Economics basics


Published on

Published in: Economy & Finance, Technology
  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Economics basics

  1. 1. PPEA Key ConceptsLecture 1: Key conceptsMarkets, Supply and Demand, Economic Efficiency, Market Failures, Utility-maximization,Marginal Utility, Pareto Efficiency, Profit-maximization, Perfect Competition, Consumer andProducer Surplus, Diminishing marginal utility and Marginal rate of substitution.Questions for discussion1. Do firms maximize profits? Is this a factual claim about the decision-making process withinfirms, or an observation about the outcome of natural selection in a market economy?2. "The claim that rational individuals behave so as to maximize their utility is tautological". Isit conceivable that individuals could behave in a way that does not maximize their utility?3. Is "altruistic" behavior compatible with the assertion that individuals maximize their utility?4. Is "Pareto optimality" the right yardstick for identifying a socially-optimal outcome?5. What do we learn about the value and limitations of the market mechanism from thefollowing observation?"If there really were some basic intrinsic advantages to a system which employed prices asplanning instruments, we would expect to observe many organizations 5 operating with thismode of control, especially among multidivisional business firms in a competitiveenvironment. Yet the allocation of resources within private companies (not to mentiongovernmental or non-profit organizations) is almost never controlled by setting administeredtransfer prices on commodities and letting self-interested profit maximization do the rest. Theprice system as an allocator of internal resources does not pass the market test". (MartinWeitzman, "Prices versus Quantities" Review of Economic Studies, 1974)Lecture 2: Key conceptsPublic goods, Private goods, Non-rivalry, Non-excludability, Congestion, Free-rider,Prisoner’s Dilemma, Collective Action Problem and Tragedy of the Commons.Questions for discussion1. What are the principal categories of public spending that consist of the provision of "publicgoods"?2. Are there examples of public goods which are privately-provided, and if so, how does thiscome about?3. Should the tolls on the Skye road bridge be scrapped?4. What, if anything, is wrong with deciding whether a public good should be provided or notby a simple majority vote?Lecture 3: Key conceptsExternality, Coase Theorem, Information Asymmetry, Transaction costs, "MarketMechanisms", Pigouvian Tax, Tradeable permits, "Command and Control", Marginalabatement costQuestions for discussion1. How much should we spend on pollution control? Is it worth reducing pollution to zero, or issome level of pollution "economically efficient".2. Are "market mechanisms" better than "command and control"?3. Should we use the money raised by environmental taxes to compensate the victims ofpollution?4. Could we ever rely on the Coase theorem to achieve adequate levels of pollution control?5. In what sense does traffic congestion constitute an externality? What would be the efficientlevel of control of the traffic congestion externality, and to what extent might efficient control ofthis externality conflict with considerations of equity or justice?
  2. 2. Lecture 4: Key conceptsMarket Power, Monopoly, Oligopoly, Competition Policy, Collusion, Mergers, Exclusionarybehaviour.Questions for discussion1. What are the arguments in favour and against using consumer surplus rather than totalsurplus as the objective of competition policy?2. To what extent might trade policy and competition policy be in conflict with each other?3. If having one firm (or very few firms) leads to welfare losses, then should competition policytry to increase the number of firms which operate in the industry (for instance subsidizing andprotecting less successful firms)? Why?4. There are only three sellers in a given industry. One day, one of the firms sends thefollowing fax to its two competitors: “In the interest of fair competition, and for the sake ofmarket transparency, we hereby inform you that the Board of our company has decided thatfrom the next quarter our sale prices will be increased by 10%.” Do you think that thecompetition authority should allow or forbid sending such faxes? Why?Lecture 5: Key conceptsInformation asymmetry, moral hazard, adverse selection, actuarially-fair insurance, poolingequilibrium, separating equilibrium, deductibles, experience-rating1. How do motor insurers limit their vulnerability to moral hazard and adverse selection?2. Does employer-provided health insurance reduce the problems of moral hazard andadverse selection that arise if health insurance is purchased by individuals?3. Social security support for unemployed people (in the UK formerly UnemploymentBenefit, now Job Seekers Allowance) is funded from earnings-related National InsuranceContributions. What would be the implications of replacing this system with a requirement forworking individuals to take out private insurance against the risk of unemployment?4. How will the increasing scope for genetic testing to assess an individuals risk ofdeveloping serious diseases in later life affect the feasibility and cost of individual insuranceagainst future care costs?
