3 Fundamentals Components of Economic Anaysis Tuesday, 28 January 2025 3:24 pm 1. Theories ○ systematic explanations of economic behavior and relationships ○ all economic concepts are theories ○ examples ▪ Theory of Supply and Demand □ market equilibrium and between supply and demand □ relationship between the quantity of good or service that producers are willing to sell (supply) and the quantity that consumers are willing to buy (demand) □ Demand Curve: Indirect relationship between price and quantity □ Supply Curve: Direct relationship between price and quantity □ exemptions to the demand and supply theory: daily necessities and utilities = Inelastic Demand ▪ Keynesian Economic Theory □ need for government intervention to help the government □ emphasizes the role of government intervention in stabilizing the economy □ advocated the increased government spending and lower taxes to boost demand and pull the economic out of recession □ importance of aggregate demand (total spending in the economy) as the primary driver of economic growth and employment, suggesting that active fiscal policy can help manage economic cycles □ capital markets debt market equity market - stock market derivatives market (U.S.) 2. Principles ○ widely accepted generalization 3. Models ○ simplified representation of compel economic processes ○ examples: ▪ Supply and Demand Model ▪ Production Possibilities Frontier (PPF) Theories, Principles, and Models Purposeful Simplification - distill complex economic realities into more manageable forms - simplification is necessary for understanding and predicting economic behavior, as the full scope of economic interactions is often too intricate to analyze its entirety Ceteris Paribus Assumption - other things being equal - they hold all other relevant factors constant while examining the relationship between specific variables - helps clarify the direct effects of changes in one variable on another without the confusion of simultaneous changes in other factors □ Economizing Problem: Individual vs. Society Aspect Individual Society Definition need to make choices due to limited income and unlimited wants need to allocate scarce resources among competing uses Focus individual preferences and choices regarding consumption and spending collective decisions about resource allocation for public goods and services Resources limited personal income, savings, and time limited societal resources, including labor, capital, and land Decision-making personal utility maximation and opportunity costs societal welfare and trade-offs between different sectors (education vs. defense) Examples of choices allocate more resources to healthcare or education buy new phone or save for a vacation □ Budget Line: Key Components Income Prices of Goods Combinations of Goods ◊ all possible combinations of the two goods that can be purchases without exceeding the budget AC 2203 Page 1 ◊ all possible combinations of the two goods that can be purchases without exceeding the budget on the budget line: most efficient below the budget line: inefficient – utilities are not fully maximized above the budget line: unattainable – debt □ PPM: Shifts in the PPC Economic Growth ◊ outward shift = economic growth increase in resources or improvements in technology greater production of both goods Economic Contraction ◊ inward shift = reduced production capabilities decrease in resources or a decline in technology PPC is similar to the budget line Applications of the PPC ◊ Resource allocation decisions ◊ Understanding trade-offs ◊ Comparative advantage and specialization Limitations of PPC ◊ Simplification focuses only on two goods ◊ Assumptions of fixed resources ◊ Ignores external factors government policies, market conditions and global economic influences that affect production capabilities asymmetric information – seller holds more information than the buyer □ Marginal Benefit vs Marginal Cost Marginal Benefit ◊ additional satisfaction or utility gained from consuming one more unit of a good or service ◊ more units of good consumed = marginal benefit typically decreases due to the law of diminishing marginal utility, which stat es that the additional satisfaction gained from consuming each additional unit tend to decline Marginal Cost ◊ additional cost incurred from producing one more unit of a good or service ◊ reflects the change in total cost that arises when the quantity produced in increased by one unit ◊ increases as production expands = law of increasing opportunity costs resources are not equally efficient in all uses Optimal Production Point ◊ MB = MC If MB > MC – increase production If MB < MC – decrease production AC 2203 Page 2 Implications of MB and MC ◊ Decision-making ◊ Resource allocation AC 2203 Page 3 The Market Systems and Circular Flow Tuesday, 28 January 2025 4:12 pm Economic Systems ○ Command system ▪ planned or centrally planned economy ▪ government makes all economic decisions □ factors of productions ▪ examples: North Korea, Puerto Rico ▪ characteristics: □ centralized control □ production goals □ limited consumer choice government dictates supply □ price controls ▪ advantages: □ government can aim to distribute resources more evenly among the population, potentially