BSB113 Study Notes

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1 BSB 113 – ECONOMICS NOTES LECTURE 1: THE BARE BONES OF ECONOMICS LECTURE NOTES At the heart of economics lies the problem of scarcity! What is economics?  The application of rigorous, often mathematical thinking to understand how scarce resources are best used  Tries to understand how scarce resources are used in the real world  Positive vs. normative theory: how are resources used and what is the best way to use resources in the economy  Theory of how to run a business ie. how to improve efficiency by making better use of resources and to make a profit without incurring extra costs. The basic economic problem  All decision-makers (consumers, firms and gov) want more than is possible ie. demand is larger than what is possible to produce/supply  Issue of scarcity (Insufficiency of amount or supply; shortage) All of the groups have infinite needs and only finite resources  Demand vs. supply  People are concerned only for their own interests ie. they look after themselves/their own needs or wants etc.  People always care about their material welfare – all strive to increase it. Economics: how to best use limited resources in a way which is beneficial for the people (a majority?) Economists: claim everyone is selfish A short history of economic thought Basic Stance “What government should care about is the combined welfare of all inhabitants” – Adam Smith The role of economists “To find out what is in the best interests of all and to relay this information to the benevolent decision maker.” This implies  Economics is implicitly idealistic ie. it is for the common good But … whose welfare should be maximised  The welfare of the poor? Or the welfare of the average?  „Average‟ is found through GDP or the average income which is often seen as a measure of a successful country. Economics contains a lot of idealisms and therefore doesn’t tell you want to do immediately. Therefore, it is not practical in some situations. Eight Basic Ideas of Economics * Scarcity 1. Competition 2. Functioning Markets Jessica King BSB113 - Economics Semester 1, 2009 2 3. Benevolent Markets 4. Homo Economicus 5. Equilibrium 6. Money Circulation 7. Creative Destruction 1. Competition  Prices ensure that individuals specialise in what they do relatively best  Business want to sell goods to make profit but increasing competition limits prices and ensures consumers get the lowest possible price.  Stores therefore have an incentive to provide goods to ensure customers return to their store  Specialise: reduces costs, produce more and arguably goods of better quality (occurs as a result of competition)  The use of scarce resources efficiently ensures a business will earn an optimum profit  Economics of scale eg. car makers merge which allows them to cut production costs and therefore increase efficiency 2. Functioning Markets  Competition only works when a situation of many sellers exists  Only 1 seller (monopoly or no competition) means prices rise  Functioning market – where competition can occur  Buyers have access to price from all sellers and can purchase from anyone ie. they can chose the best product for their needs  Ownership is honoured. 3. Who sets market rules?  Believe that the rule setter is interested  In the common good (not always!) eg. the government, rule setters: competition boards (eg. ACCC), courts with impartial judges, government or those with independent power ie. a king 4. Homo Economicus  People maximise their own individual material gain and act highly rational in doing so  Eg. Cultural inhibitions against eating cows in India – the standard explanation from economists is that this prevents people when times are bad from eating their productive future capacity ie. keep food resources under control  People behave the way Homo Economicus predicts  Homo Economicus presumes pure selfishness  Eg. Experience with socialism 5. Equilibrium  An economic situation is said to be in equilibrium when it is not possible for anyone to improve their outcome by changing their current behaviour  A system should always be moving towards this but should never reach it  Occurs only in a stable market situation 6. Money circulation Main functions of money  allows trade in small quantities with little transaction costs – allows specialisation  a store of value: allows for pensions over weeks, years or decades  a unit of calculation – gives a price or a value Bottom line: allows/is needed for cheap trade of the result of time investments with others and oneself Jessica King BSB113 - Economics Semester 1, 2009 3  critical for trade  needed in a functioning market Money Circulation  Keeps control of money in the market – if not it leads to money problems eg. inflation  people use money to store value Inflation  more money for the same amount of goods, increases the number of notes (value) per good  ie. money loses its value  hyper-inflation – wipes out the value of savings and leads to fluctuations in relative prices, undermining specialisation (eg. Germany 1930‟s)  loss of confidence in money leads to alternative means of exchange eg. barter or people trading goods and reduced specialisation 7. Creative Destruction  How do we progress?  A continuous stream of shocks and discoveries constantly creates new opportunities and closes down ways of doing things  Always new ideas/opportunities coming up.  Links are need to work in an economy but new opportunities often break existing links  A firm faced with new technological possibilities must attain expertise of incorporating the new technology and has to ditch the old technology ie. Job loss as technology increases the issue of human vs capital labor will become more significant especially in certain manufacturing industries Policy implications of the bones of economics  Individuals must have an incentive to invest and innovate. Therefore, good rules are need to ensure one receives rewards for their efforts  Equilibrium requests everybody can do what he/she wants and everyone has a much information as possible  Market systems allow everybody to participate and as such, barriers to entering the market should be lower  Allow as much trade as possible TEXTBOOK NOTES – Chapter 1: The Bare Bones of Economic Thought Definitions Home economicus: someone who rationally maximises his or her own material welfare Economics: how and why a society produces things and how governments should manage things for the best in a calm and rational way Utilitarianism: what a government should care about is the combined welfare of all inhabitants. Inflation: More money without extra production in an economy is going to put upward pressure on prices because there would be more bank notes buying the same amount of goods Equilibrium: An economic system is said to be in equilibrium when it is not possible for anyone to improve on their outcome by changing their current behaviour. Economics by moral philosophy  Economists‟ view f the rest of humanity is that they are almost solely interested in having as many possessions as possible ie. materialism Functioning markets: the advantage of specialisation  Not everyone has equal abilities in terms of production and it is therefore efficient to