BASIC CONCEPTS IN ECONOMICS

Problem of economics can be summarized in one sentence: How to best satisfy unlimited wants with unlimited resources. We can break this problem into two parts: Preferences - What do we like, what do we dislike. Resources - We all have limited resources. Even Warren Buffett and Bill Gates have limited resources. They have the same 24 hours in a day that we do and neither is going to live forever. Choice as an economic problem: Human wants are unlimited but the means or resources to satisfy these wants are limited or scarce. Resources are not only scarce but they have alternative uses. This give rise to the problem of choice in economics. For example, iron can be used for making tanks, it can be used for making trains, it can also be used for building houses. It is because of the various alternative uses of the resources that we have to decide about the best allocation of resources. Thus, economics develops principles for making the best use of available resources. (If our wants are limited or the resources are unlimited, or if the resources have no alternative uses, then there would have been no economic problem at all). Opportunity cost An opportunity cost represents what you forego to obtain something that you want. This can be phrased as 'What would you have done had this opportunity not have been available' or 'What was the next best alternative?' Unlike most costs discussed in economics, an opportunity cost is not always a number. The opportunity cost of any action is simply the next best alternative to that action - or put more simply, "What you would have done if you didn't make the choice that you did". I have a number of alternatives of how to spend my Friday night: I can go to the movies, I can stay home and watch the baseball game on TV, or go out for coffee with friends. If I choose to go to the movies, my opportunity cost of that action is what I would have chose if I had not gone to the movies - either watching the baseball game or going out for coffee with friends. Note that an opportunity cost only considers the next bestalternative to an action, not the entire set of alternatives.

Note: Opportunity costs do not measure all possible alternatives, just the second best one. Example: Had I not watched the Blue Jay game, I would have studied for my economics test. The opportunity cost of watching the game is the 3 hours of study time lost. Note that the opportunity cost needs to account for all differences between the choice made and the second best alternative. Suppose I take a one year leave of absence from a job paying $95,000/yr to obtain an MBA at a school with a tuition of $55,000/yr. Then the

opportunity cost of the MBA program, measured in dollars, is $150,000. This includes both the $55,000 paid in tuition and the $95,000 lost in wages. How do we then make the best decisions possible? We need to compare the benefits of anything obtained to the costs of obtaining them. We do this through marginal analysis. . Marginal analysis From an economist's perspective, making choices involves making decisions 'at the margin' - that is, making decisions based on small changes in resources: How should I spend the next hour? How should I spend the next dollar? On the surface, this seems like a strange way of considering the choices made by people and firms. It is rare that someone would consciously ask themselves - 'How will I spend dollar number 24,387?', 'How will I spend dollar number 24,388?'. Treating the problem in this matter does have some distinct advantages: Doing so leads to the optimal decisions being made, subject to preferences, resources and informational constraints. It makes the problem less messy from an analytic point of view, as we are not trying to analyze a million decisions at once. While this does not exactly mimic conscious decision making processes, it does provide results similar to the decisions people actually make. That is, people may not think using this method, but the decisions they make are as if they do. Marginal Analysis - An Example Consider the decision on how many hours to work, as given by the following chart: Hour - Hourly Wage - Value of Time Hour 1 - $10 - $2 Hour 2 - $10 - $2 Hour 3 - $10 - $3 Hour 4 - $10 - $3 Hour 5 - $10 - $4 Hour 6 - $10 - $5 Hour 7 - $10 - $6 Hour 8 - $10 - $8 Hour 9 - $15 - $9 Hour 10 - $15 - $12 Hour 11 - $15 - $18 Hour 12 - $15 - $20

