Fundamentals of Economics

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Fundamentals of Economics
The focus of this lecture is the basic concepts
of economics. Students will learn to think like
an economist by applying some economic models to
practical examples. OBJECTIVES 1. Define the
term Economics 2. Explain the role of
government in a mixed economy 3. Understand
Production Possibility Frontier 4. Illustrate
market equilibrium using supply and demand
curves 5. Explain the relationship between market
and aggregate supply and demand. TOPICS Please
read all the following topics. ECONOMIC
ESSENTIALS PRODUCTION POSSIBILITY FRONTIER
ECONOMIC SYSTEMS INTERNATIONAL
TRADE               DEMAND SUPPLY MARKET
EQUILIBRIUM
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Economic Essentials

• Economics is a social science. It studies how to
  efficiently allocate the limited resources to
  satisfy unlimited human wants. Since resources
  are scarce, but wants are unlimited, we learn to
  make choices. When choices are made, certain
  wants must be sacrificed. For example, when you
  decided to take this class, you are prepared to
  give up some of your leisure time. The leisure
  time you give up in order to finish this class
  plus what you would have otherwise used the
  tuition money for is your opportunity cost for
  this class. Since every one of you has decided to
  take this class, that means you valued the
  benefit of this class more than the cost (which
  is the time you give up and what you would have
  used the tuition money for). Economists are
  making wise choices by comparing the extra
  benefit to the corresponding extra cost at each
  decision. The extra benefit is called Marginal
  benefit (MB) the extra cost is called Marginal
  cost (MC). You should only choose an item when
  its MB is greater or equal to its MC.
•  
• Marginal Rule MBgt or MC, then do it MB lt MC,
  then dont do it.

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Production Possibility Frontier

• In any society, people have to deal with limited
  resources by comparing their opportunity costs.
  If a country choose to produce more weapons, then
  this country must give up some of the other
  goods, say food. It is because resources like
  labor or capital must be relocated to produce
  weapons. In other words, an economy producing
  only weapons and food can only increase its
  weapons output by reducing its food output.
  (Under the assumption of fixed technological
  level, full employment and full efficiency).
• The combinations of weapons and food can be
  illustrated by using a production possibility
  frontier (PPF) or called production possibility
  curve (PPC). Most of the PPF curves are concave
  due to the inadaptability of the resources. The
  law of increasing opportunity cost states as the
  production of one good rises, the opportunity
  cost of producing that good increases. However,
  this country can have more weapons and food at
  the same time by a) improving its technological
  level, b) having economic growth, C) trading with
  another country.

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Production Possibility Frontier
PRODUCTION ALTERNATIVES PRODUCTION ALTERNATIVES PRODUCTION ALTERNATIVES TYPE OF PRODUCTS TYPE OF PRODUCTS TYPE OF PRODUCTS
PIZZAS(in thousands) ROBOTS
A 0 10
B 1 9
C 2 7
D 3 4
E 4 0
The PPC curve shown in the graph is constructed
using the above data. Assuming this country
produced only two products pizzas and robots
this country's resources are fixed in quantity
and quality this country's technology level is
fixed and production cost is at its minimum.
Every point on the curve is an efficient point.
The purple area is the attainable area where this
country is capable of reaching, but worse off
than any point on the PPC. The grey area is the
unattainable area where this country is not
capable of reaching at this point, but the
country will be better off by moving into this
area.
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Economic Systems

