Topic 1 Fundamentals of Economics

Introduction and Goals of the Firm

Key Concepts Summary Practice Quiz Online Exercises
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What will you learn in this chapter?

You will be acquainted with the foundation of the economic way of thinking
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What are the 3 building blocks in the economic way of thinking?

scarcity & choice model building pitfalls of economic reasoning
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What is the economic problem?

Providing for peoples wants and needs in a world of scarcity

What is meant by scarcity?

The condition in which wants are forever greater than the available supply of time, goods, and resources
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What does scarcity force us to do?

It forces us to make choices

What are resources?

The basic categories of inputs used to produce goods and services
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What are the three categories of resources? Land Labor Capital

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What is a land resource?

A shorthand expression for any natural resource provided by nature
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What is labor?
The mental and physical capacity of workers to produce goods and services

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What is capital?
The physical plants, machinery, and equipment used to produce other goods

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What is financial capital?

The money used to purchase capital

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What is entrepreneurship?
The creative ability of individuals to seek profits by combining resources to produce innovative products.
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Land

Labor

Capital

Entrepreneurship organizes resources to produce goods and services

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What is economics?
The study of how society chooses to allocate its scarce resources to the production of goods and services in order to satisfy unlimited wants
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What is macroeconomics?
The branch of economics that studies decisionmaking for the economy as a whole
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What is microeconomics?
The branch of economics that studies decisionmaking by a single individual, household, firm, industry, or level of government

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What is the purpose of an economic model?

To forecast or predict the results of various changes in variables
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What is the scientific method?

Problem identification Model development Testing a theory
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Identify the problem

Develop a model based on simplified assumptions

Collect data and test the model

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What are the two common pitfalls in understanding how the economy works?
failing to understand the ceteris paribus assumption confusing association with causation
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What assumption is always made when testing a model?

ceteris paribus

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What is ceteris paribus?

A Latin phrase that means that while certain variables can change, all other things remain unchanged
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What is the difference between association and causation?

We cannot always assume that when one event follows another, the first caused the second
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Why do some economists disagree?

The answer lies in understanding the difference between positive and normative economics
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What is positive economics?

An analysis limited to statements that are verifiable
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What is normative economics?

An analysis based on value judgement

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Key Concepts

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 What are the three building blocks in the economic way of thinking? What is the economic problem? What is meant by scarcity? What are resources? What are the three categories of resources? What is entrepreneurship? What is economics? What is macroeconomics? What is microeconomics?
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 What is the scientific method? What are the two common pitfalls in understanding how the economy works? Why do some economists disagree? What assumption is always made when testing a model? What is ceteris paribus? What is the purpose of model building? What is positive economics? What is normative economics?

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Summary

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Scarcity is the fundamental economic problem that human wants exceed the availability to time, goods, and resources. Individuals and society therefore can never have everything they desire.

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Resources are factors of production classified as land, labor, and capital. Entrepreneurship is a special type of labor. An entrepreneur combines resources to produce innovative products.

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Economics is the study of how individuals and society choose to allocate scarce resources in order to satisfy unlimited wants. Faced with unlimited wants and scarce resources, we must make choices among alternatives.

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Society Chooses Resources Scarcity Unlimited wants

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Macroeconomics applies an economy wide perspective that focuses on such issues as inflation, unemployment, and the growth rate of the economy.

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Microeconomics examines individual decision-making units within an economy. Microeconomics studies such topics as a consumers response to changes in the price of coffee and the reasons for changes in the market price of personal computers.
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Models are simplified descriptions of reality used to understand and predict economic events. An economic model can be stated verbally or in a table, graph, or equation. If the evidence is not consistent with the model, the model is rejected.
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Collect data and test the model

Develop a model based on assumptions Identify the problem

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Ceteris paribus holds all other factors unchanged that might affect a particular relationship. If this assumption is violated, a model cannot be tested. Another reasoning pitfall is to think association means causation.

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Positive economics uses testable statements. Often a positive argument is expressed as an if-the statement. Normative economics is based on value judgments or opinions and uses words such as good, bad, ought to, and ought not to.

