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Summary Introduction to economics
- Instelling
- Rijksuniversiteit Groningen (RuG)
Complete summary for the Introduction to Economics course 2020: all the graphs and calculations needed for this course are included.
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Voorbeeld van de inhoud
Introduction toEconomics
Exam Notes
,Week 1
, Week 1
Core Principles of Economics
AGENDA
5 weeks on micro-economics: consumers and firms
2 weeks on macro-economic: economy as a whole
=Explanation
=Calculation
Micro and macro economics
Microeconomics: Focuses on individual people and businesses
Examples: Supply and demand, competition, property rights, problems with markets and the economies of healthcare
Macroeconomics: Focuses on economy as an organic whole
Examples: Interest rates, inflation and unemployment, study of economic growth and moderation of recessions
Central question of this course
How does the economy work, including markets, and when is government intervention in markets necessary?
Course outcomes
Describe the core principles of economics
Explain how consumer and producer behaviour gives rise to a market equilibrium
Clarify the various forms of market failures and the welfare impact of government interventions
Discuss the economy as a whole and policy options to address inflation and recession
Apply simple micro and macro-economic techniques
LEGAL RELEVANCE OF ECONOMICS
You cannot have a legal career without encountering economic considerations/arguments
Why?
1. Individuals weigh costs and benefits
- Could be policy makers/entrepreneurs/criminals
-Individuals are rational and weigh costs/benefits when considering taking action
2. Judges stress the role of efficiency in law
-Need to know about economics in court because there are economic cases and arguments
-Economics is one way of looking at the law-need to look at things from different angles in law
3. Lawyers are increasingly confronted with economic arguments
A. Efficiency operations in courts
B. Efficiency in government policy-law can actually require that you weigh costs and benefits in policy
4. Efficiency has become more important due to liberalization and privatization of previously government
owned companies
Overall, economics is on the rise but it has also been heavily criticised
WHAT IS ECONOMICS
Economics is about humanities struggle to achieve happiness in a world full of constraints
It is the science that studies how people make everyday life choices
PRINCIPLES OF ECONOMICS
If you allow individuals to perform transactions within an efficient legal framework they are in a position to improve
welfare
,Core Principle 1: Efficiency
Efficiency is at the centre of economics; it’s the most important concept of economics
-Economists strive for efficient laws/regulations/decisions/actions which contrasts with how lawyers usually think in
terms of fairness
What does efficiency mean?
Economic efficiency [strict terms]: cost-benefit
-We want to maximise net benefits
-Want highest possible benefits and lowest possible costs
Need to be talking about both costs and benefits to be looking at economic efficiency
What does efficiency not mean?
1. Cost effectiveness [narrower concept]: Focuses on costs only
-Reducing costs
Example:
Politicians cutting the number of judges to save costs; not looking at the benefits; reducing costs is not necessarily
efficient is the balance between cost and benefit is not considered
2. Transaction costs [narrower part of costs]: Information costs, Bargaining costs, Monitoring costs, Enforcement costs
Information costs: Consumers/producers make decisions about products in the market and they must inform
themselves
Monitoring/enforcement: Contracts may need to be concluded which have to be monitored and enforced; a
consumer buying a product must get what they have paid for
Philosophical outlook on efficiency: Pareto-efficiency
An economic situation in which it is impossible to make one party better-off without making another party worse-off
When this is true, the situation would be deemed pareto efficient
Example:
Taking one euro from each law student and giving it to each economic student; one group is better- off, but the other is
worse off= not pareto efficient
Core Principle 2: Welfare
Economists want people to be happy and become happier if possible
-All about satisfying the consumers desires
Analytical basis: Welfare economics
-Core question when applied to law: Do legal rules increase welfare or not?
