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Chapter 1
Basic Principles of Economics
What is Economics?
• Scarcity … our wants exceed our
resources
• Decisions
– Consumers
– Business
– Governments
“Micro”
• Microeconomics relates to specific individuals,
companies, industries and markets
• e.g. the price of milk or dvds
“Macro”
• Macroeconomics relates to the whole
economy
• e.g. Gov’t decides to raise interest rates
to lower inflation
More Macro…
Terms
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Ceteris Peribus
Opportunity Cost
Production Possibilities
Supply and Demand
Price
Elasticity
Economic Profit
Profit Maximum Rule
Costs (marginal, average, minimum, etc.)
Monopoly, Oligopoly, Perfect Competition, etc.
Labour
Globalization
Economists
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David Ricardo
Adam Smith
Karl Marx
John Maynard Keynes
Frederick Von Hayek
John Kenneth Galbraith
Theories
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Law of Diminishing Returns
Law of Increasing Opportunity Costs
Profit Maximization Rule
Quantity Theory of Money
Labour Theory of Value
Okun’s Law
Formulas
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Total Revenue = Price x Quantity
Total Costs = Fixed Costs + Variable Costs
Average Cost = Total Cost / Quantity
Average Variable Cost = Variable Cost / Quantity
Marginal Revenue = rTotal Revenue / rTotal
Quantity
• Marginal Cost = rTotal Cost / rTotal Quantity
• Profit Max. Point where Marginal Revenue =
Marginal Cost
• Profit in $ = Total Revenue – Total Costs
Graphs
And more graphs
Revenue
MC
AC
D=AR=MR
P
Profit
AVC
Cost
Revenue
Rectangle
Quantity
People
Expectations of Teacher
• Excellent knowledge and delivery of
content
• Provide multiple opportunities to earn
marks in each category
• Create inviting atmosphere of shared
experience
Expectations of Student
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Come to class
Come to class on time (1:30pm)
Leave class when it ends (2:45pm)
Do your homework
Participate
Listen
Allow others to learn
Actively review
Come for extra help
Things NOT to do:
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Part time student status
Hand in assignments late
Miss tests
Say “I wasn’t here”
Say “My partner isn’t here”
Waste work periods
Plagiarize or copy
Wine about marks
What is Economics?
• the study of how we make decisions
about the use of scarce resources
• a social science because it’s a study of
people making decisions
• a self-sustaining system in which
independent transactions create distinct
flows of money
About Economics
• difficult to predict individual human
behaviour it is often possible to predict
group behaviour
• Economic decisions should be effective
(achieve goal) and efficient (use least
amount of resources)
Opportunity Cost
• the sum of all that is lost from taking one
course of action over another
• eg. Study or work the night before a big
test … opportunity cost is what you give
up by taking one course of action
Production Possibilities Model
• a visual model showing the choices
faced by people in a simple economy
• Assumptions:
- only two products can be produced …
leading to a trade-off
- fixed resources and technology
- full-employment
Production Possibilities Model
• The economy can produce good A or
good B (in this case food or clothing)
Production Possibilities Model
• If the economy chooses to produce more
of one good over another it can but must
shift resources
• resources do not shift easily and it costs
progressively more of one good to
produce more of the other … this is
called the law of increasing relative cost
More “Laws”
• The Law of Diminishing Returns states
outputs increase with a particular input
but only to a point
• The Law of Increasing Returns to Scale
states output can increase if all
productive resources are increased at
the same time and in the same quantity
Productive Resources
Tangible:
• Land (raw
materials)
• Labour
• Capital – real:
goods used to
produce other
goods
• Capital – money:
funds used
Intangible:
• Knowledge
• Entrepreneurship
• Environment for
enterprise
Three Fundamental Questions
• What to Produce
• For Whom to Produce
• How to Produce
Types of Economy
Traditional:
• Focus on family
needs
• Methods handed
down
• Use most, trade
surplus
Types of Economy
Command:
• Central authority
decides what, for
whom and how to
produce
Types of Economy
Market:
• sell popular goods at
best price
• keep costs low and be
efficient
• consumers are those
that can afford the
product
Types of Economy
Mixed:
• markets and
governments interact
as producers and
consumers
• taxes create the
desire to cheat, e.g.
