EBF 200 Study Guide (Exam 1)
Lesson 1 – Thinking About Economics
Economics is the social science that concerns itself with how people make consumption and production choices in a world of endless wants and limited means.
An axiom is an assumed statement, sort of a "first principle" that is not, or need not be proved. It is a basic understanding of how things happen.
Axiom 1: Things that we want to consume more of are called economic goods or, usually, just "goods". The opposite of a good is a "bad," which is something that we want less of.
Axiom 2: All goods are scarce. In economics, scarce simply means that something is not limitless.
Axiom 3: Wants are unlimited. This is perhaps a polite way of saying, "people are greedy" in the sense that people almost always prefer to consume more goods than less.
Principles of Economics
∙ 1 – People face tradeoffs
∙ 2 – The cost of something is what you give up to get it ∙ 3 – Rational people think at the margin
∙ 4 – People respond to incentives
∙ 5 – Trade can make everyone better off
∙ 6 – Markets are usually a good way to organize economic activity ∙ 7 – Governments can sometimes improve market outcomes
People are rational utility maximizers.
The scientific method is a structured method of attempting to answer questions about the world about us. In the case of economics, the "world"
refers to the multitude of consumption and production decisions made by every person and firm every day.
Scientific method: observe, hypothesize, test, repeat first step. This is the key aspect of the scientific method: we need to have a hypothesis that is testable and falsifiable. If something is not falsifiable, it cannot be tested scientifically.
We also discuss several other topics like What is the function of cardiovascular system?
A positive question is one that can be falsifiable, or put more simply, has a yes/no answer.
A different kind of question does not ask how the world is, but how it "should be." These are referred to as "normative" questions.
For example, speaking again about minimum wage laws, a positive question would be "Do higher minimum wages cause higher rates of youth unemployment?” whereas a normative question might be "Are higher minimum wages better for young workers?"
For somebody to hold a property right, they have to have both Use Rights and Disposal Rights. That is, for something to be considered a person's property, you have to have the right to use it as you please, and the right to exchange it for something else, or to dispose of it some other way, which can include destroying the good in question.
Positive economics – study of facts If you want to learn more check out Ethnographic methods
Normative economics – concerned with what ought to be. Don't forget about the age old question of What Tylenol Did?
Marginal analysis – how something changes if we change some other thing a little bit. Don't forget about the age old question of Who is carolus linnaeus?
Lesson 2 – Markets: Demand
In centrally planned economies, government agents are responsible for making decisions about production, distribution, and pricing of goods. In markets, these decisions are decentralized, placed in the hands of millions of individuals, who invest their time, money and ideas into the manufacture
or sale of some product, with the hope of making a profit and enhancing their own lives.
The great problem of attempting to centrally plan an economy is that of information.
An economy without any form of government intervention is referred to as "laissezfaire." This is a French term that translates to "let it happen," and the United States is certainly not a laissezfaire economy.
Thus, when speaking of market economies, it is best to refer to them as "competitive markets," and not as free markets, because they certainly are not free in the sense that market participants are not unrestricted agents. We also discuss several other topics like What is covariance?
Declining Marginal Utility: the more we have consumed of something, the less value the next unit of consumption holds for us.
Don't forget about the age old question of What are the Androgenic effects?
Figure 2.1 Supply and Demand diagram
Credit: B. Posner
Parts of the Supply and Demand Diagram:
∙ Xaxis: measurement of quantity
∙ Yaxis: measurement of price
∙ Demand curve: functional relationship between price and quantity people are willing to buy
∙ Supply curve: functional relationship between price and
quantity that firms are willing to sell
∙ Intersection point of supply and demand curves: “market equilibrium”
Markets are dynamic (i.e. always changing).
Individual demand curve – how much a person would pay for a certain amount.
Product homogeneity – identical product
"First Law of Demand": demand curves are downward sloping. This means that if a seller raises the price, fewer of an item will sell.
(Total) Happiness/ Consumer Surplus = Good happiness – total cost Marginal happiness = good happiness (x) – good happiness (x1)
You keep buying a good until your marginal good happiness is LOWER than the cost of the good.
Giffen Good: This is a mythical good with an upward sloping demand curve, meaning that more sell if the price is higher.
***Demand curves ALWAYS slope downwards (“First Law of Demand”) because of DECLINING MARGINAL UTILITY.
Elasticity: we are interested in how much a quantity demanded or supplied will change when some “force” is applied to the market.
