Chapter 1: Ten Principle of Economics 1/11/2013 9:55:00 AM
The word economy comes from the Greek work for “one who manages a
A household faces many decisions
It must decide which members of the household do which tasks and
what each members gets in return
The household must allocate its scarce resources among its various
members, taking into account each member‟s abilities, efforts, and
Like a household, a society faces many decisions
A society must decide what jobs will be done and who will do them
It needs some people to grow food, other people to make clothing,
and still others to design computer software
Once society has allocated people (as well as land, buildings, and
machines) to various jobs, it must allocate the output of goods and
services that they produce
Economics is about…
Scarcity: the limited nature of society‟s resources
The management of society‟s resources (e.g., people, land,
buildings, machinery) is important because resources are scarce
Natural resource, land and worker‟s time are all limited in its
Economics is about how the society manages its limited resources
In most societies, resources are allocated not by a single central
planner but through the combined actions of millions of households
Economists study how people make decisions:
o Firms: what to produce, how much to produce, how many
workers to hire, etc.
o Individuals: what to purchase, how to save, how many hours
to work, etc.
Economists also study how people interact with one another
o They examine how the multitude of buyers and sellers of a
good together determine the price at which the good is sold
and the quantity that is sold Economist analyze forces and trends that affect the economy as a
whole, including the growth in average income, the fraction of
population that cannot find work, and the rate at which prices are
How People Make Decisions
Principle #1: People Face Tradeoffs
To get one thing that we like, we usually have to give up another
thing that we like
Making decisions requires trading off one goal against another
Think of the allocations of your time and money etc.
o If you buy a new iPhone today, you have to wait before
buying a new laptop.
o If you invest in a stock, you are giving up other forms of
investments, such as RESP and bonds.
o For every hour you spend on studying, you could have
When people are grouped into societies, they face different kinds of
The classic tradeoff is between “guns and butter”. The more we
spend on national defence (guns) to protect our shores from foreign
aggressors, the less we can spend on customer good (butter) to
raise our standard of living at home.
The modern tradeoff is between a clean environment and a high
level of income. While pollution regulations give us the benefit of a
cleaner environment and the improved health that come with it,
they have the cost of reducing the incomes of the firms‟ owners,
workers, and customers.
Society faces the tradeoff between efficiency and equity.
Efficiency: the property of society getting the most it can from its
Equity: the property of distributing economic prosperity fairly
among the members of society
Efficiency can be referred to the economic pie, and equity to how
the economic pie is divided among society‟s members Principle #2: The Cost of Something is What You Give Up to Get It
Opportunity cost: whatever must be given up to obtain some item
o Decision makers should be aware of the opportunity costs
that accompany each possible action
o To become a doctor, you need to go to medical school. In
addition, you are giving up other career paths.
o Waiting in a long line for a free item costs your time.
o “There is no such thing as a free lunch”
Principle #3: Rational People Think at the Margin
Rational people: people who systematically and purposefully do
the best they can to achieve their objectives, given the
opportunities they have
In economics, we usually assume that firms‟ objective is to
maximize its profit and consumers‟ objective is to achieve the
highest level of satisfaction.
Marginal changes: small incremental adjustments to an existing
situation or plan of action
o “marginal” means “edge”, so marginal changes are
adjustments around the edges of what you are doing
Rational people make decision by comparing marginal benefits and
o Suppose you have already eaten 3 tacos. Whether to have an
extra taco depends on price of the taco (marginal cost) and
the extra satisfaction it gives (marginal benefit).
o To study one more hour the night before the exam has
benefits and costs (less sleep).
A rational decision maker takes an action if and only if the marginal
benefit of the action exceeds the marginal cost
Principle #4: People Responds to Incentives
Incentive: something, such as a punishment or reward, that
induces a person to act
Rational people respond to incentive
o “People respond to incentives. The rest is commentary.”
o Incentives are crucial to analyzing how markets work If price of gasoline rises, people drive less.
If a neighboring country let people visit without a visa,
the number of tourists will increase.
If a famous food critic is waiting for a dinner, the chef is
trying her/his best.
Public policymakers should never forget about incentives, because
many policies change the cost or benefits that people face and,
therefore, alter behaviour
o When government changes a rule or regulation, it gives an
incentive to (some) people to change their action.
When policymakers fail to consider how their policies affect
incentives, they often end up with results they did not intend
o When the government didn‟t think thoroughly about all the
incentives, unintended consequences can happen.
o Seat belt law changes how people drive. As result, there were
no change in the number of driver deaths.
o Some say, to decrease the number of concussions in the NFL,
you need to stop the use of helmets.
