ECON1000 - Unit 1 Lecture Notes - wn (1).pdf

PRINCIPLES OF ECONOMICS UNIT 1 – LECTURE NOTES THE FOUNDATION David Tennant Objectives of Unit 1 What is economics? How do economists think? What value does an economist’s perspective add? How do people make decisions? How do economies work? What is Economics? ‘A social science directed at the satisfaction of needs and wants through the allocation of scarce resources which have alternative uses… Economics is about the study of scarcity and choice’ www.aeaweb.org/resou rces/students/what-is-e conomics What is Economics? But what is it really? It is a way of thinking about many of the world’s economic problems and quite a few of the problems that may not traditionally be considered to be economic in nature. It is NOT the only way. It is NOT the only correct way. It, however, adds a valuable perspective from which to consider and comprehend many societal issues. What is Economics? Which, if any, of these topics do you think would be studied by economists? 1. The impact of AIDS on the sexual preference of individuals 2. Is the threat of prison a deterrent to juvenile criminality? 3. The shadow of the Jacket: Do fathers spend more time with children who look like them? 4. Do children who attend shift schools underperform relative to those in traditional schools? 5. Does corporal punishment in schools impact the incidence of corporal punishment in the home? 6. Understanding Poverty: The Livelihoods and Lifestyles of the Very Poor, Poor and Near-Poor 7. The impact of politics and governance on national measures of happiness and well-being. 8. Sovereign Debt and Credit Rating Bias 9. Why do People Risk Exposure to Ponzi Schemes 0. Corporate Proﬁtability and Effective Tax Rate: The Enforcement Effect of Large Taxpayer Units What is Economics? Food for Thought: What is YOUR major? What is YOUR passion? Could an economist’s perspective add value in your ﬁeld? What is Economics? What is the Economist’s Perspective? Five fundamental ideas that shape the way most economists think: 1. People respond to incentives 2. Resources are scarce Idea 3. Real values matter Insights 4. Prices reﬂect scarcity Implications 5. Returns eventually diminish 1st Foundation: People respond to incentives The Idea: An improvement in the beneﬁt or reduction of the cost or effort to engage in an activity will lead more people to engage in the activity more frequently. This works in both directions – A reduction in the beneﬁt or increase in the cost will generally result in fewer people engaging in the activity and/or doing so less often. Examples: Jamaica Gleaner Headlines – 9-22-2022 Bank of England raises rates but avoids bolder hike like Fed TAJ rounds up alleged tax cheats 1st Foundation: People respond to incentives Types of Incentives: Money, or more broadly, material value, is not the only incentive that motivates people to change their behaviour. There are non-ﬁnancial rewards and costs that can also serve as powerful reasons for people to take action: ❑ Praise and other forms of social approval ❑ Criticism, ostracism, shame and other forms of social disapproval ❑ One’s conscience or moral compass ❑ Physiological and emotional incentives In order to have a full understanding of the decisions that people make, we have to take account of all their motivations (whether material, social, moral, emotional or physiological). 1st Foundation: People respond to incentives Types of Incentives: Examples: Before sports became lucrative, athletes made great sacriﬁces to win gold medals, why? In an experiment it was shown that the mere presence of a Bible reduced the likelihood that people will lie, why? 1st Foundation: People respond to incentives Insights: The recognition that people respond to incentives allows us to interpret what we see in the world around us in the light of this insight. People’s response to incentives provides the basis for understanding what economists mean by “rationality” Rationality in economics does not mean the same thing as the word used in everyday language. ▫ It does not mean that each individual always conducts careful and detailed analyses to ensure that he/she always acts in their own best possible long-term interest. ▫ It does not mean that individuals are always rational in the sense that they always make sensible decisions. 1st Foundation: People respond to incentives Insights: Rationality in economics means that, taken as a group, people can be relied upon to respond predictably to increased incentives, by participating more in the activity that has become more rewarding. Such a response does not require that every individual in the group does the activity more often. Some individuals may even do the activity less. But, if there are such persons, their contrary decision will be swamped by those with the expected response. The assumption of rationality is only a statement about the general predictability of the behaviour of large groups in the face of changing incentives. 