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ECON 101 Textbook Notes

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Department
Economics
Course
ECON 101
Professor
Eva Lau
Semester
Fall

Description
Chapter 1: What is Economics? September-11-12 1:00 PM Definition of Economics - Scarcity: the inability to get everything we want (universal problem) - What society can get is limited by the productive resourcesavailable. We are forced to make choices. - Your choices must somehowbe made consistent with the choices of others. If you choose to buy a laptop, someoneelse must choose to sell it. - Incentives reconcile choices. An incentiveis a reward that encourages an action or a penalty that discourages one. Prices act as incentives. If the price of a laptop is too high, more will be offered for sale than people want to buy. There is a price at which choices to buy and sell are consistent. - Economics:the social science that studies the choices that individuals, businesses, governments,and entire societiesmake as they cope with scarcity and the incentives that influence and reconcile those choices (2 parts: microeconomics& macroeconomics) - Microeconomics: the study of the choices that individuals and businesses make, the way these choices interact in markets,and the influence of governments - Macroeconomics:the study of the performance of the national economyand the global economy Two Big Economic Questions - How do choices end up determining what, how, and for whom goods and services are produced? - Can the choices that people make in the pursuit of their own self-interest also promotethe broader social interest? What, How, and For Whom? - Goodsand services are the objects that people value and produce to satisfy human wants. Goods are physical objects. Services are tasks performedfor people. How? - Factors of production: goods and services that are produced by using productive resources (grouped into 4 categories: land, labour,capital,entrepreneurship) Land - Land = natural resources - Our land surface and water resources are renewable and some of our mineral resources can be recycled. But the resourcesthat we use to create energy are nonrenewable (can only be used once). Labour - The work time and work effort that people devote to producing goods and services - Includes the physical and mental efforts of all the people who work - The quality of labour depends on human capital,which is the knowledge and skill that people obtain from education, on-the-job training, and work experience. Capital - The tools, instruments, machines, buildings, and other constructions that businesses use to produce goods and services - Money, stocks,bonds = financial capital -> used to buy physical capital, is not used to produce goods and services -> not a productive resource Entrepreneurship - The human resource that organizes labour, land, and capital - Entrepreneurs come up with new ideas about what and how to produce, make business decisions, and bear the risks that arise from these decisions. For Whom? - Who consumesthe goods and services that are produced depends on the incomes that people earn. - People earn their incomes by selling the services of the factors of production they own: • Land earns rent. • Labour earns wages. -> earns the most income (around 70%) • Capital earns interest. • Entrepreneurship earns profit. - Distribution of income is unequal. Can the Pursuit of Self-Interest Promotethe Social Interest? Self-Interest - A choice is in your self-interest if you think that choice is the best one available for you. You order a home delivery pizza because you're hungry and want to eat. Social Interest - A choice is in the socialinterest if it leads to an outcomethat is the best for societyas a whole. - 2 dimensions: efficiency and equity (or fairness) -> What is best for society is an efficient and fair use of resources. - Efficiency: when the available resources are used to produce goods and servicesat the lowest possible cost and in the quantities that give the greatest possible value or benefit Globalization - Expansion of international trade, borrowing and lending, and investment - In the self-interest of those consumerswho buy low-cost goods and services produced in other countries; is in the self-interestof the multinational firms that produce in low-costregions and sell in high-price regions The Information-Age Economy - Technological change of the past 40 years: the Information Revolution - The information revolutionhas served your self-interest:it has provided your cell phone and laptop. Climate Change - make self-interested choices to use electricity and gasoline -> contribute to carbon emissions Economic Instability - All the banks' choices to borrow and lend and the choices of people and businesses to lend to and borrow from banks are made in self-interest. The Economic Way of Thinking - 6 key ideas that define the economic way of thinking: • A choice is a tradeoff. • People make rational choices by comparing benefits and costs. • Benefit is what you gain from something. • Cost is what you must give up to get something. • Most choices are "how much" choices made at the margin. • Choices respond to incentives. A Choice Is a Tradeoff - When we make a choice, we select from the available alternatives. - Choices are tradeoffs. A tradeoff is an exchange, giving up one thing to get something else. Making a Rational Choice - Rationalchoice:choice that comparescosts and benefits and achieves the greatest benefit over cost for the person making the choice - Only the wants of the person making a choice are relevant to determine its rationality. For example, you might like your coffee black and strong but your friend prefers his milky and sweet. It is rational for you to choose espresso and for your friend to choose cappuccino. - What goods and services will be produced and in what quantities? Those that people rationally choose to buy. Benefit: What You Gain - The benefit of something is the gain or pleasure that it brings and is determined by preferences: by what a person likes and dislikes and the intensity of those feelings. - Economistsmeasure benefit as the most that a person is willing to give up to get something. Cost: What You Must Give Up - Opportunitycost: the highest-valued alternative that must be given up to get it - Most situations involve choosing how much of an activityto do. How Much? Choosing at the Margin - When you compare the benefit with its cost, you're making your choice at the margin. - When you compare the benefit with its cost, you're making your choice at the margin. - Marginalbenefit: the benefit that arises from an increase in an activity • e.g. Your marginal benefit from one more night of study before a test is the boost it gives to your grade. Your marginal benefit doesn't include the grade you're already achieving without that extra night. - The opportunity cost of an increase in an activity is called marginalcost. The marginal cost of studying one more night is the cost of not spending that night on your favourite leisure activity. Choices Respond to Incentives - Self-interested actions are not necessarily selfish actions. A self-interested act gets the most benefit for you based on your view about benefit. - The central idea of economicsis that we can predict the self-interested choices that people make by looking at the incentives they face. People undertake those activitiesfor which marginal benefit exceeds marginal cost; and they reject options for which marginal cost exceed marginal benefit. - Incentives is the key to reconciling self-interest and social interest. When our choices are not in the social interest, it is because of the incentives we face. Economics as Social Science and Policy Tool Economistas Social Scientist Positive Statements - A positive statementis about what is. It says what is currently believed about the way the world operates. A positive statementmight be right or wrong, but we can test it by checking it against facts. - Economics-> emerged in late 1700s Normative Statements - A normative statementis about what ought to be. It depends on values. Policy goals are normative statements.You may agree or disagree with it. It doesn't assert a fact that can be checked. Unscrambling Cause and Effect - Economicmodel: a description of some aspect of the economicworld that includes only those features that are needed for the purpose at hand • e.g. An economicmodel of a cellphone network might include features such as the prices of calls, the number of cellphone users, and the volume of calls. But the model would ignore cellphone colours. - A model is tested by comparing its predictions with the facts -> difficult, we observe the outcomesof the simultaneous change of many factors - To cope with this problem, economistslook for natural experiments (situations in the ordinary course of economiclife in which the one factor of interest is different and other things are equal or similar); conduct statistical investigations to find correlations;and perform