The price elasticity of demand is defined as the percentage change in quantity divided by the percentage change in price:
A percent change in some variable is: [(value 2 value 1)/value 1] x 100%. Midpoint elasticity is:
η = [(Q2 Q1)/(Q1 + Q2)]/[(P2 P1)/(P1 + P2)]
Point elasticity at a point (Q1, P1) then we would calculate it as: η=(ΔP/ΔQ)x(P1/Q1)
In economics, we say that a good is inelastic if its quantity demanded does not change very much with a change in price. On a supply and demand diagram, an inelastic good is one that has a very steep slope.
Figure 2.5 Elasticity’s of various demand curves
Credit: Barry Posner
Typically, goods that are thought of as necessities will be very inelastic. That is, no matter how expensive they get, we will still buy them. Health care, staple foods and gasoline are goods with low elasticity.
If a demand curve is perfectly vertical (up and down) then we say it is perfectly inelastic.
If the curve is not steep, but instead shallow, then the good is said to be “elastic” or “highly elastic.” This means that a small change in the price of the good will have a large change in the quantity demanded.
If the curve is perfectly flat (horizontal), then we say that it is perfectly elastic.
Luxury goods are often very elastic – if the price increases a little, then people will move over to something else.
NOTE: The lower the elasticity (numerical) value, the closer to inelasticity i.e. consumption drop wont be too low.
Some sample elasticity (from the real world):
1 Gasoline: 0.04
2 Sugar: 0.31
3 Long distance phone service (1995): 0.35
4 Tires: 1.20
5 Movies: 3.70
Causes of Demand Shifts
∙ 1 – Population
∙ 2 – Income
“Income elasticity of demand”:
η (I) = %ΔQ/%ΔI
The income elasticity can either be positive or negative.
If it is positive, then the quantity demanded increases as income increases (a positive number divided by a positive number).
Economists usually refer to goods that have positive income elasticity as “normal” goods. Luxury cars have positive income elasticity.
It is also possible for a good to have negative income elasticity. This means that as I increase, Q decreases (a negative number divided by a positive
number = a negative number). As a person makes more money, their marginal utility from consuming a certain good declines. We might say that used cars, or economy cars, have negative elasticity.
Economists as “inferior” goods refer to goods that have negative income elasticity.
∙ 3 – Price of other goods
A complement is a good that you consume in addition to the good in question, with the condition that without one, you would not consume the other. For example, cars and gasoline (and tires) are all complements.
A substitute is a good that you would consume instead of the good in question. As mentioned above, ramen noodles and steaks can be thought of as substitutes: if you are eating a lot of one, you are likely not eating a lot of the other.
“Crosselasticity of demand”:
η (XY) = %ΔQ (X)/%ΔP (Y)
(Where X and Y are subscripts denoting the two goods in question.)
∙ 4 – Expectations
∙ 5 – Taste (or Fashion)
∙ 6 – Information
Figure 1: Petroleum demand curve
Figure 2: Natural Gas Demand Curve
Lesson 4 – Market Dynamics
The demand curve the relationship between the maximum amounts that somebody will pay for a certain quantity of goods, which is defined by the marginal utility derived from consuming that good.
Supply curve which defines the relationship between the minimum amounts that a firm is willing to accept for a certain quantity of goods, derived from the notion of marginal cost and declining marginal returns to a factor.
The point where the supply and demand curves intersect is called the Market Equilibrium. Equilibrium is defined as some condition that is not prone to change from minor perturbances.
The equilibrium is not a number, but an ordered pair of numbers: a price and a quantity. We typically use the notation (Q*, P*) to describe equilibrium.
Perfect competition is based upon four assumptions:
Nobody has market power. This means that nobody has the ability to change the market equilibrium price based on their own behavior. This means that there must be many buyers and many sellers. We also say, “everybody is a pricetaker,” which means that they must accept the market price, and they are not “pricesetters.”
Perfect information. This means two things – first, that everybody knows what their own choices are, and also that they know everything about the product.
Product homogeneity. This means that in a specific market, all products are identical. In real life, no two things are identical, and people make “differentiation” between products. But, for purposes of modeling, we assume that certain groups of products are close enough to being the same.
Free entry and exit. This means that people only make production and consumption decisions based upon their own free will. They are not forced to buy or sell things they do not want. It also means that people
are not negatively affected by other people’s market decisions.
There are two reasons why we have trade in markets:
∙ People trying to maximize their utility
∙ Firms trying to maximize their profits, which increases what they can pay their owners, who can then convert these profits into utility bearing goods to help maximize owner utility.
