4QQMN509

Principles of Economics
Lecture One
Introduction to Principles of Economics
Learning Outcomes

◆ Define economics and distinguish between

microeconomics and macroeconomics

◆ Explain the key ideas that define the economic way of

thinking

◆ Explain the economic questions, PPF curve,

opportunity cost

◆ Explain how specialization and trade expand

production possibilities

◆ Describe the three types of economic systems

 Definition of Economics

All economic questions arise because we want more than

we can get.
Our inability to satisfy all our wants is called scarcity.
Because we face scarcity, we must make choices.
The choices we make depend on the incentives we face.
An incentive is a reward that encourages an action or a
penalty that discourages an action.
 Definition of Economics

Economics is the social science that studies the choices

that individuals, businesses, governments, and entire
societies make as they cope with scarcity and the
incentives that influence and reconcile those choices.
Economics divides in two main parts:
■ Microeconomics
■ Macroeconomics
 Definition of Economics

Microeconomics is the study of choices that individuals

and businesses make, the way those choices interact in
markets, and the influence of governments.
Two microeconomic questions:
Why are people streaming more movies?
Would a tax on online shopping effect Amazon?
Macroeconomics is the study of the performance of the
national and global economies.
Two macroeconomic questions:
Why does the unemployment rate fluctuate?
Can the Federal Reserve make the unemployment rate fall
by keeping interest rates low?
 Two Big Economic Questions

Two big questions summarize the scope of economics:

■ How do choices end up determining what, how, and
for whom goods and services get produced?
■ When do choices made in the pursuit of self-interest
also promote the social interest?
 Two Big Economic Questions

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 as cell phones and

automobiles.
Services are tasks performed for people, such as cell
phone and auto-repair services.
 Two Big Economic Questions

What?
In the United States,
agriculture accounts for less
than 1 percent of total
production, industry
(manufactured goods) for 11
percent, and services for 80
percent.
In low-income Ethiopia,
agriculture accounts for
35 percent of total production,
industry goods for 22 percent,
and services for 44 percent.
 Two Big Economic Questions

How?
Goods and services are produced by using productive
resources that economists call factors of production.
Factors of production are grouped into four categories:
■ Land
■ Labour
■ Capital
■ Entrepreneurship
 Two Big Economic Questions

The “gifts of nature” that we use to produce goods and

services are land.
The work time and work effort that people devote to
producing goods and services is labour.
The quality of labour depends on human capital, which is
the knowledge and skill that people obtain from education,
on-the-job training, and work experience.
The tools, instruments, machines, buildings, and other
constructions that businesses use to produce goods and
services are capital.
The human resource that organizes land, labour, and
capital is entrepreneurship.
 Two Big Economic Questions

For Whom?
Who gets the goods and services depends on the incomes
that people earn.
 Two Big Economic Questions

Do Choices Made in the Pursuit of Self-Interest also

Promote the Social Interest?
Every day, 328 million Americans and 7.9 billion people in
other countries make economic choices that result in what,
how, and for whom goods and services are produced.
These choices are made by people who are pursuing their
self-interest.
Are they promoting the social interest?
 Two Big Economic Questions

Self-Interest
You make choices that are in your self-interest—choices
that you think are best for you.
Social Interest
Choices that are best for society as a whole are said to be
in the social interest.
Social interest has two dimensions: efficiency and fair
shares.
 Two Big Economic Questions

Efficiency and Social Interest

Resource use is efficient if it is not possible to make
someone better off without making someone else worse
off.
Fair Shares/Equity and Social Interest
The idea that the social interest requires “fair shares” is a
deeply held one.
But what is a fair share?
 Two Big Economic Questions

There is often a trade-off between efficiency and equity.

E.g., high rates of income tax may increase equity but may
also reduce output by hampering incentives to work hard
or innovate....
Low rates of inheritance tax which push the tax burden
onto income tax may therefore reduce output (so there is a
trade-off between types of taxation).
 Two Big Economic Questions

Questions about the social interest are hard ones to

answer and they generate discussion, debate, and
disagreement.
A couple of topics that generate discussion and illustrate
the tension between self-interest and social interest are:
■ Climate change
■ The Covid pandemic
 Two Big Economic Questions

Climate Change
Climate change is a huge political issue today.
Every serious political leader is acutely aware of the
problem and of the popularity of having proposals that
might lower carbon emissions.
Burning fossil fuels to generate electricity and to power
airplanes, automobiles, and trucks pours a staggering
28 billion tons—4 tons per person—of carbon dioxide into
the atmosphere each year.
 Two Big Economic Questions

