By Mr. LAU san-fat/ver 2004CH1-The Scope of Economic Analysis1 Chapter 1: The Scope of Economic Analysis HKAL Microeconomics T. W. G. Hs. Lo Kon Ting Memorial

By Mr. LAU san-fat/ver 2004By Mr. LAU san-fat/ver 2004 CH1-The Scope of Economic AnalysisCH1-The Scope of Economic Analysis 11

Chapter 1: The Scope Chapter 1: The Scope of Economic Analysisof Economic AnalysisHKAL Microeconomics HKAL Microeconomics T. W. G. Hs. T. W. G. Hs. Lo Kon Ting Memorial CollegeLo Kon Ting Memorial College

References:References:– A-Level MicroeconomicsA-Level Microeconomics, CH. 1, 2 & 15, CH. 1, 2 & 15– HKALE MicroeconomicsHKALE Microeconomics, CH. 1, 2, 14 & , CH. 1, 2, 14 &

1919– 張五常張五常《經濟解釋卷一》《經濟解釋卷一》第一至第三章第一至第三章– Exchange and ProductionExchange and Production, CH. 1 & 5, CH. 1 & 5


What is Economics?What is Economics? an empirical science resting onan empirical science resting on thethe

assertion or postulate of self-interest assertion or postulate of self-interest to explain observable economic to explain observable economic behavior or phenomenabehavior or phenomena

history repeats itself, however, facts history repeats itself, however, facts do not speak for themselves do not speak for themselves

economists therefore need to economists therefore need to ‘theorize’ in order to explain and ‘theorize’ in order to explain and predict facts/economic phenomena. predict facts/economic phenomena.


What is Economics?What is Economics?

As an empirical science, economic As an empirical science, economic theories are constructed:theories are constructed:

– to explain human behavior by finding to explain human behavior by finding out what conditions lead to what out what conditions lead to what consequencesconsequences

– toto predict predict the occurrence of similar the occurrence of similar events in the future and how events in the future and how behavior will change when there is a behavior will change when there is a change in the constraints they face.change in the constraints they face.


Positive Versus Positive Versus Normative EconomicsNormative Economics Positive Positive economics contains descripeconomics contains descrip

tive statements, propositions and prtive statements, propositions and predictions about the world. edictions about the world.

NormativeNormative economics makes statem economics makes statements about what ought to be, or aboents about what ought to be, or about what a person, organization or natut what a person, organization or nation ought to do.ion ought to do.

Ex 1:Ex 1: Is A-L economics concerning about positivIs A-L economics concerning about positive or normative one?e or normative one?


Attributes of Economic Attributes of Economic AnalysisAnalysis Economic analysis is solely scientific Economic analysis is solely scientific

and strictly positive.and strictly positive. Economic theory rests on understanEconomic theory rests on understan

ding of human traits.ding of human traits.– theories are abstractions of the worldtheories are abstractions of the world– to theorize is to pick out the ‘relevantsto theorize is to pick out the ‘relevants

’ from the ‘irrelevants’’ from the ‘irrelevants’ Economists construct and test theoriEconomists construct and test theori

es.es.


Methodology – Scientific Methodology – Scientific Inquiry: Constructing Inquiry: Constructing TheoriesTheories interesting real-world observations interesting real-world observations

prompt the construction of a theorprompt the construction of a theoryy

postulating economic behavior (i.e. postulating economic behavior (i.e. making axioms or basic assumptiomaking axioms or basic assumptions)ns)

picking out 'relevants' from the 'irrpicking out 'relevants' from the 'irrelevants' (i.e. making abstractions)elevants' (i.e. making abstractions)


Methodology – Scientific Methodology – Scientific Inquiry: Constructing a Inquiry: Constructing a TheoryTheory establishing the interrelationship establishing the interrelationship

among variables and ideas in among variables and ideas in the form of hypothesis (including the form of hypothesis (including ‘test conditions’ & ‘predicted ‘test conditions’ & ‘predicted outcomes’) i.e. ‘If A, then B’ via outcomes’) i.e. ‘If A, then B’ via logical deductionlogical deduction

making a making a logically consistentlogically consistent implication or predictionimplication or prediction


