CHAPTER 1 INTRODUCTION TO ECONOMIC ANALYSIS 2 nd Semester, S.Y 2013 – 2014

1. CHAPTER 1 INTRODUCTION TO ECONOMIC ANALYSIS 2nd Semester, S.Y 2013 – 2014

2. What is Economics? The study of how individuals and societies choose to allocate and use scarce resources to satisfy unlimited wants. Economics is about economizing; that is, about choice among alternative uses of scarce resources. Choices are made by millions of individuals, businesses, and government units. Economics examines how these choices add up to an economic system, and how this system operates. (L.G. Reynolds).

3. Concept of Scarcity Scarcity exists because individuals want more than can be produced • Scarcity means the goods available are too few to satisfy individuals’ desires • The degree of scarcity is constantly changing • The quantity of goods, services and usable resources depends on technology and human action

4. Microeconomics vs. Macroeconomics Microeconomicsfocuses on the individual parts of the economy. How households and firms make decisions and how they interact in specific markets Macroeconomics looks at the economy as a whole. Economy-wide phenomena, including inflation, unemployment, and economic growth

5. Scope of Microeconomics Microeconomics studies Buying decisions of the individual Consumers’ satisfaction Buying and selling decisions of the firm The determination of prices and in markets The quantity, quality and variety of products Profits

6. Scope of Macroeconomics Macroeconomics studies Economic growth Unemployment and inflation Aggregate demand and aggregate supply Economic policies – fiscal and monetary International trade – exports and imports Money supply

7. Microeconomics vs. Macroeconomic Questions Should I go to business school or take a job right now? How many people are employed in the economy as a whole this year? What determines the salary offered by San Miguel Corporation to Juan Dela Cruz, a new MBA? What determines the overall salary levels paid to workers in a given year? What determines the cost to a university or college of offering a new course? What determines the overall level of prices in the economy as a whole? What government policies should be adopted to make it easier for low-income students to attend college? What government policies should be adopted to promote employment and growth in the economy as a whole? What determines whether BPI opens a new Branch in Shanghai? What determines the overall trade in goods, services, and financial assets between the Philippines and the rest of the world

8. Let’s Check Your Understanding! Which of the following questions involve microeconomics, and which involve macroeconomics? In each case, explain your answer. Why did consumers switch to smaller cars in 2012? Why did overall consumer spending slow down in 2012? Why did the standard of living rise more rapidly in the current administration compared to previous administration? Why have starting salaries for students with geology degrees risen sharply of late? What determines the choice between rail and road transportation? Why has salmon got cheaper over the past 20 years? Why did inflation fall in the 1990s?

9. 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 Economics

10. Society 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

11. 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.

12. 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

13. 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. Ten Principles of Economics

14. Principle #1: People Face Tradeoffs “There is no such thing as a free lunch!”

15. 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 Making decisions requires trading off one goal against another.

16. 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.

17. Principle #2: The Cost of SomethingIs 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.

18. Opportunity Cost • Opportunity cost is the benefit forgone of the next-best alternative to the activity you have chosen • Opportunity cost should always be less than the benefit of what you have chosen • Opportunity cost is the basis of cost/benefit economic reasoning

19. Marginal Costs and Marginal Benefits • Using economic reasoning, decisions are often made by comparing marginal costs and marginal benefits • Marginal cost is the additional cost or sacrifice one makes of participating in an activity or purchasing a product. • Marginal benefit is the additional satisfaction or value one obtains from an activity or product.

20. The economic decision rule: Marginal Costs and Marginal benefits • If the marginal benefits of doing something exceed the marginal costs, do it. MB > MC  Do it! • If the marginal costs of doing something exceed the marginal benefits, don’t do it. MC > MB  Don’t do it!

21. Examples of opportunity cost: Opportunity Cost Individual decisions • The opportunity cost of college includes: • Items you could have purchased with the money spent for tuition and books • Loss of the income from a full-time job 2. Government decisions • The opportunity cost of money spent on the war on terrorism is less spending on health care or education

22. 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. Principle #2: The Cost of SomethingIs What You Give Up to Get It.

23. Principle #3: Rational People Thinkat the Margin. Marginal changes are small, incremental adjustments to an existing plan of action. People make decisions by comparing costs and benefits at the margin.

24. Principle #4: People Respond toIncentives. 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!

25. 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.

26. 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.

27. 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. Principle #6: Markets Are Usually a Good Way to Organize Economic Activity

28. 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.

29. 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 #7: Governments Can Sometimes Improve Market Outcomes

30. 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.

31. Principle #8: The Standard of Living 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.

32. 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 #8: The Standard of Living Depends on a Country’s Production

33. 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.

34. Principle #10: Society Faces a Short-run Tradeoff Bet. Inflation and Unemployment The Phillips Curve illustrates the tradeoff between inflation and unemployment: òInflationðñUnemployment It’s a short-run tradeoff!

35. Economics trains you to. . . . Think in terms of alternatives. Evaluate the cost of individual and social choices. Examine and understand how certain events and issues are related. Thinking Like an Economist

36. The Economist As a Scientist The economic way of thinking . . . Involves thinking analytically and objectively. Makes use of the scientific method.

37. Economic Model This is a simple analytic frame which shows the relationship between the main factors, and explains the behavior of an economic theory or phenomenon. Economists use economic models to simplify reality and to facilitate the understanding of the actual world economic inconveniences.

38. Types of Economic Model • Descriptive • Like the Circular Flow • Analytical • Assumptions • Mathematical model ( functions and equations) • Graphical analysis

39. First Model: The Circular-Flow Diagram The circular-flow diagramis a visual model of the economy that shows how income flows through markets among households and firms.

40. MARKETS FOR GOODS AND SERVICES • Firms sell Goods and Goods • Households buy services and services sold bought HOUSEHOLDS FIRMS • Buy and consume • Produce and sell goods and services goods and services • Own and sell factors • Hire and use factors of production of production MARKETS Labor, land, Factors of FOR and capital production FACTORS OF PRODUCTION • Households sell Wages, rent, • Firms buy and profit First Model: The Circular-Flow Diagram Income Spending Income = Flow of inputs and outputs = Flow of Money

41. General Features of Economic Model • All economic models incorporate three common elements: • The ceteris paribus (other things the same) assumption; • The supposition that economic decision makers seek to optimize something; • Acareful distinction between “positive” and “normative” questions.

42. Ceteris Paribus Assumption • The ceteris paribus (other things the same) assumption– which allows analysis of the effect of a change in one factor by holding all other relevant factors unchanged.

43. Optimization Assumption 2. The supposition that economic decision makers seek to optimize something; • Many economic models start from the assumption that the economic actors being studied are rationally pursuing some goal.

44. Positive versus Normative Analysis Positive economics are statements that attempt to describe how the economy functions and the the world as it is. Called descriptive analysis Normative economics are statements about how the economy or world should be which relies on value judgments to evaluate or recommend alternative policies. Called prescriptive analysis

45. Positive or Normative Statements? If the minimum wage increases, then firms’ cost of production rises. POSITIVE Higher budget deficits will cause interest rates to increase. POSITIVE Positive versus Normative Analysis

46. Positive or Normative Statements? The minimum wage in Metro Manila should increase to P600. NORMATIVE The government should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor. NORMATIVE Positive versus Normative Analysis

47. Let’s Check You Understanding! Which of the following statements is a positive statement? Which is a normative statement? A. Society should take measures to prevent people from engaging in dangerous personal behavior. B. People who engage in dangerous personal behavior impose higher costs on society through higher medical costs.