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DSME 1030GI Economics For

Business Studies 1
INTRODUCTION TO ECONOMICS
Dr. Paul M. Kitney
Term 1, 2021-22
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What is Economics?

“Economics is a science that studies human

behavior as a relationship between limited
resources and unlimited wants which
have alternative uses”
Lionel Robbins, An Essay on the Nature and Significance of Economic Science, 1932
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Economics In Other Words…

Economics is concerned with SCARCITY – the limited nature of society’s

resources, which cannot produce all the goods and services people wish
to have

Economics is the study of how society manages its scarce resources

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Economics – Theory and Practice

• Economics as field of academic endeavor came from the desire to solve

real economic problems – historically and contemporarily

• Economic theory has a rich intellectual history to develop to where it is

today

• Originally conceived as a branch of philosophy, Economics has evolved

over time towards a scientific method and mathematical rigor that now
rivals the Natural Sciences
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History of Economic Thought

• Mercantilism - Emergence of 17th century European powers’ desire to
accumulate bullion through trade surpluses. Thomas Mun (1571-1641,
England) classic “England’s Treasure by Forraign Trade, or the Balance of
our Forraign Trade is the Rule of our Treasure” (1623) – N.B. Archaic
English!
• French Physiocrats – Rejected Mercantilist thought. Contributed to the
understanding of factors of production – Introduced the circular flow of
money and goods among various sectors and conceived of a
macroeconomic equilibrium. Francois Quesnay (1694-1774, France)
graphically illustrated these ideas in the famous “Tableau Economique”
(1758)
• Classical Economics – Adam Smith (1723-90, Scotland) “Wealth of
Nations” created a full system of economics based on productivity of
labor – “division of labor” and the market mechanism “invisible hand”.
Other key figures: Jean-Baptiste Say (1767-1832, France) – “Say’s Law”,
Thomas Malthus (1766-1834) – “An Essay on the Principle of Population”,
David Ricardo (1772-1823) – “Essay on Profits” (1815) argued the case for
free trade in corn, Karl Marx (1818-83) critique of Classical Economics
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History of Economic Thought

• Marginal Revolution and the Evolution of Neoclassical Economics –
William Stanley Jevons (1835-82, England) – “Utilitarianism”, Carl Menger
(1840-1921, Austria) – “Marginal Utility and Scarcity”, Leon Walras (1834-
1910, France) – “General Equilibrium” and “Walras Law” – formalizing
economics in mathematics, Alfred Marshall (1842-1924, England) –
classic text “Principles of Economics” (1890) – contributed to the theory
of the firm and demand theory in a more practical “Partial Equilibrium”

• Pioneers of Macroeconomics – Knut Wicksell (1851-1926, Sweden) –

“Natural Rate of Interest”, Irving Fischer (1867-1947, USA) – “Debt-
Deflation Theory”, John Maynard Keynes (1883-1946, England) – “The
General Theory of Employment, Interest and Money” and the multi-
decade “Keynesian Revolution”, Milton Friedman (1912-2006, USA)
challenged Keynesianism with “Monetarism”
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History of Economic Thought

• Microeconomics and the Age of Rigor – Contributions by Kenneth Arrow
(1921-2017, USA) and Gerard Debreu (1921-2004, France) on the
mathematical formalization – “general equilibrium”, “welfare theory”,
Ronald Coase (1910-2013, UK) – “property rights”, Maurice Allias (1911-
2010, France) on “efficient resource allocation”

• Game Theory – John Forbes Nash (1928-2015, USA) – “Nash

Equilibrium”, popularized by Hollywood - “A Beautiful Mind” (Russell
Crowe) – showed that cooperation improves economic outcomes –
modified Adam Smith’s “invisible hand”

• Modern Macroeconomics, Rich in Micro Foundations – Robert Lucas

(1937-, USA) – “Rational Expectations” in macro models, “Lucas Critique”
requiring micro foundations for consistency in macro models, “Real
Business Cycle Models” and later “Dynamic Stochastic General
Equilibrium Models” origins with Finn Erling Kydland (1943-, Norway) and
Edward C. Prescott (1940-, USA)
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Microeconomics and Macroeconomics

Microeconomics is the study of

• how households and firms make choices,
• how they interact in markets, and
• how the government attempts to influence their choices

Macroeconomics is the study of the economy as a whole, including

topics such as inflation, unemployment, and economic growth.

