ECONOMICS 1- WORKSHOP1Chapter 1

INTRODUCTION

Economic questions arise due to the principle that resources are scarce ie: not sufficient.

People have unlimited needs and wants that they try to satisfy with these limited resources. Economics focuses on how these needs and wants are satisfied with the most efficient outcome possible.

• Economics is regarded as a social science because it tries to predict human behavior and measure the impact of human behavior on the economy by using economic models.

• Economics can be classified into two main categories: Micro economics which focuses on the study of choices made by individuals and firms. And the those choices impact on the markets and influence government decisions.

• Macro economics is the study of the national and global economy and how they are influenced by individuals, firms and government.

There are two questions that summarize economics-

1)what, how, when, where and for whom goods and services get produced?

2)When do choices made in the pursuit of self-interest also promote the social interest?

• What, How, When, Where and For Whom? • Goods and services are the objects that people

value and produce to satisfy wants. • What? • What we produce changes over time as changes in

technology allow us to produce more. • Today, most people in the rich industrial countries

produce services. • How? • Goods and services are produced by using productive

resources that economists call factors of production, which are grouped as:

• Land • Labor • Capital • Entrepreneurship

When? Sometimes production slackens off in a

recession and other times it expands rapidly in a business cycle.

What makes production rise and fall? Can government action prevent recession?

Economics helps us to answer questions about when things are produced.

Where? Volkswagen produces cars in several

countries and sells them throughout the world.

• Financial services are concentrated in Frankfurt and London, while telecommunications industries concentrate in Finland.

• Economics helps us to answer questions about where things are produced.

• For Whom? • Who gets the goods and services depends on the

incomes that people earn. • Land earns rent. • Labor earns wages. • Capital earns interest. • Entrepreneurship earns profit.

• Land, labour, capital and entrepreneurship are known as the factors of production and different people own them.

• When is the Pursuit of Self-Interest in Society’s Interest?

• Every day, millions of South Africans and 6.1 billion other people make economic choices that result in ―What‖, ―How‖, ―When‖, ―Where‖ and ―For Whom‖ goods and services get produced.

• You make choices that are in your self-interest—choices that you think are best for you.

• Choices that are best for society as a whole are said to be in the social interest.

• Is it possible that when each one of us makes choices that are in our self-interest, it also turns out that these choices are also in the social interest?

• A few issues in today’s world illustrate the importance of this question:

• Do the technological advances in the ―new economy‖ bring benefits to all?

• Corporate scandals show that big business works against the social interest?

• Who will bear the cost of global warming? • The argument of responsibility for global

warming is very complex as it is generally thought that the main contributors to pollution are 1st world countries and this aided their economic growth, should 3rd world countries slow down their growth and bear the higher cost of being environmentally sensitive while achieving economic growth at a higher cost?

• 1.1 The Fundamental Economic Challenge • Choices and Trade-offs • The economic way of thinking places scarcity and its

implication, choice, at centre stage. Because we face scarcity, we must make choices. And when we make a choice we select from the available alternatives. You can think about every choice as a trade-off—giving up one thing to get something else. ―Books versus butter‖ is a simple trade-off. ―Books‖ and ―butter‖ can stand for any two goods. Whatever choice you make, you could have chosen something else instead.

• In making choices, we have to make decisions about the best possible choices in terms of allocating resources efficiently and effectively. This includes incurring opportunity costs. Thus for every decision we take, we incur opportunity costs.

• The highest-valued alternative that we give up to get something is the opportunity cost of the activity chosen.

The concept of opportunity costs Refers to the best option forgone. It is simply, giving up

something to gain something else. For example, as a business manager you are constantly faced with the problem of choosing among alternative methods of production, pricing of products, and maximizing profits and minimizing losses. Other decisions may relate to aspects of budgeting, human resources, and a range of other firm activities. Understanding economics and employing economic tools can help you solve many business problems.

