Econ 1000: Mod 1

1. Econ 1000: Mod 1 C.L. Mattoli (C) Red Hill Capital Corp., 2008

2. Information Information • Lecturer: Craig Mattoli • Email: clm@clmattioli.com • Phone (text messages only) 136 3241 0877; include your name and course in message. • Office hours: by appointment. Temporarily located in room 221. • Don’t be shy. Ask Questions of your Instructor, not your classmates. No one cares as much as he does! • Sometimes, I talk fast, use words that you might not know, and write abbreviations on the board. Again, if you don’t understand my written or spoken word, ask. It’s ok! (C) Red Hill Capital Corp., 2008

3. Introduction to Economics (C) Red Hill Capital Corp., 2008

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6. 10 Principles of Econ Behavior of decision-making (people are self-interested) • People face trade-offs in daily life. • The cost of a choice between things is what you give up to get it. • Rational thinking is at the margin in all situations. • People, in general, respond to incentives. How people interact • Trading can make everyone better off. • Markets are usually a good way to organize economic activity. (C) Red Hill Capital Corp., 2008

7. Principles of Econ • Government (or law) can sometimes improve market outcomes. How the marcoeconomy works • A country's standard of living depends on their ability to produce. • Prices rise when the government prints too much money. • Societies will face a short-term tradeoff between inflation and unemployment. Governments have 2 reasons to become involved in the economy: to promote efficiency or equity. (C) Red Hill Capital Corp., 2008

8. The course • First we get our feet wet by looking at what economics is, and how it is put together: it is about opportunities and decisions. • Economics takes psychology and uses it in logical and mathematical models, using a lot of graphical analysis. • It looks at how resources of production are pulled together to make things in the best way to satisfy society. • Our first look, in this chapter will be the production possibilities frontier (PPF). (C) Red Hill Capital Corp., 2008

9. The course • The way that an economy operates is that there are people who want things, consumers, they demand, and people who produce things, they supply; and when supply meets demand, there are transactions: buying and selling in the market. • We shall study supply and demand in markets and look at market structures. • Then, we will look at cost analysis to see how producers determine how much to produce and what prices to charge to make a profit. That will include looking at elacticity. (C) Red Hill Capital Corp., 2008

10. The course • After that, we will look at economics on the larger, country-wide scale, and look at national production, price inflation, and employment. We will look at aggregate supply and demand. • Governments are always involved in the economy. First of all, they print the money, which is a liability of the central bank, that is used for all of the economic transactions. (C) Red Hill Capital Corp., 2008

11. The course • Governments are also part of the economy, in that they spend money on large scale projects, like highways, and they get revenues from taxation, which also takes money away from the society. They give money to the needy to help the less fortunate in society. They also borrow money to finance their spending. • Thus, governments will also need policy about money, monetary policy, and spending and taxation, fiscal policy. (C) Red Hill Capital Corp., 2008

12. Material covered this week • Chapters 1, Intro to Economics, plus appendix, & 2, Micro-econ Fundamentals, plus pages 532-40, Int’l Trade (C) Red Hill Capital Corp., 2008

13. Learning objectives On successful completion of this module, you should be able to: • Discuss the social science of economics as the study of scarcity and choice • Discuss the ‘economic way of thinking’ • Describe the construction and testing of economic models • Apply graphical techniques in economic analysis • Explain the concepts of opportunity cost, marginal analysisand comparative advantage • Apply the model of the production possibilities frontier (PPF) to illustrate the concepts of opportunity cost, economic growth, and the gains from trade. (C) Red Hill Capital Corp., 2008

14. Economics: Social Science • Economics is a so-called social science. • It looks at the behavior of society members, separately and in mass, in producing and exchanging goods and services. Thus, it is social. • It looks at using the scientific method of investigation to make logical and mathematical models to describe the behavior. Thus it is a soft science, a social science. (C) Red Hill Capital Corp., 2008

