Chapter 1: Ten Principles of Economics
8/24/2011
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Economy: Greek, to manage a household.
Economics: the study of decisions made when dealing with scarcity.
Scarcity: Not enough resources to satisfy
*Margin: “step, by step” changes.
Rationality: making decisions based on all of the information you have. In economics we assume
rationality.
Incentive: Something that induces a person to act.
Market: a place buyers and sellers meet to exchange goods and services
Inflation: general increase in price level
10 Economic Principles
(Micro Economics)
1. People face trade offs
a. Efficiency: getting the highest benefit from scarce resources
b. Equity: equal shares from different groups
2. Opportunity Cost (OC): What you give up to get something else.
3. People make choices at the margin.
4. People respond to incentives.
a. Weighing costs and benefits
b. Increase the cost -> less likely to do something
c. Decrease benefits -> less likely to do something
5. Trade can make everyone better off
a. Allows specialization
6. Markets are usually a good way to organize economic activity
7. Governments can sometimes improve market outcomes
(Macro Economics)
8. A country’s standard of living depends on its ability to produce goods and services (G&S)
9. Prices rise when government prints too much money
10. Short-run tradeoff between inflation and unemployment
a. When one goes up the other goes down
Chapter 2: Thinking Like an Economist
08/26/2011
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Microeconomics: Decisions by households or firms and interactions between households and
firms in the marketplace
Macroeconomics: Studies the forces and trends that affect the economy as a whole
The Economist as a Scientist
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Use models to simplify reality
Use scientific method
1. Use observations to develop theory
2. Collect and analyze data
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5.
Positive Statement: “What is; fact”
 Economics
Normative Statement: “What should be; opinions”
 Political Science
 Social Sciences
Much disagreement in Economics
1. Production Possibility Frontier (PPF): Shows the combinations of output an economy can
produce with given inputs
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3. Observe natural experiments to test theory
Use assumptions: limits (ex: It is summer in Texas)
Goal of a model is to simplify reality to increase understanding
2 models
1. Circular Flow Diagram:
 3 Different Actors
1. Households = Consumers
2. Firms = Producers
3. Government (Taxation/Regulation)
 Factors of Production: Inputs or resources into production
1. Capital (K)
2. Land/Nature Resources
3. Human Capital
4. Technology (A)
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Production: What firms produce G&S
Possibility: Combinations
Frontier: limit border
Assumptions
1. Can produce 2 goods
o Computers
o Cars
2. Limited number of inputs
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4. Produce on PPF (F,A,B,E): Efficiency
5. D: can produce, but inefficient
6. C: cannot produce
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Economics
1. Graph with 2 variables
2. Looking at the relationship between 2 variables
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4. Omitted Variables
 Changes do to variable not on graph
5. Reverse Causality
 Does A cause B
 Does B cause A
 Neither?
6. Correlation: A and B happen at the same time
7. Demand Curve
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8. Supply Curve
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Chapter 3:
08/31/2011
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Absolute advantage: The ability to produce a good using fewer inputs than another producer
Comparative Advantage: The ability to produce a good at a lower opportunity cost than another
producer
Opportunity Cost (OC): what you must give up to get something else
2 basic ways to satisfy wants
o Economic self-sufficiency: Produce everything you want to consume
o Specialize in the production of a good and trade for other goods
Trade will only happen if it makes people better off
Ex: 2 Individuals, Rancher and farmer. Produce 2 products: Meat and Potatoes.
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With no trade, PPF is the person’s Consumption possibility frontier.
Imports (M): Goods produced abroad and sold domestically
Exports (X): Goods produced domestically and sold abroad
Trade: Importing one product and exporting another
Chapter 4:
9/9/11
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Market: a place where buyers and sellers get together to exchange goods and services
Competitive Market: A market which there are many buyers and many sellers and no one can
affect the price
a. Goods sold are exactly the same
Price Takers: take the market price as given
Demand (D): a relationship between the price and the quantity demanded a each price
a. Any relationship can be put on a graph
Quantity Demanded (QD): the quantity that buyers are willing and plan to buy at a given price
Law of Demand: other things being equal (ceteris paribus) the quantity demanded falls when
the price rises
Market Demand: The total quantity demanded by all buyers in the market at each price
Horizontal Summation: at each price what is the total quantity demanded?
