Basic Principles of Economics

Economics A social science seeking to analyze and describe the production, distribution, and consumption of goods and services The study of the choices people make to cope with scarcity.

A social science seeking to analyze and describe the production, distribution, and consumption of goods and services

The study of the choices people make to cope with scarcity.

Micro vs. Macro Economics Microeconomics examines the economic behaviour of individual units such as businesses and households in the face of scarcity and government interactions, as well as the economic consequences of these decisions on other actors. Macroeconomics examines an economy as a whole with a view to understanding the interaction between economic aggregates such as national income, employment and inflation.

Microeconomics examines the economic behaviour of individual units such as businesses and households in the face of scarcity and government interactions, as well as the economic consequences of these decisions on other actors.

Macroeconomics examines an economy as a whole with a view to understanding the interaction between economic aggregates such as national income, employment and inflation.

Economic Principles Everything has a cost People choose for good reasons Incentives matter People create economic systems to influence choices and incentives People gain from voluntary trade Economic thinking is marginal thinking The value of a good or service is affected by people’s choices Economic actions create secondary effects

Everything has a cost

People choose for good reasons

Incentives matter

People create economic systems to influence choices and incentives

People gain from voluntary trade

Economic thinking is marginal thinking

The value of a good or service is affected by people’s choices

Economic actions create secondary effects

Positive vs. Normative Economics Positive (Analytical) Economics Concerned with descriptive and conditional statements Descriptive – portray things as they are or have been in the past Conditional – forecasts based on careful analysis of economic behaviour Normative (Policy) Economics Deals primarily with statements that contain value judgments Cannot be confirmed or refuted solely by reference to facts

Positive (Analytical) Economics

Concerned with descriptive and conditional statements

Descriptive – portray things as they are or have been in the past

Conditional – forecasts based on careful analysis of economic behaviour

Normative (Policy) Economics

Deals primarily with statements that contain value judgments

Cannot be confirmed or refuted solely by reference to facts

Economic Fallacies The Fallacy of Composition What is true for an individual in not necessarily true for the economy as a whole What is good/bad for an individual is not automatically good/bad for society as a whole. The Post Hoc Fallacy Derived from Latin phrase post hoc ergo propter hoc “after this there because of this” As known as the ‘Cause and Effect’ Fallacy Just because event A happened before event B, it doesn’t mean that event B caused event A The relationship between two things may be coincidence instead of cause and effect

The Fallacy of Composition

What is true for an individual in not necessarily true for the economy as a whole

What is good/bad for an individual is not automatically good/bad for society as a whole.

The Post Hoc Fallacy

Derived from Latin phrase post hoc ergo propter hoc “after this there because of this”

As known as the ‘Cause and Effect’ Fallacy

Just because event A happened before event B, it doesn’t mean that event B caused event A

The relationship between two things may be coincidence instead of cause and effect

Economic Fallacies Continued The Fallacy of Single Causation Cannot assume that a single factor caused something to happen

The Fallacy of Single Causation

Cannot assume that a single factor caused something to happen

Scarcity The study of the allocation of scarce goods among competing ends Human wants tend to be unlimited, but human, natural, and capital resources are limited.

The study of the allocation of scarce goods among competing ends

Human wants tend to be unlimited, but human, natural, and capital resources are limited.

Methods of Dealing With Scarcity People can do without some of the things they want. People can create more resources by new discoveries, more training, better tools People can produce more by better use of resources People can redistribute goods and services so that everyone has enough.

People can do without some of the things they want.

People can create more resources by new discoveries, more training, better tools

People can produce more by better use of resources

People can redistribute goods and services so that everyone has enough.

Opportunity Cost The most highly valued sacrificed alternative; the value of the "next-best" choice. Opportunity cost is the value of the benefits of the foregone alternative, of the next best alternative that could have been chosen, but was not. Another way to look at it is that "choosing is refusing;" one choice can only be accepted by refusing another.

The most highly valued sacrificed alternative; the value of the "next-best" choice.

Opportunity cost is the value of the benefits of the foregone alternative, of the next best alternative that could have been chosen, but was not.

Another way to look at it is that "choosing is refusing;" one choice can only be accepted by refusing another.

Incentives Economics is the study of incentives: how people get what they want or need, especially when other people want or need the same thing An incentive is a means of urging people to do more of a good thing and less of a bad thing Three basic kinds of incentives: Economic (What’s it worth to me?) Social (Will society act in a bad way if I do this thing?) Moral (Is it the right thing to do?) Often all three are combined

Economics is the study of incentives: how people get what they want or need, especially when other people want or need the same thing

An incentive is a means of urging people to do more of a good thing and less of a bad thing

Three basic kinds of incentives:

Economic (What’s it worth to me?)

