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What is Economics

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Title: What is Economics


1
What is Economics?
  • The Science of Choice.
  • It studies the distribution of scarce resources
    among unlimited wants.
  • Why do we say scarce resources
  • labour, land, capital and entreprenourship

2
  • Economic questions
  • What goods and services should be
    produced and in what quantities?
  • How should they be produced?
  • Who consumes the goods and services?

3
Self Interest vs. Social Interest
  • Could it be possible that when each and one of
    us makes choices that are in our own best
    interest, it turns out that these choices are
    also the best for society as a whole
  • How to answer this question?
  • There has been progress in some issues like
  • Privatization
  • Globalization
  • The New Economy
  • 9/11
  • Corporate Scandals
  • HIV/AIDS
  • Natural Resources
  • Water Shortages
  • Unemployment
  • Deficits and Debts

4
Economic Way of Thinking
  • Choice, Tradeoff, and Opportunity Cost.
  • Because the resources available are scarce,
    individuals must choose among their wants, and by
    doing so they face an opportunity cost.
  • There is no free lunch.
  • Opportunity Cost is the highest-valued
    alternative forgone, not all the possible
    alternatives forgone

5
  • Margins and Incentives.
  • The important thing is the benefit of a bit more
    or a bit less.
  • Marginal Benefit
  • Marginal Cost
  • The way to decide MGB MGC
  • Incentives affect these margins
  • higher wages, lower prices.

6
There is Macro and Microeconomics
  • Macro is the study of the aggregated economy.
  • Micro is the study of the components of the
    economy.
  • What is the difference?
  • Imagine a football team
  • MACRO It might be having a winning or loosing
    season.
  • MICRO The statistics of the offense and the
    defense.

7
Three important concepts
  • Normative Statements What it ought to be, these
    statements depend on values and cannot be tested.
  • More foreign aid should be given to African
    countries, so they can reduce the levels of
    poverty.
  • Positive Statements What it is. These statements
    say what is currently believed about the way the
    world operates.
  • Poverty levels in African countries are high.
  • Ceteris Paribus!!

8
Resources and Wants
  • Economics studies the distribution of
    scarce/limited resources among unlimited wants.
  • What are those scarce/limited resources
  • Labour Time and effort.
  • Land natural resources (air, water, surface, and
    minerals)
  • Capital goods that were produced and that now
    are used to produce more goods. (planes,
    buses, trucks, highways, production lines)
  • Entrepreneurship ideas, management.

9
  • Also because scarcity of resources, there are
    certain combinations of goods and services that
    can be produced, and some that cannot.
  • The boundary between these two sets is defined by
    the Production Possibility Frontier (PPF).
  • In other words, the PPF shows the different
    combinations of goods and services that can be
    produced, using ALL the available resources.

10
Overhead transparency of Figure 2.1
  • Production Efficiency
  • Trade-off give something to get something
  • Opportunity Cost it is a ratio
  • The decrease in the qty produced of one good
    The increase in the qty produced of
    another good
  • Increasing Opportunity Cost The PPF is bowed
    outward because resources are not all equally
    productive in all activities. Example
    Football and Soccer players

11
Overhead transparency of Figure 2.2
  • Marginal Cost Is the opportunity cost of
    producing one more unit of a good or service.
    (Usually increasing)
  • Marginal Benefit Is the benefit that a person
    receives from getting one more unit of a good or
    service. (Usually decreasing)

Overhead transparency of Figure 2.3
12
What is the difference between the two concepts?
(marginal benefit and opportunity cost)
  • Both are measured in units of a good (forgone)
  • But they are different
  • Opportunity Cost of good A how much of good B an
    individual MUST forgo to get another unit of good
    A.
  • Marginal Benefit of good A amount of good B that
    an individual is WILLING to forgo to get one more
    unit of good A.

13
The efficient use of resources?
Overhead transparency of Figure 2.4
  • Marginal Benefit Marginal Cost
  • The goods and services that are produced are the
    ones that are valued the most. Nothing more or no
    other good can be produced, without giving up
    something that is valued even higher.

14
Economic Growth
  • Defined as the expansion of production.
  • What influences economic growth
  • Technological Change better ways to produce
    something
  • Capital Accumulation the growth of capital
    resources.
  • New Natural Resources (very rare, like oil on the
    moon)
  • An example Figure 2.5 (page 38) and computers
    factory example.

15
Gains from Trade
  • First we need to get a couple of concepts under
    our belts
  • Specialization Concentrating on the production
    of only one or some goods.
  • Comparative Advantage to be able to produce
    something at a lower opportunity cost. Sometimes
    depends on the characteristics of the economy
    (like geographical features)
  • The best way to understand this is with an
    exercise.

16
Gains from Trade
  • Graphs 2.7 and 2.8
  • If each individual produces a combination instead
    of specializing in one good, then the benefits
    are less than when both agents specialize and
    trade between them.
  • Absolute advantage One agent can produce more
    goods than anybody else with the same resources.
  • Productivity makes some changes, but it is not
    possible for anyone to have a comparative
    advantage in everything.
  • Dynamic Comparative Advantage Learning by doing.

17
The Market Economy It is all about incentives
  • Property Rights
  • Markets
  • Circular Flows in the Market Economy
  • (figure 2.10)
  • Coordinating Decision.

18
Demand and Supply How Markets Work?
  • Prices and quantities demanded fluctuate, but in
    different ways, sometimes together and other
    times in different directions.
  • Price and Opportunity Cost
  • There is a relation between them that is called
    a relative price.
  • Demand and supply determine relative prices,
    and in our studies the word price means relative
    price!!

