Economics 101

Chapter 1

What is Economics ??

Economics

Economics is the study of the choices people make to deal with scarcity.

or

Economics is the study of how people transform natural resources into final products and services that people can use.

Economic Systems

An economic system consists of a set of rules, goals, and incentives that govern economic relations among people in a society and provide a way to answer the basic economic questions.

Economic systems may rely heavily on:
- Tradition
- Brute Force
- First come -- First Serve
- Central Authorities
- Markets

Why Study Economics ?

To increase your understanding of how markets work.
To help you make better economic decisions.
To help you realize how government actions affect your life.
To make you a better practical economist.

Practical Economists

We assume that people behave as if they were "Practical Economists."
Behavioral_ Assumptions
- Act according to self interest.
- Maximize their satisfaction.
- Respond to incentives
- Decide at the Margin.

How Economists Think

Scarcity
Opportunity Cost
Marginal Analysis
Substitution
Competition

What Economists Do

Microeconomics
- is concerned with the economic actions of individuals and firms
- as well as how government regulations and taxes effect the decisions of individuals and firms.
Macroeconomics
- is the study of the national economy.
- It is concerned with government actions that affect total employment, income and production.

Economic Science

Economic Science is concerned with "what is."
Statements about "what is" are called "positive statements."
- Positive statements may be right or wrong but they can be checked against the "facts."

Economic Policy

Economic Policy is concerned with "what ought to be."
Statements about "what ought to be" are called "normative statements."
- Normative statements can not be "tested" with facts. They represent personal opinions.

Microeconomic Goals

Economic efficiency
- Production efficiency
- Allocative efficiency
Distributional equity
- An equitable distribution of income. (??)
Economic Freedom
- Includes the right to own productive resources and to use them as one sees fit.
- Your property rights are limited.

Macroeconomic Goals

Economic Growth
Full Employment
Price Stability

Others
- Balanced Budget
- No Trade Deficit
- Low Interest Rates

Government's Role

Allocation
- Regulation of Businesses
- Production of goods and services
Redistribution
- Affects the distribution of income through welfare, social security, price supports, etc._.
Stabilization
- Actions that promote stable prices and stable employment levels.
Economic Growth
- Is of particular importance to state and local governments.

The Economic Method

State the problem.
Use a relevant model
Identify solutions
Evaluate solutions
------------------------------
Implement appropriate programs

Economic Models

Simplifying assumptions
- Focus on the most important things
Comparative statics
- Ignore time
Ceteris paribus
- Other things held constant
Secondary effects
- Consider side effects
Short vs. Long Run
- In the short-run some things are fixed

Economic Tools

Graphs
- Used to visualize both data and theories.
- Some economic models require the use of several linked graphs.
- Can be descriptive or analytical.
Statistics -- the numbers used with economic models
- Mortgage rates
- Oil prices
- Government spending
- Money supply

More Tools

Benefit/Cost Ratios
Money Multipliers_
Cash Flow Models
Marginal Cost Graphs
Breakeven Charts
Elasticities

Graphs

Plot this function

Q = 15 - 15 P

Plot Quantity on the horizontal axis
Plot Price on the vertical axis

Quantity is the dependent variable.
Price is the independent variable.
There is a "negative" relationship between Price and Quantity.

Markets

Market = any setting in which exchange takes place between buyers and sellers.
- Supermarkets
- Labor markets
- Regional markets
- Stock markets
Prices = the key information provided by markets.
Essential Market Elements
- Property Rights
- Competition

Market Units

Households
- Own all productive resources either directly or indirectly.
- Most household income comes from wages and salaries.
Firms
- Proprietorship_
- Partnership
- Corporation
  - Limited Liability
Governments
- Federal
- State
- Local

Specialization

People and firms specialize because it enables them to produce more total output from the available resources.
If you specialize -- you must trade.
Specialization with trade allows people to consume more than would be possible otherwise.

Resources

Land
- Includes all raw materials
Labor
- Both physical and mental
Capital
- Both physical and financial
- Technology is often embodied in capital
Enterprise
- Involves combining other resources.

Circular Flows

Households sell productive services to firms and buy goods and services.

Economic Rights

All persons living in the United State of America have the RIGHT to :
- Unlimited health care.
- Excellent housing.
- A new car every five years.
- Retirement at age 55.
- An exciting job.
- Three months annual vacation.
- Unlimited travel.
- Low cost food and entertainment.
Don't you agree !

Chapter 2

Graphs

Two-Variable Graphs

Y = dependent variable
X = independent variable

Scatter Diagrams

We are interested in knowing if the variables are correlated.
- i.e. Show a positive or negative relationship.
- Correlation does not imply causation.

Time-Series Graphs

A trend is a general tendency for a variable to rise or fall.

Cross-Section Graphs

Graph the same variable for different groups at the same point in time.

