Introduction To Economics PDF

Introduction to Economics Outline 1. Basic Economic Problem of Scarcity 2. Types of Economies 3. Specialisation and Division of Labour 4. Economics as a Social Science 5. Production Possibility Frontiers Model Basic Economic Problem: Scarcity Humans have infinite needs and wants for g...

Introduction to Economics Outline 1. Basic Economic Problem of Scarcity 2. Types of Economies 3. Specialisation and Division of Labour 4. Economics as a Social Science 5. Production Possibility Frontiers Model Basic Economic Problem: Scarcity Humans have infinite needs and wants for goods and services Needs: goods and services that are essential for basic survival such as food, shelter, sanitation, drinking water, etc. Wants: goods and services that are not essential for survival but do enhance the quality of life such as entertainment, fine dining restaurant meals, luxury clothing Goods: Tangible items for consumption (chocolate, clothing, etc.) Services: Intangible activities for consumption (football match, a tuition lesson, etc.) Needs are generally limited but wants are infinite Basic Economic Problem: Scarcity Resources to produce goods and services are finite and limited in quantity Four Factors of Production: 1. Land: All natural resources such as (wood from trees, fertile soil, earth minerals, wild animals, etc.) Non-renewable: Resources whose stocks are not easily or quickly replaced or replenished after they are used (examples: coal, gold, iron ore, fossil fuels) Renewable: Resources whose stocks are easily replenished after use (examples: forest timber, solar energy) 2. Labour: The skills and work supplied by people in the workforce 3. Capital (Fixed Capital):Man-made factor of production; tools and machinery that are used in the production of other goods Working or Circulating Capital: Unfinished goods that will be later transformed into final goods for sale and consumption Human Capital: The skills, knowledge, and talents of workers that are acquired through experience and education. It represents the value of workers to an economy’s productive potential. 4. Entrepreneurship: The skill of entrepreneurs (business owners) in organising the other three factors of production and taking risks for the purpose of making profits Rewards for each factor: Rent for owners of land; Wages for owners of labour; Rents, lease payments, share of profits for owners of capital; profits for entrepreneurs Basic Economic Problem: Scarcity Problem of Scarcity: There is a mismatch between the infinite human needs and wants for goods and services and the finite resources needed to produce those goods and services Consequence of Scarcity: Choices have to be made on how scarce resources are allocated among competing uses Any time a resource is used for a particular purpose, an opportunity cost is incurred. It is the value of the benefits of that resource’s next best alternative use. Economic Goods: goods and resources that are scarce in quantity and have opportunity costs. Most goods and resources are economic goods. Free Goods: goods and resources that do not have opportunity costs because their availability is excessively abundant to the point of not being scarce (air, sunlight, water in general) Free goods can become economic goods if their availability becomes scarce Societies will need a system, an economy, that answers 3 economic questions regarding the allocation and distribution of resources 1. What goods and services and in what quantities should be produced? 2. How should goods and services be produced? 3. For whom should goods and services be produced? 3 Types of Economic Systems All societies rely on an economic system to answer the 3 basic economic questions Economic system: A complex network of individuals, organisations and institutions that allocates scarce resources Two main mechanisms for allocating resources 1. Market: Buyers and sellers of goods and services interact and carry out exchange. How resources are allocated depends on the market price of goods and services 2. Central Planning/Command: An administrative body, usually the government, is responsible for allocating and distributing resources 3 Types of Economic Systems 1. Free market Economies Most resources are allocated through markets with very little central planning Production of goods and services is primarily carried out by private entities rather than government institutions Government spending is relatively small in size compared to the whole economy Examples: Hong Kong, USA 2. Mixed Economies Roughly 40-60% of resources are allocated by governments and markets respectively Governments are actively involved in the redistribution of income through the provision of welfare benefits such as state pensions, unemployment income, child allowances Healthcare system is primarily administered and financed by the state Examples: Western European and Scandinavian countries: Germany, France, Sweden, etc. 3. Command Economies Most resources are allocated through central planning from the government while markets play an insignificant role Examples: Cuba, North Korea, Soviet Union, China Evaluating the 3 types of Economic Systems Choice Generally, free market economies provide greater choices in terms of variety of goods and services because of the possibility of private enterprise and competition Workers in free market economies also have greater choices with regards to career paths Choice also depends on other factors such as level of income and degree of competition in markets. It is not necessarily the case that free market economies always provide lots of choices for both consumers and workers Quality and Innovation Generally, free market economies enjoy higher quality of goods and services as well as greater product innovation due to the presence of private enterprise and competition Companies that fail to innovate may fail to make a profit and be eliminated by their competitors Quality and innovation improvements can also stagnate in free market economies when competition is no longer present Evaluating the 3 types of Economic Systems Efficiency Planned economies are generally less efficient compared to free market economies with regards to the use of resources The lack of competition in planned economies leads to little consequences for the central authority when resources