Principle #5: Trade can Make Everyone Better Off
Trade allows each individual to specialize in the activities she or he
does best and to enjoy a greater variety of goods and services. By
doing so, everyone will be better off (than being self sufficient).
Similarly, countries benefit from trade and specialization.
Principle #6: Markets Are Usually a Good Way to Organize Economic Activity
Market economy: an economy that allocates resources through
the decentralized decisions of many firms and households as they
interact in markets for goods and services
In a market economy, firms and households make self-interested
decisions guided by the market price.
o Firms decide whom to hire and what to make
o Households decide which firms to work for and what to buy
with their incomes
Price reveals the buyer‟s valuation of the good and the seller‟s cost
of producing it. Usually, prices adjust to guide the economy to the outcome that
maximizes society‟s economic well-being (resources allocated
In his famous book, Wealth of Nations (1776), Adam Smith wrote:
“Every individual…neither intends to promote the public interest,
nor knows how much he is promoting…He intends only his own
gain, and he is in this, as in many other cases, led by an invisible
hand to promote an end which was no part of his intention.”
Principle #7: Government Can Sometimes Improve Market Outcomes
We all rely on government-provided police services and courts to
enforce our rights over the things we produce-and the invisible
hand counts on our ability to enforce our rights
We need government because the invisible hand is powerful, but is
Market failure refers to a situation in which a market left on its
own fails to allocate resources efficiently. It can happen if there is:
o Externality: the impact of one person‟s actions on the well-
being of a bystander. Example: Pollution
o Market power: the ability of a single economic actor (or a
small group of actors) to have a substantial influence on
market prices. Example: Monopoly
o In the presence of externalities or market power, well-
designed public policy can enhance economic efficiency
If there is market failure, government can intervene in the economy
and improve the market outcome. In this case, government
intervention is promoting efficiency.
Government also can take actions that promote equity. Income tax
and welfare system are examples of such action.
One of the most important government role is to enforce property
right by law.
o Property rights: the ability of an individual to own and
exercise control over scarce resources
Principle #8: A Country‟s Standard of Living Depends on Its Ability to
Produce Goods and Services Living standards vary a lot across countries and over time.
The main determinant of living standard is productivity, the
quantity of goods and services produced from each hour of a
In nations where workers can produce a large quantity of goods and
services per unit of time, most enjoy a high standard of living; in
nations where workers are less productive, most people must
endure a more meager existence
o The growth rate of a nation‟s productivity determines the
growth rate of its average income
Productivity depends on technology, skills of workers and
1. Give three examples of important tradeoffs that face in your life.
2. What is the opportunity cost of a seeing a movie?
3. Water is necessary for life. Is the marginal benefit of a glass of water or
small? …. Chapter 2: Thinking Like an Economist 1/11/2013 9:55:00 AM
The Economist as Scientist
Scientific Method: the dispassionate development and testing of
theories on the workings of the universe.
Since experiment is very difficult to conduct in economics,
economists use historical events as natural experiments.
o Example: decrease in housing sales after interest rate hike.
Assumptions and Economic Models
Assumption is used to simplify complexity of the world.
o Example: To study consumption behavior, we may assume
there are only two goods. Unrealistic, but will give a valuable
insight on consumption behavior.
Economic model is an explanation of workings of an economic
phenomenon, based on simplifying assumptions.
The Circular-Flow Diagram
Circular-Flow Diagram is a visual model of the economy that
shows how dollars flow through markets among households and
There are two types of decision makers.
o Households: own the factors of production and consume all
the goods and services that the firms produce
o Firms: produce goods and services using inputs (labour,
land/natural resources, and capital/buildings and machines)
There are two markets.
o Market for goods and services
o Market for factors of production
Factors of production are the inputs that are necessary for
production such as land, labor and capital.
In the market for goods and services, households are buyers and
firms are sellers.
In the market for factors of production, households are sellers and
firms are buyers.
If you trace a loonie in the economy for period of time, it will be
used in transactions in the above two markets repeatedly.
see figure on slide 6 Production Possibilities Frontier
Production Possibilities Frontier (PPF) is a graph that shows
the combinations of outputs that the economy can possibly produce
given the available factors of production and the available
We assume that there are two goods.
Since the factors of production are limited in quantity, not every
combination of goods is feasible.