Graphs of Models

Qs = a + bP

Qd = c - dP

Qs = Qd

Slope

Slope = rise over run

Slope = ²Y/²X

Maximum & Minimum

The slope at a maximum or minimum point is zero.

Cost Curves

Cost curves show the relationship between different types of costs and the level of output.

> 2 Variable Graphs

Many economic functions involve_ more than two variables.

Chapter 3

Production & Trade

Production Possibilities

The Production Possibilities Frontier (PPF) shows the maximum output combinations for a nation that is using its resources effectively.

PPF Concepts

Scarcity
- A nation can only produce so much.
Opportunity Cost
- To get more of one good you have to give up some of another.
- Corn = 100 - 2 Cars
Efficient Resource Use
- Only combinations on the PPF reflect the maximum possible output.
Law of Increasing Cost
Economic Growth
- Shifts the PPF outward.

Economic Efficiency

Allocative Efficiency
- Requires the pattern of national output to mirror what people want and are willing and able to buy.
Productive Efficiency
- Requires minimizing opportunity cost for a given value of output.
Distributive Efficiency
- Requires that specific goods be used by the people who value them relatively the most.

Increasing Costs

The Law of Increasing Costs states that the opportunity cost of producing more of one good increases as more units of that good are produced.

This is reflected in an outward curve for the PPF.

Opportunity Cost

The OPPORTUNITY COST of doing something is the value of the next best alternative you give up.

Specialization

If you specialize you develop a comparative advantage in the area of your specialty.
If you have a comparative advantage in something it is to your advantage to trade.
The same is true for firms and nations.

Comparative Advantage

The principle of comparative advantage states that each person should specialize in the production of goods or services for which his or her opportunity cost is lower than others.

Consider two farmers who have decided NOT to trade. Instead, they produce the following:

PPFs & Costs

Suppose the PPFs are:

Trade Benefits

With specialization we have:

Consumption Possibilities

With specialization and trade a nation may consume more than would be possible without trade.

Economic Growth

Economic growth shifts the PPF outward. This may take place due to:
- More resources.
- Improved technology.

Absolute Advantage

Suppose that with the same amount of resources Country A can produce twice as much of anything as Country B.
A has an "absolute advantage" in the production of anything.
Trade will still benefit both A & B, however, provided they have different opportunity costs.

Trade Requirements

What types of economic institutions, regulations, agreements, etc. are needed to facilitate trade?
- Protection of property rights
  - Real property
  - Financial property
  - Intellectual_ property
- Exchange rate systems
- Standardization
- Financial arrangements
- ?
- ??
- ???
- ????

Chapter 4 Markets

Markets differ in terms of:
- Information available
- Size of Buyers and Sellers
- Ease of entry & exit
- Type of products
- Trading traditions
- Definition of property rights
- Extent of regulation
- Stage of development
- Geographic scope
But all have one essential element in common. Trade in the market determines product prices.

Market Prices

Market prices serve to
- Provide information
- Ration goods
- Alert buyers and sellers to changing market needs.
Market prices are relative prices.
- They represent the price of one good relative to another.

Prices

Monetary Prices
- Monetary (Absolute) Prices are prices in terms of some monetary unit.
Relative Prices

Relative Prices are the prices of goods or resources in terms of each other, and are computed by dividing their absolute prices by one another.

Prices
- Provide Information
- Serve as Incentives
- Act as Rationing Devices

Opportunity Cost

The OPPORTUNITY COST of doing something is the value of the next best alternative you give up.

Law of Demand

The Law of Demand = quantity is negatively related to price.
- Price represents other goods that must be given up.
- Your income does not go as far when prices are higher so you buy less.

Demand Functions

Demand schedules show the amounts of a good consumers are willing and able to buy at various prices during a particular period of time.

Demand Factors

Determinants of Demand
- Number of consumers, N
- Consumer tastes, T
- Consumer income, Y
- Prices of related goods, Pr
- Consumer expectations, E

Related Goods

Related goods can be
- Substitutes
- Complements

Substitutes -- an increase in the price of a substitute will cause an increase in demand for an item. Pb Qda

Complements -- an increase in the price of a complement will cause a decrease in demand for an item.

Demand Changes

Changes in demand -- are the result of changes in demand determinants other than price. (N, T, Y, Pr, & E )
Changes in the quantity demanded -- are the result of changes in price, P

Law of Supply

The Law of Supply = quantity is positively related to price.
- Higher prices provide the extra funds producers need to obtain more production resources.
- Higher prices create profit opportunities that attract more producers.

Supply Functions

Supply schedules show the amounts of a good producers are willing and able to produce at various prices during a particular period of time.

Supply Factors

Determinants of Supply
- Number of sellers, N
- Resource Prices, C
- Prices of related goods in production, Pr
- Technology, T
- Producers expectations, E

Supply Changes

Changes in supply -- are the result of changes in supply determinants other than price. (N, T, C, Pr, & E )
Changes in the quantity supplied -- are the result of changes in price, P

Equilibrium Prices

Market equilibrium exists when supply equals demand.

