Principles of 1
UNIT I INTRODUCTION TO MACROECONOMICS Learning Objectives 1. Introduction to economics, meaning and definition of economics, Principles of economics 2. Economic models, the circular flow diagram, production possibilities frontier 3. Classification of economics, micro and macro economics, Markets and competition 4. Demand, the law of demand, the demand curve, market demand versus individual demand 5. Supply, the supply curve, market supply versus individual supply 6. Elasticity of demand, elasticity of supply 2
Definition of Economics Economics is the social science that studies the choices that individuals, businesses, governments, and societies make as they cope with scarcity and the incentives that influence and reconcile those choices. 3
Principles of Economics 1. People face trade-offs 2. The cost of something is what you give up to get it 3. Rational people think at the margin 4. People respond to incentives 5. Trade can make everyone better off 6. Markets are usually a good way to organize economic activity 7. Governments can sometimes improve market outcomes 8. A country s standard of living depends on its ability to produce goods and services 9. Prices rise when the government prints too much money 10. Society faces a short-run trade-off between inflation and unemployment 4
Principle #1: People Face Tradeoffs. To get one thing, we usually have to give up another thing. Guns Vs. butter Food Vs. clothing Leisure time Vs. work Efficiency Vs. Equity Making decisions requires trading off one goal against another. Efficiency means that society is getting the maximum benefits from its scarce resources. Equity means that those benefits are distributed fairly among society s members. Efficiency refers to the size of the economic pie. Equity refers to how the pie is divided. Principle #2: The Cost of Something Is What You Give Up to Get It. Decisions require comparing costs and benefits of alternatives. Whether to go to college or to work? Whether to go to class or sleep in? Wages given up to attend school are the largest single cost of education. The opportunity cost of an item is what you give up to get that item. 5
Principle #3: Rational People Think at the Margin. People make decisions by comparing costs and benefits at the margin. Example of Rational People Think at the Margin Flying a 200-seat plane across Oman costs the airline OMR 10,000. The average cost of each seat is OMR 50 (OMR 10,000/200). Imagine that an airline is about to take off with tem empty seats and the standby passenger waiting at the gate will pay OMR 30 for a seat. Should the airline sell the ticket? If the plane has empty seats, the cost of adding one more passenger is minuscule. Although the average cost of flying a passenger is OMR 50, the marginal cost is merely the cost of a pouch of peanuts and a can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable. 6
Principle #4: People Respond to Incentives. Marginal changes in costs or benefits motivate people to respond. The decision to choose one alternative over another occurs when that alternative s marginal benefits exceed its marginal costs! E. g. When the price of apple rises, people decide to eat more pears and fewer apples because the cost of buying an apple is higher. At the same time, apple orchards decide to hire more workers and harvest more apples because the benefit of selling an apple is also higher. Principle #5: Trade Can Make Everyone Better Off. People gain from their ability to trade with one another. Competition results in gains from trading. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services, whether it is farming or home building. By trading with others people can buy a greater variety of goods and services at lower cost. 7
Principle #6: Markets Are Usually a Good Way to Organize Economic Activity. A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Households decide what to buy and who to work for. Firms decide who to hire and what to produce. Principle #7: Governments Can Sometimes Improve Market Outcomes. Most government policies aim either to enlarge the economic pie or to change how the pie is divided. Market failure occurs when the market fails to allocate resources efficiently. When the market fails, government can intervene to promote efficiency and equity. Economic pie is the whole revenue of government. Invisible hand: Prices are the instrument with which the invisible hand directs the economic activity. In any market buyers look at the price when determining how much to demand and sellers look at the price when deciding how much to supply. 8
Principle #8: The Standard of Living Depends on a Country s Production. Standard of living refers to the level of wealth, comfort, material goods and necessities available to a certain socioeconomic class in a certain geographic area. Total income divided by the population is per capita income Countries with most per capita income: 1. Monaco, Liechtenstein, Luxembourg, Norway, Qatar, Bermuda, Switzerland, Macau, Australia, 10. San Marino, 44. Oman 9