reducing inequality □ lead to stability in production and employment ▪ disadvantages: □ lack of innovation and efficiency due to no competition and profit motives □ excessive bureaucracy slowing down responses to economic changes □ little economic freedom ○ Laissez-Faire System ▪ "let it be" ▪ minimal government intervention in economic ▪ markets operate freely ▪ characteristics: □ minimal regulation □ free competition □ self-regulating markets ▪ advantages □ individual and businesses have the freedom to make their own economic choices without government constraints □ foster innovation and economic growth businesses are free to experiment and take risks ▪ disadvantages: □ risk of exploitation of workers and consumers, as businesses may prioritize profits over ethical consideration □ can lead to economic cycles of boom and bust, as markets may not-self correct effectively ○ Market System ▪ capitalism or a free market economy ▪ decentralized decision-making where individuals and businesses make their own economic choices ▪ prices are determined by supply and demand in the market place ▪ characteristics: □ private property right to own and control property and resources □ voluntary exchange mutual agreement between buyer and seller □ competition □ price mechanism price fluctuation guides resource allocation ▪ advantages: □ encourages efficiency and innovation as businesses strive to meet consumer needs □ consumers have the power to influence production through purchasing choices □ market can quickly adapt to changes in consumer preferences and resource availability ▪ disadvantages: □ can lead to significant income and wealth disparities □ monopolies, externalities, and public goods can lead to inefficiencies and require government intervention □ businesses may prioritize short-term profits over long-term sustainability and social responsibility Invisible Hand ○ self-regulating nature of the marketplace, where individuals pursuing their own interests inadvertently contribute to the overall economic well-being of society ▪ each participant in the market seeks to maximize their own benefits □ whether through profits, utility, or satisfaction □ collective actions of these individuals lead to the efficient allocation of resources ▪ applicable to both laissez-faire and market system ○ four mechanisms ▪ self-interest as a driving force □ individuals and firms act based on their self-interest □ producers maximize profits □ consumers seek to obtain the best value for their money □ pursuit of self-interest drives innovation, efficiency and competition ▪ competition and resource allocation □ ensures that resources are allocated to their most valued uses □ compelled to improve their products and services reduce prices operate efficiently □ competition = regulatory mechanism aligns individual actions with societal needs AC 2203 Page 4 aligns individual actions with societal needs ▪ market signals □ prices serve as signals in the market reflecting the relative scarcity or abundance of goods and services demand increase, price increase ◊ producers allocate more resources to its production demand falls, prices decrease ◊ producers reduce output ▪ consumer sovereignty □ consumers dictate what is produced based on their preferences and purchasing decisions □ business that fail to meet consumer demands risk losing market share reinforcing the need for responsiveness to consumer needs consumer sovereignty provides you what are the needs of the consumers ○ benefits: ▪ efficiency □ efficient use of resources by guiding them toward the production of goods and services that society values the most ▪ innovative and growth □ firms seek to differentiate themselves and gain a competitive edge ▪ adaptability □ respond changes in consumer preferences, resource availability and technological advancements ○ Limitations and Criticisms ▪ market failures □ does not account for market failure which can lead to inefficient outcomes externalities: pollution public goods - considered as a good market failure as everyone benefits from it ◊ public education ◊ streetlights ◊ plaza information asymmetries □ government intervention may be necessary to correct these failures ▪ income inequality □ not all individuals have equal access to resources and opportunities ▪ short-term focus □ businesses may prioritize short-term profits over long-term sustainability negative consequences for the environment and society The Circular Flow Model ○ depicts the continuous movement of money, resources, and goods and services in an economy ○ key components of circular flow ▪ households □ consumers in the economy □ provide factors of production labor land capital ◊ two branches debt market – loans equity market – ownership entrepreneurship □ in exchange for income wages rent interest profits ▪ businesses □ producers of goods and services ▪ resource market □ factor market □ where factors of production are bought and sold □ essential for businesses to acquire the inputs needed for production ▪ product market □ primary participants households ◊ consumers who purchase goods and service businesses ◊ producers that supply these goods and services ▪ can be expanded to include: □ government □ foreign sectors □ technology AC 2203 Page 5
