Economics 1B03 Mid-Term Review
Economics 1B03 Mid-Term Review Chapter 1
There are never enough resources to satisfy all the wants and needs of a society – management of society’s resources are scarce Economics – study of how society allocates the scarce resources to satisfy people’s unlimited wants Basic principles: households and economies face many decisions (who will work, what goods to produce, what price to sell goods at); every economic issue involves individual choice Scarcity – limited resources; can not produce all the goods and products people wish to have Resources – often allocated not by a single central planner but through combined actions of millions of households and firms Microeconomics – study of the decisions made by households and firms and how they interact in markets (make decisions) ; focus on individual parts; specificity Macroeconomics – things that effect economies as a whole and larger scale; economic growth at a national level; ie. inflation, unemployment Market economy – allocates resources through the decentralized decisions of firms and households (individuals) (each making own individual decisions with no central consensus) ie. firms decide who to hire, what to buy Command/Centrally planned economy – all production and distribution decisions are made by a central authority, like a government; ie. former USSR – being told who provides, produces and buys what Traditional economy – refers to underdeveloped economies that rely heavily on agriculture for domestic consumption (subsistence economy); economic decisions based on customs, beliefs, religion, habits Mixed economies – most economies; combination of market and command economies; mostly free market ex. Canada We assume that when people are making decisions they are acting rationally: Economic rationality – making the best decisions that maximize the benefits received from the decision Perfect information – We assume people have this when making a decision. Everyone knows everything about everything; not settling for anything less b/c they know what is best. Ex. Firms know all prices Asymmetrical information – Hard to have perfect information, some have more info than others; harder to make the best decision. Ex. Sellers have more info than buyers, Lack of perfect info makes it harder to make the best decisions.
Resource (factors of production) – anything that can be used in production (inputs of production) ; three factors, recently we have been including entrepreneurship as a resource 1. Land (space) 2. Labour (people to create, assemble, produce) 3. Capital (what is needed by the laborers in the space- buildings, physical etc.) Equilibrium – when no individual would be better off doing something different; markets usually reach equilibrium through price changes; economy’s situation is in equilibrium when there is NO incentive for economic actors to change their behavior Economist’s Role – when economists are trying to explain the world, they are scientists; when they are trying to change the world, they are policy advisors Positive statement – describes the world as it IS (descriptive analysis) Normative statements – describes the world as it SHOULD BE (prescriptive analysis) Economists disagree – about the validity of alternative positive theories about how the world works; different values therefore different normative views about what policy should try to accomplish Economic models – economists try to model human behavior so we can make accurate predictions about potential economic outcomes; involves making assumptions based on theory; to help us explain how the economy works Circular-Flow Diagram: firms – produce and sell goods and services, hire and use factors of production; households – buy and consume goods and services, own and sell factors of production - Markets for Goods and Services: firms sell; households buy - Markets for Factors of Production: households sell; firms buy - Factors of Production: land, labour, capital (+entrepreneurs)
How People Make Decisions -
Gains from trades, we specialize in goods we produce efficiently and trade them for goods other nations produce efficiently that we need. Between efficiency and equity Efficiency – resources are used as best as possible to meet society’s goals. Welfare of society will be maximized. Markets left to operate freely lead to efficiency. Economics* Equity – Fairness. The fair distribution of resources. Political* Higher equity = lower future efficiency Government redistributes income from rich to the poor, reduces the reward for working hard, people work less and produce fewer goods (increase equity, lowers efficiency)
-
*Acknowledging tradeoffs with respect to equity and efficiency = good future decisions in society
Cost of Something Is What You Give Up to Get It - Facing tradeoffs, thus decisions require comparing the costs and benefits of alternative courses of action - Opportunity cost – whatever must be given up to obtain some item; decision makers should be aware of the opportunity costs that accompany each possible action; cost of the BEST forgone alternative - Forgone alternative – what you lose in the process of achieving one goal Rational People Think at the Margin - Rational people – systematically and purposefully do the best they can to achieve their objectives; rationalize to obtain greatest benefit; know that decisions involve shades of gray; consider marginal changes in their decisions - Marginal changes – small incremental adjustments to a plan of action; small changes around the edges (firm producing one more good...) - Marginal benefit – depends on how many units a person already has (diamonds have high marginal benefit; water has low) - *Decision based on marginal benefit > marginal cost = rational decision - Marginal changes in costs or benefits motivate people to respond. If adding one more good adds more revenue than cost it should be produced- being rational. People Respond to Incentives - Incentive – prospective punishment or reward; play a central role in the study of economics; crucial to analyzing how markets work - Example of policy failing to consider the effects of incentive: seat belt initiative intended to increase safety – people then drive faster; therefore, more accidents occur - Must consider not only the direct effects but also the indirect effects of incentives
How People Interact Trade Can Make Everyone Better Off - Competition in economy is good: trade amongst countries allows for a greater variety of services - Trade allows countries to specialize in what they do best and enjoy a greater variety of goods and services Markets are Usually a Good Way to Organize Economic Activity - In a market economy – no one is looking out for the economic well-being of society as a whole; yet have proven successful in organizing economic activity in a way that promotes overall economic well-being
-
-
Market prices – to society, reflects both the value of a good and the cost of making it; prices guide buyers and sellers to maximize welfare of whole society Important corollary to the skill of the invisible hand in guiding economic activity: government prevents prices from adjusting naturally to supply and demand which impedes the invisible hand’s ability to coordinate the households and firms that make up the economy (ie. why taxes adversely affect the allocation of resources; taxes distort prices and thus the decisions of households and firms Invisible hand – free market economy based on consumer and best interest; Adam Smith. Participants in the economy are motivated by selfinterest and that the “invisible hand” of the marketplace guides this selfinterest into promoting general economic well being
