Lecture # 2

Isaac Newton, the famous seventeenth-century scientist and mathematician,

allegedly became intrigued one day when he saw an apple fall from an apple
tree. This observation motivated Newton to develop a theory of gravity that
applies not only to an apple falling to the earth but to any two objects in the
universe.
This interplay between theory and observation also occurs in the field of
economics. An economist might live in a country experiencing rapid increases in
prices and be moved by this observation to develop a theory of inflation. The
theory might assert that high inflation arises when the government prints too
much money. To test this theory, the economist could collect and analyze data on
prices and money from many different countries. If growth in the quantity of
money were not at all related to the rate at which prices are rising, the
economist
would start to doubt the validity of his theory of inflation. If money growth and
inflation were strongly correlated in international data, as in fact they are, the
economist would become more confident in his theory.

Although economists use theory and observation like other

scientists, they do face an obstacle that makes their task
especially challenging: Experiments are often difficult in
economics. Physicists studying gravity can drop many
objects in their laboratories to generate data to test their
theories. By contrast, economists studying
inflation are not allowed to manipulate a nations monetary
policy simply to generate useful data.
Economists, like astronomers and evolutionary biologists,
usually have to make do with whatever data the world
happens to give them.
To find a substitute for laboratory experiments, economists
pay close attention to the natural experiments offered by
history.

The cost of an alternative that must be forgone in order to pursue

a certain action. Put another way, the benefits you could have
received by taking an alternative action.
The opportunity cost of going to college is the money you would
have earned if you worked instead. On the one hand, you lose four
years of salary while getting your degree; on the other hand, you
hope to earn more during your career, thanks to your education, to
offset the lost wages.
Here's another example: if a gardener decides to grow carrots, his
or her opportunity cost is the alternative crop that might have been
grown instead (potatoes, tomatoes, pumpkins, etc.).
In both cases, a choice between two options must be made. It
would be an easy decision if you knew the end outcome; however,
the risk that you could achieve greater "benefits" (be they
monetary or otherwise) with another option is the opportunity cost.

You cant get output without inputs of resources. Economists traditionally

divide inputs, or factors of production, into three classes:
Land: To economists, land means a little more than just real estate or
property. Land also refers to all naturally occurring resources that can
be used to produce things people want to consume. Land includes the
weather, plant and animal life, geothermal energy and the
electromagnetic
spectrum.
Labour: The work that people must do in order to produce
things. A tree doesnt become a house without human intervention.
Capital: Man-made machines, tools and structures that arent directly
consumed but are used to produce other things that people do directly
consume. For example, a car that you drive for pleasure is a consumption
good, whereas an identical car that you use to haul around bricks
For your construction business is capital. Capital includes factories,
roads, sewers, electrical grids, the Internet and so on.

A lot of Debate regarding the 4th factor of production:

Entrepreneur:

an individual who organizes and operates a

business or businesses, taking on financial risk to do so.
Technology:

technology determines how efficiently all the other

factors of production are being used and hence how much output
will be produced.
Human

Capital: which is the knowledge and skills that people

use to help them produce output. For example, I have quite good
human capital with regard to teaching economics, but I have
extremely low human capital with regard to painting and singing.

In economics, an agent is a decision maker in a

model. Typically, every agent makes decisions
by solving a optimization/choice problem.
In microeconomics there are two agents:
a) Consumer / Buyer/Household
b) Producer / Seller/Firm
In macroeconomics there are four agents:
a) Consumers/Households
b) Producers/Firms
c) Government
d) Foreign Country

Not everything is measurable in terms of money in

economics, for example happiness/satisfaction.
Utilityis usefulness, the ability of something to
satisfy needs or wants. Utility is an important
concept ineconomicsandgame theory, because it
represents satisfaction experienced by the
consumer of agood.

A law of economics stating that as a person

increases consumption of a product - while keeping
consumption of other products constant - there is a
decline in the marginal utility that person derives
from consuming each additional unit of that
product, i.e. drinking when thirsty
Buffet-style restaurant use this concept. They
entice you with "all you can eat," all the while
knowing each additional plate of food provides less
utility than the one before.

A law of economics stating that, as the number of

new employees increases, the marginal product of
an additional employee will at some point be less
than the marginal product of the previous employee.
Consider a factory that employs laborers to produce
its product. If all other factors of production remain
constant, at some point each additional laborer will
provide less output than the previous laborer. At this
point, each additional employee provides less and
less return. If new employees are constantly added,
the plant will eventually become so crowded that
additional workers actually decrease the efficiency
of the other workers, decreasing the production of
the factory.

High school biology teachers teach basic anatomy with plastic

replicas of the human body. These models have all the major
organsthe heart, the liver, the kidneys ,and so on. The
models allow teachers to show their students in a simple way
how the important parts of the body fit together .
Economists also use models to learn about the world, but
instead of being made of plastic, they are most often
composed of diagrams and equations. Like a biology teachers
plastic model, economic models omit many details to allow us
to see what is truly important. Just as the biology teachers
model does not include all of the bodys muscles and
capillaries, an economists model does not include every
feature of the economy.

The economy consists of millions of people engaged in many

activitiesbuying, selling, working, hiring, manufacturing, and
so on. To understand how the economy works, we must find
some way to simplify our thinking about all these activities.
In other words, we need a model that explains, in general terms,
how the
economy is organized and how participants in the economy
interact with one another.
Figure below presents a visual model of the economy, called a
circular-flow diagram. In this model, the economy has two
types of decisionmakershouseholds and firms. Firms produce
goods and services using inputs, such as labor, land, and capital
(buildings and machines). These inputs are called the factors of
production. Households own the factors of production and
consume all the goods
and services that the firms produce.

