Definition, Nature and Scope of Economics BASIC MICROECONOMICS Definition, Nature and Scope of Economics

Definition The word economy comes from a Greek word “oikonomias” for “one who manages a household.” A household and an economy face many decisions: Which goods shall be produced & in what quantities? What resources should be used in production? Who will work? Use more capital or labor? How should the produced goods be distributed? Who gets how much? At what price should the goods be sold?

Society and Scarce Resources Economists view the world through the lens of scarcity The management of society’s resources is important because resources are scarce. Scarcity. . . means that society has limited resources and therefore cannot produce all the goods and services people wish to have Scarcity limits are options & necessitates that we make choices Economics is the study of how society manages its scarce resources.

Ten principles of Economics There are ten basic principles of Economics which can be divided into three broad areas: How people make decisions People face tradeoffs. The cost of something is what you give up to get it. Rational people think at the margin. People respond to incentives

Ten principles of economics 2. How people interact with each other Trade can make everyone better off. Markets are usually a good way to organize economic activity. Governments can sometimes improve economic outcomes.

Ten principles of Economics 3. There are forces and trends that affect how the economy as a whole works. The standard of living depends on a country’s production. Prices rise when the government prints too much money. Society faces a short-run tradeoff between inflation and unemployment

Principle 1: People face trade-offs To get one thing, we usually have to give up another thing. So more of one thing means less of another. Guns v. books Food v. clothing Leisure time v. work Making decisions requires trading off one goal against another.

Principle 2: The cost of something is what you give up to acquire it Decisions require comparing costs and benefits of alternatives. Whether to go to college or to work? Whether to study or go out on a date? Whether to go to class or sleep in? The opportunity cost of an item is what you give up to obtain that item or sacrifices made in order to obtain that item.

Principle 3: Rational People think at the Margin Economics is grounded on the assumption of “rational self-interest” – meaning individuals pursue actions that will enable them to achieve their greatest satisfaction Marginal changes are small, incremental adjustments to an existing plan of action People make decisions by comparing costs and benefits at the margin.

Principle 4: People respond to incentives Marginal changes in costs or benefits motivate people to respond. The decision to choose one alternative over another occurs when that alternative’s marginal benefits exceed its marginal costs!

Principle 5: Trade can make everyone better off People gain from their ability to trade with one another. Competition results in gains from trading. Trade allows people to specialize in what they do best. Specialization improves efficiency with which resources are used.

Principle 6: Markets are usually a good way to organise economic activity A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Households decide what to buy and who to work for. Firms decide who to hire and what to produce

Principle 6: Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social costs of their actions. As a result, prices guide decision makers to reach outcomes that tend to maximize the welfare of society as a whole

Principle 7: Governments can sometimes improve market outcomes Market failure occurs when the market fails to allocate resources efficiently. When the market fails (breaks down) government can intervene to promote efficiency and equity Market failure may be caused by an externality, which is the impact of one person or firm’s actions on the well-being of a bystander. market power, which is the ability of a single person or firm to unduly influence market prices.

Principle 8: The Standards of Living Depends on a Country’s Production Standard of living may be measured in different ways: By comparing personal incomes. By comparing the total market value of a nation’s production Almost all variations in living standards are explained by differences in countries’ productivities. Productivity is the amount of goods and services produced from each hour of a worker’s time.

Principle 9: Prices Rise when a Government Prints too much Money Inflation is an increase in the overall level of prices in the economy. One cause of inflation is the growth in the quantity of money. When the government creates large quantities of money, the value of the money falls.

òInflation ð ñUnemployment Principle 10: Society faces a Short-run tradeoff between Inflation and Unemployment The Phillips Curve illustrates the tradeoff between inflation and unemployment: òInflation ð ñUnemployment It’s a short-run tradeoff!

METHODOLOGY OF ECONOMICS Economics trains you to. . . . Think in terms of alternatives. Evaluate the cost of individual and social choices. Examine and understand how certain events and issues are related

Is Economics a Science? The scientific method deals with questions which can be verified or falsified by actual observations of the real world. It involves: observation, Hypothesis, theory and more observation The economic way of thinking . . . Involves thinking analytically and objectively. Makes use of the scientific method

Economics relies on the scientific method Consists of a number of elements: The observation of facts (real world data) Make simplifying assumptions and formulate a hypothesis, A hypothesis is a possible explanation of cause and effect Make predictions based on the hypothesis- Testing the explanation by comparing the outcomes of specific events to the outcome predicted by the hypothesis The acceptance, rejection, or modification of the hypothesis, based on the comparisons.

