Economics for Business

Economics (definition)

The social science that studies the choices individuals, businesses and governments make as they cope with scarcity, and the incentives that influence those choices.

Microeconomics vs macroeconomics

Micro = individual agents (households, firms) and how they interact in markets. Macro = the economy as a whole (growth, inflation, unemployment).

Lesson 1: People face ___

Trade-offs. Because resources are scarce, to get one thing you want you have to give up something else.

Opportunity cost

The value of the single next-best alternative you give up in order to obtain an item or make a choice.

Economic cost formula

Economic (opportunity) cost = Explicit (monetary) cost + Implicit cost.

Why does economic cost differ from accounting cost?

Accounting cost only records explicit monetary costs; economic cost also includes implicit costs (forgone alternatives) that never appear on an invoice.

Explicit vs implicit costs of going to university

Explicit: tuition, books. Implicit: forgone full-time income, forgone leisure, forgone returns from investing that time/money elsewhere.

Marginal change

A small incremental adjustment to a plan of action.

Decision rule for thinking at the margin

A rational person undertakes a marginal change only if marginal benefit (MB) >= marginal cost (MC).

Airline seat example: why sell a $300 standby seat when average cost is $500?

Marginal cost of the extra seat is about $0 and marginal benefit is $300, so MB > MC. The $500 average cost is a sunk cost and is irrelevant.

Sunk cost fallacy

Wrongly letting a cost already incurred and unrecoverable influence a forward-looking decision. Sunk costs are irrelevant to marginal decisions.

Incentive

A reward or punishment that induces a person to act (or not act) in a certain way.

Baby bonus case study (2004): what happened and what was the lesson?

A $3,000 payment for births on or after 1 July 2004 shifted about 1,167 births from June into July. Lesson: phase in policies gradually to avoid sharp incentive jumps around one date.

Lessons 5-10 of economics (one line each)

5 Trade can make everyone better off; 6 Markets are usually a good way to organise activity; 7 Governments can sometimes improve market outcomes; 8 Living standards depend on productive capacity; 9 Prices rise when government prints too much money; 10 Short-run trade-off between inflation and unemployment.

Economic model

A simplified framework for analysing complex real-world behaviour, judged by how reasonable its assumptions are and how well it captures real-world phenomena.

Market

A group of buyers and sellers interacting to trade a particular good or service (physical or virtual).

Competitive market

A market with so many buyers and sellers that each has a negligible impact on the market price.

Two characteristics of a perfectly competitive market

1) The goods offered are identical (homogeneous). 2) Buyers and sellers are so numerous that none can influence the price (price takers).

Monopoly vs monopolistic competition vs oligopoly

Monopoly: one seller, barriers to entry. Monopolistic competition: many sellers with differentiated products. Oligopoly: a few sellers dominate the market.

Quantity demanded

The amount of a good buyers are willing (preferences) AND able (income) to purchase at a given price.

Law of demand

Ceteris paribus, quantity demanded falls when the price rises, and vice versa (downward-sloping demand curve).

How is market demand derived from individual demand?

By summing individual demand curves horizontally (add quantities at each price).

Movement along vs shift of the demand curve

Change in the good's OWN price = movement along the curve (change in quantity demanded). Change in any other factor = shift of the whole curve (change in demand).

Memory rule for shifts vs movements

A curve shifts when a relevant variable that is NOT on either axis changes. Only price is on the axes.

Five determinants (shifters) of demand

Income, prices of related goods, tastes, expectations, number of buyers.

Normal vs inferior good

Normal: demand rises when income rises. Inferior: demand falls when income rises (e.g. instant noodles).

Substitutes vs complements

Substitutes: a fall in the price of one reduces demand for the other (Coke/Pepsi). Complements: a fall in the price of one raises demand for the other (printers/ink).

Quantity supplied

The amount of a good sellers are willing and able to sell at a given price.

Law of supply

Ceteris paribus, quantity supplied rises when the price rises, and vice versa (upward-sloping supply curve).

Four determinants (shifters) of supply

Input prices, technology, expectations, number of sellers.

Effect of a rise in input prices on supply

Supply FALLS (shifts left), because production is less profitable at every price.

Effect of improved technology on supply

Supply INCREASES (shifts right): the same inputs produce more output.

