Econ 110 notes on chap 1-8
Econ 110 notes on chap 1-8 ECON 0110
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Date Created: 02/14/16
Color Code Video key term Econ Reading Chapter 1: How People Make Decisions (10 principals of economic) o The behavior of an economy reflects the behavior of the individuals making up the economy o There are 4 principles about individual decision making Principal 1: People Face Trade-offs o In order to get something that you want, you usually have to give up something else that you want o Classic trade off (guns and butter) the more a country spends on foreign defense (guns) the less it can spend on consumer goods (butter) o Efficiency vs equality (efficiency refers to the size of the economic pie and the equality to the way with which the pie is divided) o Economic Efficiency means that there is an absence of waste On the production side this means lowest cost produces On the consumption side this means the goods are being used by those who value it the highest o Economic Equity – Benefits distributed uniformly among society’s members o When the government reduces the income of the rich by taxing more they create a disincentive to work overall making the pie smaller Principal 2: Cost of something is what you give up to get it o To find the true cost of something you must also include the time given up o opportunity cost – what you give up to get something college athletes could could drop and of school and make millions realize that the opportunity cost of the education is very high Principal 3: Rational people think at the Margin o Rational People – People who systematically and purposefully do the best they can to achieve their objectives o Marginal Change – a small incremental adjustment to a plan of action o Rational people often make decisions by comparing marginal benefits and marginal cost o Marginal Decision making – using the marginal change to help make a choice Principal 4: People Respond to Incentives o Incentive – something that induces a person to act Because rational people make decisions by comparing costs to benefits people respond to incentives o The change of incentives causes people to change their behavior Principal 5: Trade can make everyone better off o Although the Chinese are our direct competitors, the trade between our countries can result in mutual success o Trade allows each person to specialize in what they do best or are most capable of o Allows consumer to experience a greater verity of goods Principal 6: Markets are usually a good way to organize economic activity o Centrally planned economies Economies controlled by the government Government is in charge of the economic well-being of society o Market economies An economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services o Prices are the instrument which Adam Smith’s “invisible hand” controls the economy Prices adjust through supply and demand to guide the invisible hand of the market to reach the maximize the well being of society When the government attempts to prevent prices from adjusting naturally the economy sufferers Principal 7: Government can sometimes improve market outcomes o Government needs to to enforce the rules and maintain institutions namely property rights o Property rights – the ability of an individual to own and exercise control over scarce resources o Two reasons for a government to intervene in the economy Promote efficiency or equality o Market failure – when the market left on its own fails to efficiently allocate resources Externality – the impact of one person’s actions on the well-being of a bystander (unpriced cost of benefit) - Externality can cause market failure Ex pollution (the market on its own could fail to take pollution into account) Market Power – the ability of a single economic factor (or small group of factors) to have a substantial influence on market prices Market manipulations through monopolies o Equality – the invisible hand does not ensure everyone’s well being o The government does not always make decisions that benefit the economy as a whole Principal 8: A country’s standard of living depends on its ability to produce goods and services o Productivity - The quality of goods and services produced from each unit of labor input o Higher productivity = higher standard of living o You can raise productivity by ensuring that workers are well educated, have the tools they need to produces goods and services and have access to the best technology Principal 9: Prices raise when the government prints too much money o Inflation- an increase in the overall level of prices in the economy o high inflation imposes various costs on society so a goal is to keep it low Principal 10: Society faces a short fun trade-off between inflation and unemployment o Positive line of short term reasoning that results in printing more money Increasing money stimulates the level of spending in an economy (higher demand for goods and services) Encourages companies to hire more workers and produce more goods (in long term causes prices to be raised) More hiring lowers unemployment o Business cycle – fluctuations in economic activity, such as employment and productions o Policy makers need to balance inflation and unemployment See chapter summery for break down of the ten principles of economics Chapter 2 Scientific Method o Economists use the scientific method They draw their conclusion using theory and observation However, it is challenging for economists to use experiments They therefore use history as evidence o Economists make assumptions or simplifications in order to analyze and explain events Circular flow diagram o A visual model of the economy that shows how dollars’ flow through markets among households and firms o Offers a simple way of explaining the interaction between firms and household in the economy o productions possibilities o a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology o An economy is said to be efficient if its production is on (not inside) the frontier o Because of limited resources point c is not feasible o Point d is an inefficient economy o Shows the opportunity cost of the production of one object in terms of another Microeconomics o The study of how household and firms make decisions and how they interact in markets Macroeconomics o The study economy-wide phenomena, including inflation, unemployment and economic growth