LECTURE 1 1808 THE CENTRAL IDEA OF ECONOMICS

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LECTURE 1 (18/08)THE CENTRAL IDEA OF ECONOMICS
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Agenda

• What is economics?
• Economic questions commonly posed
• Positive versus normative economics
• Economic decisions are made at every level of
  society
• The importance of economic analysis
• The economic way of thinking
• Microeconomics versus macroeconomics
• Foundation for economic analysis Some Key
  Principles of Economics
• The Principle of Opportunity Cost
• The Marginal Principle (Incremental)
• The Principle of Voluntary Exchange
• The Principle of Diminishing Returns
• The RealNominal Principle (Reality Principle)
• In addition The Spillover Principle
• Implications of these principles
• Thinking economically in the new economy

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Practice Assignments
1. Multiple choice exercises Go to the Textbook
Companion Website at http//wps.prenhall.co
m/bp_osullivan_economics_4 Go to Chapter 2, Try
Practice Quiz 2. Using the Tools Page 40 of
Economics Principles Tools, OSullivan and
Sheffrin,4th Edition, Prentice Hall, 2005.
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1. What is economics?

• the science of choice, exploring the choices
  made by individual people and organizations
  (OSullivan and Sheffrin)
• ...the study of how people deal with scarcity
  (Taylor)
• the study of mankind in the everyday business
  of life (Alfred Marshall, 1842 1924)
• provides a framework to diagnose all sorts of
  problems faced by societyand evaluate various
  proposals to solve them (OSullivan and
  Sheffrin)

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Some JARGONS used by an economist

• choice ceteris paribus
• scarcity diminishing returns
• opportunity cost nominal value
• tradeoffs real value
• economize The Invisible Hand
• marginal market forces
• factors of production on the other hand,
• efficiency act rationally
• assumptions externality

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I. Economic questions commonly posed

• Consumption and production choices
• What, how and for whom to produce goods and
  services?
• How do people choose what and how much to
  consume?
• Price changes and inflation
• Why do some prices rise? fall?
• Why do some countries sometimes experience rapid
  price increase while others have stable prices?
• Economic growth
• How do countries grow rich?
• Why are some richer than others?

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• Rich versus poor
• Why do incomes vary?
• What determines peoples incomes?
• What are the causes of wage gaps between the
  skilled and unskilled workers?
• Government policies and policy analysis
• How do governments economic policies affect
  peoples choices and decisions?
• How do taxes and government spending affect the
  general public?
• Can deficits be good for the country?
• Trade and finance
• What determines the pattern and the volume of
  trade between countries?
• What are the effects of tariffs and quotas on
  international trade?
• How are exchange rates determined?

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II. Positive versus normative economics

• Positive economics
• Predicts the consequences of alternative actions
• Answers questions, What is? or What will
  be?eg. If the minimum wage increases, how many
  workers will lose their jobs?
• If the minimum wage increases, x no. of
  people will lose their jobs.
• Normative economics
• Analysis that answers questions of what ought to
  be?
• Such questions lie at the heart of policy
  debateseg. Should the government cut taxes to
  stimulate the Singapore economy?

Example Mr. Tan Big Bucks has donated S50
million to the university. It can be used to
build a new stadium or a state of the art
library. (Positive) What do you think should be
built and why? (Normative)
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• Economists contribute to policy debates by doing
  positive analysis about the consequences of
  alternative actions
• The policy-makers could then make a normative
  decision on which action to pursue

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III. Economic decisions are made at every level
of society The Invisible Hand?

• Key players in the marketplace
• Individuals/ consumers
• Firms/ producers
• Governments
• Choices made by the these key players answer
  three questions
• What goods and services do we produce? (involves
  tradeoffs)
• How do we produce these goods and services?
  (alternative means of production)
• Who consumes the goods and services produced?
  (distribution by wealth, need?)

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• Why are decisions made? - SCARCITY

Scarcity is a situation in which resources are
limited and can be used in different ways, so one
good or service must be sacrificed for another.

• Wants exceed the resources available to satisfy
  them
• Scarcity implies choice
• In choosing, we economize ie. make the best use
  of available resources
• Choice implies cost opportunity cost
• Scarce goods have an opportunity cost, ie. people
  must sacrifice something for them

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IV. The importance of economic analysis

• Provides important insights into realworld
  problems
• Economists attempt to diagnose and provide
  solutions to these problems
• Traffic congestion impose congestion tax, use
  Electronic Road Pricing (ERP)
• Poverty in Third World countries increase
  economic growth (increase production facilities,
  infrastructure, educational opportunities adopts
  new technology), improve legal system and
  regulatory environment
• Japan policies designed to stimulate economy,
  make changes to financial system

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V. The economic way of thinking

• Use assumptions to simplify and facilitate
  learning
• eliminate irrelevant details and focus on what
  really matters
• key assumption
• people act rationally act in their own
  selfinterest
• rational people respond to incentives
• Exploring relationships between variables and the
  Ceteris Paribus assumption
• Consider changes in one variable, holding all
  other variables constant (effect of other
  tendencies is neglected for a time)
• Example 1 given my income doesnt change no
  other major expense occurs no new technology to
  be introduced as yet, etc.
• I should be able to buy the new MP3 player that I
  would like to own.
• Example 2 given factor prices, state of
  technology / preferences
• I will produce x amount of good Y.
• Think at the margin
• a small, oneunit change in value is called a
  marginal change
• consider small, incremental changes to determine
  whether it is desirable to change the level of
  economic activity eg. If a car dealer hires one
  more sales man, how many cars will the dealer
  sell?

