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The Fundamental Principles of Economics 1. Scarcity (limited/fixed in supply ) is inescapable 2. Risk is unavoidable 3. Therefore, all persons must make choices (opportunity cost—the next best choice) a. Unlimited wants/fixed resources 4. Incentives matter 5. People generally act in their own self-interest a. Adam Smith—Wealth of Nations; “Invisible Hand” motivated by self-interest 6. There is often more than one way to produce things a. Cobb-Douglass Production Function i. Q=f(K,L) ii. Output=f(capital, labor) b. Can produce things in capital intensive or labor intensive i. In US, typically cheaper to produce in capital goods ii. Why is Gas more expensive than Orange Juice even though Gas is more complicated to make (bc Gas is a capital good) c. Where you produce: productivity relative to wage rate 7. Voluntary exchange is mutually advantageous 8. It is wealth, not poverty which has causes a. Focus on why nations become rich and not why they become poor b. What creates wealth Specialize and Trade (not because they have a lot resources) 9. Public policies have primary effects & secondary effects, some good, some bad a. Primary effects: intended b. Secondary effects: unintended consequences c. Examples: i. “Path to hell is paid with good intentions” ii. In Indonesia: if you save a drowning woman, you’ll be put to death 1. Telling woman in Indonesia to learn how to swim because no one will save you---results Woman in Indonesia rarely drown iii. ↑Minimum Wage---helps lower-income people, but ↑unemployment iv. Seatbelt law---↓traffic fatality, but ↑traffic accidents 10. In the end, economic laws tend to prevail Topics studied under microeconomics  Individuals (maximize utility/satisfaction)  Firms/Entrepreneurs (maximize profit)  Politicians (maximize votes/power) Intelligence—comes from “inter” and “lego” meaning “between” and “to choose” 2 Most Noble Profession Plumber/AC Repair (“menial” jobs that are often overlooked); Manager of McDonalds (promoting trade btwn nations) Economics Overview  Economics: o a social science (lack of experimentation in the macro level for it to be a hard science), o which attempts to explain how individuals, firms, & nations allocate (how to distribute) o scarce resources (limited ‘inputs’ or ‘factors of production’) o among competing interests (opportunity cost)  Positive vs Normative o Positive: fact, “what is” o Normative: value judgment, “what should” or “ought to be”  Macro vs Micro o Macro (Sectors of Macro)  aggregate (sum, total, whole)  π=inflation o Micro (Levels of Micro)  individuals, entrepreneurs, firms, industries  politicians and voters  π=profit  = TR (total revenue) – TC (total cost)  = P (price) * Q (quantity) – ATC (avg total cost) * Q (quantity)  = Q(P-ATC)  *fun fact: P > AVC (keep operating) not necessarily when P < ATC  Three Questions o What --- Allocation of inputs (resources) o How --- Production (capital or labor intensive) o For whom --- Allocation of outputs (products, goods)  Four Systems o Capitalists (free market/Laissez-faire)---Pricecontrols o Command and Control---Government controls o Compromise---Price AND Government both control o Customary (traditional)---Tradition (everything by tradition)  Four Factors of Production & Their Respective Payments o Land---Rent o Labor----Wage o Capital---Interest National Income (for MACRO) o Entrepreneurship---Profit  Circular Flow Diagram---movement of cash and goods/services  Six Economic Warnings---choose one with less variables 1. Post hoc ergo propter hoc ‘fallacy (after this ∴ because of this fallacy) (time series data) 2. Fallacy of Composition---what works for one person doesn’t mean it’ll work for group 3. Correlation ≠ Causation (cross sectional data) 4. Violation of “ceteris paribus” (all else equal) 5. Inclusion of an Irrelevant Variable 6. Exclude a Relevant Variable Demand, Supply, Equilibrium & Disequilibrium  Demand 1. Definition 1. The various quantities 2. Of a good or service 3. Which a consumer 4. Is both willing and able 5. To purchase 6. At various prices 7. Per unit of time 8. Ceteris paribus 