19
DEMAND
  • The good is wanted, can be afforded and there is
    a definite plan to buy it.
  • The quantity demanded of a good or service is the
    amount that consumers plan to buy during a
    given time period at a particular price.
  • The quantity demanded is measured as an amount
    per unit of time

20
DEMAND
  • There are many factors that affect the buying
    plans / demand
  • price of the good
  • prices of related goods
  • expected future prices
  • income
  • population
  • preferences
  • Lets take a look at the first factor
  • The law of Demand Other things remaining the
    same, the higher the price of a good, the smaller
    is the quantity demanded.

21
DEMAND
  • Why higher prices means lower demand?
  • The answer for this comes from two logical
    effects that everybody knows already, but they do
    not know their names
  • Substitution effect When the price of a good
    rises, other things being the same, its relative
    price (opportunity cost) rises. And consumers
    start looking for substitutes, buying less of the
    original good.
  • Income effect Facing higher prices, with
    unchanged income, people cannot afford to buy all
    the things they previously bought. The
    quantities demanded of at least some goods and
    services must be decreased. (Normally, the good
    whose price has increased is one of those bought
    in smaller quantity).

22
DEMAND
  • Demand this term refers to the ENTIRE
    relationship between the quantity demanded and
    the price of a good, and it is illustrated by a
    demand curve and a demand schedule.
  • Demand Curve It shows the relationship
    between the price of a good and the quantity
    demanded, when all other influences on consumers
    planed purchases remain the same.
  • Demand Schedule It lists the quantities
    demanded at each different price when all the
    other influences on consumers planned purchases
    remain the same.
  • We graph the demand schedule as a demand curve
    with the quantity demanded on the horizontal axis
    and price on the vertical axis. (figure 3.1)

23
DEMAND
  • Quantity demandedRefers to a point on the
    demand curve, the quantity demanded at a
    particular price.
  • A Change in DEMAND When any factor that
    influences the buying plans changes, other than
    the price of the good, there is a change in
    demand. If demand increases, then the demand
    curve shifts to the right and the quantity
    demanded is greater at each and every price.
    (figure 3.2)

24
DEMAND
  • What factors bring a change in demand?
  • Prices of related goods
  • substitutes
  • complements
  • Expected future prices
  • if good can be stored (special cases)
  • Income
  • normal good
  • inferior good
  • Population
  • size
  • structure
  • Preferences

25
DEMAND
  • A Change in the Quantity Demanded Vs a Change
    in Demand (figure 3.3)
  • Movement along the demand curve shows a change
    in the quantity demanded.
  • Shifts of the demand curve shows a change in
    demand.
  • So what happens when the factors or the price
    change? (table 3.1)

26
SUPPLY
  • The good can be produced, profit can be made from
    producing it and there is a definite plan to
    produce it and sell it.
  • The quantity supplied of a good or service is the
    amount that producers plant to sell during a
    given time period at a particular price.
  • The quantity supplied is measured as an amount
    per unit of time

27
Supply
  • There are many factors that affect the selling
    plans / supply
  • price of the good
  • prices of the resources used to produced the
    good.
  • prices of related goods produced
  • expected future prices
  • number of suppliers
  • technology
  • Lets take a look at the first factor
  • The law of Supply Other things remaining the
    same, the higher the price of a good, the greater
    is the quantity supplied.

28
SUPPLY
  • Why higher prices means greater supply?
  • The answer comes from a well known term,
    increasing marginal cost. As the quantity
    produced of any good increases, the marginal cost
    of producing the good increases.
  • So, when the price increases, producers are
    willing to incur in higher marginal costs to
    increase production. The higher price brings
    forth an increase in the quantity supplied.

29
SUPPLY
  • Supply this term refers to the ENTIRE
    relationship between the quantity supplied and
    the price of a good, and it is illustrated by a
    supply curve and a supply schedule.
  • Supply Curve It shows the relationship
    between the price of a good and the quantity
    supplied, when all other influences on producers
    planed sales remain the same.
  • Supply Schedule It lists the quantities
    supplied at each different price when all the
    other influences on producers planned sales
    remain the same.
  • We graph the supply schedule as a supply curve
    with the quantity supplied on the horizontal axis
    and price on the vertical axis. (figure 3.4)

30
SUPPLY
  • Quantity suppliedRefers to a point on the
    supply curve, the quantity supplied at a
    particular price.
  • A Change in SUPPLY When any factor that
    influences the selling plans changes, other than
    the price of the good, there is a change in
    supply. If supply increases, then the supply
    curve shifts to the right and the quantity
    supplied is greater at each and every price.
    (figure 3.5)

31
SUPPLY
  • What factors bring a change in supply?
  • Prices of productive resources
  • Prices of related goods produced
  • substitutes in production
  • complements in production
  • Expected future prices
  • Number of producers
  • size
  • structure (could be)
  • Technology

32
SUPPLY
  • A Change in the Quantity Supplied Vs a Change
    in Supply (figure 3.6)
  • Movement along the supply curve shows a change
    in the quantity supplied.
  • Shifts of the supply curve shows a change in
    supply.
  • So what happens when the factors or the price
    change? (table 3.2)

33
MARKET EQUILIBRIUM (figure 3.7)
  • Equilibrium price
  • Price at which the quantity demanded equals the
    quantity supplied
  • Equilibrium quantity
  • Quantity bought and sold at the equilibrium
    price.
  • Price is what regulates the market
  • price as a regulator
  • price adjustments

34
MARKET EQUILIBRIUM (figure 3.7)
  • A shortage forces the price up
  • A surplus forces the price down
  • The best deal available for buyers and sellers
  • In equilibrium, buyers pay the highest price
    they are willing to pay for the last unit bought
    and sellers receive the lowest price at which
    they are willing to supply the last unit sold.