Equilibrium price

The price that sets quantity demanded equal to quantity supplied (market-clearing price); where S and D intersect.

Surplus (excess supply)

Price is ABOVE equilibrium: quantity supplied > quantity demanded. Sellers lower the price.

Shortage (excess demand)

Price is BELOW equilibrium: quantity demanded > quantity supplied. Sellers raise the price.

Law of supply and demand

The price of any good adjusts to bring quantity supplied and quantity demanded into balance.

Exogenous vs endogenous change

Exogenous: an event outside the model that shifts S and/or D. Endogenous: the resulting change in equilibrium price/quantity generated by the model.

Three steps of comparative statics

1) Does the event shift S, D or both? 2) Which direction (left/right)? 3) Use the diagram to find the new equilibrium P and Q.

Demand increases, supply unchanged: effect on P and Q?

Both equilibrium price and quantity rise.

Supply decreases, demand unchanged: effect on P and Q?

Price rises and quantity falls.

Both demand and supply increase: effect on P and Q?

Quantity rises for certain; price is ambiguous (depends on relative size of the shifts).

Demand increases and supply decreases: effect on P and Q?

Price rises for certain; quantity is ambiguous.

When is the change in a variable ambiguous when both curves shift?

When the two shifts push that variable in OPPOSITE directions.

Rationing function of prices

Prices allocate scarce goods: anyone willing and able to pay the equilibrium price can buy; no queues or coupons needed.

Elasticity

A measure of how much one variable responds to a change in one of its determinants.

Price elasticity of demand (PED) formula

PED = % change in quantity demanded / % change in price (use the absolute value).

Elastic vs inelastic vs unit elastic demand

Elastic: PED > 1. Inelastic: PED < 1. Unit elastic: PED = 1.

Four determinants of PED

Availability of close substitutes, necessity vs luxury, scope of the market (narrow = more elastic), time horizon (longer = more elastic).

Perfectly inelastic vs perfectly elastic demand curve

Perfectly inelastic (elasticity 0): vertical. Perfectly elastic (elasticity infinity): horizontal.

Mid-point formula for % change

% change = (X1 - X0) / [(X1 + X0) / 2].

Milk example: price $1 to $3, quantity 7 to 3. PED?

% change Q = -4/5 = -80%; % change P = 2/2 = +100%; PED = 0.8 (inelastic).

Total revenue formula

TR = P x Q (equals total expenditure by buyers).

Price rises and demand is INELASTIC: what happens to total revenue?

TR increases (price and TR move together).

Price rises and demand is ELASTIC: what happens to total revenue?

TR decreases (price and TR move in opposite directions).

Income elasticity of demand

% change in quantity demanded / % change in income. Positive for normal goods, negative for inferior goods. Sign matters.

Necessities vs luxuries in income elasticity

Necessities: income-inelastic (0 to 1). Luxuries: income-elastic (> 1).

Cross-price elasticity of demand

% change in quantity demanded of good 1 / % change in price of good 2. Positive = substitutes, negative = complements.

Price elasticity of supply: sign and determinants

Always positive. Determinants: ability of sellers to change output, and time period (longer = more elastic).

Drug policy example: why can tougher law enforcement raise total drug expenditure?

Enforcement shifts supply left. Demand is inelastic, so price rises proportionally more than quantity falls, so total expenditure rises.

Price ceiling

A legal MAXIMUM price at which a good can be sold.

Price floor

A legal MINIMUM price at which a good can be sold.

When is a price ceiling binding, and what happens?

When set BELOW the equilibrium price. It creates a shortage (Qd > Qs). If set above equilibrium it has no effect.

When is a price floor binding, and what happens?

When set ABOVE the equilibrium price. It creates a surplus (Qs > Qd). If set below equilibrium it has no effect.

Ice-cream ceiling example: equilibrium $3 and 100 units, ceiling $2

Binding. Qs = 75, Qd = 125, so a shortage of 50 units.

Ice-cream floor example: equilibrium $3 and 100 units, floor $4

Binding. Qd = 80, Qs = 120, so a surplus of 40 units.

Rent caps: Saul Eslake's argument

Rent caps are a short-term, ineffective fix: they discourage investment in rental housing and create a privileged class of existing tenants at the expense of others who can't find a rental.

Minimum wage in the labour market diagram

A binding minimum wage (above equilibrium) makes labour supply exceed labour demand; the surplus of labour is unemployment.

