Basic Economic Concepts
economics is the study of Choices
Scarcity: Society’s wants are unlimited, but ALL resources are limited
choices must be made. Every choice has an inherent cost --> max satisfaction
Marginal Cost vs. Marginal Benefit
Marginal Analysis involves making decisions based on the additional benefit vs. the additional cost.
YOU WILL CONTINUE TO DO SOMETHING UNTIL THE MARGINAL COST OUTWEIGHS THE MARGINAL BENEFIT!
Trade-offs are all the alternatives that we give up whenever we choose one course of action over others.
Using transitive preferences we know that there is always a most desirable option forgone to do something else, this is called Opportunity Cost!
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Change in trade.
Change in technology.
Change in resource quantity or quality.
investment in capital.
OPPORTUNITY COST
UNITS GAINED
During Trade
Absolute Advantage: The producer that can produce the most output or require the least amount of inputs (resources).
Comparative Advantage: The producer with the lowest opportunity cost.
Types of Economies
Centrally- Planned Economy
The state will decide what goods and services will be produced.
The state will determine how the goods and services will be produced.
Everyone will have the same opportunity to consume the goods and service equally.
Capitalism/ Free Market
There is little government involvement in the economy.
Individuals OWN resources and answer the three economic questions.
The opportunity to make PROFIT gives people INCENTIVE to produce quality items efficiently.
There is a wide variety of goods and services available to consumers.
Competition and self-interest work together to regulate the economy.
Supply, Demand, and Consumer Choice
Demand is the different quantities of goods that consumers are WILLING and ABLE to buy at different price points.
There is an INVERSE relationship between price and the quantity demanded
Sub Effect: This effect states that if the price goes up for one product, consumers of that product will choose to purchase a substitute product (and vice versa).
This effect occurs because if the price goes down for a product, the PURCHASING POWER increases for consumers – allowing them to purchase more.
The Law of Diminishing Marginal Utility states that as you consume more units of any good, the additional satisfaction from each additional unit will eventually start to decrease.
Demand Shifters
Tastes and Preferences
Number of Consumers
Price of Related Goods
Income
Future Expectations
NOT changes in PRICE
Supply is the different quantities of a good or service that sellers are willing and able to sell (produce) at different price points.
There is a DIRECT (or positive) relationship between price and quantity supplied.
Supply Shifters
Prices/Availability of Inputs (Resources)
Number of Sellers
Technology
Government Action: Taxes & Subsidies
Opportunity Cost of Alternative Production
Expectations of Future Profits.
Supply and Demand are put together to determine equilibrium price and equilibrium quantity
If TWO curves shift at the same time (S+D), EITHER price or quantity will be indeterminate.
Price Ceiling
If TWO curves shift at the same time, EITHER price or quantity will be indeterminate.
Price Floorr
This control sets the MINIMUM legal price a seller can sell a product.
NOT EFFICIENT: Cause shortage or surplus
Producer Tax
To dissuade the producer from making their good or service. This is because the government deems their product dangerous or unwanted
Subsidy
This government intervention strategy is used to encourage producers to make more of their good because it is deemed beneficial to people of our society.
Quota and Tarrifs
The purpose is to 1) Protect domestic producers from cheaper world prices and 2) prevent domestic unemployment created by increased importation from other countries.
Supply, Demand, and Consumer Choice
Elasticity shows how SENSITIVE quantity is to a change in price.
Types of Elasticity
Elasticity of Demand
Elasticity of Supply
Cross-Price Elasticity (Subs or Comps)
Income Elasticity (Normal and Inferior Goods)
Change in Q demanded/ Change in Price
When we do not know specific % change, we can use this test to determine how changes in price will affect total revenue
Total Revenue = Price x Quantity
You will continue to consume until MARGINAL BENEFIT = MARGINAL COST
Marginal Utility per Dollar: MUX/PX=MUY/PY
%Chnage in Qx/ %Change in Py
%change in Q/ %change in income
%Change in Price/ % Change in supply
Perfectly Competitive Markets
PRODUCTION = THE CONVERSION OF INPUTS (RESOURCES) TO OUTPUTS (FINISHED PRODUCTS)
Fixed Resources: Resources that DON’T change with the amount produced.
Variable Resources: Resources that DO change as more or less is produced.
MP=Change in product/ change in labor
AP= total product/ number of labor units
As variable resources are added to fixed resources the additional output produced from each new worker will eventually fall.
ACCOUNTING PROFIT = TOTAL REVENUE – ACCOUNTING COSTS
ECONOMIC PROFIT = TOTAL REVENUE – ECONOMIC COSTS
The short-run is a period in which at least one resource is fixed.
In the Long-run, ALL resources are variable and can be changed.
Average costs
AFC= FC/Q
AVC= VC/Q
ATC= TC/Q
MC= Change in TC/ change in TQ
Economies of Scale: Long Run Average Cost falls because mass production techniques are used.