15. Summed up • Economics is based on psychology, logic and a little math. • Scare resources must be allocated. There are financial and opportunity costs. • People want, so producers produce to satisfythem and make a profit to satisfy themselves. • Consumers have sovereignty, and they have decreasing marginal utility for things. (C) Red Hill Capital Corp., 2008

16. Summed up • We look at psychology for the underlying behavioral motivations of people in economic circumstances as buyers or sellers. • People must make decisions: to be in business, which business they should be in, and what they must or should buy to live or to make their lives better. • That involves choosing from among the opportunities available to them. (C) Red Hill Capital Corp., 2008

17. Summed up • In choosing one opportunity, they forego others, and the foregone other opportunities are their opportunity costs. • We use logic to set up causal chains, which are simple summaries, using box diagrams in flow charts, like: One thing Leads to (Causes) Another thing Leads to (Causes) Yet Another thing (C) Red Hill Capital Corp., 2008

18. Summed up • They help us imagine the chain of events that relate one thing that happens in an economy to ultimate logical outcomes. • Thus, we develop logical relationships among variables and concepts. • We use math to characterize those logical relationships as best we can. Indeed, we rely heavily on graphical analysis as the mathematical framework. Actual equations are so complicated as to be next to impossible, in many cases, anyway. (C) Red Hill Capital Corp., 2008

19. Economic Way if Thinking • The economic way of thinking involves: • A logical framework for analyzing problems. • A language of economic terms. • Graphical analysis and algebraic equations. • A little logic, simple psychology and basic math, using some special terms that economists have made up. (C) Red Hill Capital Corp., 2008

20. Economic Way if Thinking • This course will emphasize the logic and psychology involved in economic thought, which is in some ways more difficult than a course with equations. • Although you will be required to understand equations and interpret graphical and tabular information, you will have to be sharp on verbal skills and on making well thought out, concise, convincing, logical arguments. (C) Red Hill Capital Corp., 2008

21. Advice to Remember • The course requires thinking, not memorization of things because economics is easy when you think about it in the right way. • Ask yourself: is it logical for people to want to buy more of something if the price goes down or when the price goes up? • Simple logic and psychology will give you the answer, and your answer will also give you the law of demand. (C) Red Hill Capital Corp., 2008

22. Advice to Remember • Lets suppose that you are given the following table of data and asked to find the intersection of supply and demand, given in the table, and you are asked to draw a graph of the data. • Without doing any “analysis” at all, the intersection will occur when both are equal, which is a P = 2.40 and S = D = 500. (C) Red Hill Capital Corp., 2008

23. Graph from a table (C) Red Hill Capital Corp., 2008

24. Scarcity: where economics begins • Economics can be described, in part, as the theory of the allocation of scarce resources. • Scarcity is the condition that human wants are forever greater than the available supply of time, goods, services and resources. • Because of scarcity no society has enough resources, the basic inputs for production of goods and services, to fulfill all of its citizens’ wants and needs. (C) Red Hill Capital Corp., 2008

25. Resources: factors of production • Economics divides resources, the factors of production, into 3 basic categories: • Land • Labor • Capital (C) Red Hill Capital Corp., 2008

26. Land: what mother nature provides • Land is anything above or below the ground provided by nature. It includes: water, air, crops, animals, minerals, the moon, the sun, trees, and water. Question: how could you make use of the moon for a business? • Renewable land resources are those that are replaced by nature without help, for example, animals, water, and the air we breath. • Nonrenewable cannot be replaced by nature, including things, like oil and coal. (C) Red Hill Capital Corp., 2008

27. Labor: the people factor • Labor is the mental and physical ability of people to produce goods and services. • Both the number of people available in the workforce and their level of skill are measures of the labor resource. • Thus, increases in the labor resource of a countrycan come from greater population that is available to work and produce or an increase in skills of the present workforce (C) Red Hill Capital Corp., 2008