Two thirds of the world’s carbon emissions comes from the

United States, China, the European Union, Russia, and
India.
The fastest growing emissions are coming from India and
China.
The amount of global warming caused by economic
activity and its effects are uncertain, but the emissions
continue to grow and pose huge risks.
 Two Big Economic Questions
Every day, when you make self-interested choices to use
electricity and gasoline, you contribute to carbon
emissions.
You leave your carbon footprint.
You can lessen your carbon footprint by walking, riding a
bike, taking a cold shower, or planting a tree.
But can each one of us be relied upon to make decisions
that affect the Earth’s carbon-dioxide concentration in the
social interest?
Can governments change the incentives we face so that
our self-interested choices are also in the social interest?
What are your thoughts?
 Two Big Economic Questions
The Covid Pandemic
Covid-19 spreads through close contact and social
interaction.
With no social isolation, one infected person infects more
than one other person, each infected person infects more
than one other, leading to an exponential spread of the
disease?
A person who socially isolates avoids infection, but also
avoids infecting others. People choose their degree of
social isolation in their self-interest.
Do individual choices serve the social interest?
What are your thoughts?
 Economic Way of Thinking

Six key ideas define the economic way of thinking:

■ A choice is a tradeoff.
■ People make rational choices by comparing benefits
and costs.
■ Benefit is what you gain from something.
■ Cost is what you must give up to get something.
■ Most choices are “how-much” choices made at the
margin.
■ Choices respond to incentives.
 Economic Way of Thinking

A Choice Is a Tradeoff
The economic way of thinking places scarcity and its
implication, choice, at center stage.
You can think about every choice as a tradeoff—an
exchange—giving up one thing to get something else.
On Saturday night, will you study or have fun?
You can’t study and have fun at the same time, so you
must make a choice.
Whatever you choose, you could have chosen something
else. Your choice is a tradeoff.
 Economic Way of Thinking

Making a Rational Choice

A rational choice is one that compares costs and benefits
and achieves the greatest benefit over cost for the person
making the choice.
Only the wants of the person making a choice are relevant
to determine its rationality.
The idea of rational choice provides an answer to the first
question: What goods and services will be produced and in
what quantities?
The answer is: Those that people rationally choose to buy!
 The Economic Way of Thinking

How do people choose rationally?

The answers turn on benefits and costs.
Benefit: What you Gain
The benefit of something is the gain or pleasure that it
brings and is determined by preferences
Preferences are what a person likes and dislikes and the
intensity of those feelings.
Some benefits are large and easy to identify, such as the
benefit that you get from being in school.
 The Economic Way of Thinking

Cost: What you Must Give Up

The opportunity cost of something is the highest-valued
alternative that must be given up to get it.
What is your opportunity cost of going to a live concert?
Opportunity cost has two components:
1. The things you can’t afford to buy if you purchase the
concert ticket.
2. The things you can’t do with your time if you attend the
concert.
 The Economic Way of Thinking

How Much? Choosing at the Margin

You can allocate the next hour between studying and
instant messaging your friends.
The choice is not all or nothing, but you must decide how
many minutes to allocate to each activity.
To make this decision, you compare the benefit of a little
bit more study time with its cost—you make your choice at
the margin.
 The Economic Way of Thinking

To make a choice at the margin, you evaluate the

consequences of making incremental changes in the use
of your time.
The benefit from pursuing an incremental increase in an
activity is its marginal benefit.
The opportunity cost of pursuing an incremental increase
in an activity is its marginal cost.
If the marginal benefit from an incremental increase in an
activity exceeds its marginal cost, your rational choice is to
do more of that activity.
 The Economic Way of Thinking

