Download Chapter 2: The Key Principles of Economics

What Is Economics?
• Economics is the study of the
choices made by people who
are faced with scarcity.
• Scarcity is a situation in which
resources are limited and can be
used in different ways, so one good
or service must be sacrificed for
another.
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Positive versus Normative Analysis
• Positive economics
predicts the consequences
of alternative actions,
answering the questions,
“What is?” or “What will be?”
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Positive versus Normative Analysis
• Normative economics
answers the question,
What ought to be?
Normative questions lie at
the heart of policy
debates.
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The Economic Way of Thinking
• The economic way of thinking is best
summarized by British economist
John Maynard Keynes (1883-1946)
as follows:
“The theory of economics does not furnish a
body of settled conclusions immediately
applicable to policy. It is a method rather than a
doctrine, an apparatus of the mind, a technique
of thinking which helps its possesor draw
correct conclusions.”
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The Economic Way of Thinking
• Three elements of the economic way
of thinking:
1. Use assumptions to simplify
• Eliminate irrelevant details and focus on
what really matters. Keep in mind that
simplifying assumptions do not have to
be realistic.
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The Economic Way of Thinking
• Three elements of the economic way
of thinking:
2. Isolate variables—Ceteris Paribus
• Economists are interested in exploring
relationships between two variables. A
variable is a measure of something that
can take on different values.
• The expression ceteris paribus means
that the effect of other tendencies is
neglected for a time.
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The Economic Way of Thinking
• Three elements of the economic way
of thinking:
3. Think at the margin
• A small, one-unit change in value is
called a marginal change.
• Economists use the answer to a
marginal question as the first step in
deciding whether to do more or less of
something.
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The Economic Way of Thinking
• A key assumption of most
economic analysis is that people
act rationally, meaning that they
act in their own self-interest.
• Rational people respond to
incentives.
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The Principle of Opportunity Cost
PRINCIPLE of Opportunity Cost
The opportunity cost of something is
what you sacrifice to get it.
•
Most decisions involve several
alternatives. The principle of opportunity
cost incorporates the notion of scarcity.
•
There is no such thing as a free lunch.
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Opportunity Cost and the
Production Possibilities Curve
• The production possibilities curve
illustrates the principle of opportunity
cost for an entire economy.
• The ability of an economy to produce
goods and services is determined by
its factors of production, including
labor, land, and capital.
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Opportunity Cost and the
Production Possibilities Curve
• The shaded area
shows all the possible
combinations of the
two goods that can be
produced.
• Only points on the
curve show the
combinations that fully
employ the economy’s
resources.
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Opportunity Cost and the
Production Possibilities Curve
•
As we move downward
along the curve, we must
sacrifice more
manufactured goods to get
the same 10-ton increase
in agricultural goods.
•
The curve is bowed
outwards because
resources are not perfectly
adaptable for the
production of both goods.
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Opportunity Cost and the
Production Possibilities Curve
•
An increase in the amount
of resources available, or a
technological innovation,
causes the production
possibilities to shift
outward, allowing us to
produce more output with a
given quantity of resources.
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Using the Principle:
The Cost of College
Total opportunity cost of college
Opportunity cost of money spent on tuition and books
Opportunity cost of college time (4 years at $20,000 per year)
Economic cost or total opportunity cost
$ 40,000
80,000
$120,000
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The Marginal Principle
Marginal PRINCIPLE
Increase the level of an activity if its
marginal benefit exceeds its
marginal cost; reduce the level of an
activity if its marginal cost exceeds
its marginal benefit. If possible, pick
the level at which the activity’s
marginal benefit equals its marginal
cost.
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The Marginal Principle
•
When we say marginal, we’re looking at
the effect of only a small, incremental
change.
•
The marginal benefit of some activity is
the extra benefit resulting from a small
increase in the activity.
•
The marginal cost is the additional cost
resulting from a small increase in the
activity.
•
Thinking at the margin enables us to finetune our decisions.
