Lecture notes on Economics

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Introduction to economics O. Birchall assisted by D. Verry EC1002 2016 Undergraduate study in Economics, Management, Finance and the Social Sciences This is an extract from a subject guide for an undergraduate course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. Materials for these programmes are developed by academics at the London School of Economics and Political Science (LSE). For more information, see: www.londoninternational.ac.ukThis guide was prepared for the University of London International Programmes by: O. Birchall, The London School of Economics and Political Science, assisted by D. Verry, The London School of Economics and Political Science. This is one of a series of subject guides published by the University. We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide. University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom www.londoninternational.ac.uk Published by: University of London © University of London 2016 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to respect copyright. If you think we have inadvertently used your copyright material, please let us know.Contents Contents Introduction ............................................................................................................ 1 Introduction to the subject area ..................................................................................... 1 Aims of the course ......................................................................................................... 1 Learning outcomes ........................................................................................................ 2 Overview of learning resources ...................................................................................... 2 Route map to the guide ................................................................................................. 4 Study advice .................................................................................................................. 6 Use of mathematics ....................................................................................................... 7 Examination advice........................................................................................................ 7 Block 1: Economics, the economy and tools of economic analysis ........................ 9 Introduction .................................................................................................................. 9 Scarcity ....................................................................................................................... 12 Rationality ................................................................................................................... 13 The production possibility frontier (PPF) ........................................................................ 13 Opportunity cost and absolute and comparative advantage .......................................... 15 Markets ....................................................................................................................... 16 Microeconomics and macroeconomics ......................................................................... 18 A note on mathematics................................................................................................ 18 Models and theory ....................................................................................................... 19 Criticisms of economics .............................................................................................. 22 Overview ..................................................................................................................... 22 Reminder of learning outcomes.................................................................................... 23 Sample examination questions ..................................................................................... 23 Block 2: Demand, supply and the market ............................................................. 25 Introduction ................................................................................................................ 25 Equilibrium .................................................................................................................. 26 Demand and supply curves .......................................................................................... 27 Shifts in the demand and supply curves ........................................................................ 28 Consumer and producer surplus ................................................................................... 29 Overview ..................................................................................................................... 32 Reminder of learning outcomes.................................................................................... 32 Sample examination questions ..................................................................................... 32 Block 3: Elasticity ................................................................................................ 35 Introduction ................................................................................................................ 35 Price elasticity of demand ........................................................................................... 36 Cross-price elasticity of demand ................................................................................... 39 Income elasticity of demand ........................................................................................ 40 Price elasticity of supply ............................................................................................... 41 Incidence of a tax ....................................................................................................... 41 Overview ..................................................................................................................... 43 Reminder of learning outcomes.................................................................................... 43 Sample examination questions ..................................................................................... 43 iEC1002 Introduction to economics Block 4: Consumer choice ..................................................................................... 47 Introduction ................................................................................................................ 47 Consumer choice and demand decisions ...................................................................... 48 Utility maximisation and choice .................................................................................... 52 Income and price changes ........................................................................................... 54 Deriving demand: ‘The individual demand curve’ .......................................................... 56 Deriving demand: ‘The market demand curve’ .............................................................. 58 Complements and substitutes ...................................................................................... 58 Cash transfers versus transfers in kind .......................................................................... 59 Overview ..................................................................................................................... 60 Reminder of your learning outcomes ............................................................................ 61 Sample examination questions ..................................................................................... 61 Block 5: The Firm I ................................................................................................ 