Market Equilibrium

Equilibrium: Qs = Qd

Equilibrium Changes

Suppose the cost of making tires fell. What would happen to :
- Supply of tires?
- Demand for tires?
- Equilibrium price of tires?
- Demand for automobiles?

Advertising

Why do companies advertise ?
- To be able to sell more at the same price.
- To be able to sell the same amount at a higher price.
Why do retailers advertise price and manufacturers advertise features or image ?

Increase in Demand

An increase in demand usually results in an increase in both market price and quantity.

Fixed Supply

If supply is fixed, an increase in demand results in a higher market price but no change in quantity.

Increase in Supply

An increase in supply results in a lower market price and an increase in the quantity traded.

Both S & D Increase

If both supply and demand increase we can be sure that quantity will increase but price may higher or lower.

Chapter 5 OPEC Revenue

Suppose you are an advisor for OPEC. It wants to increase its revenues from oil sales.
Would you advise:
- Increasing oil production?
- Reducing oil production?
You can not answer the question without knowing the price elasticity of demand.

Total Revenue: 1

TR = PQ

Total Revenue: 2

TR = PQ

Price Elasticity: 1

Price Elasticity of Demand = the % ² in quantity demanded divided by the % ² in price.

It tells us how responsive quantity demanded is to price changes. With this information we can determine how a change in price will affect total revenues.

Price Elasticity: 2

When the % ² in quantity demanded is larger than the % ² in price, we say that demand is price elastic.
On the other hand, if PEd < 1, demand is price inelastic.
If PEd = 1, demand exhibits unitary elasticity.

Price Elasticity: 3

The factors affecting price elasticities are:
- availability of substitutes_
- relative importance of the good in consumers' budgets
- the time period of demand.
If a good accounts for a large part of consumption, it is likely_ to be price elastic.
If a good has many substitutes_ its price elasticity will be greater.
The more time for adjustment, the more elastic demand will be.

Revenue & Elasticity

Total Revenue (TR) is price times quantity. TR = P x Q

If demand is price inelastic, then an increase in price results in a relatively smaller decrease in quantity. Therefore TR increases.

Using Elasticities: 1

Suppose Congress increases the excise tax on cigarettes.
- What will happen to tax revenues?
- Who will pay the higher taxes?
- The answers depend on the price elasticity of demand for cigarettes.
The higher the elasticity of demand
- the smaller the amount of the tax that sellers will be able to pass on to consumers and
- the lower the tax revenues received by the Government.

Using Elasticities: 2

Excise Tax Objectives
- Raise revenues.
- Discourage consumption.
Cigarettes have an inelastic demand.
- Thus producers can pass a larger part of the tax on to consumers.

Cigarette consumption will not fall as much as prices increase. Therefore, the tax will be an effective source of tax revenues.

Using Elasticities: 3

Excise Tax Shifting

Income Elasticity: 1

Income Elasticity of Demand = the % ² in quantity demanded divided by the % ² in income.

It tells us how responsive quantity demanded is to income changes. With this information we can determine how a change in income will affect total sales.

Income Elasticity: 2

Goods with income elasticities greater than zero are called normal goods.
- For these goods, demand increases as income increases.
Goods with income elasticities less than zero are called inferior goods.
- For these goods, demand decreases as income increases.

Income Elasticity: 3

The level of income has a big effect on the value of the income elasticity.
- The income elasticity for food in the United States is 0.15 and 0.75 in India.
- A 10 % increase in income results in a 1.5 % increase in food consumption in the United States and a 7.5 % increase in India.

In other words, as incomes increase in low income nations they will spend more on items classified as "necessities" such as food, housing, and basic clothing.

Cross Elasticity: 1

The Cross Elasticity of Demand = the % ² in quantity of Good A demanded divided by the % ² in the price of Good B.
- It tells us how responsive the quantity demanded of Good A is to a change in the price of Good B.

Cross Elasticity: 2

The Cross Elasticity of demand is:
- Positive for substitutes
- Negative for complements.
Substitutes are goods that compete for the consumer's $s.
- Pepsi & Coke Cola
- Music Tapes & CDs
Complements are goods that are frequently consumed together.
- Beer & Beer Nuts
- Video Tapes & VCRs

Supply Elasticity: 1

Price Elasticity of Supply = the % ² in quantity supplied divided by the % ² in price.
- It tells us how responsive quantity supplied is to a price change.

Supply Elasticity: 2

The Elasticity of Supply depends on:
- Factor Substitution Possibilities
- Time Period of Supply Decisions

If resources can be switched from one use to another fairly easily, the supply of the item the resources are used to produce is likely to be very price sensitive.

If the price of the good falls, the resources used to produce it are quickly shifted to some other use.