are used inefficiently Firms in competitive markets cannot survive if they are inefficient relative to their competitors It is also possible for inefficient firms to exist in free market economies when large firms dominate their industries without much threat of competition Economic Growth Evidence suggests that free market economies and mixed economies do not differ significantly with respect to economic growth rates of national output Planned economies have collapsed in the past and present ones struggle to grow Evaluating the 3 types of Economic Systems Distribution of Wealth and Income Free market economies generally have higher levels of income and wealth inequality compared to mixed and planned economies because in those economies individuals are encouraged to pursue profits and governments are not active in the redistribution of income Mixed and Planned economies have lower levels of inequality as they tend to levy relatively higher taxes on the wealthy which are then redistributed through the provision of basic goods and services and the welfare system to support the less wealthy Risk Citizens in free market economies are generally exposed to greater risks than those in mixed and planned economies. The lack of an extensive social safety net provided by the government leaves citizens vulnerable to adverse situations such as poor health, unemployment, and natural disasters. Governments in mixed and planned economies place a greater importance on providing affordable essential goods and services to their citizens as well as establishing a strong welfare system that protects the well being of the most vulnerable in society Evaluating the 3 types of Economic Systems Political Freedom Free and mixed market economies generally offer greater political freedom to its citizens in the form of regular elections of public officials, which theoretically should give citizens more agency in the implementation of policies that affect their economic well-being Command economies tend to rely on authoritarian measures to enforce their economic policies. One such measure is the removal of political opposition by restricting the political freedom of its citizens. There is no perfect economic system, each has its own merits and flaws. Famous Economists: Adam Smith Scottish philosopher then turned economist; father of Classical economics An Enquiry into the Nature and Causes of the Wealth of Nations Increases in productivity of labour and capital is the main cause of increase in national wealth A key driver of increase in labour productivity is the division of labour as well as the accumulation of capital Critical of government policies that restricted domestic and international trade such as monopoly charters and trade barriers on imported goods A proponent of a laissez faire approach to managing the economy: Allow markets to allocate resources on their own without government intervention Believed that self-interest and competition in markets can allocate resources most efficiently in the sense that it best satisfies the needs and wants of society: Invisible Hand of the market Acknowledged that the state still had a role to play in ensuring markets function properly: Provide physical infrastructure and national defence to facilitate trade and ensure national security Establish a legal framework and enforce laws Protect the poor from being exploited by property owners Famous Economists: Karl Marx German philosopher/economist; the leading figure of the heterodox Marxian school of thought Das Capital: Capital a Critique of Political Economy Argues that capitalist economies inherently lead to significant wealth and income inequalities between owners of capital (wealthy bourgeoise) and owners of labour (workers), the former exploiting the latter through diminishing wages. The disgruntled and exploited workers form a new social class called the proletariat and will seek to overthrow the capitalist system by seizing control of the means of production from their oppressors The conclusion of this revolution will be the establishment of a new economic system called socialism where the means of production will be collectively owned through the state rather than in the hands of private individuals and the distribution of resources and wealth would be more equitable Famous Economists: Friedrich Hayek Austrian economist; one of the leading figures of the heterodox Austrian school of thought The Road to Serfdom Warned that greater government involvement in the economy could slowly lead to a loss of individual freedom and the descent of a nation towards totalitarian dictatorships such as Nazi Germany, Fascist Italy, and Stalinist Soviet Union Strong supporter of minimally regulated markets and believed that centralized planning is a way of imposing the will of a minority upon the people Specialisation One of the most important causes of improvements in labour and capital productivity and ultimately economic growth an increases in the standard of living is the specialisation Specialisation: Production of a limited range of goods and services by an individual workers, firms, or countries Between countries: In a globalized economy, different countries can specialise in the production of certain goods and services and import those that it doesn’t produce from other countries Between firms: Businesses generally produce a limited range of goods and services that are closely related and only operate within a particular sector or industry Primary Sector: Firms that are involved in the extraction of natural resources Secondary/Manufacturing Sector: Firms that take raw materials and transforms them into finished goods for consumption Tertiary/Services Sector: Firms that provide intangible services for consumption Firms can also be divided between private and public entities Private Sector: Firms that are operated by private individuals, companies, and charities. Their main objective is usually to maximize profits Public Sector: Firms that are operated by government organisations, departments, local authorities, or state owned businesses. The common assumption is that the public entities are more concerned about the overall welfare of society rather than the profits of the enterprise. Division of Labour Specialisation of production of goods and services between individual workers The production of