63 Introduction ................................................................................................................ 63 Introduction to the firm................................................................................................ 64 The firm’s supply decision ........................................................................................... 64 Profit = Total revenue – Total cost ................................................................................ 69 Overview ..................................................................................................................... 72 Reminder of learning outcomes.................................................................................... 72 Sample examination questions ..................................................................................... 72 Block 6: The Firm II ............................................................................................... 75 Introduction ................................................................................................................ 75 Cost, production and output ........................................................................................ 75 Overview ..................................................................................................................... 81 Reminder of learning outcomes.................................................................................... 83 Sample examination questions ..................................................................................... 83 Block 7: Perfect competition .............................................................................. 87 Introduction ................................................................................................................ 87 Assumptions and implications ...................................................................................... 88 The firm’s supply decision ............................................................................................ 89 Industry supply curves .................................................................................................. 92 Comparative statics .................................................................................................... 93 Perfect competition and efficiency ............................................................................... 94 Overview ..................................................................................................................... 95 Reminder of learning outcomes.................................................................................... 96 Sample examination questions ..................................................................................... 96 Block 8: Pure monopoly ........................................................................................ 99 Introduction ................................................................................................................ 99 Perfect competition and perfect monopoly .................................................................. 100 Monopoly analysis ..................................................................................................... 100 Social cost of monopoly ............................................................................................. 105 Price discrimination ................................................................................................... 106 When can monopolies be justified? ............................................................................ 107 Overview ................................................................................................................... 108 Reminder of learning outcomes.................................................................................. 108 Sample examination questions ................................................................................... 108 Block 9: Market structure and imperfect competition ....................................... 111 Introduction .............................................................................................................. 111 A theory of market structure ...................................................................................... 112 Monopolistic competition .......................................................................................... 113 iiContents Oligopoly................................................................................................................... 114 Game theory ............................................................................................................. 115 Models of oligopoly ................................................................................................... 116 Reminder of learning outcomes.................................................................................. 120 Sample examination questions ................................................................................... 120 Block 10: The labour market ............................................................................... 123 Introduction .............................................................................................................. 123 The factors of production ........................................................................................... 124 Analysis of the labour market ..................................................................................... 125 Labour supply ............................................................................................................ 127 Labour market equilibrium ........................................................................................ 128 Disequilibrium in the labour market............................................................................ 130 Wage discrimination .................................................................................................. 131 Overview ................................................................................................................... 131 Reminder of learning outcomes.................................................................................. 132 Sample examination questions ................................................................................... 132 Block 11: Welfare economics .............................................................................. 135 Introduction .............................................................................................................. 135 Equity and efficiency .................................................................................................. 136 Distortion of the market ............................................................................................. 141 Sources of market failure ........................................................................................... 141 Overview ................................................................................................................... 145 Reminder of learning outcomes.................................................................................. 145 Sample examination questions ................................................................................... 145 Block 12: The role of government ...................................................................... 147 Introduction .............................................................................................................. 147 Government functions ............................................................................................... 148 Taxation .................................................................................................................... 148 Public goods .............................................................................................................. 