Economics 101 Study Notes

Fundamental Principles of Economics and Scarcity

• Definition of Economics: Economics is the study of how individuals, institutions, and society choose to deal with the condition of scarcity.

• The Condition of Scarcity: Scarcity is a universal condition that exists because there is not enough time, money, or resources to satisfy everyone's needs or wants. It faces everyone from the rich to the poor, though it manifests differently (e.g., food scarcity in Somalia versus unlimited wants in America).

• Factors of Production: Resources used to produce goods and services are categorized into four factors:

  • Land: Includes all natural resources, divided into renewable (e.g., pine trees, chickens) and nonrenewable (e.g., oil, Atlantic cod). The payment for land is referred to as Rent.

  • Labor: Human skills and abilities, categorized as unskilled (repetitive tasks), skilled (welding, plumbing), and professional (doctors, lawyers). Labor is paid in Wages.

  • Capital: Physical tools, factories, and equipment used in production. It is the product of investment. In chemistry/physics contexts, capital is the physical stuff, while Investment is the money spent on that stuff.

  • Entrepreneurship: The human resource that combines the other factors to create goods/services.

• Divisions of Study:

  • Microeconomics: Focuses on decision-making by individuals and businesses, primarily concerned with markets for goods, services, and resources.

  • Macroeconomics: The study of how entire nations deal with scarcity, focusing on GDP, unemployment, inflation, and government policy.

• Allocative Efficiency: Occurs when the marginal benefit equals the marginal cost ($MB = MC$). This condition ensures the greatest benefit accrues to society.

Trade-Offs, Opportunity Cost, and Marginal Analysis

• Trade-Offs: The various choices faced when a resource is used for one purpose over another.

• Opportunity Cost: Defined as the next best alternative use of a resource. It is also referred to as Implicit Cost.

  • Example: Choosing to spend an hour weaving a hammock instead of writing a book (the next best alternative) means the book is the opportunity cost.

  • Explicit Costs: Easily calculated costs like labor, raw materials, and overhead.

• Marginal Analysis: The process of comparing the benefit of a decision (Marginal Benefit) versus its cost (Marginal Cost).

  • Utils: A measure of utility or happiness. Economists assume individuals maximize utility.

  • Decision Rule: A rational individual will consume or produce a unit as long as the marginal benefit exceeds or equals the marginal cost ($MB \geq MC$).

• Economic Assumptions:

  1. Ceteris Paribus: "Holding all other things constant."

  2. Rationality: People make choices with all available information to maximize their well-being.

  3. Self-Interest: Pure altruism is not recognized in strict economic modeling; behavior is motivated by self-interest.

Theory of Trade and Advantage

• Mercantilism: A 17th-18th century policy asserting wealth is built by exporting more than importing to amass gold.

• Absolute Advantage: Exists if a party can produce more of a good or produce it faster than someone else with the same resources.

• Comparative Advantage: David Ricardo's theory that specialization should occur where the opportunity cost is lowest.

  • Calculation Example: Art can write 1 song or do 2 surgeries in an hour. Paul can write 2 songs or do 2 surgeries.

  • Art's cost for 1 song = 2 surgeries.

  • Paul's cost for 1 song = 1 surgery.

  • Paul has the comparative advantage in songs; Art has the comparative advantage in surgery ($0.5$ songs given up per surgery versus Paul's $1$ song per surgery).

• International Trade Barriers:

  • Tariffs: A tax on trade (e.g., Smoot-Hawley Tariff of 1930).

  • Quotas: Quantitative limits on imports (e.g., Japanese car quotas in the 70s/80s).

  • Embargoes: Total ban on trade with a country (e.g., U.S. embargo against Cuba).

Economic Systems and Philosophical Foundations

• Traditional Economy: Questions of production are answered by ritual, habit, or custom (e.g., Kalahari Bushmen).

• Command Economy: Centralized decision-making by a leader or group (e.g., North Korea, Ancient Egypt/Pharaohs, Stalin's Soviet Union).

• Market Economy: Decentralized decision-making based on individual self-interest and exchange (e.g., New Zealand, Hong Kong).

• Socialism vs. Capitalism:

  • Capitalism: Private ownership, market prices for allocation, government limited to regulation and contract enforcement.

