40424 Principles of Economics Week 1: Introduction of Economics Dr. Lai, Po-Lin

About me

•! Dr. PO-LIN LAI •! PhD. of Cardiff University •! Research interests: •! Transportation Economics •! Air transportation •! Air cargo supply chain •! Airport management and operations. •! Airline finance

•! Email: polin@cau.ac.kr

Textbook

N. Gregory Mankiw, Principles of Economics, 6th edition, South-Western.

1 Ten Principles of Economics

Learning Goal

Define economics and distinguish between microeconomics and macroeconomics Explain the principles of economics Explain the key ideas that define the economic way of thinking Explain how economists go about their work as social scientists

Understanding Our Changing World

•! You are studying economics at a time of enormous change.

•! Much of the change is for the better—the information age and all the benefits that it brings.

•! But some of the change is for the worse—terrorism, natural disasters, and recession that have devastated many of our lives.

•! Your economics course will help you to understand the powerful forces that are shaping and changing our world.

Economy. . .

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

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

Society and Scarce Resources: •! Scarcity. . . means that society has limited resources

and therefore cannot produce all the goods and services people wish to have.

•! The management of society’s resources is important because resources are scarce.

TEN PRINCIPLES OF ECONOMICS

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

•! Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices.

Microeconomics and Macroeconomics

•! Microeconomics is the study of how households and firms make decisions and how they interact in markets.

•! Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment, and economic growth.

•! These two branches of economics are closely intertwined, yet distinct—they address different questions.

TEN PRINCIPLES OF ECONOMICS

•! How people make decisions? •! How people interact with each other? •! The forces and trends that affect how the

economy as a whole works?

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.

TEN PRINCIPLES OF ECONOMICS

•! 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.

TEN PRINCIPLES OF ECONOMICS

•! 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.

There is no such thing as a free lunch!

Making decisions requires trading off one goal against another.

Principle #1: People Face Tradeoffs.

To get one thing, we usually have to give up another thing. •! Going to a party the night before your midterm leaves

less time for studying. •! Having more money to buy stuff requires working

longer hours, which leaves less time for leisure. •! Protecting the environment requires resources that

could otherwise be used to produce consumer goods.

PRINCIPLE #1: People Face Tradeoffs

•! Society faces an important tradeoff: efficiency vs. equality

•! Efficiency: when society gets the most from its scarce resources

•! Equality: when the property is distributed uniformly among society’s members

•! Tradeoff: To achieve greater equality, could redistribute income from wealthy to poor. But this reduces incentive to work and produce, shrinks the size of the economic “pie.”

communism

Principle #2: The Cost of Something Is What You Give Up to Get It.

•! Making decisions requires comparing the costs and benefits of alternative choices.

•! The opportunity cost of any item is whatever must be given up to obtain it.

•! The opportunity cost of… …going to college for a year is not just the tuition,

books, and fees, but also the foregone wages.

…seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater.

Principle #2: The Cost of Something Is What You Give Up to Get It.

Lakers basketball star Kobe Bryant chose to skip college and go straight from high school to the pros where he has earned millions of dollars.

Principle #3: Rational People Think at the Margin.

Rational people •! systematically and purposefully do the best they can

to achieve their objectives. •! make decisions by evaluating costs and benefits of

marginal changes, incremental adjustments to an existing plan.

Principle #3: Rational People Think at the Margin.

Examples:

•! When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education.

•! When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue.

Principle #4: People Respond to Incentives.

•! Incentive: something that induces a person to act, i.e. the prospect of a reward or punishment.

•! Rational people respond to incentives. Examples: •! When gas prices rise, consumers buy more hybrid

cars and fewer gas guzzling SUVs. •! When cigarette taxes increase, teen smoking falls.

The principles of HOW PEOPLE INTERACT

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.

•! Market: a group of buyers and sellers (need not be in a single location)

•! “Organize economic activity” means determining •! what goods to produce •! how to produce them •! how much of each to produce •! who gets them

Principle #6: Markets Are Usually a Good Way to Organize Economic Activity.

