Unit 1: Introduction to Economics
This unit sets the stage for our journey into the principles of microeconomics. We begin by defining economics and its foundations, emphasizing the concepts of scarcity, choice, and opportunity cost and the need for economic models and theories. Next, we delve into the trade-offs economic agents face when confronting scarcity and applying marginal analysis in their decision-making processes. Once we have discussed the introductory economic toolbox, we finish this unit by introducing basic economic models.
Completing this unit should take you approximately 5 hours.
Upon successful completion of this unit, you will be able to:
- explain the economic way of thinking;
- identify how individual economic agents make rational choices and optimize the use of scarce resources by responding to incentives and calculating opportunity costs;
- apply marginal analysis to make optimal choices by identifying whether choices are efficient; and
- identify basic economic models related to the circular flow of resources and the production possibilities frontier.
1.1: Economics Unveiled: A Beginner's Journey
Many students believe economics is challenging due to its complex theories, mathematical components, and specific language. Some are initially anxious when they hear the word economics. But there is nothing to fear! Economics is simply a set of interesting questions organized around a simple fact: there are not enough resources to satisfy all our needs and wants. How do we decide?
This section teaches that economics shapes how we understand everything around us. Analyzing how you got to drink that first-morning coffee or why you have decided to enroll in this course is economic thinking. Economics studies how humans make decisions in the face of scarcity. These can be individual, family, business, or societal decisions. If you look around carefully, you will see that scarcity is a fact of life.
Watch this video for examples of scarcity. We learn how to classify resources in economics and how to confront scarcity when making decisions on consumption and production.
Watch this video on the definition of economics, the essential role incentives play, and how studying economics shapes your mind. Make sure you understand the historical example.
Is there anything you need that you do not have? Is there anything that you want that you do not have? Why? Write down your answers. When you finish this course, you will enjoy looking at them. Understanding microeconomics will give you a different perspective on how things work.
The answer to the previous questions is that most of us do not produce the things we want or need; we buy them! While it may sound obvious, we need to have a source of income to buy these things. Yet, most of us never have enough to buy everything we want.
One possible solution would be to produce all the goods we consume. Would this make sense? Most of us would have to learn how to create these items and would likely conclude that it is just not worth it. In 1776, Adam Smith introduced the concepts of division and specialization of labor in his book The Wealth of Nations.
Watch this video, which explains how the division of labor enables workers to specialize in the tasks where they have an advantage.
Read this text on how the division and subdivision of tasks increase production and enable firms to reduce the average cost of producing each unit (economies of scale).
In a capitalist economy with scarce resources, the market allows us to trade the resources needed for production and the goods and services produced. The price system determines this trading or exchange. We will analyze how the market works in Unit 2. For now, think of prices as an incentive that drives the behavior of consumers and firms. For example, how would you react to an increase in the price of butter?
An increase in the price of butter is probably not a big deal. You can easily replace it with other products or consume less butter. Because your decisions are rational, many other consumers will make a similar decision. This rational behavior will impact the markets of butter, margarine, and cooking oils. However, these changes will probably not affect the national economy.
The differences between individual market behavior and the national economy exemplify why we study micro and macroeconomics. Read this text on the difference between microeconomics, which focuses on individuals, households, workers, and businesses, and macroeconomics, which studies the economy as a whole.
Microeconomics studies exchanges among individual consumers and firms in the market to purchase goods and services. In contrast, macroeconomics focuses on exchanges across all of the markets within a country. We consider the interrelated actions of consumers, businesses, government agencies, financial intermediaries, and global trading partners as they exchange resources, goods, and services and facilitate currency and quantity flows. Microeconomics examines how to achieve profit maximization. Macroeconomics explores how to achieve overall economic stability and growth nationally.
1.2: Scarcity, Choices, Incentives, and Opportunity Costs
Why are you reading this unit? This question has countless answers. Microeconomics approaches queries like this from a fascinating perspective: what alternative activity would you engage in if you were not reading this unit? Your answer will uncover the rationale behind our first question.
Here is our thought process. Your time is a limited resource, and you must decide how to allocate it. When you choose an option (such as reading this unit), you do so with an incentive (like improving your skills). However, you are also forgoing another activity that would have occupied your time. This simple paragraph introduces the relationship between four essential economic concepts: scarcity, choices, incentives, and opportunity costs.
Watch this video on scarcity and choice. How do we make choices based on our self-interest when resources are scarce? We know that satisfying unlimited wants is impossible. Finding ways to use scarce resources to optimize society's well-being is one of the most important tasks of economics.
You are already familiar with the concepts of scarcity, choices, and incentives. Opportunity cost is one of the most valuable economic concepts: it is the value of the next best alternative. For instance, consider the value of your next best alternative to reading this unit. What would you be doing if you were not reading this unit? Your response will vary depending on age, socio-cultural background, family structure, and other factors.
Watch this video on opportunity costs and trade-offs. Opportunity cost and trade-offs are two fundamental economic concepts. They are all around us. Trade-offs arise from scarcity and choice. For instance, you face a trade-off when you decide between reading this unit or cooking dinner.
Opportunity cost is about what you give up when you make a choice, not just the money you spend. For example, when you go to college, you are not just spending money on tuition and books; you are also missing out on other things you could be doing with your time. Similarly, when you go to the doctor, the cost is not just the money for the visit; it is also what you could be doing instead of waiting in the office.
