Economics: Foundations and Models Chapter 1 Economics: Foundations and Models

Learning Objectives Discuss these three important economic ideas: people are rational; people respond to incentives; optimal decisions are made at the margin. Understand the issues of scarcity and trade-offs, and how the market makes decisions on these issues. Understand the role of economics in modern analysis. Distinguish between microeconomics and macroeconomics.

Water scarcity and its consequences Many regions across the Australian continent face intense water scarcity. The challenge facing the nation is therefore the efficient management of this scarce resource to maximise the possible benefits across various uses.

Economics and Individual Decisions LEARNING OBJECTIVE 1 Economics and Individual Decisions Economics is the study of the choices people and societies make to attain their unlimited wants, given their scarce resources. In this subject we study how people make choices and interact in markets. Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

Economics and Individual Decisions LEARNING OBJECTIVE 1 Economics and Individual Decisions Three ideas are primary throughout the subject: People are rational. People respond to economic incentives. Optimal decisions are made at the margin. Marginal Analysis: Analysis that involves comparing marginal benefits and marginal costs.

Scarcity and Trade-offs LEARNING OBJECTIVE 2 Scarcity and Trade-offs Scarcity: The situation in which unlimited wants exceed the limited resources available to fulfill those wants. Trade-off: The idea that, because of scarcity, producing more of one good or service means producing less of another good or service.

Scarcity and Trade-offs LEARNING OBJECTIVE 2 Scarcity and Trade-offs Trade-offs force society to make choices. This is especially true with respect to three fundamental questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?

Scarcity and Trade-offs LEARNING OBJECTIVE 2 Scarcity and Trade-offs What goods and services will be produced? When choosing between alternative options, economists use the concept of opportunity cost. Opportunity cost: The opportunity cost of any activity is the highest-valued alternative that must be given up to engage in the activity under consideration.

Scarcity and Trade-offs LEARNING OBJECTIVE 2 Scarcity and Trade-offs How will the goods and services be produced? In many cases, firms face a trade-off between using more workers and using more machines. Who will receive the goods and services produced? This largely depends on how income is distributed.

Scarcity and Trade-offs LEARNING OBJECTIVE 2 Scarcity and Trade-offs Centrally planned economies versus market economies Centrally planned economy: An economy in which the government decides how economic resources will be allocated. Market economy: An economy in which the decisions of households and firms interacting in markets determine the allocation of economic resources.

Scarcity and Trade-offs LEARNING OBJECTIVE 2 Scarcity and Trade-offs A central feature of market economies is consumer sovereignty. Consumer sovereignty occurs because firms must produce goods and services that meet the wants of the consumers, in order to be successful. It is therefore consumers who ultimately decide what will be produced.

Scarcity and Trade-offs LEARNING OBJECTIVE 2 Scarcity and Trade-offs The modern economy is a ‘mixed’ economy: Mixed economy: An economy in which most economic decisions result from the interaction of buyers and sellers in markets, but in which the government plays a significant role in the allocation of resources.

Scarcity and Trade-offs LEARNING OBJECTIVE 2 Scarcity and Trade-offs Efficiency and Equity Productive efficiency: The situation in which a good or service is produced using the least amount of resources. Allocative efficiency: A state of the economy in which production reflects consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Dynamic efficiency: Occurs when new technology and innovation are adopted over time.

Scarcity and Trade-offs LEARNING OBJECTIVE 2 Scarcity and Trade-offs Voluntary exchange: The situation that occurs in markets when both buyer and seller of a product are made better off by the transaction. Equity: A fair distribution of economic benefits between individuals and between societies. An efficient outcome may or may not be considered by society to be equitable.

Do you agree with this statement? Explain why or why not. LEARNING OBJECTIVE 2 Scarcity and trade-offs Fortunately for the world’s developed nations, they no longer face the problem of scarcity. As a result, they can direct their efforts to addressing scarcity in developing nations. Do you agree with this statement? Explain why or why not.

Scarcity and trade-offs LEARNING OBJECTIVE 2 Scarcity and trade-offs Solving the problem: STEP 1: Review the material. This problem is about the concept of scarcity as it is defined in economics. This is covered on pages 4 and 7 of the text. STEP 2: The concept of scarcity as defined in economics is based on the assumption of unlimited human wants. Resources will always be scarce in this context, regardless of whether we are in the developed or developing world. Human beings will always want more than they have, and every society is therefore faced with the problem of allocating its scarce resources to maximise the satisfaction of wants.

