Introduction to Economics

What is economics? How do economists approach the world?

Introduction to Economics
- Economics is a social science characterized by interdependence, which focuses on how people interact with
each other to improve their economic well-being, influenced and enabled by their values and their natural
surroundings.
- The economic world is dynamic in nature and constantly subject to change.
- Economic theories are based on logic and empirical data, using models to represent and analyse this complex
reality. Individual and collective motivations and behaviours are complex and diverse, and their understanding
entails the interaction of a variety of disciplines such as philosophy, politics, history, and psychology.
- Economic decision-making impacts the relative economic well-being of individuals and societies
- The central problems of economics are scarcity and choice. This forces societies to face trade-offs, opportunity
costs and the challenge of sustainability.
- Debates exist in economics regarding the potential conflicts between economic growth and equity and between
free markets and government intervention.
- Endless economic growth, based on the consumption of finite resources, cannot continue indefinitely. New
economic models and social movements have challenged mainstream opinion about the purpose of growth and
how the economy could be redesigned to support long-term prosperity
What is economics?
- Economics as a social science
- Microeconomics vs. Macroeconomics
- Microeconomics
- Macroeconomics
- The problem of choice
- Scarcity
- Unlimited wants vs. Limited resources
- Factors of Production
- Land, Labour, Capital and Entrepreneurship
- Opportunity Cost
- Free Good
- The Basic economic questions
- What/how much to produce, how to produce and for whom to produce?
Types of economic systems
The Production Possibilities Curve (PPC)
- The maximum possible output
combinations of two goods or
services an economy can achieve
when all resources are fully and
efficiently employed
- Assumptions of the model
- Two goods / services produced
- Concavity
- The law of increasing opportunity
cost
- Imperfect factor substitution (factors
of production are not perfectly
mobile)
The Production Possibilities Curve (PPC)
- Outward shift of the PPC: increase in the quantity
and / or quality of factors of production

Quantity Quality

Land

Labour

Capital
How do economists approach the world?
- Economic methodology
- The role of positive economics
- The use of logic
- The use of hypotheses, models, theories
- The ceteris paribus assumption
- Empirical Evidence
- Reputation
- The role of normative economics
- Value judgements in policy making
Economic thought
- 18th century: Adam Smith and laissez faire
- 19th century: Classical microeconomics, Marxist critique
- 20th century: Keynesian revolution, rise of macroeconomic policy, monetarist /
new classical counter revolution
- 21st century: increasing dialogue with other disciplines such as psychology
and the growing role of behavioural economics; increasing awareness of the
interdependencies that exist between the economy, society and environment
and the need to appreciate the compelling reasons for moving toward a
circular economy
Microeconomics
How do consumers and producers make choices in trying
to meet their economic objectives?
- Interaction between consumers and producers in a market is the main
mechanism through which resources are directed to meet the needs and
wants in an economy.
- Consumer and producer choices are the outcome of complex decision-making.
- Welfare is maximized if allocative efficiency is achieved.
- Constant change produces dynamic markets
Demand
- Definition: the willingness and the ability to
purchase at a given price at a given time
- The law of demand: inverse relationship
between price and quantity demanded
- Assumptions underlying the law of demand
- The income effect
- The substitution effect
- The law of diminishing marginal utility
- Each individual consumer’s demand curve
accumulated becomes a market demand
Movements along the curve vs. Shifts of the curve
- Movement along - Shift (factors affecting demand)
- Income
- Tastes and preferences
- Future price expectations
- Price of related goods
- Substitutes
- Complements
- Number of consumers
Supply
- Definition: the willingness and the ability to sell at a given price at a given time
- The law of supply: direct relationship between price and quantity supplied
- The law of diminishing marginal returns
- Increasing marginal costs
Movements along the curve vs. Shifts of the curve
- Movement along
- Shift (factors affecting supply)
- Changes in costs of factors of production
- Productivity
- Prices of related goods
- Joint supply
- Competitive supply
- Indirect taxation
- Subsidies
- Future price expectations
- Number of firms
Disequilibrium
- Excess Demand (Shortage) - Excess Supply (Surplus)
Price mechanism
- Signalling function: prices perform a signalling function (they adjust to demonstrate where resources
are required)
- Prices rise and fall to reflect scarcities and surpluses
- If prices are rising because of high demand from consumers, this is a signal to suppliers to
expand production to meet the higher demand
- If there is excess supply in a market, the price mechanism will help to eliminate a surplus of a
good by allowing the market price to fall
- Incentive function
- Through choices consumers send information to producers about their changing nature of
needs and wants
- Producers/consumers are incentivized to increase/decrease their Qs/Qd
- Rationing function
- Prices ration scarce resources when demand outstrips supply
- When there is a shortage, price is bid up - leaving only those with willingness and ability to pay
to buy
Competitive market equilibrium
- Excess Demand (Shortage) - Excess Supply (Surplus)
Consumer and Producer Surplus
- Market Equilibrium: Achieved at the price at
which quantities demanded and supplied are
equal. Also known as the state of no change.
- Consumer Surplus: Consumers’ willingness and
the ability to purchase minus the actual price
they pay.
- Producer Surplus: The actual price producers
receive minus producers’ willingness and the
ability to supply.
- Social welfare = consumer surplus + producer
surplus
- Social welfare is maximized at the equilibrium (Qd =
Qs)
- When social welfare is maximized = allocative
efficiency
- Loss of social welfare = deadweight loss
- DWL represents the losses to buyers and sellers
Elasticities
- Concept of elasticity
- Price Elasticity of Demand (PED)
- Price Elasticity of Supply (PES)
- Income Elasticity of Demand (YED)
Price Elasticities of Demand [1]
- Formula:

