ECON 202: Chapter 1 to 5 Bundle of Notes
ECON 202: Chapter 1 to 5 Bundle of Notes Econ 202
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Chapter 1: Ten Principles of Economics Economics is the study of how socity manages its scarce resources. There are two types of economics – microeconomics and macroeconomics. Microeconomics is the study of individual choice – household, people, and business firms. Macroeconomics is the study of country, policy, employment, inflation, gross domestic product. There two stament types that you should distinguish between – positive and normative statements. Positive statements are fact and usually contain words like is, was, and be. Normative statements are policy statements and usually contain words like ought and should. Scarcity is the limited nature of socities natural resources. Because resources are scarce people make a choice to maximize utility (satisfaction) and to maximize profit. 1.1 Economic Ideas (Assumptions We Make) 1. People are rational – meaning that they are capable of using all available information to make a choice. 2. People respond to economic incentive. 3. Optimal decisions are made at margin (marginal) – one additional unit. Marginal Benifit = Marginal Cost 1.2 How People Make Decisions a. Principle 1: People Face Trade-offs People face trade-offs because one person cannot do two things at once. For instance, a student must decided how to spend her or his time. It can be spent studing Economics, Precalculus, and Biology. For one hour spent studying Economics they give up a hour to study Precalculus and Biology. However, when people are grouped together into socities they face different trade-offs.An example of a trade-off that society may face is cleaner environment and a high level of income. If a law (policy) was to be passed requiring firms to reduce carbon dioxide emmissions it would cause a rise in the cost of producing goods and services. This would cause firms to earn smallers profits, which would result in paying lower wages, charging higher prices for that good or service, or a combination of these. While the law would yeild the benefit of a cleaner environment and the improved health that comes with it. The trade-off in this example would be the cost of ruducing the incomes of the firms' owners, workers, and customers. Another trade-off that socitey face is efficiency and equality. Efficiency means that society is getting the maximum benefits from its scarce resources. Equality means that those benefits are distributed uniformly amoung society's members. “In other words, efficiency referes to the size of the economic pie, and equality refers to how the pie is divided into individual slices.” b. Principle 2: The Cost of Something Is What You Give Up to Get It The cost of something you give up to get one is called the opportunity cost.An example of opportunity cost is the hour that you give up to study Economics to gain a better grade on the exam. c. Principle 3: Rational People Think at the Margin Optimal decision --> marginal benefit = marginal cost. d. Principle 4: People Respond to Incentives Incentive is something that makes people act. Say if the cost of an apple increases but the cost of a banana doesnt, people are going to buy more bananas. 1.3 How People Interact a. Priciple 5: Trade Can Make Everyone Better Off Trade allows one person or country to specialize in what they are good at because they can trade that good or service for something else at a lower cost.An example of this would be Japan trading computers for grain that is made in the United States. b. Priciple 6: Markets Are Usually a Good Way to Organize Eonomic Activity Amarket economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Market --> Buyer/Seller --> Invisiable Hand Prices are the instrument with which the invisible hand directs economic activity. In any markey buyers look at the price when determining how much to demand, and sellers look at the proce when deciding how much to supply. However, when goverments prevent prices form adjusting naturally to supply and demand, it impedes the invisible hand's ability to coordinate the decisions of the households and firms that make up an economy. c. Priciple 7: Governments Can Sometimes Improve Market Outcomes Government's role in in the market is to protect property rights, reduce social cost, and prevent market failure. Property rights is the ability of an individual to own and exercise control over scare resources. Market failure is a situation in which a market left on its own fails to allocate resources efficently. There are two causes to market failures – externality and market power.An externality is the impact of one person's actions on the well-being of a bystander.An example of an externality is pollution. Market power is the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices.An example of market power would be one firm or person owning the water well in a town and taking advantage of the situation by restricting the output of water so that they can charge a higher price. This is also known as a monopoly. 