Twelve key elements of economics


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Twelve key elements of economics

  1. 1. Common Sense Economics Twelve Key Elements of Economics
  2. 2. Twelve Key Elements of Economics 1) Incentives Matter. 2) There is no such thing as a free lunch. (Milton Friedman) 3) Decisions are made at the margin. 4) Trade promotes economic progress. 5) Transaction costs are an obstacle to trade. 6) Prices bring the choices of buyers and sellers into balance.
  3. 3. Twelve Key Elements of Economics 7) Profits direct businesses toward activities that increase wealth. 8) People earn income by helping others 9) Production of goods and services people value, not just jobs, provides the source of high living standards. 10) Economic progress comes primarily through trade, investment, better ways of doing things, and sound economic institutions. 11) The “invisible hand” of market prices directs buyers and sellers toward activities that promote general welfare. 12) Too often long-term consequences, or the secondary effects, of an action are ignored.
  4. 4. Incentives Matter • Economics rest on one simple principle – INCENTIVES MATTER!!! – What costs are associated with decisions? – How do you make decisions? – Why do you make those decisions?
  5. 5. Incentives Matter • Two Important functions of incentives are: 1) To communicate information on the best things to do and 2) To motivate people to do them.
  6. 6. Incentives Matter • How do incentives affect the market? – The Sellers • An increase in price will cause an increase in amount supplied – The Buyers • An decrease in price will cause an increase in amount demanded
  7. 7. There is no such thing as a free lunch • Reality is… “resources are limited, while the human desire for goods and services is virtually unlimited.” – Scarcity is the condition in which human wants are forever greater than the available supply of time, goods, and resources • Since we face scarcity, then we must choose our resources wisely.
  8. 8. There is no such thing as a free lunch • Opportunity Cost – The best alternative sacrificed for a chosen action, i.e. the next best alternative. – It is expressed in terms of the most valuable alternative that is sacrificed. – What are some opportunity costs in your life?
  9. 9. There is no such thing as a free lunch • Example of Opportunity Cost • Please view the YouTube video:
  10. 10. Decisions are made at the margin • Decisions are made at the margin • Make choices where the benefits are greater than the costs. – MB (marginal benefit) > MC (marginal cost) • Choices are made at the margin. – They involve additions to, or subtractions from, current conditions – Decisions are made by evaluating “marginal” effects of change
  11. 11. Trade Promotes Economic Progress • Why would we trade? • Why do people agree to trade? • They expect that it will improve their current situation
  12. 12. Trade Promotes Economic Progress • Three Major Sources of Gains from trade: 1) Trade moves goods from people who value them less to people who value them more 2) Trade makes larger outputs and consumption levels possible because it allows each of us to specialize more fully in things that we do best. 3) Voluntary exchange makes it possible for lower per-unit costs by adopting mass production methods.
  13. 13. Number Two- How do we get Number Two- How do we get larger outputs??? larger outputs???
  14. 14. Law of Comparative Advantage  Specialize in the task that you do better  Law of comparative advantage  Specialize in producing a good IF  Lower opportunity cost of producing it  Specialization and exchange  Better off  Absolute advantage  Use fewer resources  But does not have the lowest opportunity cost
  15. 15. Example of Comparative and Example of Comparative and Absolute Advantage Absolute Advantage
  16. 16. Law of Comparative Advantage • It is about what productive actions you are giving up, not about how good you are at each action. – It is possible that you can be the best at both goods, but we are interested in the foregone production that may be lost by you doing both actions.
  17. 17. Number Three- lower costs Number Three- lower costs
  18. 18. Economies of Scale • A larger size often allows for larger, more specialized machines and greater specialization of labor. • A larger scale of operation allows a firm to use larger, more efficient machines to assign workers to more specialized tasks. • Production techniques such as assembly lines can be introduced only if the rate of output is sufficiently large.
  19. 19. Division of Labor  Division of labor  Specialization; Increased productivity  Individual preferences; natural ability  Experience  No need to shift between tasks  Laborsaving machinery  Downside:  Repetitive, tedious  Routine tasks - robots
  20. 20. Transaction Costs are an Obstacle to Trade • Voluntary exchange promotes cooperation and helps us get more of what we want. • Is trade costly? • Time, effort, and other resources • Transactions Costs.
  21. 21. Transactions Costs???
  22. 22. Transaction Costs Are an Obstacle to Trade • How does the middlemen help? • Would you like to kill your own meat? • Knit your own sweaters?? • From the youtube video, what were the transaction costs? • Time!!!
  23. 23. Prices Bring the Choices of Buyers and Sellers into Balance • Market prices will influence the choices of both buyers and sellers • What happens when the price of a good increases? • The buyer tends to buy less (known as the law of demand) • The supplier tends to want more (known as the law of supply) • We will discuss the law of demand and law of supply in more detail later in the chapter
  24. 24. Read I, Pencil and watch the short video describing it! This is what price does!!!
