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Economics Basics

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  • 1. Some Econ Concepts
  • 2. Definition of economics
    • the study of how individuals and societies use limited resources to satisfy unlimited wants.
  • 3. Fundamental economic problem
    • scarcity.
    • Economics is the study of how individuals and economies deal with the fundamental problem of scarcity.
    • As a result of scarcity, individuals and societies must make choices among competing alternatives.
  • 4. Opportunity Cost
    • Economics is all about trade offs
    • Because of scarcity our choices require that in order to get something we must give something up
    • What you give up to get something else is your opportunity cost.
  • 5. Rational self-interest
    • When an individual makes a choice they go through a cost-benefit evaluation
    • This is the idea that an individual compares the opportunity costs to the benefits and chooses the option which benefits them most ( rationality)
  • 6. Positive and normative analysis
    • positive economics
      • attempt to describe how the economy functions
      • relies on testable hypotheses
    • normative economics
      • relies on value judgements to evaluate or recommend alternative policies.
  • 7. Economic methodology
    • scientific method
      • observe a phenomenon,
      • make simplifying assumptions and formulate a hypothesis,
      • generate predictions, and
      • test the hypothesis.
  • 8. Efficiency
    • Economists strive to achieve 100% efficiency known as Parato Efficiency
    • In Parato Efficiency society is 100 $ efficient and there is no way to improve on persons well being without reducing another ones.
  • 9. Microeconomics
  • 10. Microeconomics vs. macroeconomics
    • microeconomics - the study of individual economic decisions and choices and how they effect individual markets
    • Macroeconomics - brings all the individual markets together and observes the behavior of the entire market
  • 11. Algebra and graphical analysis
    • direct relationship
  • 12. Direct relationship
  • 13. Inverse relationship
  • 14. Linear relationships
    • A linear relationship possesses a constant slope, defined as:
  • 15. Demand and Supply
  • 16. Markets
    • In a market economy, the price of a good is determined by the interaction of demand and supply
    • A market for a good is comprised of all the buyers and sellers of that particular good
  • 17. Demand
    • A relationship between price and quantity demanded in a given time period
    • The quantity demanded is the amount of good buyers are willing to purchase at a set price
  • 18. Demand schedule
  • 19. Demand curve
  • 20. Law of demand
    • An inverse relationship exists between the price of a good and the quantity demanded in a given time period,
    • Reasons:
      • Related goods
      • Income
      • Tastes
      • Expectations
      • Number of buyers
  • 21. Income
    • If someone's income is lowered they will be less willing to spend money on goods and vice versa
    • Normal goods
    • Inferior goods
  • 22. Income and demand: normal goods
    • A good is a normal good if an increase in income results in an increase in the demand for the good.
  • 23. Income and demand: inferior goods
    • A good is an inferior good if an increase in income results in a reduction in the demand for the good.
  • 24. Price of Related Goods
    • Substitutes – a good which causes a decline in the demand of another good if its price declines
    • Complement – a good which causes an increase in the demand of another good if its price declines
  • 25. Change in the price of a substitute good
    • Price of coffee rises:
  • 26. Change in the price of a complementary good
    • Price of DVDs rises:
  • 27. Tastes
    • The idea that if an buyers perception of benefits from buying a good changes so will the buyers willingness to purchase the good
  • 28. Expectations
    • A higher expected future price will increase current demand.
    • A lower expected future price will decrease current demand.
    • A higher expected future income will increase the demand for all normal goods.
    • A lower expected future income will reduce the demand for all normal goods.
  • 29. Number of Buyers
    • The market demand curve consists of all the individual demand curves put together
    • So if there are more consumers in the market the market demand will increase
  • 30. Change in quantity demanded vs. change in demand Change in quantity demanded Change in demand
  • 31. Market demand curve
    • Market demand is the horizontal summation of individual consumer demand curves
  • 32. Supply
    • the relationship that exists between the price of a good and the quantity supplied in a given time period
    • Quantity supplied is the amount that a seller is able to produce for a set price
  • 33. Supply schedule
  • 34. Demand curve
  • 35. Law of supply
    • A direct relationship exists between the price of a good and the quantity supplied in a given time period
  • 36. Reason for law of supply
    • The law of supply is the result of the law of increasing cost .
      • As the quantity of a good produced rises, the marginal opportunity cost rises.
      • Sellers will only produce and sell an additional unit of a good if the price rises above the marginal opportunity cost of producing the additional unit.
  • 37. Change in supply vs. change in quantity supplied Change in supply Change in quantity supplied
  • 38. Individual firm and market supply curves
    • The market supply curve is the horizontal summation of the supply curves of individual firms. (This is equivalent to the relationship between individual and market demand curves.)