See figure + explanation on slide 8
PPF and opportunity cost
Opportunity cost is what you have to give up in order to obtain
If economy moves from one efficient point to other on PPF, it faces
a trade-off. Increasing the production of one good means, we need
to decrease the production of the second good.
The slope of the PPF is opportunity cost of one good in terms of the
See figure + explanation on slide 10
Shape of PPF
Generally, the shape of PPF is bowed out. But, sometimes, it can be
a straight line.
If the PPF is straight line, then that means the opportunity cost (in
terms of other good) of a good is constant regardless of output.
Bowed out PPF implies opportunity cost of a good increases as
economy produces more of it.
See figure + explanation on slide 12 and 13
PPF and the Economic Growth
The production possible frontier shows the tradeoff between the
outputs of different goods at a given time, but the tradeoff can
change over time
Society can move production from a point on the old frontier to a
point on the new frontier The production possible frontier simplifies a complex economy to
highlight and clarify some basic but powerful ideas
See figure + explanation on slide 14
The Economists as Policy Advisors
As a scientists, an economist makes a positive statement
(descriptive). Positive statement is a description of the world as is
As a policy advisor, an economist makes a normative statement
(prescriptive). Its is a statement that expresses the economist‟s
view on how things should be.
Confirm or refute positive statements by examining evidence.
Evaluating normative statements involves values as well as facts.
Positive and Normative Statements
Is the following a positive and normative statement?
o “We should increase the interest rate in order to cool the
o Normative, involves judgment.
o “Price decrease of iPhone decreases the number of Galaxy S3
o Positive, describes a relationship. Chapter 3: Interdependence and the Gains from
Trade 1/11/2013 9:55:00 AM
Every day you reply on many people from around the world, most
of whom you‟ve never met, to provide you with the goods and
services you enjoy.
One of the Ten Principles from Chapter 1: Trade can make
everyone better off.
We now learn why people - and nations – choose to be
interdependent, and how they can gain from trade.
Two countries: Canada and Japan
Two goods: computers and wheat
One resource: labour, measured in hours
We will look at how much of both good each country produces and
o If the country chooses to be self-sufficient
o If it trades with the other country
Production Possibilities in Canada
Canada has 50,000 hours of labour available for production, per
Producing one computer requires 100 hours of labour
Producing one ton of wheat requires 10 hours of labour
Canada‟s PPF: Canada has enough labour to produce 500 computers, or
5000 tons of wheat, or any combination along the PPF
Canada Without Trade: Suppose Canada uses half its labour to produce each
of the two goods. Then it will produce and consume 250 computers and
2500 tons of wheat.
Active Learning 1: Derive Japan’s PPF
Use the following information to draw Japan‟s PPF
Japan has 30,000 hours of labour available for production, per
Producing one computer requires 125 hours of labour
Producing one ton of wheat requires 25 hours of labour
Japan‟s PPF: Japan has enough labour to produce 240 computers, or 1200
tons of wheat, or any combination along the PPF Japan Without Trade: Suppose Japan uses half its labour to produce each
good. Then it will produce and consume 120 computers and 600 tons of
Consumption With and Without Trade
o Canadian consumers get 250 computers and 2500 tons of
o Japanese consumers get 120 computers and 600 tons what
We will compare consumption without trade to consumption with
First, we need to see how much of each good is produced and
traded by the two countries
Active Learning 2: Production under trade
1. Suppose Canada produces 3400 tons of wheat. How many computers
could Canada be able to produce with its remaining labour? Draw the point
representing this combination of computers and wheat on Canada PPF
2. Suppose Japan produces 240 computers. How many tons of wheat would
Japan be able to produce with its remaining labour? Draw this point on
U.S. Production With Trade: Producing 3400 tons of wheat requires 34,000
labour hours. The remaining 16,000 labour hours are used to produce 160
Japan‟s Production With Trade: Producing 240 computers requires all of
Japan‟s 30,000 labour hours. So, Japan would produce 0 tons of wheat.
Basic International Trade Terms
Exports: goods and services produced domestically and sold
o To export means to sell domestically produced goods
Imports: goods and services produced aboard and sold
o To import means to purchase goods produced in other
Active Learning 3: Consumption under trade Suppose Canada exports 700 tons of wheat to Japan, and imports 110
computers from Japan. (So, Japan imports 700 tons wheat and exports 110
How much of each good is consumed in Canada? Plot this
combination on Canada PPF.
