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Chapter 1: Ten Principles of Economics
8/24/2011
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Economy: Greek, to manage a household.
Economics: the study of decisions made when dealing with scarcity.
Scarcity: Not enough resources to satisfy
*Margin: “step, by step” changes.
Rationality: making decisions based on all of the information you have. In economics we assume
rationality.
Incentive: Something that induces a person to act.
Market: a place buyers and sellers meet to exchange goods and services
Inflation: general increase in price level
10 Economic Principles
(Micro Economics)
• People face trade offs
• Efficiency: getting the highest benefit from scarce resources
• Equity: equal shares from different groups
• Opportunity Cost (OC): What you give up to get something else.
• People make choices at the margin.
• People respond to incentives.
• Weighing costs and benefits
• Increase the cost -> less likely to do something
• Decrease benefits -> less likely to do something
• Trade can make everyone better off
• Allows specialization
• Markets are usually a good way to organize economic activity
• Governments can sometimes improve market outcomes
(Macro Economics)
• A country’s standard of living depends on its ability to produce goods and services (G&S)
• Prices rise when government prints too much money
• Short-run tradeoff between inflation and unemployment
• When one goes up the other goes down
Chapter 2: Thinking Like an Economist
08/26/2011
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Microeconomics: Decisions by households or firms and interactions between households and
firms in the marketplace
Macroeconomics: Studies the forces and trends that affect the economy as a whole
The Economist as a Scientist
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Use models to simplify reality
Use scientific method
• Use observations to develop theory
• Collect and analyze data
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• Observe natural experiments to test theory
Use assumptions: limits (ex: It is summer in Texas)
Goal of a model is to simplify reality to increase understanding
2 models
• Circular Flow Diagram:
• 3 Different Actors
• Households = Consumers
• Firms = Producers
• Government (Taxation/Regulation)
• Factors of Production: Inputs or resources into production
• Capital (K)
• Land/Nature Resources
• Human Capital
• Technology (A)
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Positive Statement: “What is; fact”
• Economics
Normative Statement: “What should be; opinions”
• Political Science
• Social Sciences
Much disagreement in Economics
• Production Possibility Frontier (PPF): Shows the combinations of output an economy can
produce with given inputs
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Production: What firms produce G&S
Possibility: Combinations
Frontier: limit border
Assumptions
• Can produce 2 goods
• Computers
• Cars
• Limited number of inputs
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Produce on PPF (F,A,B,E): Efficiency
D: can produce, but inefficient
C: cannot produce
Economics
• Graph with 2 variables
• Looking at the relationship between 2 variables
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Omitted Variables
• Changes do to variable not on graph
Reverse Causality
• Does A cause B
• Does B cause A
• Neither?
Correlation: A and B happen at the same time
Demand Curve
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Supply Curve
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Chapter 3:
08/31/2011
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Absolute advantage: The ability to produce a good using fewer inputs than another producer
Comparative Advantage: The ability to produce a good at a lower opportunity cost than another
producer
Opportunity Cost (OC): what you must give up to get something else
2 basic ways to satisfy wants
• Economic self-sufficiency: Produce everything you want to consume
• Specialize in the production of a good and trade for other goods
Trade will only happen if it makes people better off
Ex: 2 Individuals, Rancher and farmer. Produce 2 products: Meat and Potatoes.
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With no trade, PPF is the person’s Consumption possibility frontier.
Imports (M): Goods produced abroad and sold domestically
Exports (X): Goods produced domestically and sold abroad
Trade: Importing one product and exporting another
Chapter 4:
9/9/11
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Market: a place where buyers and sellers get together to exchange goods and services
Competitive Market: A market which there are many buyers and many sellers and no one can
affect the price
• Goods sold are exactly the same
Price Takers: take the market price as given
Demand (D): a relationship between the price and the quantity demanded a each price
• Any relationship can be put on a graph
Quantity Demanded (QD): the quantity that buyers are willing and plan to buy at a given price
Law of Demand: other things being equal (ceteris paribus) the quantity demanded falls when
the price rises
Market Demand: The total quantity demanded by all buyers in the market at each price
Horizontal Summation: at each price what is the total quantity demanded?
