Principles of Economics

Economic Issues and Concepts

Lecture 1

Jossias Matias
 Learning Outcomes
Describe and utilize the fundamental economic
concepts and microeconomic theories of
pricing, markets, supply, demand, trade,
efficiency and equity.
Analyze the economic behaviour of individuals
and firms within an economy
Describe the different market structures,
production and costs
 learning outcomes
 Identify the key characteristics and consequences of
monopoly, monopolistic competition and oligopoly
 Explain the general roles of the free market and
government in the economy.
 Identify the relevance of economics in a changing
world
 Identify and apply critical reasoning to economic
issues
 Describe the basic jargon used to model
microeconomic behaviour
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Economy. . .

The word economy comes from a Greek

word for “oikonomia the one who
manages a household.”
based on oikos ‘house’ + nemein
‘manage’.
 Definition of Economics
Economics is the social science that studies the choices that
individuals, businesses, governments, and entire societies make as
they cope/handle with scarcity and the incentives that influence and
reconcile those choices

Economics - is the study of how society manages its scarce

resources.

Economics - is a science of choices.

Economics divides in to main parts:
 Microeconomics
 Macroeconomics
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 Definition of Economics
 Microeconomics is the study of choices that individuals
and businesses make, the way those choices interact in
markets, and the influence of governments.
 An example of a microeconomic question is: Why are
people buying more e-books and fewer hard copy
books?

 Macroeconomics is the study of the performance of the

national and global economies.
 An example of a macroeconomic question is: Why does
the unemployment rate in Mozambique fluctuate?
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 Definition of Economics
 All economic questions arise because
we want more than we can get.
 Our inability to satisfy all our wants is
called scarcity.
 Because we face scarcity, we must
make choices.
 The choices we make depend on the
incentives we face.
 An incentive is a reward that
encourages an action or a penalty
that discourages an action.

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 ECONOMIC ISSUES AND CONCEPTS

Decision making include consideration of :Limited Resources and Scarcity

The Scarcity Problem: Boundless needs and wants, limited resources so that
having more of one good thing usually means having less of another.
Scarcity is a fundamental problem faced by all economies because not enough
resources - land, labour, capital, and entrepreneurship - are available to produce
all the goods and services that people would like to consume.
Scarcity makes it necessary to choose among alternative possibilities: what
products will be produced and in what quantities.
 Economic concepts
Limited Resources includes:
 Land: includes minerals, water, fish, oxygen, natural
resources
 Labour: mental and physical efforts
 Capital:
 Real capital – Refers to tangible assets buildings,
roads, manufacturing plants, equipment
 Human capital –refers to intangible assets training,
health, skills, networks
 Entrepreneurship: organization of the above items
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 Economic concepts
Choices: refers to the ability of a consumer or producer to decide which
good, service or resource to purchase or provide from a range of possible
options.
Every person, business, and government in the world must make choices
concerning the use of limited resources.
Rationality – well defined goals & values
Costs - The sacrifice involved in performing an activity, or following a
decision or course of action.
Explicit
Opportunity cost: Next best alternative
Sunk cost: money already spent as a result of a past decision. Should be
neglected in decision making
Marginal cost: cost of one additional activity/product

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 Economic concepts
The concept of opportunity cost emphasises scarcity and
choice by measuring the cost of obtaining a unit of one
product in terms of the number of units of other
products that could have been obtained instead.
A production-possibility boundary shows all of the
combinations of goods that can be produced by an
economy whose resources are fully employed.
Movement from one point to another on the boundary
shows a shift in the amounts of goods being produced,
which requires a reallocation of resources.
 Economic concepts
Who Makes the Choices and How
Modern economies are based on the specialization and division of labour,
which necessitate the exchange of goods and services.
Exchange takes place in markets and is facilitated by the use of money.
Much of economics is devoted to a study of how markets work to co-ordinate
millions of individual, decentralized decisions.
Three pure types of economy can be distinguished: traditional, command, and
free market.
In practice, all economies are mixed economies in that their economic
behaviour responds to mixes of tradition, government command, and price
incentives.
 Economic concepts
Governments play an important part in modern mixed
economies.
They create and enforce important background institutions
such as private property.
They intervene to increase economic efficiency by correcting
situations where markets do not effectively perform their co-
ordinating functions.
They also redistribute income and wealth in the interests of
equity.
Two big economic questions

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 Two Big Economic Questions
Two big questions summarize the scope of economics:

1. How do choices end up determining what, how, and for

whom goods and services get produced?

