Econ 201Lecture 2.4

Essential Concepts and Terms

1-15-2009

Defining Economics

• Economics studies (Wikipedia): – 1) the production,– 2) distribution, and – 3) consumption of goods and services.

• The term economics comes from the Greek for oikos (house) and nomos (custom or law), hence "rules of the house(hold).“

Production of Goods and Services

• How do we decide which goods and services get produced? – How much is produced?– Who/which firms produce it?– Which resources are used to produce it?

• A couple of approaches:– Decentralized – Adam Smith’s invisible hand

• Market demand determines which goods (and how much) gets produced

– Centralized – planned economy• Government planners determine production

Distribution of Goods and Services

• How are the goods and services distributed?– To which consumers?– How much to each consumer?

• A couple of approaches– Decentralized: goods are allocated to consumers

based on their willingness-to-pay– Centralized: allocated or rationed to consumers

• WW II: rationing food/clothing by coupons

Another Way of Looking At It

• Lionel Robbins (1932): • "the science which studies human behaviour as

a relationship between ends and scarce means which have alternative uses."

• Scarcity means that available resources are insufficient to satisfy all wants and needs.

• Absent scarcity and alternative uses of available resources, there is no economic problem. The subject thus defined involves the study of choices as they are affected by incentives and resources.

Scarcity

• There are not enough resources to produce and consume all of the goods and services we desire– An example: production possibilities frontier

(PPF)• Federal Government: guns and butter (or child

health care and the Iraq war)• Detroit: SUVs/Humvees and smaller/fuel-efficient

cars

Production Possibilities Frontier

• Tradeoff between producing computers and food in a

two good economy

Paul’s example

• Two brewers• Two beers: Stout or Lager

– What is the opportunity cost?• “Next” best alternative

Brewer Gal of

Stout

Gal of Lager

Opp Cost of Stout

Opp Cost of Lager

Jones 5 10

Brown 4 3

Opportunity Cost

• Jones– Can produce either:

• 5 gals of stout or 10 gals of lager– Or any “linear” combination in between

• What is the cost of producing 1 more gal of stout– Start at 0 gal of stout & 10 gal of lager– Next: produce 1 gal of stout -> can only produce 8 gal of

lager -> had to give up 2 gal of stout to produce 1 more gal of lager: opp cost of 1 more g of stout = 2 gal of lager

• Or alternatively– Cost of producing 1 gal of lager = ½ gal of stout

» (8->10 g lager) -> (1->0 g of stout)

Paul’s example

• Two brewers• Two beers: Stout or Lager

– What is the opportunity cost?• “Next” best alternative

Brewer Gal of

Stout

Gal of Lager

Opp Cost of Stout

Opp Cost of Lager

Jones 5 10 2 g lager ½ g stout

Brown 4 3 ¾ g lager 4/3 g stout

Gains From Trade

Wealth through Exchange

0

2

4

6

8

10

12

14

1 2 3 4 5 6

Gallo

ns o

f Bee

r Pro

duce

d

Scenario

Jones Lager

Stout

Brown Lager

Both Stout

Both Lager

  Both

Stout Lager

8 0

8 2

6 4.75

4 7.5

2 10.25

0 13

Jones   Brown

Lager Stout Lager

0 5 0

2 4 0

4 3 0.75

6 2 1.5

8 1 2.25

10 0 3

PPF for Stout and LagerIndividually

PPF for Jones and Brown

0

2

4

6

8

10

12

5 4 3 2 1 0

Gals of Lager Produced

Ga

llo

ns

of

Sto

ut

Pro

du

ce

d

Jones

Brown

The Combined PPFGains from Trade

Jones   Brown   Both

Lager Stout Lager Stout Lager

0 5     0

2 4 0 8 2

4 3 0.75 6 4.75

6 2 1.5 4 7.5

8 1 2.25 2 10.25

10 0 3 0 13