ECN Lecture 2 PDF

ECN Lecture # 2 Some Basic & Important concepts in Economics THE SCIENTIFIC METHOD: OBSERVATION, THEORY, AND MORE OBSERVATION Isaac Newton, the famous seventeenth-century scientist and mathematician, allegedly became intrigued one day when he saw an apple fall from an apple tree. This observati...

ECN Lecture # 2 Some Basic & Important concepts in Economics THE SCIENTIFIC METHOD: OBSERVATION, THEORY, AND MORE OBSERVATION Isaac Newton, the famous seventeenth-century scientist and mathematician, allegedly became intrigued one day when he saw an apple fall from an apple tree. This observation motivated Newton to develop a theory of gravity that applies not only to an apple falling to the earth but to any two objects in the universe. This interplay between theory and observation also occurs in the field of economics. An economist might live in a country experiencing rapid increases in prices and be moved by this observation to develop a theory of inflation. The theory might assert that high inflation arises when the government prints too much money. To test this theory, the economist could collect and analyze data on prices and money from many different countries. If growth in the quantity of money were not at all related to the rate at which prices are rising, the economist would start to doubt the validity of his theory of inflation. If money growth and inflation were strongly correlated in international data, as in fact they are, the economist would become more confident in his theory. Although economists use theory and observation like other scientists, they do face an obstacle that makes their task especially challenging: Experiments are often difficult in economics. Physicists studying gravity can drop many objects in their laboratories to generate data to test their theories. By contrast, economists studying inflation are not allowed to manipulate a nation’s monetary policy simply to generate useful data. Economists, like astronomers and evolutionary biologists, usually have to make do with whatever data the world happens to give them. To find a substitute for laboratory experiments, economists pay close attention to the natural experiments offered by history. Opportunity Cost The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action. The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages. Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.). In both cases, a choice between two options must be made. It would be an easy decision if you knew the end outcome; however, the risk that you could achieve greater "benefits" (be they monetary or otherwise) with another option is the opportunity cost. Factors of Production You can’t get output without inputs of resources. Economists traditionally divide inputs, or factors of production, into three classes: ✓ Land: To economists, land means a little more than just real estate or property. Land also refers to all naturally occurring resources that can be used to produce things people want to consume. Land includes the weather, plant and animal life, geothermal energy and the electromagnetic spectrum. ✓ Labour: The work that people must do in order to produce things. A tree doesn’t become a house without human intervention. ✓ Capital: Man-made machines, tools and structures that aren’t directly consumed but are used to produce other things that people do directly consume. For example, a car that you drive for pleasure is a consumption good, whereas an identical car that you use to haul around bricks For your construction business is capital. Capital includes factories, roads, sewers, electrical grids, the Internet and so on. A fourth Factor of Production? A lot of Debate regarding the 4th factor of production: ▣Entrepreneur: an individual who organizes and operates a business or businesses, taking on financial risk to do so. Utility Not everything is measurable in terms of money in economics, for example – happiness/satisfaction. Utility is usefulness, the ability of something to satisfy needs or wants. Utility is an important concept in economics and game theory, because it represents satisfaction experienced by the consumer of a good. Law of Diminishing Marginal Utility A law of economics stating that as a person increases consumption of a product - while keeping consumption of other products constant - there is a decline in the marginal utility that person derives from consuming each additional unit of that product, i.e. – drinking when thirsty Buffet-style restaurant use this concept. They entice you with "all you can eat," all the while knowing each additional plate of food provides less utility than the one before. Law of Diminishing Marginal Returns A law of economics stating that, as the number of new employees increases, the marginal product of an additional employee will at some point be less than the marginal product of the previous employee. Consider a factory that employs laborers to produce its product. If all other factors of production remain constant, at some point each additional laborer will provide less output than the previous laborer. At this point, each additional employee provides less and less return. If new employees are constantly added, the plant will eventually become so crowded that additional workers actually decrease the efficiency of the other workers, decreasing the production of the factory. ECONOMIC MODELS High school biology teachers teach basic anatomy with plastic replicas of the human body. These models have all the major organs—the heart, the liver, the kidneys ,and so on. The models allow teachers to show their students in a simple way how the important parts of the body fit together. Economists also use models to learn about the world, but instead of being made of plastic, they are most often composed of diagrams and equations. Like a biology teacher’s plastic model, economic models omit many details to allow us to see what is truly important. Just as the biology teacher’s model does not include all of the body’s muscles and capillaries, an economist’s model does not include every feature of the economy. OUR FIRST MODEL: THE CIRCULAR-FLOW DIAGRAM The economy consists of millions of people engaged in many activities—buying, selling, working, hiring, manufacturing, and so on. To understand how the economy works, we must find some way to simplify our thinking about all these activities. In other words, we need a model that explains, in general terms, how the economy is organized and how participants in the economy interact with one another. Figure below presents a visual model of the economy, called a circular-flow diagram. In this model, the economy has two types of decisionmakers—households and firms. Firms produce goods and services using inputs, such as labor, land, and capital (buildings and machines). These inputs are called the factors of production. Households own the factors of production and consume all the goods and services that the firms produce. A more complex circular flow of income OUR SECOND MODEL: THE PRODUCTION POSSIBILITIES FRONTIER Most economic models, unlike the circular-flow diagram, are built using the tools of mathematics. Here we consider one of the simplest such models, called the production possibilities frontier, and see how this model illustrates some basic economic ideas. Although real economies produce thousands of goods and services, let’s imagine an economy that produces only two goods—cars and computers. Together the car industry and the computer industry use all of the economy’s factors of production. The production possibilities frontier is a graph that shows the various combinations of output—in this case, cars and computers—that the economy can possibly produce given the available factors of production and the available production technology that firms can use to turn these factors into output. In this economy, if all resources were used in the car industry, the economy would produce 1,000 cars and no computers. If all resources were used in the computer industry, the economy would produce 3,000 computers and no cars. The two end points of the production possibilities frontier represent these extreme possibilities Things we can see from the graph ▣ An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available. Points on (rather than inside) the production possibilities frontier represent efficient levels of production. When the economy is producing at such a point, say point A, there is no way to produce more of one good without producing less of the other. Point B represents an inefficient outcome ▣ One of the Ten Principles of Economics discussed in Chapter 1 is that people face tradeoffs. The production possibilities frontier shows one tradeoff that society faces. Once we have reached the efficient points on the frontier, the only way of getting more of one good is to get less of the other. When the economy moves from point A to point C, for instance, society produces more computers but at the expense of producing fewer cars. ▣ Another of the Ten Principles of Economics is that the cost of something is what you give up to get it. This is called the opportunity cost. The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good. When society reallocates some of the factors of production from the car industry to the computer industry, moving the economy from point A to point C, it gives up 100 cars to get 200 additional computers. In other words, when the economy is at point A, the opportunity cost of 200 computers is 100 cars. ▣Productive Efficiency - Any point on the line is considered to be productively efficient because you are using your resources in the best possible way to create the most out of it. ▣Allocative Efficiency – Only one of the chosen combinations will be allocatively efficient which meets the needs and wants of the society the most and produces exactly what the society desires. What are the effects of changes in technology ▣ If technology of both the products increases ▣ If technology of only one of the product increases (most cases in reality): Absolute vs. Comparative Advantage: An Overview Absolute advantage and comparative advantage are two important concepts in economics and international trade. They largely influence how and why nations and businesses devote resources to the production of particular goods. Absolute advantage: refers to the uncontested superiority of a country or business to produce a particular good better. Comparative advantage: introduces opportunity cost as a factor for analysis in choosing between different options for production diversification THE END Any Questions