E111 Introduction to Economics ontct detils: E111 Introduction to Economics Ginluigi Vernsc Room: 5B.217 Office hours: Wednesdy 2pm to 4pm Emil: gvern@essex.c.uk Lecture 1: Introduction to Economics I her nd I forget. I see nd I remember. I do nd I understnd (onfucius) Lecture Outline: - Scope nd methodology in economics; - Opportunity costs; - The production possibility frontier (PP); Essentil reding: Begg nd Vernsc: h. 1. The Scope of Economics Economics del with centrl problem fced by ll individuls nd ll societies: the problem of Scrcity. The problem of scrcity mens tht every time we tke n economic decision (for exmple, how much to consume or for firm how much to produce of given good) we fce some constrints tht ffect our decision. This is lwys true for ny possible decision. We cnnot simply get everything we wnt (becuse of scrcity), we hve to mke choices. Economics is the study of choices (economic choices) in the fce of scrcity of resources. Scrcity rises becuse resources tht re used to produce nd consume goods re limited by physicl spce. or exmple, to produce goods nd services we need to use productive resources like Lbour, Lnd nd Rw Mterils, pitl (mchines,
fctories, equipment, etc. etc.). The mount of Lbour is limited both in number nd in skills. The world s lnd re is limited nd so re rw mterils (think t petrol). The stock of cpitl is limited since we hve limited mount of fctories, mchines, trnsporttion nd other equipment. Lbour, Rw Mterils, Lnd nd pitl re wht we cll ctors of Production (or productive Inputs). urthermore, scrcity rises from other resources, like time or income (we re constrined in our economic choices by how much income we hve, firm my not be ble to strt new fctory if it not ble to get bnk lon, etc. etc.). Given the limited mount of resources we con only produce nd consume limited mount of goods nd services. Why is scrcity problem? If we know tht we hve limited resources we could just behve ccordingly. The problem rises becuse humn wnts nd needs re virtully unlimited but resources vilble to stisfy them re not. Therefore economists tend to define scrcity in the following wy: Definition of Scrcity: the excess of humn needs over wht cn ctully be produced. Scrcity implies tht we cnnot choose whtever we wnt (I cnnot buy tody BMW tht costs 50000 if my totl income tody is 10000, etc. etc.) or when we decide bout wht nd how much to produce (I cnnot produce good tht requires 1000 workers if only 100 re vilble, etc. etc.). We know tht scrcity implies tht we fce some sort of constrints every time we tke n economic decision. The presence of those constrints hs the min impliction of creting trde-offs mong different lterntives. The concept of trde-off is one of the core principles in economics. In economics trde-off implies tht hving more of one thing usully it implies hving less of nother. Exmple, suppose you fce the following problem: you like susges nd beer. You hve only 10 in your pocket (tht is the only income you hve). You wnt to consume both, eting susges nd drinking beer. However, more beers you buy less money you hve to spend on susges (nd vice vers). Here the fct tht you hve limited mount of resources (in this cse your income) cretes this trde-off.
rom the previous exmple, the problem you hve is: given your mount of money, wht is the right trde-off you cn get between beers nd susges. This simple exmple illustrtes the min problem we re going to study in the first prt of this course: how gents decide wht the right trde-off mong different vilble lterntives is? Obviously we need to define wht right trde-off mens. But this is exctly wht we wnt to explin with the theories we re going to study. Now we cn link the concept of scrcity with forml definition of wht economics is. Definition of Economics: economics is the study of choices under conditions of scrcity, or the study of choice with constrints. Specificlly, we cn sy tht economics is the study of how individuls nd societies choose to employ scrce resources tht could hve lterntive uses to produce goods nd services, nd distribute them mong vrious individuls nd groups in societies. Therefore, economics dels with theories of choice. We wnt to understnd how (nd why) economic gents decide bout consumption ctivity nd bout production ctivity. onsumption nd production ctivities re the two bsic ctivities we re going to study in the first prt of the course. onsumption: the ct of using goods nd services to stisfy wnts. This will normlly involve purchsing the goods nd services. Production: the trnsformtion of inputs (lbour, rw mterils, lnd nd cpitl) into outputs by firms in order to ern profits. We will study the consumption ctivity nd the production ctivity seprtely. We shll do so in order to understnd how consumers tke decisions nd how firms tke decisions. However, it is cler tht both ctivities re linked. In generl we cnnot consume good (or service) tht hs not been produced, nd in generl firms will not produce goods tht re likely not to be consumed. Therefore we need to study how production ctivity cn meet the consumption ctivity. In generl, those two ctivities will meet in wht we cll Mrket. A Mrket is defined s ny plce where the sellers of prticulr good or service cn meet with the buyers of tht goods nd service.
