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Summary EC100 MT notes
Clear, detailed yet concise notes on the Michaelmas Term material. I got a First Class Honours (85%) in the January exams.
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1. INTRODUCTIONKey ideas
• Economics is the study of people’s choices: ‘choice - not money - is the unifying feature of all things that economists study.’
• First principle of economics: people optimise
• Second principle of economics: economic systems tend to be in equilibrium (a situation in which nobody would benefit from
changing their behaviour)
• Third principle of economics: empiricism (economists use data to understand the causes of things)
1.1. THE SCOPE OF ECONOMICS
Economic agents and economic resources
An economic agent is an individual or group that makes choices (consumer, parents, criminal, senators, governments…)
Scarce resources are the things that people want, where the quantity that people want exceeds the quantity that is available.
Definition of economics
Lionel Robbins: ‘the science that studies human behaviour as a relationship between ends and scarce means which have
alternative uses'. More formally, economics is the study of how agents choose to allocate scarce resources and how those
choices affect society.
Positive economics and normative economics
Positive economics describe what people actually do, these are objective statements tested with data. Describing what has
happened or predicting what will happen is known as positive economics.
Normative economics recommends what people ought to do, almost always dependant on subjective judgements.
Microeconomics and macroeconomics
Microeconomics is the study of how individuals, firms, households, governments make choices and how these choices affect
prices, the allocation of resources and the well-being of other agents.
Macroeconomics is the study of the economy as a whole. Macroeconomists study economy-wide phenomena like the growth
rate of a country’s total economic output, inflation rate (percentage increase in overall prices) or the unemployment rate.
Why do people cooperate?
It is desirable to do things for other people. Economies of scale, gains from insurance and gains from specialisation. Usually
people do something for others return for something else, this is called exchange.
Markets
Markets are social constructs, governed by laws where conflict and cooperation coexist. In some areas markets prohibited
(slavery), others deliberately created (carbon trading). It is estimated that around 20% of exchanges in human society are done
through markets.
Specialisation (division of labour) and exchange
Industrialisation can be thought of as people specialising much more in what they do and then exchanging what they produced.
Innovation has also been key in raising productivity. Exchange is important to support the innovation that has been so important
to raise the living standards.
, 1.2. THREE PRINCIPLES OF ECONOMICS
All social sciences study human behaviour, so what sets economics apart?
1. Optimisation means picking the best feasible option, given whatever (limited) information, knowledge, experience, and
training the economic agent has. Economists believe that economic agents try to optimise but sometimes make mistakes.
2. Equilibrium is the special situation in which everyone is simultaneously optimising, so nobody would benefit personally by
changing his or her own behaviour, given the choices of others.
3. Empiricism is analysis that uses data—evidence-based analysis. Economists use data to develop theories, to test theories,
to evaluate the success of different government policies, and to determine what is causing things to happen in the world.
1.3. THE FIRST PRINCIPLE OF ECONOMICS: OPTIMISATION
Evaluating the rationality of a decision means examining the quality of your initial decision, not the outcome. In cases where
agents make mistakes, prescriptive economic analysis can help them realise their mistakes and make better choices in the
future. Optimisation is about much more than money.
Trade-off and budget constraints
An economic agent faces a trade-off when the agent needs to give up one thing to get something else.
Economists use budget constraints to quantify trade-offs. A budget constraint shows the bundles of goods or services that a
consumer can choose given her limited budget.
Opportunity cost
Evaluating trade-offs can be difficult, because so many options are under consideration. Economists tend to focus on the best
alternative activity. We refer to this best alternative activity as the opportunity cost.
Cost benefit analysis
Cost-benefit analysis is a calculation that identifies the best alternative, by summing benefits and subtracting costs, with both
benefits and costs denominated in a common unit of measurement, like dollars. Cost-benefit analysis is used to identify the
alternative that has the greatest net benefit (the sum of the benefits of choosing an alternative minus the sum of the costs of
choosing that alternative).
1.4. THE SECOND PRINCIPLE OF ECONOMICS: EQUILIBRIUM
In equilibrium, everyone is simultaneously optimising, so nobody would benefit by changing his or her own behaviour.
The free-rider problem
The equilibrium prediction is that when people live in large rooming groups, they will have messier apartments than if the same
people each had their own apartment. Roommates who leave the cleaning to others are an example of something that
economists call the free-rider problem . Most people want to let someone else do the dirty work. We would like to be the free
riders who don’t contribute but still benefit from the investments that others make. Equilibrium analysis explains why individuals
sometimes fail to serve the interest of society and how the incentive structure can be redesigned to fix these problems.
1.5. THE THIRD PRINCIPLE OF ECONOMICS: EMPIRICISM
Sometimes causes are easy to determine, but sometimes identifying cause and effect requires great ingenuity.
THE SCIENTIFIC METHOD: Empiricism—using data to analyse the world—is at the heart of all scientific analysis. The scientific
method is the name for the ongoing process that economists, other social scientists, and natural scientists use to:
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