Download Econ 201 Review Notes

Econ 201 Review Notes - Part 2
This is intended as a supplement to the lectures and section. It is what I would talk about
in section if we had more time.
After the first three chapters where we talked about rational decision makers; what they
do and how they should make decisions, what happens when one individual interacts with
another, and finally when many individuals interact together in a market.
Now we want to look more closely at markets and how economists describe it and what
it tells us.
4. Demand (The consumer's/buyer's side of the market)
The first thing to understand is what we call the law of demand. This says simply that
people do or buy less of what they like as the price of doing or buying goes up. Note that
this is the same thing as saying that the demand curve is downward sloping, and in fact
this is exactly why we draw a downward sloping demand curve.
A. Law of Demand: People do (or buy) less of what they like as the cost of doing it (or
price of buying it) goes up.
But how do you decide if and how much to buy? Well, economists need some idea of
how much pleasure or enjoyment or usefulness you get from doing or consuming
something (by the way consuming can be thought of as buying or doing something in
general, not just something you eat), economists call this "utility." This is a generic
term that we use usually only to compare different individuals but also more generally to
measure a persons satisfaction or happiness.
With the consumption of a good, we say you derive utility from it.
B. Total Utility: The total amount of utility you get from consuming a certain quantity
of a good.
C. Marginal Utility: The extra or additional utility you get from consuming one more
of a good.
D. Law of Diminishing Marginal Utility: This is a law that economists assume holds
(and you should too, unless specifically instructed not to do so) that states that as you
consume more and more of a good, the additional utility you receive from consuming
one more goes down. Think of this simple relationship: More QA -- Less MUA.
Now if you are a rational individual, economists believe that you should always try and
maximize your total utility (after all shouldn't you always try to make yourself as happy
as possible?). To do so it means that you should consume the optimal combination of
goods, or simply the combination of goods that maximizes your total utility (and that you
can afford with your income). To make it easier for you to do so there is a simple rule to
follow:
E. The Rational Spending Rule: This rule simply says that the next good you should
consume is the one that gives you the highest marginal utility per dollar, so that in the
end (when you have spent all of your money) the marginal utility per dollar of each
good is equal. For two goods this means that: MUA/PA = MUB/PB.
Why? Suppose you were in Wegmans and you bought only cookies and apples and you
put enough of both in your basket that the cost was exactly equal tot he amount of money
you had to spend. A cookie costs the same as an apple, and it turned out that at the
combination of apples and cookies in your basket the marginal utility per dollar of an
apple was higher than the MU per dollar of a cookie. Then you could put back a cookie
and take another apple and your total utility from consuming what is in your basket
would go up.
Finally, we introduced the concept of elasticity. Elasticity is a way that economists
measure the responsiveness of quantity demanded to price.
F. Price Elasticity of Demand: The percentage change in quantity demanded that
results from a 1% change in price.
This is important because price and quantity determine total revenue or total
expenditure .
G. Total Revenue = Total Expenditure: P*Q, or price times quantity demanded.
For a point on a demand curve, if elasticity is greater than 1 (in absolute value), then we
call it elastic, and if it is less then one, we call it inelastic. If the elasticity at the point is
equal to one we call it unit elastic. The unit elastic point has a special feature, it is the
point of maximum total revenue.
5. Supply (The producer's/seller's side of the market)
The supply side of the market is in many ways analogous to the demand side. In general
we know that if a person values a good at least as much as its price, than he/she will buy
it. The same is true on the supply side, except in this case we are looking at sellers. We
know that if the cost of production is less than the price of a good, a seller will sell it.
So where on the demand side we were interested in marginal benefits, on the supply side,
we are interested in marginal costs: If the marginal cost of producing one more of a
certain good is less than the price you can sell it for, then you should go ahead and
produce one more. Firms keep doing this until price equals marginal cost or until the
last good that is produced costs exactly as much to produce as its price. It is this simple
idea that induces the supply curve. By selling goods for more than they cost to produce,
firms make profits.
A. Profit: Profit is the difference between the total revenue earned from the sale of a
product and total costs (both explicit and implicit (i.e. opportunity costs)).
Profit maximizing firms are those firms who try and maximize this difference. Firms
can compete in different types of markets. For this class the main distinction is between
perfectly competitive markets, where each firm is a price-taker or has no influence on
market price for their good, and imperfectly competitive markets, where firms have
some control over the price of the market (usually because they supply a large percentage
of the total amount of one good to the market).
When producing goods firms need inputs: materials, labor, factories, machines, etc. We
split these inputs up into two categories: fixed factors of production and variable
factors of production.
B. Fixed Factor of Production: An input whose quantity cannot be changed in the
short-run.
C. Variable Factor of Production: An input whose quantity can be changed in the
short-run.
Why the short-run for both? Well we define the long run as a time period long enough
that all factors of production are variable.
Now, just like the law of diminishing marginal utility on the demand side, we have a
relation about the quantity of goods produced and their benefit, it is called the law of
diminishing returns.
D. The Law of Diminishing Returns: This law states that (after some point) as you
make more and more of a good, the variable inputs needed to make one more of the
good get bigger and bigger. This says that the marginal costs increase (similar to the
way the marginal benefits decrease in the demand side).
We can also talk about the price elasticity of supply in the same way we talked about
elasticity in the demand side, namely that it is the percentage change in quantity supplied
given a 1% change in price. What affects the elasticity of supply? Well, if inputs are
flexible or especially mobile, then it is easy for a producer to change production
quantities when prices change, so elasticity will increase. The same is true if it is easy to
produce substitutes or if the product is narrowly defined (doritos corn chips rather than
corn chips in general), etc.
6. The Market Revisited: Efficiency and Exchange
Before we looked at how the market works mechanically, through the supply and demand
diagram, but now we want to think about aspects of this mechanism that we find
particularly good or useful. The first thing that we know and one of the most powerful
ideas in all of economics is that market outcomes are efficient. (A word of caution: this
is also one of the most abused ideas in economics, before spouting off about the wonders
of the market just be aware that there are a huge amount of conditions for this to be true:
people must be well informed, there must be perfect competition, etc. This rarely
happens in the real world, BUT the market often still does better than anything else in
these situations).
A. Efficient: A situation is efficient if it is not possible to rearrange things so that some
people are better off and no one is worse off.
Why is the market outcome efficient? Try and find an exchange that has not already
happened that will make someone better off and no one worse off - it is not possible
because if it were the market would have brought about that exchange. Why? This is the
idea of the invisible hand, self interested people will look for just those trades and do
them if they can.
Economists measure how much people benefit from market exchanges by looking at total
economic surplus or just total surplus. This is the sum of consumer and producer
surplus.
B. Consumer Surplus: This is the difference between the value a consumer places on a
product (the maximum they are willing to pay) and the price they do pay for it. If we
add these up for all consumers in a market that purchase a good, then we find total
consumer surplus. This is the area beneath the demand curve and above the
equilibrium price.
C. Producer Surplus: This is the difference in what a producer would be willing to sell
a good at and what he/she actually does sell it at. Total PS is the area above the
supply curve and beneath the equilibrium price.
D. Total Economic Surplus: This is the sum of total consumer surplus and total
producer surplus.
So another way of seeing efficiency is that it is the outcome that maximizes total surplus.
When the government alters the market with price controls or price supports or perunit taxes on buyers or sellers then efficiency breaks down. The moral of the story (in
the simple world) is that the market should maximize the total surplus on its own, and the
government should pursue its goals by adjusting outside of the market.