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CHAPTER 1 ECONOMY AND ECONOMICS

FOREWORD

Teaching and, especially, understanding economic issues has never been more important than they are today. The impact of new technologies allows us to produce many goods that were unheard of a few decades ago and also to produce old products in new ways. ew opportunities, but also ew

new constraints, have been opened by changes in government policies. and difficult problems rise almost every day around us.

!anagers at different levels face various economic problems. The main areas covered are" productivity and economic growth, labor# management relationships, competition and antitrust actions,

unemployment and inflation, ta$ation and public e$penditures, poverty and income maintenance, the balance of payments and the international

monetary system, pollution, discrimination, immigration and emigration, and so on.

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%or decades, the &fundations of economics' boo( has been e$pected to codify the entire discipline of economics. )n recent years, this has become at once more difficult and more imperative. The e$plosion of economic (nowledge has made it impossible to put all of economics between two covers. *ut at the same time, more and more public policy issues either are basically economic in nature or involve important economic consideration. These are some of the most important reasons for which professional managers and intelligent citi+ens can no longer afford to be innocent of economics.

,espite the large public dedicated, this boo( is mainly targeted to civil engineer students who prepare them to buld constructions in the future by comunicating with their partners in English. -ur hope is to ma(e easy understanding and acting accordly the challenge of modern Economics.

The Author

1.1.WHAT IS ECONOMICS? 1.1.1. Definition of Economics Economics is concerned with the efficient allocation of scarce resources in order to attain the ma$imum satisfaction of the human unlimited needs .wants/.

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Provided by nature and by investment made by successive generations, resources (factors of production) are the inputs that society uses to produce output, called goods (material, tangible goods, services, information). They are scarce because they are not abundant enough for everyone to be able to use all they want or need. Outputs, on the other hand, are the various useful goods and services that result from the production process and are either consumed or employed in further production. Society s !ermanent tendency is to demand more resources and goods than are available. "n the other hand, human needs (wants) are unlimited. "ver time, wants change and multi!ly, and this tendency is inducted by the develo!ment of new !roducts and by e#tensive advertising and sales !romotion. $onse%uently, it is the !resence of scarcity that motivate the study of the manner (ways) in which !eo!le and societies choose to allocate resources and goods. This is the central, theme of economics. &our se!arate factors are the ingredients of all !roduction' natural resources (land), labor, ca!ital and entre!reneurshi!. (1) Provided by nature and called by some economists land, natural resources contain the mineral in the ground, forests, waterfalls, arable land a.s.o. They are !articularly im!ortant in determining its !roduction due to their scarcity. (2) Labor (human capital) ada!ts natural resources for human use. (t refers to all the !hysical and mental talents of men and women which are usable in !roducing goods and services. That means the s)ills and the amount of wor) will also be im!ortant in determining !roduction. (3) Capital (investment goods) is any manufactured instrument of !roduction' buildings, machinery, tools, e%ui!ments, raw materials, storage, trans!ortation and distribution facilities. (*) Entrepreneurship is the art and science of ma)ing such decisions and ta)ing the ris)s involved in doing so. +ntre!reneurshi! refers to the res!onsability to initiate !roduction, to organi,e the factors of !roduction, to o!erate the !roductive establisment, in order to ma)e !rofits. The return to entre!reneurshi! is profit- entre!reneurs see) !rofit as their incentive for !erforming their functions. The entrepreneur is the !erson res!onsable for o!erating a firm and ma)ing decisions about what it does and how it does it. The entre!reneur accom!lishes four related functions' . he ta(es the initiative in combining the resources of land, ca!ital and labor in the !roduction of goods land, ca!ital and labor in the !roduction of goods and services. he underta)es the chose of ma(ing basic business / !olicy decisions-

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. he is an innovator by attem!ting to introduce on a commercial basis new forms of business organi,ation. he is a ris( bearer of invested funds, time, effort, and business re!utation.

There is always a close interaction between the four factors of !roduction. Their mi#ture in a s!ecific !rocess of !roduction de!ands on the ty!e of good or service !roduced. 1.1.2. Exchanges an Ma!"ets

(ndividual resources can t be !ut to every )ind of use. +ach one could be better at some destinations than at others. This means that resources specialize. (t is a ma0or rule in every modern economy. 1y s!eciali,ation, individual resources will be more !roductive or, in economic terms, more efficient. +fficiency means the allocation of resources to the uses that lead to the most desirable set of out!uts to the uses that lead to the most desirable set of out!uts to the society. 2s a result of s!eciali,ation the exchan e was born. S!eciali,ed resources !roduce what they are best at and e#change some of their !roduct for the things that are best !roduced by others. (n this res!ect, it is the mar!et who has the function to allocate resources by e%uating %uantity su!!lied and %uantity demanded. (n short, allocation determines' . what is to be !roduced. how much is to be !roduced. for whom is to be !roduced. These are the three main economic 0uestions. 1.1.#. Economic $!o%&ems' $!inci(&es' an $o&icies

Economic principles are formulated by the economists. These are useful in the establishment of economic policies thought to solve economic problems" (t is !recisely the concern for !olicy that ma)es economic theory so necessary and im!ortant. 3hile economists can contribute the best theoretical and factual )nowledge there is on a !articular issue, the final decision on !olicy %uestion often rests either on information that is not currently available or on tastes and ethical o!inions about which !eo!le differ (the things we call 4value 0udgments4), or on both. 5ethodologycally, economists use in their studies both deductive and inductive methods.