1st Foundation: People respond to incentives Insights: Since economics is about the choices that people make, then a clear understanding of the motivations that underlie those choices is essential to understanding the economic way of thinking. The role of incentives is essential to that understanding. Incentives often result in consequences that, while logical in hindsight, were unintended by those who promulgated the incentives in the ﬁrst place. In learning to think like an economist, it is a good habit, whenever you notice an activity that is prevalent, to try to unearth the incentive driving it. 1st Foundation: People respond to incentives Implications – Food for Thought: 1. Why do so many buildings in Cairo Egypt have roofs with steel protruding from the top? 2. Why is the informal economy so large in many countries? 3. How would most economists respond to the popular saying that ‘Crime Doesn’t Pay’? 1st Foundation: People respond to incentives Implications – Food for Thought: Why do so many buildings in Cairo Egypt have roofs with naked steel protruding from the top? ❑ In Egypt, the value of a building is not taxed at the full rate until the construction is ﬁnished. ❑ The intention was to be fair to owners who had not yet ﬁnished construction and so were not able to generate an income stream from the building. ❑ The implication was to create an incentive to have buildings that seem to be unﬁnished, in perpetuity. 1st Foundation: People respond to incentives Implications – Food for Thought: Why is the informal economy so large in many countries? ❑ The informal economy is that portion of economic activity that is out of sight and reach of tax authorities and regulations. ❑ Many well-intentioned governments provide a social safety net for the working poor. One way of ﬁnancing this is to obligate workers to pay into a national insurance scheme whenever they are employed, from which they can draw a small income when they are not. ❑ Such impositions raise the cost of being formally employed, and so create a disincentive to formal employment. 1st Foundation: People respond to incentives Implications – Food for Thought: How would most economists respond to the popular saying that ‘Crime Doesn’t Pay’? ❑ They would say that it must. Otherwise few people would engage in it. ❑ In places where there is a lot of crime, economists would conclude that it pays quite well, or, at least, it pays better than lawful alternatives. 2nd Foundation: Resources are Scarce The Idea: For most people, desires are unlimited. Resources (like land, capital and time) are limited. Finite resources are insufﬁcient to satisfy boundless desires, and hence they are scarce relative to the unlimited ways in which they could be deployed to satisfy our limitless wants. The reality of pervasive scarcity gives rise to the salient fact of economic life: having to make choices in the use of resources. Every choice means that there is a trade-off. 2nd Foundation: Resources are Scarce The Idea: Each time we choose to use a resource for one purpose, we are necessarily forgoing the alternative for which the resource could have been used. The sacriﬁced alternative is called opportunity cost. The true cost of any choice we make, the opportunity cost, is the best alternative forgone when one alternative is chosen. This is different from how we normally think of the cost of a choice. Opportunity cost provides a different answer, conceptually and quantitatively, from cost in the conventional 2nd Foundation: Resources are Scarce Insights: An insight from the concept of opportunity cost is that nothing can truly be free. If the true cost of any good or service is the value of the best alternative use of the resources used, and, in the presence of multiple possible uses, all resources must have some alternative use, then no good or service can be truly free. Every product has an opportunity cost; every product’s creation uses up resources that could have produced something else of value. In the presence of unlimited ways to use limited resources, how does society choose amongst the possible alternatives? Individuals weigh (not necessarily consciously) the incentive (the beneﬁts and costs) of each option and choose the one they think is best for them. 2nd Foundation: Resources are Scarce Implications – Food for Thought: 1. How would an accountant and an economist measure the cost of your university education? 2. ‘There’s no such thing as a free lunch’ – do you agree/disagree? 3. What do you think was the hidden cost of Gangnam Style? 2nd Foundation: Resources are Scarce Implications – Food for Thought: How would an economist measure the cost of your university education? ❑ Accounting answer: What you pay for – tuition, books and either cost of housing on/near campus or transportation cost. ❑ Economist’s answer: The opportunity cost of attending university full time: ❑ The income you would have been earning from a full time job ❑ But, if you were not at university living on hall, you would still need somewhere to live, and so would likely have to pay for some kind of housing. So the cost of housing is not part of the opportunity cost of going to university. 