Methodology – Scientific Methodology – Scientific Inquiry: Constructing a Inquiry: Constructing a TheoryTheory confronting the real-world observaconfronting the real-world observa

tions with the testable implication tions with the testable implication (i.e. testing the hypothesis/model/t(i.e. testing the hypothesis/model/theory)heory)

a theory isa theory is valid valid if it is if it is confirmedconfirmed/n/not rejected by the factsot rejected by the facts


Methodology – Scientific Methodology – Scientific Inquiry: Constructing a Inquiry: Constructing a TheoryTheory a theory is invalid if it is rejected a theory is invalid if it is rejected

by facts, and is being by facts, and is being discardeddiscarded or or amendedamended with adding more with adding more constraints and is being re-constraints and is being re-tested.tested.


Six Basic PostulatesSix Basic Postulates

Each person desires many goods Each person desires many goods & has many goals.& has many goals.

For each person, some goods For each person, some goods are scarce.are scarce.

Each person is willing to forsake Each person is willing to forsake some of a good to get more of some of a good to get more of other goods.other goods.


Six Basic PostulatesSix Basic Postulates

The more of a good one has, the The more of a good one has, the larger the total personal use larger the total personal use value, but the lower the value, but the lower the marginal personal value of a marginal personal value of a unit.unit.

Not all people have identical Not all people have identical tastes and preferences.tastes and preferences.

People are innovative but People are innovative but consistent.consistent.


The Validity and The Validity and Usefulness of a TheoryUsefulness of a Theory a theory is said to be a useful if it has a theory is said to be a useful if it has

implications that are potentially refuimplications that are potentially refutable but have not yet refutedtable but have not yet refuted

Ex 2:Ex 2: Can a theory be proved wrong?Can a theory be proved wrong?

We never say a theory is 'proven' becWe never say a theory is 'proven' because we just do not know whether thause we just do not know whether the next set of collected data will still ae next set of collected data will still agree with the implications or not. gree with the implications or not.


The Validity and The Validity and Usefulness of a TheoryUsefulness of a Theory If the If the empirically empirically collected data agrcollected data agr

ee with the implications, then the thee with the implications, then the theory is said to be 'confirmed' and 'vaeory is said to be 'confirmed' and 'valid'. If not, it is 'refuted' or 'rejected' lid'. If not, it is 'refuted' or 'rejected' and 'invalid'.and 'invalid'.

A theory that can never be rejected is A theory that can never be rejected is useless because it is either a useless because it is either a tautolotautologygy (a (a definitional identitydefinitional identity) or we are ) or we are not clear what is about.not clear what is about.


The Validity and The Validity and Usefulness of a TheoryUsefulness of a Theory The usefulness of a theory is based oThe usefulness of a theory is based o

n its n its explanatoryexplanatory and and predictive powpredictive powerer. . – As As Milton FriedmanMilton Friedman said, "The value of a said, "The value of a

model does not depend on the 'realism' model does not depend on the 'realism' of its assumptions but on its ability to eof its assumptions but on its ability to explain or predict real world events.“xplain or predict real world events.“


Attributes of a Useful Attributes of a Useful TheoryTheory economic theory must be a simplification economic theory must be a simplification

of realityof reality assumptions may be unrealistic because:assumptions may be unrealistic because:

– the statement does not give an exhaustive the statement does not give an exhaustive description of an objectdescription of an object

– the statement is false or highly improbablethe statement is false or highly improbable– the statement (excluding test conditions) is the statement (excluding test conditions) is

used to formulate pure cases or ideal typesused to formulate pure cases or ideal types the arguments must be the arguments must be logically logically

consistentconsistent– if A then B and B then C, A is preferred to Cif A then B and B then C, A is preferred to C


Attributes of a Useful Attributes of a Useful TheoryTheory implications and predictions must implications and predictions must

be testable or observablebe testable or observable the theory is potentially refutable the theory is potentially refutable

by factsby facts variables in the theory must be variables in the theory must be

observableobservable


Attributes of a Useful Attributes of a Useful TheoryTheory the power to generalizethe power to generalize

– if a hypothesis is repeatedly supported if a hypothesis is repeatedly supported by the evidence and repeatedly accepteby the evidence and repeatedly accepted (or confirmed), it may be called a lawd (or confirmed), it may be called a law

Great predictive power, not forecastiGreat predictive power, not forecasting powerng power

Ex 3:Ex 3: What is the difference between forecast &What is the difference between forecast &predict?predict?


