Introduction to econ

What is Economics

Unlimited wants + limited resources = scarcity

Division of Labour

Specialisation (skilling and deskilling)

Highly structured, routinized work

No switching between tasks

Improved methods and tools

Right person for the job

Self interest

“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”

Note: Smith was not advocating a purely selfish approach

The invisible hand of the market

Unintended consequences

Positive effects of self-interested actions

Later economists use the phrase to mean a self-regulating market mechanism

Libertarians: free market produces the socially optimal outcomes

Creative Destructions

Joseph Schumpeter

Economic innovation

Technological change, new markets, new methods of transportation

Destruction of older industries and jobs

Pareto

Pareto improvement

Reallocation of resources can make at least one person better off, without making anyone else worse off

Pareto efficiency

No more pareto improvements can be made

Trade-offs

Jeremy Bentham

Economics

Utility Function

Maximising Utility

Marginal analysis

Marginal Benefit versus Marginal cost

Return to scale

Economics of scales (diseconomies of scale)

Marginal Utility

Overall, in well-behaved problems, the optimal decision entails that: Marginal Benefit=Marginal Cost

Opportunity Cost

Value of the second best option forgone

For example:

Self-employed person can make £150 per day (after taxes and expenses). If this person takes a day off, the the opportunity cost is £150

Short run and Long run

Short run: only some production factors are variable → continue producing with a loss

Long run: all factors of production an costs are variable

John Maynard Keynes

‘In the long run, we are all dead’

Economies of scale

How can we make a company/ economy more productive? A fundamental idea is that often this can be achieved by scaling the level of production.

If we scale the production x times, and the production increase by more than x times, then we say that we have positive returns to scale

Bigger companies are often more production than smaller companies

Causes: specialisation of the workers

Potential to invest in special capital equipment

Large size allows for resources for R&D

Neoclassical Economics: the dominant school in economics

Influenced by hard sciences, it views economics as a science

It is a highly mathematical approach, developed in the 20th century

Typically assumes ‘Economics Man’: Utility maximising, Rational

It evolves to accommodate criticisms:

• Behavioural economics

• Neo-Keynesian economics

Value vs Price

Value of a good to someone depends on how much it satisfies them and how much they want it

Maximum price someone is willing to pay is sometimes called economic value or willingness to pay for the good

Value and price are not the same thing

Price is usually decided by market to which economic value pays role but is not the only factor

Price is determined by government in some cases

Market

Traditionally, it has been a physical location where sellers of a particular good or service meet buyers of that good or service
There is a potential for a transaction to take place
Sellers adjust their prices to demand:
When they see no people, they lower the prices to sell off
When they see queues, they increase the price in order to increase their profits until people no longer queue
These days, online markets are predominant.

Demand and supply

Quantity demanded - Amount buyers plan to purchase in the market at a given price

Quantity supplied - Amount that suppliers plan to supply to the market at a given price

Demand versus wants

Demand is the willingness to purchase a good and ability to pay for it

Needs (necessities to live) and Wants (desires for non-necessities translate into demand if there is the capacity to pay as well

Construction of demand curves

Factors which influence demand

Price of the good

Income of consumers

Number of consumers

Prices of related goods (substitutes, complements)

Tastes (e.g. by advertising)

External conditions (e.g. weather)

Supply

The supplied quantity for a given price is the total amount that the producers in the market are willing to produce for a given price
As the demand is informed by the (marginal) benefit of
consumption to buyers, supply is determined by the
(marginal) cost of production to sellers
The higher the price, the more sellers will want to provide the good (positive slope)

Factors which influence supply

• Price of good
• Number of sellers
• External shocks (e.g. weather)
• Costs of production
• Technology

Functions

• A single-variable function is a mapping rule from one
variable to another one.
• Independent variable on 𝑥 axis
• Dependent variable (the one that depends on x) on 𝑦 axis
The function implies causality: 𝑥 affects 𝑦
The function does not require also 𝑦 to affect 𝑥
For every value of 𝑥 the function assigns exactly one value of 𝑦

Demand Functions

• A single-variable function is a mapping rule from one
variable to another one.
• Independent variable on 𝑥 axis
• Dependent variable (the one that depends on x) on 𝑦 axis
The function implies causality: 𝑥 affects 𝑦
The function does not require also 𝑦 to affect 𝑥
For every value of 𝑥 the function assigns exactly one value of 𝑦

Equation of a straight line

For a linear relationship
𝑦 = 𝑚𝑥 + 𝑐
𝑚 is the slope or gradient
𝑐 is the 𝑦 intercept
Slope (gradient) = 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑦/ 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑥

• Co-ordinates (x, y) on the xy-plane
• Two points on a straight line with known co-ordinates allow us to determine the equation of the whole line: First we find m -> use either line to find c

