Mr Sydney Armstrong ECN 1100 Introduction to Microeconomic Lecture Note (2)

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1 Mr Sydney Armstrong ECN 1100 Introduction to Microeconomic Lecture Note (2) Economics Systems The market System The private ownership of resources and the use of markets and prices to coordinate and direct economic activity characterize the market system, or Capitalism. In this system each participant acts in his or her own self-interest; each individual or business seeks to maximize its satisfaction or profit through its own decisions regarding consumption or production. The system allows for the private ownership of Capital, communicates through prices and coordinate economic activity through markets (a place where buyers and sellers meet to transact business). Goods and services are produced and resources are supplied be whoever is willing and able to do so. The result is competition among independently acting buyers and sellers of each product and resource. Thus economic decision making is widely dispersed. In pure capitalism or laissez-fare capitalism the government s role is limited to protecting private property and establishing an environment appropriate to the operation of the market system. The term laissezfare means let it be, that is, keep government from interfering with the economy. The idea is that such interference will disturb the efficient working of the market system. The Command System The alternative to the market system is the command system, also known as socialism or communism. In this system, government owns most property, resources and economic decision making occurs through a central economic plan. A central planning board appointed by the government makes nearly all the major decisions concerning the use of resources, the composition and distribution of output, and the organization of production. The government owns most of the business firms, which produce according to government directives. A central planning board determines production goals for each enterprise and specifies the amount of resources to be allocated to each enterprise so that it can reach its production goals. The division of output between capital and consumer goods is centrally decided. A pure command economy would rely exclusively on a central plan to allocate the government owned property resources. But, in reality, even the preeminent command economy (the Soviet Union) tolerated some private ownership and incorporated some markets before it demise in 1992.

2 Income Consumption Point per week per week $ 0 $ 50 a b c d e Plot this information on a graph. Slope of a line Lines can be described in terms of their slopes. The slope of a straight line is the ratio of change in the dependent variable to changes in the independent variable. Slope = in the dependent variable/ in the independent variable Calculate the slope from the above information using any two points. Slopes can be positive or negative and depict the underpinning relationship between the two variables. Slopes and Marginal Analysis Economics is largely concerned with changes from the status quo. The concept of slope is important in economics because it reflects marginal changes- Those involve 1 more (or less) unit. In our example the slope is 0.5 which tells us that for every 1 $ change in income consumption will change by $0.5 If the variables are price and quantity demanded and the slope is -5, what is the meaning of this slope? Infinite and zero slopes Many variables are unrelated or independent of one another e.g. quantity of computer purchase and the price of bananas. Price Of infinite slope Bananas Quantity of computers

3 The graph of this relationship is a line parallel to the vertical axis indicating that the same quantity of computer is purchased no matter what the price of bananas is. The slope of such line is infinite. Similarly, consumption is completely unrelated to the divorce rate. C o n s u m p t i o n Slope = 0 Divorce Rate The line parallel to the horizontal axis represents this lack of relationship. The vertical Intercept A line can be located on a graph (without plotting points) if we know the slope and its intercept. The intercept of a line is the point where the line meets the vertical axis. In our case it is 50 which means $50 of consumption is needed even if we have no income. Equation of a linear relationship If we know the intercept and slope we can describe line succinctly in equation form. In its general form the equation of a straight line is Y = a + bx or y = mx + c Where a/c = intercept b/m = slope y = dependent variable x = independent variable

4 From our information the equation is c = y (in economics income is referred to as y). With this equation we can determine any level of consumption once we know what income is. What is difference between the slope of linear graph and that of a non -linear graph? Basic Algebra 24 = x solve for x Solving simultaneous equations 2x + 3y = 6 3x -2y = 2 solve for x and y Percentage and percentage change Sector year 2011 percentage year 2012 percentage Agriculture Manufacture Mining Service Total GDP % = (total of the category/ grand total) *100 % = {(new value old value)/ old value}* 100 Simple calculus First order differentiation or first derivative of a function allows us to find the marginal aspect of the function. E.g. y = 3x 3 + 5x 2 30x +100 δy = 9x x - 30 δx Application of differentiation in economics TC = 10Q 3 6Q Q -6

5 TR = 25Q 4 2Q Q +15 What is the opposite of differentiation? THE PRODUCTION POSSIBILITY MODEL Because resources are scarce, a full employment, full production economy cannot have unlimited output of goods and services. By full production we mean that all employed resources should be used so that they provide the maximum possible satisfaction of our material wants. If we fail to realize full production economist say our resources are underemployed. Full production implies two kinds of efficiency, Productive efficiency and allocative efficiency. Productive efficiency is the production of any particular mix of goods and services in the least costly way. In contrast, allocative efficiency is the production of that particular mix of goods and services most wanted by society. Allocative efficiency requires that an economy produce the right mix of goods and services, with each item being produce at the lowest possible unit cost. This means apportioning limited resources among firms and industries in such a way that society obtains the combination of goods and services it wants the most. Because of scarcity society must choose which goods and services to produce and which to forgo. The necessity and consequences of those choices can best be understood through a production possibilities model. Assumptions- We begin our discussion of the production possibilities model with simplifying assumptions: Full employment and productive efficiency the economy is employing all of its available resources (full employment) and is producing goods and services at least cost (production efficiency). Fixed Resources the available supply of factors of production are fixed in both quantity and quality. Nevertheless, they can be reallocated, within limits, among different uses; example land can be used for either factory sites or for food production. Fixed Technology the state of technology (the method used to produce output) does not change during the analysis. This assumption and the previous one imply that we are looking at an economy at a certain point in time or over a very short period of time. Two goods the economy is producing only two goods