35
MARKET EQUILIBRIUM (figure 3.8 and 3.9)
  • A Change in Demand There is a shift (left or
    right) of the demand curve, and there is an
    increase or decrease in the quantity supplied.
    But there is no change in supply, the supply
    curve does not move!.
  • If the demand increases, both price and
    quantity supplied increase
  • If the demand decreases, both price and quantity
    supplied decrease
  • A Change in Supply There is a shift (left or
    right) of the supply curve, and there is an
    increase or decrease in the quantity demanded.
    But there is no change in demand, the demand
    curve does not move!.
  • If the supply increases, price falls and
    quantity demanded increases
  • If the supply decreases, price rises and
    quantity demanded decreases

36
MARKET EQUILIBRIUM (figure 3.10 and 3.11)
  • If both, demand and supply, change
  • Change in the same direction
  • If both increase the quantity increases and
    price increases, decreases or remains constant
  • if both decreasethe quantity decreases and price
    increases, decreases or remains constant
  • Change in opposite direction
  • If demand decreases and supply increases the
    price falls and quantity increases, decreases or
    remains constant
  • if demand increases and supply decreases the
    rice rises and the quantity increases, decreases
    or remains constant
  • Some examples

37
MARKET EQUILIBRIUM
  • A Mathematical Note
  • Demand and Supply Curves The equation of the
    lines
  • Demand Supply
  • P a - bQd P c dQs
  • What information is contained in these two
    expressions?
  • What is a, b, c and d?

38
MARKET EQUILIBRIUM
  • Solving a system of equations two equations for
    two unknown variables.
  • A simple Example
  • P 800 - 2Qd (this is the _______ curve,
    why? ____________)
  • P 200 1Qs (this is the _______ curve,
    why? ____________)
  • Solving the system we get P and Q (
    means equilibrium)

39
Elasticity
  • The elasticity is a unit free measure of
    responsiveness, and there are many kinds of
    elasticities that are used in economics
  • Price elasticity of demand
  • Cross elasticity of demand
  • Income elasticity of demand
  • Elasticity of supply
  • Why does it matter? (some examples and figure
    4.1)

40
Price Elasticity of Demand
  • This is a units free measure of the
    responsiveness of the quantity demanded of a good
    to a change in its price when all other
    influences on buyers plans remain the same.
  • Why do we use a units free measure?
  • How to calculate the price elasticity of demand
    (figure 4.2)
  • We want to get a relation between percentage
    changes of quantity demanded and percentage
    changes in price (so this is a ratio).
  • Price Elasticity of demand change in
    Quantity demanded
  • change in price
  • NOTE The changes in price and quantity demanded
    are expressed as percentage changes of the
    average price and the average quantity, we do it
    to get a more precise measurement. We ignore the
    minus sign, because we are interested in the
    magnitude of the price elasticity of demand (we
    use the absolute value)

41
Price Elasticity of Demand
  • Inelastic or elastic demand, what is this???
    (figure 4.3)
  • This is just a simple way of expressing the
    degree of responsiveness of the demand towards
    price changes.
  • Perfectly elastic demand price changes but
    quantity does not, elasticity is 0.
  • Unit elastic percentage change in price is
    equal to the percentage change in quantity
    demanded, so the elasticity is equal to 1.
  • Inelastic demand between the two above, the
    percentage change in price is greater than the
    percentage change in quantity demanded, so the
    elasticity is between 0 and 1.
  • Perfectly elastic demand quantity demanded
    changes by an infinite amount in response of a
    tiny price change, so the elasticity is equal to
    infinite.
  • Elastic demand this is between unit elastic and
    perfectly elastic, and it means that the
    percentage change in quantity demanded is greater
    than the percentage change in price, so the price
    elasticity is greater than 1.
  • Elasticity Along a Straight Line An Example
    (figure 4.4)

42
Price Elasticity of Demand
  • Another way to look at this is from the revenue
    generated by the sale of a good, this is call the
    Total Revenue Test. (figure 4.5)
  • If demand is elastic, a 1 percent price cut
    increases the quantity demanded sold by more than
    1 percent and total revenue increases.
  • If demand is unit elastic, a 1 percent price cut
    increases the quantity by 1 percent and total
    revenue does not change.
  • If demand is inelastic, a 1 percent price cut
    increases the quantity demanded by less than 1
    percent and total revenue decreases.
  • Your expenditure and your elasticity
  • If your demand is inelastic, then a 1 percent
    price cut increases the quantity you buy by less
    than 1 and your expenditure on the item
    decreases.
  • For unit elastic and elastic it is very straight
    forward, the first one doesnt change your
    expenditure on the item, while the later
    increases it.

43
Price Elasticity of Demand
  • What influences the Elasticity of Demand?
  • Closeness of substitutes
  • It depends on how we define them.
  • Necessities (Inelastic)
  • Luxuries (Elastic)
  • Proportion of income spent on the item
  • It is just like saying size matters doesnt it.
    (cars and candies)
  • Time elapsed since a price change
  • give me some time and I will find another thing
    that looks like that or can be used for the same
    thing.

44
Cross Elasticity of Demand (figure 4.7)
  • This is a measure of responsiveness of the
    demand for a good to a change in price of a
    substitute or complement, other things remaining
    the same.
  • Cross Elasticity of demand change in
    Quantity demanded
  • change in price of a substitute
  • or complement
  • NOTE The cross elasticity is positive for
    substitutes and negative for complements.

