CHAPTER 1 INTRODUCTION THE BIG IDEAS

Microeconomics Curtis & Irvine, 2013

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

Learning outcomes
By the end of this chapter you should understand
The nature and objective of economics The role of theory, models, hypotheses and data The centrality of government How microeconomics differs from macroeconomics Opportunity cost, productivity advantage and efficiency Specialization, exchange and markets The production possibility frontier Full employment, booms, recessions and economic growth

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

A Working Definition of Economics

Economics, at its best, is a set of ideas and methods for the improvement of society. It is not, as so often seems the case today, a set of ideological rules for asserting why we cannot face the challenges of stagnation, job loss and widening inequality.
Christopher Sims, Nobel Laureate in Economics, 2011

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

Ideas and Methods

Economics is a social science It is concerned with ideas that may improve society It is scientific in its approach Use of mathematics Use of models Use of data and statistical methods Translation of ideas into formal models through mathematics, and testing of the ideas/models through the use of statistical methods (more in chapter 2)

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

Challenges for todays society

Unemployment rates among young people are at historic highs
Government balance sheets are in disarray Inequality is on the rise. In addition, the world simultaneously faces structural upheaval: overpopulation climate change political instability globalization These issues challenge us to understand and formulate policies

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

But there is Good News too

Literacy rates rising dramatically in the developing world
Child mortality has plummeted Family size is a fraction of what it was 50 years ago

Prosperity is on the rise in much of Asia

Life expectancy is increasing universally

Deaths through wars are in a state of long term decline.

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

Microeconomics and Macroeconomics

Macroeconomics studies the economy as a system in which feedbacks among sectors determine national output, employment and prices Microeconomics is the study of individual behavior in the context of scarcity In a mixed economy goods and services are supplied both by private suppliers and government

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

Government

Government is not an add-on to our economy.

It plays an integral role in regulating, redistributing and enforcing contracts. Without this legal structure the private sector could decline into a state of Hobbesian anarchy

Example: Congo in the modern era

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

Understanding Economics through the Use of Models

A model is a formalization of theory that facilitates scientific enquiry
A theory is a logical view of how things work, and is frequently formulated on the basis of observation Frequently we transform theories into models and test the theories in this way by confronting them with data and statistical analysis . Examples below

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

Markets, Trading and Opportunity Cost

Markets are central to our economic lives they permit us to trade, work efficiently and improve our living standards
Example of Gardner and Plummer who are neighbors: Trading skills == market place Let us take a numerical example that we can develop into a model of production and exchange.

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A Model of Exchange and Specialization

Table 1.1 Production Possibilities in a Two-Person Economy
Hours/fish Amanda Zoe Hours/vegetable Fish production Vegetable production

3 2

2 4

12 18

18 9

Each producer has a time allocation of 36 hours

By allocating total time to one activity, Amanda can produce 12F or 18V Zoe can produce 18F or 9V By splitting their time each person can also produce a combination of the two

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Opportunity Cost

The opportunity cost of a choice is what must be sacrificed when a choice is made Zoes opportunity cost is 1:2 (1 unit of V for 2 units of F) Amandas opportunity cost is 3:2 (18 units of V for 12 units of F)

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Specialization
Lets now see what can happen as a result of each individual specializing in the production of the good where their opportunity cost dictates: Amanda specializes in Vegetable Zoe specializes in Fish

We are about to develop our first graphical model

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Absolute Advantage - Production

Vegetable
18 Amanda specializes Amandas PPF Amandas assumed initial consumption
Amandas initial consumption is {6, 9} and Zoes is {9, 4.5}. With specialization they can produce a greater total {18, 18} than when operating individually. Hence, if they trade, after specializing, they each have the potential to consume more.