2. When do choices made in the pursuit of self-interest also

promote the social interest?

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Two Big Economic Questions
1. How do choices end up
determining what, how, and
for whom goods and services
get produced?

What ?
 What determines these
patterns of production?

 How do choices end up

determining the quantity of
each item produced in
Canada and around the
world?

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 Two Big Economic Questions
 How?
 Goods and services are produced by using productive
resources that economists call factors of production.
 Factors of production are grouped into four
categories:
 Land
 Labour
 Capital
 Entrepreneurship

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 Two Big Economic Questions
For Whom?
Who gets the goods and services depends on
the incomes that people earn.
 Land earns rent.
 Labour earns wages.
 Capital earns interest.
 Entrepreneurship earns profit.

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 Two Big Economic Questions
2. When do choices made in the pursuit of self-interest also
promote the social interest?
 Self-Interest
 You make choices that are in your self-interest—choices that
you think are best for you.
 Social Interest
 Choices that are best for society as a whole are said to be in
the social interest.
 Social interest has two dimensions:
 Efficiency
 Equity
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 Two Big Economic Questions
Efficiency and Social Interest
Resource use is efficient if it is not
possible to make someone better off
without making someone else worse off.

Equity is fairness, but economists have a

variety of views about what is fair.

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Economics has two broad branches:

 Microeconomics… the firm and individual level

 Macroeconomics… the whole economy level

Microeconomics
 Study of how people and firms make decisions regarding the
allocation of resources and prices of goods and services.

 Focuses on supply and demand and other forces that determine

the price levels seen in the economy
The economic way of thinking

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 The Economic Way of Thinking
Six key ideas define the economic way of thinking:
 A choice is a tradeoff.
 Benefit is what you gain from something.
 Cost is what you must give up to get something.
 People make rational choices by comparing benefits
and costs.
 Most choices are “how-much” choices made at the
margin.
 Choices respond to incentives.

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 The Economic Way of Thinking
A Choice Is a Tradeoff
The economic way of thinking places
scarcity and its implication, choice, at
center stage.

25
 The Economic Way of Thinking
 Making a Rational Choice
 A rational choice is one that compares costs and benefits and
achieves the greatest benefit over cost for the person making
the choice.
 How do people choose rationally?
 Consider.
 Benefit: What person gains based upon preferences
 Cost: What you Must Give Up

26
 The Economic Way of Thinking
 Cost: What you Must Give Up
 opportunity cost – cost of what you give up - the next best
alternative you give up.

Example
What is your opportunity cost of going to an AC/DC concert?
 Opportunity cost has two components:
 1. The things you can’t afford to buy if you purchase the AC/DC
ticket.
 2. The things you can’t do with your time if you go to the
concert.

27
 The Economic Way of Thinking
 How Much? Choosing at the Margin
 Choice is usually not all or nothing, but you must decide how many
minutes to allocate to each activity.

 Ex: You can allocate the next hour between studying and instant
messaging your friends.

 To make this decision, you compare the benefit of a little bit more
study time with its cost—you make your choice at the margin.

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The Economic Way of Thinking
How Much? Choosing at the Margin
 What do we mean by margin?
 incremental changes in the use of your time.
 benefit from pursuing an incremental increase in an activity is
its marginal benefit.
 opportunity cost of pursuing an incremental increase in an
activity is its marginal cost.

