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ECON 101 (318)
Lecture

ECON101 - September 9-November 7, 2013

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Department
Economics
Course Code
ECON 101
Professor
Shadab Qaiser

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⇚ Return to University Notes index ECON101 Microeconomics Section: 008 Instructor: Name: Shadab Qaiser Office: HH104 Office Hours: Tuesdays, Thurdays at 6:00PM-7:00PM or by appointment Email: [email protected] (put "Econ 101" and full name in subject) T.A.: Greg 12/9/13 Economics Economy - one who manages a household Economics is the study of how society manages scarce resources. Society has limited resources and can't produce all the goods and services everyone wishes to have. Economics is a social science. Scarcity is the inability to satisfy all of our wants. Economics studies the choices that we make in the face of scarcity. These choices are influenced by incentives. An incentive is a reward that encourages an action, or a penalty that discourages an action. An incentive pushes people to act in a certain way. A disincentive is another word for a negative incentive. There are two main parts to economics: Microeconomics: the study of the individual part of the economy - how individuals and entities make decisions and how they act individually. It studies the choices and the interactions and influence of these choices. Macroeconomics: the study of the performance of economies on the large scale. It studies phenomena such as inflation, unemployment, and growth. Resources are anything that can be used to produce something else. Resources are scarce. This may include life, land, labour, buildings, machines, etc. The big questions of economics are what to produce, how to produce it, and for whom to produce individuals deal with economic actions. Microeconomics Who will work? What and how much goods should be produced? What resources are needed in production? What price should goods be sold at? These questions are dealt with in the field of microeconomics. Goods and services are the things that people value and produce to satisfy needs and wants. Canadian production: Agriculture: <1% Manufactured goods: 20% Services: 80% Chinese production: Agriculture: 10% Manufactured goods: 50% Services: 40% Factors of production are the resources needed to produce goods and services. These include land, labour, capital, entrepreneurship. Land is a general term that refers to factors of production taken from nature, such as real estate, water, or raw materials. It means "natural resources" in economic contexts. Labour is the work time and work effort that people devote to producing goods and services. The quality of labour depends on human capital - the knowledge and skill people have. Human capital is created through education, training, and experience. Capital are the tools, instruments, machines, buildings, etc. used to produce goods and services. Entrepreneurship is the human resource organizing land, labour, and capital. Land earns rent. Labour earns wages. Capital earns interest. Entrepreneurship earns profit. It is helpful and reasonably accurate to assume that people make choices in their own self-interest - choices that people believe are best for them. However, this does not always hold - people can often be irrational or act in a way contrary to self interest, due to psychological factors such as mental capacity and willpower. The goal is to have everyone make choices in the social interest - choices that are best for society as a whole. This is the case if it uses resources efficiently and distributes goods and services fairly. Adam Smith's "Invisible Hand": phenomenon in which economic agents acting purely out of self-interest also promote social 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. Adam Smith (regarded as the father of economics) Sometimes, conflicts can occur between self-interest and social interest: Globalization (outsourcing jobs to the lowest common denominator). Information-age economies (non-physical resources make regulation difficult). Global warming and environmental concerns (profit over pollution). Running out of natural resources (natural resource exploitation). Economic instability (stabilization of economy is difficult). Scarcity Scarcity requires choices, and choices require tradeoffs - giving up certain things to get others. Canada is a labour-scarce country. Therefore, the economy favours production with less labour and more of other things such as capital. What, how, and for whom? What do we spend resources on? How do we produce goods and services with our resources? For whom do we produce for? Tradeoffs in what to produce arise when people, businesses, or governments choose how to spend money or what to produce. Tradeoffs in how to produce arise when businesses choose between different means of production. Tradeoffs in for whom to produce arise when there are choices that affect individual buying power. The big tradeoff: equality vs. efficiency. Efficiency is the ability to get the most possible out of its scarce resources. Equality or equity is the fair distribution of the benefits of those resources among the members of a society. Tradeoff: guns vs. butter - whether to build munitions or increase food output. Current consumption vs. future consumption: if we save more and consume less today, we can buy more capital and increase our future income. Leisure vs. education: If we take less leisure time, we can educate and train ourselves to be able to become more productive and earn higher income in the future. Production vs. research: if a business produces less today and devote resources to research and development, they can produce more in the future. A choice or tradeoff is essentially an opportunity given up for another. The missed opportunity with the highest value (the best alternative to the