Choices Respond to Incentives

A change in marginal cost or a change in marginal benefit
changes the incentives that we face and leads us to
change our choice.
The central idea of economics is that we can predict how
choices will change by looking at changes in incentives.
Incentives are also the key to reconciling self-interest and
the social interest.
 Economics: A Social Science and
Policy Tool
Economist as Social Scientist
Economists distinguish between two types of statement:
■ Positive statements
■ Normative statements
A positive statement can be tested by checking it against
facts.
A normative statement expresses an opinion and cannot
be tested.
 Economics: A Social Science and
Policy Tool
Unscrambling Cause and Effect
The task of economic science is to discover positive
statements that are consistent with what we observe in the
world and that enable us to understand how the economic
world works.
Economists create and test economic models.
An economic model is a description of some aspect of
the economic world that includes only those features that
are needed for the purpose at hand.
A model is tested by comparing its predictions with the
facts.
 Production Possibilities and
Opportunity Cost
The production possibilities frontier (PPF) is the
boundary between those combinations of goods and
services that can be produced and those that cannot.
To illustrate the PPF, we focus on two goods and hold the
quantities of all other goods and services constant.
That is, we look at a model economy in which everything
remains the same (ceteris paribus) except the two goods
we’re considering.
 Production Possibilities and
Opportunity Cost
Production Possibilities Frontier
The figure shows the PPF for two goods: cola and pizzas.
 Production Possibilities and
Opportunity Cost
Any point on the frontier such as E and any point inside
the PPF such as Z are attainable.
Points outside the PPF are unattainable.
 Production Possibilities and
Opportunity Cost
Production Efficiency
We achieve production
efficiency if we cannot
produce more of one good
without producing less of
some other good.
All points on the PPF are
efficient.
 Production Possibilities and
Opportunity Cost
Any point inside the
frontier, such as Z, is
inefficient.
At such a point, it is
possible to produce more
of one good without
producing less of the other
good.
At Z, resources are either
unemployed or
misallocated.
 Production Possibilities and
Opportunity Cost
Tradeoff Along the PPF
Every choice along the
PPF involves a tradeoff.
On this PPF, we must give
up some cola to get more
pizzas or we must give up
some pizzas to get more
cola.
 Production Possibilities and
Opportunity Cost
Opportunity Cost
As we move down along
the PPF,
we produce more pizzas,
but the quantity of cola we
can produce decreases.
The opportunity cost of a
pizza is the cola forgone.
 Production Possibilities and
Opportunity Cost
In moving from E to F:
The quantity of pizzas
increases by 1 million.
The quantity of cola
decreases by 5 million cans.
The opportunity cost of the
fifth 1 million pizzas is
5 million cans of cola.
One of these pizzas costs
5 cans of cola.
 Production Possibilities and
Opportunity Cost
In moving from F to E:
The quantity of cola
increases by 5 million cans.
The quantity of pizzas
decreases by 1 million.
The opportunity cost of the
first 5 million cans of cola is
1 million pizzas.
One of these cans of cola
costs 1/5 of a pizza.
 Production Possibilities and
Opportunity Cost
Opportunity Cost Is a
Ratio
The opportunity cost of
producing a can of cola is
the inverse of the
opportunity cost of
producing a pizza.
One pizza costs 5 cans of
cola.
One can of cola costs 1/5
of a pizza.
 Production Possibilities and
Opportunity Cost
Increasing Opportunity
Cost
Because resources are not
equally productive in all
activities, the PPF bows
outward.
The outward bow of the
PPF means that as the
quantity produced of each
good increases, so does its
opportunity cost.
 Gains from Trade

Comparative Advantage and Absolute Advantage

A person has a comparative advantage in an activity if
that person can perform the activity at a lower opportunity
cost than anyone else.
A person has an absolute advantage if that person is
more productive than others.
Let’s look at Joe and Liz who operate smoothie bars.
 Gains from Trade

Joe’s Smoothie Bar

In an hour, Joe can
produce 6 smoothies or
30 salads.
Joe's opportunity cost of
producing 1 smoothie is
5 salads.
Joe's opportunity cost of producing 1 salad is 1/5 smoothie.
Joe spends 10 minutes making salads and 50 minutes
making smoothies, so he produces 5 smoothies and
5 salads an hour.
 Gains from Trade

Liz's Smoothie Bar

In an hour, Liz can
produce 30 smoothies or
30 salads.
Liz's opportunity cost of
producing 1 smoothie is
1 salad.
Liz's opportunity cost of producing 1 salad is 1 smoothie.
Liz’s customers buy salads and smoothies in equal number,
so she produces 15 smoothies and 15 salads an hour.
 Gains from Trade

In part (a), Joe’s opportunity cost of a smoothie is 5 salads. Joe

produces at a point on his PPF.
In part (b), Liz’s opportunity cost of a smoothie is 1 salad. Liz produces
at a point on her PPF.
 Gains from Trade

Joe’s Comparative Advantage

Joe’s opportunity cost of a salad is 1/5 smoothie.
Liz’s opportunity cost of a salad is 1 smoothie.
So Joe has a comparative advantage in producing salads.

