15-Aug-16

SS 132: Microeconomics

Basic Concepts

Dr Arshad Ali Bhatti

Fall 2016

Text Book/ Other References

• Main Text:
• Mankiw, G. N. (2011), Principles of
Economics OR Principles of
Microeconomics, 6th Ed., South-Western
• Other Readings:
• Case, Fair and Oster (2012), Principles of
Economics, 10th Ed., Pearson.
• Gwartney and Stroup (2006), Economics:
Private and Public Choice, 11th Ed.,
Addison.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 2

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In this lecture you will…

Learn that economics is about the
allocation of scarce resources.
Examine some of the tradeoffs that
people face.
Learn the meaning of opportunity cost.
See how to use marginal reasoning
when making decisions.
Discuss how incentives affect people’s
behaviour.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 3

In this lecture you will…

Consider why trade among people or
nations can be good for everyone.
Discuss why markets are a good, but
not perfect, way to allocate resources.
Learn what determines some trends in
the overall economy.

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Basic Principles Of Economics

• A household and an economy
face many decisions:
– Who will work?
– What goods and how many of them
should be produced?
– What resources should be used in
production?
– At what price should the goods be
sold?

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 5

Basic Principles Of Economics

Society and Scarce Resources:
– The management of society’s
resources is important because
resources are scarce.
– Scarcity. . . means that society has
limited resources and therefore cannot
produce all the goods and services
people wish to have.

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Basic Principles Of Economics

Economics is the study of how society
manages its scarce resources.
Economists study how people make
decisions:
How much they work
What they buy
How much they save
How they invest their savings

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 7

Basic Principles Of Economics

Economists also study how people
interact such as buyers and sellers.
Price determination.
Economists also analyze forces and
trends that affect the economy as a whole.
Growth in average income
The rate of price increase.

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HOW PEOPLE MAKE DECISIONS

There is no mystery to what an “economy”
is.
It’s a group people interacting with one
another as they go about their lives.
We start the study of economics with four
principles of individual decision making:
People face tradeoffs
The cost of something is what you give up to
get it.
Rational people think at the margin.
People respond to incentives.
Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 9

Principle 1: People Face Tradeoffs

“There is no such thing as a free lunch”
To get something we like we usually have
to give up something we don’t like.
A student and her time:
Studying vs. napping or cycling.
Society’s tradeoffs:
Guns vs. Butter
Clean environment and higher income

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 10

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Principle 1: People Face Tradeoffs

Society’s tradeoffs (cont’d):
Efficiency vs. Equity
Efficiency: Society getting the most it
can from its scarce resources.
Equity: Distributing economic
prosperity fairly among the members of
society.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 11

Principle 2: The Cost of

Something is what You Give Up
Making decisions requires comparing
the costs and benefits of alternative
courses of actions.
To go to university or not to go?
Opportunity cost: Whatever must be
given up to obtain some item.

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Principle 3: Rational People Think

at the Margin
Marginal changes: Small incremental
adjustments to marginal changes.
Individuals and firms can make better
decisions by thinking at the margin.
By comparing the marginal benefits
(MB) with the associated marginal costs
(MC) of a decision.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 13

Principle 4: People Respond to

Incentive
• Marginal changes in costs or benefits
motivate people to respond.
– When the price of apples rise…
• The decision to choose one alternative
over another occurs when that
alternative’s marginal benefits exceed its
marginal costs!

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 14

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HOW PEOPLE INTERACT

• The first four principles discussed how

individuals make decisions.
• The next three principles concern how
people interact with one another.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 15

Principle 5: Trade can Make

Everyone Better Off

• People gain from their ability to trade with

one another.
• Competition results in gains from trading.
• Trade allows people to specialize in what
they do best.

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Principle 6: Markets are Usually a

Good Way to Organize Economic
Activity
Market economy: An economy that
allocates resources through the
decentralized decisions of many firms and
households as they interact in markets for
goods and services.
Firms decide whom to hire and what to
make.
Households decide which firms to work
for and what to buy with their incomes.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 17

Principle 7: Governments can

Sometimes Improve Market
Outcomes
When the invisible hand does not work.
Market failure: A solution in which a market left
on its own fails to allocate resources
efficiently.
Externality: The impact of one person’s actions
on the well-being of a bystander.
Market power: The ability of a single economic
actor (or small group of actors) to have a
substantial influence on market prices.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 18

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HOW THE ECONOMY AS A

WHOLE WORKS
The last three principles concern the workings of
the economy as a whole.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 19

Principle 8: A Country’s Standard

of Living Depends on its Ability to
Produce Goods and Services
Standard of Living may be measured in
different ways (e.g. personal income or total
market value of a nation’s production.)
– Differences in standard of living between
countries or even provinces is attributable to
the productivity of the country or province.
Productivity: The amount of goods and
services produced from each hour of a
worker’s time.

