Principles of Economics

Introduction: Ten Principles Of Economics. →Thinking Like An Economist.

Interdependence And The Gains From Trade.
Microeconomics: Working of Markets: The Market Forces of Supply and
Demand. Elasticity and Its Application. Supply, Demand, and Government
Policies. Markets and welfare: Consumers, Producers, and the Efficiency of
Markets. Applications: The Costs of Taxation. Economics of the public sector:
Externalities. Public Goods and Common Resources. The Design of the Tax
System. Firm behavior and the organization of industry: The Costs of
Production. Firms in competitive Markets. Monopoly. Monopolistic Competition.
Oligopoly.
Macroeconomics: The data of macroeconomics: Measuring a Nation’s Income.
Measuring the Cost of Living. The real economy in the long run: Production and
Growth. Saving, Investment, and the Financial System. Tools of Finance.
Unemployment and Its Natural Rate.
Money and prices in the long run: The Monetary System. Money Growth and
Inflation. Short-run economic fluctuations: Aggregate Demand and Aggregate
Supply. The Influence of Monetary and Fiscal Policy on Aggregate Demand. The
Short-Run Tradeoff between Inflation and Unemployment. Six Debates over
Macroeconomic Policy.
Thinking Like An Economist

Economics
ESSENTIALS OF
 The Economist as Scientist
• Economists play two roles:
1. Scientists: try to explain the world
2. Policy advisors: try to improve it

• In the first, economists employ the

scientific method,
the dispassionate development and testing
of theories about how the world works.

THINKING LIKE AN ECONOMIST 2

 Assumptions & Models
• Assumptions simplify the complex world,
make it easier to understand.
• Example: To study international trade,
assume two countries and two goods.
Unrealistic, but simple to learn and
gives useful insights about the real world.
• Model: a highly simplified representation
of
a more complicated reality.
Economists use models to study economic
issues.
THINKING LIKE AN ECONOMIST 3
Some Familiar Models

A road map

THINKING LIKE AN ECONOMIST 4

 Some Familiar Models

A model of human
anatomy from high
school biology class

THINKING LIKE AN ECONOMIST 5

Some Familiar Models

A model airplane

THINKING LIKE AN ECONOMIST 6

Our First Model:
The Circular-Flow Diagram
• The Circular-Flow Diagram: a visual
model of the economy, shows how dollars
flow through markets among households
and firms
• Two types of “actors”:
– households
– firms
• Two markets:
– the market for goods and services
– the market for “factors of production”
THINKING LIKE AN ECONOMIST 7
 Factors of Production
• Factors of production: the resources the
economy uses to produce goods & services,
including
– labour
– land
– capital (buildings & machines used in
production)

THINKING LIKE AN ECONOMIST 8

FIGURE 1: The Circular-Flow Diagram

Households:
▪ Own the factors of production,
sell/rent them to firms for income
▪ Buy and consume goods & services

Firms Households

Firms:
▪ Buy/hire factors of production,
use them to produce goods
and services
▪ Sell goods & services
THINKING LIKE AN ECONOMIST 9
FIGURE 1: The Circular-Flow Diagram

Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of labour, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
THINKING LIKE AN ECONOMIST 10
Our Second Model:
The Production Possibilities Frontier
• The Production Possibilities Frontier (PPF):
a graph that shows the combinations of
two goods the economy can possibly produce
given the available resources and the available
technology
• Example:
– Two goods: computers and wheat
– One resource: labour (measured in hours)
– Economy has 50,000 labour hours per month
available for production.
THINKING LIKE AN ECONOMIST 11
 PPF Example
• Producing one computer requires 100 hours labour.
• Producing one ton of wheat requires 10 hours labour.
Employment of
Production
labour hours
Computers Wheat Computers Wheat
A 50,000 0 500 0
B 40,000 10,000 400 1,000
C 25,000 25,000 250 2,500
D 10,000 40,000 100 4,000
E 0 50,000 0 5,000
 PPF Example
Wheat
Point Production
(tons)
on Com- 6,000
graph puters Wheat E
5,000
A 500 0 D
4,000
B 400 1,000
3,000 C
C 250 2,500
2,000
D 100 4,000 B
1,000
E 0 5,000 A
0
0 100 200 300 400 500 600
Computers
THINKING LIKE AN ECONOMIST 13
ACTIVE LEARNING 1
Points off the PPF
A. On the graph, find the point that represents
(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce
this combination of the two goods?
Why or why not?
B. Next, find the point that represents
(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce
this combination of the two goods?

