Economic Theory Shashi Abeysinghe B.Sc(eng), CIMA
What’s the difference between Microeconomics & Macroeconomics? • Microeconomics examines small economic units, the components of the economy. For example: individuals, households, firms, industries • Macroeconomics looks at aggregates. • For example: national output, overall price level, aggregate unemployment
What is a market? • The interaction of buyers & sellers of a good or service
Questions relevant to all economies, market-oriented or not • What goods & services should be produced and how much? • How should the goods & services be produced? • Who gets the goods & services? • How do changes in the production & distribution mixes take place?
In a market economy, these questions are handled by the market. • What & how much to produce:determined by demand & supply conditions, individual choices, & pursuit of profit. • How to produce:determined by technology & resource costs. • Distribution:based on ability & willingness to pay the price. • What if consumer wants or technology change?Those changes alter demand & supply, which changes prices, profits, & consequently output levels & distribution.
The Circular Flow Product Markets money to pay for goods & services goods & services Households & Resource Owners Firms labor & other resources resource payments such as wages, rents, & interest Resource or Factor Markets
The market is not the only way that the basic questions of economics can be answered. • In some less developed nations, a traditional economic system is used. • Custom & tradition determine the answers. • Social arrangements & culture dictate the solutions. • Change occurs very gradually.
Historically the former Soviet Union had a command economy. • Resources are government/publicly owned and centralized control is used to determine what is produced, how it is produced, and how it is distributed.
No country in the world has a purely market or purely command economy. • They have mixed economies with both market and government sectors. • In this course, we will deal primarily with the market system.
What is the law of demand? • The lower the price of a good, the larger the quantity consumers will buy. • So the demand curve slopes downward from left to right.
What is the difference between demand & quantity demanded? • Demand is the entire curve that shows the relation between price & quantity purchased. • Quantity demanded is one particular quantity on the demand curve.
Example: Apple Market Price of apples(in dollars) The demand for apples is the curve D. The quantity demanded of apples when the price is 25 cents is 6 thousand bushels. $ 0.25 D 6 Quantity of apples(in thousands of bushels)
What factors change demand (that is, shift the entire curve)? • Consumer income • Prices of substitutes and complements • Tastes • Consumer expectations
Example: Apple Market Price of apples(in dollars) If income increases, people will buy more apples at every price & the entire curve will shift to the right. D2 D1 Quantity of apples(in thousands of bushels)
What makes the quantity demanded of apples change? • In other words, what causes a movement along the demand curve for apples? • A change in the price of apples. • That’s it, only a change in the price of apples.
Example: Apple Market Price of apples(in dollars) Suppose the price of apples falls from 25 cents to 20 cents. Then the quantity demanded of apples rises from 6 thousand bushels to 8 thousand bushels. $ 0.25 $ 0.20 D 6 8 Quantity of apples(in thousands of bushels)
What is the law of supply? • The higher the price of a good, the larger the quantity firms will be willing to produce and sell. • So the supply curve slopes upward from left to right.
What is the difference between supply & quantity supplied? • Supply is the entire curve that shows the relation between price & quantity provided. • Quantity supplied is one particular quantity on the supply curve.
Example: Apple Market Price of apples(in dollars) S The supply of apples is the curve S. The quantity supplied of apples when the price is 22 cents is 7 thousand bushels. $ 0.22 Quantity of apples(in thousands of bushels) 7
What factors change supply (that is, shift the entire curve)? • Technology • Prices of inputs (for example: land, labor, machinery, raw materials) • Weather (in the case of agriculture)
Example: Apple Market Price of apples(in dollars) S2 S1 If rainfall is low, the supply of apples will be reduced. At each price, there will be fewer apples provided. Quantity of apples(in thousands of bushels)
What makes the quantity supplied of apples change? • What causes a movement along the supply curve for apples? • Just a change in the price of apples.
Example: Apple Market Price of apples(in dollars) S $ 0.22 When the price of apples falls from 22 cents to 20 cents, the amount provided falls from 7 thousand bushels to 6 thousand bushels. $ 0.20 Quantity of apples(in thousands of bushels) 6 7
What is equilibrium? • It is a state of balance, where there is no tendency for things to change.
Equilibrium occurs where the quantity demanded equals the quantity supplied, which is at the intersection of the supply and demand curves.
