Chapter 1 Introduction – The Big Ideas Microeconomics Curtis & Irvine, 2013

Learning outcomes By the end of this chapter you should understand… The nature and objective of economics The role of theory, models, hypotheses and data The centrality of government How microeconomics differs from macroeconomics Opportunity cost, productivity advantage and efficiency Specialization, exchange and markets The production possibility frontier Full employment, booms, recessions and economic growth

A Working Definition of Economics “Economics, at its best, is a set of ideas and methods for the improvement of society. It is not, as so often seems the case today, a set of ideological rules for asserting why we cannot face the challenges of stagnation, job loss and widening inequality.” Christopher Sims, Nobel Laureate in Economics, 2011

Ideas and Methods Economics is a social science It is concerned with ideas that may improve society It is scientific in its approach Use of mathematics Use of models Use of data and statistical methods Translation of ideas into formal models through mathematics, and testing of the ideas/models through the use of statistical methods (more in chapter 2)

Challenges for today’s society Unemployment rates among young people are at historic highs Government balance sheets are in disarray Inequality is on the rise. In addition, the world simultaneously faces structural upheaval: overpopulation climate change political instability globalization These issues challenge us to understand and formulate policies

But there is Good News too… Literacy rates rising dramatically in the developing world Child mortality has plummeted Family size is a fraction of what it was 50 years ago Prosperity is on the rise in much of Asia Life expectancy is increasing universally Deaths through wars are in a state of long term decline.

Microeconomics and Macroeconomics Macroeconomics studies the economy as a system in which feedbacks among sectors determine national output, employment and prices Microeconomics is the study of individual behavior in the context of scarcity In a mixed economy goods and services are supplied both by private suppliers and government

Government Government is not an add-on to our economy. It plays an integral role in regulating, redistributing and enforcing contracts. Without this legal structure the private sector could decline into a state of Hobbesian anarchy Example: Congo in the modern era

Understanding Economics through the Use of Models A model is a formalization of theory that facilitates scientific enquiry A theory is a logical view of how things work, and is frequently formulated on the basis of observation Frequently we transform theories into models and test the theories in this way by confronting them with data and statistical analysis …. Examples below…

Markets, Trading and Opportunity Cost Markets are central to our economic lives – they permit us to trade, work efficiently and improve our living standards Example of Gardner and Plummer who are neighbors: Trading skills == market place Let us take a numerical example that we can develop into a model of production and exchange.

A Model of Exchange and Specialization Table 1.1 Production Possibilities in a Two-Person Economy Hours/fish Hours/vegetable Fish production Vegetable production Amanda 3 2 12 18 Zoe 4 9 Each producer has a time allocation of 36 hours By allocating total time to one activity, Amanda can produce 12F or 18V Zoe can produce 18F or 9V By splitting their time each person can also produce a combination of the two

Opportunity Cost The opportunity cost of a choice is what must be sacrificed when a choice is made Zoe’s opportunity cost is 1:2 (1 unit of V for 2 units of F) Amanda’s opportunity cost is 3:2 (18 units of V for 12 units of F)

We are about to develop our first graphical model Specialization Let’s now see what can happen as a result of each individual specializing in the production of the good where their opportunity cost dictates: Amanda specializes in Vegetable Zoe specializes in Fish We are about to develop our first graphical model

Absolute Advantage - Production Amanda’s initial consumption is {6, 9} and Zoe’s is {9, 4.5}. With specialization they can produce a greater total {18, 18} than when operating individually. Hence, if they trade, after specializing, they each have the potential to consume more. Vegetable Amanda specializes 18 Amanda’s assumed initial consumption Amanda’s PPF 9 * 6,9 Zoe’s assumed initial consumption Zoe’s PPF 9,4.5 * Zoe specializes 12 18 Fish

From Production to Consumption Let us see how specialization, that produces more output can translate into more consumption. It is consumption rather than production which is of ultimate interest First they must decide upon a rate at which to exchange the two goods: If each individual is to benefit this rate should lie between their individual rates of transformation. To illustrate: suppose they exchange at a rate of 1:1

Absolute Advantage - Consumption Vegetable With specialization, and trade at 1:1, they consume along the line joining the specialization points Amanda specializes 18 If Amanda trades 8V to Zoe in return for 8F Amanda moves to the point {8, 10} and Zoe to {10, 8}. Both consume more after specialization, relative to pre-specialization Amanda’s assumed final consumption 8,10 Zoe’s final consumption Amanda’s initial consumption = {6, 9} 10,8 Zoe specializes Zoe’s initial consumption = {9, 4.5} 18 Fish

From Individuals to the Economy Can we represent the production possibilities of the whole economy by ‘aggregating’ the production capabilities of each individual? The economy-wide PPF is the set of products combinations that can be produced in the economy when all available productive resources are in use.

Economy-wide PPF a 0, 27 c 18,18 e 30, 0 Vegetable With complete specialization this economy can produce 27V or 30 F a 0, 27 PPF for whole economy From a, to produce Fish it is more efficient to use Zoe because her opportunity cost is less (segment ac). When Zoe is completely specialized Amanda is used (section ce) c 18,18 18 Amanda’s PPF 9 Zoe’s PPF 18 Fish 12 e 30, 0

A Multi-person PPF Vegetable a b c d Fish e The PPF for the whole economy abcde, is obtained by allocating productive resources most efficiently. Vegetable The opportunity cost in the economy of producing more fish is the amount of vegetable that must be foregone. a b c Opportunity cost depends upon how much of the economy’s productive resources (individuals) are already producing F and V. The opportunity cost along bc differs from along cd d With many individuals the PPF is the concave envelope of the individual capabilities Fish e

Growth and the PPF Services Economic growth or an increase in the available resources can be envisioned as an outward shift in the PPF from PPF0 to PPF1. With PPF1 the economy can produce more in both sectors than with PPF0. A S’max a Smax PPF1 PPF0 S1 X1 S0 X0 B Goods b G0 G1 Gmax G’max

Recessions and Booms In an economic recession output falls below the economy’s capacity output A boom is a period of high growth that raises output above normal capacity output. illustrate through the PPF…

Booms and Recessions Services Economic recessions leave the economy below its normal capacity; the economy might be driven to a point such as Z. a Smax W Economic expansions, or booms, may drive capacity above its normal level, to a point such as W. X S0 Z PPF b Goods G0 Gmax

Productivity of the Economy The productivity of labour, defined as output per worker, depends on: the skill, knowledge and experience of the labour force the capital stock: buildings, machinery, equipment, and software the labour force has to work with the current technology embodied in the labour force and the capital stock.

Full Employment and the PPF When everyone who is willing to work at current wage rates and normal hours of work is actually working, the economy is a full employment In this state the economy’s actual output is also termed its capacity output or full employment output In 2012 the actual unemployment was 7.3% in Canada. Economists believe that full employment corresponds to approximately 6% unemployment Hence the PPF in Canada has an associated unemployment rate of 6%!

Chapter Summary Economics: methods and ideas for the improvement of society Economists use models to test theories with data Markets improve the economy’s efficiency Opportunity cost reflects the alternative possibilities Production possibility frontier represents the capabilities of the economy when functioning efficiently

Chapter Summary Absolute advantage refers to greater absolute efficiency Specialization increases consumption possibilities With many individuals the PPF may be concave Economic growth shifts the PPF Booms and recessions see increases and decreases in output beyond what is normal