• Capitalism and socialism
• From the PPF, we understand that it is impossible
  to produce as much of every good as we might
  want, so choices must be made. Different economic
  systems will make different choices. There are
  two major economic systems capitalism and
  socialism, but most countries use some
  combination of the two known as a mixed economy.
• In pure or laissez-faire capitalism, there is
  private ownership, and markets and prices
  coordinate and direct economic activity. In
  socialism, there is public (state) ownership, and
  central government planning coordinates economic
  activity. Socialists believe that government
  decision makers are persons who promote the best
  interests of society as a whole and make every
  effort to obtain the information needed to make
  the right decision. However, capitalists think
  that government is more likely to respond to
  producers who have the political power to lobby
  congress than to consumers who do not lobby.
  Central government planning may favor special
  interest groups at the expense of the rest of
  the society. Therefore, governments role should
  be limited to order maintenance. Pure capitalism
  is an abstract model. The economy is
  self-regulating.
• The U.S. system is a mixed economy, but closer to
  pure capitalism. There are two major markets
  (product and resources market), and three major
  sectors (household, business, government) in the
  domestic economy.   In the product market,  goods
  and services are produced in the business sector
  and sold to households. In return, businesses get
  revenue from the household as they pay for the
  goods and services. In the resources market,
  resources are supplied by the households.
  Businesses pay for the desired resources, which
  produce good and services. In return, households
  get income, which they will use to pay for the
  goods and services. U.S. government collects
  taxes from both sectors, buys goods and services
  from the businesses, pays for resources they
  employed, provides services and will intervene by
  their policies according to different market
  situations.

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International Trade

• From the PPF curve, we understand that
  trading can expand PPF outward. Domestic trading
  is comparatively simpler than international
  trading. Since different countries have different
  standards and regulations on various products,
  exporters and importers have to learn to cope
  with them. International trading has to involve
  customs, and quota, tariffs, and some other
  barriers limiting producers right.
• A large number of producers are engaged in
  international trading because of the comparative
  advantages. Look around your household, you
  probably have a lot of imported items.
• Why did you choose to buy foreign goods
  instead of  U.S. goods? The answer is very
  simple imports are cheaper. Producers decided to
  move production to other countries for the same
  reason. Countries with abundant labor resources
  have comparative advantage on labor intensive
  goods, such as clothing, shoes, and most of the
  consumer goods. Therefore these countries will
  produce consumer goods and export them to the
  U.S. The U.S. has comparative advantage on many
  capital goods (tools and equipment used to
  produce consumer goods), therefore the U.S.
  exports capital goods and imports consumer goods.
  Through international trading, the PPF of U.S.
  can expand outward.

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Demand

• Demand  (D) is a schedule that shows the various
  amounts of product consumers are willing and able
  to buy
• at each specific price in a series of possible
  prices during a specified time period.
• Quantity demanded  (Qd) is the amount of a good
  or service that individuals are willing and able
  to buy
• at a particular price at a particular time.
• In another words, demand is the quantity demanded
  at all prices during a specific time period. A
  change in
• price will change the quantity demanded, not the
  demand. Any other factors other than price change
  will
• change the demand.
• The law of demand As price of a good increases,
  the quantity demanded of the good falls, and as
  the price of a good decreases, the quantity
  demanded of the good rises, ceteris paribus.
• Restated there is an inverse relationship
  between price (P) and quantity demanded (Qd).
• Explanation of Law of Demand
• 1.Substitution Effect As the price of product A
  increases, product A is comparatively more
  expensive than
• product B if B's price remain constant.
  Therefore, consumers will substitute B for A,
  causing the
• consumption of A to decrease.
• 2. Income Effect higher price will lower the
  consumption power of your income and decrease the
  
• quantity demanded.
• 3. Law of diminishing marginal utility As a
  person consumes more of a good, the additional
  utility of
• consuming more will eventually decreases. This
  means that to encourage additional consumption,
  price

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Demand Curve

• It is the graphical of presentation of the
  relationship between the quantity demanded of a
  good and the price of the good. It is a downward
  sloping curve.  
• The demand curve shown here is drawn
  according to the following data  
• Price P Quantity demandedQd
• P  2    4      6    8   10
• Qd 40   30   20  10   0
• Price and quantity demanded are negatively
  related.

Individual Demand Vs Market Demand Market demand
is the summation of all of the individual demand
curves for a particular item.  The transaction
from an individual to a market demand schedule is
accomplished by summing individual quantities at
various price levels. Aggregate demand (AD) is
not the same as market demand. AD is a schedule
that shows the various amount of real domestic
output (GDP) which domestic and foreign buyers
will desire to purchase at each possible price
level. 
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Determinants of Demand

