1

University of Essex Session 2011/12

Department of Economics Autumn Term

EC111: INTRODUCTION TO ECONOMICS

Lecturer: Tim Hatton; Room 5B:313; email: hatton@essex.ac.uk

INTRODUCTION

The scope of economics

How society decides what, how and for whom to produce

The central problem is reconciling unlimited wants with limited resources to
satisfy those wants. The resources are the means of producing goods and
services.

The main mechanism for the allocation of resources is the market. We study the
way in which markets work and the outcomes that the market mechanism
produces.

The main economic actors (or agents) are:
Households, who consume goods and supply labour and capital.
Firms, which employ workers and capital to produce goods.

There is also an important role for the government in:
Creating and enforcing the conditions for markets to work.
Intervening to correct situations where markets fail.
Redistributing income and wealth in the interest of equity.
Stabilising economy wide fluctuations.

Positive versus normative economics

Positive economics involves ifthen statements: e.g. a tax on cigarettes will
cause the price to rise and the quantity consumed to fall.

Normative economics: makes recommendations about what should be, based on
value judgments: e.g. the government should put more tax on cigarettes to cut
smoking.


The methodology of economics

Economists mostly focus on positive aspects and they use economic models
which abstract from many details in order to focus on the key economic
mechanisms. These economic models:
Attempt to capture the key elements of economic behaviour
Produce predictions that can be tested against the available data.


2


Thinking like an economist

Economics is not a set of facts to be learned. It is a way of addressing issues and
problems using a coherent framework of thought and a rigorous methodology.

Economic methodology can be used to analyse a wide range of issues, not just the
quantities and prices of goods and services but social issues such as marriage and
divorce, crime, drug use, social discrimination, education fashion and politics.

Key assumptions of this approach:
Individuals seek to maximise their own welfare as they perceive it
Individuals are on the whole rational, forward looking and have
preferences that are consistent over time
Actions and choices are constrained by what is feasible

Some popular fallacies about economics and economists

Economists always disagree
Economics is mainly about predicting the future
Economics is common sense dressed up with jargon and maths
Economic models are too simple to capture reality.
Economics views individuals as caring only about money


Microeconomics versus Macroeconomics

Microeconomics studies the behaviour of individual decision-making units, the
individual, the household, the firm, the industry; and how these agents in
interact in markets.

Macroeconomics studies the behaviour of the economy as a whole focusing on
aggregates such as consumption investment, unemployment, inflation; and the
and in particular the overall consequences of government policy.

Macro and micro are obviously related and the distinction between them is not
as sharp as it looks at first sight.

3
The production possibility set

To illustrate some key concepts, suppose that we have a very simple economy
that produces only two goods, guns and butter





The production possibility set is the area inside the curve: it is all feasible
combinations of guns and butter.

The production possibility frontier (PPF) is the maximum number of tonnes of
butter for any given number of guns.

The position of the PPF is determined by (a) the productive resources that are
available for use in producing guns or butter (e.g. factories and labour), and (b)
by technology that determines how much output can be produced for a given
resource input.

Q: what could shift the PPF outwards to the right?







40





30

D

C


A


B


Guns (per year)
10 13 Butter (tonnes per year)
4
Point A does not achieve production efficiency; points C and D do. Point B is not
feasible.

The PPF slopes downward from left to right: more butter means fewer guns

The key concept of opportunity cost.
Start at point C and move to point D. This economy has given up 10 guns and
obtained an extra 3 tonnes of butter. The opportunity cost of 3 tonnes of butter is
10 guns.

For a small change, the opportunity cost of butter is the slope of a line tangent to
the PPF. Because the PPF is concavethe opportunity cost of a kilo of butter
increases the more butter is produced (the slope becomes steeper).

Q: Why should the PPF be concave?



Comparative advantage and the gains from trade


Suppose there are two countries A and B, each with 100 units of labour but their
technologies differ. Output per worker in each industry is:

Butter Guns

Country A 2 6

Country B 3.2 2

In country A the opportunity cost of a gun is 2/6 = 1/3 of a unit of butter; the
opportunity cost of a unit of butter is 6/2 = 3 guns

Q: What are the opportunity costs in Country B?

Country B has an absolute advantagein butter, country A has an absolute
advantagein guns.




5



Note that here the PPF is a straight line (constant opportunity cost)

How should the countries allocate production to maximise world output?

Scenario 1: allocate labour equally to the two goods in the two countries

Total output of guns: (6 50) + (2 50) = 400
Total output of butter: (2 50) + (3.2 50) = 260

Scenario 2: county A specialises in guns, country B specialises in butter

Total output of guns: (6 100) = 600
Total output of butter: (3.2 100) = 320


There are gains from specialisation more guns and more butter are produced in
Scenario 2

But what if one of the countries is more efficient in the production of both goods?


Suppose instead productivity levels are:


Butter Guns

Country A 4 6

Country B 2.5 3

Country A Country B
200 Butter 320 Butter
Guns
600
Guns




200
PPF, A
PPF, B
6
Scenario 1: No specialisation:

Total output of guns: (6 50) + (3 50) = 450
Total output of butter: (4 50) + (2.5 50) = 325

Scenario 2: Now suppose country A specialises a bit more in guns and country B
a bit more in butter

Total output of guns: (6 60) + (3 30) = 450
Total output of butter: (4 40) + (2.5 70) = 335

Total output of guns is the same but the output of butter has increased. This
reallocation could continue until one country is completely specialised.