 If marginal benefit > marginal cost for an activity the rational

choice is to do more of that activity.

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 The Economic Way of Thinking
 Choices Respond to Incentives
 Incentives can change marginal cost or marginal
benefit and leads us to change our choice.
 The central idea of economics is that we can
predict how choices will change by looking at
changes in incentives

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Ten principles of economics

A household and an economy

face many decisions:
◦ Who will work?
◦ What goods and how many of them should
be produced?
◦ What resources should be used in
production?
◦ At what price should the goods be sold?
Ten principles of economics
Economics is the study of how society manages its scarce resources.
 Ten principles of economics
How people make decisions.
◦ People face tradeoffs.
◦ The cost of something is what you give up to get it.
◦ Rational people think at the margin.
◦ People respond to incentives.

How people interact with each other.

◦ Trade can make everyone better off.
◦ Markets are usually a good way to organize economic activity.
◦ Governments can sometimes improve economic outcomes.

The forces and trends that affect how the economy as a whole works.
◦ The standard of living depends on a country’s production.
◦ Prices rise when the government prints too much money.
◦ Society faces a short-run tradeoff between inflation and unemployment.
 Principle 1: People Face Tradeoffs

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

 Guns v. butter
 Food v. clothing
 Leisure time v. work
 Efficiency v. equity

Making decisions requires trading

off one goal against another.
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Principle #1: People face tradeoffs

Efficiency v. Equity
◦ Efficiency means society gets the most that it
can from its scarce resources.

◦ Equity means the benefits of those resources

are distributed fairly among the members of
society.
Principle #2: the cost of something is what
Principle
you 2:up
give theto
cost
getof it.
something is what you give up to
get it.

Decisions require comparing costs and

benefits of alternatives.
◦ 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?
The opportunity cost of an item is what you
give up to obtain that item.
Principle #3: Rational people think at the
margin.
Principle 3: Rational people think at the margin
Marginal changes are small, incremental adjustments to an existing plan of
action.

People make decisions by comparing

costs and benefits at the margin.
Principle 4: People Respond to Incentives.
Marginal changes in costs or benefits motivate people to respond.
The decision to choose one alternative over another occurs when that
alternative’s marginal benefits exceed its marginal costs!
Principle #5: Trade Can Make Everyone Better Off.
Principle 5: Trade Can Make Everyone Better Off.

People gain from their ability to trade with one another.

Competition results in gains from trading.
Trade allows people to specialize in what they do best.
Principle 6: Markets are usually a good way
to organize economic activity.
A market economy is an economy that allocates resources through the
decentralized decisions of many firms and households as they interact
in markets for goods and services.
◦ Households decide what to buy and who to work for.
◦ Firms decide who to hire and what to produce.
 Principle 6: cont….

Adam Smith made the observation that households and

firms interacting in markets act as if guided by an
“invisible hand.”
◦ Because households and firms look at prices when
deciding what to buy and sell, they unknowingly take
into account the social costs of their actions.
◦ As a result, prices guide decision makers to reach
outcomes that tend to maximize the welfare of society
as a whole.
.

Principle 7: Governments Can Sometimes Improve

Market Outcomes.

Market failure occurs when the market fails

to allocate resources efficiently.
When the market fails (breaks down)
government can intervene to promote
efficiency and equity.
 Principle 7: cont……

Market failure may be caused by

◦an externality, which is the impact of
one person or firm’s actions on the
well-being of a bystander/Participant.
◦market power, which is the ability of a
single person or firm to unduly
influence market prices.
Principle 8: The Standard of Living Depends on a
Countrys Production.

Standard of living may be measured in

different ways:
◦ By comparing personal incomes.
◦ By comparing the total market value
of a nation’s production.
 Principle 8: Cont……

Almost all variations in living standards

are explained by differences in
countries’ productivities.
Productivity is the amount of goods and
services produced from each hour of a
worker’s time.
Principle 9: Prices Rise When the Government
Prints Too Much Money.

