Microeconomics Notes ECON 12200
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Micro Time is Everything Opportunity cost = putting a concrete number on time being spent • ie: Opening a restaurant Expenses: buy the food, pay the waiters, rent the building, TIME You have to spend all of your time at the restaurant—you can’t have another job • Giving up some earnings—whatever your salary would be at that other job • That amount = opportunity cost How much is an hour of your time worth? • It’s worth whatever wage you would get if you spent that hour working • Same logic if you don’t work at all: If you did get a job, what would the wage be? The opportunitycost equation simply tells you what the cost of your time is, not how you should spend it or how you want to spend it ie: Grocery shopping, Cleaning, • Is time going to the store and browsing the aisles worth more or less than if you order grocery online and have them delivered? • Should you hire a cleaning service, rather than spending three hours every other week cleaning the bathrooms yourself? Depends on the opportunity cost of your time—more or less than the hourly rate for the service? Make sure you are outsourcing wisely • Would you do this chore for someone else if they paid you the market wage for it? Would you go grocery shopping for your friend if she paid you the delivery fee? • If not, you probably shouldn’t be doing it for yourself either. The higher the pay for a profession, the higher the opportunity cost • ie: Doctor Doctors are highly paid, therefore they have a high opportunity cost 1 Chapter 1 Scarcity: limited nature of society’s resources • ie: Chairs example Income Prices Time Economics: the study of how society manages its scare resources • how people decide what to buy; how much to work, save, and spend • how firms decide how much to produce; how many workers to hire • how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs • “The science of decision making under constraints” professors definition Efficiency: the property of society getting the most it can from its scarce resources Equality: benefits are distributed uniformly throughout society Opportunity Cost: whatever must be given up to obtain some item Rational people: people who systematically and purposefully do the best they can to achieve their objectives Marginal change: a small incremental adjustment to a plan of action Incentive: something that induces a person to act Market Economy: an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services Property rights: the ability of an individual to own and exercise control over scarce resources Market Failure: a situation in which a market left on its own fails to allocate resources efficiently Externality: impact of one person’s actions on the wellbeing of a bystander 2 Market Power: the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices Productivity: the quality of goods and services produced from each unit of labor input Inflation: an increase int he overall level of prices int he economy Business cycle: fluctuations in economic activity, such as employment production People Face Tradeoffs All decisions involve tradeoffs. Examples: • going to a party the night before your midterm leaves less time for studying • having more money to buy stuff requires working longer hours, which leaves less time for leisure Society faces an important tradeoff • Efficiency vs. Equality Efficiency: the property of society getting the most it can from its scarce resources Equality: benefits are distributed uniformly throughout society • Equality in this case can be interchangeable with equity Equity = fairness Tradeoff: to achieve greater equality, could redistribute income from wealthy to poor. but this reduces incentive to work and produce, shrinks the size of the economic pie The Cost of Something Is What You Give Up to Get It Making decisions requires comparing the costs and benefits of alternative choices The opportunity cost of any item is whatever must be given up to obtain it It is the relevant cost for decision making 3 Example: 2 Choices on transportation home for fall break Plane Bus 1. Financial Cost———— $400 ——————— $200 2. Time to get there —4 hours (one way)—— 24 hours (one way) 3. Value of time———$8/ hour——————$8/ hour For the plane: 8 (hours) x 8= 64 64 + $400= $464 For the bus 48 (hours) x 8= 384 384 + $200= %84 Plane is cheaper Find value of time $400 + 8x= $200 + 48x Solve for x $200= 40x x = $5 4 Rational People Think at the Margin Rational people • systematically and purposefully do the best they can to achieve their objectives • make decisions by evaluating costs and benefits of marginal changes incremental adjustments to an existing plan People respond to incentives Incentive : something that induces a person to act • ie: the prospect of a reward or punishment • Rational people respond to incentives Applying the principles You are selling your 1996 mustang. You’ve already spent $1,000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car “as is” In each of the following scenarios, should you have the transmission repaired? Explain. • Blue