Econ First Assessment Notecards

Economics

the study of the allocation of scarce resources among alternative and competing.

Goal: use resources where highest valued.

Rational-Actor Paradigm

People tend to act rationally, optimally, and self-interestedly.

• at the time decision is made, not in retrospect

• explains behavior when incentives change

• suggests methods to change behavior

Policy Efficiency

• not wasteful socially

• does not mean desirable to each individual

• want policies to improve efficiency

• does not touch on distribution of wealth

Business Efficiency

• not wasteful of resources

• maximizing output for a given number of inputs

• maximizing inputs for a given number of outputs

• inefficiency is to be exploited

Economic Theory

a general principle that enables us to understand and predict the economic choices that people make

Economic Model

abstract world focused on a narrow set of relationships

• leaves out irrelevant factors to question at hand

• purpose is to understand relationships of interest

Utility

satisfaction from consuming a good or service

Fundamental Assumption of Economics

People are utility maximizers

Scarcity

Condition where our wants exceed what we can produce

Economic Cost

Accounting Cost + Opportunity Cost

Accounting Cost

(Explicit)

• Dollar cost on your books

Opportunity Cost

(Implicit)

• What you would have made in the best thing you didn’t do

Economic Profit

• Total Revenue - Accounting Cost - Opportunity Cost

• Total Revenue - Economic Cost

What is capitalism’s coordinating mechanism?

Price system

Thomas Mun background

• 1571-1641

• Wealthy merchant

• Director of East India company

Thomas Mun view

Mercantilism

What is mercantilism?

• gold is wealth, gold is limited

• so wealth is limited

• become wealthy by acquiring gold

• export more than you import

• government encourages exports and not imports

• “zero sum game”

• trade isn’t even, one always gains more

England’s Treasure by Foreign Trade (1664)

wrote for mercantilist view on trade

• written by Thomas Mun

Adam Smith background

• 1723 - 1790

• born in Kirkcaldy, Scotland

• known as fumbling, bumbling bachelor father of economics

• became famous for “The Theory of Moral Sentiments”

• “An Inquiry into the Nature and Causes of the Wealth of Nations”

Adam Smith view

• Wealth (National Standard of Living) = Goods + Services

• Division of Labor / Specialization (limited by market)

• Gains from Trade

  • trade because both better off

  • gain something from trade that’s valued more than the money

• Invisible Hand Doctrine

• Role of Government / Tax Policies / Externalities

• Subsistence Theory of Wages X

• Banking Regulation

• Utility (Self-Interest)

• Diamond-Water Paradox X

• Monopoly

• Rent Seeking

• Price Fixing

• Free Trade

• Absolute Advantage

• Antitrust

What is Invisible Hand Doctrine?

in a decentralized, free market economy, individuals pursuing their own self-interest will tend to benefit the economy as a whole

Thomas Robert Malthus background

• 1766 - 1834

• godson of David Hume

• best friends with David Ricardo - Intellectual adversaries

Thomas Malthus view

• Law of Diminishing Returns (1815)

  • Population growth grows 2.5% / yr, doubles in 28 years

  • food production growing at decreasing rate

  • doomed unless economic choices at work, those who adapt best will survive

  • Malthusian “struggle for existence” inspires Darwin

  • "An Essay on the Principles of Population”

• Cost-benefit analysis

• Comparative Advantage

What is Labor Theory of Value?

value of an output is equal to the sum of its labor inputs

Karl Heinrich Marx background

• rejected Jewish ancestry, debate over whether anti semitic

• Religion “… opium of the people”

• drank himself out of university

• unwashed slob - “the Moor”

• developed severe boils - Carbuncles

• strong believer in Hegelian method - dialectic

  • life always in flux, things are always changing

  • any idea has opposite, they will do battle, change will come from it “synthesis”

• "The Communist Manifesto” (1848)

• “Das Kapital” (1867)

• “From each according to his ability, to each according to his needs!”

