Topic 1: Basic Ideas in Economics

TOPIC 1
Basic Ideas in Economics
OBJECTIVES OF THIS COURSE
• To understand the key ideas in microeconomics.
• To acquire the ‘economic way of thinking’.
• To analyse problems from an economic

perspective.
1
WHAT IS ECONOMICS
• Economics is a decision-science
– It analyses how people & firms make consumption &
production decisions & consequences of these
decisions.
• Examples:
– How do consumers choose what goods to buy?
– How do firms decide what to produce & how to
produce?
– How do firms decide to price the goods they sell?
DECISION MAKERS IN ECONOMICS

• A household is the basic unit in the economy
– it buys goods & services in markets & supplies
inputs (e.g. labour) used by
• firms – the other basic unit

– it sells goods & services in markets & use inputs
(e.g. labour) supplied by households
2
SCARCITY
• Resources are scarce
– consumers cannot buy everything &
– firms are constrained in their choices by technology
& prices.
• Similarly, society has limited resources

– therefore it cannot produce all the goods & services
people want.
SCARCITY
• Likewise,
– society must decide what jobs will be done and who
will do them.
– It must also allocate the goods and services that are
produced.
• Therefore,
– management of society’s resources is important
because we cannot produce all the goods and
services people wish to have.
3
ECONOMICS
• Economics is the study of how society
manages its scarce resources.
• In most societies, resources are allocated

through the combined decisions of millions of
households and firms.
• Economists study
– how people make decisions
– how people interact with one another.
LESSONS IN ECONOMICS
There are 7 key lessons learned

from economics in this unit.
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LESSON 1
• People face trade-offs.
– Scarcity creates trade-offs.
• How do you divide your time between studying different
subjects.
• Or between work, hanging out with friends and sleeping in?
– To get one thing, we usually have to give up something.
• clothing v. holidays
• leisure time v. university study (& income)
• clean environment v. income
• (for governments) ‘spending on defence’ v. ‘spending on
education’
AN IMPORTANT TRADE-OFF
• Efficiency means society getting the most it can
from its scarce resources.
– For example, when most output is produced.
• Equity means distributing resources fairly

among the members of society.
– For example, taxation can be used to redistribute
output from rich households to poor households,
thereby increasing equity.
5
EFFICIENCY VERSUS EQUITY
• Most societies value both efficiency and equity.
– Unfortunately, there is often a trade-off between
these two goals.
• For example,
– funding public education and health care requires
the government to raise taxes.
– But taxes reduce the reward for working hard and
being successful, leading to a loss of efficiency.
LESSON 2
• The cost of something is what you give up to
get it.
• Decisions require comparing costs & benefits

of alternatives.
– Whether to go to the class at the university or go
swimming?
• The opportunity cost of an item is what you

give up to obtain that item.
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OPPORTUNITY COST
• Alternatively, opportunity cost is benefit
foregone by giving up the best alternative.
• For example, your opportunity cost of sitting

through this lecture may be reading a book or
enjoying an espresso at a local café.
WHAT DID YOU GIVE UP TO

ATTEND UNIVERSITY TODAY?
• Decision
– Whether to come to class or go swimming.
• Benefits you would get by going swimming.
• Benefits from coming to class.
– That you are attending (today) suggests you

believe that this maximises your benefits.
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• For example
– The benefits of going swimming might be $30
– Cost of getting to a pool (say $5)
– So the net benefit is $25.
– The benefits of coming to class today might be $45

– Cost of getting to university (say $10)
– So the net benefit is $35.

– Since the net benefits of coming to class today are
larger than the net benefits of going swimming
– You should choose to come to class
– i.e., You choose the item with maximum net benefits.
• Alternatively
– The opportunity cost of swimming is $35 &
– that of coming to class $25.
– You choose the item with minimum opportunity costs
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LESSON 3
• Rational people think at the margin.
– Marginal changes are small incremental
adjustments to a plan.
– Rational people make decisions by comparing costs
& benefits at the margin.
• Firms decide how many workers to hire by adding them
incrementally &
• seeing whether their cost (the wage paid) exceeds the
value of the extra production they provide.
• Consumers decide how many glasses of juice to drink by
focusing on whether drinking an additional glass will
provide benefits that exceed costs.
A PARABLE: HOW DOES A BLIND

PERSON CLIMB A MOUNTAIN
• By taking one step at a time &
– retracting the step if it does not move them uphill.
– If the mountain has one peak they will get to its top.
• Think about ‘getting to the peak’ as ‘doing the

best you can’ for yourself.
– This involves ‘marginal’ reasoning.
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LESSON 4
• People respond to incentives.
– Understanding how people respond to incentives is
central to understanding how markets work.
• When the price of beef rises, people decide to eat fewer
steaks.
• At the same time, beef farmers increase the size of their
herds and employ additional stockmen.
– Incentives are also important in public policy.