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Example: How Many Movie Sequels?
• The marginal benefit
exceeds the marginal
cost for the first two
movies, so it is sensible
to produce two, but not
three movies.
Number of
Movies
Marginal
Benefit
Marginal
Cost
1
$300 million
$125 million
2
$210 million
$150 million
3
$135 million
$175 million
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The Principle of Voluntary Exchange
PRINCIPLE of Voluntary Exchange
A voluntary exchange between two
people makes both people better
off.
•
A market is an arrangement that allows
people to exchange things.
•
If participation in a market is voluntary,
both the buyer and the seller must be
better off as a result of a transaction.
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The Principle of Diminishing Returns
PRINCIPLE of Diminishing Returns
Suppose output is produced with
two or more inputs and we increase
one input while holding the other
input or inputs fixed. Beyond some
point—called the point of
diminishing returns—output will
increase at a decreasing rate.
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Comparative Advantage
and Exchange
Specialization and the Gains From Trade:
• We can use the principle of opportunity
cost to explain the benefits from
specialization and trade.
PRINCIPLE of Opportunity Cost
The opportunity cost of something is
what you sacrifice to get it.
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Specialization and the
Gains from Trade
Table 3.1: Productivity and Opportunity Cost
Abe
Output per day
Opportunity cost
Bea
Paintings
Pizzas
Paintings
Pizzas
2
6
1
1
3 pizzas
1/3 painting
1 pizza
1 painting
•
People can benefit by specialization and trade
based on opportunity cost.
•
We say that a person has a comparative
advantage in producing a particular product if he
or she has a lower opportunity cost than another
person.
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Specialization and the
Gains from Trade
Table 3.2: Specialization, Exchange, and Gains from Trade
Abe
Bea
Total
Paintings
per week
Pizzas per
week
Paintings
per week
Pizzas
per week
Paintings
per week
Pizzas
per week
Abe and Be are
self-sufficient
4
24
1
5
5
29
Abe and Bea
specialize
0
36
6
0
6
36
After specializing,
Abe and Bea
exchange 2 pizzas
per painting
0+5=5
(Abe gets
5 painting)
36 – 10 =26
(Abe gives
up 10 pizzas)
6–5=1
(Bea gives up
5 paintings)
0 + 10 = 10
(Bea gets
10 pizzas)
Gains from
specialization and
exchange
1
2
0
5
1
7
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Production and
Consumption Possibilities
• Abe starts at the self-sufficient
point a1. Specialization moves him
to point a2, and exchange moves
him down the consumption
possibilities curve to point a3.
• Bea starts at the self-sufficient
point b1. Specialization moves her
to point b2, and exchange moves
her up the consumption
possibilities curve to point b3.
• The consumption possibilities curve shows the
possible combinations of the two goods when Abe and
Bea specialize and exchange two pizzas per painting.
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Specialization and the
Gains from Trade
• Specialization and exchange makes
both people better off, illustrating
one of the key principles of
economics:
PRINCIPLE of Voluntary Exchange
A voluntary exchange between two
people makes both people better off.
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Comparative Advantage
versus Absolute Advantage
• In the previous example, Abe is more
productive than Bea in producing
both goods. Economists say that
Abe has an absolute advantage in
producing both goods.
• Despite his absolute advantage, Abe
gains from specialization and trade
because he has a comparative
advantage in producing pizza.
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The Division of Labor
and Exchange
• Three reasons for productivity to
increase with specialization:
1. Repetition
2. Continuity
3. Innovation
• Specialization and exchange result from
differences in productivity, which in turn
come from differences in innate skills and
the benefits associated with the division of
labor.
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Comparative Advantage
and International Trade
• Many people are skeptical about the
idea that international trade can make
everyone better off. Most economists,
however, favor international trade. In
the words of economist Todd Buchholz:
“Money may not make the world go round,
but money certainly goes around the world.
To stop it prevents goods from traveling from
where they are produced most inexpensively
to where they are desired most deeply.”
