Economic Principles

Olta Myslimi ECON 200

1. Invisible Hand
➢ Characterizes the mechanisms through which beneficial social and economic outcomes may arise from the
accumulated self-interested actions of individuals, none of whom intends to bring about such outcomes.
➢ To explain the division of labour, the emergence of a medium of exchange, the growth of wealth, the patterns
(such as price levels) manifest in market competition, and the institutions and rules of society.
➢ The invisible market force that brings a free market to equilibrium with levels of supply and demand by actions of
self-interested individuals.
➢ The benefits derived from the free market are maximum and more than those in a regulated and planned
economy.
Every individual, acting in their self-interest, generates a demand or supply which compels others to buy or sell
goods or services. In return, he either receives or pays compensation and one party makes a profit. In this
process of exchange in a free economy, resources are allocated in the most efficient manner.
➢ If each consumer is allowed to choose what and how much to buy and each producer is free to choose its
production quantity, technique, and prices, it will be beneficial, as a whole, to the economy. Producers would use
an efficient method of production to cut costs and charge low prices to maximize revenue. Consumers would buy
from sellers who offer the lowest price. Also, investors would invest in industries that maximize their return. All
this would take place automatically if the economy is set free.
2. Opportunity Cost
• Your decision involves a trade-off—a comparison of costs and benefits
• Decisions about whether to do a bit more or a bit less of an activity are marginal
decisions. The study of such decisions is known as marginal analysis. An incentive is
anything that offers rewards to people who change their behavior.
• When you try to predict how individuals will behave in an economic situation, it is a very
good bet that they will respond to incentives—that is, exploit opportunities to make
themselves better off. Furthermore, individuals will continue to exploit these
opportunities until they have been fully exhausted.
• In fact, the principle that people will exploit opportunities to make themselves better off
is the basis of all predictions by economists about individual behavior. If the earnings of
those who get MBAs soar while the earnings of those who get law degrees decline, we
can expect more students to go to business school and fewer to go to law school
3. Specializations=Gains from Trade
• Interaction of choices—my choices affect your choices, and vice versa—is a feature of
most economic situations.
• In a market economy, individuals engage in trade: they provide goods and services to
others and receive goods and services in return.
• There are gains from trade: people can get more of what they want through trade than
they could if they tried to be self-sufficient. This increase in output is due to
specialization: each person specializes in the task that he or she is good at performing.
The economy, as a whole, can produce more when each person specializes in a task and
trades with others.
4. Models in Economics
A model is a simplified representation of a real situation that is used to better understand real-life
situations.
One possibility—an economist’s equivalent of a wind tunnel—is to find or create a real but
simplified economy.
➢ For example, economists interested in the economic role of money have studied the system of
exchange that developed in World War II prison camps, in which cigarettes became a
universally accepted form of payment even among prisoners who didn’t smoke. Another
possibility is to simulate the workings of the economy on a computer.
➢ For example, when changes in tax law are proposed, government officials use tax models—
large mathematical computer programs—to assess how the proposed changes would affect
different types of people. Models are important because their simplicity allows economists to
focus on the effects of only one change at a time. (CETERIS PARIBUS the other things equal
assumption means that all other relevant factors remain unchanged)
5. Three key Concepts in Economics Models
1. The production possibility frontier illustrates the trade-offs facing
an economy that produces only two goods. It shows the maximum
quantity of one good that can be produced for any given quantity
produced of the other.
2. Comparative advantage, a model that clarifies the principle of gains
from trade—trade both between individuals and between
countries.
3. Circular-flow diagram, a schematic representation that helps us
understand how flows of money, goods, and services are channeled
through the economy.
5.1 Production
Possibility
Frontier (PPF)
By simplifying reality, the
production possibility frontier
helps us understand some
aspects of the real economy
better than we could without
the model: efficiency,
opportunity cost, and
economic growth. There is a
crucial distinction between
points inside or on the
production possibility frontier
(the shaded area) and outside
the frontier.
5.1 Efficiency in Production