percentage change in quantity demanded / percentage change in price

Price Elasticities of Demand [2]
- Determinants of PED
- Number and closeness of substitutes
- Degree of necessity
- Proportion of income spent on the good
- Time
Price Elasticities of Demand [3]

- Relationship between PED and Total Revenue

- Total revenue = P * Q
- Under the law of demand, there is an inverse relationship between P * Q
- If PED is elastic, a decrease in price → a more than a proportionate increase in the Qd →
higher TR
- If PED is inelastic, an increase in price → a less than a proportionate decrease in the Qd →
higher TR
Changing PED along a straight line downward sloping
demand curve
Importance of PED for firms and government
decision-making
For firms, they have two choices to reach their ultimate goal, increasing total revenue. This can be done by either
increasing the price or decreasing the price of a product. In a PED curve, there are always elastic and inelastic
sectors that firms can benefit by taking a smart move.
- If PED is elastic (e.g. laptop - high number of substitutes), this means that if we decrease the price, a more
than a proportionate increase in the Qd will happen, and this results in a higher total revenue.
- If PED is inelastic (e.g. cigarette/gasoline - high degree of addictiveness), this means that if we decrease
the price, a less than a proportionate increase in the Qd will happen, resulting in a lower total revenue.
For governments, they have two aspects to consider.
- Firstly, to increase or decrease the market output. This can be done by imposing indirect tax or either
imposing a subsidy, both done for different reasons and goals. The effectiveness depends on the PED
- Secondly, the amount of tax revenue or total amount of subsidy given depends on the PED (this will be
evaluated after reviewing on taxation/subsidy in depth)
Income Elasticity of demand (YED)
- Formula

Percentage change in quantity demanded / percentage change in income

- Degrees of YED
- YED < 0
- 0 < YED < 1
- 1 < YED
Price Elasticity of Supply [1]
- Formula

Percentage change in quantity supplied / percentage change in price

Price Elasticity of Supply [2]
- Determinants of PES
- Time
- Production time: products that take a longer period to produce would be inelastic
- Time given: examining the firm’s ability to alter its production range → right now (inelastic) vs. 1 year (elastic)
- Mobility of factors of production
- how fast a firm can change the usage of its (land, labor, capital) from one production to another (e.g. apple farm →
semi-conductor factory: inelastic)
- Unused capacity
- Operating at full capacity will require the firm to (build new factories, employ more workers, purchase more
machinery) which will take a certain amount of time for a firm to alter its production level (inelastic)
- However, if the firm was operating with high amount of spare capacity, increasing the level of production can be
conducted in a shorter time period (elastic)
- Ability to store (perishability)
- If we can store (not perish), the firm can respond to an increase in demand from the market by releasing their
available stocks (elastic)
- If we cannot store (perish; agricultural products), the firm will have to produce the produce every time market
demand goes up (inelastic)
- Rate at which costs increase
- If the rate at which costs increase is rapid, increasing the production level gives a burden for firms (inelastic)
- If the rate at which costs increase is slow, increasing the production level would be fairly easy for firms (elastic)
 Microeconomics
Role of government in microeconomics
When are markets unable to satisfy important economic
objectives —and does government intervention help?
- The market mechanism may result in socially undesirable outcomes that do
not achieve efficiency, environmental sustainability and/or equity.
- Market failure, resulting in allocative inefficiency and welfare loss.
- Resource overuse, resulting in challenges to environmental sustainability.
- Inequity, resulting in inequalities.
- Governments have policy tools which can affect market outcomes, and
government intervention is effective, to varying degrees, in different real-world
markets
Reasons for government intervention in markets
- Influencing market outcomes in order to:
- Earn government revenue
- Support firms
- Support households on low incomes
- Influence level of production
- Influence the level of consumption
- Correct market failure
- Promote equity
Main forms of government intervention in markets
- Price controls: price ceilings (maximum prices) and price floors (minimum
prices)
- Indirect taxes and subsidies
- Direct provision of services
- Command and control regulation and legislation
Price Ceilings (Maximum Prices)
- To be effective, the price control has to be
below the equilibrium price
- Aim:
- Impact on:
- Producers