economicexperiments by putting people in decision-making situations and varying the influence of one factor at a time. Economistas Policy Adviser - Economicsis a toolkit used to provide advice on government,business, & personal economic decisions. - All the policy questions on which economistsprovide advice involve a blend of the positive and normative.Economicscan't help with the normativepart, the policy goal. But for a given goal, economicsprovide a method of evaluating alternativesolutions, comparing marginal benefits and marginal costs and finding the solution that makes the best use of available resources. Chapter 2: The Economic Problem September-13-12 1:00 PM Production Possibilitiesand Opportunity Cost - The quantities of goods and services that we can produce are limited both by our available resources and by technology. If we want to increase our production of one good, we must decrease our production of somethingelse - we face a tradeoff. - The productionpossibilitiesfrontier (PPF) is the boundary between those combinationsof goods and services that can be produced and those that cannot. We focus on 2 goods at a time and hold the quantities produced of all the other goods and services constant. Production-PossibilitiesFrontier - Figure 2.1 (p.30) • Illustrates scarcity -> cannot attain the points outside the frontier (wants that can't be satisfied) • We can produce any point inside the PPF or on the PPF -> points are attainable Production Efficiency - Productionefficiency is achieved if we produce goods and services at the lowestpossible cost. This outcomeoccurs at all the points on the PPF. At points inside the PPF, production is inefficient because we are giving up more than necessary of one good to produce a given quantity of the other good. - Production is inefficient inside the PPF because resources are either unused or misallocated or both. - Resources are unused when they are idle but could be working. - Resources are misallocated when they are assigned to tasks for which they are not the best match. Tradeoff Along the PPF - Every choice along the PPF involves a tradeoff. - Tradeoffs arise in every real-world situation in which a choice must be made. At any given point in time, we have a fixed amount of labour, land, capital, and entrepreneurship. By using our available technologies,we can employthese resources to produce goods and services, but we are limited in what we can produce. This limit defines a boundary between what we can attain and what we cannot attain. On our real-world PPF, we can produce more of any one good or service only if we produce less of some other goods or services. - All tradeoffs involve a cost: an opportunity cost. Opportunity Cost - The highest-valued alternative forgone - The opportunity cost of producing an additional pizza is the cola we must forgo. - The opportunity cost of producing an additional can of cola is equal to the inverse of the opportunity cost of producing an additional pizza. Opportunity Cost Is a Ratio - decrease in the quantity produced of 1 good ÷ the increase in the quantity produced of another good as we movealong the PPF (Give Up ÷ Get) Increasing Opportunity Cost - The PPF is bowed outward because resources are not all equally productive in all activities.People with many years of experience working at PepsiCo are good at producing cola but not very good at making pizzas. So if we movesome of these people from PepsiCo to Domino's,we get a small increase in the quantity of pizzas but a large decrease in the quantity of cola. - As we produce more of 1 good, we must use resources that are less suited to that activity and more suited to producing the other good, so we face increasing opportunity cost. - Increasing opportunity cost is a universal phenomenon. When the rate of production increases, so does the opportunity cost of production. Using Resources Efficiently - We achieve production efficiency at every point on the PPF, but which point is best? The point on the PPF at which goods and services are produced in the quantities that provide the greatest possible benefit. When goods and services are produced at the lowest possible cost and in the quantities that benefit. When goods and services are produced at the lowest possible cost and in the quantities that provide the greatest possible benefit, we have achieved allocativeefficiency. The PPF and Marginal Cost - Marginalcost: the opportunity cost of producing one moreunit of it, calculated from the slope of PPF - As the quantity of pizzas produced increases, the PPF gets steeper and the marginal cost of a pizza increases (Figure 2.2 (p.33)). - Marginal cost curve slopes upwards because of increasing opportunity cost Preferencesand Marginal Benefit - The marginalbenefit from a good or service is the benefit received from consuming 1 more unit of it. This benefit is subjective; it depends on people's preferences: people's likes and dislikes and the intensity of those feelings. - Marginal benefit and preferences stand in sharp contrast to marginal cost and production possibilities. Preferencesdescribe what people like and want and the production possibilities describe the limits or constraints on what is feasible. - We use the marginalbenefitcurve (a curve that shows the relationship between the marginal benefit from a good and the quantity consumed of that good) to show the preferences. The marginal benefit curve is unrelated to the PPF and cannot be derived from it. The marginalbenefit curve slopes downwards because of decreasing marginal benefit. - We measure the marginal benefit from a good or service by the most that people are willing to pay for an additional unit of it. You are willing to pay less for a good than it is worth to you but you are not willing to pay more: the most you are willing to pay for something is its marginal benefit. - principleof decreasing marginalbenefit: the more we have of any good/service,the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it - Marginal benefit decreases because we like variety (get tired and switch to somethingelse). - The marginal benefit, measured by what you are willing to pay for something, is the quantity of other goods and services that you are willing to forgo. - Figure 2.3 (p.34) Allocative Efficiency - Figure 2.4 (p.35) • MB > MC (produce more pizzas) • MB < MC (produce fewer pizzas) • MB = MC (efficient quantity of pizzas) Economic Growth - The expansion of production possibilities - Increases our standard of living, but it doesn't overcomescarcity and avoid opportunity cost - To make our economygrow, we face a tradeoff: the faster we make production grow, the greater is the opportunity cost of economicgrowth. The Cost of EconomicGrowth - Economicgrowth comesfrom technological change and capital accumulation (expanded production possibilities). Technologicalchange is the developmentof new goods and of better ways of producing goods and services. Capitalaccumulation is the growth of capital resources,including human capital. - If we use our resources to develop new technologiesand produce capital, we must decrease our production of consumptiongoods and services. There is an opportunity cost. - Figure 2.5 (p.36) • The amount by which our production possibilities expand depends on the resourceswe devote to technological change and capital accumulation. If we devote no resources to this activity (point A), our PPF remains the blue curve. If we cut the current pizza production and produce 6 ovens (point B), then in the future, we'll have more capital and our PPF will rotate outward to the position shown in red. The fewer resources we use for producing pizza and the more resources we use for producing ovens, the greater is the expansion of our future production possibilities. - Economicgrowth brings enormousbenefits in the form of increased consumption in the future, but - Economicgrowth brings enormousbenefits in the form of increased consumption in the future, but it is not free and it doesn't abolish scarcity. - The opportunity cost of more pizzas in the future is fewer pizzas today. A Nation's EconomicGrowth - If a nation devotes all its factors of production to producing consumption goods and services and none to advancing technology and accumulating capital, its production possibilities in the future will be the same as they are today. - To expand production possibilities in the future, a nation must devotefewer resources to producing current consumption goods and services and some resources to accumulating capital and developing new technologies. As production possibilities expand, consumptionin the future can increase. The decrease in today's consumption is the opportunity cost of tomorrow'sincrease in consumption. Gains from Trade - Specialization: producing only one good or a few goods ComparativeAdvantage and Absolute Advantage - A person has a comparativeadvantage in an activityif that person can perform the activity at a lower opportunity cost than anyone else. Differencesin opportunity costs arise from differences in individual