Introduction To Economics: Topic 1

Outline
1. Basic principles of economics

2. Economic models
Introduction to Economics 3. Positive vs. normative economics
4. The production possibility frontier
Topic 1 5. Trade
What is economics?  Reference: Krugman and Wells (Chapter 1 & 2).
GADE, GDADE, GFICO, GDFICO

Academic Year 2017-2018 Introduction to Economics
GADE, GDADE, GFICO, GDFICO, Academic Year 2017-2018. 2
What is Economics? What is Economics?

 Economics is a social science that studies the  Market economy: an economy in which decisions about
production, distribution and consumption of goods and production and consumption are made by individual
services (from the Greek oikonomia, meaning administration or producers and consumers
management of a household)  (i.e. supply and demand are the result of decentralized decisions by
many producers and consumers).
 Economics is about how society deals with the problem

of scarcity  Command economy: an economy in which decisions about
production, consumption is decided by the government
planning office
 Examples of issues analyzed by economists: Oil price
shocks, income distribution, reforms in education, health
economics, etc.
Introduction to Economics Introduction to Economics

GADE, GDADE, GFICO, GDFICO, Academic Year 2017-2018. 3 GADE, GDADE, GFICO, GDFICO, Academic Year 2017-2018. 4
Outline
Microeconomics vs. Macroeconomics:
 Microeconomics: A. Individual Choice
Set of principles for understanding the economics of how individuals
Branch of economics concerned with how people make make choices
decisions and how these decisions interact.
B. Choice Interaction
(i.e. it deals with the behavior of individual economic units - consumers,
firms, workers, and investors - as well as the markets that these units Set of principles for understanding how individual choices interact
comprise).
2. Economic models
 Macroeconomics: 3. Positive vs. normative economics
Branch of economics concerned with the overall economy 4. The production possibility frontier
(i.e. it deals with aggregate economic variables, such as the level and 5. Trade
growth rate of national output, interest rates, unemployment, and
inflation).  Reference: Krugman and Wells (Chapter 1 & 2).

Basic Principals of Individual Choice

Economics
 4 basic economic principles behind the individual
Making choices and interaction choices:
A. Resources are scarce
B. Opportunity costs: The real cost of
To understand how an economy works, we need to
understand how individuals make choices and how
something is what you must give up to get it
these choices interact with each other. C. Marignal analysis: “How much?” is a
decision at the margin
D. Incentives and self-interest: People take
advantage of opportunities to make
themselves better off
Individual Choice Individual Choice
Resources are scarce Resources are scarce

Scarcity = the gap between human wants and  A resource is anything that can be used to produce
available resources
something else.
 Goods have value because they are scarce.  i.e. any commodities or services used to produce
The more scarce resources are, relative to their demand, goods and services.
the greater their value.
 Resources most used are the primary factors of
 The theories of economics can be applied to any scarce
resource, not just traditional commodities. production:
 Economics is not simply about profits and money!
 land, labor, and capital
It applies anywhere constraints are faced and choices
must be made.

Opportunity Cost Marginal Analysis

 Decisions involve a trade-off: a comparison of the costs
 The real cost of an item is its opportunity cost: with the benefits of doing something.
what you must give up in order to get it.  A trade-off usually refers to losing one quality or aspect of
 Highest valued alternative that must be sacrificed to obtain something in return for gaining another quality or aspect.
something or satisfy a want.
 Many decisions are not “either-or” but instead “how
 The opportunity cost is crucial to understanding much.”
individual choice.  Some of you may decide not to study for the economics
 Ex.: The cost of attending the economics class is what you exam but many of you will decide to study. The question is
must give up to be in the classroom during the lecture. how much: ten hours, twenty hours, thirty hours?
Sleep? Watching TV? Going to the cafeteria? Work?
 Decisions about whether to do a bit more or a bit less of
 All costs are ultimately opportunity costs. an activity are marginal decisions.