The economy is efficient if there are no missed opportunities—there is no way to

make some people better off without making other people worse off.
One key element of efficiency is that there are no missed opportunities in
production—there is no way to produce more of one good without producing less of
other goods.
Efficiency in production is only part of what’s required for the economy as a whole to
be efficient. Efficiency also requires that the economy allocate its resources so that
consumers are as well off as possible. If an economy does this, we say that it is
efficient in allocation.
5.1 Opportunity Cost in Production: A.1

If Boeing increases its production of small jets from

28 to 40, the number of Dreamliners it produces
falls from 9 to zero. So Boeing’s opportunity cost
per additional small jet is 9 /12 = 3 /4 of a
Dreamliner, the same as it was when Boeing went
from 20 small jets produced to 28.
Whenever we assume that the opportunity cost of
an additional unit of a good doesn’t change
regardless of the output mix, the production
possibility frontier is a straight line.
5.1 Opportunity Cost in Production: A.2
The more small jets it produces, the more costly it is
to produce yet another small jet in terms of forgone
production of a Dreamliner. And the same holds true
in reverse. For example, to go from producing zero
small jets to producing 20, Boeing has to forgo
producing 5 Dreamliners. That is, the opportunity cost
of those 20 small jets is 5 Dreamliners.

Opportunity costs increase as you allocate resources

to the production of each additional alternative unit.
This can arise when it's necessary for businesses with
limited resources to choose between the production
of two different goods.
 5.1 Economic Growth and PPF

➢ Economic growth: the growing

ability of the economy to produce
goods and services.
➢ Economic growth means an
expansion of the economy’s
production possibilities; that is, the
economy can produce more of
everything.
 What can lead the production
possibility frontier to shift outward?
1. Factors of Production are
5.1 Economic resources used to produce goods
Growth and and services
PPF 2. Technology is the technical
means for producing goods and
services
5.2 Comparative Advantage

Gains from trade—the mutual gains that individuals

can achieve by specializing in doing different things
and trading with one another.

A country has a comparative advantage in producing

a good or service if its opportunity cost of producing
the good or service is lower than other countries’.
5.2 Comparative Advantage
5.2 Comparative Advantage

▪ The United States can produce 40 small jets if it makes no large jets and can manufacture 30
large jets if it produces no small jets. Recall that this means that the slope of the U.S.
production possibility frontier is −3 /4: its opportunity cost of 1 small jet is 3 /4 of a large jet.
▪ Brazil’s production possibility frontier has a constant slope of – 1 /3. Brazil can’t produce as
much of anything as the United States can: at most it can produce 30 small jets or 10 large
jets. But it is relatively better at manufacturing small jets than the United States; whereas the
United States sacrifices 3 /4 of a large jet per small jet produced, for Brazil the opportunity
cost of a small jet is only 1 /3 of a large jet.
 5.2 Comparative Advantage

What we would say in this

case is that the United
States has a comparative
advantage in the
production of large jets and
Brazil has a comparative
advantage in the
production of small jets.
5.3 Transactions: The Circular-Flow Diagram

Trade takes the form of barter

The circular-flow diagram
when people directly exchange
represents the transactions in
goods or services that they
an economy by flows around a
have for goods or services that
circle.
they want.
5.3 Transactions:
The Circular-Flow
Diagram

• This diagram represents the flows of

money and of goods and services in the
economy.
• In the markets for goods and services,
households purchase goods and services
from firms, generating a flow of money to
the firms and a flow of goods and
services to the households.

• The money flows back to households

as firms purchase factors of production
from the households in factor markets.
Review Key Concepts
1. The production possibility frontier model illustrates the concepts of
efficiency, opportunity cost, and economic growth.
2. Every person and every country has a comparative advantage in
something, giving rise to gains from trade. Comparative advantage is
often confused with absolute advantage.
3. In the simplest economies people barter rather than transact with
money. The circular-flow diagram illustrates transactions within the
economy as flows of goods and services, factors of production, and
money between households and firms. These transactions occur in
markets for goods and services and factor markets. Ultimately, factor
markets determine the economy’s income distribution.