abilities and from differences in the characteristicsof other resources. - Although no one excels at everything, some people excel and can outperform others in a large number of activities (even in all activities).A person who is more productive than others has an absoluteadvantage. - Absolute advantage involves comparing productivities, production per hour, whereas comparative advantage involvescomparing opportunity costs. - A person who has an absolute advantage does not have a comparative advantage in every activity. John Grisham is a better lawyer and a better author of fast-paced thrillers than most people. He has an absolute advantage in these 2 activities. But compared to others, he is a better writer than lawyer, so his comparative advantage is in writing. - Table 2.1 & 2.2 (p.38-39) Liz's Comparative Advantage - Liz has a comparativeadvantage in producing smoothies.Her opportunity cost of a smoothieis lower. Joe's Comparative Advantage - If Liz has a comparativeadvantage in producing smoothies,Joe must have a comparativeadvantage in producing salads. His opportunity cost of a salad is lower. Achieving the Gains from Trade - Table 2.3 (p.39) - Despite Liz being more productive than Joe, both of them gain from specializing, producing the good in which they have a comparativeadvantage, and trading. EconomicCoordination - People gain by specializing in the production of those goods and services in which they have a comparativeadvantage and then trading with each other. For billions of individuals to specialize and produce millions of different goods and services,their choices must somehowbe coordinated. - Two competing economiccoordination systemshave been used: central economicplanning and decentralized markets. - Central economicplanning was tried in Russia and China and is still used in Cuba and North Korea. This system works badly because governmenteconomicplanners don't know people's production possibilities and preferences. Resourcesget wasted, production ends up inside the PPF, and the wrong things get produced. - Decentralized coordination works best but to do so it needs 4 complementarysocial institutions: firms, markets, property rights, and money. Firms - An economicunit that hires factors of production and organizes those factors to produce and sell goods and services (e.g. Tim Hortons) goods and services (e.g. Tim Hortons) - Coordinate a huge amount of economicactivity, but there is a limit to the efficient size of a firm • e.g. Canadian Tire buys or rents buildings. - Canadian Tire doesn't produce the goods that it sells. It could own and coordinateproduction of all the goods it sells. But John W. and Alfred J. Billes succeeded by specializing in providing good service and retailing supplies from other firms that specialize. This trade between firms takes place in markets. Markets - Any arrangement that enables buyers and sellers to get information and to do business with each other - Have evolvedbecause they facilitate trade. Without organized markets,we would miss out on a substantial part of the potential gains from trade. Enterprising individuals and firms, each pursuing their own self-interest, have profited from making markets, standing ready to buy or sell the items in which they specialize. But marketscan work only when property rights exist. Property Rights - Social arrangements that govern the ownership, use, and disposal of anything that people value - Real property includes land, buildings and durable goods, such as plant and equipment. - Financial property includes stocks, bonds, and money in the bank. - Intellectual property is the intangible product of creative effort (e.g. books, music computer programs, and inventions of all kinds and is protected by copyrights and patents). - Where property rights are enforced, people have the incentive to specialize and produce the goods in which they have a comparativeadvantage. Where people can steal the production of others, resources are devoted not to production, but to protecting possessions. Money - Any commodityor token that is generally acceptable as a means of payment - Trade in markets can exchange any item for any other item. - Makes trading in marketsmuch moreefficient Circular Flows Through Markets - Figure 2.7 (p.43) • Households specialize and choose the quantities of labour, land, capital, and entrepreneurial services to sell or rent to firms. Firms choosethe quantities of factors of production to hire. These (red) flows go through the factor markets. Households choose the quantities of goods and services to buy, and firms choose the quantities to produce. These (red) flows go through the goods markets. Households receive incomes and make expenses on goods and services (the green flows). Coordinating Decisions - Markets coordinatedecisions through price adjustments. - Suppose that too few hamburgers are available and some people who want to buy hamburgers are not able to do so. To make buying and selling plans the same, either more hamburgers must be offered for sale or buyers must scale down their appetites (or both). A rise in the price of a hamburger produces this outcome.A higher price encourages producers to offer more hamburgers for sale. Chapter 3: Demand and Supply September-18-12 1:00 PM Markets and Prices - Market: any arrangement that enables buyers and sellers to get informationand to do business with each other • 2 sides: buyers & sellers • for goods, services, factors of production, other manufactured inputs, money & financial securities • May have physical places where buyers and sellers meet and where an auctioneer/brokerhelps determine the prices (e.g. produce markets) • May be groups of people spread around the world who never meet but connected through the Internet or by telephone and fax (e.g. e-commerce,currency markets, etc.) • Most are unorganized collectionsof buyers & sellers (do most of your trading in this type of market) - Competitivemarket: a market that has many buyers and many sellers, so no single buyer or seller can influence the price - Producers offer items for sale only if the price is high enough to covertheir opportunity cost. Consumers respond to changing opportunity cost by seeking cheaper alternatives to expensive items. - Price: the # of dollars that must be given up in exchange for a good/service - Relative price: the ratio of one price to another (Relative price is an opportunity cost.) - Normal to express a relative price in terms of a "basket" of all goods & services • Relative price = Money price of a good ÷ Money price of a "basket" of all goods (price index) - When we predict that a price will fall, we mean that its relative price will fall. Its price will fall relative to the average price of other goods and services. Demand - Demand exists only if: you want it, can afford it, and plan to buy it. - Wants are the unlimited desires/wishesthat people have for goods & services. - Quantitydemanded: amount that consumers plan to buy during a given time period at a particular price (measured as an amount per unit of time). Sometimesthe quantity demanded exceeds the amount of goods available, so the quantity bought is less than the quantity demanded. The Law of Demand - Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded. - Why does a higher price reduce the quantity demanded? Substitution effect & income effect Substitution Effect - When the price of a good rises, other things remaining the same, its relative price rises. - Substitutes(other goods that can be used in its place) are available. - As the opportunity cost of a good rises, the incentive to economizeon its use and switch to a substitute becomesstronger. Income Effect - When a price rises, other things remaining the same, the price rises relative to income. With higher prices and unchanged income, people cannot afford to buy all the things they previously bought. They must decrease the quantities demanded of at least somegoods & services. Normally, the good whose price has increased will be one of the goods that people buy less of. Demand Curve and Demand Schedule - Demand: the entire relationship between the price of a good and the quantity demanded of that good • Shown with a demand curve & demand schedule - Quantity demanded: a point on a demand curve, the quantity demanded at a particular price - Demand curve: shows the relationship between the quantity demanded of a good and its price when all other influences on consumers' planned purchases remain the same - Demand schedule: lists the quantities demanded at each price when all the other influences on consumers' planned purchases remain the same Willingness and Ability to Pay Willingness and Ability to Pay - Demand curve = willingness-and-ability-to-pay curve - Willingness and ability to pay is a measure of marginal benefit - If a small quantity is available, the highest price that someoneis willing and able to pay for one more unit is high. But as the quantity available increases, the marginal benefit of each additional unit falls and the highest price that