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Economics The study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society. Unlimited wants Limited resources to satisfy wants Choose between alternatives Economic reasoning focuses on the impact of marginal changes. Decisions will be based on marginal costs -the cost of buying or making one more unit and marginal benefits (utility). - The increase in satisfaction from buying or making one more unit MB > MC Do it! MC > MB Don’t do it! don’t necessarily consider sunk costs. The use of scarce resources to produce a good is always costly. This class? a. Someone must give up something if we are to have more scarce goods. b. The highest valued alternative that must be sacrificed is the opportunity cost of the choice. What must be given up to get one more unit of another good or service the price mechanism that guides our actions in a market. The invisible hand is an example of a market force. • If there is a shortage, prices rise • If there is a surplus, prices fall a. Inductive Methods Use facts to develop a model Take a survey and study the results b. Deductive See if the facts support a hypothesis Start with a theory and see if facts support it c. Abduction the combination of deduction and induction Predicting Behavior Positive Economic Statements - relationships that can be tested - The class is half full - Unemployment is 6% - if incomes rise people spend money Normative Economic Statements - statements about “what should be” or make a value judgment - It is too hot - Unemployment should be around 4% - we should raise the minimum wage. Art of Economics - application of knowledge learned in positive economics to the achievement of goals determined in normative economics. Economic graphs 1. Direct Relationship - Graph slopes up from left to right 2. Inverse Relationship - Graph slopes down from left to right 3. Slope Rise Run The U.S. Economy in Historical Perspective The U.S. economic system is a market economy based on private property and the markets in which individuals decide how, what, and for whom to produce • Markets work through a system of rewards and payments • Individuals are free to do whatever they want as long as it is legal • Fluctuations in prices play a central role in coordinating individuals’ wants in a market economy Most economists believe the market is a good way to coordinate economic activity Capitalism and Socialism • Capitalism is an economic system based on the market in which the ownership of the means of production resides with a small group of individuals (called capitalists) • Socialism is an economic system based on individuals’ goodwill towards others, not on their own self-interest, and in which, in principle, society decides what, how, and for whom to produce 3-13 Evolving Economic Systems Feudalism is an economic system based on tradition and dominated the Western world from the 8th to the 15th century Mercantilism is an economic system in which the government controls economic activity by doling out the rights to undertake economic activities and was dominant until the 18th century During the Industrial Revolution, technology and machines rapidly modernized industrial production Capitalism Source of income % Dividends 1.7 Interest 4.9 Proprietor’s Income 8.4 Rental Income 11.1 Social Security 13.4 Transfer Payments 64.7 Wages and Salaries -4.3 Savings 84 Spending 15.2 Taxes 1.9 Durable Goods Non-durable Goods Services 59 29 12 Type Number Revenue proprietorship 72.2 partnership 7.7 7.9 corporation 20.1 87.3 4.8 Business: Forms of Business Advantages Disadvantages • Minimum bureaucratic hassle • Direct control by owner • Limited ability to get funds • Unlimited personal liability Partnership • Ability to share work and risk • Relatively easy to form • Limited ability to get funds • Unlimited personal liability (even for a partner's blunder) Corporation • No personal liability • Increasing ability to get funds • Ability to avoid personal income taxes • Legal hassle to organize • Possible double taxation of income • Monitoring problems Proprietorship Government The government plays two general roles in the economy: 1. An actor who collects money in taxes and spends that money on projects, such as defense and education 3-20 Government 2. A referee who sets the rules that determine relations between businesses and households a. Provide a stable set of institutions and rules. -Enforce contracts and protect property rights b. Promote effective and workable competition. -restrict and regulate monopolies c. Correct for externalities. -pollution d. Ensure economic stability and growth. -Employment Act of 1946 e. Provide public goods. -Enforce contracts and protect property rights f. Adjust for undesirable market results. -drug busts Factor Markets Product Markets Income Taxes Goods and