45
Income Elasticity of Demand (do graphs)
  • This is a measure of responsiveness of the
    demand for a good to a change in income, other
    things remaining the same.
  • Income Elasticity of demand change in
    Quantity demanded
  • change in income
  • NOTE The income elasticity can be positive or
    negative
  • Greater than one income elastic, normal good.
  • Between zero and one income inelastic, normal
    good.
  • Less than zero inferior good

46
Elasticity of Supply
  • Measures the responsiveness of the quantity
    supplied to a change in the price of a good when
    all other influences on selling plans remain the
    same.
  • How to calculate the elasticity of supply (figure
    4.9)
  • We want to get a relation between percentage
    changes of quantity supplied and percentage
    changes in price (so this is a ratio).
  • Elasticity of supply change in Quantity
    supplied
  • change in price
  • Degrees of Elasticity of Supply (figure 4.10)
  • Perfectly elastic
  • Unit elastic
  • Perfectly elastic

47
Elasticity of Supply
  • What influences the elasticity of supply?
  • Resource substitution possibilities
  • Time frame for the supply decision
  • Momentary supply
  • Lon run supply
  • Short run supply

48
Efficiency and Equity
  • More with less may not be more efficient.
  • An allocation is said to be efficient if the
    goods and services produced are the ones that are
    valued the most.
  • Efficiency has something to do with value, and
    value is related to feelings
  • Is the current situation fair?

49
Efficiency
  • Do you remember these terms?
  • Marginal Benefit is the benefit that a person
    receives from consuming one more unit of a good
    or service and it is measured as the maximum
    amount that a person is willing to pay for one
    more unit of it. (usually decreasing)
  • Marginal Cost is the opportunity cost of
    producing one more unit of a good or service and
    it is measured as the value of the best
    alternative forgone. (usually increasing)
  • Inefficient Allocations if marginal benefit
    exceeds marginal cost or if the opposite happens.
  • Efficient Allocations marginal benefit equals
    marginal cost. (figure 5.1)

50
Consumer Surplus
  • What do we mean with the term value of the good
    or service?
  • It is simply the marginal benefit of a good or
    service.
  • Recall that the marginal benefit can be
    expressed as the maximum price that people are
    willing to pay for another unit of the good or
    service. And this willingness determines the
    demand for the good or service.
  • And also recall that a demand curve tells us the
    quantity of other goods and services that people
    are willing to forgo to get an additional unit of
    a good.
  • So we can conclude that a demand curve is a
    marginal benefit curve. (figure 5.2)

51
Consumer Surplus
  • If people buy something for less than it is
    worth to them, they receive a consumer surplus.
    (figure 5.3)
  • Consumer surplus the value of the good - the
    price paid for it

52
Producer Surplus
  • What do we mean with the term cost of producing
    the good or service?
  • It is simply the marginal cost, the minimum
    price that producers must receive to induce them
    to produce another unit of the good or service,
    this minimum acceptable price determines supply.
  • A supply curve tells us the quantity of other
    good and services that sellers must forgo to
    produce one more unit of the good or service.
  • So we can conclude that a supply curve is a
    marginal cost curve. (figure 5.4)

53
Producer Surplus
  • When a firm sells something for more than it
    costs to produce, the firm obtains a producer
    surplus. (figure 5.5)
  • Producer surplus price of a good -
    opportunity cost of producing it.

54
Efficient Competitive Markets?
  • Why do we say, that markets are efficient when
    marginal cost equals marginal benefit? (figure
    5.6)
  • It maximizes the consumer and producer surplus.
  • Any other allocation than the one in equilibrium
    puts the forces of supply and demand to work and
    the equilibrium allocation will be the final
    result.
  • Resources are allocated efficiently (where they
    create the greatest possible value)
  • The invisible hand is working!!

55
Efficient Competitive Markets?
  • Obstacles to efficiency
  • Price ceilings and floors incorrect quantities
    (chpt.6)
  • Taxes, subsidies and Quotas distortions on
    market prices (example prices received by
    producers are lower than those paid by buyers)
    (chpt.6)
  • Monopoly larger profits, wrong quantity supplied
    (chpt. 12)
  • Public goods the free rider problem (chpt. 16)
  • External costs and external benefits
  • External costs is a cost not borne by the
    producer but borne by other people.
  • External benefit benefit that accrues to people
    other than the buyer of a good.
  • In consequence we have overproduction or
    underproduction

56
Efficient Competitive Markets?
  • And this two problems decreases the total
    surplus (producer surplus plus consumer surplus).
  • Figure (5.7)
  • Deadweight loss is the decrease in consumer
    surplus and producer surplus that results from an
    inefficient level of production.The deadweight
    loss is borne by the entire society, it is a
    social loss.

57
Fair Competitive Markets?
  • It is not fair if the result is not fair.
  • Utilitarianism
  • The big tradeoff
  • Make the poorest as well off as possible
  • a bigger piece of a smaller pie can be less than
    a smaller piece of a bigger pie.
  • It is not fair if the rules are not fair.
  • The symmetry principle Behave toward other
    people in the way you expect them to behave
    toward you.
  • The two basic rules for fairness
  • The state must enforce laws that establish and
    protect private property.
  • Private property may be transferred from one
    person to another only by voluntary exchange.

58
Acquisition of Customers Utility and Demand
  • Why some things are more expensive than others,
    even when the ones that are cheap are the ones
    that we need the most?
  • What makes the demand for some goods price
    elastic, while the demanders for others is price
    inelastic?