1.4 How the Economy as a Whole Works a. Priciple 8: A Country's Standard of Living Depends on Its Ability to Produce Goods and Services Productivity is the amount of goods and services produced by each unit of labor input. b. Priciple 9: Prices Rise When the Goverment Prints Too Much Money Inflation occures when the goverment produces too much money because the value of the money decreases. Inflation is an increase in the overall level of prices in the economy. c. Priciple 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment Ashort-run trade-off that society faces betwen inflation and unemployment is that increasing the amount of money in the economy stimulates the overall level of speding and thus the demand for goods and services increase. Higher demand may over time cause firms to raise their prices , but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services. By hiring more people the lower the unemployment rate. The short-run trade-off plays a key role in the analysis of the of the business cycle. The business cycle describes the fluctuations in econic activity such as employment and production. Chapter 2: Thinking Like an Economist 2.1 The Economist as Scientist Economists try to address theit subject with a scientist's objectivity. They approach the study of economy in much the same way as physicist approaches the study of matter and a biologist approaches the study of life: They devise theories, collect data, and then analyze the data collected in an attempt to verify or refute their theories. a. The Scientific Method: Observation, Theory, and More Observation Economists like any other scientist may observe something and be moved to develope a theory. Then to test the theory, the economist could collect and analyze data from different areas. Depending on the data, the economist will either start to debate the validity of the theory or become more confident in the validity of the theory. Unlike a physicist or a biologist, economics often find conducting experiments impractical. However, the substitute for laboratory experiments a economist pays close attention to the natural experiments offered by history. b. The Role ofAssumptions Assumtions can simplify the complex world and make it easier to understand. Econimists use different assumptions when studying the short-tun and the long-run effects of a change, leaving everthing else constant. c. Economic Models An economic models simplify reality to improve our understanding of it. d. Our First Model: The Circular-Flow Diagram The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms. In this model, the economy is simplified to include only two types of decision makers – firms and households. Firms produce goods and services using inputs, such as labor, land and capital. These inputs are called factors of production. Households own the factors of production and consume all the goods and services that the firms produce. The following diagram shows a circular-flow diagram. As you can see outerset of arrows shows the flow of dollars, and the inner set of arrows shows the corresponding flow of inputs and outputs. Households and firms interact in two types of markets. In the markets for goods and services, households are the buyers, and firms are sellers. In the markets for the factors of production, households are sellers, and firms are the buyers. e. Our Second Model: The Production Possibilities Frontier The productions possiblities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and available production technology. The production possiblities fontier shows the combinations of output of two goods. The following figure shows the production possibility fontier of ipads and iphones. If the company budgets 500,000 dollars per year, the company can make 5,000 ipads and no iphones or they can make 7,000 iphones and no ipads. The opportunity cost when they make 7,000 iphones is equal to 5,000 ipads. If a company wants to make both products they face a trade off. For example, if the company wants to make 500 iphones and 45000 ipads, they make 500 less ipads to make 500 more iphones.As long as the possibilities are on the possibiliy frontier it is efficient and feasable. If the possibilites are within the possibility frontier, such as 500 iphone and 3000 ipad, it is inefficient but feasable. However, if the possibility is outside of the possibility frontier, such as 1000 iphone and 5000 ipad, it is infeasable or unattainable. When moving from an inefficient possibility point the opportunity cost is zero. It is possible to shift the possibility frontier outward if there has been a technological advancement. This would then allow for unattainable possibilies to become attainable and/or efficient. f. Microeconomics and MacroeconomicsS The study of economics can be broken up into two levels – microeconomics and macroeconomics. Microeconomics is the study of how households and firms make decisions and how they interact in specific markets. Macroeconomics is the study of economy-wide phenomena. 2.2 The Economist as PolicyAdviser a. Positive versus NormativeAnalysis Positive statements are claims that attempt to describe the world as it is. Normative statements are claims that attempt to prescribe how the world should be. b. Economists in Washington c. Why Economists'Advise is NotAlways Followed 2.3 Why Economists Disagree a. Differences in Scientific Judgments b. Differences in Values c. Perception versus Reality 2.4 Let's Get Going Chapter 3: Interdependence and the Gains from Trade This is the chapter that was skipped over in class because it contained the same concepts from chapter 2 but if anyone else was wondering where did specialization, absolute advantage, and comparative advantage come from in the class lecture before winter break it is found here. I will skip over a few sections but they will be in the outline to assist in organization. 3.1 A parable for the Modern Economy 3.1.a Production Possibilities 3.1.b Specialization and Trade 3.2 Comparative Advantage: The Driving Force of Specialization 3.2.a Absolute Advantage AbsoluteAdvantage is the ability to produce a good using fewer inputs than another producer. 3.2.b Opportunity Cost and Comparative Advantage Opportunity cost is some item that must be given up to obtain some other item. Comparative advantage is the ability to produce a good at a lower opportunity cost than another producer. 