someoneis willing and able to pay also falls along the demand curve. A Change in Demand - Changein demand: when any factor that influences buying plans change (other than the price) - When demand ↑, the demand curve shifts rightward & the quantity demanded at each price is greater. - 6 main factors: the prices of related goods, expected future prices, income, expected future income and credit, population, preferences Prices of Related Goods - The quantity of a good that consumersplan to buy depends in part on the prices of its substitutes. If the price of a substitute for a good rises, people buy less of the substitute (demand for good increases). - The quantity of a good that people plan to buy also depends on the prices of its complements.A complementis a good that is used in conjunction with another good (e.g. hamburgers & fries). Expected Future Prices - If the expected future price of a good rises and if the good can be stored, the opportunity cost of obtaining the good for future use is lower today than it will be in the future when people expect the price to be higher. They buy moreof the good now (demand ↑) before its price is expected to rise. - If the price is expected to keep falling, the current demand for the good is less than otherwisewould be. Income - When income increases, consumers buy moreof most (not all) goods. - A normalgood is one for which demand increases as income increases. An inferior good is one for which demand decreases as income increases. As incomes increase, the demand for air travel (a normal good) increases, and the demand for long-distance bus trips (an inferior good) decreases. Expected Future Income and Credit - When expected future income increases or credit becomeseasier to get, demand for the good might increase now. (e.g. A salesperson gets the news that she will receive a big bonus at the end of the year, so she goes into debt and buys a car now, rather than wait until she receivesthe bonus.) Population - Demand also depends on the size and age structure of the population. The larger the population, the greater is the demand for all goods and services. - The larger the proportion of the population in a given age group, the greater is the demand for the goods & services used by that age group. Preferences - Determinethe value that people place on each good & service - Depend on things like weather, information,& fashion - Table 3.1 (p.60) A Change in the Quantity Demanded Versus a Change in Demand - Changes in the influences on buying brings either a movementalong or a shift of the demand curve. Movement Along the Demand Curve - Price changes -> changein the quantitydemanded - Fall in price -> quantity demanded increases; rise in price -> quantity demanded decreases A Shift of the Demand Curve - Caused by a change in demand (shift to left = decreased demand; shift to right = increased demand) Supply - If a firm supplies a good/service,the firm has the resources & technologyto produce it, can profit from producing it, and plans to produce & sell it. - Resources & technology are the constraints that limit what is possible. - Quantitysupplied: amount that producers plan to sell during a given time period at a particular price (measured as an amount per unit of time). Sometimesthe quantity supplied is greater than the price (measured as an amount per unit of time). Sometimesthe quantity supplied is greater than the quantity demanded, so the quantity sold is less than the quantity supplied. Without the time dimension, we cannot tell whether a particular quantity is large or small. Law of Supply - Other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is quantity supplied. - Why does a higher price increase the quantity supplied? The marginal cost of producing increases. - It is never worth producing a good if the price received for the good does not at least cover the marginal cost of producing it. When the price of a good rises, other things remaining the same, producers are willing to incur a higher marginal cost, so they increase production. (Higher price = ↑ quantity supplied) Supply Curve and Supply Schedule - Supply:the entire relationship between the price of a good and the quantity supplied of it • Illustrated by the supply curve & supply schedule - Quantity supplied: a point on a supply curve, the quantity supplied at a particular price - Supplycurve: shows the relationship between the quantity supplied of a good and its price when all other influences on producers' planned sales remain the same - Supply schedule: lists the quantities supplied at each price when all the other influences on producers' planned sales remain the same Minimum Supply Price - Supply curve = minimum-supply-pricecurve (a curve that shows the lowestprice (marginal cost) at which someoneis willing to sell) - If a small quantity is produced, the lowest price at which someoneis willing to sell one more unit is low. But as the quantity produced increases, the marginal cost of each additional unit rises, so the lowest price at which someoneis willing to sell an additional unit rises along the supply curve. A Change in Supply - When any factor that influences selling plans other than the price of the good changes 6 main factors: prices of factors of production, prices of related goods produced, expected future - prices, # of suppliers, technology,state of nature Prices of Factors of Production - If the price of a factor of production rises, the lowest price that a producer is willing to accept for that good rises, so supply decreases (e.g. rise in min. wage = decreases supply of hamburgers). Prices of Related Goods Purchased - e.g. If the price of energy gel rises, firms switch production from bars to gel. The supply of energy bars decreases. Energy bars and energy gel are substitutes in production (goods that can be produced by using the same resources). - e.g. If the price of beef rises, the supply of cowhide increases. Beef and cowhide are complements in production (goods that must be produced together). Expected Future Prices - If the expected future price of a good rises, the return from selling the good in the future increases and is higher than it is today. Supply decreases today and increases in the future. The Number of Suppliers - The larger the number of firms that produce a good, the greater is the supply of the good. Technology - The way that factors of production are used to produce a good - A technologychange occurs when a new method is discoveredthat lowers the cost of producing a good (supply ↑). The State of Nature - All the natural forces that influence production (state of weather and natural environment) - Good weather can increase the supply of many agricultural products. Bad weather decreases supply. - Table 3.2 (p.65) A Change in the Quantity Supplied Versus a Change in Supply - Changein quantitysupplied: movementalong the supply curve (Price falls = QS↓; price rises = QS↑) QS↑) - Change in supply: shift of the supply curve (shift left = decreased supply; shift right = increased supply) Market Equilibrium - Price of good rises -> QD decreases and QS increases - Equilibrium: a situation in which opposing forces balance each other, occurs when the price balances buying plans and selling plans - Equilibriumprice: price at which the QD = QS (no surplus, no shortage) - Equilibriumquantity:quantity bought and sold at the equilibrium price - A market movestowards its equilibrium because: prices regulates buying and selling plans & price adjusts when plans don't match. Price as a Regulator - The price of a good regulates the quantities demanded and supplied. - If the price is too high QS > QD. If the price is too low, QD > QS. Price Adjustments - Price is below equilibrium = shortage (QD > QS) - Price is above equilibrium = surplus (QS > QD) A Shortage Forces the Price Up - Powerful forces operate to increase the price and moveit towards the equilibrium price. Some producers, noticing lines of unsatisfied customers,raise the price. Some producers increase their output. As producers push the price up, the price rises towards its equilibrium. The rising price reduces the shortage because it decreases the QD and increases the QS. When the price has increased to the point at which there is no longer a shortage, the forces moving the price stop operating. The price comes to rest at its equilibrium. A Surplus Forces the Price Down - Powerful forces operate to lower the price and move it towards the equilibrium price. Some producers, unable to sell the quantities they planned to sell, cut their prices. Some producers scale back production. As producers cut the price, the price falls towards its equilibrium. The falling price decreases the surplus because it increases the QD and decreases the QS. When the price has fallen to the point at which there is no longer a surplus, the forces moving the price stop operating. The Best Deal Available for Buyers and Sellers - When the price is below equilibrium, it is forced upward. Why don't buyers resist the increase and refuse to buy at the