Thinking about a choice as a trade-off emphasizes cost as an opportunity forgone.

Choosing at the Margin People make choices at the margin, which means that

they evaluate the consequences of making incremental changes in the use of their resources.

The benefit from pursuing an incremental increase in an activity is its marginal benefit.

The opportunity cost of pursuing an incremental increase in an activity is its marginal cost.

By evaluating marginal benefits and marginal costs and choosing only those actions that bring greater benefit than cost, we use our scarce resource in the way that makes us as well off as possible.

Human Nature, Incentives and Institutions

Economists take human nature as given and view people as acting in their self-interest.

Self-interested

Human Nature, Incentives and Institutions Economists take human nature as given and view people as

acting in their self-interest. Self-interested actions are not necessarily selfish actions. 8

Regent Business School But if human nature is given and people pursue self-interest, how can the social interest be served?

Ceteris Paribus This is a Latin term that means ―other things being equal‖

or ―if all other relevant things remain the same‖ (Parkin et al 2005:15). Economic models enable us to determine the influence of one factor at a time in the ‗imaginary world‘ of the model.

PRODUCTION POSSIBILITIES FRONTIER The quantities of goods and services that we can produce are limited

by both our available resources and by technology. If we want to increase our production of one good, we must decrease our production of something else – we face trade-offs.

The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot, that is, it is the limit to what we can produce (Parkin, Powell, and Mathews 2005:32).

To illustrate the PPF, we focus on two goods and hold the quantities of all other goods constant.

That is, we look at a model economy in which everything remains the same (ceteris paribus) except the two goods we‘re considering. Figure 1.1 shows the PPF for CDs and pizza, which stand for any pair of goods and services.

Points on the frontier, such as points A, B, C, D, E and F and points inside the frontier, such as Z, are attainable. Points outside the frontier are unattainable.

PPF- FIG1.1

The PPF makes the concept of opportunity cost precise. If we move along the PPF from C to D, the opportunity cost of the increase in pizza is the decrease in CDs. Note that the opportunity cost of a CD is the inverse of the opportunity cost of a pizza. One pizza costs 3 CDs. One CD costs 1/3 of a pizza. All the points along the PPF are efficient. To determine which of the alternative efficient quantities to produce, we compare costs and benefits.

The PPF and Marginal Cost The PPF determines opportunity cost. The marginal cost of a good or service is the opportunity cost of producing one more unit of it. Figure 1.2 illustrates the marginal cost of pizza. As we move along the PPF in part (a), the opportunity cost and the marginal cost of pizza increases. Fig1.2 below

In figure 1.3 the blocks illustrate the increasing opportunity cost of pizza. Fig 1.3 below

The black dots and the line labeled MC shows the marginal cost of pizza. Preferences and Marginal Benefit

Preferences are a description of a person‘s likes and dislikes. Economists use marginal benefit and the marginal benefit curve to describe them. The marginal benefit of a good is the benefit received from consuming one more unit of it. We measure marginal benefit by the amount that a person is willing to pay for an additional unit of a good or service. It is a general principle that the more we have of any good or service, the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it. We call this general principle the principle of decreasing marginal benefit.

Figure 1.4 illustrates the marginal benefit curve which shows the relationship between the marginal benefit of a good and the quantity of that good consumed. The marginal benefit curve slopes downward to reflect the principle of decreasing marginal benefit. At point A, with pizza production at 0.5 million, people are willing to pay 5 CDs per pizza. At point E, with pizza production at 4.5 million, people are willing to pay 1 CD per pizza. Fig 1.4 below

Efficient Use of Resources When we cannot produce more of any one good without giving up some other good, we have achieved production efficiency, and we are producing at a point on the PPF. When we cannot produce more of any one good without giving up some other good that we value more highly, we have achieved allocative efficiency, and we are producing at the point on the PPF that we prefer above all other points. The following figure illustrates allocative efficiency. Fig 1.5 below

The point of allocative efficiency is the point on the PPF at which marginal benefit equals marginal cost. This point is determined by the quantity at which the marginal benefit curve intersects the marginal cost curve which is shown in figure 1.6 below.

