Lu 1 introduction_to_micro

Principle of Economics

Learning Objectives

At the end of the lecture class, students will be able to:

1. Define the meaning of economics and several economics terms

2. Illustrate the Production Possibility Curve 3. Provide comparison between different type

of economic system

WHAT IS

E-C-O-N-O-M-I-C-S?

Origin The term "economy," from which we get

"economics," comes most directly from the Old French word "economie," meaning "management of a household."

The French adopted the term from the Latin word "oeconomia," which was in turn derived from the Greek word "oikonomia." Oikonomia came from the word "oikonomos," which separates into "oikos," meaning house, and "-nomos" meaning managing.

The oldest recognized written work in the field of economics is Oeconomicus, a book on farming and household management, written by the Greek philosopher Xenophon.

In short, “one who manages a

household.”

Microeconomics vs Macroeconomics

Microeconomics is the branch of economics that examines the individual economics units or particular parts of the economy

Macroeconomics is the branch of economics that examines the behavior of economic aggregates — income, output, employment, and so on—on a national scale

Examples of Microeconomic and Macroeconomic concerns

Production Prices Income Employment

Micro •Production/Output in Individual Industries and Businesses

•How much steel•How many offices•How many cars

•Price of Individual Goods and Services •Price of medical care•Price of gasoline•Food prices•Apartment rents

•Distribution of Income and Wealth

•Wages in the auto industry

•Minimum wages•Executive salaries•Poverty

•Employment by Individual Businesses & Industries

•Jobs in the steel industry

•Number of employees in a firm

Macro •National Production/Output

•Total Industrial Output•Gross Domestic Product•Growth of Output

•Aggregate Price Level

•Consumer prices•Producer Prices•Rate of Inflation

•National Income

•Total wages and salaries

•Total corporate profits

•Employment and Unemployment in the Economy

•Total number of jobs•Unemployment rate

Definition of Economics

Concerned with the efficient use of limited or scarce resources to achieve maximum satisfaction of human materials wants.

Human wants are unlimited, but the means to satisfy the wants are limited. Thus, economics is the study of the use of scarce resource to satisfy unlimited human wants.

Definition of Economics

Or economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. In large measure it is the study of how people make choices.

Resources ??

Resources Categories Land: gifts of nature that we use to produce

goods and services. eg. Water, tree, mineral, etc.

Labor: time and effort that we devote to produce goods and services. Both physical and mental.

Capital: the goods that we have produced and that we can now use to produce other goods and services. Physical capital such as factory and human capital consists of knowledge and skill.

Entrepreneurship: the resource that organizes other factors of production.

Resources Categories

Resources/Input

Production Commodities

Consumption

Goods

Services

Value the

goods & services

Economists call such resources as inputs or factors of production because they are used to produce things what people desire.

The things produced are called commodities. Commodities may be divided into goods and services. Goods are tangible (e.g cars or shoes), and service are intangible (e.g haircuts or education).

People use goods and services to satisfy many of their wants (needs). The act of making goods and services called production, and the act of using them to satisfy wants is called consumption.

Goods are valued for services they provide. An automobile, for example, helps to satisfy its owner’s desires for transportation, mobility and possibility status.

Resources Categories

Scarcity, Choice and Opportunity Cost

Scarcity: the central economic

problem

Scarcity. . . means that society has limited resources and therefore cannot produce all the

goods and services people wish to have.

ChoicesBecause resources are scares, all societies face the problem of deciding what to produce

and how to produce and divide the products

among their members.

Societies differ in who makes the choices and

how they are made, but the need to choose is

common to all. Just as scarcity implies the need

for choice, so choice implies the existence of cost.

Human wants are unlimited, but resources are not!!

The best alternative that we forgo, or give up, when we make a choice or a decision.

Every decision means giving up something. Economists are fond of trade-offs as a way of thinking about decision making. Taking one action usually means giving up something else.

Opportunity costs arise because resources are scarce. Resources are scarce because human wants exceed what we can produce from our current resources.

Opportunity cost

“There is no such thing as a free lunch!”

Nearly all decisions involve trade-offs. The cost of something is what you give up to get it. Rational people think at the margin. People respond to incentives.

