COMMONWEALTH OF AUSTRALIA

Copyright Regulations 1969

WARNING
This material has been reproduced and communicated to you by or on behalf of Monash University pursuant
to Part VB of the Copyright Act 1968 (the Act).
The material in this communication may be subject to copyright under the Act. Any further reproduction or
communication of this material by you may be the subject of copyright protection under the Act.
Do not remove this notice.
MCD2020 2
 AFTER LEARNING TOPIC 1, YOU SHOULD BE ABLE TO:

1. Explain what is economics

2. Understand the five foundations of economics

3. Understand how do economists study the economy

4. Explain what is a production possibilities frontier

5. Understand how comparative advantage explains specialisation

and gains from trade

6. Explain how investment in capital facilitate growth

MCD2020 3
 WHAT IS ECONOMICS?

• Economics: The study of how individuals and societies allocate

their limited resources to satisfy their practically unlimited wants.

• Economics is a social science that studies how people behave.

MCD2020 4
 MICROECONOMICS AND MACROECONOMICS
Microeconomics
• The study of individual units that
make up the economy
• Focus is on individuals,
businesses, industries
• Example: How does a rise in sales
taxes impact the retail industry?
MCD2020
Macroeconomics
• The study of the overall aspects
and workings of an economy
• Focus is on “big picture”
• Example: Is the economy of Japan
in a recession?
5
 SCARCITY

• Scarcity: The inherently limited nature of society’s resources,

given society’s unlimited wants and needs.

• Economics seeks to answer how individuals and societies make

decisions about scarce resources.

MCD2020 6
 FOUNDATIONS OF ECONOMICS

Economists use these five principles to think of every issue:

• Incentives

• Trade-offs

• Opportunity cost

• Marginal thinking

• Trade creates value

MCD2020 7
 INCENTIVES MATTER - 1

• Incentives: Factors that motivate you to act or exert effort.

• Incentives are used to affect how people respond.

• Example: Getting paid to do a job.

MCD2020 8
 INCENTIVES MATTER - 2
Positive Incentives
• Encourage action by offering
rewards or payments.
• Example: Extra credit for
participating in class.
MCD2020
Negative Incentives
• Discourage action by providing
undesirable consequences or
punishments.
• Example: Going to jail for stealing
candy from a store.
9
 TRADE-OFFS

• With scarce resources, people have to choose some things over

others.

• Doing one thing often means you will not have the time,
resources, or energy to do something else.

• Every trade-off incurs a cost.

MCD2020 10
 OPPORTUNITY COST

• Opportunity cost: The next best (highest-

valued) alternative that must be sacrificed to
get something else.

• The best possible decision is the one that

minimizes the opportunity cost.

• What is the opportunity cost of going to

college?

MCD2020 11
 MARGINAL THINKING - 1

• Economic thinking: A purposeful evaluation of the available

opportunities to make the best decision possible.

• Requires marginal thinking.

MCD2020 12
 MARGINAL THINKING - 2

• Marginal thinking: Evaluating whether the benefit of one more unit of

something is greater than its cost.

• Marginal benefit: Additional benefit derived from extra unit.

• Marginal cost: Additional cost incurred from extra unit.

MCD2020 13
 TRADE CREATES VALUE - 1

• Trade: The voluntary exchange of goods and services between

two or more parties.
• Trade creates value.
• Without trade, you would have to produce everything you
consume.
• Trade fosters exchange of goods and promotes specialization

MCD2020 14
 TRADE CREATES VALUE - 2

Markets facilitate trading

Markets bring buyers and sellers together to exchange goods and

services.

Example: Supermarkets, eBay, Queen Victoria market

MCD2020 15
 ECONOMIC MODELS

• Models are simplified versions of reality used to understand the

complex real-world economy.

• Models simplify reality by making assumptions.

• Good models are simple, flexible, and accurate in making

predictions.

MCD2020 16
 CETERIS PARIBUS

• Ceteris Paribus means “other things being equal” in Latin.

• Central assumption in model building.

• Allows economists to study the effect of one variable by holding

everything else constant .