59
Household Consumption Choices
  • These are delimited by two things mainly
  • Consumption possibilities (figure 7.1) Consumers
    have a certain amount of income to spend and
    cannot influence the prices of good and services
    that they buy.
  • THE BUDGET LINE IS A CONSTRAINT ON CHOICES. (IT
    TELLS WHAT CAN BE AND WHAT CAN NOT BE AFFORDED)
  • Preferences How do consumers distribute their
    incomes? Well it depends on what they like and
    what they do not, in other words their
    PREFERENCES
  • Economists use the term of UTILITY to describe
    PREFERENCES
  • The benefit that a persons derives from the
    consumption of a good or service is called
    UTILITY. (abstract concept!!)

60
UTILITY (table 7.1)
  • TOTAL UTILITY Total benefit that a persons
    derives from the consumption of goods and
    services. It depends on the level of consumption,
    more generally means more utility.
  • MARGINAL UTILITY Is the change in total utility
    that results from one unit increase in the
    quantity of a good consumed. (figure 7.2)
  • Marginal Utility is positive but diminishes as
    the consumption of the good increases (again you
    get tired of the goods)
  • That is why we have DIMINISHING MARGINAL UTILITY

61
MAXIMIZING UTILITY
  • The Households income and the prices she/he
    faces limit her/his choices, and her/his
    preferences determined the amount of utility that
    she/he gets from each affordable combination. But
    the main objective is to choose the combination
    that MAXIMIZES UTILITY!.
  • Just find out what is the total utility of each
    combination and choose the one that gives the
    highest number and that will be the best the
    consumer can do given the prices and her/his
    income. (table 7.2)
  • CONSUMER EQUILIBRIUM Is a situation in which a
    consumer has allocated all his or her available
    income in the way that, given prices and income,
    maximizes his or her utility.

62
MAXIMIZING UTILITY
  • EQUALIZING MARGINAL UTILITY PER DOLLAR SPENT
  • Total utility is maximized when all the
    consumers available income is spent and when the
    marginal utility per dollar spent is equal for
    all goods
  • Marginal Utility from X Marginal Utility
    from Y
  • Price of X Price of Y
  • EXAMPLE
  • TABLE 7.3 AND FIGURE 7.3
  • As always, if the marginal utility of the last
    dollar spent on X exceeds the marginal utility
    per dollar spent on Y, buy more X and less of Y.
    (VICEVERSA)

63
Predictions of Marginal Utility
  • After a change on prices or income, to find the
    new utility maximizing combination follow the
    next three steps
  • Determine the new combinations that exhaust new
    income at the new prices.
  • Calculate the marginal utilities per dollar
    spent.
  • Determine the combination that makes the marginal
    utilities per dollar spent on X and Y equal.

64
Predictions of Marginal Utility
  • Change in Prices
  • If price of X falls
  • Table 7.4
  • Figure 7.4
  • If price of Y rises
  • Table 7.5
  • Figure 7.5
  • This tells us that
  • When price of a good rises, the quantity demanded
    of the good decreases.
  • When the price of one good rises, the demand for
    another good that can serve as a substitute
    increases.

65
Predictions of Marginal Utility
  • If income increases
  • Table 7.6
  • This tells us that
  • With more income the consumer always buys more of
    a normal good and less of an inferior good.
  • Table 7.7 A summary.

66
Individual and Market Demand
  • Marginal Utility theory explains how an
    individual household spends its income and
    enables us to derive an individual households
    demand curve.
  • Before during the first part of the course we
    used market demand curves
  • But Market demand can be derived from individual
    demand curves (figure 7.6)
  • The market demand is the horizontal sum of the
    individual demand curves and is formed by adding
    the quantities demanded by each individual at
    each price

67
Efficiency, Price and Values
  • Consumer Efficiency and Consumer Surplus
  • Marginal benefit is the maximum price that a
    consumer is willing to pay for an extra unit of a
    god or service when utility is maximized
  • The paradox of Value Everything comes from the
    equality of the marginal utilities per dollar
    spent.

68
POSSIBILITIES, PREFERENCES AND CHOICES
  • Why do changes in prices or income change demand
    and quantity demanded?
  • Here we will study what effects do these changes
    have, how and why?

69
Consumption Possibilities
  • The budget line, again!! (figure 8.1)
  • Divisible goods and indivisible goods
  • The budget line equation
  • Expenditure Income
  • PxQx PyQy Y
  • Qx (Y/Px) - (PyQy/Px)
  • Real Income
  • Relative Price
  • Change in Prices and Changes in Income (figure
    8.2)

70
Preferences and Indifference Curves
  • A preference Map this is based on the assumption
    that people can sort all the possible
    combinations of goods into three groups
    preferred, not preferred and indifferent.
  • Indifference Curve is a line that shows
    combinations of goods among which a consumer is
    indifferent. (figure 8.3)

71
Marginal Rate of Substitution (MRS) (figure 8.4)
  • Is the rate at which a person will give up good y
    (measured on the y-axis) to get more of good x
    (measured on the x-axis), and at the same time
    remain indifferent. It is measured by the slope
    of the indifference curve.
  • Steep curve, high substitution
  • Flat curve, low substitution
  • Diminishing Marginal Rate of Substitution
  • Degree of Substitution (figure 8.5)
  • Close substitutes easily substituted for each
    other.
  • Complementscan not be substituted for each other
    at all.

