Economics: Foundations and Models – Study Notes

Economics: Foundations and Models

Introduction

Economics is the study of how individuals and societies allocate scarce resources to satisfy unlimited wants. This foundational chapter introduces the core concepts, problems, and models that underpin microeconomic analysis.

Key Problem: Scarcity

Scarcity and Economics

• Scarcity: A situation in which unlimited wants exceed the limited resources available to fulfill those wants.

• Economics: The social science that studies how best to allocate scarce resources to satisfy unlimited wants; also known as the science of decision-making in the face of scarcity.

Factors of Production

• Labor: The number and quality of workers.

• Land: All natural resources (e.g., clay, water, oil).

• Capital: Tools, equipment, and factories used in production.

• Entrepreneurship: The abilities of those willing to take risks and develop new products.

Three Important Economic Ideas

1. Rationality

• Economists assume that people are rational: they use all available information to achieve their goals.

• Rational individuals weigh the benefits and costs of each action, choosing an action only if the benefits outweigh the costs.

• This assumption is crucial for building economic models, though it does not imply perfection.

2. Economic Incentives

• Individuals and firms consistently respond to economic incentives.

• Policies can have unintended consequences that policymakers did not anticipate.

• Example: Rent control policies may make housing more affordable but can discourage landlords from renting out properties, reducing housing quality.

3. Marginal Thinking

• Most decisions are made at the margin, involving small, incremental choices rather than all-or-nothing decisions.

• Marginal analysis compares the marginal benefit (MB) of an activity to its marginal cost (MC).

• Optimal decisions are made at the margin: Continue an activity up to the point where $MB = MC$.

The Economic Problem Every Society Must Solve

Trade-offs and Opportunity Cost

• Trade-off: Producing more of one good or service means producing less of another due to scarcity.

• Opportunity cost: The highest-valued alternative that must be given up to engage in an activity.

• Example: Spending $60 on a video game means forgoing the next best use of that $60.

Three Fundamental Economic Questions

1. What goods and services will be produced? Determined by consumers, firms, and government choices.

2. How will the goods and services be produced? Firms decide between different production methods (e.g., labor vs. machines).

3. Who will receive the goods and services produced? Distribution depends on income and government redistribution policies.

Types of Economic Systems

Centrally Planned vs. Market Economies

	Centrally Planned Economies	Market Economies
Definition	Government makes all major economic decisions and controls all resources.	Decisions about production, investment, and distribution are guided by market signals and private ownership.
Decision-Making	Centralized; decisions made by government planners.	Decentralized; decisions made by individuals and businesses based on supply and demand.
Ownership of Resources	Government ownership or control of resources and means of production.	Private ownership of resources and businesses.
Role of Prices	Set by the government; may not reflect supply and demand.	Determined by market forces of supply and demand.
Economic Planning	Detailed plans created and implemented by the government.	No central planning; market dictates allocation of resources.
Consumer Choice	Limited; government decides what goods and services are available.	Broad; consumers have a wide range of choices based on preferences and purchasing power.

Mixed Economies

• Most modern economies, including the U.S., are mixed economies, where markets play a major role but government intervenes to achieve social goals.

Efficiency and Equity in Market Economies

Types of Efficiency

• Productive efficiency: Goods and services are produced at the lowest possible cost.

• Allocative efficiency: Production is in line with consumer preferences; every good or service is produced up to the point where the last unit provides a marginal benefit equal to the marginal cost ($MB = MC$).

Equity

• Equity: The fair distribution of economic benefits.

• There is often a trade-off between efficiency and equity. Policies that promote equity (e.g., taxation and redistribution) may reduce efficiency, but can improve social welfare.

Economic Models

Building and Using Economic Models

• Economic models are simplified representations of reality used to analyze real-world issues.

• Steps in building a model:

  1. Decide on the assumptions to use.

  2. Formulate a testable hypothesis.

  3. Use economic data to test the hypothesis.

  4. Revise the model if it fails to explain the data well.

  5. Retain the revised model for future analysis.

The Role of Assumptions

• All models require assumptions and simplifications to be useful.

• Behavioral assumptions:

  • Consumers maximize well-being.

  • Firms maximize profits.

Forming and Testing Hypotheses

• Hypothesis: A statement about an economic variable that can be tested.

• Economic variable: Something measurable that can have different values (e.g., employment levels).

• Most economic hypotheses are about causal relationships.

• It is often difficult to distinguish causation from correlation.

Positive and Normative Analysis

• Positive analysis: Concerned with what is; objective and testable.

• Normative analysis: Concerned with what ought to be; subjective and value-based.

• Economists primarily use positive analysis, but policy decisions often require normative judgments.

Microeconomics vs. Macroeconomics

• Microeconomics: The study of how households and firms make choices, interact in markets, and how governments influence these choices.

• Macroeconomics: The study of the economy as a whole, including inflation, unemployment, and economic growth.

• Example: Analyzing the effect of a new tax on the supply and demand for a particular product is microeconomics; studying national unemployment rates is macroeconomics.