Chapter 1 – What is Economics?

Definition of Economics

• Scarcity: inability to satisfy all our wants; what we can get is limited by
time, income, and prices we must pay; a child may want a $1.00 can of pop and two
50 cent packs of gum but only has $1.00

• Microeconomics: study of choices that individuals and businesses make,

how these choices interact, and influence that gov’t exert on them; why are more
people buying SUVs and fewer buying minivans? How will a decline in air travel
affect the producers of airplanes?

• Macroeconomics: study of the effects on the national economy and global

economy of the choices that individuals, businesses, and gov’t make; why did
production and jobs shrink in 2001? Will a tax cut increase the number of jobs and
total production?

Three Big Microeconomic Questions

• What goods and services are produced?

o Canada is a service economy (wholesale trade, retail trade, health
care, education, finance)
o Among goods, only construction is a big factor
o Over past 50 years, more Canadians have service jobs and leaving
mining, construction, and manufacturing jobs
• How are goods and services produced?
o Factors of production: resources used to produce goods &
services:
• Land: natural resources, including land, minerals, energy, water,
and air
• Labour: work time and effort that people devote to producing
goods & services, including physical and mental efforts;
quality of labour depends on human capital, which is
knowledge & skills that people learn
• Capital: tools, instruments, machines, buildings, and other
constructions that are used to produce goods & services
• Entrepreneurship: human resource that organizes labour, land,
and capital
• For whom are goods and services produced?
o Depends on the incomes that people earn
o Land earns rent
o Labour earns wages earns most income
o Capital earns interest
o Entrepreneurship earns profit
Three Big Macroeconomic Questions

• What determines the standard of living?

o Standard of living: level of consumption that people enjoy,
measured by average income per person (higher income per person =
higher s.o.l)
• What determines the cost of living?
o Cost of living: amount of money it takes to buy goods & services
that the average family consumes
o Inflation: rising cost of living (decreasing value of the dollar)
o Deflation: falling cost of living ( increasing value of the dollar)
• Why does our economy fluctuate?
o Business cycle: periodic but irregular up-and-down movement in
production and jobs; expansion, expansion, recession, trough, expansion,
etc., p. 8 for graph
.

The Economic Way of Thinking

• Tradeoff: exchange of one thing for another; when facing scarcity, we

must make choices and select from available alternatives
• “Guns vs. Butter”: any pair of goods & services; if we want more of one
thing, we must trade something else in exchange for it

• Microeconomic Tradeoffs
o “What” Tradeoffs: what goods & services get produced depends
on choices made by us, the government, and by businesses; e.g. we go to
a movie instead of buying a few cups of coffee (trade off coffee for
movie); government votes for more hospitals but cuts back on
educational programs (trade off education for hospitals)
o “How” Tradeoffs: how goods & services get produced depends
on choices made by businesses that produce the things we buy; e.g. Tim
Horton’s opens a new doughnut store with automated production line
and closes an older store with traditional kitchen – they trade off labour
for capital
o “For Whom” Tradeoffs: for whom goods & services are
produced depends on distribution of buying power; buying power can be
redistributed by: voluntary payments, theft, or through taxes & benefits
organized by gov’t
• the big tradeoff: tradeoff between equality and efficiency
made by gov’t; if everyone receives a share of the pie that
reflects the size of their effort, the pie will be as large as
possible since everyone works harder, but if pie is equally
shared, regardless of contribution, some may slack off and
pie will shrink
• Macroeconomic Tradeoffs
o Standard of Living Tradeoffs: standard of living improves over
time, and its rate of improvement depends on choices made by us, gov’t,
and businesses;
• One choice: how much of our income to consume and how
much to save; savings can be channelled through financial
system to finance business and pay for new capital that
increases productivity; saving $1000 and forgoing a
vacation is tradeing off the vacation for a higher future
income; society trades off current consumption for
increased productivity and higher future standard of living
• Second choice: how much effort to devote to education and
training; becoming better educated and more skilled makes
us more productive and increases standard of living; society
trades off current consumption and leisure time for
increased productivity and higher future standard of living
• Third choice: how much effort to devote to research and
development of new products and production methods
(usually made by businesses); more research brings greater
productivity in future but means smaller current production
o Opportunity Cost: highest-valued alternative that we give up to
get something; opportunity cost of a movie ticket is the number of cups
of coffee forgone
• Margins and Incentives
o Comparing the benefits with its cost, and making a choice at the
margin
o Marginal benefit: benefit that arises from increase in an activity;
e.g. suppose you study four nights a week and grade point average is
3.0; you decide to study an extra night each week, and your grade rises
to 3.5; marginal benefit from studying for one additional night a week is
the 0.5 increase in your grade, not the 3.5 grade
o Marginal cost: cost of an increase in an activity; e.g. marginal cost
of increasing your study time by one night a week is the cost of the
additional night not spent with your friends
o To make a decision, you compare marginal benefit with marginal
cost; if marginal benefit exceeds marginal cost, go ahead with activity
o Incentive: an inducement to take a particular action; inducement
can be a benefit or a cost
 Chapter 2: The Economic Problem

Production Possibilities Frontier

- Production Possibilities Frontier (PPF) is the boundary between those
combinations of goods and services that can be produced and those that cannot
- Focus on two goods at a time, hold quantities produced of all the other goods and
services constant
- Look at model economy in which everything remains the same (ceteris paribus)
except for the production of two goods considered
- X-axis will show quantities of one good produced, Y-axis will show quantity of
other good produced
- PPF illustrates scarcity because we cannot attain points outside the frontier (wants
that cannot be satisfied)
- We can produced all points inside the PPF and on the PPF