Social (Will society act in a bad way if I do this thing?)

Moral (Is it the right thing to do?)

Often all three are combined

The Production Possibilities Curve The Production Possibilities Curve is a graphical representation showing various maximum combinations of output a nation can produce with limited economic resources in a fixed time period. Illustrates the problem of scarcity – wants will always exceed resources

The Production Possibilities Curve is a graphical representation showing various maximum combinations of output a nation can produce with limited economic resources in a fixed time period.

Illustrates the problem of scarcity – wants will always exceed resources

Assumptions of the Production Possibilities Curve Two goods are produced depicting choices and trade-offs for a nation. Full employment and full production are achieved allowing for maximum utilization of resources. Short-term time frame over which resources cannot be improved or increased. The output represented by the curve is limited

Two goods are produced depicting choices and trade-offs for a nation.

Full employment and full production are achieved allowing for maximum utilization of resources.

Short-term time frame over which resources cannot be improved or increased. The output represented by the curve is limited

Production Possibilities Curve

Production Possibilities Curve The bow-shaped curve is a number of maximum combinations of product X and product Y that this hypothetical economy can produce in the short run. More X can be produced only with the sacrifice of good Y. As a nation attempts to produce more of any good, it must accept giving up more and more and more of other goods. The opportunity costs increase at an increasing rate . In the conversion of production from X to Y, the most convertible resources were shifted first. Once transferred they are consumed. The resources remaining may not be as convertible, and are therefore less productive in producing Y. The yield of good Y will be less. Less output per unit of input, increases the cost of producing good Y. Hence, “increasing opportunity costs.”

The bow-shaped curve is a number of maximum combinations of product X and product Y that this hypothetical economy can produce in the short run.

More X can be produced only with the sacrifice of good Y.

As a nation attempts to produce more of any good, it must accept giving up more and more and more of other goods.

The opportunity costs increase at an increasing rate .

In the conversion of production from X to Y, the most convertible resources were shifted first. Once transferred they are consumed. The resources remaining may not be as convertible, and are therefore less productive in producing Y. The yield of good Y will be less. Less output per unit of input, increases the cost of producing good Y. Hence, “increasing opportunity costs.”

The Law of Increasing Relative Cost As the output of good increases, the opportunity cost of producing additional units of this good increase Reasons: The Law of Diminishing Returns – After some point, successive, equal-sized increases of a resource (factor), added to the fixed factors of other resources (factors), will result in smaller increases in output Diseconomies of Scale – Declining efficiencies of production; as output increases, average total cost/unit of production increases Factor Suitability – As economy increases production of a specific good, the available resources utilized become less suited for the production of that good

As the output of good increases, the opportunity cost of producing additional units of this good increase

Reasons:

The Law of Diminishing Returns – After some point, successive, equal-sized increases of a resource (factor), added to the fixed factors of other resources (factors), will result in smaller increases in output

Diseconomies of Scale – Declining efficiencies of production; as output increases, average total cost/unit of production increases

Factor Suitability – As economy increases production of a specific good, the available resources utilized become less suited for the production of that good

Example

The Law of Increasing Returns to Scale Also called economies of scale The increase in the rate of extra outputs produced when all inputs are used in production are increased and no inputs are held constant Allows for specialization and division of labour

Also called economies of scale

The increase in the rate of extra outputs produced when all inputs are used in production are increased and no inputs are held constant

Allows for specialization and division of labour

Productive Efficiency and Full Employment Full Employment does not mean 100% utilization of a factor Factors will not normally be 100% utilized Full Employment of Labor – 95% employment rate or 5% unemployment is equivalent of full employment People voluntarily changing jobs Certain amount of reentry to the labor force Certain amount of job obsolescence; geographical dislocations, etc. Full Employment of Capital – 85-90% capacity utilization considered full employment – scheduled and unscheduled maintenance

Full Employment does not mean 100% utilization of a factor

Factors will not normally be 100% utilized

Full Employment of Labor – 95% employment rate or 5% unemployment is equivalent of full employment

People voluntarily changing jobs

Certain amount of reentry to the labor force

Certain amount of job obsolescence; geographical dislocations, etc.