28. Labor: the people factor • A reason that nations differ in their ability to produce is the education, experience, health, and motivation of their labor force. • Entrepreneurs are a special kind of labor. They seek profits by taking on risk by combining resources to create new products. They are agents of change who bring material progress to a society, and they are a very scarce resource. (C) Red Hill Capital Corp., 2008

29. Capital: the facilities of production • Capital in economics, is the physical plant, machinery, and equipment that is used to produce other goods and services. • Capital goods are man-made goods that do not directly satisfy human wants. • They are used to transform the other factors of production into goods and services that people want. (C) Red Hill Capital Corp., 2008

30. Capital: the facilities of production • Financial capital, from studies of finance, has no place in economics. • Capital in economics has nothing to do with money or monetary assets. • Money is only a measure of value, it is not economic capital. (C) Red Hill Capital Corp., 2008

31. Pictorial Economics: Production Land Labour Capital Resource inputs are pulled together and transformed by entrepreneurs into output Entrepreneur Risk Goods & Services (C) Red Hill Capital Corp., 2008

32. Economics: the study of scarcity & choice • Economics is the study of how society chooses to allocate scarce resources to produce goods and services to satisfy unlimited wants. • Society makes two kinds of choices: macro, from the Greek word for large, is economy-wide; micro, from the Greek word for small, refers to individual choices. • Thus, the study of economics is broken into two broad branches: microeconomics and macroeconomics. (C) Red Hill Capital Corp., 2008

33. Microeconomics • The micro scale of economics looks at decision-making of individuals, firms, and industries. • Thus, small, in economic terms, ranges from one person to groups of people but not the whole of the society. Micro, for example, might look at computer makers or households as groups. • Micro questions might involve looking at how computer chip makers will respond to changes in chip prices in terms of supply and at how consumer demand might also change. (C) Red Hill Capital Corp., 2008

34. Macroeconomics • Macro is an overall perspective of the whole economic system. • Macro variables are economy-wide things, like unemployment, money supply, investment in PP&E, GDP, imports & exports. • Macroeconomics looks at questions, like how will an increase the money supply affect the price of exports, or how will unemployment affect GDP. (C) Red Hill Capital Corp., 2008

35. Macroeconomics • Macro and micro are interrelated. • On the one hand, the Macro economy is the sum of all of the micro’s. We sum up all of the micro activity of a country, and we get the macro economy • However, changes on the Macro level can affect micro change. For example, a new income tax will affect how industries produce and how consumers consume, and it might affect different micro groups in the economy differently. (C) Red Hill Capital Corp., 2008

36. Economic Methodology • Economics uses the scientific method. • The scientific method involves: 1) observing a system, 2) postulating a theory to explain the workings of the system, 3) collecting appropriate data, and 4) testing the theory against the data to see how well data fits theory, then, 5) going back to see how the theory might be revised to better fit observation. • In economics it becomes: 1) identify a problem, 2) make a simplified model, and 3) test it. (C) Red Hill Capital Corp., 2008

37. Economic Modeling • Identify a problem: for example, why do gasoline prices vary over the year? Part of the problem of economics is to ask a question properly. • Develop a simplified model. A model is a simplified description of something, based on the important variables that one would expect to be involved in the description according to some sort of underlying theoretical framework. • A model can involve logical verbal arguments, graphical or tabular information, or precise equations. (C) Red Hill Capital Corp., 2008

38. Example: A Model of the Atmosphere • The earth’s atmosphere is made up of billions upon billions of air molecules, each speeding around bumping into each other. • We could try to describe the atmosphere by trying to find the speeds and directions of all of those molecules. • Instead, we have built a simpler model using variables of temperature, pressure and wind speed. (C) Red Hill Capital Corp., 2008

39. Economic Modeling • Part of the art of modeling is to choose the right question to ask and the use of minimal important variables to formulate an answer. • Finally, a model must be tested. That involves taking data for the variables, using it as input for the model, looking at the result that the model generates, and seeing how well the model’s predictions fit the reality of the situation. (C) Red Hill Capital Corp., 2008