3.2.c Comparative Advantage and Trade 3.2.d The Price of the Trade 3.3 Applications of Comparative Advantage 3.3.a Should Tom Brandy Mow His Own Lawn? 3.3.b Should the United States Trade with Other Countries? Imports are goods produced abroad and sold domestically. Exports are goods produced domestically and sold abroad. Chapter 4: The Market Forces of Supply and Demand “Supply and demand are the two words economists use most often – and for good reason. Supply and demand are the forces that make market economies work. They determine the quantity of each good produced and the price at which it is sold.” 4-1 Markets and Competition Supply and demand refer to the behaviour of people as they interact with one another in competitive markets. What is a Market? Amarket is a group of buyers and sellers for a good or service. Buyers determine the demand for the product and sellers determine the supply of the product. There are many forms of markets. What is Competition? Acompetitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price. For a market to reach the highest form of competition, a market must have the following characteristics: 1. The goods offered for sale are all exactly the same. 2. There are numerous buyers and sellers so that no single buyer or seller has any influence over the market price. Buyers and sellers in a perfectly competitive market are price takers – they accept the price that the market determines. 4-2 Demand The Demand Curve: The Relationship between Price and Quantity Demanded The quantity demanded is the amount of a good that buyers are willing and able to purchase. There are many factors that determine the quantity demanded of any good, but price plays a central role in determining the quantity demanded. The relationship between price and quantity demanded can be summed up by the law of demand. The Law of Demand is a claim that, other things being equal, the quantity demanded of a good falls when the price of a good rises. The best way to represent this relationship between the price of a good and the quantity demanded is through the demand schedule. The demand schedule is a table that shows the relationship between the price of a good and the quantity demanded. The following table shows the demand schedule for ice cream. Price Quantity Demanded $1.25 100 $2.25 80 $3.25 40 $4.25 20 As you can see the demand of ice cream falls as the price rises. Using the data from the table we can create the demand curve to illustrate how the quantity demanded of a good changes as its price varies. Because a lower price increases the quantity demanded, the demand curve slopes downward. The vertical access is the price and the horizontal axis is the quantity demanded. The line relating price and quantity demanded is called the demand curve. The demand curve is a graph of the relationship between the price of a good and the quantity demanded. Market Demand versus Individual Demand To properly analyze how markets work, we need to determine the market demand – the sum of all individual demands for a particular good or service. The following table shows the demand schedules for ice cream of two individuals in this market –Adam and Eve – and the market demand. Price Adam's Eve's Demand Market Demand Demand 1.00 5 7 12 2.00 3 6 9 3.00 1 5 6 The quantity demanded for the market is figured by adding the quantity demanded by all buyers at each price. To find the market demand curve we graph the market quantity demanded at each price. The following graph displays the market demand curve from the table above. The market demand curve shows how the total quantity demanded of a good varies as the price of the good varies, while assuming that all other factors that affect how much consumers want to buy are held constant. Shifts in the Demand Curve Because the market demand curve holds other things constant, it need not be stable over time. That is there are events that can cause the market demand curve to shift.Any change that raises the quantity that buyers wish to purchase at any give price shifts the demand curve to the right and is called an increase in demand. Any change that lowers the quantity that buyers wish to purchase at any given price shifts the demand curve to the left and is called a decrease in demand. For example, lets say that it has been discover that people who eat ice cream live longer, healthier lives. This discovery would raise the demand for ice cream. At any given price, buyers would want to purchase a larger quantity of ice cream, and the demand curve for ice cream would shift. The following graph illustrates this shift in demand. The arrow points the direction of the shift in the demand curve due to the discovery. Discoveries are just one variable that can shift the demand curve. The following can change the demand curve: • Price of the good itself ( movement along the demand curve) • Income ( Shifts the demand curve) ◦ Normal good is a good for which, other things being equal, an increase in income leads to an increase in demand. ◦ Inferior good is a good for which, other things being equal, an increase in income leads to an decease in demand. • Price of Related Goods (Shifts the demand curve) ◦ Substitutes are two goods for which an increase in price of one leads to an increase in demand for the other. ◦ Complements are two goods for which an increase in the price of one leads to a decrease in the demand for the other. • Tastes (shifts the demand curve) • Expectations (shift the demand curve) ◦ if price increases in the future then demand will increase today ◦ if price decreases in the future then demand will decrease today. • Number of Buyers (shift the demand curve) 4-3 Supply The Supply Curve: The Relationship between Price and Quantity Supplied The quantity supplied is the amount of a good that sellers are willing and able to sell. Price play a special role in quantity supplied. The relationship between price and quantity