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