Marginal Analysis Incentives and self-interest
 Making trade-offs at the margin: comparing the costs
and benefits of doing a little bit more of an activity versus  People usually exploit opportunities to make themselves
doing a little bit less. better off. Thus, incentives can change people’s behavior.
 Ex.: Studying one more hour, drinking one more beer,  People respond to incentives.
buying one more CD, etc..
 Incentives = anything that offers rewards to people to do
 The study of such decisions is known as marginal something (or change behavior).
analysis.
 Marginal changes in costs or benefits motivate people to
 Marginal benefit: The extra benefit resulting from a
respond.
small increase in some activity.
 Marginal cost: The additional cost resulting from a  Ex.: If people are charged for parking their car at the
small increase in some activity. UPO, we can expect that more people will use the metro.
Choice Interaction Choice Interaction

Choice Interaction Trade: Gains from trade
 5 basic economic principles that underlie the interaction
 In a market economy, individuals engage in trade.
of individual choices:
A. Trade: There are gains from trade.  Trade: individuals provide goods and services to others
B. Equilibrium: Markets move toward equilibrium. and receive goods and services in return.
C. Efficiency: Resources should be used as efficiently  Trade can make everyone better off.
as possible to achieve society’s goals.  There are gains from trade: people can get more of what
D. Markets and efficiency: Markets lead to efficiency they want through trade than they could if they try to be self-
sufficient.
E. Government intervention: When markets don’t
achieve efficiency, government intervention can  Trade allows people to specialize in what they do best.
improve society’s welfare.  Specialization: when each person specializes in the task
that he or she is good at performing.

Trade: Gains from Trade Market Equilibrium
Ed Frascino from cartoonbank.com.
© The New Yorker Collection 1991
 An economic situation is in equilibrium

when no individual would be better off
All Rights Reserved.
doing something different.
 Any time there is a change, the economy

will move to a new equilibrium.
“I hunt and she gathers – otherwise we couldn’t make ends meet.”
 It is beneficial if each person specializes in the task that he or she is good at

 Ex.: What happens when a new
performing. checkout line opens at a busy supermarket?
 The economy, as a whole, can produce more when each person specializes in
a task and trades with others.

Efficiency Efficiency and Equity

 Efficiency means society gets the most that it can from its
 An economy is efficient if it takes all opportunities to
scarce resources.
make some people better off without making other people
worse off.
 Thus, if a situation is efficient, it is not possible to make  Equity means the benefits of that resources are
someone better off without making someone else worse off. distributed ‘fairly’ among the members of society.
 But: people can disagree about what’s “fair”
 Should governments always strive to achieve economic
efficiency?  Even when an efficient solution occurs, it might not be
 Equity issues are also important.
desirable

Markets and Efficiency Markets and Efficiency
 Recall that a market economy is an economy that allocates
resources through the decentralized decisions of many firms  Markets are usually a good way to organize economic
and households as they interact in markets for goods and activity. Why?
services.
- coordinating actions and at transmitting information
- Households decide what to buy and who to work for. - responding to changes in relative scarcity
- Firms decide who to hire and what to produce.
- trade is a good way of increasing social welfare as a whole
 Adam Smith made the observation that households and firms

interacting in markets act as if guided by an “invisible hand”.  However, there are occasions when the free market
(Adam Smith (1776): An Inquiry into the Nature and Causes of the Wealth of Nations) system may not work efficiently and this problem is known in
economics as market failure.

Choice Interaction
Government Intervention Types of market failures

 When market failure occurs, private marginal benefits or  Imperfect competition
costs are not equal to social marginal benefits or costs. = One party prevents mutually beneficial trades from
occurring in the attempt to capture a greater share of
 In the case of market failure, government intervention can resources for itself
improve society’s welfare.  i.e. if the market is "monopolized" or a small group of
 There are various types of market failure: businesses holds significant market power.
 imperfect competition  Imperfect information
 imperfect information, = when different parties have different levels of information.
 public goods,  The market depends on perfect information, so that everyone
 externalities knows all of the options available to them. If this is not
possible, people may not make optimal choices.