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Practice Quiz

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1. Scarcity exists a. when people consume beyond their needs. b. only in rich nations. c. in all countries in the world. d. only in poor nations. C. No matter what economic system a country has, it is always faced with the problem of scarcity.
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2. Which of the following would eliminate scarcity as an economic problem? a. Moderation of peoples competitive instincts. b. Discovery of large new energy reserves. c. Resumption of steady productivity growth. d. None of the above. e. All of the above. D. Because it is impossible to provide everyone with everything they want, we will always have scarcity. 44

3. Which of the following is not a resource? a. Land. b. Labor. c. Money. d. Capital. C. Money is not a resource because it has no intrinsic value. Money that is used to make an investment is called financial capital.
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4. Economics is the study of a. how to make money. b. how to operate a business. c. people making choices because of the problem of scarcity. d. none of the above. C. Economics is the study of how people must decide among alternatives to meet their wants and needs in this world of scarcity.
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5. Microeconomics approaches the study of economics from the viewpoint of a. individuals or specific markets. b. the operation of the Federal Reserve. c. economy wide effects d. the national economy.
A. Microeconomics is the study of the decision- making process for individuals, business owners, and government.
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6. A review of the performance of the U.S. economy during the 1990s is primarily the concern of a. macroeconomics. b. microeconomics. c. both macroeconomics and microeconomics. d. neither macroeconomics nor microeconomics.

A. Macroeconomics is the study of the economy as a whole.

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7. An economic theory claims that a rise I gasoline prices will cause gasoline purchases to fall, ceteris paribus. The phrase ceteris paribus means that a. other relevant factors like consumer incomes must be held constant. b. the gasoline prices must first be adjusted for inflation. c. the theory is widely accepted, but cannot be accurately tested. d. consumers need for gasoline remains the same regardless of price. A. Anytime price changes we always make the assumption that nothing else changes. 49

8. An economist notices that sunspot activity is high just prior to recessions and concludes that sunspots cause recessions. The economist has a. confused association with and causation. b. misunderstood the ceteris paribus assumption. c. Used normative economics to answer a positive question. d. built an untestable model. A. Just because one action follows another, does not mean that the first caused the second.
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9. Which of the following is a statement of positive economics? a. The income tax system collects a lower percentage of the incomes of the poor. b. A reduction in the tax rates of the rich makes the tax system more fair. c. Taxes ought to be raised to finance health care. d. All of the above are primarily statements of positive economics. A. Positive economic statements are testable by facts and explain the world as it is without making value judgements.51

10. Which of the following is a statement of positive economics? a. An unemployment rate of greater than 8 percent is good because prices will fall. b. An unemployment rate of 7% is a serious problem. c. If the overall unemployment rate is 7%, black unemployment rates will average 15%. d. Unemployment is a more severe problem than inflation. C. Other answers are based on a value judgement between black and white unemployment rates. 52

11. Which of the following is a statement of normative economics? a. A minimum wage is good because it raises wages for the working poor. b. The minimum wage is supported by unions. c. The minimum wage reduces jobs for unskilled workers. d. The minimum wage encourages firms to substitute capital for labor A. Even though the minimum wage reduces jobs for some working poor, it is a value judgement that the minimum wage is beneficial overall. 53

12. Select the normative statement that completes the following sentence: If the minimum wage is raised rapidly, then a. inflation increases. b. workers will gain their rightful share of total income. c. profits will fall. d. unemployment will rise. B. To say that workers have right to a certain part of total income entails a value judgement.
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Online Exercises

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Exercise 1 Does the Internet raise or lower the cost of making friends? As you consider this question, visit a virtual meeting place: the American Intercultural Student Exchange (http://www.aise.com). Or you may wish to participate in a live chat with other people on the Internetif so, visit Yahoo! (http://chat.yahoo.com). Explain how scarcity relates to the Internet.

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Exercise 2

Visit World Factbook (http://www.odci.gov/cia/publications/factbook/inde x.html) and follow these steps:

1. Select the United States. 2. Note the land area and population in the United States.

3. Compute the land area per person by dividing the land area of the United States by its population size.
4. Select Japan. Repeat steps 2 and 3 for Japan. 5. How does the scarcity of land influence land-use choices? Would you find as many golf courses 57 inJapan as in the United States? Explain.

Exercise 3 If water is inexpensive and readily available, why does the demand for bottled water, which can cost more than $2 for a 12-ounce bottle, remain strong? Why are consumers willing to pay such a steep price for bottled water? For references, visit the Evian water Web site at http://www.evian.com.

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Exercise 4 Visit the White House home page http://www.whitehouse .gov/. Look under Current News. Choose a topic you think pertains to economics. Does the subject matter pertain to macroeconomics or microeconomics? Is the analysis primarily normative or positive?

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