The Mrket is wy to llocte resources (goods, services, etc. etc.) mong people in society. We will tend to study in this course the economic theory tht pplies to wht we cll free-mrket economy. A free-mrket economy is n economy where gents decide for themselves which product to produce or to buy. Another wy to sy the sme thing: free-mrket economy is n economy where property rights re voluntrily exchnged t price rrnged completely by the mutul consent of sellers nd buyers. Property right mens tht individuls tht hve or produce prticulr good re lso the owner of tht prticulr good. Therefore they cn decide freely to sell it (or consume it) or not. A free-mrket economy (lso clled cpitlist economy) is possible wy to orgnise the economic ctivity of one economy. Another possibility is the so clled ommnd (or Plnned) economy. A typicl exmple of such n economy ws the Soviet Union before the 1989, or nowdys, ub nd North Kore. In Plnned economy ll the relevnt economic decisions re mde centrlly, by n individul or smll number of individuls on behlf of lrger group of people. In generl centrl plnner (think bout government) would estblish the production trget for the country s fctories, would develop mster pln for how to chieve those trgets nd would set up guidelines for the distribution nd use of the goods nd services produced (in the ncient Soviet Union those trgets were set up on 5 yer bse, the so clled five yer plns). In plnned economy ll the productive sectors re ntionlised (under the direct control of the government) nd so individuls re not free to strt their own businesses s they do in free-mrket economy. In Plnned economy the lloction of resources is not chieved by the work of free mrket but it is decided centrlly. The free mrket nd the plnned economies represent two extremes of how to orgnize economic ctivity in given economy. In relity, most of the economies we see cn be clled mixed economies. A mixed economy is n economy where not ll the economic decisions re left to the privte individuls but governments intervene s well. However, it mkes sense to refer to such economies s free-mrket economies or t lest s mrket economies, since individuls re still free to strt businesses, to shut them down or to sell them.
Microecnomics vs Mcroeconomics Methodologiclly we tend to seprte two min res in economics. Microeconomics is the study of the economic behviour of single units ( consumer, household, firm, prticulr industries, etc. etc.) nd of the interreltionship between those units. Mcroeconomics is the study of n economy s whole. This distinction is merely methodologicl since it is cler tht wht hppens in n economy s whole depends lso on the ggregtion of the individul behviour in tht economy. In the first prt of this course we will del with microeconomic problems. In the second prt you will study mcroeconomic problems. On the Methodology of Economics In economics we study prticulr spects of the relity tht we re interested in. We re not interested (it will lso be unfesible) to understnd everything in one go. We cnnot hve single economic theory tht explins everything hppens in the economic world (this is different from physics where physicists try to obtin single theory of everything, like for exmple in String Theory). To explin prticulr spect of relity we use theories nd models. or us the words theory nd model re going to be synonyms. Models (or theories) re n bstrct nd logicl description of the prticulr spect of economics we re interested to study. It is bstrct becuse it isoltes only few of the numerous complicted interctions mong the intercting elements in n economy. It is logicl becuse it uses logics (e.g. the lnguge of mthemtics) to nlyse problem. A model (or theory) consists minly of 3 prts: -) definition of the economic vribles we re interested in (notice the use of word vrible tht sound like mthemticl object); -) A set of ssumptions tht describes how the economic vribles interct; -) A set of predictions tht re the results of the model nd follow logiclly from the definitions nd ssumptions; A good economic model is the one tht hs predictions tht re consistent with the dt relted to the prticulr spect of the relity we wnt to explin. There is nothing new in this methodology, it is the scientific method developed by Glileo mny centuries go.