higher price? Because they value the good more highly than its current price, and they can't satisfy their demand at the current price. In some markets(e.g. eBay), the buyers might even be the ones who force the price up by offering to pay a higher price. - When the price is above equilibrium, it is bid downward. Why don't sellers resist this decrease and refuse to sell at the lower price? Because their minimum supply price is below the current price, and they cannot sell all they would like to at the current price. Sellers willingly lower the price to gain market share. - At the price at which QD = QS, neither buyers nor sellers can do business at a better price. Buyers pay the highest price they are willing to pay for the last unit bought, and sellers receive the lowest price at which they are willing to supply the last unit sold. - When people freely make offers to buy and sell and when demanders try to buy at the lowest possible price and suppliers try to sell at the highest possible price, the price at which trade takes place is the equilibrium price. PredictingChanges in Price and Quantity - For a single change either in demand or supply, ceteris paribus (all things equal), when • Demand increases, P rises and Q increases. • Demand decreases, P falls and Q decreases. • Supply increases, P falls and Q increases. • Supply decreases, P rises and Q decreases. - When there is a simultaneous change both in demand and supply, we can determine the effect on either price or quantity. But without information about the relative size of the shifts of the demand and supply curves, the effect on the other variable is ambiguous. Ceteris paribus, when and supply curves, the effect on the other variable is ambiguous. Ceteris paribus, when • Both demand and supply increase, P may rise/fall/remainconstant and Q increases. • Both demand and supply decrease, P may rise/fall/remainconstant and Q decreases. • Demand increases and supply decreases, P rises and Q may fall/rise/remainconstant. • Demand decreases and supply increases, P falls and Q may rise/fall/remainconstant. Chapter 4: Elasticity September-25-12 1:00 PM Price Elasticityof Demand - Price elasticityof demand: a units-free measure of the responsivenessof the QD of a good to a change in its price when all other influences on buying plans remain the same - Figure 4.1 (p.84) Calculating Price Elasticity of Demand - Price elasticity of demand = % change in QD ÷ % change in price = ΔQ/Q ave÷ ΔP/P ave • Change in price = % of average price • Change in QD = % of the average quantity Average Price and Quantity - Average price and quantity gives the most precise measurementof elasticity (midpoint between the original price and new price) Percentages and Proportions - % change = proportionate change multiplied by 100 A Units-Free Measure - Elasticity is a units-free measure because the % change in each variable is independent of the units in which the variable is measured. The ratio of the two % is a # without units. Minus Sign and Elasticity - When the price of a good rises, the QD decreases. Because a positive change in price brings a negative change in the QD, the price elasticity of demand is a negative number. But it is the magnitude (absolute value) of the price elasticity of demand that tells us how responsive the QD is. Inelastic and Elastic Demand - If the QD remains constant when the price changes, then the price elasticity of demand is 0 -> perfectly inelasticdemand.(e.g. Insulin is so important to somediabetics that if the price changes, they do not change the quantity they buy.) - If the % change in the QD equals the % change in the price, then the price elasticity is 1 -> unit elastic demand. - 2 cases above: the % change in QD < % change in price - In this case, the price elasticity of demand is between 0 and 1 -> inelasticdemand (e.g. food & shelter) - If the QD changes by an infinitely large % in response to a tiny price change, the price elasticity of demand is infinity -> perfectly elastic demand (e.g. a soft drink from 2 campus machines side to side: If one machine's price is higher than the other's, by even a small amount, no one buys from the machine with the higher price. Drinks from the 2 machines are perfect substitutes.). The demand for a good that has a perfect substitute is perfectly elastic. - % change in QD > % change in price -> The price elasticityof demand is > 1 -> elastic demand (e.g. automobiles& furniture) Elasticity Along a Linear Demand Curve - Elasticity =/= slope - Prices above the midpoint -> demand is elastic; prices below the midpoint -> demand is inelastic Total Revenue and Elasticity - Total Revenue = Price of good × Quantity sold - The change in total revenue depends on the elasticity of demand in the following ways: • If demand is elastic, a 1% price cut increases the quantity sold by more than 1 percent and total revenue increases. • If the demand is inelastic, a 1% price cut increases the quantity sold by less than 1% and total revenue decreases. • If demand is unit elastic, a 1% price cut increases the quantity sold by 1% and total revenue does not change. - Totalrevenue test: a method of estimating the price elasticity of demand by observing the change in total revenue that results from a change in the price, when all other influences on the quantity sold total revenue that results from a change in the price, when all other influences on the quantity sold remain the same. • If the price cut increases total revenue, demand is elastic. • If the price cut decreases total revenue, demand is inelastic. • If a price cut leaves total revenue unchanged, demand is unit elastic. Your Expenditure and Your Elasticity - When a price changes, the change in your expenditure on the good depends on your elasticity of demand. • If your demand is elastic, a 1% price cut increases the quantity you buy more than 1% of your expenditure on the item increases. • If your demand is inelastic, a 1% price cut increases the quantity you buy by less than 1% and your expenditure on the item decreases. • If your demand is unit elastic, a 1% price cut increases the quantity you buy by 1% and your expenditure on the item does not change. - So if you spend more on an item when its price falls, your demand for that item is elastic; if you spend the same amount, your demand is unit elastic; and if you spend less, your demand is inelastic. The Factors That Influence the Elasticity of Demand - Closeness of substitutes - Proportionof income spent on the good - Time elapsed since the price change Closeness of Substitutes - The closer the substitutes for a good/service,the more elastic is the demand for it. Oil from which we make gasoline has no close substitutes, so the demand for oil is inelastic. Plastics are close substitutes for metals, so the demand for metals is elastic. - The degree of substitutability depends on how narrowly (or broadly) we define a good. A PC has no close substitutes, but a Dell PC is a close substitute for a HP PC. The elasticity of demand for PCs is lower than the elasticity of demand for a Dell or a HP. - A necessity has poor substitutes and is crucial for our well being, so it generally has an inelastic demand. A luxury usually has many substitutes, one of which is not buying it, so it has an elastic demand. Proportion of Income Spent on the Good - Other things remaining the same, the greater the proportion of income spent on a good, the more elastic is the demand for it. If the price of gum doubles, you consumealmost as much as before (inelastic demand). If apartment rents double, you look for morestudents to share accommodation(elastic). Time Elapsed Since Price Change - The longer the time that has elapsed since a price change, the more elastic is demand. When the price of oil increased by 400% during the 1970s, people barely changed the quantity of oil and gasoline they bought. But gradually, as more efficient auto and airplane engines were developed, the quantity bought decreased. The demand for oil became more elastic as more time elapsed following the huge price hike. More Elasticitiesof Demand Cross Elasticity of Demand - A measure of the responsivenessof the demand for a good to a change in the price of a substitute or complement,other things remaining the same - Cross elasticityof demand = % change in QD ÷ % change in price of a substitute or complement - The cross elasticity of demand is positive for a substitute and negative for a complement. Substitutes - Pizzas and burgers are substitutes. Because a rise in the price of a burger brings an increase in the demand for pizza, the cross elasticity of demand for pizza w.r.t. the price of the burger is positive. Both the price and the quantity change in the same direction. Complements - Soft drinks and pizzas are complements.Because a rise in the price of a soft drink brings a decrease in the demand for pizza, the cross elasticity of demand for pizza w.r.t. the price of a soft drink is negative. The price and quantity change in opposite directions. - The magnitude of the cross