Economic Methodology & the Economising Problem

MODULE 1-PART 1

Economic Methodology

& the Economising Problem

What is Economics?

Definition: A social science concerned with the allocation of scarce/limited resources between unlimited and often competing needs and wants.

Resource Categories

Resources are divided into 4 main categories.

• Land: represents all natural resources such as rivers, forests, lakes, mineral deposits, flora and fauna, including biological and environmental diversity. 
• Labour: Requires a fundamentally scarce resource - TIME. LABOUR includes human effort, both physical and mental. Labour requires a fundamentally scarce resource: TIME. (In deciding how much time to devote to your studies at RMIT, solving an economic problem. You have limited time each day and competing alternative demands on your time. E.g. study, sleep, eating, socialising, paid work. Thus you must make a choice between valued alternatives)
• Capital: are investment goods, used in the production of goods and services. One can distinguish between two types of capital: 

• Human capital: knowledge & skills that people develop (through experience, education, and on-the-job training) that enhance their ability to produce or become more productive. 
• Physical Capital: buildings, machinery tools, etc. which consists of buildings, machinery, tools, and other manufactured items that are used to produce other goods and services. 

• Enterprise or entrepreneurial ability represents the input responsible for:

• Seeing a business or commercial opportunity,
• Engaging in risk taking,
• Collecting or acquiring, and coordinating the relevant resources.

Lessons

1. Trade-offs: Principle #1: People Face Trade-offs - “There is no such thing as a free lunch”. We usually give up another thing to get one thing that we like. Making decisions requires trading off one goal against another.

Ex: When students spend an hour to study one subject, they have to give up an hour                  that they could study the other.

Social trade off: Gun- Butter (protection and standard of living, environment and level of income), Efficiency and Equity (greater equity-lower efficiency).

1. Opportunity cost: Principle #2: The Cost of Something Is What You Give Up to Get It - The cost of something is what you give up to get it. Making decisions requires individuals to consider the benefits and costs of some action.

Ex: study at RMIT

1. Being rational: Principle #3: Rational People Think at the Margin - Rational people think at the margin (they think about the negative and positive benefits of making decision).

Economists generally assume that people are rational. To be rational means to take an action if and only if its benefits exceed its costs.

Consumers want to purchase the bundle of goods and services that allows them the greatest level of satisfaction given their incomes and the prices they face.

Firms want to produce the level of output that maximizes the profits they earn.

Many decisions in life involve incremental decisions: Should I study an additional hour for tomorrow’s exam?

Marginal changes: small incremental adjustments to a plan of action. Example: Why is water so cheap while diamonds are expensive? Because water is plentiful, the marginal benefit of an additional cup is small. Because diamonds are rare, the marginal benefit of an extra diamond is high.

1. Incentives: Principle #4: People Respond to Incentives - something that encourage people to do something.

Because rational people make decisions by weighing costs and benefits, their decisions may change in response to incentives.

When the price of a good rises, consumers will buy less of it because its cost has risen.

When the price of a good rises, producers will allocate more resources to the production of the good because the benefit from producing the good has risen.

1. Benefit of trade: Principle #5: Trade Can Make Everyone Better Off - Trade can make everyone better off.

Trade is not like a sports competition, where one side gains and the other side loses.

Trade between two countries can make each country better off.

Trade allows for specialization in products that countries can do best.

1. Benefit of markets: Principle #6: Markets Are Usually a Good Way to Organize Economic Activity - Efficient distribution of resources

     Many countries that once had centrally planned economies have abandoned this system and are trying to develop market economies.

    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. Market prices reflect both the value of a product to consumers and the cost of the resources used to produce it. When a government interferes in a market and restricts price from adjusting, household and firm decisions are not based on the proper information. Thus, these decisions may be inefficient. 

1. Government involvement: Principle #7: Governments Can Sometimes Improve Market Outcomes – the government is involved in the economy to promote efficiency and equity Government policy can be most useful when there is market failure (a situation of market fails to allocate resources efficiently).

Ex: pollution-when a factory pollutes the air and rivers, the government can use    environmental regulation to raise economic wellbeing.