INTRODUCTION NOTES
Economics is a social science that studies individuals’ economic
behavior, economic phenomena, as well as how individual agents, such as
consumers, firms, and government agencies, make trade-off choices that
allocate limited resources among competing uses. People’s desires are
unlimited, but resources are limited, therefore individuals must make
tradeoffs. We need economics to study this fundamental conflict and how
these trade-offs are best made.
Four basic questions must be answered by any economic institution:
- What goods and services should be produced and in what quantity?
- How should the product be produced?
- For whom should it be produced and how should it be distributed?
- Who makes the decision?
The answers depend on the use of economic institutions. There are two
basic economic institutions that have been so far used in the real world:
(1) Market economic institution (the price mechanism): Most decisions on
economic activities are made by individuals. This primarily
decentralized decision system is the most important economic institution
discovered for reaching cooperation amongst individuals and solving the
conflicts that occur between them. The market economy has been proven to
be only economic institution, so far, that can keep sustainable
development and growth within an economy.
(2) Planed economic institution: Most decisions on economic activities
are made by governments, which are mainly centralized decision systems.
1.2 Economic Theory
An economic theory, which can be considered an axiomatic approach,
consists of a set of assumptions and conditions, an analytical
framework, and conclusions (explanations and/or predications) that are
derived from the assumptions and the analytical framework. Like any
science, economics is concerned with the explanation of observed
phenomena and also makes economic predictions and assessments based on
economic theories. Economic theories are developed to explain the
observed phenomena in terms of a set of basic assumptions and rules.
Roles of Economic Theory
An economic theory has three possible roles: (1) It can be used to
explain economic behavior and economic phenomena in the real world. (2)
It can make scientific predictions or deductions about possible outcomes
and consequences of adopted economic mechanisms when economic
environments and individuals’ behavior are appropriately described. (3)
It can be used to refute faulty goals or projects before they are
actually undertaken. If a conclusion is not possible in theory, then it
is not possible in a real world setting, as long as the assumptions were
approximated realistically.
Generality of Economic Theory
An economic theory is based on assumptions imposed on economic
environments, individuals’ behavior, and economic institutions. The more
general these assumptions are, the more powerful, useful, or meaningful
the theory that comes from them is. The general equilibrium theory is
considered such a theory.
Limitation of Economic Theory
When examining the generality of an economic theory, one should realize
any theory or assumption has a boundary limitation, and applicable range of economic theory. Thus, two common
misunderstandings in economic theory should be avoided. One
misunderstanding is to over-evaluate the role of an economic theory.
Every theory is based on some imposed assumptions. Therefore, it is
important to keep in mind that every theory is not universal, cannot
explain everything, but has its limitation and boundary of suitability.
When applying a theory to make an economic conclusion and discuss an
economic problem, it is important to notice the
boundary, limitation, and applicable range of the theory. It cannot be
applied arbitrarily, or a wrong conclusion will be the result.
The other misunderstanding is to under-evaluate the role of an economic
theory. Some people consider an economic theory useless because they
think assumptions imposed in the theory are unrealistic. In fact, no
theory, whether in economics, physics, or any other science, is
perfectly correct. The validity of a theory depends on whether or not it
succeeds in explaining and predicting the set of phenomena that it is
intended to explain and predict. Theories, therefore, are continually
tested against observations. As a result of this testing, they are often
modified, refined, and even discarded.
The process of testing and refining theories is central to the
development of modern economics as a science. One example is the
assumption of perfect competition. In reality, no competition is
perfect. Real world markets seldom achieve this ideal status. The
question is then not whether any particular market is perfectly
competitive, almost no one is. The appropriate question is to what
degree models of perfect competition can generate insights about
real-world markets. We think this assumption is approximately correct in
certain situations. Just like frictionless models in physics, such as in
free falling body movement (no air resistance), ideal gas (molecules do
not collide), and ideal fluids, frictionless models of perfect
competition generate useful insights in the economic world.
It is often heard that someone is claiming they have toppled an existing
theory or conclusion, or that it has been overthrown, when some
condition or assumption behind it is criticized. This is usually
needless claim, because any formal rigorous theory can be criticized at
anytime because no assumption can coincide fully with reality or cover
everything. So, as long as there are no logic errors or inconsistency in
a theory, we cannot say that the theory is wrong. We can only criticize
it for being too limited or unrealistic.
What economists should do is to weaken or relax the assumptions, and
obtain new theories based on old theories. We cannot say though that the
new theory topples the old one, but instead that the new theory extends
the old theory to cover more general situations and different economic
environments.