Production Efficiency
- Production efficiency is achieved if we cannot produce more of one good without
producing less of another good
- When production is efficient we are at a point on the PPF
- If we are at a point inside the PPF then production is inefficient because of unused
resources, misallocated resources or both
- Resources are unused when they are idle but could be working (factories idle,
workers unemployed)
- Resources are misallocated when they assigned to tasks for which they are not the
best match (workers not assigned to tasks that match their skills)
- When producing efficiently (along the PPF) we face a tradeoff

Tradeoff Along the PPF

- Every choice along the PPF involves a tradeoff – something must be given up to
get more of something else
- At any given point in time, we have a fixed amount of labour, land, capital and
entrepreneurship
- By using available technologies we can employ these resources to produce a
limited amount of goods and services
- Limit defines boundary between what we can attain and what we cannot attain

Opportunity Cost
- Opportunity cost of an action is the highest valued alternative forgone
- PPF helps us to calculate the opportunity cost since there are only two goods
- Opportunity cost is ratio (decrease in the quantity produced of one good divided
by the increase in the quantity produced of another good)
- Because opportunity cost is a ratio, the opportunity cost of producing more of one
item is equal to the inverse of the opportunity cost of producing the other item
- Sometimes the opportunity cost of creating more of an item will occur – this
results in the shape of the PPF bowing outward
Marginal Cost
- Marginal Cost of a good is the opportunity cost of producing one more unit of it
- Calculated from the slope of the PPF
- Calculated as the increase in total cost divided by the increase in output

Preferences and Marginal Benefit

- Preferences are a description of a person’s likes and dislikes
- Marginal benefit of a good or service is the benefit received from consuming one
more unit of it
- Measured by the most people are willing to pay for an additional unit of
something
- Marginal Benefit Curve shows the relationship between the marginal benefit of a
good and the quantity of it consumed
- General principle is that the more we have of a good or service, the smaller the
marginal benefit is and the less we are willing to pay for an additional unit of it

Efficient Use of Resources

- When we cannot produce more of any one good without giving up some other
good we have achieved production efficiency (point on the PPF)
- When we cannot produce more of any good without giving up some other good
that we value more highly we have achieved allocative efficiency (producing at
point on PPF that is preferred above other points)

Economic Growth
- During the past 30 years, production per person in Canada has doubled
- An expansion of production is called economic growth
- Economic growth increases our standard of living, but it doesn’t overcome
scarcity and avoid opportunity cost
- Two key factors influence economic growth: technological change (better ways of
producing goods and services) and capital accumulation (growth of capital
resources)
- New technologies and new capital have an opportunity cost (to use resources in
research and development and to produce new capital, we must decreased our
production of consumption goods and services

Gains from Trade

- People can produce for themselves all the goods that they consume, or they can
concentrate on producing just a few good and then trade with others
- Concentration on the production of only one good or a few goods is called
specialization

Comparative Advantage and Absolute Advantage

- A person has a comparative advantage if that person can perform the activity at a
lower opportunity cost than anyone else
- Differences in opportunity costs arise from differences in individual abilities and
from differences in the characteristics of capital and land
 - Although no one excels at everything, some people excel and can outperform
others in a large number of activities
- A person who is more productive than others has an absolute advantage
- Absolute advantage involves comparing production per hour while comparative
advantage involves comparing opportunity costs

Dynamic Comparative Advantage

- At any given point in time, the resources and technologies available determine the
comparative advantage that individuals and nations have
- Just by repeatedly producing a particular good or service, people become more
productive in that activity by learning-by-doing
- Dynamic comparative advantage is a comparative advantage that someone
possesses as a result of having specialized in an activity (having become the
producer with the lowest opportunity cost)

Economic Coordination
- People gain by specializing in the production of those goods and services in
which they have a comparative advantage and then trading with others
- Two competing economic coordination systems have been used – central
economic planning and decentralized markets
- Central economic planning might appear to be the best system because it can
express national priorities but it failed miserable in China and Russia
- To make a decentralized coordination work, four complementary social
institutions are required

o Firms
 Economic unit that hires factors of production and organizes those
factors to produce and sell goods and services
 Firms coordinate a huge amount of economic activity, but if a firm
gets to big than the firm needs to trade and specialize with each
other (Wal-Mart trades with other firms in markets)

o Property Rights
 Property rights are the social arrangements that govern the
ownership, use and disposal of resources, goods and services
 Real property includes land and buildings
 Financial property includes stocks and bonds
 Intellectual property is the intangible product of creative effort
 When property rights are enforced, people have the incentive to
special and produce the goods in which each person has a
comparative advantage

o Markets
 A market is any arrangement that enables buyers and sellers to get
information and do business with each other
  Markets evolve because they facilitate trade (without organized
markets we would miss out on a substantial part of the potential
gains from trade)

o Money
 Any commodity or token that is an acceptable means of payment
 In principle, trade in markets can exchange any item for any other
item

Circular Glows Through Markets

- Households specialize and choose the quantities of labour, land, capital and
entrepreneurship to sell or rent to firms
- Firms choose the quantities of factors of production to hire
- Households choose the quantities of goods and services to buy
- Firms choose the quantities to produce