An individual's maximum willingness to pay is sometimes called the "reservation price."
In a perfectly competitive market, we hold that an individual (a consumer, or demander, or buyer) will freely enter into a market to exchange money for goods, and that a firm (a producer, or supplier, or seller) will take that cash in exchange for the good in question.
The consumer surplus is the sum of the net wealth gain for each buyer in the market.
This is what we call the “profit maximizing condition”: profit is maximized when the quantity produced is sufficient to make MC = P*. Make less than this quantity, and you are leaving money (and profit) on the table. Make more than this quantity, and you will be losing money on some items. In either case, making the MC = P* quantity will give you the most amount of profit. Hence, the use of the term “profit maximizing” condition.
To get the total profit generated from all goods sold in the market, add the “net gain” up for all goods from sellers, and we have the total wealth created by the market for producers. This is called Producer Surplus (PS).
The sum of the consumer surplus and the producer surplus is the total wealth created by a market.
The demand curve can be shifted to the right. This is the same as shifting it upwards, or the same as shifting it diagonally away from the origin. This is called an “outward” shift of the demand curve, as it moves out from the origin.
An outward shift of the demand curve results in a larger quantity of goods
being sold, and at a higher price.
The supply curve is a functional relationship (there’s that phrase again), which describes the marginal cost of producing a given quantity of goods. If the curve shifts down, it means that the cost of producing the nth instance of the good has decreased. Repeating myself: costs have come down. Producers are willing to accept a lower payment for each unit of the good in question because it does not cost as much to produce.
We know that Q* increases, because the supply curve movement makes the
equilibrium move to the right, and then the demand curve movement also makes the equilibrium move to the right. Both changes push quantity in the same direction, so we know that Q* must increase. But P*, we don’t know.
So, to summarize, if D shifts up and S shifts down, then Q* increases and the change in P* is undetermined.
Lesson 5 – Market Power
When we talk about "perfect," we mean that this form of market gives the best possible outcome with respect to "aggregate wealth," which is just consumer surplus and producer surplus added together.
If a market produces less than the optimal (maximum) amount of wealth, then we say we have "market failure."
In situations where a private economic transaction negatively affects a person who is not a willing participant in that economic transaction, we have something called an "externality."
In reality, in many situations, somebody in the market has some power to change prices through their individual actions. These include: Monopoly: only 1 seller.
Duopoly: 2 sellers.
Oligopoly: a few sellers.
Monopsony: only 1 buyer.
A monopoly is a market with only one seller. A monopolist is free to set prices or production quantities, but not both because he faces a downward sloping demand curve. He cannot have a high price and a high quantity of sales – if he has a high price, people will buy less.
There are three ways that a monopoly can exist and/or persist: ∙ All of some resource is owned by some firm (e.g., DeBeers and diamonds).
∙ The government allows a monopoly to exist (not common in
the US, but in many countries things like airlines or railways are governmentdesignated monopolies).
∙ A Natural Monopoly exists (e.g., your local power company). We will talk more about natural monopolies a bit later in the course.
If a firm obtains an inordinate market share due to offering a product that many people want to buy, we do not have a monopoly.
In a competitive market, wealth is the sum of the red, yellow, and blue areas. In the monopoly market, it is just the sum of the yellow and red areas. The blue area is wealth that is lost to society. This area is the Deadweight Loss.
Instead of looking at the producer's marginal revenue function to define the monopoly quantity and price, we instead look at the consumer's "marginal expenditure," the amount of money he has to spend to obtain one more unit of a good, which changes with his purchase decision.
Profit (producer surplus) is the area below the equilibrium price and above the supply curve. The supply curve is the same thing as the Marginal Cost curve for the firm.
At which value of Q (m) is the producer surplus (the profit, the red area) the largest?
Answer: it is maximized when supply = MC = MR (Marginal Revenue). Generally, if a Demand curve is given as P = a bQ, then MR = a 2bQ.
So, it is important to remember two things:
∙ The marginal revenue (MR) is a line with the same intercept as the demand curve, but with a slope twice as steep; and
∙ When MR = MC, profit is maximized.
Price discrimination refers to charging different prices to different customers. In a perfectly competitive market, this is not possible, because there are many firms competing for the price; but it is possible in a monopoly, because people have no other place to buy.
There are three general ways in which price discrimination can occur: ∙ Firstdegree (or perfect) price discrimination refers to charging a different price to every consumer. This is not very possible in real life. ∙ Seconddegree price discrimination refers to charging different amounts for different sized purchases. If a car rental company buys 300 cars from a dealer, they will get a better price than if I go and try to buy 1 car. This is known as bulk pricing.