14
 ACTIVE LEARNING 1
Answers
Wheat
▪ Point F: (tons)
100 computers, 6,000
3000 tons wheat 5,000
▪ Point F requires 4,000
40,000 hours
3,000
of labour. F
Possible but 2,000
not efficient: 1,000
could get more 0
of either good 0 100 200 300 400 500 600
w/o sacrificing Computers
any of the other.
15
ACTIVE LEARNING 1
Answers
Wheat
▪ Point G: (tons)
300 computers, 6,000
3500 tons wheat 5,000

▪ Point G requires 4,000 G

65,000 hours 3,000
of labour.
2,000
Not possible
because 1,000

economy 0
only has 0 100 200 300 400 500 600
50,000 hours. Computers

16
 The PPF: What We Know So Far
Points on the PPF (like A – E)
– possible
– efficient: all resources are fully utilized
Points under the PPF (like F)
– possible
– not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
Points above the PPF (like G)
– not possible

THINKING LIKE AN ECONOMIST 17

 The PPF and Opportunity Cost
• Recall: The opportunity cost of an item
is what must be given up to obtain that item.
▪ Moving along a PPF involves shifting resources
(e.g., labour) from the production of one good to
the other.
▪ Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
▪ The slope of the PPF tells you the opportunity
cost of one good in terms of the other.

THINKING LIKE AN ECONOMIST 18

ACTIVE LEARNING 2
PPF and Opportunity Cost
In which country is the opportunity cost of cloth lower?
FRANCE ENGLAND
Wine Wine
600 600

500 500

400 400

300 300

200 200

100 100

0 0
0 100 200 300 400 0 100 200 300 400
Cloth Cloth19
ACTIVE LEARNING 2
Answers
England, because its PPF is not as steep as France’s.
FRANCE ENGLAND
Wine Wine
600 600

500 500

400 400

300 300

200 200

100 100

0 0
0 100 200 300 400 0 100 200 300 400
Cloth Cloth20
 Economic Growth and the PPF
With additional Wheat
resources or an (tons) Economic
improvement in 6,000 growth shifts
the PPF
technology, 5,000 outward.
the economy can
4,000
produce more
computers, 3,000
2,000
more wheat,
or any combination 1,000
in between. 0
0 100 200 300 400 500 600
Computers
THINKING LIKE AN ECONOMIST 21
 The Shape of the PPF
• The PPF could be a straight line, or bow-shaped
• Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
– If opp. cost remains constant,
PPF is a straight line.
(In the previous example, opp. cost of a computer
was always 10 tons of wheat.)
– If opp. cost of a good rises as the economy
produces more of the good, PPF is bow-shaped.

THINKING LIKE AN ECONOMIST 22

 Why the PPF Might Be Bow-Shaped

As the economy

Cold Drinks
shifts resources
from Cold Drinks
to mountain bikes:
▪ PPF becomes
steeper
▪ opp. cost of
mountain bikes
increases
Mountain
Bikes
THINKING LIKE AN ECONOMIST 23
 Why the PPF Might Be Bow-Shaped
• So, PPF is bow-shaped when different
workers have different skills, different
opportunity costs of producing one good in
terms of the other.
• The PPF would also be bow-shaped when
there is some other resource, or mix of
resources with varying opportunity costs
(E.g., different types of land suited for
different uses).

THINKING LIKE AN ECONOMIST 24

 The PPF: A Summary
• The PPF shows all combinations of two goods
that an economy can possibly produce,
given its resources and technology.

▪ The PPF illustrates the concepts of

tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.
▪ A bow-shaped PPF illustrates the concept of
increasing opportunity cost.

THINKING LIKE AN ECONOMIST 25

 Microeconomics and Macroeconomics
• Microeconomics is the study of how
households and firms make decisions and
how they interact in markets.
• Macroeconomics is the study of economy-
wide phenomena, including inflation,
unemployment, and economic growth.
• These two branches of economics are closely
intertwined, yet distinct – they address
different questions.

THINKING LIKE AN ECONOMIST 26

 The Economist as Policy Advisor
• As scientists, economists make
positive statements,
which attempt to describe the world as it is.
• As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
• Positive statements can be true or false i.e. they may
be confirmed or refuted, normative statements
cannot.
• Govt employs many economists for policy advice. E.g.,
the Indian Prime Minister has a Council of Economic
Advisors.

