Summary Economics 1
Questions you sometimes get as an economist:
• Can you help me with filing my taxes?
• Is this a good time to buy stocks?
• What will happen to the interest rate?
“Economics studies how people and firms make choices”
• What to consume?
• How much to produce?
• How much to work?
• What to study?
To analyze these questions, economists use models
Economic Models
• The rail map of Amsterdam is a great model for finding your way if you want to
go around town by tram
• It’s a poor model for cycling around town
• In every model, you need to make simplifications and assumptions
• Which assumptions make sense, depend on the goal of the model
Why models?
• Understand complex situations
• Analyze the effect of a (policy) change
Ø What happens to employment when the minimum wage goes up?
Ø What is the effect on consumption of raising the VAT?
Ø How large should an emissions tax be to reduce CO2 pollution by 20%?
Positive vs Normative Analysis
Positive analysis studies “how things are”
• Descriptive
• Theoretically, there is an objectively correct answer
How large should an emissions tax be to reduce CO2 pollution by 20%?
Normative analysis studies “how things should be”
• Prescriptive
• The answer is (at least in part) subjective
What is the best way to reduce CO2 pollution?
Most economic research is empirical (i.e. with data)
,First Principles
Principle #1: Choices are necessary because resources are scarce
• You can’t always get what you want…
• You always need to give up something to get something
• Resources do not have to be monetary: e.g. time, health, the environment
Principle #2: The true cost of something is its opportunity cost
• Opportunity cost of something is what you must give up in order to get it (what
you forgo by not choosing the next best alternative)
Example: Assume that you received free tickets for the Euroscoop Tilburg. You go and
watch the movie. What is the cost to you going to the movie?
• Opportunity cost: whatever else you could have done in the time you watched the
movie
For free ≠ costless
Principle #3: “How much” is a decision at the margin
• In decisions about “how much”, the amount will be determined by the value and
cost of the last unit
• A decision “at the margin”
Example: My colleague Jan Boone studies the Dutch healthcare system. In the Dutch
system, everyone of 18 years old and above faces a deductible (€385 in 2020). How does
changing the deductible affect health care use?
• This is a decision at the margin
• Suppose the deductible goes up to €500
• Suppose that going to the doctor costs €100 à What happens to people who spent
€100?
Principle #4: People usually respond to incentives, exploiting opportunities to make
themselves better off
• But “Incentives” can be many things, monetary and non-monetary.
• Similarly, “making themselves better off” does not need to relate to maximizing
income (altruism, helping others, support your kids, etc.)
• Caveat: People may sometimes be unresponsive to incentives; or they may over-
react to incentives. In the end, an empirical question.
Example: plastic bags. Since 2016, there has been a ban on free plastic bags in the
Netherlands.
• Very effective à the ban results in fewer plastic bags.
Example: Fining parents if they pick up their children late in daycare.
• If there is a fine, parents are more eager to pick their kids up on time, so less
parents arrive late.
,Principle #5: There are gains from trade
• You can try to produce everything by yourself…
• There are specialization benefits: we can benefit from specializing and then
exchanging output rather than being self-sufficient
• This is true even if one side has strong absolute advantages in producing all goods
of interest; importance of comparative advantage
Principle #6: Markets move toward equilibrium
• Equilibrium: Supply=demand, Game Theory
• In equilibrium, no individual would be better off doing something different
• Example: queuing in the supermarket à In equilibrium: all lines are equally long
• Markets usually reach equilibrium via prices (E.g. too large demand of a good =>
prices go up)
Principle #7: Resources should be used efficiently to achieve society’s goals
• Economists are concerned about efficiency: no waste of resources, no one can be
made better off without making others worse off
• If there is no waste of resources, that does not imply anything about a fair
distribution of these resources (equity)
• Often, there is a trade-off between equity and efficiency
Principle #8: Markets usually lead to efficiency
• Positive view: People usually take opportunities for mutual gains => markets
usually lead to efficiency
• Not so positive view: There are many situations in which markets do not lead to
efficiency! For instance, in the case of externalities, asymmetric information or
market power
Principle #9: When markets don’t achieve efficiency, government intervention can
improve society’s welfare
• Often markets do not lead to efficiency, e.g. in the case of externalities,
asymmetric information or market power
• In this case, “free” markets do not lead to good outcomes (efficiency), and
government can improve by intervention
• Reminder: even when an outcome is efficient, governments may want to intervene
because of inequity concerns
, Economic Models: Trade-offs and Trade
Let’s look at an example of a model to illustrate the concept of comparative advantage.
In deciding what to produce, a producer faces trade-offs à principle 1.
We can model the production possibilities of an economic agent (a country, a firm, a
worker) with the production possibility frontier (PPF)
The Production Possibility Frontier
Example: Given her land and machinery constraint, a farmer can produce at maximum
the following combination of milk and eggs
Feasible + Efficient:
Principle #2: The true cost of something is its opportunity cost
• The production possibility frontier also shows the opportunity costs
• |slope| of the PPF = opportunity costs of good x (eggs) in terms of y (milk)
Questions you sometimes get as an economist:
• Can you help me with filing my taxes?