Inflation is an increase in the overall level of

prices in the economy.
One cause of inflation is the growth in the
quantity of money.
When the government creates large
quantities of money, the value of the money
falls.
 Principle 10: Society Faces a Short-run
Tradeoff Between Inflation and
Unemployment
The Phillips Curve illustrates the
tradeoff between inflation and
unemployment
Inflation or Unemployment
Its a short-run tradeoff!

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 Summary
 When individuals make decisions, they face tradeoffs among alternative goals.
 The cost of any action is measured in terms of foregone opportunities.
 Rational people make decisions by comparing marginal costs and marginal benefits.
 People change their behavior in response to the incentives they face.
 Trade can be mutually beneficial.
 Markets are usually a good way of coordinating trade among people.
 Government can potentially improve market outcomes if there is some market
failure or if the market outcome is inequitable.
 Productivity is the ultimate source of living standards.
 Money growth is the ultimate source of inflation.
 Society faces a short-run tradeoff between inflation and unemployment.

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 Production possibilities frontier (PPF)/
Boundary

It is a method of illustrating the economic problem of Scarcity.

The production possibility boundary shows the maximum
amount of goods and services that can be produced by an
economy at a given point in time with available resources and
technology.
The shows the combinations of output that the economy can
possibly produce given the available factors of production and
the available production technology
The production possibilities frontier is a graph that shows the
combinations of output that the economy can possibly produce
given the available factors of production and the available
production technology
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A production-possibility boundary

· The quantity of public sector goods produced is measured

along the horizontal axis.
· The quantity of private sector goods is measured along the
vertical axis.
· Any point on the diagram indicates some amount of each kind
of good produced.
· The production-possibility boundary separates the attainable
combinations, such as a, b, and c, from unattainable
combinations, such as d.
· Points a and b represent efficient uses of society’s resources.
· Point c represents either an inefficient use of resources or a
failure to use all the resources that are available.
A production-possibility boundary

·The boundary is negatively sloped because in a fully

employed economy more of one good can be
produced only if resources are freed by producing
less of other goods.
· Moving from point a (with coordinates c0 and g0) to
point b (with coordinates c1 and g1) implies producing
an additional amount of public sector goods,
indicated by G in the figure
·The opportunity cost of this increase in G is a
reduction in private sector goods by the amount
indicated by C.
 A Production-Possibility Boundary

Unattainable combinations
Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

0
Quantity of public sector goods
 A Production-Possibility Boundary

Unattainable combinations
c0 a
Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

0 g0

Quantity of public sector goods

 A Production-Possibility Boundary

Unattainable combinations
c0 a
• d
Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

c1 b
c

0 g0 g1

Quantity of public sector goods

 A Production-Possibility Boundary

Unattainable combinations
c0 a
• d
Quantity of private sector goods

Production possibility
C boundary
Attainable
combinations

c1 b
c
G

0 g0 g1

Quantity of public sector goods

The effect of economic growth on the
production possibility boundary

·Economic growth shifts the boundary

outwards.
·Some combinations of goods that were
previously unattainable become
attainable.
 The Effect of Economic Growth on the Production-Possibility
Boundary
Quantity of private sector goods

Production possibility
boundary before growth

Quantity of public sector goods

0
 The Effect of Economic Growth on the
Production-Possibility Boundary
Quantity of private sector goods

a
d Production possibility
boundary after growth

Production possibility b
boundary before growth

0
Quantity of public sector goods
What Are Economic Agents?

There are four major economic agents:

 Households/Individuals,
 Firms,
 governments, and
 Central banks.
Some economists put governments and central
banks together.

59
Households
 The first type of economic agent is households. These are people or
families that serve primarily as consumers in a capital market. Their
job is to buy goods and services. In finance, they often buy financial
products and services. It's the money of households and individuals
that keeps the economy going. Without households to consume, the
economy does not exist.
Firms
 Another economic agent is firms. These are businesses and are
mostly thought of as producers in the economy. That is, they
produce the goods and services that households consume. In capital
markets, they are often producing financial products and/or selling
financial-related advice.