  3. 3. Economics Basics: Demand and SupplySupply and demand is perhaps one of the most fundamental concepts of economics and it isthe backbone of a market economy. Demand refers to how much (quantity) of a product orservice is desired by buyers. The quantity demanded is the amount of a product people arewilling to buy at a certain price; the relationship between price and quantity demanded isknown as the demand relationship. Supply represents how much the market can offer. Thequantity supplied refers to the amount of a certain good producers are willing to supply whenreceiving a certain price. The correlation between price and how much of a good or service issupplied to the market is known as the supply relationship. Price, therefore, is a reflection ofsupply and demand.The relationship between demand and supply underlie the forces behind the allocation ofresources. In market economy theories, demand and supply theory will allocate resources inthe most efficient way possible. How? Let us take a closer look at the law of demand and thelaw of supply.A. The Law of DemandThe law of demand states that, if all other factors remain equal, the higher the price of a good,the less people will demand that good. In other words, the higher the price, the lower thequantity demanded. The amount of a good that buyers purchase at a higher price is lessbecause as the price of a good goes up, so does the opportunity cost of buying that good. Asa result, people will naturally avoid buying a product that will force them to forgo theconsumption of something else they value more. The chart below shows that the curve is adownward slope. A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).B. The Law of SupplyLike the law of demand, the law of supply demonstrates the quantities that will be sold at acertain price. But unlike the law of demand, the supply relationship shows an upward slope.This means that the higher the price, the higher the quantity supplied. Producers supply moreat a higher price because selling a higher quantity at a higher price increases revenue.A, B and C are points on the supply curve.Each point on the curve reflects a directcorrelation between quantity supplied (Q)and price (P). At point B, the quantitysupplied will be Q2 and the price will be P2,and so on. (To learn how economic factorsare used in currency trading, read ForexWalkthrough: Economics.)Time and SupplyUnlike the demand relationship, however,the supply relationship is a factor of time.
  4. 4. Time is important to supply because suppliers must, but cannot always, react quickly to achange in demand or price. So it is important to try and determine whether a price changethat is caused by demand will be temporary or permanent.Lets say theres a sudden increase in the demand and price for umbrellas in an unexpectedrainy season; suppliers may simply accommodate demand by using their productionequipment more intensively. If, however, there is a climate change, and the population willneed umbrellas year-round, the change in demand and price will be expected to be longterm; suppliers will have to change their equipment and production facilities in order to meetthe long-term levels of demand.C. Supply and Demand RelationshipNow that we know the laws of supply and demand, lets turn to an example to show howsupply and demand affect price.Imagine that a special edition CD of your favorite band is released for $20. Because therecord companys previous analysis showed that consumers will not demand CDs at a pricehigher than $20, only ten CDs were released because the opportunity cost is too high forsuppliers to produce more. If, however, the ten CDs are demanded by 20 people, the pricewill subsequently rise because, according to the demand relationship, as demand increases,so does the price. Consequently, the rise in price should prompt more CDs to be supplied asthe supply relationship shows that the higher the price, the higher the quantity supplied.If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushedup because the supply more than accommodates demand. In fact after the 20 consumershave been satisfied with their CD purchases, the price of the leftover CDs may drop as CDproducers attempt to sell the remaining ten CDs. The lower price will then make the CD moreavailable to people who had previously decided that the opportunity cost of buying the CD at$20 was too high.The four basic laws of supply and demand are:1. If demand increases and supply remains unchanged, then it leads to higher equilibriumprice and higher quantity.2. If demand decreases and supply remains unchanged, then it leads to lower equilibriumprice and lower quantity.3. If supply increases and demand remains unchanged, then it leads to lower equilibriumprice and higher quantity.4. If supply decreases and demand remains unchanged, then it leads to higher equilibriumprice and lower quantity.
