Introductory Economics

Chapter 1

Chapter 1: First Principles &

Economic Models: Trade-offs and Trade
Objectives: • To view the market economy as a self-organizing entity in which
order emerges from a large number of decentralized decisions
• The importance of scarcity, choice, and opportunity cost
illustrated by the production possibility frontier
• The importance of specialization and trading with others
• About the circular flow of income and expenditure

1. Modern Economy
The economy is a system in which scarce resources are allocated among competing
uses.

Q: What are the resources needed in every economy?

physical capitals.

The Nature of Market Economies

The economy is self-organizing since the interaction of self-interested people

creates a spontaneous social order.

A market economy allocates resources through the ___________________

decisions of households and firms as they interact in markets.

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Main Characteristics of the Market Economies

1. Self-interest & Incentives: Individuals respond to incentives.

2. Price and Market quantity: are set in (relatively) free markets in which i

3. Institutions (a minimum role of government in a free market):

The main characteristics of market economies above produce spontaneous self-

organization.

2. Scarcity, Choice, and Opportunity Cost

Economics is the study of the use of scarce or limited resources to satisfy
_______________ human wants.

Economic Resources
To be viewed as economic resources, they must be available only for production.

• Labour & human capital:

• Land and Natural resources:

• Physical capital ( ≠ money):

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The economic resources above are called factors of production, and outputs
produced using them are called goods (tangibles) or services (intangibles).

Scarcity and Choice

Scarcity implies the need that __________ must be made, and making decisions
implies the existence of ________.

➔ Trade‐off: To get more of one thing, we must give up another.

Opportunity cost is the cost of using resources for a particular purpose,

measured by the benefit ____________ by not using them in their best
alternative activity.

How do you measure the opportunity cost of your current activity?

Your current activity Best alternative activity

Attending the lecture

Benefits
Gained
Benefits
Forgone

Therefore, at all times, we make a choice by choosing the activity that yields the
__________ opportunity cost than that of _______ alternative activity, with a
given amount of resources available.

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Q: How would you measure the opportunity cost of earning a

degree from the university?

3. Production Possibility Frontier (PPF)

The PPF curve shows which alternative combinations of commodities or outputs
can be attained if all available resources are used efficiently under the current
technology and productivity.

Suppose you have 100 kg of wheat (as a raw material). Under the current
technology and productivity, you can produce a noodle using 0.5 kg of wheat
and a loaf of bread using 0.25kg of wheat.

# of
Noodles

# of bread

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Q: What does each area inside and outside the PPF represent,
respectively?
The area inside: an attainable set of current production
The area outside: an unattainable set of current production

Q: What does a set of points on the PPF curve represent?

Q: What does the negative slope of the PPF represent?

Q: What does an outward shift of the PPF curve illustrate?

According to the PPF model, the long-run economic growth illustrates an

economic process whereby unattainable ______________ today becomes
attainable in the future.

The PPF with an increasing opportunity cost

The increasing opportunity costs: As an economy’s total production level of any
particular output increases, the per unit cost of producing an additional unit of
that item will rise. Why?

• Different workers have different skills and different opportunity costs of

producing one good over the another.

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Consider three different works with daily output produced as below:

Noodles produced A loaf of bread produced
Worker A 3 1
Worker B 2 2
Worker C 1 3

Suppose each worker is allocated to a different production.

Noodle production Bread production # of noodles produced # of bread produced

# of
Noodles

# of bread

The shape of a PPF, referred to as ____________ to the origin or bowed-out

shape, represents increasing opportunity cost with increasing output.

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4. Comparative Advantage and Gains from Trade

Production usually displays two characteristics noted long ago by Adam Smith:
Specialization or Division of labour (that must be accompanied by trade.)

• The theory of __________________ advantage states that if a country

specializes in producing a particular output that yields a lower opportunity
cost than other countries – then there will be a gain from trade with
others.
• The principle of absolute advantage refers to the ability of a country to
produce a larger ____________ of output than the others, using the same
amount of resources.

During the year, Wayne and Jun produce apples and peaches with constant
opportunity costs.

Wayne Jun
Apples Apples

50 45

20
15

30 50 Peaches 20 30 Peaches

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Q: Who has the absolute advantage in producing each output?

Q: How would it be possible for both Wayne and Jun to achieve a

consumption bundle beyond the given PPF today?

The opportunity cost of producing

1 unit of peaches 1 unit of apples
Wayne

Jun

Theory predicts both individuals will be better off if Jun specializes in

____________ and Wayne specializes in _____________, and then they trade
at the agreed trade terms.

Suppose both Wayne and Jun agree to trade 23 units of apples for 20 units of
peaches, called "Terms of Trade."

Without trade (autarky) With Trade Gains

from
Production Consumption Production Consumption
Trade
Apples 20 20
Wayne
Peaches 30 30
Apples 15 15
Jun
Peaches 20 20

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Q: What would happen to the gains from trade if Jun's productivity

of either apples or peaches increases?

5. Transactions: The Circular-Flow Diagram

Money as a financial resource eliminates the cumbersome system of barter by
separating the transactions involved in the exchange of products, thereby
facilitating specialization and trade.

The circular flow diagram below represents the transactions in an economy by

two kinds of flows around a circle.

Markets for goods

and services

Individuals Domestic firms

Markets for factors of

production

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6. Positive versus Normative Economics

Two Roles Played by Economists

• Scientists: try to __________ the world
• Policy advisors: try to ___________ the situation

Positive economics is the analysis of how the world works, in which there are
definite right and wrong answers.

Normative economics makes prescriptions about the way the economy

___________work. There are often no right answers and only value judgements.

Identify each of the following statements as either positive (P) or normative (N)

• The federal government’s budget this year is the largest in history.

• The national debt is at a manageable level and, therefore, is nothing to
worry about.
• The price of gasoline is higher than it needs to be.
• Rising Canadian exports are creating many new jobs in the country.
• We should lower taxes to encourage more work.

As scientists, economists make _____________ statements.

As policy advisors, economists make ________________ statements.

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