LEARNING OBJECTIVE 3 Economic Models Economic models: Simplified versions of reality used to analyse real-world economic situations.

LEARNING OBJECTIVE 3 Economic Models To develop a model economists generally follow these steps: Decide on the assumptions to be used in developing the model. Formulate a testable hypothesis. Use economic data to test the hypothesis. Revise the model if it fails to explain the economic data. Retain the revised model to help answer similar economic questions in the future.

Economic Models Forming and testing hypotheses in economic models. LEARNING OBJECTIVE 3 Economic Models Forming and testing hypotheses in economic models. A hypothesis in an economic model: A statement about an economic variable that may be either correct or incorrect. Economic variable: Something measurable that relates to resources that can have different values, for example, wages, prices, litres of water. In testing hypotheses, economists distinguish between correlation and causality.

Economic Models Normative and positive analysis LEARNING OBJECTIVE 3 Economic Models Normative and positive analysis Positive analysis: Analysis concerned with what is. Involves value-free statements that can be tested by using the facts. Normative analysis: Analysis concerned with what ought to be. Involves making value judgments which cannot be tested.

Normative and positive analysis LEARNING OBJECTIVE 3 Normative and positive analysis Which of the following represent a positive analysis and which represent a normative analysis? Explain your answer. Unemployment in Australia is currently 8.5%. The unemployment rate in Australia is too high and policies should be devised to reduce the unemployment rate. When unemployment falls, wages increase.

Normative and positive analysis LEARNING OBJECTIVE 3 Normative and positive analysis Solving the problem: STEP 1: Review the material. This problem relates to normative and positive analysis which is covered on pages 13 – 14 of the text. STEP 2: Answering a) This is a positive statement as it can be verified or refuted by reference to data on unemployment.

Normative and positive analysis LEARNING OBJECTIVE 3 Normative and positive analysis STEP 3: Answering b) This is a normative statement. Whether resources should be allocated to reducing the unemployment rate involves value judgments. STEP 4: Answering c) This is a positive statement as it can be verified by reference to the facts - although it may be difficult to isolate the relationship between falling unemployment and rising wages.

Economists don’t always agree Former federal economic policy adviser, Dr Fred Argy, reminds current and future policy makers that economics is not an exact science.

Microeconomics and Macroeconomics LEARNING OBJECTIVE 4 Microeconomics and Macroeconomics Microeconomics: The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics: The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

An Inside Look Figure 1. Water use in Australia, 2004-05 Industry, particularly agriculture (as you would expect) is the largest user of water in Australia Includes sewage and drainage Includes water loss

Key Terms Allocative efficiency Centrally planned economy Consumer sovereignty Dynamic efficiency Economic models Economic variable Economics Equity Macroeconomics Marginal analysis Market Market economy Microeconomics Mixed economy Normative analysis Opportunity cost Positive analysis Productive (technical) efficiency Scarcity Trade-off Voluntary exchange

Check Your Knowledge Q1. Which of the following statements best describes scarcity? Scarcity studies the choices people make to attain their goals. Scarcity is a situation where unlimited wants exceed limited resources. Scarcity is an imbalance between buyers and sellers in a specific market. Scarcity refers to a lack of trade-offs.

Check Your Knowledge Q1. Which of the following statements best describes scarcity? Scarcity studies the choices people make to attain their goals. Scarcity is a situation where unlimited wants exceed limited resources. Scarcity is an imbalance between buyers and sellers in a specific market. Scarcity refers to a lack of trade-offs.

Check Your Knowledge Q2. What does an economy achieve by producing a good or service using the least amount of resources? a. Productive efficiency b. Allocative efficiency c. Voluntary exchange d. Equity

Check Your Knowledge Q2. What does an economy achieve by producing a good or service using the least amount of resources? a. Productive efficiency b. Allocative efficiency c. Voluntary exchange d. Equity

Check Your Knowledge Q3. What is the purpose of an economic hypothesis? a. To establish a behavioural assumption. b. To establish a causal relationship. c. To make a statement based on fact. d. To determine the validity of statistical analyses used in testing a model.