Change in Price
a. Move along demand curve
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b. Change quantity demanded
Changes in demand
a. Increase in demand (D1 to D2)
i. At each Px QD is higher
ii. Shift D curve to right
b. Decrease in demand
i. At each price, QD is lower
ii. Shift D curve left
Reasons for changes in Demand (All shift Demand Curve)
a. Price of related Goods
i. Substitutes: If the price of a substitute increases, the demand for the original
good increases
ii. Compliments: If the price of a Compliment increases, the demand for the
original good decrease
b. Income
i. Normal Good: When income increases, demand for a normal good increases
ii. Inferior Goods: When income increases, demand for an inferior good decreases
c. Tastes
d. Expectations
i. Future Income: changes current demand
ii. Future Prices: changes current demand
e. Number of Buyers
Supply (S):the relationship between the price and the quantity supplied by sellers at each price
Quantity Supplied (QS): the quantity of a good or service that firms are willing and able to sell at
each price
Law of Supply: All else equal (ceteris paribus) as the price increases the quantity supplied
increases
Changes in Quantity supplied (QS)
a. P => QS UP
b. P => QS DOWN
Changes in Supply (S)
a. Increases in supply: QS UP at each P; S Curve shifts Rights
b. Decrease in Supply: QS DOWN at each P; S Curve shifts Left
Reasons the supply curve shifts
a. Changes in input prices
i. Ex: Up P of Wood for tables the firm produces
b. Technology
i. Ex: better machines to produce goods
c. Expectations
i. Ex: Businesses trends the firm expects
d. Number of Sellers
i. Sellers UP => Market Supply UP
Equilibrium Price: the rpice at which quantity supplied equals quantity demanded in the market
Equilibrium Quantity (Qe): where QS = QD
Ch 5:
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Elasticity €: responsiveness
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A measure of responsiveness of quantity demanded (QD) or quantity supplied (QS) to on
of its determinants
o
Price Elasticity of Demand €P: the measure of how much the QD of a good responds to a
change in price of that good
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€P = %Change QD/%Change P
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(Q2-Q1)/(Q1+Q2)/2/(P2-P1)/(P1+P2)/2
When €P, Demand is elastic.
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When €P=1, Demand is unit elastic.
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IF P UP by 1% => QD DOWN by 1%
When €P<1, Demand is inelastic
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IF P UP by 1% => QD DOWN by > 1%
IF P UP by 1% => QD DOWN by < 1%
If demand is inelastic, then the percent change price is greater than the percent change in
Quantity demanded
o
UP P by 1% => DOWN QD by < 1% => UP TR
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DOWN P by 1% => UP QD by < 1%
o
IF D is unit elastic => no change in TR
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Profit: Total revenue (TR) – Total Cost (TC)
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Total Revenue = Price (P) X Quantity (Q)
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TR = P x Q
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IF TR UP => UP Profit (if costs fixed)
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IF demand is elastic, than the percent change in price is less than the percent change in quantity
demanded
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UP P by 1% => QD by> 1%
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DOWN by 1% => UP QD by > 1%
For price Elasticity of Demand, take the absolute value (drop the minus sign)
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€P = abs(%CHANGE QD / %CHANGE P)
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Price Elasticity of Demand: €P = %Change QD/%Change P
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Income Elasticity of Demand: €I = %Change QD/%Change I
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The measure of how the QD responds to the change in Income (I)
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Normal Good: UP QD when UP I
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€I > 0
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Necessities: Small income elasticity
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Luxury Goods: large income elasticity
Inferior Good: DOWN QD when UP I
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€I < 0
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Cross - Price Elasticity of demand: €X = %CHANGE QD1 / %CHANGE P2
