Introduction Notes (ECON 272)
Why study economics?
What is economics?
Purposeful –
Human –
Individual -
Action –
This section relates to IMPORTANT CONCEPT READING ONE: ECONOMICS IS ABOUT PEOPLE
Social Science vs. Physical Science –
Economist’s Assumptions About Human Action:
Self-interest Axiom:
Same as: individuals act purposefully.
Others use the word "rational" for self-interested or purposeful. A "rational" action:
People often make the mistake of forgetting that the costs and benefits from actions (and also the costs and benefits used to determine if an action should take place) are subjective – and that actions are always undertaken without perfect knowledge. Someone's behavior might seem strange to you, but it isn't to them. And people will do things that turn out to be bad for them but at the time of the action, it was still purposeful and rational.
Remember also that action reveals preferences or "words are cheap" - why?
This section relates to IMPORTANT CONCEPT READING TWO: HUMAN BEINGS ACT PURPOSEFULLY
What Do Economist’s Do? What Questions Do Economists Specifically Address?
There are two fundamental economic problems or questions:
First Problem - CHOICES:
a. Scarce good –
Free good -
b. Alternative ways to use scarce goods means . . .
So the problem becomes: which use of the resource is the “best” use? Tough question!
Requires a value judgment.
Second Problem - COORDINATION:
Examples (consumer side):
Examples (producer side):
So the problem becomes one of how does this coordination take place or how do we utilize the subjective individual knowledge of time and circumstances in our decision making about the use of scarce resources? If individuals like oranges more than they like lemons, how can producers utilize that knowledge such that resources are used to make more oranges and fewer lemons? If Bob knows a very efficient way of producing oranges (because he is the "man on the spot" with respect to being an orange grower - how do we make sure that Bob's specialized knowledge is used in the production of oranges?
What Do Economists Do In An Attempt To Address These Problems?
Rules of the game:
(Another term for rules is "institutions")
This section relates to IMPORTANT CONCEPT READING THREE: INSTITUTIONS MATTER and IMPORTANT CONCEPT READING FOUR: RULES OR INSTITUTIONS DON'T HAVE TO BE (AND EVEN CANNOT SUCCESSFULLY BE) PLANNED AND LEGISLATED TO HAVE ORDER IN SOCIETY
So the process of analysis is such:
Rules or institutions create Incentives (changes in the costs or benefits of those individuals who are subject to the rules), which lead to particular Actions by those individuals, which create particular Outcomes in society.
It is the economist’s job to determine (or at least attempt to determine) which rules will lead to which outcomes. This is not an easy job. There are many places within the analysis where the economist can go wrong.
For example:
Incentives comes about because of purposeful human action or self-interest (what are the costs and benefits of the individuals involved and how will a change in a rule change those costs and/or benefits?).
If the costs of an action decrease because of a rule change, this gives people an incentive to do more of that action and vice versa. For example: Here's an example of a rule change that occurred in Boulder, CO. The municipal water authority there used to charge a "flat rate" for water use. In other words - no matter how much water someone used, they paid a flat rate. Then the rule changed - use of water was "metered" and people who used more water had to pay more. Did that rule change increase the cost of using water? Yes - so what do you think happened? Actions - people used less water!! Outcome - water was conserved!! Prices are a wonderful mechanism for conservation efforts!!
Some outcomes might be "predictable" with respect to a pattern of behavior emerging due to a change in the rules. Like the water example above.
However, not all outcomes are always predictable.
There will almost always be:
Unintended outcomes or consequences:
Examples: http://www.youtube.com/watch?v=pSwMEtuL-GQ
Which Rules Are the Best? This depends upon what people want. If we want a higher standard of living defined as more food, clothing, shelter and free time -- private property rights, free trade and the rule of law.
Private property rights:
Free trade:
Rule of law (what we discussed above):
What others did the book mention?
Why/how do these rules provide the incentives that lead to more food, clothing, shelter and free time?
Let's use the model with property rights and free trade and the rules of law (which allows for the predictability and more certainty of rules):
1. These rules lead to what incentives (again, assuming people act in their own self interest)? Why (how do their costs/benefits change)?
2. What actions do we see then? Why?
3. What outcomes come about from these actions?
Notice how broad these rules are. They don't specify what can and can't be traded, how property must be used, and the rule of law gives us more certainty about the rules -- it basically says that everyone, regardless of who they are, is subject to the same rules. As the rules get more specific and as they come about through legislation (or "executive order") -- less individual choice and knowledge can be utilized -- and more unintended consequences come about (especially if people don't like the rule).
This section relates to the Handout on Examples of Using the R-I-A-O Model - make sure you go over that handout!!
Adam Smith, Trade, Opportunity Cost, Comparative Advantage and Efficiency
His most famous book: An Inquiry Into The Nature and Causes of the Wealth of Nations (1776)
The wealth of a nation and productivity (to Smith):
Smith's work was to a large extent directed towards the system of mercantilism:
Division and Specialization of Labor:
"The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour."