Government Can Sometimes Improve Market Outcomes - Markets work only if property rights are enforces; therefore, we all rely on government-provided police service to enforce our rights over the things we produce – the invisible hand counts on our ability to enforce our rights - Governments are important to markets because they enforce property rights and ensure reliable production of goods - Two reasons for a government to intervene in the economy and change the allocation of resources people would choose on their own – promote efficiency and promote equity - Market failure – a market on its own fails to produce an efficient allocation of resources; government intervention needed - Externality – the impact of one person’s actions on the well-being of the bystander - Market power – ability of a single person or firm can influence market prices. - Market failure caused by externality and market power governments can promote efficiency and equity to reduce market failure governments can do what invisible hand can’t
How the Economy Works as a Whole A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services - Productivity – amount of goods and services produced from each hour of a worker’s time - All variation in living standards is attributable to differences in countries’ productivity - Greater productivity = greater living standards = better public policy Prices Rise When the Government Prints Too Much Money - Inflation – an increase in the overall level of prices in the economy
-
Government produces more $ value of $ decreases = inflation
Society Faces a Short-Run Tradeoff between Inflation and Unemployment - Short term benefit – stimulates spending and increases demand for goods; therefore more workers are hired and unemployment is temporarily decreased - Higher demand for goods and services may cause firms to raise their prices but not in the short-term - Many economic policies push inflation and unemployment in opposite directions – plays a key role in the business cycle - Business cycle – fluctuations in economic activity such as employment and production
Chapter 2 Economist as Scientist -
-
-
Scientific method – dispassionate development and testing of theories about how the world works Scientific thinking = theory and observation = making assumptions based on historical episodes Interplay between theory and observation occurs in the field of economics; but experiments are difficult in economics; therefore, they usually have to make do with whatever data the world happens o give them Economists make theories based on similar episodes in history since experiments are difficult in economies; use different assumptions to answer different questions (ie. answering questions relating to short term vs. long term calculations – price assumed to be fixed short term and flexible long term) Assumptions – simplify the complex world and make it easier to understand; allows us to focus our thinking and easily understand more complex situations afterwards Economists use models to learn about the world, often composed of diagrams and equations; models are built with assumptions Circular-Flow diagrams – how the economy is organized and how participants in the economy interact; how dollars flow through markets among households and firms; shows economic transactions between buyers and sellers in the economy Production possibilities frontier – a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology; shows which combinations/ amounts of products or services can be carried out with the given resources, the best an economy can do if it uses its resources efficiently given the current technology.
-
-
Points outside the frontier are not reachable given the economy’s resources, Points below are inefficient. Shows the opportunity cost of one good measured in terms of another; PPFs often have a bowed shape Every point on the PPF is productively efficient; however, you could be on the PPF but producing a combination of goods that society doesn’t want (Ie. The wrong combination) could be resourcefully efficient but not socially efficient; Efficiency, then, includes productive efficiency (on the PPF) AND social efficiency (the right combination of goods) Efficient – an outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available Opportunity Cost= give up/get To find the opportunity cost of the other good, we take the inverse 1/opp. Of the opp. of the good to find opp. of the other good. As we move down the curve, the opp. Increases this explains why it is rounded out. If the PPF is linear, it’s the same opp. For each good. Economic growth shifts the PPF up to the right; inefficient use of resources shifts it in to the left.
Chapter 3 Specialization and Trade -
-
-
Absolute advantage – productivity = quantity produced/ number of inputs used; the comparison among producers of a good according to their productivity; the producer that requires a smaller quantity of inputs (ie. time) to produce a good is said to have an absolute advantage in producing that good; producer who produces more efficiently and quicker and more. Remember, opportunity cost measures the tradeoff between the two goods that each producer faces Comparative advantage – the comparison among producers of a good according to how low their opportunity cost is. When comparative advantage exists, each individual or firm should specialize in the good they have the comparative advantage in and trade to the good the other has a comparative advantage in resulting in a gain from trade. Possible to have an absolute advantage in BOTH goods, but impossible to have a comparative advantage in BOTH goods When there exists comparative advantage, each individual should specialize in the production of the good in which they have comparative advantage **On any tests and the exam, we’ll assume that when a firm specializes in the production of a good, it produces only that good**
-
Note that if no economy has a comparative advantage (that is, they have the same opportunity costs), there won’t be any trade General rule – for both parties to gain from trade, the price at which they trade must lie between the two opportunity costs The principle of comparative advantage states that each good should be produced by the country that has the smaller opportunity cost of producing that good – trade allows countries to achieve greater prosperity
Chapter 4 -
-
Market – group of buyers and sellers of a particular good or service; buyers determine the demand, sellers determine the supply Supply & demand – refers to the behavior of people as they interact with one another in markets Price & quantity – are determined by the buyers and sellers as they interact in the marketplace Competitive market – a market in which there are many buyers and many sellers so that each has a negligible impact on the market price Market demand – the sum of all individual demands for a particular good or service Market supply – the sum of all individual supplies of a particular good or service Perfectly competitive market – all goods are identical (homogenous); since no one can affect market price, everyone who participates in the market is a price taker Monopoly – one seller who sets the price Quantity demanded – amount of a good that buyers are willing and able to purchase at a given price. Price and Qd are negatively related. Law of demand – other things being equal, the quantity demanded of a good falls when the price of the good rises v.v Demand schedule – a table that shows the relationship between the price of a good and the quantity demanded As P increases, Q decreases Demand curve – the downward-sloping line relating price and quantity demanded Change in quantity demanded – a movement along the demand due to a change in the price of the good (the demand curve itself does not move) Change in demand – is a shift at the demand curve due to a change in a determinant other than price (An increase in demand: curve shifts to the right demand will be higher at every price level; A decrease in demand: curve shifts to the left demand will be lower at every price level) To analyze how markets work, we need to determine the market demand Market demand – the sum of all the individual demands for a particular good or service