Hidden Economy
Political Economies
• Democracy means political system
involves freely elected government and
allows differing political views
• Dictatorship involves a single person or
party having authority over a nation
Political Economies
Communism:
• the “left”
• government owns
control of all means of
productions
• no private property
rights
• can use violence to
retain power
• Marx and Engells
Political Economies
Socialism:
• left centre
• government control
of means of
production
• democracy
favoured
• free enterprise is
inefficient and
wasteful
Political Economies
Capitalism:
• moving to the right
• freely elected gov’t
• private property
encouraged
• free market for
consumers and
producers
• Adam Smith stressed the
“invisible hand”
Political Economies
Facism:
• extreme right
• free market economy
• nondemocratic/authoritarian
gov’t
• private property
ownership encouraged if
gov’t dictates followed
Adam Smith
(1723 –1790 The Wealth of Nations)
• laissez-faire term meaning leaves things
alone
• individual self-interest and wealth
creation good for all individuals
• “invisible hand” is the market
competition and will serve the common
good
• division of labour
Adam Smith
• division of labour (specialization of
workers) led to increased production,
increased profits for investors, more
consumer goods for workers and
greater economic efficiency for society
• law of accumulation meant profits would
be reinvested and create more
prosperity for investors and workers
Adam Smith
• law of population implies increased
capital requires more workers, leading
to higher wages, improved living
conditions, reduced mortality, increase
in population and labour force …
keeping wages low
Thomas Robert Malthus
(1766-1834 Population)
• predicted inevitable poverty and famine for the
masses
• Industrial Revolution meant farm to urban change
• Population doubles every 25 years if unchecked,
geometric progression
• but food can only grow in an arithmetic progression,
Positive checks include war, famine, disease,
epidemics and reduce pop. Growth rate
• preventative checks include late marriage, sexual
abstinence (and now birth control)
• tech. breakthroughs in food production were not
imagined
Thomas Robert Malthus
• Positive checks include war, famine,
disease, epidemics and reduce pop.
Growth rate
• preventative checks include late
marriage, sexual abstinence (and now
birth control)
• tech. breakthroughs in food production
were not imagined
David Ricardo
(1772-1823 Rent)
• three groups: working class, industrialist class,
landlords
• one group could only prosper at the expense of
others
• Iron Law of Wages implied higher reproduction
kept wages low
• Trade – absolute advantage meant a nation
could produce a product more efficiently than
another nation
• but Trade could still exist if each nation
produced the product it had a comparative
advantage in and traded the surplus
David Ricardo
• Trade – absolute advantage meant a
nation could produce a product more
efficiently than another nation
• but Trade could still exist if each nation
produced the product it had a
comparative advantage in and traded
the surplus
Karl Marx
(1818-1883 Communist Manifesto)
• believed workers – the proletariat – would always be
exploited by the ruling class
• workers in urban areas endured no labour laws and
children were abused
• believed all workers would eventually unite to
overthrow the ruling class
• Labour Theory of Value – means labour receives only
a portion of its worth; the rest being surplus value
• e.g. cost of sweater is $10 in materials, $40 in labour
and sold for $80 … surplus value is $30
Karl Marx
• Labour Theory of Value – means labour
receives only a portion of its worth; the
rest being surplus value
• e.g. cost of sweater is $10 in materials,
$40 in labour and sold for $80 …
surplus value is $30
John Maynard Keynes
(1883-1946 Gov’t intervention)
• gov’t could and should intervene in
economy to smooth the effects of
business cycles methods
• include control of interest rates and
gov’t spending
• critics suggest his policies lead to high
inflation rates and massive public debts
John Kenneth Galbraith
(1908 Social Balance)
• in good times consumer goods such as tv’s
and cars produced in abundance but public
goods such as hospitals and parks not a
priority
• believed corporate managers held real
decision-making power (not shareholders or
consumers)
• argued for more gov’t involvement and
regulation
Milton Friedman
(1912 Monetarism)
• argued gov’t involvement worsened economy
• also it put individuals more dependent on
gov’t
• pro-laissez-faire, self-sufficiency and work
ethic
• replace gov’t welfare programs with a
guaranteed income (negative income tax)
• advocated voucher system for schools
• Monetarist School of Thought – gov’t should
only manage the economy by guaranteeing a
constant money supply and yearly increase
(3-5%)
The Market
• can be a location,
network of buyers and
sellers for a product,
demand for a product or
a price-determination
process
• the interaction of buyers
and sellers determines
what the price will be
for a good or service
Demand
• the quantity of a good or service buyers
will purchase at various prices during a
given period of time
• the law of demand states the quantity
demanded varies inversely with price
(Ceteris Paribus – all other things
remain the same)
Demand
Reasons supporting the law of demand:
• Substitution Effect – we buy different
goods when prices rise or fall
• Income Effect – we can more if price
falls or less if it rises
Demand
• the demand schedule is the entire
relationship between each price and
quantity demanded
• the demand is downward-sloping
Demand
• the sum of all individual consumer
demand curves for a good is the market
demand curve
• “demand” is the entire set of price and
quantity relationships while “quantity
demanded” is the amount demanded at
one price
Supply
• the quantities sellers will offer for sale at
various prices during a given period of time
• law of supply states the quantity supplied will
increase if price increases and fall if price falls
• “supply” is the entire set of price and quantity
relationships while “quantity supplied” is the
amount offered at one price
Supply
• Supply curve is upward sloping to the
right
Market Equilibrium
• the interaction of buyers and sellers, of
demand and supply
• equilibrium price is the result of supply and
demand forces
• a price above the equilibrium leads to a
surplus which can only be cleared by a drop
in price
• a price below equilibrium leads to a shortage
and can only be cleared with a price increase
Market Equilibrium
• The intersection of demand and supply
Demand Determinants
(changes in Demand)
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Non-price factors shifting the entire curve (at every price)
Income – more leads to increased demand
Population – more leads to increased demand
Tastes/Preferences – various reasons, reports, advertising
Expectations – of a future event may lead to more or less
demand now
Price of Substitute Goods – if a compliment, demand shifts
in the same direction; if substitute the opposite direction; eg.