27
ACTIVE LEARNING 3
Identifying positive vs. normative
Which of these statements are “positive” and which
are “normative”? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of popcorn will cause an
increase in consumer demand for movie tickets.

28
ACTIVE LEARNING 3
Answers
a. Prices rise when the government increases the
quantity of money.
Positive – describes a relationship, could use
data to confirm or refute.
b. The government should print less money.
Normative – this is a value judgment, cannot be
confirmed or refuted.

29
ACTIVE LEARNING 3
Answers
c. A tax cut is needed to stimulate the economy.
Normative – another value judgment.
d. An increase in the price of popcorn will cause an
increase in consumer demand for movie tickets.
Positive – describes a relationship.
Note that a statement need not be true to be
positive.

30
 Why Economists Disagree
• Economists often give conflicting policy
advice.
• They sometimes disagree about the validity
of alternative positive theories about the
world.
• They may have different values and,
therefore, different normative views about
what policy should try to accomplish.
• Yet, there are many propositions about
which most economists agree.

THINKING LIKE AN ECONOMIST 31

CHAPTER SUMMARY

• As scientists, economists try to explain the world

using models with appropriate assumptions.
• Two simple models are the Circular-Flow Diagram
and the Production Possibilities Frontier.
• Microeconomics studies the behavior of consumers
and firms, and their interactions in markets.
Macroeconomics studies the economy as a whole.
• As policy advisers, economists offer advice on how to
improve the world.

32
 Principles of Economics
Introduction: Ten Principles Of Economics. Thinking Like An Economist.
→ Interdependence And The Gains From Trade.
Microeconomics: Working of Markets: The Market Forces of Supply and
Demand. Elasticity and Its Application. Supply, Demand, and Government
Policies. Markets and welfare: Consumers, Producers, and the Efficiency of
Markets. Applications: The Costs of Taxation. Economics of the public sector:
Externalities. Public Goods and Common Resources. The Design of the Tax
System. Firm behavior and the organization of industry: The Costs of
Production. Firms in competitive Markets. Monopoly. Monopolistic Competition.
Oligopoly.
Macroeconomics: The data of macroeconomics: Measuring a Nation’s Income.
Measuring the Cost of Living. The real economy in the long run: Production and
Growth. Saving, Investment, and the Financial System. Tools of Finance.
Unemployment and Its Natural Rate.
Money and prices in the long run: The Monetary System. Money Growth and
Inflation. Short-run economic fluctuations: Aggregate Demand and Aggregate
Supply. The Influence of Monetary and Fiscal Policy on Aggregate Demand. The
Short-Run Tradeoff between Inflation and Unemployment. Six Debates over
Macroeconomic Policy.
In this sub-topic,
look for the answers to these questions:
• Why do people – and nations – choose to be
economically interdependent?
• How can trade make everyone better off?
• What is absolute advantage?
What is comparative advantage?
How are these concepts similar?
How are they different?

34
 Interdependence & Gains
• One of the Ten Principles:
Trade can make everyone better off.
• We now learn why people – and nations –
choose to be interdependent,
and how they can gain from trade.
• If there is an interdependence between two
or more things, they depend on each other.
Example: the interdependence between global trading partners

• Gain refers to an increase in wealth or

resources.

INTERDEPENDENCE AND
35
THE GAINS FROM TRADE
 Our Example
• Two countries: India and Bhutan
• Two goods: computers and wheat
• One resource: labour, measured in hours
• We will look at how much of both goods
each country produces and consumes
– if the country chooses to be self-sufficient
– if it trades with the other country
INTERDEPENDENCE AND
36
THE GAINS FROM TRADE
 Production Possibilities in India
• India has 50,000 hours of labour
available for production, per month.
• Producing one computer
requires 100 hours of labour.
• Producing one ton of wheat
requires 10 hours of labour.

INTERDEPENDENCE AND
37
THE GAINS FROM TRADE
 Wheat India PPF
(tons) India has enough labour to
5,000 produce 500 computers, or
5000 tons of wheat, or any
4,000 combination along the PPF.
3,000

2,000

1,000

Computers
0
100 200 300 400 500
INTERDEPENDENCE AND
38
THE GAINS FROM TRADE
 Wheat India Without Trade
(tons)
Suppose India uses half its labour to
5,000
produce each of the two goods.
4,000 Then it will produce and consume
250 computers and
3,000 2500 tons of wheat.