Change in Price
• Move along demand curve
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• Change quantity demanded
Changes in demand
• Increase in demand (D1 to D2)
• At each Px QD is higher
• Shift D curve to right
• Decrease in demand
• At each price, QD is lower
• Shift D curve left
Reasons for changes in Demand (All shift Demand Curve)
• Price of related Goods
• Substitutes: If the price of a substitute increases, the demand for the original
good increases
• Compliments: If the price of a Compliment increases, the demand for the
original good decrease
• Income
• Normal Good: When income increases, demand for a normal good increases
• Inferior Goods: When income increases, demand for an inferior good decreases
• Tastes
• Expectations
• Future Income: changes current demand
• Future Prices: changes current demand
• Number of Buyers
Supply (S):the relationship between the price and the quantity supplied by sellers at each price
Quantity Supplied (QS): the quantity of a good or service that firms are willing and able to sell at
each price
Law of Supply: All else equal (ceteris paribus) as the price increases the quantity supplied
increases
Changes in Quantity supplied (QS)
• P => QS UP
• P => QS DOWN
Changes in Supply (S)
• Increases in supply: QS UP at each P; S Curve shifts Rights
• Decrease in Supply: QS DOWN at each P; S Curve shifts Left
Reasons the supply curve shifts
• Changes in input prices
• Ex: Up P of Wood for tables the firm produces
• Technology
• Ex: better machines to produce goods
• Expectations
• Ex: Businesses trends the firm expects
• Number of Sellers
• Sellers UP => Market Supply UP
Equilibrium Price: the rpice at which quantity supplied equals quantity demanded in the market
Equilibrium Quantity (Qe): where QS = QD
Ch 5:
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Elasticity €: responsiveness
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A measure of responsiveness of quantity demanded (QD) or quantity supplied (QS) to on
of its determinants
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Price Elasticity of Demand €P: the measure of how much the QD of a good responds to a
change in price of that good
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€P = %Change QD/%Change P
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(Q2-Q1)/(Q1+Q2)/2/(P2-P1)/(P1+P2)/2
When €P, Demand is elastic.
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When €P=1, Demand is unit elastic.
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IF P UP by 1% => QD DOWN by 1%
When €P<1, Demand is inelastic
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IF P UP by 1% => QD DOWN by > 1%
IF P UP by 1% => QD DOWN by < 1%
If demand is inelastic, then the percent change price is greater than the percent change in
Quantity demanded
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UP P by 1% => DOWN QD by < 1% => UP TR
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DOWN P by 1% => UP QD by < 1%
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IF D is unit elastic => no change in TR
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Profit: Total revenue (TR) – Total Cost (TC)
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Total Revenue = Price (P) X Quantity (Q)
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TR = P x Q
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IF TR UP => UP Profit (if costs fixed)
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IF demand is elastic, than the percent change in price is less than the percent change in quantity
demanded
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UP P by 1% => QD by> 1%
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DOWN by 1% => UP QD by > 1%
For price Elasticity of Demand, take the absolute value (drop the minus sign)
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€P = abs(%CHANGE QD / %CHANGE P)
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Price Elasticity of Demand: €P = %Change QD/%Change P
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Income Elasticity of Demand: €I = %Change QD/%Change I
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The measure of how the QD responds to the change in Income (I)
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Normal Good: UP QD when UP I
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€I > 0
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Necessities: Small income elasticity
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Luxury Goods: large income elasticity
Inferior Good: DOWN QD when UP I
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€I < 0
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Cross - Price Elasticity of demand: €X = %CHANGE QD1 / %CHANGE P2
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The measure of how much the QD of one good responds to the change in price of another good
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Substitute: UP P2 => UP QD
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Compliments: UP P2 => DOWN QD1
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€X < 0
Price elasticity of supply (€PS): the measure of how quantity supplied of a good responds to a
change in the price of that good, what the seller receives
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€X > 0
(€PS) = %CHANGE QS / %CHANGE P
Determinants of €PS
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Flexibility of sellers (EX: Complicated production)
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Time horizon: Supply is usually more elastic in the short run
Ch 6: Government Policy
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Price Ceiling: a legal maximum on the price at which a good can be sold
• Price is below Pe
• Causes Shortage
• Ex: Rent Control
Price Floor: a legal minimum on the price at which a good can be sold
• Price is Above Pe
• Causes Surplus
• Ex: Minimum Wage