2. Graph Price (independent) 3. Formula Quantity (dependent) t  Q =f(P)  Inverse relationship 4. Change in quantity demanded vs Change in Demand  Quantity Demanded: movement ALONG the curve/changes only by price  Non-price parameters of demand (shifts entire line):  # of buyers  Expectations of buyers  Price of other goods, income, # of burgers, tastes, preferences, advertising, price expectations of burgers  Income: NORMAL vs INFERIOR  Price of other goods: COMPLIMENTS “and” vs SUBSTITUTES “or” vs UNRELATED  Supply 1. Definition 1. The various quantities 2. Of a good or service 3. Which a producer 4. Is both willing and able 5. To produce 6. At various prices 7. Per unit of time 8. Ceteris paribus 2. Graph Price (independent) Quantity (dependent) 3. Formula s  Q =f(P)  Positive relationship 4. Change in Quantity Supply (price changes---move along line) vs Change in Supply  Non-price parameters of supply (change in supply---shifts entire line)  # of sellers  Expectations of sellers  The price of inputs  Technology  Taxes/subsidies  Weather  Comparative Statics 1. Identify initial equilibrium price and quantity 2. Identify the shifts  DLor DR  SLor SR 3. Identify the new equilibrium price and quantity  Price Floors and Price Ceilings  Price Flooring  MIN value  govt sided with the seller  Must be set above the eq price to be effective and must result in a surplus  Price Ceiling  MAX value  govt sided with the buyer  Must be set below the eq price to be effective and must result in shortage  Shifting Both Demand & Supply  DRand S R P Q↑  DLand S L P Q↓  DRand S L P↑ Q  DLand S R P↓ Q Production Possibilities  Perfectly Adaptable (perfectly straight line/constant ratio---unlikely) for Good #2 Quantity Made Quantity Made for Good #1  Specialized Resources---resources catered to a certain good (increasing opportunity cost from shifting between amount of goods produced)---the graph is bowed out for Good #2 Quantity Made Quantity Made for Good #1  Consumer Sovereignty  Production Efficiency---Any point on PPF  Allocative Efficiency---The best combination of goods on the PPF according to demand/supply  Unattainable---any point to the right of the PPF  Inefficient---any point to the left of the PPF Elasticity---a measure of usefulness Price Elastic Unit elastic Inelastic Quantity 2− 1  % change in quantity = %∆Q* = ∗ 100 (2+ 1/2  % change in price = %∆P* = 2− 1 ∗ 100 (2+ 1/2 %∆Q ∗  |%∆P ∗|> 1 it is elastic or = ∞ it is perfectly elastic o Uptight/sensitive o Does not need a huge discount to get people’s attention ∗  |%∆Q∗|< 1 it is inelastic or = 0 it is perfectly inelastic %∆P o Insensitive o Should be more dramatic in price decrease to get people’s attention %∆Q∗  |%∆P∗|= 1 it is unit elastic  # of Substitute o Many Substitutes---Elastic o Few Substitutes---Inelastic  Time o Long Run---Elastic o Short Run---Inelastic  Product o Narrowly Defined---Elastic o Broadly Defined---Inelastic  % of Budget o Large Part---Elastic o Small Part---Inelastic  Luxury vs Necessity o Luxury---Elastic o Necessity---Inelastic Elasticity  Elasticity and Total Revenue o If demand is elastic at P, then decreasing price will increase total revenue o If demand is inelastic at P, then increasing price will increase total revenue o If demand is unit elastic at P, then raising/lowering price does not have a huge effect  Elasticity and Taxation o Raise tax by $0.50, Q* from 1200 units to 1000 units, P* from 0.80 to 1.20 o Tax Revenue = $0.50 * 1000 units = $500 o Tax incidence = 80 o Consumer Burden = $0.40 * 1000 units = $400 o Producer Burden = $0.10 * 1000 units = $100  CB > PB = Inelastic  CB < PB = Elastic  PB = CB = Unit Elastic o Dead Wight Loss = $0.50 * (1200 – 1000) units * ½ = $50 Type General Formu∗a Sign or magnitude important Interpretation Price %∆Q (based on demand curve so sign >1 elastic OR ∞ perf elastic %∆P ∗ is always negative) <1 inelastic OR 0 perf inelastic Magnitude =1 unit elastic Income %∆Q ∗ Sign (+) = normal good ∗ (-) = inferior %∆Income Advertising %∆Q ∗ (Hopefully) positive (-)=BAD AD ∗ Magnitude %∆ ∗ Cross-price %∆ Sign (+) = substitutes %∆ ∗ (-) = compliments (0) = unrelated