2,000

1,000

Computers
0
100 200 300 400 500
INTERDEPENDENCE AND
39
THE GAINS FROM TRADE
ACTIVE LEARNING 1
Derive Bhutan’s PPF
Use the following information to draw
Bhutan’s PPF.
– Bhutan has 30,000 hours of labour available for
production, per month.
– Producing one computer requires 125 hours of
labour.
– Producing one ton of wheat requires 25 hours of
labour.
Your graph should measure computers on the
horizontal axis.
40
 Bhutan’s PPF
Wheat
Bhutan has enough labour
(tons)
to produce 240 computers,
2,000 or 1200 tons of wheat,
or any combination
along the PPF.
1,000

0 Computers
100 200 300
INTERDEPENDENCE AND
41
THE GAINS FROM TRADE
 Bhutan Without Trade
Wheat
(tons) Suppose Bhutan uses half its labour to
produce each good.
2,000 Then it will produce and consume
120 computers and
600 tons of wheat.
1,000

0 Computers
100 200 300
INTERDEPENDENCE AND
42
THE GAINS FROM TRADE
 Consumption With and Without Trade
• Without trade,
– Indian consumers get 250 computers
and 2500 tons wheat.
– Bhutanese consumers get 120 computers
and 600 tons wheat.
• We will compare consumption without trade to
consumption with trade.
• First, we need to see how much of each good is
produced and traded by the two countries.

INTERDEPENDENCE AND
43
THE GAINS FROM TRADE
ACTIVE LEARNING 2
Production under trade
1. Suppose India produces 3400 tons of
wheat. How many computers would India
be able to produce with its remaining
labour? Draw the point representing this
combination of computers and wheat on
India PPF.
2. Suppose Bhutan produces 240 computers.
How many tons of wheat would Bhutan be
able to produce with its remaining labour?
Draw this point on Bhutan’s PPF.
44
 Wheat India Production With Trade
(tons)
5,000 Producing 3400 tons of wheat
requires 34,000 labour hours.
4,000
The remaining 16,000
3,000 labour hours are used to
produce 160 computers.
2,000

1,000

Computers
0
100 200 300 400 500
INTERDEPENDENCE AND
45
THE GAINS FROM TRADE
 Bhutan’s Production With Trade
Wheat Producing 240 computers
(tons) requires all of Bhutan’s
30,000 labour hours.
2,000
So, Bhutan would produce
0 tons of wheat.

1,000

0 Computers
100 200 300
INTERDEPENDENCE AND
46
THE GAINS FROM TRADE
 Basic international trade terms

• Exports:
goods produced domestically and sold abroad
To export means to sell domestically produced
goods abroad.
• Imports:
goods produced abroad and sold domestically
To import means to purchase goods produced
in other countries.

INTERDEPENDENCE AND
47
THE GAINS FROM TRADE
ACTIVE LEARNING 3
Consumption under trade
Suppose India exports 700 tons of wheat to
Bhutan, and imports 110 computers from Bhutan.
(So, Bhutan imports 700 tons wheat and exports
110 computers.)
▪ How much of each good is consumed in India?
Plot this combination on India PPF.
▪ How much of each good is consumed in
Bhutan? Plot this combination on Bhutan’s PPF.

48
 India Consumption With Trade
Wheat
(tons) computers wheat
5,000 produced 160 3400
+ imported 110 0
4,000 – exported 0 700
= amount
3,000 270 2700
consumed
2,000

1,000

Computers
0
100 200 300 400 500
INTERDEPENDENCE AND
49
THE GAINS FROM TRADE
 Bhutan’s Consumption With Trade

computers wheat
Wheat produced 240 0
(tons)
+ imported 0 700
2,000 – exported 110 0
= amount
130 700
consumed