2nd Foundation: Resources are Scarce Implications – Food for Thought: ‘There’s no such thing as a free lunch’ – do you agree/disagree? ❑ This reference is to the popular practice in 19th century America of bars offering a free lunch to patrons who bought at least one drink. ❑ The lunch was usually heavily salted to make patrons thirsty, inducing them to buy more drinks. ❑ While the “free” lunch may have been a useful promotional tool, the preparation of the meal incurred a cost, and that cost was paid for by the customers in the mark-up of their drinks. 2nd Foundation: Resources are Scarce Implications – Food for Thought: What do you think was the hidden cost of Gangnam Style? ❑ Gangnam Style surpassed 2 billion views on YouTube. ❑ At 4.12 minutes, that equates to more than 140m hours, or more than 16,000 years. ❑ What other achievements were foregone in the time spent watching that video? 3rd Foundation: Real Values Matter The Idea: When people make choices, they must have an appreciation of the beneﬁt/cost of the alternatives being considered. They must have a sense of their value. But how is the concept of value understood and expressed? Values may be expressed in either “nominal” or “real” terms. A nominal value is one measured in terms of currency. The values are deﬁned in currency units, whatever that currency unit is worth (e.g. JMD or USD). 3rd Foundation: Real Values Matter The Idea: Nominal values are susceptible to changing and ambiguous worth. So if you were travelling to Mexico for the ﬁrst time, and you were told that you would be accommodated in a 100,000 peso house – are you impressed or not? If you got a job in Mexico and you were told that your pay will be 20,000 pesos per annum, which is twice the amount that your predecessor got three years ago – are you happy or not? 3rd Foundation: Real Values Matter The Idea: A real value is one denominated in amounts of goods or services. A real value is therefore similar to the concept of “purchasing power”. A popular way to calculate the real (or purchasing power) value of your pay is to express it in terms of how many typical consumer items it can purchase. 3rd Foundation: Real Values Matter The Idea: For most economic decision-making, it is real values that matter rather than nominal ones. When you choose not to buy the newest iPhone, is it because it costs JMD150,000, or is it because you value paying your rent more than having the latest phone? Each time a consumer compares the price of alternative purchases, they are using a real value. 3rd Foundation: Real Values Matter The Idea: Comparing nominal values over time will always be misleading because nominal values are expressed in money and money changes value over time. Because of inﬂation (the steady rise in average prices year after year) the value of money itself, as reﬂected in its purchasing power, gradually (and sometimes rapidly) diminishes over time. For many purposes, meaningful comparisons over time require the use of real values or the real equivalents of nominal values. 3rd Foundation: Real Values Matter Insight: In most countries, the prices of nearly every good and service goes up over time. Most people’s salaries also increase as the years go by. In some countries, the exchange rate of the local currency against the USD also tends to rise over time. But do these changes in nominal prices precipitate changes in the economic decisions? ❑ Are the higher prices causing a continual reduction in the amount of all goods being bought? ❑ Are the repeated increases in the exchange rate causing a reduction in the quantity of imports which must be paid for in USD? 3rd Foundation: Real Values Matter Insight: The continual nominal changes seem to have little effect on economic decision-making. Why is this so? Shouldn’t demand respond to a change in price? The reason for this relative constancy in the face of continual nominal changes is that real values may not be changing signiﬁcantly. When your nominal salary increases, but the nominal prices of the goods you purchase increase by a similar percentage, then what you can buy with your salary hasn’t really changed – so your real salary remains constant. 3rd Foundation: Real Values Matter Insight: To have a correct understanding of how and why consumers, producers and workers alter their economic behaviour in response to price or income changes, we have to be sure that real rather than nominal values have changed. People generally are not fooled by nominal values when they evaluate the choices they face. The determination of what is the best option relies on real values. 