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1 ECON649/ECON991 Lecture 1. 2 Overview Administration and Introductory Comments The Economic Problem The Price Mechanism.

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Presentation on theme: "1 ECON649/ECON991 Lecture 1. 2 Overview Administration and Introductory Comments The Economic Problem The Price Mechanism."— Presentation transcript:

1 1 ECON649/ECON991 Lecture 1

2 2 Overview Administration and Introductory Comments The Economic Problem The Price Mechanism

3 3 Administration My name is email: Download a copy of the unit guide from the unit web page: 3 hours of lectures per week 3 workshops held during normal lecture times in weeks 5, 7, and 13.

4 4 Workload You should be spending at least 6-9 hours at home studying this unit each week.

5 5 Key Dates for Within Semester Assessment Tasks Test 1 – First hour of the week 4 lecture. Note: For this test you must attend the lecture in which you are enrolled. Joint ECON649 and 991 assignment to be handed in during class in Week 9 (November 8 – 12) – No late assignments accepted. ECON991 students only hand in their second assignment at the front desk on Level 2 of E4A on the 2 nd of November – No late assignments accepted.

6 6 Textbook Hubbard, R.G., Garnett, A.M., Lewis, P., and O’Brien, A.P., 2010, Essentials of Economics, Pearson Education, Australia.

7 7 Web Resources The unit web site is at MyEconLab – see unit web site for details about how to access MyEconLab

8 8 Course Outline A.MICROECONOMICS 1.Introduction: The Economic Problem, An Overview of the Price Mechanism, Reasons for Government Intervention 2.Supply and Demand Analysis 3.Applications of Supply and Demand, Elasticity Concepts 4.Production and Costs 5.Pricing in Different Market Structures: Perfect Competition and Monopoly

9 9 Course Outline B.MACROECONOMICS 1.Introduction to Macroeconomics; An Overview of Keynesian Theory & Classical Theory 2.The Income-Expenditure Model; Inflationary and Deflationary Gaps; Multipliers 3.Money and Interest Rates 4.AD-AS Model 5.Monetary & Fiscal Policy

10 10 What is Economics? Economics is concerned with how society allocates scarce resources in order to satisfy unlimited wants. There are 2 branches of economics: MICROECONOMICS and MACROECONOMICS Micro=smallMacro=large

11 11 Microeconomics Is concerned with economic decisions made by a single individual, household, firm or industry. e.g. The market for petrol. If the price of petrol increases will an individual person buy more or less? Will a petrol producing firm supply more or less petrol to the market?

12 12 Macroeconomics Is concerned with economic decisions and the performance of the economy as a whole. It examines economy-wide variables such as inflation, unemployment, exports, imports, and the exchange rate; as well as the effects of changes in policies, such as monetary policy and the federal budget (fiscal policy).

13 13 Fallacy* of composition Fallacy of Composition – fallacy that what is true for the individual is true for the group The basis for distinguishing between micro and macro-level analyses * Fallacy means a misleading or false idea

14 14 Post Hoc Ergo Propter Hoc (Fallacy of Association) Latin phrase meaning “after this, therefore because of this” Fallacy that a first event causes the second event, because the first event occurred before the second

15 15 Positive & Normative Statements Positive statements – statements that can be verified by reference to facts Normative statements – statements that involve opinions, “what ought to be”; they cannot be tested

16 16 Economic Models We use the scientific method to develop models: 1.Identify the variables of interest. 2.Formulate a theory or hypothesis which tries to explain relationships between the variables. Need to make simplifying assumptions. 3.Test the predictions of the theory to see if they line up with reality. 4. If the model works we can use it to make forecasts or predictions, otherwise we need to start again.

17 17 Ceteris Paribus One of the most important assumptions in economics is CETERIS PARIBUS. Ceteris Paribus = all other things remain constant (or unchanged)

18 18 The Economic Problem We live in a world of unlimited wants. Resources are scarce. Wants > Resources Our desire for goods and services exceeds the capacity of the economy to produce those goods and services Therefore choices have to be made.

