FIRST INTRODUCTION TO. Dr. Mohammed A. Alwosabi. ECON140: Microeconomics Ch.1 Dr. Mohammed Alwosabi. Chapter 1

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1 Chapter 1 FIRST INTRODUCTION TO ECONOMICS Dr. Mohammed A. Alwosabi 1 The Fundamental Problem of Economics: Scarcity and Choice It is a fact of life that we cannot get everything we want. We all want more than we can get. Our inability to satisfy all our "unlimited wants" because of our "limited resources" is called scarcity. We live in a world of scarcity of resources relative to human wants. Scarcity means that unlimited wants always exceed the limited resources available to 2 satisfy them. Scarcity does not imply poverty. Every individual, every firm, and every countryregardless of its economic system or the level of development- experiences scarcity. Scarcity applies to money and time, Scarcity confronts (experienced by) every one whether they are poor or rich. Scarcity cannot be eliminated so we have to learn how to cope with it. The existence of scarcity forces us to make choices. 3 A choice is a comparison of alternatives. The choices we make depend on the incentives we face. An incentive is a reward that encourages an action (or choice) or penalty that discourages an action (or a choice). The incentives that t we face will influence the choices that we make when dealing with scarcity. For example, if a price of a good falls, people have incentive to buy more of that good. 4 Incentives are influenced by the changes in the marginal benefits (MB) and marginal costs (MC) and hence, lead to changes in our choices People compare the benefit from a small change in an activity (MB) to the cost of making a small change in an activity (MC). MB is the benefit from one more unit of an activity (or the benefit from a small change in an activity). MC is the opportunity cost of one additional activity (the opportunity cost of a small change in an activity). 5 A change in a MB or in a MC changes the incentives that we face and leads us to change our choices. If MB > MC, people have an incentive to do more of that activity. If MB < MC, people have an incentive to do less of that activity. Optimization is making the best use of the available resources given the available information and technology. Optimization implies that people choose only the actions that will bring greater MBs than MCs 6 1

2 Trade off Every choice has its tradeoff an exchange. To get more of one thing you have to get less of something else. A tradeoff is giving up one thing to get something else. The big tradeoff is the tradeoff between efficiency and equity at business level and at government level. Thinking about a choice as a tradeoff emphasizes cost as an opportunity forgone. What we give up is the cost of what we get. Economists call this cost the opportunity 7 cost. Opportunity Cost: Every time we choose to use scarce resources in one way, we give up the opportunity to use them in other ways. The opportunity cost of making a choice is the highest-valued thing we give up in order to get something else. The best thing you choose not to do is the opportunity cost of the thing that you choose to do. The forgone alternative or the next best alternative is the opportunity cost of the thing that you choose to do. 8 The opportunity cost of an increase in one extra action is its marginal cost. In a world of scarcity, everything we do involves an opportunity cost. If there is no scarcity (resources are not limited), there will be no opportunity cost (i.e., opportunity cost is zero) Example: Suppose on one Thursday night, you can do only one of three actions. You rank these three alternatives as follows: meet your friends, study ECON140 or watch your favorite show on TV. What is the opportunity cost of meeting your friend? 9 Example: Suppose Ahmed is faced with two choices: either to work and get BD500 or study at the local university and pay BD200 tuition for the course and BD50 to buy the textbooks. If Ahmed decides to join the university, what is the opportunity(ies) cost(s) of joining the university? 10 Exercise: Suppose you have a holiday for one week and you have 3 choices: to go to Mekka for Umrah, to go to Dubai, or to spend the week preparing for the midterm exams. If you decide to go for Umrah, what is the opportunity cost of the week? 11 FACTORS OF PRODUCTION The factors of production are the productive resources (also called inputs) used to produce goods and services. The four basic factors of production (the inputs) are: 1. Land: refers to all natural resources on the ground, above it, and beneath it such as water, air, oil, and minerals. Rent is the reward (return or income) for using land. 12 2

3 2. Labor: refers to the time and efforts that people devote to produce goods and services. Labor involves mental and physical skills and abilities of people to produce goods and services. Quantity and quality are included in the "labor" factor. The quality of labor depends on human capital. Human Capital refers to the knowledge and skills that people obtain from education, on-the-job training, and work experience. Wage is the income for labor. 3. Capital: final goods produced to be used in producing other goods and services, e.g., equipments, machines, tools, and structures. Interest is the reward for using capital In everyday terms, we talk about money, stocks, and bonds as being capital. These items are financial capital. They play an important role in providing businesses and individuals with financial resources, but they are not used to produce goods and services. Because financial capital are not productive resources, they are not part of capital in economic definition Entrepreneurship: refers to organizing and managing the resources to produce new or improved goods or services. An entrepreneur is an innovator who comes up with new ideas, brings resources together, organize them and manage them to produce new or improved products and technologies. An entrepreneur is a risk taker. He bears the risks that arise from his business decisions. The reward for entrepreneur is profit. 16 ECONOMICS: Economics is a social science that studies how best individuals, businesses, governments, and societies make their choices to cope with scarcity (to allocate scarce resources among competing uses). The study of economics is typically divided into two main branches: microeconomics and macroeconomics. Microeconomics is the study of individual behavior and choices in the economy. The focus of microeconomics is on the individual consumers, individual firms, individual industries and individual markets. It studies supply and demand in individual markets, the prices and quantities of inputs and individual goods and services, production processes, cost structure for individual goods and services, and distribution of goods and services