9 Zoes PPF

* 6,9 Zoes assumed initial consumption

9,4.5 * Zoe specializes

12

18

Fish

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From Production to Consumption

Let us see how specialization, that produces more output can translate into more consumption. It is consumption rather than production which is of ultimate interest

First they must decide upon a rate at which to exchange the two goods:

If each individual is to benefit this rate should lie between their individual rates of transformation. To illustrate: suppose they exchange at a rate of 1:1

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

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Absolute Advantage - Consumption

Vegetable 18
Amanda specializes
With specialization, and trade at 1:1, they consume along the line joining the specialization points

Amandas assumed final consumption 8,10 Amandas initial consumption = {6, 9} 10,8 Zoes final consumption

If Amanda trades 8V
to Zoe in return for 8F Amanda moves to the point {8, 10} and Zoe to {10, 8}. Both consume more after specialization, relative to prespecialization

Zoes initial consumption = {9, 4.5}

Zoe specializes

18 Fish

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From Individuals to the Economy

Can we represent the production possibilities of the whole economy by aggregating the production capabilities of each individual?

The economy-wide PPF is the set of products combinations that can be produced in the economy when all available productive resources are in use.

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Economy-wide PPF
Vegetable

a 0, 27

With complete specialization this economy can produce 27V or 30 F PPF for whole economy
From a, to produce Fish it is more efficient to use Zoe because her opportunity cost is less (segment ac). When Zoe is completely specialized Amanda is used (section ce) Zoes PPF 12 18 Fish

18

c 18,18
Amandas PPF

e 30, 0
18

Chapter 1 - Microeconomics, Curtis & Irvine, 2013

A Multi-person PPF
Vegetable
The PPF for the whole economy abcde, is obtained by allocating productive resources most efficiently.

b
c

The opportunity cost in the economy of producing more fish is the amount of vegetable that must be foregone.
Opportunity cost depends upon how much of the economys productive resources (individuals) are already producing F and V. The opportunity cost along bc differs from along cd With many individuals the PPF is the concave envelope of the individual capabilities

Fish

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Growth and the PPF

Services A Smax Smax S1 S0 a

PPF1 PPF0
X0 X1

Economic growth or an increase in the available resources can be envisioned as an outward shift in the PPF from PPF0 to PPF1. With PPF1 the economy can produce more in both sectors than with PPF0.

G0 G1
Chapter 1 - Microeconomics, Curtis & Irvine, 2013

Goods B b Gmax Gmax

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Recessions and Booms

In an economic recession output

falls below the economys capacity output

A boom is a period of high growth

that raises output above normal capacity output.

illustrate through the PPF

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Booms and Recessions

Services Economic recessions leave the economy below its normal capacity; the economy might be driven to a point such as Z. W
X

Smax

S0
Z PPF

Economic expansions, or booms, may drive capacity above its normal level, to a point such as W.

b G0
Chapter 1 - Microeconomics, Curtis & Irvine, 2013

Goods

Gmax
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Productivity of the Economy

The productivity of labour, defined as output per worker, depends on: the skill, knowledge and experience of the labour force the capital stock: buildings, machinery, equipment, and software the labour force has to work with the current technology embodied in the labour force and the capital stock.

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Full Employment and the PPF

When everyone who is willing to work at current wage rates and normal hours of work is actually working, the economy is a full employment
In this state the economys actual output is also termed its capacity output or full employment output In 2012 the actual unemployment was 7.3% in Canada. Economists believe that full employment corresponds to approximately 6% unemployment Hence the PPF in Canada has an associated unemployment rate of 6%!

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Chapter Summary
Economics: methods and ideas for the improvement of society
Economists use models to test theories with data Markets improve the economys efficiency

Opportunity cost reflects the alternative possibilities

Production possibility frontier represents the capabilities of the

economy when functioning efficiently

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Chapter Summary
Absolute advantage refers to greater absolute efficiency
Specialization increases consumption possibilities With many individuals the PPF may be concave

Economic growth shifts the PPF

Booms and recessions see increases and decreases in output

beyond what is normal

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