specialise. Jessica King BSB113 - Economics Semester 1, 2009 4  Through specialisation everyone will gain from trade as, all will benefit from the fact that they do not have to make all products individually but can specialise in what they do best  Trade allows specialisation into fields of relative excellence (also known as comparative advantage) The immutability of Homo economicus  Two related big ideas in economics: A large part of the behaviour of individuals is dictated by their material interest and that it is not possible to have a continuously growing economy without appealing to material motivations Equilibrium and rationality  An economic system is said to be in equilibrium when it is not possible for anyone to improve on their outcome by changing their current behaviour  When individuals have all available information as to all possible opportunities for improvements and can freely contract with others, that the whole system will move towards a situation where all opportunities from improvement gradually disappear  The relation between the notion of equilibrium and rationality is clear: if expectations are roughly right then the economy should always be moving towards equilibrium Economies of Scale  Increasing economies of scale occur when the average cost of producing something goes down if the scale of production goes up.  Decreasing economies of scale also know as diseconomies of scale, occur when the average cost of production goes up if the sale of production goes up.  Eg. The cheapest way to produce billions of cares and computer chips is believed to involve very large plants with lots of automated processes rather than many small backyard production facilities.  However, when companies become too big they may begin to suffer from disadvantage eg. Law firms made up from merely a couple of lawyers are for instance believed to operate at lower average costs than huge law firms. Money and Money Circulation  The main role of money was as a means of exchange and a storage of value  Money allows people to trade the equivalent goods for the value of the notes/coins  Money allows individuals with different talents to trade the result of their time without even meeting each other and to allow any individual to trade with himself over time.  More money without extra production in an economy is going to put upward pressure on prices because there would be more bank notes buying the same amount of goods, which is known as inflation. Creative destruction and growth  Creative destruction believes that the world around us is constantly changing in a million different ways, opening new business opportunities and closing old ones.  Continuous search for new opportunities via experimentation with organisations, technology and trading partners  Within the market place, flexibility in terms of who does what and well-established property right such that individuals have incentives to take opportunities that present themselves (ie. enterprise) is needed.  In order for individuals to take opportunities there must be something in it for them, hence patent laws and business ownership  The fact that changes are so massive and multiply all the time means a large slice of the population needs to be on the lookout for these new opportunities  Recognition of opportunities needs as much useful information as possible  More barriers to changes = the less new opportunities that can be taken up quickly. Jessica King BSB113 - Economics Semester 1, 2009 5 Summary Table of Basic Ideas and their Relevance Basic Concept Intuitive Content of Basic Concept Policy Relevance of Basic Concept Scarcity Everyone wants more than is possible There is always a trade-off implicit in any choice Competition The fear of losing business to another will Social production costs can be lowered by make me demand no more than my costs competition for a service Functioning Markets Competition arises when the fear of losing Close down all options of avoiding cannot be taken away except by efficient competition or making money by defrauding specialisation consumers in other ways Benevolent rue setters The state can count on a loyalty to overall The state can somewhat impartially set the good from some of its employees rules for overall good. Homo economicus All individuals and their organisations are Do not design policies that go heavily against to a large degree consciously looking for material motives for long periods of time material gain Economic rationality Homo econmicus is a fairly good Take account of the fact that people calculator anticipate and adapt to policies Equilibrium The situation where all opportunities for Thinking of all the opportunities that open up gain are exhausted towards which we after a policy change forever move Money circulation All exchange is paid for in money, linking Increasing the money supply without the prices of the supply of money producing more goods means more money per good ie. inflation Creative Destruction A continuous stream of shocks and 1. Allow incentives to search and take the discoveries constantly creates new new opportunities opportunities and closes down old ones 2. Aid the exchange of information 3. Allow old ways to die in order to make room for the new. Jessica King BSB113 - Economics Semester 1, 2009 6 LECTURE 2: BASIC MICROECONOMICS – SCARCITY AND CHOICE LECTURE NOTES Key Concepts 1. Scarcity 2. Free goods 3. Production 4. Transfers 5. Choice 6. Opportunity cost 7. QuALY 8. Tax rates 9. Poverty trap Unlimited Wants  Everyone has many different types of wants and needs  4 key reasons why wants and needs are virtually unlimited: - goods eventually wear out and need to be replaced - new or improved products become available - people got fed up with what they already own - the more you have, the more you want What is actually scarce?  Commodities are produced by using resources  Resources/factors of production: Type Description Reward Land* All natural resources RENT Labour* All physical and mental work of people WAGES Capital All human-made tools/machines INTEREST Enterprise All managers and organisers PROFIT *limited and are the only ones which are actually scarce  All resources are eventually reducible to labour (time) and natural resources (restricted in the amount). Physical and other capital can be seen as the conserved result of previous production. Entrepreneurship effort is actually another form of labour and therefore, time. Types of (scarce) goods  Free good: available without the use of resources eg. air  Economic good: limited in supply eg. water or oil  Expenditure on capital goods is called a cost or an investment  Capital (good) is a productive asset eg. a machine, building Terminology of economics  Production: transforming the combination of production factors into something consumable – it contributes to GDP  Home production: untaxed production in households  Transfer: a change/swap in ownership of a resource or good eg. trade for trade or a good for money Economists often look at things from different perspectives. The difference between cost, a transfer, a return on an asset and production depends on the judge/their perspective. Jessica King BSB113 - Economics Semester 1, 2009 7 The economic problem  Refers to the scarcity of commodities – only a limited amount of resources available to produce the unlimited amount of goods and services desired by society Choice implies to choose one thing and forego another  Opportunity cost principle – the cost (or value) of one good in terms of the next best alternative  Implicitly or explicitly a choice for X limits the other options – there are tradeoffs inherent in any choice  The set of possible choices is called the opportunity set, the feasibility set or the budget constraint ie. something‟s are just not possible.  