CHAPTER 1 Economics and the economy ©McGraw-Hill Education, 2014

The subject area of economics Every group of people must solve three basic problems of daily living: what goods and services to produce how to produce them for whom to produce them ©McGraw-Hill Education, 2014

How economists think about choices In economic models it is assumed that economic agents act rationally. Willingness-to-pay can be used to quantify the non-monetary costs and benefits of decisions. When resources are scarce all choices have an opportunity cost. Economic agents are assumed to respond to incentives. ©McGraw-Hill Education, 2014

Economic issues the financial crisis of 2007 (1) In 2007 many of the world’s largest financial institutions either collapsed or came close to doing so. The crisis in financial markets quickly spread to the wider economy as many countries throughout the world went into recession. ©McGraw-Hill Education, 2014

Economic issues the financial crisis of 2007 (2) ©McGraw-Hill Education, 2014 Figure 1.1 reveals the severity of the 2007 recession when compared to earlier economic downturns.

Economic issues the financial crisis of 2007 (3) The financial crisis originated in the sub-prime crisis in the United States. Rising house prices, combined with low interest rates, created a financial incentive to expand lending to low income borrowers. ©McGraw-Hill Education, 2014

US house prices ©McGraw-Hill Education, 2014

The boom in trade in Mortgage Backed Securities (MBSs) ©McGraw-Hill Education, 2014 Figure 1.3 shows how the trade in MBSs boomed in the run up to the crisis.

Key features of the crisis (1) Sub-prime borrowers start to default on loans and this set in motion a fall in house prices and the value of MBSs. Financial institutions holding MBSs incurred huge losses. ©McGraw-Hill Education, 2014

Key features of the crisis (2) Losses lowered the willingness and ability of banks to lend to each other, and the this led to a ‘credit crunch’. Non-financial businesses struggled to get funding and the wider economy went into recession. ©McGraw-Hill Education, 2014

An example: Oil price fluctuations The price of oil tripled in , and doubled again in It rose sharply again in ©McGraw-Hill Education, 2014

Higher oil prices make the economy produce in a way that uses less oil. reduce the demand for oil-related commodities encouraging consumers to purchase substitute commodities make the world economy produce more for OPEC and less for the big oil importers (e.g., Germany and Japan) ©McGraw-Hill Education, 2014

The distribution of world population and income ©McGraw-Hill Education, 2014

The law of diminishing marginal returns Each extra worker adds less to output than the previous extra worker added. ©McGraw-Hill Education, 2014

Film output A  Food output Production possibility frontier The production possibility frontier (1) This tells us the maximum amount the economy can produce using all available resources. A is impossible. B inefficient. B ©McGraw-Hill Education, 2014

 F/  G = opportunity cost (=1/2) The production possibility frontier (2) Film output (G)  F= 4  G = 8 B A   Food output (F) Production possibility frontier ©McGraw-Hill Education, 2014

Opportunity cost In the previous figure, suppose we begin at point A with 14 units of food and 6 films. Moving from A to B, we gain 8 films but lose 4 units of food. Thus, 4 units of food is the opportunity cost of producing an additional 8 films. ©McGraw-Hill Education, 2014 The opportunity cost of a good is the quantity of other goods that must be sacrificed.

Comparative advantage An individual has a comparative advantage compared to another in the production of a good if he/she has a lower opportunity cost in producing it. This is different to absolute advantage. An individual has an absolute advantage in producing a good if he/she is more efficient at producing that good compared to someone else. ©McGraw-Hill Education, 2014

Comparative advantage In determining possible benefits from trade it is the concept of comparative advantage that matters not the absolute one. Comparative advantage also applies to countries. ©McGraw-Hill Education, 2014

Markets and the price mechanism The price mechanism ensures that…  households’ decisions about consumption of alternative goods  firms’ decisions about what and how to produce  and workers’ decisions about how much and for whom to work … are all reconciled. ©McGraw-Hill Education, 2014

The command economy Is an alternative to the market economy In a command economy, a government planning office decides:  what will be produced,  how it will be produced,  and for whom it will be produced. Detailed instructions are then issued to households, firms and workers. ©McGraw-Hill Education, 2014

The invisible hand ©McGraw-Hill Education, 2014 In contrast, Adam Smith in the Wealth of Nations (1776) argued that individuals pursuing their self-interest would be led ‘as by an invisible hand’ to do things that are in the interests of society as a whole. The command economy has tended not to perform well.

A mixed economy In a mixed economy the government and private sector jointly solve economic problems. The government influences decisions through taxation, subsidies, and provision of free services such as defence and the police. It also regulates the extent to which individuals may pursue their own self- interest. ©McGraw-Hill Education, 2014

Command economy Free market economy UKUSAIndiaCubaHungarySweden Market orientation ©McGraw-Hill Education, 2014

Positive and normative economics Positive economics studies objective or scientific explanations of how the economy works. Normative economics offers recommendations based on personal value judgments. ©McGraw-Hill Education, 2014

Microeconomics Microeconomics offers a detailed treatment of individual decisions about particular commodities ©McGraw-Hill Education, 2014

Macroeconomics Macroeconomics emphasizes interactions in the economy as a whole. It deliberately simplifies the individual building blocks of the analysis in order to retain a manageable analysis of the complete interaction of the economy. ©McGraw-Hill Education, 2014

Concluding comments (1) Economics analyses what, how and for whom society produces. Rational individuals, in making choices, must compare the benefits and the costs associated with those choices. The production possibility frontier ( PPF ) shows the maximum amount of one good that can be produced given the output of another good. The opportunity cost of an activity is the value of the best alternative that we must sacrifice. It is the slope of the PPF. ©McGraw-Hill Education, 2014

Concluding comments (2) If individuals, firms or countries have different opportunity costs of producing a good compared to others, they have a comparative advantage. In a command economy, decisions on what, how and for whom are made in a central planning office. A free market economy has no government intervention. Modern economies are mixed, relying mainly on the market but with a large dose of government intervention. ©McGraw-Hill Education, 2014

Concluding comments (3) Positive economics studies how the economy actually behaves. Normative economics recommends what should be done. Microeconomics offers a detailed analysis of particular activities in the economy. Macroeconomics emphasizes these interactions at the cost of simplifying the individual building blocks. ©McGraw-Hill Education, 2014