Opportunity cost

Making decisions requires trading

off one goal against another.

People Face Tradeoffs

To get one thing, we usually have to give up another thing.

– Whether to go to college or to work?– Whether to study or go out on a date?– Whether to go to class or sleep in?

Decisions require comparing costs and benefits of alternatives. The opportunity cost of an item is what you give up to obtain that item.

1. Products provided for “free” to an individual are not free for society because of the required use of scarce resources to produce them.

2. Companies provide “free” goods as a marketing strategy to promote brand awareness.

3. Products that are promoted as “free” to the individual may actually be bundled with another good for which the consumer must pay. Because a purchase is required to obtain them, these products are not really free to the buyer.

Consider This … Free for All?

The principles of HOW PEOPLE

MAKE DECISIONS

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All decisions involve tradeoffs. Examples:• Going to a party the night before your

midterm leaves less time for studying.• Having more money to buy stuff requires

working longer hours, which leaves less time for leisure.

• Protecting the environment requires resources that could otherwise be used to produce consumer goods.

Principle 1: People Face TradeoffsPrinciple 1: People Face Tradeoffs

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• Society faces an important tradeoff: efficiency vs. equality

• Efficiency: when society gets the most from its scarce resources

• Equality: when prosperity is distributed uniformly among society’s members

• Tradeoff: To achieve greater equality, could redistribute income from wealthy to poor. But this reduces incentive to work and produce, shrinks the size of the economic “pie.”

Principle 1: People Face TradeoffsPrinciple 1: People Face Tradeoffs

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• Making decisions requires comparing the costs and benefits of alternative choices.

• The opportunity cost of any item is whatever must be given up to obtain it.

• It is the relevant cost for decision making.

Examples: The opportunity cost of…

…going to college for a year is not just the tuition, books, and fees, but also the foregone wages.

…seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater.

Principle 2: The Cost of Something Is What You Give Up to Get It

Principle 2: The Cost of Something Is What You Give Up to Get It

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Rational people – systematically and purposefully do the best they

can to achieve their objectives.– make decisions by evaluating costs and benefits of

marginal changes – incremental adjustments to an existing plan.

Examples:• When a student considers whether to go to college

for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education.

• When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue.

Principle 3: Rational People Think at the Margin

Principle 3: Rational People Think at the Margin

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• Incentive: something that induces a person to act, i.e. the prospect of a reward or punishment.

• Rational people respond to incentives.Examples:– When gas prices rises, encourages people

to carpool and take public transportation.– When cigarette taxes increase,

teen smoking falls.

Principle 4: People Respond to IncentivesPrinciple 4: People Respond to Incentives

The principles of HOW PEOPLE

INTERACT

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• Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods.

• Countries also benefit from trade & specialization:– Get a better price abroad for goods

they produce– Buy other goods more cheaply

from abroad than could be produced at home

Principle 5: Trade Can Make Everyone Better Off

Principle 5: Trade Can Make Everyone Better Off

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• Market: a group of buyers and sellers (need not be in a single location)

• “Organize economic activity” means determining – what goods to produce – how to produce them – how much of each to produce– who gets them

• A market economy allocates resources through the decentralized decisions of many households and firms as they interact in markets.

Principle 6: Markets Are Usually A Good Way to Organize Economic Activity


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• Famous insight by Adam Smith in The Wealth of Nations (1776):

Each of these households and firms acts as if “led by an invisible hand” to promote general economic well-being.

• The invisible hand works through the price system:– The interaction of buyers and sellers

determines prices. – Each price reflects the good’s value to buyers and

the cost of producing the good. – Prices guide self-interested households and firms

to make decisions that, in many cases, maximize society’s economic well-being.



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• Important role for govt: enforce property rights (with police, courts)

• People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen.

• Market failure: when the market fails to allocate society’s resources efficiently

• Causes:– Externalities, when the production or

consumption of a good affects bystanders (e.g. pollution)

– Market power, a single buyer or seller has substantial influence on market price (e.g. monopoly)

• In such cases, public policy may promote efficiency.

