1 econ649/econ991 lecture 1. 2 overview administration and introductory comments the economic...

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ECON649/ECON991

Lecture 1

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Overview

• Administration and Introductory Comments

• The Economic Problem

• The Price Mechanism

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Administration

• My name is email:

• Download a copy of the unit guide from the unit web page: https://ilearn.mq.edu.au/login/MQ/

• 3 hours of lectures per week

• 3 workshops held during normal lecture times in weeks 5, 7, and 13.

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Workload

You should be spending at least 6-9 hours at home studying this unit each week.

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Key Dates for Within Semester Assessment Tasks• Test 1 – First hour of the week 4 lecture. Note:

For this test you must attend the lecture in which you are enrolled.

• Joint ECON649 and 991 assignment to be handed in during class in Week 9 (November 8 – 12) – No late assignments accepted.

• ECON991 students only hand in their second assignment at the front desk on Level 2 of E4A on the 2nd of November – No late assignments accepted.

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Textbook

• Hubbard, R.G., Garnett, A.M., Lewis, P., and O’Brien, A.P., 2010, Essentials of Economics, Pearson Education, Australia.

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Web Resources

• The unit web site is at https://ilearn.mq.edu.au/login/MQ/

• MyEconLab – www.myeconlab.com

see unit web site for details about how to access MyEconLab

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Course Outline

A. MICROECONOMICS

1. Introduction: The Economic Problem, An Overview of the Price Mechanism, Reasons for Government Intervention

2. Supply and Demand Analysis

3. Applications of Supply and Demand, Elasticity Concepts

4. Production and Costs

5. Pricing in Different Market Structures: Perfect Competition and Monopoly

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Course Outline

B. MACROECONOMICS

1. Introduction to Macroeconomics; An Overview of Keynesian Theory & Classical Theory

2. The Income-Expenditure Model; Inflationary and Deflationary Gaps; Multipliers

3. Money and Interest Rates

4. AD-AS Model

5. Monetary & Fiscal Policy

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What is Economics?

Economics is concerned with how society allocates scarce resources in order to satisfy unlimited wants.

There are 2 branches of economics:

MICROECONOMICS and MACROECONOMICS

Micro=small Macro=large

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Microeconomics

Is concerned with economic decisions made by a single individual, household, firm or industry.

e.g. The market for petrol.

If the price of petrol increases will an individual person buy more or less? Will a petrol producing firm supply more or less petrol to the market?

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Macroeconomics

Is concerned with economic decisions and the performance of the economy as a whole.

It examines economy-wide variables such as inflation, unemployment, exports, imports, and the exchange rate; as well as the effects of changes in policies, such as monetary policy and the federal budget (fiscal policy).

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Fallacy* of composition

• Fallacy of Composition – fallacy that what is true for the individual is true for the group

• The basis for distinguishing between micro and macro-level analyses

*Fallacy means a misleading or false idea

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Post Hoc Ergo Propter Hoc(Fallacy of Association)

• Latin phrase meaning “after this, therefore because of this”

• Fallacy that a first event causes the second event, because the first event occurred before the second

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Positive & Normative Statements

• Positive statements – statements that can be verified by reference to facts

• Normative statements – statements that involve opinions, “what ought to be”; they cannot be tested

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Economic ModelsWe use the scientific method to develop models:

1. Identify the variables of interest.

2. Formulate a theory or hypothesis which tries to explain relationships between the variables.

Need to make simplifying assumptions.

3. Test the predictions of the theory to see if they line up with reality.

4. If the model works we can use it to make forecasts or predictions, otherwise we need to start again.

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Ceteris Paribus

One of the most important assumptions in economics is CETERIS PARIBUS.

Ceteris Paribus = all other things remain constant (or unchanged)

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The Economic Problem

• We live in a world of unlimited wants.• Resources are scarce.• Wants > Resources • Our desire for goods and services exceeds the

capacity of the economy to produce those goods and services

• Therefore choices have to be made.

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Resources = factors = inputs There are 4 factors of production:

1. Land – any natural resource, e.g. land, coal, oil, water, air. Can be

renewable or non-renewable.

2. Labour – the mental and physical capacity of people to produce

goods and services. Includes both time spent working and work effort.

Is influenced by quality (e.g. education level, health) and quantity.

3. Capital – physical equipment, buildings and machinery used to

produce other goods and services.