72
Predicting Consumer Behavior
  • Assume we start at equilibrium (huh!!)
  • What is equilibrium here?!! (figure 8.6)
  • Is on her budget line
  • Is on her highest attainable indifference curve
  • Has a marginal rate of substitution between y and
    x equal to the relative price of y and x.
  • What happens when prices change? (figure 8.7)
  • Find the demand curve.
  • What happens when income changes? (figure 8.8)
  • Income effect
  • Less consumption of all goods (if they are normal
    goods), remember that income changes switch the
    demand curve!!

73
Substitution and Income Effect
  • Substitution Effect is the effect of a change in
    price on the quantity bought when the consumer
    (hypothetically) remains indifferent between the
    original and the new situation.
  • Income Effect is the effect of a change in
    income on consumption.
  • Analysis of figure 8.9 (very important!!!)
  • The case of inferior goods remember that the
    income effect is negative in this case!!

74
Work and Leisure Choices
  • Using this model to explain the labor supply
  • More work means more income
  • Figure 8.10
  • The labor supply curve
  • Higher wage has both a substitution effect and an
    income effect

75
ORGANIZING PRODUCTION
  • A Firm is an institution that hires productive
    resources and that organizes those resources to
    produce and sell goods and services.
  • The main goal of any firm is to maximize profit.
  • To measure profits, first we need to review one
    concept that we have been using before
    (Opportunity Cost) and understand 4 new ones
    (Explicit Costs, Implicit Costs, Economic
    Depreciation, Cost of owners resources)

76
Opportunity Cost
  • The opportunity cost of any action is the
    highest-valued alternative forgone.
  • The firms opportunity costs are
  • Explicit Costs are paid in money. Money that
    could have been used in something else.
  • Implicit Costs when it forgoes an alternative
    action but does not make a payment.
  • Using own capital (because it could be rented to
    another firm), this is also called the implicit
    rental rate of capital, which is made up of
  • Economic Depreciation change in the market value
    of capital over time.
  • Interest forgone the funds used to buy own
    capital could have been used in something
    different and they would have yielded a return.
  • Using owners time and financial resources
  • Usually the entrepreneurial ability, the return
    on entrepreneurship is profit and the average
    return for supplying entrepreneurial ability is
    called normal profit, and this is a part of a
    firms opportunity cost because it is the cost of
    a forgone alternative, like running another firm.

77
Economic Profit and Economic Accounting
  • The Economic Profit is simply the result of the
    next subtraction Total Revenue - Opportunity
    Cost
  • Where the Opportunity Cost is equal to the sum of
    its implicit costs and explicit costs.
  • Economic Accounting (table 9.1)
  • How do firms achieve their objective of profit
    maximization
  • By answering the five questions
  • What goods to produce
  • How to produce them
  • How to organize and compensate managers and
    workers
  • How to market and price its products
  • What to produce itself and what to buy from other
    firms

78
But how do firms answer this questions?
  • The must take in to account their constraints,
    which are
  • Technology Constraints
  • A technology is any method of producing a good or
    service. It includes the detailed designs of
    machines, the layout of the workplace and the
    organization of the firm. You can produce up to
    a certain amount with the current technology!!
  • Information Constraints
  • We never have enough information about the
    present and future buying plans of customers and
    competitors and suppliers.
  • Market Constraints
  • What each firm can sell, the price it can obtain
    the resources that it can buy and the prices it
    pays form them are constrained by the willingness
    to pay of its customers, by the prices and
    marketing efforts of other firms, but the
    willingness of people to work and invest in the
    firm.

79
Technology and Economic Efficiency
  • Technological Efficiency When a firm produces a
    given output by using the least inputs. (table
    9.2)
  • Economic Efficiency When a firm produces a given
    output at lest cost. (table 9.3)
  • A Technologically Inefficient method is never
    economically efficient!!
  • Technological efficiency depends only on what is
    feasible, economic efficiency depends on the
    relative cost of resources

80
Information and Organization
  • Command Systems A method of organizing
    productions that uses a managerial hierarchy
  • Incentive Systems Instead of keeping a very
    close eye on workers, the managers use a
    market-like mechanism inside the firm, creating
    compensation schemes that will induce workers to
    perform in ways that maximize profit. The case
    of supervision Vs no supervision and the effect
    on costs!
  • Mixing the systems Use commands when it is easy
    to monitor performance or when a small deviation
    from ideal performance is very costly, and use
    incentives when monitoring performance is either
    not possible or too costly.

81
Information and Organization
  • Principal Agent Problem is the problem of
    devising compensation rules that induce an agent
    to act in the best interest of a principal. (the
    brokerage house example, the extra hours example
    and the bank tellers example)
  • Coping with the principal agent problem
  • Ownership Give them a piece of the pie!!
  • Incentive pay Pay related to performance
  • Long Term-Contracts maximize profit over a
    sustained period.
  • These three ways of coping with the principal
    agent problem give rise to different types of
    business organization.