a single good or service is divided into the smaller component tasks and each worker is responsible for one or few tasks at a time Benefits: Workers become specialists in their roles and could develop specialist tools for particular tasks that further improve overall productivity Time can be saved as workers no longer need to switch between tasks as frequently Overall productivity of labour and capital is significantly increased and ultimately leads to improved quality of life through greater consumption Costs: Work can become very mechanical and boring for workers which may lead to decreased motivation and ultimately decreased quality of good or service Specialisation makes it more difficult for workers to transition between jobs and careers as skills developed in a particular job will be very narrow and are most likely not transferrable to other roles The overall production process becomes more vulnerable to shocks as problems in one particular part of the process can lead to total shutdown of production.  Markets and Money Specialisation alone is insufficient to bring about economic prosperity and improvements in quality of life. Markets and money are also needed. Markets: Any set of arrangements that allows buyers and sellers of goods and services to meet, communicate, and carry out exchange Provide an efficient method for specialised firms to sell their increased production, and specialised workers to purchase goods and services that they do not produce Markets are generally divided based on the type of goods and services traded Markets can also be subdivided into smaller submarkets based on product specificity or location (e.g. the market for homes, the market for homes in Mid- Levels, the market for apartment homes) Submarkets are part of the overall larger market but may behave independently from it. (e.g. prices of homes can fall in general while the prices of homes in Mid- Levels do not change) What is Money? Money: Anything that is widely accepted for payment of goods and services and repayment of debt. Before money existed, people had to barter goods and services which was very inefficient Successful bartering required a double coincidence of wants, the buyer and seller had exactly the type of goods and services the other desired Specialisation would not be feasible under bartering economies as the producer would find it very difficult to sell off increased production 4 Functions of Money 1. A medium of exchange: An intermediary exchange commodity for goods and services that guarantees double coincidence of wants 2. A measure of value: a unit of account that the value of all goods and services can be measured in 3. A store of value: The expected quantity of goods and services that can be purchased with a certain amount of money does not fluctuate significantly over short periods of time. This gives confidence to sellers who receive money in exchange for providing a certain quantity of goods and services will be able to purchase other goods and services of similar value in the future. 4. A method of deferred payment Loans can be lent and repaid using money 5 Types of Money 1. Cash Banknotes and coins issued by the central bank of a country 2. Current Accounts in Banks Deposits in banks that can be withdrawn immediately and converted into cash at no cost. Examples: debit cards, and cheques 3. Near Monies Assets that have all functions of money except medium of exchange They are quite liquid and can be converted into other mediums of exchange at little cost Examples: Time Deposits 4. Non-money Financial Assets Assets that are not mediums of exchange and not reliable stores of values Conversion into other mediums of exchange may be difficult and costly The value of these assets can change significantly even in a short period of time Examples: Houses, shares of companies, cars, etc. 5. Money Substitutes All functions of money except store of value. Example: Credit Cards Financial Markets Markets where buyers and sellers can trade monetary goods and services. Functions of Financial Markets 1. Facilitate savings in an economy: Individuals with surplus cash can purchase financial assets that earn interest or may increase in value. The returns from these assets can be used for future consumption spending. 2. Facilitate lending in an economy: Businesses and individuals with insufficient cash for investment and consumption can borrow surplus funds provided by savers in the economy. 3. Facilitate exchange of goods and services in an economy: Financial institutions provide and maintain payment systems that facilitate everyday trade. Banks and money changers (bureau de changes) provide currency exchange services that facilitate international trade. 4. Facilitate risk taking and risk mitigating activities Certain financial assets such as forwards and futures allows speculators to take risky bets and profit from price changes of other commodities/currencies. These assets also allow firms to reduce the risk of adverse price changes affecting their incomes. 5. Facilitate trading in financial assets Stock markets and bond markets allow firms to obtain needed funds for expansion through issuing shares and debt securities. Investors can conveniently buy and sell these assets on public stock and bond exchanges. Economics as a Social Science Economics is the social science that seeks to explain how economic agents such as consumers, firms, governments, and countries, etc. behave under the constraint of scarcity The development and testing of economic theories and models relies upon the scientific method commonly used in the natural sciences Scientific Method: 1. A hypothesis about the relationship between variables of interest is put forth by the scientist/economist. Usually this is either in the form of a model or a theory that the scientist believes explain how the world works Theory: the hypothesis stated in words; Model: the hypothesis described mathematically 2. The theory or model is then tested by comparing the evidence from real world experiments to the predictions of the hypothesis If the evidence is sufficiently similar to the predictions then the validity of the hypothesis is supported Otherwise the hypothesis may be rejected Problems with Using the Scientific Method While the scientific method works well in the natural sciences it may not be completely appropriate for the development of economics Problems of using the scientific method in economics: 1. Controlled experiments are difficult to produce in economics because economic variables are constantly changing. Some experiments may even be impossible to produce such as economic recessions. 