book value (what you would get for the car) is $6,500 if transmission works. $5,700 if it doesn't Benefit of getting the transmission fixed = $800 ($6500$5700) Get the transmission fixed. • Blue book value is $6000 if transmission works, $5500 if it doesn't Benefit = $500 You would lose $100 Trade Can Make Everyone Better Off Rather than being selfsufficient, people can specialize in producing one good or service and exchange it for other goods 5 Countries also benefit from trade and specialization • Get a better price abroad for goods they produce • Buy other goods more cheaply from abroad than could be produced at home Trade is not a zero sum game ——mutually beneficial 6 Markets Are Usually A Good Way to Organize Economic Activity Market: a group of buyers and sellers (need not be in a single location) “Organize economic activity” means determining what goods to produce how to produce them how much of each to produce who gets them Consumption good: consumed w/in a short time period • ie: coffee, food Capital goods: usually used by a firm or the gov in order to become more productive • ie public transportation USA = capital abundant country The invisible hand works through the price system: • the interaction of buyers and sellers determines prices • each price reflects the goods value to buyers and the cost of producing the good • prices guide selfinterested households and firms to make decisions that in many cases, maximize society’s economic wellbeing Is selfinterest always in the social interest? Governments Can Sometimes Improve Market Options Important role for govt: enforce property rights (with police, courts) People are less inclines to work, produce, invest, or purchase if large risk of their property being stolen Market failure: when the market fails to allocate society’s resources efficiency Causes of market failure: • externalities: when the production or consumption of a good affects bystanders 7 ie: pollution • market power: a single buyer or seller has substantial influence on parket price ie: monopoly Public policy may promote efficiency Govt may alter market outcome to promote equality 8 Distribution of Income in the US Huge variation in living standards across countries overtime: • average income in rich countries is more than then times average income in poor countries • the US standard of living today is about eight times larger than 100 yrs ago • the poorest 20% earned only 3% total income, the richest 20% earned 50% total income (distribution of income in the US in 2011) absolute poverty: fall below the ability to spend a $1 a day, relationship between the people and the poverty line relative poverty: how well you're doing compared to everyone else Quintile analysis: compare top distribution as bottom distribution The Country’s Standard of Living Depends on Its Ability to Produce Goods & Services The most important determinant of living standards: productivity, the amount of goods and services produced per unit of labor productivity depends on the equipment, skills, and technology available to workers other factors (labor unions, competition from abroad) have far less impact on living standards Chapter 2 The Economist as a Scientist Economists play two roles: • Scientists: try to explain the world • Policy Advisors: try to improve it In the first: economists employ the scientific method, the dispassionate development and testing of theories about how the world works Assumptions & Models Assumptions simplify the complex world, make it easier to understand 9 ie: to study international trade, assume two countries and two goods. • Unrealistic, but simple to learn and gives useful insights about the real world Model: a highly simplified representation of a more complicated reality • economists use models to study economic issues Ceteris Paribus: all else equal, change one thing at a time The Circular Flow Model (pencil example) A visual model of the economy, shows how dollars flow through market among households and firms Two types of “actors” • households • firms Two markets • the market for goods and services • the market for “factors of production” Factors of Production Labor • Labor: the work time and work effort that people devote to producing goods and services • the quality of labor depends on how skilled people are— what economists call human capital • Human capital is the knowledge and skill that people obtain from education, on thejob training, and work experience Factors of Production Land included all the “gifts of nature” that we use to produce goods and services • included all the things we call natural resources 10 • included minerals, water, air, wild plants, animals, birds, and fish as well as farmland and forests Capital: consists of tools, instruments, machines, buildings, and other items that have been produced in the past and that businesses now use to produce goods and services • included semifinished goods, office buildings, and computers • does not include money, stocks, and bonds. They are financial resources 11 Entrepreneurship: is the human resource that organizes labor, land, and