82
Information and Organization
  • Types of Business Organization
  • Proprietorship single owner, with unlimited
    liability
  • Partnership two or more owners who have
    unlimited liability
  • Corporation Firm owned by one or more limited
    liability stockholders, limited liability means
    that the owners have legal liability only for the
    value of the initial investment.
  • Pros and Cons of Different Types of Firms
  • Table 9.4

83
Market an the Competitive Environment
  • Some are highly competitive, with profits hard to
    come by, some are almost free from competition
    and firms earn large profits. Some markets are
    dominated by fierce advertising campaigns in
    which each firm seeks to persuade buyers that it
    has the best products, and some markets display a
    warlike character.
  • Economist identify four market types (table 9.6)
  • Perfect competition (identical product)
  • Monopolistic Competition (differentiated
    product)
  • Oligopoly (either identical or differentiated
    product)
  • Monopoly (No close substitutes)

84
How to determine Market Type in Reality?
  • We have what is called the Measures of
    Concentration
  • The four-firm concentration ration Is the of
    the value of sales accounted by the four largest
    firms in an industry (0 for perfect competition
    to 100 for Monopoly)
  • The Herfindahl-Hirschman Index Is the square of
    the market share of each firm summed over the
    largest 50 firms (or summed over all the firms if
    there are fewer than 50) in the market.
  • In perfect competition the HHI index is small and
    large for monopoly.
  • In the 80s the Federal Trade Commission used it
    to classify markets and said that a market with
    an HHI between 1000 and 1800 is regarded as a
    competitive market and an HHI higher than 1800 is
    regarded as as being un-competitive.
  • Figure 9.2 for the US Economy.
  • Limitations of Concentration Measures
  • Geographical scope of the market
  • Barriers to entry and firm turnover
  • Correspondence between a market and an industry.

85
Markets and Firms
  • Market coordination
  • Why Firms?
  • Transaction Costs
  • Economies of Scale
  • Economies of Scope
  • Economies of Team Production

86
OUTPUT AND COSTS
  • All firms must decide how much to produce and how
    to produce it.
  • How do firms make these decisions?
  • First, the objective is to maximize profits, but
    to do that the firms must decide the quantity to
    produce, the quantities of resources to hire and
    the price at which sell the output.
  • Decisions about the quantity to produce and the
    price to charge depend on the type of market in
    which the firm operates. But decisions about how
    to produce a given output do not depend on the
    type of market. These decisions are similar for
    all firms in all type of markets.

87
Decision Time Frames
  • The actions that a firm can take to influence the
    relationship between output and cost depend on
    how soon the firm wants to act.
  • The short run is the time frame in which the
    quantities of some resources are fixed. For most
    of the firms, the fixed resources are the firms
    buildings and capital. (the management
    organization and the technology it uses are also
    fixed in the short run) We call the collection of
    fixed resources, the firms plant.To increase
    output in the short run, a firm must increase the
    quantity of variable inputs it uses. Labor is
    usually the variable input.
  • The long run is the time frame in which the
    quantities of all resources can be varied. That
    is, the long run is a period in which the firm
    can change its plant and the amount of labor that
    is used.
  • Long run decisions are not easily reversed, short
    run decisions are easily reversed, these is the
    result of the cost of buying a new plant, these
    are called the sunk costs.

88
Short Run Technology Constraint
  • To increase output in the short run a firm must
    increase the quantity of labor employed
  • As usual we can analyze the relation between
    production and labor with the following concepts
    (Table 10.1)
  • Total Product Total quantity produced
  • Marginal Product of Labor is the increase in
    total product that results from a one unit
    increase in the quantity of labor employed.First
    increases and then begins to decrease
  • Average Product of Labor Total product divided
    by the quantity of labor employed.First
    increases and then begins to decrease

89
Product Curves (figure 10.1 and 10.2)
  • Total Product it is similar to the Production
    Possibility Frontier, it separates the attainable
    from the unattainable. And points on the curve
    are technologically efficient.
  • Marginal Product The height of this curve
    measures the slope of the total product curve at
    a point. We plot the marginal product at the
    midpoint because it is the result of going from
    x1 units of labor to x2 units of labor.
  • Increasing Marginal Returns these occur when the
    marginal product of an additional worker exceeds
    the marginal product of the previous worker.
  • Diminishing Marginal Returns these occur when
    the marginal product of an additional worker is
    less than the marginal product of the previous
    worker. They arise from the fact that more and
    more workers are using the same capital and
    working in the same space.
  • Law of Diminishing Returns As firms uses more of
    a variable input, with a given quantity of fixed
    inputs, the marginal product of the variable
    input eventually diminishes

90
Product Curves (figure 10.3)
  • Average Product The marginal product curve, cuts
    the average product curve at the point of maximum
    average product. So, for employment levels where
    the marginal product exceeds average product,
    average product is increasing. This is a LOGICAL
    result, right? A very good example is the
    Marginal Grade and GPA.

91
Short Run Cost
  • To produce more output in the short run, a firm
    must employ more labor, which means that it must
    increase its costs.
  • As always we can analyze the costs with the
    following concepts
  • Total Cost
  • Marginal Cost
  • Average Cost

92
Short Run Cost
  • TOTAL COST Is the cost of all the productive
    resources that a firm uses, including the cost of
    land, capital, labor and the cost of
    entrepreneurship, which is normal profit.
  • Total Cost is divided in two (figure 10.4)
  • Total Fixed Cost Cost of all fixed inputs, it is
    horizontal because total fixed cost does not
    change when output changes.
  • Total Variable Cost Cost of all the firms
    variable inputs.
  • The vertical distance between the TVC and TC
    curve is total fixed cost.
  • Total Variable Cost and Total Cost increase at a
    decreasing rate at small levels of output and
    then begin to increase at an increasing rate as
    output increases, to understand this we need to
    take a look at marginal cost.

93
Short Run Cost
  • MARGINAL COST is the increase in total cost that
    results from a one unit increase in output. We
    calculate it by the increase in total cost
    divided by the increase in output.
  • The Marginal Cost curve is U shaped because of
    the Law of Diminishing Returns!, which tells us
    that each additional worker produces a
    successively smaller addition to output, so to
    get an additional unit of output, ever more
    workers are required. (figure 10.5)
  • The marginal cost curve tells us how total cost
    change as output changes.