19 19 Resources = factors = inputs There are 4 factors of production: 1.Land – any natural resource, e.g. land, coal, oil, water, air. Can be renewable or non-renewable. 2.Labour – the mental and physical capacity of people to produce goods and services. Includes both time spent working and work effort. Is influenced by quality (e.g. education level, health) and quantity. 3.Capital – physical equipment, buildings and machinery used to produce other goods and services. 4.Entrepreneurial ability – special human skill. An entrepreneur is someone who creates and runs a business and organises the other factors of production to make goods and services.

20 20 Resources = factors = inputs The incomes earned by these factors are: 1.Land → rent 2.Labour → wages 3.Capital → interest 4.Entrepreneurial ability → profits

21 21 Resources produce commodities. commodities = goods + services  tangible intangible Goods & Services = means of satisfying wants

22 22 Choices All societies face choices of: What to produce? How to produce? For whom? At the level of an individual consumer choice is an every day fact of life

23 23 Choices Consider a consumer with a certain amount of money, he decides to buy more books Could say cost of a book = so many dollars OR Look at cost in terms of what other consumption our consumer must forego to obtain this item.

24 24 Choices Suppose consumer gives up some movies If P book = 3 times price of a movie then cost of a book = 3 movies forgone.

25 25 Opportunity Cost Economists use the term, opportunity cost to express the cost of a given activity in terms of the value of the next best alternative forgone Opportunity cost = opportunity lost

26 26 Opportunity Cost individuals Opp cost applies tofirms economy (e.g. the cost of a new road can be expressed as so many new hospitals forgone)

27 27 Rational Self Interest This is a key assumption in microeconomics. A rational self-interested individual uses all available information to achieve their goals. A rational self-interested individual attempts to achieve something desirable to his or her own self. A rational self-interested individual weighs the benefits and costs of an action, and they only choose to undertake an action if it has a positive net benefit. Net Benefit = Benefits - Costs When choosing between different actions a rational self- interested individual will choose the action with the greatest positive net benefit.

28 28 Marginal Analysis Rational self-interested individuals are assumed to know that optimal decisions are made at the margin. Recall that scarcity → need to make choices Frequently choices being made involve incremental or decremental changes to the status quo*. (*status quo = the existing situation)

29 29 Marginal Analysis Consumers are concerned with whether to purchase an extra juice, whether to spend an extra hour studying. Producers may face choice about whether to run an extra post graduate class, whether to produce an extra kilo of bananas. These are all marginal decisions.

30 30 Marginal Analysis Each decision yields some additional or marginal benefit (MB) and incurs some form of marginal cost (MC). If MB > MC then the activity will yield a net benefit and a rational individual will be induced to undertake the activity. Marginal Analysis = techniques of assessing costs and benefits at the margin to decide: –if  status quo worthwhile and –The ideal level of activity

31 31 Scarcity, Choice & the Production Possibility Frontier (PPF) We can use the PPF to illustrate the economic problem. Assume:  Given time period  Given technology  Fixed supply of resources  Economy produces two items (“guns” and “butter”) Assumptions designed to “freeze” the economy so we can focus on the production possibilities given the available resources and technology

32 32 PPF shows all the maximum combinations of guns and butter that can be produced if all available resources are fully employed and used efficiently. Q of Guns Q of Butter T D 0 PPF

33 33 *If all resources devoted to butter production → OD units of butter But zero guns *If all resources devoted to production of guns → OT units of guns but zero butter *All points on PPF between end points  butter plus guns Q of Guns Q of Butter T D 0 PPF A B M R PS E K X

34 34 PPF is concave to the origin (more on this later). PPF separates attainable from unattainable output combinations. Attainable = combinations on & underneath PPF = Q of Guns Q of Butter T D 0 PPF A B M R PS Z F

35 35 The slope of the PPF =  guns/  butter = quantity of guns that economy must forgo if butter production is increased by 1 unit Q of Guns Q of Butter T D 0 PPF A B M R PS C G V Q NW

36 36 *The negative slope shows the opportunity cost when production of one of the goods in the diagram is increased. *Movement A → B shows movement into more butter production *The opportunity cost of producing PS more butter is distance MR of guns forgone. Q of Guns Q of Butter T D 0 PPF A B M R PS

37 37 The concave shape of the PPF reflects the law of increasing opportunity cost. Law states as more of a particular good is produced, larger and larger Q’s of an alternative good must be forgone. This is shown by an increase in the slope of the PPF as we move along it. Q of Guns Q of Butter T D 0 Slope increasing along PPF