-
-
-
The market demand curve shows how the total quantity demanded of a good varies as the price of the good varies, while all other facts that affect how much the consumers want to buy are held constant Any change that increases the quantity demanded at every price shifts the demand curve to the right and is called an increase in demand Income – a determinant of demand Normal good – an increase in income leads to an increase in demand (curve shifts right) buy more ; something positive, that you like (ie, If I had more money I would buy more of this/go here more often/ spend more money on this item) Inferior good – an increase in income leads to a decrease in demand, buy less; something you are forced to buy or eat or spend money on due to a low income; therefore, when your income increases you spend less money on this item curve shifts left (ie, most people do not enjoy eating KD but will do so often due to a low income; therefore, if their income were to increase the amount of money they’d spend on KD would decrease) Most goods are normal goods. Examples of inferior goods include Kraft Dinner (as your income increases, you don’t have to eat KD anymore- you can afford steak) and bus rides (as income increases, you can take a cab or buy a car)
Prices of Related Goods -
Substitutes – two goods for which an increase in the price of one leads to an increase in the demand of the other (ie. coke and pepsi) Complements – two goods for which an increase in the price of one leads to a decrease in the demand for the other (ie. automobiles and gasoline)
-
Tastes – If people’s preferences change towards a good demand for that good will increase (advertising, government policies etc. can change preferences)
-
Expectations – what you expect to happen in the future may affect your demand today (ex. if gas price is increasing tomorrow, demand for gas will increase today)
-
Population – an increase in population will lead to an increase in demand (more consumers) A curve shifts when there is a change in a relevant variable that is not measured on either axis
-
Demand schedules – tables that show the relationship between price and quantity demanded for a good Demand curves – graphs of demand schedules If two goods are substitutes Quantity supplied – amount of a good that sellers are willing and able to sell; when the price of a good increases, selling that good becomes more
-
profitable and firms will want to offer more for sale; Price and Qs are positively related; as P increases Q increases The law of supply – other things being equal, the quantity supplied of a good rises when the price of the good rises; relationship between price and quantity supplied Supply schedule – a table that shows the relationship between the price of a good and the quantity supplied Supply curve – graph of the relationship between the price of a good and the quantity supplied Market demand is the sum of all the demands of all buyers; market supply is the sum of the supplies of all sellers Increase in supply shifts curve to the right; decrease in supply shifts curve to the left
Variables that can shift the supply curve -
-
-
-
Input prices – when the price of an input into production increases, producing the good becomes less profitable and firms will offer fewer goods for sale at any price (and vice versa); when costs increase, S decreases Technology – advances which reduce production costs will increase supply (S) Expectations – If a firms expects P to increase in the future, it will hold off selling today so current S will decrease Number of firms – more firms = more supply Change in quantity supplied – a movement along the supply curve due to a change in the P of the good (the supply curve does not move) Change in supply – a shift in the curve due to change in a determinant other than price (an increase in supply means a shift to the right; a decrease in supply means a shift to the left) Equilibrium – at the equilibrium price, the quantity of the good that buyers are willing to buy exactly balances the quantity that sellers are willing to sell In the market when there’s no incentive for buyers and sellers to change what they’re doing;; happens when P is such that Qd=Qs;; buyers have bought all they want at that price and sellers have sold all they want to sell; no one is left without (no shortages) and no one has any extra (no surplus) – the market clears Quantity traded – in the market, the equilibrium quantity sold at the equilibrium price (the quantity actually sold) Surplus – a situation in which quantity supplied is greater than quantity demanded (excess supply) Firms will want to decrease inventory by lower price, as price lowers more of the good is bought eventually turn back into equilibrium. Shortage – a situation in which quantity demanded is greater than quantity supplied. Too many buyers will bid up the price and firms will
-
-
supply more, demand decrease when price goes up, eventually back to equilibrium. Law of supply and demand – the price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance Shocks – events can happen which will shift demand or supply or both; leads to a change in eqm P and eqm Q Comparative statics – analyzing the diagrams to see what happens to equilibrium when curves shift: Decide whether the event shifts the supply or demand curve (or both) Decide whether the curve(s) shift(s) to the left or to the right Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity. Shifts in curve VS movements along curve – supply refers to the position of the supply curve, whereas the quantity supplied refers to the amount suppliers wish to sell Changes in both demand and supply – when an event or events shift both D and S at the same time, what happens to eqm P and Q depends on the size of the relative shifts. For example, we have a simultaneous increase in D and increase in S Q will increase, but we don’t know what will happen to P – the change in P is ambiguous and depends on the relative magnitudes of the shifts in D and S. Whenever an event shifts the supply curve, the demand curve, or perhaps both curves, you can use these tools to predict how the event will alter the amount sold in equilibrium and the price at which the good is sold Supply and demand together determine the prices of the economy’s many different good and services; prices in turn are the signals that guide the allocation of resources If market economies are guided by an invisible hand, as Adam Smith famously suggested, then the price system is the baton that the invisible hand uses to conduct the economic orchestra IN equilibrium Qd=Qs, set equal to find equilibrium price, sub price in Qd or Qs to find quantity.