There is not necessarily always a „best‟ decision – but some decisions are worse than others Quality Adjusted Life Year (QuALY)  The estimated costs for various medical procedures, environmental regulation and safety measures  Policies implicitly set the value of a year of decent life and not all get an equal amount  Try to cease the more ineffective measures (less QuALY/dollar spent) in favour of more effective ones Managing People: Policies and the work place Taxation is the policy which most affects people’s behaviour Basic Terms Suppose pre-tax revenue = Y and tax bill = T  Average tax is total bill divided by pre-tax revenue ie. T/Y  Marginal tax is the percentage of the last dollar of revenue that gets paid in tax ie. dT/dY  Progressive tax – average tax increases with pre-tax revenue  Regressive tax – average tax decreases with pre-tax revenue ie. a lump sum tax is set for the whole population of eg. $1000. For a person on a high salary this amount would be small, but for a person on a low salary, this amount could be significant  Effective marginal tax rate – percentage of the last dollar in Y that is paid in tax or reduces the slide payments. Where transfers from the government which depend on income = W, (d(T-W)/dY). Taxation and Choice  The effect of taxes on people‟s choices particular their decision to work, is significant  In example 1 (slide 28), tax system has high EMTR, in area where marginal taxes kick in and welfare payments are reduced.  High EMTR makes it less attractive to seek work  This situation can be changed by decreasing welfare payments or avoiding areas where the reduction of welfare payments coincide with marginal tax  Poverty trap: situation whereby a person with generally few marketable skills earns less in work than out of work. Occurs when EMTR goes over 100%. Retirement/Pension Schemes Defined contributions compared to defined benefits and the effect on taxes  When does one stop working? - EMTR is the percentage of a year‟s income somebody close to retirement loses due to taxes and changes in pension payments  Two possible systems: 1. Defined contributions – save 12% of income. Sum of savings defines your pension 2. Defined benefits – pay 12% into a pension fund and get a fixed percentage of average income for the last 3 years you work.  With the potential income situation, it can be seen that the average drops compared to the last year and never reaches that high again  Defined contributions – save less in last years of working life but overall, you will have more money Jessica King BSB113 - Economics Semester 1, 2009 8  Therefore, pensions systems which are based on last=earned incomes can give rise to very high EMTR TEXTBOOK NOTES – Chapter 2: Scarcity Definitions  Goods and services: physical items and non-physical items that satisfy wants and needs  Factors of production: the items of value used in the production of goods and services  Transfer: a change in ownership of a resource of a consumption good  Scarcity: there is only a limited amount of resources available to produce the unlimited amount of goods and services that we desire. Scarcity requires making choices  Opportunity cost of a choice x: best available alternative for the resources involved in choosing X (value of the next best use)  Tradeoffs: exchange of one thing is return for another due to alternative key objectives that cannot be attained together  Budget constraint: the set of possible choices (eg. set of bundles that a consumer can afford)  Quality Adjusted Life Year (QuALY): equals a year of normal living of a person in good health and average happiness  Cost-effective policy: policy that minimises the cost of obtaining a given desirable outcome  Cost-benefit analysis: an analysis of all the benefits of a choice as well as the (opportunity) costs involved in making that choice.  Effective marginal tax rate (EMRT): the increase in taxes and the decrease in side-payments due to the last additional dollar of pre-tax revenue  Progressive tax: when the average tax increases with pre-tax revenue, the tax is progressive  Regressive tax: when average tax decreases with pre-tax revenue  Poverty trap: when earning more income in the formal economy reduces the material welfare of a relatively low skilled person  Defined contribution system: a superannuation system whereby the sum you get at the end is determined by how much you contributed  Benefit system: a superannuation system whereby the sum you get at the end is determined by an administrative rule not determined by your total contribution Unlimited Wants  Everyone has many different types of wants and needs  There are four reasons why wants and needs are virtually unlimited: 1. goods eventually wear out and need to be replaced 2. new or improved products become available 3. people get fed up with what they already own 4. the more you have, the more you want Factors of Production  Physical capital and natural resources are relatively easy to measure  Capital is something that eventually comes from time investments and natural resources spent in the previous period  Hence, from a long-term perspective, the only two ultimate production factors are natural resources and human time investments Types of Commodities  A free good is available without the use of priced resources  An economic good is a commodity in limited supply  Expenditure on producer or capital goods is called a cost or an investment Opportunity costs Jessica King BSB113 - Economics Semester 1, 2009 9  The set of possible choices we can make is called the opportunity set, the feasibility set or the budget constraint  Principle states the cost (or value) of one good in terms of the next best alternative Scarcity and the value of life  The essential task is to make problems comparable by expressing the value of different activities in the same way QuALY  Scarcity of resources forces you to think hard about what you fund and what you don‟t fund  It forces you to think of who loses when someone else wins  Completely reverses what it means to be kind: eg. You are not being kind if you refuse to value life and simply willy-nilly choose medicine and policies to find How the government affects choice by changing opportunity costs  Government policy affects the choices of individuals by changing the trade-offs between alternatives – seen in the taxation and retirement examples  Taxation promotes the thing untaxed and discourages the thing taxed ie. taxation changes the opportunity costs and therefore will change individual choices. Jessica King BSB113 - Economics Semester 1, 2009 10 LECTURE 3: DEMAND AND SUPPLY LECTURE NOTES What determines the demand, supply and prices in a market? Price taking behaviour  Price taking: you can only decide whether to buy or not. You cannot determine the price.  