What Economics Is About?

Sakib Bin Amin, Ph.D.

Assistant Professor

School of Business and Economics

North South University

ECO 101: Introduction to Microeconomics

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What is Economics?

o Economics is the Social Science that studies thechoice that individuals, businesses, governmentsand the entire societies make as they cope withscarcity.

o Economics is the study of how societies use scarceresources to produce valuable commodities anddistribute them among different people.

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Scarcity

o Economics deal with a central problem faced byall individuals and all societies: The Problem ofScarcity

Fundamental Reason:

o Our wants far exceed our resources. So, scarcity of resources is the key problem.

o The excess of Human needs over what can actually be produced.

o Our inability to satisfy all our wants is called scarcity.

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Scarcity

The problem of scarcity means that every time wetake an economic decision (for example, how muchto consume or for a firm how much to produce of agiven good) we face some constraints that affect ourdecision.

Scarcity arises because some resources that areused to produce goods are limited by physical space.

For example, to produce goods and services weneed to use productive resources like Labour, Landand Raw Materials, Capital (machines, factories,equipment, etc.etc.).

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Scarcity

The amount of Labour is limited both in number andin skills.

The world’s land area is limited and so are rawmaterials (think of petrol).

The stock of capital is limited since we have alimited amount of factories, machines,transportation and other equipment.

Labour, Raw Materials, Land and Capital are whatwe call Factors of Production (or productive Inputs).

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Scarcity

Furthermore, scarcity arises from other “resources”,like time or income (normally we cannot consumemore than what we earn, a firm may not be able tostart a new factory if it not able to get a bank loan,etc. etc.).

Given the limited amount of resources we con onlyproduce and consume a limited amount of goodsand services.

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Why is scarcity a problem?

If we know that we have limited resources we couldjust behave accordingly. The problem arises becausein general human wants and needs are virtuallyunlimited. We all would like to have more money tobe able to consume more goods and services. Thus,scarcity becomes a problem because it implies thatthe means of fulfilling human needs are limited.

Therefore economists tend to define scarcity in thefollowing way:

“the excess of human needs over what can actually be produced.”

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Scarcity

Scarcity implies that we cannot choose whatever wewant when we decide about what and how much toconsume (I cannot buy today a BMW that costs£50000 if my total income today is £10000, etc.etc.) or when we decide about what and how muchto produce (I cannot produce a good that requires1000 workers if only 100 are available, etc. etc.)..

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Economic Categories

Four common Economic Categories are:

1. Microeconomics

2. Macroeconomics

3. Positive Economics

4. Normative Economics

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Microeconomics

Adam Smith is usually considered the founder of thefield of Microeconomics. This is the branch ofEconomics, which is concerned with the behaviour ofindividual entities such as markets, firms andhouseholds.

In The Wealth of Nations, Smith considered howindividual prices are set, studied the determinationof prices of Land, Labour and Capital, and inquiredinto the strengths and weaknesses of the marketmechanism.

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Microeconomics

Microeconomics studies the behaviour of individualdecision-making units, the individual, the household,the firm, the industry and how these agents interactin markets.

Microeconomics is the study of the economicbehaviour of single units( a consumer, a household,a firm, a particular industries, etc.etc) and of theinterrelationship between those units.

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Microeconomics

A Micro economist might be interested in answeringsuch questions as:

How does a Market work?

What level of output does a firm produce?

What price does a firm charge for the good itproduces?

How does a consumer determine how much of agood he/she will buy?

Can Government policy affect business andconsumer behaviour?

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Microeconomics

Generally Microeconomics looks at the production,exchange and consumption of goods and services atthe level of an individual producer of the good or themarket in which a single good or service isexchanged or an individual consumer of the product.

The Key word is individual: Microeconomics dealswith the behaviour of the individual entities thatmake up the economy.

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Macroeconomics

Macroeconomics is the study of the entire economyin terms of the total amount of goods and servicesproduced, total income earned, the level ofemployment of productive resources, and thegeneral behavior of prices. Macroeconomics can beused to analyze how best to influence policy goalssuch as economic growth, price stability, fullemployment and the attainment of a sustainablebalance of payments.

Rather than worrying about why the price ofgasoline has risen or fallen over the last severaldays Macroeconomics is concerned with the inflationrate, a measure of how the average price of allgoods and services has changed.

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Macroeconomics

A Macroeconomist might be interested in answeringsuch questions as:

How does the Economy work?

Why is the unemployment rate sometimes high andsometimes low?

What causes inflation?

Why do some national economies grow faster thanother national economies?

What might cause interest rates to be low one yearand high the next?

How do the changes in the money supply affect theeconomy?

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Micro vs. Macro

Macroeconomics and Microeconomics are obviouslyrelated and the distinction between them is not assharp as it looks at first sight.