  • 39. Determinants of supply
    • Price received by supplier
    • Input price
    • technology
    • the expectations of producers
    • the number of producers
    • Relative Goods
  • 40. Price Received by Supplier
    • This is the law of supply
    • The more money the supplier receives for the good he’s selling the more willing he/she will be to sell it
  • 41. Price of resources (Input Price)
    • Inputs are the goods the supplier has to purchase in order to produce the supply
    • As the price of a resource rises, profitability declines, leading to a reduction in the quantity supplied at any price.
  • 42. Technological improvements
    • Technological improvements (and any changes that raise the productivity of labor) lower production costs and increase profitability.
  • 43. Expectations and supply
    • An increase in the expected future price of a good or service results in a reduction in current supply.
    • The supplier will hold off on selling his goods if he can sell them for a greater profit later.
  • 44. Increase in the Number of Sellers
  • 45. Prices of other goods
    • More than one firm produces and sells the same good or a relative good
    • Because of this firms compete with each other to sell more goods and in order to do so they have to lower their prices below that of their competition
    • Without this effect all markets would be monopolistic and we would all be screwed
  • 46. Equilibrium…the fun never stops
  • 47. Market equilibrium
  • 48. Price above equilibrium
    • If the price exceeds the equilibrium price, a surplus occurs:
  • 49. Price below equilibrium
    • If the price is below the equilibrium a shortage occurs:
  • 50. Consumer and Producer Surplus
    • Consumer surplus – the utility (or level of satisfaction) a buyer receives by being able to purchase a product for a price less then the maximum they were willing to pay
    • Producer surplus – the amount that producers benefit by selling at a market price which is greater than the minimum they would be willing to sell for
  • 51. Consumer/Producer Surplus Visualized
  • 52. Consumer surplus
    • Individuals buy an item only if they receive a net gain from the purchase ( i.e., total benefit exceeds opportunity cost.)
    • This net gain is called “consumer surplus.”
  • 53. Example
    • Suppose that an individual buys 10 units of a good when the price is $5
  • 54. Benefits and cost of first unit
    • Benefit = blue + green rectangles (=$9)
    • Cost = green rectangle (=$5)
    • Consumer surplus = blue rectangle (=$4)
  • 55. Total benefit to consumer
  • 56. Total cost to consumer
  • 57. Consumer surplus
  • 58. Demand rises
  • 59. Demand falls
  • 60. Supply rises
  • 61. Supply falls
  • 62. Price ceiling
    • Price ceiling - legally mandated maximum price
    • Purpose: keep price below the market equilibrium price
  • 63. Price ceiling (continued)
  • 64. Price floor
    • price floor - legally mandated minimum price
    • designed to maintain a price above the equilibrium level
  • 65. Price floor (continued)
  • 66. Elasticity
  • 67. Elasticity
    • A measure of the responsiveness of one variable (quantity demanded or supplied) to a change in another variable (price)
    • Most commonly used elasticity: price elasticity of demand, defined as:
    Price elasticity of demand =
  • 68. Price elasticity of demand
    • Demand is said to be:
      • elastic when Ed > 1,
      • unit elastic when Ed = 1, and
      • inelastic when Ed < 1.
  • 69. Perfectly elastic demand
  • 70. Perfectly inelastic demand
  • 71. Elasticity & slope
    • a price increase from $1 to $2 represents a 100% increase in price,
    • a price increase from $2 to $3 represents a 50% increase in price,
    • a price increase from $3 to $4 represents a 33% increase in price, and
    • a price increase from $10 to $11 represents a 10% increase in price.
    • Notice that, even though the price increases by $1 in each case, the percentage change in price becomes smaller when the starting value is larger.
  • 72. Elasticity along a linear demand curve
  • 73. Elasticity along a linear demand curve
  • 74. Determinants of price elasticity
    • Price elasticity is relatively high when:
    • close substitutes are available
    • the good or service is a large share of the consumer's budget (necessities)
    • a longer time period is considered (time horizon)
  • 75. Price elasticity of supply
  • 76. Perfectly inelastic supply
  • 77. Perfectly elastic supply
  • 78. Determinants of supply elasticity
    • Ease of Entry and Exit
    • Scarce Resources
    • Time Horizon
  • 79. Elasticity and total revenue
    • Total revenue = price x quantity
    • What happens to total revenue if the price rises?
    Price elasticity of demand =
  • 80. Elasticity and TR (cont.)
    • A reduction in price will lead to:
      • an increase in TR when demand is elastic.
      • a decrease in TR when demand is inelastic.
      • an unchanged level of total revenue when demand is unit elastic.
    Price elasticity of demand =
  • 81. Elasticity and TR (cont.)
    • In a similar manner, an increase in price will lead to:
      • a decrease in TR when demand is elastic.
      • an increase in TR when demand is inelastic.
      • an unchanged level of total revenue when demand is unit elastic.