elasticity of demand determineshow far the demand curve shifts. The larger the cross elasticity (absolute value), the greater is the change in demand and the larger is the shift in the the cross elasticity (absolute value), the greater is the change in demand and the larger is the shift in the demand curve. - If 2 items are close substitutes, such as 2 brands of spring water, the cross elasticity is large. If 2 items are close complements,such as moviesand popcorn, the cross elasticity is large. - If 2 items are somewhatunrelated to each other, such as newspapers and orange juice, the cross elasticity is smallperhaps even 0. Income Elasticity of Demand - A measure of the responsivenessof the demand for a good/serviceto a change in income, other things remaining the same - Income elasticityof demand = % change in QD ÷ % change in income - Income elasticities of demand can be + or - and they fall into 3 interesting ranges: • Greater than 1 (normal good, incomeelastic) • Positiveand less than 1 (normal good, income inelastic) • Negative (inferior good) Income Elastic Demand - When the demand for a good is income elastic, the percentage of income spent on that good increases as income increases. Income Inelastic Demand - The % increase in QD is +, but less than the % increase in income. - When the demand for a good is income inelastic, the percentage of income spent on that good decreases as income increases. Inferior Goods - The QD of an inferior good and the amount spent on it decrease when income increases (e.g. small motorcycles,potatoes,rice -> Low-incomeconsumersbuy most of these goods.). Elasticityof Supply - When demand increases, the equilibrium price rises, and the equilibrium quantity increases. - Figure 4.7 (p.94) Calculating the Elasticity of Supply - Elasticityof supply: measures the responsivenessof QS to a change in price of a good when all other influences on selling plans remain the same - Elasticityof supply = % change in QS ÷ % change in price - If the QS is fixed regardless of the price, the supply curve is vertical and the elasticity of supply is 0 -> perfectly inelastic - Special case when the % change in price = % change in quantity -> unit elastic -> No matter how steep the supply curve is and if it is linear and passes through the origin - If there is a price at which sellers are willing to offer any quantity for sale, the supply curve is horizontal and the elasticity of supply is infinite -> perfectly elastic The Factors That Influence the Elasticity of Supply - Resource substitution possibilities - Time frame for the supply decision Resource Substitution Possibilities - Some goods & services can be produced only by using unique or rare productive resources. These items have a low, perhaps even 0, elasticity of supply (e.g. a Van Gogh painting). Other goods & services can be produced by using commonlyavailable resourcesthat could be allocated to a wide variety of tasks (high elasticity). - Wheat can be grown on land that is almostequally good for growing corn, so it is just as easy to grow wheat as corn. The opportunity cost of wheat in terms of forgone corn is almost constant. Thus, the supply curve of wheat is almost horizontal and its elasticity of supply is very large. Similarly, when a good is produced in many different countries (e.g. sugar & beef), the supply of the good is highly elastic. - The supply of most goods & services lies between these 2 extremes. The quantity produced can be increased but only by incurring a higher cost. If a higher price is offered, the quantity supplied increases. Such goods & serviceshave an elasticity of supply between 0 and infinity. Time Frame of the Supply Decision - 3 time frames of supply: momentarysupply, short-run supply, long-run supply - 3 time frames of supply: momentarysupply, short-run supply, long-run supply Momentary Supply - When the price of a good changes, the immediate response of the QS is determined by the momentary supply of that good. - Some goods, (e.g. fruits & vegetables)have a perfectly inelastic momentarysupply. For example, oranges' planting decisions have to be made many years in advance of the crop being available. Momentarysupply is perfectly inelastic because, on a given day, no matter what the price of oranges, producers cannot change their output. They have been picked, packed, and shipped their crop to market, and the quantity available for that day is fixed. - Perfectlyelastic momentarysupply -> long-distance phone calls -> When many people simultaneously make a call, there is a big surge in the demand for telephone cables, computerswitching, and satellite time. The QS increases, but the price remains constant. Short-Run Supply - The response of the QS to a price change when only some technologicallypossible adjustments to production can be made is determined by short-run supply. Most goods have an inelastic short-run supply. - For the orange grower, if the price of oranges falls, somepickers can be laid off and oranges left on the trees to rot. Or if the price of oranges rises, the grower can use more fertilizer and improved irrigation to increase the yields of their existing trees. But an orange grower can't change the # of trees producing oranges in the short run. Long-Run Supply - The response of the QS to a price change after all the technologically possible ways of adjusting supply have been exploited is determined by long-run supply. For most goods & services,long-run supply is elastic and perhaps perfectly elastic. - For the orange grower, the long run is the time it takes new tree plantings to grow to full maturity (about 15 years). In some cases, the long-run adjustment occurs only after a completelynew production plant has been built and workershave been trained to operate it (typically a process that takes several years). - Table 4.1 (p. 97) Chapter 6: Government Actions in Markets September-25-12 1:00 PM A Housing Market with a Rent Ceiling - Price ceiling/pricecap: a governmentregulation that makes it illegal to charge a price higher than a specified level - A price ceiling set above the equilibrium price has no effect. The price ceiling does not constrain the market forces. The force of the law and the market forces are not in conflict. A price ceiling below the equilibrium price has powerful effects on a market. The price ceiling attemptsto prevent the price from regulating the QD and QS. The force of the law and the market forces are in conflict. - Rent ceiling: when a price ceiling is applied to a housing market. If it is set below the equilibrium rent, it creates: a housing shortage, increased search activity, and a black market. A Housing Shortage - In a housing market, when the rent is at the equilibrium level, the quantity of housing supplied equals the quantity of housing demanded and there is neither a shortage nor a surplus of housing. - Rent set below the equilibrium rent: QD > QS (shortage) • Shortage occurs: quantity available = QS (must be allocated), 1 way to allocate through↑ search activity Increased Search Activity - Search activity: time spent looking for someonewith whom to do business - When a price is regulated and there is a shortage, search activity increases. - Opportunity cost of housing = the rent (regulated price) + time/resourcesspent searching for the restricted quantity available - Search activity is costly. It uses time & resources that could have been used in other productive ways. - A rent ceiling controls only the rent portion of the cost of housing. The cost of increased search activity might end up making the full cost of housing higher than it would be without a rent ceiling. A Black Market - An illegal market in which the equilibrium price > the price ceiling - Occur in rent-controlledhousing and many other markets (e.g. Scalpers run black markets in tickets for rock concerts.) - When rent ceiling is in force, frustrated renters and landlords constantly seek ways of increasing rents. One commonway is for a new tenant to pay a high price for worthless fittings. Another is for the tenant to pay an exorbitant price for new locks and keys ("key money"). - The level of a black market rent depends on how tightly the rent ceiling is enforced. With loose enforcement,the black market rent is close to the unregulated rent. But with strict enforcement,the black market rent is equal to the maximum price that a renter is willing to pay. - Figure 6.1 (p.129): To rent the 60 000th unit, someoneis willing to pay $1 200 a month. They might pay this amount by incurring search costs that bring the total cost of housing to $1 200 a month, or they might pay a black market price of $1 200 a month. They end up incurring a cost that exceeds what the equilibrium rent would be in an unregulated market. Inefficiency of a Rent Ceiling - A rent ceiling set below the equilibrium rent results in an inefficient underproduction of housing services. The marginal social benefit of housing exceeds its marginal social cost and a deadweight loss shrinks the producer surplus and consumer surplus. - Figure 