60
The circular flow of income and expenditure

·Factor services flow from individuals who own the

factors (including their own labour) through factor
markets to firms who use them to make goods and
services (yellow arrow).
·The goods and services then flow through goods
markets to those who consume them (yellow arrow).
·Money payments flow through factor markets from
firms to individuals (white arrow).
·When individuals spend this income buying goods
and services, money flows through goods markets
back to producers (white arrow).
The Circular Flow of Income and Expenditure

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
• Firms sell Goods and
Goods
• Households buy services
and services
sold bought

FIRMS HOUSEHOLDS
• Produce and sell • Buy and consume
goods and services goods and services
• Hire and use factors • Own and sell factors
of production of production

Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, • Households sell Income
and profit • Firms buy
= Flow of inputs
and outputs
= Flow of dollars

Copyright © 2004 South-Western

Our First Model: The 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 production
Our First Model: The Circular-Flow
Diagram
Markets for Goods and Services
◦ Firms sell
◦ Households buy
Markets for Factors of Production
◦ Households sell
◦ Firms buy
Our First Model: The Circular-Flow
Diagram
Factors of Production
◦ Inputs used to produce goods and services
◦ Land, labor, and capital
economic market systems

66
What do we mean by the term
economic market systems?
1. Factors of production (term for resources)
Ownership is important - needed to produce the goods or
services
 Land and natural resources (natural resources)
 Labor (including all human resources)
 Capital (including all man-made resources)
 Entrepreneurship (this brings all the resources together for
production)
 Knowledge is often seen as a distinct from human resources

67
What do we mean by the term
economic market systems?
2. Goods and services
3. Exchange:
4. Capital and Labor
5. Price:
6. Gov’t role?

68
What types of economic market
systems exist?
 Market-based economy (capitalist system)
 Factors of production ownership: Private
 Goods and services: Freely produced and exchanged according to
demand and supply between consumers and producers
 Exchange: Medium of exchange
 Capital and labor: Moves freely across places, industries and firms in
search of higher profit.
 Price: Allocates resources among competing users.
 Gov’t role? defense & assist, laws , taxes, regulations, enforcing
contracts, correcting market failures, ensuring strong economy,
provision for poor, children, vulnerable & elderly, pursue national
goals established by society, & protection environment and natural
resources.

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Capitalism


70
What types of economic market
systems exist?
Command-based economy (Socialism)
 Factors of production? State owned, controlled & allocated
 Goods and services? Government central planning markets and
how/where exchange of goods and services - manufacturing,
production, trade and distribution
 Exchange: Allocated basic needs
 Capital and Labour Private ownership banned and only
consumption based goods are allowed to be privately owned..
food/clothing.
 Price of goods set by government not production cost
 Profits do not exist and labour compensation and benefits and
investment expenditures are defined by central planners.
 Capital, labor, and land are assigned by the state and free
movement of labor is severely restricted.
 Gov’t role?
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Centrally Planned Market


72
What types of economic market
systems exist?
 Mixed economy (combo of capitalism and socialism )
 Factors of production
 Goods and services?
 Exchange:
 Capital and Labour
 Price
 Gov’t role

73
How does a market work?

74
 How does a market work?
Market place is any structure that allows buyers and sellers to
exchange any type of goods, services and information.
 Market
Network of buyers and sellers that
come together to trade in a given
product or service.

Consists of amount of something

that is available – the supply – and
the amount of something that
people want – the demand

Economic activity between buyers

and sellers

Free exchange
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 How does a market work?
 Market
 Buyers (Consumers)
 Goal Max utility
 Demand for a particular product varies
with price

 Suppliers (Firms)
 Goal: Max Profit
 Supply of a particular product varies
with price.

 Both are self-interested.

