LECTURE 1
Thinking like an Economist
Production possibilities and opportunity cost
LEARNING OBJECTIVES
• Understand why the problem of scarcity is central to economics.
• Explore the differences between macroeconomics and microeconomics.
• Discover the methodology of economics.
• Understand the hazards of the economic way of thinking.
• Understand why economists disagree.
• Discover the practical applications of economics.
THE PROBLEM OF SCARCITY
• The condition in which human wants are forever greater than the
available supply of resources.
• Examples:
• Individuals: more restaurant meals, latest model of iPhone, a pair of
designer shoes
• Governments: higher education, highways, defence
SCARCE RESOURCES AND PRODUCTION
• Because of the economic problem of scarcity, no society has enough
resources to produce all the goods and services necessary to satisfy all
human wants.
• Economists divide resources into three categories: land, labour and
capital.
THREE FACTORS OF PRODUCTION
LAND
• Any resource provided by nature
• Includes anything natural above or below the ground, e.g. forests,
minerals, oil, wildlife, rivers, lakes, oceans
• May be renewable or non-renewable
LABOUR
• The mental and physical human capacity of workers to produce goods
and services
• Examples: Services of farmers, factory workers, lawyers, professional
footballers and economists
• Entrepreneurship is the creative ability of individuals to seek profits by
combining resources to produce new or existing products:
• Examples: Joseph Nathan, Mark Zuckerberg.
CAPITAL
• The physical plant, machinery and equipment used to produce other
goods
• Human-made goods that do not directly satisfy human wants
• In economics, money is not capital; it simply gives a measure of the value
of assets, including capital goods.
TWO BRANCHES OF ECONOMICS
Microeconomics
• Studies decision-making by
a single individual,
household, firm or industry
Macroeconomics
• Studies the performance of,
and decision-making in, the
economy as a whole
THE METHODOLOGY OF ECONOMICS
• Economists use the same scientific method used in other disciplines (e.g.
criminology, biology, physics).
• The scientific method is a step-by-step procedure for solving problems.
THE STEPS IN THE MODEL-BUILDING PROCESS
EXAMPLE: PETROL CONSUMPTION
Identifying the problem:
• Petrol consumption by motorists has fallen. Why?
Developing a model:
• Identify the variables (e.g. petrol prices, car prices).
• Express these verbally, graphically or mathematically.
Testing the model:
• Gather data that tell us how well the model estimates
or predicts relationships.
HAZARDS OF THE ECONOMIC WAY OF THINKING
There are two potential problems to be aware of:
• the ceteris paribus assumption
• possible confusion between association and causation.
CETERIS PARIBUS
• Ceteris paribus is a Latin phrase meaning that, while certain variables
change, ‘all other things remain unchanged’.
• The assumption holds everything else constant and therefore allows us
to concentrate on the study of the relationship between two key
variables.
ASSOCIATION VERSUS CAUSATION
• We cannot always assume that, when one event follows another, the first
caused the second.
• For example, suppose that Indonesian exports to Australia increased in the
last month and the hole in the ozone layer grew.
• Is there any economic relation between the two events? Is this
association or causation?
WHY DO ECONOMISTS DISAGREE?
• As in other professions, disagreements occur in economics.
• A major reason for these disagreements is the assumptions economists
make about human nature.
• Investigation into these assumptions led to the development of
behavioural economics.
BEHAVIOURAL ECONOMICS
• Behavioural economics is the study of human behaviour by combining
economics and psychological factors.
• It is determined by:
• the pleasure/pain principle
• ethical and moral beliefs
• social mores
• class relationships.
POSITIVE ECONOMICS
• Positive economics is an analysis limited to statements that are verifiable.
• The key consideration for a positive statement is whether the statement is testable,
not whether it is true or false.
• Example:
• ‘If the national unemployment rate is 7 per cent, then youth unemployment
exceeds 80 per cent.’
NORMATIVE ECONOMICS
• Normative economics is an analysis based on value judgments.
• It cannot be proven by facts to be true or false.
• Examples:
• ‘Every teenager who wants a job should have one.’
• ‘Keeping inflation under control is more important than teenage
unemployment.’
PRACTICAL APPLICATIONS OF ECONOMICS
• When new infrastructure projects are planned or new government policy
measures are put in place, an economic analysis of costs and benefits is usually
undertaken.
• Example:
– ‘More recently, in relation to the Australian government’s stimulus response to
the pandemic in the 2020 budget, business and academic economists
debated the pros and cons of different aspects of the stimulus spending.’
APPLYING GRAPHS TO ECONOMICS
• Direct relationship
• A direct relationship is a positive association between two variables.
• When one variable increases (decreases), the other also increases
(decreases).
APPLYING GRAPHS TO ECONOMICS
• An inverse relationship
• An inverse relationship is a negative association between two variables.
• When one variable increases (decreases), the other decreases (increases).
SLOPES OF LINES IN A GRAPH
• The slope is the ratio of the changes in the variable on the vertical axis (the rise or
fall) to the change in the variable on the horizontal axis (the run):
AN INDEPENDENT RELATIONSHIP
• An independent relationship is one in which there is no (i.e. zero) association
between two variables.
• When one variable changes, the other remains unchanged.
THE THREE FUNDAMENTAL ECONOMIC QUESTIONS
What to
produce?
• Scarcity
imposes
restrictions on
ability to
produce.
How to
produce?
• What
production
technique
should be
used?
For whom to
produce?
• Who receives
the goods
and services
that are
produced?
OPPORTUNITY COST
• Because of scarcity, people must make choices, and each choice incurs a cost
(sacrifice) known as opportunity cost.
• It is the best alternative sacrificed for a chosen alternative.
• It implies that no decision can be made without cost.
OPPORTUNITY COST: EXAMPLES
• What would you be doing if you were not currently studying?
• How many new roads have to be forgone if the government spends tax revenues
on hospitals?
• If you have $100, would you spend it on attending a concert or spending on
food?
MARGINAL ANALYSIS
• Marginal analysis examines the effects of additions to, or subtractions from, a
current situation.
• It is a very valuable tool in economics because it considers the effects of change
that result from decision-making.
• Individuals, firms and governments all face marginal analysis.
THE PRODUCTION POSSIBILITIES FRONTIER (PPF)
• The economic problem of scarcity can be represented in a model called the
production possibilities frontier (PPF).
• The PPF shows the maximum combinations of two outputs that an economy can
produce, given its available resources and technology.
THE PRODUCTION POSSIBILITIES FRONTIER (PPF) (CONT.)
Three basic assumptions underlie the PPF model:
1.
fixed resources
2.
fully employed resources
3.
unchanged technology.
THE PRODUCTION POSSIBILITIES FRONTIER (PPF) (CONT.)
THE PRODUCTION POSSIBILITIES FRONTIER (PPF) (CONT.)
• All the points along the frontier are maximum output levels with the given
resources and technology. They are all efficient points.
• Points outside the PPF represent unattainable production possibilities, given
current resources and technology.
• Points inside the PPF represent an inefficient use of current resources.
THE LAW OF INCREASING OPPORTUNITY COSTS
• Opportunity cost increases as
production of one output expands at
the expense of another.
• This occurs because factors of
production are generally not equally
suited to producing one good
compared with another good.
• That is, opportunity costs rise as
resources are shifted away from their
best use.
SHIFTING THE PPF
• The PPF can be used to
represent changes in the level
of technology and available
resources.
• Economic growth (the ability of
an economy to produce
greater levels of output) is
represented by an outward
shift of the production
possibilities curve.
SHIFTING THE PPF (CONT.)
• Economic growth could be caused by:
• changes in resources
• investment
• technological change.