chosen option) is the opportunity cost of the choice. It is the cost of not taking the second best option. The cost of something is what is given up to get it. Incentives Rational people make choices at the margin; they look at the consequences of making incremental changes in usage of resources. For example, the decision whether to buy something might depend on the cost of buying it, compared to the benefit of buying it. People look at doing the next unit of something, rather than looking at and considering everything in the past. The benefit from incremental increase is the marginal benefit. The marginal benefit curve measures the marginal benefit as units of a good or service available changes. It measures the most people are willing to pay for one more unit of a good or service, and is not derivable from the PPF. The opportunity cost from an incremental increase (benefit of not pursuing the increase) is the marginal cost. Example: speeding tickets give a negative incentive against speeding, which goes against the social interest. If an economy is operating on the PPF, one good cannot be produced without giving up another. So as the marginal benefit of a good or service decreases, its marginal cost increases. If they are equal, we say that the economy is working at allocative efficiency. This is where the graphs of marginal cost and benefit intersect. This is efficient because the most possible people get access to the good, while each one enjoys a benefit. For example, at allocative efficiency, the pizzas would be worth a number of colas such that if more pizzas were produced, they would not be worth the cola foregone, and if more colas were produced, they would not be worth the pizza foregone. Choices respond to incentives. If the marginal benefit exceeds the marginal cost for a certain activity, people have an incentive to perform it. Otherwise, people have an incentive not to perform it. Incentives are hugely useful in aligning self-interest and the social interest. Economic way of thinking: human nature is a given, and people always act in their self interest, which are not necessarily selfish actions. The role of institutions is to create incentives for people to behave in the social interest. Institutions are rules and laws that define incentive structures in society and govern the behaviour of people and groups. Institutions have many different qualities: Political institutions: democracy, accountability, human rights, freedoms. Economic institutions: property rights and contract enforcement, financial policy. Other: corruption control, rule of law, civil order. Social Science Positive statements are statements about the way things are. They can be tested by checking them against facts. Normative statements are statements about how things ought to be. They cannot be tested. Economists might disagree about the validity of various positive statements, about the way things are. They may also disagree about how things should be, and have different views on different normative statements. Economics is about thinking in terms of alternatives, evaluating choices, and discovering how certain events and issues are related. Economics tries to find the cause and effects for economic phenomena. Economic science tries to discover positive statements that are consistent with what we observe in the world. It creates and tests economic models. 19/9/13 Economic Models Economic models are used to simplify reality in order to improve understading, and to make predictions about potential economic outcomes. Scientific thinking requires deciding which assumptions to make. Economic models almost always require at least a few assumptions. A model is tested by comparing its predictions with facts. However, this is difficult, so economists also use natural experiments (observing natural phenomena), statistical investigations (statistical analysis of data), economic experiments (applying various incentives and seeing the result). Economics applies to personal, business, and government economic policies. It affects the decisions made about what, how, and for whom things are done. Production Possibility Frontier PPF (Production Possibility Frontier), also known as PPB (Production Possibilities Boundary) is a simple economic model. It is a 2D graph with each axis representing the units of a given good or service produced. There is a clearly defined boundary at the edge of being unattainable that represents the maximum efficiency of the economy. The graph is investigated in a model economy focusing on two goods, pretending that the value of all other goods are held constant. Cola vs. Pizza Production v 15 million | | Unattainable |#### C |######### o |############ l |################ a |##################### |##### Attainable ######## |############################ |############################## |___________________________________ 0 Pizza ^ 5 million All points in the shaded regions are attainable, while all others are not. Producing more of one good results in fewer resources available for the other. To produce more pizza, we need to produce less cola, and vice versa. The efficiency of the economy is determined by how close the economy works to the frontier. The goal is to have an economy that works on the frontier, the boundary of maximum efficiency. A point inside the shaded region is inefficient. At this point, resources are either unemployed or misallocated. Production efficiency is achieved when efficiency is at 100% - the economy is on the frontier. Changes to various actors of production affect the graph. For example, if a new technology is created to produce cola more efficiently, the PPF graph will be stretched along the Y axis. Likewise, if the labour force increased, the graph stretches in both axes. Opportunity Cost The opportunity cost of making more pizzas is the colas not produced. If by producing 1 million more pizzas (moving 