1.3 What is Macroeconomics?
Definition (Macroeconomics): is the study of relationships between
aggregate economic variables, such as between output, unemployment, and
the rate of inflation Macroeconomics was born out of the Great
Depression in the 1930s due to the work of John Maynard Keynes, a
British economist. It was the result of people desperately wanting to
know what caused the Depression and how it could be ended. People study
macroeconomics to understand two types of behaviour of an economy and
everything in macroeconomics ultimately centres on these two issues:
Why study macro-economics
- Curiosity — people want to figure out how what we observe happens
- To Become Educated — as ―the development of character or mental
powers‖ which is very different from being trained which is ―to
teach a person a specified skill by practice - Employment. — Employment can be gained directly through the
education and knowledge received at university
How Do We Study Macroeconomics?
Economics is a social science which means it involves studying society
to understand why people do what they do, but it tries to approach it
‖scientifically‖. Note that this approach is not the myth of the neutral
uninvolved scientist in a white lab coat seeking the greater absolute
truth. Instead, it is prejudiced, emotive, involved people seeking to
make some sense of what we observe and experience. Note also that
Economics is not business, which is more a vocational orientated subject
designed to help start and run companies.
1.4 Economic Models
A fundamental tool used by economists to understand people‘s behaviour
and thus the economy, and one which we will use repeatedly through this
course, is an economic ―model‖.
Definition (Economic Model): is a theory that summarizes, often in
mathematical terms, relationships among economic variables.
Definition (Theory): is a system of ideas explaining something,
especially one based on general principles independent of the particular
things to be explained. or, an economic theory is a generalization based
on a few principles that enables us to understand and predict the
economic choices made by people. For example, the common
characterization of what we study in economics is a self-interested
rational person with scarce resources and voluntary choices. In
developing a model we use two types of variables: exogenous variables and endogenous variables:
Definition (Exogenous Variables): are determined outside of the model.
so that they do not capture the decisions made by people in which we are
primarily
Interested in learning about. Assuming that some variables are exogenous
helps to simplify matters by not having everything being decided at once.
Definition (Endogenous Variables): are determined within the model. and
do capture the decisions made by people in which we are primarily
interested in learning about.
So a model is a set of very general ―assumptions‖ plus some more
specific assumptions. Using deductive logic we can then deduce what we
expect to happen given certain circumstances.
1.5 Why Macroeconomics is Different from Microeconomics
The Issue of Aggregation
Since the previously described approach to developing an economic
understanding of society is generic in nature, an obvious question to
ask is what makes macroeconomics different from microeconomics since
they both just involve studying economic behaviour of people? Recall
that microeconomics is the study of the decisions made by firms and
households, and how these decision makers interact in the marketplace.
Macroeconomics is the study of the decision made by all firms and
households, and the interactions of these decision makers in all
markets. Furthermore, when studying a single market we invoke the
ceteris paribus assumption but in macroeconomics this is no longer true
since we are studying all markets at the same time. So macroeconomics is
different because of the sheer scale, all markets are aggregated
together, and because the general effects of any changes in behaviour
have to be taken into account, rather than just analyzing economic
decisions in isolation from each other.
Micro-economic theory
Investigates how individuals and firms in society allocate scarce
resources among competing consumption and production goals respectively
It also studies factors affecting the relative prices of different goods
and factors of production in individual markets (e.g. the supply of
demand for milk)
Macro-economic theory
It is concerned with aggregate variables such as the aggregate demand by
all consumers for all goods and services produced in an economy over a
given period of time
Among aggregate economic phenomena macro-economic theory considers include
- Inflation
- The interest rate
- The rate of income /output
- The rate of unemployment
- Government spending
- Private domestic investment
- Aggregate disposable income
- The general price level
Macro-economic theory is the explanation of how the aggregate variables
interact to produce the state of a nation‘s economic situation.
Macro economics
summarized in three models
The study of macroeconomics is organized around three models that
describe the world as follows:
- The very long run: concerned with the long run behavior of the
economy. It is the domain of growth theory, which focuses on the
growth of productive capacity i.e the factors of production and the
technology that firms use to produce goods and services. - The long run: here the product capacity is treated as given. The
level of productive capacity determines output, and fluctuations in
demand relative to this level of supply determine prices and inflation. - The short run: where fluctuations in demand determine how much of
the available capacity is used and thus the level of output and
employment
