Economics

positive economics

Independent of the ethical value system of the economist

normative economics

Reflects the ethical value system of the economist (implicitly, explicitly or by omission)

macro-economics

The study of the performance of national economies and the policies that governments use to try to improve that performance

micro-economics

– The study of individual choice under conditions of scarcity, and its implications for society

– Standard economic theory assumes decision makers are rational

scarcity

– Resources available to satisfy boundless needs and wants are limited

– Having more of one good thing usually means having less of another (no free lunch)

economics surplus

• the benefit of taking an action (value) - the cost of taking that action (monetary and opportunity costs)

• only undertake the actions that create additional surplus.

opportunity cost (= implicit cost)

The net value of the next best alternative that must be foregone in order to undertake that activity

rationality

demands that an individual (or firm or other decision maker) takes an action if, and only if, the extra benefits (=marginal benefits) from taking that action are at least as great as the extra costs (=marginal costs)

Pitfalls

• Measuring costs and benefits as proportions rather than absolute money amounts(Should you walk 3km to save 10€ on a 1,000€ laptop?

• Ignoring opportunity (i.e. implicit) costs

• failure to ignore sunk cost

• Failure to understand the distinction between average and marginal —> The focus should always be on the benefit and cost of an additional unit of activity

sunk cost

costs that are beyond recovery at the moment a decision must be made

marginal benefit

The increase in benefit that results from carrying out one additional unit of an activity

average benefit

The total benefit of undertaking n units of an activity divided by n

marginal cost

The increase in total cost that results from carrying out one additional unit of an activity

average cost

The total cost of undertaking n units of an activity divided by n

absolute advantage

One party has an absolute advantage over another if an hour spent in performing a task earns more than the other party can earn in an hour at the same task.

comparative advantage

One party has a comparative advantage over another in a task if his or her opportunity cost of performing a task is lower than the other party’s opportunity cost of performing the same task

sources individual level (micro)

Inborn talent, education, training, experience

sources national level (macro)

Land, labor, capital, entrepreneurship, knowledge, natural resources, cultural, legal and political institutions

production possibilities curve (PPC)

graph that shows the quantity of a good that can be produced for every possible level of production of another good

attainable point

any combination of goods that can be produced using currently available resources

unattainable point

any combination of goods that cannot be produced using currently available resources

efficient point

any combination of goods for which currently available resources do not allow an increase in the production of one good without a reduction in the production of the other

inefficient point

any combination of goods for which currently available resources enable an increase in the production of one good without a reduction in the production of the other

production possibility frontier (PPF)

The PPC for a multi-person and million- person economy

—> Increases in productive resources or improvements in knowledge and technology cause the PPF to shift outwards. They are the main factors that drive economic growth.

market

The market for any good or service consists of all buyers and sellers of that good or service

demand curve

A schedule or graph showing the quantity of a good that buyers wish to buy at each price

substitution effect

The change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes

income effect

The change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’ purchasing power

buyer’'s reservation price

– The largest amount of money a buyer would be willing to pay for a unit of a good

– The cost of the good is its market price

– If the reservation price (benefit) exceeds the market price (cost), the consumer will purchase the good

– The benefit will exceed the cost for fewer buyers at higher prices than at lower prices

the supply curve

A curve or schedule that tells us the quantity of a good that sellers wish to sell at each price

market equilibrium

– At the intersection of demand and supply

– All buyers (consumers) and sellers (producers) are satisfied with their respective quantities at the prevailing market price

– No tendency for the system to change

equilibrium price

price at which a good will sell

equilibrium quantity

quantity supplied and quantity demanded are equal

excess supply

The amount by which quantity supplied exceeds quantity demanded when the price of a good exceeds the equilibrium price

excess demand

The amount by which quantity demanded exceeds quantity supplied when the price of a good lies below the equilibrium price

price ceiling

a maximum allowable price, specified by law

—> effective when ceiling <p

price floor

a minimum allowable price, specified by law

—> effective when floor>p

change in quantity demanded

a movement along the demand curve that occurs in response to a price change

change in demand

a shift of the entire demand curve: a demand change at the same price

change in quantity supplies

a movement along the supply curve that occurs in response to a price change

change in supply

a shift of the entire supply curve: a supply change at the same price

complements

Two goods are complements in consumption if an increase (decrease) in the price of one causes a leftward (rightward) shift in the demand curve for the other