Chapter 5 -
-
Elasticity – measure of how much buyers and sellers respond to a change in market conditions; measures how responsive Qd or Qs is to change in price, income, or prices of related goods Price elasticity of demand – a measure of how much the quantity demanded of a good responds to a change in the price of that good; the percentage change in quantity demanded given a percent change in the price; computed as the percentage change in the quantity demanded divided by the percentage change in price The number we get from our calculations is called the coefficient of elasticity
-
-
-
-
The size of the coefficient, Ep, will tell us how elastic the good is – how responsive demand is to a change in price. Since elasticity will vary, we can define different types of elasticity. Respond to changes in price differently depending on various factors are there a large number of substitutes, is the good a luxury or a necessity, how narrowly defined is the market, what about time period Price elasticity of demand = (% change in Qd) / (% change in P) Inelastic demand – Qd does not respond strongly to P changes; % change in Qd < % change in P; Ep < 1; demand curve would be fairly steep (Ex. required textbooks – your only option to buying a new book is to find a used copy which may be difficult) Elastic demand – Qd responds strongly to changes in P; the % change in Qd > % change in P; Ep > 1; demand curve would be fairly flat (Ex. most manufactures) Perfectly inelastic demand – Qd does not respond at all to price changes; Ep = 0 (Ex. prescription heart medicine – if you need it to stay alive, price is not even an issue) Perfectly elastic demand – Qd changes infinitely with any change in price; Ep infinity; demand curve is horizontal (Ex. wheat – if a supplier increases the P you’ll find a cheaper supplier because wheat is wheat – she won’t sell – guaranteed to go and find an alternative supplier with any change in price because there are so many available options to the buyers) Unit elastic – Qd changes by the same % as P; Ep = 1; demand curve is non-linear (Ex. think of unit elastic as the dividing point between elastic and inelastic demand – wine in the US) Midpoint formula – formula to measure arc elasticity; preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change; used when we are given two prices and their corresponding Qd values The midpoint formula is: Ep = (Q2 – Q1) / ([Q2 + Q1] / 2) (P2 – P1) / ([P2 + P1] / 2) Point elasticity – the impact of a marginal change in price on quantity demanded Ep = dQ/dP * P/Q This is actually easy to compute, since dQ/dP is just the slope of a linear demand curve when demand is in the form Q = f(P). Goods that are necessities tend to have inelastic demand Goods that are luxuries tend to have elastic demand Goods that have close substitutes tend to have elastic demand Goods tend to have more elastic demand over longer time horizons How you define a market makes a difference (a more narrowly defined market more elastic demand) How much of your budget you spend on a good determines elasticity
-
-
-
-
-
-
Elasticity is not constant along a linear demand curve; elasticity is not the same as slope (slope measures rates of change – elasticity measures percentage changes) Total revenue – knowing the price elasticity of demand is handy for a firm; TR = PQ (price times the quantity traded) With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller (the gain to TR from the P increase will outweigh the loss to TF from a decrease in Q) TR will increase if P increases if demand is inelastic – a firm wants to increase TF and demand for its good is inelastic, it should increase P With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger; TR will decrease if P increases if demand is elastic – if a firm wants to increase TR and demand for its good is elastic it should decrease P Income elasticity of demand – measures how much the quantity demanded of a good responds to a change in consumers’ income;; computed as the percentage change in the quantity demanded divided by the percentage change in income; denoted as EI If we are given percentage changes in income and the corresponding changes in Qd, we use the formula EI = %change in Qd %change in I If we are given 2 levels of income and their corresponding Qd, we use the midpoint formula. The midpoint formula is: EI = (Q2 – Q1) / ([Q2 + Q1] / 2) (I2 – I1) /([I2 + I1] / 2) (Recall that normal goods – higher income raises quantity demanded) Normal goods have positive income elasticities Inferior goods have negative income elasticities The plus or minus sign matters with income elasticity of demand If Ei > 0 the good is a normal good; as I increases, Qd increases If Ei < 0 the good is an inferior good; as I decreases, Qd increases If EI is between -1 and 1, the good is income inelastic. If EI is greater than 1 or less than -1, the good is income elastic. Cross price elasticity of demand – measures the response of Qd of a good “a” to a change in price of good “b” Eab = %r in Qd of good “a” %r in P of good “b” The midpoint formula is: Eab = (Q2a – Q1a) / (Q2a + Q1a) / 2 (P2b – P1b) / (P2b + P1b) / 2 The plus or minus sign matters with cross price elasticity of demand If elasticity is > 0, an increase in P of “b” will lead to an increase in Qd of “a” - the goods are substitutes
-
If elasticity is < 0, an increase in P of “b” will lead to a decrease in Qd of “a” - the goods are complements If cross-price elasticity = 0 , the goods are not related The larger the cross-price elasticity coefficient, the stronger the relationship between the two goods In first year, we don’t use point elasticity for income elasticity or crossprice elasticity Price elasticity of supply – measure of how much the quantity supplied of a good responds to a change in the price of that good; the percentage change in quantity supplied resulting from a percentage change in price Since P and Qs always move in the same direction, Es will always be > 0 Es = %r in Qs %r in P The midpoint formula is: Es = (Q2 – Q1) / ([Q2 + Q1] / 2) (P2 – P1) / ([P2 + P1] / 2) where Q = quantity supplied. The point elasticity formula is Es = dQ/dP * P/Q where Q = quantity supplied. Perfectly inelastic supply – Es = 0, supply curve is vertical (Ex. agricultural products, rare art) Inelastic supply – Es is between 0 and 1 (faction); supply curve is fairly steep (Ex. lakefront property) Elastic supply – Es > 1; supply curve is fairly flat (Ex. most manufactures) Perfectly elastic supply – Es infinity; supply curve is horizontal (Ex. any good for which a decrease in selling P means that a firm will not supply any amount) Unit elastic supply – Es = 1; % change in Qs = % change in P (Ex. any good for which this relationship is true is an example) Key determinant of supply elasticity is time; supply is usually more elastic in the long run than in the short run ** The flatter the supply curve, the more elastic is the supply of the good (Just like the demand curve)
There are never enough resources to satisfy all the wants and needs of a society – management of society’s resources are scarce Economics – study of how society allocates the scarce resources to satisfy people’s unlimited wants Basic principles: households and economies face many decisions (who will work, what goods to produce, what price to sell goods at); every economic issue involves individual choice Scarcity – limited resources; can not produce all the goods and products people wish to have Resources – often allocated not by a single central planner but through combined actions of millions of households and firms Microeconomics – study of the decisions made by households and firms and how they interact in markets (make decisions) ; focus on individual parts; specificity Macroeconomics – things that effect economies as a whole and larger scale; economic growth at a national level; ie. inflation, unemployment Market economy – allocates resources through the decentralized decisions of firms and households (individuals) (each making own individual decisions with no central consensus) ie. firms decide who to hire, what to buy Command/Centrally planned economy – all production and distribution decisions are made by a central authority, like a government; ie. former USSR – being told who provides, produces and buys what Traditional economy – refers to underdeveloped economies that rely heavily on agriculture for domestic consumption (subsistence economy); economic decisions based on customs, beliefs, religion, habits Mixed economies – most economies; combination of market and command economies; mostly free market ex. Canada We assume that when people are making decisions they are acting rationally: Economic rationality – making the best decisions that maximize the benefits received from the decision Perfect information – We assume people have this when making a decision. Everyone knows everything about everything; not settling for anything less b/c they know what is best. Ex. Firms know all prices Asymmetrical information – Hard to have perfect information, some have more info than others; harder to make the best decision. Ex. Sellers have more info than buyers, Lack of perfect info makes it harder to make the best decisions.
