WEEK 4: Economics: Foundations and Models

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1 WEEK 4: Economics: Foundations and Models Economics: study of the choices people and societies make to attain their unlimited wants, given their scarce resources Market: group of buyers and seels of good or service and the institution or arrangement by which they come together to trade Three important ideas in economics: 1. People are rational 2. People response to economic incentives 3. Optimal decisions are made at the margin Marginal analysis: analysis that involves comparing marginal benefits and marginal costs Scarcity: The situation in which unlimited wants exceed the limited resources available to fulfil those wants. Resources: Inputs used to produce goods and services, including natural resources such as land, water and minerals, labour, capital and entrepreneurial ability. Trade-off: The idea that, because of scarcity, producing more of one good or service means producing less of another good or service. Trade-offs force society to make choices: 1. What goods and services will be produced 2. How will the goods and services be produced 3. Who will receive the goods and services produced 1. What goods and services will be produced? When choosing between alternative options, economists use the concept of opportunity cost. - Opportunity cost: The opportunity cost of any activity is the highest-valued alternative that must be given up to engage in that activity. 2. How will the goods and services be produced? In many cases, firms face a trade-off between using more workers and using more machines. 3. Who will receive the goods and services produced? This largely depends on how income is distributed. Centrally planned vs. market economics: Centrally planned economy: economy in which the government decides how economic resources will be allocated Market economy: economy in which the decisions of households and firms interacting markets allocate economic resources A central feature of market economies is consumer sovereignty. o o Consumer sovereignty: The concept that in a market economy it is ultimately consumers who decide what goods and services will be produced. This occurs because firms must produce goods and services that meet the wants of the consumers, or the firms will go out of business. The modern mixed economy Mixed economy: An economy in which most economic decisions result from the interaction of buyers and sellers in markets, but in which the government plays a significant role in the allocation of resources.

2 Efficiency and equity Productive efficiency: When a good or service is produced using the least amount of resources. Allocative efficiency: When production reflects consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Dynamic efficiency: Occurs when new technology and innovation are adopted over time Voluntary exchange: Occurs in markets when both the buyer and seller of a product are made better off by the transaction. Equity: The fair distribution of economic benefits between individuals and between societies. An efficient outcome may or may not be considered by society to be equitable. Economic Models: Economic models: Simplified versions of reality used to analyses real-world economic situations. Economic variable: Something measurable that relates to resources that can have different values, for example, wages, prices, liters of petrol. Economic models make behavioral assumptions about the motives of consumers and firms. To develop a model economists generally follow these steps: 1. Decide on the assumptions to be used in developing the model. 2. Formulate a testable hypothesis. 3. Use economic data to test the hypothesis. 4. Revise the model if it fails to explain the economic data. 5. Retain the revised model to help answer similar economic questions in the future. Forming and testing hypotheses in economic models A hypothesis in an economic model is a statement that may be either correct or incorrect about an economic variable. In testing hypotheses, economists distinguish between correlation and causality. Normative and positive analysis Positive analysis: Analysis concerned with what is, and involving value-free statements that can be checked by using the facts. Normative analysis: Analysis concerned with what ought to be, and involving value judgements, which cannot be tested.

3 WEEK 1: Choices and Trade-Offs in the Market Graphing the Production Possibility Frontier Production possibility frontier: a curve showing the maximum attainable combinations of two products that may be produced with available resources Opportunity cost: the highest-valued alternative that must be given up to engage in an activity Increasing marginal opportunity costs: The bowed out shape of the production possibility frontier illustrates the concept of increasing marginal opportunity costs Increasing marginal opportunity costs demonstrate an important economic concept: Economic growth: Economic growth: expansion of society s production potential. (Illustrated using the production possibility frontier) Trade: the act of buying or selling a good or service in a market Absolute advantage vs. comparative advantage Absolute advantage: ability of an individual, firm or country to produce moreof a good or service than competitors using the same amount of resources Comparative advantage: ability of an individual, firm or country to produce a good or service at a lower opportunity cost than other producer Comparative advantage and gains from trade: Basis for trade is comparative advantage, not absolute advantage Individuals, firms or countries are better off if they specialise in producing goods and services for which they have a comparative advantage and obtain other desirable goods and services by trading The Market System: Market: a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade Product Markets: markets for good such as computers and services - such as medical treatment Factor markets: markets for the factors of production, such as labour, capital, natural resources and entrepreneurial ability The gains from free markets: Free Market: market with few government restrictions on how a good or service can be produced or sold, or on how a factor of production can be employed

4 Smith assumed individuals act in a rational, self-interested way If not restricted by government, then firms would be led by the invisible hand to the market to provide consumers with what they wanted Price mechanism: system in the free market where price changes lead to producers changing production in accordance with the level of consumer demand The role of the entrepreneur: Entrepreneur: someone who operates a business, bringing together the factors of production to produce goods and services Entrepreneurs are central to the working of the market system The legal basis of a successful market: Property rights: rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it Private property rights provide the legal basis of a successful market system To enforce contracts and property rights there must be an independent court system with impartial judges Production will fall if property rights are not well enforced a move to a point inside the PPF

5 WEEK 2: The Interaction of Demand and Supply The demand side of the market: Quantity demanded: amount of a good or service that a consumer is willing and able to buy at a given price Demand schedule: table showing the relationship between the price of a product and the quantity of the product demanded Demand curve: a curve that shows the relationship between the price of a product and the quantity of the product demanded Market demand: demand by all the consumers of a given good or service The Law of Demand: holding everything else constant, when the price of a product falls the quantity demanded will increase, and when the price of a product rises the quantity demanded will decrease Ceteris paribus holding everything else constant. Requirement that when analysing the relationship between two variables such as price and quantity demanded other variables must be held constant What explains the law of demand: 1. The substitution effect: The change in the quantity demanded of a good or service that results from a change in price, making the good or service more or less expensive relative to other goods or services that are substitutes (holding constant the effect of the price change on consumer purchasing power) 2. The income effect: The change in the quantity demanded of a good or service that results from the effect of a change in price on consumer purchasing power (holding all other factors constant) Variables that shift market demand: 1. Income 2. Prices of related goods 3. Tastes 4. Population and demographics 5. Expected future prices 1. Income o Normal good: good for which the demand increases as income rises and decreases as income falls o Inferior good: good for which the demand increases as income falls and decreases as income rises 2. Prices of related goods o Substitutes: goods or services that can be used for the same or similar purpose o Complements: goods and services that are used together 3. Tastes

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