3rd Foundation: Real Values Matter Implications – Food for Thought: John, a UWI graduate, was paid JMD4m in 2015, JMD4.18m in 2016 and JMD4.8m in 2017. Should he be satisﬁed with the salary increase he has received over each of these years? Hint: Do you have enough information to answer this question? If not, what additional information do you need? 3rd Foundation: Real Values Matter Implications – Food for Thought: Should John be satisﬁed with the salary increase he has received over each of these years? 3rd Foundation: Real Values Matter Implications – Food for Thought: Should John be satisﬁed? ❑ The second column shows the nominal value of John’s salary for each year. ❑ The third column shows the average price of all the commodities purchased by a typical consumer for the same years (as calculated by the country’s public statistical agency). ❑ How do we calculate the real values? ❑ Real values = Nominal Values/Average Price. ❑ This shows how many typical consumer items the salary each year could buy. 3rd Foundation: Real Values Matter Implications – Food for Thought: Should John be satisﬁed with the salary increase he has received over each of these years? 4th Foundation: Prices Reﬂect Scarcity The Idea: The price (i.e. real price) of a good or service tends to rise and fall to reﬂect changes in its relative scarcity. When a commodity becomes more scarce, either because more people desire to have it or because the supplies have shrunk, then the price of the commodity will tend to rise. When a commodity becomes less scarce, its price will tend to fall. 4th Foundation: Prices Reﬂect Scarcity The Idea: Price movements take place in the context of a market – a place where buyers an sellers get together. The concept of a market requires neither a concentration of market participants nor a particular geographical location. 4th Foundation: Prices Reﬂect Scarcity The Idea: Movements in prices reﬂect changes in market conditions. A change in relative scarcity comes about because either buyers or sellers change the quantity they try to buy or sell. The automatic changes in relative prices to reﬂect changes in relative scarcities is a key part of the functioning of an economy. The “signal” of price changes allows the economy to automatically adjust to changing conditions an disturbances. Prices are the economy’s automatic signaling mechanism, rising and falling to stimulate or discourage consumption and availability. 4th Foundation: Prices Reﬂect Scarcity The Idea: The natural behaviour of prices in response to changing market conditions ensures that other markets, consumers, and producers adjust automatically and appropriately to those changed conditions. When will the price changes occur? While changes in the actual availability of a product or resource will trigger a change in its price, in some cases the price change will not occur at the moment of the event that triggers the change in the market, but rather can precede it, follow it with a delay, or even be obscured. If the movement in price reﬂects changes in market conditions, then how can the change in price precede the event that triggers the change in the market? 4th Foundation: Prices Reﬂect Scarcity The Idea: Buyers who can anticipate an event that may reduce supply an thus trigger a price increase may decide to stock up on the commodity before the actual event occurs in an attempt to beat the price increase. The attempt to stock up, however, given unchanged supplies in the present, makes the commodity relatively more scarce straightaway, even before the supply-reducing event occurs. This scarcity stimulates the price to rise, also before the supply-reducing event occurs. In this way, the price increase is in anticipation of the actual event that would cause it to increase. Can you think of an example of this? 4th Foundation: Prices Reﬂect Scarcity The Idea: An example of anticipatory price increases is evident every time there is threat of military action, social unrest or political instability in the Middle East. Because that region produces more than half of the world’s oil, any threat to the ﬂow of oil from the Middle East will have a big effect on the world price of oil. Whenever such a disruption looms, buyers immediately start to stockpile oil, driving up the price well ahead of any actual disruption. 4th Foundation: Prices Reﬂect Scarcity The Idea: In what circumstances will the price change be delayed? In some circumstances the change in price will come after, maybe even long after, the event precipitating the price change. Can you think of an example where this occurs regularly? 4th Foundation: Prices Reﬂect Scarcity The Idea: Example: The market for people’s labour. Employees are the suppliers of labour and businesses are the demanders. A sudden fall off in economic activity will reduce the need for labour by businesses. How should the price of labour (wages) respond to this reduction in demand for labour? Will this price change occur instantaneously? 