    Price elasticity of demand =
  • 82. … ...Let’s Stick to the Non-confusing Example
  • 83. Everyone's Favorite…Taxes!!!!
  • 84. Tax incidence
    • distribution of the burden of a tax depends on the elasticities of demand and supply.
    • When supply is more elastic than demand, consumers bear a larger share of the tax burden.
    • Producers bear a larger share of the burden of a tax when demand is more elastic than supply.
  • 85. Costs and production
  • 86. Production possibilities curve
    • Assumptions:
      • A fixed quantity and quality of available resources
      • A fixed level of technology
  • 87. Specialization and trade
    • Adam Smith – economic growth is caused by increased specialization and division of labor.
  • 88. Specialization and trade
    • As noted by Adam Smith, specialization and trade are inextricably linked.
    • Adam Smith used this argument to support free trade among nations.
  • 89. Absolute and comparative advantage
    • Absolute advantage – an individual (or country) is more productive than other individuals (or countries).
    • Comparative advantage – an individual (or country) may produce a good at a lower opportunity cost than can other individuals (or countries).
  • 90. Example: U.S. and Japan
    • Suppose the U.S. and Japan produce only two goods: CD players and wheat.
  • 91. Absolute advantage?
    • Who has an absolute advantage in producing each good?
  • 92. Comparative advantage?
    • Who has a comparative advantage in producing each good?
  • 93. Gains from trade
    • Opportunity cost of CD player in U.S. = 2 units of wheat
    • Opportunity cost of CD player in Japan = 4/3 unit of wheat
    • If Japan produces and trades each CD player to the U.S. for more than 4/3 of a unit of wheat but less than 2 units of wheat, both the U.S. and Japan gain from trade and can consume more goods than they could produce by themselves.
  • 94. Gains from trade (continued)
    • Note that the U.S. has a comparative advantage in producing wheat.
    • Countries always expand their consumption possibilities by engaging in trade (since they acquire goods at a lower opportunity cost than if they produced them themselves).
  • 95. Free trade?
    • If each country specializes in the production of those goods in which it possesses a comparative advantage and trades with other countries, global output and consumption is increased.
  • 96. Robinson and Crusoe? Really USAD……Really?
  • 97. Profit Motive and Behavior of Firms
    • Profit = total revenue – total cost
    • (costs will likely only include only monetary expenses)
    • Total cost is comprised of expenses plus all monetary opportunity costs
  • 98. Different Costs
    • The costs that do not depend on production and can’t change in the short run are called fixed costs
    • However costs that can be varied in the short run are called variable costs
  • 99. Marginal Cost
    • Notice in figure 23 that when you go down 1 row there are 50 more loaves of bread produced; however, there is an additional cost for producing more goods
    • This increase in cost when producing an additional unit of output is called the marginal cost
  • 100. How to find marginal cost
    • (increase in total cost)
    • MC = -------------------------------------
    • (increase in quantity produced)
  • 101. Law of Diminishing Returns
    • Next notice that the maximum profit is made when marginal cost is equal to marginal revenue
    • Think of the marginal cost as the opportunity cost for making an extra unit of good and the marginal revenue as the profit for making that extra unit
  • 102. Law of Diminishing Returns
    • as the level of a variable input rises in a production process in which other inputs are fixed, output ultimately increases by progressively smaller increments
    • So this means that at some point it’s no longer productive to make that extra unit of good
  • 103. Imperfect Markets
  • 104. Monopolies
    • A monopoly is an extreme case in which there is a market with only one producer
    • Ownership Monopolies
    • Government-Created Monopolies
    • Natural Monopolies
  • 105. Why Monopolies Are Bad?
    • Because the supplier can charge whatever amount he/she wants for the product and there is no competition to force the supplier to lower the prices on goods
  • 106. Price discrimination
    • different customers are charged different prices for the same product, due to differences in price elasticity of demand
    • higher prices for those customers who have the most inelastic demand
    • lower prices for those customers who have a more elastic demand.
  • 107. Price discrimination (cont.)
    • customers who are willing to pay the highest prices are charged a high price, and
    • customers who are more sensitive to price differentials are charged a low price.
  • 108. Next up…Oligopolies
    • An oligopoly is a market with very few suppliers
    • Not quite as bad as a monopoly but still 
    • Example: OPEC (Organization of Petroleum Exporting Countries)
  • 109. Creative Destruction
    • A term coined by the Australian economist Joseph Schumpeter
    • “ creative destruction” states that as new industries surged, older industries grow more slowly, stagnate, and shrink
  • 110. Market failures
    • Not all markets are perfect and sometimes a market failure will occur when externalities or breakdowns in the system of private property cause markets to deviate from the socially efficient outcome
  • 111. Oh the Government
    • Pork Barrel Politics – elected officials introduce projects that steer money into their of pockets
    • Logrolling – vote trading within legislation