• Is this a good time to buy stocks?
• What will happen to the interest rate?
“Economics studies how people and firms make choices”
• What to consume?
• How much to produce?
• How much to work?
• What to study?
To analyze these questions, economists use models
Economic Models
• The rail map of Amsterdam is a great model for finding your way if you want to
go around town by tram
• It’s a poor model for cycling around town
• In every model, you need to make simplifications and assumptions
• Which assumptions make sense, depend on the goal of the model
Why models?
• Understand complex situations
• Analyze the effect of a (policy) change
Ø What happens to employment when the minimum wage goes up?
Ø What is the effect on consumption of raising the VAT?
Ø How large should an emissions tax be to reduce CO2 pollution by 20%?
Positive vs Normative Analysis
Positive analysis studies “how things are”
• Descriptive
• Theoretically, there is an objectively correct answer
How large should an emissions tax be to reduce CO2 pollution by 20%?
Normative analysis studies “how things should be”
• Prescriptive
• The answer is (at least in part) subjective
What is the best way to reduce CO2 pollution?
Most economic research is empirical (i.e. with data)
,First Principles
Principle #1: Choices are necessary because resources are scarce
• You can’t always get what you want…
• You always need to give up something to get something
• Resources do not have to be monetary: e.g. time, health, the environment
Principle #2: The true cost of something is its opportunity cost
• Opportunity cost of something is what you must give up in order to get it (what
you forgo by not choosing the next best alternative)
Example: Assume that you received free tickets for the Euroscoop Tilburg. You go and
watch the movie. What is the cost to you going to the movie?
• Opportunity cost: whatever else you could have done in the time you watched the
movie
For free ≠ costless
Principle #3: “How much” is a decision at the margin
• In decisions about “how much”, the amount will be determined by the value and
cost of the last unit
• A decision “at the margin”
Example: My colleague Jan Boone studies the Dutch healthcare system. In the Dutch
system, everyone of 18 years old and above faces a deductible (€385 in 2020). How does
changing the deductible affect health care use?
• This is a decision at the margin
• Suppose the deductible goes up to €500
• Suppose that going to the doctor costs €100 à What happens to people who spent
€100?
Principle #4: People usually respond to incentives, exploiting opportunities to make
themselves better off
• But “Incentives” can be many things, monetary and non-monetary.
• Similarly, “making themselves better off” does not need to relate to maximizing
income (altruism, helping others, support your kids, etc.)
• Caveat: People may sometimes be unresponsive to incentives; or they may over-
react to incentives. In the end, an empirical question.
Example: plastic bags. Since 2016, there has been a ban on free plastic bags in the
Netherlands.
• Very effective à the ban results in fewer plastic bags.
Example: Fining parents if they pick up their children late in daycare.
• If there is a fine, parents are more eager to pick their kids up on time, so less
parents arrive late.
,Principle #5: There are gains from trade
• You can try to produce everything by yourself…
• There are specialization benefits: we can benefit from specializing and then
exchanging output rather than being self-sufficient
• This is true even if one side has strong absolute advantages in producing all goods
of interest; importance of comparative advantage
Principle #6: Markets move toward equilibrium
• Equilibrium: Supply=demand, Game Theory
• In equilibrium, no individual would be better off doing something different
• Example: queuing in the supermarket à In equilibrium: all lines are equally long
• Markets usually reach equilibrium via prices (E.g. too large demand of a good =>
prices go up)
Principle #7: Resources should be used efficiently to achieve society’s goals
• Economists are concerned about efficiency: no waste of resources, no one can be
made better off without making others worse off
• If there is no waste of resources, that does not imply anything about a fair
distribution of these resources (equity)
• Often, there is a trade-off between equity and efficiency
Principle #8: Markets usually lead to efficiency
• Positive view: People usually take opportunities for mutual gains => markets
usually lead to efficiency
• Not so positive view: There are many situations in which markets do not lead to
efficiency! For instance, in the case of externalities, asymmetric information or
market power
Principle #9: When markets don’t achieve efficiency, government intervention can
improve society’s welfare
• Often markets do not lead to efficiency, e.g. in the case of externalities,
asymmetric information or market power
• In this case, “free” markets do not lead to good outcomes (efficiency), and
government can improve by intervention
• Reminder: even when an outcome is efficient, governments may want to intervene
because of inequity concerns
, Economic Models: Trade-offs and Trade
Let’s look at an example of a model to illustrate the concept of comparative advantage.
In deciding what to produce, a producer faces trade-offs à principle 1.
We can model the production possibilities of an economic agent (a country, a firm, a
worker) with the production possibility frontier (PPF)
The Production Possibility Frontier
Example: Given her land and machinery constraint, a farmer can produce at maximum
the following combination of milk and eggs
Feasible + Efficient:
Principle #2: The true cost of something is its opportunity cost
• The production possibility frontier also shows the opportunity costs
• |slope| of the PPF = opportunity costs of good x (eggs) in terms of y (milk)