Liz’s Comparative Advantage

Liz’s opportunity cost of a smoothie is 1 salad.
Joe’s opportunity cost of a smoothie is 5 salads.
So Liz has a comparative advantage in producing
smoothies.
 Gains from Trade

Achieving the Gains from

Trade
Liz and Joe produce the
good in which they have a
comparative advantage:
 Lizproduces 30 smoothies
and 0 salads.
 Joe produces 30 salads
and 0 smoothies.
 Gains from Trade

Liz and Joe trade (2 salads

per smoothie):
 Lizsells Joe 10 smoothies
and buys 20 salads.
 Joe sells Liz 20 salads and
buys 10 smoothies.
After trade:
 Lizhas 20 smoothies and
20 salads.
 Joe has 10 smoothies and
10 salads.
 Gains from Trade

Gains from trade:

 Lizgains 5 smoothies and
5 salads an hour
 Joe gains 5 smoothies and
5 salads an hour
 Economic Growth

The expansion of production possibilities—an increase in

the standard of living—is called economic growth.
Two key factors influence economic growth:
▪ Technological change
▪ Capital accumulation
Technological change is the development of new goods
and of better ways of producing goods and services.
Capital accumulation is the growth of capital resources,
which includes human capital.
 Economic Growth

The Cost of Economic Growth

To use resources in research and development and to
produce new capital, we must decrease our production
of consumption goods and services.
So economic growth is not free.
The opportunity cost of economic growth is less current
consumption.
 Economic Growth

The figure illustrates the

tradeoff we face.
We can produce pizzas or
pizza ovens along PPF0.
By using some resources to
produce pizza ovens today,
the PPF shifts outward in
the future.
 Economic Growth

The figure compares Singapore and the United States.

 Solving the Economic Questions
There are three types of economic system to
address economic questions.
▪Free market or pure market economy or capitalism
▪Command or centrally planned economy or communism
▪Mixed economy or socialism
 Free market economy
(developed by Adam Smith)
▪Market economies work by
allowing the direct interaction of
consumers and producers who are
pursuing their own self-interest
(i.e., no government intervention).
▪The allocation of resources would
be taken by individual producers
and consumers, through a system
known as the price mechanism or
market mechanism.
▪Price acts as a signal for both
producers and consumers.
 Free market economy
(developed by Adam Smith)

Advantages Disadvantages
▪Resources are allocated according ▪People with higher income levels
to both supply and demand, which have greater say in what is
guarantees efficiency. produced.
▪There is a large choice of goods ▪Certain goods (education,
and services. healthcare, even electricity, etc)
may be underprovided or not
▪Competition can encourage
provided at all.
innovation.
 Command or planned economy
(Developed by Karl Marx)
▪In a command economy the
government mainly makes
decisions on what to produce, how
resources are allocated and at
certain times, through rationing,
who gets it.
▪A government planning office
decides on the allocation of
resources, estimating the types of
products it considers individuals to
want.
 Command or planned economy
(Developed by Karl Marx)

Advantages Disadvantages
▪Everyone has their basic needs ▪Misjudgement of consumers’
met. needs and wants resulting in
shortages and surpluses
▪More government benefits can be
provided if needed. ▪Products may lack variety and
quality due to lack of competition
▪The government can control the and hence innovation.
gap between rich and poor.
▪Market prices are controlled.
 Mixed economy
(developed by John Maynard Keynes)
▪The term mixed economy refers
to an economy in which both free
market and the government have
significant effect on the allocation
of resources.
▪This system aims to allow the
market to operate with government
intervening in the economy only
where the market fails.
▪In reality, most economies are
mixed economies in the sense that
they combine significant elements
of both command and free market
in determining economic
behaviour.
 Mixed economy
(developed by John Maynard Keynes)
▪Interventions of a government
▪Protection of natural resources (fishing grounds, forests) tend to
be overexploited to the point of destruction under free market.
▪The government makes sure that firms take account of the
pollution they create.
▪Education, health services, etc would have been under-provided
if they were left to the market.
▪Free market is volatile/changeable (frequent booms and slumps
also known as growth and recession). Governments try to create a
stable economic environment.
▪Reduction of inequalities in terms of income and wealth, which is
done through the taxation system.