Simultaneous equations

• In equilibrium, quantity supplied equals quantity demanded
• Solve the simultaneous equations to find
market clearing price (or equilibrium price)
market clearing quantity (or equilibrium quantity)

Special cases

Parallel lines - No Solutions (lines don’t cross)

Same line (repeated) Infinite number of solutions

Area of triangle

½ x base x height

Market efficiency

Total surplus = consumer surplus + producer surplus (no government intervention

Free markets maximise total surplus

• They thus achieve pareto efficiency: cannot make one person better off without making someone else worse off

  • But this observation is not concerned with equity and distribution of the surplus

Shocks

Economies are often stricken by shocks (weather shocks, accidents, wars, market crises, etc)

There are positive and negative shocks

Demand and supply curves can shift as the result of shocks

Size of surplus can show us the effects of shocks on consumer and producer welfare

Interventions in the market

Government policies also affect outcomes:

• Price ceiling

• Minimum prices

• Subsidies

• Taxes

Potential consequences:

Excess demand

Excess supply

Illegal markets (black market)

Elasticity

It is the % change in the quantity or supplied in response to a 1% change in price (or income)

We are interested in this because it is directly comparable across goods

It is also used as a tool for decision-making: to estimate effects of pricing change or policy interventions

Components of elasticity

To calculate own price elasticity of demand, we need:

Magnitude of change in price

Magnitude of change in quantity demanded

Initial level of quantity demanded

Initial level of price

Own price elasticity

By convention

As normal goods have a downward- sloping demand schedule, the resulting elasticity will be negative

Some economists take the absolute value of the elasticity for easier interpretation (i.e. the equivalent positive number)

Notation for absolute values is (x)

Therefore | − 3| = 3

How do we interpret the results?

If we are using the absolute value approach

Example

A customer usually buys 500 oranges at a price of £1 each

Price increases to £1.20 each

Customer now buys 450 oranges

What is the own price elasticity of demand at this point

Percentage increase = 20%%

Percentage decrease in Quantity = 10%

Absolute value of Elasticity = 10/20 = 0.5

Detailed solution

How do we interpret the results

If we are using the absolute value approach

Example 2

• The customer usually buys 500 lemons at a price of £1 each.
• The price increases to £1.20 each.
• The customer now buys 100 lemons.
What is the own price elasticity of demand at this point?
Percentage increase in Price: 20%
Percentage Decrease in Quantity: 80%
(Absolute value of) Elasticity: 80/20=4

Detailed solution for example 2

How do we interpret the results

Easier version of the formula

Cross price elasticity of demand

% change in the quantity demand of good x, given a % change in the price of good y

How do we intepret the results for cross price

Easier version of the formula cross price

Example

Customers usually buys 500 oranges at price of £1 each

She also buys 500 lemons at price of £1 each

Price of oranges increase to 2.50

Customer buys 600 lemons

How do we interpret cross price example results

Income elasticity of demand

% change in quantity demanded given a % change in come M

Easier version of income elacsticity formula

How do we interpret income elasticity results

Example of income elasticity

• A customer usually buys 2 mangoes at a cost of £4 each
• The customer’s income is £30,000
• The customer’s income then increases to £45,000
• The customer now buys 10 mangoes

As it is above 1 it is classified as a luxury good

Veblen Goods

• Defined in economics as:
A positive own price elasticity of demand
(when Normal and Inferior goods have negative PED)
e.g: If Picasso paintings were not so expensive, many rich
people would not be so passionate about obtaining them.

Why tax goods?

Governments need money to sustain the public goods and services

Tax on goods (e.g. VAT is usually more difficult to avoid than income tax

On top of generating revenue, the government may want to discourage the consumption of some goods such as cigarettes, sweets, etc

Sometimes good have good externalities, and their consumption is subsided (e.g. good appearance of a building’s façade

Which good can we tax

Own price elasticity of demand (absolute value)

Total welfare = CS + PS

As we saw, the optimal level of consumption (absent externalities) is Q* with high social surplus CS+PS

Essentially what the tax will do is cause a lower level of consumption

Deadweight loss

Essentially, what the tax will do is cause a lower level of consumption

This will lead to a welfare loss

Taxation

Tax can be seen as a wedge between the price consumer pays and the amount the producer receives

Deadweight loss

Tax also generates government revenue equal to the (New level of production) *tax

Imposing a tax on the supplier

Tax of the supplier essentially shifts the supply curve upwards

The supplier now faces higher cost per unit sold, which makes them want a higher price in order to supply the good