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Perfectly Competitive Market
• We use the model of supply and demand—
the most important tool of economic
analysis—to see how markets work.
• The model of supply and demand explains
how a perfectly competitive market
operates.
• A perfectly competitive market is a market
has a very large number of firms, each of which
produces the same standardized product in
amounts so small that no individual firm can
affect the market price.
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The Demand Curve
• Here is a list of variables that affect
the individual consumer’s decision,
using the pizza market as an
example:
• The price of the product, for example,
the price of pizza
• The consumer’s income
• The price of substitute goods such as
tacos or sandwiches
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The Demand Curve
• Here is a list of variables that affect
the individual consumer’s decision,
using the pizza market as an
example:
• The price of complementary goods
such as beer or lemonade
• The consumer’s tastes and advertising
that may influence tastes
• The consumer’s expectations about
future prices
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The Individual Demand Curve and
the Law of Demand
Table 4.1 Al’s Demand Schedule for Pizza
Price
Quantity of pizzas per month
$2
13
4
10
6
7
8
4
10
1
• The demand schedule is a table that shows
the relationship between price and quantity
demanded by an individual consumer, ceteris
paribus (everything else held fixed).
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The Individual Demand Curve
and the Law of Demand
• The individual demand
curve is a graphical
representation of the
demand schedule.
• LAW OF DEMAND: The
higher the price, the
smaller the quantity
demanded, ceteris paribus
(everything else held fixed).
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The Individual Demand Curve
and the Law of Demand
• Quantity demanded is the
amount of a good an
individual consumer or
consumers as a group are
willing to buy.
• A change in quantity
demanded is a change in
the amount of a good
• In this case, an increase in
demanded resulting from a
price causes a decrease in
change in the price of the
quantity demanded, and a
good.
movement upward along the
individual’s demand curve.
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The Substitution Effect
• The substitution effect is the
change in consumption resulting
from a change in the price of one
good relative to the price of other
goods.
• The lower the price of a good, the
smaller the sacrifice associated with
the consumption of that good.
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The Income Effect
• The income effect describes the
change in consumption resulting
from an increase in the consumer’s
real income, or the income in terms
of the goods the money can buy.
• Real income is the consumer’s
income measured in terms of the
goods it can buy.
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From Individual to Market Demand
• The market demand curve shows the
relationship between price and quantity
demanded by all consumers together,
ceteris paribus (everything else held fixed).
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The Supply Curve
• Here are the variables that affect the
decisions of sellers, using the market
for pizza as an example:
• The price of the product—in this case, the
price of pizza.
• The cost of the inputs used to produce the
product, for example, wages paid to
workers, the cost of dough and cheese, and
the cost of the pizza oven.
• The state of production technology, such as
the knowledge used in making pizza.
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The Supply Curve
• Here are the variables that affect the
decisions of sellers, using the market
for pizza as an example:
• The number of producers—in this case, the
number of pizzerias.
• Producer expectations about the future price
of pizza.
• Taxes paid to the government or subsidies
received from the government.
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The Individual Supply Curve
and the Law of Supply
Table 4.2 Nora’s Schedule for Pizza
Price
Quantity of pizzas per month
$4
100
6
200
8
300
10
400
12
500
• A firm’s supply schedule is a table that
shows the relationship between price and
quantity supplied, ceteris paribus
(everything else held fixed).
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The Individual Supply Curve
and the Law of Supply
• The individual supply
curve is a graphical
representation of the
supply schedule. Its
positive slope reflects the
law of supply.
• LAW OF SUPPLY: The
higher the price, the larger
the quantity supplied,
ceteris paribus.
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The Individual Supply Curve
and the Law of Supply
• Quantity supplied is the
amount of a good an
individual firm or firms as a
group are willing to sell.
• A change in quantity
supplied is a change in the
amount of a good supplied
resulting from a change in
• In this case, an increase in
the price of the good;
price causes an increase in
represented graphically by
quantity supplied and a
a movement along the
movement upward along
supply curve.
the supply curve.