Principle 7: Governments Can Sometimes Improve Market Outcomes


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• Govt may alter market outcome to promote equity

• If the market’s distribution of economic well-being is not desirable, tax or welfare policies can change how the economic “pie” is divided.



The principles of HOW THE

ECONOMY AS A WHOLE

WORKS

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• Huge variation in living standards across countries and over time:– Average income in rich countries is more than

ten times average income in poor countries. – The U.S. standard of living today is about

eight times larger than 100 years ago.• The most important determinant of living standards:

productivity, the amount of goods and services produced per unit of labor.

• Productivity depends on the equipment, skills, and technology available to workers.

• Other factors (e.g., labor unions, competition from abroad) have far less impact on living standards.

Principle 8: A country’s standard of living depends on its ability to produce goods &

services.

Principle 8: A country’s standard of living depends on its ability to produce goods &

services.

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• Inflation: increases in the general level of prices.

• In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall.

• The faster the govt creates money, the greater the inflation rate.

Principle 9: Prices rise when the government prints too much money

Principle 9: Prices rise when the government prints too much money

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• In the short-run (1 – 2 years), many economic policies push inflation and unemployment in opposite directions.

• Other factors can make this tradeoff more or less favorable, but the tradeoff is always present.

Principle 10: Society faces a short-run tradeoff between inflation and

unemployment

Principle 10: Society faces a short-run tradeoff between inflation and

unemployment

Why Study Economics? An important reason for studying

economics is to learn a way of thinking. It is an essential part of the study of society.

Most political problems have an economic aspect, whether it is balancing the budget, fighting over the tax structure, welfare reform, international trade, or concern for the environment.

Economic decisions often have enormous consequences.

Why Study Economics? THE ECONOMIST is like A SCIENTIST to the

economy. Involves thinking analytically and objectively.e.g. what sort of formula is the best for the country or maybe firm. [The pegging of RM to US$ (RM3.80 = US$1)]. Was it the best option?

An understanding of economics is essential to an understanding of global affairs. e.g. the impact of 1997 crisis, 911 and the world oil prices increase.

The study of economics helps to develop an individual’s analytical skills and allows students to better predict the logical consequences of their actions.

Economics can help individuals make better buying decisions, better employment choices and better financial investments.

Economics is however, mainly an academic, not a vocational subject. Its primary objective is to examine problems and decisions from a social rather than personal point of view. It is not a series of “how to make money” examples.

Evan Lau for EBE1053 (CHAP 1)

Why Study Economics?

One of the most important

generalizations in economics is

ceteris paribus

Other-Things-Equalceteris paribus, or all else equal,

assumption, economists study the relationship between two variables while the values of other variables remain constant.

The Latin phrase "ceteris paribus" and its use in economic commentary are centuries older than the formal discipline of economics.

Ceteris Paribus

Other-Things-EqualThe first recorded use of the phrase in an

economic context was in "De Officiis," written by Cicero in 44 B.C. Cicero (106-43 B.C.) wrote that "the proper way to render aid is - if cetera are paria - to bring it to one who needs it most, and not to one whom we expect to be useful for us."

Ceteris Paribus

The production possibility curve

Production possibilities curve: a curve that showing alternative combinations of goods when available resources are used fully and efficiently.

Assumptions:1. Full employment level2. Level of technology is fixed3. Only two goods can be produced4. Resources are fixed in quantity and quality.

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0 1 2 3 4 5 6 7 8Units of clothing (millions)

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Units of food Units of clothing (millions) (millions)

8.0 0.0 7.0 2.2 6.0 4.0 5.0 5.0 4.0 5.6 3.0 6.0 2.0 6.4 1.0 6.7 0.0 7.0

Sloman, Norris: Principles of Economics © 2004 Pearson Education Australia

A production possibility curve

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Sloman, Norris: Principles of Economics © 2004 Pearson Education AustraliaUnits of clothing (millions)


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8.0 0.0b 7.0 2.2 6.0 4.0 5.0 5.0 4.0 5.6 3.0 6.0 2.0 6.4 1.0 6.7 0.0 7.0

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Point C is one of the possible combinations of goods produced when resources are fully and efficiently employed.

