R. GLENN

HUBBARD
O’BRIEN
ANTHONY PATRICK

Economics
FOURTH EDITION

CHAPTER

1

Economics:

Foundations and Models
Chapter Outline and
Learning Objectives
1.1

Three Key Economic Ideas

1.2

The Economic Problem That
Every Society Must Solve

1.3

Economic Models

1.4

Microeconomics and
Macroeconomics

1.5

A Preview of Important
Economic Terms

APPENDIX: Using Graphs and
Formulas
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What is this class about?
People make choices as they try to attain their goals. Choices are necessary because we live in a world of scarcity.
Scarcity: A situation in which unlimited wants exceed the limited resources available to fulfill those wants
Economics is the study of these choices.
Economists study these choices using economic models, simplified versions of reality used to analyze real-world economic applications. © 2013 Pearson Education, Inc. Publishing as Prentice Hall

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What is this class about?
We will learn how to answer questions like these:
• How are the prices of goods and services determined?
• How does pollution affect the economy, and how should government policy deal with these effects?
• Why do firms engage in international trade, and how do government policies affect international trade?
• Why does government control the prices of some goods and services, and what are the effects of those controls?

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Three Key Economic Ideas

1.1 LEARNING OBJECTIVE

Explain these three key economic ideas:
People are rational,
People respond to incentives, and
Optimal decisions are made at the margin.

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1. People are rational
Economists generally assume that people are rational.

Rational: Using all available information to achieve your goals.

Rational consumers and firms weigh the benefits and costs of each action, and try to make the best decision possible.

Example: Microsoft doesn’t randomly choose the price of its
Windows software; it chooses the price(s) that it thinks will be most profitable.

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2. People respond to incentives
As incentives change, so do the actions that people will take.
Example: Changes in several factors have resulted in increased obesity in Americans over the last couple of decades, including:
• Decreases in the price of fast food relative to healthful food
• Improved non-active entertainment options
• Increased availability of health care and insurance, protecting people against the consequences of their actions

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3. Optimal decisions are made at the margin
While some decisions are all-or-nothing, most decisions involve doing a little more or a little less of something.
Example: Should you watch an extra hour of TV, or study instead? Economists think about decisions like this in terms of the marginal cost and benefit (MC and MB): the additional cost or benefit associated with a small amount extra of some action.
Comparing MC and MB is known as Marginal Analysis.

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Making the Connection

How will you spend this evening?

You probably didn’t answer this question with “studying”!
What about the night before your first exam? Hopefully, you will study then. An economist sees you as a rational person who performs marginal analysis unknowingly:
• The marginal cost of study (i.e. foregoing the opportunity for more entertaining activities) has stayed the same, but…
• The marginal benefit of study (i.e. the likely increase in your grade) has increased.
So you switch your choice from “entertainment” to “study”.
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The Economic Problem That Every Society Must
Solve

1.2 LEARNING OBJECTIVE

Discuss how an economy answers these questions: