RBBS 7112: Principles of Microeconomics - Introduction to Economics

Origins and Fundamental Meaning of Economics

  • Etymology: The word "economy" is derived from the Greek word oikonomos, which literally means "one who manages a household."
  • The Household Analogy: Similar to an economy, a household must make decisions regarding resource allocation and must navigate the reality of scarce resources.
  • Foundation of Economics: Scarcity serves as the fundamental concept upon which the entire field of economics is built.
  • Definition of Scarcity: Scarcity refers to the limited nature of society's resources in the face of unlimited wants and needs.
  • Definition of Economics: Economics is defined as the study of how society manages its scarce resources.
  • Primary Concerns of Economics:
    • Individual Decisions: How people decide what products to buy, the amount of time they devote to work, how much they save for the future, and how much they choose to spend.
    • Firm Decisions: How business entities determine their production levels and how many workers they need to hire.
    • Societal Decisions: How society collectively decides to divide its resources between sectors such as national defense, consumer goods, environmental protection, and other competing needs.

Branches of Economics

  • Microeconomics:
    • This branch focuses on how households and firms make specific decisions and how these entities interact within individual markets.
    • It addresses issues such as the determination of prices and quantities for specific goods and services.
    • It also examines the effects of government regulation and taxation on individual market behaviors.
  • Macroeconomics:
    • This branch is the study of economy-wide phenomena.
    • it views the economy as a whole and analyzes the interactions between different national economies.
    • Key focus areas include National Income, economic cycles (booms and recessions), inflation, and unemployment.

Economic Perspectives: Positive vs. Normative

  • Roles of Economists: Economists serve as both analysts/scientists and as policy advisers.
  • Positive Economics:
    • A descriptive branch of economics.
    • It seeks to explain "what is" by describing factual relationships and cause-and-effect scenarios.
  • Normative Economics:
    • A prescriptive branch of economics.
    • It attempts to prescribe "what ought to be," involving value judgments and recommendations for policy.

Fundamental Economic Concepts

  • Scarcity and Choice:
    • Resources are deemed scarce if they are insufficient to satisfy all human wants. This creates an unavoidable necessity for choice.
    • Consumers: Face a limited income and unlimited wants. They must create a list of preferences to decide how to allocate their income effectively.
    • Producers: Must allocate resources to maximize profits. They decide on the most profitable output and organize production resources accordingly.
    • Social Allocation: The problem of choice is fundamentally a problem of allocation—deciding what to produce with scarce resources and how to distribute those goods and services among society members.
  • Opportunity Cost:
    • The opportunity cost of any action is defined as the value of the foregone best alternative.
    • Because resources have multiple alternative uses, choosing one use means sacrificing another.
  • Rationality Assumption:
    • In economic analysis, it is assumed that agents (individuals and firms) behave rationally.
    • Rationality implies that agents act systematically and purposefully to meet their objectives, given the opportunities available to them.

Economic Systems and the Price Mechanism

  • Resource Allocation Methods:
    • Central Planning: Associated with Communism and Socialism. The central command (government) decides the allocation of resources for both production and consumption.
    • Market Economy: Resource allocation is decentralized, left to millions of firms and households who interact to decide what to produce and for whom.
  • Adam Smith and the "Invisible Hand":
    • In his 1776 work The Wealth of Nations, Adam Smith observed that households and firms act as if led by an "invisible hand" that promotes general economic well-being.
    • Price Determination: The interaction of buyers and sellers determines prices.
    • Information in Prices: Each price reflects the value of a good to the buyer and the cost of production to the seller.
    • Guidance: Prices guide self-interested actors to make decisions that, in many cases, maximize the well-being of society as a whole.

The Ten Principles of Economics

Category 1: How People Make Decisions

  • Principle #1: People Face Tradeoffs:
    • To get one thing, we usually have to give up another.
    • Efficiency vs. Equality: Efficiency is when society gets the maximum benefit from its scarce resources (the size of the economic pie). Equality is when prosperity is distributed uniformly among members (how the pie is sliced).
    • The Tradeoff: Redistributing income from the wealthy to the poor to increase equality may reduce the incentive to work, thereby shrinking the overall size of the economic "pie."
  • Principle #2: The Cost of Something Is What You Give Up to Get It:
    • Decision-making requires comparing the costs and benefits of alternatives.
    • The relevant cost is the opportunity cost—whatever must be given up to obtain an item.
  • Principle #3: Rational People Think at the Margin:
    • Rational agents evaluate marginal changes: incremental adjustments to an existing plan of action.
    • Decisions are made by comparing marginal costs and marginal benefits.
  • Principle #4: People Respond to Incentives:
    • An incentive is something that induces action, such as the prospect of reward or punishment.
    • Examples: Rising gas prices lead to increased purchases of hybrid cars; higher cigarette taxes lead to a decrease in teenage smoking.

Category 2: How People Interact

  • Principle #5: Trade Can Make Everyone Better Off:
    • Rather than being self-sufficient, people and countries can specialize in what they do best and exchange it for other goods.
    • Trade allows countries to get better prices abroad for their products and buy foreign goods more cheaply than they could produce them locally.
  • Principle #6: Markets Are Usually a Good Way to Organize Economic Activity:
    • A market is any group of buyers and sellers. Organizing economic activity involves determining what to produced, how, how much, and for whom.
    • Market economies use decentralized decisions to allocate resources through the "invisible hand" and the price system.
  • Principle #7: Governments Can Sometimes Improve Market Outcomes:
    • Property Rights: Governments must enforce rights (via courts and police) so individuals are willing to work and invest without fear of theft.
    • Market Failure: This occurs when a market fails to allocate resources efficiently on its own.
      • Externalities: When production or consumption affects bystanders (e.g., pollution).
      • Market Power: When a single entity (monopoly) significantly influences market prices.
    • Equity: Government may intervene via tax or welfare policies to change how the economic pie is divided if the market outcome is deemed unfair.

Category 3: How the Economy as a Whole Works

  • Principle #8: A Country’s Standard of Living Depends on Its Ability to Produce Goods & Services:
    • There is huge variation in living standards (e.g., rich country average income is over 1010 times that of poor countries).
    • Productivity: The most important determinant of living standards, defined as the amount of goods and services produced per unit of labor.
    • Productivity is driven by available equipment, worker skills, and technology.
  • Principle #9: Prices Rise When the Government Prints Too Much Money:
    • Inflation: An increase in the general level of prices.
    • Long-run inflation is almost always caused by excessive growth in the quantity of money, which causes money to lose its value.
  • Principle #10: Society Faces a Short-Run Tradeoff Between Inflation and Unemployment:
    • In the short run (approximately 11 to 22 years), many policies push inflation and unemployment in opposite directions.

Active Learning and Discussion

Active Learning 1: Applying Marginal Thinking

  • Scenario: You are selling a 20062006 Mercedes Benz. You have already spent 10001000 on repairs. The transmission dies at the last minute. It costs 600600 to fix it. Should you repair it?
  • Analysis:
    • The 10001000 previously spent is a sunk cost and is irrelevant to the current decision.
    • Case A: Value is 65006500 if fixed, 57005700 if not.
      • Marginal Benefit = 6500−5700=8006500 - 5700 = 800.
      • Marginal Cost = 600600.
      • Decision: Fix it (Benefit > Cost).
    • Case B: Value is 60006000 if fixed, 55005500 if not.
      • Marginal Benefit = 6000−5500=5006000 - 5500 = 500.
      • Marginal Cost = 600600.
      • Decision: Do not fix it (Cost > Benefit).

Questions & Discussion

  • Question: In each of the following situations, what is the government’s role? Does the government’s intervention improve the outcome?
    • a. Public schools
    • b. Workplace safety regulations
    • c. Public highways
    • d. Patent laws, which allow drug companies to charge high prices for life-saving drugs