6.2 (p.129) • QS < EQ = deadweight loss • Potential loss from housing search is carried by consumers and the full loss from the rent ceiling is the sum of the deadweight loss and the increased cost of search. Are Rent Ceilings Fair? - According to the fair rules view, anything that blocks voluntaryexchange is unfair, so rent ceilings are unfair. But according to the fair result view, a fair outcomeis one that benefits the less well off. are unfair. But according to the fair result view, a fair outcomeis one that benefits the less well off. Thus, the fairest outcomeis the one that allocates scarce housing to the poorest. - Blocking rent adjustments doesn't eliminate scarcity. Because it decreases the quantity of housing available, it creates an even bigger challenge for the housing market. The market must ration a smaller quantity of housing and allocate that housing among the people who demand it. - When the rent is not permitted to allocate scarce housing, some possible mechanisms are: a lottery, first-come,first served, & discrimination. - A lotteryallocates housing to those who are lucky, not to those who are poor. First-come, first- served allocates housing to those who have the greatest foresight and who get their names on a list first, not to the poorest. Discriminationallocates scarce housing based on the views and self-interest of the owner of the housing. In the case of public housing, what counts is the self-interest of the bureaucracy that administers the allocation. - In principle, self-interested owners and bureaucracy could allocate housing to satisfy some criterion of fairness, but they are not likely to do so. A Labour Market with a Minimum Wage - The labour market is the market the influences the jobs we get and the wages we earn. Firms decide how much labour to demand, and the lower the wage rate, the greater is the QD. Households decide how much labour to supply, and the higher the wage rate, the greater is the QS. The wage rate adjusts to make QD = QS. - When wage rates are low, or when they fail to keep up with rising prices, labour unions might turn to governmentsand lobby for a higher wage rate. - Price floor: a governmentregulation that makes it illegal to charge a price lower than a specified level - A price floor set below the equilibrium price has no effect. The price floor does not constrain the market forces. The force of the law and the market forces are not in conflict. But a price above the equilibrium price has powerful effects on a market.The reason is that the price floor attemptsto prevent the price from regulating the QD and QS. The force of the law and the market forces are in conflict. - Minimumwage: when a price floor is applied to a labour market • Imposed at a level that is above the equilibrium wage creates unemployment Minimum Wage Brings Unemployment - At a wage rate above the equilibrium wage (e.g. minimum wage), the QS > QD (surplus -> unemployed). - Figure 6.3 (p.131) Inefficiency of a Minimum Wage - In the labour market, the supply curve measuresthe marginal social cost of labour to workers. This cost is leisure forgone. The demand curve measures the marginal social benefit from labour. This benefit is the value of the goods and services produced. An unregulated labour market allocates the economy'sscarce labour resourcesto the jobs in which they are valued mosthighly. The market is efficient. - The minimum wage frustrates the market mechanism and results in unemploymentand increased job search. At the quantity of labour employed, the marginal social benefit of labour exceeds its marginal cost and a deadweight loss shrinks the firms' surplus and the workers' surplus. - Figure 6.4 (p.132) • QS < EQ = deadweight loss • Potential loss from job search is carried by workers. The full loss from the minimum wage is the sum of the deadweight loss and the increased cost of job search. Is the Minimum Wage Fair? - The result is unfair because only those people who have jobs and keep them benefit from the minimum wage. The unemployed end up worse off than they would be with no minimumwage. Some of those who search for jobs and find them end up worse off because of the increased cost of job search they incur. Those who find jobs aren't always the least well off. When the wage rate doesn't allocate labour, other mechanisms determine who finds a job. One mechanismis discrimination (unfairness). discrimination (unfairness). - The minimum wage imposes an unfair rule because it blocks voluntary exchange. Firms are willing to hire more labour and people are willing to work more, but they are not permitted by the minimum wage law to do so. Taxes Tax Incidence - The division of the burden of a tax between buyers and sellers - When the governmentimposes a tax on the sale of a good, the price paid by buyers might rise by the full amount of the tax, by a lesser amount, or not at all. If the price paid by buyers rises by the full amount of the tax, then the burden of the tax falls entirely on buyers (the buyers pay the tax). If the price paid by buyers rises by a lesser amount than the tax, then the burden of the tax falls partly on buyers and partly on sellers. If the price paid by buyers doesn't change at all, then the burden of the tax falls entirely on sellers. - Does not depend on the tax law A Tax on Sellers - A tax on sellers is like an increase in cost, so it decreases supply. - Figure 6.5 (p.134) A Tax on Buyers - Lowers the amount buyers are willing to pay sellers: decreases demand - Figure 6.6 (p.135) Equivalence of Tax on Buyers and Sellers Can We Share the Burden Equally? - When a transaction is taxed, there are 2 prices: the price paid by buyers, which includes the tax; and the price received by sellers, which excludes the tax. Buyers respond to the price that includes the tax and sellers respond to the price that excludes the tax. The Employment Insurance Tax A tax that the federal governmentimposes equally on both buyers (employers)and sellers (workers) - of labour. The marketfor labour decides how the burden of the EI tax is divided between firms & workers. Tax Incidence and Elasticity of Demand - The division of the tax between buyers and sellers depend in part on the elasticity of demand. There are 2 extremecases: • Perfectlyinelastic demand -> buyers pay. • Perfectlyelastic demand -> sellers pay. Perfectly Inelastic Demand - Figure 6.7 (p.135) Perfectly Elastic Demand - Figure 6.8 (p.136) - Usual case: demand is neither perfectly inelastic nor perfectly elastic & the tax is split (buyers & sellers) - The division depends on the elasticity of demand, the more inelastic the demand, the larger is the amount of the tax paid by buyers. Tax Incidence and Elasticity of Supply - The division of the tax between buyers and sellers also depends on the elasticityof supply There are 2 extremecases: • Perfectlyinelastic supply -> sellers pay. • Perfectlyelastic supply -> buyers pay. Perfectly Inelastic Supply - Figure 6.9 (p.137) Perfectly Elastic Supply - Figure 6.9 (p.137) - Usual case: supply is neither perfectly inelastic nor perfectly elastic & the tax is split (buyers & - Usual case: supply is neither perfectly inelastic nor perfectly elastic & the tax is split (buyers & sellers) - The division depends on the elasticity of supply: the more elastic the supply, the larger is the amount of tax paid by buyers. Taxes and Efficiency - The price buyers pay is the buyers' willingness to pay, which measures marginal social benefit. The price sellers receive is also the sellers' minimum supply-price, which equals marginal social cost. - A tax makes marginal social benefit exceed marginal social cost, shrinks the producer surplus and consumer surplus, and creates a deadweight loss. - Figure 6.10 (p.137) -> The new supply curve does not show marginal social cost. The tax component isn't a social cost of production. It is a transfer of resources to the government. - Only in the extremecases of perfectly inelastic demand and perfectly inelastic supply does a tax not change the quantity bought and sold so that no deadweight loss arises. Taxes and Fairness - Economistshave proposed 2 conflicting principles of fairness to apply to a tax system:the benefits principle and the ability-to-pay principle. The Benefits Principle - The proposition that people should pay taxes equal to the benefits they receive from the services provided by government(those who benefit the most pay the most taxes) - Can justify high fuel taxes to pay for highways, high taxes on alcoholic beverages and tobacco products to pay for public healthcare services, and high rates of income tax on high incomes to pay for the benefits from law and order and from living in a secure environment The Ability-To-Pay Principle - The proposition that people should pay taxes according to how easily they can bear the burden of the tax (e.g. a rich person can more easily bear the burden than a poor person) - Reinforces the benefits principle to justify high rates of income tax on high incomes Production Quotas and Subsidies Fluctuations