GMU Econ Midterm

Economics

The study of human behavior whenever there is choice

Economic Way of Thinking

Applies across people, time, and geographic space

Assumptions of Economics

1. Methodological individualism

2. Purposive, goal-oriented, action

3. Individuals economize by considering costs

   and benefits

Methodological individualism

Economic assumption 1

• The individual is the unit of analysis

• Economics emphasizes that all social phenomena emerge from individuals’ actions and interactions

Cost and benefit analysis

Economic assumption 3

• Individuals seek the desired ends in the least cost way from their perspective

• Does not mean:

  • people never make mistakes

  • people are automatons

  • people are extremely intelligent

Guideposts to economic thinking

1. scarcity

2. competition is ubiquitous

3. opportunity cost

4. marginal analysis

5. incentives matter (utility)

6. seen and unseen (observable and hidden consequences of choices)

7. value of a good/activity is subjective

8. information is costly (no one knows everything = cannot make perfect choices = uncertainty is a fact of life)

Scarcity

There are more human desires than resources for the satisfaction of these desires freely available in nature

Scarcity vs Poverty

• Absence of poverty = some basic level of need has been met

• Absence of scarcity = all desires for goods are fully satisfied

Poverty can be theoretically eliminated — scarcity cannot.

Rationing

How to allocate scarce resources among competing uses in society

• first come, first serve

• lottery

• markets

• government

• violence

Competition

Arises from scarcity, not greed

Having to choose between alternatives creates natural competition

rationing method changes form of competition, but cannot eliminate competition

Opportunity cost

The cost of a choice is the next best alternative foregone

Choosing how to allocate resources is the implication of opportunity cost

Marginal

One additional unit

Marginal benefits

the additional benefit from one more unit of an activity

Marginal cost

the additional cost of one more unit of an activity

Marginal analysis

Individuals engage in an activity when the expected marginal benefit exceeds the expected marginal cost

Individuals refrain from an activity when the expected marginal cost exceeds the expected marginal benefit

Incentives matter

Utility (happiness) is the motivation

Marginal cost increases = marginal benefit decreases = less likely to engage in the activity

Marginal cost decreases = marginal benefit increases = more likely to engage in the activity

Private property

The right to use, control, and obtain benefits from a resource, good, or service

Private property rights

• the right to exclusive use

• legal protection against invaders

• the right to transfer to another

Economists seek to understand current assignment of rights to understand incentives facing relevant actors

Importance of private property rights

• Private owners can gain by using their resources in ways beneficial to others

• Owners have a strong incentive to care for and manage what they own

• They have an incentive to conserve for the future (if valued)

• Owners have an incentive to lower the chance that their property will cause damage to the property of others

• Private property both disperses power and shields us from the coercion of others

Consequences of lacking or poorly defined property rights

• Create problems with resource allocation

• Weaker incentive to conserve and care for resources

  • Tragedy of the commons

• Distorts incentive to produce

  • The free-rider problem

Subsistence production

People produce only enough to survive

No specialization, no trade

Subsistence incentivized by no property rights because it’s risky to produce extra if anyone can steal it

Barter economy

Transition out of subsistence production

Specializing in producing one good (more than they personally need) and trade with others

Barter encouraged by property rights because people can safely trade their surplus

Positive-sum, voluntary trade

• Both parties are better off because each values what they receive more than what they give up (marginal analysis)

• Both parties informed of what they’re receiving

• both parties must own what thyere

Gains from Trade

• Channels goods toward those who value them the most

• makes it possible for people to produce more as a result of the specialization and division of labor ad the dissemination of improved products and lower cost production methods

Economic Pie

Idea that the economy is a fixed pie that is divided up (zero-sum view)

• Neglects the potential for human creativity leading to innovation and a bigger pie

Transaction Costs

Time, effort, and other resources needed to search out, negotiate, and consummate an exchange

• these reduce our ability to produce gains from potential trades

• innovations reduce these

Institutions

the formal and informal rules governing human behaviour

Institutions as the rules of the exchange game

Influence the payoffs associated with certain courses of action

Policy vs institutions

Tax rate = policy

Process through which tax rates are set (government) = institution

Two types of institutions

Designed

Emergent

Designed institutions

The result of human reason

Emergent institution

the result of emergent processes that do not rely on human design

Institutions and coordination

They facilitate, or prevent, interaction and exchange

How? raise the net benefit (cost) of certain activities for better or worse

Source of property rights

Establisher and enforcer can be anyone

Public (government) property rights

Formal laws and state enforcement institutions define and enforce the rights that emerge

Private property rights

Norms and private agreements define and enforce the rights that emerge

Order without formal law

Norms exist in everyday life

formal law (legislation) is much less important for order than most people assume