Why do we use models to explin something? Through the use of models we cn experiment, t lest logiclly, by producing different possible scenrios for the spect of the relity we wnt to understnd, by evluting the effects of lterntive policies, etc. etc. In most of this module you will see mny economic models nd most of them will be explined using grphs. Grphs re pictures relted to n economic problem, with lines nd curves etc. etc. tht tell n economic story. They re the visul spect of n economic model. Therefore you need to become fmilir with grphs, how to drw lines, how lines shifts in the grph etc. etc., nd of course with how to interpret the grphs in n economic wy. Rtionl hoice nd Opportunity ost Economics is the study of choices. We use models to understnd those choices. Models strt with ssumption we mde bout the prticulr problem under nlysis. A very importnt ssumption tht is used in mny economic models is the ssumption tht economic gents (consumers, firms, governments, etc. etc.) re rtionl in their choices. Rtionl mens tht ech gent behves in his/her self-interest in mking choices. They do the best they cn for themselves given the constrints they fce. This is very powerful ssumption tht hs proven to be very effective in the sense tht it helps explining mny rel world situtions. However, it is just n ssumption nd for some prticulr economic problems tht ssumption my not be good representtion of relity. The brnch of economics tht try to explin when rtionlity is not good ssumption is clled behviourl economics. Nevertheless, in most of this module we will ssume tht individuls re rtionl in their choices nd they mke choices in their self-interest. Rtionl individuls mke their choices by compring the benefits (whtever they my be or mesured) with the costs (whtever they my be nd mesured) ssocited with tht choice. A prticulr choice is mde if the benefit is lrger thn the cost ssocited with tht prticulr choice. However, we normlly choose mong different lterntives nd becuse of scrcity when choose something we lose something else. In mking choice we need to tke into ccount not only wht we re choosing but wht we cn lose if prticulr choice is mde.
Relted to the lst point (how to tke into ccount the lterntives we lose when choosing something) we now introduce n importnt concept in economics tht will help us in building our theories of choice for our economic gents. Economists use the term opportunity cost to highlight the fct tht mking choices in the fce of scrcity implies cost (this is exctly relted to the concept of trde-off we hve discussed previously). As summrised by the concept of trde-off, ny choice, mde when resources re scrce, involves some scrifice. The opportunity cost expresses "the bsic reltionship between scrcity nd choice. More food you buy less money you hve for other goods nd so on. The more food ntion produce the less resources cn be used to produce other goods. Therefore, production nd consumption ctivities involve the scrifice of lterntives. However, we do not consider ll the possible lterntives in defining the opportunity cost s it is cler from the following definition: Opportunity cost of ny ction: is the best or next highest rnked lterntive foregone becuse of choosing the given ction. Another wy to sy the sme thing: n opportunity cost is the cost of ny ctivity mesured in terms of the best lterntive foregone. or exmple, the opportunity cost for student tht buys the textbook for E111 my be new pir of jens tht he could hve bought insted. Obviously we should consider only the best lterntive in evluting the opportunity cost. or exmple, if the best lterntive ws to go to resturnt nd buy dinner with the money spent for the book, then the opportunity cost is represented by the dinner nd NOT by the dinner nd the pir of jens. The concept of opportunity costs gives n ide of wht theory choice could be. Every time you tke decision it is probbly becuse the cost opportunity ssocited with tht is not prticulrly lrge. However, this is not yet theory of choice s we will see lter in the course. The true importnce of the concept of opportunity cost is tht when two individuls (or ntions) hve different opportunity costs of performing vrious tsks, they cn lwys increse the totl vlue of vilble goods nd services by trding with one nother.
