WEEK 4: Economics: Foundations and Models
Economics: study of the choices people and societies make to attain their unlimited wants, given their
scarce resources
Market: group of buyers and seels of good or service and the institution or arrangement by which they
come together to trade
Three important ideas in economics:
1. People are rational
2. People response to economic incentives
3. Optimal decisions are made at the margin
 Marginal analysis: analysis that involves comparing marginal benefits and marginal costs
Scarcity: The situation in which unlimited wants exceed the limited resources available to fulfil those wants.
Resources: Inputs used to produce goods and services, including natural resources such as land, water
and minerals, labour, capital and entrepreneurial ability.
Trade-off: The idea that, because of scarcity, producing more of one good or service means producing less
of another good or service.
Trade-offs force society to make choices:
1. What goods and services will be produced
2. How will the goods and services be produced
3. Who will receive the goods and services produced
1. What goods and services will be produced?

When choosing between alternative options, economists use the concept of opportunity cost.
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Opportunity cost: The opportunity cost of any activity is the highest-valued alternative that
must be given up to engage in that activity.
2. How will the goods and services be produced?

In many cases, firms face a trade-off between using more workers and using more machines.
3. Who will receive the goods and services produced?

This largely depends on how income is distributed.
Centrally planned vs. market economics:
Centrally planned economy: economy in which the government decides how economic resources will be
allocated
Market economy: economy in which the decisions of households and firms interacting markets allocate
economic resources

A central feature of market economies is consumer sovereignty.
o
o
Consumer sovereignty: The concept that in a market economy it is ultimately
consumers who decide what goods and services will be produced.
This occurs because firms must produce goods and services that meet the wants of
the consumers, or the firms will go out of business.
The modern ‘mixed’ economy

Mixed economy: An economy in which most economic decisions result from the
interaction of buyers and sellers in markets, but in which the government plays a significant
role in the allocation of resources.
Efficiency and equity
Productive efficiency: When a good or service is produced using the least amount of resources.
Allocative efficiency: When production reflects consumer preferences; in particular, every good or service
is produced up to the point where the last unit provides a marginal benefit to consumers equal to the
marginal cost of producing it.
Dynamic efficiency: Occurs when new technology and innovation are adopted over time
Voluntary exchange: Occurs in markets when both the buyer and seller of a product are made better off
by the transaction.
Equity: The fair distribution of economic benefits between individuals and between societies.

An efficient outcome may or may not be considered by society to be equitable.
Economic Models:
Economic models: Simplified versions of reality used to analyses real-world economic situations.
Economic variable: Something measurable that relates to resources that can have different values, for
example, wages, prices, liters of petrol.
Economic models make behavioral assumptions about the motives of consumers and firms.
To develop a model economists generally follow these steps:
1. Decide on the assumptions to be used in developing the model.
2. Formulate a testable hypothesis.
3. Use economic data to test the hypothesis.
4. Revise the model if it fails to explain the economic data.
5. Retain the revised model to help answer similar economic questions in the future.
Forming and testing hypotheses in economic models

A hypothesis in an economic model is a statement that may be either correct or incorrect about an
economic variable.

In testing hypotheses, economists distinguish between correlation and causality.
Normative and positive analysis
Positive analysis: Analysis concerned with what is, and involving value-free statements that can be
checked by using the facts.
Normative analysis: Analysis concerned with what ought to be, and involving value judgements, which
cannot be tested.
WEEK 1: Choices and Trade-Offs in the Market
Graphing the Production Possibility Frontier
Production possibility frontier: a curve showing the maximum attainable combinations of two
products that may be produced with available resources
Opportunity cost: the highest-valued alternative that must be given up to engage in an activity
Increasing marginal opportunity costs:


The bowed out shape of the production possibility frontier illustrates the concept of increasing
marginal opportunity costs
Increasing marginal opportunity costs demonstrate an important economic concept:
Economic growth:
Economic growth: expansion of society’s production potential. (Illustrated using the production
possibility frontier)
Trade: the act of buying or selling a good or service in a market
Absolute advantage vs. comparative advantage
Absolute advantage: ability of an individual, firm or country to produce moreof a good or service
than competitors using the same amount of resources
Comparative advantage: ability of an individual, firm or country to produce a good or service at a
lower opportunity cost than other producer
Comparative advantage and gains from trade:


Basis for trade is comparative advantage, not absolute advantage
Individuals, firms or countries are better off if they specialise in producing goods and services
for which they have a comparative advantage and obtain other desirable goods and services
by trading
The Market System:
Market: a group of buyers and sellers of a good or service and the institution or arrangement by
which they come together to trade
Product Markets: markets for good – such as computers – and services - such as medical treatment
Factor markets: markets for the factors of production, such as labour, capital, natural resources and
entrepreneurial ability
The gains from free markets:
Free Market: market with few government restrictions on how a good or service can be produced or
sold, or on how a factor of production can be employed


Smith assumed individuals act in a rational, self-interested way
If not restricted by government, then firms would be led by the invisible hand to the market to
provide consumers with what they wanted
Price mechanism: system in the free market where price changes lead to producers changing
production in accordance with the level of consumer demand
The role of the entrepreneur:
Entrepreneur: someone who operates a business, bringing together the factors of production to
produce goods and services

Entrepreneurs are central to the working of the market system
The legal basis of a successful market:
Property rights: rights individuals or firms have to the exclusive use of their property, including the
right to buy or sell it


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Private property rights provide the legal basis of a successful market system
To enforce contracts and property rights there must be an independent court system with
impartial judges
Production will fall if property rights are not well enforced – a move to a point inside the PPF
WEEK 2: The Interaction of Demand and Supply
The demand side of the market:
Quantity demanded: amount of a good or service that a consumer is willing and able to buy at a
given price
Demand schedule: table showing the relationship between the price of a product and the quantity of
the product demanded
Demand curve: a curve that shows the relationship between the price of a product and the quantity
of the product demanded
Market demand: demand by all the consumers of a given good or service
The Law of Demand: holding everything else constant, when the price of a product falls the quantity
demanded will increase, and when the price of a product rises the quantity demanded will decrease

Ceteris paribus – holding everything else constant. Requirement that when analysing the
relationship between two variables – such as price and quantity demanded – other variables
must be held constant
What explains the law of demand:
1. The substitution effect:

The change in the quantity demanded of a good or service that results from a change in price,
making the good or service more or less expensive relative to other goods or services that are
substitutes (holding constant the effect of the price change on consumer purchasing power)
2. The income effect:

The change in the quantity demanded of a good or service that results from the effect of a
change in price on consumer purchasing power (holding all other factors constant)
Variables that shift market demand:
1.
2.
3.
4.
5.
Income
Prices of related goods
Tastes
Population and demographics
Expected future prices
1. Income
o Normal good: good for which the demand increases as income rises and decreases
as income falls
o Inferior good: good for which the demand increases as income falls and decreases
as income rises
2. Prices of related goods
o Substitutes: goods or services that can be used for the same or similar purpose
o Complements: goods and services that are used together
3. Tastes