  25. 25. Profits Direct Businesses Toward Activities That Increase Wealth • When resources produce valuable good and services then people are better off. • What does profit and losses tell us about how resources are allocated? • The higher the marginal value, the greater the amount supplied.
  26. 26. People Earn Income by Helping Others • High earnings come from providing goods and services that others value. • How does Wal-mart help the average household? • People seeking wealth notice people’s wants for goods and services. • Read the article “Profit-Friend or Foe” to help understand this concept.
  27. 27. Production of Goods and Services People Value, Not Just Jobs, Provides the Source of High Living Standards • Often government spending “crowds out” private spending and no net increase in employment is seen
  28. 28. Summary of Key Points 7-9 • The article entitled “Profit, Friend or Foe” describes how the Key Points-7-9 relate to the economy. • Please read the article!!
  29. 29. Economic Progress Comes Primarily Through Trade, Investment, Better Ways of Doing Things, and Sound Economic Institutions • How does this happen? • Technological changes • Better machines, roads, and communication • Agricultural society, now service based
  30. 30. Economic Progress Comes Primarily Through Trade, Investment, Better Ways of Doing Things, and Sound Economic Institutions • What’s important: • Investments in productive assets and in the skills of workers enhance our ability to produce goods and service. • Improvements in Technology spur economic progress. • Improvements in economic organization can promote growth.
  31. 31. The Invisible Hand • “Self-interest” will further the general prosperity of a community or nation. • How does this work? • The “invisible hand” of market prices to promote the goals of others. • “…Adam Smith contends that pursuing one’s own advantage creates an orderly society in which demands are routinely satisfied without a central plan.
  32. 32. The Invisible Hand • The market price of a particular good or service provides buyers and sellers with what they need to know to bring their actions into harmony with the actions and preferences of others. • What does the price tell about consumers and sellers? • Preferences, Sellers’ costs, location, and circumstances in the market
  33. 33. Discussion of Demand and Supply Discussion of Demand and Supply
  34. 34. The Law of Demand The Law of Demand The Law of Demand • Law of Demand: the inverse ( or negative) relationship between the price of a good and the quantity consumers are willing to purchase, other things held constant (ceteris paribus).  As the price of a good rises, consumers buy less.
  35. 35. The Law of Demand The Law of Demand • The demand curve allows you to find the quantity demanded by a buyer at different selling prices by moving along the curve
  36. 36. The Substitution Effect of a Price Substitution Effect Substitution Effect Change • What explains this “Law of Demand?” – Lower Price= Greater Amount Consumer… Why? – Substitution effect: The consumer will substitute a cheaper good for a more expensive good.
  37. 37. Income Effect • Income Effect: A fall in the price of the good increases the consumers purchasing power. – The consumer can now buy more with NO change in their income level.
  38. 38. The Demand Schedule and The Demand Schedule and The Demand Demand Curve Demand Curve • Demand: a curve or schedule showing the various quantities of a product consumers are willing to purchase at possible prices during a specific period of time, other things held constant. – Demand is the quantity consumers are both willing and able to buy at each possible price.
  39. 39. Market Demand Schedule • A demand schedule is simply a table listing the various quantities of something consumers are willing to purchase prices – Example of the demand schedule
  40. 40. Example of a Market Schedule • Demand of Hula Hoops Price (in Dollars) Quantity Demanded (Hula Hoops) $10.00 0 8.00 10 6.00 20 4.00 30 2.00 40
  41. 41. The Demand Curve Using the Schedule • The demand curve is the plots of this table – Example of demand curve using the demand schedule
  42. 42. Demand Curve of Hula Hoops Price of the Hula Hoops (measured in dollars) Quantity Demanded of Hula Hoops
  43. 43. Market Demand • The transition from the individual to the market demand curve is done by totaling or summing the individual demand schedules (this is known as the horizontal summation of demand). – Example of horizontal summation
  44. 44. Horizontal Summation of Demand + = Market Demand of Hula Hoops
  45. 45. Market Demand of Hula Hoops • The market demand of hula hoops, is the horizontal summation of the two individuals demand for hula hoops (i.e. the summation of quantity demanded at each individual price).
  46. 46. Market Demand of Hula Hoops Price (measured in dollars) Quantity Demanded of Hula Hoops
  47. 47. Changes in demand vs. changes in quantity demanded • A movement along the curve- CHANGES IN PRICE ONLY • Changes in quantity demanded – Example of movement
  48. 48. Movement along the Curve A movement from $8 to $6 represents an increase in quantity demanded A movement from $8 to $10 represents an decrease in quantity demanded
  49. 49. The distinction between changes in Quantity Demanded and Changes in Demand • Remember that price and quantity variables in our model are subject to the ceteris paribus assumption (other things held constant). – IT IS VERY IMPORTANT TO REMEMBER THE FOLLOWING: – If you are dealing with price of the item it is a movement along the curve, a change in quantity demanded not DEMAND, NO SHIFT!!!!!!