2. The lack of control over experiments may lead to varying interpretations of the data and consequently different conclusions about the same hypothesis 3. Human behaviour is very complex and unpredictable. It is impossible to reduce human behaviour down to scientific laws or axioms. Simplifications and Assumptions used in Economics Economic behaviour and variables are possibly influenced by many different factors. However, in order for a model/theory to be useful in application, it should not be overcomplicated in its description of how variables are related The model/theory should be simplified by including only the most significant and relevant variables while omitting others that are less important The assumption of ceteris paribus: “All other things being equal” Commonly used in describing economic theories and models By isolating changes to only two variables, cause and effect relationships are more clearly stated. 2 Approaches to Economics 1. Positive Economics An objective approach that only considers statements that can be verified as either true or false Examples of Positive Statements: The unemployment rate is currently 5% The GDP of Hong Kong will rise by 2% next quarter 2. Normative Economics A subjective approach to economics that considers statements reflecting the personal beliefs and value judgements on economic issues. Examples of Normative Statements: Healthcare should be provided by the public sector at cost High income inequality stifles economic growth The current inflation rate is too high Normative statements are usually accompanied by positive statements to support their arguments. However they can never be fully refuted nor validated as they are simply opinions and beliefs. Production Possibility Frontiers Model (PPF) A graph that shows all the possible combinations of two economic goods that an economy can produce at a point in time when all resources are fully and efficiently employed The model can be used to illustrate 4 basic economic concepts: 1. Scarcity 2. Opportunity Cost 3. Economic Growth and Decline 4. Efficiency and Choice Different pairs of economic goods are chosen depending on the concept one wishes to highlight Consumption goods versus Capital goods (esp. 3) Civilian goods versus Defence goods (esp. 4) PPF and Scarcity Only combinations within the frontier and on the frontier are feasible (points A and B) Combinations outside of the frontier such as point C are infeasible The current quantity and quality of factors of production and technology do not allow for the production and consumption of 80 units of cars and 60 units of beef  PPF and Opportunity Costs Increasing production of one good comes at the cost of decreasing production of the other good Moving from B to C on the PPF, the quantity of cars produced increases by 40 units The opportunity cost is reducing production of beef by 5 units If the economy wants to further increase production of cars by another 40 units (C to A), production of beef needs to be reduced by 55 units Concave PPF: Increasing Opportunity Costs Resources for producing beef may not be equally productive when used in the production of cars  Linear PPF: Constant Opportunity Costs Special Case: Linear PPF Opportunity costs remain the same moving along the PPF B to C: +40 wheat at the cost of -30 corn C to A: +40 wheat at the cost of -30 corn B to A: +80 wheat at the cost of -60 corn Opportunity Cost: 4 units of wheat for 3 units of corn Resources used to produce corn are equally suitable for the production of wheat  PPF and Economic Growth and Decline Economic Growth: An expansion in productive capacity of the economy represented by a shift outwards of the PPF (A to B) Economic Decline: A contraction in productive capacity of the economy represented by a shift inwards of the PPF (A to C) Causes of Economic Growth/Decline 1. Increase/Decrease in the quantity of the factors of production in an economy 2. Increase/Decrease in the quality of the factors of production in an economy 3. Improvements/Setbacks in production technology  Sustained Economic Growth Two goods: consumer goods and capital goods Consumer goods are goods that simply provide direct pleasure to the consumer through consumption such as chocolate, luxury homes, etc. Capital goods are goods that are used to produce other goods such as machinery, factories, infrastructure, etc. Capital goods increase the productive capacity of the economy but consumer goods do not Sustained economic growth requires sufficient investment in capital goods over time Investment in the production of capital goods is only possible if the economy reduces its spending on consumption goods and provides the necessary savings to finance spending on capital goods. Thus there is a trade-off between consumption and investment A reduction in consumption today may temporarily reduce living standards but it allows sufficient investment in capital goods that will increase consumption in the future. Likewise an increase in consumption today may temporarily improve living standards at the expense of future consumption because of insufficient investment in capital goods. Trade-off Between Consumption and Investment  PPF, Efficiency, and Choice Productive Efficiency The economy is using all of its resources as efficiently as possible to produce the two goods Only points on the PPF (Points B, C, and D) are productively efficient Any point within the PPF (Point A) is productively inefficient as there may be slack and/or some resources are not efficiently utilised Allocative Efficiency The economy is producing the combination of the two goods that best satisfies the needs and wants of the economy (maximizes social welfare) Must be a point on the PPF (Points B, C, and D) and cannot be a point within the PPF (Point A). Among the points on the PPF, the allocatively efficient combination depends on the preferences of the consumers The economy has to make a choice with regards to which point on the PPF it decides to produce and consume AE implies PE; no PE implies no AE PE does not imply AE