150 Merit and demerit goods ........................................................................................... 151 Transfer payments and income redistribution .............................................................. 151 Principles of taxation ................................................................................................. 153 Local government ...................................................................................................... 155 Impact of globalisation .............................................................................................. 155 Political economy ....................................................................................................... 155 Overview ................................................................................................................... 155 Reminder of learning outcomes.................................................................................. 156 Sample examination questions ................................................................................... 156 Block 13: Introduction to macroeconomics ........................................................ 159 Introduction .............................................................................................................. 159 Macroeconomic analysis ............................................................................................ 160 The circular flow of income ........................................................................................ 160 Measuring GDP ......................................................................................................... 161 Overview ................................................................................................................... 164 Reminder of learning outcomes.................................................................................. 165 Sample examination questions .................................................................................. 165 Block 14: Output and aggregate demand .......................................................... 169 Introduction .............................................................................................................. 169 Components of aggregate demand: consumption and investment .............................. 170 Equilibrium output ..................................................................................................... 171 iiiEC1002 Introduction to economics The multiplier ............................................................................................................ 173 Foreign trade: exports and imports ............................................................................. 176 Overview ................................................................................................................... 178 Reminder of learning outcomes.................................................................................. 178 Sample examination questions .................................................................................. 179 Block 15: Money and banking; interest rates and monetary transmission ........ 181 Introduction .............................................................................................................. 181 Money and banking ................................................................................................... 182 Interest rates and monetary transmission ................................................................... 185 Overview ................................................................................................................... 187 Reminder of learning outcomes.................................................................................. 188 Sample examination questions .................................................................................. 188 Block 16: Monetary and fiscal policy ................................................................. 191 Introduction .............................................................................................................. 191 Monetary policy ......................................................................................................... 192 The IS-LM model ....................................................................................................... 192 The policy mix ........................................................................................................... 201 Overview ................................................................................................................... 203 Reminder of learning outcomes.................................................................................. 203 Sample examination questions .................................................................................. 203 Block 17: Aggregate demand and aggregate supply ......................................... 205 Introduction .............................................................................................................. 205 Aggregate demand .................................................................................................... 206 Aggregate supply ...................................................................................................... 207 Equilibrium inflation .................................................................................................. 208 Wage rigidity ............................................................................................................. 209 Short-run aggregate supply ........................................................................................ 209 Adjustment to demand shocks ................................................................................... 210 Overview ................................................................................................................... 212 Reminder of learning outcomes.................................................................................. 213 Sample examination questions .................................................................................. 213 Appendix 17a – The AD curve: output and the price level ........................................... 215 Appendix 17b – Upwardly sloping SAS curves: output and the price level ................... 216 Block 18: Inflation .............................................................................................. 217 Introduction .............................................................................................................. 217 Money and inflation .................................................................................................. 218 The Phillips curve and inflation expectations ............................................................... 220 The costs of inflation ................................................................................................. 224 Controlling inflation ................................................................................................... 225 Overview ................................................................................................................... 225 Reminder of learning outcomes.................................................................................. 226 Sample examination questions ................................................................................... 226 Block 19: Unemployment.................................................................................... 229 Introduction .............................................................................................................. 229 Rates of unemployment ............................................................................................. 