Imposing a tax on the buyer

Tax of the buyer essentially shifts the demand curve to the left

Buyer now needs to subtract the tax from their WTP for the good

Taxation

Direct costs of taxation

e.g. paying salaries at the Inland Revenue

Deadweight loss

Consumer and producer surpluses fall

Quantity traded is less

Buyers pay higher prices

Sellers obtain lower prices

Laffer curve

Sin taxes

Aim at reducing consumption of harmful goods

Have paternalistic flavour

Not necessarily concerned with revenue-raising

Recent example: Taxes of sugar, tobacco, alcohol

Sin taxes have negative consequences

often are regressive taxes

induce the development of black markets

Sin taxes vs pigouvian taxes

Sin taxes have one primary focus:

Reduce consumption of goods/ activities which have negative effect on oneself

Different to pigouvian tax

Pigouvian taxes reduce activities which have a negative effect on others

In practice, sin taxes and pigouvian taxes are often part of the same politicial debates

Example: tax on sugary soda drinks

• Soda Tax of 2018 (UK)
• Tax on sugary fizzy drinks
• Poorer consumers drink more soda than wealthier people
• Would cutting out soda help the poor?
Only one product in a larger junk food category
Limited time for food preparation
Super-sizing and tight family budgets
Lack of access to exercise facilities

Black Markets

Sin taxes may encourage people to hide their transactions. Such
shadow transactions take place within Black Markets. These tend
to be highly problematic because they:
-Transfer funds to criminal gangs
They then use those funds for other criminal activities
-Undermine the rule of law
Seen as an acceptable or victimless crime
-Exhibit a lack of oversight on product safety and quality
No consumer rights
-The product is still being consumed
The underlying health issue is not being tackled

Indoor smoking ban

Bans can be seen as a prohibitively high on sin tax

This ban was particularly aimed at passive smoking. Indeed it has been very successful in many countries:

Drop in hospital admissions for childhood asthma

Drop in hospital admissions for heart attacks

Drop in cigarette sales

Taxation at international level

• Taxes imposed on international trade
• Tariffs are taxes on imports or exports
• Is it better to buy only domestically
produced goods? Economics teaches us
that it is generally not so.
Ricardian Comparative Advantage
• Autarky is not beneficially economically

Tariffs and their consequences

• Protectionism: protect local industries from foreign
competition
• Trade Wars: tariffs lead to retaliation by other nations,
resulting in ‘trade wars’ that harm international trade.
• Many economists have argued in favour of free trade
throughout the centuries

Gains from trade

• Avoids trade wars (and actual wars)
• Transfer of knowledge
• Effect of competition on innovation
• Absolute Advantage: counties export the goods they are not productive in, relative to other countries

Absolute advantage

Producer can make a product at a lower cost per unit (or
more efficiently) than others.
• Different producers with different absolute advantages gain from trade
• Specialisation
• Division of Labour

Critiques to unfettered free trade

• Infant industries: Firms in some industries need to survive an
initial phase, before becoming ‘exponentially’ productive,
especially in technology industries
• Strategic industries, such as pertaining to national defence,
telecommunications, transportation, etc.
• Specialisation may lead to excessive dependence on
international conditions, and this may be risky

Losers from free trade

Unspecialised workers in rich countries are greatly affected by imports
from poorer countries
In theory, they could be compensated for their loses (because the
economy as a whole gains from trade). This is called the
‘compensation principle’.
Unfortunately, in practice, this compensation rarely happens.

Tax havens

Globalisation and liberalisation has come with a fundamental change: free mobility of capital across countries and jurisdictions
• This leads to tax competition: counties that impose lower taxes attract capital. This is particularly true for very small nations (Cyprus, Monaco, Cayman Islands, Virgin Islands, Luxemburg, etc.)
• This leads to a major global problem of tax avoidance (legal and illegal)
• Tax havens and Dutch disease: negative effects for tax havens

Tax ‘competition

Different jurisdiction have different rules on tax

Ability of nations to tax is curtailed by outside options
Free-riding problems: firms and individuals, avoiding to pay their share of taxes

Tax avoidance in general

• Legally acceptable tax avoidance can be problematic
– Reduces tax revenue
– Diverts resources into financial sector aimed at reducing tax payments, taking away from other sectors
• Cash economy and under-reporting
– In several countries, there is a very large shadow economy, where even major transactions take place by cash
– This is in order to avoid showing profits
• Money laundering
– The need to show origin of funds creates compliance costs for everyone

International Monetary Fund Estimate (2019)

• Tax havens cost $500-600 billion a year in lost corporate tax revenue globally
• Low-income economies lose $200 billion per year
• Low-income economies receive $150 billion per annum in foreign development assistance

Effects on the tax haven itself

• Dutch Disease
– Resources move to one sector: finance/banking
– Prices of non-tradeable goods increase: local consumers from non-tradeable sectors lose out
– Currency becomes stronger
– Exports less competitive
– More imports