Is this the same for a seller? No, he/she can set the price … BUT if many shops sell the same (similar) goods, then a higher price in one shop implies that all customers would buy from another shop. We assume that (at least in the long run) sellers are also price takers, i.e. can only decide whether to sell at a price or not. Perfect Competition  What do we think that buyers know when they make their decision? • All prices that are offered by some sellers • All the sellers (and where their shops are) • The exact quality/design of products offered • Buyers know how much a good is worth to them • Sellers know their costs to produce/supply a good If buyers and sellers are price takers and all of the five assumptions are holding we speak of Perfect Competition. Willingness to pay  One way to express the opportunity cost is to give the foregone opportunities a monetary value. This is called the willingness to pay.  The amount of money willing to give up (opportunity cost)/spend on one item  Is influenced by other opportunities Demand curve  A demand curve depicts the quantity of a good that an individual demands (wants to buy) at a given price.  Demand curves are (almost always) downwards sloping because for most goods the additional benefit we get out of consuming more of the same is decreasing. This is called diminishing marginal* utility or diminishing marginal propensity to consume. This fact is so pervasive that we speak of it as the LAW OF DEMAND  Higher price = less likely to consume  The more you have consumed the less willing you are to pay What affects demand for a (normal) good?  Besides the price (as shown by the demand curve – low price = high demand), the budget, prices of other goods (opportunity costs) and the taste for something affect the demand and the demand curve Jessica King BSB113 - Economics Semester 1, 2009 11 Shifts in the Demand Curve Can the effect of prices on demand be measured?  What is the effect of a price increase from A$ 7 to A$8 or from A$2 to A$3?  But is this the same? Take the seller‟s perspective, if the price is increased from A$7 to A$8 the number of drinks demanded drops by 50%. If the price is increased from A$2 to A$3 the number of drinks drops by only 20%. At the same time, an increase from $7 to $8 is a price increase of 14.3% while an increase from A$2 to A$3 is a price increase of 50%.  The absolute change in the number of drinks demanded if the price increases by $A 1 is not a good measure for the effect the price has on demand Price elasticity of demand  We need to make sure that our measurement is not affected by the size or scale of the price and quantity involved. Economists use the price elasticity of demand. This answer is always negative and this calculation allows you to maximise profit percentagechangeinquantitydemanded Price elasticity of Demand = percentagechangeinprice This can also be represented as: Q/Q P Q      P/ P Q P Cross price elasticity and substitutes  The price of other goods can also affect the demand for a good. To solve the problem economists use the cross price elasticity of demand. Cross price elasticity of demand =percentagechangeinquantitydemandedofgoodstudied percentagechangeint hepriceofanothergood Jessica King BSB113 - Economics Semester 1, 2009 12 Income elasticity of demand  Reaction of the demand to a change in the income a consumer has available for spending. Economists use the same trick and call it income elasticity of demand. If Y<0 economists speak of inferior goods, if Y>0 they are normal goods, if Y>1 they are luxury goods, if Y<1 they are necessary goods. (inferior good = basic food item) percentagechangeinquantitydemanded Income Elasticity of demand = percentagechangeinincome  Illustrates that consumers consume more relevant to how much the income is ie. more income=more consumption What doe elasticises less us?  If price increases, demand decrease  Given that elasticises are small, the price increase has to be quite large.  The effect of tax is that price increases ie. new price is greater than only price hence less is demanded  Alternative policies include: making a substitute more attractive, reduce income, make a complement more expensive, change owner preferences The supply side of the market  The supply to a market is determined by producer of goods and services, we need to understand the production process to understand supply  Matters for the price/how much it costs to produce a good INPUTS • Labour (workers, bar men) • Land (resources, use of space, the place where the bar is) • Capital (incl. intermediate goods, furniture of the bar, glasses etc.) ↓ Production Y = f(G,L,K) ↓ OUTPUTS • Final consumption goods (Drinks in the bar) • Intermediate goods (eg. the glasses that are used in the bar) • Services (the taxi ride to get you home after the bar)  Production just combines inputs to get an output. As economists we can describe this process by stating the inputs needed to produce a certain quantity of an output. This can be done by formula: y = f (G, L, K) where y = Quantity of the output ... Is equal to f = a function (a certain combination of inputs) of G = the size of the bar (the ground it covers), L = labour (hours) used K = the amount of capital (glasses) used The letters represent numbers (they are variables). (Dis)Economies of Scale  Sometimes it needs less additional input the more we produce. In this case we speak of economies of scale. Jessica King BSB113 - Economics Semester 1, 2009 13  In other cases producing more can imply that a lot more of (additional) inputs is needed. In the latter case we speak of diseconomies of scale.  If we need constant additional quantities of inputs to increase the output we speak of constant economies of scale. Complements and Substitutes in Production  Complements: some inputs are always needed together to produce something  Substitutes: inputs can replace one another Cost of Production  Calculate the cost if we know the prices for the inputs.  The sum of the expenditures for each input (quantity*price) is equal to the total cost. TC = pG*G + w*L + pK*K Components of the Cost Function  Some costs arise independent of whether something is produced or not. These are called fixed cost.  Total cost – fixed cost are the variable cost. This is the part of the cost that varies with the quantity produced Average Cost  Average cost = Total cost / quantity  Average cost can tell us about (dis)economies of scale. If the average costs are decreasing with quantity we observe economies of scale. If the average costs are increasing we observe diseconomies of scale.  Economies of scale are usually only present for some range of quantities produced.  If a firm sells goods at a certain price, comparing the price to the average cost gives an indication whether the firm makes a profit. Marginal cost  Firms maximize their profit: Revenue – Total cost.  The cost of producing the additional unit (and really just the cost for this one additional unit) are called marginal cost  The marginal cost curve is the supply curve of an individual firm. Aggregate Supply  When more than one firm supplies to the market, we need to add up the quantities supplied by each individual firm.  