4. Entrepreneurial ability – special human skill. An entrepreneur is

someone who creates and runs a business and organises the other

factors of production to make goods and services.

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Resources = factors = inputs

The incomes earned by these factors are:

1. Land → rent

2. Labour → wages

3. Capital → interest

4. Entrepreneurial ability → profits

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Resources produce commodities.

commodities = goods + services

tangible intangible

Goods & Services = means of satisfying wants

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Choices

All societies face choices of:

• What to produce?• How to produce?• For whom?

At the level of an individual consumer choice is an every day fact of life

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Choices

• Consider a consumer with a certain amount of money, he decides to buy more books

• Could say cost of a book = so many dollars

OR• Look at cost in terms of what other consumption

our consumer must forego to obtain this item.

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Choices

• Suppose consumer gives up some movies

• If Pbook = 3 times price of a movie then cost of a book = 3 movies forgone.

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Opportunity Cost

• Economists use the term, opportunity cost to express the cost of a given activity in terms of the value of the next best alternative forgone

• Opportunity cost = opportunity lost

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Opportunity Cost

individuals

Opp cost applies to firms

economy

(e.g. the cost of a new road can be expressed as so many new hospitals forgone)

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Rational Self Interest • This is a key assumption in microeconomics.• A rational self-interested individual uses all available

information to achieve their goals.• A rational self-interested individual attempts to achieve

something desirable to his or her own self.• A rational self-interested individual weighs the benefits

and costs of an action, and they only choose to undertake an action if it has a positive net benefit.

Net Benefit = Benefits - Costs• When choosing between different actions a rational self-

interested individual will choose the action with the greatest positive net benefit.

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Marginal Analysis • Rational self-interested individuals are assumed

to know that optimal decisions are made at the margin.

• Recall that scarcity → need to make choices• Frequently choices being made involve

incremental or decremental changes to the status quo*.

(*status quo = the existing situation)

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Marginal Analysis

Consumers are concerned with whether to purchase an extra juice, whether to spend an extra hour studying.

Producers may face choice about whether to run an extra post graduate class, whether to produce an extra kilo of bananas.

These are all marginal decisions.

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Marginal Analysis

Each decision yields some additional or marginal benefit (MB) and incurs some form of marginal cost (MC).

If MB > MC then the activity will yield a net benefit and a rational individual will be induced to undertake the activity.

Marginal Analysis = techniques of assessing costs and benefits at the margin to decide:

– if status quo worthwhile and– The ideal level of activity

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Scarcity, Choice & the Production Possibility Frontier (PPF)

We can use the PPF to illustrate the economic problem.

Assume: Given time period Given technology Fixed supply of resources Economy produces two items (“guns” and “butter”)

Assumptions designed to “freeze” the economy so we can focus on the production possibilities given the available resources and technology

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PPF shows all the maximum combinations of guns and butter that can be produced if all available resources are fully employed and used efficiently.

Q o

f G

uns

Q of Butter

T

D0

PPF

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* If all resources devoted to butter production

→ OD units of butter

But zero guns

* If all resources devoted to production of guns

→ OT units of guns

but zero butter

* All points on PPF between end points butter plus guns

Q o

f G

uns

Q of Butter

T

D0

PPF

A

B

M

R

P S

EK

X

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PPF is concave to the origin (more on this later).

PPF separates attainable from unattainable output combinations.

Attainable = combinations on & underneath PPF

=

Q o

f G

uns

Q of Butter

T

D0

PPF

A

B

M

R

P S

Z

F

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The slope of the PPF

= guns/ butter

= quantity of guns that economy must forgo if butter production is increased by 1 unitQ

of

Gun

s

Q of Butter

T

D0

PPF

A

B

M

R

P S

C

GV

Q

N W

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* The negative slope shows the opportunity cost when production of one of the goods in the diagram is increased.

* Movement A → B shows movement into more butter production

* The opportunity cost of producing PS more butter is distance MR of guns forgone.

Q o

f G

uns

Q of Butter

T

D0

PPF

A

B

M

R

P S

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The concave shape of the PPF reflects the law of increasing opportunity cost.

Law states as more of a particular good is produced, larger and larger Q’s of an alternative good must be forgone.

This is shown by an increase in the slope of the PPF as we move along it.