Types of market failures Types of market failures
Externalities
Public goods Activity of one entity that affects the welfare of another and is not
Have two key features: reflected in market prices.
 Positive or negative external effects.
 non-rivalry: The same unit of a public good can be
consumed by many individuals: one person enjoying the  External cost
= an uncompensated cost that an individual or firm imposes on
good does not keep others from enjoying it. others. => Negative externality.
 non-excludability: Once a good is provided to some  External benefit
individuals it is not possible (or at least very costly) to = a benefit that an individual or firm confers on others without
exclude others from benefiting from it. receiving compensation. => Positive externality.
 Leads to free-rider problem  Without government intervention, the free market will not lead to
an efficient solution, as prices will reflect private costs, but not the
Examples: street lightning, lighthouses, national defence. additional external costs

Market failures
Example negative externality: Markets and Government Intervention
Pollution is delivered as a
 Market failure is a rational for policy intervention into the
public ‘bad‘ to the laundry market
The pollution is a negative external

 Another rational for government intervention is income
effect to the laundry. It is raising the redistribution.
laundry‘s production costs
 In this case the government intervenes in the market
because of distributional reasons (i.e. social reasons/
reasons of ‘equity’).
The cost for the brickworks The laundry is an unwilling  In this case government intervention usually reduces
of making bricks is less than free rider: It can not charge economic efficiency of the market.
the real cost, which includes a price for the pollution it
the cost of pollution receives

Outline Economic Models
Tunnel vision
1. Basic principles of economics A miniature airplane sitting motionless
2. Economic models in a wind tunnel isn’t the same thing as
3. Positive vs. normative economics an actual aircraft in flight.
4. The production possibility frontier
 But it is a very useful model of a
5. Trade flying plane.
 Reference: Krugman and Wells (Chapter 1 & 2).

Economic theory consists mainly of a
collection of models.

Economic Models Economic Models

What is an economic model ?  An economic model represents economic processes by a
set of variables and a set of logical and/or quantitative
= Simplified representation of a system (of the real world). relationships between them.
 A model tries to preserve the features that are essential to
the question being analysed
 Economists must make a reasoned choice of which
 A model shows how different elements are linked by variables and which relationships between these variables
relationships are.
 Simplification is particularly important for economics given
the enormous complexity of economic processes  The “other things being equal” (ceteris paribus)
assumption is important in economic models.
- It allows to focus on the effects of only one change at a time.

Economic Models Outline
 We construct models in order to explain and understand.
 Why do we want to explain reality? 2. Economic models
a) Pure curiosity. 3. Positive vs. normative economics
b) To know what could happen if something changes. 4. The production possibility frontier
c) To learn, how we can influence the system to come 5. Trade
near an optimal solution

Positive vs. normative

Positive vs. normative economics
economics
 Economics distinguishes between what is and what
should be – Normative vs. Positive
 Positive economics is the branch of economic analysis  Economists can determine
that describes the way the economy actually works. correct answers for positive
– what is questions (forecasts).
 Normative economics makes prescriptions about the

way the economy should work (requires judgment).  But economists may disagree
- what should be in normative questions, which
involve value judgments.

Outline The Production Possibility Frontier
 The Production Possibility Frontier (PPF) is a curve
1. Basic principles of economics depicting all maximum output possibilities for two
goods or services given a set of inputs (resources,
2. Economic models
labor, etc.).
3. Positive vs. normative economics
4. The production possibility frontier  Imagine Robinson Crusoe stranded on a remote island
with limited resources (i.e. the natural resources of the
5. Trade
island, his own time and effort).
 Reference: Krugman and Wells (Chapter 1 & 2).  How to distribute his resources?
- Catching fish, or
- gather coconuts?