Supply curves are summed up horizontally Demand Meets Supply  A market equilibrium is a combination of a quantity and a price where neither agent – neither seller (producer) nor buyer (consumer) – wants to sell or buy more than s/he currently does.  In equilibrium exists neither excess demand nor excess supply.  If the price is too low, we observe excess demand  If the price is too high we observe excess supply  If the price is right (we say the price is equal to the market clearing price) neither excess demand nor excess supply exists. The market is in equilibrium. TEXTBOOK NOTES – Chapter 3: Demand and Supply Definitions Price taking: Buyers and sellers cannot influence the price, they can only decide whether to buy or sell a good at a given market price Jessica King BSB113 - Economics Semester 1, 2009 14 Perfect competition: a situation where everybody (buyers and sellers) are price takers, because there are many buyers and many sellers and everybody has perfect competition Willingness to pay: the maximum price at which a buyer would purchase a unit of a good Demand curve: combination of the quantity demanded at a certain price and the respective price. Given by the willingness to pay for a certain unit of the good Law of demand: the higher the price, the fewer units‟ consumers‟ demand of a good Complements: goods that go well together, a price decrease for one good increase the demand for another good Substitutes: goods that compete with each other, a price decrease for one good decrease the demand for the other Elastic demand: the percentage change in the quantity demanded is larger than the percentage change in the price Market demand: the sum of individual demands of many customers Inputs: all factors used for production – classified as either land, labour or capital Final consumption goods: goods produced for immediate consumption by consumers Intermediate goods: products/goods that are inputs in another production process Services: intangible outputs that can be directly consumed or used as inputs in other production processes Production function: representation of the production technology using a mathematical function Substitutes in production: factors that can replace each other to produce a certain quantity of output Complements in production: factors that both have to increase production of an output Diminishing marginal return or diseconomies of scale: these are present if the marginal productivity of production factors decrease the larger the produced quantity Total cost: sum of costs to produce a certain quantity Average cost: total cost divided by quantity produced Cost function: (minimum) cost to produce a certain quantity using the production technology in the best way Fixed cost: cost that is independent of the quantity produced Variable cost: cost that changes with the quantity produced Marginal cost: cost to produce one additional unit equals the change in the total cost when output is increased by one unit. Profit maximisation: the quantity is chosen such that the price is equal to the marginal cost. At a lower quantity the price is larger than the marginal cost hence profits increase with an increase in the quantity produced. Supply curve: quantity that a firm supplies to the market at a given price Market supply: sum of the supplies of all firms active on the market Market clearing price: price at which market demand equals market supply Market equilibrium: situation where neither buyers nor sellers want to change their behaviour ie. they cannot profit from a change Excess demand: demand is larger than supply usually because the price is too low Excess supply: supply in a market is larger than demand usually because the price is too high Price Takers  Customers are price takers  But so too are sellers as a seller charging higher prices may sell some items but in the long run nobody will buy from this sell if the competition are selling it cheaper Willingness to pay and demand curves  Willingness to pay provides all the information needed to derive the quantity demanded at a given price  This information is represented on a demand curve. A demand curve depicts the quantity of a good that an individual demands at a given price. It is simply the picture of the willingness to pay for a good  Demand curve captures the important observation that as the quantity demanded decreases, price increases The law of demand Jessica King BSB113 - Economics Semester 1, 2009 15  Demand curves are downward slopping which comes from the observation that the willingness to pay for each unit of a good decreases with each additional unit consumed  Consumers tend to demand less of a good as its price becomes higher is so pervasive that economists refer to it as the law of demand  The reason for this is diminishing marginal propensity to consume or diminishing marginal utility meaning willingness to pay becomes less for each additional item consumed. What affects demand?  Preferences change and this changes willingness to consume/pay for a commodities  Goods that have a characteristic that demand increases when income or budget of a consumer increases are referred to as normal goods  Goods for which there is lower demand as income increases are called inferior goods  Whenever demand for a good increases with a lower price of another good, we call these goods complements  High price usually results in a lower quantity demanded as shown in the downward slope of the demand curve  Rightward shift in the demand curve is illustrated by a change in the demand for complements  Demand curve only shows the quantity demanded of a certain good at each price, therefore showing the relationship between price and quantity keeping everything else equal. Shifts in the demand curve result from changes in one of the factors included in “everything else” Price elasticity of demand  By what percentage does the quantity demanded decrease if the price increases by 1%?  By representing changes in relative or percentage terms, the problem of scale is avoided ie. comparing a change from $2 to $3 and a change from $10 to $11  This is the idea of the economist‟s description of the reactivity of demand towards price changes defined as the price elasticity of demand. percentagechangeinquantitydemanded Price elasticity of demand = percentagechangeinprice This can also be represented as: Q/Q P Q      P/ P Q P Where  = the change in the variable when considering a change in quantity (Q) and a change in price (P). The minus sign in front of the faction simply demonstrated that an increase in the price of a good is always associated with a decrease in the demand for that good.  Economists refer to an elastic demand if the elasticity is greater than one and to an inelastic demand if it is less than one.  The elasticity of demand changes along the demand curve.  One must also study the income elasticity of demand which is defined as: Income Elasticity of demand = percentagechangeinquantitydemanded percentagechangeinincome This is used to observe whether the demand for a good increases or decreases if income increases. If demand for a good increase with income, income elasticity of demand is positive and economists call such goods normal goods. If demand for a good decrease with income, the income elasticity of demand is negative and such goods are called inferior goods.  