supplied by sellers can be explained by the law of supply. The law of supply claims that, other things being equal, the quantity supplied of a good rises when the price of the good rises. Just like with demand we can create a supply schedule to show the relationship between the price of a good and the quantity supplied. This table is called a supply schedule. The following table displays the supply schedule for Golden Brook, who manufactures ice cream. Price Quantity Supplied (millions) 4.00 100 5.00 200 6.00 300 7.00 400 We can display the quantity supplied at each price in a graph to illustrate how the quantity supplied of the good changes as its price varies. The following graph displays the supply curve for Golden Brook. Because a higher price increase the quantity supplied, the supply curve slopes upward. The supply curve is a graph of the relationship between the price of a good and the quantity supplied. Market Supply versus Individual Supply The market supply is the sum of the quantities supplied by all sellers at each price. Just like with the Market demand we can find the market supply by summing the quantities supplied by each seller (see table below graph) or summing the individual supply curves horizontally to obtain the market supply curve. The following graph illustrates the market supply curve of Golden Brooks and Blue Bell and the table below illustrates the market demand. Price Quantity Supplied (millions) 4.00 100 5.00 200 6.00 300 7.00 400 Price Golden Brook Blue Bell Quantity Quantity Supplied Quantity Supplied Supplied (millions) (millions) (millions) 4.00 100 150 250 5.00 200 250 450 6.00 300 450 750 7.00 400 400 800 Shifts in the Supply Curve The supply curve can also shift just like the demand curve.Any change that raises the quantity supplied at every price shifts the supply curve to the right and is called an increase in supply.Any change that reduces the quantity supplied at every price shifts the supply curve to the left and is called a decrease in supply. Lets say that the price of cream falls by $0.50 per gallon, what would happen to the supply curve? The following graph illustrates a shift in the supply curve due to the price decrease of cream. Because the price of cream decreased the producers of ice cream where able supply more ice cream which shifted the supply curve to the right. There are many other variables that can shift the supply and I have listed below. • Price of the good itself ( movement along the supply curve) • Input Prices (shifts the supply curve) • Technology (shifts the supply curve) • Expectations (shifts the supply curve) • Number of sellers (shifts the supply curve) 4-4 Supply and Demand Together Supply and demand determine the price and quantity of a good sold in market. Equilibrium When combining the demand curve and the supply curve there is a point that the two interest. This point is called the market's equilibrium is a situation in which the market price has reached the level at which quantity supplied equals quantity demanded. The equilibrium price is the price that balances quantity supplied and quantity demanded. The equilibrium quantity is the quantity supplied and the quantity demanded at equilibrium price. The following graph displays the demand curve and the supply curve of ice cream cones. At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to sell. If the market price is $10 per item and the quantity demanded is 100, but one company wants to charge more than $10 there would be a surplus.Asurplus is a situation that the quantity supplied is greater than quantity demanded.And if one company was to sell that item at $6 there would be a shortage.Ashortage is a situation that the quantity supplied is lesser then the quantity demanded. The following figure shows what the surplus and shortage would look like if ice-cream cones were sold at $2.50 and $1.50. With surplus sellers can lower their prices in response to the surplus and the market will reach the equilibrium. With shortage, sellers can raise their prices and the market will reach the equilibrium. This can be also summed up by the law of supply and demand. The law of supply and demand is a claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance. Three Steps to Analyzing Changes in Equilibrium Because the equilibrium contains both the demand and supply curve it will shift with any shift in the supply or demand curve. To assist with analyzing how an event will shift the equilibrium you will want to follow the steps listed below. 1. Decide whether the event shifts the supply or demand curve (or perhaps both). 2. Decide in which direction the curve shifts. 3. Use the supply-and-demand diagram to see how the shift changes the equilibrium price and quantity. Using the steps listed above we can determine what causes the equilibrium to shift. For example, in summer we have hot weather which makes people want to eat more ice cream and so the demand of ice cream increases. The graph below shows the change in equilibrium. The graph shows that the shift in demand shifted the equilibrium price from $2.00 to $2.50 and moved the the equilibrium quantity demanded from 7 to 10. To display the change in the equilibrium by a shift in supply, lets say that the sugar cane crop was destroyed due to a drought. The graph bellow shows that the supply curve shifted which caused the price of ice-cream cones to raise from $2.00 to $2.50 and thus the quantity demanded dropped from 7 to 4. Now, lets say that its summer but the price of sugar has raised. The supply and demand graph may look like the following: As we can see the demand for ice cream increased because it is summer but the supply of ice cream decreased because the price of sugar is higher. The price and quantity increase when demand increase is higher than the