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. #nduction entails the distilling or creating of principles and theories derived from facts. $ Deduction involves stating hypothesis and then gathering facts to determine whether the hypothesis is valid. 2s techni%ues of investigation, both methods are com!lementary, rather than o!!osite (&ig.1.1).

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%ig.1.1. Economics 2tudies Relationships between %acts, Principles, and Policies .2ource" !cConnell, *rue, 1334/

1.2. THE ECONOMIC $O)ICY The ultimate goal of economics is to design !olicies to deal with economic !roblems. 8sually made and im!lemented by government, an

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economic polic% is a course of action that is intended to influence or control the behaviour of the economy. (t can be develo!ed by the government / ta#ation, government s!ending !rograms, regulation of !articular industries a.s.o., but also by private business / !roduction organi,ation, !rice level setting, new !roduct develo!ment and launching on the mar)et a.s.o. :egardles its level, an economic !olicy has to follow three steps in order to be formulated' . ma)ing a clear statement of goals. designing alternative policies to achieve the goal and recogni,ing their !ossible effects. trac(ing the implementation of chosen !olicies and evaluating their effectiveness. The main value 5udgements may be briefly listed as follows' . Economic rowth. 2 higher standard of living in the future is !ossible only on the basis of the !roduction. . Economic freedom. (t is the right of economic actors (managers, wor)ers, consumers a.s.o.) to develo! their own actions in a s!irit of liberty. . Economic efficienc%" That means to get as much as we reasonally can out, of our !roductive efforts, or to get ma#imum benefits at the minimum cost. . &rice le'el stabilit%. (t is allways desirable to avoid dramatic and;or ra!id fluctuations (inflation;deflation) in the average level of !rices. . Full emplo%ment. 2!!ro!riate 0obs should be available for those !eo!le who are able and willing to wor). . Economic securit%. Society should su!!ort any de!endend !erson beign in a dis!erate financial situation. . (n e)uitable distribution of income. Society has a res!onsability to hel! those !eo!le at the bottom of the economic ladder.

1.#. $OSITI*E AND NO+MATI*E ECONOMICS The effectiveness of economic !olicies can be assessed in one of two ways, )nown as !ositive and normative economics. &ositi'e (descripti'e) economics deals with facts, aims at understanding how the economy wor)s, how things seem to be o!erating,

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and is devoid of value 0udgments. (t is directed towards e#!laining the world as it is, and how various forces can cause it to change. Positive economics attem!ts to set forth scientific statements about economic behaviour. &or e#em!le' 4=early inflation is 26>4. *ormati'e economics deals with the way the world has to be. 1eing !rescri!tive, the normative economics involve value 0udgments and ma)e statements about whether something is ?good@ or ?bad@. (t embodies someone s value 0udgments about what the economy should be li)e or what !articular action is recommended. &or e#em!le' 4=early inflation has to be reduced at 16>4.

1.,. MIC+OECONOMICS AND MAC+OECONOMICS 1ranches of +conomics can be classified according to the a!!roach or methodology that is used. There are two different levels of analysis at which the economists may derive laws concerning economic behavior' microeconomics and macroeconomics. +icroeconomics offers a detailed analysis of !articular activities in the economy and concerns the interactions of the individual !layers in the economy' consumers, firms, and mar)ets for individual goods and services. (t loo)s at the individual mar)ets that ma)e u! the mar)et system and studies how !roducers (entre!reneurs or firms) and consumers (households or individual government agencies) interact with each other. &or sim!licity, it may neglect some interactions with the rest of the economy. 5uch of microeconomics is !ositive analysis' em!irical observation may be able to solve differences of o!inion on !ositive %uestions. +acroeconomics, in turn, as o!!osite to microeconomics, is concerned either with the economy as a whole or with their basic subdivisions. (t considers the aggregate !erformance of all mar)ets in the mar)et system and studies the choices made by the large entities of the economy' the business sector, the household sector, and the government sector. 5acroeconomics also studies the monetary system, overall !rice levels and changes, the effects of government s e#!enditures, ta#ation and borrowing u!on the economy, %uestions of gross national !roduct, economic macro/dise%uilibriums such inflation, unem!loyment a.s.o. There is still a convergence of microeconomics and macroeconomics' many to!ics and subdivisions of economics are rooted in both. 1y e#!loring behavior at the individual level and then aggregating u! to the collective level, economists are develo!ing the underlying foundations of

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macroeconomics. $onse%uently, the districtions between microeconomics and macroeconomics areas are fle#ible, and borders have some degree of relativity, becoming less and less clear.