1,000

0 Computers
100 200 300
INTERDEPENDENCE AND
50
THE GAINS FROM TRADE
 Trade Makes Both Countries Better Off
India
consumption consumption gains from
without trade with trade trade
computers 250 270 20
wheat 2,500 2,700 200
Bhutan
consumption consumption gains from
without trade with trade trade
computers 120 130 10
wheat 600 700 100
INTERDEPENDENCE AND
51
THE GAINS FROM TRADE
 Where Do These Gains Come From?
• Absolute advantage: the ability to produce
a good using fewer inputs than another
producer
• India has an absolute advantage in wheat:
producing a ton of wheat uses 10 labour
hours
in India vs. 25 in Bhutan.
• If each country has an absolute advantage
in one good and specializes in that good,
then both countries can gain from trade.
INTERDEPENDENCE AND
52
THE GAINS FROM TRADE
 Where Do These Gains Come From?
• Which country has an absolute advantage in
computers?
• Producing one computer requires
125 labour hours in Bhutan,
but only 100 in India
• India has an absolute advantage in both
goods!

So why does Bhutan specialize in computers?

Why do both countries gain from trade?
INTERDEPENDENCE AND
53
THE GAINS FROM TRADE
 Two Measures of the Cost of a Good
• Two countries can gain from trade when each
specializes in the good it produces at lowest
cost.
• Absolute advantage measures the cost of a good
in terms of the inputs required to produce it.
• Recall:
Another measure of cost is opportunity cost.
• In our example, the opportunity cost of a
computer is the amount of wheat that could be
produced using the labour needed to produce
one computer.
INTERDEPENDENCE AND
54
THE GAINS FROM TRADE
 Opportunity Cost and
Comparative Advantage
• Comparative advantage: the ability to produce
a good at a lower opportunity cost than another
producer
• Which country has the comparative advantage in
computers?
• To answer this, must determine the opp. cost of
a computer in each country.

INTERDEPENDENCE AND
55
THE GAINS FROM TRADE
 Opportunity Cost and
Comparative Advantage
• The opp. cost of a computer is
– 10 tons of wheat in India, because producing
one computer requires 100 labour hours,
which instead could produce 10 tons of wheat.
– 5 tons of wheat in Bhutan, because producing
one computer requires 125 labour hours,
which instead could produce 5 tons of wheat.
• So, Bhutan has a comparative advantage in
computers. Lesson: Absolute advantage is
not necessary for comparative advantage!
INTERDEPENDENCE AND
56
THE GAINS FROM TRADE
 Comparative Advantage and Trade
• Gains from trade arise from comparative
advantage (differences in opportunity costs).
• When each country specializes in the good(s)
in which it has a comparative advantage,
total production in all countries is higher,
the world’s “economic pie” is bigger,
and all countries can gain from trade.
• The same applies to individual producers
(like the farmer and the rancher) specializing
in different goods and trading with each other.

INTERDEPENDENCE AND
57
THE GAINS FROM TRADE
ACTIVE LEARNING 4
Absolute & comparative advantage
Argentina and Brazil each have 10,000 hours of labour
per month.
In Argentina,
– producing one pound coffee requires 2 hours
– producing one bottle Wine requires 4 hours
In Brazil,
– producing one pound coffee requires 1 hour
– producing one bottle Wine requires 5 hours
Which country has an absolute advantage in the
production of coffee? Which country has a
comparative advantage in the production of Wine?
58
ACTIVE LEARNING 4
Answers
Brazil has an absolute advantage in coffee:
– Producing a pound of coffee requires only one
labour-hour in Brazil, but two in Argentina.
Argentina has a comparative advantage in Wine:
– Argentina’s opp. cost of Wine is two pounds of
coffee, because the four labour-hours required
to produce a bottle of Wine could instead
produce two pounds of coffee.
– Brazil’s opp. cost of Wine is five pounds of
coffee.
59
 Unanswered Questions….
• We made a lot of assumptions about the quantities
of each good that each country produces, trades, and
consumes, and the price at which the countries
trade wheat for computers.
• In the real world, these quantities and prices would
be determined by the preferences of consumers and
the technology and resources in both countries.
• We will begin to study this in the next chapter.
• For now, though, our goal was merely to
see how trade can make everyone better off.

INTERDEPENDENCE AND
60
THE GAINS FROM TRADE
CHAPTER SUMMARY

• Interdependence and trade allow everyone to enjoy a

greater quantity and variety of goods & services.
• Comparative advantage means being able to produce a
good at a lower opportunity cost. Absolute advantage
means being able to produce a good with fewer
inputs.
• When people – or countries – specialize in the goods
in which they have a comparative advantage, the
economic “pie” grows and trade can make everyone
better off.
61