Point F is desirable because it yields more of both goods, but it is not attainable given the amount of resources available in the economy.

Points inside of the curve are inefficient. At point H, resources are either unemployed, or are used inefficiently.

A move along the curve illustrates the concept of opportunity cost. Opportunity cost increases because resources are not all perfectly adaptable to the production of both types of goods.

From point D, an increase the production of capital goods requires a decrease in the amount of consumer goods.

The slope of the curve is also called the marginal rate of transformation (MRT).

The negative slope of the reflects the law of increasing opportunity cost. As we increase the production of one good, we sacrifice progressively more of the other.

Growth in production capacity could be represented by a pushing outward of the production possibility boundary.

If an economy’s capacity to produce goods and services is growing, combinations that are unattainable today will become attainable tomorrow. Growth makes it possible to have more of all goods.

Possibility of shifts in PPC

1. Changes in resource availability

2. Technological change

3. Increases in the capital stocks

Can the PPC shifts?

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Growth in potential output

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5 years’ time

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O

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Growth in potential and actual output

Every society has some system or mechanism that transforms that society’s scarce resources into useful goods and services.

Three basic questions that must be answered to understand the functioning of economic system.– What gets produced?– How is it produced?– Who gets what is produced?

The Economic Problem

To demonstrate we used circular-flow diagram. This diagram is a visual model of the economy that outline the flow of resources, products, income and revenue among economic decision maker.

Households as resource suppliers and demanders for goods and services. They attempt to maximize utility.

Firm exists when a person or group of people decides to produce output by transforming inputs into output through production process. Objective is to maximize profit.

The Economic Problem

Copyright © 2004 South-Western

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of money

Factors ofproduction

Wages, rent,and profit

FIRMS• Produce and sell

goods and services• Hire and use factors

of production

• Buy and consumegoods and services

• Own and sell factorsof production

HOUSEHOLDS

• Households sell• Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

• Firms sell• Households buy

MARKETSFOR

GOODS AND SERVICES

Circular-Flow Diagram

Firms– Produce and sell goods and services– Hire and use factors of production

Households– Buy and consume goods and services– Own and sell factors of productionfirms

and households


Markets for Goods and Services– Firms sell– Households buy

Markets for Factors of Production– Households sell– Firms buy

Factors of Production– Inputs used to produce goods and

services– Land, labor, and capital


Economic Systems Economic systems are the basic arrangements

made by societies to solve the economic problem.

1. Capitalist system. This is also known as laissez- faire, market economy, free enterprise, and price mechanism, free market economy.

2. Command economy. This is also known as planned economy system, centrally planned economy, controlled economy or totalitarian economy.

3. Mixed economy system. A combination between both capitalist and command economy system.

4. Traditional Economy system (extreme case) 5. Economies Based on Custom or Religion

(extreme case)

Characteristics Individuals and firms pursue their own self

interest without any central direction or regulation. Also implies a complete lack of government involvement in the economy.

Existence of consumer sovereignty. i.e. consumers are the ones who would determine and influence the types and quantities of goods to be produced. In other words ‘consumers decision would influence the producers’ decision of what to produce. The consumer is said to be a ‘King’.

Price mechanism (market) answer the economic questions and demand and supply decisions. The invisible hand works in the economy. If demand shortage price rises while surplus price falls and settle at equilibrium price where demand equals supply.

1.Laissez-faire economy

Term used by Adam Smith to describe the natural force that guides free market through competition for scarce resources.

According to Adam Smith, in a free market each participant will try to maximize self-interest, and the interaction of market participants, leading to exchange of goods and services

No regulation of any type would be needed to ensure that the mutually beneficial exchange of goods and services took place, since this "invisible hand" would guide market participants to trade in the most mutually beneficial manner.

What is invisible hand

i. Competition may be limited

ii. Inequality - wide gap between the rich and the poor. This will result in a pyramid-shaped income distribution pattern in the economy.

iii. Environment and social goals may be ignored

iv. Monopoly

v. By-product

vi. Do not produce “public goods”

vii. No central authority to protect property rights, enforce contracts

Problems of a free-market economy

Characteristics An economy in which a central

government planning either directly or indirectly sets output targets, incomes, and prices. The three basic economic problems will be solved by the government.

