ECON6066

Macro and Micro Economics

Week 1
Introduction to economics
 Outline

 Ten principles of economics

 Thinking Like an Economist

 Interdependence and the Gains from Trade

Ten Principles of Economics
 What Economics is All About

Scarcity: the limited nature of society’s resources

Economics: the study of how society manages its scarce resources, e.g.
how people decide what to buy,
how much to work, save, and spend
how firms decide how much to produce,
how many workers to hire
how society decides how to divide its resources between national defense, consumer
goods, protecting the environment, and other needs
 How People Make Decisions
Principle 1 : People Face Tradeoffs

Society faces an important tradeoff:

efficiency vs. equality
Efficiency: when society gets the most from its scarce resources
Equality: when prosperity is distributed uniformly among society’s members
Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce, shrinks the size of the economic “pie.”
 How People Make Decisions
Principle 2 : The Cost of Something is What You Give Up to Get
It

Making decisions requires comparing the costs

and benefits of alternative choices.
The opportunity cost of any item is
whatever must be given up to obtain it.
It is the relevant cost for decision making.
 How People Make Decisions
Principle 3 :
Rational People Think at the Margin

Rational people
systematically and purposefully do the best they can to achieve their objectives.
make decisions by evaluating costs and benefits of marginal changes – incremental adjustments
to an existing plan.
 How People Make Decisions
Principle 4 : People Respond to Incentives

Incentive: something that induces a person to act, i.e. the prospect of a reward or
punishment.
Rational people respond to incentives.
Examples:
When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs.
When cigarette taxes increase,
teen smoking falls.
 How People Make Decisions
Principle 5 :
Trade Can Make Everyone Better Off

Rather than being self-sufficient,

people can specialize in producing one good or service
and exchange it for other goods.
Countries also benefit from trade & specialization:
Get a better price abroad for goods they produce
Buy other goods more cheaply from abroad than
could be produced at home
 How People Make Decisions
Principle 6 : Markets Are Usually A Good Way to Organize
Economic Activity

Market: a group of buyers and sellers

(need not be in a single location)
“Organize economic activity” means determining
what goods to produce
how to produce them
how much of each to produce
who gets them
A market economy allocates resources through the
decentralized decisions of many households and firms as
they interact in markets.

Famous insight by Adam Smith in The Wealth of Nations

(1776): Each of these households and firms acts as if “led by
an invisible hand” to promote general economic well-being.
 How People Make Decisions
Principle 7 : Governments Can Sometimes Improve Market
Outcomes

Important role for got: enforce property rights

(with police, courts)
People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen.
Market failure: when the market fails to allocate society’s resources efficiently
Causes:
Externalities, when the production or consumption of a good affects bystanders (e.g. pollution)
Market power, a single buyer or seller has substantial influence on market price (e.g. monopoly)
In such cases, public policy may promote efficiency.
 How People Make Decisions
Principle 8 : A country’s standard of living depends on its ability to
produce goods & services

Huge variation in living standards across countries and over time:

Average income in rich countries is more than ten times average income in poor
countries.
The U.S. standard of living today is about eight times larger than 100 years ago.
The most important determinant of living standards: productivity, the amount of goods and
services produced per unit of labor.
Productivity depends on the equipment, skills, and technology available to workers.
Other factors (e.g., labor unions, competition from abroad) have far less impact on living
standards.
 How People Make Decisions
Principle 9 : Prices rise when the government prints too much
money

Inflation: increases in the general level of prices.

In the long run, inflation is almost always caused by excessive growth in the quantity of money,
which causes the value of money to fall.
The faster the govt creates money, the greater the inflation rate.
 How People Make Decisions
Principle 10 :
Society faces a short-run tradeoff between inflation and
unemployment

In the short-run (1 – 2 years),

many economic policies push inflation and unemployment in opposite directions.
Other factors can make this tradeoff more or less favorable, but the tradeoff is always present.
Thinking Like an Economist
 The Economist as a scientist

The scientific method: observation, theory, and

more observation
 Observation
 Theory
 Conducting experiments
– Difficult / impossible
 Observation
– Close attention to natural experiments -
history
 The Economist as a scientist

The role of assumptions

 Assumptions
 Can simplify the complex world
o Make it easier to understand
 Focus our thinking - essence of the problem
 Different assumptions
 To answer different questions
 Short-run effects
 Long-run effects
 Economic Models

first model: The circular-flow diagram

Revenue
Markets for Goods Spending
& Services
G & S sold G & S bought

Firms Households

Factors of Labor, land,

production Markets for Factors capital
of Production
Wages, rent, profit Income
 Economic Models

second model: The production possibilities frontier

 Definition
 The boundary between the combinations of goods and services that can be produced
and the combinations that cannot be produced, given the available resources and the
state of technology.
 The PPF is a valuable tool for illustrating the effects of scarcity and its consequences.
 Available resources
 Land: both raw land and natural resources taken from the land
 Capital: Machines, tools, other equipment, buildings, and business inventories
 Labor force: All people willing and able to work whether they are currently employed or
unemployed

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The Production Possibilities Frontier

The Production Possibilities

Frontier
The production possibilities frontier
shows the combinations of
output—in this case, cars and
computers—that the economy can
possibly
produce. The economy can
produce any combination on or
inside the frontier. Points outside
the frontier are not feasible given
the economy’s resources.
 Microeconomics and Macroeconomics

 Microeconomics is the study of how households and firms make decisions and
how they interact in markets.