  50. 50. Shifts of the Demand Curve: 1) Changes in consumer income • Normal goods • Inferior goods 2) Changes in the price of a related good • Substitutes • Complements 3) Changes in expectations- prices, income, or availability of goods. 4) Changes in the number of consumers in the market 5) Changes in consumer tastes and preferences
  51. 51. Examples • Income – Normal goods: direct relationship – Inferior goods: inverse relationship
  52. 52. Changes in Demand • Most of us would consider steak to be a normal good. Since, steak is a more expensive meat as income increases then more consumption of steak should occur. • Thus, when consumer income increases, the demand for steak increases.
  53. 53. Normal Good D2 D1
  54. 54. Inferior Goods • However, we could argue that Ramon Noodles would be an inferior good, meaning as income increases then the demand for Ramon Noodles would decline. • Thus, when income increases, then the demand of Ramon Noodles will decrease. – This would be a leftward shift of the demand curve
  55. 55. Examples • Related goods – Substitute good: if the price of the substitutable good decreases, then demand decreases for the good of interest – Complementary good: if the price of the complement good increases, then demand decreases for the good of interest.
  56. 56. Substitute goods • Let’s assume that Pepsi and Coke are substitute goods for one another. • If the price of Pepsi increases, then what happens to the demand of Coke? – The demand for Coke will increase, because now consumers will substitute Coke for Pepsi
  57. 57. Graph of Coke Price (measured in dollars) D2 D1 Quantity Demanded of Coke (in millions)
  58. 58. Complementary Goods • Complementary goods are goods that we buy together, I think it is safe to say that peanut butter and jelly are bought together. • Thus, what would happen to the demand of jelly, if the price of peanut butter increased? – The demand for jelly would decrease. • This is a leftward shift of the demand curve
  59. 59. Demand for Jelly D2 D1
  60. 60. Supply • Supply indicates how much producers are willing and able to offer for sale per period at each possible price, other things held constant.
  61. 61. Law of Supply • There is a direct (positive) relationship between the price of a good or service and the amount of it that suppliers are willing to produce. – Example of the supply curve – When price increases, then the amount supplied will increase. – Why are sellers willing to sell more at a higher price? Does this make sense?
  62. 62. Market Supply • Again, it is the horizontal summation of the quantity produced by the sellers – Example of Horizontal Summation
  63. 63. Changes in Supply VS. Changes in Quantity Supplies • Increase or decrease in the price of the good is a movement along the curve • This is a change in “quantity supplied” – Example here
  64. 64. Shifts of the Supply Curve 1) Changes in Technology 2) Changes in the Prices of Relevant resources – Inputs into production. 3) Changes in the Price of Alternative Goods – Other goods that the producer could produce 3) Changes in Producer Expectations 4) Changes in the Number of Producers
  65. 65. Markets • A market is any arrangement in which buyers and sellers interact to determine the price and quantity of goods and services exchanged. – Markets reduce transaction costs
  66. 66. Market Equilibrium • The market is where the buyers and sellers come together • Equilibrium is no conflict between demand and supply – Quantity supplied= Quantity demand – Example of the equilibrium • This is the theory of how the price system operates and it is the cornerstone of microeconomic analysis
  67. 67. Exhibit 5(a) Equilibrium in the Pizza Market (a) Market schedules Millions of pizzas per Week Price per pizza $15 12 9 6 3 Quantity Quantity Surplus or Demanded Supplied Shortage 8 14 20 26 32 28 24 20 16 12 Surplus of 20 Surplus of 10 Equilibrium Shortage of 10 Shortage of 20 Effect on Price Falls Falls Remains the same Rises Rises
  68. 68. Exhibit 5(b) Equilibrium in the Pizza Market (b) Market curves S $15 Surplus Price per pizza 12 Above the equilibrium price: QS>QD; Surplus; Downward pressure on P c 9 Market equilibrium occurs at: Price where QD=QS; Point c 6 Shortage 3 0 D 14 16 20 24 26 Millions of pizzas per week Below the equilibrium price: QD>QS; Shortage; Upward pressure on P
  69. 69. Economic Efficiency • When a market reaches equilibrium, all the gains from trade between the buyer and seller have been fully realized and Economic efficiency is met
  70. 70. Too Often Long-Term Consequences, or the Secondary Effects, of an Action Are Ignored • When the short-term benefits are greater than the longer-term consequences. • Policy • Secondary Effects
  71. 71. Price Floors  Price Floors  Set above equilibrium P  Minimum selling P  Surplus  Distort markets  Reduce economic welfare
  72. 72. Price Ceilings  Price Ceilings  Set below the equilibrium P  Maximum selling P  Shortage  Distort markets  Reduce economic welfare
  73. 73. Exhibit 11 Price Floors and Price Ceilings (b) Price ceiling for rent (a) Price floor for milk $2.50 Monthly rental price Price per gallon Surplus S S $1,000 1.90 600 D 0 14 19 24 Millions of gallons per month No effect if price floor is set at or below equilibrium P Shortage D 40 50 60 0 Thousands of rental units per month No effect if price ceiling is set at or above equilibrium P