Welfare=Utility [same word] =satisfying peoples desires [clearer definition]
-Desires can be monetary or non-monetary (such as a calm environment)
Welfare:
Concept that is subjective
-Similar phenomenon increases welfare for some while decreasing it for others
-Something can make you happy but can actually leave somebody else unhappy
Concept that is indifferent
-In economics we are indifferent to other people’s preferences; this means we do not judge their desires as long
as this will make them happy
Nuisances
-However, If the thing you do actually creates a nuisance to others welfare then economics says that something
should be done
Scarcity is important;
-People have limited means [time, money and labour]
-People want to achieve the highest possible welfare with these limited means
-Economics has concepts in order to make this happen
Core Principle 3: Transaction
Transaction=transfer of property rights
-People make transactions all the time such as grocery shopping or paying tuition fees
Simultaneous economic and legal change:
, Physical transfer of goods or service=Economic transfer of money+ Legal transfer of property rights in return
Transaction costs: Such as notary costs when buying a house
-The sale has to be registered at a notary office for you to receive the property rights of that house
-You receive benefits that are higher than the transaction costs
ECONOMIC APPROACHES
The evolution of economic theory
1. Neo-classical economics
-First approach to economics- still important today but now only part of the story
-Focus on;
Production costs and willingness of consumer to pay
Rationality
-Assumption that producers and consumers were always rational
2. Neo- institutional economics (1900s)
-New wave of economics
-Focus on;
Transaction costs not just production costs
-Cost of people exchanging goods and services
Bounded rationality
-Not just assuming rationality but considering the limits to rationality
-People are thought to strive for rational decisions but they are hampered by all sorts of uncertainties such as
imperfect information
3. Behavioural economics
-Combination of economics and psychology
Cognitive costs
-Costs for you to make decisions
Predictable irrationality
-The assumption of rationality is replaced by the idea that people are predictably irrational
MEASURING COSTS AND BENEFITS: CALCULATING EFFICIENCY
Although we know that people sometimes act irrationality, economists believe that we should strive for rational decision
making by entrepreneurs, policy makers, judges
When striving for efficiency you want to maximise net benefits
Three lessons to measuring this;
Lesson 1: Don’t forget opportunity costs
Explanation of opportunity costs
You can only do one thing at a time which means that you are always giving up a bunch of other things
Opportunity costs= It refers to the value of the next best alternative that must be foregone in
order to undertake an activity
Simplistic explanation:
-Means the value of what you could have done instead; the reason you make the choice is because you
perceive the value of the option you take to be higher
Overall:
Rational decisions always depend upon the opportunity costs
Opportunity costs are the value of the next-best alternative which must be less
How it works
You need to simplify a decision down to only two options
You can choose option X versus the next best alternative option out of all the possible options there are
Option 1: You should go with X rather than the next best alternative option only if the pleasure you will receive from
option X exceeds the opportunity cost of foregoing the next best alternative option
Option 2: You select the next best alternative option only if the opportunity cost of foregoing it exceeds the pleasure you
would get from consuming option X
,Application
1. Out of a choice of 4 deserts, select one at random and this becomes X
2. Out of the remaining 3 deserts identify the one you like best of the group, this becomes the next best alternative option
3. Not determine whether option 1 or option 2 is true
Option 1: Now you will opt for option X only if the opportunity cost of foregoing it exceeds the pleasure that you would
get from the next best alternative option
Option 2: Now you will opt for the next best alterative option only if the opportunity cost of foregoing it exceeds the
pleasure that you would get from X
Lesson 2: Ignore sunk costs
Explanation of sunk costs
Sunk costs= Past costs that have already been incurred and cannot be recovered whether or not future action is
taken and should not affect current or future decision making
Simplistic explanation:
- Expenditures you made in the past that don’t play a role in deciding about the future; they are in the past and
they cannot be changed, the expenditure is gone
Overall;
Irrelevant to the decision of whether to take an action
-For the future the only thing that is relevant is the marginal benefit of additional actions in the system
v the marginal costs of doing so. If the marginal benefit is higher then you should take the action.
Rational decision makers compare benefits only of the additional costs when taking an action that must
be incurred
-Looking at future actions and not at past expenditures
Application
Question: When you pay $15 to get into an all you can eat restaurant and are deciding how much you should eat should you think
about sunk costs?
Answer: Economists believe not, this cost is not in the past and for example you wouldn’t refuse $1,000 to eat at a next door
competitors restaurant now just because you felt you had to get your money’s worth out of the $15 restaurant.
Lesson 3: Relevant costs and benefits are marginal
-This lesson links to the previous
Explanation of marginal costs and benefits
Marginal costs and benefits: Marginal is an economics term which parallels with the common word ‘extra’.
You need to assess if the extra costs of the action are higher than the extra benefit.
Marginal cost: The additional cost incurred in the production of one more unit of a good or service. Fixed costs
do not change as output changes, hence no additional fixed cost is incurred in producing another unit of a good
or service once production has already started.
Marginal benefit: The additional satisfaction or utility that consumer receives when the additional good or
service is purchased.
