Economics Exam Notes

Introduction

• What is economics?

• How do economists think? (The methodology of economics)

• What do economists do?

• The main ideas in economics

• Production possibilities model

What is Economics?

• Social science: economics is a way of thinking about behavior.

• Economics studies every instance of human behavior

  • Why people go to school

  • How to protect the environment

  • Is media biased

Two Fields of Economics

• Microeconomics: studies the behavior of individual people or individual firms

• Macroeconomics: studies the behavior of the whole economy.

  • Micro foundation of macroeconomics

How do economists think? (The methodology of economics) I

• Economists make assumptions

• Economists use formal language to construct models based on the assumptions they make

  • Formal language: mathematics (symbolic logic) or verbal logic

  • Model: simplification of reality

  • Economic model: assumptions + constraints => conclusions

How do economists think? (The methodology of economics) II

• Economists try to construct useful models

  • Models that can explain real stuff

  • Models that are testable

  • Models that are simple

What Do Economists Do?

• Two ways economic analysis can be done

  • Positive analysis: explain behavior

    • is an objective, value-free, testable statement.

    • what is

  • Normative analysis: prescribe behavior

    • based upon subjective beliefs and involves value judgement

    • what should be

What about This Course?

• Positive analysis

  • How is the market price determined?

  • What will be the effect of government policies: rent control, carbon tax?

• Normative analysis

  • Should we control the rent?

The Main Ideas in Economics

• Scarcity: it exists when the price of a good is zero and people want more of it than the amount available.

  • The price of every scarce good must be positive.

• We live in a world characterized by scarcity.

  • We must constantly face trade-offs and make choices: to get more of something we have to get less of something else.

• Economics studies people’s choices.

Opportunity Cost I

• What is cost?

• Accounting cost (historical cost) is most commonly used: the price you pay to get it

• We don’t use it in economic analysis because it is often irrelevant of the current behavior we are interested in.

  • The selling price of Manhattan was US$24.

  • The price of your house was $500,000 10 years ago

Opportunity Cost II

• We use opportunity cost in economics.

• Opportunity cost: the value of the next best alternative that is forgone when one alternative is chosen.

• It is up to the choices you have

• It is the value of the highest forgone alternative

• Adding up opportunity cost

The Production Possibilities Boundary (PPB)

• It illustrates the tradeoffs that society faces in using its scarce resources.

• Three assumptions:

  • an economy makes only two products

  • resources and technology are fixed

  • all resources are employed to their fullest capacity ( production efficiency)

• The production possibilities boundary (PPB) shows a range of possible output combinations for an economy.

• It highlights the scarcity of resources.

• Points on PPB: efficiency

• Points inside PPB: inefficiency

• It has a concave shape, which reflects the law of increasing opportunity costs.

• Shift of PPB: economic growth or contraction

The Law of Increasing Opportunity Costs

• As the quantity of computers rises, so does their opportunity cost.

Shifts in Production Possibilities

• With more computers, the curve shifts out in the next period.

How to Deal with Scarcity?

• Adam Smith assumed that people deal with scarcity by engaging in a particular type of behavior aimed to make them as happy as they can be – maximizing behavior or optimization.

• Maximizing behavior

  • is different from maximizing revenue/wealth.

  • doesn’t mean people are always right.

  • helps us understand how people respond to incentives.

Equilibrium

• Equilibrium: a situation in which no one wants to change their behavior.

  • Everyone is maximizing in equilibrium.

Why believe in maximization?

• It works

• Evolution

Economic systems

• Specialization and trade

Economic Systems

• Two economic systems:

  • The command system

  • The market system

Characteristics of Market Economy

• Private property

• Freedom of enterprise & choice

• Self-interest

• Competition

• Markets and prices

  • Prices signal scarcity and guide resource allocation

  • “The Invisible Hand”

Three Fundamental Questions

• What will be produced?

  • those goods & services that can generate profits

  • What consumers vote for with their dollar: Consumer Sovereignty

  • Market restraints on freedom

• How will the goods & services be produced?

  • With the most efficient, least costly methods

• Who will get the goods & services?

  • Those with the highest willingness & ability to pay

Topics Covered in the Course

• Demand, supply and market equilibrium

• Consumer behavior

• Producer behaviour in different market structures

• Factor markets

• Market failures

• Government policies

Absolute Advantage and Comparative Advantage

• One person has an absolute advantage over another in the production of good X when an equal quantity of resources can produce more X by him/her than by another person.

• One person has a comparative advantage in the production of good X if his/her opportunity cost of producing X is lower than that of another person.