Therefore, the ide of opportunity cost cn provide reson why individuls trde nd why trde cn be mutully beneficil. The concept of opportunity cost is the bsic element of very fmous economic model tht is known s the Ricrdin model of interntionl trde (Dvid Ricrdo ws British economist of the 19 th century tht proposed tht model). To see how opportunity costs is relted to gins from trde let s consider simple exmple. This exmple is simple ppliction of the Ricrdin model of interntionl trde. It is not exctly microeconomic issue (since we will tlk bout ntions it is more relted to mcroeconomic issue) but it gives n ide tht will be vlid independently of the exmple considered (insted of ntions you my consider individuls nd the ide will be the sme). onsider two countries: UK nd US. UK nd US cn both produce food nd clothing. People in US nd UK consume both goods. The two goods re the sme independently on where they re produced (sy the qulity of the food nd the qulity of clothing is the sme in both country). The problem is the following: should the UK nd the US produce their own food nd clothing or should they trde with ech other? The nswer depends on how the UK nd the US cn produce the two goods. Suppose tht in UK to produce 1 unit of food it is necessry 1 worker, while to produce 1 unit of clothing it is necessry 2 workers. In the US to produce 1 unit of food it is necessry to employ 2 workers while to produce 1 unit of clothing it is necessry to employ 1 worker. Where is scrcity in this exmple? We introduce scrcity by sying tht the number of workers vilble in ech country is fixed number, sy 100. urthermore we ssume tht some workers re employed in the sector producing food nd the others in the sector producing clothing. Now you cn see how this ssumption cretes trde-off: if UK wnts to increse the production of food it must shift some workers from the clothing sector to the food sector. As result the production of clothing will decrese becuse the number of workers working in tht sector will be reduced. irst scenrio: ssume first tht 50 workers re employed in the food sector nd 50 in the clothing sector in ech country.
This implies tht in UK we hve: we hve 50 units of food produced (1 worker produces 1 unit of food) nd 25 units of clothing (2 workers produce 1 unit of clothing). In US we hve 25 units of food nd 50 units of clothing. So the totl quntity of food produced is 75 nd the totl quntity of clothing produced is 75. Second scenrio: ssume tht in UK ll the workers re now employed in the food sector while in the US ll the workers re employed in the clothing sector. In this cse the totl mount of food is now 100 nd the totl mount of clothing is now 100. To summrise: irst scenrio: totl food = 75, totl clothing = 75 Second scenrio: totl food = 100, totl clothing = 100 As you cn see in the second scenrio the totl mount of the two goods produced by the two countries hs incresed. We cll the second scenrio cse: the full specilistion cse. In tht cse ech country specilises in producing only one good nd not the other. onsider lso third scenrio: now UK produces only clothing nd US produces only food (nother cse of specilistion). In this cse the totl mount of clothing produced is 50 nd the totl mount of food produced is 50. As we cn see this is not prticulrly good scenrio since the totl mount of the two goods is now lower thn in the previous cse. So the second scenrio looks better becuse it increse the totl production of the two goods. But wht is the reson for tht? The reson is tht UK nd US in our exmple hve different opportunity costs in producing the two goods. In prticulr, UK is more efficient thn US in producing food in reltive terms ( = in terms of clothing). On the other hnd the US is more efficient in producing clothing (in terms of food) thn UK is. Wht is the opportunity cost of food in terms of clothing fced by UK? (in our exmple the only lterntive to food is clothing nd vice vers). Remember the definition of opportunity cost: if UK increses the production of food how much production of clothing should be forgone?