Hypothesis, Ad Hoc Hypothesis, Ad Hoc Theory and TautologyTheory and Tautology HypothesisHypothesis is logically deducted, is logically deducted,

testable, refutable, and usually testable, refutable, and usually expressed in terms of 'If A expressed in terms of 'If A (assumptions), then B (assumptions), then B (implications)’.(implications)’.


Hypothesis, Ad Hoc Hypothesis, Ad Hoc Theory and TautologyTheory and Tautology Rejected theory can be modified Rejected theory can be modified

by adding by adding moremore assumptions to assumptions to the theory at the expense of the theory at the expense of losing its power to generalizelosing its power to generalize, i.e. , i.e. it can apply to a narrower variety it can apply to a narrower variety of situations. of situations.


Hypothesis, Ad Hoc Hypothesis, Ad Hoc Theory and TautologyTheory and Tautology an an ad hoc theoryad hoc theory is a very specific is a very specific

theory that can be applied only to theory that can be applied only to oneone (or a few) particular situation. (or a few) particular situation.


Hypothesis, Ad Hoc Hypothesis, Ad Hoc Theory and TautologyTheory and Tautology An example of ad hoc theory:An example of ad hoc theory:

– If it rains + outdoor + without umbrella If it rains + outdoor + without umbrella + without raincoat + without cap + with+ without raincoat + without cap + without hat + without shelter + not standing out hat + without shelter + not standing under a tree + not standing under a covunder a tree + not standing under a coverer (A) (A), ,

– then you’ll get wetthen you’ll get wet (B) (B).. ExampleExample from Steven N. S. Cheung: from Steven N. S. Cheung:

dropping temperature in high mountainsdropping temperature in high mountains


Hypothesis, Ad Hoc Hypothesis, Ad Hoc Theory and TautologyTheory and Tautology A tautology (a definitional identity) is A tautology (a definitional identity) is

so generalized and true for all values so generalized and true for all values of the variables. of the variables.

EExample:xample: ‘A four-leg-animal has fo ‘A four-leg-animal has four legs’ ur legs’

It is empty and has It is empty and has nono explanatory n explanatory nor predictive power at all. or predictive power at all.


Hypothesis, Ad Hoc Hypothesis, Ad Hoc Theory and TautologyTheory and Tautology But a tautology could be But a tautology could be

developed into a useful theory if developed into a useful theory if testable conditions are added. testable conditions are added. The Coase Theorem and Quantity The Coase Theorem and Quantity Theorem of Money are two Theorem of Money are two examples of these. examples of these.


Hypothesis, Ad Hoc Theory Hypothesis, Ad Hoc Theory and Tautologyand Tautology

Ex 4:Ex 4: Is an ad hoc theory or a tautology better Is an ad hoc theory or a tautology better theory?theory?


Hypothesis, Ad Hoc Hypothesis, Ad Hoc Theory and TautologyTheory and Tautology A useful theory must then strive for A useful theory must then strive for

the right balance between the degree the right balance between the degree of generality and refutability by of generality and refutability by avoiding adding too specific or avoiding adding too specific or generalized conditions to its generalized conditions to its construction. Therefore, a useful construction. Therefore, a useful theory must fall theory must fall in betweenin between the ad hoc the ad hoc theory and tautology.theory and tautology.


Hypothesis, Ad Hoc Hypothesis, Ad Hoc Theory and TautologyTheory and Tautology..


Logical FallaciesLogical Fallacies

Logically speaking, we must ‘affirm the antecedent’ in the hypothesis in order for the consequent to follow with logical necessity.

– If A is true, then B is true; A is true, therefore B is true.



Example:If Jessie is a trained secretary, then she knows how to use a typewriter correctly; Jessie is a trained secretary, therefore she knows how to use a typewriter correctly.



On the other hand, we can deny the truth of a hypothesis with reference to the facts: denying the consequent.– If A is true, then B is true; B is NOT true,

therefore A is NOT true.