230 Analysis of unemployment ........................................................................................ 233 Changes in unemployment ........................................................................................ 235 Cyclical unemployment .............................................................................................. 236 Cost of unemployment............................................................................................... 237 Overview ................................................................................................................... 238 ivContents Reminder of learning outcomes.................................................................................. 238 Sample examination questions ................................................................................... 239 Block 20: Exchange rates and the balance of payments .................................... 241 Introduction .............................................................................................................. 241 The exchange rate ..................................................................................................... 242 The balance of payments ........................................................................................... 244 Real and PPP exchange rates ..................................................................................... 245 The current and financial accounts ............................................................................. 246 Long-run equilibrium ................................................................................................. 248 Overview ................................................................................................................... 248 Reminder of learning outcomes.................................................................................. 249 Sample examination questions ................................................................................... 249 Block 21: Open economy macroeconomics ........................................................ 251 Introduction .............................................................................................................. 251 The macroeconomy under fixed exchange rates .......................................................... 252 Devalution of a fixed exchange rate ........................................................................... 255 The macroeconomy under floating exchange rates ...................................................... 256 Overview ................................................................................................................... 259 Reminder of learning outcomes.................................................................................. 259 Sample examination questions ................................................................................... 259 Block 22: Business cycles .................................................................................... 263 Introduction .............................................................................................................. 263 Phases of the business cycle ...................................................................................... 264 Theorising the business cycle ..................................................................................... 264 Real business cycle theories ....................................................................................... 267 Business cycle synchronisation ................................................................................... 268 Schools of macroeconomic thought ............................................................................ 268 Overview ................................................................................................................... 270 Reminder of learning outcomes.................................................................................. 270 Sample examination questions ................................................................................... 270 Block 23: Supply-side economics and economic growth.................................... 273 Introduction .............................................................................................................. 273 Supply-side economics ............................................................................................... 274 Economic growth....................................................................................................... 275 Inputs to production .................................................................................................. 276 Solow growth model ................................................................................................. 276 Romer’s model of endogenous growth ....................................................................... 281 Costs of growth ......................................................................................................... 282 Overview ................................................................................................................... 282 Reminder of learning outcomes.................................................................................. 283 Sample examination questions ................................................................................... 283 Appendix 1: Syllabus .......................................................................................... 285 Appendix 2: Outline of readings......................................................................... 287 vEC1002 Introduction to economics Notes viIntroduction Introduction Introduction to the subject area Every day people make decisions that belong within the realm of economics. What to buy? What to make and sell? How many hours to work? We have all participated in the economy as consumers, many of us as workers, some of us also as producers. We have paid taxes. We have saved our earnings in a bank account. All of these activities (and many more) belong to the realm of economics. Households and firms are the basic units of an economy and are concerned with the economic problem: how best to satisfy unlimited wants using the limited resources that are available? As such, economics is the study of how society uses its scarce resources. Its aim is to provide insight into the processes governing the production, distribution and consumption of goods and services in an exchange economy. The previous paragraph could be taken to imply that the ‘realm of economics’ is limited and clearly defined. However, if economics is viewed as a way of thinking, or a set of tools that can be used to analyse human behaviour and the world around us, then you will find that the principles of economics can be applied to many different areas of life. The scope is thus very broad, but the principles of analysis are well defined and these are what you will become familiar with through undertaking this course. Although the course provides some information that is descriptive, such as how the banking system works, for example, its main focus is on introducing models and concepts which are used as tools of economic analysis. Concepts such as opportunity cost and approaches such as marginal analysis can be widely applied and prove very useful in understanding various aspects of society and people’s lives. Studying economics doesn’t just impart knowledge; it also develops skills such as logical and analytical thinking and problem-solving skills, which are useful beyond the formal study of economics. For some of you, economics is not the main area of study, and you may not be intending to pursue a career as an economist. However, we are sure that an understanding of basic economic concepts will still prove useful to you in whatever direction your studies and subsequent career may take. Aims of the course The course aims to: • introduce you to an understanding of the domain of economics as a social theory • introduce you to the main analytical tools which are used in economic analysis • introduce you to the main conclusions derived from economic analysis and to develop your understanding of their organisational and policy implications • enable you to participate in debates on economic matters. 