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VI. Microeconomics versus Macroeconomics

• Microeconomics
• The study of choices made by individual
  households, firms and government and of how these
  choices affect the markets for all sorts of goods
  and services
• Concerned with price of a particular good or
  service, quantity of a good or service sold
• Why study microeconomics?
• To understand how markets work and predict
  changes
• To make personal or managerial decisions
• To evaluate the merits of public policies
• Macroeconomics
• The study of the economy as a whole
• Issues include unemployment, inflation, budget
  deficit, trade deficit
• Why study macroeconomics?
• To understand how a national economy operates
• To understand the grand debates over economic
  policies
• To make informed business decisions

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2. Foundation for economic analysis Some Key
Principles

• The Principle of Opportunity Cost
• The Marginal Principle (Incremental)
• The Principle of Voluntary Exchange
• The Principle of Diminishing Returns
• The RealNominal Principle (Reality Principle)
• In addition ..The Spillover Principle

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I. The Principle of Opportunity Cost
PRINCIPLE of Opportunity Cost The opportunity
cost of something is what you sacrifice to get it.

• Most decisions involve several alternatives. The
  principle of opportunity cost incorporates the
  notion of scarcity. Trade-offs arise because of
  scarcity.
• Theres no such thing as a free lunch
• Opportunity cost involves choices (eg. how should
  I spend my money /time?)
• Opportunity cost is always measured by how much
  you give up of the next best alternative to get
  what you want (ie. benefits not enjoyed)

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The Production Possibility Curve (PPC)

• Illustrates the principle of opportunity cost for
  an entire economy
• The ability of an economy to produce goods and
  services is determined by its factors of
  production, including labor, land, and capital
  (machines and buildings)
• Shows how all the available resources can be used
  to produce the various combinations of the two
  goods
• A visual representation of tradeoffs that arise
  in a 2-good economy ie. to obtain more of one of
  the two choices, one must give up more of the
  other choice
• What are resources?
• Labor human effort used to produce
• Production facilities (physical capital)
  factories, offices, stores, restaurants
• Human capital knowledge and skills acquired by
  workers
• Natural resources (land) things created by acts
  of nature and used for production

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Figure 2.1The Production Possibility Curve
(PPC)
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The Production Possibility Curve (PPC)

• The shaded area shows all the possible
  combinations of the two goods that can be
  produced
• Points on the curve combinations that fully
  employ the economys resources
• Points inside the curve inefficient, not
  utilizing all resources or resources not used in
  the leastcost manner
• Points outside the curve not feasible given
  current technologies and resources
• As we move downward along the curve, we must
  sacrifice more manufactured goods to get the same
  10ton increase in agricultural goods
• PPC shifts outwards allows production of more
  output with a given quantity of resources
• Increase resources (natural resources, labor,
  physical capital, human capital)
• Technological innovations

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The Cost of College (page 31)
Example 1 What are some of your pre- university/
junior college friends currently doing? Some will
not have gone to university. They may have chosen
to work instead. How much are they earning? This
becomes the opportunity cost of attending
university. Example 2 The cost of keeping
money in a piggy bank or under the mattress also
illustrates the portion of foregone interest.
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II. The Marginal Principle (Incremental)

• When we say marginal, were looking at the effect
  of only a small, incremental change
• Not allornothing, but incremental
• Ignores past decisions, maximize selfinterest
• Will one additional unit of a variable increase
  or decrease objective function?
• The marginal benefit (MB) of some activity is the
  extra benefit resulting from a small increase in
  the activity eg. extra revenue generated by
  keeping the café open for one more hour
• The marginal cost (MC) is the additional cost
  resulting from a small increase in the activity
  eg. additional expense incurred by keeping the
  café open for one more hour

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• MB and MC change in opposite direction as
  activity is continued.
• MB gt MC ? increase activity
• MB lt MC ? decrease activity
• Pick the level at which the activitys MBMC

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Table 2.1 How Many Movie Sequels?
Example The marginal benefit exceeds the
marginal cost for the first two movies, so it is
sensible to produce two, but not three
movies Thinking at the margin enables us to
fine-tune our decisions
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III. The Principle of Voluntary Exchange