Example: If Jessie is a trained secretary, then she knows how to use a typewriter correctly;

Jessie does not know how to use a typewriter correctly, therefore she is not a trained secretary.



Fallacy 1: Affirming the consequent– If A is true, then B is true; if B is true,

therefore A is true.– Example: If Jessie is a trained secretary,

then she knows how to use a typewriter correctly; Jessie knows how to use a typewriter correctly, therefore she is a trained secretary.



Fallacy 2: Denying the antecedent– If A is true, then B is true; if A is not true,

therefore B is not true.– Example: If Jessie is a trained secretary,

then she knows how to use a typewriter correctly; Jessie is not a trained secretary, therefore she must not know how to use a typewriter correctly.



When “A” is said to be a necessary condition for “B”, it means that occurrence (or true) of “B” implies the occurrence (or true) of “A”, i.e. “If A is true, then B is true; B is true, therefore A is true”.



While “A” is said to be a sufficient condition for “B”, it means that the occurrence (or true) of “A” implies the occurrence (or true) of “B”, i.e. “If A is true, then B is true; A is true, therefore B is true”.



When “A” is both a necessary and sufficient condition for “B”, it means that the occurrence of one implies the occurrence (or true) of the other, i.e. “If A is true, then B is true; A is true, therefore B is true” and “B is true, therefore A is true”.



Economic proposition/hypothesis of “If A, then B” only posits that “A” is a sufficient condition for the occurrence of “B”, i.e.– “If A is true, then B is true; A is true,

therefore B is true.” (Affirming the antecedent but with no logical fallacy)



Example: If “If Jessie is a trained secretary, then she knows how to use a typewriter correctly; Jessie is a trained secretary, therefore she knows how to use a typewriter correctly.”



By confronting the hypothesis with observable facts, if Jessie is a trained secretary and good at using a typewriter, the hypothesis is said to be confirmed; if, however, she is a trained secretary but does NOT know how to use a typewriter, the hypothesis (though is free from logical fallacy) is said to be rejected (by facts).



– ‘If A is true, then B is true; B is NOT true, therefore A is NOT true.” (Denying the consequent but with no logical fallacy.)



Example: ‘If Jessie is a trained secretary, then she knows how to use a typewriter correctly; Jessie does NOT know how to use correctly a typewriter, therefore she is NOT a trained secretary.’



By confronting with observable facts, if Jessie does NOT know how to use a typewriter correctly and is NOT a trained secretary, the hypothesis is said to be confirmed; if, however, she does NOT know of using correctly a typewriter but is indeed a trained secretary the hypothesis is said to be rejected.


Constrained Constrained MaximizationMaximization Economists assume Economists assume individualindividualss make cho make cho

ices subject to constraints (i.e. rules of the gices subject to constraints (i.e. rules of the game) in order to maximize his gains (in termame) in order to maximize his gains (in terms of utility, income, wealth, rent or profit)s of utility, income, wealth, rent or profit)

In economics, individual choice and self-In economics, individual choice and self-interest are basic postulates used to interest are basic postulates used to explain an individual's maximizing explain an individual's maximizing behavior, subject to constraints behavior, subject to constraints (available alternatives).(available alternatives).

Ex 5:Ex 5: What are the major constraints? What are the major constraints?


Major ConstraintsMajor Constraints

ConstraintsConstraints One-man One-man economyeconomy

SocietSocietyy

Scarcity of Scarcity of resourcesresources YesYes YesYes

Production Production costcost YesYes YesYes

Transaction Transaction costscosts NoNo YesYes

Property Property rightsrights NoNo YesYes


Transaction CostsTransaction Costs

Transaction costs, in their Transaction costs, in their broadest sense, encompass all broadest sense, encompass all those costs that cannot be those costs that cannot be conceived to exist in a Robinson conceived to exist in a Robinson Crusoe economy where there are Crusoe economy where there are no property rights, transactions or no property rights, transactions or any kind of economic any kind of economic organization. organization.


Transaction CostsTransaction Costs

Economic organization is defined as Economic organization is defined as any production and exchange any production and exchange activities which are not guided by the activities which are not guided by the invisible hand of the market, then all invisible hand of the market, then all organization costs are transaction organization costs are transaction costs.costs.

