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Summary: Weeks 1,2 Jacob Coreno 18 July 2017

Chapter 1: Ten Lessons in Economics How People Make Decisions Lesson 1: People face trade-offs • Resources (e.g., labour, capital, time, etc.) are scarce. This means we cannot have everything that we desire. – In order to get something that we desire, we must forego something else that we might like. Lesson 2: The cost of something is what you give up to get it • The economic or opportunity cost of an object or action is the value of the next best alternative that must be foregone in order to obtain the object or undertake the action. – What do we mean by “next best”? – If spending an hour in a tutorial means you give up an hour of work or leisure, then the opportunity cost of attending the tutorial is the value of the hour of work or the hour of leisure: whichever is preferred. Lesson 3: Rational people think at the margin • When evaluating alternative courses of action, rational decision makers consider the benefits and costs associated with marginal changes in the existing plan of action. – A marginal change is a small incremental change. • For example, a firm deciding whether to increase output should consider benefits and costs associated with increasing output at the margin (i.e., increasing output by a single unit) – The firm should increase output if the marginal benefit (marginal revenue, i.e., the additional revenue earned from producing an extra unit) exceeds the marginal cost (more on this in later weeks)

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Chapters: 1, 2 3

MAE101: Economic Principles

J. Coreno

Lesson 4: People respond to incentives • An incentive is a reason to act in a particular way • Because we make decisions by comparing costs and benefits, incentives can influence a decision maker’s behaviour. – For example, when the market price of apples rises, consumers have an incentive to purchase fewer apples and producers have an incentive to sell more apples.

How People Interact Lesson 5: Trade can make everyone better off • Trade is not a “zero-sum game”, where one party’s gain is exactly balanced by another party’s losses. • Trading with others allows us to specialise in the activities that we do best, in order to produce more goods and services to be enjoyed by everybody. Lesson 6: Markets are usually a good way to organise economic activity • In market economies, the collective decisions of many self-interested households and firms allocate goods and services efficiently – i.e., lowest-cost producers sell to consumers with the highest valuation • Price is the key allocation mechanism which directs economic activity (the invisible hand ) – Prices determine how much a producer is willing to sell – Prices determine how much a consumer is willing to buy • In centrally-planned economies, price controls distort market activity and inhibit efficiency Lesson 7: Governments can sometimes improve market outcomes • A market failure is a situation in which a market, if left unregulated, fails to allocate goods and services efficiently, e.g., – externality : the impact of an agent’s actions on an external party (i.e., a party acting in a market confers a benefit or cost to some bystander, e.g., pollution) – market power : the ability of a single economic agent to influence market prices

How the Economy as a Whole Works Lesson 8: A country’s standard of living depends on its ability to produce goods and services • The standard of living is measured by average real income 2

Chapters: 1, 2 3

MAE101: Economic Principles

J. Coreno

• Almost all cross-country variation in living standards is the result of differences in productivity – Productivity is a measure of the amount of output that can be produced per unit of input – When making cross-country comparisons, we often use 1 hour of a worker’s time as the relevant unit of input Lesson 9: Prices rise when the government prints too much money • Inflation is the increase in the overall price level of the economy over time – Long-run inflation occurs when the monetary growth rate exceeds the growth rate of real GDP – i.e., money is neutral in the long-run Lesson 10: Society faces a short-term trade-off between inflation and unemployment • Sticky prices means that changes in the quantity of money have real effects in the short-run. – Increasing the supply of money increases the amount that people spend, thereby increasing the amount of goods and services that firms can sell, thereby increasing the amount of labour that firms demand, i.e., unemployment decreases. – The opposite is true for a decrease in the supply of money. • The government can reduce unemployment but it must tolerate greater inflation; otherwise, it can reduce inflation but it must tolerate greater unemployment.

Chapter 2: Thinking Like an Economist The Economist as a Scientist The Role of Assumptions • Economists make assumptions to simplify the analysis of complex problems – Even if assumptions are not entirely realistic, they can still be useful if relaxing the assumptions does not substantially alter the conclusions Economic Models • Economists use models to simplify and describe various aspects of the world. – Different models use different assumptions and omit different details in order to focus on a particular issue • A good model is not necessarily complex and need not include every specific detail. – We already have one perfect model of the world, i.e., the world itself

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Chapters: 1, 2 3

MAE101: Economic Principles

J. Coreno

– However, this is very complicated and it is difficult to extract useful insight • Examples: – The circular-flow diagram (see pp. 25-26, Gans et al.) – The production possibilities frontier (see pp. 26-28, Gans et al.) Microeconomics and Macroeconomics • Microeconomics is the study of the behaviour of various economic agents (e.g., firms, consumers, politicians, etc.) and how they interact in markets • Macroeconomics is the study of the broader economy – Looks at various economic aggregates (e.g., unemployment, real GDP, inflation) – Macroeconomic theory has microfoundations, i.e., economic aggregates are determined by the collective decisions of millions of economic agents.