Productivity => Standard of Living

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 20

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Principle 9: Prices Rise when the

Government Prints Too Much
Money
In Germany…
In January 1921, a daily newspaper cost 0.30
marks.
In November 1922, the same paper cost
70,000,000 marks.
Inflation: An increase in the overall level of
prices in the economy.
• One cause of inflation is the growth in the
quantity of money.
• When the government creates large quantities of
money, the value of the money falls.
Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 21

Principle 10: Society Faces a

Short-Run Tradeoff Between
Inflation and Unemployment.

Phillips curve: A curve that shows the

short-run tradeoff between inflation and
unemployment.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 22

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Part 2

Thinking Like an Economist

In this lecture you will…

See how economists apply the
method of science.
Consider how assumptions and
models can shed light on the world.
Learn two simple models - the
circular flow and production
possibilities frontier.
Distinguish between microeconomics
and macroeconomics.
Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 24

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In this lecture you will…

Learn the difference between and
normative statements.
Examine the role of economists in
making policy.
Consider why economists sometimes
disagree with one another.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 25

Thinking Like an Economist

Every field of study has its own terminology
– Mathematics
• integrals axioms vector spaces
– Psychology
• ego id cognitive dissonance

– Economics
• supply opportunity cost elasticity
consumer surplus demand
comparative advantage deadweight loss

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 26

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Thinking Like an Economist

Economics trains you to. . . .
– Think in terms of alternatives.
– Evaluate the cost of individual and
social choices.
– Examine and understand how certain
events and issues are related.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 27

THE ECONOMIST AS A SCIENTIST

The economic way of thinking . . .
– Involves thinking analytically and
objectively.
– Economists…
• Devise theories
• Collect data
• Analyze the data to verify or refute their
theories
– Economics makes use of the scientific
method.

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The Scientific Method:

observation, theory, and more
observation
• Uses abstract models to help explain how
a complex, real world operates.

• Develops theories, collects, and analyzes

data to evaluate the theories.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 29

The Role of Assumptions

• Economists make assumptions in order to
make the world easier to understand.

• The art in scientific thinking is deciding

which assumptions to make.

• Economists use different assumptions to

answer different questions.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 30

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Economic Models
• Economists use models to simplify
reality in order to improve our
understanding of the world

• Two of the most basic economic

models include:
– The Circular Flow Diagram
– The Production Possibilities
Frontier

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 31

Our First Model: The Circular-Flow

Diagram

• The circular-flow diagram is a visual model of

the economy that shows how dollars flow
through markets among households and
firms.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 32

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Figure 1: The Circular Flow

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
Goods •Firms sell Goods and
and services •Households buy services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

Factors of MARKETS Labour, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 33

Copyright © 2004 South-Western

Our First Model: The Circular-Flow

Diagram
• Firms
– Produce and sell goods and services
– Hire and use factors of production
• Households
– Buy and consume goods and services
– Own and sell factors of production

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 34

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Our First Model: The Circular-Flow

Diagram
• Markets for Goods and Services
– Firms sell
– Households buy
• Markets for Factors of Production
– Households sell
– Firms buy
• Factors of Production
– Inputs used to produce goods and
services
– Land, labour, and capital

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 35

Our Second Model:

The Production Possibilities Frontier

• The production possibilities frontier is a graph

that shows the combinations of output
that the economy can possibly produce
given the available factors of production
and the available production technology.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 36

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Figure 2: The Production Possibilities Frontier (PPF)

Quantity of
Computers
Produced
D

3000
C
2200
A
2000

Production
possibilities
frontier
B
1000

0 300 600 700 1000 Quantity of

Cars Produced

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 37

Our Second Model:

The Production Possibilities Frontier

• Concepts Illustrated by the Production

Possibilities Frontier
– Efficiency
– Tradeoffs
– Opportunity Cost
– Economic Growth