Specialization and Trade

• No specialization and trade:

  • Suppose each of them spend ½ days on each chore.

  • They will cook meals and wash _ clothes in total.

• Specialization and trade:

  • Suppose they produce according to the comparative advantage.

  • Let Mary specialize in washing clothes, and David spend ¾ days on cooking and the remaining ¼ days on washing.

  • They will cook meals and wash _ clothes in total.

  • What is the total gain from specialization and trade?

  • With specialization and trade, both of them get better off with more consumption.

Readings

• Chapter 1-2, 19.1 (the part about absolute advantage and comparative advantage)

Topics

• Demand

• Supply

• Market equilibrium

A Demand Schedule and a Demand Curve

• The total amount that consumers are willing and able to purchase at a given price level during a certain period of time is called the quantity demanded of a product ($QD$$$QD$$).

  • Willingness to buy

  • Ability to buy

• A change in quantity demanded refers to a movement from one point on a demand curve to another point.

  • is shown by movements along the demand curve

  • Is caused by price changes

Demand and The Law of Demand

• Demand ($D$$$D$$)is the entire relationship between a product’s price and quantity demanded during a certain period of time, other things being equal.

• The law of demand states that price of a product ($P$$$P$$) and quantity demanded ($QD$$$QD$$) are negatively related.

  • When the price goes up, the quantity demanded decreases.

  • When the price goes down, the quantity demanded increases.

Changes in Demand

• A change in demand is a change of quantity demanded at every price level.

  • is shown by shifts in the demand curve

  • is caused by demand factors (factors other than the price of the product)

An Increase in the Demand for Apples

• A rightward shift indicates an increase in demand.

• A leftward shift indicates a decrease in demand.

Demand Factors I

• The number of buyers ( an increase causes the demand curve to shift to_)

• Consumers’ income

  • Normal goods: the quantity demanded increases when income rises (demand curve shifts to _)

  • Inferior goods: the quantity demanded decreases when income rises (demand curve shifts to_)

Demand Factors II

• Prices of other goods

  • Substitutes in consumption are products that can be used in place of another product to satisfy similar needs or desires. (An increase in the price of a substitute goods shifts the demand curve to _)

  • Complements in consumption are products that tend to be used jointly. (An increase in the price of a complementary goods shifts the demand curve to )

• Consumer preferences

• Consumer expectations

• Government taxes/subsidies (imposing a tax shifts the demand curve to ; imposing a subsidy shifts it to _)

A Supply Schedule and a Supply Curve

• The amount of a product that firms are willing and able to sell during a certain period of time is called the quantity supplied of that product ($QS$$$QS$$).

  • Willingness to supply

  • Ability to supply

• A change in quantity supplied refers to a movement from one point on a supply curve to another point.

  • is shown by movements along the supply curve

  • is caused by price changes

Supply and The Law of Supply

• Supply ($S$$$S$$)is the entire relationship between a product’s price and quantity supplied during a certain period of time.

• The law of supply states that the price of the product and the quantity supplied are positively related.

  • When the price goes up, the quantity supplied increases.

  • When the price goes down, the quantity supplied decreases.

Changes in Supply

• A change in supply is a change in the quantity that will be supplied at every price.

  • is shown by shifts in the supply curve

  • is caused by changes in supply factors (factors other than the price of the product)

An Increase in the Supply of Apples

• A change in any variable other than price will shift the supply curve to a new position.

Supply Factors

• Number of producers (An increase causes the supply curve to shift to _)

• Prices of inputs (an increase in input prices causes the supply curve to shift to )

• Technology (an improvement of technology causes the supply curve to shift to _)

• Prices of other products

• Producer expectations

• Government taxes or subsidies (imposing a tax shifts the supply curve to ; imposing a subsidy shifts it to ____)

Market Equilibrium

• Market equilibrium occurs when the quantity demanded equals the quantity supplied.

• Surpluses (excess supply) drive prices down.

• Shortages (excess demand) drive prices up.

• Equilibrium price is the only price at which the quantity demanded equals the quantity supplied.

Changes in Equilibrium

• Shift of demand or supply curve

• When both demand and supply change, the total effect is the sum of the two individual effects.

• One of either price or quantity cannot be predicted–the result is indeterminate.

The four “laws” of supply and demand:

1. An increase in demand causes _ in both the equilibrium price and equilibrium quantity.

2. A decrease in demand causes _ in both equilibrium price and equilibrium quantity.

Shifts in the Supply Curve

3. An increase in supply causes in the equilibrium price and _ in the equilibrium quantity.

4. A decrease in supply causes in the equilibrium price and _ in the equilibrium quantity.

Readings

• Chapter 3

Roadmap

• Demand-Supply model (cont’)

Consumer Surplus and Producer Surplus

• Both consumers and producers gain from market activity.