Constant Returns to Scale – The long-run average total cost is as low as it can get.
Diseconomies of Scale: Long run average costs increase as the firm gets too big and difficult to manage.
The Law of Diminishing Marginal Returns doesn’t apply in the long run because there are no FIXED RESOURCES.
Characteristics of Perfect Competition
Many small firms
Identical products (perfect substitutes)
Easy for firms to enter or exit the industry
Seller has no need to advertise
Firms are “Price Takers”
Demand is perfectly elastic
Shut down rule: A firm should continue to produce as long as the price received per unit is GREATER than AVC
Profit Max rule: MR=MC
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Unit Elastic: Price changes and the TR remains unchanged
Inelastic
Price increase causes TR to DECREASE.
Price decrease causes TR to INCREASE.
Elastic:
Price increases causes TR to INCREASE.
Price decrease causes TR to DECREASE.
Intro to Monopolies
Characteristics
Single Seller
Unique good with NO close substitutes
Price Makers
High barriers to Entry
Some “Non-price” Competition
MR< D
A monopolist produces where MR=MC, but charges the price consumers are willing to pay, identified by the demand curve!
Monopolies under-produce and over charge, decreasing CS and increasing PS
Monopolies are inefficient because
They charge a higher price than the market demands.
They don’t produce enough (meaning they are not allocatively efficient).
They produce at higher costs (which means they are not productively efficient either).
They have little incentive to innovate
Reasons to Regulate monopolies
To keep prices low for consumers
To make monopolies efficient (productive and allocative)
Produce more for market demand.
How?
Price control
Taxes/ Subsidies
Natural monopolies are created by the fact that the start up cost, or fixed costs, are extremely high and continued cost of production is very high as well.
Price Discrimination: The practice of selling the same products to different buyers at different prices based on their elasticity
Requirements to Discriminate
Must have monopoly power.
Must be able to segregate the market.
Consumers cannot be able to resell the product.
A perfectly discriminating firm can charge each person differently so the Marginal Revenue is equal to Demand=Price
Monopolistic Competition
Relatively large number of sellers
Differentiated products
Some control over price
Easy entry and exit (low barriers)
A lot of non-price competition (advertising)
In the long-run, new firms will enter, driving down DEMAND for firms already in the market!
this firm has excess capacity
Oligopolies
A few large firms (Less than 10)
Identical or Differentiated Products
High Barriers to Entry
Control over price (Price Makers)
Mutual Interdependence
Oligopolies must use strategic pricing
Oligopolies have a tendency to collude to gain profit
Collusion results in the incentive to cheat consumers and each other.
Firms make informed decisions based on their dominant strategies
Supply and Demand of Resources
MRC= Change in total cost/ change in imput
Labor demand: workers that businesses are willing and able to hire at diff wages
Law of demand of labor: wages are inversely proportional to demand
Labor supply: diff quantities of people who are willing and able to offer their labor at different wages
Labor supply law: wages and quantities supplied are directly proportional
Derived demand: resources derived from the products they help produce
Demand Shifters
change in resource productivity
change in other resources price
Change in product demand
Supply shifters
Number of qualified workers
Gov regulations
Personal values regarding leisure vs. work time
MRP= change in TR/ change in input
Perfectly competitive market: MRC= Wage
MRP determines demand
Hire until MRP=MRC
Labor imperfections
Misleading job info
Geographical immobility
Wage discrimination
Unions
Profit max combo: MRPX/MRCX=MRPY/MRCY=1
Monopsony characteristics
One firm hires workers --> very large
relatively immobile workers
Firm is wage maker
MRC DOESNT EQUAL WAGES
Labor unions goals
lobbying gov officials to increase demand
Increase the price of substitutes
Convince consumers to buy from the union
Market Failure and Government Intervention
when should the gov intervene
Worker Safety Laws
Licences
Bank Bailouts
Free Market
Little gov intervention
Individuals own their resources
Profit opportunity
Wide product variety
Competition and self interest regulate the economy
Market failure: when the invisible hand does not work
Failures
Public goods: nonrival and nonexcludable. Creates free rider problem
Externalities: societal costs/ benefits of someone doing something
Monopolies
Unequal wealth distribution
Lorenz Curve exposes income inequality
Gini coefficient: closer to zero, closer to perfect income equality
How to fix market failures
Unequal wealth distribution: welfare, and progressive taxes
positive externalities: subsidies
negative externalities: taxes
Public goods: taxes and/or punish free riders
negative externalities: MSC> MPC
Positive externality: MSB> MPB
Types of taxes
Progressive tax: take from rich the most
proportional tax: takes same amount from all groups
Regressive tax: takes from the poor the most
Produce until MSB=MSC
Laffer Curve: relationship between tax rate and tax revenue