Resource (factors of production) – anything that can be used in production (inputs of production) ; three factors, recently we have been including entrepreneurship as a resource 1. Land (space) 2. Labour (people to create, assemble, produce) 3. Capital (what is needed by the laborers in the space- buildings, physical etc.) Equilibrium – when no individual would be better off doing something different; markets usually reach equilibrium through price changes; economy’s situation is in equilibrium when there is NO incentive for economic actors to change their behavior Economist’s Role – when economists are trying to explain the world, they are scientists; when they are trying to change the world, they are policy advisors Positive statement – describes the world as it IS (descriptive analysis) Normative statements – describes the world as it SHOULD BE (prescriptive analysis) Economists disagree – about the validity of alternative positive theories about how the world works; different values therefore different normative views about what policy should try to accomplish Economic models – economists try to model human behavior so we can make accurate predictions about potential economic outcomes; involves making assumptions based on theory; to help us explain how the economy works Circular-Flow Diagram: firms – produce and sell goods and services, hire and use factors of production; households – buy and consume goods and services, own and sell factors of production - Markets for Goods and Services: firms sell; households buy - Markets for Factors of Production: households sell; firms buy - Factors of Production: land, labour, capital (+entrepreneurs)
How People Make Decisions -
Gains from trades, we specialize in goods we produce efficiently and trade them for goods other nations produce efficiently that we need. Between efficiency and equity Efficiency – resources are used as best as possible to meet society’s goals. Welfare of society will be maximized. Markets left to operate freely lead to efficiency. Economics* Equity – Fairness. The fair distribution of resources. Political* Higher equity = lower future efficiency Government redistributes income from rich to the poor, reduces the reward for working hard, people work less and produce fewer goods (increase equity, lowers efficiency)
-
*Acknowledging tradeoffs with respect to equity and efficiency = good future decisions in society
Cost of Something Is What You Give Up to Get It - Facing tradeoffs, thus decisions require comparing the costs and benefits of alternative courses of action - Opportunity cost – whatever must be given up to obtain some item; decision makers should be aware of the opportunity costs that accompany each possible action; cost of the BEST forgone alternative - Forgone alternative – what you lose in the process of achieving one goal Rational People Think at the Margin - Rational people – systematically and purposefully do the best they can to achieve their objectives; rationalize to obtain greatest benefit; know that decisions involve shades of gray; consider marginal changes in their decisions - Marginal changes – small incremental adjustments to a plan of action; small changes around the edges (firm producing one more good...) - Marginal benefit – depends on how many units a person already has (diamonds have high marginal benefit; water has low) - *Decision based on marginal benefit > marginal cost = rational decision - Marginal changes in costs or benefits motivate people to respond. If adding one more good adds more revenue than cost it should be produced- being rational. People Respond to Incentives - Incentive – prospective punishment or reward; play a central role in the study of economics; crucial to analyzing how markets work - Example of policy failing to consider the effects of incentive: seat belt initiative intended to increase safety – people then drive faster; therefore, more accidents occur - Must consider not only the direct effects but also the indirect effects of incentives
How People Interact Trade Can Make Everyone Better Off - Competition in economy is good: trade amongst countries allows for a greater variety of services - Trade allows countries to specialize in what they do best and enjoy a greater variety of goods and services Markets are Usually a Good Way to Organize Economic Activity - In a market economy – no one is looking out for the economic well-being of society as a whole; yet have proven successful in organizing economic activity in a way that promotes overall economic well-being
-
-
Market prices – to society, reflects both the value of a good and the cost of making it; prices guide buyers and sellers to maximize welfare of whole society Important corollary to the skill of the invisible hand in guiding economic activity: government prevents prices from adjusting naturally to supply and demand which impedes the invisible hand’s ability to coordinate the households and firms that make up the economy (ie. why taxes adversely affect the allocation of resources; taxes distort prices and thus the decisions of households and firms Invisible hand – free market economy based on consumer and best interest; Adam Smith. Participants in the economy are motivated by selfinterest and that the “invisible hand” of the marketplace guides this selfinterest into promoting general economic well being
Government Can Sometimes Improve Market Outcomes - Markets work only if property rights are enforces; therefore, we all rely on government-provided police service to enforce our rights over the things we produce – the invisible hand counts on our ability to enforce our rights - Governments are important to markets because they enforce property rights and ensure reliable production of goods - Two reasons for a government to intervene in the economy and change the allocation of resources people would choose on their own – promote efficiency and promote equity - Market failure – a market on its own fails to produce an efficient allocation of resources; government intervention needed - Externality – the impact of one person’s actions on the well-being of the bystander - Market power – ability of a single person or firm can influence market prices. - Market failure caused by externality and market power governments can promote efficiency and equity to reduce market failure governments can do what invisible hand can’t
How the Economy Works as a Whole A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services - Productivity – amount of goods and services produced from each hour of a worker’s time - All variation in living standards is attributable to differences in countries’ productivity - Greater productivity = greater living standards = better public policy Prices Rise When the Government Prints Too Much Money - Inflation – an increase in the overall level of prices in the economy