The costs associated with learning about legislated law and utilizing formal resolution procedures is high relative to following informal norms

Three key functions of law

1. rule formation

2. dispute resolution

3. rule enforcement

Market

Interaction between people categorized as buyers and sellers

• categories not predetermined nor fixed, rather fluid

• anyone could be a buyer or seller in a market for a good or service

• people tend to be buyers in some markets and sellers in other markets

Market prices

generated by exchanges with a monetary unit which capture relative scarcity

• serve as guides for economic actors:

  • inform the actions of individuals without informing them of specifics

  • present perceived profit opportunities

Perceived profit opportunities

Information for sellers assumed by market price

• subjected to the market test of profit and loss

Profit

Indication to producers that they have combined scarce resources in a manner which is valued by consumers

• green light to continue to produce

• attracts additional production

Loss

Indication to producers that they have failed to combine scarce resources in a manner which is valued by consumers

• red light to stop production

• scarce resources valued more highly in other activities

Entrepreneurship

Alertness to possible profit opportunities

• driving force of markets

• rivalry between these people is what drives the ongoing reallocation of scarce resources

Order

Integration or coordination of activities between members of a group

Two types which vary in complexity:

1. planned

2. unplanned/spontaneous

Planned order

rationally constructed

ends driven

Unplanned/spontaneous order

emergent order resulting from the interactions of many people, each pursuing their own goals

• market process is this type of order

  • outcomes emerge from the interactions of people pursuing their own goals

  • not predetermined by a final decision maker

Barriers to free entry into a market

Economies of scale

government licensing

patents

control over an essential resource

Monopoly

Market with

• high entry barriers and/or

• a single seller of a well defined product for which there are no substitutes

Concern with monopolies

high entry barriers remove the competitive market pressure created by contestable markets

allows monopoly companies to charge high prices and limit output

discipline of market forces is weakened

Contestable market

incumbents can be challenged by potential entrants

• different from the number of firms or market share at a point in time

Competitive forces

these are present even in markets with what appear to be high entry barriers

i.e.

• product quality and the development of substitutes

• profitability and high prices encourage innovation and technological change

• lower transportation and communication costs broaden markets and increase competition (i.e. trade protections)

Price Gouging

When the seller charges an “unfair” price

Emergency price gouging statutes

Many states have these in place

Some specify certain percentages

i.e. Alabama is specific: gouging occurs if a business sells goods at a price that is 25 percent higher than the average price at which the same commodity was sold during the 30 days immediately prior to the state of emergency

i.e. Virginia is ambiguous: During any time of disaster, it shall be unlawful for any supplier to sell, lease, or license, or to offer to sell, lease, or license, any necessary goods and services at an unconscionable price within the area for which the state of emergency is declared. Actual sales at the increased price shall not be required for the increase to be considered unconscionable.

Economics of price gouging

Disasters (i.e. natural) change the scarcity conditions

• otherwise basic goods and services become increasingly scarce

• emergency impacts supply and/or demand and hence price

Increase in price makes buyers unhappy but it is not driven by seller greed and desire to take advantage of plight of buyers

• change in price is a signal of changes in supply and/or demand (i.e. change in relative scarcity)

Factors leading to a change in demand (shift the curve)

changes in consumer income

change in the number of consumers

change in the price of a related good

changes in expectations

demographic changes

changes in consumer tastes and preferences

Factors leading to a change in supply (shift the curve)

changes in resource prices

changes in technology

elements of nature and political disruptions

changes in taxes

Impact of higher prices

Provide an incentive to entrepreneurs to voluntarily act in the social interest

Incentive for producers to increase supply of goods brought to market

• reallocate goods and services from outside the emergency area and deliver them to the emergency area (helps people in need)

Fallacies of price gouging

1. prices are determined by cost

2. prices stay constant over time

3. it is possible to determine if a price is unconscionable

4. people “take advantage” of others through voluntary exchange

5. - businesses have an incentive to take advantage of customers

Economic realities relative to price gouging

• prices reflect relative scarcities

  • provide information to producers and consumers so they can determine how to allocate scarce resources among competing ends

• allowing prices to increase leads to a fast reallocation of resources

  • higher price provides an important incentive to suppliers to increase supply and to anticipate emergencies

  • leads to an eventual fall in price

• restricting prices by legal mandate is the equivalent of a price control (i.e. price ceiling)

  • results in a shortage hurting those in need of goods and services

  • provides a disincentive to plan for emergencies

No Free Lunch (Caleb Fuller) - Introduction

Economics as a framework for thinking, not a collection of facts

Economics is not money, business, finance, stock markets, gdp, graphs

Economics is the study of how people pursue goals under conditions of scarcity

Repeatedly compares economics to a pair of glasses — without them you only see the obvious, with them you begin seeing hidden tradeoffs and unintended consequences