—> coffee and creamer

substitutes

Two goods are substitutes in consumption if an increase (decrease) in the price of one causes a rightward (leftward) shift in the demand curve for the other

—> wine and beer

shift in demand

income changes

normal good

Demand curve shifts rightwards (leftwards) when the incomes of buyers increase (decrease)

inferior good

Demand curve shifts leftwards (rightwards) when the incomes of buyers increase (decrease)

shifts in supply

The supply curve is based on costs of production

• Thus, anything that changes production costs will shift the supply curve

• Other factors may shift supply as well, f.ex. the number of sellers (producers)

buyer’s surplus

is the difference between the buyer’s reservation price and the price actually paid

Seller’'s surplus

is the difference between the price received by the seller and the lowest price she is willing to sell a

Total surplus

is the sum of buyer’s surplus and seller’s surplus

socially optimal

marginal cost= marginal benefit —> almost always in the market equilibrium

market efficiency

−When all costs of producing the good or service are borne directly by the seller

−When all benefits from the good or service accrue directly to buyers

market inefficiency

• When some costs of production fall on people other than those who sell the good or service the market equilibrium is inefficient

• When some benefits from the good or service accrue to people who did not buy the good or service the market equilibrium is inefficient

inefficient market equilibrium

– Buyers and Sellers are behaving rationally

– There are no unexploited opportunities for individuals

– But, Economic Surplus is not maximized (i.e. smart for one, dumb for all)

price elasticity of demand

• A measure of the responsiveness of the quantity demanded of a good to a change in the price of that good

• different at each point of the demand curve

When price and quantity are the same, the price elasticity of demand is always greater for the less steep of two demand curves.

• The percentage change in the quantity demanded that results from a 1 percent change in its price

—> percentage change in quantity demanded/ percentage change in price

meaning price elasticity of demand

• >1 we call it elastic

• =1 we call it unit elastic

• <1 we call it inelastic

• 0%-1 inelastic

• < -2 elastic

determinants of demand price elasticity

– Substitution Possibilities

– Budget Share

– Time

fomula price elasticity of demand, small changes in price

percentage change Q/ Q divided by percentage change P/P

formula slope

rise/ run

perfectly elastic demand (elasticity is infinite)

even the slightest increase in price leads consumers to switch to substitutes

perfectly inelastic demand (elasticity is 0)

consumers can not switch to substitutes or stop buying when the price increases

price elasticity of demand, larger changes in price

For larger changes in price we must take into account that at any two points on the demand curve there might be a different price elasticity of the good

—> see slide 21 of week 2

the midpoint approach

The mid-point approach is an approximation to the value of elasticity at all points between the upper and lower point on the demand curve

• But: The demand curve could be “curved” rather than straight

– This would make the mid-point approach less accurate

Total expenditure = Total revenue

PxQ
Market demand measures the quantity (Q) at each price (P)
- For a straight- line demand curve total expenditure is maximised at the price corresponding to the midpoint of the demand curve

general rule

A price increase will increase total revenue when the % change in P > than the % change in Q

cross- price elasticity

The percentage change in quantity demanded of one good in response to a 1 percent change in the price of another good

substitute goods

Cross-Price Elasticity of demand is positive

complement goods

Cross-Price Elasticity of demand is negative

income elasticity of demand

is the percentage change in quantity demanded in response to a 1 percent change in income

Normal goods

Income elasticity of demand is positive

inferior goods

Income elasticity of demand is negative

price elasticity of supply

The percentage change in the quantity supplied that occurs in response to a 1 percent change in price

• the price elasticity of supply is equal to 1 at any point along a straight-line supply curve that passes through the origin

—> percentage change Q/ Q divided by percentage change P/P is the same as (P/Q) x (1/ slope)

perfectly inelastic supply

Supply is perfectly inelastic with respect to price if elasticity is zero

perfectly elastic supply

Supply is perfectly elastic with respect to price if elasticity is infinite

determinants of supply elasticity

– Flexibility of inputs

– Mobility of inputs

– Input substitutes

– Time

utility

The satisfaction people derive from their consumption activities.

