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ECON649/ECON991 Lecture 1.

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1 ECON649/ECON991 Lecture 1

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

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

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 2nd of November – No late assignments accepted.

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

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

Introduction: The Economic Problem, An Overview of the Price Mechanism, Reasons for Government Intervention Supply and Demand Analysis Applications of Supply and Demand, Elasticity Concepts Production and Costs Pricing in Different Market Structures: Perfect Competition and Monopoly

Introduction to Macroeconomics; An Overview of Keynesian Theory & Classical Theory The Income-Expenditure Model; Inflationary and Deflationary Gaps; Multipliers Money and Interest Rates AD-AS Model Monetary & Fiscal Policy

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=small Macro=large

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 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 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 Fallacy of composition EXAMPLE 1 – if one person stands up in a football stadium to get a better view they will – but if everyone stands up it is not true that everyone will have a better view. EXAMPLE 2 – a farmer experiences a very good season and his harvest of wheat is larger than normal, so he expects to do well financially. However, all the other farmers have also experienced the same season and their harvests are also larger than normal. The effect of this is to increase supply and cause the price of wheat to fall, so that the farmer does not make any extra return compared to other years. EXAMPLE 3 - A tiger eats more food than a human being. Therefore, tigers, as a group, eat more food than do all the humans on the earth. EXAMPLE 4 - Atoms are colourless. Birds are made of atoms, so birds are colourless. EXAMPLE 5 - Ocean Fishing: Every fisherman logically puts out more boats to increase profits. The additional profits provide funds for even more boats and fishing. But as total fishing approaches the sustainable ocean fishing capacity, the effort required per fish caught increases, which reduces profits because all are less efficient. EXAMPLE 6 - The fallacy of composition arises mainly in macroeconomics where economic units (households, businesses) are treated as if they were one unit. When individual parts interact with each other, the outcome for the whole may be different from that intended by the individual part. To illustrate: A firm (an individual part) lays off employees in order to cut down on expenses and increase profits. If all firms (the whole) do the same, incomes and spending will fall. The sales for the firm are smaller and its profits do not increase.

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 EXAMPLE 1 - You observe that when people put on their raincoats it then rains. You draw the conclusion that wearing raincoats causes it to rain. EXAMPLE 2 – I have a University degree and now I earn a high income. Therefore gaining any University degree will guarantee a person a high income.

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 Positive statements – statements that can be verified by reference to facts – they can be true or false, i.e.: what is e.g. The current rate of inflation is within the Reserve Bank of Australia’s target range of 2-3%. Normative statements – statements that involve value judgements, “what should be” – they express an opinion and cannot be tested against facts to be proved true or false e.g. Keeping inflation under control should be more important than keeping unemployment low.

16 Economic Models We use the scientific method to develop models:
Identify the variables of interest. 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 Ceteris Paribus One of the most important assumptions in economics is CETERIS PARIBUS. Ceteris Paribus = all other things remain constant (or unchanged) This assumption allows us to focus on the relationship between the variables of interest. Without it we cannot be sure whether the relationship we observe is due to the interaction of the two variables or caused by some other factor changing e.g. changes in income, population, preferences etc…

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. Choices involve: Rational self interest/ rational decision making – more on this later comparing marginal benefits to marginal costs – more on this later time and information

19 Resources = factors = inputs
There are 4 factors of production: Land – any natural resource, e.g. land, coal, oil, water, air. Can be renewable or non-renewable. 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. Capital – physical equipment, buildings and machinery used to produce other goods and services. 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. Resources are the inputs used to produce goods and services. LAND – means any resource provided by nature, such as forests, minerals, oil, wildlife, fish, the ocean, rivers, sun and moon. Some natural resources are renewable (i.e. can be replaced by nature without human interference, e.g. fruit, crops, animals). Others are non-renewable and as such will not automatically be replaced (i.e. coal, oil, copper, gold etc..). LABOUR – means the mental and physical capacity of workers to produce goods and services. Labour is affected by both quality (education, health, motivation, experience) and quantity (the sheer number of workers available). e.g. teachers, accountants, miners, football players, farmers, economists, sales assistants CAPITAL – is the physical plant, machinery and equipment used to produce other goods. Capital goods are those made to produce goods and services, but do not directly satisfy human wants. E.g. hammer, shovel, factories, office buildings, trucks, warehouses etc… IMPORTANT NOTE: The meaning of CAPITAL in ECONOMICS is not the same as the normal everyday meaning – it does NOT refer to shares, money, or the money value of assets – this is financial capital. ENTREPRENEURIAL ABILITY – is a special kind of human skill – they are people who are willing to take risks, organise production, find better ways

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

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

22 Choices What to produce? How to produce? For whom?
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 What to produce – what combination of goods & services are chosen. How to produce – aim to produce the most output at the lowest cost using the most efficient techniques. Depends on relative abundance of factors of production. For whom – the problem of distribution – depends upon your income.