Consumer’s sovereignty does not exist in this system. Consumers have no choice but to except all the decision made by the government or the central authorities.

2. The command economy

High investment, high and stable growth

There is no different in society socially or economically - no different between the rich and the poor. However, in practice, there is still a gap between the two groups although the gap is not as apparent as in a capitalist system.

Theoretically, unemployment does not exist in a communist economy, because every potential worker available will be given a job by the government. However, in practice, this is not possible because of the scarce resources. Government will not be able to provide job opportunities for everyone.

2. The command economy

Problems of gathering information (e.g. getting reliable data)

– inefficient allocation of resources - government may produces goods that are not required by the public.

• no system of prices

• shortages and surpluses

• lack of response to consumer demand inappropriate incentives

less freedom for the society in making economic choice choice of occupation

2. Problems of a command economy

Characteristics There are both public and private sectors

working hand in hand so to ensure economic growth of the economy.

The role of the public sector is to complement the private sector by providing the infrastructure so that economic activities can be carried out effectively and efficiently.

The government will try to reduce income inequality by imposing a progressive tax system where higher income earners are taxed more than the lower income earners. In this way, the gap between the rich and the poor will be narrowed.

3. The mixed economy

The government will also control the existence of monopolies and regulate the power of monopolists.

Since markets are not perfect, governments intervene and often play a major role in the economy. Some of the goals of government are to

Minimize market inefficiencies

Provide public goods

Redistribute income

Stabilize the macro foundation of the economy

• Promote low levels of unemployment• Promote low levels of inflation

3. The mixed economy

Characteristics

Situation in which individuals produce commodities primarily for their own use.

(a) No market

(b) No money

(c) Low level of technology

(d) Low standard of living

(e) Primitive transportation system

4. Traditional Economy system

5. Economies Based on Custom or Religion

Economic Concepts Positive economics studies economic

behavior without making judgments. Positive economics can be referred to as “What is, what was, and what probably will be” economics.

Positive economics is based on sound economic theory, probability, and statistical methods. (e.g. study and determines the probable outcomes from an increase or decrease in taxes)

Normative economics, also called policy economics, analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. It tends to be subjective, value laden, and emotional in its presentation.

Normative economics is often referred to as “What ought to be” economics. “We ought to do this,” or “we ought to do that.”

(e.g. during political elections, candidates claims have the answer to all the country’s economic problems. “We should raise taxes.” “We should lower taxes.” “The rich do not pay enough taxes”).

Economic Concepts

Theoretical economics: The systematic arranging of facts, interpretation of the facts, making generalizations.

Empirical economics refers to the collection and use of data to test economic theories. Many data sets are available to facilitate economic research. They are collected by both government agencies and private companies, Theories involve models, and models involve variables.

A model is a formal statement of a theory. It is usually a mathematical statement of a presumed relationship between two or more variables. (e.g. DD=f(P,Y,Y*,PRE)

A variable is a measure that can change from observation to observation. Economists use the scientific method to establish theories, laws, and principles.

The Method of Economics

The scientific method consists of:

a. The observation of facts (real data).b. The formulations of explanations of cause

and effect relationships (hypotheses) based upon the facts.

c. The testing of the hypotheses.d. The acceptance, rejection, or modification

of the hypotheses.e. The determination of a theory, law,

principle, or model.

Scientific Method

Uses abstract models to help explain how a complex, real world operates develops theories, collects, and analyzes data to evaluate the theories.

Economists use models to simplify reality in order to improve our understanding of the world. Makes use of the scientific method e.g. econometrics model to evaluate the impact of oil price increase to the economy. Economists make assumptions in order to make the world easier to understand.

The art in scientific thinking is deciding which assumptions to make. Economists use different assumptions to answer different questions.

Economic ConceptsDefine the following terms:

1. Free goods2. Economic goods3. Public goods4. Merit goods5. Consumption6. Production7. Utility

Conclusion

Lu 1 introduction_to_micro

Documents

meaning of economics

economics termsillustrate

field of economics

principle of economics

greek word oikonomia

word oikonomos

household management

latin word oeconomia