Macroeconomics builds on Microeconomic foundations – behavioral

assumptions of firms and households
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Types of Economies
• Centrally planned economies result when governments decide what to
produce, how to produce it, and who received the goods and services
(e.g. North Korea)

• Market economies result when the decisions of households and firms

determine what is produced, how it is produced, and who receives the
goods and services (e.g. USA, Japan, Europe, Hong Kong)

• Market: A group of buyers and sellers of a good or service and the

institution or arrangement by which they come together to trade

• Mixed economies have features of both of the above. Most economic

decisions result from the interaction of buyers and sellers, but
governments play a significant role in the allocation of resources (e.g.
China)
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Currency Market
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Key Economic Concepts

• People Face Trade Offs - We trade off one goal against another – Do I
study an extra hour to make sure I pass an exam, giving up Playstation for
a while?

• Society Faces Trade Offs – Defense versus healthcare? What about

efficiency versus equality?

• Efficiency – Policies that maximize benefits from scarce resources for all
– a Utilitarian concept!

• Equality – Policies that distribute prosperity more evenly (e.g.

progressive income tax) – An Egalitarian concept!
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Key Economic Concepts

• Opportunity Cost – What do we give up when we trade off one thing for
another? - For example, the opportunity cost of me doing a PhD was over
4 years salary

• Rationality – Economics assumes agents (consumers, firms) act in their

own interest to achieve objectives.

• Rational Decision Making – Requires marginal benefit > marginal cost -

Before I decided on a PhD did I think the benefit I would get from a PhD
be worth the marginal cost (4 years salary)? Answer: Yes…

• Maximizers (Optimizers) – Rational behavior requires firms maximize

profits and consumers maximize utility (happiness)
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Key Economic Concepts

• Behavior is Influenced by Incentives – E.g. If prices rise, people buy less

and firms produce more. E.g. If governments tax cigarettes sufficiently,
people smoke less, resulting in health benefits and lower health care
costs.
• Free Trade Can Make Everyone a Winner – Trade increases the variety of
goods and services, allowing each person (or country) to specialize in
what they are best at doing. Later we define this as Comparative
Advantage.
• Usually Markets Allocate Resources Efficiently Through the “Invisible
Hand” – Adam Smith (Scotland, 1723-1790), famous for the Wealth of
Nations, argued that decentralized decisions of many firms and
households, operating in free markets, guided by prices and self interest,
act as if guided by an “invisible hand”, leading to desirable market
outcomes, including efficiency.
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Key Economic Concepts

• Property Rights – To allow the market system to work, institutions such
as courts are needed to ensure property rights – the ability to won and
exercise control over scarce resources (e.g. land).

• Market Failure – Situations where the market left on its own fails to
allocate resources efficiently. (e.g. Externalities, Market Power)

• Externality – Impact of one firm/person’s actions on the well-being of

another. For example, the effect of pollution from a chemical plant on the
drinking water of local residents. Note, not all externalities are bad.

• Market Power – Ability of a single agent (Monopolist, Oligopolist –

defined later) to have substantial influence on market prices
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Scientific Method in Economics

• Economic Models – Highly simplified representations of more
complicated systems, used to study economic phenomena. Models
employ simplifying assumptions

• Circular Flow Model (Example)

• Factors of Production – These are inputs into the production process

and include labor, land and capital

• Firms – 1. Produce goods and services; and 2. Use factors of production

• Households – 1. Own factors of production; and 2. Consume goods and

services
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Circular Flow Diagram