Effects on the tax haven

Lack of jobs outside ‘the sector’

Increase house prices

Political system ‘captured’ by the sector

Too big to fail problems

Banking sector unconditionally supported, creating moral hazard problems

Financial secrecy= global crime

Market power

• Does a given firm have control over the market price? Is so, it has market power.
– This is closely associated with the elasticity of demand
• Number of firms in the market
– Small number indicates market power
• Entry and exit
– Are there barriers to entering a market (legal, strategic, etc.)
• Differentiation of products
– Can create brand loyalty and market power
– Can reduce elasticity of demand

Forms of market structure

• Perfect competition
• Monopoly/Monopsony
– Price discrimination
– Competition and regulation
• Oligopoly
– Game theory as an analysis tool

Anti-competitive measures at national level

Subsidies for local companies

Tariffs

Quotas on volume of imports

Boycotts of foreign product (buy UK)

Opaque or unfair rules for imports

Perfect competition

• An ideal case, very hard to find in practice. This is where the traditional demand and supply paradigm is grounded.
• Free entry and exit of firms in the industry
• Many identical firms – each small relative to market
• Identical products, no differentiation or market power
• Many consumers
• Free and complete information about the good and prices

Horizontal demand curve for individual firm

No firm can increase the price above P* without losing all its customers

So firms are price-takers: they take prices as given, and have no control over them

Marginal Cost and Marginal Revenue

• Marginal Cost
The extra cost generated by an increase in output of 1 unit
• Marginal Revenue
The extra revenue generated by an increase in output of 1 unit
NOTE: Not the same as Average Cost and Average Revenue

Marginal versus Average

Example of marginal and average

• A factory can produce 1000 cars.
• The total cost of production is £150,000
• If the company wishes to make 1001 cars, it will need a new factory. The cost of the factory is £20,000.
Total Cost = £170,000
Average Cost = £170 (rounded to nearest integer)
Marginal Cost = £20,000

Definitions in Economics

Assumer firms are profit-maximisers

Profit π = TR – TC

Accounting profit is different

Normal profit (i.e. TR=TC)

Supernormal profits

Shut down rule

• At chosen Q (MR = MC)
SR Production if p cover AVC If not Q = 0
LR Production if p cover AC If not SHUT DOWN

Points to note

• MC schedule always cuts AC schedule at the minimum point
(of AC)
• Price is the same as ‘Average Revenue’
• For perfectly competitive firms, AR = MR

Perfect competition

Imperfect competition

The perfect competition market is better seen as a benchmark
In reality, firms differ in products, location and costs
Individual producers (or consumers) exercise some control over market prices
Today we shall see the strongest types of market power and control over the prices: Monopoly and Oligopoly

Natural monopoly

Recall than the demand curve tells us the prevailing market price required in order to sell a specific amount Q of units in the market

Monopoly's Marginal Revenue is lower than the Price, because when production expands, the price needs to fall in order to sell more units

Price discrimination

Charging different prices to different customers

Prevent resale

Knowledge of reservation prices

Transfer consumer surplus to producer surplus

Second degree price discrimination

Regulation of Monopoly

• Encourage competition, enforcing division of monopolists
• For Natural Monopoly: public ownership
• Technological barriers can be reduced by insistence on knowledge sharing
– US insists Microsoft provides information
• Advertising and excess capacity as entry deterrence strategies
– Advertising expenditure can be limited (e.g. tobacco)
– Proving that excess capacity is held to deter entry is difficult
• Reducing barriers to entry
– Legal Barriers can be removed by changing law

Oligopoly

A small number of large players in the market (think most advanced technology markets)
In these environment, firms need to behave strategically
The price they set depends on what they expect others to do
Alternatively, firms may also choose to collude

Cartel

Firms collude to increase profits

Price fixing

Reducing output

Market sharing

Tacit collusion

Game theory

• It is a method to predict the outcome of social interactions when people can anticipate the possible behaviour of others
• A Game consists of a set of players, who each have a set of strategies and payoffs that depend on each outcome
• The outcome of a game is predicted to be according to the equilibrium of the game

Terminology

• Dominant Strategy
The strategy that yields a higher payoff regardless of the actions of the other player(s)
• Dominated Strategy
If a player has a dominant strategy, then all the other available strategies are dominated strategies
• Nash equilibrium
Each player chooses his or her best strategy given the choices of the others

Income Distribution

• We have seen that, since the time of Adam Smith, economics has examined the idea that markets are efficient and a system
with free markets is likely to create wealth.
• However, this does not mean that this wealth is equitably of fairly distributed
• Redistribution of income is a major objective of State
intervention in the economy