Principles of Economics

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World ViewSample of 20th –century futurology that flopped1.Airplanes are interesting toys but no military use

= Marshall Ferdinand Foch French military strategist

Word War I commander 19812.The Horse is here to stay but the automobile is only a novelty – a fad

= president of Michigan Bank that advice Horace Racham not to invest in Ford

Motors

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3. There is no reason for individual to have a computer in their home= Kenneth Olsen, president of Digital Equipment 1977

Analysis: no one predicts the future well, but the economic choices we make today about the use of scarce resources will determine the kind of future we have

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Chapter 1: PreliminariesSlide 4

The Themes of Microeconomics

According to Mick Jagger* & the Rolling Stones“You can’t always get what

you want”

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Chapter 1: PreliminariesSlide 5

The Themes of Microeconomics

Why Not?Limited Resources

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Chapter 1: PreliminariesSlide 6

Preliminaries

Microeconomics deals with:Behavior of individual units

• When Consuming– How we choose what to buy

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Chapter 1: PreliminariesSlide 7

Preliminaries

Microeconomics deals with:Behavior of individual units

• When Producing– How we choose what to produce

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Chapter 1: PreliminariesSlide 8

Preliminaries

Microeconomics deals with:Markets: The interaction of

consumers and producers

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Chapter 1: PreliminariesSlide 9

Preliminaries Macroeconomics deals with:

Analysis of aggregate issues:• Economic growth

• Inflation

• Unemployment

The Linkage Between Micro and Macro-economicsMicroeconomics is the foundation of

macroeconomic analysis

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Chapter 1: PreliminariesSlide 10

The Themes of Microeconomics MicroeconomicsAllocation of Scarce Resources and Trade-offs

• In a planned economy• In a market economy

Microeconomics and Optimal Trade-offs1. Consumer Theory

2. Workers

3. Theory of the Firm

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Chapter 1: PreliminariesSlide 11

The Themes of Microeconomics

Microeconomics and PricesThe role of prices in a market

economyHow prices are determined

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Economy. . .

. . . The word economy comes from a Greek word Oikonomia for “one who manages a household.”

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Society and Scarce Resources:

The management of society’s resources is important because resources are scarce.Scarcity implies choice and choice implies cost.

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Scarcity . . .

. . . means that society has limited resources and therefore cannot produce all the goods and services people wish to have.

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Scarce Resources and ProductionFour types of resources

1.Land – a shorthand expression for any natural resource provided by nature2.Labor – the mental and physical capacity of workers to produce goods/services

2.1 skilled2.2 unskilled2.3 Professional

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3. Capital – the physical plants machinery, and equipment used to produced other goods.3.1 Capital goods – are human-made goods that do not directly satisfy human wants and needs3.2 Financial Capital

4. Entrepreneurship/entrepreneur – the creative ability of individual to seek profits by taking risk and combining resources to produces innovative product

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Economics

Economics is the study of how society manages its scarce resources.

- science which studies human behavior as

relationship between end and scarce means

which have alternative uses

-- study of how societies use scarce

resources to produce valuable commodities

and distribute them among people

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Branches of Economics

1. Microeconomics

- study the small unit of economy like individual as an economic agent

2. Macroeconomics- study the economy as a whole like

behavior of the aggregate of economic activity.

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Economists study. . .

How people make decisions.

How people interact with each other.

The forces and trends that affect the economy as a whole.

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Ten Principles of Economics

1. People face tradeoffs.

2. The cost of something is what you give up to get it.

3. Rational people think at the margin.

4. People respond to incentives.

How People Make Decisions

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Ten Principles of Economics

5. Trade can make everyone better off.

6. Markets are usually a good way to organize economic activity.

7. Governments can sometimes improve economic outcomes.

How People Interact

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Ten Principles of Economics

8. The standard of living depends on a country’s production.

9. Prices rise when the government prints too much money.

10. Society faces a short-run tradeoff between inflation and unemployment.

How the Economy as a Whole Works

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Chapter 1: PreliminariesSlide 23

Theories and Models Microeconomic Analysis

Theories are used to explain observed phenomena in terms of a set of basic rules and assumptions.

For example• The Theory of the Firm

• The Theory of Consumer Behavior

Microeconomic Analysis Models:

• a mathematical representation of a theory used to make a prediction.

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Pitfalls in Economics1.Cetiris Paribus – a latin phrase means while certain variable changes, “all other things remain unchanged”

Note: a theory cannot be tested legitimately unless its cetiris paribus assumption satisfied.1.Association versus Causation

Note:The fact that one event follows another does not necessarily means that the first event caused the second event

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Chapter 1: PreliminariesSlide 25

Why Do Economist Diasagree Positive Analysis

Positive analysis is the use of theories and models to predict the impact of a choice.