4th Foundation: Prices Reﬂect Scarcity The Idea: Since workers don’t renegotiate their pay anew each week (in reality, most ﬁrms don’t adjust salaries more often than once a year), then the opportunity to reduce real salaries will come much later. It is well known that changes in wages can lag behind changes in labour market conditions by some time. 4th Foundation: Prices Reﬂect Scarcity The Idea: Are there any circumstances when prices don’t change at all in response to changing market conditions? There are circumstances where sellers are reluctant to or are prevented from making a change in the stated price of a good or service. Governments, for example, may try to inhibit price increases by implementing price controls. Note, however, that the market pressure for a price to change is irrepressible. So the market will effect the change in price by other means. Examples: 4th Foundation: Prices Reﬂect Scarcity The Idea: Examples: ❑ Reducing the amount of a product in a package while sticking to the same posted price is equivalent to a price increase. ❑ The same is true if the quality of the product is reduced. ❑ Sellers may tie the sale of the price-controlled item to that of a second, deliberately over-priced item (a tactic called “marrying”). 4th Foundation: Prices Reﬂect Scarcity The Idea: So if the degree of scarcity implies a price other than the price on the sticker, the market will ﬁnd a way to effect its price increase. Insight: Using the principle that prices tend to reﬂect relative scarcity can help us to understand both price movements and the outcomes when prices can’t change or don’t change fast enough. If prices tend to rise whenever there is scarcity, or fall in the event of abundance, how do shortages and surpluses occur? 4th Foundation: Prices Reﬂect Scarcity Insight: If prices tend to rise whenever there is scarcity, or fall in the event of abundance, how do shortages and surpluses occur? ❑ Normally, shortages in the supply of a good or service result in an increase in its price. ❑ An surplus in the supply of a good or service results in a decrease in its price. ❑ But, in some cases, prices either cannot change at all or cannot change fast enough to reconcile the imbalance. 4th Foundation: Prices Reﬂect Scarcity Implications – Food for Thought: After a hurricane, supermarkets are usually accused of “price gouging” with respect to agricultural produce, canned foods and water. Is there any possible explanation for the dramatic increase in prices of such goods, other than the wickedness of the shop owners? In 2021 there was a glut in the market for tomatoes (i.e. the market was ﬂooded with tomatoes to the extent that supply exceeded demand). What was the consequence for tomato farmers? Suggest a feasible solution to this problem. 4th Foundation: Prices Reﬂect Scarcity Implications – Food for Thought: After a hurricane, supermarkets are usually accused of “price gouging” with respect to agricultural produce, canned foods and water. Is there any possible explanation for the dramatic increase in prices of such goods, other than the wickedness of the shop owners? ❑ Natural disasters, like hurricanes, usual leave goods, such as canned foods and water, in short supply. ❑ Sellers respond to the incipient shortages by raising the prices of these items. ❑ The behaviour of prices under these circumstances is easily understood by reference to the principle that price 4th Foundation: Prices Reﬂect Scarcity Implications – Food for Thought: In 2021 there was a glut in the market for tomatoes (i.e. the market was ﬂooded with tomatoes to the extent that supply exceeded demand). What was the consequence for tomato farmers? Suggest a feasible solution to this problem. ❑ The surplus supply would lead to a signiﬁcant fall in the price of tomatoes, making it unproﬁtable for the farmers to sell them. ❑ A possible solution is to create an alternative source of demand for the tomatoes: ❑ ‘As the country sees a glut in the market for tomatoes, the Scientiﬁc Research Council (SRC) says there is an opportunity for entrepreneurs to utilise its pilot processing plant to create tomato-based products such 5th Foundation: Returns Eventually Diminish The Idea: Each time a consumer or a producer expends money or effort, it is with the expectation of obtaining a beneﬁt or return on the expenditure. This principle speaks to the additional beneﬁt that you get from repeating an activity, or continuously incrementing one input in a process. Eventually though, the satisfaction that you get from repeating an activity, or the return/yield that you get from adding more of one input to a production process, will diminish. 5th Foundation: Returns Eventually Diminish The Idea: The principle is: if all other factors remain unchanged while only one input is repeatedly added, eventually the additional beneﬁt from adding more of the input will be less than was gained from previous additions. This does not necessarily apply at every level of the inputs. At some levels, returns may rise. Or they could remain constant. But the principle suggest that eventually, if you keep adding only one input, returns to increasing the single input will diminish. 