Introduction to Economics Flashcards

Introduction to Economics

• What is economics? Economics is a social science that studies human behavior. It's a way of thinking about how people make decisions.

• How do economists think? Economists use a specific methodology involving assumptions and models.

• What do economists do? Economists perform positive and normative analyses.

• The main ideas in economics: Scarcity, trade-offs, and choices.

• Production possibilities model: A model to illustrate the trade-offs that society faces in using its scarce resources.

What is Economics?

• Economics is a social science focused on understanding human behavior in various contexts.

• It encompasses the study of a wide array of human actions, including:

  • Educational choices (Why people go to school).

  • Environmental protection strategies.

  • Media bias analysis.

Two Fields of Economics

• Microeconomics:

  • Focuses on the behavior of individual economic agents.

  • These agents can be people or firms.

• Macroeconomics:

  • Examines the behavior of the economy as a whole.

  • Employs micro foundations to understand macro phenomena.

How Do Economists Think? (Methodology)

• Assumptions: Economists begin by making assumptions to simplify complex situations. These assumptions are the foundation of their models.

• Formal Language & Models:

  • Economists construct models using formal language, often mathematics or symbolic logic.

  • Model Definition: A model is a simplification of reality.

  • Economic Model: Defined as:

    • Assumptions + Constraints => Conclusions

Constructing Useful Models

• Model Utility: Economists aim to create models that:

  • Explain real-world phenomena.

  • Are testable through empirical analysis.

  • Are simple and easy to understand.

What Do Economists Do?

• Positive Analysis:

  • Seeks to explain behavior objectively.

  • It is value-free and testable.

  • Deals with "what is".

• Normative Analysis:

  • Prescribes behavior based on subjective beliefs.

  • Involves value judgments.

  • Deals with "what should be".

Application in the Course

• Positive Analysis Examples:

  • How market prices are determined.

  • The effects of government policies like rent control or carbon tax.

• Normative Analysis Examples:

  • Should we control rent?

The Main Ideas in Economics

• Scarcity:

  • Exists when a good's price is zero, yet demand exceeds availability.

  • Indicates that the price of a scarce good must be positive.

• Ubiquity of Scarcity:

  • We live in a world with pervasive scarcity.

  • This forces us to make trade-offs and choices constantly.

  • Obtaining more of one thing necessitates giving up something else.

• Economics as the Study of Choice:

  • Economics fundamentally studies how people make choices in the face of scarcity.

Opportunity Cost

• What is Cost?
  Accounting cost (historical cost): This is the most commonly used definition of cost, representing the price paid to acquire something.

• Limitations of Accounting Cost:

  • It's often irrelevant to current economic behavior.

  • Examples of accounting costs:

    • The historical selling price of Manhattan (US$24).

    • The price of a house purchased 10 years ago ($500,000).

• Opportunity Cost:

  • The value of the next best alternative that is forgone when one alternative is chosen.

  • Depends on available choices.

  • It's the value of the highest-valued forgone alternative.

The Production Possibilities Boundary (PPB)

• Definition: Illustrates the trade-offs a society faces when allocating scarce resources.

• Assumptions:

  • The economy produces only two products.

  • Resources and technology are fixed.

  • All resources are fully employed (production efficiency).

• Key Insights:

  • Shows possible output combinations for an economy.

  • Highlights the scarcity of resources.

  • Points on the PPB represent efficiency.

  • Points inside the PPB represent inefficiency.

  • It typically has a concave shape, reflecting the law of increasing opportunity costs.

  • Shifts in the PPB indicate economic growth or contraction.

Production Possibilities Schedule

The production possibilities schedule illustrates the trade-offs between producing hamburgers and computers. As more computers are produced, the opportunity cost in terms of hamburgers forgone increases, demonstrating the law of increasing opportunity costs.

Shifts in Production Possibilities

• Economic Growth: An increase in the availability of resources or technological advancements can shift the PPB outward, indicating economic growth.

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

How to Deal with Scarcity?

• Maximizing Behavior: Adam Smith proposed that people deal with scarcity by attempting to maximize their own well-being.
  Definition:
  Maximizing behavior involves individuals making choices to achieve the greatest possible satisfaction.
  Different from maximizing revenue/wealth:
  Maximizing behavior is not restricted to financial gain; it encompasses broader aspects of personal fulfillment and satisfaction.
  Not always right:
  While individuals aim to maximize their well-being, they may not always make the correct decisions due to imperfect information or cognitive biases.
  Responding to incentives:
  Maximizing behavior is influenced by incentives, which can be monetary or non-monetary, and helps explain how people respond to changes in their environment.*

Equilibrium

• Definition: A state where no individual wants to change their behavior.

• Maximization in Equilibrium: Everyone is maximizing their own well-being in equilibrium.

Why Believe in Maximization?

• Empirical Evidence: Maximization assumptions often lead to accurate predictions.

• Evolutionary Basis: Maximizing behavior may have evolved as a survival strategy.

Economic Systems

• Two Main Types:

  • The command system

  • The market system

Characteristics of a Market Economy

• Private Property: Individuals have the right to own and control resources.

• Freedom of Enterprise & Choice: Individuals can freely pursue economic activities.

• Self-Interest: People are motivated by their own desires and goals.

• Competition: Many buyers and sellers ensure no single entity has excessive market power.

