Microeconomics

All the terms

Economics

Economics is the science of scarcity Since we are unable to have everything we desire, we must make choices on how we will use our resources. Economics is the study of choices Textbook def: Social science concerned with the efficient use of scarce resources to achieve maximum satisfaction of economic wants.

Scarcity

we have unlimited wants but limited resources.

Microeconomics

Study of small economic units such as individuals, firms, and markets. Examples- Supply and demand in specific industries, production costs, labor markets

Macroeconomics

Study of the large economy as a whole or economic aggregates. Examples- economic growth, government spending, inflation, unemployment, international trade

theoretical economics.

Economists use the scientific method to make generalizations and abstractions to develop theories.

policy economics.

The theories made in theoretical economics are then applied to fix problems or meet economic goals.

Positive Statements

Based on facts. Avoids value judgements (what is).

Normative statements

Includes value judgements (what ought to be).

5 Key Economic Assumptions

Society has unlimited wants and limited resources (scarcity). Due to scarcity, choices must be made. Every choice has a cost (a trade-off). Everyone’s goal is to make choices that maximize their satisfaction. Everyone acts in their own “self-interest.” Everyone makes decisions by comparing the marginal costs and marginal benefits of every choice. Real-life situations can be explained and analyzed through simplified models and graphs.

Price

Amount buyer (or consumer) pays.

Cost

Amount seller pays to produce a good.

Investment

The money spent by BUSINESSES to improve their production.

Trade-off

Due to scarcity, choices must be made. Every choice has a cost ALL the alternatives that we give up when we make a choice. (Instead of going to the movies you could go out to eat or visit your grandma or play video games)

Consumer Goods

created for direct consumption. (example: pizza)

Capital goods

created for indirect consumption. (oven, blenders, knives, etc.) Goods used to make consumer goods.

The Four Factors of Production

ALL resources can be classified as one of the following four factors of production: Land, labor, capital, entrepreneurship

Land

All natural resources that are used to produce goods and services. (Ex: water, sun, plants, animals)

Labor

Any effort a person devotes to a task for which that person is paid. (Ex: manual laborers, lawyers, doctors, teachers, waiters, etc.)

Physical capital

Any human-made resource that is used to create other goods and services. (Ex: tools, tractors, machinery, buildings, factories, etc.)

Human capital

Any skills or knowledge gained by a worker through education and experience.

Entrepreneurship

Ambitious leaders that combine the other factors of production to create goods and services. Examples-Henry Ford, Bill Gates, Inventors, Store Owners, etc.

1. Take The Initiative

2. Innovate

3. Act as the Risk Bearers So they can obtain Profit.

Productivity

A measure of efficiency that shows the number of outputs per unit of input. Since all resources are scarce, improving productivity allows us to produce more stuff with fewer resources.

The Three Economic Questions

Every society must answer these three questions What goods and services should be produced How should these goods and services be produced? Who consumes these goods and services? The way these questions are answered determines the economic system.

Economic system

An economic system is the method used by a society to produce and distribute goods and services. Command (Centrally-Planned) Economy Free Market Economy Mixed Economy

Command (Centrally-Planned) Economies

In a centrally planned economy (communism) the government... owns all the resources answers the three economic questions Examples: Cuba, North Korea, former Soviet Union, and China? Example of Central Planners: If consumers want smartphones and only one company is making them... Other businesses CANNOT start making computers. There is NO COMPETITION.... Which means higher prices, lower quality, and less product variety. More phones will not be made until the government decides to create a new factory. The End Result: There is a shortage of goods that consumers want, produced at the highest prices and the lowest quality.

Why do centrally planned economies face problems of poor-quality goods, shortages, and unhappy citizens?

There is little incentive to work harder and central planners have a hard time predicting preferences.

What is GOOD about Communism?

Low unemployment - everyone has a job Great Job Security - the government doesn’t go out of business Less income inequality “Free” Health Care

What is BAD about Communism?