Full Employment of Capital – 85-90% capacity utilization considered full employment – scheduled and unscheduled maintenance

Full Employment Verses Full Production Efficiency Full Employment – A Utilization Concept; All factors of production are employed Productive Efficiency – Not only are all factors employed, but they are employed most efficiently as well Every point on the PPC (F) represents a point of Productive Efficiency

Full Employment – A Utilization Concept; All factors of production are employed

Productive Efficiency – Not only are all factors employed, but they are employed most efficiently as well

Every point on the PPC (F) represents a point of Productive Efficiency

Productive Efficiency means that a nation has utilized the right combination of capital and labor, etc., for the least cost of production. The nation seeks to minimize waste. To this end a nation is at a point closer and close to its production Possibilities curve.

Productive Efficiency means that a nation has utilized the right combination of capital and labor, etc., for the least cost of production. The nation seeks to minimize waste. To this end a nation is at a point closer and close to its production Possibilities curve.

Production Outside the PPC For a very limited time, a country can produce at a level outside of the PPC. Results in overuse of resources and a potential future reduction in output as factories are closed for repairs, natural resources are exhausted and people recover from overwork A country can trade with another country to reach a point outside the PPC

For a very limited time, a country can produce at a level outside of the PPC.

Results in overuse of resources and a potential future reduction in output as factories are closed for repairs, natural resources are exhausted and people recover from overwork

A country can trade with another country to reach a point outside the PPC

Absolute and Comparative Advantage Absolute Advantage: A person has an absolute advantage in the production of two goods if by using the same quantities of inputs, that person can produce more of both goods than another person. A country has an absolute advantage if its output per unit of inputs of all goods is larger than that of another country. Comparative Advantage: A person or country has a comparative advantage in an activity if that person or country can perform the activity at a lower opportunity cost than anyone else or any other country.

Absolute Advantage: A person has an absolute advantage in the production of two goods if by using the same quantities of inputs, that person can produce more of both goods than another person. A country has an absolute advantage if its output per unit of inputs of all goods is larger than that of another country.

Comparative Advantage: A person or country has a comparative advantage in an activity if that person or country can perform the activity at a lower opportunity cost than anyone else or any other country.

Example of Absolute Advantage Canada has an absolute advantage in producing Product B and the US has an absolute advantage in producing Product A Both countries will gain through trading. Canada will produce all B and the US will produce all A

Canada has an absolute advantage in producing Product B and the US has an absolute advantage in producing Product A

Both countries will gain through trading. Canada will produce all B and the US will produce all A

Trading with Absolute Advantage If Canada wants to produce one unit of Product A, it will cost 4 units of Product B. Therefore, Canada is willing to trade for less than 5 units of Product B for one unit of A. The cost to the US of producing one A is ¾ of a B. Therefore, the US wants to receive more than ¾ of B for each unit of A. 4/3 A 3/4 B USA 1/5 A 5 B Canada Product B Product A

If Canada wants to produce one unit of Product A, it will cost 4 units of Product B. Therefore, Canada is willing to trade for less than 5 units of Product B for one unit of A.

The cost to the US of producing one A is ¾ of a B. Therefore, the US wants to receive more than ¾ of B for each unit of A.

Trading Assume a ratio of 2Bs for 1A. Both countries are now at points outside their PPC. Both countries have gained from trade.

Assume a ratio of 2Bs for 1A.

Both countries are now at points outside their PPC. Both countries have gained from trade.

Comparative Advantage Jane has an absolute advantage in producing both A and B. Jack will have a comparative advantage in producing either A or B. To find the advantage you must compare opportunity costs. Both parties can still gain from trade.

Jane has an absolute advantage in producing both A and B.

Jack will have a comparative advantage in producing either A or B. To find the advantage you must compare opportunity costs.

Both parties can still gain from trade.

Comparative Advantage and Opportunity Costs Jack has a comparative advantage in producing B as his opportunity cost is lower. Jack should produce all Bs, Jane should produce all As and they will trade. 1 A 1 B Jane ½ A 2 B Jack Product B Product A

Jack has a comparative advantage in producing B as his opportunity cost is lower.

Jack should produce all Bs, Jane should produce all As and they will trade.

Comparative Advantage and Trading The trading ratio for 1B should be between ½ A and 1 A. As if it is over 1A, Jane would be better off making the B herself and if it is less than ½ there is no benefit to trading for Jack. Say ¾ A for 1 B, in whole numbers 3 A for 4 B.

The trading ratio for 1B should be between ½ A and 1 A. As if it is over 1A, Jane would be better off making the B herself and if it is less than ½ there is no benefit to trading for Jack.

Say ¾ A for 1 B, in whole numbers 3 A for 4 B.