1EC1002 Introduction to economics Learning outcomes At the end of the course and having completed the Essential reading and activities, you should be able to: • define the main concepts and describe the models and methods used in economic analysis • formulate real world issues in the language of economic modelling • apply and use economic models to analyse these issues • assess the potential and limitations of the models and methods used in economic analysis. Overview of learning resources Textbooks This subject guide follows the structure of the primary textbook (below) and works through the parts of the textbook included in the syllabus section by section, providing commentary, additional activities and extending the material in some parts. Primary textbook Begg, D., G. Vernasca, S. Fischer and R. Dornbusch Economics. (London: McGraw Hill, 2014) 11th edition ISBN 9780077154516. Referred to as BVFD. The two supplementary textbooks below can be used to extend your understanding and also provide an alternative approach which you may find suits your own style. Although you are encouraged to make use of these, you should check that you have a good understanding of the material covered in the primary textbook and the subject guide, as this is the required material for this course. Supplementary textbooks Lipsey, R.G. and K.A. Chrystal Economics. (Oxford: Oxford University Press, 2015) 13th edition ISBN 9780198746577 international edition; ISBN 9780199676835 UK edition. Referred to as L&C. Witztum, A. Economics. (Oxford: Oxford University Press, 2005) ISBN 9780199271634. Referred to as AW. The material contained in the two supplementary textbooks (where it goes beyond that contained in BVFD and the subject guide) is not directly examinable and you are not required to purchase these texts. However, if you are able to access them, you will find them beneficial and they will enhance your understanding of the text and this guide. Both have certain key advantages, for example, L&C contains very clear explanations and is structured in a very logical way, while AW provides a deeper understanding of the core concepts both philosophically and in terms of the analytical approach. How to use the subject guide Each of the 23 blocks of the subject guide covers one or two chapters from the primary textbook. The guide works through the textbook section by section and you will find additional explanations, activities and questions to aid and test your understanding. The subject guide has been designed to accompany the textbook, so you should use them jointly and follow the reading instructions listed throughout (e.g. ‘Read sections 14.2–14.3; answer the following questions to check your understanding’ etc.). 2Introduction One key aim of the guide is to encourage active engagement with the material, as this is how you will really gain a good understanding. For example, many of the models which will be covered in this course are expressed graphically and the subject guide contains empty boxes where you can practise drawing these graphs. It is very difficult to understand and remember graphs just by looking at them, so you will need to practise drawing them for yourself. For more complex graphs in later chapters, you could even practise using blank paper and then, when you are confident, draw the graph in the empty box in the subject guide. You are also encouraged to actively undertake the other activities and questions in the subject guide. Answers to these are available on the virtual learning environment (VLE). The subject guide and the primary textbook must be used together. The guide will not make much sense without the textbook. Equally, do not be tempted to neglect the guide and just focus on the textbook. You need to be aware that the subject guide not only seeks to complement and clarify the contents of the textbook, but also to extend it in certain places. For the final examination, you will need to be familiar with the material in both the textbook and the subject guide. The textbook chapters that are not covered in the guide, and are not examinable, are: Chapters 11 (except for section 11.9), 12, 26, 29. We hope that this guide will help you as you work through the textbook and that you will find it useful in your studies. Online study resources (VLE, Online Library) In addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library. You can access the VLE, the Online Library and your University of London email account via the Student Portal at: http://my.londoninternational.ac.uk You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account. If you forget your login details at any point, please email uolia.support london.ac.uk quoting your student number. The VLE The VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly. The VLE provides a range of resources for EMFSS courses: • Electronic study materials: All of the printed materials which you receive from the University of London are available to download, to give you flexibility in how and where you study. • Discussion forums: An open space for you to discuss interests and seek support from your peers, working collaboratively to solve problems and discuss subject material. Some forums are moderated by an LSE academic. 3EC1002 Introduction to economics • Videos: Recorded academic introductions to many subjects; interviews and debates with academics who have designed the courses and teach similar ones at LSE. • Recorded lectures: For a few subjects, where appropriate, various teaching sessions of the course have been recorded and made available online via the VLE. • Audiovisual tutorials and solutions: For some of the first year and larger later courses such as Introduction to Economics, Statistics, Mathematics and Principles of Banking and Accounting, audio-visual tutorials are available to help you work through key concepts and to show the standard expected in exams. • Self-testing activities: Allowing you to test your own understanding of subject material. • Study skills: Expert advice on getting started with your studies, preparing for examinations and developing your digital literacy skills. Note: Students registered for Laws courses also receive access to the dedicated Laws VLE. Some of these resources are available for certain courses only, but we are expanding our provision all the time, and you should check the VLE regularly for updates. Answers on the VLE Answers to the subject guide exercises can be found on the VLE. By far the most beneficial approach is to attempt the questions and activities yourself before you look at the answers. If, when you do look at them, you discover that your own answer is incorrect, try to work out what led you to that answer (to clear away your misconceptions) and furthermore, try to understand why the given answer is in fact correct. This will help you to gain a solid understanding. Making use of the Online Library The Online Library (http://onlinelibrary.london.ac.uk) contains a huge array of journal articles and other resources to help you read widely and extensively. To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you will be required to register and use an Athens login. The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine. If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons. For further advice, please use the online help pages (http://onlinelibrary. london.ac.uk/resources/summon) or contact the Online Library team: onlinelibraryshl.london.ac.uk Route