For example:• What will be the impact of an import quota on foreign

cars?

• What will be the impact of an increase in the gasoline excise tax?

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Chapter 1: PreliminariesSlide 26

Positive versus Normative Analysis Normative Analysis

Normative analysis addresses issues from the perspective of “What ought to be?”

For example:• Maintaining the purchasing power of the peso is more important than teenage unemployment.

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Why study Economics?1.Economics for citizenship2.Professional and personal application

Foundation of Economics1.Society’s material wants, that is material wants of its citizen is virtually unlimited2.Economic resources – means of producing goods and services are limited or scarce

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The Circular-Flow Diagram

Firms Households

Market for Factors

of Production

Market for Goods

and Services

SpendingRevenue

Wages, rent, and interest

Income

Goods & Services

sold

Goods & Services bought

Labor, land, and capital

Inputs for production

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Economic AnalysisGood - is anything which yields satisfaction to someone. It may be tangible or intangible

Types of goodsConsumer GoodsCapital GoodsEssential GoodsLuxury goodsEconomic Goods

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3. How much to produce?- the quantity that will be produced determining the demand of people.- the goal is efficiency in production or technical efficiency

4. For whom to produce?- who will be given priority in the consumption of such products.- the goal is to reach the efficiency in distribution or efficiency in exchange.

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The mechanism of choice1. Market mechanism (the invisible hand)

– the use of market prices and sales to signal desired output (or resource allocation)2.Laissez faire – the doctrine of “leave it alone” of nonintervention by government in the market mechanism3.Government Intervention and the Command Economies

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4. Mixed Economy – an economy that use both market signals and government directives to allocate goods and resources

5. Market failure – an imperfection in the market mechanism that prevents optimal outcomes

6. Government failure – government intervention that fails to improve economic outcomes

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Basic Economic Activities

Resource Maintenance

-means tending to, preserving, or improving the stocks of resources that form the basis for the preservation and quality of life.

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Basic Economic Activities Production - is the conversion of resources

into usable products, which may be either goods or services.

Distribution - is the sharing of products and resources among people. In contemporary economies, distribution activities take two main forms: exchange and transfer.

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Basic Economic Activities Consumption - refers to the process by which goods

and services are, at last, put to final use by people. There are four types of resources, also known as

factors of production, or inputs into production: Land LaborCapitalEntrepreneurial Activity

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Economics System

Story of cow and the farmer

In a capitalist system, the farmers buys the

cow ,milks it, and sells the milk. With the

profit he will buy another cow.

In a mixed system, the government interferes

in the life of the farmer and the cow via taxes

health regulation. So the farmer buy the cow

Milk it, sells it with profit and pays taxes.

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In the command system, there is no private

Property and no freedom. The government

owns everything. So the farmer milks the

cow, sells the milk, and the government takes

The cow and puts the farmer in jail.

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Economic SystemTraditional EconomyAn economic system in which production and distribution questions are answered by looking to the pastPeople will make what they always made; will do the same work their parents didEconomic decisions are made by customs and beliefs

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Command System An economic system in which production

and distribution questions are answered by central planners (government)

Economic decisions are made by the government

Planners estimate what goods will be needed in the future and work backward to decide what materials and workers are needed now

Planners can be wrong about future needs, and they do not provide people with many choices

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Market EconomyAn economic system in which production and distribution questions are answered by prices and profitsEconomic decisions are based on Free EnterpriseMost Democratic countries have a variation of a Market economy & a Command economy (Mixed economy)Businesses will make things using whatever materials, labor, and technology earn the highest profit

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Market Economy Standard of living is higher under a market

system than the others The price of a good depends on how much

of the good is available and how many people want

Producers turn resources into goods and services

Governments can also be producers when they provide goods such as roads and schools, or when they provide services such as military production or health care

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Mixed EconomyIndividuals own most resources and determine what and how to produceGovernment regulates certain industriesExample: China; most nationsMarket + Command = Mixed

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Economic SystemPure CapitalismCapitalism1.Private property – private individual and organization own control their property resources by means of the institution of private property2.Freedom of Enterprise and choice – individual/organization posses both freedom of enterprise and choice

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3. Competition – competition prevents the buyer and seller to exploit each others

4. Market and Prices (market system) - used to communicate and coordinate the decisions of buyers and sellers

5. Limited government – the role of government is limited in a competitive and capitalist economy

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Types of Market Structure

Monopolistic Competition-also called competitive market, where there are a large number of firms, each having a small proportion of the market share and slightly differentiated products(that is, the products are substitutes, but, with differences such as branding, are not exactly alike).