No incentive to work harder No incentive to innovate or come up with good ideas No Competition keeps quality of goods poor. Corrupt leaders Few individual freedoms

Free Market System (aka Capitalism)

Little government involvement in the economy. (Laissez Faire = Let it be) Individuals OWN resources and answer the three economic questions. The opportunity to make PROFIT gives people INCENTIVE to produce quality items efficiently. Wide variety of goods available to consumers. Competition and Self-Interest work together to regulate the economy (keep prices down and quality up). Example of Free Market: If consumers want smartphones and only one company is making them... Other businesses have the INCENTIVE to start making smartphones to earn PROFIT. This leads to more COMPETITION.... Which means lower prices, better quality, and more product variety. We produce the goods and services that society wants because “resources follow profits”. The End Result: Most efficient production of the goods that consumers want, produced at the lowest prices and the highest quality.

The Invisible Hand

The concept that society’s goals will be met as individuals seek their own self-interest. Example: Society wants fuel efficient cars... Profit seeking producers will make more. Competition between firms results in low prices, high quality, and greater efficiency. The government doesn’t need to get involved since the needs of society are automatically met. Competition and self-interest act as an invisible hand that regulates the free market.

Mixed Economies

A system with free markets but also some government intervention. Almost all countries, including the US, have mixed economies.

The Product Market (Circular flow model)

The “place” where goods and services produced by businesses are sold to households.

The Resource (Factor) Market (Circular flow model)

The “place” where resources (land, labor, capital, and entrepreneurship) are sold to businesses.

Circular flow model

Private Sector

Part of the economy that is run by individuals and businesses.

Public Sector

Part of the economy that is controlled by the government.

Factor Payments

Payment for the factors of production, namely: rent, wages, interest, and profit.

Transfer Payments

When the government redistributes income (ex: welfare, social security).

Subsidies

Government payments to businesses.

Production Possibilities Curve/Frontier

A production possibilities curve (or frontier) is a model that shows alternative ways that an economy can use its scarce resources. This model graphically demonstrates scarcity, trade-offs, opportunity costs, and efficiency. 4 Key Assumptions Only two goods can be produced Full employment of resources Fixed Resources (Ceteris Paribus) Fixed Technology

Constant Opportunity Cost

Resources are easily adaptable for producing either good. Result is a straight line PPC (not common).

Law of Increasing Opportunity Cost

As you produce more of any good, the opportunity cost (forgone production of another good) will increase. Why? Resources are NOT easily adaptable to producing both goods. Result is a bowed out (Convex) PPC.

3 Shifters of the PPC

Change in resource quantity or quality Change in Technology Change in Trade (allows more consumption)

Capital Goods and Future Growth

Countries that produce more capital goods will have more growth in the future.

Opportunity cost

most desirable alternative given up when you make a choice.

Explicit costs

the traditional out of pocket costs associated with making a decision. Examples: Price of a movie ticket.

Implicit costs

the opportunity costs of making a decision, Examples: The forgone time or forgone wage you could have earned when you go to the movies.

Marginal

Additional

Marginal analysis

(aka: thinking on the margin) making decisions based on increments. Example: When you decide to go to the mall, you consider the additional benefit and the additional cost (your opportunity cost). Once you get to the mall, you continue to use marginal analysis when you shop, buy food, and talk to friends. Since your marginal benefits and costs can quickly change, you’re analyzing them every second. What could make it quickly not worth it? The Point: You will continue to do something as long as the marginal benefit is greater than the marginal cost.

Law of Diminishing Marginal Utility

The law of diminishing marginal utility states that as you consume anything, the additional satisfaction that you will receive will eventually start to decrease In other words, the more you buy of ANY GOOD the less satisfaction you get from each new unit consumed. The Point: You will continue to do something as long as the marginal benefit is greater than the marginal cost.

You will continue to consume untill…

Marginal benefit = marginal cost

Utility Maximizing Rule

The consumer’s money should be spent so that the marginal utility per dollar of each goods equal each other.

Per Unit Opportunity Cost =

Opportunity Cost/Units Gained

Absolute Advantage

The producer that can produce the most output OR requires the least amount of inputs (resources).

Comparative Advantage

The producer with the lowest opportunity cost. Countries should trade if they have a relatively lower opportunity cost. They should specialize in the good that is “cheaper” for them to produce (the one they have a comparative advantage in)

Output questions

Other goes over (OOO) The higher value has the absolute advantage

Input questions

Other goes under (IUO) The lower value has the absolute advantage (it takes less time)

Terms of Trade

The agreed upon conditions that would benefit both countries.

