I.

INTRODUCTION

A. General Concepts

1. The economic problem is that of scarcity -- limited resources and unlimited wants.

a. Resources are land, labor, capital and entrepreneurial ability used to produce goods and
services.

b. Wants are the desire to consume goods and services.

Q: What economic problem does (i) an Oberlin student (ii) a Tibetan monk and
(iii) the U.S. economy face?

2. An individual makes choices to decide how to allocate his or her limited resources.

a. Such choices create opportunity costs -- the value of the best foregone alternative.

Q: What is your opportunity cost of (i) attending Oberlin College and (ii) going to
an economics 101 class?

3. Economists use economic theory or models to examine how people make choices.

a. An economic model is an abstraction that explains how the economy (macroeconomics)

or part of the economy (microeconomics) works.

b. An economic model can be as simple as an analogy or as complex as a series of 100 or

more algebraic equations.

Econ 101: Lecture Notes on Introduction Page 1

 c. Positive versus negative relationship

i. When one variable increases and the other variable increases, then the two variables
are said to be positively (or directly) related.

ii. When one variable increases and the other variable decreases, then the two
variables are said to be negatively (or inversely) related.

d. Ceteris Paribus Assumption -- "all other things equal" -- is used to isolate the effects a
change in one thing on a market or economy.

e. Example: the production function

i. Words: The production function shows how much output Y is produced by a given
amount of a labor L.

ii. Equation: Y = 10 ⋅ L0 .66

iii. Table:

output labor
(millions of units) (millions of hours worked)
0 0.00
1 0.03
2 0.09
3 0.16
4 0.25
5 0.35
? ?

Econ 101: Lecture Notes on Introduction Page 2

 iv. Graph:

Production Function

100

90

80

70
output (millions of units)

60

50

40

30

20

10

0
0 5 10 15 20 25 30 35

labor (millions of hours worked)

4. Economists apply statistical tools to economic data to test the validity of economic theory.

a. One of the most common statistical tools used is regression analysis.

b. Example: estimating the production function using post-war U.S. data

i. The equation is: ln( Y ) = β0 + β1 ⋅ ln( L) where ln is the symbol for the natural log
and β' s are the coefficients to be estimated.

Econ 101: Lecture Notes on Introduction Page 3

 ii. Results using data from 1947-1998:

Production Function Estimate of U.S. Economy

15.0

14.5
ln(real GDP - .33*real stock of capital)

14.0

13.5

13.0

12.5

12.0
3.0 3.5 4.0 4.5 5.0

ln(millions of workers)

iii. The straight line in the above diagram is the line that minimizes the squared distance
between each data point and the predicted point. The y-intercept term of the line is the
estimate for β0 , while the slope of the line is the estimate for β1 .

5. Economists not only study "what is" (positive economics), but also recommend "what should
be" (normative economics).

Q: Can you think of some positive ("what is") statements about the proposed Bush
tax cut and some normative statements about the tax cut?

Econ 101: Lecture Notes on Introduction Page 4

 B. Scarcity and Choice

We have talked about the fundamental economic question of scarcity -- unlimited wants and
limited resources -- and how people make choices in the face of scarcity. We next look at an
economic model that allows us to view scarcity and the choices made by an individual or an
economy.

1. Four factors of production

a. Labor -- time and effort that people devote to producing goods and services

b. Capital -- physical goods used in the production of other goods and services
(machinery, plants, computers) and the skills and knowledge of people

c. Land -- natural resources used in producing goods and services (water, air, land,
minerals, oil)

d. Entrepreneurial ability -- the organization of the three other factors of production

The factors of production are important because they determine how much a society or an
individual can produce. The factors determine the limits of production.

2. Production possibilities frontier (ppf)

a. Constant opportunity cost

possibility coffee computers

(millions of gallons) (millions of units)
A 0 10
B 20 8
C 40 6
D 60 4
E 80 2
F 100 0

Econ 101: Lecture Notes on Introduction Page 5

 Production Possibilities Frontier (ppf) with constant opportunity cost

12

A
10
computers (millions of units)

B
8
J

C
6

D
4 I

E
2

F
0
0 20 40 60 80 100 120

coffee (millions of gallons)

Q: Which points in the above diagram are attainable? Which points are
unattainable?

Q: Which points in the above diagram are efficient? Which points are
inefficient?

Q: What is the opportunity cost of producing 1 computer in terms of gallons of

coffee?

Q: What is the opportunity cost of producing 1 gallon of coffee in terms of

computers?

Q: What trade-off does the slope of the production possibilities frontier

represent?

