Basic Principles of Economics

1. Basic Principles of Economics Rögnvaldur J. Sæmundsson January 31 2008

2. Overview • Economics and self-organization • Assumptions/starting point • Supply, demand, cost and price • Competition • Simulations of firms and markets

3. Self-organization • How can a coherent whole emerge from individual parts without a central control?

4. Self-organizing systems are… • complex adaptive systems of interacting agents that display emergent behavior, • systems where agents residing on one scale produce behavior that lies on a scale above them, • systems where higher-level sophistication is based on lower-level rules of behavior and interactions.

5. Economic systems provide social coordination without a central control. • Economic systems provide coordination mechanisms with information hiding.

6. Assumptions/Starting point

7. Assumptions • Individuals have different wants. • Individual wants exceed resources necessary to obtain them. • Individuals have to make choices. • Every choice leads to a cost. • Individuals choose in response to expected benefits and costs to themselves.

8. The economic way of thinking • Act to economize • Interact for mutual adjustments

9. Act to economize • “To economize means to allocate available resources in a way that extracts from those resources the most of whatever the economizer wants.” (Heyne 1997, p. 5)

10. Interact for mutual adjustments “The economizing actions people take in the pursuit of their own interests create the alternatives available to others, and that social coordination is a process of continuing mutual adjustment to the changing net advantages that their interaction generate.” (Hayne 1997, p. 6)

11. Back to self-organization • Act to economize and interact for mutual adjustment are the basic rules which are the sources of emergence in economic systems. • There are however various other “rules of the game” , such as property rights, social norms, law, government policy, which influence outcomes.

12. Supply, demand, cost and price

13. Demand • A demand curve shows the relationship between the quantity of a good that consumers are willing and able to purchase and the price of the good. Price Quantity

14. Sources of demand: Preferences Needs and Values Interests and motives Goals and objectives More difficult to change

15. Sources of Demand: Other • Income (normal/inferior goods) • Price of related products (substitutes/complements) • Expectations (time-based substitution)

16. Supply • A supply curve shows the relationship between the quantity of a good that producers are willing to sell and the price of that good.” Price Quantity

17. Sources of supply • Input prices: Resources and knowledge are costly to obtain and use. Fixed and variable. • Technology: Capacity to supply (at the same cost) is increased through experience or new ways of creating value. • Opportunity Cost (alternative products) • Expectations Knowledge Resources Services Value

18. The price (market) mechanism • Equilibrating supply and demand • Innovation may change curves or create new Price P’ Quantity Q’

19. Competition

20. Competition • For outputs (products) and inputs (factors). • Two ways to compete • Price • Differentiation • Intensity of competition is proportional to similarity of the products/resources being offered – is never perfect.

21. Competition is Dynamic • Product innovation -> Differentiation • Process innovation -> Price

22. Learning and competition • Exploitation • By doing more of the same • Increases capacity and knowledge within a field. • Lowers price pr. unit • Exploration • By doing new things • Adds new fields of capacity and knowledge • Possible to meet new wants or meet wants better.

23. Simulation of firms and markets

24. Overview Labour market Product market Financial market Employees Banks Firms Consumers

25. Firm decisions: Sales&Production • Products to offer • Customer preferences • Knowledge within firm • Firm strategy (profitability, growth, innovation) • Price of products • Production costs • Demand • Quanitity of products • Production capacity • Demand • Allocation of employees for production • Employee capacity and knowledge • Firm strategy (Exploitation, Exploration)

26. Setting the price Perceived Value (Wants) Customer surplus Maximum price (Purchasing power) Realized price (Competition) Firm profit Cost (Inputs)

27. Matching production capacity and demand Learning about preferences and demand Economizing Learning to do new things Knowledge Economizing Resources Supply/Demand Preferences Capacity Learning to do more of the same

28. Firm Decisions: Resources • Financial capital needs • Innovation investments • Employee needs (hire/fire) • Expected demand & capacity • Expected innovation investments • Allocation of employees (Training, production, development) • Firm strategy (Exploitation, Exploration)

29. Firm Decisions: Innovation • What product ideas to develop/abandon • Generated product ideas • Newness, expected demand and profitability • Firm strategy (profitability, growth, innovation) • Allocate employees for development • Employee skills and knowledge • Firm strategy (Exploitation, exploration)

30. Remember • Define low level rules – allow higher level patterns to emerge • Don’t strive for optimal decisions – start with simple heuristics.