Most economic models, unlike the circular-flow diagram,

are built using the tools of mathematics. Here we
consider one of the simplest such models, called the
production possibilities frontier, and see how this model
illustrates some basic economic ideas.
Although real economies produce thousands of goods
and services, lets imagine an economy that produces
only two goodscars and computers. Together the car
industry and the computer industry use all of the
economys factors of production.
The production possibilities frontier is a graph that
shows the various combinations of outputin this case,
cars and computersthat the economy can possibly
produce given the available factors of production and
the available production
technology that firms can use to turn these factors into
output.

In this economy, if all resources were used in the car

industry, the economy would produce 1,000 cars and no
computers. If all resources were used in the computer
industry, the economy would produce 3,000 computers
and no cars. The two end points of the production
possibilities frontier represent these extreme possibilities

An outcome is said to be efficient if the economy is

getting all it can from the scarce resources it has
available. Points on (rather than inside) the production
possibilities frontier represent efficient levels of
production. When the economy is producing at such a
point, say point A, there is no way to produce more of one
good without producing less of the other. Point B
represents an inefficient outcome

One of the Ten Principles of Economics discussed in

Chapter 1 is that people face tradeoffs. The production
possibilities frontier shows one tradeoff that society faces.
Once we have reached the efficient points on the frontier,
the only way of getting more of one good is to get less of
the other. When the economy moves from point A to point
C, for instance, society produces more computers but at
the expense of producing fewer cars.

Another of the Ten Principles of Economics is that

the cost of something is what you give up to get it.
This is called the opportunity cost. The production
possibilities frontier shows the opportunity cost of
one good as measured in terms of the other good.
When society reallocates some of the factors of
production from the car industry to the computer
industry, moving the economy from point A to point
C, it gives up 100 cars to get 200 additional
computers. In other words, when the economy is at
point A, the opportunity cost of 200 computers is
100 cars.

Productive

Efficiency - Any point on the

line is considered to be productively efficient

because you are using your resources in the best
possible way to create the most out of it.
Allocative

Efficiency Only one of the

chosen combinations will be allocatively efficient

which meets the needs and wants of the society
the most and produces exactly what the society
desires.

If technology of both the products

increases

If technology of only one of the product

increases (most cases in reality):

Aneconomyoreconomic systemconsists of
theproduction,distributionortrade,
andconsumptionof limitedgoodsandservicesby
different agents in a given geographical location.
The economic agents can be individuals,
businesses, organizations, or governments.
A given economy is the result of a set of processes
that involves its culture, values, education,
technological evolution, history, social
organization, political structure and legal systems,
as well as its geography, natural resource
endowment, and ecology, as main factors.

Developed Economy:

Adeveloped country
orindustrialized country is astate that has a highly
developed economy and advanced technological
infrastructure relative to other less industrialized nations.
Most commonly, the criteria for evaluating the degree of
economic development aregross domestic
product(GDP),the per capita income, level of
industrialization, amount of widespread infrastructure and
general standard of living.

Developing economy:

Adeveloping country, also

called aless-developed country, is a nation with a
lowerstandard of living, underdeveloped industrial base, and
lowHuman Development Index(HDI) relative to other countries.
On the other hand, since the late 1990s developing countries
tended to demonstrate higher growth rates than the developed
ones. There is no universal, agreed-upon criterion for what
makes a country developing versus developed and which
countries fit these two categories, although there are general
reference points such as a nation'sGDP per capitacompared to
other nations

Least-developed economy:

Aleast developed
country(LDC) is acountrythat, according to theUnited
Nations, exhibits the lowest indicators ofsocioeconomic
development, with the lowestHuman Development Indexratings
ofall countries in the world.

 A market economy is one in which almost all economic

activity happens in markets with little or no interference by
the government. Because of the lack of government
intervention, this system is also often referred toas laissezfaire, which is French for let well alone.
A command economy is one in which all economic
activity is directed by the government.
A traditional economy is one in which production and
distribution are handled along the lines of long-standing
cultural traditions. For example, until the caste system was
abolished in India during the last century, the production of
nearly every good and service was permitted only by someone
born into the appropriate caste.

Because nearly every modern economy is a

mixture of these three pure forms, most
modern economies fall into the very
inclusive category called mixed economies.
The precise nature of the mixture depends
on the country, with the United Kingdom
and the United States featuring more
emphasis on markets whereas France and
Germany, for example, feature more
emphasis on government intervention.

Classical:
The Classical school, which is regarded as the first school of
economic thought, is associated with Adam Smith and David
Ricardo.
The main idea of the classical school was that markets work best
when they are left alone, and that there is nothing but the
smallest role for government. The approach is firmly one of freemarket economy and a strong belief in the efficiency of free
markets to generateeconomic development. Markets should be
left to work because thePrice Mechanismacts as a
powerful 'invisible hand' to allocate resources to where they
are best employed.
In terms of explainingvalue, the focus of classical thinking was
that it was determined mainly by scarcity and costs of
production.
It is widely recognized that the classical period lasted until 1870.

Keynesian economics:
Keynesian economists broadly follow the main macroeconomic ideas of British economistJohn Maynard
Keynes. Keynes is widely regarded as the most important
economist of the 20th Century, despite falling out of favor
during the 1970s and 1980s following the rise of new
classical economics.
In essence, Keynesian economists are skeptical that, if left
alone, free markets will inevitably move towards a full
employmentequilibrium.
They Keynesian approach is interventionist, coming from a
belief that the self interest which governs micro-economic
behavior does not always lead to long run macro-economic
development or short run macro-economic stability.
Keynesian economics is essentially a theory of aggregate
demand, and how best to manipulate it through macroeconomic policy.