In ECO 101 we will deal with Microeconomicproblems whereas in ECO 104 will studyMacroeconomic problems.

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Positive Economics

Positive economics involves ‘if—then’ statements:e.g. “a tax on cigarettes will cause the price to riseand the quantity consumed to fall”.

Positive Economics attempts to determine What is.It also attempts to describe how the economyfunctions. Generally, it relies on testablehypotheses.

Essentially Positive Economics deal with cause-effectrelationships that can be tested.

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Normative Economics

Normative economics makes recommendationsabout what should be based on value judgments:e.g. “the government should put more tax oncigarettes to cut smoking”.

Normative Economics deals with value judgmentsand opinions that can not be tested.

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Positive and Normative Economics

Many topics in Economics can be discussed withinboth a positive framework and a normativeframework.

Let us consider a propose cut in Income Taxes.

An economist practicing positive economics wouldwant to know the effect of a cut in income taxes,whether it affect the unemployment rate, economicgrowth, inflation and so on.

An economist practicing normative economics wouldaddress issues that directly or indirectly relate towhether income tax should be cut.

He may mention that income tax should be cutbecause the burden is currently very high.

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Rationality

Each individuals select the choices that make themhappiest, given the information available at the timeof a decision.

Every economic decisions have been made byrationality.

We assume that people act in their own rational selfinterest. People make the choices they believe leavethem best off.

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Three Basic Questions of Economics

All Economic systems must have some way ofanswering 3 basic questions:

1. What goods and services are produced and in whatquantities?

2. How are the goods and services produced and whoproduces them?

3. Who gets the goods and services that areproduced?

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Three Basic Questions of Economics

What goods and services are produced and in whatquantities?

o A society must determine how much of each of themany possible goods and services it will make, andwhen they will be produced? Will we produce pizzasand or shirts today?

o A few high quality shirts or many cheap shirts?

o Will we use scarce resources to produce manyconsumption goods( like pizzas)?

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Three Basic Questions of Economics

How are the goods and services produced and whoproduces them?

o A society must determine who will do theproduction, with what resources, and whatproduction techniques they will use.

o Whether we will apply the Labour IntensiveTechnology or Capital Intensive Technology?

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Three Basic Questions of Economics

Who gets the goods and services that areproduced?

o Who gets to eat the fruit of economic activity?

o How is the national product divided among differenthouseholds?

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Three Basic Questions of Economics

There are two extreme systems for answering thesequestions. In a Command Economy, theGovernment decides all the answers. In a MarketEconomy, the questions get answered through theinteraction of buyers and sellers in the market

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Market Economy

o A Market Economy is one in which individualsand private firms make the major decisions aboutproduction and consumption.

o A system of prices, of markets, of profits andlosses, of incentives and rewards determine what,how and for whom.

o Firms produce the commodities that yield thehighest profits ( the what) by the techniques ofproduction that are least costly(the how).

o Consumption is determined by individuals’decisions about how to spend the wages andproperty incomes generated by their labour andproperty ownership( the for whom)

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Market Economy

A free-market economy is an economy where agentsdecide for themselves which product to produce orto buy. Another way to say the same thing: a free-market economy is an economy where propertyrights are voluntarily exchanged at a price arrangedcompletely by the mutual consent of sellers abuyers.

The extreme case of a market economy, in whichthe government keeps it hands off economicdecisions is called a laissez-faire economy.

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Command Economy

By contrast, a command economy is one in whichthe government makes all important decisions aboutproduction and distribution through its ownership ofresources and its power to enforce decisions.

A typical example of such an economy was theSoviet Union before the 1989, or nowadays, Cubaand North Korea.

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Command Economy

In a Planned economy all the relevant economicdecisions are made centrally, by an individual or asmall number of individuals on behalf of a largergroup of people. In general a central planner orgovernment would establish the production targetfor the country’s factories, would develop masterplan for how to achieve those targets and would setup guidelines for the distribution and use of thegoods and services produced (in the ancient SovietUnion those targets were set up on a 5 year base.

All the productive sectors are nationalized (underthe direct control of the government) and soindividuals are not free to start their own businessesas they do in free-market economy.

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Mixed Economies

The free market and the planned economiesrepresent two extremes of how to organizeeconomic activity in a given economy. In reality,most of the economies we see can be called mixedeconomies.

A mixed economy is an economy where not all theeconomic decisions are left to the private individualsbut governments intervene as well.

There has never been a 100 percent marketeconomy ( although nineteenth-century Englandcame close).

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Economic Resources

Economists divide resources into four broad categories:

1. Land

2. Labour

3. Capital and

4. Entrepreneurship

Sometimes Resources are referred to as inputs orfactors of production

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Economic Resources

Land Includes natural resources, such as minerals,forests, water, and unimproved land. For example,oil, wood and animals fall into this category.