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 38

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Figure 3. A Shift in the Production Possibilities

Frontier
Quantity of
Computers
Produced
4000

3000 E
2100

2000
A

0 700 750 1000 Quantity of

Cars Produced

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 39

Microeconomics and Macroeconomics

• Microeconomics focuses on the individual
parts of the economy.
– How households and firms make
decisions and how they interact in
specific markets
• Macroeconomics looks at the economy as a
whole.
– Economy-wide phenomena, including
inflation, unemployment, and economic
growth

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 40

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THE ECONOMIST AS POLICY

ADVISER

• When economists are trying to explain the

world, they are scientists.

• When economists are trying to change the

world, they are policy advisor.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 41

Positive Versus Normative Statements

• Positive statements are statements that

attempt to describe the world as it is.
– Called descriptive analysis

• Normative statements are statements

about how the world should be.
– Called prescriptive analysis

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 42

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Positive Versus Normative Statements

• Positive or Normative Statements?
– An increase in the minimum wage will cause a
decrease in employment among the least-
skilled.
POSITIVE

– Higher federal budget deficits will cause

interest rates to increase.
POSITIVE

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 43

Positive Versus Normative Statements

• Positive or Normative Statements?
– The income gains from a higher minimum
wage are worth more than any slight
reductions in employment.

NORMATIVE

– State governments should be allowed to

collect from tobacco companies the costs of
treating smoking-related illnesses among the
poor.
NORMATIVE

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 44

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WHY ECONOMISTS DISAGREE

• They may disagree about the validity
of alternative positive theories about
how the world works.

• They may have different values and,

therefore, different normative views
about what policy should try to
accomplish.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 45

Graphing: A Brief
Review

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Graphs of a single variable

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 47

Graphs of two variables: The

Coordinate System

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Curves in the Coordinate System

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 49

Curves in the Coordinate System

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Slope = ∆y / ∆x

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 51

Cause and effect

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Cause and effect

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 2: Page 53

Part 3

Interdependence and the Gains

from Trade

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In this lecture you will…

• Consider how everyone can benefit when
people trade with another country.
• Learn the meaning of absolute advantage
and comparative advantage.
• See how comparative advantage explains
the gains from trade.
• Apply the theory of comparative advantage
to everyday life and national policy.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 55

Interdependence and the Gains

from Trade
• Consider your typical day:
– You pour yourself orange juice made
from Florida oranges and coffee from
beans grown in Brazil.
– You put on some clothes made of
cotton grown in Georgia and sewn in
factories in Thailand.
– You watch the morning news broadcast
from New York on your TV made in
Japan.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 56

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Interdependence and the Gains

from Trade
• Consider your typical day (more):
– You drive to class in a car made of parts
manufactured in a half-dozen different
countries.
– Then you open your economics
textbook written by authors living in
Massachusetts, Alberta, and Quebec,
published by a company located in
Ontario, and printed from paper made
from trees grown in New Brunswick.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 57

Interdependence and the Gains

from Trade
• Economics studies how society
produces and distributes goods and
services so that wants and needs are
satisfied.

• Trade can make everyone better off.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 58

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Interdependence and the Gains

from Trade
• How do we satisfy our wants
and needs?
• We can be economically Self-
Sufficient.
• We can specialize and trade
with others leading to
Economic Interdependence.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 59

Interdependence and the Gains

from Trade
• A general observation . . .
– Individuals and nations rely on
specialized production and exchange
as a way to address problems caused
by scarcity.
• This gives rise to two questions. . .
– Why is interdependence the norm?
– What determines production & trade?

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Interdependence and the Gains

from Trade
• Why is interdependence the norm?
Interdependence occurs because
people are better off when they
specialize and trade with others.
• What determines the pattern of
production & trade?
Patterns of production and trade
are based upon differences in
opportunity costs.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 61

A PARABLE FOR MODERN ECONOMY

• Imagine that there are…
… two goods in the world:
1. Potatoes
2. Meat
… and two people in the world:
1. Potato farmer
2. Cattle rancher

• What should each produce?

• Why should they trade?

