ECON104

PRINCIPLES OF MICROECONOMICS

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WHAT IS ECONOMICS?
Economic Issues And Concepts

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Economic Issues And Concepts
 Economics: study of the use of scarce
resources to satisfy unlimited human
wants.
 Other definition:
 Marshall (1824-1924): study of
mankind in the ordinary business of
life.
 Art of living, we encounter problems

that need to be solved.

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Economic Issues And Concepts
 Inany decision of life there is an
economic problem: choice under
conditions of scarcity.
 Two fundamental facts:

i. Society’s wants are unlimited or

insatiable.
ii. economic resources are limited in
supply or scarce.

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 Resources
 Land: natural endowments e.g. arable land,
forests, lakes and minerals.
 Labour: human resources (mental &
physical); size of labour force (quantity)
and skills (quality).
 Capital: all manufactured aids to
production i.e. goods used to produce
other goods e.g. tools, machinery and
buildings NOT financial capital.
 Entrepreneurship: ideas.

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 Resources
Factorsof production are used
to produce the things that
people desire (goods &
services).
 Goods: tangible.
 Services: intangible.
People use goods & services to
satisfy many of their wants.
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 Resources
 Production: act of making goods.
 Consumption: act of using them.
 Scarce resources entail constrained

choice.
 Making choices implies the
existence of costs (opportunity
cost): decision to have more of
something requires a decision to
have less of something else.
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 Resources
How then can the scarce
resources be allocated to
satisfy unlimited wants in a
manner that will create the
most benefit to society?
Think and make decisions

like an economist.

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How
How people
people make
make decisions:
decisions: some
some
lessons
lessons of
of economics
economics
(Mankiw
(Mankiw (2007),
(2007), pp.3-14)
pp.3-14)

Lesson
Lesson 1: 1: People
People face
face trade-offs
trade-offs
•• Decision
Decision making
making generally
generally
involves
involves trading
trading off
off one
one thing
thing for
for
another.
another.
•• Good
Good decision
decision making
making requires
requires
an
an understanding/evaluation
understanding/evaluation of of
the
the available
available options.
options.
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Lesson 2: The cost of something is what
you give up to get it.
 Decision making requires a comparison

of the costs and benefits of alternative

choices.
 Determining the ‘real’ cost of a choice is

not always easy.

 An opportunity cost applies to all
choices
“The opportunity cost [of an item is]
whatever must be given up to obtain
some item.”
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Lesson 2: The cost of something is what you
give up to get it.

 To calculate opportunity cost consider all of

the resources used if that choice is taken.
 Next, estimate the value of these resources

if they were to be used in their next-best

alternative use. E.g. Should I purchase a new
laptop? Consider:
◦ purchase price of laptop.
◦ time spent researching best brand.
◦ time spent researching where you can get the best
price.

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Lesson 2: The cost of something is what
you give up to get it.

 Consider the next best alternative use

of your time.
 Consider the next best alternative use

of the purchase price of the laptop.

 Now consider the following:

a) Enrolling at UZ for HACC/HBBSCT vs

Work.
b) Going to a lecture or sleep in res.

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Lesson 3: Rational people think at the margin

“Marginal changes [are] small incremental

adjustments to a plan of action”
 People make decision by comparing costs

and benefits.
 E.g. Studying for one more hour for your

exam (marginal cost) compared to the

benefit from studying for that additional
hour (marginal benefit)?
 A decision is rational if the marginal benefit

is equal to or exceeds the marginal cost.

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Lesson 4: People respond to incentives
 Marginal changes in costs or
benefits motivate people to
respond.
 Example:
 Financial incentives such as changes to
tax rules alter the savings/spending
patterns of individuals.
 Changes in price alter the spending
patterns of consumers.

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Lesson
Lesson 5:
5: Trade
Trade can
can make
make everyone
everyone better
better off
off

Trade allows
Trade allows individuals
individuals andand
countries
countries to
to specialise
specialise in
in what
what
they
they do
do best.
best.
Think
Think about
about the the types
types of of
goods
goods && services
services that
that
Zimbabwe
Zimbabwe exports
exports and
and
imports.
imports.
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 Lesson
Lesson 6:
6: Markets
Markets are
are usually
usually aa good
good
way
way to
to organise
organise economic
economic activity
activity
Households decide
Households decide
what
what to
to buy
buy and
and who
who to
to
work
work for.
for.
Firms decide who to
Firms decide who to
hire
hire and
and what
what toto
produce.
produce.
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Lesson
Lesson 7:
7: Governments
Governments can
can sometimes
sometimes
improve
improve market
market outcomes
outcomes
Markets sometimes
Markets sometimes failfail to
to operate
operate
efficiently.
efficiently.
“Market failure [is] a situation in
“Market failure [is] a situation in
which
which aa market,
market, left
left on
on its
its own,
own, fails
fails
to
to allocate
allocate resources
resources efficiently.”
efficiently.” (ibid:
(ibid:
11)
11)
Causes of market failure include:
Causes of market failure include:
••Externalities
Externalities
••Market
Market power
power
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Lesson
Lesson 7:
7: Governments
Governments can
can sometimes
sometimes
improve
improve market
market outcomes
outcomes

