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Basic Principles of Economics
Rögnvaldur J. Sæmundsson
January 31
2008
Overview
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Economics and self-organization
Assumptions/starting point
Supply, demand, cost and price
Competition
Simulations of firms and markets
Self-organization
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How can a coherent
whole emerge from
individual parts
without a central
control?
Self-organizing systems are…
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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.
• Economic systems provide social
coordination without a central control.
• Economic systems provide coordination
mechanisms with information hiding.
Assumptions/Starting point
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.
The economic way of thinking
• Act to economize
• Interact for mutual adjustments
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)
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)
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.
Supply, demand, cost and price
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
Sources of demand: Preferences
Needs and
Values
Interests and
motives
More difficult to change
Goals and
objectives
Sources of Demand: Other
• Income (normal/inferior goods)
• Price of related products (substitutes/complements)
• Expectations (time-based substitution)
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
Sources of supply
Knowledge
Resources
Services
Value
• 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
The price (market) mechanism
• Equilibrating supply and demand
• Innovation may change curves or create new
Price
P’
Q’
Quantity
Competition
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.
Competition is Dynamic
• Product innovation -> Differentiation
• Process innovation -> Price
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.
Simulation of firms and markets
Overview
Employees
Labour
market
Firms
Financial
market
Banks
Product
market
Consumers
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)
Setting the price
Perceived Value
(Wants)
Customer surplus
Maximum price
(Purchasing power)
Realized price
(Competition)
Firm profit
Cost
(Inputs)
Matching production capacity and demand
Learning to do new things
Economizing
Knowledge
Resources
Learning about
preferences
and demand
Economizing
Supply/Demand
Preferences
Capacity
Learning to do more of the same
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)
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)
Remember
• Define low level rules – allow higher level
patterns to emerge
• Don’t strive for optimal decisions – start
with simple heuristics.