Principle #9: Prices Rise When the Government Prints Too Much Money. Inflation is an increase in the overall level of prices in the economy. One cause of inflation is the growth in the quantity of money. When the government creates large quantities of money, the value of the money falls. Principle #10: Society Faces a Short-run Tradeoff Between Inflation and Unemployment. The Phillips Curve illustrates the tradeoff between inflation and unemployment: It s a short-run tradeoff! Inflation Unemployment 10
Economic Models Economists use economic models to understand the world. A model is a formal statement of a theory. Models are descriptions of the relationship between two or more variables. 11
Economic Models The circular-flow diagram The production possibilities frontier The circular-flow diagram is a visual model of the economy that shows how money flows through markets among households and firms. The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. 12
Circular Flow Diagram Revenue Goods and services sold MARKETS FOR GOODS AND SERVICES Firms sell Households buy Spending Goods and services bought FIRMS Produce and sell goods and services Hire and use factors of production HOUSEHOLDS Buy and consume goods and services Own and sell factors of production Factors of production Wages, rent and profit MARKETS FOR FACTORS OF PRODUCTION Households ell Firms buy Labor, land and capital Income 13
First model: circular flow diagram Millions of people buying, selling, working and hiring. Economy has two types of decision-makers: 1. Firms produce goods and services using factors of production. 2. Households own factors of production and consume. 14
Factors of Production The basic resources that are available to a society are factors of production: 1. Land 2. Labor 3. Capital 4. Enterprise 15
Production Possibilities Frontier Production is the process that transforms scarce resources into useful goods and services. Resources or factors of production are the inputs into the process of production; goods and services of value to households are the outputs of the process of production. 16
Production Possibilities Frontier The production possibilities frontier (ppf) is a graph that shows all of the combinations of goods and services that can be produced if all of society s resources are used efficiently. 17
The Production Possibilities Frontier Quantity of Computers Produced 3,000 X If we look at production of both computers and cars, the straight line joining X and Y shows the combinations assuming that there is only a single factor of production => constant trade off between goods Y 0 1,000 Quantity of Cars Produced 18
The Production Possibilities Frontier Quantity of Computers Produced 4,000 3,000 If we look at production of both computers and cars, the concave line joining X and Y shows the combinations assuming that there is more than one factor of production => changing trade-off. 2,100 2,000 A 0 700 750 1,000 Quantity of Cars Produced 19
Classification of Economics 1. Microeconomics is the study of choices made by individuals and businesses, and the influence of government on those choices. 2. Macroeconomics is the study of the effects on the national and global economy of the choices that individuals, businesses, and governments make. 20
Microeconomics Macroeconomics Examples of microeconomic and macroeconomic concerns Production Prices Income Employment Production/Output in Individual Industries and Businesses How much steel How many offices How many cars National Production/Output Total Industrial Output Gross Domestic Product Growth of Output Price of Individual Goods and Services Price of medical care Price of gasoline Food prices Apartment rents Aggregate Price Level Consumer prices Producer Prices Rate of Inflation Distribution of Income and Wealth Wages in the auto industry Minimum wages Executive salaries Poverty National Income Total wages and salaries Total corporate profits Employment by Individual Businesses & Industries Jobs in the steel industry Number of employees in a firm Employment and Unemployment in the Economy Total number of jobs Unemployment rate 21
MARKETS AND COMPETITION A market is a group of buyers and sellers of a particular good or service. The terms supply and demand refer to the behavior of people... as they interact with one another in markets. 22
MARKETS AND COMPETITION Buyers determine demand. Sellers determine supply 23
Competitive Markets A competitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price. 24
Competition: Perfect and Otherwise Perfect Competition Products are the same Numerous buyers and sellers so that each has no influence over price Buyers and Sellers are price takers Monopoly One seller, and seller controls price 25
Competition: Perfect and Otherwise Oligopoly Few sellers Not always aggressive competition Monopolistic Competition Many sellers Slightly differentiated products Each seller may set price for its own product 26
DEMAND Quantity demanded is the amount of a good that buyers are willing and able to purchase. Law of Demand The law of demand states that, other things equal, the quantity demanded of a good falls when the price of the good rises. 27