An “externality
An “externality [is]
[is] the
the impact
impact of
of one
one
person’s
person’s actions
actions onon the
the wellbeing
wellbeing of
of aa
bystander”.
bystander”.
“Market power [is] the ability of a single
“Market power [is] the ability of a single
economic
economic actor
actor (or(or small
small group
group ofof
actors)
actors) to
to have
have aa substantial
substantial influence
influence
on
on market
market prices.
prices.

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Four Key Economic Questions
 Since resources are scarce, all
societies face the problem of
deciding what to produce and
how each person will consume.
 Societies differ as to who
makes the choices and how
they are made.
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 Four Key Economic Questions
• What is produced and how? - concerns
the allocation of scarce resources among
alternative uses.
• What is consumed and by whom? These
two questions fall in the realm of
microeconomics: study of the causes
and consequences of the allocation of
resources as it is affected by the
workings of the price system and
government policies that seek to
influence it.
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 Four Key Economic Questions
 Why are some resources sometimes
idle?
 Is productive capacity growing
(shown by outward shift of PPF)?
 These questions fall in the realm of

macroeconomics: study of the

determination of economic
aggregates such as total output,
total employment, the price level,
and the rate of economic growth.
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 Who Makes the Choice and How?
• Done through the organisational mechanism
called The Economic System.
 Social organisation is an important part of

economic organisation because it can influence

the use of resources.
 Three aspects need to be highlighted.

a) Ownership of resources.
b) Control of the uses of resources.
c) Goals & objectives of the controllers of resources.
• Types of Economic Systems:

Traditional Command
Free market Mixed
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 Types of Economic Systems
 Traditional Economies
- Based mainly on tradition, custom and
habit.
 Works best in a static environment
because where events are dynamic,
adaptation is inevitable.
 This resulted in the eroding of this
economic system.
 Command Economies
 Economic decisions are made by a central
planning authority usually the
government.
 Centralization of decision making since
the government owns all the resources.
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 Command Economy
 Based on the notion of “growth with
equity” a socialist/communist
ideology.
 Has not fared well in the world.
 There is a marked decrease in
countries that rely on central planning.
 Even in the world’s leading proponents

(China, Cuba) there is an increase in

market determination. Why?

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Failure of Command Economies
Failure of organisation due
to large economic size and
population.
Failure of quality control.
Lack of incentives.
Environmental degradation.

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 Free Market Economy
• Households and firms pursue their own self–
interests without any central regulation.
• System works through a market: institution

through which buyers and sellers interact and

engage in exchange of goods and services.
• Components:-
• a) consumer sovereignty.
• b) free enterprise.
 Price Function: operates to allocate resources

in such a way as to answer the 3 economic

questions of what, how and for whom.

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 Free Market Economy
 Price signals to producers which
goods are profitable to produce.
 Also signals to consumers which
goods give the most value for their
money and they purchase based on
this information.
 Proponents argue that it leads to

efficient production and better

response to diverse and changing
consumer preferences.
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 Mixed Economy
• Not fully traditional, centrally planned,
free market (pure types useful only for
studying basic principles).
• In practice, every economy is mixed in
the sense that it combines significant
elements of all three systems in
determining economic behaviour.
• Within any economy the degree of mix
varies.

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 Mixed Economy
 There is no pure economic system
working alone, even in a so-called
market economy the command
principle is applied:
a) legislated minimum wages and
prices.
b) Restrictions on imports.
c) Rules and regulations for
environment protection.
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HOW DO ECONOMISTS WORK?
Economics is a social
science.
We explore what it
means to be
‘scientific’ in terms of
economics.
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Methodology of Economists
Economists seek to
understand the world by
developing theories and
models that explain some
of the things that have
been seen and to predict
some of the things that
will be seen.
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Methodology of Economists
 Economists observe complex
economic behaviours and
generalise.
 Economic theories are broad
generalisations about complex
economic behaviour (hypothesis).
 E.g. there is negative relationship
between price and quantity
demanded, ceteris paribus.
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 Scientific Method
a) Observe a phenomenon.
b) Make simplifying
assumptions & formulate a
hypothesis.
c) Generate predictions.
d) Test the hypothesis.

