to the demand side of the supply and demand market model.

Law of Demand

A concept called the law of demand helps us answer this question. The law of demand states:

Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and … the lower the price of a good, the larger is the quantity demanded.  Generally speaking, there is a

negative relationship between the price and quantity of goods and services demanded.

When you pause to think about it, the law of demand really does make sense, as people ordinarily will buy more of a product at a lower price than a higher price — there is a negative or inverse relationship

between product price and quantity. This is really just saying that, as a good or service becomes more   expensive, people economize it. Why this occurs is for two reasons — something called a substitution effect and an income effect.

Substitution Effect

First of all, what does substitute mean in this definition? It simply means two goods that can really be   interchanged with each other to satisfy a want. For example, ifyou cannot buy a sports drink to quench your thirst after a workout, you buy bottled water instead. The sports drink and the bottle of water both meet the need of quenching your thirst.

When the price of a good or service increases, the relative price of the good has changed. Remember that relative price of a good is simply the ratio of its money price to the money price of another good. When   the relative price changes, the opportunity cost changes. An increase in the price of a good or service

increases the opportunity cost of buying a good or service. As the opportunity costs of a good or service rises, consumers will in turn buy less of the good or service and buy more of its substitute.

If we carry forward our sports drink and bottled water example: If the price of a sports drink rises relative to a bottle of water, consumers will buy more bottled water to quench their thirst because it is a relatively  cheaper means of satisfying a want.

In summary, the substitution effect means that when an increase in the relative price of a good or service occurs, consumers will purchase less of the good or service and more of a substitute for the good or

service. Almost all goods and services have some form. of substitute, so we can see how an increase in the price of a good or service drives consumers to shop around for a lower price substitute