To nswer tht question: suppose tht UK wnts to increse the production of food by 1 unit. In this cse we need n extr worker to work in the food sector nd we tke him from the clothing sector. If we tke wy worker from the clothing sector how much of clothing production re we going to lose. The nswer is ½ units of clothing (= 2 workers needed to produce 1 unit, if we tke wy 1 worker we re going to lose ½ units of clothing). So the opportunity cost of incresing by 1 unit the food production is ½ units of clothing in UK. Wht bout in the US? In tht cse if we increse by 1 unit the food production we re going to lose 2 units of clothing. As we cn see: ½ < 2. This mens tht the opportunity cost of producing food in terms of clothing is lower in UK thn in the US. urthermore, we cn see tht the opportunity cost of producing clothing in US is lower thn in UK (2 units of food in UK nd ½ units of food in US). We sy tht in this cse UK hs comprtive dvntge in producing food compred to US, while US hs comprtive dvntge in producing clothing compred to UK. omprtive dvntge: consider two ntions (or individuls) A nd B. Both producing two goods, X nd Y. We sy tht A hs comprtive dvntge in producing X, if nd only if the cost opportunity of producing X in terms of Y is lower for A thn for B. Absolute dvntge: we sy tht, compred to B, A hs n bsolute dvntge in producing X, if it is more efficient in producing X thn B. Notice tht differently from the concept of bsolute dvntge, comprtive dvntge is defined on reltive terms (X in terms of Y). In the previous exmple, UK hs n bsolute dvntge in producing food while US hs n bsolute dvntge in producing in clothing. urthermore, UK hs comprtive dvntge in producing food nd US hs comprtive dvntge in producing in clothing. Does this men tht if you hve n bsolute dvntge in producing good you hve lso comprtive dvntge in producing tht good? The nswer is NO. onsider the following exmple:
UK uses 1 worker to produce 1 unit of food nd 2 workers to produce 1 unit of clothing. US uses 10 workers to produce 1 unit of food nd 10 workers to produce 1 unit of clothing. In this cse we hve tht UK hs n bsolute dvntge in producing both goods. However, US still hve comprtive dvntge in producing clothing. The opportunity cost of producing clothing in terms of food in UK is 2/1=2. In US the opportunity cost of producing clothing is 10/10=1 units of food, tht is lower thn 2. Therefore, wht relly mtters in trde decisions is the concept of comprtive dvntge ( = opportunity cost) nd NOT the concept of bsolute dvntge, s we stte below. The result from the second scenrio cn be stted more properly: if ech country specilises more in the production of the good where it hs comprtive dvntge then there re possible gins from trde between countries. (The ide tht specilistion cn increse totl output goes bck to Adm Smith s fmous book: An Inquiry into the Nture nd uses of the Welth of Ntions (1776)). Since now the quntity of goods vilble between the two countries hs incresed, there is the possibility, by trding (= UK cn export food in US in exchnging for clothing, so tht people in UK nd in US cn hve both goods), to divide this now lrger cke in such wy tht ech country will be better-off thn in the cse where no specilistion tkes plce. Notice tht possible gins from specilistion rise only if the two countries differ in the technology they hve (for exmple, UK nd US to produce the sme mount of food nd clothing use different mounts of workers). Even if this exmple is quite simple nd mybe not very relistic it still gives us n ide on how opportunity costs re relted to trde. The Production Possibility rontier Opportunity costs re importnt lso to define nother importnt concept widely used in economics tht is wht we cll the Production Possibility rontier (PP). (In the book you my find it clled Production Possibility curve but it is exctly the sme thing). onsider gin the previous exmple bout UK nd US.
The Production Possibility rontier is curve showing ll the possible combintions of two goods tht country cn produce within specified time period when ll its resources re fully nd efficiently employed. The cse of two goods is mde for simplicity nd lso becuse in tht cse we re ble to drw picture of the PP (with 3 goods (= 3 dimensions) we cn still drw plne, with more thn 3 goods we re not ble to drw nything). onsider the UK cse. How cn we drw the PP of UK from our exmple? irst from the definition we know tht the PP is shows the ll possible combintion of two goods. Therefore, we cn mke grph where on the two xes we hve the quntities of the two goods (sy lothing on the verticl xis nd ood on the horizontl xis). How much of food nd clothing cn be produced in UK? Suppose tht ll the workers in UK work in the food sector, then we know tht in this cse UK will produce 100 units of food nd ZERO units of clothing. We now hve the first geometric point where our curve should pss. Suppose tht ll the workers in UK work in the clothing sector, then we know tht UK should produce 50 units of clothing nd ZERO units of food. Now we hve our second geometric point. The PP for UK is displyed in the following picture: igure 1. lothing 50 A PP B 100 ood