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What are these assumptions?
 All other things held constant
(ceteris paribus).
 Helps to simplify reality & focus
on the relationships that interest
us.
 Usually we study at least two
variables of interest. e.g. money
supply and interest rates, income
and demand for a product.
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Fallacies in Economic Reasoning
 Post hoc fallacy: it is quite tempting to
look at two events that happen in
sequence and assume that the first
caused the second to happen. This is not
always the case.
 Fallacy of composition: erroneous belief
that what is true for a part is necessarily
true for the whole. Theories that seem to
work well when applied to individuals,
often break down when they are applied
to the whole.
 Failure to hold all other things constant
(ceteris paribus).
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 Using Economic Models
 Simple diagrams: visual style
makes it easier to demonstrate
economic principles.
 Model: an abstraction designed to

illustrate some point but not

designed to generate testable
hypotheses.
 Models can be described with
words; math or pictures (graphs).
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 Using Economic Models
Graphs: plot economic
variables (bars, histograms,
line, pie chats).
Statistical analysis:
mathematical manipulation
of economic data.
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Production Possibility Frontier (PPF)
 Model of scarcity, choice between 2
goods) and opportunity cost.
 PPF shows maximum combination of 2

goods given current resources.

 A “production possibility frontier [is] a

graph that shows the various

combinations of output that the
economy can possibly produce given
the available factors of production and
the available technology”.
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 Production Possibility Frontier
(PPF)
 We need to ask and answer the
following questions.
 How can we use a diagram to

illustrate the concept of the

economic problem?
 What does the model (PPF) enable

us to predict about the notions of

scarcity, choice and opportunity
cost?
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Production
Production Possibility
Possibility Frontier
Frontier

Two goods produced

Bread
A are Bread and Lamb.

CC
B1

DD
B2

E
O
L1 L2 Lamb

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 Production
Production Possibility
Possibility Frontier
Frontier

Bread What does point A tell us?

A
What does point E tell us?
What about points C and D?
CC
B1

B2 DD

E
O
L1 L2 Lamb

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Production
Production Possibility
Possibility Frontier
Frontier

How does this model help

Bread us understand the concepts
A
of choice and opportunity cost?
The economy must choose
CC Between points along the PPF.
B1

B2 DD

E
O
L1 L2 Lamb

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Production
Production Possibility
Possibility Frontier
Frontier
Assume we are initially at point C
Bread What is the opportunity cost of
A
choosing to move to point D?
To gain L2 minus L1 of Lamb,
B1 CC we give up
B1 minus B2 of Bread
Loss of
Bread

DD
B2
Gain of
Lamb
E
O
L1 L2 Lamb

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Production
Production Possibility
Possibility Frontier
Frontier

Bread Add a point to the diagram to

A indicate scarcity.
Any point outside the PPF
CC represents an unattainable
B1 Combination – due to scarce
resources

DD
B2

E
O
L1 L2 Lamb

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Production
Production Possibility
Possibility Frontier
Frontier

Bread Add a point to the diagram to

A indicate an inefficient use of
resources.
CC Any point inside the PPF
B1 represents an inefficient use
of resources.

DD
B2

E
O
L1 L2 Lamb

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Production
Production Possibility
Possibility Frontier
Frontier

Bread What shocks to the model

A would cause the PPF to
shift
• Inwards
CC
B1 • Outwards?

DD
B2

E
O
L1 L2 Lamb

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 SUMMARY
 Scarcity: unattainability of
combinations.
 Choice: selection of attainable
combinations.
 Opportunity Cost: downward sloping.
 Concavity: increasing opportunity
costs. Implication is that economic
resources are not completely
adaptable to alternative uses.
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Positive and Normative Advice
Economist give two broad
types of advice:

a) normative
b) positive
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 Positive Economics
 Deals with facts and avoids value
judgements.
 It attempts to set forth scientific
statements about economic
behaviour.
 Positive statement: what actually is
as opposed to what ought to be.
 Resolved by analysis and empirical
evidence.
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 Normative Economics
 Involves value judgements about what
the economy should be like.
 No right or wrong answers because

they involve ethics and values rather

than facts.
 Normative statement: what ought to be

as opposed to what actually is.

 Resolved through political debate &

decisions but not by economic analysis

alone.
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 Example
Government advice on
resource idleness.
◦Government ought to try
harder to reduce UE.
◦If government wants to
reduce UE, reducing UE
benefits is an effective way
of doing so.
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