6 A production possibilities table lists the different combinations of two products that can be produce with a specific set of resources. Production Alternative Type of A B C D E Product Pizzas Cars The data presented in the table above can also be shown graphically. We use a simple two dimensional graph called a production possibilities curve or production possibilities frontier (PPC or PPF). A production possibility curve is a graph which shows the various combinations of two products that can be produced with a specific set of resources with full employment and full productive efficiency ceterus pribus Production Possibilities Curve Each point on the PPC represents some maximum attainable output of the two products with full utilization of available resources. These points are also associated with opportunity cost. Points lying inside the curve are also attainable but reflect inefficiency and therefore are not as desirable as points on the curve. Points lying outside the curve would represent a greater output than the output at any point on the curve. Such points however are unattainable with the current supply of resources and technology. In essence at any point in time an economy is achieving full employment and productive efficiency must sacrifice some of one good to obtain more of another. Scarce resources prohibit such economy from having more of both goods.

7 Opportunity cost and the Law of Increasing Opportunity Cost The amount of other products that must be forgone or sacrificed to obtain 1 unit of a specific good is called the opportunity cost of that good. In our case the amount of cars that must be given up to get another unit of pizza is the opportunity cost, or simply the cost of that unit of pizza. In moving from alternative A to B to C to D, an important economic principle is revealed: the opportunity cost of each additional unit of pizza is greater than the opportunity cost of the preceding one. When we move from A to B, just 1 unit of cars is sacrificed for 1 more unit of pizza; but in going from B to C we sacrificed 2 additional units of cars for 1 more unit of pizza; then 3 more of cars for 1 unit of pizza; and finally 4 for 1. Our example illustrates the law of increasing opportunity costs: The more of a product that is produced, the greater is its opportunity cost. The law of increasing opportunity cost is reflected in the shape of the PPC. The curve is bowed out from the origin of the graph. Draw a graph that depicts constant opportunity cost and one that depicts decreasing opportunity cost. A Growing Economy and shifts of your PPC When we drop the assumption that the quantity and quality of resources and technology are fixed, the production possibilities curve shifts position, that is the potential maximum output of the economy changes. Increases in resource supplies- Although resource supplies are fixed at any specific moment, they can and do change over time. Example, a nation s growing population will bring about increases in the supply of labour and entrepreneur ability. Also with training labour quality usually improve overtime. Historically, the economy s stock of capital has increased at a significant, though unsteady, rate. The net result of these increased supplies of the factors of production is the ability to produce more of both pizzas and cars. Advances in Technology- Our second assumption is that we have constant, unchanging technology. In reality, technology has progressed dramatically over time. An advancing technology brings both new and better goods and improved way of producing them. An advance in technology, for now, is referred to as improvements in capital facilities (more efficient machinery and equipment). As with increases in resource supplies, technological advances make possible the production of more cars and pizzas. Thus when either supply of resources increase or an improvement in technology occurs, the production possibilities curve shifts outwards to the right.

12 10 8 6 4 2 0 Production Possibilities Curve 0 1 2 3 4 5 The Circular Flow Model Because nearly all the major nations now use the market system, we need to gain a good understanding of how the

The model also has two broad markets: the resource market and the product market.

8 Production Possibilities Curve The Circular Flow Model Because nearly all the major nations now use the market system, we need to gain a good understanding of how the system operates. As shown in the graph above the market economy has two groups of decision makers: households and businesses (we will add government as a third decision maker next semester). The model also has two broad markets: the resource market and the product market. The upper half of the diagram represents the resource market: the place where resources or the service of resource suppliers are bought and sold. In the resource market, households sell resources and businesses demand them. Household (that is people) own all economic resources either directly as workers or entrepreneurs or indirectly through their ownership of business corporations. They sell their resources to business, which buy them because they are necessary for producing goods and services. The funds that businesses pay for resources are costs to the businesses but are flows of wage, rent, interest and profit income to the households.

9 Resources therefore flow from households to businesses and money flows from businesses to households. The lower part of the diagram represents the product market: the place where goods and services produced by businesses are bought and sold. In the product market, businesses combine the resources they have obtained to produce and sell goods and services. Households use the income they have received from the sale of resources to buy goods and services. The monetary flows of consumer spending on goods and services yield sales revenue for businesses. The circular flow model suggests a complex, interrelated web of decision making and economic activity involving businesses and households. Businesses and households are both buyers and sellers. Businesses buy resources and sell products. Households buy products and sell resources. As shown in the diagram there is a counterclockwise real flow of economic resources and finished goods and services, and a clockwise money flow of income and consumption expenditures. These flows are simultaneous and repetitive. These notes came from McConnell &Brue, Economics, 15th edition, 2002 You are required to supplement this with additional reading.

Individual & Market Demand and Supply

Mr Sydney Armstrong ECN 1100 Introduction to Microeconomic Lecture Note (3) Individual & Market Demand and Supply The tools of demand and supply can take us a far way in understanding both specific economic