The Production Possibility Frontier The Production Possibility Frontier

Quantity of
 The PPF illustrates trade-offs facing an economy that coconuts
produces only two goods. 30 D
- Note: In the example Robinson Crusoe represents a one-man economy Feasible and
efficient Not
in production feasible
 It shows the maximum quantity of one good that can 21
be produced for any given production of the other. 15

A
 The PPF improves our understanding of trade-offs Feasible B

9 but
C
not efficient
Production possibility frontier
PPF
0 12 20 28 40
Quantity of fish

Quantity of
coconuts  A and B are efficient situations, no possibilities are
30 wasted (it is not possible to produce more of one
good without producing less of the other).
21
 C is feasible, but not efficient (it would be possible
A
15 to produce more of both goods).
B
9  D is not feasible.
Production possibility frontier
PPF
0 12 20 28 40
Quantity of fish


Opportunity cost Opportunity cost
 The PPF is also useful in measuring the opportunity  And what is the opportunity cost of catching 20 fish
cost (what has to be sacrificed of one good in order instead of 12?
to obtain one unit of the other good) also 6 coconuts
 What is the opportunity cost of catching 28 fish  Observation: If the PPF has a linear slope, the
instead of 20? trade-off remains constant along the PPF, i.e. we
6 coconuts face a constant opportunity cost.

PPF with increasing opportunity cost The Production Possibility Frontier
Quantity of coconuts Producing the first …requires giving up Opportunity cost
35 20 fish . . . 5 coconuts
30 But producing  What is the opportunity cost of catching 20 fish

20 more fish . . .
A instead of 0? 5 coconuts
25
 And what is the opportunity cost of catching 40 fish

20
…requires giving up
instead of 20? 25 coconuts
15 25 more coconuts…
10  Observation: If the PPF has a nonlinear slope, the

trade-off increases along the PPF, i.e. we face an
5
PPF increasing opportunity cost.
0 10 20 30 40 50
Quantity of fish
The PPF and economic growth Economic growth Economic growth results in an outward
shift of the PPF because production
possibilities are expanded.
Quantity of coconuts
 Economic growth is the growing ability of the 35
The economy can
economy to produce goods and services E
now produce more of
30
everything.
A
 Economic growth can come from two sources: 25 If e.g. production is
initially at point A (20
 Increase in factors of production - resources used to 20 fish and 25
produce goods and services (land, labor and capital) coconuts),  it can
15 move to point E (25
 Technological Improvement - improvement in the fish and 30
technical means of producing goods and services 10 coconuts).
5 Original New
PPF PPF
0 10 20 25 30 40 50
Quantity of fish
Outline Trade
 Now we have a look how gains from trade are
1. Basic principles of economics generated.
2. Economic models  Remember: How can we satisfy our wants and
3. Positive vs. normative economics needs in a economy?
4. The production possibility frontier - We can be economically self-sufficient.
5. Trade - We can specialize and trade with others.
 Let’s suppose that there is a second castaway on

our island (now we have Robinson and Friday).
- Can they benefit from trading with each other?

Trade Trade
a) PPF of Robinson b) PPF of Friday
30 To catch another Fish, Robinson To catch another Fish,

must give up ¾ of a coconut. Friday must give up 2
coconuts.
20
Robinson’s consumption
Friday’s consumption
without trade
without trade
9
8
Robinson’s
Friday’s
PPF
PPF
0 28 40 Quantity of fish 0 6 10
Quantity of fish
Robinson and Friday’s Trade
Opportunity Costs
We can observe that:
Robinson’s Friday’s  Friday is less productive in both (as a maximum he
Opportunity Opportunity can gather 20 coconuts and catch 10 fish).
Cost Cost
 But Friday is especially inefficient in fishing (his
opportunity cost for catching one fish is 2 coconuts).
One fish 3/4 coconut 2 coconuts
 Can both castaway benefit/be better off if they reach
an agreement?
One
4/3 fish 1/2 fish
coconut