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-In monopolistic competition firms can behave like monopolies in the short run - including using market power to generate profit

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Monopolistically competitive markets have the following characteristics:There are many producers and many consumers in a given market, and no business has total control over the market price.Consumers perceive that there are non-price differences among the competitors' products.There are few barriers to entry and exitProducers have a degree of control over price.

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Perfect Competition-is characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes.Characteristicthere are few, if any, barriers to entry for new companiesprices are determined by supply and demand

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Oligopoly-Market form in which market or industry is dominated by a small number of sellers (oligopolists) -The products that the oligopolistic firms produce are often nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of market forces.

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CharacteristicsProfit maximization conditions: An oligopoly maximizes profits by producing where marginal revenue equals marginal costsAbility to set price: Oligopolies are price setters rather than price takers.Entry and exit: Barriers to entry are high. The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy nascent firms

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Number of firms: "Few" – a "handful" of sellers.

There are so few firms that the actions of one firm can influence the actions of the other firms.Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering market to capture excess profits.Product differentiation: Product may be homogeneous (steel) or differentiated (automobiles)

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Duopoly-Is a specific type of oligopoly where only two producers exist in one market.Example;Boeing and Airbus

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Oligopsony-A market form in which the number of buyers is small while the number of sellers in theory could be large.-This typically happens in a market for inputs where numerous suppliers are competing to sell their product to a small number of (often large and powerful) buyers

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ExampleCocoa - Cargill, Archer Daniels Midland, Callebaut

American Tobacco Growers- Altria, Brown and Williamson, Lorillard Tobacco Company buy almost 90% of all tobacco grown in the US

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Monopoly-exists when a specific individual or an enterprise has sufficient control over a particular product or service to determine significantly the terms on which other individuals shall have access to it.- Monopoly characterized by a lack of economic competition, and lack of viable substitute goods

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Types of Monopoly1. Natural monopoly or through merger2. Government Granted 2.1 Single seller 2.2 Market powerFirm and industryPrice Discrimination - sells more quantities charging less price against the product in a highly elastic market and sells less quantities charging high price in a less elastic market.

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Example-Coercive monopoly - government grants exclusive privilege to a private individual or firm to be the sole provider of a good or service-law, regulation, copyright , patent, trademark

Sources of Monopoly powers-Monopolies derive their market power from barriers to entry - circumstances that prevent or greatly impede a potential competitor's entry into the market or ability to compete in the market.

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Three types of barrier to entry1. Economic barriers: Economic barriers include economies of scale, capital requirements, cost advantages and technological superiorityEconomy of scale - large start up costs give monopolies an advantage over would be competitors.Capital requirements – large investment capital and Large fixed costs also make it difficult for a small firm to enter an industry and expand

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Technological superiority - A monopoly may be better able to acquire, integrate and use the best possible technology in producing its goods while entrants do not have the size or fiscal muscle to use the best available technologyNo substitute goods - A monopoly sells a good for which there is no close substitutes.Control of Natural Resources - A prime source of monopoly power is the control of resources that are critical to the production of a final good.

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2.Legal Barriers Legal rights can provide opportunity to monopolize the market in a goodExample:Intellectual property rights, including patents and copyrights3. Deliberate Actions: A firm engage in various types of deliberate action to exclude competitors or eliminate competition. Example; collusion, lobbying governmental authorities, and force.

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Monopoly versus competitive markets1. Market power - ability to raise prices without losing all one's customers to competitors.Perfectly competitive market - zero market power when it comes in setting prices. Monopoly – has the power to set prices or quantities2. Price - In a perfectly competitive market price equals marginal cost. In a monopolistic market price is greater than marginal cost.

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3. Product differentiation -There is zero product differentiation in a perfectly competitive market-In monopoly, there is high to absolute product differentiation in the sense that there is no available substitute for a monopolized good4. Number of competitors5. Barriers to Entry

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Monopsony-Market structure in which only one buyer faces many sellersExample:Government

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Scarcity and the World of Trade – Offs and Unlimited Human Wantsa.If society can get all it wants of good A when the price of good A is zero good A is _____b.If the price of good B is zero and the society cannot get all it wants of good B then good B is ____

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Scarcity and the World of Trade – Offs and Unlimited Human Wants

Scarcity – is a natural phenomenon which sets a limit in the production of goods and services needed by man.

