Welcome to the first session of PRBE001. This session will introduce you to the core principles of Economics. Society, businesses and households face

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1 Welcome to the first session of PRBE001. This session will introduce you to the core principles of Economics. Society, businesses and households face a number of economic decisions. These economic decisions require us all to make choices. In this unit we will analyse how people make decisions such as what to buy, what to produce, how much to produce, how much to invest etc. 1

2 Economics is decision-making under scarcity and scarcity is having limited resources. Lets take an example, such as time. For example, coming to lecture involves the use of your time. Time available to you in a day is a limited resource, it is not unlimited. Hence, you have to decide whether to attend the lecture or work on an assignment at home. In other words, you have to give up something to come to this lecture. Similarly, a manager has to decide how to allocate scarce resources. If a soft drink company spends a lot on advertising then it has less resources to spend on product development. Effective management requires making these choices. Businesses allocate scarce resources among competing uses, taking into account a range of stakeholder wants and needs. Just like businesses, each individual as well as the government has to decide on how to manage its scarce resources. Economics is the study of how society manages its scarce resources 2

3 In most societies in the modern day there is no central planner or a king or a monarch deciding the optimal allocation of resources. A lot of the times management of scarce resources is down to individual and group decisions. Thus the study of economics requires a study of how individuals and groups make decisions as well as how they interact with each other. Along with analysing decision making at a micro level, the course will look at the forces that impact the whole economy such as unemployment rate, inflation and GDP etc. Although the study of economics is multifaceted, there are some core principles that aid economic decision at all levels. In this session we will look at ten key principles of economics. You may find some of these principles slightly unconvincing. Don t worry too much at this stage as we will continue to expand on these core ideas as we go along in the course, making things a lot easier to grasp. 3

4 The first principle of economics is that people face trade-offs or another common expression used to express the same thing in economics is there is no such thing as a free lunch. To get something we have to give up something. For example, no matter how much you love Economics, in order to study for this course you have to give up something. Every hour you spend studying this subject takes away time from studying another subject, sleeping, biking, watching TV or working. Another important example of trade-off is clean environment and high level of income. Reducing pollution has a cost and it typically raises the costs of production. Because of higher costs, incomes goes down as firm s profitability reduces which then impacts households through lower salaries, shareholder wealth etc. Another commonly identified trade-off is efficiency vs equity. Equity is simple enough to understand and is about fairness or how society distributes its resources amongst it population. Efficiency however is less straightforward. Very broadly, efficiency is about making the most of scarce resources. Efficiency can be looked at from different perspectives. This includes technical efficiency, productive efficiency, allocative efficiency and social efficiency. Technical efficiency relates to business finding a way of using its existing resources to produce more. For example, increasing reliance on machines rather than people may improve technical efficiency. Productive efficiency entails producing output at the lowest cost possible. For example, sourcing cheaper raw materials can improve productive efficiency. Allocative efficiency occurs when the cost of production match the value placed by consumers on the goods produced. The issue is whether the products being produced by businesses are wanted and valued by consumers (both individual consumers and business consumers)? Efficiency occurs where the goods and services being produced match the demand. Social efficiency is when the social costs and social benefits of production are equal. When businesses undertake production activities they encounter costs. Costs incurred by business include raw 4

5 materials, wages, rents, interest payments, insurance, plant and equipment. These are all private costs of production and solely the responsibility of the businesses. But sometimes businesses may impose costs on the whole society such as pollution. These social costs may go unaccounted in the production process. Social efficiency occurs when we account for both private and social costs in the production process. Back to the issue of trade-offs, society sometimes face a trade-off between efficiency and equity. For example, to achieve greater equality, governments could redistribute income from wealthy to poor. But this reduces incentive to work and produce, therefore reducing overall efficiency in the economy. 4

6 Here we have an extremely important new term-opportunity cost which is whatever is given up to obtain some item. Opportunity cost is the value of the next best alternative forgone. It includes both implicit and explicit costs in its valuation. Lets take a simple examples. I get paid to $200 per hour for this lecture (I wish!). My next best alternative to this lecture was taking tutorials paying me $100 per hour. Therefore, the value of next best alternative is $100. Here $100 is the opportunity cost of my time and an implicit cost. Lets say the explicit costs are zero. Will I take this lecture? Yes of course! Lets modify this a bit. My costs of getting to the lecture are $50. Making the opportunity cost $150 but still not changing the outcome. Lets take another example of me running a restaurant. Opportunity cost of my restaurant will include both explicit cost (like costs of supplies) + the value of my time if I am running the restaurant, which is an implicit cost. Explicit cost require a financial outlay so are easier to spot. Opportunity costs sometimes do not require a cash outlay. For example, if I am a skilled computer programmer and could earn $100 per hour working as a programmer but chooses not to do so and instead use this time to manage the restaurant then this is an implicit cost. 5