If we produce less than 2.5 million pizza, marginal benefit exceeds marginal cost. We get more value from our resources by producing more pizza. Looking at figure 1.7, on the PPF at point A, we are producing too many CDs, and we are better off moving along the PPF to produce more pizza.

From Figure 1.5, if we produce more than 2.5 million pizzas, marginal cost exceeds marginal benefit. We get more value from our resources by producing less pizza. On the PPF at point C, we are producing too much pizza, and we are better off moving along the PPF to produce less pizza.

Economic GrowthThere are two factors that influence economic growth:a) Technological Change- Development of new goods and improved

ways to manufacture new goodsb) Capital accumulation- Growth of capital resources, includes human capital. To use resources in research and development we must decrease our production of consumption goods and services.

We can produce pizza or pizza ovens along PPF0. By using some resources to produce pizza ovens, the PPF shifts outward in the future.

Gains from trade

Comparative Advantage A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. In other words, it refers to the ability of a party (an individual, a firm, or a country) to produce a product with the highest relative efficiency given all the other products that could be produced. It can be contrasted with absolute advantage which refers to the ability of a party to produce a particular good at a lower absolute cost than another. Comparative advantage explains how trade can create value for both parties even when one can produce all goods with fewer resources than the other. The net benefits of such an outcome are called gains from trade. It is the main concept of the pure theory of international trade.

Gains from trade continued…..

Table 1.1 Possibility Discs (thousands per hour) Cases

(thousands per hour) A 0 4 B 3 3 C 6 2 D 9 1 E 12 0

The table shows Ace‘s production possibilities. Ace produces 3,000 discs and 3,000 cases at possibility B. If Ace increases production of discs by 3,000 an hour, it must decrease production of cases by 1,000.

Production Without Trade Suppose that Ace and Galaxy produce two components: case and discs. Each firm produces its own cases and discs. Total production at each factory is 3,000 CDs an hour. Table 1.1 shows their production possibilities.

Table 1.2 shows Galaxy‘s production possibilities. Possibility Discs (thousands per hour) Cases (thousands per hour)

E' 0 12 D' 1 9 C' 2 6 B' 3 3 A' 4 0

Galaxy produces 3,000 discs and 3,000 cases at possibility B'. If Galaxy increases production of discs by 1,000 an hour, it must decrease production of cases by 3,000.

Differences in Opportunity Cost Fig 1.9 below Ace can produce 3,000 discs

and 3,000 cases at point B. Along its PPF, Ace‘s

opportunity cost of a disc is 1/3 case and its opportunity cost of a case is 3 discs.

Galaxy can produce 3,000 discs and 3,000 cases at point B'.

Along its PPF, Galaxy‘s opportunity cost of a disc is 3 cases and its opportunity cost of a case is 1/3 of a disc.

If Ace and Galaxy exchange cases and discs at one case per disc (one disc per case), they exchange along the Trade line, figure 1.10.

Ace ends up at point F with 6,000 CDs—twice what it can achieve

without specialization and trade.

Galaxy ends up at point at point at point F' with 6,000 CDs—twice what it can achieve without specialization and trade

Fig 1.10

Absolute Advantage A person (or nation) has an absolute advantage if that person (or nation) can produce more goods with a given amount of resources than another person (or nation) can. Because the gains from trade arise from comparative advantage, people can gain from trade in they also have an absolute advantage. Dynamic Comparative Advantage

Learning-by-doing occurs when a person (or nation) specializes and by repeatedly producing a particular good or service becomes more productive in that activity and lowers its opportunity cost of producing that good over time. Dynamic comparative advantage occurs when a person (or nation) gains a comparative advantage from learning-by-doing.

END OF CHAPTER 1Thank you