  5. 5. D. EquilibriumWhen supply and demand are equal (i.e. when the supply function and demand functionintersect) the economy is said to be at equilibrium. At this point, the allocation of goods is atits most efficient because the amount of goods being supplied is exactly the same as theamount of goods being demanded. Thus, everyone (individuals, firms, or countries) issatisfied with the current economic condition. At the given price, suppliers are selling all thegoods that they have produced and consumers are getting all the goods that they aredemanding.As you can see on the chart, equilibrium occurs at the intersection of the demand and supplycurve, which indicates no allocative inefficiency. At this point, the price of the goods will be P*and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.In the real market place equilibrium can only ever be reached in theory, so the prices of goodsand services are constantly changing in relation to fluctuations in demand and supply.E. DisequilibriumDisequilibrium occurs whenever the price or quantity is not equal to P* or Q*.1. Excess SupplyIf the price is set too high, excess supply will be created within the economy and there will beallocative inefficiency. At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high. 2. Excess Demand Excess demand is created when price is set below the equilibrium price. Because the price isso low, too many consumers want the goodwhile producers are not making enough ofit.In this situation, at price P1, the quantity ofgoods demanded by consumers at this price isQ2. Conversely, the quantity of goods thatproducers are willing to produce at this price is
  6. 6. Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of theconsumers. However, as consumers have to compete with one other to buy the good at thisprice, the demand will push the price up, making suppliers want to supply more and bringingthe price closer to its equilibrium.F. Shifts vs. MovementFor economics, the “movements” and “shifts” in relation to the supply and demand curvesrepresent very different market phenomena:1. MovementsA movement refers to a change along a curve. On the demand curve, a movement denotes achange in both price and quantity demanded fromone point to another on the curve. The movementimplies that the demand relationship remainsconsistent. Therefore, a movement along thedemand curve will occur when the price of thegood changes and the quantity demandedchanges in accordance to the original demandrelationship. In other words, a movement occurswhen a change in the quantity demanded iscaused only by a change in price, and vice versa. Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.2. ShiftsA shift in a demand or supply curve occurswhen a goods quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottleof be er was $2 and the quantity of beer demanded increased from Q1 to Q2, thenthere would be a shift in the demand for beer.Shifts in the demand curve imply that the original demand relationship has changed, meaningthat quantity demand is affected by a factorother than price. A shift in the demand relationship would occur if, for instance,beer suddenly became the only type of alcoholavailable for consumption.
  7. 7. Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.Economics Basics: Pareto Efficiency
  8. 8. What is Pareto efficiency?Pareto efficiency, or Pareto optimality, is a concept in economics with applications inengineering and social sciences. The term is named after Vilfredo Pareto (1848–1923), anItalian economist who used the concept in his studies of economic efficiency and incomedistribution.In a Pareto efficient economic system no allocation of given goods can be made withoutmaking at least one individual worse off. Given an initial allocation of goods among a set ofindividuals, a change to a different allocation that makes at least one individual better offwithout making any other individual worse off is called a Pareto improvement. An allocation isdefined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can bemade.Pareto efficiency is a minimal notion of efficiency and does not necessarily result in a sociallydesirable distribution of resources: it makes no statement about equality, or the overall well-being of a societyIn order to explain what Pareto efficiency is, it might first be best to explain a Paretoimprovement. A Pareto improvement occurs when there is a change in the allocation ofresources which makes one person better off but doesn’t make anybody else worse off. Forexample if three people have 10 apples and one person gets one more apple it will be aPareto improvement so long as the extra apple did not come at the expense of one of theother three individual’s apples. Pareto efficiency is said to exist when no other improvementscan be made in the allocation of resources to one individual without it casing a loss to others.A simple way of explaining Pareto efficiency would be to say that it refers to a situation whereit is not possible to make one person better off without it necessitating other people beingworse off.The reason why Pareto efficiency is not the same as equityThe reason why Pareto efficiency is not related to equity is quite easy to understand. If oneindividual had a million apples and everybody else only had one apple then it would still bePareto efficient so long as there is no way for the individual to get a million and one appleswithout it making everyone else poorer. If he could get a million and one apples without itmaking other people less well off then it could be described as Pareto efficient.How is Pareto efficiency used?The idea of Pareto efficiency is often used in the real world. It provides justification forincreasing the resources given to one group if doing so does not lower the resources of othergroups. All though Pareto efficiency is not concerned with equity there are many who wouldsee it as fair. When applying the concept to the real world there is often the idea ofcompensation; if a change causes a loss to one group they receive compensation so thatthere is no real loss.