Example: Apple Market Price of apples(in dollars) S Here the equilibrium price is 22 cents & the equilibrium quantity is 7 thousand bushels. $ 0.22 D Quantity of apples(in thousands of bushels) 7
Suppose there is an increase in the price of pears (a substitute for apples). Then the demand for apples will increase. Equilibrium price increases & equilibrium quantity increases. price S P2 P1 D2 D1 quantity Q2 Q1
Suppose there is a long spell of bad weather for apple growing. Then the supply of apples will decrease. Equilibrium price increases & equilibrium quantity decreases. S2 price S1 P2 P1 D Q2 quantity Q1
Example: cigarette market Suppose that the surgeon general comes out with stronger health warnings. That will reduce the demand for cigarettes. Simultaneously, there is a year of bad weather. That decreases the supply of cigarettes.
So S & D both decrease. The equilibrium quantity decreases. Equilibrium price may increase, decrease or stay the same. In this example, the price remained the same. price S2 S1 P2 = P1 D1 D2 quantity Q2 Q1
Resources are limited; wants are unlimited Scarcity = not enough resources to produce the goods to satisfy our wants. Resources: Adam Smith in his Wealth of Nations (1776) divided resources into land, labor and capital. http://www.adamsmith.org/smith/won-intro.htm
Adam Smith’s 3 resources: Land, Labor and Capital 1. LAND: used as shorthand for any natural resource, not simply for agricultural land. 2. LABOR: manual power + skill ("human capital") 3. CAPITAL: produced means of production for example, hammers, drill presses, computers ... . Although money is used to BUY all the above, money is not itself a productive resource. Capital grows through investment –.
Scarcity means that choices are necessary. • When you can’t have all you want of everything, you must make choices. • Microeconomics is the study of how to make the best possible ( or the optimal) choice under the constraint of limited resources.
Tradeoffs and the Production Possibility Frontier • Economists would want to develop a more precise model of the tradeoffs involved – • And that model can be represented graphically by a “Production Possibility Frontier”, showing the choices which are • -- possible (on or within the frontier) • -- efficient (exactly on the frontier) • -- inefficient (within the frontier) • -- impossible (beyond the frontier)
Cadillacs ... 1944 and 1946 Opportunity cost of tank = 10 passenger autos M5 Tank Cadillac Coupe
M5 tanks The tank-auto trade-off: an economist's view using the Production Possibility Frontier 500 Autos 5,000
M5 tanks The tank-auto PPF: one POSSIBLE point is (2000 autos, 300 tanks) another POSSIBLE point is (4000 autos, 100 tanks) 500 300 Autos 5,000 2,000
M5 tanks The tank-auto PPF: an IMPOSSIBLE point is (4000 autos, 300 tanks) 500 300 Autos 4,000 5,000
M5 tanks 500 200 an INEFFICIENT point is (1000 autos, 200 tanks) Autos 1,000 5,000
M5 tanks The tank-auto equation: TANKS = 500 – 0.1 AUTOS Check out a few values: AUTOS TANKS 0 500 1000 400 2000 300 2001 299.9 500 Autos 5,000
M5 tanks • Equation in general form: • TANKS = a + b AUTOS • How to find the equation from the graph: • a = Y-INTERCEPT = 500 • b = SLOPE = rise over run = - 500 divided by 5000 = - 0.1 500 Autos 5,000
What the intercept means: TANKS = 500 – 0.1 AUTOS IF we produced zero autos, we could produce up to 500 tanks, since TANKS = 500 – 0.1 (0) = 500 M5 tanks 500 Autos 5,000
What happens when the intercept changes: TANKS = 600 – 0.1 AUTOS IF we produced zero autos, we could produce up to 600 tanks, since TANKS = 600 – 0.1 (0) = 600 The PPF would shift OUT and parallel to itself. M5 tanks 600 500 This might be due to an increase in the resources available for production – for example, an increase in the labor force, and a new assembly line in the factory Autos 5,000 6000
What the slope means: TANKS = 500 – 0.1 AUTOS IF we were producing 2000 autos and 300 tanks and if we decided to produce one more auto, we would have to reduce tank production to 299.9 The OPPORTUNITY COST of an auto is one-tenth of a tank. M5 tanks 500 Autos 5,000
What happens when the slope changes: TANKS = 500 – 0.05 AUTOS If autos = 0, TANKS = 500 If autos = 5,000, TANKS = 250 If autos = 10,000, TANKS = 0 The possibility exists of producing more autos – perhaps some way of producing auto transmissions (but NOT tank transmissions) more rapidly has been discovered. M5 tanks 500 Autos 5000 10,000
Introduction to Macroeconomics