Labour consists of the physical and mental talentspeople contribute to the production process. Forexample, a person building a house is using his orher own labor.

Capital consists of produced goods that can be used asinputs for further production. Factories, machinery,tools, computers and buildings are examples ofcapital.

Entrepreneurship refers to the particular talent that soe

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Economic Resources

Entrepreneurship refers to the particular talent thatsome people have for organizing the resources ofland, labor, and capital to produce goods, seek newbusiness opportunities, and develop new ways ofdoing things.

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Economic Resources

Economic Resource Resource payment

land rent

labor wages

capital interest

entrepreneurial ability profit

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Market Mechanism

The main mechanism for the allocation of resourcesis the market. We study the way in which marketswork and the outcomes that the market mechanismproduces.

A Market is defined as any place where the sellers ofa particular good or service can meet with thebuyers of that goods and service.

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Market Mechanism

The main economic actors (or agents) are:

Households, who consume goods and supply labour and capital.

Firms, which employ workers and capital to produce goods.

There is also an important role for the government in:

Creating and enforcing the conditions for markets to work.

Intervening to correct situations where markets ‘fail’.

Redistributing income and wealth in the interest of equity.

Stabilizing economy wide fluctuations.

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Logical Fallacies

The following are some of the common fallaciesencountered in Economics reasoning:

1. The Post hoc Fallacy

2. Failure to hold other things constant

3. The Fallacy of Composition

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Logical Fallacies

The post hoc fallacy occurs when we assume that,because one event occurred before another event,the first event caused the second event.

A Post Hoc is a fallacy with the following form:

1.A occurs before B

2. Therefore A is the cause of B

Remember to hold other things constant when youare analyzing the impact of a variable on theeconomic system.

When you assume that what is true for the part isalso true for the whole, you are committing thefallacy of composition.

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Logical Fallacies

Some popular fallacies about economics andeconomists:

Economists always disagree

Economics is mainly about predicting the future

Economic models are too simple to capture reality.

Economics views individuals as caring only aboutmoney

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Opportunity Cost

Opportunity cost of any action: is the best or next highest ranked alternative foregone because of choosing the given action.

Another way to say the same thing: an opportunity cost is the cost of any activity measured in terms of the best alternative foregone.

Opportunity Costs arise because time and resources are scarce. Nearly all decisions involve Teade-offs.

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Opportunity Cost

For example, the opportunity cost for a student thatbuys the textbook for Eco 101 may be a new pair ofjeans that he could have bought instead. Obviouslywe should consider only the best alternative inevaluating the opportunity cost.

For example, if the best alternative was to go to arestaurant and buy a dinner with the money spentfor the book, then the opportunity cost Irepresented by the dinner and NOT by the pair ofjeans.

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Marginalism

In weighing the costs and benefits of a decision, it isimportant to weigh only the costs and benefits thatarise from the decision.

For example, when deciding whether to produceadditional output, a firm considers only theadditional cost (or marginal cost) with theadditional benefit.

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Marginalism

Marginal benefit = additional benefit resulting from aone-unit increase in the level of an activity

Marginal cost = additional cost associated with one-unit increase in the level of an activity

According to Economists, when individual makedecisions by comparing marginal benefits tomarginal costs, they are making decisions at themargin.

MB > MC expand the activity

MB < MC contract the activity

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Efficiency

Optimal level of activity: MB = MC (Net benefit ismaximized at this point).This is the Efficient amountof output.

Suppose we are studying for an economist test:

If MB Studying first hour> MC studying first hour;Keep Studying.

If MB Studying second hour> MC studying secondhour; Keep Studying.

You should stop reading when MB=MC. This is whereEfficiency is achieved.

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Figure: Efficiency

MB>MC

MC>MB

MC of Studying

MB of Studying

MB, MC

Time Spent Studying (Hrs)

MB=MC

3 Hrs

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Working with Diagrams and Slope:Positive and Negative Relationships

An upward-sloping line describes a

positive relationship between X and Y

A downward sloping line describes a

negative relationship between X and Y

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Working with Diagrams and Slope:

The Component of a Line

b =

Y

X

Y Y

X X

1 0

1 0

• The algebraic expression of this line is as follows:

a = Y-intercept, or value ofY when X = 0.

Y = a + bX

where:

Y = dependent variableX = independent variable

+ = positive relationshipbetween X and Y

b = slope of the line, or therate of change in Ygiven a change in X.

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Working with Diagrams and Slope:Strength of the Relationship Between

X and Y

• This line is relatively flat.

Changes in the value of X have

only a small influence on the

value of Y.

• This line is relatively steep.

Changes in the value of X have a

greater influence on the value of

Y.

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Working with Diagrams and Slope:

Different Slope Values

b 5

1005. b

7

100 7.

b 0

100

b 10

0

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Thank You

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