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 62

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Table 1: the Production Opportunities of the

Farmer and the Rancher
Amount produced in Amount produced in
1 Hour (in Kg) 8 Hours (in Kg)

Meat Potatoes Meat Potatoes

Farmer 1 1 8 8

Rancher 8 2 64 16

Note that based on the Productivity Table above

the Rancher is more productive in producing
both of the products.
Yet, we will see that both the Rancher and the
Farmer can gain from trade ...
Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 63

Figure 1(A): The Farmer’s Production

Possibilities Frontier
Meat
(kilograms) Derived from Table 1 by working 8 hours a day

A
4

0 4 8 Potatoes
(kilograms)

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 64

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Figure 1(B): The Rancher’s Production

Possibilities Frontier
Meat
(kilograms) Derived from Table 1 by working 8 hours a day

64

B
32

0 8 16 Potatoes
(kilograms)

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 65

Specialization and Trade

• The Farmer and the Rancher Specialize
and Trade
– Each would be better off if they
specialized in producing the product
they are more suited to produce, and
then trade with each other.

The farmer should produce potatoes.

The rancher should produce meat.
They should trade

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 66

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Dr Arshad Ali Bhatti/ Fall 2016 Chapter 1: Page 67

Figure 2 (B): How Trade Increases the

Rancher’s Consumption
Meat
(kilograms)

64

Consumption
B* with trade
34
32 Consumption
B without trade

0 8 9 16 Potatoes
(kilograms)

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 68

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THE PRINCIPLE OF
COMPARATIVE ADVANTAGE
• Differences in the costs of
production determine the following:
– Who should produce what?
– How much should be traded for
each product?

Who can produce potatoes at a lower

cost? The farmer or the rancher!

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 69

THE PRINCIPLE OF
COMPARATIVE ADVANTAGE

• Measuring differences in costs of

production:
– Number of hours required to produce
a standardized unit of output.
One pound of potatoes
– Opportunity Cost: Whatever must be
given up to obtain some item.

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Absolute Advantage
• Describes the productivity of one
person, firm, or nation to that of
another.
- The producer that requires a
smaller quantity of inputs to
produce a good is said to have an
absolute advantage in producing
that good

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 71

Table 3: The Opportunity Cost of

Meat and Potatoes
Opportunity Cost of 1 Kg of

Meat (in terms of Potatoes (in terms of

potatoes given up) meat given up)

Farmer 1 1

Rancher 1/4 4

• Who has the Absolute Advantage in each

product?
• Rancher, in both products!
• Yet, we have seen that both the Rancher and the
Farmer can gain from trade?
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Opportunity Cost and

Comparative Advantage

• The comparison among producers

of a good according to their
opportunity cost.
- The producer who has the smaller
opportunity cost of producing a good
is said to have a comparative
advantage in producing that good.

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 73

Opportunity Cost and

Comparative Advantage
• Comparative advantage, which
refers to differences in opportunity
costs, is the basis for specialized
production and trade.

• Whenever potential trading parties

have differences in opportunity
costs, they can each benefit from
trade.
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Comparative Advantage and Trade

• Based on the earlier Productivity Table
(Table 3)…
– The Rancher’s opportunity cost of 1 Kg of
potatoes is 4 Kg of meat, whereas the
Farmer’s opportunity cost of a Kg of
potatoes is 1 Kg of meat.

– The Rancher’s opportunity cost of 1 Kg of

meat is only 1/4 Kg of potatoes, while the
Farmer’s opportunity cost of 1 Kg of meat is
only 1 Kg of potatoes...

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 75

Comparative Advantage and Trade

• The Rancher has the Comparative

Advantage in producing Meat (lower
opportunity cost).

• The Farmer has the Comparative

Advantage in producing Potatoes (lower
opportunity cost)

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 76

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Comparative Advantage and Trade

• Comparative advantage and

differences in opportunity costs are
the basis for specialized production
and trade.

• Whenever potential trading parties

have differences in opportunity
costs, they can each benefit from
trade.
Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 77

Comparative Advantage and Trade

Moral of the Story:

“Trade can benefit everyone in a society

because it allows people to specialize in
activities in which they have a
comparative advantage.”

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 78

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Should Pakistan Trade with other

Countries?
• Each country has many citizens with
different interests. International trade can
make some individuals worse off, even as
it makes the country as a whole better off.
– Imports: goods produced abroad and
sold domestically
– Exports: goods produced domestically
and sold abroad

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 3: Page 79

The End

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