Introduction to economics Topic 1 1 Fundamental

Introduction to economics Topic 1 1

Fundamental economic terms n Scarcity n Choice n Opportunity cost n Incentives 2

Scarcity n SCARCITY = inability to satisfy all our wants; the imbalance between our desires and means of satisfying them. 3

Choice n CHOICE = the decision to use scarce resources for one purpose, sacrificing other purposes. 4

Opportunity cost n OPPORTUNITY COST = the cost of choosing to use resources for one purpose measured by sacrifice of the next best alternative for using those resources; opportunity cost of something is the highest-valued alternative that we must give up to get it. n TINSTAAFL (TANSTAAFL)! 5

TINSTAAFL n „There is no such thing as a free lunch”. (Anonymous) n …meaning „Nothing in our life is for free”. 6

Incentive n INCENTIVE = a reward that encourages an action or a penalty that discourages one. Source: Parkin 7

Scope of economics in a nutshell n All economic questions arise because we want more than we can get. 8

Economics n n n ECONOMICS = the study of how human beings make choices to use scarce resources in order to satisfy their unlimited (and often conflicting) needs. ECONOMICS = social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity, and the incentives that influence and reconcile those choices. ECONOMICS = science that studies the choices that can be made when there is scarcity. Source: Parkin; O'Sullivan & Sheffrin 9

Branches of economics n MICROECONOMICS = the study of the choices that individuals and businesses make, the way these choices interact, and the influence of governments. n Source: Parkin MACROECONOMICS = the study of the performance of the national economy and the global economy. 10

Types of economic reasoning n POSITIVE ECONOMICS predits the consequences of alternative actions, answering questions „What is? ” or „What will be? ” n „All my economists say, Give me a one-handed economist!” (Harry Truman) n Source: O'Sullivan & Sheffrin NORMATIVE ECONOMICS answers the question „What ought to be? ” 11

Economic way of thinking n Three elements of the economic way of thinking: q utilization of assumptions (abstract to simplify), q isolation of variables (use ceteris paribus rule), q thinking at the margin (check the results of oneunit change). Source: O'Sullivan & Sheffrin 12

The key principles of economics n The principle of opportunity cost n The marginal principle n The principle of diminishing returns 13

The principle of opportunity cost n To get something you have to sacrifice something else. TINSTAAFL. 14

The marginal principle n Increase the level of an activity if its marginal benefit exceeds its marginal cost; reduce the level of an activity if its marginal cost exceeds its marginal benefit; if possible, pick the level at which the activity’s marginal benefit equals its marginal cost. MB = MC. Source: O'Sullivan & Sheffrin 15

The principle of diminishing returns n Suppose output is produced with two or more inputs and we increase one input while holding the other input or inputs fixed. Beyond some point – called the point of diminishing returns – output will increase at a decreasing rate. Source: O'Sullivan & Sheffrin 16

Diminishing returns – an example n Let’s say that we use 3 machines (fixed capital) to produce a good and we measure output at various levels of employment (changing labor). Amount of labor (number of workers) Total production Additional production 0 0 - 1 0, 8 2 1, 8 1, 0 3 3, 1 1, 3 4 4, 3 1, 2 5 5, 4 1, 1 6 6, 3 0, 9 7 7, 0 0, 7 8 7, 5 0, 5 17

The key principles of economics in motion n Say that a hypothetical economy produces two goods: meals and films. The table below presents production results of various combinations of employment in two sectors of the economy. Combination Employment in meals sector Production of meals Employment in films sector Production of films A 4 25 0 0 B 3 22 1 9 C 2 17 D 1 10 3 24 E 0 0 4 30 18

Production possibilities curve (PPC) n PRODUCTION POSSIBILITIES CURVE – a curve that shows all possible combinations of two goods that can be produced with available resources and current technology. 19

PPC – things to remember n n It illustrates fundamental terms of economics: scarcity, choices, opportunity cost, incentives. Points below, on, and above PPC have different meanings: q q q n below – attainable but inefficient (we’re giving up more than necessary of one good to produce a given quantity of the other good), on – attainable and efficient, above – unattainable. We achieve production efficiency if we produce goods and services at the lowest possible cost. 20

PPC – things to remember (cont. ) n n n PPC shifts inwards / outwards because of changes in inputs and / or technology. PPC is outward bowed reflecting rising opportunity cost (decrease in the quantity produced of one good divided by the increase in the quantity produced of another good). Opportunity cost increases for at least two reasons: q q the law of diminishing returns, resources are not equally productive in all activities. 21

Why do we study PPC? n Because it it simplified representation of reality which gives you a perspective of the big picture of how the economy works. 22