INTRODUCTION CHAPTER 1. INTRODUCTION What is Economics Economic Models

INTRODUCTION

CHAPTER1

INTRODUCTION

What is EconomicsEconomic Models

INTRODUCTION

All individuals and households have some basic needs and wants.

These needs and wants are insatiable or unlimited. That is, our needs and wants are so many that we

cannot possibly satisfy them all. It is almost impossible to satisfy all our needs and

wants, at any given time, because the resources needed to satisfy them are scarce or limited in supply.

INTRODUCTION

Take for example, the two basic resources - time and money.

It is virtually impossible to have enough money and or time to do all the things that we wish to accomplish at any given point in time.

The problem of scarcity of resources needed to satisfy unlimited needs and wants, exits at the individual level, at the household level, as well as at the societal level.

INTRODUCTION

Since it is impossible to satisfy all our needs and wants with the resources we have, at any given point in time, how do we then as individuals, households and as a society, manage our limited or scarce resources to satisfy our most basic needs and wants?

INTRODUCTION

The solution to the problem of scarcity is to prioritize or choose the most important of our needs and wants to the extent that our scarce resources can satisfy them.

But making these choices requires that we give up or sacrifice those things that we cannot afford to have or what we consider as less important.

The value (or the cost) of the choices we make can be expressed in terms of the alternatives we decided to forgo.

OPPORTUNITY COST

The cost of any choice is the option or options that a person gives up.

• For example, if you gave up the option of playing a computer game to read this text, the cost of reading this text is the enjoyment you would have received playing the game.

Most of economics is based on the simple idea that people make choices by comparing the benefits of option A with the benefits of option B (and all other options that are available) and choosing the one with the highest benefit.

OPPORTUNITY COST

Since our resources are limited, the efficient use of these resources to satisfy the most important needs and wants can have a positive impact on the quality of lives of individuals, households or society.

The efficient allocation of scarce resources to satisfy the most important needs and wants that are likely to improve the quality of life is the main objective of the study of Economics.

OPPORTUNITY COST

Economics is the social science which examines how people choose to use limited or scarce resources in attempting to satisfy their unlimited wants.

MAIN BRANCHES OF ECONOMICS BRANCHES

The field of economics is broken down into two distinct areas of study:

Microeconomics• The study of the choices that individuals and businesses make and

the way these choices interact and are influenced by governments.

• This branch of economics analyzes the market behavior of individual consumers and firms in an attempt to understand the decision-making process of firms and households.

• It is concerned with the interaction between individual buyers and sellers and the factors that influence the choices made by buyers and sellers.

• In particular, microeconomics focuses on patterns of supply and demand and the determination of price and output in individual markets (e.g. coffee industry).

Macroeconomics:

• The study of the aggregate or total effects of the choices that individuals, businesses, and governments make on the national economy and the global economy

• It analyzes economic factors such as gross domestic product, consumer price index, national investment and saving, international trade, aggregate expenditure, and fiscal and monetary policies.

• It also seeks to explain the causes of inflation, recessions, budget and trade (deficits and surpluses) unemployment and the sources of economic growth.

FACTORS OF PRODUCTION

In market-oriented economies, scarce resources needed to produce goods and services for the market are classified into four broad categories called the factors of production:

Natural resources: These are the things created by acts of nature (land, water, mineral resources, oil and gas deposits (non-renewable resources), and nonrenewable resources (solar energy, forest products).

Labor: this includes the human effort - physical and mental, used by workers in the production of goods and services

Physical and Human Capital: These are machines, buildings, equipment, and financial resources used in the production of final goods and services used by consumers. It also includes the knowledge and skills acquired by a worker through education and experience.

Entrepreneurship: The effort to coordinate the production and sale of goods and services. Entrepreneurs take risk and commit time and money to a business without any guarantee of profit.

■ The efficient allocation of these resources to produce goods and services most desired by the market is a major determinant of economic growth.

MODELS IN ECONOMICS

A model is any simplified representation of reality that is used to better understand life situations.

The importance of models is that they allow economists to focus on the effects of changes on one variable at a time.

By holding all other variables constant, models allow us study how one change affects the overall economic outcome.

This assumption, known as ceteris paribus (or all else equal), is an important assumption when building economic models.

PRODUCTION POSSIBILITIES

Production Possibilities Frontier

It is boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the state of technology.