capital • Entrepreneurs come up with new ideas about what and how to produce, make business decisions, and bear the risks that arise from these decisions For whom do we produce? • Factors of production are paid incomes: Rent income paid for the use of land Wages income paid for the services of labor Interest income paid for the use of capital Profit (or loss) income earned by and entrepreneur for running a business The Production Possibilities Frontier PPF: a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology • ie: two goods: computers & wheat One resource: labor (measured in hours) Economy has 50,000 labor hours per month available for production The PPF and Opportunity Cost Recall: the opportunity cost of an item is what must be given up to obtain that item • Moving along a PPF involved shifting resources (ie labor) from the production of one good to the other • Society faces a tradeoff: getting more of one good reward sacrificing some of the other • The slope of the PPF tell you the opportunity cost of one good in terms of the other 12 slope of the line (rise over run), the amount of the line rises when you move the right by one unit 13 The Shape of the PPF The PPF could be a straight line or bowshaped Depends on what happens to opportunity cost as economy shifts resources from one industry to the other • is opp cost remains constant, PPF is a straight line In the example, pop cost of a computer was always 10 tons of wheat • If opp cost of a goo rises as more of the good is produced, PPF is bowshaped Why the PPF might be bowshaped • so PPF is bow shaped when different workers have different skills, different opp costs of producing one good in terms of the other • the PPF would also be bow shaped when her is some other resource or mix of resources with varying opp costs Interdependence One of the ten principles of chapter 1 • Trade can make everyone better off • Trade is not a zero sum game with trading, a country can consume OUTSIDE of what they are able to produce Consumption under trade Suppose the US exports 700 tons of wheat to Japan, and imports 110 computers from Japan • Japan imports 700 tons of wheat and exports 110 computers How much of each good is consumed in the US? How much if each good is consumed in Japan? Where do these Gains Come from? 14 Absolute advantage: the ability to produce a good using fewer inputs than another producer The US has an absolute advantage in wheat: producing a ton of wheat uses 10 labor hours in the US vs 25 in Japan If each country has an absolute advantage in one good and specializes in that good then both countries can gain from trade The US also has an absolute advantage in computers (100 labor hours in US, 125 in Japan) Comparative Advantage: the ability to produce a good at a lower opportunity cost than another producer Which country has the comparative advantage in computers? To answer this question, you must determine the opportunity cost of a computer in each country • opportunity cost of good X = input required for one unit X/ input required for one unity Y USA • opportunity cost for one computer = 100 / 10 = 10 tons of wheat • in order to produce one computer it will cost us 10 tons of wheat Japan • opp cost for one computer =125 / 25 = 5 tons of wheat Japan has the comparative advantage bc it only costs them 5 tons of wheat to produce a computer instead of 10 tons in the US Absolute advantage is not necessary for comparative advantage! 15 Chapter 4 Markets and competition A market is a group of buyers and sellers of a particular product A competetive market is one with many buyer and sellers, each has a negligible effect on price In a perfectly competitive market: • All goods exactly the same • Buyers & sellers so numerous that no one can affect market price each is a “price taker” In this chapter, we will assume the market is perfectly competitive Demand The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal Demand schedule: a table that shows the relationship between the price of a good and the quantity demanded • downward sloping Market Demand The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price Demand Curve Shifters 16 The demand curve shows how price affects quantity demanded, other things being equal Decrease in demand leftward shift of the demand curve • The quantity demanded for individual products is less per price Increase in demand rightward shift of the demand curve • The quantity demanded for individual products is more per price Demand Curve Shifters: # of buyers Increase in numbers of buyers: increases quantity demanded at each price, shifts D curve to right Decrease in number of buyers; decreases quantity demanded at each price, shifts D curve to left Demand Curve Shifters: Income Demand for a normal good is positively related to income • Increase in income cases increase in quantity demanded at each price, shifts D curve to right • (Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left) Demand Curve Shifters: Prices of Related Goods Two goods are substitutes if an increase in the price of one causes an increase in demand for the other • ie: coke and pepsi Two good area complements if an increase in the price of one causes a fall in demand for the other • ie: burgers and buns Demand Curve Shifters: Tastes (Preferences) 17 Anything that causes a shift in tastes toward a good will increase demand for that good and shifts the D curve to the right Demand Curve Shifters: Expectations Expectations affect consumers buying decisions ie: • If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now • If the economy sours and people worry about hate future job security, demand for new cars may fall now 18 Supply The quantity supplied of any good is the amount that sellers are willing and able t sell Law of Supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal Supply schedule: a table that shows the relationship between the price of a good and the quantity supplied Market Supply vs Individual Supply The quantity supplied in the market is the sum of the quintiles supplied by all sellers at each price suppose Starbucks and Pete’s are the only two sellers of coffee Supply Curve Shifters: Input Prices ie: Wages, prices of raw materials A fall in input prices makes production more profitable at each output price so firms supply a larger quantity at each price and the S curve shifts to the right Supply Curve Shifters: Prices of Related Goods A Change in the price of one good can being a change in the supply of another good a substitute in production is a good that can be produced in place of another good ie: a truck and an SUV are substitutes in production in an auto factory • the supply of a good increases if the price of one of its substitutes in production falls a complement in production is a good that is produced along with another good • ie: cream is a complement in production of skim milk in a dairy the supply of a good increases if the price of its complements in production rises the supply of a good decreases if the price of one of its complements in production falls 19 Supply Curve Shifters: Technology (productivity) Technology determines how much inputs are required to produce a unit of output A costsaving technological improvement has the same effect as a fall in input prices, shifts S curve to the right Supply Curve Shifters: # of Sellers An increase in the number of sellers increases the quantity Terms for Shift vs Movement along Change in Supply: a shift in the S curve • occurs when a nonprice determinant of supply changes like technology or costs • Change in the quantity demanded: a movement along a fixed S curve occures when P changes • Change in demand: ashift in the D curve occurs when a nonprice determinant Price elasticity of demand is a measure of the extent to which the quantity demanded of a good changes when the price of the good changes To determine the price elasticity of a demand, we compare the percentage change in the quantity demanded with the percentage change in price Percentage changes in price • Suppose Starbucks raises the price of a latte from $3 to $5 a cup. What is the percentage change in price? • Percentage change in price = (New price Initial Price/ initial price) x 100 Midpoint method • to calculate the percentage change in the price divide the change in the price by the average price and then multiply by 100 20 • the average price is a the midpoint between the initial price and the new price, hence the name midpoint method • % change in price= (new price initial price/ (new price + initial price) /2) x 100 Percentage Change in Quantity Demanded • If Starbucks raises the prices of a latte, the quantity of lattes demanded decreases $3 15 lattes $5 5 lattes percentage change quantity = (new initial/ (new + initial)/2) x 100 • When the price rises, the quantity demanded decreases along the demand curve 21 • Similarly, when the price falls the quantity demanded increases along the demand curve Elastic and inelastic demand Demand is elastic if the percentage change in the quantity demanded exceeds the percentage change in price Demand is unit elastic if the % change in the quantity demanded equals the % change in price The Price Elasticity of Demand Demand is inelastic if the % change in the QD is less than the % change in price Demand is perfectly elastic if the QD changes by a very large % in response to an almost zero % change in price Demand is perfectly inelastic if the quantity demanded remains constant as the price changes Influences on the Price Elasticity of Demand Influences on the price elasticity of demand fall into two categories • Availability of substitutes • Proportion of income spent Availability of Substitutes • The demand for a good is elastic if a substitute for it is easy to find Luxury vs Necessity • A necessity has poor substitutes so the demand for a necessity is inelastic • A luxury has many substitutes, so the demand for a luxury is elastic Narrowness of Definition • The demand for a narrowly defined good is elastic • The demand for a broadly defined good is inelastic Time Elapsed Since Price Change 22 • The longer the time elapsed since the price change, the more elastic the demand for the good is Proportion of