1 unit right), we produce 5 million fewer colas (moving 5 units down), the cost of those pizzas is 5 colas each. Likewise, by moving 5 units down, we produce 1 million fewer pizzas, the cost of one cola is 1/5 pizzas. This cost is not necessarily fixed, and depends on the current state of the economy. The slope of the frontier determines the cost. For example, if the graph is quadratic, the cost of pizzas increases linearly as more are produced. Graph Shape This graph is concave - this means that as the quantity of the good produced increases, so does its cost. If the graph is convex, the cost of producing a good goes down as the quantity produced increases. In other words, if the resources invested are more productive in one product than another, the graph is curved. This is because as we produce more of one good, we must use resources that are less suited to producing this good and more suited for the other good, so the opportunity cost is greater. If the cost stays the same regardless of quantity, the graph is a straight downwards line - it is linear. Demand Supply and demand are very common terms in economics - they are the forces that make the markets work. Microeconomics is the study of supply, demand, and market equilibrium. A market is a group of buyers and sellers of a particular good or service, and an arrangement where they can get information and do business with each other. Supply and demand describes the behaviour of people as they interact in markets. A competitive market is a market with many buyers and sellers, so no single entity can influence prices. The money price of a good is the amount of money needed to buy it. The relative price of a good is the ratio of its money price to the money price of the next best alternative. This is the opportunity cost of buying something. If you demand something, you want it, can afford it, and plan to buy it. This contrasts with wants, which are unlimited wishes or desires. The quantity demanded is the amount buyers are willing and able to purchase, in a given time period and price. Law of Demand All other things being equal, price is inversely correlated to quantity demanded. This is a result of the substitution effect and the income effect. The substitution effect is a phenomena that occurs when the relative price of a good or service increases, and as a result, people seek substitutes for it, reducing the quantity demanded. The income effect is a phenomenon that occurs when the relative price of a good or service increases compared to income, so people cannot afford it as much, reducing the quantity demanded. The demand curve shows the relationship between the relationship between the quantity demanded of a good and the largest price people are willing to pay for it, all other influences on consumers' planned purchases remain the same. The demand schedule is the table of values for this curve. Demand is a measure of marginal benefit - the willingness and ability to pay given a marginal cost - the price. For example, the demand curve for energy bars might appear as follows: Price vs. Demand v 3.00 | |.... P | ..... r | .... i | .... c | .... e | ..... | ... |________________________________________ 0 Demand ^ 25 million Demand refers to the relationship between quantity demanded and the price - the demand curve. The quantity demanded is the quantity demanded at a particular price - the X axis on the demand curve. The demand curve measures the marginal benefit, the benefit from consuming one more unit of a good or service. For example, the marginal benefit of money is the best good or service that can be bought with it. When an influence other than the price of a good changes, there is a change in demand. Change is demand is different from a change in quantity demanded. Change in demand is a change in the demand curve, while a change in quantity demanded is simply movement along the non-changing demand curve. When demand increases, the graph shifts rightwards. When demand decreases, the graph shifts leftwards. A substitute is a good that replaces another good. A complement is a good that is used together with another good. The price of a good is inversely correlated to the price of its substitutes, and correlated to the price of its complements. If the price of a good is expected to rise, then current demand increases - consumers want to buy at the lower price before it rises. When income increases, consumers buy more of certain goods. These are called normal goods. Some goods, however, are bought less often as income increases. These are called inferior goods. Likewise with expected increases in income, or credit. Population is directly correlated to demand. The more people, the more demand. All other factors being equal, people have different demands due to personal preferences. Supply A firm supplies a good or service if it has the resources/technology to produce it, can profit from it, and plans to do so. The quantity supplied is the amount that the producers plan to sell during a given time period and price. Law of Supply All other things being equal, price is correlated to quantity supplied. This is a result of the general tendency for the marginal cost of producing a good or service to increase with increases in quantity produced. Producers will only supply a good if they can at least cover the marginal cost of production - if they can profit from it. The supply curve shows the relationship between the quantity supplied of a good and the price it is sold at, all other influences remaining the same. The supply schedule is the table of values for this curve. For example, the supply curve for energy bars might appear as follows: Price vs. Quantity Supplied v 3.00 | | .... P | ..... r | .... i | .... c | .... e | ..... |... |________________________________________ 0 Supply ^ 25 million Supply refers to the relationship between the quantity supplied and the