map to the guide The subject guide consists of 23 blocks – an introductory block, and then 11 for microeconomics and 11 for macroeconomics. Throughout the guide, ‘chapter’ refers to the sections of the textbook, while ‘block’ refers to the sections of the subject guide. This is to avoid confusion – for example, when the guide says ‘this concept will be explored further in Chapter 12’, it 4Introduction should be clear to the reader that this refers to Chapter 12 of the textbook (BVFD). Breakdown of readings for each block: Microeconomics Block 1 2 3 4 5 6 7 8 9 10 11 12 Chapter 1, 2 3 4 5 6; 7.1, 7.2 and 7.3– 8.1– 8.5– 9 10 13 14; 7–appendix 7.9 8.4 8.10 11.9 Macroeconomics Block 13 14 15 16 17 18 19 20 21 22 23 Chapter 15 16, 17 18, 19 20 21 22 23 24 25 27 28 Specific topics and concepts to be covered are as follows: This differs from the syllabus only in the order that topics are listed. The full syllabus can be found in Appendix 1. Introduction: The economic problem, production possibility frontiers, opportunity cost, the role of the market, absolute and comparative advantage, Block 1 positive and normative economics, micro and macro economics, nominal and real values, theory and models in economics Microeconomics Demand, supply and the market: demand, supply, demand functions, Block 2 supply functions, equilibrium, consumer and producer surplus. Elasticity: price elasticity of demand, cross-price elasticity of demand, income Block 3 elasticity (normal, inferior and luxury goods), elasticity of supply. Consumer choice: rationality, utility, indifference curves, the budget Block 4 constraint, utility maximisation, substitution and income effects, substitutes and complements. The Firm I: the firm, profit maximisation, marginal cost and marginal revenue, Block 5 technology and production functions, returns to scale, the law of diminishing marginal returns, isoquants and isocost lines. The Firm II: cost functions, the distinction between the long and the short-run, Block 6 fixed and variable costs, behaviour of the firm in the long and in the short-run, the firm’s supply function. Perfect competition: competitive industry, the competitive firm, entry and Block 7 exit, short-run and long-run equilibrium, some comparative statics. Pure monopoly: monopoly, price discrimination, natural monopoly, Block 8 supernormal profit, monopoly and competitive equilibrium compared. Market structure and imperfect competition: monopolistic competition Block 9 (differentiated products, the firm’s behaviour, the role of entry), oligopoly (interdependence, game theory, reaction functions). Inputs to production: the labour market: the factors of production, demand and supply of labour (profit maximisation and the demand for labour, Block 10 utility maximisation and the supply of labour), economic rent, monopsony, factors affecting labour market equilibrium (unions, minimum wages). Welfare economics: general equilibrium, horizontal and vertical equity, Block 11 allocative and Pareto efficiency, market failures, externalities, Coase theorem. The role of government: government interventions, public goods, taxation; Block 12 the income distribution, the Gini coefficient and Lorenz curves. 5EC1002 Introduction to economics Macroeconomics Introduction to macroeconomics: the problem of aggregation, the circular flow of income, leakages and injections, national income accounting, Block 13 depreciation, value added and the NNP = Y identity, real and nominal gross domestic product (GDP). Aggregate demand: actual and potential output, consumption, investment, income determination, equilibrium, the multiplier, the paradox of thrift, Block 14 consumption and taxation, the government budget, automatic stabilisers (the financing of government), the multiplier and taxation, the role of fiscal policy, imports and exports, the multiplier in an open economy. Money and banking: the role of money, real balances, the liquidity preference approach and the demand for money (liquid assets), commercial Block 15 banks and the supply of money (banks and the various multipliers), central banks and monetary control, equilibrium in the money market. Monetary and fiscal policy: aggregate demand and equilibrium (IS), Block 16 equilibrium in the money market (LM), the IS-LM model, monetary and fiscal policies in a closed economy. Aggregate demand and aggregate supply: Keynesian and classical Block 17 assumptions regarding wages and prices, aggregate supply in the long-run and the short-run, the effects of exogenous demand and supply shocks. Inflation: inflation targeting, the Taylor rule, the quantity theory of money, Block 18 the Phillips curve in the long-run and the short-run, stagflation and the role of expectations, costs of inflation Unemployment: types of unemployment, voluntary and involuntary Block 19 unemployment, causes of unemployment, private and social costs, hysteresis Exchange rates and the balance of payments: the foreign currency Block 20 market, exchange rate regimes, the balance of payments, capital mobility, the rate of interest and the price of foreign currency Open economy macroeconomics: the effects of fiscal and monetary policies Block 21 under fixed and floating exchange rates with and without capital mobility Business cycles: trend path and business cycles, theories of the business Block 22 cycle, real business cycles Supply-side economics and economic growth: growth in potential Block 23 output, the steady state, technological progress, capital accumulation, convergence, endogenous growth, policies to promote growth Study advice The British education system, possibly more than others, and economics as a subject, possibly more than others, both emphasise understanding above rote learning (learning by heart). It is very difficult (if not impossible) to do well in economics examinations simply by rote learning. A much better strategy is to try to gain a good understanding of the concepts and the models. Although this may involve more work in the short term, the final outcome will be much better, and the examination much easier. For example, many of the models we will cover can be summarised in a single graph or set of equations. You will need to be able to use these graphs to demonstrate the effects of changes in the economic environment to which the model relates. This is very difficult to do well through memorisation, but if you understand why the different lines of the graph are drawn in that particular way or what a particular equation represents, then adjusting the graph or modifying the equations will become a relatively simple and straightforward exercise. 6Introduction The textbook, which the subject guide accompanies, assumes that you haven’t done any economics before and starts from the basics. It gives a good explanation of all concepts and uses examples to make these new concepts intuitive. It also includes material to stretch you, including Maths boxes. You are required to really master this textbook, including the Maths boxes and more challenging elements. If there are sections which are difficult to understand at first, you may find that reading these through several times is very helpful. In certain places, the subject guide will also seek to extend the textbook if there are areas where it does not go far enough. Although you will find the textbook approach of starting at a fairly basic level very useful, you should expect the examination to be quite rigorous. For example, examination questions are likely to be similar to the ‘hard’ questions in the review questions at the end of each chapter. In this way, we hope to help you really lay a firm foundation of understanding in economics, and at the same time demonstrate the high standard that is expected of you as University of London students. Use of mathematics Economic models can be expressed in various ways, in words, in diagrams and in equations. Although