The Art and Science of

Economic Analysis -
The Basics

2
References
1. Krugman and Wells, 2006 Microeconomics
2. Salvatore, 2005, Managerial Economics in a Global
Economy
3. Samuelsone and Nordhus, Economics
4. Rubinfield and Pindayak, Microeconomics
5. Browning and Browning, Microeconomics
6. Lipsey, RG, An intro to Positive Economics
 What is Economics?
◆ Economics is the study of
how people choose to use
their scarce resources in
an attempt to satisfy
unlimited wants
◆ A resource is scarce if the
amount people desire
exceeds the amount that is
available
◆ Without scarcity there
would be no economic
problem
Resources
◆ Land
 used in the production of goods and services
◆ Labor
 The physical and mental effort of humans
◆ Capital
 Skills, and Buildings & equipment
◆ Entrepreneurial Ability
 Managerial, organizational, and risk-taking
skills
Resources - Payments
◆ Land or Natural Resources
Rent (for land)
◆ Labor or Human Resources
Wages (for labor)
◆ Capital (Physical and Human)
Interest (for capital)
◆ Entrepreneurial Ability
Profit (for entrepreneurial ability)
Markets
◆ A market is a set of
arrangements through
which buyers and sellers
carry out exchange at
mutually agreeable terms
◆ Product Market
A market in which goods and
services are exchanged
◆ Resource/Input Market
A market in which
resources/input are
exchanged
Economic Actors

◆ Households
◆ Firms
◆ Financial Intermediaries
◆ Government
◆ Rest of the World
 The circular flow of income

INJECTIONS

Export
Export
expenditure
expenditure (X)
(X)
Investment
Investment (I)
(I)
Government
Government
Consumption expenditure
expenditure ((G
G))
Consumption of
of
Factor
Factor domestically
domestically BANKS, etc GOV. ABROAD
payments
payments produced
produced goods
goods
and
and services
services (C
(Cdd))
Import
Import
Net
Net expenditure
Net
Net expenditure (M)
(M)
taxes (T)
taxes (T)
saving
saving (S)
(S)

WITHDRAWALS
 Distinction between
Microeconomics &
Macroeconomics
◆ Microeconomics is the study of the
economic behavior of individual decision
makers, e.g. Firm, Household etc. & how
they interact with one another in
markets.
◆ Macroeconomics is the study of the
behavior of entire economies. Its goal is
to explain the economic changes that
affect many households, firms, and
markets at once.
Rational Self-Interest
◆ Individuals
rationally select
alternatives
they perceive to
be in their best
interests
Marginal Effects
◆ A term meaning
“incremental” or
“decremental,”
used to describe a
change in an
economic variable
◆ Marginal benefits
and marginal costs
 Economic Models
◆ A model is a simplified
representation of a real
situation that is used to
better understand real-life
situations.
◆ A model is usually a graph
or a set of mathematical
equations

Clearly, the Wright

brothers believed
in their model.
Ceteris Paribus
(“other things constant”)
◆ When focusing on key economic
variables, other variables are held
constant
◆ This is important for model building
 Aseconomic models become more
complex, fewer and fewer variables
will be held constant
Behavioral Assumptions
◆ A behavioral
assumption describes
the expected behavior
of economic actors
◆ Most behavioral
assumptions are
applied to the most
sophisticated decision
makers: households
and firms
Positive Versus Normative Economic
Analysis

The Glass
is half full
half
empty
Positive Vs Normative Economic Analysis

◆ A positive economic statement can be proved

or disproved by reference to facts
 "A
ceiling on rents (or rent- control) reduces the
quantity and quality of housing available"
◆ A normative economic statement represents
an opinion, which cannot be proved or
disproved
 "Thegovernment should be the employer of last
resort"
 Some Tools
of
Economic Analysis
Opportunity Cost
◆ When an activity is chosen,
the opportunity cost is the
benefit expected from the
best alternative forgone
 Example: If you choose
to attend B-School this
year, your opportunity
cost is the salary you
would have received from
the best available full-
time job.
Law of Comparative Advantage

◆ The individual (or

country) with the
lowest opportunity
cost of producing a
particular good
should specialize in
producing that
good
Barter
◆ Barter is the direct
exchange of one
good for another
without the use of
money
◆ Modern economies
moved beyond
barter by using
money to facilitate
exchange
Division of Labor: Adam Smith (1776)
◆ The organization of
production of goods into
separate tasks in which
workers specialize
◆ The specialization of labor
takes advantage of the
individual preferences
and natural abilities of
workers
Trade-offs: The Production Possibility Frontier

What to do?
Even a castaway faces trade-offs.
The Economy’s Production
Possibilities Frontier

30
Fish

Coconut 20
 The Economy’s Production
Possibilities Frontier
The
Thelaw
lawof
ofincreasing
increasing
◆ The production opportunity
opportunitycost
cost
possibilities frontier is makes
makesthe
theproduction
production
a curve showing all possibilities
possibilitiesfrontier
frontier

Consumer Goods
concave
concave(bowed-out)
(bowed-out)
alternative
combinations of goods
that can be produced
when available
resources are used
fully and efficiently

Capital Goods
Efficiency & Production Possibilities
Frontier

Efficiency exists when there is

no way resources can be
reallocated to increase the
production of one good without
decreasing the production of
another good
 Efficiency & Production Possibilities
Frontier

Consumer
Goods
Unattainable

Inefficient

Capital Goods
 An Increase in Resources (growth)
An
Anincrease
increasein inresources
resources
Consumer will
willcause
causethe
theproduction
production
Goods possibilities
possibilitiesfrontier
frontiertotoshift
shift

Capital Goods
 A Technological Change
Technological
Technologicalimprovement
improvementin in
Consumer the
theproduction
productionofofone
onegood
goodwill
will
cause
causethe
theproduction
productionpossibilities
possibilities
Goods frontier
frontierto
torotate
rotate

Capital Goods
3- Important Economic Questions

1.What goods will be produced

• what markets to serve
• how differentiated should the products be
• what price to charge
• How goods will be produced

1.What mix of inputs to use in the

process of production
2.Who gets the goods that are
produced
Economic Systems
◆ An economic
system is a set of
mechanisms and
institutions that
resolve the what,
how and for whom
questions
Types of Economic Systems

◆ Pure capitalism (or Free Market

Economy)
 A system with private ownership of
resources and the use of prices to
coordinate economic activity in free,
competitive markets
• Planned (or Command) Economy
• A system with centralized economic
planning and public ownership of
resources
• Mixed economy
lassifying economic system
Early 1980s

Poland
N. Korea China UK Hong
Cuba India France USA Kong
Totally Totally
planned free-market
economy economy
lassifying economic system
Early 1980s
Poland
N. Korea China UK Hong
Cuba India France USA Kong
Totally Totally
planned free-market
economy economy
N. Korea Cuba China India France USA Hong Kong
Poland UK
Singapore

Early 2000s

N. Korea China India China

Cuba Poland France UK Singapore
USA(Hong
Kong)
late 2000s
 Appendix:
Understanding
Graphs
The Slope of a Line
change in y
y slope =
change in x

change in y

change in x

x
A Line with Positive Slope

change in y >0

change in x

x
A Line with Negative Slope

change in y < 0

change in x

x
The Slope of a Curve

change
in y

change in x