Class 1 - UV



1st. Session

Scarcity = escasez

Resources = recursos

Tradeoff = disyuntiva

Goal = objetivo

Trade = intercambio comercio

Household = economía doméstica

Welfare = bienestar

Allocate = asignar

Income = renta

Short run = corto plazo

Feasible = realizable

Ceteris paribus = todo lo demás constante

Lesson 1. Basic Ideas

Economics is the study of how society manages its scarce resources.

Economists study:

▪ Principles concerning the way people make decisions.

▪ Principles concerning the interaction between agents.

▪ Principles related to the workings of the whole economy.

• Principles concerning the way people make decisions

1. People face trade offs

A trade off is an alternative between different courses of action. A trade off exists because there is scarcity. If resources are scarce and I have two objectives, then the more I have of one, the less I will have of the other.

2. The true cost of something is what you give up to get it

Because people face trade offs, making decisions requires the comparison of costs and benefits of alternative courses of action.

Example: Costs and benefits of going to university.

Opportunity cost of doing something: the cost of what you have to give up to get or to do something.

3. Correct economic decisions are arrived at by using marginal thinking

We think at the margin when we put ourselves at the border, at the margin of our present situation, and think of the consequences (costs and benefits) of going beyond this border, of doing something additional to this present situation.

4. People respond to incentives

People make decisions comparing benefits and costs. If these benefits or these costs change, the decisions also change.

In other words: people respond to relative prices. If something becomes more expensive, I buy less of it; if something becomes cheaper, I buy more of it.

• Principles concerning the interaction between agents

5. Trade can make everyone better off.

6. Markets are usually a good way to organize economic activity

*Market economy: an economy that allocate resources through the decentralized decisions of many firms and households as they interact in markets for goods and services.

*Planners decide everything: what goods, how much, who, etc.

*Firms and households interact in the market, where prices and self-interest guide their decisions. They promote overall economic well-being (A. smith 1776 “An Inquiry into the nature and causes of the wealth of nations”) guided by an invisible hand that leads them. How this invisible hand works its magic? Answer in the course.

*Prices are the instrument with which the invisible hand directs economic activity.

*Prices reflect both the value of a good to society and the cost to society of making the good.

*Prices guide these individual decision makers to reach outcomes that, in many cases, maximize the welfare of society as a whole.

Corollary from the invisible hand: when the Gov. prevent prices from adjusting naturally to supply and demand it impedes the invisible hand’s ability to coordinate.

• That explains why taxes adversely affect the allocation of resources.

• Taxes distort prices and thus the decisions of households and firms.

• Also the harm caused by policies that directly control prices.

7. Governments can sometimes improve market outcomes

*Markets work only if property rights are enforced.

*Although markets are a good way to organize economic activity, there are some important exceptions: two reasons

1. To promote efficiency, to promote equity: size of the pie, to enlarge it, to change it.

2. Market failure: the market fails to allocate de resources efficiently.

Externality: is one cause of market failure e.g. pollution.

Externality is the impact of one person’s actions on the wellbeing of a bystander.

Market power: the ability of a single economic actor to have a substantial influence on market prices. E.g. only one well.

Another failure: to ensure that economic activity is distributed equitably. E.g. chess and basket.

• Principles related to the workings of the whole economy

8. A country’s standard of living depends on its ability to produce goods and services.

9. Prices rise when the government prints too much money.

10. Society faces a short-run trade off between inflation and unemployment.

1.4 Micro and macroeconomics: positive and normative economics

Economics is studied at various levels: that is, the field of economics is divided into two broad fields:

1. Microeconomics; Is the study of how individuals make decisions and how they interact in specific markets.

2. Macroeconomics; Is the study of economy wide phenomena.

Micro and macroeconomics are closely related, it is impossible to understand macroeconomic developments without considering the associated microeconomics decisions.

Example: analyse the effect of an income cut tax on the overall production of goods and services, but the first question is, how the tax cut affect the decisions of household? In fact, the two fields are distinct.

The economist as policy adviser

We are often asked to explain the causes of economic events.

When economists are trying to explain the world, they are scientists.

When they are trying to help improve it, they are policy makers

Positive vs. normative analysis

Scientists and policy makers have different goals.

Positive statements are descriptive, how the words is, how it works.

Normative statements are prescriptive, how the world ought to be, according to my personal point of view.

Why economists disagree?

Policies cannot be judged on scientific grounds alone. Economists give conflicting advice, sometimes because they have different values, additionally political thinking lead to different consideration of the problems.

1.5 Economic methodology: models and empirical applications

Economy is a science because it applies the scientific method, that means: development and testing of theories about how the world works.

The scientific method: observation, theory and more observation.

1. Observation from reality

2. testing with data

3. If results agree with theory, the economist will be more confident with the theory.

Experiments are difficult in economics, so pay close attention to the natural experiments offered by history.

The role of assumptions

Assumptions simplify the complex world and make it easier to understand. E.g. two countries, two goods.

The issue: which assumptions to make?

With short-run policies we may assume that prices do not change.

Economic models, we do use models, all models are built with assumptions.

• Two examples of models

1. The circular flow diagram

Assumptions:

a) The economy has two types of agents: households and firms.

Households consume goods and own factors of production that they hire to firms.

Firms produce goods and use (hire) factors of production (labour, land machines, etc.)

b) Households and firms interact in two types of markets:

- market for goods and services (in this market households buy and firms sell).

- market for factors of production (in this market households sell and firms buy).

2. The production possibilities frontier (PPF)

Assumptions:

a) The economy produces only two goods: cars and houses.

b) All factors of production are employed in the production of these two goods.

c) Technological data:

Characteristics of the PPF

-If all resources are used, we are at the frontier. For example, point C (2000 cars; 300 houses).

-If some of the resources are not used, we are inside the frontier. For example, point D (2000;200).

-Point C is called an efficient point. At C the economy can only produce more of one good by producing less of another. This is the definition of efficiency.

-Point D is an inefficient point.

-The slope of the PPF shows the opportunity cost of producing these two goods.

[pic]

At C, each additional house costs 20 cars. The opportunity costs o a house is 20 cars.

-The opportunity cost is not constant along the PPF. For example, at F (going from F to C), the opportunity cost of a house is 7.5 cars. Why?

-More resources, or better technology, will shift the PPF outwards.

• Opportunity cost depends on one’s particular situation.

• Growing opportunity cost for concavity. The slope is bigger when going downwards and to the right.

• Absolute value of the slope is the opportunity cost of producing one more unit.

• Resources are scarce and more adequate for producing some certain goods than others, so, the more of one thing is being produced, the highest will be the opportunity cost of producing one more unit.

• Any production has an opportunity cost, to produce more of one good, society must pass resources from the production of others goods.

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Market for´Goods and Services

Market for factors of production

Firms

Households

Spending

Goods and services bought

Revenue

Goods and services sold

Wages, profits and rents

Income

Factors for production bought

Labour, land, capital sold

Cars / year

Houses / year

4.000

3.000

2.000

1.000

100

200

300

400

A

F

D

C

E

B

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