-
Government produces more $ value of $ decreases = inflation
Society Faces a Short-Run Tradeoff between Inflation and Unemployment - Short term benefit – stimulates spending and increases demand for goods; therefore more workers are hired and unemployment is temporarily decreased - Higher demand for goods and services may cause firms to raise their prices but not in the short-term - Many economic policies push inflation and unemployment in opposite directions – plays a key role in the business cycle - Business cycle – fluctuations in economic activity such as employment and production
Chapter 2 Economist as Scientist -
-
-
Scientific method – dispassionate development and testing of theories about how the world works Scientific thinking = theory and observation = making assumptions based on historical episodes Interplay between theory and observation occurs in the field of economics; but experiments are difficult in economics; therefore, they usually have to make do with whatever data the world happens o give them Economists make theories based on similar episodes in history since experiments are difficult in economies; use different assumptions to answer different questions (ie. answering questions relating to short term vs. long term calculations – price assumed to be fixed short term and flexible long term) Assumptions – simplify the complex world and make it easier to understand; allows us to focus our thinking and easily understand more complex situations afterwards Economists use models to learn about the world, often composed of diagrams and equations; models are built with assumptions Circular-Flow diagrams – how the economy is organized and how participants in the economy interact; how dollars flow through markets among households and firms; shows economic transactions between buyers and sellers in the economy Production possibilities frontier – a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology; shows which combinations/ amounts of products or services can be carried out with the given resources, the best an economy can do if it uses its resources efficiently given the current technology.
-
-
Points outside the frontier are not reachable given the economy’s resources, Points below are inefficient. Shows the opportunity cost of one good measured in terms of another; PPFs often have a bowed shape Every point on the PPF is productively efficient; however, you could be on the PPF but producing a combination of goods that society doesn’t want (Ie. The wrong combination) could be resourcefully efficient but not socially efficient; Efficiency, then, includes productive efficiency (on the PPF) AND social efficiency (the right combination of goods) Efficient – an outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available Opportunity Cost= give up/get To find the opportunity cost of the other good, we take the inverse 1/opp. Of the opp. of the good to find opp. of the other good. As we move down the curve, the opp. Increases this explains why it is rounded out. If the PPF is linear, it’s the same opp. For each good. Economic growth shifts the PPF up to the right; inefficient use of resources shifts it in to the left.
Chapter 3 Specialization and Trade -
-
-
Absolute advantage – productivity = quantity produced/ number of inputs used; the comparison among producers of a good according to their productivity; the producer that requires a smaller quantity of inputs (ie. time) to produce a good is said to have an absolute advantage in producing that good; producer who produces more efficiently and quicker and more. Remember, opportunity cost measures the tradeoff between the two goods that each producer faces Comparative advantage – the comparison among producers of a good according to how low their opportunity cost is. When comparative advantage exists, each individual or firm should specialize in the good they have the comparative advantage in and trade to the good the other has a comparative advantage in resulting in a gain from trade. Possible to have an absolute advantage in BOTH goods, but impossible to have a comparative advantage in BOTH goods When there exists comparative advantage, each individual should specialize in the production of the good in which they have comparative advantage **On any tests and the exam, we’ll assume that when a firm specializes in the production of a good, it produces only that good**
-
Note that if no economy has a comparative advantage (that is, they have the same opportunity costs), there won’t be any trade General rule – for both parties to gain from trade, the price at which they trade must lie between the two opportunity costs The principle of comparative advantage states that each good should be produced by the country that has the smaller opportunity cost of producing that good – trade allows countries to achieve greater prosperity
Chapter 4 -
-
Market – group of buyers and sellers of a particular good or service; buyers determine the demand, sellers determine the supply Supply & demand – refers to the behavior of people as they interact with one another in markets Price & quantity – are determined by the buyers and sellers as they interact in the marketplace Competitive market – a market in which there are many buyers and many sellers so that each has a negligible impact on the market price Market demand – the sum of all individual demands for a particular good or service Market supply – the sum of all individual supplies of a particular good or service Perfectly competitive market – all goods are identical (homogenous); since no one can affect market price, everyone who participates in the market is a price taker Monopoly – one seller who sets the price Quantity demanded – amount of a good that buyers are willing and able to purchase at a given price. Price and Qd are negatively related. Law of demand – other things being equal, the quantity demanded of a good falls when the price of the good rises v.v Demand schedule – a table that shows the relationship between the price of a good and the quantity demanded As P increases, Q decreases Demand curve – the downward-sloping line relating price and quantity demanded Change in quantity demanded – a movement along the demand due to a change in the price of the good (the demand curve itself does not move) Change in demand – is a shift at the demand curve due to a change in a determinant other than price (An increase in demand: curve shifts to the right demand will be higher at every price level; A decrease in demand: curve shifts to the left demand will be lower at every price level) To analyze how markets work, we need to determine the market demand Market demand – the sum of all the individual demands for a particular good or service