The hourly wage represents what I earn for working an extra hour - it is the marginal gain or the marginal benefit. The value of time is essentially an opportunity cost - it is how much I value having that hour off. In this example it represents a marginal cost - what it costs me by working an additional hour. The increase in marginal costs is a common phenomenon; I do not mind working a few hours since there are 24 hours in a day. I still have plenty of time to do other things. However, as I start to work more hours it reduces the number of hours I have for other activities. I have to start giving up more and more valuable opportunities to work those extra hours. It is clear that I should work the first hour, as I gain $10 in marginal benefits and lose only $2 in marginal costs, for a net gain of $8. By the same logic I should work the second and third hours as well. I will want to work until which time the marginal cost exceeds the marginal benefit. I will want to work the 10th hour as I receive a net benefit of #3 (marginal benefit of $15, marginal cost of $12). However, I will not want to work the 11th hour, as the marginal cost ($18) exceeds the marginal benefit ($15) by three dollars. Thus marginal analysis suggests that rational maximizing behavior is to work for 10 hours. Rational Maximizing Behavior In order to understand an economic model that how humans attempt to do rational behaviour, we need a basic behavioral assumption. The assumption is that people attempt to maximize outcomes (that is, to do as well as possible for themselves) as defined by their preferences given their resource constraints. Economists refer to people who do this as exhibiting 'rational maximizing behavior'. Note that in more complex economic models that this assumption can be weakened, but at a cost of added complexity. This 'rational maximizing behavior' assumption does not necessarily mean that people make, ex ante, perfect decisions. People may be limited by the amount of information they have (e.g. 'It seemed like a good idea at the time!'). As well, 'rational maximizing behavior' says nothing about the quality or nature of people's preferences (But I enjoy hitting myself on the head with a hammer!') Opportunity cost and production possibility frontiers An opportunity cost will usually arise whenever an economic agent chooses between alternative ways of allocating scarce resources. The opportunity cost of such a decision is the value of the next best alternative use of scarce resources. Opportunity cost can be illustrated by using production possibility frontiers (PPFs) which provide a simple, yet powerful tool to illustrate the effects of making an economic choice. A PPF shows all the possible combinations of two goods, or two options available at one point in time.

Production possibilities Mythica, which is a hypothetical economy, produces only two goods - textbooks and computers. When it uses all of its resources, it can produce five million computers and fifty five million textbooks. In fact, it can produce all the following combinations of computers and books.

COMPUTERS (m TEXTBOOKS (m) 0 1 2 3 4 5 6 7 8 9 70 69 68 65 60 55 48 39 24 0

These combinations can also be shown graphically, the result being a production possibility frontier. The production possibility frontier (PPF) for computers and textbooks is shown here. Interpreting PPFs Firstly, we can describe the opportunity cost to Mythica of producing a given output of computers or textbooks. For example, If Mythica produces 3m computers; the opportunity cost is 5m textbooks. This is the difference between the maximum output of textbooks that can be produced if no computers are produced (which is 70m) and the number of textbooks that can be produced if 3m

computers are produced (which is 65m). Similarly, the opportunity cost of producing 7m computers is 31m textbooks - which is 70 - 39. PPFs can also illustrate the opportunity cost of a change in the quantity produced of one good. For example, suppose Mythica currently produces 3 million computers and 65m textbooks. We can calculate the opportunity cost to Mythica if it decides to increase production from 3 million computers to 7 million, shown on the PPF as a movement from point A to point B. and textbooks is shown here.

The result is a loss of output of 26 million textbooks (from 65 to 39m). Hence, the opportunity cost to Mythica of this decision can be expressed as 26m textbooks. In fact, this is the same as comparing the static opportunity cost of producing 3m computers (5m textbooks) and 7m computers (31m textbooks).

Production Possibility Frontier (PPF)

Under the field of macroeconomics, the production possibility frontier (PPF) represents the point at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible. If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the production of society will dwindle. The production possibility frontier shows there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can be produced. Let's turn to the chart below. Imagine an economy that can produce only wine and cotton. According to the PPF, points A, B and C - all appearing on the curve - represent the most efficient use of resources by the economy. Point X represents an inefficient use of resources, while point Y represents the goals that the economy cannot attain with its present levels of resources.

As we can see, in order for this economy to produce more wine, it must give up some of the resources it uses to produce cotton (point A). If the economy starts producing more cotton (represented by points B and C), it would have to divert resources from making wine and, consequently, it will produce less wine than it is producing at point A. As the chart shows, by moving production from point A to B, the economy must decrease wine production by a small amount in comparison to the increase in cotton output. However, if the economy moves from point B to C, wine output will be significantly reduced while the increase in cotton will be quite small. Keep in mind that A, B, and C all represent the most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF and which combination to use. If more wine is in demand, the cost of increasing its output is proportional to the cost of decreasing cotton production. Point X means that the country's resources are not being used efficiently or, more specifically, that the country is not producing enough cotton or wine given the potential of its resources. Point Y, as we mentioned above, represents an output level that is currently unreachable by this economy. However, if there was a change in technology while the level of land, labor and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new efficient allocation of resources.