Simplistic explanation
-Not about total costs and total benefits when deciding about action but marginal
Overall;
At every step: compare the additional costs and benefits of that step before taking it
The level of an activity should be increased only if the marginal net benefit is positive
-So, when marginal benefit exceeds the marginal cost
How it works
If the marginal benefits exceed the marginal costs then you should take the action, however, if the marginal costs exceed
the marginal benefits then you should not take the action
Application
,Question: The local government builds 3 bridges at $10 million per bridge and the total benefits of the 3 bridges is $36 million, so
that’s an average of $12 million per bridge. A politician wants to build a 4 th bridge arguing that $10 million cost and $12 million
benefit per bridge brings society a net gain of $2 million. Should you build the bridge or not?
Answer: The fourth bridge actually needs to be much longer to cross this part of the river so it will cost $15 million, the marginal
benefit of this bridge given that there are already 3 is $8 million. This means that the marginal costs outweigh the marginal
benefits and the bridge should not be built.
THE SCIENCE OF HOW PEOPLE DEAL WITH SCARCITY
Economics studies how people and societies make decisions to allow them to get the most out of their resources
Goal: Convert humanities limited resources into goods and services that best satisfy human wants
Economists analyse the decisions people make on what to produce and consume
Maximising social welfare
Scare resources:
Resources are in limited supply; economists are challenged with maximising social welfare under scarcity
Land, labour, capital and human capital are ‘production factors’ or input factors: when combined they are used to
produce goods and services
Land: All naturally occurring resources used in production process
The weather, plant and animal life, geothermal energy and the electromagnetic spectrum
Labour: The physical and mental talents of individuals that produces things
A tree doesn’t become a house without human intervention
Capital: Human made machines, tools and structures that aren’t directly consumed and used to produce things
that people do directly consume
Factories, roads, sewers, electrical grids, the internet
Note: A car that you drive for pleasure is a consumption good, the identical car used to haul around
bricks for your construction business is capital
Human capital: The entrepreneurial abilities
-Individuals leading companies and putting all these factors; land, labour and capital together to produce goods
Note: Difference between labour and human capital is that labour is work at a known task whereas
human capital is the skill of improving, without which we would be stuck making the same thing in the
same way forever
Production Possibilities Frontier [PPF]
Explanation of PPF
There is a limited availability of land in a state, a certain group of people able to work and a number of
machines and computers
PPF=Graph that shows the various combinations of output that the economy can produce given its production
factors. It captures the effect of scarce resources on production
Assume:
-Fixed resources
-Fixed technology
-Full employment
How it works
Shows the various combinations of two outputs that can be produced and allocates one input between the two
You plot on a graph the various combinations of two output goods that can be produced as you vary the amount
of a resource that is allocated between them
What is the input in PPF?
The input is any combination of the four actors of production: natural resources, labour, capital and human capital
The manufacture of most goods requires a mixture of all four.
Plotting the graph
,How many computers and cars could you produce in country A?
There are production alternatives/possibilities
F=Attainable but inefficient point
-You could produce more computers and cars given the production factors in your country than this, therefore F
is an inefficient point
G= Unattainable point
-With the production factors in your country you are not able to produce this
Interpreting the graph
Any point that lies on the PPF is efficient because you are wasting no resources
You trade-off between the two different outputs as you slide along the graph, you have to make this trade off because
there is an assumption with this graph that there is no wasted labour (unemployment), resources or technology around in
which you could increase the production of one without decreasing the production of the other
Innovation and investment
PPF shows the trade-offs that a society faces
Short run: Producing more computers means you can produce fewer cars
-You have to make a choice between the two
Long run: Increase production of both goods through;
1. Technological innovation:
If new machines are developed you may be able to produce more goods
2. Investment:
In research and development and in new factories and equipment’s so that you can produce more
Drawing a new PPF
Technological innovation and investments are crucial for the economy
The graph demonstrates what happens- what you are able to realise once you
have innovated and made investment
Focus: Improvements in technology
Improvements in technology mean that people are able to produce more from a
given set of resources than before
A. For both goods
Increased productivity is shown in the PPF by a shift outwards
The technological shift is balanced because it increases your ability to produce more
of both goods
Example: Improvements in fertilizers may increase crop yields for apples and oranges
B. For only one good
Most technological innovations are biased shown by the fact that the PPF does not
shift out evenly
, An improvement in technology will benefit one while having no effect on the production of the other
Example: Improvement in steel making technology will allow you to make more steel but will have no effect on the production of
wheat
Deciding what to produce
Once the frontier of efficient output combinations has been located the next step is to choose the point along the frontier
that produces the combination of goods and services that makes people most happy
Optimal allocation
Explanation of optimal allocation
How to achieve an optimal allocation of those production factors? Who makes the decision on what will actually
get produced to please the most people?