-EY CONCE$TS Economics Human needs .wants/ Resources Relative scarcity of resources %actors of production 6and .natural resources/ 6abor .human capital/ Capital .investment goods/ Entrepreneurship 2peciali+ation Efficiency E$change !ar(et The three economic 0uestions Economic facts Economic problems Economic principles Economic theory Economic policy )nduction ,eduction Abstraction Positive economics ormative economics !icroeconomics !acroeconomics

CHAPTER 7 THE MA+-ET ECONOMY SYSTEM

2.1. THE ECONOMIC SECTO+S :eal/world economics are arrayed between the two e#tremes' !ure (laisse,/faire) ca!italism and command economy. . &ure (laissez,faire) capitalism is characteri,ed by the !rivate ownershi! of resources and the use of a system of mar)ets and !rices to coordinate and direct economic activity. . Command econom% is characteri,ed by !ublic ownershi! of virtually all !ro!erty resources and collective determination of economic decisions through a central economic !lanning. They are distinguished by the degree to which government influences and controls economic activity (economic role of the o'erment). "ne of the ways in which economy can be viewed is to ma)e inside it the distinction between the !rivate sector and the !ublic sector. The pri'ate sector, made u! of firms and households, ma(es its own economic decisions according to its own private views of the operating mar(ets, its own needs and desires, and its economic ability to satisfy them. 2lthough they ma)e their decisions themselves, firms and household, as elements of the !rivate sector, are influenced by the o!erations of the mar)ets in which they !artici!ate. 3hen between buyers and sellers in the mar)et ta)e !lace with little or no government interference, a private or a free mar(et e#ists. &irms ta)e decisions concerning the use of resources in order to produce output as good and services. 2ll firms together determine the

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mar)et su!!ly of goods and services. The theory of the firm studies the economic forces that influence what they !roduce, how much they !roduce, and what combinations of resources are used to !roduce it. 2s consumers, firms buy factors of !roduction in in!ut mar)ets' raw materials, e%ui!ment, labor, etc., which they combine in !roduction. &irm s decisions are based, u!on the !rinci!le of profit ma$imi+ation. The firm s goal is to !erforme its o!erations so that it ma)es the highest !ossible !rofit from them. "n the other hand, households ta)e consumption decisions" what to consume and how much of it to consume. Their collective action determines mar)et demand for goods and services. 1ut households also act as !roducers in that they !rovide and sell labor, which is one of the in!uts used by firms. The economic goal of the household is to ma$imi+e utility as a measure of the satisfaction and en0oyment received from the consum!tion of goods and services. The public sector contains the economic activity of government who influences decisions made by individual firms and households. 2llocation of public goods is not necessarily influenced by mar)ets, because some !ublic goods cannot be distributed by mar)et forces. 8overnment secures most of its income through various )ind of ta#es and other sources. Ta#ation has effects u!on households incomes and firm s !rofits, and sometimes u!on mar)et !rices. Bovernment also ta)es decisions concerning the services and facilities it !rovides and !ays for.

2.2. THE MI.ED ECONOMY AND /O*E+NMENT +O)E The ultimate ob0ective of economics is to develo! !olicies to deal with societyCs issues. (n this res!ect, there are two (ey 0uestions in economics' . why things ha!!en li)e thisD . what should be doneD 1efore formulating !olicies, economists must first ma)e every effort to understand how the economy has wor)ed in the !ast, how it wor)s today, and how it seems to wor) in the future. The centre of attention is usually the governmentCs !olicies when studying economic !olicies. There is a controversial role of the government regarding its intervention in the economy. 5ain %uestions are here' . which are the circumstances in which government should ta)e an active roleD

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. which is the a!!ro!riate amount and when is it best for government to leave decisions to the !rivate !artici!ants in the economyD Private mar)ets should be liberated from the tyranny of government control, said (dam -mith, the author of An )n0uiry into the ature and Causes of the 9ealth of ations , !ublished in 1997. Bovernment intervention usually ma)es things worse, and, conse%uently, government should be cautious in interfering with the o!erations of the !rivate mar)et. (n !ursuit of their !rivate interests, individual !roducers would ma)e the goods that consumers want. There is ?the invisible hand@ of the mar)et that causes the !roducer to !romote the interests of society. 2t the other e#treme, .ohn +a%nard /e%nes !ublished in 1A37 his 8eneral Theory of Employment, )nterest and !oney, which !ut the laisse, faire tradition in economics under attac). (t was the time of' . depression E a decline in the total out!ut, income, em!loyment, and trade, usually lasting 7 months to a year, and mar)ed by wides!read contractions in many sectors of the economy. inflation E an increase in the average level of !rices. (n this situation, according to Feynes, government has the duty to turn the unem!loyment bac) to wor) by building !ublic investments, such as roads, !ost offices, dams a.s.o. Go contem!orary society falls com!letely into either of these e#treme categories. 2ll societies are rather mi#ed economies, with elements of mar)et and command in different !ercentages. (n a mixed econom%, government !lays an active role in' . strengthening and facilitating the operation of the mar(et system by' H !roviding the legal foundation and social environment conducive to the effective o!eration of the mar)et systemH maintaining com!etition as the basic regulatory mechanism in a ca!italistic economy. . supplementing and modifying the operation of the mar(et system by' H redistributing income and wealth in order to ameliorate ine%uality in the societyH ad0usting the allocation of resources so as to alter the com!osition of the national !roductH stabili,ing the economy, that is, controlling unem!loyment and inflation caused by business fluctuations, and !romoting economic growth.

