CHAPTER 1Economics and the economy

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The subject area of economics

Every group of people must solve three basic problems of daily living:

• what goods and services to produce• how to produce them

• for whom to produce them

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How economists think about choices

• In economic models it is assumed that economic agents act rationally.

• Willingness-to-pay can be used to quantify the non-monetary costs and benefits of decisions.

• When resources are scarce all choices have an opportunity cost.

• Economic agents are assumed to respond to incentives.

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Economic issuesthe financial crisis of 2007 (1)

•In 2007 many of the world’s largest financial institutions either collapsed or came close to doing so.•The crisis in financial markets quickly spread to the wider economy as many countries throughout the world went into recession.

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Economic issuesthe financial crisis of 2007 (2)

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Figure 1.1 reveals the severity of the 2007 recession when compared to earlier economic downturns.

Economic issuesthe financial crisis of 2007 (3)

• The financial crisis originated in the sub-prime crisis in the United States.

• Rising house prices, combined with low interest rates, created a financial incentive to expand lending to low income borrowers.

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US house prices

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The boom in trade in Mortgage Backed Securities (MBSs)

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Figure 1.3 shows how the trade in MBSs boomed in the run up to the crisis.

Key features of the crisis (1)

• Sub-prime borrowers start to default on loans and this set in motion a fall in house prices and the value of MBSs.

• Financial institutions holding MBSs incurred huge losses.

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Key features of the crisis (2)

• Losses lowered the willingness and ability of banks to lend to each other, and the this led to a ‘credit crunch’.

• Non-financial businesses struggled to get funding and the wider economy went into recession.

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An example: Oil price fluctuations

The price of oil tripled in 1973-74, and doubled again in 1979-80. It rose sharply again in 2008.

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Higher oil prices

• make the economy produce in a way that uses less oil.

• reduce the demand for oil-related commodities encouraging consumers to purchase substitute commodities

• make the world economy produce more for OPEC and less for the big oil importers (e.g., Germany and Japan)

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The distribution of world population and income

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The law of diminishing marginal returns

• Each extra worker adds less to output than the previous extra worker added.

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Film output

A

Food

ou

tpu

t

Production possibility frontier

The production possibility frontier (1)

This tells us the maximum amount the economy can produce using all available resources. A is impossible. B inefficient.

B

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F/G = opportunity cost (=1/2)

The production possibility frontier (2)

Film output (G)

F= 4

G = 8B

A

Food

ou

tpu

t (F

)

Production possibility frontier

10

14

6 14

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Opportunity cost

• In the previous figure, suppose we begin at point A with 14 units of food and 6 films.

• Moving from A to B, we gain 8 films but lose 4 units of food.

• Thus, 4 units of food is the opportunity cost of producing an additional 8 films.

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• The opportunity cost of a good is the quantity of other goods that must be sacrificed.

Comparative advantage

• An individual has a comparative advantage compared to another in the production of a good if he/she has a lower opportunity cost in producing it.

• This is different to absolute advantage. An individual has an absolute advantage in producing a good if he/she is more efficient at producing that good compared to someone else.

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Comparative advantage

• In determining possible benefits from trade it is the concept of comparative advantage that matters not the absolute one.

• Comparative advantage also applies to countries.

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Markets and the price mechanism

• The price mechanism ensures that… households’ decisions about

consumption of alternative goodsfirms’ decisions about what and how to

produceand workers’ decisions about how

much and for whom to work• … are all reconciled.

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The command economy

• Is an alternative to the market economy

• In a command economy, a government planning office decides:

what will be produced, how it will be produced, and for whom it will be produced. • Detailed instructions are then issued to

households, firms and workers.©McGraw-Hill Education, 2014

The invisible hand

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In contrast, Adam Smith in the Wealth of Nations (1776) argued that individuals pursuing their self-interest would be led ‘as by an invisible hand’ to do things that are in the interests of society as a whole.

The command economy has tended not to perform well.

A mixed economy• In a mixed economy the government

and private sector jointly solve economic problems.

• The government influences decisions through taxation, subsidies, and provision of free services such as defence and the police.

• It also regulates the extent to which individuals may pursue their own self-interest. ©McGraw-Hill Education, 2014

Commandeconomy

Freemarketeconomy

UK

USAIndia

CubaHungary

Sweden

Market orientation

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Positive and normative economics

• Positive economics studies objective or scientific explanations of how the economy works.

• Normative economics offers recommendations based on personal value judgments.

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Microeconomics

• Microeconomics offers a detailed treatment of individual decisions about particular commodities

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Macroeconomics

• Macroeconomics emphasizes interactions in the economy as a whole.

• It deliberately simplifies the individual building blocks of the analysis in order to retain a manageable analysis of the complete interaction of the economy.

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Concluding comments (1)• Economics analyses what, how and for

whom society produces.• Rational individuals, in making choices, must

compare the benefits and the costs associated with those choices.

• The production possibility frontier (PPF) shows the maximum amount of one good that can be produced given the output of another good.

• The opportunity cost of an activity is the value of the best alternative that we must sacrifice. It is the slope of the PPF.

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Concluding comments (2)• If individuals, firms or countries have different

opportunity costs of producing a good compared to others, they have a comparative advantage.

• In a command economy, decisions on what, how and for whom are made in a central planning office.

• A free market economy has no government intervention.

• Modern economies are mixed, relying mainly on the market but with a large dose of government

• intervention. ©McGraw-Hill Education, 2014

Concluding comments (3)• Positive economics studies how the

economy actually behaves.• Normative economics recommends

what should be done.• Microeconomics offers a detailed

analysis of particular activities in the economy.

• Macroeconomics emphasizes these interactions at the cost of simplifying the individual building blocks.

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