•! A market economy allocates resources through the decentralized decisions of many households and firms as they interact in markets.

•! Famous insight by Adam Smith in The Wealth of Nations (1776):

Each of these households and firms acts as if “led by an invisible hand” to promote general economic well-being.

Principle #7: Governments Can Sometimes Improve Market Outcomes. •! Important role for government: enforce property

rights (with police, courts) •! People are less inclined to work, produce, invest, or

purchase if large risk of their property being stolen. •! 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: Governments Can Sometimes Improve Market Outcomes.

•! 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. •! market power, which is the ability of a single

person or firm to unduly influence market prices.

The principles of HOW THE ECONOMY AS A WHOLE WORKS

PRINCIPLE #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods & Services •! Huge variation in living standards across

countries and over time: •! Average income in rich countries is more than ten

times average income in poor countries. •! The U.S. standard of living today is about

eight times larger than 100 years ago.

PRINCIPLE #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods & Services

•! The most important determinant of living standards: productivity, the amount of goods and services produced per unit of labor.

•! Productivity depends on the equipment, skills, and technology available to workers.

•! Other factors (e.g., labor unions, competition from abroad) have far less impact on living standards.

PRINCIPLE #9: Prices Rise When the Government Prints Too Much Money

•! Inflation: increases in the general level of prices. •! In the long run, inflation is almost always caused by

excessive growth in the quantity of money, which causes the value of money to fall.

•! The faster the govt creates money, the greater the inflation rate.

PRINCIPLE #10: Society Faces a Short-run Tradeoff Between Inflation and Unemployment

•! In the short-run (1–2 years), many economic policies push inflation and unemployment in opposite directions.

•! Other factors can make this tradeoff more or less favorable, but the tradeoff is always present.

In the section, look for the answers to these questions:

•!What are economists’ two roles? How do they differ?

•!What are models? How do economists use them?

•!What are the elements of the Circular-Flow Diagram? What concepts does the diagram illustrate?

•! How is the Production Possibilities Frontier related to opportunity cost? What other concepts does it illustrate?

The Economist as Scientist

•! Economists play two roles: 1. Scientists: try to explain the world 2. Policy advisors: try to improve it

•! In the first, economists employ the scientific method, the dispassionate development and testing of theories about how the world works.

Assumptions & Models

•! Assumptions simplify the complex world, make it easier to understand.

•! Example: To study international trade, assume two countries and two goods. Unrealistic, but simple to learn and gives useful insights about the real world.

•! Model: a highly simplified representation of a more complicated reality.

•! Economists use models to study economic issues.

Some Familiar Models

A road map

Some Familiar Models

A model of human anatomy from high school biology class

Our First Model: The Circular-Flow Diagram •! The Circular-Flow Diagram: a visual model of the

economy, shows how dollars flow through markets among households and firms

•! Two types of “actors”: •! households •! firms

•! Two markets: •! the market for goods and services •! the market for “factors of production”

Factors of Production

•! Factors of production: the resources the economy uses to produce goods & services, including •! labor •! land •! capital (buildings & machines used in production)

FIGURE 1: The Circular-Flow Diagram

Households: !!Own the factors of production,

sell/rent them to firms for income !!Buy and consume goods & services

Households

Firms

Firms: !!Buy/hire factors of production,

use them to produce goods and services

!!Sell goods & services

FIGURE 1: The Circular-Flow Diagram

Markets for Factors of Production

Households Firms

Income Wages, rent, profit

Factors of production

Labor, land, capital

Spending

G & S bought

G & S sold

Revenue Markets for Goods & Services

Our Second Model: The Production Possibilities Frontier •! The Production Possibilities Frontier (PPF):

a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology

•! Example: •! Two goods: computers and wheat •! One resource: labor (measured in hours) •! Economy has 50,000 labor hours per month available for

production.