94
Short Run Cost
  • AVERAGE COST
  • Average Fixed Cost Total fixed cost per unit of
    output. Slopes downward.
  • Average Variable Cost Total variable cost per
    unit of output. U shaped
  • Average Total Cost Total cost per unit of
    output. U shaped.
  • The Marginal Cost curve intersects the average
    variable cost curve and the average total cost
    curve at their minimum points.
  • The distance between ATC and AVC is equal to the
    AFC and it shrinks as output increases, since AFC
    declines with increasing output.

95
Short Run Cost
  • Cost Curves and Product Curves (figure 10.6)
  • what are the relations?
  • Shifts in the Cost Curves
  • Technology
  • Prices of Productive Resources.

96
Long Run Cost
  • In the long run, a firm can vary both the
    quantity of labor and the quantity of capital.
  • Long run cost is the cost of production when a
    firm uses the economically efficient quantities
    of labor and capital, there are no fixed costs in
    the long run.
  • The behavior of the long run cost depends on the
    firms production function, which is the
    relationship between the maximum output
    attainable and the quantities of both labor and
    capital.

97
Long Run Cost
  • Diminishing Returns, happen at each level of
    capital utilization.
  • Diminishing Marginal Product of Capital
    Diminishing returns also occur as the quantity of
    labor increases. Marginal product of capital is
    the change in total product divided by the change
    in capital when the quantity of labor is
    constant.
  • Short run cost and Long Run Cost. (table 10.3 and
    figure 10.7)
  • Each short-run average total cost curve is U
    shaped
  • For each short-run average total cost curve, the
    larger the plant, the greater is the output at
    which average total cost is a minimum.

98
Long Run Cost
  • The economically efficient plant size for
    producing a given output is the one that has the
    lowest average total cost.
  • The Long run average cost curve is the
    relationship between the lowest attainable
    average total cost and output when both the plant
    size and labor are varied.(Figure 10.8)
  • The Long run average cost curve is derived from
    the short run average total cost curves.

99
Long Run Cost
  • Some more concepts that we need to know
  • Economies of Scale are features of a firms
    technology that lead to falling long run average
    cost as output increases. When economies of scale
    are present the LRAC curve slopes downward. The
    percentage increase in output exceeds the
    percentage increase in all inputs the main
    source of economies of scale is greater
    specialization.
  • Diseconomies of Scale are features of a firms
    technology that lead to rising long-run average
    cost as output increases. When diseconomies of
    scale are present the LRAC curve slopes upwards.
    The percentage increase in output is less than
    the percentage increase in all inputs the main
    source of diseconomies of scales is the
    difficulty of managing a very large enterprise.
  • Constant Returns to Scale are features of a
    firms technology that lead to constant long-run
    average cost as output increases. When constant
    returns to scale are present, the LARC curve is
    horizontal. The percentage increase in output
    equals the percentage increase in inputs.
  • Minimum Efficient Scale is the smallest quantity
    of output at which long-run average cost reaches
    its lowest level and as we will see it plays a
    role in determining market structure.

100
PERFECT COMPETITION
  • How does competition affect prices and profits?
  • What causes some firms to enter and industry and
    others to leave it?
  • What are the effects on profits and prices of new
    firms entering and old firms leaving an industry?

101
Competition
  • Perfect Competition is an industry in which
  • Many firms sell identical products to many buyers
  • There are no restrictions on entry into the
    industry
  • Established firms have no advantage over new ones
  • Sellers and buyers are well informed about
    prices.
  • How Perfect Competition Arises
  • If the minimum efficient scale of a single
    producer is small relative to the demand for the
    good or service
  • If each firm is perceived to produce a good or
    service that has no unique characteristics so
    that consumers do not care which firm they buy
    from
  • NOTE Minimum efficient scale is the smallest
    quantity of output at which long run average cost
    reaches its lowest level.

102
Competition
  • Economic Profit and Revenue (figure 11.1)
  • Economic Profit Total Revenue - Total Cost
  • Total Revenue QP
  • Total Cost the opportunity cost of production,
    which includes normal profit.
  • Marginal Revenue is the change in total revenue
    that results from a one unit increase in the
    quantity sold.
  • In Perfect Competition Marginal Revenue Price
    !!!

103
Firms Decisions in Perfect Comp.
  • The revenue curves summarize the market
    constraints faced by a perfectly competitive
    firm. Firms also have a technology constraint
    which is described by the product curves.
  • Short Run Decisions
  • Whether to produce or to shut down
  • If the decision is to produce, what quantity to
    produce.
  • Long Run Decisions
  • Whether to increase or decrease its plant size
  • Whether to stay in the industry or leave it.

104
Firms Decisions in Perfect Comp.
  • Profit Maximizing Output (figure 11.2)
  • A Perfectly competitive firm maximizes economic
    profit by choosing its output level.
  • We can look at the Total Revenue (TR) and the
    Total Cost (TC) and see where does the firm gets
    the highest economic profit.
  • An output where TR TC, is called a break-even
    point, the firms economic profit is zero, but
    because normal profit is part of total cost, the
    firm makes normal profit at a break-even point.
  • Graphically, economic profit is measured by the
    vertical distance between the total revenue and
    total cost curves.
  • The profit curve is at a maximum when TR exceeds
    TC by the largest amount!.

105
Firms Decisions in Perfect Comp.
  • As always we could also look at this with the
    Marginal Analysis (figure 11.3)
  • Marginal Revenue Marginal Cost ? Max.
    Econ. Profit
  • Marginal Revenue gt Marginal Cost ? Sell more
  • The extra revenue from selling on
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