40. Economic Modeling • The true test of a model is how well it can predict the future. After all, that is the true value of any model. • Models may do well. They may not, and we have to go back to the drawing board. Or models might work for a while and then stop working as other things change. (C) Red Hill Capital Corp., 2008

41. Hazards in Economic Thinking • There are always problems in theoretical pursuits. • The first is called ceteris paribus. It is the assumption that everything else remains fixed and constant, while only certain key variables change. • For example, you might make a model of cola demand which says that demand will decrease, ceteris paribus, if price increases. (C) Red Hill Capital Corp., 2008

42. Hazards in Economic Thinking • However, if, in the summer time, demand increases after a price rise, it does not make the model invalid. • It was just that the temperature was extremely hot and the model did not include temperature as a variable. • Another common error in modeling in any field, even the hard sciences, like physics, is taking correlation for causation. (C) Red Hill Capital Corp., 2008

43. Hazards in Economic Thinking • For example, for many years it was observed that the length of women’s skirts (hem-line) was a good predictor of the level of the stock market in the U.S. • As hem-lines went up (as dresses got shorter), the stock market rose, and as hemlines went down (as dresses got longer), the market went down. • However, it would be foolish to think that the direction of moves in women’s hemlines was actually the cause for moves in stock market prices. (C) Red Hill Capital Corp., 2008

44. Hazards in Economic Thinking • It is often very difficult to distinguish between simple statistical correlations and cause and effect relationships. • What can happen, in reality, is that the two variables that seem to be related are both affected by a common third variable. Then, changes in that third variable causes changes in the first two, and they move like they are related. • Thus, great care must be taken in postulating true relationships among economic variables. (C) Red Hill Capital Corp., 2008

45. Why Economists disagree • One reason that economists seem to disagree is the difference between positive and normative economics. • Positive economics deals with verifiable, “if A, then B” statements, which can be proved true or false. It is objective. • Normative economics is about value judgments, not facts. (C) Red Hill Capital Corp., 2008

46. Why Economists disagree • Disagreement can arise around positive economics. • For example, 2 economists might agree that, if GNP falls, unemployment will rise, but in the newspaper, one might be quoted as saying that unemployment will be stable, while the other says it will fall. • The disagreement arises because of their different assumptions about GNP. • Disagreements in positive economics can also arise around which model is the better model of something (C) Red Hill Capital Corp., 2008

47. Test yourself: Can a simple model explain housing prices? • Many analysts had postulated that housing in Australia could be explained by immigration patterns, consumer confidence, government policy, interest rates, and seasonal affects. • When the latest housing boom came to an abrupt end in 2004, their forecasts turned out to be wrong. • Why might explanations of house prices turn out to be incorrect? (C) Red Hill Capital Corp., 2008

48. Explanation • What are true relations of prices and other variables? Are some of these assumptions of relations really relations or just correlations? • To really find the true answer to prices would require surveying thousands of buyers and potential buyers. • What many observers have done is simply look at the coincidence of prices with some other variables. • Moreover, even if some of the relationships are genuine, there might be other variables in the process that had not been prominent in the past but did become in the last cycle, overshadowing the assumed variables…ceteris paribus. (C) Red Hill Capital Corp., 2008

49. Why Economists disagree • Normative economics deals with what should be. It is subjective analysis based on value judgments, not facts. • Normative statements express opinions that cannot be proven true of false. • Key words include in normative are: good, bad, should. (C) Red Hill Capital Corp., 2008

50. Why Economists disagree • When considering the answer to a problem, be careful to separate the arguments into positive and normative components. • Then, you can see if you are reaching a conclusion based on the facts or opinions. • Normative differences between economists can also lead them to different conclusions about the same topic. (C) Red Hill Capital Corp., 2008