Introduction to Economics: Principles of Individual Choice and Market Equilibrium, Apuntes de Administración de Empresas

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Introduction to Economics

Topic 1

What is economics?

GADE, GDADE, GFICO, GDFICO

Course 2015 - 2016

Outline

Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 2

1. Basic principles of economics

2. Economic models

3. Positive vs. normative economics

4. The production possibility frontier

5. Trade

 Reference: Krugman and Wells (Chapter 1 & 2).

What is Economics?

Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 3  Economics is a social science that studies the production, distribution and consumption of goods and services (from the Greek oikonomia, meaning administration or management of a household)  Economics is about how society deals with the problem of scarcity  Examples of issues analyzed by economists: Oil price shocks, income distribution, reforms in education, health economics, etc.

What is Economics?

Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 4  Market economy: an economy in which decisions about production and consumption are made by individual producers and consumers  (i.e. supply and demand are the result of decentralized decisions by many producers and consumers).  Command economy: an economy in which decisions about production, consumption is decided by the government planning office

Microeconomics vs. Macroeconomics: Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 5

 Microeconomics:

Branch of economics concerned with how people make decisions and how these decisions interact. (i.e. it deals with the behavior of individual economic units - consumers, firms, workers, and investors - as well as the markets that these units comprise).

 Macroeconomics:

Branch of economics concerned with the overall economy (i.e. it deals with aggregate economic variables, such as the level and growth rate of national output, interest rates, unemployment, and inflation). Outline Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 6

1. Basic principles of economics A. Individual Choice Set of principles for understanding the economics of how individuals make choices B. Choice Interaction Set of principles for understanding how individual choices interact
2. Economic models
3. Positive vs. normative economics
4. The production possibility frontier
5. Trade  Reference: Krugman and Wells (Chapter 1 & 2). Making choices and interaction Basic Principals of Economics To understand how an economy works, we need to understand how individuals make choices and how these choices interact with each other. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 7 Individual Choice Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 8

 4 basic economic principles behind the individual

choices: A. Resources are scarce B. Opportunity costs : The real cost of something is what you must give up to get it C. Marignal analysis : “How much?” is a decision at the margin D. Incentives and self-interest : People take advantage of opportunities to make themselves better off

 Making trade-offs at the margin : comparing the costs and benefits of doing a little bit more of an activity versus doing a little bit less.  Ex.: Studying one more hour, drinking one more beer, buying one more CD, etc..  The study of such decisions is known as marginal analysis.  Marginal benefit: The extra benefit resulting from a small increase in some activity.  Marginal cost: The additional cost resulting from a small increase in some activity. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 13 Marginal Analysis Individual Choice  People usually exploit opportunities to make themselves better off. Thus, incentives can change people’s behavior.  People respond to incentives.  Incentives = anything that offers rewards to people to do something (or change behavior).  Marginal changes in costs or benefits motivate people to respond.  Ex.: If people are charged for parking their car at the UPO, we can expect that more people will use the metro. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 14 Incentives and self-interest Individual Choice  5 basic economic principles that underlie the interaction of individual choices: A. Trade : There are gains from trade. B. Equilibrium : Markets move toward equilibrium. C. Efficiency : Resources should be used as efficiently as possible to achieve society’s goals. D. Markets and efficiency : Markets lead to efficiency E. Government intervention : When markets don’t achieve efficiency, government intervention can improve society’s welfare. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 15 Choice Interaction Choice Interaction  In a market economy, individuals engage in trade.  Trade: individuals provide goods and services to others and receive goods and services in return.  Trade can make everyone better off.  There are gains from trade: people can get more of what they want through trade than they could if they try to be self- sufficient.  Trade allows people to specialize in what they do best.  Specialization: when each person specializes in the task that he or she is good at performing. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 16 Trade: Gains from trade Choice Interaction

©^ Th e^ Ne w^ Y orke r^ Collectio n^^1991 Ed^ Frascin o^ fro m^ cartoonbank.com. All^ Right s^ Reserved. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 17 “I hunt and she gathers – otherwise we couldn’t make ends meet.”  It is beneficial if each person specializes in the task that he or she is good at performing.  The economy, as a whole, can produce more when each person specializes in a task and trades with others. Trade: Gains from Trade Choice Interaction  An economic situation is in equilibrium when no individual would be better off doing something different.  Any time there is a change, the economy will move to a new equilibrium.  Ex.: What happens when a new checkout line opens at a busy supermarket? Market Equilibrium Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 18 Choice Interaction  An economy is efficient if it takes all opportunities to make some people better off without making other people worse off.  Thus, if a situation is efficient, it is not possible to make someone better off without making someone else worse off.  Should governments always strive to achieve economic efficiency?  Equity issues are also important. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 19 Efficiency Choice Interaction  Efficiency means society gets the most that it can from its scarce resources.  Equity means the benefits of that resources are distributed ‘fairly’ among the members of society.  But: people can disagree about what’s “fair”  Even when an efficient solution occurs, it might not be desirable Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 20 Efficiency and Equity Choice Interaction

Public goods

Have two key features:  non-rivalry: The same unit of a public good can be consumed by many individuals: one person enjoying the good does not keep others from enjoying it.  non-excludability: Once a good is provided to some individuals it is not possible (or at least very costly) to exclude others from benefiting from it. Leads to free-rider problem Examples: street lightning, lighthouses, national defence. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 25 Types of market failures Types^ of^ market^ failures Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 26

Externalities

Activity of one entity that affects the welfare of another and is not reflected in market prices.  Positive or negative external effects.  External cost = an uncompensated cost that an individual or firm imposes on others. => Negative externality.  External benefit = a benefit that an individual or firm confers on others without receiving compensation. => Positive externality.  Without government intervention, the free market will not lead to an efficient solution, as prices will reflect private costs, but not the additional external costs