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Why is the Individual Supply
Curve Positively Sloped?
• To determine how much to produce, the
individual firm chooses the quantity of
output that satisfies the marginal principle.
Marginal PRINCIPLE
Increase the level of an activity if its
marginal benefit exceeds its marginal cost;
reduce the level of an activity if its marginal
cost exceeds its marginal benefit. If
possible, pick the level at which the
activity’s marginal benefit equals its
marginal cost.
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The Marginal Principle and
the Output Decision
• The marginal benefit of
selling a pizza is the price
received when the pizza is
sold.
• Marginal cost is the cost of
producing an additional
pizza.
• The marginal cost of producing
the first 299 pizzas is less than
the $8 marginal benefit. The
marginal principle is satisfied
when 300 pizzas are produced.
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The Marginal Principle and
the Output Decision
• An increase in the price
shifts the marginal benefit
curve upward and
increases the quantity at
which the marginal
principle is satisfied.
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From Individual Supply
to Market Supply
• The market supply curve shows the relationship
between price and quantity supplied by all producers
together, ceteris paribus (everything else held fixed).
• If there are 100 identical pizzerias, market supply
equals 100 times the quantity supplied by a single
firm at each price level.
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Market Equilibrium
• Market equilibrium is
a situation in which
the quantity of a
product demanded
equals the quantity
supplied, so there is
no pressure to change
the price.
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Excess Demand Causes
the Price to Increase
• Excess demand is a
situation in which, at
the prevailing price,
consumers are willing
to buy more than
producers are willing
to sell.
• The market moves upward along the demand curve,
decreasing quantity demanded, and upward along the
supply curve, increasing quantity supplied.
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Excess Supply Causes
the Price to Drop
• Excess supply is a
situation in which, at
the prevailing price,
producers are willing
to sell more than
consumers are willing
to buy.
• The market moves downward along the demand
curve, increasing quantity demanded, and downward
along the supply curve, decreasing quantity supplied.
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Market Effects of
Changes in Demand
Change in Quantity Demanded versus Change in Demand
• A change in price
causes a change in
quantity demanded.
• A change in demand
(caused by changes in
something other than the
price of the good) shifts
the entire demand curve.
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Increases in Demand
• An increase in demand
shifts the market demand
curve to the right.
• At the initial price of $8,
there is now excess
quantity demanded.
• Equilibrium is restored at
point n, with a higher
equilibrium price and a
larger equilibrium quantity.
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Causes of an Increase in Demand
• An increase in demand can occur
for several reasons:
• An increase in income (for a normal
good). A normal good is a good that
consumers buy more of when their
income increases. Most goods fall in
this category.
• A decrease in income (for an inferior
good). An inferior good is the
opposite of a normal good. Consumers
buy more of inferior goods when their
income decreases.
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Causes of an Increase in Demand
• An increase in demand can occur
for several reasons:
• An increase in the price of a substitute
good. When to goods are
substitutes, an increase in the price
of one good increases the demand for
the other good.
• A decrease in the price of a
complementary good. Two goods are
complements when an increase in
the price of one good decreases the
demand for the other good.
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Causes of an Increase in Demand
• An increase in demand can occur
for several reasons:
• An increase in population
• A shift in consumer tastes
• Favorable advertising
• Expectations of higher future
prices
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Decreases in Demand
• A decrease in demand
shifts the demand curve to
the left.
• At the initial price of $8,
there is now an excess
supply.
• Equilibrium is restored at
point n, with a lower
equilibrium price ($6) and a
smaller equilibrium quantity
(20,000 pizzas).