The Economist as a Policy Adviser Positive vs. normative analysis • A positive statement is an objective statement about how the world is – A positive statement can be true or false; however, its validity can be tested scientifically by examining evidence. – e.g., “prices rise when the government prints too much money” • A normative statement is a subjective statement about how the world should be – A normative statement involves value judgements; they cannot be evaluated by simply examining evidence. – e.g., “the government should not print money” • Positive and normative statements are related – positive, scientific analysis helps to improve our normative judgements

Chapter 3: Interdependence and the Gains from Trade Production Possibilities • The production possibilities frontier (PPF) is the set of all maximum output combinations between two goods • We often assume the PPF is concave to the origin, i.e., it bows outwards

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Chapters: 1, 2 3

MAE101: Economic Principles

J. Coreno

– The assumption here is that some inputs (e.g., labour) are better suited to the production of a particular good – e.g., Suppose an economy can produce two goods, x and y, but it is currently producing only y. This means that good y is being produced by some workers who are better at producing x. If the economy increases production of good x by a small amount, the first workers to switch from producing y to x are those workers that specialise in x production. Hence, the gain in x production is relatively large and the reduction in y production is relatively small (i.e., the PPF is relatively flat). However, as you continue to increase production of good x, the workers who switch from y to x will be progressively less suited to producing x and better at producing y. Hence, the gain in x will be relatively small and the reduction in y will be relatively large. – In short, the trade-off between the two goods depends on the amounts of each good being produced. • We sometimes assume the PPF is linear, i.e., a straight line – The assumption here is that the opportunity cost of each good does not depend on the amounts of each good being produced. • Slope of PPF between two goods x and y represents the amount of y you must sacrifice to get an extra unit of x, i.e., the opportunity cost of producing x. Specialisation and trade See pages 52-53 of your textbook for a nice example of how trade can make two parties better off, even when there is a party who is “better” at everything (i.e., one party has an absolute advantage in producing both goods). In doing so, it would be useful to verify the calculations.

The Principle of Comparative Advantage Absolute advantage • A producer has an absolute advantage in the production of a good if it can produce that good using fewer inputs than another producer (or, equivalently, if it can produce more output from a unit of input) – e.g., if Leonard can produce a meal in less time than Sheldon (or Leonard can produce more meals in the same amount of time), then Leonard has an absolute advantage in producing meals. Opportunity cost • Suppose the economy can produce two goods, x and y. • The opportunity cost of producing x is the amount of the other good y that must be foregone in order to produce x, e.g., 5

Chapters: 1, 2 3

MAE101: Economic Principles

J. Coreno

– Suppose that in 1 hour you can produce either 4 chairs or 6 tables – The opportunity cost of 4 chairs is 6 tables – Dividing by the number of chairs gives the opportunity cost of a single chair, which is

6 4

tables – The opportunity cost of 6 tables is 4 chairs – Therefore, the opportunity cost of 1 table is

4 6

chairs

• Note that the opportunity cost of a chair is the reciprocal of the opportunity cost of a table.1 Comparative advantage • A producer has a comparative advantage in the production of a good if it can produce that good at a lower opportunity cost than another producer. • It is impossible to have a comparative advantage in the production of both goods – If there are two possible goods, x and y, then the opportunity cost of x is the reciprocal of the opportunity cost of y. – If the opportunity cost of x is relatively high, then the opportunity cost of y (i.e., the reciprocal of the opportunity cost of x) is relatively low. Comparative advantage and trade • Gains from trade arise from differences in opportunity cost and comparative advantage – When each party specialises in producing the good for which they have a comparative advantage, total output increases. • Each party can benefit from trade by buying goods at a price that is less than their opportunity cost of producing that good. Applications of comparative advantage See pp. 56-58, Gans et al. for some examples.

1 The

reciprocal of a number a is the number b such that a × b = 1.

Dividing both sides by a, we get b=

6

1 . a...