Transaction costs are actually Transaction costs are actually institutional costs, including the costs institutional costs, including the costs of organization and law enforcement.of organization and law enforcement.


Transaction Costs as a Transaction Costs as a Spectrum of Institutional Spectrum of Institutional CostsCosts


Transaction Costs as a Transaction Costs as a Spectrum of Institutional Spectrum of Institutional CostsCosts1.1. information cost or searching costinformation cost or searching cost

2.2. defining cost or delineating costdefining cost or delineating cost the cost incurred in setting the limits in the cost incurred in setting the limits in

the use of property rights by legal or the use of property rights by legal or social institutionssocial institutions

3.3. measurement cost and pricing costmeasurement cost and pricing cost

4.4. negotiating and contracting or negotiating and contracting or exchange costsexchange costs

5.5. policing and enforcing costspolicing and enforcing costs


Transaction Costs as a Transaction Costs as a Spectrum of Institutional Spectrum of Institutional CostsCosts In a one-man economy, information costs In a one-man economy, information costs

and policing costs (say of preventing wild and policing costs (say of preventing wild animals) would still exist. However, they animals) would still exist. However, they are not regarded as transaction costs. They are not regarded as transaction costs. They are regarded as the production costs are regarded as the production costs incurred in maintaining the living standard.incurred in maintaining the living standard.

As it is almost impossible to distinguish As it is almost impossible to distinguish clearly between different types of costs, we clearly between different types of costs, we simply lump them together as ‘transaction simply lump them together as ‘transaction costs’.costs’.


Ways of Reducing Ways of Reducing Transaction CostsTransaction Costs

1.1. the use of money as a common the use of money as a common medium of exchangemedium of exchange

2.2. the existence of a marketplacethe existence of a marketplace

3.3. the existence of middlementhe existence of middlemen

4.4. the upholding of private property the upholding of private property rights by an effective governmentrights by an effective government

5.5. the existence of social custom and the existence of social custom and etiquetteetiquette


Scarcity, Choices & Scarcity, Choices & Opportunity CostOpportunity Cost ScarcityScarcity

– we want more than we havewe want more than we have– a relative concepta relative concept– a universal problema universal problem

Ex 6:Ex 6: Is shortage the same as scarcity? Is shortage the same as scarcity?


Scarcity, Choices & Scarcity, Choices & Opportunity CostOpportunity Cost

ScarcityScarcity ShortageShortage

DefinitioDefinitionn

We want more We want more than we have at than we have at zero Pzero P

Qd is larger than Qd is larger than Qs at a positive PQs at a positive P

CauseCause

Unlimited wants Unlimited wants cannot satisfied cannot satisfied with limited with limited resourcesresources

Market price is Market price is controlled a level controlled a level below the below the equilibriumequilibrium



ScarcityScarcity ShortageShortage

CurableCurable??

NO way to NO way to eliminateeliminate

BBy allowing the may allowing the market price to adjust rket price to adjust to the equilibrium lto the equilibrium level evel

OthersOthers

the existence of the existence of “scarcity” does “scarcity” does NOT imply the NOT imply the problem of problem of “shortage” “shortage”

the existence of the existence of “shortage” “shortage” implies the implies the problem of problem of “scarcity” “scarcity”



P

D S

0 Qs Qd QP=0

P

P1

D S

0 Qs Qd Q

shortage scarcity


Scarcity, Choices & Scarcity, Choices & Opportunity CostOpportunity Cost With scarcity, we With scarcity, we choose the option tchoose the option t

hat incurs the lowest opportunity costhat incurs the lowest opportunity cost.. Opportunity cost is defined as the Opportunity cost is defined as the

highest-valued option necessarily highest-valued option necessarily forgone in making choice.forgone in making choice.

WW henever we choose, opportunity coshenever we choose, opportunity cost arises.t arises.

Ex 7:Ex 7: Does cost exist in Robinson Crusoe or one- Does cost exist in Robinson Crusoe or one-manman

economy? economy?


Scarcity, Choices & Scarcity, Choices & Opportunity CostOpportunity Cost Whenever there is competition, disWhenever there is competition, dis

crimination then follows.crimination then follows. To discriminate is just to separate tTo discriminate is just to separate t

he winners from the losers in a comhe winners from the losers in a competition. petition.