decrease in supply. This leads us to assume that whichever dominating change will determine how price and quantity change. Chapter 5: Elasticity and Its Application 5-1 The Elasticity of Demand Elasticity is a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants. The Price Elasticity of Demand and Its Determinants The price elasticity of demand is the measure of how much the quantity demanded of a good responds to a change in the price of that good. The equation for price elasticity of demand is computed as the percentage change in quantity demanded divided by the percentage change in price. Because a demand curve reflects the many economic, social, and psychological forces that shape consumer preferences we can state that the following influence the price of elasticity of demand: • Availability of Close Substitutes ◦ More substitutes the more elastic demand is. ▪ If price of elasticity of demand is equal to 1 it is called unit elastic. ▪ If price of elasticity of demand is greater than 1 it is called elastic. ▪ If price of elasticity of demand is less than 1 it is called inelastic. ▪ Less choice of close substitutes the less elastic demand is. • Necessities versus Luxuries ◦ Necessities tend to have inelastic demands. ◦ Luxuries tend to have elastic demands. • Definition of the Market ◦ Narrowly defined markets have elastic demands. ◦ Broadly defined markets have inelastic demands. • Time Horizon ◦ The shorter the time horizon the more inelastic demand. The longer the time horizon the more elastic demand. Computing the Price Elasticity of Demand The equation for price elasticity of demand is as follows: To display how this equation works lets say that a 10 percent increase in the price of an ice-cream cone cause the amount of ice-cream you buy to fall by 20 percent. Using the price elasticity of demand equation above we calculate that your elasticity of demand is 2. Which means that your demand is more elastic. Because the quantity demanded of a good is negatively related to its price, the percentage change in quantity will always have the opposite sign as the percentage change in price. We follow the common practice of dropping the minus sign and report all price elasticities of demand as positive numbers. The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities If you try to calculate the price of elasticity of demand between two points of the demand curve, you will notice that the elasticity from pointAto point B seem different from the elasticity from point B to pointA. One way to avoid this problem is to use the midpoint method for calculating elasticities. The midpoint method is as follows: To illustrate how this works lets say that Q1 is 10, Q2 is 5, P1 is $5, and P2 is $10. Using the midpoint method find the price elasticity of demand. It can be said that the demand is unit elastic because the price of elasticity is equal to 1. The Variety of Demand Curves The following graphs display the different types of elasticities. Graph e shows the perfect elastic demand which is common with goods that have many substitutes. Graph a shows the perfect inelastic demand which is common with goods without many substitutes. Total Revenue and the Price Elasticity of Demand Total revenue is the amount paid by buyers and received by sellers of a good. It can be computed as the price of good times the quantity sold. The amount area of the box under the demand curve equals the total revenue. For example, the total revenue for the demand curve below is 18. The impact of a price change on total revenue depends on the elasticity of demand. The following rules can assist in determining the type of change price has on total revenue: 1. When demand is inelastic, price and total revenue move in the same direction: If the price increases, total revenue also increases. 2. When demand is elastic, price and total revenue move in opposite directions: If the price increases, total revenue decreases. 3. If demand is unit elastic, total revenue remains constant when the price changes. Other Demand Elasticities Income elasticity of demand is a measure of how much the quantity demanded of a good responds to change in consumers' income. This can be computed as percentage change in quantity demanded divided by the percentage change in income. Because quantity demanded and income move in the same direction, normal goods have positive income elasticities while inferior goods have a negative income elasticities. Cross-price elasticity of demand is a measure of how much the quantity demanded of one good responds to a change in the price of another good. The equation for cross-price elasticity of demand is as follows: Substitute goods typically have positive cross-price elasticities. Whereas complement goods have a negative cross-price elasticities. 5-2 The Elasticity of Supply The Price Elasticity of Supply and Its Determinants Price elasticity of supply measures how much the quantity supplied responds to change in the price of that good. Computing the Price Elasticity of Supply The price elasticity of supply can be calculated by the following: For example, suppose that an increase in the price of milk from $2.85 to $4.67 a gallon raises the amount that dairy farmers produce from 9,000 to 13,000 gallons per month. Using the midpoint method to calculate the change in price as Percentage change in price = [(4.67-2.85)/[(2.85+4.67)/2]]*100 = [1.82/3.76]*100 = 0.484042553*100 = 48.40 percent Percentage change in quantity supplied = [(13,000-9,000)/[(9,000+13,000)/2]]*100 = 36.36 percent Price elasticity of supply = 48.40 percent / 36.36 percentage = 1.33 In this example, the elasticity of 1.33 indicated that the quantity supplied changes proportionately as much as the price. The Variety of Supply Curves
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