Wht the PP tells us? onsider point A. Point A lies on the PP line, mening tht t point A the UK is producing some mount of food nd some mount of clothing by using efficiently the resources employed in production (in this cse lbour force). Why? onsider point B. Point B lies below the PP line. At point B UK cn produce some mount of food nd some mount of clothing but less thn t point A. Remember the definition of the PP: the possible combintions of goods tht country cn produce when resources re fully nd efficiently employed. Since point B is not on the PP it must men tht we re producing by not using fully nd efficiently our resources. So point B represents point where production is not efficient: we cn use in better wy our resources in order to produce more like t point A. All the points the lie below nd on the PP line, re prts of wht we cll the esible Set: ll the combintions of the two goods tht re fesible to produce given our resources. onsider point. Point lies bove the PP line, this mens tht given our resources we cnnot rech point. Therefore every point bove the PP line is not esible. At mximum, we cn rech point on the PP line. So point A is efficient since it lies on the PP nd it is fesible. Point B is fesible but it is inefficient. Point is not fesible. Now we cn see the reltionship between the opportunity cost nd the PP line in previous figure. We cn see tht the slope of tht line (in prticulr the bsolute vlue of the slope) is exctly the opportunity cost of producing food in terms of clothing ( = ½). In this prticulr cse the opportunity cost is constnt over the PP line (lwys equl to ½) nd therefore the PP is stright line. To see this let s write the totl good production of UK in the following wy: L = Totl mount of workers in UK (in our exmple it ws equl to 100, here we leve it s L). = units of ood produced in UK
= units of lothing produced in UK = mount of workers needed to produce one unit of ood (in the exmple it ws constnt equl to 1); = mount of workers needed to produce one unit of lothing The PP line is derived by the following Resource onstrint: L = + Tht eqution sys tht to produce efficiently the two goods I must use ll the resources I hve (in this cse ll the workers L). Tht eqution is resource constrint in the sense tht is sys tht we cnnot use more thn L workers to produce. Now we cn derive the PP from tht resource constrint. Rewrite tht resource constrint s: = + L Tht is the eqution of the stright line tht ppered in the figure 1. Notice tht the slope of the eqution is But wht is lothing..? It is exctly the opportunity cost of producing ood in terms of Suppose I increse by 1 unity the production of food. Then my production of food increses by the mount. The eqution L = must still hold fter this chnge. + But this implies tht tht must decrese by the sme mount (to keep the equlity with L). or to diminish by we must hve tht diminishes by the mount = ). ( c Therefore, denotes the mount of lothing we need to foregone when we increse the production of food by 1 unit. But this is exctly the definition of n opportunity cost. Since we hve ssumed the terms nd to be constnt, then our PP is stright line. However, more generl PP need not to be stright line. In
prticulr the PP will not be stright line when the opportunity cost over the PP is not constnt. Here is n exmple: ood 8 7 6 5 A B 4 3 2 1 0 0 1 2 3 4 5 6 7 8 lothing The picture is mde by using the following tble of dt: Units of food Units of clothing (millions) (millions) 8m 0.0 7m 2.2m 6m 4.0m 5m 5.0m 4m 5.6m 3m 6.0m 2m 6.4m 1m 6.7m 0 7.0m
In this cse the PP is not stright line. It hs prticulr shpe. In mthemtics function like the PP bove is clled strictly concve function. This mthemticl property hs n importnt economic impliction nd so we will mke wide use of concve (nd convex) functions during the course. In this prticulr cse the strictly concvity of the PP implies tht there is n Incresing Opportunity ost of Production. In order to produce more nd more units of clothing we need to scrifice n incresing mount of food. Suppose we strt t point A where you produce 6m of ood nd 4m of lothing. Now suppose tht you wnt to move t point B. At point B you now produce 5m of ood nd 5m of lothing. rom A to B you hve tht to produce 1m of lothing you need to scrifice 1m of ood. So from A to B the opportunity cost of lothing in terms of ood is 1m. Now suppose you wnt to move from B to. In you produce 6m of lothing nd 3m of ood. rom B to the opportunity cost of lothing in terms of ood is now 2m. So you cn see tht the opportunity cost now vries long the PP nd tht explins its shpe.