In economics, we often talk about scarcity and choice. Scarcity means we cannot have everything we want, so we have to make choices. The opportunity cost is what we give up when making those choices.
Economists use the idea of a "budget constraint" to talk about making choices when you have a limited amount of money. Understanding opportunity cost helps you make better decisions about how to use your time and money.
Pay attention to the example of Alphonso, which explores the concept of opportunity cost. For Alphonso, the opportunity cost of a burger is the four bus tickets he would have to give up to afford another one. He must decide whether or not to choose the burger depending on whether the value of the burger exceeds the value of the forgone alternative – in this case, bus tickets.
1.3: Economic Decision-Making: Budget Constraint and Thinking in Marginal Terms
Every choice you make comes down to choosing between different options that are competing with one another. Here, we analyze how economic agents make decisions when faced with budget constraints. This decision-making process involves comparing the benefits and costs of consuming a little more or less of a certain good or service. In economics, we say economic agents think in marginal terms when they consume or produce a little more or a little less.
Drawing upon a simple analysis of the variables influencing the price of a cup of coffee, this video explains the fundamentals of budget constraints. You can use this resource to revisit the concept of opportunity cost introduced earlier.
Watch this video on the budget line and how to obtain it mathematically through equations.
The budget constraint framework helps us understand that most choices in the real world are not about getting all of one thing or all of another – choosing a point at one end of the budget constraint or all the way at the other end. Instead, most choices involve marginal analysis, comparing the benefits and costs of choosing a little more or a little less of a certain good.
Watch this video on marginal thinking to understand why it is a valuable tool for making optimal decisions. With everyday examples, Alex Tabarrok explains why thinking on the margin is one of the most fundamental economic concepts and how focusing on past decisions can lead to the sunk cost fallacy.
1.4: The Economic Toolbox: Interpreting Diagrams and Equations
We can use mathematics to explain practically every important concept in microeconomics. Equations and diagrams help explain and illustrate economic concepts. Mathematics is a tool to help you grasp economic concepts and their relations.
Read this text on how mathematics can help you in your study of economics.
Watch this video to review how to interpret graphs. Graphs are essential for analyzing economic behavior because they enable us to understand the relationship between two or more factors. Feel free to skip this video if you feel comfortable interpreting graphs.
1.5: Economic Models
When visiting a new city, the first thing we typically reach for is an online or printed map. When studying economics, you should first reach for economic models. They help simplify a reality that would be too vast to analyze otherwise. In this section, we analyze why economists use models and theories to simplify reality and how they use them. We also introduce two basic economic models: the production possibilities frontier and the circular flow model.
Watch this video on why economists need models and theories to simplify reality. Once economic reality is simplified, it is easier to understand and predict its future behavior.
Remember that economics is a social science. We must deal with an important restriction: we cannot conduct experiments in a laboratory. In this sense, we confront constantly changing variables while seeking to understand the impact of these changes. A useful tool with a weird name helps us conduct economic experiments and build models: ceteris paribus (with everything else remaining constant)
Watch this video on why economists must use ceteris paribus to build models and test theories.
Now that we have embraced an economic mindset, let's explore some simple economic models and theories. We start with the Production Possibilities Frontier (PPF), a straightforward model of the production of two goods (or two services). It helps simplify the reality of attainable efficient production within a specific time frame. The PPF shows the goods and services an economy can produce – the possibilities, given the factors of production and available technology. The model specifies what it means to use resources fully and efficiently when a combination of goods is represented on the line.
Read this text on the production possibilities frontier (PPF). Note the economic implications of the downward slope and the bowed-out shape of the PPF curve. Compare the meaning of producing on the curve versus inside the curve. What does it mean to move along the curve?
Watch this video on the PPF to review how the diagram is constructed and how to identify attainable and unattainable production points when economic agents face scarcity.
While the PPF appears to be a basic economic model, it finds applications in complex economic scenarios, including the analysis of international trade. Read this text on absolute and comparative advantage, which uses the PPF and opportunity costs to analyze the rationale of international trade and the benefits countries derive from specializing based on comparative advantage.
Watch this video to review the law of increasing opportunity cost as it applies when society moves between two different points in the PPF.
Watch this video on allocative efficiency and marginal benefit using the production possibilities frontier. The PPF can illustrate two kinds of efficiency: productive and allocative. Make sure you understand that while the PPF shows many combinations that are productively efficient, only one of the productively efficient choices will be the allocatively efficient choice for society as a whole.
We wrap up this unit by introducing another essential model in Economics: the circular flow model, which pictures the economy as consisting of two groups – households and firms – that interact in two markets: the goods and services market, where firms sell, and households buy, and the labor market, where households sell labor to business firms or other employees.
Watch this video on the circular flow model of income and expenditures. Make sure you understand the concepts related to the payments of the factors of production. Is income the same thing as revenue?
The circular flow model is a fundamental economic concept. Read this text to better understand this model and its interactions with the broader economy. It explores the flows of resources between firms and households and interactions with the environment.
Unit 1 Assessment
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Take this assessment to see how well you understood this unit.
- This assessment does not count towards your grade. It is just for practice!
- You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
- You can take this assessment as many times as you want, whenever you want.