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

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

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. That is whatever people’s preferences are they pursue them. They aim to make decisions that will leave them better off or at least no worse off than before.

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 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 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 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 PPF T 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 D Q of Butter

33 * If all resources devoted to butter production → OD units of butter
PPF T A * 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 M Q of Guns E K B R P X S D Q of Butter

34 PPF is concave to the origin (more on this later).
Z M 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 F B R Talk about what it means to be on a point inside the PPF – e.g. inefficient, resources may be unemployed. P S D Q of Butter

35 The slope of the PPF =  guns/ butter
A M C Q 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 G V B R P N W S D Q of Butter

36 * Movement A → B shows movement into more butter production
PPF T A * 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. M Q of Guns B R P S D Q of Butter

37 Slope increasing along PPF
T 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 D Q of Butter

38 What is the economic rationale for increasing opportunity cost?
small - ∆ guns T A M C Q 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 G V B R P N W S D large - ∆ guns Q of Butter

39 What is the economic rationale for increasing opportunity cost
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 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 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

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

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 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 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 Market Economy 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 mechanism – is the mechanism where wishes of consumers are matched those by producers. It allows for exchange to take place between buyers and sellers of g&s.

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. Exchange value – the value of a particular commodity which a person will be prepared to exchange for another commodity. If this other commodity is the standard medium of exchange (i.e. money) then the value of the commodity is its price.

48 Functions of Price P’s are a rationing device P’s act as an incentive
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. Rationing device – because supply is scarce (scarcity of resources) relative to demand, those consumers who cannot afford the goods will be eliminated from the market. Incentive – relative prices act as a guide to producers concerning what to produce, and which factors to employ. Also encourages resources into some activities and not others. Allocate resources – in choosing the most efficient mix of factors of production firms are guided by relative prices. Income – they are a payment for resources, e.g. wages are the price of labour. Cost of production – e.g. wages are a cost to firms

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 The Size of the Government Sector
There are three commonly used ways of measuring the size of the government (public) sector The value of the goods and services produced by the government as a proportion of total production in the economy (gross domestic product, GDP). The number of people employed as a proportion of total employment in the economy. 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 The Size of the Government Sector
Method of measurement Australia, 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% Note: Increases in government expenditure as a proportion of GDP will see the figures increasing significantly.

52 Government Expenditure by Country, 2008: Hubbard et al Figure 11.1
Figure 11.1: Government expenditure by country, 2008. Australia’s government expenditure is smaller than that of the UK and Canada, which are often considered very market based countries. It is much smaller than that of the government sectors of the countries of Scandinavia, such as Sweden. Source: OECD (2008), Annex Table 25, General Government Total Outlays, viewed 19 April 2008, at <>. Source: Annex Table 25, General Government Total Outlays, OECD, 2008 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

53 Government Expenditure on Goods and Services as a percentage of GDP, Australia, : Hubbard et al, Figure 11.2 Figure 11.2: Government expenditure on goods and services as a percentage of GDP, Australia, 1960 – 2008. Government expenditure on goods and services as a proportion of GDP fluctuated quite significantly during the 1960s, and then trended upwards until the mid-1980s. Government expenditure peaked in 1986 at almost 25%. Throughout most of the 1990s and early 2000s, there was a downward trend—in large part as a result of the microeconomic reform policies of governments during this time. Source: Reserve Bank of Australia (2008), Gross Domestic Product—Expenditure Components, Table G11, viewed 8 July 2008, at <>. 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 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. Figure 11.3: Federal government expenditure by function. The largest share of federal government expenditure in Australia is allocated to social security and welfare payments, 41% in the 2007/08 financial year. The second largest share of total government expenditure is health care, 18%, while expenditure on education represents 8%. Source: Australian Government (2007), Budget 2007–08, Appendix D—Australian Government Taxation and Spending, viewed 18 March 2008, at <>. Copyright Commonwealth of Australia. Reproduced by permission. 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

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

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

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