-
-
-
The market demand curve shows how the total quantity demanded of a good varies as the price of the good varies, while all other facts that affect how much the consumers want to buy are held constant Any change that increases the quantity demanded at every price shifts the demand curve to the right and is called an increase in demand Income – a determinant of demand Normal good – an increase in income leads to an increase in demand (curve shifts right) buy more ; something positive, that you like (ie, If I had more money I would buy more of this/go here more often/ spend more money on this item) Inferior good – an increase in income leads to a decrease in demand, buy less; something you are forced to buy or eat or spend money on due to a low income; therefore, when your income increases you spend less money on this item curve shifts left (ie, most people do not enjoy eating KD but will do so often due to a low income; therefore, if their income were to increase the amount of money they’d spend on KD would decrease) Most goods are normal goods. Examples of inferior goods include Kraft Dinner (as your income increases, you don’t have to eat KD anymore- you can afford steak) and bus rides (as income increases, you can take a cab or buy a car)
Prices of Related Goods -
Substitutes – two goods for which an increase in the price of one leads to an increase in the demand of the other (ie. coke and pepsi) Complements – two goods for which an increase in the price of one leads to a decrease in the demand for the other (ie. automobiles and gasoline)
-
Tastes – If people’s preferences change towards a good demand for that good will increase (advertising, government policies etc. can change preferences)
-
Expectations – what you expect to happen in the future may affect your demand today (ex. if gas price is increasing tomorrow, demand for gas will increase today)
-
Population – an increase in population will lead to an increase in demand (more consumers) A curve shifts when there is a change in a relevant variable that is not measured on either axis
-
Demand schedules – tables that show the relationship between price and quantity demanded for a good Demand curves – graphs of demand schedules If two goods are substitutes Quantity supplied – amount of a good that sellers are willing and able to sell; when the price of a good increases, selling that good becomes more
-
profitable and firms will want to offer more for sale; Price and Qs are positively related; as P increases Q increases The law of supply – other things being equal, the quantity supplied of a good rises when the price of the good rises; relationship between price and quantity supplied Supply schedule – a table that shows the relationship between the price of a good and the quantity supplied Supply curve – graph of the relationship between the price of a good and the quantity supplied Market demand is the sum of all the demands of all buyers; market supply is the sum of the supplies of all sellers Increase in supply shifts curve to the right; decrease in supply shifts curve to the left
Variables that can shift the supply curve -
-
-
-
Input prices – when the price of an input into production increases, producing the good becomes less profitable and firms will offer fewer goods for sale at any price (and vice versa); when costs increase, S decreases Technology – advances which reduce production costs will increase supply (S) Expectations – If a firms expects P to increase in the future, it will hold off selling today so current S will decrease Number of firms – more firms = more supply Change in quantity supplied – a movement along the supply curve due to a change in the P of the good (the supply curve does not move) Change in supply – a shift in the curve due to change in a determinant other than price (an increase in supply means a shift to the right; a decrease in supply means a shift to the left) Equilibrium – at the equilibrium price, the quantity of the good that buyers are willing to buy exactly balances the quantity that sellers are willing to sell In the market when there’s no incentive for buyers and sellers to change what they’re doing;; happens when P is such that Qd=Qs;; buyers have bought all they want at that price and sellers have sold all they want to sell; no one is left without (no shortages) and no one has any extra (no surplus) – the market clears Quantity traded – in the market, the equilibrium quantity sold at the equilibrium price (the quantity actually sold) Surplus – a situation in which quantity supplied is greater than quantity demanded (excess supply) Firms will want to decrease inventory by lower price, as price lowers more of the good is bought eventually turn back into equilibrium. Shortage – a situation in which quantity demanded is greater than quantity supplied. Too many buyers will bid up the price and firms will
-
-
supply more, demand decrease when price goes up, eventually back to equilibrium. Law of supply and demand – the price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance Shocks – events can happen which will shift demand or supply or both; leads to a change in eqm P and eqm Q Comparative statics – analyzing the diagrams to see what happens to equilibrium when curves shift: Decide whether the event shifts the supply or demand curve (or both) Decide whether the curve(s) shift(s) to the left or to the right Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity. Shifts in curve VS movements along curve – supply refers to the position of the supply curve, whereas the quantity supplied refers to the amount suppliers wish to sell Changes in both demand and supply – when an event or events shift both D and S at the same time, what happens to eqm P and Q depends on the size of the relative shifts. For example, we have a simultaneous increase in D and increase in S Q will increase, but we don’t know what will happen to P – the change in P is ambiguous and depends on the relative magnitudes of the shifts in D and S. Whenever an event shifts the supply curve, the demand curve, or perhaps both curves, you can use these tools to predict how the event will alter the amount sold in equilibrium and the price at which the good is sold Supply and demand together determine the prices of the economy’s many different good and services; prices in turn are the signals that guide the allocation of resources If market economies are guided by an invisible hand, as Adam Smith famously suggested, then the price system is the baton that the invisible hand uses to conduct the economic orchestra IN equilibrium Qd=Qs, set equal to find equilibrium price, sub price in Qd or Qs to find quantity.