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Decreases in Demand
• A decrease in demand can occur
for several reasons:
• A decrease in income
(for a normal good)
• A decrease in the price
of a substitute good
• A decrease in population
• A shift in consumer tastes
• Favorable advertising
• Expectations of lower future
• An increase in the price
prices
of a complementary
good
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Market Effects of
Changes in Demand
Table 4.3 Changes in Demand Shift the Demand Curve (pg. 1)
An increase in demand shifts
the demand curve to the
right when:
A decrease in demand shifts
the demand curve to the left
when:
The good is normal and income
increases
The good is normal and income
decreases
The good is inferior and income
decreases
The good is inferior and income
increases
The price of a substitute good
increases
The price of a substitute good
decreases
The price of a complementary
good decreases
The price of a complementary
good increases
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Market Effects of
Changes in Demand
Table 4.3 Changes in Demand Shift the Demand Curve (pg. 2)
An increase in demand shifts
the demand curve to the
right when:
A decrease in demand shifts
the demand curve to the left
when:
Population increases
Population decreases
Consumer tastes shift in favor
of the product
Consumer tastes shift away
from the product
Consumers expect a higher
price in the future
Consumers expect a lower
price in the future
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Market Effects of
Changes in Supply
Change in Quantity Supplied versus Change in Supply
• A change in price
causes a change in
quantity supplied.
• A change in supply
(caused by changes in
something other than the
price of the good) shifts
the entire supply curve.
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Increases in Supply
• An increase in supply shifts
the market supply curve to
the right.
• At the initial price of $8,
there is now excess supply.
• Equilibrium is restored at
point n, with a lower
equilibrium price and a
larger equilibrium quantity.
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Causes of an Increase in Supply
• An increase in supply can occur for
several reasons:
• A decrease in input costs.
• An increase in the number of
producers.
• Expectations of lower future prices.
• Product is subsidized.
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Decreases in Supply
• A decrease in supply shifts
the supply curve to the left.
• At the initial price of $8,
there is now an excess
demand.
• Equilibrium is restored at
point n, with a higher
equilibrium price ($10) and
a smaller equilibrium
quantity (23,000 pizzas).
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Causes of a Decrease in Supply
• A decrease in supply can occur for
several reasons:
• An increase in input costs.
• A decrease in the number of producers.
• Expectations of higher future prices.
• Taxes. If a tax per unit is imposed,
which will make the product less
profitable, firms will produce less.
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Market Effects of
Changes in Supply
Table 4.4 Changes in Supply Shift the Supply Curve
An increase in supply shifts
the supply curve to the right
when:
A decrease in supply shifts
the supply curve to the left
when:
The cost of an input decreases
The cost of an input increases
A technological advance
decreases production cost
The number of firms increases
The number of firms decreases
Producers expect a lower price
in the future
Producers expect a higher price
in the future
Product is subsidized
Product is taxed
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Market Effects of Simultaneous
Changes in Supply and Demand
• Both the equilibrium price
and the equilibrium quantity
will increase.
• The equilibrium price will
decrease and the equilibrium
quantity will increase.
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Using the Model to Predict
Changes in Price and Quantity
Predicting the Effects of Changes in Demand
• An increase in university enrollment will • A report of pesticide residue on apples
increase the demand for apartments,
decreases the demand for apples, shifting
shifting the demand curve to the right.
the demand curve to the left. Both the
Both the equilibrium price and the
equilibrium price and the equilibrium
equilibrium quantity will increase.
quantity will decrease.
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Using the Model to Predict
Changes in Price and Quantity
Predicting the Effects of Changes in Supply
• Technological innovation decreases
• Bad weather decreases the supply of
production costs, shifting the supply
coffee beans, shifting the supply curve to
curve to the right. The equilibrium price
the left. The equilibrium price increases,
decreases, and the equilibrium quantity
and the equilibrium quantity decreases.
increases.
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Explaining Changes in
Price or Quantity
• At the same time the quantity
• At the same time the price decreased, the
increased, the price decreased.
quantity decreased. Therefore, the
Therefore, the increase in consumption
decrease in price was caused by a
resulted from an increase in supply, not
decrease in demand, not an increase in
an increase in demand.
supply.
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