• For example, a tax on petrol leads people to purchase
smaller, more fuel efficient cars.
DO SEAT BELT LAWS CAUSE

ACCIDENTS?
• It is compulsory to wear seat belts in many
countries because
– wearing a seatbelt increases the probability that you
will survive an accident.
– But, seat belt laws may reduce your incentive to
drive safely.
• Seat belts reduce the marginal benefit of safe driving
because they reduce the risk of serious injury and death.
10
LESSON 5
• Trade can make everyone better off.
– People gain from trade with one another because they
get more choices.
– Trade allows people to specialize in what they do best.
– Imagine a world in which your family didn’t trade with

anyone else.
• You would have to grow your own food, make your own
clothes, build your own house and make your own tools.
TRADE CAN MAKE EVERYONE

BETTER OFF
– Instead, we each specialise in the activities we do
best.
– Trade allows us to enjoy a greater variety of

products at lower cost.
– The same is true for trade between nations.

• Trade allows countries to specialise in what they do best
and to enjoy a greater variety of goods and services.
11
LESSON 6
• Markets are usually a good way to organise
economic activity.
– A market economy allocates resources
through the decentralised decisions of firms
and households as they interact in markets.
• Decisions are made by millions of self-interested households
and firms.
• Firms decide whom to hire and what to make.
• Households decide who to work for and what to buy with
their incomes.
THE INVISIBLE HAND

• The invisible hand is the idea that buyers and
sellers freely interacting in a market economy
– make the best use of scarce resources
– by allocating goods and services to those people who
value them most.
• The concept was proposed by Adam Smith in An

Inquiry into the Nature and Causes of the Wealth
of Nations (1776).
12
THE INVISIBLE HAND
• In any market,
– buyers look at the price when determining how
much to buy, and
– sellers look at the price when deciding how much to
sell.
• Smith’s great insight was that

– prices adjust to guide buyers and sellers to reach
outcomes that can maximise society’s wellbeing as
a whole.
LESSON 7
• Governments can sometimes improve market
outcomes.
• Market failures occur when markets fail to

allocate resources efficiently or equitably.
• When the market fails (breaks down) government

can intervene to promote efficiency and equity.
13
MARKET FAILURE
• Market failure can be caused by
– an Externality – the impact of one person’s actions
on the wellbeing of a bystander.
• Governments can tax or subsidise these activities to force
better outcomes.
– Market power - the ability of a single person or firm

to have a substantial influence on market prices.
• Governments can act to limit the formation of monopolies
or encourage competition.
SUMMARY
• When individuals make decisions, they face trade-offs.
• The cost of any action is measured in terms of foregone

opportunities – opportunity costs. This is perhaps the most
crucial idea in economics.
• Rational people make decisions by comparing marginal

costs & marginal benefits – use marginal analysis.
• People change behaviour in response to incentives.
14
SUMMARY
• Trade can be mutually beneficial.
• Markets are often a good way of coordinating trade among

people.
• Government can sometimes improve market outcomes if

there is market failure or if the market outcome is
inequitable.
15

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TOPIC 1

Basic Ideas in Economics

OBJECTIVES OF THIS COURSE

• To understand the key ideas in microeconomics.

• To acquire the ‘economic way of thinking’.

• To analyse problems from an economic

DECISION MAKERS IN ECONOMICS

• firms – the other basic unit

• Similarly, society has limited resources

• In most societies, resources are allocated

There are 7 key lessons learned

• Equity means distributing resources fairly

• Decisions require comparing costs & benefits

• The opportunity cost of an item is what you

• For example, your opportunity cost of sitting

WHAT DID YOU GIVE UP TO

– That you are attending (today) suggests you

– The benefits of coming to class today might be $45

WHAT DID YOU GIVE UP TO

A PARABLE: HOW DOES A BLIND

• Think about ‘getting to the peak’ as ‘doing the

– Incentives are also important in public policy.

DO SEAT BELT LAWS CAUSE

– Trade allows people to specialize in what they do best.

– Imagine a world in which your family didn’t trade with

TRADE CAN MAKE EVERYONE

– Trade allows us to enjoy a greater variety of

– The same is true for trade between nations.

THE INVISIBLE HAND

• The concept was proposed by Adam Smith in An

• Smith’s great insight was that

• Market failures occur when markets fail to

• When the market fails (breaks down) government

– Market power - the ability of a single person or firm

• The cost of any action is measured in terms of foregone

• Rational people make decisions by comparing marginal

• People change behaviour in response to incentives.

• Markets are often a good way of coordinating trade among

• Government can sometimes improve market outcomes if

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