Income Spent • A price rise, like a decrease in income, means that people cannot afford to buy the same quantities • The greater the proportion of income spent on a good, the more elastic is the demand for the good Government Policies That Alter the Private Market Outcome Price Controls • Price Ceiling: legal maximum on the price of a good or service ie: rent control • Price Floor: legal minimum on the price of a good or service ie: minimum wage Taxes: the government can make buyers or sellers pay a specific amount on each unit Price Ceiling Equilibrium price is above ceiling> illegal • therefore ceiling is a binding constraint • creates shortage bc high QD and low QS Two developments occur • Black market: illegal market that operates alongside a government regulated market • Increased search activity Inelastic small shortage Elastic large shortage 23 price elasticity of supply & demand get more elastic as time goes on 24 What determines the Size of the DWL Which goods or services should get govt tax to raise the revenue it needs? • One answer: those with the smallest DWL When is the DWL small vs large? • Turns out it depends on the price elasticities of supply and demand Recall: • The price elasticity of demand (or supply) measures how much QD (or QS) changes when P changes Elasticity and the DWL of a tax Would the DWL of a tax be larger if the tax were on: • Breakfast cereal or sunscreen? • Hotels rooms in the short run or hotel rooms in the long run? • Groceries or meals at fancy restaurants? Income tax and Social Security tax The Personal Income Tax • In 2012, the personal income tax raised: $1.3 trillion for the federal government About $260 billion for state and local govt • The amount of income tax that a person pays depends on her or his taxable income and on the tax rates • Taxable income is total income minus a personal exemption and a standard deduction Marginal tax rate is the percentage of an additional dollar of income that is paid in tax Average tax rate is the percentage of income that is paid in tax A tax can be a progressive, proportional, or regressive 25 • Progressive tax is a tax whose average rate increases as income increases • Proportional tax is a tax whose average rate is constant at all income levels • Regressive tax is a tax whose average rate decreases as income increases How big should the govt be? A bigger govt provides more services but requires higher taxes which cause DWL’s The larger the DWL from taxation, the greater the argument for smaller govt The tax on labor income is especial important bc its the biggest source of govt revenue higher the taxes are, the more dead weight loss when the tax is larger, increasing it causes tax revenue to fall market gets smaller as tax increases consumers or producers leave if the tax is too high, causing a change in behavior and change in the market Laffer Curve Shows the relationship between the size of the tax and tax revenue Two conflicting principles: the benefits principle the abilitytopay principle Benefits Principle: proposition that people should pay taxes equal to the benefits they receive from public goods and services • those who benefit most pay the most Abilitytopay principle: proposition that people should pay taxes according to how easily they can bear the burden rich people can more easily bear the burden of providing public goods than a poor person can, so rich pay higher taxes than poor 26 Then Why All the Opposition to Trade? Recall one of the Ten Principles from Chapter 1: • Trade can make everyone better off The winners from trade could compensate the losers and still be better off Yet, such compensation rarely occurs The losses are often highly concentrated among a small group of people 27 Other Benefits of International Trade consumers enjoy increased variety of goods producers sell to a larger market, ay achieve low costs by producing on a larger scale competition from abroad may reduce market power of domestic firms, which would increase total welfare trade enhances the flow of ideas, facilitates the spread of technology around the world Tariff: An example of Trade Restriction Tariff: tax on imports ie: Cotton shirts • P(w) = $20 • Tariff T= $10/shirt • Consumers must pay $30 for an imported shirt, • so domestic producers can charge $30 per shirt • In general the price facing domestic buyers and sellers = p(w) + t International Trade Restrictions Winners, Losers and the Social Loss from a Tariff When the US gov imposes a tariff on imported tshirts Import Quota: a quantitative limit on imports of a good Mosty has the same effects as a tariff: • raises prices, reduces quantity of imports • Reduces buyers welfare • Increases sellers welfare 28 Tariff creates revenue for gov. quota increases profits for the foreign producers of the imported goods who can sell them at higher price or gov could auction license to import capture this profit as revenue. usually it does not Export Subsidies • a subsidy is a payment made by the gov to a producer • and export subsidy is a payment made by the gov to a domestic producer of an exported good • export