Market failures

Example negative externality:

The cost for the brickworks of making bricks is less than the real cost, which includes the cost of pollution Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 27 The laundry is an unwilling free rider: It can not charge a price for the pollution it receives The pollution is a negative external effect to the laundry. It is raising the laundry‘s production costs Pollution is delivered as a public ‘bad‘ to the laundry  Market failure is a rational for policy intervention into the market  Another rational for government intervention is income redistribution.  In this case the government intervenes in the market because of distributional reasons (i.e. social reasons/ reasons of ‘equity’).  In this case government intervention usually reduces economic efficiency of the market. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 28 Markets and Government Intervention

Outline Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 29

1. Basic principles of economics

2. Economic models

3. Positive vs. normative economics

4. The production possibility frontier

5. Trade

 Reference: Krugman and Wells (Chapter 1 & 2). Economic Models Tunnel vision A miniature airplane sitting motionless in a wind tunnel isn’t the same thing as an actual aircraft in flight. But it is a very useful model of a flying plane. Economic theory consists mainly of a collection of models. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 30 What is an economic model? = Simplified representation of a system (of the real world).  A model tries to preserve the features that are essential to the question being analysed  A model shows how different elements are linked by relationships  Simplification is particularly important for economics given the enormous complexity of economic processes Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 31 Economic Models  An economic model represents economic processes by a set of variables and a set of logical and/or quantitative relationships between them.  Economists must make a reasoned choice of which variables and which relationships between these variables are.  The “other things being equal” (ceteris paribus) assumption is important in economic models.

• It allows to focus on the effects of only one change at a time. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 32 Economic Models

Outline Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 37

1. Basic principles of economics

2. Economic models

3. Positive vs. normative economics

4. The production possibility frontier

5. Trade

 Reference: Krugman and Wells (Chapter 1 & 2).  The Production Possibility Frontier (PPF) is a curve depicting all maximum output possibilities for two goods or services given a set of inputs (resources, labor, etc.).  Imagine Robinson Crusoe stranded on a remote island with limited resources (i.e. the natural resources of the island, his own time and effort).  How to distribute his resources?

• Catching fish, or
• gather coconuts? The Production Possibility Frontier Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 38  The PPF illustrates trade-offs facing an economy that produces only two goods.
• Note: In the example Robinson Crusoe represents a one-man economy  It shows the maximum quantity of one good that can be produced for any given production of the other.  The PPF improves our understanding of trade-offs Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 39 The Production Possibility Frontier 0 20 28 40 30 9 15 Quantity of coconuts A B D C Feasible and efficient in production Not feasible Production possibility frontier PPF Quantity of fish The Production Possibility Frontier 21 12 Feasible but not efficient Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 40

0 20 28 40 Quantity of coconuts 30 Quantity of fish The Production Possibility Frontier 21 A 15 9 B Production possibility frontier PPF 12 Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 41  A and B are efficient situations, no possibilities are wasted (it is not possible to produce more of one good without producing less of the other).  C is feasible, but not efficient (it would be possible to produce more of both goods).  D is not feasible. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 42 The Production Possibility Frontier

Opportunity cost

 The PPF is also useful in measuring the opportunity cost (what has to be sacrificed of one good in order to obtain one unit of the other good)  What is the opportunity cost of catching 28 fish instead of 20? 6 coconuts Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 43 The Production Possibility Frontier

Opportunity cost

 And what is the opportunity cost of catching 20 fish instead of 12? also 6 coconuts  Observation: If the PPF has a linear slope, the trade-off remains constant along the PPF, i.e. we face a constant opportunity cost. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 44 The Production Possibility Frontier

Outline Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 49

1. Basic principles of economics

2. Economic models

3. Positive vs. normative economics

4. The production possibility frontier

5. Trade

 Reference: Krugman and Wells (Chapter 1 & 2).  Now we have a look how gains from trade are generated.  Remember: How can we satisfy our wants and needs in a economy?

• We can be economically self-sufficient.
• We can specialize and trade with others.  Let’s suppose that there is a second castaway on our island (now we have Robinson and Friday).
• Can they benefit from trading with each other? Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 50 Trade 0 28 40 9 a) FPP of Robinson Robinson’s consumption without trade Quantity of coconuts 30 Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 51 Robinson’s PPF Quantity of fish Trade To catch another Fish, Robinson must give up ¾ of a coconut. 0 6 10 20 8 Friday’s PPF Quantity of coconuts Quantity of fish Friday’s consumption without trade Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 52 b) FPP of Friday Trade To catch another Fish, Friday must give up 2 coconuts.

Robinson and Friday’s Opportunity Costs Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 53 Robinson’s Opportunity Cost Friday’s Opportunity Cost One fish 3/ 4 coconut 2 coconuts One coconut 4/^3 fish^ 1/^2 fish We can observe that:  Friday is less productive in both (as a maximum he can gather 20 coconuts and catch 10 fish).  But Friday is especially inefficient in fishing (his opportunity cost for catching one fish is 2 coconuts).  Can both castaway benefit/be better off if they reach an agreement? Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 54 Trade  Both castaways are better off when they each specialize in what they are good at and trade.

 It’s a good idea for Robinson to catch the fish for

both of them, because his opportunity cost of a fish in terms of coconuts not gathered is only 3/4 of a coconut, versus 2 coconuts for Friday.  Correspondingly, it’s a good idea for Friday to gather coconuts for the both of them. His opportunity costs is less, only 1/2 of a fish to 4/3 fish for Robinson. Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 55 Trade => Both Robinson and Friday experience gains from trade Trade Robinson Friday Introduction to Economics GADE, GDADE, GFICO, GDFICO, course 2015 - 2016. 56 How Robinson and Friday gain from trading with each other