Every chapter is about opportunity cost, applying it to different situations

“Lies” are not honest mistakes, economics has understood issues for centuries and repeating ideas today is ignorance to what has already been disproven

No Free Lunch (Caleb Fuller) - Chapter 1

Destroying wealth does not make society richer

• may increase work, spending, increase measured GDP

• resources used for rebuilding could have created something new instead

Economic eyeglasses: most people only notice what is seen (broken window repaired, workers hired, money changes hands, companies earn revenue)

• What is unseen: what would workers build otherwise? what would the steel be used for? All other possibilities disappear

GDP does not equal living standards

• gdp can increase while ordinary people are worse off.

Myopia: bastiats term for only looking at immediate visible effects

Folk economics: people believe simple stories. economics requires looking at unseen opportunity cost

Bastiats broken window:

A vandal breaks a shop window

Someone says great because the glazier gets business, then he will buy shoes, the shoemaker buys bread, everyone benefits.

Bastiat asks what the shopkeeper could have done if his window had never broken…he could have bought a suit, books, etc. Those opportunities are gone

Community now spends resources merely replacing something it already had

End result is one repaired window

Could have been an existing window and a new suit.

9/11 example:

Paul Krugman said rebuilding after 9/11 stimulated the economy.

The construction activity increased, yes.

but it was all resources taken from new projects. we did not become richer.

A Marvel of Cooperation (Russel Roberts)

Modern society functions because millions of strangers cooperate with one another without anyone planning or directing them.

Connects to bastiat question: why does nobody worry that Paris will run out of bread tomorrow?

Adam smith: prosperity comes from specialization

henry george: nothing is actually simple. each item of your breakfast is incredibly complicated and results from enormous cooperation.

Leonard Read’s essay “I, pencil”: no single person possesses all the knowledge required to make a pencil. one person knows graphite, one knows cedar, etc. but still pencils are made.

Hayek: for pencils, graphite becomes scarce. no one sends a mass email so prices rise which naturally encourages conservation, substitution, innovation, increased production. everyone responds to price change without knowing why it changed.

Chinese: millions moved from rural to cities. should have caused shortages but most americans barely noticed because markets adjusted.

Reality of Markets (Russel Roberts)

“Why do people misunderstand markets"?”

Emergent

People naturally think of two categories of things, there are 3

1. designed = having planners

2. natural = nobody controls them

3. emergent systems = not planned, not random, produced by millions of human decisions

Language example: nobody approved of modern slang, it just started because people use them

Traffic: follows predictable patterns that no one wants

Housing prices: sellers dont make them expensive, the market does

Markets and prices are emergent

Engineering thinking vs economic thinking: design vs out of human control

Property Rights (Armen Alchian)

Property rights are human rights

Property rights are essential because they create incentives for people to use resources efficiently, cooperate peacefully, and create wealth.

the legally protected authority to decide how a resource is used.

1. Right to decide how the resource is used i.e. renovating house

2. Right to enjoy the benefits (services) of the resource

3. Right to exchange the resource

Private property is subject to public preferences:

• prices reveal what others value

• i.e. farmer wanting to grow corn but people want apartments (lose opportunity cost if pursuing corn instead of development)

No property rights = compete through force

with = through voluntary exchange

Makes discrimination more expensive (i.e. denying a black tenant offering $2200 vs white tenant offering $1900)

• reducing property rights with controls (i.e. ceiling) increases discrimination (now the max price is $1000, so landlord chooses tenant on race, gender, etc)

Tragedy of the commons: common ownership encourages overuse

Socialism: deincentivices extra work because the individual does not reap extra benefit

Shared property works i.e. corporation but must be defined

sometimes property rights are too complicated (i.e. air) so government regulations assign ownership without high cost

How I Built a Toaster from Scratch (Thomas Thwaites)

Modern products are only possible because of the extraordinary cooperation, specialization, and division of labor that exist in market economies.

Douglas Adams' The Hitchhiker's Guide to the Galaxy: thought if he were stranded among primitive people, he could recreate modern technology. but realized Without society, he can barely make a sandwich.

buys cheapest toaster, disassembles it to find its not cheap = simple. 400 individual parts, over 100 materials. narrows to 5 major materials.

• raw materials arent easy to obtain and turn into usable material (steel from iron ore; copper collected from water)

• Plastic from petroleum cant get petroleum, makes from potatoes and snails eat it, ends up having to reuse old electronics for material (reusing and recycling)

toaster barely works in the end, melts after 5 seconds, proves that no individual can make a cheap toaster from scracth