4 Macroeconomics studies the total (aggregate) behavior and performance of an entire economy (country) or the global economy. It focuses on the total (aggregate) economic activity such as the total output, total employment, total income, inflation, and government policies such as government spending and taxation, and so forth. Macroeconomic policies such as fiscal policy and monetary policy focus on national goals such as achieving full employment, reducing inflation, smoothing business cycle, and increasing the economic growth of the country. 19 ECONOMY An economy is simply a collection of all our production and consumption activities in a defined geographical area Bahrain economy, German economy, Japanese economy, or the global economy. What people collectively produce is what the economy produces, what people collectively consume is the economy's consumption. 20 An economy is also called economic system. Economic system can be defined as a mechanism (a way) that is used by a society to allocate (decides how to use) its limited resources among the competing uses to satisfy the human wants. This mechanism answers the two big Economic questions that summarize the scope of economics. 1. How do choices end up determining what, how, and for whom goods services are produced? 2. How can choices made in the pursuit of self-interest also promote the social interest? What, How, and For Whom? Goods and Services are the objects that people value and produce to satisfy human wants Goods are physical objects such apple, laptops, and cars. Services are tasks performed for people such as auto-repair, hair-cut saloons, and doctors clinics We will discuss the three questions of what, how and for whom to emphasize the concepts of choices and tradeoff What goods and services to produce with our limited resources and in what quantities (types of gods and services). What to produce varies across countries and over time. 1. How to produce the goods and services we select using the available factors of production (production methods). 2. For whom goods and services are produced depends on the incomes that people earn. (who consumes these goods and services) 24 4

5 Self-interest vs. Social-interest A choice is in your self-interest if you think that choice is the best one available for you. Social interest occur if the outcome of an action or a choice is the best for the society as a whole. Economists try to find the factors that assure pursuing self- interest does not contradict promoting social interest and work out the trade off between efficiency and equity 25 ECONOMICS AS A SOCIAL SCIENCE Economics is a social science. Like all other sciences, in order to discover how an economic world works, economists distinguish between two types of statements: positive statements and normative statements. 26 Positive statements are statements about "what is". They describe how the world actually exists or behaves. They are objective statements. They may be right or wrong. Positive statement can be tested and checked. Examples of positive statements: The high temperature today was 35 degrees. Higher interest rates reduce the total amount of borrowing. Bahrain economy has lower unemployment than Saudi's economy The American stock market boomed in the 1990s 27 Normative statements are statements about "what ought to be". They describe how the world should exist or behave. Normative statements are subjective and matters of opinions. That you agree or disagree with them. Normative statements cannot be tested. Examples of normative statements: It was too hot today. 5% unemployment rate is too high. It is desirable to have a minimum wage law Every citizen must have a free health care 28 The task of economics is to discover positive statements that are consistent with what we observe and that helps us to understand how the economic world works. This task can be divided into three steps: 1. observation and measurement, 2. model building, and 3. testing models. An economic model is an explanation and simple representation of some aspect of the economic world that includes only those features of the world that are needed for the purpose at hand. Every economic model is based on a set of assumptions and results in some implications

6 Economic model is a diagrammatic, mathematical, written or verbal representation of the economy. Economic models are used to explain and predict economic behavior, and to design and evaluate economic policies. The success of a model is judged by its ability to predict. An economic theory is a general rule or principle that enables us to understand and predict the economic behavior and performance by people, firms and the entire economy. It explains the relationship between factors. It is a bridge between a model and reality. Economic theory is a proposition about which model work Unscrambling cause-and-effect: Ceteris Paribus Most economic behavior has many simultaneous causes. Confusion can result when too many things change and so it might not be possible to understand what caused what. So, in their models, economists change one factor at a time, holding all other relevant factors unchanged, to isolate (unscramble) the factor of interest and investigate its effects in a clear way. 33 To identify cause and effect, economist use a Latin phrase called ceteris paribus Ceteris Paribus means 1. other things being equal, 2. other things being constant, 3. nothing else changing, or 4. everything else remains the same, "Ceteris Paribus" assumption is necessary because of complexity of real economy. It makes it easier to formulate economic theory and policy, but it also increases the risk of error. 34 Economists try to avoid fallacies (errors of reasoning that lead to a wrong conclusion). But two fallacies are common, and you have to be careful and alert to avoid them. They are: 1. The Fallacy of Composition is the (false) statement that what is true for the parts is true of the whole or that what is true for the whole is true of the parts. For example, one person can walk through the door into the class, so the entire 40-person class can simultaneously walk through the door The Post Hoc Fallacy means after this, therefore, because of this. This fallacy is a (false) claim that a first event causes a second event because the first occurred before the second. 36 6

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