Lesson One Introduction, The Ten Key Principles ... · Interdependence and the Gains from Trade How...

Lesson One

Introduction, The Ten Key

Principles, Interdependence and

Trade

Peter Rumble

Transfer Abroad Programme

BUS 111 – Micro Economics

BUS 111 - Micro Economics

What I want you to be able to do by 1st

November?

Understand Economic news In Context

Example – What is going on with President Trump and

PRC?

Example – what is going on in Europe? Brexit?

Example - India and China = same population but

different in what ways?

Human aspect


What you need to do..

Be able to understand economic terms

Discuss economic matters

One handed economist….so there is no right

answer as long as well argued..

Two economist = three opinions


Economics Introductory Thoughts

What is Economics?

Micro – Economics

Macro – Economics


Economy. . .

. . . The word economy comes from a

Greek word for “one who manages a

household.”



Micro Economics

This is concerned with the individual parts – the

demand and supply of goods and services

Focuses on households (consumer expenditure) and

firms (organisations)

How markets work.



Macro Economics

This is concerned with the economic aggregate demand

and supply – the grand totals of households /individuals

and firms activities.

The impact nationally of prices- inflation, employment

and savings/ investments

Governments & International aspects.


It’s the economy - stupid

"It's the economy, stupid" is a slight variation of the

phrase "The economy, stupid" which James Carville

had coined as a campaign strategist of Bill Clinton's

successful 1992 presidential campaign against sitting

president George H. W. Bush.

Carville's original phrase was meant for the internal

audience of Clinton's campaign workers as one of the

three messages to focus on, the other two messages

being "Change vs. more of the same" and "Don't

forget health care.”

http://en.wikipedia.org/wiki/James_Carville

http://en.wikipedia.org/wiki/Bill_Clinton

http://en.wikipedia.org/wiki/United_States_presidential_election,_1992

http://en.wikipedia.org/wiki/George_H._W._Bush


Economics?

Handling scarce resources

Factors of production..

Labour

Land

Capital

Entrepreneurial skills

Maximising Wealth – Well being

Tackling Climate Change issues


Maximising Wealth

Economic Choices – Production

Possibilities Frontiers

Wheat or Rice ?

Rice or Computers?

Computers or Cars? Page 26


The Circular Flow

The simple circular flow model of

the economy is designed to

understand the basic operations

of the economy


58

7 6

43

21

HouseholdsBusinesses

Markets for factors of

production

Markets for good

and services


The simple circular flow

In the simple circular flow model two players of the economic game: Households

and Businesses.

Households are: sellers of all inputs, or factors of production, and buyers of all

output of good and services.

Businesses are: buyers of all inputs and sellers of all output.


Flow 1 – Households sell their land , labour and capital in the market as factors of production.

Flow 2 – Businesses buy these factors of production and use them to make goods and services.

Flow 3 – Businesses sell the goods and services made.

Flow 4 - Households buy the goods and services.

So, when we start at the households and go counterclockwise from 1 to 4 we will follow the flows of what are called “real”

things – the resources and the goods and services made. These are what are really important in the economy because these

are the items used to create our standard of living.


So, when we start at the households and go counterclockwise from 1 to 4 we will follow the flows of what are called “real” things –the resources and the goods and services

made. These are what are really important in the economy because these are the items used

to create our standard of living

Consumption


Next we look at flows 5 through 8 and these are financial flows and we see a connection between spending, revenues,

and income.

Flow 5 – The households payment after selling resources in the factor markets is called income.

Flow 6 – When the households buy stuff they pay for it and the term used in the national economy sense to represent this buying is spending or consumption expenditure. The

households buy from businesses in the markets for output of good and services.

Flow 7 – When the businesses sell goods and services to household the businesses bring home revenue. (So, if we

ignore government for now, expenditure = revenue).


Flow 8 – When businesses take in revenue from sales then they use the money to pay for the

resources they have purchased in the markets for factors of production. Here we talk about costs of

business

So the flows 5 through 8 are the financial flows that correspond to our “real” flows.

The simple circular flow model is a simple model of the day to day operations of the economy.


Flows 1 through 4 are flows of inputs (resources) and output (goods and services).

Flows 5 through 8 are flows of money.

The flow of money is one way we account for the flow of resources and goods and services.


Analogy – A grocery store Denis

We look at the revenue of a grocery store to get a feel for the output amount – but we know the output is made up of items like milk, noodles , drinks etc…

We look at expenses to get a feel for amount of inputs used – but we know the inputs are hours of labor (wages), electricity used, property taxes / costs


Final thoughtThe economy is large and complex. Each individual business has a pretty decent grip on what resources are being used and

can probably make a list of what those resources are on a sheet of paper – you know, labor, cash registers, etc

Each individual household knows what goods and services are being bought and can probably make a list of those items

on a sheet of paper – you know, noodles, milk, electricity.

In large complex economies it would be difficult to get these lists from businesses and households. But we have come up with ways to get at the money flows. Often our focus will be on money flows when we really want to talk about the lists.


The Circular Flow

Basic model but in reality it is more

complex – Government Trade

Advertising, The Invisible Hand,

Not complicated…. Just complex

Quick break….


1

Ten Principles of Economics


TEN PRINCIPLES OF

ECONOMICS

A household and an economy

face many decisions:

Who will work?

What goods and how many of them should

be produced?

What resources should be used in

production?

At what price should the goods be sold?


TEN PRINCIPLES OF

ECONOMICSSociety and Scarce Resources:

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.


TEN PRINCIPLES OF

ECONOMICS

Economics is the study of how society

manages its scarce resources.


TEN PRINCIPLES OF

ECONOMICS

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

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

The 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 Tradeoffs.

“There is no such thing as a free lunch!”


Making decisions requires trading

off one goal against another.

Principle #1: People Face Tradeoffs.

To get one thing, we usually have to give up

another thing.

Guns v. butter

Food v. clothing

Leisure time v. work

Efficiency v. equity


Principle #1: People Face Tradeoffs

Efficiency v. Equity

Efficiency means society gets the most that it

can from its scarce resources.

Equity means the benefits of those resources

are distributed fairly among the members of

society.


Principle #2: The Cost of Something Is

What You Give Up to Get 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.


Principle #2: The Cost of Something Is

What You Give Up to Get It.

LA Laker basketball

star Kobe Bryant chose

to skip college and go

straight from high

school to the pros

where he has earned

millions of dollars.


People make decisions by comparing

costs and benefits at the margin.

Principle #3: Rational People Think at

the Margin.

Marginal changes are small, incremental

adjustments to an existing plan of action.


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!

Work at weekend? Overtime – payment..


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.


Principle #6: Markets Are Usually a

Good Way to Organize 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: Markets Are Usually a

Good Way to Organize Economic

Activity. Adam Smith made the observation that

households and firms interacting in markets

act as if guided by an “invisible hand.”

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.


3

Interdependence and the Gains

from Trade


Consider your typical day:

You wake up to an alarm clock made in

Korea.

You pour yourself orange juice made from

Florida oranges and coffee from beans

grown in Brazil.

You put on some clothes made of cotton

grown in Georgia and sewn in factories in

Thailand.

You watch the morning news broadcast

from New York on your TV made in Japan.


. . . and you haven’t been up for more

than two hours yet!


Interdependence and the

Gains from Trade

Remember, economics is the study of how

societies produce and distribute goods in

an attempt to satisfy the wants and needs

of its members.



Gains from Trade

How do we satisfy our wants and needs in

a global economy?

We can be economically self-sufficient.

We can specialize and trade

with others, leading to

economic interdependence.



Gains from Trade

Individuals and nations rely on

specialized production and exchange as a

way to address problems caused by

scarcity.

But this gives rise to two questions:

Why is interdependence the norm?

What determines production and trade?



Gains from Trade

Why is interdependence the norm?

Interdependence occurs because people are

better off when they specialize and trade

with others.

What determines the pattern of

production and trade?

Patterns of production and trade are based

upon differences in opportunity costs.


A PARABLE FOR THE

MODERN ECONOMY

Imagine . . .

only two goods: potatoes and meat• only two people: a potato farmer and a cattle

rancher

• What should each produce?

• Why should they trade?

BUS 111 - Micro EconomicsTable 1 The Production Opportunities of the

Farmer and Rancher

Copyright © 2004 South-Western


Production Possibilities

Self-Sufficiency

By ignoring each other:

Each consumes what they each produce.

The production possibilities frontier is also

the consumption possibilities frontier.

Without trade, economic gains are

diminished.

BUS 111 - Micro EconomicsFigure 1 The Production Possibilities Curve

Potatoes (ounces)

4

16

8

32

A

0

Meat (ounces)

(a) The Farmer ’s Production Possibilities Frontier

If there is no trade,

the farmer chooses

this production and

consumption.

Copyright©2003 Southwestern/Thomson Learning

BUS 111 - Micro EconomicsFigure 1 The Production Possibilities Curve


Potatoes (ounces)

12

24

B

0

Meat (ounces)

(b) The Rancher ’s Production Possibilities Frontier

48

24

If there is no trade,

the rancher chooses

this production and

consumption.


The farmer should produce potatoes.

The rancher should produce meat.

Specialization and Trade

The Farmer and the Rancher Specialize

and Trade

Each would be better off if they specialized

in producing the product they are more

suited to produce, and then trade with each

other.

BUS 111 - Micro EconomicsTable 2 The Gains from Trade: A Summary


BUS 111 - Micro EconomicsFigure 2 How Trade Expands the Set of Consumption Opportunities


Potatoes (ounces)

4

16

5

17

8

32

A

A*

0

Meat (ounces)

(a) The Farmer ’s Production and Consumption

Farmer's

production and

consumption

without trade

Farmer's

consumption

with trade

Farmer's

production

with trade

BUS 111 - Micro EconomicsFigure 2 How Trade Expands the Set of Consumption Opportunities


Potatoes (ounces)

12

24

13

27

B

0

Meat (ounces)

(b) The Rancher ’s Production and Consumption

48

24

12

18

B*

Rancher's

consumption

with trade

Rancher's

production

with trade

Rancher's

production and

consumption

without trade

BUS 111 - Micro EconomicsTable 2 The Gains from Trade: A Summary



Who can produce potatoes at a lower

cost--the farmer or the rancher?

THE PRINCIPLE OF

COMPARATIVE

ADVANTAGE Differences in the costs of production

determine the following:

Who should produce what?

How much should be traded for each

product?

BUS 111 - Micro EconomicsTHE PRINCIPLE OF

COMPARATIVE

ADVANTAGE Differences in Costs of Production

Two ways to measure differences in costs

of production:

The number of hours required to produce a

unit of output (for example, one pound of

potatoes).

The opportunity cost of sacrificing one good

for another.


Absolute Advantage

The comparison among producers of a

good according to their productivity—absolute advantage

Describes the productivity of one person,

firm, or nation compared to that of another.

The producer that requires a smaller

quantity of inputs to produce a good is said

to have an absolute advantage in producing

that good.


The Rancher has an absolute advantage in the

production of both meat and potatoes.

Absolute Advantage

The Rancher needs only 10 minutes to

produce an ounce of potatoes, whereas

the Farmer needs 15 minutes.

The Rancher needs only 20 minutes to

produce an ounce of meat, whereas the

Farmer needs 60 minutes.


Opportunity Cost and Comparative

Advantage

Compares producers of a good according

to their opportunity cost.

Whatever must be given up to obtain some

item

The producer who has the smaller

opportunity cost of producing a good is

said to have a comparative advantage in

producing that good.


Comparative Advantage and Trade

Who has the absolute advantage?

The farmer or the rancher?

Who has the comparative advantage?

The farmer or the rancher?


Table 3 The Opportunity Cost of

Meat and Potatoes

Opportunity Cost of:

1 oz of Meat 1 oz of Potatoes

Farmer 4 oz potatoes 1/4 oz meat

Rancher 2 oz potatoes 1/2 oz meat



The Rancher’s opportunity cost of an

ounce of potatoes is ¼ an ounce of meat,

whereas the Farmer’s opportunity cost of

an ounce of potatoes is ½ an ounce of

meat.

The Rancher’s opportunity cost of a

pound of meat is only 4 ounces of

potatoes, while the Farmer’s opportunity

cost of an ounce of meat is only 2 ounces


…so, the Rancher has a comparative

advantage in the production of meat

but the Farmer has a comparative

advantage in the production of

potatoes.




Comparative advantage and differences

in opportunity costs are the basis for

specialized production and trade.

Whenever potential trading parties have

differences in opportunity costs, they can

each benefit from trade.



Benefits of Trade

Trade can benefit everyone in a society

because it allows people to specialize in

activities in which they have a comparative

advantage.


FYI—The Legacy of Adam

Smith and David Ricardo

Adam Smith

In his 1776 book An Inquiry into the Nature

and Causes of the Wealth of Nations, Adam

Smith performed a detailed analysis of trade

and economic interdependence, which

economists still adhere to today.

David Ricardo

In his 1816 book Principles of Political

Economy and Taxation, David Ricardo

developed the principle of comparative

advantage as we know it today.


APPLICATIONS OF

COMPARATIVE ADVANTAGE

?? ?

Should Tiger Woods Mow His Own Lawn?


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. Housing


Principle #7: Governments Can

Sometimes Improve Market Outcomes. 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 Standard 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.



Depends on a Country’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.



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.


Principle #9: Prices Rise When the

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.


Principle #10: Society Faces a Short-

run Tradeoff Between Inflation and

Unemployment.

The Phillips Curve illustrates the tradeoff

between inflation and unemployment:

Inflation Unemployment

It’s a short-run tradeoff!


Summary

When individuals make decisions, they

face tradeoffs among alternative goals.

The cost of any action is measured in

terms of foregone opportunities.

Rational people make decisions by

comparing marginal costs and marginal

benefits.

People change their behavior in response

to the incentives they face.


Summary

Trade can be mutually beneficial.

Markets are usually a good way of

coordinating trade among people.

Government can potentially improve

market outcomes if there is some market

failure or if the market outcome is

inequitable.


APPLICATIONS OF

COMPARATIVE ADVANTAGE

Should the United States Trade with Other

Countries?

Each country has many citizens with different

interests. International trade can make some

individuals worse off, even as it makes the

country as a whole better off.

Imports—goods produced abroad and sold

domestically

Exports—goods produced domestically and sold

abroad


Summary

Each person consumes goods and services

produced by many other people both in

our country and around the world.

Interdependence and trade are desirable

because they allow everyone to enjoy a

greater quantity and variety of goods and

services.


Summary

There are two ways to compare the

ability of two people producing a good.

The person who can produce a good with a

smaller quantity of inputs has an absolute

advantage.

The person with a smaller opportunity cost

has a comparative advantage.


Summary

The gains from trade are based on

comparative advantage, not absolute

advantage.

Trade makes everyone better off because

it allows people to specialize in those

activities in which they have a

comparative advantage.

The principle of comparative advantage

applies to countries as well as people.


Summary

Productivity is the ultimate source of

living standards.

Money growth is the ultimate source of

inflation.

Society faces a short-run tradeoff

between inflation and unemployment.

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