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To sum u!, the characteristics of all modern economies are' (1) the !rivate !ro!erty(2) the freedom of entre!rise and choice(3) the self/interest as a motivating force(*) the com!etition(6) the reliance on a mar)et system(7) the use of advanced technologies and large amounts of ca!ital goods(9) the s!eciali,ation(<) the use of money.

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There are strong interrelationshi!s between economic goals of the government. They can be' . complementary as, for instance, economic growth !olicy, and the !olicy of decreasing unem!loyment- in these situations, economic !olicy/ ma)ing is relatively easy. : conflicting as, for instance, reducing unem!loyment !olicy and reducing inflation !olicy- when the unem!loyment !roblem is reduced, by some reasons, the inflation !roblem tends to get worse. $onflicts li)e this among goals test the science and the art of !olicyma)ers.

2.#. THE CI+C0)A+ 1)OW MODE) O1 THE ECONOMY &irms are ma0or actors of any economy. 2 firm is a business organi+ation that produces goods and;or services. 2 plant is an establisment at a single location used in the !roduction of a good or service (for e#em!le, a factory, mine, farm, or store). The dimension of a firm often de!ends on the number of !lants it has. 2n industr% refers to all the !roducers of a good or service. &or e#em!le, we are in the construction industry. &rom a strictly economic !oint of view, we s!ea) about the construction business. 2n overview of the o!eration of the mar)et system can be obtained through the circular flow model (&ig.1.2). This simplified model locates the product and resources mar(ets and !resents the ma0or income / e#!enditure flows and resources / out!ut flows which constitute the lifeblood of the mar)et economy. (n a monetary economy, households, as resource owners, sell their resources to business and, as consumers, s!end the money income received therefrom in buying goods and services. 1usinesses must buy resources in

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order to !roduce goods and services- their finished !roducts are then sold to households in e#change for consum!tion e#!enditures or, as businesses view it, revenues. The net result is a countercloc)wise real flow of economic resources and finished goods and services, and a cloc)wise monetary flow of income and consum!tion e#!enditures. These flows are simultaneous and re!etitive. Bovernment e#!enditures, ta#es, and transfer !ayments affect the distribution of income, the allocation of resources, and the level of economic activity. The circular flow model is a useful means for envisioning how government !erforms its redistributional, allocative, and stabili,ing functions.

2.,. MONEY +one%, one of the most crucial elements of economic science, are essential in every economies with s!eciali,ation of !roduction, where e#change is necessary. The monetary system is the life blood of the circular flows of income and e#!enditure which ty!ify all economics.

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%ig.1.7. The Circular %low !odel There are three functions of money" medium of e#change, measure of value, and store of value.

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(1) +edium of exchan e means anything that is widely accepted in payment for goods and services and in settlement of debt . 2s a convenient social invention, money is the most common medium of e#change and it allows society to avoid the main com!lication of barter' the re%uired coincidence of wants. (2) +easure of 'alue" 1usiness actors need measurements for the value of things offered at the mar(et. These allows us' H to state the price of each !roduct in terms of the monetary unit (unit of account)H to really compare the relative worth of various commodities and resources in order to facilitate rational decision ma)ingH to measure transactions involving future !ayments (debt obligations of all )ind).

(3) -tore of 'alue" 5oney is a very convenient form in which savings are accumulated. $om!aring with other methods of storing wealth (real estate !ro!erty, stoc)s, bonds, a.s.o.), money offers the advantage of being immediately usable by a firm or a household in meeting any and all financial obligations.

5oney can !erform the mentioned functions only in following conditions' . it must be acceptable as !urchasing !ower in the whole mar)et. it must be easily recogni+able so that will )now what it is and what its value is. it must be homogeneous, that means any two similar units have e%ual value. it must be divi+ible, this way the value of goods that are fractions of the unit of account can be calculated, e#!ressed and handeled easily. it must be portable so that to facilitate carrying it. it must be durable, that means to last for a %uite long !eriod or, if it is strictly necessary, to be re!laceable at a low cost. it must have a high degree of stability of value so that to ins!ire trust.

5oney, which is essentially the debts of government and de!ositary institutions (commercial ban)s and thrift institutions), has value because of the goods and services which it will command in the mar)et. 5aintenance of the !urchasing !ower of money de!ends to a considerable degree u!on the effectiveness with which government manages the money su!!ly. 5oney are usually related to prices. +conomists ma)e a clear distinction between nominal !rice and real !rice.