  • Consumer surplus: Consumer’s net gain from market activity

  • It’s the difference between the total value of the product for consumers and the price that they pay to purchase it.

  • Producer surplus: Producer’s net gain from market activity.

  • It’s the difference between the price of a product and the cost of producing it.

Two Ways to Read Demand Curve

• Horizontally: At each possible price level, how much of that product the consumer want to purchase.

• Vertically: For a particular unit of goods, what’s the individual’s maximum willingness to pay for it – the value of the product for the consumers.

Two Ways to Read Supply Curve

• Horizontally: At each possible price, how much producers are willing and able to sell.

• Vertically: For a particular unit of goods, what’s the minimum price that producers are willing to accept- the additional cost of producing it.

The Case of Perfect Competition

• Social surplus (or economic surplus) is the society’s total net gain from trade.

• It’s the sum of CS and PS.

• In a perfectly competitive market, social surplus will be maximized at equilibrium – efficiency.

  • The invisible hand

Market Equilibrium and Efficiency

• Consumer Surplus

• Producer Surplus

Price Elasticity of Demand

• Question: How much does quantity demanded change when price changes?

• Price elasticity of demand shows how responsive consumer’s demands are to price changes.

  • Elastic demand: an increase (decrease) in price reduces (boosts) the quantity demanded a lot

    • The % change in quantity demanded is more than the % change in price

  • Inelastic demand: an increase (decrease) in price reduces (boosts) the quantity demanded just a little

    • The % change in quantity demanded is less than the % change in price

  • Unit-elastic demand: The % change in quantity demanded is equal to the % change in price

Calculating Price Elasticity of Demand

• Price elasticity of demand = the % change in quantity demanded divided by the % change in price

  • $\eta = \frac{\%\Delta Q_d}{\%\Delta P}$$$\eta = \frac{\%\Delta Q_d}{\%\Delta P}$$

• Example:

  • If the price of peanut butter increases by 10% and the quantity demanded falls by 5%, what is the price elasticity of demand for peanut butter?

• Note: The price elasticity of demand is negative in general. We usually drop the negative sign and use the absolute value instead.

  • If $\eta > 1$$$\eta > 1$$, the demand is elastic

  • If $\eta = \infty$$$\eta = \infty$$, the demand is perfectly elastic

  • If $\eta = 1$$$\eta = 1$$, the demand is unit elastic

  • If $\eta < 1$$$\eta < 1$$, the demand is inelastic

  • If $\eta = 0$$$\eta = 0$$, the demand is perfectly inelastic

The Midpoint Formula for Elasticity

• Problem with calculation of % change

  • Example: When the price is $10, the quantity demanded is 100. When the price rises to $20, the quantity demanded falls to 90. What is the elasticity of demand?

• To erase the natural bias according to base point, we calculate the price elasticity of demand by midpoint formula:

  • $$\eta = \frac{\%\Delta Qd}{\%\Delta P} = \frac{\frac{\Delta Qd}{Avg. Q_d}}{\frac{\Delta P}{Avg. P}}$$

Price Elasticity of Demand and Slope of Demand Curve

• Elasticity is not the slope of the demand curve.

• But if two demand curves run through a common point, then at this point the curve that is flatter is more elastic.

  • $$\eta = \frac{\frac{\Delta Qd}{Avg. Qd}}{\frac{\Delta P}{Avg. P}} = \frac{\Delta Qd}{\Delta P} \frac{Avg. P}{Avg. Qd} = \frac{1}{Slope} \frac{Avg. P}{Avg. Q_d}$$

• A linear demand curve has different price elasticity of demand at every point.

• At high prices, a large elasticity.

• At low prices, a small elasticity.

What Determines Elasticity of Demand?

• Availability of substitutes

• Time: short run vs. long run

Elasticity and Total Revenue

• Total revenue ($TR$$$TR$$) = $P*Q$$$P*Q$$

• Relationship between elasticity and $TR$$$TR$$

  • A price change causes total revenue to change in the opposite direction when demand is elastic.

  • A price change causes total revenue to change in the same direction when demand is inelastic.

  • A price change does not affect total revenue when demand is unit-elastic.

• Example: The war against drugs

Price Elasticity of Supply

• The price elasticity of supply measures how responsive the quantity sellers are willing to sell is to changes in the price.