38 38 Compare points A and G regarding size of  guns when butter ↑ by 1 unit. What is the economic rationale for increasing opportunity cost? Q of Guns Q of Butter T D 0 A B M R PS C G V Q NW small - ∆ guns large - ∆ guns

39 39 What is the economic rationale for increasing opportunity cost? ANSWER: Resources are not completely adaptable to alternative uses (i.e. some resources are better suited to the production of one good than another). Butter ↑ and ↑ takes more and more resources most suited to gun production  increasingly greater sacrifice of guns With perfect adaptability of resources → straight line PPF → constant slope → constant opportunity cost

40 40 PPF is quite illuminating: Illustrates concept of scarcity With given amount of resources, economy can only achieve certain combinations of G & S –Not all wants can be satisfied during given time period –Need to make choices about which combination of G & S to produce Choice  opportunity costs are involved Concavity illustrates law of increasing opportunity cost

41 41 Shifts in the PPF A change in the availability or amount of resources will cause a shift in the PPF. Q of Guns Q of Butter 0

42 42 Shifts in the PPF A change technology may cause both a change in the slope and location of the PPF. The change does not have to affect both goods equally. e.g. diagram shows effects of a positive change in technology for gun production only (suppose found a more efficient way of producing guns) Q of Guns Q of Butter 0

43 43 Alternative Economic Systems or Economies Returning to the questions of: –What ? –How ? –For whom ? Different types of economic systems answer these questions differently.

44 44 Tradition-oriented economy Main forces organising production and distribution = custom & tradition Tasks and skills handed down Distribution is via age-old patterns e.g. communal feasts

45 45 Command or centrally planned Economy Central planning authority asserts its will on: –How many guns, cars, bottles, etc.. –Plus how to produce required G & S

46 46 In a pure market economy, Mechanism is known as “market mechanism” Prices & Markets & Individuals Provide mechanism for communication and coordination of different choices being made Market Economy

47 47 Functions of Price Prices are the language of markets. They transmit information between market participants. Prices have an important role as measure of exchange value.

48 48 Functions of Price Additionally:  P’s are a rationing device  P’s act as an incentive  P’s serve to allocate resources  P’s serve as income  P’s also viewed as cost of production Microeconomics is so concerned with prices and impact of price changes that it is often called Price Theory.

49 49 Mixed Economy The Australian economy is a mixed economy. It is market-oriented but it also has a command element since government plays an important role. Government intervenes in both macro and micro economy. The government sector is also called the public sector.

50 50 The Size of the Government Sector There are three commonly used ways of measuring the size of the government (public) sector 1.The value of the goods and services produced by the government as a proportion of total production in the economy (gross domestic product, GDP). 2.The number of people employed as a proportion of total employment in the economy. 3.The level of government expenditure as a proportion of total expenditure in the economy (as measured by GDP). This measure includes transfer payments, such as pensions, unemployment benefits and family support payments.

51 51 The Size of the Government Sector Method of measurementAustralia, 2008 Government purchases as a percentage of GDP 22% Government employment as a percentage of total employment 16% Government expenditure as a proportion of total expenditure 35%

52 52 Source: Annex Table 25, General Government Total Outlays, OECD, 2008 Government Expenditure by Country, 2008: Hubbard et al Figure 11.1 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

53 53 Government Expenditure on Goods and Services as a percentage of GDP, Australia, 1960-2008: Hubbard et al, Figure 11.2 Source: Source: Reserve Bank of Australia (2008), Gross Domestic Product-Expenditure Components, Table G11. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

54 54 Source: Australian Government (2007), Budget 2007–08, Appendix D—Australian Government Taxation and Spending. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Federal Government Expenditure by Function: Hubbard et al, Figure 11.3 Please insert Figure 11.3 from page 328, as large as possible while retaining clarity.

55 55 REQUIRED READING This week’s lecture: Introduction to Economics Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics Chapters 1 & 2, Ch 11(pp 324-332 only)

56 56 REQUIRED READING Next week’s lecture: Reasons for Government Intervention Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics Chapters,3, 5(pp. 131-136) & 11 (pp. 324-332) Demand and Supply Hubbard, Garnett, Lewis & O’Brien, Microeconomics Chapters 3 & 5(pp.125-143)

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