Services Payments Goods and Services Payments and Legal Businesses Goods and Services Resources Business Taxes Resources Payments $$ Households Selling Price $5 $4 $3 $2 $1 Quantity Demanded 10 15 25 40 60 Graphing: -Plot the points -Connect the dots Price $6 $5 Downsloping to right $4 $3 left Demand $2 $1 0 10 20 30 40 50 60 Quantity Shifts in Demand versus Movements Along a Demand Curve Quantity demanded – is a specific amount that will be demanded per unit of time at a specific price, other things constant Demand refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant • A change in price changes quantity demanded • A change in price causes a movement along the demand curve Why the curve shifts 1 Society’s Income 2 Price of Other Goods 3 Consumer Tastes 4 Consumer Expectations 5 Taxes and Subsidies 6 Number of Consumers Selling Price Quantity Supplied $5 $4 $3 $2 $1 60 40 25 15 10 Graphing: -Plot the points -Connect the dots Price $6 $5 $4 Upsloping right to left $3 Supply $2 $1 0 10 20 30 40 50 60 Quantity Selling Price $5 $4 $3 $2 $1 Quantity Demanded Supplied 60 10 40 15 25 25 15 40 10 60 Graphing: -Plot Demand -Plot Supply Price $6 D S $5 $4 $3 $2 $1 0 D S 10 20 30 40 50 60 Quantity Why the curve shifts 1 Resource Prices 2 Changes in Technology 3 Prices of other goods 4 Taxes and Subsidies 5 Number of Producers Economic Examples 1. Cyclone Larry in Australia • Destroyed 80% of the banana crop. • Prices went from $1.00 to $2.00 per pound • Supply or Demand problem?? S2 Price Banana Market S1 $2.00 $1.00 DR Quantity Q2 Q 1 Sales of SUVs in the U.S. Average price fell 10% SUVs P Supply or Demand problem? S0 Increasing gas costs causes the demand curve to shift left Price for SUVs fell from P0 to P1 where Q demanded = Q supplied P0 P1 D0 D1 Q1 Q0 Q Coffee Beans • fell from $2.00/pound in 1997 to $.50 in 2002 Supply or Demand problem? New growing techniques and the entry of new growers shifted the supply Price curve. S2 Coffee Bean Market S1 $2.00 $0.50 Dc Q1 Q2 Quantity Increase in the Demand for Foreign Exchange • Beginning equilibrium exchange rate: (10 cents = 1quetzal). • An increase in American demand for Guatemalan coffee will also increase the demand for quetzals • Equilibrium occurs where the new demand for quetzals D2 just equals the supply S – at $.20 per quetzal with Q2 > Q1 quetzals clearing the market. U.S. sales to Guatemala Exchange rate S ($ per quetzal) 0.20 0.10 D2 U.S. purchases from Guatemala D1 Q1 Q2 Quantity of quetzal exchange 1. Price Ceilings • Price ceiling is a legally established maximum price that sellers may charge. • It stops the price from rising to the equilibrium level. • • Example: rent control The direct effect of a price ceiling is a shortage: quantity demanded exceeds quantity supplied. 2. Price Floors • Price floor is a legally established minimum price that buyers must pay. • It stops the price from dropping down to equilibrium level. • Example: minimum wage • The direct effect of a price floor above the equilibrium price is a surplus: quantity supplied exceeds quantity demanded. Excise Taxes • Government impacts markets through taxation • An excise tax is a tax that is levied on a specific good • A tariff is an excise tax on an imported good • The result of taxes and tariffs is an increase in equilibrium prices and reduce equilibrium quantities 5-41 The Effect of an Excise Tax P Government imposes a $10,000 luxury tax on the suppliers of boats Luxury Boats S1 S0 Tax = $10,000 $70,000 The supply curve shifts up by the amount of the tax $65,000 $60,000 D0 420 510 Q The price of boats rises by less than the tax to $70,000 Quantity Restrictions • Government regulates markets with licenses, which limit entry into a market • Many professions require licenses, such as doctors, financial planners, cosmetologists, electricians, or taxi cab drivers • The results of limited number of licenses in a market are increases in wages and an increases in the price of obtaining the license 5-43 The Effect of a Quantity Restriction NYC Taxi Drivers P(wage) Successful lobbying by taxi cab drivers in NYC resulted in quantity restrictions (medallions) QR D1 $15 D0 12,000 When the demand for taxi services increased, because the number of taxi licenses was limited, wages increased Q(of drivers) Application: The Effect of a Quantity Restriction P NYC Taxis Medallions QR The demand for taxi medallions also increased because wages were increasing. But because the number of taxi licenses was limited, the price of a medallion also increased $400,000 D1 Initial Fee D0 12,000 Q(of medallions) Third-Party-Payer Markets • In third-party-payer markets, the person who receives the good differs from the person paying for the good • Under a third-party-payer system, the person who chooses how much to purchase doesn’t pay the entire cost • Equilibrium quantity