Scarcity, Choices & Scarcity, Choices & Opportunity CostOpportunity Cost The The criteria of competitioncriteria of competition (i.e. (i.e.

rules of the game or rules of the game or constraintsconstraints) ) are not just important in deciding are not just important in deciding who are winners or losers, but who are winners or losers, but also affect human behavior. A also affect human behavior. A change in the competition criteria change in the competition criteria will definitely induce changes in will definitely induce changes in human behavior. human behavior.


Forms of CompetitionForms of Competition

Price Competition:Price Competition:– Goods & services are allocated to Goods & services are allocated to

the highest bidder under the price the highest bidder under the price or market system.or market system.

– Resources allocation under price Resources allocation under price competition is said to be competition is said to be efficientefficient because the product will be in the because the product will be in the hands of the highest-valued users.hands of the highest-valued users.


Forms of CompetitionForms of Competition

Non-price Competition:Non-price Competition:– by social customs & traditionsby social customs & traditions– by seniority or beautyby seniority or beauty– by religion affiliationby religion affiliation– by academic performanceby academic performance– by violence or physical forceby violence or physical force– by queuing or first come first servedby queuing or first come first served– by lottery or ballot or rationing or luckby lottery or ballot or rationing or luck

Ex 7:Ex 7: Which form of competition is more efficient? Which form of competition is more efficient?


Remarks on Remarks on Opportunity CostOpportunity Cost We can predict whether a certain act We can predict whether a certain act

will be pursued voluntarily or not by will be pursued voluntarily or not by means of comparing its value (i.e. thmeans of comparing its value (i.e. the maximum one is willing to pay) wite maximum one is willing to pay) with its cost (i.e. the maximum one will h its cost (i.e. the maximum one will have to sacrifice)have to sacrifice)..

IIf its value exceeds cost, the act will f its value exceeds cost, the act will be taken, vice versa.be taken, vice versa.


Remarks on Remarks on Opportunity CostOpportunity Cost BBad consequences and the cost of a ad consequences and the cost of a

choicechoice are NOT the same. are NOT the same.

Ex 8:Ex 8: If Peter & Mary are secondary teachers earning If Peter & Mary are secondary teachers earning

$16000 per month, is their opportunity cost of quitting$16000 per month, is their opportunity cost of quitting

the job definitely the same? Explain.the job definitely the same? Explain.


Remarks on Remarks on Opportunity CostOpportunity Cost CC osts are not necessarily expressed iosts are not necessarily expressed i

n terms of money or out-of-pocket cn terms of money or out-of-pocket costost..– full cost = explicit cost + implicit full cost = explicit cost + implicit

costcost– explicit cost = out-of-pocket cost = explicit cost = out-of-pocket cost =

money costmoney cost– implicit cost = income forgoneimplicit cost = income forgone

Ex 9:Ex 9: Referring to Ex 8, will Peter & Mary bear the Referring to Ex 8, will Peter & Mary bear the

same opportunity cost when they decide to becomesame opportunity cost when they decide to become

a secondary teacher?a secondary teacher?


Remarks on Remarks on Opportunity CostOpportunity Cost No choice, no cost.No choice, no cost. Time itself is not a cost, however, Time itself is not a cost, however,

the highest-valued alternative use the highest-valued alternative use of that period is part of cost.of that period is part of cost.

When cost increases, it does NOT When cost increases, it does NOT imply one is worse off.imply one is worse off.– however, it means the value of the however, it means the value of the

highest-valued alternative use highest-valued alternative use increases.increases.


Historical or Sunk CostHistorical or Sunk Cost

Historical or sHistorical or sunk costunk cost– is is simply a past expenditure (for a past simply a past expenditure (for a past

act)act)– is the original cost at which a firm is the original cost at which a firm

acquired a factoracquired a factor

Ex 8:Ex 8: Distinguish sunk cost from opportunity Distinguish sunk cost from opportunity cost.cost.