- Consumers
Price Floors (Minimum Prices)
- To be effective, the price control has to be
above the equilibrium price
- Aim:
- Impact on:
- Producers

- Consumers
Indirect Taxation
- Producers

- Consumers

- Government
Tax burden
- The incidence of taxes and subsidies depends on the elasticity of supply and
demand
→ More inelastic party (consumers/producers) will be burdened with a higher incidence
Evaluation
- Time: in the short run, firms/consumers may not respond as much - firms may
not exit the market/consumers may continue to purchase a similar amount
- Magnitude: this fall in TR, profit and income would depend on the extent of
change in taxation
- Elasticity: if PED is inelastic, firms can pass on the increase in taxation to
consumers in a form of higher price → limited contraction in the Qd and TR
- Burden: producer/consumer burden depends on the relative elasticity of PED
and PES - more inelastic party will bear a higher burden
- DWL
- Government
- If PED is elastic, ineffective in raising tax revenue
- If PED is inelastic, ineffective in reducing the market output
Subsidies
- Aim:
- Impact on:
- Producers

- Consumers

- Government
Evaluation
- Time: in the short run, firms may not respond as much
- Magnitude
- Gain: producer/consumer gain depends on the relative elasticity of PED and
PES - more inelastic party will bear a higher burden
- DWL (a loss to social welfare)
- If PED is inelastic, ineffective in increasing the market output
- The burden of subsidy - opportunity cost arising → the government could
have spent the money elsewhere
- burden on taxpayers
Microeconomics
Market Failure - Externalities
Socially Efficient and Inefficient Market Outcomes
- Social efficiency
- the optimal quantity of a good occurs where the marginal benefit of consuming the last unit equals the
marginal cost of producing that last unit, thus maximizing total economic surplus. The market
equilibrium quantity is equal to the socially optimal quantity only when all social benefits and costs are
internalized by individuals in the market. Total economic surplus is maximized at that quantity.
- Private incentives can lead to actions by rational agents that are socially undesirable
(inefficient) market outcomes
- Rational agents can pursue private actions to exploit or exercise market characteristics known as
market power. Rational agents make optimal decisions by equating private marginal benefits and
private marginal costs that can result in market inefficiencies.
- Policymakers use cost-benefit analysis to evaluate different actions to reduce or
eliminate market inefficiencies
- Market inefficiencies can be eliminated by designing policies that equate marginal social benefit with
marginal social cost.
Equilibrium allocations being inefficient
- Market failure happens when the price mechanism fails to allocate scarce
resources efficiently or when the operation of market forces lead to a net
social welfare loss
- Market failure exists when the competitive outcome of markets is not
satisfactory from the point of view of society. What is satisfactory nearly
always involves value judgements
- Equilibrium allocations can deviate from efficient allocations due to situations
such
- Externalities: positive/negative externalities in production or consumption
- Merit/demerit goods
- Insufficient production of public goods
- Common pool resources
- Known as “Market Failures”
Externalities
- Spill-over effect to the third party arising from consumption and / or production
of goods and services without an appropriate compensation is paid
- Negative externalities: causing the social cost of production / consumption to
exceed the private cost
- Positive externalities: causing the social benefit of production / consumption
to exceed the private benefit
Terminology
- Marginal Private Cost: Per unit change in cost arising to producers from producing
- Marginal External Cost: Per unit change in cost arising to the third party (externalities)
- MEC > 0: external cost (negative externalities)
- MEC < 0: positive externalities
- Marginal Social Cost: Per unit change in cost arising to the society.
- MPC + MEC = MSC
- MSC > MPC
- MSC < MPC
- Marginal Private Benefit: Per unit change in benefit arising to consumers from consuming
- Marginal External Benefit: Per unit change in benefit arising to the third party (externalities)
- MEB > 0: external benefit (positive externalities)
- MEB < 0: negative externalities
- Marginal Social Benefit: Per unit change in benefit arising to the society.
- MPB + MEB = MSB
- MSB > MPB
- MSB < MPB
Equilibrium points
- Market Equilibrium: MPB = MPC
- Socially Optimal Output: MSB = MSC
- Allocative efficiency; social / community surplus maximized
Negative Externalities of Production
NEP - Government intervention [1]
● Indirect taxation: increasing the cost of production → decrease in supply
○ Internalizing the cost
○ Making the polluters pay
○ MPC + unit of taxation (MEC) = MSC
■ Evaluation
● Assigning the right of taxation is impossible
● Placing a monetary value on externalities is difficult
● Consumer welfare effect: if PED is inelastic, producers may pass on the burden to consumers →
regressive effect