Cross price elasticity of demand, defined as: percentagechangeinquantitydemandedofgoodstudied Cross price elasticity of demand = percentagechangeint hepriceofanothergood Classification of Outputs Jessica King BSB113 - Economics Semester 1, 2009 16 Definition Examples Final consumption goods Goods produced for final Drinks, car, TV sets, clothes consumption by consumers Intermediate goods Goods that are produced by one Drinks in casks, electronic circuits, firm to serve as inputs for other oil, grains, fabrics firms producing final consumption goods Services Goods that are intangible but of Cleaning services, car repairs, immediate value to the consumer or health services producer consuming them Complements and substitutes in production  Substitutes in the production process: one input factor can, to some extent, be replaced by another factor, but with other inputs this may not be possible  If two inputs must be combined to supply a certain quantity of output, we say the inputs are complements.  Alternatively, to produce more output you need more of both inputs if they are complements but if the inputs are substitutes you can use more of one or more of another. Rules of thumb 1. highly skilled labour and capital are usually complements. This implies that highly skilled labour profits from a lower price of capital 2. low skilled labour and capital are usually substitutes. This implies low skilled labour suffers a loss from a lower price of capital 3. the more specialised a produce process the more complementary the different types of labour. Economies of scale and diseconomies of scale in production  Diseconomies of scale are important for equilibrium in an economy and are more common in many production processes  Where the marginal contribution of an increase in input factors increases, we speak of economies of scale. If the marginal contribution decreases we are speaking of diseconomies of scale and if it stays constant we speak of constant economies of scale The cost of production  Inputs in the production process need to be paid for, they are the cost of production  The average cost of production is the cost per unit of output – calculated by divided the total cost (TC) by the quantity of output (Q)  Total cost and average cost are closely related – both can be used to determine a firm‟s profitability.  The profit of a firm is calculated as total revenue minus total cost (TR – TC)  Revenue is the quantity of sold output multiplied by the price received (TR = Q x P)  One can use average costs (AC = TC/Q) to determine the profitability of a firm – firm is profitable when price per unit sold is greater than average cost of production The cost function  Gives the lowest possible costs of producing a certain quantity of the output Components of the total cost  Costs that have been paid independent of the quantity produced are called fixed costs  Some costs are variable that is costs that vary with the quantity of output eg. the hours of labour. Variable cost is the total cost minus fixed cost (VC = TC – FC) Jessica King BSB113 - Economics Semester 1, 2009 17  Firms care about their marginal cost when determining their output. Marginal cost is the change in the total cost when producing one more unit. Total cost and economies of scale  If total cost increase faster than the quantity of output then we can say that a production technology exhibits diseconomies of scale. If total cost increases less rapidly than the quantity of output then we can say a technology exhibits economies of scale.  Economies of scale are usually not present for the whole range of quantities produced Supply of a firm and profit maximisation  To maximise profits, the owner compares for each additional unit sold whether the price earned is larger than the cost incurred to produce the additional unit of output, the marginal cost of this unit.  Quantity supplied depends only on the marginal cost Market Equilibrium  Supply curve indicates the quantity that firms will supply at each price  Demand curve indicates the quantity consumer‟s demand at each price.  The intersection of the supply and demand curve indicates the price at which no seller wants to sell more and no buyer would like to buy more – equilibrium or market clearing price  Thus, the market is in equilibrium, nobody active in this market would like to change their behaviour, consumers do not demand more (or less) units at this price and sellers do want to supply more (or less) units at this price Excess demand and excess supply  If demand is higher than supply at a certain price, there is excess demand. Whenever demand is in excess, we expect the price to rise because buyers will be willing to pay more for the good and thus sellers will be able to increase prices  If demand is lower than supply at a certain price there is excess supply. In this case, sellers will be required and willing to lower their price to sell more.  Only at the market clearing price is the quantity demanded equal to the quantity supplied, there is no excess supply and no excess demand. Concepts in this chapter 1. Price taking 2. Willingness to pay 3. Complements and Substitutes in Demand 4. Aggregation of demand 5. Demand curve 6. Factors of production 7. Complements and substitutes in production 8. Economies of scale and diseconomies of scale 9. The production function 10. Total costs = FC plus VC 11. The cost function 12. Marginal Cost 13. Price = Marginal cost determines the supply curve 14. Aggregate supply 15. Market clearing price 16. Excess demand and excess supply Jessica King BSB113 - Economics Semester 1, 2009 18 LECTURE 4: THE BARE BONES OF ECONOMICS LECTURE NOTES What is good for an economist?  Allocation: the division of resources among people. Allocations can change across time through the exchange of goods - seller: allocation of money increases and allocation of goods decreases - buyer: allocation of money decreases and allocation of goods increases  Pareto Efficient: an allocation is efficient (good) if we cannot improve anyone‟s allocation without making someone worse off. It does not consider the fairness (equity) of allocations.  If an allocation if Pareto inefficient (bad) then we should change it.  Normative analysis: When asking what is „good‟ for a society, we need to make a judgement.  Positive analysis: (alternative to above) tries to understand what is happening and avoids value judgements eg. cause and effect questions such as how interest rates affect inflation Advantage of exchanging goods  Self-sufficiency: the situation where a person, household or village consumes one what it produces themselves – no goods are exchanged  As a result of exchange, the total number of goods increased – therefore resulting in more overall goods to share  Consumption possibilities: combinations of goods a person can choose from  Whenever an individual can choose among more options, he or she will never be worse of (they can still choose the original option!). Therefore, exchanging goods is good! Are Markets Efficient?  