How much of each good is consumed in Japan? Plot this
combination on Japan‟s PPF.
See slide 18 and slide 20
Trade Makes Both Countries Better Off
see slide 20
Where Do These Gains Come From?
Absolute advantage: the comparison among producers of a good
according to their productivity
Canada has an absolute advantage in wheat: producing a ton of
wheat uses 10 labour hours in Canada vs. 25 in Japan
If each country has an absolute advantage in one good and
specializes in that good, then both countries can gain from trade
Which country has an absolute advantage in computers?
Producing one computer requires 125 labour hours in Japan, but
only 100 in Canada
Canada has an absolute advantage in both goods!
Two Measures of the Cost of a Good
Two countries can gain from trade when each specializes in the
good it produces at lowest cost
Absolute advantage measures the cost of a good in terms of the
inputs required to produce it
Recall: another measure of cost is opportunity cost
o Opportunity cost: whatever must be given up to obtain
In our example, the opportunity cost of a computer is the amount
of wheat that could be produced using the labour needed to
produce one computer
Opportunity Cost and Comparative Advantage Comparative advantage: the comparison among producers of a
good according to their opportunity cost
Which country has the comparative advantage in computers?
To answer this, must determine the opp. cost of a computer in each
The opp. cost of a computer is
o 10 tons of wheat in Canada, because producing one computer
requires 100 labour hours, which instead could produce 10
tons of wheat
o 5 tons of wheat in Japan, because producing one computer
requires 125 labour hours, which instead could produce 5
tons of wheat
So, japan has a comparative advantage in computers. Lesson:
Absolute advantage is not necessary for comparative advantage!
Comparative Advantage and Trade
Gains from trade arise from comparative advantage (differences in
When each country specializes in the good(s) in which it has a
comparative advantage, total production in all countries is higher,
the world‟s “economic pie” is bigger, and all countries can gain from
The same applies to individual producers (like the farmer and the
rancher) specializing in different goods and trading with each other.
NOTE: for both parties, to gain from trade, the price at which they
trade must lie between the two opportunity costs
Active Learning 4: Absolute & comparative advantage
Argentina and Brazil each have 10,000 hours of labour per month.
Producing one pound coffee requires 2 hours
Producing one bottle wine requires 4 hours
Producing one pound coffee requires 1 hour
Producing one bottle wine requires 5 hours Which country has an absolute advantage in the production of coffee?
Which country has a comparative advantage in the production of wine?
Brazil has an absolute advantage in coffee:
Producing a pound of coffee requires only one
labour-hour in Brazil, but two in Argentina.
Argentina has a comparative advantage in wine:
Argentina‟s opp. cost of wine is two pounds of coffee, because the
four labour-hours required
to produce a bottle of wine could instead produce two pounds of
Brazil‟s opp. cost of wine is five pounds of coffee.
Active Learning 5: Constructing PPF
Suppose your factory has 3 workers and it produces chairs and tables. A
workday has 8 working hours.
In each hour, Tom can produce 2 chairs or 2 tables.
In each hour, Jim can produce 4 chairs or 1 table.
In each hour, John can produce 4 chairs or 2 tables.
See slide 30
Who has absolute advantage and who has comparative advantage
o Absolute - Jim and John
o Comparative – Jim
If everyone makes chair, how many chairs can the factory produce
in one day?
o 80 chairs.
If everyone makes table, how many tables can the factory produce
in one day?
o 40 tables.
See slide 32
Suppose Jim and Tom are making only chairs and John is making
only tables. Is this production plan efficient?
Not efficient. 48 chairs and 16 tables - point E in the graph. How do you increase productions of tables and chairs? (We want to
find a production plan that produces more than 48 chairs and 16
Make Tom spends only 1.5 hours in table production and John only
1 hour in chair production. (As result, chairs will be produced by
Jim (8 hours), Tom (6.5 hours) and John (1hour). Tables will be
produced by Tom (1.5 hours) and John (7 hours).)
See slide 34
We made a lot of assumptions about the quantities of each good
that each country produces, trades, and consumes, and the price at
which the countries trade wheat for computers.
In the real world, these quantities and prices would be determined
by the preferences of consumers and the technology and resources
in both countries. (next chapter)
For now, though our goal was merely to see how trade can make
everyone better off.
Interdependence and trade allow everyone to enjoy a greater
quantity and variety of goods & services.
Comparative advantage means being able to produce a good at a
lower opportunity cost. Absolute advantage means being able to
produce a good with fewer inputs.