The Demand Curve: The Relationship between Price and Quantity Demanded Demand Schedule The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded. 28
Demand Schedule 29
The Demand Curve: The Relationship between Price and Quantity Demanded Demand Curve The demand curve is a graph of the relationship between the price of a good and the quantity demanded. 30
Copyright 2004 South-Western Demand Schedule and Demand Curve Price of Ice-Cream Cone $3.00 2.50 1. A decrease in price... 2.00 1.50 1.00 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 2.... increases quantity of cones demanded. 31
Market Demand versus Individual Demand Market demand refers to the sum of all individual demands for a particular good or service. Graphically, individual demand curves are summed horizontally to obtain the market demand curve. 32
Shifts in the Demand Curve Change in Quantity Demanded Movement along the demand curve. Caused by a change in the price of the product. 33
Changes in Quantity Demanded Price of Ice- Cream Cones $2.00 B A tax that raises the price of ice-cream cones results in a movement along the demand curve. 1.00 A 0 4 8 D Quantity of Ice-Cream Cones 34
Reasons for shifts in the Demand Curve The reasons for shifts in the demand curve are: 1. Consumer income 2. Prices of related goods 3. Tastes 4. Expectations 5. Number of buyers 35
Shifts in the Demand Curve Consumer Income As income increases the demand for a normal good will increase. As income increases the demand for an inferior good will decrease. 36
Price of Ice- Cream Cone $3.00 2.50 2.00 1.50 1.00 Consumer Income Normal Good Increase in demand An increase in income... 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 D 1 D 2 Quantity of Ice-Cream Cones 37
Consumer Income Inferior Good Price of Ice-Cream Cone $3.00 2.50 2.00 1.50 1.00 Decrease in demand An increase in income... 0.50 0 D 2 D 1 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 38
Shifts in the Demand Curve Prices of Related Goods When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. When a fall in the price of one good increases the demand for another good, the two goods are called complements. 39
SUPPLY Quantity supplied is the amount of a good that sellers are willing and able to sell. Law of Supply The law of supply states that, other things equal, the quantity supplied of a good rises when the price of the good rises. 40
The Supply Curve: The Relationship between Price and Quantity Supplied Supply Schedule The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied. 41
Supply Schedule 42
The Supply Curve: The Relationship between Price and Quantity Supplied Supply Curve The supply curve is the graph of the relationship between the price of a good and the quantity supplied. 43
Copyright 2003 Southwestern/Thomson Learning Supply Schedule and Supply Curve Price of Ice-Cream Cone $3.00 1. An increase in price... 2.50 2.00 1.50 1.00 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 2.... increases BABY THOMAS quantity 2016 of cones supplied. 44
Market Supply versus Individual Supply Market supply refers to the sum of all individual supplies for all sellers of a particular good or service. Graphically, individual supply curves are summed horizontally to obtain the market supply curve. 45
Shifts in the Supply Curve Input prices Technology Expectations Number of sellers 46
Shifts in the Supply Curve Change in Quantity Supplied Movement along the supply curve. Caused by a change in anything that alters the quantity supplied at each price. 47
Change in Quantity Supplied Price of Ice- Cream Cone $3.00 C S A rise in the price of ice cream cones results in a movement along the supply curve. 1.00 A 0 1 5 Quantity of Ice-Cream Cones 48
Shifts in the Supply Curve Change in Supply A shift in the supply curve, either to the left or right. Caused by a change in a determinant other than price. 49
SUPPLY AND DEMAND TOGETHER Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. 50
SUPPLY AND DEMAND TOGETHER Equilibrium Price The price that balances quantity supplied and quantity demanded. On a graph, it is the price at which the supply and demand curves intersect. Equilibrium Quantity The quantity supplied and the quantity demanded at the equilibrium price. On a graph it is the quantity at which the supply and demand curves intersect. 51
SUPPLY AND DEMAND TOGETHER Demand Schedule Supply Schedule At $2.00, the quantity demanded is equal to the quantity supplied! 52
Copyright 2003 Southwestern/Thomson Learning The Equilibrium of Supply and Demand Price of Ice-Cream Cone Supply $2.00 Equilibrium price Equilibrium Equilibrium quantity Demand 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of Ice-Cream Cones 53
Competition Competition is the rivalry among sellers trying to achieve such goals as increasing profits, market share, and sales volume by varying the elements of the marketing mix: price, product, distribution, and promotion. 54
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