● If PED is inelastic, limited contraction
● Regulation (Tradable pollution Permit)
○ limiting the total amount of emission and distributing permits to each firms → allow to trade
○ Firms have an incentive to invest incentive to invest in clean technology, firms are able to bank their permits for
future use
■ Evaluation
● Firms may pass the cost of purchasing permits on to their consumers leading to higher price
● Cost of enforcement (regulation) → burden on taxpayers
● Difficulties in establishing the “right” level of permits
NEP - Government intervention [2]
● Limit/Ban
○ Decreasing the supply/demand curve
● Price control (maximum/minimum price)
Negative Externalities of Consumption
Government intervention
● Indirect tax
● Regulation
● Public Campaign
Positive Externalities of Production
Government intervention
● Subsidies
● Direct provision from the government
Positive Externalities of Consumption
Government intervention
● Subsidies
● Direct provision from the government
● Provision of information (public campaign)
○ Provision of information (public campaign)
■ Arguments for ‘advertising’
● transmission (chain of reasoning): advertisement showing the benefits/positive spill-over effect to
the society may positive alters consumers’ taste and preferences → increase the demand curve
→ (ideally) MPB + information = MSB
● advertising can create a wider understanding to the impacts → Can arouse wise expenditure of
the society → ultimately change the behaviour of consumers (long-term benefit)
● this could be less costly compared to a direct provision/ subsidy
■ Arguments against ‘advertising’ (evaluation)
● consumers/public may already be aware of the consequences (third party effect) → ineffective
● Costly → burden on taxpayer
● unlike regulation or taxation, reaching the socially optimal point is harder (hard to measure the
‘right’ amount of the provision of information)
Steps of drawing an externality diagram
1. Production (2 cost curves, 1 benefit curve) vs. Consumption (2 benefit curves,
1 cost curve)
2. Negative (Private on the right side) vs. Positive (Social on the right side)
3. Market equilibrium: MPC = MPB
4. Socially optimal point: MSC = MSB
Broad government intervention in response to externalities
- Indirect (Pigouvian) taxes
- Carbon taxes
- Legislation and regulation
- Education—awareness creation
- Tradable permits
- International agreements
- Collective self-governance
- Subsidies
- Government provision
Strengths and limitations of government policies to correct
externalities
- Challenges involved in measurement of externalities
- Degree of effectiveness
- Consequences for stakeholders
Public Goods
- Non-rivalrous
- consumption of a good by one person does not reduce the amount available for others
- Non-excludable
- The benefits derived from pure public goods cannot be confined solely to those who have paid
for it. Indeed non-payers can enjoy the benefits of consumption at no financial cost –
economists call this the ‘free-rider’ problem. With private goods, consumption ultimately
depends on the ability to pay
- Free-rider Problem
- Government intervention
- Direct provision
- Contracting out to the private sector
Public goods - direct provision for/against
● Arguments for
○ as non-excludability shows, the private sector won’t be willing to provide yet the society needs such
product (application) - and it is the government’s role to correct allocations within the market
○ with the problem of being unable to charge consumers at the point of usage, the government has the
ability to impose taxation on consumers after the use (many public goods are provided free at the
point of use and then funded by taxation or a charge)
○ State provision may help to prevent under-provision and under-consumption which may lead to an
improvement of social welfare - the government can solve inequality as well - provision to those
needed (providing essential public goods helps affordability and access to important services for lower
income households and therefore help to address inequalities of income)
● Arguments against
○ burden on taxpayers
○ efficiency: the governments may lack efficiency compared to a private sector business due to a lack of
profit incentive
○ information failure: the government do not possess perfect information - hard to correctly decide the
socially optimal point of output
Common Pool or Common Access Resources
- Characteristics
- Rivalry
- Non-excludable
- “Tragedy of commons”
- Threats to sustainability
- extraction of non-renewable resources → external cost (such as air pollution) →
environmental damage
- extraction of non-renewable resources → resource depletion of limited resources
- agriculture → soil erosion, deforestation, desertification
- Unsustainable production creating negative externalities
Government intervention
● Licensing (private ownership/ allocation of property rights)
● International agreement (cap)
● Subsidising
● Regulating the total amount (fishing permit)
● International aid to support LEDCs

Evaluation
● cost of administering
● imperfect information possessed by the government
● cost of subsidy/aid → dependency culture may arise/ burden on tax payers