Trade Trade
How Robinson and Friday gain from trading with each other
 Both castaways are better off when they each
specialize in what they are good at and trade.
 It’s a good idea for Robinson to catch the fish for
Robinson
both of them, because his opportunity cost of a fish
in terms of coconuts not gathered is only 3/4 of a
Friday
coconut, versus 2 coconuts for Friday.
 Correspondingly, it’s a good idea for Friday to
gather coconuts for the both of them. His => Both Robinson and Friday experience gains from trade
opportunity costs is less, only 1/2 of a fish to 4/3 fish
for Robinson.
Comparative Advantage and Gains from Trade Comparative vs. absolute advantage
(a) Robinson’s Production and Consumption (b) Friday’s Production and Consumption
Quantity of coconuts Quantity of coconuts

 An individual has a comparative advantage in
producing a good or service if the opportunity cost of
producing the good is lower for that individual than for
30 Robinson’s consumption
without trade Friday’s production other people.
with trade
Robinson’s  An individual has an absolute advantage in an activity if
consumption with trade 20
Friday’s consumption
with trade
he or she can do it better than other people.
10
Robinson’s
production with 10 Friday’s consumption
 Having an absolute advantage is not the same thing as
9 trade 8 without trade having a comparative advantage. You can have an
Robinson’s Friday’s absolute advantage in both goods and still benefit from
PPF PPF
0 2830 40 Quantity of fish 0 6 10
trade.
Quantity of fish

Comparative advantage and trade
 Comparative advantage and differences in opportunity

costs are the basis for specialized production and
trade.
 Whenever potential trading parties have differences in
opportunity costs, they can each benefit from trade.
 Benefits from trade: Trade can benefit everyone in a
society because it allows people to specialize in
activities in which they have a comparative advantage.
Introduction to Economics
GADE, GDADE, GFICO, GDFICO, Academic Year 2017-2018. 59

Introduction To Economics: Topic 1

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Outline

1. Basic principles of economics

GADE, GDADE, GFICO, GDFICO

What is Economics? What is Economics?

 Economics is about how society deals with the problem

Introduction to Economics Introduction to Economics

Introduction to Economics Introduction to Economics

Basic Principals of Individual Choice

Resources are scarce Resources are scarce

Introduction to Economics Introduction to Economics

Individual Choice Individual Choice

Opportunity Cost Marginal Analysis

Introduction to Economics Introduction to Economics

Choice Interaction Choice Interaction

Introduction to Economics Introduction to Economics

 An economic situation is in equilibrium

doing something different.

 Any time there is a change, the economy

 It is beneficial if each person specializes in the task that he or she is good at

Introduction to Economics Introduction to Economics

Choice Interaction Choice Interaction

Efficiency Efficiency and Equity

Introduction to Economics Introduction to Economics

 Adam Smith made the observation that households and firms

Introduction to Economics Introduction to Economics

Government Intervention Types of market failures

Introduction to Economics Introduction to Economics

Introduction to Economics Introduction to Economics

The pollution is a negative external

Introduction to Economics Introduction to Economics

 Reference: Krugman and Wells (Chapter 1 & 2).

Introduction to Economics Introduction to Economics

Economic Models Economic Models

Introduction to Economics Introduction to Economics

Introduction to Economics Introduction to Economics

Positive vs. normative

 Normative economics makes prescriptions about the

Introduction to Economics Introduction to Economics

Introduction to Economics Introduction to Economics

The Production Possibility Frontier The Production Possibility Frontier

be produced for any given production of the other. 15

 The PPF improves our understanding of trade-offs Feasible B

Introduction to Economics Introduction to Economics

Introduction to Economics Introduction to Economics

The Production Possibility Frontier The Production Possibility Frontier

Introduction to Economics Introduction to Economics

30 But producing  What is the opportunity cost of catching 20 fish

 And what is the opportunity cost of catching 40 fish

10  Observation: If the PPF has a nonlinear slope, the

 Let’s suppose that there is a second castaway on

Introduction to Economics Introduction to Economics

30 To catch another Fish, Robinson To catch another Fish,

Introduction to Economics Introduction to Economics

Quantity of coconuts Quantity of coconuts

Introduction to Economics Introduction to Economics

Comparative advantage and trade

 Comparative advantage and differences in opportunity

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