  • Socialism: State may own key industries; higher taxes for income redistribution (e.g., Germany's marginal tax rate of $47.5\%$ compared to the U.S. $39.6\%$ in 2015).

• Key Figures:

  • Adam Smith: Father of modern economics; The Wealth of Nations (1776). Advocated for the "Invisible Hand" and self-interest.

  • Karl Marx: Advocated for redistribution based on need; emphasized social justice over productivity.

The Nature of Money and Interest Rates

• Functions of Money:

  1. Medium of Exchange: Used for buying and selling.

  2. Store of Value: Can be held and used later.

  3. Standard of Value: Measures the worth of goods/services.

• Characteristics of Money: Portability, Durability, Divisibility, Stability, and Acceptability.

• Evolution of Money:

  • Commodity Money: Objects with intrinsic value (salt, tobacco, gold coins).

  • Representative Money: Paper receipts redeemable for a commodity (gold/silver).

  • Inconvertible Fiat Money: Intrinsically worthless; backed only by government decree and faith (U.S. Dollar since 1933).

• Money Supply Measures:

  • M1: Liquid cash, coins, checking account balances, and traveler's checks.

  • M2: M1 plus savings accounts, certificates of deposit (CDs), and money market accounts.

• Interests Rates components:

  • Total Nominal Interest Rate = Real Interest Rate + Expected Inflation + Default Risk Premium + Liquidity Premium + Maturity Risk Premium.

  • Example: $2\% + 3\% + 4\% + 2\% + 1\% = 12\%$

Banking and the Creation of Money

• Fractional Reserve Banking: Banks keep only a fraction of deposits in reserve and lend the rest.

• Bank Balance Sheet: $Assets = Liabilities + Stockholder's Equity$.

  • Assets: Reserves (Vault cash/Fed deposits), Loans, Securities.

  • Liabilities: Deposits, Borrowings.

• Money Multiplier: Formula to determine the maximum expansion of the money supply.

  • $\text{Multiplier} = \frac{1}{\text{Required Reserve Ratio}}$

  • If Ratio = $10\%$, Multiplier = $10$. Excess reserves of $\$27,000$ can create up to $\$270,000$.

• Federal Reserve System: Founded in 1913. Consists of 12 district banks and a Board of Governors.

• Monetary Policy Tools:

  1. Reserve Requirement: Changing the % banks must hold.

  2. Discount Rate: The rate the Fed charges banks for overnight loans.

  3. Open Market Operations (OMO): Buying/Selling Treasury securities. (Buying increases money supply; Selling decreases it).

Supply, Demand, and Consumer Behavior

• Law of Demand: Inverse relationship between price and quantity demanded.

  • Substitution Effect: Buying lower-priced substitutes.

  • Income Effect: Change in purchasing power.

  • Diminishing Marginal Utility: Each additional unit provides less satisfaction than the last.

• Law of Supply: Direct relationship between price and quantity supplied due to increasing marginal costs.

• Elasticity: Sensitivity to price changes.

  • Elastic: Sensitive (many substitutes, luxury items).

  • Inelastic: Insensitive (necessities, no substitutes, short time frame).

• Cross-Price Elasticity:

  • > 0: Substitutes.

  • < 0: Complements.

• Income Elasticity:

  • Normal Good: Demand increases as income increases.

  • Inferior Good: Demand decreases as income increases (e.g., powdered milk).

Costs of Production and Market Structures

• Stages of Production:

  1. Increasing Returns: Marginal product increases with each worker.

  2. Diminishing Returns: Output increases at a decreasing rate.

  3. Negative Returns: Total output declines.

• Cost Equations:

  • $Total Cost = Fixed Cost + Variable Cost$

  • $Marginal Cost = \frac{\Delta Total Cost}{\Delta Quantity}$

• Market Types:

  • Perfect Competition: Many firms, identical products, price-takers.

  • Monopolistic Competition: Many firms, differentiated products (e.g., fast food).

  • Oligopoly: Few large firms, interdependent (e.g., airlines). Measured by the Herfindahl-Hirschman Index (HHI).

  • Monopoly: Single seller (Natural, Technological, Government). Prices are typically higher and output lower.

• Game Theory: Study of interdependent decision-making (e.g., The Prisoner's Dilemma). Outcomes often reach a "dominant strategy" that is sub-optimal compared to collusion.