  • Critique of the Gothra Programme, 1875

Karl Marx view

• Dialectical Materialism

  • fusing of dialectic method with materialism

• Business cycles (20 years of trough-to-trough)

  • Capitalism “Laws of Motion”: Unguided production — rises and slumps of higher intensity

  • socialism: rationally planned production

• Collapse of capitalism inevitable “Iron necessity”

  • dependent on “Labor Theory of Value”

  • exploited workers

  • attacked perfect capitalism — perfect competition

  • but, capitalism was a necessary precondition for socialism

• said virtually nothing about what to do after revolution

Alfred Marshall background

• 1842 - 1924

• Teacher of John Maynard Keynes

• Interested in philosophy

• devoted life to economics after walking through “poorest of quarters” of cities, “looking at the faces of poor people”

  • focus on education to fix

Alfred Marshall view

• Diagrammatic Economics

• Scissors analogy for S & D

• Partial Equilibrium

  • I only care about my market for my firm

• Elasticity Theory

• Theory of the Firm

• Consumer Surplus

• “Principles of Economics (1890)

Horizontal (Supply)

Quantity supplied at a particular price

Vertical (Supply)

Willingness to sell a little more at a particular quantity

• i.e., economic cost of a marginal increase in output

Supply shifters

• input prices

• price/profitability of other goods

• expectations of future prices

• number of suppliers

• technology

• regulation

Surplus

Excess of supply over demand at a given price

Shortage

excess of demand over supply at a given price

Competitive prices signal

value and scarcity on the margin

• “demand, willingness to pay” “supply” “of one more, of one extra unit”

Marginal Analysis

examines the change in one variable with respect to a small change in another

Why do economists care about marginal analysis?

• prices determined on the margin

• most economic decisions are marginal

Consumer surplus

• excess of what consumers are willing to pay over what they have to pay for a good

• net value to consumers (i.e., utility received but not paid for)

Producer surplus

• excess of what sellers receive over the minimum they require (i.e., economic cost) to produce a particular quantity

• net value to the company

Social Welfare

• excess of consumer willingness to pay over the minimum producers require for a particular quantity

• sum of consumer and producer surplus

Deadweight Loss (Welfare Loss, Inefficiency)

• loss in social welfare due to market inefficiency

• DWLs are wasteful of resources

Who became famous for “The Theory of Moral Sentiments” and “An Inquiry Into the Nature and Causes of the Wealth of Nations”

Adam Smith

Who said Wealth = Goods + Services

Adam Smith

Who said both parties gain from trade?

Adam Smith

Who was famous for “The Communist Manifesto” and “Das Kapital”

Karl Marx

Who wrote “The Essay on the Principles of Population”

Thomas Malthus

Elasticity

Measures the sensitivity of one variable to small changes in another

• invariant to units of measure

• affected by slope, but not slope

Formula for price elasticity of demand

• % change in quantity / % change in price OR

• (change in quantity / quantity) / (change in price / price)

Formula for Arc Price Elasticity of Demand (two prices and two quantities)

| ((Q2 - Q1) / AVG (Q1 and Q2)) / ((P2 - P1) / AVG (P1 and P2))

Pricing tradeoff assumes you are maximizing what?

Total Revenue

Pricing is

tradeoff between revenue and variable costs

With respect to elasticity, the goal of business is to

make its demand as inelastic (vertical) as possible

Determinants of Elasticity

• number of close substitutes

• proportion of budget (related to price)

• time period to adjust

• individual brand or industry aggregate

Formula for Cross Price Elasticity of Demand

• % change in quantity of X / % change in price of Y OR

• (change in quantity of X / quantity of X) / (change in price of Y / price of Y)

Economic definition of a firm

• institution specializing in the production of goods and services for others

Why do firms exist?