- Adam Smith, An Inquiry Into the Nature & Causes of the Wealth of Nations, Vol. 1
Why/how does the division of labor increase productivity?
1.
2.
3.
But division and specialization make us Interdependent:
Not a problem though, as long as we can Trade (more on trade soon):
Therefore, Smith concluded that free trade was a necessary rule if a country is going to take advantage of division and specialization and thereby increase productivity.
Smith is also known for:
The Invisible Hand and the Coordination Problem:
Natural Instinct of Self-Interest -
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.
We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages.”
- Adam Smith, An Inquiry Into the Nature
& Causes of the Wealth of Nations, Vol.
1
Economic Order (Society Benefits - with the right rules in place!) -
So self interest is NOT bad if the right rules are in place that direct that self interest in such a way that generally speaking - most all individuals within society benefit.
Now let's look at a few very important concepts that we will discuss throughout the semester:
1. The Concept of TRADE: When two people trade, what happens?
Is it mutually advantageous in the absence of force and fraud? How do we know? What is assumed?
This section relates to IMPORTANT CONCEPT READING FIVE: TRADE IS MUTUALLY BENEFICIAL - BUT CANNOT BE CONSIDERED "EQUAL"
2. The Concept of OPPORTUNITY COST (VERY IMPORTANT):
A good economist will be able to understand and apply the concept of opportunity cost. A bad economist will not!! Unfortunately there are a lot of bad economists!
The fact that we all undertake an opportunity cost with every action leads us to the conclusion that action reveals preferences or "words are cheap" - why?
3. Opportunity cost also brings us to the Concept of COMPARATIVE ADVANTAGE (an application of the concept of opportunity cost):
Most people will only consider absolute advantage when thinking about trade. But the real cost that should be considered is the opportunity cost.
Absolute Advantage -
Comparative Advantage -
Trade should be based upon comparative advantage -- example:
4. The Concept of EFFICIENCY:
Let's be careful about defining efficiency though (we have to talk about more than simply resource use):
From our point of view as economists -- no one is being more efficient than someone else when producing something unless they take into consideration three things (remember, due to uncertainty, we never know if we are ever being the MOST efficient possible - most likely, we are not). This is why we can't ever know if we have "minimized costs" or "maximized profit" -- be careful with those terms please!! If you use them then you are assuming perfect knowledge (which we don't have)!!
1) Internal costs (costs that the producer pays - and these do include, of course, opportunity costs of the producer and of the resources used). How "efficient" is the producer when it comes to internal costs -
2) Efficiency and Wealth (is the producer producing something of value?):
And we also must consider:
3) External Costs (costs that someone else bears, but is created by the producer):
We need to take all three into consideration - even when things can't be measured (which is most often the case - especially with respect to value and external costs) - it is our job as economists to point out that all three exist!
This section relates to IMPORTANT CONCEPT READING SIX: EFFICIENCY AND WEALTH
The Production Possibilities Frontier and Economic Growth
Given our criteria for efficiency:
Here's our Second Model - The Production Possibilities Frontier (PPF)
Assumptions:
Marginal:
Marginal Opportunity Cost:
The Frontier (graph):
The problem of choice and the PPF (remember, due to scarcity we must make choices) - so if we want more of one thing, we must give up some of the other. We have to choose where to be on the frontier (we being consumers).
The coordination problem and the PPF (remember, due to uncertainty about what it is that consumers want - what their choices are - producers are not sure how to utilize the scarce resources we have). Therefore, the producers face a:
Knowledge problem -- we must look at this model in terms of a process of discovery that never stops! We must constantly try to discover where on the frontier we should be. It is always changing as consumer choices change.
What gives knowledge to producers to help them determine how to use resources in order to meet the wants of consumers: Market prices, profits and losses. And, of course, these are always changing as per above.
Economic Growth (usually seen as a shift outward of the frontier). But what does that really mean?
What is economic growth? What is wealth?
Mainstream economic definitions:
This Class: Wealth is:
Therefore, economic growth can be seen as:
So we can alter our PPF now (graph):
Why economic growth, why not? Some argue that economic growth should not be a goal of society. What do you think? How would an economist approach this issue?
Savings and Economic Growth:
Saving is also:
Capital Good:
Consumer Good:
A new PPF (graph):
BUT REMEMBER - economic growth (or any outcome that takes place in an economy) depends upon _________________________________________________!!
Whether or not savings occur, capital goods exist, technology increases, resources are utilized more "efficiently" (as we have defined it in this class) are all OUTCOMES!!
In terms of rules -
We often hear about different economic systems (basically meaning different rules that pertain to the economy). So let's look at:
What rule distinguishes capitalism from socialism from communism (as defined by economists)?
Capitalism (markets):
Socialism (government planning):
Communism:
So after understanding the difference - why do capitalist countries experience more economic growth (in terms of goods and services - and in terms of free time, etc.) than either socialist or communist countries?