Economists role o Economist can play the role of either scientist or policy advisor o In each position they use different language o Positive statements - claims that attempt to describe the world as it is can be judged by data o Normative statements – claims that attempt to prescribe how the world should be Involve value judgments as well Chapter 3: Interdependence and the Gains from Trade Comparative Advantage: The driving force of specialization o Absolute advantage – the ability to produce a good suing fewer inputs than another producer o Opportunity cost – whatever must be given up to obtain some item o Comparative advantage – the ability to produce a good at a lower opportunity cost than another producer o It is possible for one person to have absolute advantage in both goods but it is impossible for one person to have a comparative advantage in both goods o The opportunity cost of one good is the inverse of the opportunity cost of the other o Unless the opportunity costs are equal one person will have the comparative advantage in one good and one person will have it in the other o Trade can benefit everyone in society – NOT ZERO SUM o For both parties to gain from trade the price of the trade must lay between the the two opportunity costs Should the us trade with other countries? o Imports – goods produced abroad and sold domestically o Exports - goods produced domestically and sold abroad o Trade allows all countries to achieve greater prosperity Chapter 4: The Market Forces of Supply and Demand Market - A group of buyers and sellers of a particular good or service o Markets can be both organized and unorganized Competitive Market – a market in which there are many buyers and many sellers so that each has a negligible impact on the market price o For a market to be perfectly competitive Goods offered must be identical Buyers and sellers must be so numerous that no single buyer or seller has influence o In a perfect market buyers and sellers are called price takers o Not all goods are sold in perfectly competitive markets When a market has only one seller it is called a monopoly The Demand Curve: the relationship between price and quantity demanded o Quantity demanded – the amount of a good that buyers are willing and able to purchase o Law of Demand – the claim that, other things being equal, the quantity of demand is inversely proportional to the price of the good demanded o Demand schedule – a table that shows the relationship between the price of a good and the quantity demanded o Demand curve – a graph of the relationship between the price of a good and the quantity demanded the demand curve can increase and decrease based and a few major factors Income Normal good – a for for which an increase in income leads to an increase in demand Inferior Good – a good for which an increase in income leads to a decrease in demand Price of related goods Substitutes – two goods for which an increase in the price of one leads to an increase in the other Complements – two goods in which an increase in the price of one leads to a decrease in the demand for the other Taste Usually not explained by economists Expectations If you expect prices or income to change it could effect spending habits Number of buyers o Market demand – sum of individual demands for a particular good or service Supply curve: the relationship between price and quantity supplied o Quantity supplied – the amount of a good that sellers are willing and able to sell o Law of supply – the claim that the quantity supplied of a good is proportional to the price of the good o Supply schedule – a table that shows the relationship between the price of a good and the quantity supplied o Supply curve – the graph of the relationship between the price of a good and the quantity supplied o Market supply – the sum of supply for all sellers o Supply curve – a graph of the relationship between the price of a good and the supply of that good the supply curve can increase and decrease based and a few major factors Input prices If input prices (what goes into making a good) rise supply falls because production is less profitable Supply of a good is negatively related to the input prices of that good Technology Can reduce costs and therefor raise supply Expectation If a firm expects prices to rise in the future, it may decrease present supply Number of Sellers Equilibrium – a situation in which the market price has reach the level at which quantity supplied equals quantity demanded o Equilibrium price The price that balances quantity supplied and quantity demanded At the 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 Market clearing price o Equilibrium quantity The quantity supplied and the quantity demanded at the equilibrium prices Surplus – the situation in which quantity supplied is greater then quantity demanded Leads to cost cuts with increases demand Shortage – the situation in which quantity demanded is greater then the quantity supplied Leads to price raises o Law of supply and demand the claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance Steps to analyzing the effect of an event on the equilibrium quantity and price o Decide weather the event shifts the supply or demand curve o Decide in which direction the curve shifts o Use the supply and demand diagram to see how the shift changes equilibrium price quantity In market economies prices are the mechanism for rationing scare resources Chapter 5: Elasticity and its application Price elasticity of demand o A measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price Measures how willing consumers are to buy less of the good as its price rises Factors which effect elasticity of demand o Availability of close substitutes o Necessities versus luxuries Necessities –inelastic demand Luxuries – largely more elastic demand o Definition of the market The broader the category the more inelastic the demand because it is less likely there with be close substitutes o Time horizon Goods have more elastic demand over longer time horizons How to calculate price elasticity percentagechange∈quantitydemanded o Price elasticity of demand = percentagechange∈price o The midpoint method Solves the problem that price elasticity changes based on the based Computes the elasticity by dividing the change by the average of the initial and final levels (Q 2Q )1(Q 2Q )12 Price elasticity of demand = (P 2P )1(P 2P )12 