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Tax Incidence: the manner in which the burden of the tax is shared among participants in the market
Tax incentive: who pays the tax
• Tax on buyers shifts demand curve
• If tax changes, it changes QD to bottom of tax
• Original Price = Pe
• Both households and firms pay part of tax(T)
• Now households pay Pg > Pe, but PB < T
• Now sellers reveve PS < Pe, but PS < T
• Tax on sellers (Adds cot to sellers)
• Shifts supply curve to the top of supply curve to top of tax
• Government can tax buyers or sellers and both will still pay part of tax
• More elastic (more responsive) => flatter the curve
• Buyers pay more of tax when supply is elastic
• Sellers pay more of tax when demand is elastic
CH 7:
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Welfare Economics: the study of how allocation of resources affects economic well being
Consumers – buyers
• Demand Curve
• Willingness to pay: the maximum amount a buyer will pay for a good
• Consumer Surplus (CS): the amount a buyer is willing to pay for a good minus the amount the
buyer actually hast to pay for it
• CS = WTP-P
• Found below demand curve and above price to buyers
Sellers – firms
• Supply curve
• Cost: the value of everything a producer must give up to produce a good
• Input cost
• Opportunity cost <- included in economics but not in accounting
• Economic profit
• Producer Surplus (PS): the amount a seller is paid for a good (P) minus the seller’s cost of
producing the good
As Price falls, Consumer surplus increases for 2 reasons
• Original consumers (QD) paying lower price
• New Consumers (QD2-QD1) now enter market and buy the good
Height of Demand Curve = Willingness to Pay
As price rises, Producer surplus increases for 2 reasons
• Original sellers (QS) receive a higher price
• New sellers (QS2-QS1) enter the market and sell the good
Efficiency: resources allocation on that maximizes total surplus received by all members of society
Where is the most efficient allocation of S & D graph?
• Equilibrium Quantity and Price => Maximize total surplus
Equity: the fairness of the distribution of well-being
Chapter 10: Externality
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Externality: the uncompensated impact of one person’s actions on the well-being of a bystander
Private Cost: individual firm’s cost to produce and supply a good
• Supply Curve
• Under supply curve is Total Cost
Social Cost: Private Cost + Cost of negative externality
Internalizing an externality: Altering incentives so that people take account of the external effects of
their actions
• Makes people pay social cost rather than Private Cost
Negative Externality: The effect on the bystander is adverse (negative)
• Ex: Pollution, Neighbors’ Pets, Health risk
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Positive Externality: The effect on the bystander is beneficial (positive)
• Private Venefit: benefit on an individual of an action
• Social Benefit: private benefit from external benefit
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Externalities
• Negative:
• Private quantity > Social Quantity
• Private price < Social Price
• Positive:
• Private Quantity < Social Quantity
• Private Price < Social Price
• Internalizing on Externality
• Tax goods with negative externalities
• Subsidizing (grants) goods with positive externalities
• Private Solutions to Externalities
• Moral codes and social sanctions
• Charities (EX: sierra club)
• Contracts between market participants and bystanders
• Coase Theorem: If private parties can bargain without cost, over the allocation of resources,
they can solve the externality problem on their own.
• Problems with coase Theorem
• Transaction Costs: Costs that partners incur in the process of bargaining
• Both parties hold out for a better deal
• Number of parties is large
• Public Policies Toward Externalities
• Command and control policies
• Regulates behavior directly (EX: Speed Limit)
• Market based policies
• Provides incentives for private decision makers (EX: Pay as you go insurance)
• 2 market based approaches
• Corrective (Pigouvian) Tax: Designed to make decision makers take account for their
actions
• Corrective tax used when there is an external cost
• Corrective Subsidy used when there is an external cost
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Tradable Permits: Issue permits to decision makers
• Permits can be bought and sold
• Sets up a market for externality
Need information on demand for the externality
Ch 11: Public Goods and Common Resources
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Private goods: exclusive use to resource
Public goods: anyone can use the resource
Characteristics of Goods
• Excludable: if a person can be prevented from using the good
• Rival to Consumption: if one person’s use diminishes another person’s use
Excludable
Not Excludable
Rival to Consumption
Private Goods
Common Resources
Not Rival to consumption
Natural Monopolies
Public Goods
• Externalities: bystander affected by someone else’s actions
• Arise because something with no market value has a value attached to it
• Private decisions about production and consumption can lead to externalities
• Free-Rider Problem: a person receives the benefit of a good but avoids paying for it
• When a good is not excludable
Public Goods
• If the benefit of providing a public good exceeds the cost, the government should provide the
good and pay for it with a tax on the people who are going to benefit from the good
• Cost-Benefit Analysis: a study that compares the costs and benefits of providing a good/ doing
an action
• If Cost > Benefit => Don’t provide good/ don’t do the action
• Benefit > Cost => Provide goods/ do action
• Knowledge created through basic research
• Fighting Poverty
Common Resources
• Not excludable
• Cannot prevent free riders
• Government has a role in providing common resources
• Preventing its overuse
• Tragedy of the Commons: Private incentives (using the product for free) outweigh the social
incentives (using the land carefully).