and total spending can be much higher in third-party-payer markets • Goods from a third-party-payer system will be rationed through social and political means 5-46 Third-Party-Payer Markets P With a co-payment of $5, consumers demand 18 units Health Care Sellers require $45 per unit for that quantity S0 $45 Total expenditures for 18 units of health care $25 …are greater than when… $5 D0 10 18 Q The consumer pays the entire cost CHAPTER 6 Thinking Like a Modern Economist Economics is what economists do. — Jacob Viner Teach a parrot the words ‘supply’ and ‘demand’ and you have an economist Thomas Carlyle McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. Economic Models • Mathematical e = mc2 • or heuristic expressed informally in words Characteristics • more often use more of an inductive, as opposed to deductive, approach Behavioral vs Traditional Economics • Traditional –more reliance on relatively simple algebraic or graphical models such as the supply and demand model -provide simple and clear results, which can highlight issues that behavioral models cannot Behavioral vs Traditional Economics • Behavioral - use a broader set of building blocks than rationality and self-interest • Seem to use real-life situations to explain and illustrate economic concepts • People behave purposefully - reflecting reasoned but not necessarily rational judgment • Act with enlightened self-interest people care about other people as well as themselves Empirical Work in Modern Economics • Modern economics is highly empirical • Both traditional and modern behavioral economic building blocks rely on experiments and statistical analysis of real world observations • An empirical model is a model that statistically discovers a pattern in the data • Econometrics is the statistical analysis of economic data Modern Traditional and Behavioral Economists Modern Economics Earlier Modern Behavioral Economics Economists Assumptions Approach Types of Models Modern Traditional Economists Rationality Purposeful behavior Rationality Self-Interest Enlightened self-interest Self-Interest Deduction Induction and Induction and deduction: emphasis on deduction: emphasis experimental economics empirical models and on empirical models Simple S/D models All types including complex mathematical models and ACE models All types including complex mathematical models and ACE models the responsiveness of the amount purchased to a change in price. % Change in % Q Price Elasticity quantity demanded of demand = % Change in Price = % P - or put more simply - = (Q0 - Q1 ) Q0 ( P0 - P1 ) P0 = (Q0 - Q1 ) Q0 X P0 ( P0 - P1 ) PED > 1 Elastic < 1 Inelastic = 1 Unit Elastic Quan Price 1 X 8 2 3 4 5 6 7 8 X X X X X X X 7 6 5 4 3 2 1 Total Revenue Elasticity = ___ = ___ = ___ = ___ = ___ = ___ = ___ ___ ___ ___ ___ ___ ___ ___ ___ Different Elasticities • Perfectly inelastic: An increase in Price results in no change in Quantity Mythical demand curve (a) Quantity/ time • Relatively inelastic: A percent increase in Price results in a smaller % reduction in Quantity Demand for Cigarettes (b) Quantity/ time • Unitary elasticity: The percent change in quantity demanded due to an increase in price is equal to the % change in price. Demand curve of unitary elasticity (c) Quantity/ time =1 Elasticity of Demand Demand for Granny Smith Apples (d) • Relatively elastic: A % increase in Price leads to a larger % reduction in Quantity. Quantity/ time • Perfectly elastic: Consumers will buy all of Farmer Hollings’s wheat at the market price, but none will be sold above the market price. Demand for Farmer Hollings’s wheat (e) Quantity/ time What affects Elasticity??? 1. Available Substitutes 2. Necessity vs Luxury 3. Proportion of Income 4. Time to shop around What affects Supply Elasticity??? 1. Time a. Market Period b. Short Run c. Long Run Income Elasticity • the responsiveness of a product’s demand to a change in income. % Change in Income Elasticity quantity demanded of demand = % Change in Income • A normal good has a positive income elasticity of demand. – As income increases, the demand for normal goods increases. • Goods with a negative income elasticity are inferior goods. – As income expands, the demand for inferior goods will decline. Cross Price Elasticity • the responsiveness of a product’s demand to a change in the price of another good. Cross Price Elasticity = % Change in Qx % Change in Py • A complement has a negative cross price elasticity. – As Py increases, the demand for Y decreases, and demand for goods that are consumed with Y also decreases. • A substitute has a positive cross price elasticity – As Py increases, the demand for Y decreases, and demand for goods that can be consumed instead of Y also decreases. Consumer Surplus The total difference between what a consumer is willing to pay and how much they actually