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The measure of how much the QD of one good responds to the change in price of another good
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Substitute: UP P2 => UP QD
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Compliments: UP P2 => DOWN QD1
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€X < 0
Price elasticity of supply (€PS): the measure of how quantity supplied of a good responds to a
change in the price of that good, what the seller receives
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€X > 0
(€PS) = %CHANGE QS / %CHANGE P
Determinants of €PS
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Flexibility of sellers (EX: Complicated production)
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Time horizon: Supply is usually more elastic in the short run
Ch 6: Government Policy
 Price Ceiling: a legal maximum on the price at which a good can be sold
 Price is below Pe
 Causes Shortage
 Ex: Rent Control
 Price Floor: a legal minimum on the price at which a good can be sold
 Price is Above Pe
 Causes Surplus
 Ex: Minimum Wage
 Tax Incidence: the manner in which the burden of the tax is shared among participants in the market
 Tax incentive: who pays the tax
 Tax on buyers shifts demand curve
 If tax changes, it changes QD to bottom of tax
 Original Price = Pe
 Both households and firms pay part of tax(T)
 Now households pay Pg > Pe, but PB < T
 Now sellers reveve PS < Pe, but PS < T
 Tax on sellers (Adds cot to sellers)
 Shifts supply curve to the top of supply curve to top of tax
 Government can tax buyers or sellers and both will still pay part of tax
 More elastic (more responsive) => flatter the curve
 Buyers pay more of tax when supply is elastic
 Sellers pay more of tax when demand is elastic
CH 7:
 Welfare Economics: the study of how allocation of resources affects economic well being
 Consumers – buyers
 Demand Curve
 Willingness to pay: the maximum amount a buyer will pay for a good
 Consumer Surplus (CS): the amount a buyer is willing to pay for a good minus the amount the
buyer actually hast to pay for it
 CS = WTP-P
 Found below demand curve and above price to buyers
 Sellers – firms
 Supply curve
 Cost: the value of everything a producer must give up to produce a good
 Input cost
 Opportunity cost <- included in economics but not in accounting
 Economic profit
 Producer Surplus (PS): the amount a seller is paid for a good (P) minus the seller’s cost of
producing the good
 As Price falls, Consumer surplus increases for 2 reasons
 Original consumers (QD) paying lower price
 New Consumers (QD2-QD1) now enter market and buy the good
 Height of Demand Curve = Willingness to Pay
 As price rises, Producer surplus increases for 2 reasons
 Original sellers (QS) receive a higher price
 New sellers (QS2-QS1) enter the market and sell the good
 Efficiency: resources allocation on that maximizes total surplus received by all members of society
 Where is the most efficient allocation of S & D graph?
 Equilibrium Quantity and Price => Maximize total surplus
 Equity: the fairness of the distribution of well-being
Chapter 10: Externality
 Externality: the uncompensated impact of one person’s actions on the well-being of a bystander
 Private Cost: individual firm’s cost to produce and supply a good
 Supply Curve
 Under supply curve is Total Cost
 Social Cost: Private Cost + Cost of negative externality
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 Internalizing an externality: Altering incentives so that people take account of the external effects of
their actions
 Makes people pay social cost rather than Private Cost
 Negative Externality: The effect on the bystander is adverse (negative)
 Ex: Pollution, Neighbors’ Pets, Health risk
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 Positive Externality: The effect on the bystander is beneficial (positive)
 Private Venefit: benefit on an individual of an action
 Social Benefit: private benefit from external benefit
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 Externalities
 Negative:
 Private quantity > Social Quantity
 Private price < Social Price
 Positive:
 Private Quantity < Social Quantity
 Private Price < Social Price
 Internalizing on Externality
 Tax goods with negative externalities
 Subsidizing (grants) goods with positive externalities
 Private Solutions to Externalities
 Moral codes and social sanctions
 Charities (EX: sierra club)
 Contracts between market participants and bystanders
 Coase Theorem: If private parties can bargain without cost, over the allocation of resources,
they can solve the externality problem on their own.