7 Another useful tool for decision making is marginal analysis. Marginal analysis helps ascertain the amount of a certain activity. Deciding at the margin refers to deciding on the basis of small incremental adjustments. Whenever we refer to marginal analysis we are interested in what happens to our decision making when we change the variables of interest by just a little bit. To understand the concept of marginal analysis better we need to introduce concepts of marginal costs and marginal benefit. Marginal benefit is additional benefit associated with say buying or selling one more unit. Marginal cost is similar to marginal benefit. In a firm s case the extra cost associated with selling one more unit is the marginal cost. Something that marginal analysis can address is how much to produce? Remember the aim is to maximize profit, not revenue. Produce as much as possible is, therefore, not the right answer- because we have not taken into account the costs! One way to get the right answer is by going through the marginal analysis. Profit maximisation point can be found in two ways. First is the traditional method of finding the profit maximisation point- which is by finding total profit for each point and then settling for the point which gives the highest profit. This is incredibly tedious. Economist tend to use a simpler method of comparing marginal benefit and marginal costs. Marginal benefit of production essentially provides us with the extra revenue that we get from selling each additional unit. Marginal cost is the extra cost 6

8 associated with producing each additional unit. So if MB>MC then it pays to produce more. However, if MB<MC then it pays to cut production. Profit is therefore maximised at MB=MC. 6

9 Because economist assume that people are rational, they respond to incentives by comparing costs and benefits. An incentive is something that induces a person to act. For example, suppose the price of apples increases. What will people do? Most likely consumers will find the costs of apple too high to justify the benefits received from consuming apples. So they might reduce the consumption of apples and buy other types of fruit. On the other hand producers will find it more profitable to sell apple and they may try to expedite the harvesting of apples while the market price is high. So the price is crucial to the behaviour of both consumers and producers. Since incentives are important to people s choices, they can be used to alter behaviour. A pressing problem in market economies today is climate change. Say for example, firms provide electricity by burning fossil fuels leading to greenhouse gas pollution. This pollution poses a threat to health, economic systems and ecosystems around the world. Most economist would advocate to reduce pollution through tax. A tax would increase the cost of production of the firm and hence force the firms to reconsider the optimal production point. For example, high taxes on gasoline in Europe has induced people to drive smaller cars as opposed to Unites States. Similarly, cigarette and alcohol manufacturers produce products that can cause cancer risks and other health problems leading to increased health expenditure in the society. A tax on cigarette in Australia has raised the price of smokes and induced people to smoke less. 7

10 Economic analysis also places a huge emphasis on the interaction of people with each other and the impact this has on market outcomes. Trade is the key to interaction between various sectors in the economy. Trade enables each person to specialise in the activity of their choice and trade this in the market. For example, if there was no market exchange then we would have to produce all the goods such as grain, vegetables, meat, poultry, clothes, shoes etc. However, due to trade we are able to specialise and consume a greater variety of goods. Similarly trade between nations enable countries to specialise in what they do best and then trade with others for a greater variety of goods and services. Sometimes the negative coverage on trade masks the numerous benefits that countries have received specialisation and trade. For example, low cost manufacturing in places such as China has enabled people to enjoy a greater number of goods and services in many parts of the developed world. 8

11 One of the most important economic events includes the collapse of Soviet Union in 1980 s. Soviet Union was established on the principle that central planners will be best able to decide what goods and services are produced, how much is produced, and who produces and consumes these goods and services. This central planning was taken by the government to promote economic well-being. However, the collapse of Soviet Union showed some the flaws in this system. Most countries have since abandoned central planning in favour of market based system. In a market economy most decisions are made by the firms and households. The firms and households interact in the marketplace for exchange of goods and services. Prices form the main signalling device for successful market decisions. For example, too high a price for a good indicates firms unmet demand and as result they produce more of the good in question. Despite the lack of a central planner, market economies have been successful in regulating themselves through price signals to allocate resources efficiently. Adam Smith, the father of modern economic theory, emphasised this point in his book Wealth of Nations. Smith concluded that markets act as if they are guided by an invisible hand that lead to the most desirable outcome. In this course we will see that the invisible hand primarily plays the role of regulating market activities through price mechanisms. 9