PPF Example

•! Producing one computer requires 100 hours labor. •! Producing one ton of wheat requires 10 hours labor.

5,000 0

4,000 100

2,500 250

1,000 400

50,000 0

40,000 10,000

25,000 25,000

10,000 40,000

0 500 0 50,000

E

D

C

B

A

Wheat Computers Wheat Computers

Production Employment of labor hours

Point on

graph

Production

Com-puters Wheat

A 500 0

B 400 1,000

C 250 2,500

D 100 4,000

E 0 5,000 0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600Computers

Wheat (tons)

PPF Example

AB

C

DE

A C T I V E L E A R N I N G 1

Points off t PPF

A. On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods? Why or why not?

B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods?

A C T I V E L E A R N I N G 1

Answers

!!Point F: 100 computers, 3000 tons wheat

!!Point F requires 40,000 hours of labor. Possible but not efficient: could get more of either good w/o sacrificing any of the other.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600Computers

Wheat (tons)

F

A C T I V E L E A R N I N G 1

Answers

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600Computers

Wheat (tons)!!Point G:

300 computers, 3500 tons wheat

!!Point G requires 65,000 hours of labor. Not possible because economy only has 50,000 hours.

G

The PPF: What We Know So Far

Points on the PPF (like A – E) •! possible •! efficient: all resources are fully

utilized

Points under the PPF (like F) •! possible •! not efficient: some resources

underutilized (e.g., workers unemployed, factories idle)

Points above the PPF (like G) •! not possible 0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600Computers

Wheat (tons)

AB

C

DE

F

G

The PPF and Opportunity Cost

•! Recall: The opportunity cost of an item is what must be given up to obtain that item.

•! Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other.

•! Society faces a tradeoff: Getting more of one good requires sacrificing some of the other.

•! The slope of the PPF tells you the opportunity cost of one good in terms of the other.

The PPF and Opportunity Cost

The slope of a line equals the “rise over the run,” the amount the line rises when you move to the right by one unit.

Here, the opportunity cost of a computer is 10 tons of wheat.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600Computers

Wheat (tons)

–1000 100 slope = = –10

A C T I V E L E A R N I N G 2

PPF and Opportunity Cost In which country is the opportunity cost of cloth lower?

0

100

200

300

400

500

600

0 100 200 300 400Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400Cloth

WineFRANCE ENGLAND

A C T I V E L E A R N I N G 2

Answers England, because its PPF is not as steep as France’s.

0

100

200

300

400

500

600

0 100 200 300 400Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400Cloth

WineFRANCE ENGLAND

Economic Growth and the PPF

With additional resources or an improvement in technology, the economy can produce more computers,

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600Computers

Wheat (tons)

or any combination in between.

Economic growth shifts the PPF outward.

more wheat

The PPF: A Summary

•! The PPF shows all combinations of two goods that an economy can possibly produce, given its resources and technology.

•! The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth.

•! A bow-shaped PPF illustrates the concept of increasing opportunity cost.

The Economist as Policy Advisor

•! As scientists, economists make positive statements, which attempt to describe the world as it is.

•! As policy advisors, economists make normative statements, which attempt to prescribe how the world should be.

•! Positive statements can be confirmed or refuted, normative statements cannot.

•! Govt employs many economists for policy advice. E.g., the U.S. President has a Council of Economic Advisors, which the author of this textbook chaired from 2003 to 2005.

Why Economists Disagree

•! Economists often give conflicting policy advice.

•! They sometimes disagree about the validity of alternative positive theories about the world.

•! They may have different values and, therefore, different normative views about what policy should try to accomplish.

•! Yet, there are many propositions about which most economists agree.

S U M M A R Y

•! As scientists, economists try to explain the world using models with appropriate assumptions.

•! Two simple models are the Circular-Flow Diagram and the Production Possibilities Frontier.

•! Microeconomics studies the behavior of consumers and firms, and their interactions in markets. Macroeconomics studies the economy as a whole.

•! As policy advisers, economists offer advice on how to improve the world.