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The nominal price of a good is sim!ly the number of monetary units that must be given up to ac0uire it. 1ut, when we offer to e#change some amount of money for some amount of good, we are really offering to give u! our ca!acity to ac%uire other goods in e#change for this good. The real price of a good is the amount of other goods that could be purchased instead. This is an im!ortant economic measure because the !urchasing !ower of money erodes over time through inflation, thus the nominal !rice may not be a very good way of e#!ressing how many of some other good we must sacrifice for this one. 8sing a broad inde# of !rices, the Consumer &rice #ndex is a standard against which to com!are individual !rices. (t res!onds to the %uestion how to ad0ust for inflation by dividing the current nominal !rice of a good by some measure of how nominal !rice of all goods have changed over time.

2.6. TI+ 52:F+T 5+$I2G(S5

There are thousands of mar)ets around us and millions of interconnections among the mar)ets. 2s we already saw, there are two main mechanisms by which can be answered to the %uestions of what, how, and for whom to !roduce in one economy' the mar)et and the intervention of the government. Phisical pro$imity is not re%uired to ma)e a mar)et. &or e#em!le, stoc) mar)et transactions are made between buyers and sellers ussuallt se!arated by huge distances. 2 mar)et could be a very simple or a very comple$ one. (n a com!le# economy, in any mar)et, the !rice !rovides the focus for interactions between buyers and sellers. (n this res!ect, !rices !erforme two im!ortant and interrelated functions' . they !rovide information, summari,ing all as!ects of the mar)et. they relationshi!s. !rovide incentives for those involved in the mar)et

The way in which the !rice is determined is done by the number of !artici!ants in that mar)et. Some mar)ets are dominated by a few large com!anies, and others have tousands of sellers. 2 monopol% e#ists when in the mar(et operates only one ma5or seller . $onversely, an oli opol% e#ists when in the mar(et operate a few sellers. Je!ending the way in which the !rice is determined by the number of !artici!ants in the mar)et, there are two ty!es of com!etition in that mar)et'

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. the perfect competition , when there are so many buyers and sellers that no single buyer or seller has any influence over the !rice. the imperfect competition, when any buyer or any seller is able to influence the !rice. $hanges in mar)et conditions are reflected in changes in !rices. Prices !rovide information to mar)et !artici!ants, they !rovide them with incentives to res!ond to changing conditions, and they bring order out of a !otentially chaotic situation. 5ar)et mechanism has im!ressive strenghts, but also drawbac)s. .The ad'anta es of the mar)et mechanism are' H it !ushes !roducers to offer the goods and services that consumers want by the incentives it givesH it also !ushes !roducers to ac%uire usefull )nowledge and s)illsH it encourages !roducers to conserve scarce resourcesH it encourages customers to use scarce goods carefullyH it involves a high degree of economic freedom, every actor of the economic scene being unrestricted to choose de!ending on their owen needs, desires, tastes and !referencesH it !rovides every moment information regarding local conditions for transactions.

.The weac!nesses of the mar)et mechanism are' H it may give the wea) and the hel!less little more than the freedom to starveH an unregulated system of !rivate com!any may be %uite instable, with !eriods of inflationary boom giving way to shar! recessions. H !rices are not always the result of im!ersonal mar)et forces' the mono!oly or oligo!olist may restrict !roduction in order to )ee! the !rice high2lthough the mar)et is a vital mechanism, it has sufficient drawbac)s to !rovide the government with a ma0or role.

!ethodological )ssues in Economics
-EY CONCE$TS Pure .laisse+ faire/ capitalism Command economy Private sector Public sector Economic role of the government Circular flow model Real flow !onetary flow !oney !edium of e$change !easure of value 2tore of value

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CHAPTER < METHODO)O/ICA) ISS0ES IN ECONOMICS

#.1. ECONOMIC THEO+IES AND MODE)S +conomic analysis is a marginal one. 5arginality is e#tremely im!ortant to the understanding of the economic theory and models, es!ecially in microeconomics. 45arginal4 is the term commonly used by economists to mean 4additional4. (n mar inal anal%sis0 economists e$amine the conse0uences of the dynamics" small changes by adding or substracting from the current state of affaires. $onse%uently, many economic )ey conce!ts are