• Markets and Prices:

  • Prices signal scarcity and guide resource allocation.

  • Prices are determined by supply and demand.

  • "The Invisible Hand" – Adam Smith’s concept of self-interest guiding resource allocation.

Three Fundamental Questions

• What Will Be Produced?

  • Goods and services that generate profits.

  • Driven by consumer sovereignty: what consumers "vote" for with their dollars.

  • Market restraints on freedom exist.

• How Will the Goods & Services Be Produced?

  • Using 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 behavior in different market structures

• Factor markets

• Market failures

• Government policies

Absolute Advantage and Comparative Advantage

• Absolute Advantage:

  • One person has an absolute advantage over another in the production of a good if they can produce more of it with the same resources.

• Comparative Advantage:

  • One person has a comparative advantage in the production of a good if their opportunity cost of producing that good is lower than another person's.

Comparative Advantage Example: David vs. Mary

• Who has absolute advantage in cooking meals?

  • David

• Who has absolute advantage in washing clothes?

  • David

• Who has lower opportunity cost in these two activities?

Determining Comparative Advantage (Opportunity Cost)

• Who has comparative advantage in cooking?

  • Mary, because she has a lower opportunity cost of washing clothes (0.33 meals) compared to David (0.5 meals).

• Who has comparative advantage in washing?

  • David, because he has a lower opportunity cost of cooking (2 clothes) compared to Mary (3 clothes).

Specialization and Trade

• No specialization and trade:

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

  • They will cook 4+2=6 meals and wash 8+6=14 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 4(3/4) = 3 meals and wash 6 + 8(1/4)= 8 clothes in total.

  • They will cook 3 meals and wash 6 + 8*(1/4) = 8 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.

Demand

• Quantity Demanded (QD): The total amount consumers are willing and able to purchase at a given price level during a specific period. This is based on:

  • Willingness to buy

  • Ability to buy

• Change in Quantity Demanded: A movement from one point to another along the demand curve, caused solely by price changes.

• Demand (D): The entire relationship between a product’s price and quantity demanded over a period, assuming other factors remain constant.

Demand and The Law of Demand

• The law of demand states that the price of a product (P) and quantity demanded (Q_D) 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.

• shown by shifts in the demand curve

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

Demand Factors I

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

  • Consumers’ Income:

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

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

Demand Factors II

• Prices of other goods

  • Substitutes in consumption: 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 the right)

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

• Consumer preferences

• Consumer expectations

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

Supply

• Quantity Supplied (QS): The amount of a product that firms are willing and able to sell during a certain period of time. This depends on:

  • Willingness to supply

  • Ability to supply

• Change in Quantity Supplied: A movement from one point to another along the supply curve, caused solely by price changes.

Supply and The Law of Supply

• 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)

Supply Factors

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

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

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

• Prices of other products

• Producer expectations

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

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.

Shifts in the Demand Curve

• The four “laws” of supply and demand:

  • An increase in demand causes an increase in both the equilibrium price and equilibrium quantity.

  • A decrease in demand causes decrease in both equilibrium price and equilibrium quantity.

Shifts in the Supply Curve

• An increase in supply causes decrease in the equilibrium price and an increase in the equilibrium quantity.

• A decrease in supply causes an increase in the equilibrium price and a decrease in the equilibrium quantity.

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

Price Elasticity of Demand

• 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

• η = \%\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?

Interpreting Price Elasticity of Demand

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

  • If η > 1, the demand is elastic

  • If η = ∞, the demand is perfectly elastic

  • If η = 1, the demand is unit elastic

  • If η < 1, the demand is inelastic

  • If η = 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:

• 𝜂 = \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.

• 𝜂 = \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}

Price Elasticity of Demand and a Linear Demand Curve

• 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) = P*Q

• Relationship between elasticity and 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

• ηs = \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?

Interpreting Price Elasticity of Supply

• 𝜂_𝑠 is nonnegative in general

• If 𝜂_𝑠 =0, supply is perfectly inelastic

• If 0< 𝜂_𝑠 <1, supply is inelastic

• If 𝜂_𝑠 =1, supply is unit elastic

• If 𝜂_𝑠 >1, supply is elastic

• If 𝜂_𝑠 = ∞, 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 and Elasticity

• 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.

Other Demand Elasticities

• Income Elasticity of Demand

• Cross-Price Elasticity of Demand

Income Elasticity of Demand

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

• In mathematical terms:

• 𝜂𝑌 = \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?

Interpreting Income Elasticity

• Inferior Goods: 𝜂_𝑌<0

• Normal Goods: 𝜂_𝑌>0

• Necessities: 0<𝜂_𝑌<1

• Luxuries: 𝜂_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 (𝜂_{𝑋𝑌}) is the responsiveness of the quantity demanded of one product (X) to a change in price of another (Y).

• In mathematical terms:

• 𝜂{𝑋𝑌} = \frac{\%\Delta 𝑄{𝑑,𝑋}}{\%\Delta 𝑃𝑌} = \frac{\frac{\Delta 𝑄{𝑑,𝑋}}{𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑄{𝑑,𝑋}} }{\frac{\Delta 𝑃𝑌}{𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑃_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:𝜂_{𝑋𝑌}>0

• Complements:𝜂_{𝑋𝑌}<0