∙ Thirddegree price discrimination refers to breaking up the market into different groups who have different demand curves and maximizing profit in each different market subgroup. For example, a restaurant might have a special children’s menu, with small portions at lower prices. Adults would not want to buy these small portions,
but forcing adults to buy adult portions for children might make the customers decide to stay home.
If the HHI is less than 1000, a market is generally considered to be not concentrated.
If the HHI is between 1000 and 1800, a market is thought to be “moderately concentrated.”
If the HHI is above 1,800, the industry is considered to be highly concentrated.
In the third case, governments will often act to reduce concentration. This is called an “antitrust” action.
A cartel is a form of market power in which suppliers collude with each other to manipulate supply.
The oil in many parts of the world was controlled for about half a century by a group of American and European companies called the "Seven Sisters."
OPEC is playing a bit of a game, whereby they are trying to find the price that is as high as possible without spurring the development of alternatives. OPEC tries to "stagemanage" the price of oil to provide the longterm maximum profit.
Lesson 6 – Other Market Failures
In a competitive market, we expect firms to compete with each other until the point where marginal cost increases to match the demand curve at the equilibrium point. For this situation to be able to occur, we make the
assumption of upwardsloping supply (marginal cost) curves. This is a reasonable assumption to make, because as production of some good increases, the cost will increase because we have to compete with other goods for consumption of the inputs.
Figure 3: Natural Monopoly
If we have one firm only, the marginal cost of supply is P1, which is lower than the duopoly price, P2. This means that having two firms in a market ends up with the firms having to charge a higher price than if only one firm existed. In this case, it is efficient, or “natural,” for there to only be one firm in the market. This is why decliningmarginalcost industries are called natural monopolies.
The Problem of Natural Monopoly
The normal avenue for regulation of natural monopolies is the public utilities commission. These exist at the statelevel in the United States, and at the national level in many other countries. Utilities commissions are given the task of making sure that utility companies make enough money to stay in business, but not enough to enjoy monopoly profits.
For a firm to be able to survive in a natural monopoly, it must be able to charge at least the average cost.
Therefore, the goal of the utility commission is to make sure that a utility is able to charge no higher than average cost. Typically, a private utility will
file what is called a “rate case” to a utility commission, which is basically a statement of what the utility needs to earn in order to stay in business and ensure reliable service. It is the role of the utility commission to examine the rate case and see if it believes that the utility is exaggerating its costs.
One of the problems of regulating a utility is that they usually are allowed to earn a certain percent accounting profit on their capital base. That is, the larger the capital base (the more buildings and pipes and power plants, and so on) that a utility owns, the more money it is able to earn.
Thus, insiders can profit greatly by buying or selling stock using information that is not available to the general public. This is what is referred to as an “information asymmetry.”
When will a seller take advantage of such a situation and “ripoff” a consumer? The short answer is: when it pays to do so. More specifically, there are some conditions:
6 When you can’t find out that you are being cheated until after the purchase is made, and
7 When you can’t punish them once they’ve cheated you:
∙ When you only make a single purchase from the seller. For example, most people only purchase a house a few times in a lifetime and very rarely more than once from the same seller.
∙ When there is only one seller. If you feel like you’re getting ripped off by the power company or the only gas station for 20 miles, you cannot easily take your business elsewhere.
∙ When getting cheated is a small enough loss to not change your preferences.
∙ When you will never find out if you have been cheated. One example of this is people undergoing unnecessary surgery. This why they say you should always get a second opinion.
This type of auction is called a "common value" auction, because the value of the good is the same, regardless of who wins. This is because the value is measured in revenues or profits available to the developer.
Some auctions can be considered "private value" auctions, whereby the value of the good is not merely some financial payoff, but perhaps an esthetic choice, such as for a piece of fine art, antique furniture or a classic car.
It is also important to note that these auctions were what are know as "first price" auctions, which are auctions in which the winner pays the amount that they bid. These can be contrasted with "secondprice" auctions, which are auctions in which the highest bidder wins, but pays the second highest amount bid. EBay is a type of secondprice auction, where the winner pays the second price plus some small increment.
Bidding an amount lower than what you think the good is worth is called "bid shading", and is now considered to be standard practice in firstprice auctions for unknown commonvalue goods.
I should note that secondprice auctions are often referred to as "truth telling", because in that auction format, bidding what you value the good at is the optimal strategy.