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a!!roached by their marginalist !ers!ective' marginal cost, marginal benefit, marginal !roduct, marginal !roductivity, marginal revenue, marginal utility, a.s.o. 5uch of economics is theory and models. "ne im!ortant aim of the economic science is to develo! its tools / theories and models /, and then to test them against facts. +conomists borrow ways of investigation from different fields of the science, ad0usting each to fit the !articular !roblems !osed by economic facts. Thus, mathematical reasoning, historical study, statistical inferences, etc. are e#tensively used in economics. To understand the functioning of anything as com!le# as the economy, abstraction from unim!ortant details is necessary. 2bstraction means ignoring many details in order to focus on the most important factors in a problem. 1ut there is no such thing as one s!ecific degree of abstraction for all analytic !ur!oses. The o!timal degree of abstraction de!ends on the ob0ectives of the analysis. 2 model that is a gross oversim!lification for one !ur!ose could be needlessly com!licated for another. Theories e#ist in all scientific and investigative disci!lines, as an attem!t to e#!lain on !a!er how real/world !henomena are related. 2 world in which there are billions of consumers and millions of firms, ma)ing trillions of transactions each year, is too com!le# to be understood in details. Thus, economists attem!t to sim!lify it by using theories that ma)e sim!lifying assum!tions. A theor% is a deliberate simplification .abstraction/ of factual relationships that attempts to e$plain how those relationships wor(. (n other words, it is an e$planation of the mechanism behind observed !henomena. The tas) of economic theory or analysis is to systematically arrange, inter!ret, and generali,e u!on facts. (ts aim is to be su!!ortive in understanding and !redicting the economic real world behavior. There are always other theories that may !otentially be even better at e#!laining the world. This is the e#!lanation that economists continue collect data, in order to build better models and evaluate them. (nside an economic !henomena can be found many economic as!ects, elements or variables, related each other. Two variables are said to be in correlation if they tend to go u! or down together. Lust loo)ing at the degree of correlation between the behavior of two sets of statistics may not tell us much about cause and effect. 2n economic model is a representation, a formal illustration of a theory, or a part of a theory, for the purpose of illuminating cause#and#effect relationships. (t is a sim!lified framewor) for organi,ing the way we thin) about the !roblem, because it abstracts from the myriad unim!ortant details and !resents the essence of how the real economic world wor)s. "ften it is mathematical, but it doesn t have to be.

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&or instance, if we constructed a mathematical system to re!resent an individual consumerCs decision about buying a building a!artment, we would say that we have built a model of an real estate !urchase decision. (t will be useful in hel!ing us to understand how the real estate mar)et wor)s and to !redict what would ha!!en if we tray to im!lement a !articular real estate !olicy. The most fundamental !ositive analytical model that economists use is !erha!s the mar(et model, which illustrates the interaction between demand and su!!ly, ultimately determining the level of !rice and the resources allocation. Geither theories nor models don t !rovide a com!lete !icture of everything in the real world, but it s very im!ortant to ma)e as accurate as !ossible predictions about it. &irst of all, theory must be testable to determine if it relied u!on as an e#!lanation of real/world events. Tests of theory must be replicable, in other words, to lead to the same results when re!eated by others. 1ecause +conomics deals with human behavior, which is hard to !redict, economists have to rely u!on observation of the real world to get the information they need for testing their theories. (n this !rocess, they gather em!irical information. "n the other hand, +conomics deals with a very com!licated world. $onse%uently, most scientific theories and models e#amine only a small !art of the real world. +conomists use simplif%in assumptions to remove away much details that are not directly related to the !henomena being studied. There are several commonly used assumptions in economic theory' . 4all else (other thin s) bei n e)ual1 (ceteris paribus) assumption states all other e#ogenous variables, e#ce!t those under immediate consideration (endogenous), are held constant. the economic man assumption states that everyone in the mar)et act rationally, with the goal of ma#imi,ing their own !rofits or utility. the efficient mar!ets assumption states that economic mar)ets o!erate according to the laws of economics, with !erfect information, no elements within the mar)et ma)e abvious errors, and that any changes in mar)et conditions are instantly communicated to all economic actors, who then can react to them very %uic)ly. the instantaneous acti'it% assumption states that all sort of resources can be shifted from one use to another at once, with no time s!ending. the costless assumption states that are no costs of trans!ortation, obtaining )nowledge and s)ills, shifting resources to different uses, moving;changing the s)ills of labor, a.s.o.. the perfect information assumption states that economic actors have immediate and total access to all necessary data they need.

32
#.2. 0SIN/ /+A$HS IN ECONOMIC ANA)YSIS

Economics

There is a continuing inter!lay between models and facts in the study of economic relationshi!s and !roblems. Jata (facts) are essential for two reasons' . they suggest relationshi!s which we should aim to e#!lain. having formulated our theories, they can also be used to test our hy!otheses and to %uatify the effects they im!ly. +conomists communicate ideas (facts) by three main tools' tables, gra!hs, and e%uations. &re%uently they are used together and are accom!anied by world descri!tions. ,ata can be !resented by schedules (tables), times series data, and cross section data. (1) -chedules (tables) are an easily to understand form, which concentrate in columns and rows different related information (Tab.3.1). Tab.<.1. Relationships of the Temperature to the =alue of Refreshing .2oft/ *everages 2old Tem!erature under / 1K / 1K / K K / 1K 1K / 2K 2K / 3K above 3K Soft beverages sold (mil. monetary unit) 6 7 9 A 3K 76

(2) 2ime series data are values of a given variable at a different points in time (e#.' the !rice evolutions of the cement in 2KKK) (Tab.3.2) Tab.<.7. Price Evolutions of the Cement in 7444 5onth Lanuary 2!ril Luly "ctober Price (1.KKK monetary unit;tone) 326 36K *KK 36K