• Price elasticity of supply = the % change in quantity supplied divided by the % change in price

  • $$\etas = \frac{\%\Delta Qs}{\%\Delta P} = \frac{\frac{\Delta Qs}{Average \ Qs}}{\frac{\Delta P}{Average \ P}}$$

• Example: When the price of oranges rises from $2 to $3 per kilogram, the annual amount supplied rises from 2 million to 4 million kilograms. What’s the price elasticity of supply?

• $\eta_s$$$\eta_s$$ is nonnegative in general

  • If $\eta_s =0$$$\eta_s =0$$, supply is perfectly inelastic

  • If $0< \eta_s <1$$$0< \eta_s <1$$, supply is inelastic

  • If $\eta_s =1$$$\eta_s =1$$, supply is unit elastic

  • If $\eta_s >1$$$\eta_s >1$$, supply is elastic

  • If $\eta_s = \infty$$$\eta_s = \infty$$, supply is perfectly elastic

Tax Incidence

• Suppose producers have to pay the government $1 tax on every unit sold –excise tax.

• What’s the effect of this tax?

• Who actually bear the burden of this tax?

• The question of who bears the burden of a tax is called the question of tax incidence.

• Deadweight loss: a loss in efficiency due to market distortion.

• Tax incidence is related to elasticity.

  • In general, the tax burden falls on the side of the market that is less elastic.

  • For a given supply curve, the more elastic the demand curve the greater the proportion of a tax paid by producers.

  • For a given demand curve, the more elastic the supply curve the greater the proportion of a tax paid by consumers.

  • The tax incidence has nothing to do with who pays the tax at the time of transaction.

• Can the producers pass all the tax burden to the consumers?

Other Demand Elasticities

• Income Elasticity of Demand

• Cross-Price Elasticity of Demand

Income Elasticity of Demand

• Income elasticity ($\eta_Y$$$\eta_Y$$) is the responsiveness of a product’s quantity demanded to changes in consumer income.

• In mathematical terms:

  • $$\etaY = \frac{\%\Delta Qd}{\%\Delta Y} = \frac{\frac{\Delta Qd}{Average \ Qd}}{\frac{\Delta Y}{Average \ Y}}$$

• Example: Purchases of automobile rise from 2 million to 3 million when average consumer incomes per year increase from $50,000 to $70,000. What’s the income elasticity of demand?

• Inferior Goods: $\eta_Y<0$$$\eta_Y<0$$

• Normal Goods: $\eta_Y>0$$$\eta_Y>0$$

• Necessities: $0<\eta_Y<1$$$0<\eta_Y<1$$

• Luxuries: $\eta_Y>1$$$\eta_Y>1$$

• Engel's law: as income rises, the proportion of income spent on food falls, even if absolute expenditure on food rises.

Cross-Price Elasticity of Demand

• Cross-price elasticity ($\eta_{XY}$$$\eta_{XY}$$) is the responsiveness of the quantity demanded of one product ($X$$$X$$) to a change in price of another ($Y$$$Y$$).

• In mathematical terms:

  • $$\eta{XY} = \frac{\%\Delta Q{d,X}}{\%\Delta PY} = \frac{\frac{\Delta Q{d,X}}{Average \ Q{d,X}}}{\frac{\Delta PY}{Average P_Y}}$$

• Example: A fall in the average price of smartphones from $300 to $200 increases purchases of smartphone apps from 1 million to 3 million per month.

• Substitutes: $\eta_{XY}>0$$$\eta_{XY}>0$$

• Complements: $\eta_{XY}<0$$$\eta_{XY}<0$$

Effects of government policies

• Price control: Price ceilings and price floors

• Quota

Price Floors

• A price floor is a legal minimum price that can be charged for a particular good and service.

• A price floor that is set below the equilibrium price _.

• A price floor that is set above the equilibrium price is said to be binding.

• A binding price floor leads to ___

Minimum Wage

• A minimum wage is an example of a price floor in the labour market.

• In a competitive labour market, a binding minimum wage _ the level of employment.

• Unemployment __. Who gains?

• Who loses?

• Market efficiency?

  • Deadweight loss: a loss in efficiency due to market distortion.

Price Ceilings

• A price ceiling is the maximum price at which certain goods and services may be legally exchanged.

• A price ceiling that is set above the equilibrium price _.

• A price ceiling that is set below the equilibrium price is said to be binding.

• A binding price ceiling leads to _ --calls for other method of resource allocation.

Rent Controls

• Binding rent controls are an example of price ceiling.

• Rent control will cause a _ of rental housing.

• Who gains?

• Who loses?

• Market efficiency?

Output Quotas

• An output quota restricts output to Q1.

• The shaded area shows the reduction in overall economic surplus—the deadweight loss—created by the quota system.