Chapter 1 Economics - Foundations and Models PDF

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Lecture 1 – Economics: Foundations and Models Learning Objectives 1.1 Understand three key economic ideas: people are rational, people respond to incentives, and optimal decisions are made at the margin. 1.2 Understand the issues of scarcity and trade-offs, and how the market makes decisions on these issues. 1.3 Understand the role of models in economic analysis. 1.4 Distinguish between microeconomics and macroeconomics. Foundations: 

Economics - the study of the choices people and societies make to attain their unlimited wants, given their scarce resources.

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In economics we study how people make choices and interact in markets.

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Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

Economics is used to answer questions such as the following: -

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?

Three Key Economic Ideas 

Three important ideas in economics are: 1. People are rational. 2. People respond to economic incentives. 3. Optimal decisions are made at the margin. – Marginal analysis: Analysis that involves comparing marginal benefits and marginal costs.

Scarcity and Trade-offs Scarcity:  The situation in which unlimited wants exceed the limited resources available to fulfil those wants. Resources:  Inputs used to produce goods and services, including natural resources such as land, water and minerals, labour, capital, and entrepreneurial ability. Trade-off:  The idea that, because of scarcity, producing more of one good or service means producing less of another good or service. Trade-offs force society to make choices This is especially true with respect to three fundamental questions: 1. What goods and services will be produced? Production Possibility Curve:

When choosing between alternative options, economists use the concept of opportunity cost. Opportunity cost: The opportunity cost of any activity is the highest-valued alternative that must be given up engaging in that activity.

2. How will the goods and services be produced? 

In many cases, firms face a trade-off between using more workers and using more machines.

3. Who will receive the goods and services produced? 

This largely depends on how income is distributed

Economic Systems: 

Centrally planned versus market economies

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Centrally planned economy: An economy in which the government decides how economic resources will be allocated.

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Market economy: An economy in which the decisions of households and firms interacting in markets allocate economic resources.

Centrally planned versus market economies, continued: 

A central feature of market economies is consumer sovereignty.

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Consumer sovereignty: The concept that in a market economy it is ultimately consumers who decide what goods and services will be produced. This occurs because firms must produce goods and services that meet the wants of consumers, or the firms will go out of business.

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The modern ‘mixed’ economy  Mixed economy: An economy in which most economic decisions result from the interaction of buyers and sellers in markets, but in which the government plays a significant role in the allocation of resources. Efficiency and equity  Productive efficiency: When a good or service is produced using the least amount of resources. On the PPC. 

Allocative efficiency: When production reflects consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.

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Dynamic efficiency: Occurs when new technology and innovation are adopted over time. Movement of the PPC.

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Voluntary exchange: Occurs in markets when both the buyer and seller of a product are made better off by the transaction.

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Equity: The fair distribution of economic benefits between individuals and between societies.

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An efficient outcome may or may not be considered by society to be equitable.

Solved Problem 1: Scarcity and Trade-offs: 

‘Fortunately for the world’s developed nations, they no longer face the problem of scarcity. As a result, they can direct their efforts to addressing scarcity in developing nations.’

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Do you agree with this statement? Explain why or why not.

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Solving the problem:

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STEP 1: Review the material. This problem is about the concept of scarcity as it is defined in economics. This is covered on a number of pages throughout Chapter 1.

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STEP 2: The concept of scarcity as defined in economics is based on the assumption of unlimited human wants. Resources will always be scarce in this context, regardless of whether we are in the developed or developing world. Human beings will always want more than they have, and every society is therefore faced with the problem of allocating its scarce resources to maximise the satisfaction of wants.

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Economic Models

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Economic models: Simplified versions of reality used to analyse real-world economic situations.

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Economic variable: Something measurable that relates to resources that can have different values, for example, wages, prices, litres of petrol.

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Economic models make behavioural assumptions about the motives of consumers and firms.

To develop a model, economists generally follow these steps: 1. Decide on the assumptions to be used in developing the model. 2. Formulate a testable hypothesis. 3. Use economic data to test the hypothesis. 4. Revise the model if it fails to explain the economic data. 5. Retain the revised model to help answer similar economic questions in the future. Forming and Testing Hypotheses in economic models 

A hypothesis in an economic model is a statement that may be either correct or incorrect about an economic variable.

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In testing hypotheses, economists distinguish between correlation and causality

Normative and Positive Analysis 

Positive analysis: Analysis concerned with what is, involving value-free statements that can be checked by using the facts.

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Normative analysis: Analysis concerned with what ought to be, involving value judgements which cannot be tested.

Solved Problem 2: Normative and Positive Analysis Which of the following represents a positive analysis and which represents a normative analysis? Explain your answer. a) The unemployment rate is currently 6.5 per cent. This is a positive statement as it can be verified or refuted by reference to data on unemployment. b) The unemployment rate is too high, and policies should be devised to reduce the unemployment rate. This is a normative statement. Whether resources should be allocated to reducing the unemployment rate involves value judgements. c) When unemployment falls, wages increase.

This is a positive statement as it can be verified by reference to the facts, although it may be difficult to isolate the relationship between falling unemployment and rising wages. Economics as a social science 

Because economics studies the actions of individuals, it is a social science. Economics is therefore similar to other social science disciplines, such as psychology, political science, and sociology.

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As a social science, economics considers human behaviour—particularly decision-making behaviour—in every context, not just in the context of business.

Microeconomics and Macroeconomics 

Microeconomics: The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

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Macroeconomics: The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

Key Terms                    

Allocative efficiency Centrally planned economy Consumer sovereignty Dynamic efficiency Economic models Economic variable Economics Equity Macroeconomics Marginal analysis Market Market economy Microeconomics Mixed economy Normative analysis Opportunity cost Positive analysis Productive efficiency Scarcity •Trade-off Voluntary exchange

Summary of Using Formula’s

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Whenever you must use a formula, you should follow these steps: 1.Make sure you understand the economic concept the formula represents. 2.Make sure you are using the correct formula for the problem you are solving. 3.Make sure the number you calculate using the formula is economically reasonable. For example, if you are using a formula to calculate a firm’s revenue and your answer is a negative number, you know you made a mistake somewhere....