• Common resources
• Common grazing land for cattle
• Common hiking trail
• Overuse and destruction of the resources
• Amount of resources is fixed
• Can lead to the destruction of a whole industry
• Why?: people don’t look at the external cost of their actions
• Policies to prevent overuse
• Regulate use of resource
• Use corrective tax to internalize externality
• Auction off permits to use the resource
• Convert it to a private good
Ch 13: Costs of Production
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Firms produce goods and services in order to achieve a maximum profit.
Total Revenue (TR): The amount a frim receives from the sale of its output
• TR = P X Q = Price x Quantity
Total Cost (TC): The market value of inputs a firm uses in production
Profit = Total Total Revenue – Total Cost
• TT = TR – TC
• Accounting Profit = TR – Total Explicit Costs
• Economic Profit = TR – Total Explicit Costs – Total Implicit Costs
2 kinds of costs:
• Explicit: requires an out lay of money
• Implicit Cost: do not require an out lay of money
Need 100,00 to start a business
• Borrow 100,000 at 5%
• Explicit cost = $5,000
Borrow $60,000 @ 5% and use $40,000 from your savings
• Explicit Cost = $3,000 interest
• Implicit Cost = $2,000 interest we could have earned
Diminishing returns: added input creates more output at a decreasing rate
• Only adding one input
• Other inputs are fixed
Marginal Product of Labor (MPL): the additional output from one extra unit of labor input
MPL = Change in Q / Change in Labor
Fixed Costs: Same cost regardless of inputs
• Ex: Land costs $1,000 per month
Variable Cost: Depends on Quantity of input
• Wage of a worker = $2,000 per month
Labor
Output (Q)
Cost of Land (FC)
Cost of Labor (VC)
0
0
1,000
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1
1,000
1,000
2,000
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1,800
1,000
4,000
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2,400
1,000
6,000
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2,800
1,000
8,000
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3,000
1,000
10,000
• TC = VC + FC
• Marginal Cost is the change in total cost divided by the change in output
• MC = Change TC / Change in Q
• Average fixed cost (AFC) = FC / Q
• decreasing
• downward sloping
• Average variable cost (AVC) = VC / Q
• U-Shaped Curve
• Average Total Cost (ATC) = TC / Q = AFC + AVC
• U-Shaped
• Short Run: Some costs are fixed
• Ex. Lease on building
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Total Cost (TC)
1,000
3,000
5,000
7,000
9,000
11,000
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Long Run: All inputs are variable
• To maximize profit, ATC ar any Qunatity of output is the cost per unit using the most efficient
mix of inputs => factory size with lowest ATC
Profit maximization implies cost minimization
Economies of scale: Occurs when increasing production allow for greater specialization. This makes
workers more efficient
Diseconomies of Scale: Due to coordination problems wihin larger organizations
Ch 15: Monopolies
 Monopoly: one producer of a product
 Without close substitutes
 Key difference between monopoly and perfect competition
 Market power: ability to influence the price in a market
 Why do monopolies exist?
 Barriers to entry: other firms cannot enter the market
 Firm owns a key resource
 Government can give exclusive rights to produce a product
 EX: patents, copyrights
 Natural Monopoly: A single firm can produce the entire market quantity at a lower ATC than
several firms
 Economies of scale
 Monopoly: only producer facing total market demand so demand curve is demand for the
monopolies its product
 To sell a larger quantity monopolist must decrease price (P). MR != P
 Increasing Q produced has 2 effects
 Output Effect: the more output sold(Q), the greater the revenue (PxQ)
 Price Effect: As monopolist produces more, price falls which decreases revenue
Monopoly
Perfect Competition
 One firm/producer (S)
 Many firm & producers (S)
 Man consumers (D)
 Many consumers (D)
 P > MR
 P = MR
 Monopolist is only demand curve
 Supply and Demand Curve
because they can set whatever price
 MR = MC (Max Profit)
they wants
 MR = MC
 Choose Q to produce
 Go to D curve and find price
(willingness to pay by consumers
 Goal is to maximize profit
 MC = Supply curve
 Goal of monopoly: Maximize profit => MR = MC
 A monopoly takes quantity of where MC = MC but the price of that quantity and the demand
curve. This generally lets them produce less and charge more.