price, all other influences held constant. The quantity supplied is the quantity supplied at a particular price - the X axis on the supply curve. The lowest price anyone is willing to sell a unit is the marginal cost of production. Like with demand, there are many influences that affect supply. A change in supply caused by one of these factors, other than price, is called a change in supply. Change is supply is different from a change in quantity supplied. Change in supply is a change in the supply curve, while a change in quantity supplied is simply movement along the non-changing supply curve. When supply increases, the graph shifts rightward. When supply decreases, the graph shifts leftward. The price is correlated to the price of production. A substitute is an alternative good that can be produced using the same resources as the good. A complement is a good that must be produced together with the good. The price is inversely correlated to the price of its substitutes, and correlated to the price of its complements. If the price of the good is expected to rise, the current supply decreases - suppliers want to wait to supply the good or service at a higher price. Supply is correlated to the number of suppliers. Advances in technology can lower costs of production, and increase supply. Supply is influenced by the state of nature - weather, natural disasters, etc. A hurricane might reduce supply by destroying factories. Equilibrium Market equilibrium occurs when the quantity demanded is equal to the quantity supplied. The equilibrium price is the price at which equilibrium occurs. The equilibrium quantity is the quantity bought and sold at equilibrium. If the quantity supplied exceeds the quantity demanded, there is a surplus of the good or service. This forces the price down. If the quantity demanded exceeds the quantity supplied, there is a shortage of the good or service. This forces the price up. At equilibrium, the plans of the buyers and sellers agree and the price remains constant. Price vs. Supply & Demand v 3.00 | | *** .... P | ***** ..... r | **** .... i | ...X** c | .... ^ **** e | ..... | ***** |... Equilibrium *** |________________________________________ 0 Quantity ^ 25 million A price floor is the lower limit imposed on the price of a good or service. For example, the minimum wage is the price floor of labour. Increases in demand shift the demand graph rightward, raising the price and quantity. Increases in supply shifts the supply graph rightward, reducing the price and raising the quantity. Demand is correlated to price and quantity. Supply is inversely correlated to price and correlated to quantity. Increases in both supply and demand: the quantity increases, but the price change is uncertain because supply decreases price, and demand increases it. In Summary Increases in demand and decreases in supply increase equilibrium price and quantity. Decreases in demand and increases in supply decrease equilibrium price and quantity. Increases in both demand and supply increase quantity. Decreases in both demand and supply decrease quantity. Increases in demand and decreases in supply increase price. Decreases in demand and increases in supply decrease price. 3/10/13 Elasticity What are the effects of high gas prices on buying plans? Elasticity is the measure of how responsive buyers and sellers are to changes in market conditions. We measure how the quantity demanded and supplied is affected by changes in price, income, or price of related goods. Own price elasticity of demand Price elasticity of demand is the ratio of the percentage change in quantity demanded per percentage change in price. The percentage change is a percentage of the average of the initial and new values. This is also known as own price elasticity. Dimensionless value, a ratio. Negative due to law of demand. Values larger in magnitude mean higher sensitivity to price changes. Values smaller in magnitude mean lower sensitivity to price changes. Values larger in magnitude than 1 are called elastic demand. Values smaller in magnitude than 1 are called inelastic demand. Values equal in magnitude to 1 are called unit elastic demand. Values of 0 are called perfectly inelastic demand. Values o∞ are called perfectly elastic demand. For perfectly inelastic demand, the demand curve is vertical. The quantity demanded is the same regardless of the price. For example, life-saving surguries need to be bought regardless of the price. For perfectly elastic demand, the demand curve is horizontal. The quantity demanded is highly dependent on the price. For example, in agriculture markets a slight decrease in price means much more demand. own elasticity = % change in demand % change in price new demand − old demand % change in demand = new demand+old demand 2 new price− old price % change in price = new price+old price 2 According to the law of demand, the own price elasticity is always negative. This is because demand is inversely correlated to price. Elasticity is not the same thing as the slope of the demand curve. It measures percentage changes. Consider a linear demand curve: Price vs. Quantity v 3.00 | | *** P | ***** Inelastic r | **** v-----------v i | ***** c | ^-----------^ ^ **** e | Elastic | ***** | Unit Elastic *** |________________________________________ 0 Quantity ^ 25 million At low prices, a given change in price is a larger percentage of the average price. Likewise, a given change in demand is a larger percentage of the average demand at lower demand. At quantity demanded being 0, there is perfect elasticity. At price being 0, there is perfect inelasticity. The price of milk increases 2% and the quantity demanded decreases by 0.5%. −0.5 1 So the elasticity 2s , o− 4. In general, goods and services that are necessities or in uncompetitive markets have inelastic demand, since people need them even if they're expensive. In general, goods and