Country A has an absolute advantagein both goods but country B has a
comparative advantagein butter. The opportunity cost of butter in terms of guns
is lower for country B (3/2.5) than it is for country A (6/4).

There is scope for mutually advantageous exchange between the two countries,
with country A exchanging guns for butter from country B. Because total output
can be increased by specialisation, both countries could have more of one good
and at least as much of the other.

Note that

The fundamental insight is that there are gains from specialisation. This example
is trade between countries but it could equally be two regions or two individuals.

We have said nothing about how of much of each commodity these countries (or
individuals) wish to consume. But the more there is specialisation in production,
the greater is the necessity for exchange. That means we need some basis to
transactthis is what the market mechanism does.

How much is bought and sold will depend on prices (among other things). Those
prices have not been determined in these examples.

This example is very simpletwo goods, two countries (or individuals). But the
basic idea can be applied in much more complex settings.

Other factors may also matter in determining what is produced, how and for
whom. We have abstracted from thesebut they could be taken into account
without overturning the basic principle.








7

PRICE DETERMINATION IN A PERFECTLY COMPETITIVE MARKET


Key assumption: buyers are price-takers. There are lots of them and any one
individual is so small relative to the market that he/she cannot affect the price.


Demand

An individuals demand curve: q
D
= d(P)



Note that although quantity, q, is a function of price, P, we draw price on the
vertical axis and quantity on the horizontal axis. Note also it doesnt have to be a
straight line.

The individuals demand curve slopes down from left to right because:
As the price rises the individual switches towards substitute goods
As the price rises the individual can buy less with a given income

We expect the individuals demand to depend not only on the price of the good in
question but on his/her tastes, the prices of other goods, and his/her income.

q
D
= d(P, , m.)


Price
Per
Unit

P
1



P
2
q
1
q
2
Quantity per unit of time
d(P)
8


Market demand is the horizontal sum of all the individuals demand curves






The market demand depends on all the things that determine individual
demands:

Market demand function: Q
D
= D(P, , m
1
, m
2
,..)

The market demand curve shows the relationship between quantity demanded,
Q
D
, and price of the good, P. But other things may matter too, such as the
incomes, and the prices of other goods.


Note that when we draw the demand curve we make an assumption of ceteris
paribusall else remains the same













Market demand
Q
D

P
9

Supply

The market supply curve shows the total quantity of goods that sellers are
willing to supply at any given price.









The market supply curve is the horizontal aggregation of the supply curves of
individual suppliers. We may think of these as firms, who find it profitable to sell
more as the price rises.

Other things may affect supply: the state of technology, the prices of inputs to
the production process.

Market supply function Q
S
= S(P, .)

For now we assume ceteris paribus.




Price
Per
Unit




P
2



P
1
Q
S
1
Q
S
2

Market supply
10

Market Equilibrium: A Numerical Example

Demand function: Q
D
= 300 4P

Supply function: Q
S
= 90 + 6P



When P = 50:

Q
D
= 300 (450) = 100

Q
S
= 90 + (650) = 210

There is excess supply ( Q
S
> Q
D
)

When P = 25:

Q
D
= 300 (425) = 200

Q
S
= 90 + (625) = 60

There is excess demand ( Q
D
> Q
S
)




Price

75




50




25


15

300
Q
S

Q
D

11

Note the short side rule: buyers can not be forced to buy more than they want to,
or sellers to sell more than they want to.

At P
*
buyers and sellers are willing to transact the same amount. This is the
equilibrium price. It is the price at which Q
D
= Q
S
. There is no excess supply or
demand.

Q
D
= Q
S
; 300 4P = 90 + 6P

300 + 90 = 6P + 4P; P
*
= 39

To find the equilibrium quantity, plug the equilibrium price in to either the
supply or the demand function.




Some reasons why the market may not clear

Government intervention: minimum price (price floor) or maximum price (price
ceiling).

Example of a price floor e.g where P = 50 (see diagram), which is binding and
leads to excess supply (P
min
> P
*
, and Q
S
> Q
D
).

Example EU farm policies in the 1970s and 1980s. In order to maintain the price
for farmers the EU bought up the excess supply and stored it and/or dumped it
abroad.


Example of a price ceiling e.g. where P = 25 (see diagram). This leads to excess
demand (P
max
< P
*
, and Q
D
> Q
S
).

Example: rent control. The government wants to keep down the cost of housing
for poor families. But it will create excess demand.

Possible consequences of a price ceiling:

Queues

Allocation by sellers

Rationing by coupons






12

Black market: buy at P
max
and sell at some higher P.




Price rigidities in the private sector

Example: the labour market might not clear if unions resist wage decreases when
there is unemployment. Note here that the quantity is the number of workers
and the price is the wage. If wages are too high then there will be excess
supply of labour.


Asymmetries of information

Example: Suppose there is excess demand for bank loans. A bank may
nevertheless decide not to raise interest rates, because it fears that by doing so it
may induce borrowers to make riskier investments. So it prefers to ration credit.

Q: What is the price here? And what do we mean by asymmetric information?



P

P

P
max
Q
S
(P
max
) Q
Q
D
Q
S