Download Introduction to Economic Analysis

1
Introduction to Economic Analysis
Lesson 1. Basic Ideas
 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.
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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.
Example: Problem 4 of Lesson 1
One possible answer:
Total revenue from developing 3YX: 3 m€
Total cost of developing 3YX:
-6 m€
Net result
-3 m€
Conclusion: Suspend the development of 3YX
This conclusion is wrong
Correct answer:
Revenue from continuing the project:
Costs of continuing the project:
Net result from continuing project:
Conclusion: Finnish the project
3m€
-1m€
2m€
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Error first answer: counting the 6 m€ as cost of
continuing the development. 5 of these 6 m€
have already been spent. Nothing can be done
about them. They are a bygone, a sunk cost. In
fact they are not the costs (the opportunity
costs) of continuing the project.
Check answer is right
If I follow first answer I loose 5m€ (0-5=-5)
If I follow second answer I loose 3m€ (3-6=-3)
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.
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 Principles concerning the
interaction between agents
5. Trade can make everyone better off.
6. Markets are usually a good way to
organize economic activity
7. Governments can sometimes improve
market outcomes
 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.
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 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).
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Spending
Revenue
Market
for´Goods
and Services
Goods and
services bought
Goods and
services sold
Firms
Households
Labour,
land,
capital sold
Factors for
production
bought
Market for
factors of
production
Wages, profits and rents
Income
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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:
CARS
3500
3250
2750
2000
1000
0
HOUSES
0
100
200
300
350
375
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Cars / year
4.000
A
3.000
F
2.000
D
C
E
1.000
B
100
200
300
400 Houses / year
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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.
 cars
1000
CE

 20
 houses
50
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.