Q o

f G

uns

Q of Butter

T

D0

Slope increasing along PPF

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Compare points A and G regarding size of guns when butter ↑ by 1 unit.

What is the economic rationale for increasing opportunity cost?

Q o

f G

uns

Q of Butter

T

D0

A

B

M

R

P S

C

GV

Q

N W

small - ∆ guns

large - ∆ guns

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What is the economic rationale for increasing opportunity cost?

ANSWER: Resources are not completely adaptable to alternative uses (i.e. some resources are better suited to the production of one good than another).

Butter ↑ and ↑ takes more and more resources most suited to gun production increasingly greater sacrifice of guns

With perfect adaptability of resources → straight line PPF → constant slope → constant opportunity cost

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PPF is quite illuminating:

• Illustrates concept of scarcity

• With given amount of resources, economy can only achieve certain combinations of G & S– Not all wants can be satisfied during given time period

– Need to make choices about which combination of G & S to produce

• Choice opportunity costs are involved

• Concavity illustrates law of increasing opportunity cost

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Shifts in the PPF

A change in the availability or amount of resources will cause a shift in the PPF.

Q o

f Gun

s

Q of Butter0

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Shifts in the PPF

A change technology may cause both a change in the slope and location of the PPF. The change does not have to affect both goods equally.

e.g. diagram shows effects of a positive change in technology for gun production only

(suppose found a more efficient way of producing guns)

Q o

f Gun

s

Q of Butter0

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Alternative Economic Systems or Economies

• Returning to the questions of:– What ?– How ?– For whom ?

• Different types of economic systems answer these questions differently.

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Tradition-oriented economy

• Main forces organising production and distribution = custom & tradition

• Tasks and skills handed down

• Distribution is via age-old patterns e.g. communal feasts

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Command or centrally planned Economy

Central planning authority asserts its will on:– How many guns, cars, bottles, etc..– Plus how to produce required G & S

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In a pure market economy,

Mechanism is known as “market mechanism”

Prices & Markets & Individuals

Provide mechanism for communication and coordination of different choices being made

Market Economy

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Functions of Price

• Prices are the language of markets. They transmit information between market participants.

• Prices have an important role as measure of exchange value.

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Functions of PriceAdditionally: P’s are a rationing device

P’s act as an incentive

P’s serve to allocate resources

P’s serve as income

P’s also viewed as cost of production

Microeconomics is so concerned with prices and impact of price changes that it is often called Price Theory.

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Mixed Economy • The Australian economy is a mixed economy.

• It is market-oriented but it also has a command element since government plays an important role.

• Government intervenes in both macro and micro economy.

• The government sector is also called the public sector.

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The Size of the Government Sector• There are three commonly used ways of measuring the

size of the government (public) sector

1. The value of the goods and services produced by the government as a proportion of total production in the economy (gross domestic product, GDP).

2. The number of people employed as a proportion of total employment in the economy.

3. The level of government expenditure as a proportion of total expenditure in the economy (as measured by GDP).• This measure includes transfer payments, such

as pensions, unemployment benefits and family support payments.

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The Size of the Government Sector

Method of measurement Australia, 2008

Government purchases as a percentage of GDP

22%

Government employment as a percentage of total employment

16%

Government expenditure as a proportion of total expenditure

35%

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Source: Annex Table 25, General GovernmentTotal Outlays, OECD, 2008

Government Expenditure by Country, 2008: Hubbard et al Figure 11.1

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

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Government Expenditure on Goods and Services as a percentage of GDP, Australia, 1960-2008: Hubbard et al, Figure 11.2

Source: Source: Reserve Bank of Australia (2008), Gross Domestic Product-Expenditure Components, Table G11.

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

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Source: Australian Government (2007), Budget 2007–08, Appendix D—Australian Government Taxation and Spending.

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Federal Government Expenditure by Function: Hubbard et al, Figure 11.3

Please insert Figure 11.3 from page 328, as large as possible while retaining clarity.

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REQUIRED READING

This week’s lecture:Introduction to Economics

• Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics

Chapters 1 & 2, Ch 11(pp 324-332 only)

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REQUIRED READING

Next week’s lecture:Reasons for Government Intervention• Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics

Chapters,3, 5(pp. 131-136) & 11 (pp. 324-332)

Demand and Supply• Hubbard, Garnett, Lewis & O’Brien, Microeconomics

Chapters 3 & 5(pp.125-143)