Econ 101: Lecture Notes on Introduction Page 6

 b. Increasing opportunity cost

possibility coffee computers

(millions of gallons) (millions of units)
A 0 10.0
B 20 9.7
C 40 9.1
D 60 8.0
E 80 6.0
F 100 0.0

Production Possibilities Frontier (ppf) with increasing opportunity cost

12.0

A B
10.0 C

D
computers (millions of units)

8.0
E

6.0

4.0

2.0

F
0.0
0 20 40 60 80 100 120
coffee (millions of gallons)

Q: At point A, what is the opportunity cost of producing 1 gallon of coffee in

terms of computers?

Q: At point E, what is the opportunity cost of producing 1 gallon of coffee in

terms of computers?

Econ 101: Lecture Notes on Introduction Page 7

 Q: Why does the opportunity cost of producing 1 gallon of coffee increase in
terms of computers increase as you produce more coffee?

Q: What does the increasing opportunity cost imply about the trade-off between
coffee and computers?

c. Economic growth

possibility consumption goods investment goods

(billions of 92$) (billions of 92$)

A 0 10
B 20 8
C 40 6
D 60 4
E 80 2
F 100 0

Q: What trade-off does the above production possibilities frontier represent?

Q: Which point would correspond to a low growth outcome and which to a high
growth outcome?

Q: Why would a country willing choose a low growth outcome?

Econ 101: Lecture Notes on Introduction Page 8

 3. Utility and preferences

a. Utility is the benefit or satisfaction achieved from the consumption of goods and
services.

i. If you prefer one computer over one cup of coffee, then you say that one computer
yields a higher utility than a cup of coffee. If you prefer 500 cups of coffee over one
computer, then you say that 500 cups of coffee yields a higher utility than a
computer.

ii. Rule of Thumb: more of an economic good is better. Therefore, the more you
consume of an economic good the higher the utility.

iii. Marginal utility -- the gain in utility resulting from consuming one more unit of a good
or service.

iv. Diminishing marginal utility -- as one consumes more of a good, the marginal utility
gained declines.

cups of coffee utility from coffee Marginal utility

0 0 --
1 10 10
2 18 8
3 24 6
4 29 5
5 33 4

Econ 101: Lecture Notes on Introduction Page 9

 b. Preferences are an individual’s likes and dislikes. Preferences are independent of
income and prices.

An Indifference Mapping

combination coffee computers

(millions of gallons) (millions of units)
S 20 9.3
T 40 6.0
U 60 4.6
V 80 3.8
W 100 3.3

c. An indifference curve is a line that shows different combinations of two goods among
which an individual receives the same utility (indifferent).

An Indifference Curve

12.0

10.0
computers (millions of units)

8.0

6.0

4.0
U1

2.0

0.0
0 20 40 60 80 100 120
coffee (millions of gallons)

i. The marginal rate of substitution (MRS) is the rate at which an individual will give up
good y (computers on the vertical axis) for another unit of good x (coffee on
horizontal axis) and still remain indifferent (equally happy).

Econ 101: Lecture Notes on Introduction Page 10

 ii. The marginal rate of substitution (MRS) is the slope of the indifference curve.

Q: What happens to the marginal rate of substitution as you consume more

coffee and why?

d. An indifference curve family is a series of indifference curves where curves farther away
from the origin are more preferred to those closer to the origin

A Family of Indifference Curves

12.0

10.0
computers (millions of units)

8.0

6.0

4.0 U2
U1

2.0 U0

0.0
0 20 40 60 80 100 120
coffee (millions of gallons)

4. Utility maximization

a. The utility-maximizing combination of goods is that combination of goods on the highest

attainable indifference curve.

b. The utility-maximizing combination of goods is the point of tangency between the

production possibilities frontier (ppf) and the indifference curve.

Econ 101: Lecture Notes on Introduction Page 11

 Utility Maximization

12

A
10
computers (millions of units)

B
8

C
6

D
4 U2
U1
E
2 U0

F
0
0 20 40 60 80 100 120
coffee (millions of gallons)

i. The opportunity cost of coffee in terms of computers (relative price or cost of

computers in terms of coffee) equals the marginal rate of substitution (rate at which
people are willing to give up coffee for another computer).

c. The invisible hand of market forces drives the economy to the utility-maximizing
combination of goods.

i. At point B on the production possibilities frontier, the marginal rate of substitution is

greater than the opportunity cost. Therefore, people value computers relative to
coffee more than the cost of computers in terms of coffee. As a result, people are
willing to give up coffee for computers and the economy moves to point C.

ii. At point D on the production possibilities frontier, the marginal rate of substitution is
less than the opportunity cost. Therefore, people value computers relative to coffee
less than the cost of computers in terms of coffee. As a result, people are willing to
give up computers for coffee and the economy moves to point C.

Econ 101: Lecture Notes on Introduction Page 12