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Topic 1Introduction to Economics
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The Central EconomicProblem
Scarcity is the central economicproblem Our inability to satisfy all our wants (from
your textbook) Scarcity is a result of unlimited wants but
limited resources to satisfy these wants
Limited resources (factors of production)Unlimited wants (goods & services)
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Scarce ResourcesFactors of production - the basic categories ofinputs used to produce goods and services.Land & Raw Materials (Natural Resources) A shorthand expression for any natural resource
provided by nature
Labour (Human Resources) The mental and physical capacity of workers to
produce goods and servicesCapital (Manufactured Resources) The physical tools, machinery, equipment and
buildings used to produce other goods Not to be confused with financial capitalEntrepreneurship The creative ability of individuals to seek profits by
combining resources to produce innovative products
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Scarcity and Choice
Scarcity forces us to make choices Rational Choices refers to choices that
involve weighing up the benefit of any activityagainst its opportunity cost
Opportunity cost The highest-valued alternative that is given
up to get something.
Sacrifice
Next best thing forgone Can be in monetary or non-monetary terms
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Scarcity
Choice
OpportunityCost
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What is EconomicsEconomics: The study of choices that individuals,
businesses, governments and societies make tocope with scarcity and the incentives thatinfluence and reconcile those choices.
Macroeconomics Studies the performance of the national economy
and global economy Studies decision-making for the economy as a
wholeMicroeconomics Studies the choices that individuals and
businesses make, the way these choices interactin markets, and the influence of governments (onspecific markets)
Studies decision-making by a single individual,household, firm, industry
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Microeconomic Issues
Individual parts (economic agents)
Individual units such as households,
firms and industries Demand and supply of particular goods
and services
Market structure
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Methodology of Economics
The purpose of an economic model isto forecast or predict the results ofvarious changes in variables
A model is a simplified description ofreality used to understand and predictthe relationship between variables.
Three basic steps in the model-building process
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Identify the problem
Develop a model basedon simplified assumptions
Collect data andtest the model
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Hazards to Economic Way ofThinking
Two pitfalls (reasoning mistakes): Failing to understand the ceteris paribus
assumptionWhen testing a model we often use the assumption
of ceteris paribusMeans that while certain variables can change, allother things remain unchanged
Confusing association (correlation) with
causation Association - two events can occur together but oneevent is not the cause of the other
Cannot always assume that when one event followsanother, the first caused the second
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Choosing at the Margin People make choices at the margin they
evaluate the consequences of makingincremental changes .
Marginal benefit (MB) the benefit that arises frompursuing an incremental increase in an activity.Marginal cost (MC) the opportunity cost of pursuing anincremental increase in an activity.
Marginal benefit and marginal cost act as
incentivesWhen MB > MC, people have an incentive to do more ofthat activity.When MC > MB, people have an incentive to do less ofthat activity.
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Three Fundamental Economic Questions
Wh at , h o w and f o r w h o m
What type & what quantities of goods & services
How to produce these goods & services
what mix of resources is needed for production
For whom to produce for
basically who gets what
All societies and nations need to answer thesethree questions
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Economic Systems
Economic systems The organization and methods used to
determine what goods and services are
produced, how they are produced, and forwhom they are produced
All economic systems answers the three
fundamental economic questions Command economy, Market economy,
Mixed economy
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Totallyplanned
economy
Totallyfree-market
economy
N. Korea
N. Korea
Cuba
China
Poland
Poland France
France
UK
UKUSA
USA
Early 1980s
Early 2000s
Classifying economic systems
China HongKong
CubaChina
(HongKong)
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Command Economy
Command Economy (also known asCentrally Planned & similar to communism) A system that answers the What, How, and For
Whom questions by central authority(i.e.
government)The three fundamental economic questions areanswered through central planning
Plans what will be produced and in what quantities
Decides which resources will be used for the productionof various goods and services
Decides on the distribution of the goods and servicesproduced
All economic decisions are taken by the central
authorities
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Command Economy Advantages of a command economy
High focus on investment goods bygovernment will lead to high economicgrowth
Stable growth if properly overseen bycentral planning prevents extremefluctuations in economic growth
Low unemployment if there is accurate
matching of labour needs Social goals can be pursued (e.g. income
equality, basic needs met) Government can prevent the destruction of
the environment (e.g. control pollution)
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Command EconomyProblems of a command economy
Problems of gathering information for centralplanning due to complexity of economies (veryexpensive to administer)
Inefficient use of resources as there are no pricesignals, price arbitrarily decided by government
Inappropriate incentives for producers (not profitdriven) and workers may lead to poor quality andlow variety of goods
Loss of individual liberty Shortages and surpluses can occur with poor
planning (for the case of shortages, this may leadto a black market where buyers pay much higherprices)
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Market Economy
Market Economy (also similar toCapitalism) An economic system that answers the What,
How, and For Whom questions using pricesdetermined by the interaction of the forces ofsupply and demand
The price mechanism (demand and supply) willanswer the three fundamental economic questions
Firms will decide what goods and services to produce andhouseholds will decide what goods and service to buyFirms will decide what resources to use and householdswill decide what resources to supply
All economic decisions are taken by individualhouseholds and firms with no government
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Market Economy
Adam Smiths Invisible Hand A phrase that expresses the belief that the bestinterests of a society are served whenindividual consumers and producers competeto achieve their own private interests
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Market Economy
Advantages of a free-market economy Price mechanism transmits information
between buyers and sellers leading to widerange of products - no need for costlybureaucracy
Competitive markets (with many sellers andbuyers) leads to lower prices
Quicker response time to market changesby reacting to changes in demand andsupply
Incentives to be efficient and produce quality
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Market Economy
Problems of a free-market economy Competition may be limited which leads to theproblem of market power (where a monopolywill sell goods a high prices)
Social goals may not be met (e.g. incomeinequality and unequal distribution of wealthand power)
Environment / social problems may be ignoredNegative externalities such as pollution
Lack of desirable public goods (e.g. street lights)Poor ethics / values (selfishness)
There may be macroeconomic instability (highfluctuations in economic growth and highunemployment)
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Mixed Economy
The mixed economy An economic system that answers the What, How,
and For Whom questions through a mixture ofcommand and market systems
Both government and private sector (individuals and firms)make economic decisions
Some examples of government intervention:relative prices of goods & services (taxes, price controls)
relative incomes (taxes, welfare payments, legislations)
pattern of production & consumption (taxes, legislations,state-owned companies)
macroeconomic problems (fiscal & monetary policies)