• When price changes, quantity demanded will
  change. That is a movement along the same demand
  curve. When factors other than price changes,
  demand curve will shift. These are the
  determinants of the demand curve.
• 1. Income A rise in a persons income will lead
  to an increase in demand (shift demand curve to
  the right), a fall will lead to a decrease in
  demand for normal goods. Goods whose demand
  varies inversely with income are called inferior
  goods (e.g. Hamburger Helper).
• 2. Consumer Preferences Favorable change leads
  to an increase in demand, unfavorable change lead
  to a decrease.
• 3. Number of Buyers the more buyers lead to an
  increase in demand fewer buyers lead to
  decrease.
• 4. Price of related goods
• a. Substitute goods (those that can be used to
  replace each other) price of substitute and
  demand for the other good are directly related.
• Example If the price of coffee rises, the demand
  for tea should increase.
• b. Complement goods (those that can be used
  together) price of complement and demand for the
  other good are inversely related.
• Example if the price of ice cream rises, the
  demand for ice-cream toppings will decrease.
• 5. Expectation of future
• a. Future price consumers current demand will
  increase if they expect higher future prices
  their demand will decrease if they expect lower
  future prices.
• b. Future income consumers current demand will
  increase if they expect higher future income
  their demand will decrease if they expect lower
  future income.
•  
• Review

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Supply
  Supply (S) is a schedule, which shows amounts
of a product a producer is willing and able to
produce and sell at each specific price in a
series of possible prices during a specified time
period. Quantity supplied (Qs) is the amount of
a product that producers are willing and able to
produce and sell at a particular price at a
particular time. In another words, supply is the
quantity supplied at all prices during a specific
time period. A change in price will change the
quantity supplied, not the supply. Any other
factors other than price change will change the
supply. The law of supply Law of supply
states As price of a good increases, the
quantity supplied of the good rises, and as the
price of a good decreases, the quantity supplied
of the good falls, ceteris paribus. Restated
there is a direct relationship between price (P)
and quantity supplied (Qs). Explanation of Law
of Supply If the product cost is given, a higher
price means greater profits and thus an incentive
to increase the quantity supplied.  Price and
quantity supplied are directly related.
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Supply Curve

• Supply curve is the graphical representation of
  the
• relationship between the quantity supplied of a
  good and
• the price of the good. It is an upward sloping
  curve.
• The supply curve shown here is drawn with  the
  following
• Data Price P Quantity SuppliedQs
• P    2   4    6    8    10
• Qs    0  10  20  30  40 
• Price and quantity supplied are positively
  related.        