 Exchange of goods or services is a
transaction

76
How does a market work?
 Interaction of buyers and sellers
in the market determines the
market price
 Role of Price creates signals
 Allocating scarce goods and
services efficiently.
 Think about this ..lots of
demand lots of supply
what happens?
 Determines how much of
something to consume, and
also how much to produce.

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How does a market work?
 Function of the market
 Facilitate exchange of goods between
buyers and sellers
 Define equilibrium price when supply
and demand are in balance.

 Goods supplied are equal to what is

being demanded – no excess or
shortage

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How does a market work?
 At equilibrium there is efficient allocation
of the goods
 good thing for a society because people
are encouraged to specialize and
exchange
 specialization and exchange achieves a
higher standard of living and better for
all society

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How does a market work?
 How does it all happen?
 Invisible Hand
 Metaphor for a marketplace
 Term used by Adam Smith to describe his
belief that individuals seeking their economic
self-interest actually benefit society more than
they would if they tried to benefit society
directly.
 Does this apply to both free market system
versus centrally planner market system?

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How does a market work?
 Invisible hand
 Consumers and Producers focusing on their own gain (self interest)
and led by these price signals get a result in the market that was no
part of their intention
 pursuing own interests, equilibrium P & Q occurs, efficient
allocation of the goods and promotes better overall for society

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 Absolute advantage

Absolute advantage is the ability of an individual, company, region, or country to produce a greater quantity of a
good or service with the same quantity of inputs per unit of time, or to produce the same quantity of a good or
service per unit of time using a lesser quantity of inputs, than another entity that produces the same good or
service.
· The first columns show that, working full time on his own, Peter can produce either 100 sweaters or 40 suits per
year, whereas Jane can produce 400 sweaters or 10 suits.
· Thus Jane has an absolute advantage in producing sweaters and Jacob has an absolute advantage in producing
suits.
· The second columns show the outputs if they both spend half their time producing each commodity.
· The third columns show the results when Peter specializes in suits, producing 40 of them, and Jane specializes in
sweaters, producing 400.
· Sweaters production rises from 250 to 400, while suits production goes from 25 to 40.
 Comparative Advantage

Time spent fully

producing one
or the other

Sweaters Suits

either or
Peter
100 40

either or

Jane

400 48

Total
 Comparative Advantage

Time spent fully Time divided equally

producing one between producing the
or the other two products

Sweaters Suits Sweaters Suits

either or
Peter
100 40 50 20

either or

Jane

400 48 200 24

Total 250 44
 Comparative Advantage

Time spent fully Time divided equally Full Specialization

producing one between producing the
or the other two products

Sweaters Suits Sweaters Suits Sweaters Suits

either or
Peter
100 40 50 20 - 40

either or

Jane

400 48 200 24 300 12

Total 250 44 300 52

 Comparative advantage

Comparative advantage is an economic term that refers to an economy's ability to produce goods and services at
a lower opportunity cost than that of trade partners
· The first columns in the table show that Jane is more productive than Peter in both suits and sweaters.
· Compared with Peter, Jane is 400 per cent more efficient at producing sweaters and 20 per cent more efficient
at producing suits.
· The second columns give the outputs when Peter and Jane each divide their time equally between the two
products.
· It is possible to increase the combined production of both commodities by having Jane increase her production
of sweaters and Peter increase his production of suits.
· The third column gives an example in which Peter specializes fully in suits production and Jane spends 25 per
cent of her time on suits and 75 per cent on sweaters.
· Total production of sweaters rises from 250 to 300, while total production of suits goes from 44 to 52.
Comparative advantage

Total production of sweaters rises from 250 to 300, while total

production of suits goes from 44 to 52.
This example is only an illustration. The principles can be
generalized in the following way.
· Absolute efficiencies are not necessary for there to be gains from specialization.
· Gains from specialization occur whenever there are differences in the margin of advantage one
producer enjoys over another in various lines of production.

Total production can always be increased when each producer

becomes more specialized in the production of the
commodity in which it has a comparative advantage.