Government in the Marketplace and Market Failures

• Price Ceiling: Legal maximum price (e.g., Rent control). Causes Shortages.

• Price Floor: Legal minimum price (e.g., Minimum wage). Causes Surpluses (Unemployment).

• Public Goods: Non-rival and non-excludable (e.g., Highways, National Defense).

• Externalities:

  • Positive: Spillover benefits (e.g., Flu vaccines, Education). Usually under-produced.

  • Negative: Spillover costs (e.g., Pollution). Usually over-produced.

• Coase Theorem: Private parties can negotiate efficient solutions to externalities if property rights are defined and bargaining costs are zero.

Measuring the Economy: GDP and Unemployment

• Gross Domestic Product (GDP): The total value of all final production within a country in a year.

  • Expenditures Approach: $GDP = C + I + G + (X - M)$.

  • $C$: Personal Consumption ($70\%$ of U.S. GDP).

  • $I$: Gross Private Investment (Capital, Inventory, New Homes).

  • $G$: Government Spending (Exclude transfer payments like Social Security).

  • $X - M$: Net Exports (Exports minus Imports).

• Real vs. Nominal GDP: Real GDP accounts for inflation using a deflator.

• Unemployment Rate: Percentage of the labor force (Employed + Unemployed) that is not working.

  • Frictional: Voluntary job search/between jobs.

  • Structural: Mismatch of skills (obsolescence) or geography.

  • Cyclical: Caused by business cycle contractions.

• Natural Rate of Unemployment: The sum of frictional and structural unemployment when the economy is at full employment.

• Okun's Law: For every $1\%$ unemployment exceeds the natural rate, there is a $2\%$ gap in potential GDP.

Inflation, Aggregate Demand, and Aggregate Supply

• Inflation Types:

  • Demand-Pull: "Too much money chasing too few goods."

  • Cost-Push: Increased input costs (e.g., energy price spikes). Can lead to Stagflation.

• Measurement: Consumer Price Index (CPI), Producer Price Index (PPI), and PCE Deflator.

• Aggregate Demand (AD): Total spending by all sectors. Inverse relationship to price level.

• Aggregate Supply (AS):

  • Short-Run (SRAS): Upward sloping; wages/input prices are fixed.

  • Long-Run (LRAS): Vertical at full employment; input prices have adjusted.

• The Phillips Curve: Shows the short-run trade-off between inflation and unemployment. The Trade-off disappears in the long run ($Natural Rate Hypothesis$).

Historical Cycles and International Finance

• The Business Cycle: Expansion, Peak, Contraction (Recession), Trough.

• The Great Recession (2007-2009): Triggered by the housing bubble, subprime mortgages, and securitization (CDOs and CDSs). The Fed used Quantitative Easing to unfreeze credit.

• Foreign Exchange Market: Determining the price of one currency in terms of another.

  • Appreciation: Value increases (helps importers; harms exporters).

  • Depreciation: Value decreases (helps exporters; harms importers).

• Purchasing Power Parity (PPP): The theory that identical goods should cost the same in different countries after adjusting for exchange rates.

• Balance of Payments: Records current account (trade) and financial account (investment) flows. They must balance to zero.

Fiscal and Monetary Policy Debates

• Keynesian View: Markets are inherently unstable; government should use deficit spending to stimulate demand during recessions.

• Supply-Side Economics: Focuses on cutting taxes and deregulation to increase aggregate supply ("Voodoo Economics").

• Monetarism: (Milton Friedman) Contends that the money supply is the primary determinant of economic activity; advocates for stable, predictable growth of the money supply.

• Laffer Curve: The theoretical relationship between tax rates and tax revenue, suggesting that at certain points, cutting taxes can increase revenue by increasing incentives to work and invest.

Sustainability and the Environment

• Economic Bad: Pollution is a cost not reflected in market prices (Market Failure).

• Policy Solutions:

  • Per-Unit Taxes: To internalize the cost of pollution.

  • Pollution Permits (Cap and Trade): Creating a market where firms buy/sell the right to pollute, rewarding efficiency.

• Resource Management: Incentives for renewable resources (e.g., lumber) differ from nonrenewables (e.g., coal) due to the price mechanism and private property rights (e.g., the recovery of the American Bison via private ownership).