bread price increase, demand for butter decreases
(compliment); e.g. steak price increases, hamburger
demand increases
Supply Determinants
(changes in Supply)
1. Costs – increase/decrease in production
costs decrease or increase supply
2. Number of Sellers – new producers
increase market supply
3. Technology – usually decreases costs and
increases supply
4. Nature – weather or disaster can affect
supply
5. Prices of related outputs – if another good
has higher price, producers may shift
production
Movement along Demand curve
• Can only be caused by change in price
Movement along Supply Curve
• Can only be caused by price change
Shortage
• decrease in price, away from equilibrium
• Excess will be cleared with an increase in
price and shrinking quantity demanded
Surplus
• Increase in price, causing excess quantity
supplied
• Cleared by lowering prices and reducing
quantity demanded
Change in Demand
• Can only be caused by a demand
determinant (no price change)
• The whole demand curve shifts
Change in Supply
• Caused by change in supply determinant (no
price change)
Profit & the Firm
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The “Bottom Line”
Incentive and reward for risks
Leads to better decision making and greater productivity
Accounting profit = revenue – costs
Revenue = price x quantity
Costs = Fixed Costs + Variable Costs
Short Run – at least one resource can’t be changed
Long Run – all costs , including buildings, can be
variable
Production
• Marginal Revenue is the additional revenue
earned producing one more unit of output
• Marginal Cost is the additional cost of that
unit
• Profit maximized where MR = MC
• Productivity – maximize output from
resources used
• Efficiency – producing at lowest cost
Productivity factors
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Skills, education, experience of workforce
Quantity and quality of resources
State-of-the-art machinery
Aim to lower cost per unit
Capital-intensive (using machines) vs. Labourintensive
• Economies of scale relates to the efficient use of
machinery
• Producing more output lowers the cost per unit
Useful Formulas
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Total Revenue = Price x Quantity
Total Costs = Fixed Costs + Variable Costs
Average Cost = Total Cost / Quantity
Average Variable Cost = Variable Cost / Quantity
Marginal Revenue = rTotal Revenue / rTotal Quantity
Marginal Cost = rTotal Cost / rTotal Quantity
Profit Max. Point where Marginal Revenue = Marginal Cost
Profit in $ = Total Revenue – Total Costs
Perfect Competition
• Many buyers and sellers
• identical product
• price taker … no control over price
• no barriers to entry
• little non-price competition
• may not actually exist
Perfect Competition
Profit Maximization
Revenue
MC
Profit Max
AC
D=AR=MR
P
Profit
AVC
Cost
Revenue
Rectangle
Profit Max
Quantity
Quantity
Monopolistic Competition
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Many firms
Similar product
Some influence over supply and price
Easy entry
Non-price competition high
Monopolistic Competition
Profit Maximization
Revenue
MC
Profit
P
AC
D=AR
Cost
MR
Q
Quantity
Oligopoly
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Few firms dominate
Products may be similar or different
Influence over price varies
Barriers to entry high
Non-price competition high
Oligopoly
Profit Maximization
Revenue
P
“Kink”
MR
MC
Profit
AC
Cost
D=AR
Q
MR
Quantity
Monopoly
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One firm dominates
Unique product
Price maker and control over supply
Barriers to entry very high
No need for non-price competition
Monopoly
Profit Maximization
Revenue
MC
Profit
P
AC
Profit max
Cost
D=AR
Q
MR
Quantity
Note: Similar to Mono. Comp. but more inelastic demand curve
Issues
• Natural Monopoly – where high fixed costs make one
firm the choice (e.g. utilities, public transit)
• Deregulation – allow competition
• Privatization – sell public assets to private interests
• Fewer bigger firms may mean collusion
• Third-party costs – social costs such as pollution are
borne by others
• Public-Private Balance – gov’t as a provider of goods
and services (health, education, etc.) increased in last
40 years as deficits soared
• Regulation – firms may prefer less but gov’t must
balance with needs of individuals