• Based on the notion that people act in their own
  selfinterest wont exchange one thing for
  another unless the trade makes them better off.
  (eg. money/university education)
• A market is an arrangement that allows buyers and
  sellers to exchange goods and services
• Goods markets buyers of final goods and services
  exchange with producers
• Factor markets sellers of factors of production
  exchange with buyers of factors (producers)
• If participation in a market is voluntary, both
  the buyer and the seller must be better off as a
  result of a transaction (ie. double thankyou
  heard)

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IV. The Principle of Diminishing Returns
Suppose that output is produced with two or more
inputs, and we increase one input while holding
the others constant. Eventually output will
begin to increase at a decreasing
rate. Example Diminishing Returns for Sushi
production Number of workers 1 2 3 Total
sushi produced 10 18 23 Additional sushi
from 10 8 5 hiring the another worker

• Diminishing returns is a short-run concept (The
  short run is defined as a period of time in which
  at least one factor of production is fixed)
• In the long-run, all factors of production can be
  varied, and, thus, the principle of diminishing
  returns is not relevant (The long run can be
  defined as a period of time sufficient to vary
  all factors of production eg. increase size of
  production facility)

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V. The RealNominal Principle(Reality Principle)

• What matters to people is the real value or
  purchasing power of money or income, not its
  face value
• The nominal value of money is its face value eg.
  nominal wage paid by the bookstore is 10 per
  hour
• The real value is measured in terms of the
  quantity of goods that the money can buy eg. your
  real wage would fall as the prices of goods and
  services increase, even though your nominal wage
  stayed the same

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VI. In addition ..The Spillover Principle

• For some goods, the costs or benefits associated
  with the good are not confined to the
  individual or organization that decides how much
  of the good to produce or consume
• Spillover costs and benefits are an economic
  problem because producers and consumers base
  production and consumption decisions on their own
  costs or benefits not total costs or benefits
  including spillovers. Thus, the amount of certain
  goods produced or consumed by society may not be
  optimal.

• Examples of Spillover Costs (Negative
  externality)
• 1. Pollution created by a manufacturing plant
• 2. Traffic congestion
• Examples of Spillover Benefits (Positive
  externality)
• 1. Floodcontrol dam benefits
• Research and development in life sciences
• Compulsory immunization against childhood diseases

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VII. Implications of these principles
John Maynard Keynes (18831946) The theory of
economics does not furnish a body of settled
conclusions immediately applicable to policy. It
is a method rather than a doctrine, an apparatus
of mind, a technique of thinking which helps its
processor to draw correct conclusions.

• RATIONALITY
• People act on the basis of self-interest, innate
  selfishness
• People make rational decisions based on available
  market information
• CETERIS PARIBUS
• Other things being equal to what they were before
• Other variables remain fixed

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• OPTIMIZATION BEHAVIOUR
• Based on a set of principles
• Selfish optimization behaviors allocate a
  societys limited resources toward the kinds of
  production that satisfy the tastes and
  preferences of the people
• Adam Smiths Invisible Hand - an invisible hand
  of self-interest guides markets to beneficial
  results
• Efficiency requires certain conditions
• Free, competitive markets allow buyers and
  sellers to express and to satisfy individual
  tastes and preferences
• Free market adjust instantaneously to changes
• Government exists to provide a regulatory and
  legal framework for functioning of free market.
  (eg. Antitrust Law)

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• CRITIQUE - Herbert Simon Nobel Prize, 1978
• people dont always behave rationally
• perfect rationality is not possible in the real
  world as it is much too complicated for people to
  fully understand or to do calculations of
  marginal benefits and marginal costs
• instead of seeking for an optimal choice,
  individuals get the best information for making
  the most practical choice and then stick with it.
• Bounded rationality describes the limits on
  information that makes individual human beings
  disturbingly fallible
• if rationality were unbounded (ie. with perfect
  information), then will be able to optimize
• in a world of bounded rationality, cannot
  assume that (i) individuals maximize to promote
  self interest, and that (ii) the society welfare
  is achieved
• self-interest versus altruistic (regard for
  others as principle of action) reasons

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3. Thinking economically in the new economy

• Reference Kevin Kelly, New Rules for the New
  Economy 10 Radical Strategies for a Connected
  World, 1998

• 1. The Law of Plentitudes versus scarcity
• In the New Economy, shrinking marginal costs
  overwhelms scarcity
• Law of network the law of exponential value
• The new economy hinges on the law of networks -
  value explodes exponentially with membership,
  while this value explosion sucks in more members
  eg. emailings, netmeetings, e advertising, e
  commerce, e auction
• Low fixed costs, insignificant marginal costs and
  rapid distribution in new economy depress tipping
  points below the levels of industrial times
• 2. The law of increasing returns versus
  diminishing returns
• Virtuous circles increasing returns more than
  the textbook notion of economies of scale
• Economies of scale is not confined to one
  organization, but to the entire network eg.
  Silicon Valley

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• 3. The law of inverse pricing
• The very best gets cheaper each year
• superior quality for less price over time eg.
  prices of telecommunications, internet access,
  bandwidth
• 4. Law of generosity versus free lunch
• eg. free internet access, Netscape browser,
  freeware