Sunk Cost and Sunk Cost and Opportunity CostOpportunity Cost

Sunk CostSunk Cost Opportunity CostOpportunity Cost

An accounting cost, An accounting cost, which is historical which is historical in naturein nature

Not an accounting Not an accounting costcost

An ex-post concept: An ex-post concept: post and backward-post and backward-lookinglooking

An ex-ante concept: An ex-ante concept: anticipated and anticipated and forward-lookingforward-looking


Sunk Cost and Sunk Cost and Opportunity CostOpportunity Cost

Sunk CostSunk Cost Opportunity CostOpportunity Cost

Cannot be avoided, Cannot be avoided, i.e. irrecoverablei.e. irrecoverable

Can be avoidCan be avoid

Does NOT affect Does NOT affect present or future present or future decision-makingdecision-making

A determinant of A determinant of maximum decision-maximum decision-making: lower cost making: lower cost is preferredis preferred


Functions of Invisible Functions of Invisible HandHandEx 9:Ex 9: What is/are the function(s) of price? What is/are the function(s) of price?

Price transmits information for Price transmits information for resources allocation.resources allocation.

Price provides incentives that Price provides incentives that motivate decision-makers to act motivate decision-makers to act because it rewards correct because it rewards correct decisions and penalizes wrong decisions and penalizes wrong ones.ones.


Functions of Invisible Functions of Invisible HandHand Price distributes income as it Price distributes income as it

determines who gain how much determines who gain how much of what.of what.

The above 3 functions are inter-The above 3 functions are inter-related.related.


Property RightsProperty Rights

Property rights to something are the Property rights to something are the entire set of peoples’ expectations entire set of peoples’ expectations regarding what they can and may regarding what they can and may do.do.

Property rights are the rules of the Property rights are the rules of the game, which serve to determine the game, which serve to determine the winners and losers; when the rules winners and losers; when the rules of the game change, the winners of the game change, the winners and losers will change.and losers will change.



In a capitalist system, property In a capitalist system, property rights exist on capital and rights exist on capital and consumer goods and on personal consumer goods and on personal services. People compete in the services. People compete in the free market and the price free market and the price mechanism determines resource mechanism determines resource allocation and income allocation and income distribution.distribution.



In a socialist system, income-In a socialist system, income-generating goods are controlled generating goods are controlled by the government and are not by the government and are not transferable at market prices. transferable at market prices. Control of scarce and valuable Control of scarce and valuable resources is gained by access to resources is gained by access to political power rather than political power rather than through the price mechanism.through the price mechanism.


Private Property Private Property RightsRights A good or an asset is defined as A good or an asset is defined as

private property, if and only if, private property, if and only if, within well-defined limits, its within well-defined limits, its owner has three distinct sets of owner has three distinct sets of rights:rights:– the exclusive right to usethe exclusive right to use– the exclusive right to receive incomethe exclusive right to receive income– the transfer rightthe transfer right


Private Property Private Property RightsRights The exclusive right to use is the The exclusive right to use is the

right to exclude other individuals so right to exclude other individuals so that the owner alone may decide on that the owner alone may decide on the use of a good.the use of a good.

The exclusive right to receive The exclusive right to receive income means that the owner has income means that the owner has the exclusive right to extract income the exclusive right to extract income generated by the use of a good.generated by the use of a good.


Private Property Private Property RightsRights The transfer right means that the The transfer right means that the

owner has the full right to transfer or owner has the full right to transfer or alienate a property or resource to alienate a property or resource to anyone he or she sees fit. It implies anyone he or she sees fit. It implies the right to enter into contracts with the right to enter into contracts with anyone and to choose their form. anyone and to choose their form.

However, in practice, exclusivity and However, in practice, exclusivity and transferability of a good are transferability of a good are frequently matters of degree.frequently matters of degree.


Goods, Bads and Goods, Bads and NeutersNeuters A good is any desired entity or object; a A good is any desired entity or object; a

good is something of which some is good is something of which some is preferred to more. preferred to more.

A bad is any undesired entity or object; a A bad is any undesired entity or object; a bad is something of which less is bad is something of which less is preferred to more.preferred to more.

A neuter is something which a person is A neuter is something which a person is indifferent to having, and does not care indifferent to having, and does not care whether he or she acquires more of it or whether he or she acquires more of it or less.less.