5th Foundation: Returns Eventually Diminish Insights: The concept of diminishing returns is most powerful when applied to production. Marginal product is the addition to output that derives from employing an additional unit of an input or production factor (e.g. a worker, a machine, a square meter of ofﬁce space or fertile land), without changing the amounts of any other inputs. In production, the principle of diminishing returns suggests that, if we are unable to increase the quantity employed of all other productive factors and we keep incrementing only one factor (e.g. hiring more labour), then eventually, the marginal product will diminish. 5th Foundation: Returns Eventually Diminish Insights: The amount of additional output that is gained from hiring one more worker, if we keep hiring new workers, at some point will be less than was gained from hiring the previous one. Law of diminishing returns: if all other factors are not changing, increments to one factor will eventually add diminishing amounts to output. Should really be law of eventually diminishing returns, as marginal product may rise or stay constant over a range of employment levels, but at some point will start to diminish. 5th Foundation: Returns Eventually Diminish Implications – Food for Thought: Critique the motivational slogan – “Whatever you do, do it to the best of your ability” – using the principle of diminishing returns Will your understanding of the principle of diminishing returns change the way you study for your exams? 5th Foundation: Returns Eventually Diminish Implications – Food for Thought: Critique the motivational slogan – “Whatever you do, do it to the best of your ability” – using the principle of diminishing returns ❑ The principle of diminishing returns exposes that this slogan cannot be literally followed. ❑ Since the return to any activity will eventually diminish, you will necessarily reach a point at which the diminished return is not worth the application of more effort. 5th Foundation: Returns Eventually Diminish Implications – Food for Thought: Will your understanding of the principle of diminishing returns change the way you study for your exams? ❑ The biggest increase in your knowledge will occur in the ﬁrst few hours of learning when you little knowledge of the subject to begin with. ❑ But as you learn more, additional hours of study, while still adding to your understanding, are unlikely to be as eye opening, or add as much to your grade, as the initial hours of effort did. 5th Foundation: Returns Eventually Diminish Implications – Food for Thought: Will your understanding of the principle of diminishing returns change the way you study for your exams? ❑ The term “marginal beneﬁt” is a general term that can be applied to the additional gain from incrementing any type of input that yields a desired outcome, including additional hours of study in the pursuit of a higher grade. ❑ The marginal beneﬁt of any activity tends to diminish after a while. Pulling it All Together: How an Economy Works Recall – Five Fundamental Ideas: 1. People respond to incentives 2. Resources are scarce 3. Real values matter 4. Prices reﬂect scarcity 5. Returns eventually diminish Pulling it All Together: How an Economy Works Hypothetical Case Study: Berry Borer Beetle damages Brazil’s coffee crop Brazil is a large producer of coffee Infestation causes signiﬁcantly lower harvest World supply of coffee decreases Prices reﬂect relative scarcity indicates that price of coffee increases People respond to incentives, so demand for coffee decreases Some will switch their budget to buy tea – demand for tea rises Relative scarcity of tea increases, hence price of tea rises Farmers are incentivized to produce more tea – supply of Pulling it All Together: How an Economy Works Hypothetical Case Study: Berry Borer Beetle damages Brazil’s coffee crop Farmers reduce production of rubber plants so as to free up land to produce more tea – supply of rubber decreases Price of rubber increases, people are incentivized to use less rubber, so demand for rubber goes down Leads to production of fewer cars – supply of cars decreases, leading to increase in the price of cars Demand for cars decreases, leading to a decrease in the demand for oil Price of oil reduces, precipitating a decrease in the supply of oil Something that started in one industry in one country, has affected multiple industries across the globe Pulling it All Together: How an Economy Works Hypothetical Case Study: Berry Borer Beetle damages Brazil’s coffee crop The economy is a set of interconnected markets that affect each other What is the driving mechanism? Prices (reﬂecting relative relative scarcity) act as a signal for everyone to respond in an appropriate manner People (consumers and producers) make decisions base on price signals Prices respond to the decision people make This happens automatically Adam Smith – Wealth of Nations – refers to this as the Invisible Hand of the Marketplace

ECON1000 - Unit 1 Lecture Notes - wn (1).pdf

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