have to pay. Producer Surplus The total difference between what a supplier is willing to provide a good or service and how much they actually get for it. Producer and Consumer Surplus P $10 9 8 7 6 5 4 3 2 1 Consumer surplus = area of red triangle = ½($5)(5) = $12.5 S Producer surplus = area of green triangle = ½($5)(5) = $12.5 CS PS D 0 1 2 3 4 5 6 7 8 Q The combination of producer and consumer surplus is maximized at market equilibrium 8-64 The Burden of a Tax Tax Incidence • Who pays a tax is called the incidence. Buyer Seller Impact of a Tax Imposed on Sellers Price • If in the used car market a price of $7,000 would bring the quantity of used cars demanded into balance with the quantity supplied. • When a $1,000 tax is imposed on sellers of used cars, the supply curve shifts vertically by the $7,400 amount of the tax. S plus tax S $1000 tax $7,000 • The new price for used cars is $7,400 … sellers netting $6,400 ($7,400 - $1000 tax). $6,400 • Consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden. • Sellers end up receiving $6,400 (after taxes) instead of $7000 and bear $600 of the tax burden. D 500 750 # of used cars per month (in thousands) Impact of a Tax Imposed on Buyers Price • In the same used car market: • When a $1,000 tax is imposed on buyers of used cars, the demand curve shifts vertically by the $7,400 amount of the tax. • The new price for used cars is $6,400 …buyers then pay taxes $7,000 of $1000 making the total $7,400. $6,400 • Consumers end up paying $7,400 (after taxes) instead of $7,000 and bear $400 of the tax burden. • Sellers end up receiving $6,400 instead of $7000 and bear $600 of the tax burden. S $1000 tax D D minus tax 500 750 # of used cars per month (in thousands) Elasticity and Incidence of a Tax • The actual burden of a tax depends on the elasticity of supply and demand. • As supply becomes more inelastic, then more of the burden will fall on sellers. • As demand becomes more inelastic, then more of the burden will fall on buyers. ED ED + E S ES ED + ES Tax Burden and Elasticity • Consider the market for Gasoline and Luxury Boats individually. • We begin in equilibrium. • If we impose a $.20 tax on gasoline suppliers, the supply curve moves vertically the amount of the tax. Price goes up $.15 and output falls by 6 million gallons per week. • If we impose a $25K tax on Luxury Boat suppliers, the supply curve moves vertically the amount of the tax. Price goes up by $5K and output falls by 5 thousand units. • In the gas market, the demand is relatively more inelastic than its supply; hence, buyers bear a larger share of the burden of the tax. • In the luxury boats market, the supply curve is relatively more inelastic than its demand; hence, sellers bear a larger share of the tax burden. Price S $1.65 $1.60 $1.55 $1.50 $1.45 Gasolin e plus tax market S D Quantity (millions of gallons) 19 20 4 0 Price (thousand $) S plus tax S 110 Luxury boat market 100 90 D 80 Quantity 5 1 0 15 (thousand 20 s of boats) • An effective price ceiling is a government set price below the market equilibrium price • It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation P S A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity P0 P1 Price ceiling Shortage Q1 Q0 D Q • An effective price floor is a government set price above the market equilibrium • It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers P Surplus S P1 Price floor P0 D Q1 Q0 Q A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity The Difference Between Taxes and Price Controls • Price ceilings create shortages and taxes do not • Taxes leave people free to choose how much to supply and consume as long as they pay the tax • Shortages may also create black markets Rent Seeking, Politics, and Elasticities • The possibility of transferring surplus from one set of individuals to another causes people to spend time and resources on doing so. • Lobbying for price controls, which transfer surplus from one group to another, is an example of rent-seeking behavior • Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus • Public choice economists argue that when all rent seeking and tax consequences are netted out, there is often not a net gain to the public Inelastic Demand and Incentives to Restrict Supply Revenue gained P When demand is relatively inelastic, suppliers have incentive to restrict quantity to increase total revenue S1 S0 P1 P0 C Revenue lost A B D Q1 Q 0 Q Inelastic Supplies and Incentives to Restrict Prices • When supply is inelastic, consumers have incentives to restrict prices • When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls • Rent control in New York City is an example Application: Price Floors and Elasticity The surplus created by a price floor is larger if demand and supply are elastic P P Surplus S Surplus S P1 P1 P0 P0 Price floor D D Q1 Q0 Q Q1 Q0 Q