Figure 1.1 shows thePPF for bottled water and CDs.

Each point on the graph represents a column of the table.

The line through the points is the PPF.

1.1 PRODUCTION POSSIBILITIES


The PPF puts three features of production possibilities in sharp focus:

• Attainable and unattainable combinations

• Efficient and inefficient production

• Tradeoffs and free lunches


Attainable and Unattainable Combinations

Because the PPF shows the limits to production, it separates attainable combinations from unattainable ones.Figure 1.2 on the next slide illustrates the attainable and unattainable combinations.

The PPF separates attainable combinations from unattainable combinations.

Points outside the PPF such as point G are unattainable.

We can produce at any point inside the PPF or on the frontier.



Efficient and Inefficient Production

Production efficiency

It is a situation in which we cannot produce more of one good or service without producing less of something else.

Figure 1.3 on the next slide illustrates the distinction between efficient and inefficient production.

1. When production is on the PPF, such as at point E or D, production is efficient.

2. If production were inside the PPF, such as at point H, more could be produced of both goods without forgoing either good. Production is inefficient.



Tradeoffs

A trade-off is an exchange that involves giving up one thing to get something else.

3. When production is on the PPF, we face a tradeoff.

4. If production were inside the PPF, there would be no Trade-off. That is, moving from point H to point D does not involve a tradeoff. You can increase the production of one product without decreasing the production of the other.


1.2 OPPORTUNITY COST

The Opportunity Cost of a Bottle of Water

The opportunity cost of a bottle of water is the decrease in the quantity of CDs divided by the increase in the number of bottles of water as we move along the PPF.

Figure 3.4 illustrates the calculation of the opportunity cost of a bottle of water.

Moving from A to B, 1 bottle of water costs 1 CD.


Moving from B to C, 1 bottle of water costs 2 CDs.


Moving from C to D, 1 bottle of water costs 3 CDs.


Moving from D to E, 1 bottle of water costs 4 CDs.


Moving from E to F, 1 bottle of water costs 5 CDs.



Increasing Opportunity Cost

The opportunity cost of a bottle of water increases as more water is produced.

1.3 USING RESOURCES EFFICIENTLY

Efficient Use of Resources

Resource use is efficient when the goods and services produced are the ones that people value most highly.

That is, when resources are allocated efficiently, it is not possible to produce more of any good without producing less of something else that is valued more highly.

Figure 3.8 on the next slide shows the efficient quantity of bottled water.

Economic Growth

Economic growth results in an outward shift of the PPF because production possibilities are expanded.

1.4 ECONOMIC GROWTH

An economy grows if it:

• Develops better technologies for producing goods and services.

• Improves the quality of labor by education, on-the-job training and work experience.

• Uses more capital (machines) in production.

1.5 SPECIALIZATION AND TRADE

Comparative Advantage

The ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else. Comparative advantage comes with specialization which helps increase the level of output.

Absolute Advantage

When one person is more productive than another person in several or even all activities.

THE CIRCULAR FLOWS

Circular flow model: This model represents the flows of money and goods and services in the economy.

In the markets for goods and services, households purchase goods and services from firms, generating a flow of money to the firms and a flow of goods and services to the households.

The money flows back to households as firms purchase factors of production from the households in factor markets.

THE CIRCULAR FLOWS

Markets

A market is any arrangement that brings buyers and sellers together and enables them to get information and do business with each other.

Factor markets are markets in which factors of production (land, labor, human capital etc) are bought and sold.

Goods markets are markets in which goods and services are bought and sold.

THE CIRCULAR FLOWS

In factor markets:

• Households supply factors of production

• Firms hire factors of production.

• Firms supply goods and services produced.

• Households buy goods and services.

In goods markets:

Real Flows and Money Flows

1.2 THE CIRCULAR FLOWS

• Firms pay households incomes for the services of factors of production.

Real Flows and Money Flows

• Households pay firms for the goods and services they buy.

• These are the money flows.

• The blue flows are incomes.

• The red flows are expenditures.

The PPF in YOUR Life

The figure illustrates the PPF of a student who goes to class and studies 48 hours a week and has a GPA of 4.

1. How does your PPF compare with this one?

2. What will happen to your PPF if you take more leisure?

3. What is the trade-off involved in taking more leisure?

Documents

INTRODUCTION CHAPTER 1. INTRODUCTION What is Economics Economic Models