MCD2020 17
 TYPES OF FACTORS

Endogenous Factors Exogenous Factors

• Variables that can be • Variables that cannot be
controlled for inside a accounted for in a model.
model.

As more exogenous variables are added into the model

(making them endogenous), the more realistic the
model becomes.

MCD2020 18
 PRODUCTION POSSIBILITIES FRONTIER - 1

• Production possibilities frontier (PPF): Model that illustrates the

combinations of outputs a society can produce if all of its resources are
being used efficiently.

Assumptions

• ceteris paribus

• Technology fixed.

• Quantity of resources fixed.

• Society produces only two goods.

MCD2020 19
 PRODUCTION POSSIBILITIES FRONTIER - 2

• When the economy is operating on the curve, to increase the

production of one good, must give up another.

• The slope of the PPF will be the opportunity cost of producing

good Y in terms of good X.

MCD2020 20
 PRODUCTION POSSIBILITIES FRONTIER - 3

MCD2020 21
 PPF AND OPPORTUNITY COST - 1

• Law of increasing opportunity cost: The opportunity cost of producing a

good rises as society produces more of it.

• Not all resources are perfectly adaptable for producing both goods.

• The opportunity cost of producing a good will rise as we produce more

of it.

• Effect on PPF:
o The slope will get steeper as we move left to right.

MCD2020 22
 PPF AND OPPORTUNITY COST - 2

MCD2020 23
 PPF AND ECONOMIC GROWTH - 1

Economic growth:

• Enables a society to produce more output;

• Is shown by an outward shift.

• Increase in resources

• Improvement in technology

MCD2020 24
 PPF AND ECONOMIC GROWTH – 2

TYPES OF GOODS
Consumer goods
• Goods produced for current consumption.
• Example: Food.

Capital goods
• Goods that help produce other valuable goods.
• Example: Factories.

MCD2020 25
 CAPITAL GOODS AND FUTURE GROWTH - 1

• Investment in capital goods instead of producing consumer goods

will allow an economy to expand its PPF in the future.
• Investment: Using resources to create or buy new capital.

MCD2020 26
 CAPITAL GOODS AND FUTURE GROWTH - 2

• The more capital goods are produced, the more the PPF will
expand in the long-run

MCD2020 27
 INVESTMENT IN HUMAN CAPITAL

• Investment does not necessarily have to be toward capital goods.

• Investment can also go toward human capital in forms such as

going to college or acquiring new skills.

MCD2020 28
 SPECIALIZATION AND TRADE - 1

• Like an increase in resources and improvements in

technology, specialization and trade also generate gains
for society.

• Specialization: The limiting of one’s work to a particular

area.

MCD2020 29
 SPECIALIZATION AND TRADE - 1

Assumptions (ceteris paribus):

• Technology is fixed.

• Quantity of resources is fixed.

• Society produces only two goods.

• Two people (countries) that have different abilities in the

production of the two goods.

MCD2020 30
 ABSOLUTE AND COMPARATIVE ADVANTAGE

Absolute Advantage Comparative Advantage

• One producer’s ability • The ability to make a
to make more than good at a lower
another producer with opportunity cost than
the same quantity of another producer.
resources.

Differences in producers’ ability to produce goods allows

them to specialize in what they have a comparative
advantage in and trade for other goods that they want.

MCD2020 31
 ADVANTAGES FROM TRADE - 1

• Who has absolute advantage in pizzas? And in wings?

• Should the same person produce both pizzas and wings?
• Who has comparative advantage in pizzas? And in wings?

Daily Production
Person Pizzas Wings
Gwen 60 120
Blake 24 72

MCD2020 32
 ADVANTAGES FROM TRADE - 2

MCD2020 33
 FINDING THE PRICE FOR TRADING

• As long as the terms of trade are between the opportunity costs of

the trading partners, the trade benefits both sides.

Person Opportunity Cost Ratio

1 pizza equals 2
Gwen 1:2 = 0.50
wings
19 pizzas for 47
Terms of trade 19:47 = 0.40
wings
1 pizza equals 3
Blake 1:3 = 0.33
wings

MCD2020 34