• rises at a diminishing rate with additional consumption

marginal utility

Is the additional utility gained from consuming an additional unit of a good.

Law of diminishing marginal utility

• The tendency for the additional utility gained from consuming an extra unit of a good to diminish as consumption increases beyond some point.

• The 1st law of Hermann Heinrich Gossen (1854).

• Is an assumption.

marginal utility formula

change in utlity/ change in consumption

rational spending rule

Spending should be allocated across goods so that the marginal utility per euro is the same for each good

• MUc/Pc = MUv/Pv —> this is optimal because you cannot gain by switching between the two products

preference ordering

Identifies an individual’s preferences over various possible bundles of goods that might be consumed.

assumptions indifference curve analysis and the demand curve

1. pereferences are ‘‘complete’’

2. pereferences are ‘‘ordinal’’

3. preferences are ‘‘transitive’’

4. The individual’s utility (satisfaction level) is “increasing” in any good. —> Simply put, “more is better”

5. preferences are ‘‘continuous’’

6. preferences display a ‘‘diminishing marginal rate of substitution.’’

completeness

implies that an individual can compare any two bundles of goods and say which bundle she prefers.

ordinal

• Ordinal numbers are 1st, 2nd, 3rd, 4th…

• Cardinal numbers are 1, 2, 3, 4…

• Cardinal preferences imply ranking by a standard value.

– E.g. “I like this 16% more than that”.

• Ordinal is a less restrictive assumption: “I like this more than that

transitivity

implies consistency in preferences

—> If bundle A is preferred to bundle B (A>B), and bundle B is preferred to bundle C (B>C), then bundle A has to be preferred to bundle C (A>C).

continuity

implies that individuals can compare and evaluate the utility of bundles that differ only slightly in size or composition

utility function

for a bundle of goods A-Z

Ui= Ui (A,B,C,….,Z)

This function permits us to calculate how much of good X the consumer is willing to “trade in” for some more of good Y with her utility level being maintained.

—> for assumptions 1-5

diminishing rate of substitution

is an assumption about the utility function:

– When eating 100 apples and 100 oranges you may wish to trade one-to-one.

– When eating 190 apples and 10 oranges you may only wish to trade one orange for 20 apples

indifference curve

a smoothly convex curve that informs about combinations of two goods between which the individual is indifferent (same utility)

—> it’'s shape is duo to diminishing marginal utility

• The Marginal Rate of Substitution (MRS) between two goods gives the slope of the indifference curve.

—> The further out an indifference curve is, the higher the consumer’s utility from the bundles of A and B on the curve

—> indifference curves never touch each other. bundles on curves that are farther out give higher utility

—> the rational consumer will choose the feasible bundle that is on the highest attainable indifference curve.

indifference curve conclusion

– The consumer maximizes utility subject to the budget constraint.

– The chosen bundle will be that for which the budget line is a tangent to an indifference curve. At this point the two slopes are equal.

slope budget constraint

Pb/Pa

—> the slope of the indifference curve is the MRS between A and B, which is MUb/MUa, since the rate at which the consumer will exchange goods A and B reflects the marginal utility (MU) of the respective goods to the consumer.

consumer rationality

implies the consumer will allocate spending so that MRS equals relative price:

Pb/ Pa = MRSba = MUb / MUa

or MUa/Pa = MUb/Pb

consumer surplus

The difference between a buyer’s (consumer’s) reservation price for a product and the (market) price actually paid

—> (1/2)x(height x base)

producer surplus

the difference between the seller’s reservation price and the market price

—> (1/2)x(base x height)

factors of production

Inputs used in the production of a good or service.

short run

A period of time sufficiently short for at least some of the firm’s factors of production to be fixed.

long run

A period of time of sufficient length for all the firm’s factors of production to become variable.

variable factor of production

An input whose quantity can be altered in the short run

—> unskilled labor

fixed factor of production

An input whose quantity cannot be altered in the short run

—> specialized machine

law of diminishing returns

• Increased production of the good eventually requires ever-larger increases in the variable factor when some factors of production are fixed.

• In principle observable