Determined by determining the benefits consumers and producers receive through exchange  Consumer surplus: benefits consumers derive from using the market ie. whether the consumer benefited from buying something Consumer Surplus  Willingness to pay was the maximum price a buyer was willing to bay for a good. The difference between the willingness to pay and the actual price is a „surplus‟ to the buyer Consumer surplus = Willingness to pay – Price  Aggregate consumer surplus is the sum of individual consumer surplus.  Consumer surplus can never been negative.  Consumer surplus can be calculated as the area between the demand curve and the horizontal price line (know how to calculate this and the value!)  A fall in price increases consumer surplus through two channels: 1. again to consumers would have bought at the original price 2. again to consumers who are persuaded to buy at the lower price  Decline in price = increase in consumer surplus and therefore increase in consumer benefits  Shaded area = benefits to consumers from buying at this cost Producer Surplus  Sellers to need to benefit as well, without it there would be no sellers  Producer Surplus: benefits producers derive from using the market  Producers compare marginal cost of production to the price received – marginal cost curve is the supply curve  Difference between the price received and the marginal cost is a measure to the benefit to a producer Producer surplus = Price – Marginal Cost Where price = what they get for the good and marginal cost = what they sell the good for  Where marginal cost is higher than the selling price, producers will not sell as the cost of production is higher than cost. Therefore, if they did sell, they would selling at a loss! Jessica King BSB113 - Economics Semester 1, 2009 19  Producer surplus can be calculated as the area between the price line and the supply curve  Supply curve represents the marginal cost  When the price of goods rises, producer surplus increases through two channels: 1. A gain to producers who would have sold at the original price 2. A gain to producers who are induced to supply the good by the higher price.  Sometimes governments force producers to sell more or less or to sell at a certain level less than they would if profit maximising eg. taxi fare charges Maximising total surplus  Maximising the welfare of individuals in society is equivalent to maximising the surpluses, because it is always better to have more to share  If total surplus was not maximised, we could: - change the allocation to one that maximises total surplus - the benefit to winners will be larger than the loses to losers - winners compensate those that lose  Consumers are irrational  If the price is 30, the supply is 40 units and consumers demand 60 units, therefore there is excess demand  Marginal costs are lower than marginal willingness to pay, so the social benefit can be increased by selling more  Extra producer surplus greater than lower consumer surplus  Equilibrium – supply = demand  Producer supply+ increases producers gain and they are now selling more  If price of 40 is greater than the quantity of 60, the market is therefore efficient – maximising total surplus is crucial Markets are efficient  Equilibrium market price (demand = supply) and the resulting quantity demanded maximises total surplus  There will always be winners and losers however, the main point is that the total surplus is larger  Benefits to winners will be larger than the loses to losers and winners could make payments to losers t compensate them for the loss  Given this, the allocation is Pareto efficient and therefore so too are markets  Maximises total surpluses: 1. people who want the goods the most are the ones who want it most – i.e. they are willing the pay the most for a good 2. those who producer goods most efficiently at the lowest costs – these producers supply the goods 3. every exchange benefits both consumers and producers 4. no extra benefits to be had – every beneficial exchange has taken place. At market equilibrium, there is no way to make some people better off without making others worse of – THIS IS THE DEFINITION OF EFFICIENCY. Cost of government intervention  We do not always have free markets  Demand is restricted eg. alcohol  Supply is restricted eg. blue cards  Governments charge taxes – good reasons exist for these interventions but under such interference markets cannot work properly Jessica King BSB113 - Economics Semester 1, 2009 20 Cost of restricting demand  This rotates the demand curve inwards  Leads to lower prices and quantities and reduces the total surplus  Losers are the restricted consumers and the producers who would sell to them Cost of taxation  Cost of taxation arises from the efficiency losses  What you pay the state is income for the state, hence nothing is lost as a benefit to one is a loss to another  Efficiency costs arise because you change your behaviour ie. Consume less than you would.  Two views on consumption taxes (eg. GST) - tax is an additional cost to the seller – shifts supply curve upwards - tax reduces the buyers willingness to pay – shifts the demand curve downwards - both views yield the same results - both have the same effect- the price to consumers rises  Tax revenue forms an extra part of the demand/supply curve, therefore meaning that three people gain  Deadweight loss increases as the tax rate increases  Decreases depend on people‟s behaviour  The size of deadweight loss depends on other factors  Whenever tax significantly alters people‟s behaviour, the deadweight loss will be large – the price elasticity of demand (how much people demand as a result of changes in price)  High elasticity of demand results from price increases from tax (flat demand curve) leads to large deadweight cost. This is largely significant in the sale of luxury goods and results in a less inefficient tax system. However, high elasticity of demand increases market inefficiency  Steep demand curve results in lower elasticity of demand which is relevant to basic food/necessities  Quantity of change in demand is significant TEXTBOOK NOTES – Chapter 4: Markets and Exchange Definitions Allocation: describes the distribution of scarce goods among the members of a society Pareto efficiency: an allocation is Pareto efficient if no member of a society can be made better off without making at least one member of the society worse off Self sufficiency: is the situation where an economic unit (a person, household, village) consumes only what it produces itself. No goods are exchanged. The consumption possibilities are equal to the production possibilities Production possibilities: the combinations of goods that can be produced given the resources an economies unit has available Consumption possibilities: the set of possible combinations of goods an economic unit can choose the goods it wants to consume from Consumer surplus: the benefit that consumers derive from market interaction Producer surplus: the benefit that all producers derive from market interaction Market equilibrium is an efficient allocation: perfect markets are efficient because they maximise the sum of producer and consumer surplus Tax revenue: the money collected by government from tax Deadweight loss of taxation: the reduction in the sum of consumer and producer surplus that is not compensated by the tax revenue Pareto efficiency  Allocations can change over time  A sale is thus a particular change in the allocation of goods  Buyer‟s allocation of the good in question increases while his or her money allocation decreases. At the same time, the seller‟s allocation of the good decreases while his or her allocation of money increases Jessica King BSB113 - Economics Semester 1, 2009 21  Notion of equilibrium includes the idea that self=interested people use all beneficial opportunities  Can we improve on a situation such that nobody is worse off and at least one person is better off?  