Optimal allocation =allocate production factors in such a way that consumers are most happy; consumer
preferences are satisfied.
Option 1: Top-down= Central planning
Triangle: Government, producers, consumers
Central agency decides (top-down):
-Production targets (what/how much)
-Planning of how to achieve the targets (how)
-Distribution of goods and services (for whom)
Why is this not optimal?
If the government decides what should be produced for the consumers there is a problem because producers know all
about their costs and consumer know best their preferences; information asymmetry means that the government doesn’t
understand how companies should be run and what consumer want. If a central agency gets to decide on what is
produced, how it is produced and for whom it is produced then you end up in an inefficient situation.
Classic example: Former Soviet Union, Early 20th century China and North Korea
Option 2: Bottom-up=markets
Triangle: Producers, consumers, central government
Individuals and firms interact within a regulatory framework=Mixed economy
or regulatory capitalism
-You have markets operating within a regulatory context [contract law,
liability law, property law]
-You get decentralized decisions on:
Which career you want to take
Which products you want to buy
Where you want to start a business
-Who gets what is decided by: purchasing power and individual preferences
Classic examples: Germany, Hong Kong, USA
Why is this optimal?
The best knowledge of what the consumers want is with the consumers themselves not the central government;
The same is true for companies who know best the cost of producing goods/services
We make use of the markets to exploit both these advantage
PPF, MARKETS AND REGULATION
In terms of the PPF graph, government interventions cause the economy to produce an output combination different to
the one that society would have needed up with if the markets make the decision
The three types of economic system
, Market economy (laissez faire): An economy in which almost all economic activity happens in the markets
with little or no interference by governments. No pure market economy has or probably will ever exist.
Command economy: An economy in which all economic activity is directed by the government. There are a
few totalitarian states such as North Korea still running command economies.
Traditional: An economy that is dependent on longstanding cultural traditions. For example until the caste
system was abolished in India production of nearly every good and service could only be done by somebody
born into the appropriate caste.
Opting for a mixed economy
Most societies not opt for a mixed economy
Mixed economy: Free market that takes place within a regulatory framework. Governments and markets share
responsibility
THE PROBLEMS WITH MARKETS AND GOVERNMENT REGULATION
Markets economies
Why are economists so enthusiastic about markets?
-Markets are able to achieve an efficient allocation of resources in order to realise maximum welfare for society
Markets: A collection of billions of face to face transactions between buyers and sellers. It is what happens
when one individual offers to sell something to another individual at a price agreeable to both. It is the supply
and demand for a certain good or service (Abstract concept)
Supply [by producers]
Demand [by consumers]
We talk about regional, national and international markets for an individual product such as tomatoes; this is what we call
the relevant market
Market failures
Explanation of market failure
Market failure: Situations in which markets do not produce socially optimal outcomes
-Economists have written extensively about market failures and what to do in those cases; we should not assume
that economists only want markets and non-economists want government intervention
-Economists emphasise that if markets fail then the government needs to step in with regulation
Categories that economists distinguish as market failures where the government should step in with regulation;
1. Imperfect Competition
-When they are not constrained by competition, firms do not end up acting in a socially optimal way
Monoploy: There is only one firm in an industry so it has no competition. They may restrict output to drive up
process and increase profits
Oligopoly: There is only a few firms in the industry. Firms make deals not to compete against each other so thy
can keep prices hight and make bigger profits.
2. External effects
-Damage done to others such as environmental pollution
-Either products that are produced produce pollution or the consumption of it does
-Government needs to repair or prevent damage by designing property rights to this effect
3. Public goods [AKA collective goods]
-Goods or services which are valued by consumers but not provided by the market because consumers tend to
freeride on them and benefit without paying
-If everybody free rides then the good disappears
Example: Dykes or justice system in society
4. Information asymmetries
-Either the buyer or the seller knows more about the quality of the good he or he is negotiating over than the other
party; the suspicion created could mean that allot of potentially beneficial economic transactions never get
completed
-If consumers are not able to fully understand the characteristics and risks of a product then government needs to
step in for example with labelling requirements
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