Chapter 5 -
-
Elasticity – measure of how much buyers and sellers respond to a change in market conditions; measures how responsive Qd or Qs is to change in price, income, or prices of related goods Price elasticity of demand – a measure of how much the quantity demanded of a good responds to a change in the price of that good; the percentage change in quantity demanded given a percent change in the price; computed as the percentage change in the quantity demanded divided by the percentage change in price The number we get from our calculations is called the coefficient of elasticity
-
-
-
-
The size of the coefficient, Ep, will tell us how elastic the good is – how responsive demand is to a change in price. Since elasticity will vary, we can define different types of elasticity. Respond to changes in price differently depending on various factors are there a large number of substitutes, is the good a luxury or a necessity, how narrowly defined is the market, what about time period Price elasticity of demand = (% change in Qd) / (% change in P) Inelastic demand – Qd does not respond strongly to P changes; % change in Qd < % change in P; Ep < 1; demand curve would be fairly steep (Ex. required textbooks – your only option to buying a new book is to find a used copy which may be difficult) Elastic demand – Qd responds strongly to changes in P; the % change in Qd > % change in P; Ep > 1; demand curve would be fairly flat (Ex. most manufactures) Perfectly inelastic demand – Qd does not respond at all to price changes; Ep = 0 (Ex. prescription heart medicine – if you need it to stay alive, price is not even an issue) Perfectly elastic demand – Qd changes infinitely with any change in price; Ep infinity; demand curve is horizontal (Ex. wheat – if a supplier increases the P you’ll find a cheaper supplier because wheat is wheat – she won’t sell – guaranteed to go and find an alternative supplier with any change in price because there are so many available options to the buyers) Unit elastic – Qd changes by the same % as P; Ep = 1; demand curve is non-linear (Ex. think of unit elastic as the dividing point between elastic and inelastic demand – wine in the US) Midpoint formula – formula to measure arc elasticity; preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change; used when we are given two prices and their corresponding Qd values The midpoint formula is: Ep = (Q2 – Q1) / ([Q2 + Q1] / 2) (P2 – P1) / ([P2 + P1] / 2) Point elasticity – the impact of a marginal change in price on quantity demanded Ep = dQ/dP * P/Q This is actually easy to compute, since dQ/dP is just the slope of a linear demand curve when demand is in the form Q = f(P). Goods that are necessities tend to have inelastic demand Goods that are luxuries tend to have elastic demand Goods that have close substitutes tend to have elastic demand Goods tend to have more elastic demand over longer time horizons How you define a market makes a difference (a more narrowly defined market more elastic demand) How much of your budget you spend on a good determines elasticity
-
-
-
-
-
-
Elasticity is not constant along a linear demand curve; elasticity is not the same as slope (slope measures rates of change – elasticity measures percentage changes) Total revenue – knowing the price elasticity of demand is handy for a firm; TR = PQ (price times the quantity traded) With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller (the gain to TR from the P increase will outweigh the loss to TF from a decrease in Q) TR will increase if P increases if demand is inelastic – a firm wants to increase TF and demand for its good is inelastic, it should increase P With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger; TR will decrease if P increases if demand is elastic – if a firm wants to increase TR and demand for its good is elastic it should decrease P Income elasticity of demand – measures how much the quantity demanded of a good responds to a change in consumers’ income;; computed as the percentage change in the quantity demanded divided by the percentage change in income; denoted as EI If we are given percentage changes in income and the corresponding changes in Qd, we use the formula EI = %change in Qd %change in I If we are given 2 levels of income and their corresponding Qd, we use the midpoint formula. The midpoint formula is: EI = (Q2 – Q1) / ([Q2 + Q1] / 2) (I2 – I1) /([I2 + I1] / 2) (Recall that normal goods – higher income raises quantity demanded) Normal goods have positive income elasticities Inferior goods have negative income elasticities The plus or minus sign matters with income elasticity of demand If Ei > 0 the good is a normal good; as I increases, Qd increases If Ei < 0 the good is an inferior good; as I decreases, Qd increases If EI is between -1 and 1, the good is income inelastic. If EI is greater than 1 or less than -1, the good is income elastic. Cross price elasticity of demand – measures the response of Qd of a good “a” to a change in price of good “b” Eab = %r in Qd of good “a” %r in P of good “b” The midpoint formula is: Eab = (Q2a – Q1a) / (Q2a + Q1a) / 2 (P2b – P1b) / (P2b + P1b) / 2 The plus or minus sign matters with cross price elasticity of demand If elasticity is > 0, an increase in P of “b” will lead to an increase in Qd of “a” - the goods are substitutes
-
If elasticity is < 0, an increase in P of “b” will lead to a decrease in Qd of “a” - the goods are complements If cross-price elasticity = 0 , the goods are not related The larger the cross-price elasticity coefficient, the stronger the relationship between the two goods In first year, we don’t use point elasticity for income elasticity or crossprice elasticity Price elasticity of supply – measure of how much the quantity supplied of a good responds to a change in the price of that good; the percentage change in quantity supplied resulting from a percentage change in price Since P and Qs always move in the same direction, Es will always be > 0 Es = %r in Qs %r in P The midpoint formula is: Es = (Q2 – Q1) / ([Q2 + Q1] / 2) (P2 – P1) / ([P2 + P1] / 2) where Q = quantity supplied. The point elasticity formula is Es = dQ/dP * P/Q where Q = quantity supplied. Perfectly inelastic supply – Es = 0, supply curve is vertical (Ex. agricultural products, rare art) Inelastic supply – Es is between 0 and 1 (faction); supply curve is fairly steep (Ex. lakefront property) Elastic supply – Es > 1; supply curve is fairly flat (Ex. most manufactures) Perfectly elastic supply – Es infinity; supply curve is horizontal (Ex. any good for which a decrease in selling P means that a firm will not supply any amount) Unit elastic supply – Es = 1; % change in Qs = % change in P (Ex. any good for which this relationship is true is an example) Key determinant of supply elasticity is time; supply is usually more elastic in the long run than in the short run ** The flatter the supply curve, the more elastic is the supply of the good (Just like the demand curve)