Check Your Knowledge Q3. What is the purpose of an economic hypothesis? a. To establish a behavioural assumption. b. To establish a causal relationship. c. To make a statement based on fact. d. To determine the validity of statistical analyses used in testing a model.

Check Your Knowledge Q4. What type of statement would ‘A minimum wage actually reduces unemployment’ be considered? a. A positive statement b. A marginal statement c. A normative statement d. An irrational conclusion

Check Your Knowledge Q4. What type of statement would ‘A minimum wage actually reduces unemployment’ be considered? a. A positive statement b. A marginal statement c. A normative statement d. An irrational conclusion

Appendix Graphs can be compared to maps – they provide a simplified guide to reality.

Appendix Figure 1A.1 Bar graphs and pie charts Values for an economic variable are often displayed as a bar graph or as a pie chart. In this case panel (a) shows export share data for Australia a a bar graph where the export share of each country is represented by the height of its bar. Panel (b) displays the same information as a pie chart, where the export share of each country is represented by the size of its slice of the pie.

Appendix Figure 1A.2 Line graphs Both panels present time-series graphs of the export of Australian coal worldwide during each ear from 1999-2000 to 2000-05. Panel (a) begins the vertical axis at $8000 million while panel (b) begins he vertical axis at zero. As a result, the fluctuation in exports appears smaller in panel (b) than in panel (a).

Appendix Figure 1A.3 Plotting price and quantity points on a graph The figure shows a two-dimensional grid on which we measure the price of pizza along the vertical axis (y-axis) and the quantity of pizza sold per week along the horizontal axis (x-axis). Each point on the grid represents one of the price and quantity combinations listed in the table. By connecting the points by a line we can illustrate better the relationship between the two variables.

Appendix Figure 1A.4 Calculating the slope of a line We can calculate the slope of a line as the change in the value of the variable on the y-axis divided by the change in the value of the variable on the x-axis. Because the slope of a straight line is constant, we can use any two points in the figure to calculate the slope of the line. For example, when the price of pizza decreases from $14 to $12 the quantity of pizza demanded increases from 55 per week to 65 per week. So, the slope of this line equals -2 divided by 10, or -0.2.

Appendix Figure 1A.5 Showing three variables on a graph The demand curve for pizza shows the relationship between the price of pizzas and the quantity of pizza demanded, holding constant other factors that might affect the willingness of consumers to buy pizza. If the price of pizza is $14 (point A), and increase in the price of burgers from $1.50 to $2.00 increases the quantity of pizzas demanded from 55 to 60 per week (point B) and shifts us to Demand curve2. Or, if we start on Demand curve1, and the price of pizza is $12 (point C), a decrease in the price of burgers from $1.50 to $1.00 decreases the quantity demanded from 65 to 60 per week (point D), and shifts us to Demand curve3.

Appendix Figure 1A.6 A positive relationship between two variables. In a positive relationship between two economic variables, as one variable increases the other variable also increases. This figure shows the positive relationship between disposable personal income and consumption spending. As disposable personal income has increased so has consumption spending.

Appendix Figure 1A.7 The slope of a non-linear curve The relationship between the quantity of iPods produced and the total cost of production is curved, rather than linear. In panel (a), in moving from point A to point B, the quantity produced increases by one million iPods, while the total cost of production increases by $50 million. Further up the curve, as we move from point C to point D the change in quantity is the same – one million iPods - but the change in total cost of production is now much larger: $250 million. Because the change in the y variable has increased, while the change in the x variable has remained the same, we know that the slope has increased. In panel (b), we measure the slope of the curve at a particular point by the slope of the tangent line. The slope of the tangent line at point B is 75, and the slope of the tangent line at point C is 150.

Appendix Figure 1A.8 Showing a firm’s total revenue on a graph The area of a rectangle is equal to its base multiplied by its height. Total revenue is equal to price multiplied by quantity. Here, total revenue is equal to the price of $2.00 per bottle times 125 000 bottles, or $250 000. The area of the green-shaded rectangle shows the firm’s total revenue.

Appendix Figure 1A.9 The area of a triangle The area of a triangle is equal to ½ multiplied by its base multiplied by its height. The area of the blue-shaded triangle has a base equal to 150 000 – 125 000, or 25 000, and a height equal to $2.00 - $1.50, or $0.50. Therefore, its area equals ½ x 25 000 x $0.50, or $6250.