 Profit = TR – TC
 Profit = (Pm * Qm) – (ATCm * Qm)
 Profit = (Pm – ATCm) Qm
 Public Policy toward monopolies
 Increasing competition with trust laws ban certain competitive practices
 Sherman antitrust act of 1890
 Clayton act 1914
 Regulations
 Example p = ATC => zero economic profit
 public ownership
 Ex: US mail
 Do Nothing
 Discrimination: treating people differently based on the same characteristic
 Price Discrimination: Selling the same product or service at a different prices to different
customers
 Firms use buyers’ willingness-to-pay (height of Demand Curve) to price discriminate
 If perfect price discrimination occurs the firm would charge each person the max that they
would be willing to pay
 Examples of price discrimination
 Movie tickets
 Airline prices
 Discount coupons
 Need-based financial aid
 Quantity discounts
Ch 16:
 Monopolistic Competition: A market structure which there are many firms that sell similar, but
different products or services
 Short Run: Monopolistically competitive firm may have a profit or a loss
 Profit: P>ATC at Qm
 Loss: P<ATC at Qm
 MR = MC
 Long Run: more firms will enter market if there is a profit (=> P DOWN). more firms exit the market
there is a loss (=> P UP) (=> ZERO Economic Profit P = ATC @ Qm)
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Characteristic
# of Sellers
# of buyers
Importance of
Strategic
Interaction
between firms
Likelihood of
fierce Competition
Free entry & Exit
LR Economic Profit
Products
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Perfect
Competition
Many
Many
Yes
Zero
Identical
Monopolistic
Competition
Many
Many
Yes
Zero
Differentiated
Monopoly
Oligopoly
One
Many
Low
Few
Many
High
Low
High
No
Profit
One Product
Market Power?
NO
Yes
Yes
(Can they effect
Price)
Demand Curve
Horizontal
Downward sloping Downward Sloping
facing Firm
Perfect competition => max ts
LR Monopolistic Competition: Not Producing at lowest ATC
Not maximizing TS
In the long run, firms enter the monopolistic competition if there is profit
 Product variety externality: the consumer surplus buyers get from the introduction of new
products
 Business stealing externality: losses incur to existing firms curve shifts left when new firms enter
the market
 Advertising: the more differentiated the product, the more advertising firms buy
 Economist disagree about the social value of advertising
 As a signal of quality
 Advertising is expensive
 Producers must maintain a high quality
Critiques
 Wasting resources that could be used for production
 Main palate people’s tastes
 Decreases competition
 Make up price of product
Defense
 Provides useful information to buyers
 If buyers have information they can take advantage of price differences
 Promotes competition and reduces market power
Brand Names
 Many brand name goods and many generics
 Brand name companies spend more on advertising and charge higher prices
 Critiques
 Cause consumers to perceive differences that do not exist
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 Consumers’ willingness to pay for brand name goods is irrational
 Eliminating government protection of trademarks would reduce use of brand names
 Defense
 Provide information about quality to consumers
 Companies with brand names have incentive to maintain quality
 Reputation
Perfect Competition
 Many buyers
 Many sellers
 Individual Supply curve
 Price = MR
 Max profit = MC
 P = MR - MC
Monopolistic
 Many buyers
 Many sellers
 Individual Demand Curve
 For the firm’s market
 Max profit: MR = MC => P + Q
 Yes short run profit
 No long run profit (entry and exit)
 Advertising
 Brand Name
Oligopoly
 Many buyers
 Few sellers
Monopoly
 Many buyers
 One seller
 Individual Demand Curve
 Whole Market
 Supply curve => MC
 Short run Econ profit
 Long run Econ Profit
 Price Discrimination: S curve => MC
 Charge different => short run economic profit