Individual Firms Supply Vs Market Supply Market
supply is the summation of the individual firms
entire supply curve for a particular item. The
transaction from an individual to a market supply
schedule is accomplished by summing individual
firms quantities at various price levels.
Aggregate supply (AS) is not the same as market
supply. AS is a schedule showing level of GDP
available at each possible price level.
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Determinants of Supply
When price changes, quantity supplied will
change. That is a movement along the same supply
curve. When factors other than price changes,
supply curve will shift. Here are some
determinants of the supply curve.   1.
Production cost Since most private companies
goal is profit maximization. Higher production
cost will lower profit, thus hinder supply.
Factors affecting production cost are input
prices, wage rate, government regulation and
taxes, etc.   2. Technology Technological
improvements help reduce production cost and
increase profit, thus stimulate higher supply.
  3. Number of sellers More sellers in the
market increase the market supply.   4.
Expectation for future prices If producers
expect future price to be higher, they will try
to hold on to their inventories and offer the
products to the buyers in the future, thus they
can capture the higher price.   Review A change
in quantity supplied is caused by a change in its
own price of the good. A change in supply is
caused by a change in determinants.
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Market Equilibrium
When the supply and demand curves intersect, the
market is in equilibrium.  This is where the
quantity demanded and quantity supplied are
equal.  The corresponding price is the
equilibrium price or market-clearing price, the
quantity is the equilibrium quantity.
Putting the supply and demand curves from the
previous sections together. These two curves will
intersect at Price 6, and Quantity 20. 
In this market, the equilibrium price is 6 per
unit, and equilibrium quantity is 20 units. At
this price level, market is in equilibrium.
Quantity supplied is equal to quantity demanded (
Qs Qd).  Market is clear.
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Surplus and Shortage
If the market price is above the equilibrium
price, quantity supplied is greater than quantity
demanded, creating a surplus.  Market price will
fall. Example if you are the producer, you have
a lot of excess inventory that cannot sell. Will
you put them on sale? It is most likely yes. Once
you lower the price of your product, your
products quantity demanded will rise until
equilibrium is reached. Therefore, surplus drives
price down. If the market price is below the
equilibrium price, quantity supplied is less than
quantity demanded, creating a shortage. The
market is not clear. It is in shortage. Market
price will rise because of this
shortage. Example if you are the producer, your
product is always out of stock. Will you raise
the price to make more profit? Most for-profit
firms will say yes. Once you raise the price of
your product, your products quantity demanded
will drop until equilibrium is reached. 
Therefore, shortage drives price up. If a
surplus exist, price must fall in order to entice
additional quantity demanded and reduce quantity
supplied until the surplus is eliminated.  If a
shortage exists, price must rise in order to
entice additional supply and reduce quantity
demanded until the shortage is eliminated.
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Surplus and shortage
If the market price (P) is higher than 6 (where Qd Qs),
for example,  P8, Qs30, and Qd10.
Since  QsgtQd, there are excess quantity supplied  in the
market, the market is not clear. Market is in surplus.
THE PRICE WILL DROP BECAUSE OF THIS SURPLUS.
If the market price is lower than equilibrium price,  6,
for example,  P4, Qs10, and Qd30.
Since QsltQd, There are excess quantity demanded in the market. Market is not clear. Market is in shortage. THE PRICE WILL RISE DUE TO THIS SHORTAGE
Government Regulations Government regulations
will create surpluses and shortages in the
market.  When a price ceiling is set, there will
be a shortage. When there is a price floor, there
will be a surplus. Price Floor is legally
imposed minimum price on the market. Transactions
below this price is prohibited. Policy makers set
floor price above the market equilibrium price
which they believed is too low. Price floors are
most often placed on markets for goods that are
an important source of income for the sellers,
such as labor market.  Price floor  generate
surpluses on the market. Example minimum wage.
  Price Ceiling is legally imposed maximum price
on the market. Transactions above this price is
prohibited. Policy makers set ceiling price below
the market equilibrium price which they believed
is too high. Intention of price ceiling is
keeping stuff affordable for poor people. Price
ceiling generates shortages on the market.
Example Rent control.
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Changes in equilibrium price and quantity
Equilibrium price and quantity are determined by
the intersection of supply and demand. A change
in supply, or demand, or both, will necessarily
change the equilibrium price, quantity or both.
It is highly unlikely that the change in supply
and demand perfectly offset one another so that
equilibrium remains the same. Examples These
examples are based on the assumption of Ceteris
Paribus. 1) If there is an exporter who is
willing to export oranges from Florida to Asia,
he will increase the demand for Floridas
oranges. An increase in demand will create a
shortage, which increases the equilibrium price
and equilibrium quantity.          2) If there
is an importer who is willing to import oranges
from Mexico to Florida, he will increase the
supply for Floridas oranges. An increase in
supply will create a surplus, which lowers the
equilibrium price and increase the equilibrium
quantity.                 3) What will happen if
the exporter and importer enter the Floridas
orange market at the same time? From the above
analysis, we can tell that equilibrium quantity
will be higher. But the import and exporters
impact on price is opposite. Therefore, the
change in equilibrium price cannot be determined
unless more details are provided. Detail
information should include the exact quantity the
exporter and importer is engaged in. By comparing
the quantity between importer and exporter, we
can determine who has more impact on the market.
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Changes in Equilibrium Price and Quantity
In the first graph, supply is constant, demand
increases. As the new demand curve (Demand 2) has
shown, the new curve is located on the right hand
side of the original demand curve. The new
curve intersects the original supply curve at a
new point. At this point, the equilibrium price
(market price) is higher, and equilibrium
quantity is higher also.
In the second graph, demand is constant, and
supply increases. As the new supply curve (SUPPLY
2) has shown, the new curve is located on the
right side of the original supply curve. The
new curve intersects the original demand curve at
a new point. At this point, the equilibrium price
(market price) is lower, and the equilibrium
quantity is higher.
In this last graph, the increased demand curve
and increased supply were drawn together.  The
new intersection point is located on the right
hand side of the original intersection point.