Tax incidence

Who actually bears the economic burden of a tax; this can differ from who is legally required to pay it.

Tax on sellers: what happens to the supply curve?

Supply shifts UP by exactly the size of the tax (the tax acts like an extra cost).

Tax on buyers: what happens to the demand curve?

Demand shifts DOWN by exactly the size of the tax.

Does it matter whether a tax is levied on buyers or sellers?

No. The market outcome (price paid, price received, quantity) is identical. Legal incidence is not economic incidence.

$0.50 tax example: equilibrium $3.00, 100 units

New quantity 90. Buyers pay $3.30 (+$0.30), sellers receive $2.80 (-$0.20). The burden is shared and sums to $0.50.

Overall impact of a tax on quantity, buyers and sellers

Quantity traded falls; buyers pay more; sellers receive less.

General rule of tax incidence

The burden falls more heavily on the LESS ELASTIC side of the market.

Subsidy

A payment from the government to buyers or sellers for each unit bought/sold; a 'negative tax'.

$1.00 subsidy to sellers example (equilibrium $3.00, 100 units)

Quantity rises to 120; buyers pay $2.40, sellers receive $3.40. Both sides benefit (buyers +$0.60, sellers +$0.40).

Subsidy incidence rule

The LESS ELASTIC side receives the larger share of the subsidy's benefit.

First Home Owner Grant: why do critics say it mostly benefits sellers?

Housing supply is inelastic and first-home-buyer demand is elastic, so sellers capture most of the grant through higher prices.

Efficiency verdict on rent controls

Generally poor: a binding ceiling creates a shortage and blocks the surplus-maximising quantity, though it may serve an equity goal for existing tenants.

Welfare economics

The study of how the allocation of resources affects economic wellbeing, using consumer surplus (CS) and producer surplus (PS).

Willingness to pay (WTP)

The maximum amount a buyer is willing to pay for a good; a subjective dollar measure of its value to that buyer.

Consumer surplus

WTP minus the price actually paid. Graphically: area above the price and below the demand curve.

Burger example: WTP $13, price $10

Consumer surplus = $3.

What does the height of the demand curve show?

The WTP of the marginal buyer, i.e. the value of the last unit bought (the 'private value curve').

Why does CS rise when price falls?

Existing buyers pay less on the units they already bought, and new sales occur at the lower price (new buyers or extra units).

Willingness to sell (WTS)

The lowest price a seller will accept; equal to the seller's cost of production.

Producer surplus

Price received minus cost of production. Graphically: area below the price and above the supply curve.

House painters example: costs $500, $1,200, $3,200, $4,000 and price $3,200

Three painters sell. PS = 2,700 + 2,000 + 0 = $4,700.

What does the height of the supply curve show?

The cost of the marginal seller (the 'private cost curve').

Total surplus formula

TS = CS + PS = value to buyers - cost to sellers.

Efficiency

An allocation that maximises total surplus: goods are produced by the lowest-cost sellers and consumed by the buyers who value them most.

Why is the market equilibrium quantity efficient?

Below Qe, marginal value > marginal cost (more trade adds surplus). Above Qe, marginal value < marginal cost (extra units reduce surplus). Surplus is maximised at Qe.

Three key insights about competitive markets

1) Goods go to buyers who value them most. 2) Goods are produced by the lowest-cost sellers. 3) The quantity produced maximises total surplus.

Invisible hand and laissez-faire

Invisible hand: self-interested decisions coordinated by prices produce an efficient outcome. Laissez-faire: a planner who only wants to maximise total surplus would leave markets alone.

Two criticisms of efficiency as a measure of welfare

1) WTP reflects ability to pay as well as preference. 2) Efficiency ignores how surplus is distributed (equity).

Market failure

A situation where a market left alone fails to allocate resources efficiently (e.g. externalities, public goods, asymmetric information, market power).

Effect of a tax on CS, PS and government revenue

CS and PS fall; the government gains revenue (tax x new quantity); the total of all three falls.

Deadweight loss (DWL) of a tax

The fall in total surplus over and above the revenue collected (areas C + E); lost trades that were worth making.

What determines the size of a tax's DWL?

Price elasticities of demand and supply: the greater the elasticities, the larger the fall in quantity and the larger the DWL.