Economic Goods and Economic Goods and Free GoodsFree Goods Economic goods:Economic goods:

– a scarce good/made of scarce a scarce good/made of scarce resourcesresources

– a desired entity that we want more a desired entity that we want more than we havethan we have

– more of it is preferred to lessmore of it is preferred to less– commanding a positive pricecommanding a positive price– Qd is larger than Qs at zero priceQd is larger than Qs at zero price


Economic Goods and Economic Goods and Free GoodsFree Goods Free goods:Free goods:

– a non-scarce good/made of non-a non-scarce good/made of non-scarce resourcesscarce resources

– a desired entity that we do not want a desired entity that we do not want more than we havemore than we have

– more of it is not preferredmore of it is not preferred– commanding no pricecommanding no price– Qd is smaller than Qs at zero priceQd is smaller than Qs at zero price


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Assumptions behind PPC:Assumptions behind PPC:

– a country produces only two goodsa country produces only two goods– resources available are givenresources available are given– technology is giventechnology is given

Definition of PPC:Definition of PPC:– The PPC shows all combinations of two The PPC shows all combinations of two

goods that a country can produce, goods that a country can produce, given the resources and the best given the resources and the best technology available.technology available.


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Downward-sloping PPC shows concepts of scarcity, Downward-sloping PPC shows concepts of scarcity,

choice & opportunity costchoice & opportunity cost

Good Y

0 Good X

AB

C

D

PPC


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Production points on the PPC, e.g. A, B, C & D, Production points on the PPC, e.g. A, B, C & D,

yield production efficiencyyield production efficiency

Good Y

0 Good X

AB

C

D

PPC


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Pareto optimal/condition or efficiency means efficient use of resources.Pareto optimal/condition or efficiency means efficient use of resources. Pareto condition refers to consumption efficiency and production efficiency.Pareto condition refers to consumption efficiency and production efficiency.


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Pareto condition is a state where it is no longer possible to change the allocation of Pareto condition is a state where it is no longer possible to change the allocation of

resources so that one individual will gain without loss to another.resources so that one individual will gain without loss to another. It is a state that the wastage of resources is kept at minimum.It is a state that the wastage of resources is kept at minimum.


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency The PPC is concave to the origin.The PPC is concave to the origin.

Good Y

0 Good X

AB

C

D

PPC


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Concaved PPC implies increasing opportunity costConcaved PPC implies increasing opportunity cost

Good Y

0 Good X

AB

C

D

PPC1 2 3 4

2

3.5

54.5


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Linear PPC implies constant opportunity costLinear PPC implies constant opportunity cost

Good Y

0 Good X

E

F

G

HPPC

1 2 3 4

1

2

4

3


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Area outside the PPC, e.g. Point G: unattainable Area outside the PPC, e.g. Point G: unattainable

areaarea

Good Y

0 Good X

AB

C

D

PPC1 2 3 4

2

3.5

54.5

G


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Area inside the PPC, e.g. Point U: inefficient Area inside the PPC, e.g. Point U: inefficient

production areaproduction area

Good Y

0 Good X

AB

C

D

PPC1 2 3 4

2

3.5

54.5

U


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Outward-shifting of the PPC: economic growthOutward-shifting of the PPC: economic growth

Good Y

0 Good X

B

PPC 1

4

2

PPC 2


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Outward-shifting of the PPC: economic growthOutward-shifting of the PPC: economic growth

Good Y

0 Good X

B

PPC 1

4

2

5

PPC 2

B’


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency

Good Y

0 Good X

B

PPC 1

4

2

PPC 2

Outward-shifting of the PPC: economic growthOutward-shifting of the PPC: economic growth

4

PPC 2

B’’


Production Possibility Production Possibility Curve (PPC) & Curve (PPC) & EfficiencyEfficiency Inward-shifting of the PPC: economic recessionInward-shifting of the PPC: economic recession

Good Y

0 Good X

B

PPC 1

4

2

PPC 2



Good Y

0 Good X

B

PPC 1

4

2

PPC 2

3

B’



Good Y

0 Good X

B

PPC 1

4

2

PPC 21

B’’

Documents

By Mr. LAU san-fat/ver 2004CH1-The Scope of Economic Analysis1 Chapter 1: The Scope of Economic Analysis HKAL Microeconomics T. W. G. Hs. Lo Kon Ting Memorial