Scientific method Continue to test the hypothesis against the facts. As more favourable results accumulate, the hypothesis evolves into a theory A well tested and widely accepted theory is referred to as a law or economic principle Combinations of such laws or principles are incorporated into models. Laws, principles, and models enable the economist like the natural scientist, to understand and explain reality and predict the outcomes of particular actions

Facts, theories, and policies in economics The process of deriving theories and principles is called theoretical economics Involves establishing economic theories by gathering, systematically arranging, and generalising from facts Good economic theories are tested for validity against facts Well tested theories become economic laws or principles Such laws and principles are used to formulate economic policies. Hence theoretical versus policy economics

Theories, laws, and principles and models Hypothesis-needs initial testing Theory has been tested but needs more testing A law is a theory that has provided strong predictive accuracy over and over A model is a simplified representation of how something works in the real world.

Abstractions Economic theories, principles and models are abstractions-they are simplification that omit irrelevant facts and circumstances Economic models do not mirror the full complexity of the real world. The process of sorting out and analysing facts involves simplification and removal of clutter Is economic theory unrealistic? Economists simplify-that is develop theories and buil models –to give meaning to an otherwise confusing maze of facts

Economic Generalisations Economic theories, principles and laws are generalisations of economic behaviour. Imprecise because economic factors are usually diverse. Economic principles are expressed as the tendencies of typical or average consumers, workers, or business firms E.g. Consumer spending ↑ and household disposable income↑ Quantity demanded↑ and price ↓

The Role of Assumptions in Economics Why do economists make assumptions? Economists make assumptions in order to make the world easier to understand. The art in scientific thinking is deciding which assumptions to make. Economists use different assumptions to answer different questions ceteris paribus – other things equal assumption-assume that all other variables except those under immediate consideration are held constant for a particular analysis Difference between natural science and economics-controlled experiment vs changing real world

Economic models Economists use models to simplify reality in order to improve our understanding of the world Two of the most basic economic models include: The Circular Flow Diagram The Production Possibilities Frontier

Circular flow diagram The circular-flow diagram is a visual model of the economy that shows how money flows through markets among households and firms

Economic Policy Economic Policies are courses of action based on economic principles They are used to resolve specific economic problems Economic policies are normally applied to problems after they arise. They can also be used to “prevent” or moderate the event e.g. unemployment, inflation etc.

Steps in Economic policy formulation State the goal-clear statement of economic goal Determine the policy options-assessment of economic impact, benefits, costs and political feasibility of alternative policies Implement and evaluate selected policy

Basic Economic Goals Economic Growth– produce more & better goods/services Full employment – provide suitable jobs for all citizens who are willing & able to work Economic efficiency- achieve maximum fulfillment of wants using available productive resources Price level stability – avoid large upswings & downswings in the general price level Economic freedom- guarantee that business, workers, and consumers have a high degree of freedom in their economic activities Equitable distribution of income – ensure that no group of citizens faces poverty while others enjoy abundance Economic security- provide for chronically ill, disabled, unemployed etc to earn minimal levels of income Balance of trade – seek overall balance with rest of world in trade & financial transactions Sometimes goals compliment each other, at times conflict When they conflict, tradeoffs arise

Microeconomics Vs Macroeconomics Microeconomics focuses on the individual parts of the economy-individual economic agents and individual markets. How households and firms make decisions and how they interact in specific markets Macroeconomics looks at the economy as a whole. Economy-wide phenomena, including inflation, unemployment, and economic growth

Positive Vs Normative Statements Positive statements are statements that attempt to describe the world as it is. They are objective statements dealing with matters of fact or they question about how things actually are hence they are called descriptive analysis. The per capita income in Botswana is higher than in Namibia Positive statements are made without obvious value-judgments and emotions. They may suggest an economic relationship that can be tested by recourse to the available evidence.

Normative Statements Normative statements are statements about how the world should be. They are subjective - based on opinion only - often without a basis in fact or theory. They are value-laden, emotional statements that focus on "what ought to be". Statement like “The national minimum wage should be increased to P500 as a method of reducing poverty” Called prescriptive analysis

Graphs & Curves in Economics A graph is a visual representation of the relationship between two variables If the graph is straight line, relationship is linear If graph slopes upward to the right, it depicts a direct relationship between the two variables, i.e., variables changes in the same direction. Example - consumption & income If graph slopes downward to the right, it depicts an inverse relationship, i.e., the variables change in opposite directions. Example – price & quantity demanded

Dependent & independent variables Economists want to determine which variable is the cause & which is the effect Independent variable is the cause or source; it is the variable that changes first Dependent variable is the effect or outcome; it is the variable that changes because of the change in the independent variable Slope of a straight line is the ratio of the vertical change (the drop) to the horizontal change (the run) between any two points of the line Slope is important because it reflects marginal changes, i.e., those involving 1 more (or 1 less) unit.

Slope & vertical intercept Vertical intercept of a line is the point where the line meets the vertical axis In the price quantity demanded equation it shows the price at which quantity demanded is zero. Equation of a linear relationship Y = a + bX; y is dependent variable a is vertical intercept x is dependent variable