this course mainly uses diagrammatic representations accompanied by words, simple equations can also be a concise way of expressing an economic model, and you will need to become familiar with this approach. At this stage, the maths involved will be limited to simple algebra and elementary calculus. Some basic mathematical techniques and ideas will be also introduced in the first block. It is important to work through the Maths boxes in each chapter, as these often provide a step-by-step explanation of the mathematical approach to the models covered. The subject guide will also provide further explanations where we think this will be helpful. Economics is becoming an increasingly technical subject and, although the level of mathematics required for this course is quite basic, we hope that you will become confident in taking a mathematical approach to analysing economic issues. Examination advice Important: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Programme regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. Examination structure: The structure for the 2016–17 examination is as follows: • Part I worth 50 marks 30 multiple choice questions covering the entire syllabus in microeconomics and macroeconomics. Candidates should answer all 30 multiple choice questions. 7EC1002 Introduction to economics • Part II, Section A worth 25 marks three long response questions in microeconomics of which candidates should answer one question. • Part II, Section B worth 25 marks three long response questions in macroeconomics of which candidates should answer one question. Further advice for multiple choice questions: Read the question and each of the possible answers carefully, paying attention to words such as ‘not’ and ‘never’. Try to manage your time so you are able to check over your answers again at the end. Further advice for long-response questions: Marks are not awarded for irrelevant material. For this reason, when you read a question, it is best to spend some time thinking about your answer before you start to write. Quickly writing everything remotely connected to the topic will not impress the examiner. The best answers demonstrate that candidates recognise the tools of analysis that are relevant to that question and they are able to use them effectively to provide a well-reasoned answer. You can find further guidance on examination technique in the annual Examiners’ commentaries for the course which are available on the University of London International Programmes website, and also in your academic and study skills handbook, Strategies for success. Remember, it is important to check the VLE for: • up-to-date information on examination and assessment arrangements for this course • where available, past examination papers and Examiners’ commentaries for the course which give advice on how each question might best be answered. 8Block 1: Economics, the economy and tools of economic analysis Block 1: Economics, the economy and tools of economic analysis Introduction This block covers the first two chapters of the textbook and is designed to give you an introduction to economics and some help in starting to use the tools of economic analysis. The concepts introduced in this block, such as scarcity, opportunity cost and ceteris paribus (more on these below), are absolutely essential to your understanding of economics. The more thoroughly you work through the material in this block, the better your foundation will be for all the material that follows. So what is economics? The word ‘economy’ comes from two Greek words – oikos (meaning house) and nemein (meaning manage) – its original meaning was ‘household management’. Households have limited resources and managing these resources requires many decisions and a certain organisational system. The meaning of the word economics has developed over time. Today, economics can be defined as the study of how societies make choices on what, how and for whom to produce, given the limited resources available to them. Furthermore, the key economic problem can be defined as being to reconcile the conflict between people’s virtually unlimited desires and the scarcity of available resources and means of production. These are the definitions provided in the core textbook (BVFD) and indeed in many other textbooks. They are traditional definitions and have their origins in an essay by Lionel Robbins (of the London School of Economics 1 1 Lionel Robbins An and Political Science) written in 1932 in which he defined economics as essay on the nature and ‘the science which studies human behaviour as a relationship between significance of economic ends and scarce means which have alternative uses’. science. (London: Macmillan, 1932, 2nd It is important to realise that this definition is not without its critics. edition 2014) p.16. The textbook does not pretend to discuss in any depth the definition of economics or the legitimate domain of economic investigation. Those wishing to pursue the philosophical foundations of the nature of economics could consult the collection of papers edited by Frank Cowell 2 2 Cowell, Frank and and Amos Witztum, especially papers by Atkinson, Witztum, Backhouse Amos Witztum (eds) and Medema. Lionel Robbins’s essay On a less philosophical note, if we were to follow the definition attributed on the nature and significance of economic to Jacob Viner (an early member of the ‘Chicago School’ and a teacher of science: 75th anniversary Nobel laureate Milton Friedman) that ‘economics is what economists do’, conference proceedings. the Robbins definition stated above would fall short of describing the way (London: Suntory and in which the subject has evolved, in particular in its failure to reflect the Toyota International time and effort devoted today to empirical analysis. Centres for Economics and Related Disciplines, Arguably, the definitions provided in the textbook apply more directly to 2009) pp.1–500. microeconomics than macroeconomics, the latter being more concerned Available at http://darp. with the structure and performance of the aggregate economy and lse.ac.uk/papersdb/ such issues as growth, cycles, unemployment and inflation. However, LionelRobbinsConference ProveedingsVolume.pdf underlying these ‘big’ issues is the behaviour of individual agents such as consumers and firms. Recent developments in macroeconomics have been concerned with establishing microeconomic foundations. So scarcity and the rational responses to it are not absent from macroeconomics. 9EC1002 Introduction to economics Although the definitions above may appear abstract, economics deals with phenomena you will be very familiar with from your daily activities, and provides tools and a language to analyse these. While it is not the only language available, we hope it will prove useful to you. Economics and the real world One of the main reasons that BVFD was chosen as the textbook for the course is that it combines the exposition of economic theory with liberal use of actual data on many economic issues. Modern economics is a subject which, at its best, does not theorise in a vacuum but addresses issues of real world importance and attempts to make its concepts and theories consistent with the facts. When economists make policy recommendations these address issues of current importance and concern. Furthermore, the effectiveness of economic policy is increasingly subject to empirical evaluation. Sometimes this happens by piloting a policy on a restricted scale before it is rolled out nationally. Almost always government departments, private sector analysts and academic economists attempt to evaluate the consequences of policy in the months or years after implementation. If you pursue your study of economics to a more advanced level you will learn how applied economists attempt to test the relevance and accuracy of their theories and the success or