Free Goods – are those goods we consume freely and for which no amount is paid

Economic goods are scarce

Noneconomic goods are not scarce

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Scarcity and the World of Trade – Offs and Unlimited Human Wants

Because of Scarcity, choice and opportunity costs arise

a. Due to scarcity, people trade off options

b. Law of Diminishing Marginal Returns- Principles occurs in a short- run production

period where one particular factors of production is a fixed input.

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Scarcity and the World of Trade – Offs and Unlimited Human Wants

The (PPC) the production possibilities curve is a graph of the inherent in a decisions.

a. When the amount of one resources or good that must be given up to produce an additional units of another units of another goods remain constant the PPC is straight line

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Scarcity and the World of Trade – Offs and Unlimited Human Wants

b. When the amount of one resource or good that must be given up to produce an additional units of an additional unit of another good or resources rises PPC bowed outward

c. A point on a PPC is an efficient point; points inside a PPC are inefficient; points outside the PPC are unattainable (possible)

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Scarcity and the World of Trade – Offs and Unlimited Human Wants

How do we get to point outside the PPC? 1. Technological advancement which

increases Productivity 2. Discover new resources 3. Take resources (War) 4. Trade for Resources

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Production Possibilities Curve (Frontier)

The WHOLE PPC represents

“FULL PRODUCTION”Productive EfficiencyFull-Employment of

Resources

Consumer Goods

0

100

1000100 200 300 400 500 600 700 800 900

.A

.B

.C

.D

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Production Possibilities Curve (Frontier)

Do economy’s always produce on the PPC?

Point “E” represents a point inside the PPC.

This economy could be doing better…

Consumer Goods

0

100

1000100 200 300 400 500 600 700 800 900

.A

.B

.C

.D

.E

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Production Possibilities Curve (Frontier)

Do economy’s always produce on the PPC?

How about point “F”?

Point F is outside our PPC

It represents a combination of Capital and Consumer Goods that is currently not possible with this economies resources

Consumer Goods

0

100

1000100 200 300 400 500 600 700 800 900

.A

.B

.C

.DE

.F

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Production Possibilities CurveThe PPC shows ALL possible combinations of two goods that can be produced if ALL available resources are fully employed (used) with the best technology currently available

Robotics(Capital Good)

Compact Discs

B

C

EF

A

G

How do we get to point G??1. Technological advancement which

increases Productivity2. Discover new resources3. Take resources (War)4. Trade for Resources

D

“OUR ECONOMY IS DRIVEN BY TECHNOLOGICAL ADVANCEMENT”

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Human wants- wants are hierarchical in nature-starting from basic biological

demands progress up to upward and culminate in self actualization Hierarchy of Needs1.Physiological needs2.Safety needs3.Need for feeling of love belongings

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4. Need for self esteem, knowledge and aesthetic expression5.Need for self actualization

Factors Affecting WantsWants – can be described as the desire for goods and services.

-attempts to satisfy wants given limited resources forms the basis of all economic activity.

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Factors Affecting WantsPersonal – include sex, race, age and other demographic factorsPsychological - involve a person’s motivation, perception, ability and knowledge, attitude, personality and lifestyle.Social – roles and family influences social class, as well as culture and sub-culture

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Consumption – deals with buying and using goods and services to satisfy our human needs

- Is a major concern of economics in which different activities of man depend

Types of Consumption

Direct – happens when individual satisfies himself upon buying and using a certain product

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Productive – buying goods to be used in producing other goods describe this type of consumption

Wasteful – buying things that do not give satisfaction to a person

Harmful – goods that can endanger their health even though it gives satisfaction

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Factors that Affect ConsumptionIncome – consumption depend on how

much income we haveOccasions – celebrations of any

occasions makes people buyAdvertisement – a way of motivating and

convincing consumers to patronize a certain products

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Price – factor that limits consumption

Seasons – some things are bought depending on the weather

Imitation – as we imitate what other people buy, we consume more for the same products.

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Law of Consumption

Law of Variety Law of HarmonyLaw of ImitationLaw of Economic OrderLaw of Diminishing Marginal Utility

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Utility- Refers to the satisfaction achieved in

consuming goods and services.

Two Classification of Utility

Marginal Utility – added satisfaction you get

Total Utility – satisfaction you get in buying and using the products

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Everything you do in life involves choicesYour choices involves in many things including incentives MB=MC, and utility maximizationExample:With money in your pocket, you make choices by Maximizing your satisfaction with each pesos you spend.Utility?

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Marginal UtilityExample:Let’s say you have a choice between either renting a DVD or going to the moviesWhich would you choose?It depends on two things – budget constraint and what is marginal utility per peso spent for eachBudget Constraint – how much money allotted for renting a DVD or watching a movieMarginal Utility per peso spent is additional satisfaction per peso “you receive from each item you purchase.

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