When people – or countries – specialize in the goods in which they
have a comparative advantage, the economic “pie” grows and trade
can make everyone better off. Chapter 4: The Market Forces of Supply
and Demand 1/11/2013 9:55:00 AM
Markets and Competition
A market is a group of buyers and sellers of a particular good or
o The buyers as a group determine the demand for the product,
and the sellers as a group determine the supply of the
A competitive market is a market in which there are many buyers
and many sellers so that each has a negligible impact on the
o Price and quantity are determined by all buyers and sellers as
they interact in the marketplace
In a perfectly competitive market:
o Goods offered for sale are all exactly the same
o Buyers & sellers are so numerous that no single buyer or
seller has any influence over the market price – each is a
NOTE: for this chapter, we assume markets are perfectly
the quantity demanded of any good is the amount of the good
that buyers are willing and able to purchase
law of demand: the claim that, other things equal, when the price
of a good rises, the quantity demanded of the good falls, and when
the price falls, the quantity demanded rises
Demand schedule: a table that shows the relationship between
the price of a good and the quantity demanded, holding constant
everything else that influences how much consumers of the good
want to buy
o Example: see slide 5 + 6 (demand curve)
Demand curve: a graph of the relationship between the price of a
good and the quantity demanded Market Demand vs. Individual Demand
The quantity demanded in the market is the sum of the quantities
demanded by all buyers at each price
Market demand: Sum of all individual demands for a particular good
Qd = quantity demanded
see slide 7
The Market Demand Curve
The market demand curve shows how the total quantity demanded
of a good varies as the price of the good varies, while all the other
factors that affect how much consumers want to buy are held
see slide 8
Demand Curve Shifters
The demand curve shows how price affects quantity demanded,
other things being equal
These “other things” are non-price determinants of demand (i.e.,
things that determine buyers‟ demand for a good, other than the
Changes in them shift the D curve…
o an increase in demand; any change that increases the
quantity demanded at every price, shifts the demand curve to
o an decrease in demand; any change that reduces the quantity
demanded at every price, shifts the demand curve to the left
Demand Curve Shifters: # of Buyers
Increase in # of buyers increases quantity demanded at each price,
shifts D curve to the right
Suppose the number of buyers increases. Then, at each P, Qd will
increase. (see slide 11)
Demand Curve Shifters: Income
Demand for a normal good is positively related to income o A good for which, other things equal, an increase in income
leads to an increase in demand, shifts D curve to the right
Demand for an inferior good is negatively related to income
o A good for which, other things equal, an increase in income
leads to a decrease in demand, shifts D curves to the left
for the inferior good=> income decreases, shift
The impact of changes in wealth on both the amount and
composition of goods that individuals consume is called the wealth
effect (demand curve changes like income)
Demand Curve Shifters: Prices of Related Goods
Two goods are substitutes if an increase in the price of one leads
to an increase in demand for the other
o Example: pizza and hamburgers. An increase in the price of
pizza increases demand for hamburgers, shifting hamburger
demand curve to the right.
o Other examples: Coke and Pepsi, laptops and desktop
computers, CDs and music downloads
Two goods are complements if an increase in the price of one
leads to a decrease in demand for the other
o Example: computers and software. If price of computer rises,
people buy fewer computers, and therefore less software.
Software demand curve shifts left.
o Other examples: college tuition and textbooks, bagels and
cream cheese, eggs and bacon
Demand Curve Shifters: Tastes
Anything that causes a shift in tastes toward a good will increase
demand for that good and shifts its D curve to the right
o Example: The Atkins diet became popular in the „90s, caused
an increase in demand for eggs, shifted the eggs demand
curve to the right.
Demand Curve Shifters: Expectations
Expectations about the future affect consumers‟ buying decisions o Examples: If people expect their incomes to rise, their
demand for meals at expensive restaurants may increase
o If the economy sours and people worry about their future job
security, demand for new autos may fall now.
Summary: Variable That Influence Buyers
see table 4.1
Activity Learning 1: Demand Curve
Draw a demand curve for music downloads. What happens to it in each of
the following scenarios? Why?
A. The price of iPods falls
o Music downloads and iPods are complements. A fall in price of
iPods shifts the demand curve for music downloads to the
B. The price of music downloads falls
o The D curve does not shift. Move down along curve to a point
with lower P, higher Q.
C. The price of CDs falls
o CDs and music downloads are substitutes. A fall in price of
CDs shifts demand for mu