failure of economic policy using statistical techniques broadly known as econometrics. However, even at this early stage of your study you should attempt to familiarise yourself with actual facts about the economy and think about what these imply for economic theory and the formation and evaluation of economic policy. The statistics and policy discussions in BVFD often (but not always) relate to the UK economy; we encourage you to look for comparable examples wherever you live. Learning outcomes By the end of this block and having completed the Essential reading and activities, you should be able to: • recognise economics as the study of how society addresses the conflict between unlimited desires and scarce resources • describe ways in which society decides what, how and for whom to produce • identify the opportunity cost of a decision or action • explain the difference between positive and normative economics • define microeconomics and macroeconomics • explain why theories deliberately simplify reality • recognise time-series, cross section and panel data • construct index numbers • explain the difference between real and nominal variables • build a simple theoretical model • plot data and interpret scatter diagrams • use ‘other things equal’ to ignore, but not forget, some aspects of a problem in order to focus on core issues. 10Block 1: Economics, the economy and tools of economic analysis Essential reading Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapters 1 and 2. Further reading Lipsey and Chrystal (L&C) international edition, Chapter 1; UK edition, Chapter 1. Witztum (AW), Chapter 1. Synopsis of this block This block introduces some of the key concepts in economics. First, scarcity – the idea that the means available to society (its labour force, its capital stock, its natural resources, its technology) are insufficient to meet all the wants (or the desired goods and services) of the people making up that society. Related to scarcity is the concept of opportunity cost – which is the value of the best alternative that must be sacrificed. The concept of scarcity gives rise to the production possibility frontier (PPF), which shows the maximum amount of one good that can be produced given the output of another good. The slope of the PPF is the opportunity cost. The fact that different individuals and countries have different opportunity costs of producing various goods gives rise to comparative advantage and creates the possibilities for gains from trade. In economics, people are assumed to behave rationally – only taking a course of action if its benefits outweigh its costs. Furthermore, people are assumed to be motivated by self-interest. The idea of the ‘invisible hand’ describes how market forces allocate resources efficiently despite the self-interested motivations of individuals. Markets resolve production and consumption decisions via the adjustment of prices. Economics can be divided into different sub groups and approaches. Positive economics deals with ‘facts’ about how the economy behaves and with empirically testable propositions, while normative economics involves subjective judgements. Microeconomics studies particular markets and activities in detail, while macroeconomics deals with aggregates and studies the economy as a whole system. The interplay of data and theory/models in economics is very important. Models are deliberate simplifications of reality which help organise how we think about a problem. A key approach of economic analysis is to abstract from various factors by holding them constant – this is known as ceteris paribus or ‘other things equal’. The second half of this block examines the relationship between data and theory and also provides guidance and instruction regarding key practical concepts and skills such as index numbers, nominal and real variables, measuring change, diagrams, lines and equations. Chapter 2 concludes by briefly addressing some popular criticisms of economics and economists. ► BVFD: read Chapter 1. Sections 1.1 and 1.3 introduce the concepts of scarcity, opportunity cost, and efficiency. These are not separate concepts but are all interrelated and can be demonstrated using the production possibility frontier introduced in section 1.3. For a more detailed introduction to these fundamental concepts, you can refer to AW Chapter 1. Read section 1.1, concept 1.1 and case 1.1. 11EC1002 Introduction to economics Scarcity BVFD defines scarcity by saying: ‘a resource is scarce if the demand for that resource at a zero price would exceed the available supply’. Since the concepts of demand and supply have not yet been introduced to you, we can also define scarcity by stating that the means available to society (its labour force, its capital stock, its natural resources, its technology) are insufficient to meet all the wants (or the desired goods and services) of the people making up that society. This implies that for any one person to have more of something, they or someone else must have less of something else. In turn, this requires choice, both at the level of the individual agent but also at the societal or collective level. How individuals and societies cope with scarcity in relation to wants is central to economics. This course concentrates on the market economy as the basic organisational principle for coping with scarcity, but modified by governments to rectify market shortcomings and to achieve distributional ends. Opportunity cost Related to scarcity is the concept of opportunity cost – one of the key concepts in economic analysis. To cement your understanding of opportunity cost, complete the following activity on this concept. Activity SG1.1 a. Let us change the details of the problem in concept box 1.1. Suppose that there were no jobs in the campus shop. The only job available, and this is the alternative to going to the beach with your friends, is to work at the local fast food restaurant clearing tables and washing dishes. This job also pays £70, but because of its general unpleasantness you wouldn’t do it unless you were paid at least £55. Should you go to the beach or work at the fast food restaurant? b. A high-end ladies fashion boutique purchases winter coats from a manufacturer at a price of £300 per coat. During the winter the boutique will try to sell the coats at a price higher than £300 but may not be able to sell all of the coats. Since they are the latest fashion, no customers would be interested in buying the coats next season. However, at the end of the winter, the manufacturer will pay the boutique 20% of the original price for any unsold coats (and re-use the expensive fabrics they are made from for the next year’s designs). i. At the beginning of the year, before the boutique has purchased any coats, what is the opportunity cost of these coats? ii. After the boutique has purchased the coats, what is the opportunity cost associated with selling a coat to a prospective customer? (You can assume the coat will be unsold at the end of the winter if that customer doesn’t buy the coat). iii. Suppose towards the end of the winter the boutique still has a large inventory of unsold coats. The boutique has set a retail price of £950 per coat. The marketing manager argues that the boutique should cut the price to £199 to try to sell the remaining coats before they become unfashionable at the end of the winter. However, the general manager disagrees, arguing that would mean a loss of £101 on each coat. Which makes more economic sense – the marketing manager’s suggestion or the general manager’s argument? ► BVFD: read section 1.2 and case 1.2. This section raises various economic issues which you may be familiar with through the news or other sources. It demonstrates what kinds of issues economics deals with, although in the case of income distribution this is 12

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