When the PPF shifts outwards, we know there is growth in an economy. Alternatively, when the PPF shifts inwards it indicates that the economy is shrinking as a result of a decline in its most efficient allocation of resources and optimal production capability. A shrinking economy could be a result of a decrease in supplies or a deficiency in technology. An economy can be producing on the PPF curve only in theory. In reality, economies constantly struggle to reach an optimal production capacity. And because scarcity forces an economy to forgo one choice for another, the slope of the PPF will always be negative; if production of product A increases then production of product B will have to decrease accordingly.

Tradeoffs - You Get What You Give The struggle between preferences and constraints means that economists must, at their core, deal with the problem of tradeoffs. In order to get something we must use up some of our resources. Examples: You give up $20 to obtain the new best seller from Amazon.com. I give up 3 hours of time to watch the Blue Jays game on T.V. ('That's three hours of my life I will never get back!') Anything obtained has a cost. Economists have a saying for this - "There is no such thing as a free lunch!

Microeconomics and Macroeconomics Microeconomics is the study of the economic behaviour of individual units of the economy such as consumers, firms, industries, and markets. It explains how the prices of various goods and factors of production are determined and how resources of the economy are allocated among goods and services. On the other hand, Macroeconomics studies the functioning of the economy as a whole. It analyses behaviour of the national aggregates

such as national income, total consumption, savings, investment; total employment, the general price level and the countrys balance of payments. Stock and Flow business and related fields often distinguish between quantities that are stocks and those that are flows. These differ in their units of measurement. A stock variable is measured at one specific time, and represents a quantity existing at that point in time (say, December 31, 2004), which may have accumulated in the past. A flow variable is measured over an interval of time. Therefore a flow would be measured per unit of time (say a year). Flow is roughly analogous to rate or speed in this sense. For example, U.S. nominal gross domestic product refers to a total number of dollars spent over a time period, such as a year. Therefore it is a flow variable, and has units of dollars/year. In contrast, the U.S. nominal capital stock is the total value, in dollars, of equipment, buildings, inventories, and other real assets in the U.S. economy, and has units of dollars. The diagram provides an intuitive illustration of how the stock of capital currently available is increased by the flowof new investment and depleted by the flow of depreciation.

Market Mechanism The market mechanism, works through supply and demand in a free market economy. It acts as the principal organizing force for economic efficiency. It solves all the central problems of an economy by efficiently allocating scarce resources among alternative uses. It determines what to produce and how much to produce according to the criterion of maximum profit. It allocates the different factors of production among their various uses according to the criterion of maximizing their incomes. It brings about an equitable distribution of income by causing resources to be allocated in the right directions.

It works to ration out the existing supplies of goods and services, utilizes the economys resources fully and provides the means for economic growth.

Positive Economics and Normative Economics: 1. Positive economics is concerned with what is whereas Normative economics is concerned with what ought to be. 2. Positive economics describe economic behaviours without any value judgment while normative economics evaluate them with moral judgment. 3. Positive economics is objective while normative economics is subjective. 4. The statement, Price rise as demand increase is related to positive economics, whereas the statement, Rising prices is a social evil is related to normative economics. Inductive Method and Deductive Method of Economic Analysis Deductive method involves reasoning or inference from the general to the particular or from the universal to the individual. Deduction involves four steps: (1) Selecting the problems (2) Formulating the assumptions (3) Formulating the hypothesis through the process of logical reasoning whereby inferences are drawn and (4) Verifying the hypothesis. Inductive method involves reasoning from particulars to the general or from the individual to the universal. This method derives economic generalisations on the basis of experiments and observations. In this method detailed data are collected on certain economic phenomenon and effort is then made to arrive at certain generalizations which follow from the observations collected. (The Engels Law and the Malthusian Theory of Population have been derived from inductive reasoning).