Chapter 18 What is Economics? Section 1 The Fundamental Economic Problem Economic Choices  Economics is the study of how we make decisions in a world where resources are limited. ß  It is sometimes called the science of decision making. ß  Needs are things we need for survival, such as food, clothing, and shelter. ß  Wants are things we would like to have.  The fundamental economic problem is scarcity–we do not have enough resources to produce all the things we would like to have. ß  Because of scarcity, we must make choices among alternatives.  Society must decide what to produce with its limited resources. ß  For example, society may have to choose whether to produce goods for defense or services for poor people. ß  Society must decide how to produce. ß  For example, should we accept more pollution from factories in exchange for greater output of products?  Society must decide for whom to produce. ß  Who will receive the goods and services? ß  In the United States, most goods and services are distributed through the price system. Using Economic Models  The economy includes all the activity in a nation that together affects the production, distribution, and use of goods and services.  To study a part of the economy, economists use economic models. ß  These are simplified representations of the real world, based on economic theories. ß  Business and government often base decisions on solutions that emerge from testing economic models.  Models are based on assumptions. ß  The quality of the model’s results can be no better than the assumptions on which it is based.  Economists use models to better understand the past or present and to predict the future. ß  If predictions based on a model turn out to be wrong, economists revise the model. Section 2 Making Economic Decisions Trade-offs  Economic decision making requires that we take into account all the costs and all the benefits of an action. ß  Economic choices involve trade-offs, or exchanging one thing for the use of another. ß  For example, when you buy a product, you exchange money for the right to own that product rather than something else you could buy for the same price.  People, businesses, and societies make trade-offs every time they choose to use their resources in one way and not in another. ß  More money for education may mean less money to spend on medical research or national efense.  Opportunity cost is what you cannot buy or do when you choose to do or buy one thing rather than another. ß  It is the next best alternative that you had to give up for the choice you made.  Opportunity cost includes more than just money. ß  It also includes the discomforts and inconveniences linked to the choice made. ß  For example, the opportunity cost of cleaning the house includes not only the price of cleaning products, but also the time you spent cleaning instead of doing something else, like listening to music.  All businesses have fixed and variable costs. ß  Fixed costs are expenses that are the same no matter how many units of a good are produced. ß  Variable costs are expenses that change with the number of products produced. ß  If a business produces more, variable costs like raw materials and wages will increase.  Fixed costs plus variable costs equal total costs. ß  To find average total cost, divide total cost by the quantity produced. ß  Marginal cost is the extra cost of producing one additional unit of output. ß  If it costs an extra $50 to produce one more bicycle helmet, the marginal cost is $50.  Businesses measure total revenue and marginal revenue to decide what amount of output will produce the greatest profits. ß  Total revenue equals the number of units sold times the average price per unit. ß  Marginal revenue is the change in total revenue that results from selling one more unit of output.  We usually do something because we expect to achieve some benefit. ß  Marginal benefit is the additional benefit associated with an action. Cost-Benefit Analysis  Cost-benefit analysis is an economic model used to compare marginal costs and marginal benefits of a decision. ß  You should choose an action when the benefits are greater than the costs. ß  If costs outweigh benefits, you should reject the option.  Suppose you are a farmer trying to decide how many acres to plant. ß  The graph on page 413 of your textbook shows a cost-benefit analysis for this decision. ß  You will plant the most productive land first. ß  The extra benefits decline as you plant less productive land. ß  The graph shows that after 15 acres, the extra costs outweigh the extra benefits of planting more acres.  The result of this analysis tells you to plant no more than 15 acres. ß  You could do a similar analysis to determine what to produce. ß  For example, you could compare the results of planting crops other than wheat. ß  The crop that produces the greatest marginal benefit is the one you should plant.  You could use this method to decide for whom to produce. ß  You could compare the costs and benefits of selling your wheat nearby or 100 miles away. ß  You would choose to distribute your product wherever the marginal benefit was greatest. Section 3 Being an economically Smart Citizen Understanding Your Role in the Economy  The United States has a market economy. ß  Most economic decisions are not made by the government, but by individuals looking out for their own and their families’ self-interests.  A market economy is participatory. ß  The choices you make as a consumer affect the products that businesses make and the prices they receive for their products. ß  Likewise, the products offered and their prices affect the choices you make.  A market economy is based on capitalism, a system in which citizens own most of the means of production. ß  It is also based on free enterprise–businesses compete for profit with a minimum of government interference.  Keeping informed means reading news stories, listening to news reports, and gathering nformation about economic activities of businesses and government.  Incentives are rewards offered to try to persuade people to take certain economic actions. ß  Price is one incentive. ß  Others are bonuses for salespeople and low credit rates for consumers. ß  Knowing how incentives work will help you make wise choices.  One role of government in the economy is to help maintain competitive markets. ß  Another role is to provide services, such as education and national defense, that the private sector does not provide.  Competition forces businesses to use society’s resources efficiently to produce goods and services people prefer and to produce quality products at low costs. ß  Low production costs keep prices low for consumers.  Government can use incentives to encourage people and businesses to take certain actions. ß  For example, offering scholarships encourages more people to get higher education. ß  Government can also discourage certain actions. ß  For example, tax laws can punish companies that cause pollution. Making Wise Choices  Rational choice is choosing the alternative that has the greatest value from among comparable-quality products. ß  You make a rational choice when you buy the goods and services that you believe will best satisfy your wants for the lowest possible cost.  Wise consumers will not all make the same choices. ß  A rational choice is one that generates the greatest perceived value for any given expenditure. ß  Wise decision making by individuals also benefits society by making the best use of scarce resources. ß  Being fully informed is the best way to make the best economic as well as political decisions. Section 1: The Fundamental Economic Problem  The fundamental economic problem is scarcity. ß  Economists define needs as those things that are necessary for survival. Section 2: Making Economic Decisions  Individuals face trade-offs among alternatives. ß  The opportunity cost of an economic decision is the alternative given up when one course of action is chosen over another. ß  Cost-benefit analysis is a process that involves comparing the costs of a course of action to its benefits. Section 3: Being an Economically Smart Citizen  In a market economy, people and businesses act in their own best interests to answer the WHAT, HOW, and FOR WHOM questions. ß  The economic system of the United States is based on capitalism and free enterprise. ß  The study of economics helps people make informed decisions.