The variety of demand curves o Demand curves are classified by elasticity Demand is elastic when elasticity >1 Demand is inelastic when elasticity is <1 If elasticity = 1 demand has unit elasticity The flatter the demand curve that passes through a point – the great the elasticity of demand Perfectly inelastic – demand is stable regardless of price Perfect elastic – very small changes in price lead to huge changes in demand Total revenue o The amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold o Total revenue = P x Q o If demand is Inelastic then price and total revenue move in same direction o If demand is elastic then price and total revenue move in opposite directions o If demand is unit elastic total revenue remains constant when price changes Just because demand is linear does not guarantee that elasticity will be Income Elasticity of demand o a measure of how much the quantity demanded of a good responds to a change in consumers’ income, computed as the percentage change in a quantity demanded divided by the percentage change in income percentagechange∈quantitiydemanded o incomeelasticityof demand= percentagechange∈income o inferior goods have negative income elasticity Cross price elasticity of demand o Measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in price of the second good. o percentagechange∈quantitiydemanded of good1 cross−priceelasticityof demand= percentagechange∈priceof good 2 o cross price elasticity is negative of complements and positive in substitutes Elasticity of supply o Price elasticity of supply – a measure of how much the quantity supplied of a good responds to a change in the price of that, computed as the percentage change in quantity supplied divided by the percentage change in price o Depends on the flexibility of the sellers to change the amount of the goods they produce o The time period being consisted is a key determinant o priceelasticityof supply=centagechange∈quantitiy supplied percentagechange∈price The variety of supply curves o Supply curves are not always linear Chapter 6: Supply, Demand and government Controls on prices o Price ceiling – a legal maximum on the price at which a good can be sold If a price ceiling is above the equilibrium there is no effect If the price ceiling is below the equilibrium price there is a shortage Shortages generate their own price regulating mechanisms o Can lead to discrimination and are usually unfair o Price Floor – a legal minimum on the price at which a good can be sold If the price floor is below the equilibrium price there is not effect If the price floor is above the equilibrium price there is a surplus o Economist usually oppose price ceilings and price floors There are other ways to equalize the economy such as subsidies Taxes o Tax incidence – the manner in which the burden of a tax is shared among participants in a market o If the tax is levied on sellers the supply curve shifts up (to the left) by the exact amount of the tax while the price increases, the sellers do not get to keep more money so the market shrinks the tax discourages market activity buys and sellers share the burden of the tax o How taxes on buyers affect market outcomes The tax shifts the demand curve for the ice cream to the left by the exact amount of the tax Reduces the size of the ice cream market Buyers and sellers share the burden o Regardless of who the tax is levied against it is shared the same by both parties o Who bares the burden A tax burden falls more heavily on the side of the market that is less elastic Chapter 7: consumers, producers and the efficiency of markets Welfare economics – the study of how the allocation of resources affects economic well-being Consumer surplus o The amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it Benefit buyers receive as they themselves perceive it o Willingness to pay – the maximum amount that a buyer will pay for a good The marginal buyer - the buyer who would leave the market first if the price rose o the area below the demand curve and above the price measures the consumer surplus in the market Producer surplus o The amount a seller is paid for a good minus the seller’s cost of providing it o Cost - the value of everything a seller must give up to produce a good Includes opportunity cost and supplies o Marginal seller – seller who would leave the market first if the price were lowered o The area below the price and able the supply curve measures the producer surplus in a market o Market efficiency o Total surplus - Sum of consumer and producer surplus Consumer surplus = value to buyers- amount paid by buyers Producer surplus = amount received by sellers- cost to sellers Total surplus = (value to buyers-amount paid by buyers)+ (amount received by sellers-cost to sellers) Total surplus = value to buyers – cost to sellers o Efficiency – the property of a recourse allocation of maximizing the total surplus received by all members of society Inefficient if Goods are not being produced at the lowest price Goods are not being sold to those who value them the most o Equality – the property of distributing economic prosperity uniformly among the members of society o Laissez faire – let people do as they will Free markets allocate the supply of goods to buyers who value them most highly Free markets allocate demand for goods to sellers who can produce them for the lowest cost Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus Assumes perfectly competitive market o Market power – lack of a perfect market Assumes no externalities Market failure o Inability to allocate resources efficiently Chapter 8: Application: the costs of taxation Deadweight loss of taxation -The fall in total surplus that results from a market distortion, such as a tax o Taxes cause deadweight losses because they prevent buyers and sellers from realizing some farther gains from the trade o Tax places a wedge between the quantity sold between the amount buyers pay and sellers receive o TxQ= total tax revenue If T = size of tax and Q=quantity of good sold o Taxes distort incentives and this cause markets to allocate resources inefficiently o The more elastic the supply or demand curve the grater the deadweight tax o The deadweight loss rises faster then the size of a tax and can result in decreasing tax revenue P Q o Total Deadweight loss = (¿¿1−P )(¿¿1−Q 2) 2 2 ¿ ¿
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