 Problems with coase Theorem
 Transaction Costs: Costs that partners incur in the process of bargaining
 Both parties hold out for a better deal
 Number of parties is large
 Public Policies Toward Externalities
 Command and control policies
 Regulates behavior directly (EX: Speed Limit)
 Market based policies
 Provides incentives for private decision makers (EX: Pay as you go insurance)
 2 market based approaches
 Corrective (Pigouvian) Tax: Designed to make decision makers take account for their
actions
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 Corrective tax used when there is an external cost
 Corrective Subsidy used when there is an external cost
 Tradable Permits: Issue permits to decision makers
 Permits can be bought and sold
 Sets up a market for externality
Need information on demand for the externality
Ch 11: Public Goods and Common Resources
 Private goods: exclusive use to resource
 Public goods: anyone can use the resource
 Characteristics of Goods
 Excludable: if a person can be prevented from using the good
 Rival to Consumption: if one person’s use diminishes another person’s use
Excludable
Not Excludable
Rival to Consumption
Private Goods
Common Resources
Not Rival to consumption
Natural Monopolies
Public Goods
 Externalities: bystander affected by someone else’s actions
 Arise because something with no market value has a value attached to it
 Private decisions about production and consumption can lead to externalities
 Free-Rider Problem: a person receives the benefit of a good but avoids paying for it
 When a good is not excludable
 Public Goods
 If the benefit of providing a public good exceeds the cost, the government should provide the
good and pay for it with a tax on the people who are going to benefit from the good
 Cost-Benefit Analysis: a study that compares the costs and benefits of providing a good/ doing
an action
 If Cost > Benefit => Don’t provide good/ don’t do the action
 Benefit > Cost => Provide goods/ do action
 Knowledge created through basic research
 Fighting Poverty
 Common Resources
 Not excludable
 Cannot prevent free riders
 Government has a role in providing common resources
 Preventing its overuse
 Tragedy of the Commons: Private incentives (using the product for free) outweigh the social
incentives (using the land carefully).
 Common resources
 Common grazing land for cattle
 Common hiking trail
 Overuse and destruction of the resources
 Amount of resources is fixed
 Can lead to the destruction of a whole industry
 Why?: people don’t look at the external cost of their actions
 Policies to prevent overuse
 Regulate use of resource
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Use corrective tax to internalize externality
Auction off permits to use the resource
Convert it to a private good
Ch 13: Costs of Production
 Firms produce goods and services in order to achieve a maximum profit.
 Total Revenue (TR): The amount a frim receives from the sale of its output
 TR = P X Q = Price x Quantity
 Total Cost (TC): The market value of inputs a firm uses in production
 Profit = Total Total Revenue – Total Cost
 TT = TR – TC
 Accounting Profit = TR – Total Explicit Costs
 Economic Profit = TR – Total Explicit Costs – Total Implicit Costs
 2 kinds of costs:
 Explicit: requires an out lay of money
 Implicit Cost: do not require an out lay of money
 Need 100,00 to start a business
 Borrow 100,000 at 5%
 Explicit cost = $5,000
 Borrow $60,000 @ 5% and use $40,000 from your savings
 Explicit Cost = $3,000 interest
 Implicit Cost = $2,000 interest we could have earned
 Diminishing returns: added input creates more output at a decreasing rate
 Only adding one input
 Other inputs are fixed
 Marginal Product of Labor (MPL): the additional output from one extra unit of labor input
 MPL = Change in Q / Change in Labor
 Fixed Costs: Same cost regardless of inputs
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 Ex: Land costs $1,000 per month
 Variable Cost: Depends on Quantity of input
 Wage of a worker = $2,000 per month
Labor
Output (Q)
Cost of Land (FC)
Cost of Labor (VC)
0
0
1,000
0
1
1,000
1,000
2,000
2
1,800
1,000
4,000
3
2,400
1,000
6,000
4
2,800
1,000
8,000
5
3,000
1,000
10,000
 TC = VC + FC
 Marginal Cost is the change in total cost divided by the change in output
 MC = Change TC / Change in Q
 Average fixed cost (AFC) = FC / Q
 Average variable cost (AVC) = VC / Q
 Average Total Cost (ATC) = TC / Q = AFC + AVC
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Total Cost (TC)
1,000
3,000
5,000
7,000
9,000
11,000