12 Even though we have just discussed the power of invisible hand, market economies are sometimes regulated by the government to achieve socially desirable outcomes. Governments are needed for a number of reasons: Firstly, government are needed to enforce property rights. Markets only work if there is a clear definition of property rights. Trade will not occur if people do not expect to be paid for their goods or expect their produce to be stolen. Secondly, in some cases governments are needed to promote efficiency and to promote equity. Sometimes the invisible hand will not allocate resources efficiently due to market failure. One of the common causes of market failure is externality, which is the uncompensated impact of one person's actions on the well-being of a third party. For example, firms provide electricity by burning fossil fuels leading to greenhouse gas pollution. This pollution poses a threat to health, economic systems and ecosystems around the world. Cigarette and alcohol manufacturers produce products that can cause cancer risks and other health problems leading to increased health expenditure in the society. These costs fall on the society and are not effectively accounted for the firm unless monitored by a third party such as the government. Another common reason of market failure is market power. Markets can only effectively self-regulate if there is competition between sellers. However, if there is only one seller then there is barely any scope for self-regulation through market forces. For example, if there is only one source of water in a remote village which is owned by one owner, then the 10

13 well-owner may charge a high price and restrict output leading to less than optimal outcome. The invisible hand may also fail to ensure that the economic resources are distributed equitably. The invisible hand does not ensure that basic human rights of access to food, health care, drinking water etc, are met for all in the society. 10

14 From experience we know that differences between living standards in Australia vs China or India are overwhelming. For example in 2012 the average Australian had an income of $69007 whereas the average Indian income was $1646. Higher income countries also perform better in health measures and their citizens enjoy longer life expectancy. What explains these large differences in living standards among countries and over time? The differences are mostly explained by the country s ability to produce goods and services. Countries that produce a large amount of goods and services enjoy a better standard of living whereas countries with less productivity endure a lower standard of living. This relationship between productivity and living standards pervades all aspects of social policy. A great proportion of public discourse is therefore devoted to the economic growth and trends in GDP, where GDP is defined as the market value of all final goods and services produced within a country in a given period of time. The course will use GDP to measure living standards as well as look into factors that impact a nations productivity. 11

15 Germany experienced one of the most spectacular hyperinflation episodes experienced in history. In 1921, a German daily newspaper was priced at 0.30 marks. By November 1922, the price of the same newspaper was marks. Similar trends were observed for other commodities. In more recent times, inflation has been a major concern in some African states. Zimbabwe for example has experienced German-like hyper inflation. Inflation imposes significant costs on the economy, one of the main ones being that it erodes confidences and introduces uncertainty. The causes of inflation can generally be traced back to public policy. More specifically in the case of inflation, the culprit if often too much growth in money supply. Due to this important interrelationship between growth, money supply and inflation- we will take up the discussion of monetary policy in later sessions. 12

16 Increase in money supply is inflationary and as discussed in the previous slide too high inflation is problematic for the economy. However increased money supply and therefore higher inflation can lead to a lower level of unemployment. This is because increasing money supply encourages economic activity leading to lower unemployment. The short run trade-off between inflation and unemployment is represented using the Phillips curve. Even though the Phillips curve has been subject to come controversy, it has been widely accepted by contemporary economist. The Phillips curve shows the inverse relationship between unemployment rate and inflation. Because of these trade-offs policy makers have to carefully select the relevant goals for the economy forming the basis of much debate in political arena about the appropriate instruments for influencing economic outcomes at different points of time. 13

17 We have discussed the issue of scarcity of resources. This is only part of the story. Scarcity is an important point of concern because human needs and wants are unlimited. So because resources are scarce relative to their demand, decisions need to be made about the allocation of resources. Let s take the example of our income. Most of us have a limited amount of income and even when our income increases; it does not necessarily buy us all the things we want. So to maximise welfare, we make decisions about how best to spend our income. Economists model decisions by individuals on cost-benefit analysis on the assumption that human beings are rational such that they weigh up cost and benefits of decisions before deciding on the course of action. The same principle applies to business decision making. 14

18 Let s take the decision to buy this book to analyse how the concept of rationality and markets work together. A decision to buy this book represents that this text has some value and there is a satisfaction obtained from using this book. We cannot directly measure satisfaction or commonly referred to as utility in Economics but can safely assume that for a rational consumer utility derived from this book has to at least equal the price of the book. If many student buy this particular book this will boost the profits or royalties derived from sales of this particular book. But this will also mean that alternative Business Economics textbook will not be bought, possibly reducing their publication. This provides us with an example of a market interaction between many different buyers and sellers coming together to decide on the most valuable commodities to produce and exchange. Even though buyers and sellers don t meet each other, the market transactions enable them to interact. We will analyse the functioning of the market in greater depth in the next session. 15