Demand

Demand is the different quantities of goods that consumers are willing and able to buy at different prices. (Ex: You are able to purchase diapers, but if you aren’t willing to buy then there is NO demand).

Law of demand

There is an INVERSE relationship between price and quantity demanded.

Why does the Law of Demand occur?

The law of demand is the result of three separate behavior patterns that overlap: The Substitution effect The Income effect The Law of Diminishing Marginal Utility

The Substitution Effect

If the price goes up for a product, consumer buy less of that product and more of another substitute product (and vice versa).

The Income Effect

If the price goes down for a product, the purchasing power increases for consumers - allowing them to purchase more.

Law of Diminishing Marginal Utility

Utility = Satisfaction We buy goods because we get utility from them The law of diminishing marginal utility states that as you consume anything, the additional satisfaction that you will receive will eventually start to decrease. In other words, the more you buy of ANY GOOD the less satisfaction you get from each new unit consumed.

The Demand Curve

A demand curve is a graphical representation of a demand schedule. The demand curve is downward sloping showing the inverse relationship between price (on the y-axis) and quantity demanded (on the x-axis). When reading a demand curve, assume all outside factors, such as income, are held constant. (ceteris paribus)

Shifts in Demand

Ceteris paribus-“all other things held constant.” When the ceteris paribus assumption is dropped, movement no longer occurs along the demand curve. Rather, the entire demand curve shifts. A shift means that at the same prices, more people are willing and able to purchase that good. This is a change in demand, not a change in quantity demanded! PRICE DOESN’T SHIFT THE CURVE

5 Shifters (Determinants) of Demand:

Tastes and Preferences Number of Consumers Price of Related Goods Income Future Expectations Changes in PRICE don’t shift the curve. They only cause movement along the curve.

Substitutes

Substitutes are goods used in place of one another. Ex: If price of Pepsi falls, demand for coke will... If the price of one increases, the demand for the other will increase (or vice versa).

Complements

Complements are two goods that are bought and used together. Ex: If price of hot dogs falls, demand for hot dog buns will... If the price of one increase, the demand for the other will fall (or vice versa).

Normal goods

Ex: Luxury cars, seafood, jewelry, homes As income increases, demand increases As income falls, demand falls

Inferior goods

Ex: Top Ramen, used cars, used clothes As income increases, demand falls As income falls, demand increases

Supply

Supply is the different quantities of a good that sellers are willing and able to sell (produce) at different prices.

Law of Supply

There is a DIRECT (or positive) relationship between price and quantity supplied. As price increases, the quantity producers make increases. As price falls, the quantity producers make falls. Why? Because, at higher prices profit seeking firms have an incentive to produce more.

5 Shifters (Determinants) of Supply

Prices/Availability of inputs (resources) Number of Sellers Technology Government Action: Taxes & Subsidies Expectations of Future Profit A change in PRICE doesn’t shift the curve. It only causes a movement along the curve.

Subsidies

A subsidy is a government payment to a business or market. Subsidies cause the supply of a good to increase.

Four types of elasticity

Price Elasticity of Demand (PED) Price Elasticity of Supply (PES) Cross-Price Elasticity of Demand (XED) Income Elasticity of Demand (YED)

Price Elasticity of Demand (PED)

Measures how sensitive quantity demanded is to a change in price percent change in quantity / percent change in price

Inelastic Demand

Quantity is Insensitive to a change in price. If price increases, quantity demanded will fall a little If price decreases, quantity demanded increases a little. In other words, people will continue to buy it. An INELASTIC demand curve is steep! Few Substitutes Necessities Small portion of income Required now, rather than later Elasticity coefficient less than 1 Is generally at the bottom of the curve Price increase causes TR to increase Price decrease causes TR to decrease

Elastic Demand

Quantity is sensitive to a change in price. If price increases, quantity demanded will fall a lot If price decreases, quantity demanded increases a lot. In other words, the amount people buy is sensitive to price. Many Substitutes Luxuries Large portion of income Plenty of time to decide Elasticity coefficient greater than 1 Is generally at the top of the curve Price increase causes TR to decrease Price decrease causes TR to increase