subsidies bring gains to domestic producers, but hey result in over production in the domestic economy and underproduction in the rest of the world and so create a DWL The jobs argument • Trade destroys jobs in industries that compete with imports Economists’s response: • total unemployment does not rise and imports rise, bc job losses from imports re offset by job gains in export industries The national security argument • an industry vital to national security should be protected from foreign competition to prevent dependence on imports that could be disrupted during wartime Economist’s response • Fine, if trade restrictions based on true security needs The infantindustry argument • a new industry argues for temporary protection until its mature and can compete with foreign firms 29 Economists response: • difficult for gob to determine which industries will eventually be able to compete and whether benefits of establishing these industries exceed cost to consumers of restricting imports. • besides, if a firm will be profitable in the long run, it should deb willing to incur temporary losses The unfaircompetition argument • producers argue their competitors in a noter country have an unfair advantage ie due to gov subsidies Economists response: • we should welcome imports of lowcost products subsidized by the other country’s taxpayers • the gains to our consumers will exceed the losses to our producers Chapter 10 Markets are usually a good way to organize economy activity In absence of market failures, the competitive market outcome is efficient, maximizes total surplus One type of market failure: • Externality: the uncompensated impact of one person’s actions not he wellbeing of a bystander • Externalities can be negative or positive, depending on whether impact on a bystander is adverse or beneficial ie: 30 • Air pollution from a factory • the neighbors barking dog • latenight stereo blasting from the dorm next to yours • noise pollution from construction projects • health risk to others from secondhand smoke • talking on cell phone while driving makes the roads less safe for others Analysis of a Negative Externality Supply curve shows private cost, the costs directly incurred by sellers Demand curve shows private value, the value to buyers (the prices they are willing to pay) The market equilibrium maximizes consumer + producer surplus External costs= value of the negative impact on bystanders • $1 per gallon (value of harm from smog, greenhouse gasses) Social cost= private + external cost “Internalizing the Externality” Internalizing the externality: altering incentives so that people take account of the external effects of their actions In our example, $1/gallon tax on sellers makes sellers costs= social costs When market participants must pay social costs, market equilibrium= social optimum (Imposing the tax on buyers would achieve the same outcome; market Q would equal optima Q) Positive Externalities: 31 Int he presence of a positive externality, the social value of of a good includes • private value the direct value to buyers • external benefit the value of the proactive impact on bystanders the social optimal Q maximizes welfare • at any lower Q, the social value of additional units exceeds their costs • At any higher Q, the cost of the last unit exceeds its social value important characteristics of goods a good is excludable if a person can be prevented from using it • excludable: ie: tacos, wifi • nonexcludable: ie: radio, national defense a good is a rival in consumption if one person’s use of it diminishes th voter’s use • rival: tacos • non rival: an MP3 file of beyonce’s latest single Different kinds of goods private goods: excludable, rival in consumption • ie food public goods: not excludable, not rival • ie national defense • free rider: a person who receives the benefit of a good but avoids paying for it common resources: rival but not excludable • ie: fish in the ocean club goods: excludable but not rival 32 • ie: cable Public Goods if the benefit of a public good exceeds the cost of providing it, govt should provide the good and pay for it w a tax on people who benefit problem: measuring the benefit is usually difficult costbenefit analysis: a study that compares the costs and benefits of providing a public good cost benefit analyses are imprecise, so the efficient provision of public goods is more difficult than that of private goods Some important public goods • national defense • knowledge created through basic research • fighting poverty Common Resources like public goods, common resources are not excludable • cannot prevent free riders from using • little incentive for firms to provide • role for gov: seeing that they are provided additional problem with common resources: rival in consumption • each person’s use reduces others’ ability to use • role of gov: ensuring they are not overused Tragedy of the Commons 33 the tragedy is due to an externality: allowing ones flock to graze on the common land reduces its quality for other families people neglect this external cost, resulting in oversees of the land 34