!ethodological )ssues in Economics

33

(3) Cross section data refer to the same point in time, but to different people (e#.' unem!loyment by age grou!s in Se!tember 2KKK) (Tab.3.3) Tab.<.<. >nemployment by Age 8roups in 2eptember 7444 2ge grou! 1< / 26 26 / *6 *6 / 76 Gumber of unem!loyed !ersons 129.636 299.3K1 <A.663

Tables and gra!hs show relationshi!s between variables. There are two types of variables' . independent 'ariable, which may change freely and ?causes? the change in the dependent variable. dependent 'ariable, which is the 4effect4 or outcome, and changes with changes in the independent variable. 8sually, we !ut the inde!endent variable (cause) on the hori,ontal a#is and the de!endent variable (effect) on the vertical a#is. To see and understand, economists need sim!lier means by which to e#!ress many )inds of data and information, es!ecially that which a!!ears in tables. 3raphs are tools by which economists convert their theories and models, or the numbers in tables, into !ictures showing a visual representation of the relationship between two variables. Bra!hs are invaluable tools in economic analysis because they !ermit clear e#!ression and handling of sometimes very com!le# relationshi!s. (n a gra!h, a relationshi! between two variables can be (&ig.3.1. and &ig.3.2)' . a positi'e one (direct related), when the two variables change in the same direction (u!slo!ing line). a ne ati'e one (in'ersel% related), when the two variables change in o!!osite directions (downslo!ing line). 1oth ty!es of gra!hs could e#!ress two ty!es of relationship' . a linear one (straight line gra!h). a non,linear one (curved gra!h).

3*

Economics

The slope of a strai ht line is the ratio of the vertical change to the corresponding hori+ontal change in moving between any two points (&ig.3.3). (t indicates how much the gra!h rises !er unit when we move from left to right. The slo!e of an u!slo!ing line is !ositive, while that of a downslo!ing line is negative. The vertical (or hori,ontal) interce!t and the slo!e of a line establish its location and are used in e#!ressing the relationshi! between two variables as an e)uation' 4 5 a 6 b% $urved lines also have slo!es, but the numerical value of the slo!e is different at every !oint. -lope of a cur'e at any !oint is determined by calculating the slope of a straight line drawn tangent to that point (&ig.3.*). To understand how the economy wor)s we need both theory and facts. 3e need theory to )now what facts to loo) for' there are too many facts for the facts alone to tell us the correct answer. &acts without theory are useless, but, on the other hand, theory without facts remains an unsu!!orted assertion. $onse%uently, we need both.

!ethodological )ssues in Economics

36

%ig.<.1. ,ifferent Types of 2lope of a 2traight#line 8raph

37

Economics

%ig.<.7. ,ifferent Types of 2lope of a Curved 8raph

!ethodological )ssues in Economics

39

%ig.<.<. 2lope of a 2traight#line

3<

Economics

%ig.<.@. 2lope of a Curved 6ine

/E7 CO*CE&2!arginal analysis Abstraction Correlated variables Economic model 2implifying assumptions ?-ther things being e0ual? .ceteris paribus/ assumption Economic data 2chedules .tables/ 8raph )ndependent variable ,ependent variable 2lope of a straight line 2lope of a curved line E0uation ,irect related variables )nversely related variables

CHAPTER @ THE ECONOMI2IN/ $+O3)EM4 $+OD0CTION $OSSI3I)ITIES 1+ONTIE+ AND O$$O+T0NITY COST

,.1. $+OD0CTION $OSSI3I)ITIES 1+ONTIE+ 1ecause resources are scarce, a full/em!loyment, full/!roduction economy cannot have an unlimited out!ut of goods and services. $onse%uently, choices (trade,offs) must be made on which goods and services to !roduce and which to forgo. (n order to understand how society ma)e choices we assume' . the economy is o!erating at full/em!loyment and achieving full/ !roduction- that means it wor)s efficiently. we are loo)ing the economy at some s!ecific !oint in time, or over a very short !eriod of time, for which resources and technology are both fi$ed- no im!act from these in!uts is e#!ected. the economy is producing 5ust two products, say 4M4 / a consumer good, and 4=4 / a ca!ital good.

Nimited resources means a limited out!ut and, as a conse%uence, society has to decide how much from each good to !roduce. &or an e#em!le, the alternative !ossibilities are shown in the production possibilities table (Tab.*.1) and the !roduction !ossibilities frontier (&ig.*.1).

*K
Tab.@.1. Production Possibilities Table Bood 4M4 Possibilities (consumer good) 2 1 $ J + K 2 * 7 < Bood 4=4 (ca!ital good) 1K A 9 * K Sacrifice of ca!ital goods / 1 3 7 1K

Economics

Bain of consumer goods / 2 * 7 <

%ig.@.1. Production Possibilities %rontier The production possibilities frontier is a gra!hical tool used for economic analysis of !roduction decisions. (t measures the 0uantity of two goods that an economy is capable of producing with its currently available resources and technology. 2n economy !roducing along its !roduction !ossibilities curve is achieving at highest efficiency. The !roduction !ossibilities frontier is the curved line drawn through !oints 2, 1, $, J, and + and re!resents the ma#imum !ossible %uatities of goods M and = that the economy is able to !roduce and therefore symboli,es the efficient !roduction assum!tion. The %uantity of good M !roduced is measured on the hori,ontal a#is, while the %uantity of good = !roduced is measured on the vertical a#is.