 Macroeconomics is the study of economy-wide phenomena, including inflation,

unemployment, and economic growth.

 These two branches of economics are closely intertwined, yet distinct – they
address different questions.
 The Economist as Policy Advisor

 As scientists, economists make

positive statements,
which attempt to describe the world as it is.
 As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
 Positive statements can be confirmed or refuted,
normative statements cannot.
 Govt employs many economists for policy advice.
Interdependence and the Gains from Trade
 A Parable for the Modern Economy

 Specialization and trade

– Farmer – specialize in growing potatoes
• More time growing potatoes
• Less time raising cattle
– Rancher – specialize in raising cattle
• More time raising cattle
• Less time growing potatoes
– Trade
• Willing to trade: 3 oz of meat for 1 oz potatoes
• Final trade -5 oz of meat for 15 oz of potatoes
– Both gain from specialization and trade
 A Parable for the Modern Economy

 Two goods: meat and potatoes

 Two people: rancher and farmer
 If rancher produces only meat
– And farmer produces only potatoes
– Both gain from trade
 If both rancher and farmer produce both meat and potatoes
– They still gain from specialization and trade
 The production possibilities frontier (a)

(a) Production Opportunities

Minutes needed to Amount produced in

Make 1 ounce of: 8 hours

Meat Potatoes Meat Potatoes

Farmer 60 min/oz 15 min/oz 8 oz 32 oz

Rancher 20 min/oz 10 min/oz 24 oz 48 oz

Panel (a) shows the production opportunities available to the

farmer and the rancher.
 The production possibilities frontier (b, c)

Meat (oz) Meat (oz)

24
If there is no trade, the rancher chooses
If there is no trade, the farmer this production and consumption.
chooses this production and
consumption.
8

12 B

4 A

0 16 32 0 24 48
Potatoes (oz) Potatoes (oz)
(b) The farmer’s production (c) The rancher’s production
possibilities frontier possibilities frontier
Panel (b) shows the combinations of meat and potatoes that the farmer can produce. Panel (c) shows the combinations of meat and
potatoes that the rancher can produce. Both production possibilities frontiers are derived assuming that the farmer and rancher each
work 8 hours per day. If there is no trade, each person’s production possibilities frontier is also his or her consumption possibilities
frontier
 How Trade Expands the Set of
Consumption Opportunity
Meat (oz) Meat (oz)

24 Rancher’s
Farmer's Rancher’s
production with production and
production and
trade consumption
consumption Farmer's 18
without trade without trade
8 consumption
with trade 13 B*
A* 12 Rancher’s
5
B consumption
Farmer's with trade
4 production
A with trade

0 16 17 32 0 12 24 27 48
Potatoes (oz) Potatoes (oz)
(a) The farmer’s production (b) The rancher’s production
and consumption
and consumption

Farmer and Rancher agree to trade 5 oz of Meat for 15 oz of Potatoes (3:1)

Start at corners (specialization)
 How Trade Expands the Set of
Consumption Opportunity

Farmer Rancher

Meat Potatoes Meat Potatoes

Without trade:
Production & consumption 4 oz 16 oz 12 oz 24 oz
With trade:
Production 0 oz 32 oz 18 oz 12 oz
Trade Gets 5 oz Gives 15 oz Gives 5 oz Gets 15 oz
Consumption 5 oz 17 oz 13 oz 27 oz
GAINS FROM TRADE:
Increase in consumption +1 oz +1 oz +1 oz +3 oz

(c) The gains from trade: A summary

 Comparative Advantage

 Absolute advantage
– Produce a good using fewer inputs than another producer
– Rancher: 20 min/1 oz M; 10 min/1 oz P
– Farmer: 60 min/ 1 oz M; 15 min/ 1 oz P
 Opportunity cost
– Measures the trade-off between the two goods that each producer faces
– Rancher -1 oz M -> 2 oz P
– Farmer: 3 oz P -> -1 oz M
 The Opportunity Cost of Meat and
Potatoes

Opportunity cost of:

1 oz of Meat 1 oz of Potatoes

Farmer 4 oz potatoes ¼ oz meat

Rancher 2 oz potatoes ½ oz meat
 References

N. Gregory Mankiw. (2018). Principles of Economics. 08. Cengage Learning Asia Pte
Ltd. Singapore. ISBN : 978-981-4780-35-3, Chapter 1, 2, 3
Thank You