Pareto efficient: Given current resource allocations, we cannot improve the situation of society without making another member worse off. Describes in a normative way what type of situation allocation we would like to see (referred to as normative analysis)  Normative analysis: economists try to describe an ideal world  The alternative is positive analysis: when economists describe and try to explain how people actually behave without making any judgement on whether the behaviour is good or bad. Production Possibilities  Without exchange, every household or consumer needs to be self-sufficient Exchange  Exchange allows consumers to choose from a larger consumption possibilities et.  Whenever an individual can choose more instead of few options, they will never be worse off and they may be better off  May also result in specialisation  Under self-sufficiency, without exchange, consumption is equal to production: With exchange one can see that the consumption possibilities have improved for both  Exchange can greatly improve the options for both trading partners at the same time  A person specialising in one activity becomes more proficient at that activity. When specialisation comes improved production which increase the potential gains from exchange even more. Consumer Surplus  Efficiency means that no party active in a market can benefit without another party being harmed  A buyer has a certain willingness it pay for a good he or she wishes to buy  Willingness to pay is greater than the price of the good, the consumer will buy the good. However, the price is lower than that which he or she is willing to pay, then the buyer makes in one sense a „profit‟ – when you buy something that is cheaper than what you are prepared to pay for it.  Profit is referred to as consumer surplus  To calculate consumer surplus, we have to find the difference between the willingness to pay and the price at which consumers can buy the good.  In a market economy, nobody is forced to buy a good and thus consumer surplus is never negative.  When referring to consumer surplus, we do not refer to each individual buyer‟s surplus to the surplus of all consumers. Aggregate consumer surplus is simply the sum of the individual consumer surplus generated by market exchanges.  Consumer surplus can be calculated as the area between the demand curve and the horizontal price line Consumer surplus = area between the demand curve and the price line  The shaded area represents consumer surplus  Consumer aggregate demand depends on the relationship between willingness to pay and price Producer Surplus  Consumer surplus measures the benefits buyers derive from trade, producer surplus measures the benefits of sellers or producers of the good  Profit, or the producer surplus, when selling this unit is therefore given as the price minus the marginal cost. Usually producers sell more than one unit of output, nonetheless, the same logical applies. Producer surplus = area between the price line and the supply curve  Sometimes governments force producers to sell more or less than they would decide to sell if they based their decision on their profit maximising producer surplus – this type of government intervention is called regulation. Jessica King BSB113 - Economics Semester 1, 2009 22  Firms can be regulated to sell at a certain price all the goods that are demanded usually firms cannot be forced to enter the market  Surplus is positive show‟s producer‟s gain from selling but surplus would be higher if government could choose to sell fewer units. Maximising the sum of consumer and producer surplus  A society can share among its constituents the benefits consumers derive – the consumer surplus – plus the benefits producers derive – the producer surplus  The sum of consumer surplus and producer surplus is not maximised then changing the allocation to one that maximises the sum of surpluses would generate a benefit to the „winners‟ that is larger than the loss to „losers‟ of such a change  It is always better to have more to share among the members of society than to have less to share  Consumers are rationed – this is the case of people queuing the buy goods because there is not enough for everyone.  Still, these consumers that get the goods receive a higher consumer surplus, in the best case – if consumers with the highest willingness to pay get the goods – the consumer surplus is equal the area shaded in pink  The social benefit – the sum of producer and consumer surplus – can be increased by selling more  Lowering the price producer surplus would be recorded, but at the same time there would be a greater increase in consumer surplus Markets are efficient  A decrease in price reduces producer surplus – producers are harmed – and thus a reduction in prices I not Pareto efficient, because the benefit to consumers causes harm to the producer.  Given the benefit to consumers is larger than the loss to producers, consumers could give „presents‟/make payments to producers to compensate for their loss  This not feasible if the sum of consumer and producer surplus is already maximised  An efficient allocation is one where the sum of consumer and producer surplus is maximised.  Equilibrium market price maximises the sum of surpluses we can state that the market equilibrium is an efficient allocation.  The market mechanism ensures that the willingness to pay for products is always at least a high as the cost for society to produce the goods. The costs of government intervention  If such restrictions are imposed, markets cannot work properly and hence the outcome is usually an inefficient allocation  The loss of efficiency in one market may help to avoid efficiency costs in another market The cost of restricting supply and demand  With restricted supply, prices are usually higher compared to a market without intervention, thus increasing producer surplus, but reducing consumer surplus without intervention, thus increasing producer surplus but reducing consumer surplus  The sum of surpluses is reduced as indicated by the grey triangle which represents the costs of such intervention  Higher profits accruing to sellers may be used to force suppliers to invest in activities they would not undertake  Similar effect can be observed if the government restricts demand  Access restriction is independent of willingness to pay for the goods, demand at a particular price will simply be reduced by a certain percentage  The price is lower with a consequential lower producer surplus Jessica King BSB113 - Economics Semester 1, 2009 23 The
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