• specialization is productive

• firms and markets are complements

variable input

• varies with output over given time period

fixed input

• constant with respect to output over given time period

Short run (SR)

• time period in which at least one input is fixed

  • when you can’t reasonably expand all of your inputs

Long Run (LR)

• time period in which all inputs are variable (i.e., can be reasonably adjusted

In class, what is assumed for labor and capital in short run?

labor is variable and capital is fixed

In class, what is assumed for labor and capital in long run?

labor and capital are variable

Total fixed cost (TFC) formula

R x K

• r = rental rate (price) of capital

• k = quantity of capital (fixed input)

Average fixed cost (AFC) formula

TFC / Q

Total variable cost (TVC) formula

• w = wage rate (price of labor)

• L = quantity of labor (variable input)

Average variable cost (AVC) formula

• TVC / Q

Total cost (TC) formula

• TFC + TVC

Average Total Cost (ATC) formula

AFC + AVC

• (TFC / Q) + (TVC / Q)

Marginal Cost (MC) formula

change in total cost / change in quantity

• change in TVC / change in quantity

Sunk costs

portion of fixed costs that cannot be recovered

Decision making mistakes

• considering irrelevant costs (fixed/sunk)

• ignoring relevant costs (opportunity)

Marginal Product of Labor (MP_L)

• extra output from employing an additional laborer

Marginal Product of Labor (MP_L) formula

change in quantity / change in labor

Average Product of Labor (AP_L)

average output per laborer

Average Product of Labor (AP_L) formula

quantity / labor

Law of Diminishing Returns

when equal increments of a variable input are successively added to a fixed input, the extra output will eventually diminish due to unbalanced growth

Point of Diminishing Returns

• the output level where marginal cost is minimized

• the worker where marginal product is maximized

• the point beyond which every business must go to maximize profits

Increasing Returns to Scale (IRS, Economies of Scale)

if you increase all inputs by X%, output increases by more than X%

Constant Returns to Scale (CRS)

if you increase all inputs by X%, output increases by exactly X%

Decreasing Returns to Scale (DCS), Diseconomies of Scale)

• if you increase all inputs by X%, output increases by less than X%

Returns to scale is a what type of concept?

Long-run

Minimum Efficient Scale (MES)

the smallest production level or scale at which average costs are minimized

the smallest output level of CRS

“Top Two Principles” (Elasticity, Production, Costs)

• with respect to elasticity, the goal of business is to make its demand as inelastic (vertical) as possible

• when making a decision, consider only the costs and benefits that vary with the consequence of the decision

  • ignore irrelevant costs (fixed and sunk costs)

  • consider relevant hidden costs (opportunity costs)

Who was famous for Das Kapital (1867)?

Karl Marx

What year was Das Kapital made?

1867

Who was famous for The Principles of Economics (1890)?

Alfred Marshall

What year was The Principles of Economics made?

1890

Who was famous for An Inquiry into the Nature and Causes of the Wealth of Nations (1776)?

Adam Smith

When was An Inquiry into the Nature and Causes of the Wealth of Nations made?

1776

Whose view does the graph represent?

Karl Marx

Whose view does the graph represent?

Thomas Malthus

Whose view does the graph represent?

Adam Smith

normal good

a product where an increase in income raises its sales

inferior good

an increase in income causes a reduction in spending

Oligopoly Assumptions

• Large number of buyers and a few sellers

  • firms are price makers

• some barriers to entry

• some close substitutes

• company interaction is strategic

  • strategic interdependence in decision-making

• all others same as perfect competition

Why do oligopolies exist?

• economies of scale

  • large capital requirements

    • steel, airplanes, aluminum, pharmaceuticals

  • large advertising requirements

    • soft drinks, beer, pharmaceuticals

• network effects

  • credit cards, social media, video games, phones

• patents, reputation, etc

• magnitude of these barriers affects real-world market structure

Collusion

when a group of firms behaves as if they were a single firm

Cooperation on competitive investments like joint venture is

Per Se Illegal

Inherently illegal “without elaborate inquiry as to the precise harm they have caused or the business excuse for their use”

Price Fixing Methods

• High output prices

  • bid-ask spreads

  • vitamins

  • CDs

• High margins

• Low discounts

  • university financial aid

• Low input prices

  • NCAA

  • tech company hiring

• Allocation of customers / sales volume

  • carbon fiber / prepreg

Price fixing

typically provides NO social benefits

• unlike some monopoly situation

• simply adjusts industry P and Q to monopoly level

increases DWL without any offsetting benefits

• purely welfare

• per se illegal under antitrust laws

• can be prosecuted as a criminal offense with prison sentences for managers involved