The Economising Problem
"n the !roduction !ossibilities frontier'

*1

. at the point A, the economy is using all of its resources to !roduce 1K units of good = and K units of good M. moving down along the curve to the right of !oint 2, fewer units of = are !roduced, and more and more units of M are !roduced. at the point *, the economy is !roducing A units of = and 2 units of M.at the point C, the economy is !roducing 9 units of = and * units of M, and so on. . at the point E, the economy is !utting all its resources into !roduction of good M / 9 units and K units of good =. 2t any !oint in time, a full/em!loyment, full/!roduction economy must sacrifice some of !roduct M to obtain more of !roduct =. 1oth !oints 2 and + are clearly unrealistic e$tremes. Points that lie in the interior of the curved !roduction !ossibilities frontier, such as !oint 5, re!resent 0uantities of good A and B that are less than the ma$imum 0uantities the economy is capable to produce and are therefore considered inefficient production points (underutili+ed resources). 8nder the efficient !roduction assum!tion, !roduction %uantities, such as !oint 5, can be e#cluded from any economic analysis. Points that lie beyond the !roduction !ossibilities frontier, such as !oint P, re!resent, because this curve shows the ma#imum !ossible %uantities of good M and = that the economy is ca!able of !roducing, unattainable production points (greater in!ut of resources), and can also be ruled out. Thus, the curve is, in effect, a really frontier. Two im!ortant notices are to be made regarding the !roduction !ossibilities frontier. . The bowed/out, concave shape of the !roduction !ossibilities frontier is due to the !resum!tion that the economy s resources are not e%ually well suited to the !roduction of both goods M and =. &or e#em!le, for construction !ur!oses, the land from !lane is different from the land from mountains. 2 s!ecial case arises when the resources used to !roduce good = are e0ually well suited for the !roduction of good M. (n this case, the !roduction !ossibilities frontier would not be curved outward. (nstead, it will sim!ly be a straight line, connecting the !oints where the economy is using all of its resources to !roduce good M (!oint +) and where is using all of its resources to !roduce good = (!oint 2). . 3e assumed the use of fi$ed resources and technology. (f the amount of resources available to !roduce goods M and = were to increase as a result of economic growth, then the !roduction !ossibilities curve would shift outward, to the right, im!lying that the economy could !roduce greater

*2

Economics

%uantities of both M and =. The same holds true when im!rovements in technology allow for more efficient use of available resources. (n situations li)e this, !roduction !oints such as !oint P may then become attainable.

,.2. THE O$$O+T0NITY COST The opportunit% cost of a decision or choice that one ma)es is the value of the highest valued alternative that could have been chosen but was instead forgone .sacrificed/. +conomic resources are not com!letely ada!table to alternative uses. This lac( of perfect fle$ibility, or interchangeability, on the part of resources and the resulting increase in the sacrifice of one good that must be made in the ac0uisition of more and more units of another good is the rationale for the law of increasin opportunit% cost . (t is reflected in the sha!e of the !roduction !ossibilities curve. 3hen rational choices are made, o!!ortunity cost always is less than the value of what is chosen. (n the figure *.1, su!!ose that the economy is initially at !oint 1, !roducing 2 units of good M and A units of good =. $onsider what ha!!ens when the economy desires another unit of good M and so changes its production from !oint 1 on the !roduction !ossibilities frontier to !oint $. The o!!ortunity cost of the additional unit of good M is the 2 units of good = (A units of = / 9 units of =) that are forgone in moving from !oint 1 to !oint $. (n the case of the !roduction !ossibilities frontier, where there are only two goods, the highest valued alternative to good M is good = and vice versa. &urther, su!!ose that the economy desires yet another unit of good M and so changes its production from !oint $ on the !roduction !ossibilities curve to !oint J. The o!!ortunity cost of this additional unit of good M is now 3 units (9 units of = E * units of =). (n this e#em!le, the o!!ortunity cost of !roducing one more unit of good M increases as more of good M is !roduced. The e#!lanation is that some of the resources used to !roduce good = are not as well suited to !roduce good M. $onse%uently, as more and more of the economy s resources are devoted to !roducing good M, the o!!ortunity cost of good M, as measured in units of good = forgone, will be increasing. (n summary, the !roduction !ossibilities frontier illustrates four basic economic conce!ts' . the scarcity of resources is im!licit in that all combinations of out!ut lying outside the !roduction !ossibilities curve are unobtainable-

The Economising Problem

*3

: choice is reflected in the need of a society to select among the various attainable combinations of goods lying on the curve. the downward slo!e of the curve im!lies the notion of opportunity cost. the concavity of the curve reveals increasing opportunity costs.

/E7 CO*CE&2Choices .trade#offs/ Production possibilities table Production possibilities curve .frontier/ )nefficient production points >nattainable production points -pportunity cost 6aw of increasing opportunity costs