services that are luxuries or in highly competitive markets have elastic demand, since people have a lot of choice with whether to buy these things. In general, goods and services with close substitutes have elastic demand. For example, Coca Cola and Pepsi. Over longer amounts of time between price changes, goods and services tend to be more elastic - people can find more substitutes with more time. In other words, the longer consumers have had time to adjust to a price change, or the longer the good can be stored without losing its value, the more elastic is the demand. Narrowly defined markets are more elastic than broader ones. For example, demand for food is inelastic, but demand for broccoli is elastic. Goods on which a larger proportion of budgets are spent tend to be more elastic. For example, demand for cars is more elastic than groceries. Revenue Revenue is the product of price with quantity. The goal is to maximize revenue. When demand is elastic, there is an incentive to reduce prices. This is because any given reduction in price has a larger increase in demand, so revenue would increase. When demand is inelastic, there is an incentive to raise prices. This is because any given rise in price has a smaller decrease in demand, so revenue would increase. Revenue is maximized at unit elasticity - when revenue would decrease from any changes in the price. Price vs. Quantity v 3.00 | R | ....X.... e | ... ^ ... v | .. | .. e | . Unit Elasticity . n | . | . u | . Elastic | Inelastic . e |. | . |________________________________________ 0 Quantity ^ 25 million Real elasticities: furniture is 1.26, motor vehicles is 1.14, clothing is 0.64, and oil is 0.05. Cross price elasticity of demand This measures the effect changes in the price of substitutes and complements on demand. Instead of using the percentage change in the price of a good itself, we use the percentage change in the price of a substitute or a complement. % change in demand cross elasticity = % change in price of substitute or complement new demand − old demand % change in demand = new demand+old demand 2 new price of substitute or complement − old price of substitute or complement % change in price of substitute or complement = new price of substitute or complement+old price of substitute or complement 2 Using this, we can determine whether a good is a substitute or a complement: Positive cross elasticity means the good is a substitute. Negative cross elasticity means the good is a complement. A zero cross elasticity means the good is unrelated. Income elasticity of demand This measures the effect of changes in income on demand. Instead of using the percentage change in the price of a good itself, we use the percentage change in income. % change in demand income elasticity = % change in price new demand − old demand % change in demand = new demand+old demand 2 % change in income = new income− old income new income+old income 2 Using this, we can determine whether a good is a normal good or an inferior good: Positive income elasticity means the good is a normal good - greater demand as income increases. Negative income elasticity means the good is an inferior good - lesser demand as income increases. Income elasticity less in magnitude than 1 is income inelastic. Income elasticity greater in magnitude than 1 is income elastic. Income elasticity equal in magnitude to 1 is income unit elastic. Own price elasticity of supply The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good, all other influences being constant. % change in supply own elasticity = % change in price new supply − old supply % change in supply = new supply+old supply 2 new price− old price % change in price = new price+old price 2 Perfectly inelastic supply has a vertical supply curve - supply is fixed regardless of price. For example, Picasso's paintings are fixed in number, and cannot have any more produced. Perfectly elastic supply has a horizontal supply curve - price is fixed regardless of supply. For example, agriculture can be produced in variable quantities. Unit elastic supply has a linear supply curve that passes through the origin. The y-intercept of a linear supply curve determines the sign of the elasticity. A negative y-intercept means supply is inelastic, while a positive one means supply is elastic. Elasticity of supply depends on: Resource substitution possibilities: if the resources needed to produce a good or service is easily substituted, the good has more elastic supply. Time since price change: elasticity increases as time passes. Efficiency vs. equity Scarce resources are allocated by a number of factors. The goal is to operate on the PPF, but we must balance this with giving out resources fairly. This is the efficiency vs. equity tradeoff. Market price People who can and do pay the price get the good or service. This works for many goods and is the most common allocation scheme. Markets are very efficient since they adjust themselves. This is because price is an efficient regulating mechanism. For example, cars are bought by those who can afford it. Command system Authorities determine resource allocation. This works for organizations but not for entire economies. For example, labour time is allocated by a boss at work. Majority rule The majority vote determines resource allocation. This is used for society for some of its largest decisions. For example, tax rates are decided by the government, which is in turn decided by majority vote. Tax rates influence how resources are allocated between private and public use. Majority rule is useful when self-interest must be suppressed to use resources efficiently. Contest Resources are allocated to the winners. This is used for places where the efforts of players are hard to monitor and reward directly. For example, in sporting events the prize is awarded to the best
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