in the weather bring fluctuations in farm output and prices and sometimesleave - farmers with low incomes. To help farmers avoid low prices and low incomes, governments intervene in the markets for farm products. - Governmentsoften use 2 methodsof intervention in the markets for farm products: production quotas & subsidies. Production Quotas - An upper limit to the quantity of a good that may be produced in a specified period - If the governmentintroduced a production quota above the equilibrium quantity, nothing would change because milk farmers would already be producing less than the quota. But a production quota set below the equilibrium quantity has big effects: a decrease in supply, a rise in price, a decrease in marginal cost, inefficient underproduction, and an incentive to cheat and overproduce (Figure 6.11 (p.139)). A Decrease in Supply - The QS becomesthe amount permitted by the production quota, and this quantity is fixed. The supply becomesperfectly inelastic at the quantity permitted under the quota. A Rise in Price - The production quota raises the price of milk. When the governmentsets a production quota, it leaves market forces free to determine the price. Because the quota decreases the supply, it raises the price. A Decrease in Marginal Cost - Occurs because farmers produce less and stop using the resources with the highest marginal cost Inefficiency - Marginal social benefit at the quantity produced is equal to the market price, which as risen. Marginal social cost at the quantity produced has decreased and is less than the market price. So marginal social benefit exceeds marginal social cost and a deadweight loss arises. An Incentive to Cheat and Overproduce - With the quota, the price exceeds marginal cost, so the farmer can get a larger profit by producing - With the quota, the price exceeds marginal cost, so the farmer can get a larger profit by producing one more unit. If all farmers produce more than their assigned limit, the production quota becomes ineffective,and the price falls to the equilibrium (no quota) price. - To make the production quota effective,farmers must set up a monitoring system to ensure that no one cheats and overproduces. - Because of the difficulty of operating a quota, producers often lobby governmentsto establish a quota and provide the monitoring and punishment systems that make it work. Subsidies - Paymentmade by the governmentto a producer - Effects of a subsidy: an increase in supply, a fall in price and increase in quantity produced, an increase in marginal cost, payments by governmentto farmers, inefficient overproduction(Figure 6.12 (p.141)). An Increase in Supply - A subsidy is like a negative tax. A tax is equivalent to an increase in cost, so a subsidy is equivalent to a decrease in cost. The subsidy brings an increase in supply. - To determine the position of the new supply curve, we subtract the subsidy from the farmers' minimum supply-price. A Fall in Price and Increase in Quantity Produced - The subsidy lowers the price and increases the quantity produced. An Increase in Marginal Cost - Occurs because farmers grow more -> begin to use some resourcesthat are less ideal for growing Payments by Government to Farmers - The governmentpays a subsidy to farmers on, for example, each tonne of grain produced. Inefficient Overproduction - At the quantity produced with the subsidy, marginal social benefit is equal to the market price, which has fallen. Marginal social cost has increased and it exceeds the market price. Because marginal social cost exceeds marginal social benefit, the increased production brings inefficiency. - Because a subsidy lowers the domesticmarket price, subsidized farmers will offer some of their output for sale on the world market. The increase in supply on the world marketlowers the price in the rest of the world. Faced with lower prices, farmers in other countries ↓ production & receive smaller revenues. Markets for IllegalGoods A Free Market for a Drug - Figure 6.13 (p.142): If the drug was not illegal, price and quantity would be at equilibrium. A Market for an Illegal Drug - When a good is illegal, the cost of trading in the good increases. By how much the cost increases and who bears the cost depend on the penalties for violating the law and the degree to which the law is enforced. The larger the penalties and the better the policing, the higher are the costs. Penalties on Sellers - Penalties are part of the cost of supplying illegal drugs, and they bring a decrease in supply. To determine the new supply curve, we add the cost of breaking the law to the minimum price that drug dealers are willing to accept. - When sellers' penalties > buyers' penalties, Q decreases & P rises. Penalties on Buyers - The cost of breaking the law must be subtracted from the value of the good to determine the maximum price buyers are willing to pay for the illegal goods. Demand decreases. - When sellers' penalties < buyers' penalties, Q decreases & P falls. Penalties on Both Sellers and Buyers - Both supply and demand will decrease. - The larger the penalties and the greater the degree of law enforcement,the larger is the decrease in demand and/or supply. If the penalties are heavier on sellers, the supply curve shifts farther than the demand curve and the market price rises above EP. If the penalties are heavier on buyers, the demand curve shifts farther than the supply curve and the market price falls below EP. - With high enough penalties and effective law enforcement,it is possible to decrease demand and/or supply to the point at which the quantity bought is 0. In reality, such an outcomeis unusual. supply to the point at which the quantity bought is 0. In reality, such an outcomeis unusual. Legalizing and Taxing Drugs - Imposing a sufficiently high tax could decrease the supply, raise the price, and achieve the same decrease in the quantity bought as does a prohibition on drugs. The governmentwould collect a large tax revenue. Illegal Trading to Evade the Tax - It is likely that an extremelyhigh tax rate would be needed to cut the quantity of drugs bought to the level prevailing with a prohibition. It is also likely that many drug dealers and consumerswould try to cover up their activities to evade the tax. However, they would face the cost of breaking the tax law. Taxes Versus Prohibition: Some Pros and Cons - Prohibition or taxes? In favour of taxes is the fact that the tax revenue can be used to make law enforcementmore effective.In favour of prohibition is the fact that prohibition sends a signal that might influence preferences, decreasing the demand for illegal drugs. Some people intensely dislike the idea of the governmentprofiting from trade in harmful substances. Chapter 8: Utility and Demand October-16-12 1:00 PM Consumption Choices - Influenced by consumptionpossibilities & preferences Consumption Possibilities - All things that you can afford to buy (limited by income & prices) A Consumer's Budget Line - Budgetline: limit to consumption possibilities/boundarybetween what is affordable & unaffordable - Figure 8.1 (p.180) • Can afford all points on budget line & inside it; points outside the line = unaffordable Changes in Consumption Possibilities - Changes occur when income or prices change - ↑ income shifts the budget line outward, slope is unchanged - Change in price changes the slope of the line - Budget line shows what is possible; preferences (likes & dislikes) determine which possibility is chosen Preferences - Utility: the benefit/satisfactionthat a person gets from the consumption of goods & services Total Utility - Total benefit that a person gets from the consumption of all the different goods & services - Depends on the level of consumption -> moreconsumption = more total utility Marginal Utility - Change in total utility that results from a one-unit increase in the quantity of a good consumed - Is positive, but it diminishes as the quantity of a good consumed ↑ Positive Marginal Utility - All things that people enjoy and want more of have positive marginal utility. Hard labour & polluted air can generate negative marginal utility & lower total utility. - Total utility ↑ as quantity consumed ↑ Diminishing Marginal Utility - Tendency for marginal utility to↓ as the consumptionof a good increases Graphing Lisa's Utility Schedules - Figure 8.2 (p.182) • Total utility curve slopes upwards • Marginal utility curve slopes downward Utility-MaximizingChoice Find the Total Utility for Each Just-Affordable Combination - consumer's objective:maximize total utility (best choice) Consumer Equilibrium - A situation in which a consumer has allocated all of his/her available income in the way that maximizes his/her total utility, given the prices of goods & services Choosing at the Margin Marginal Utility per Dollar - the marginal utility from a good that results from spending one more dollar on it - Marginal utility: the increase in total utility that results from consuming one more unit of a good - Equi-marginal Principle: - MU a/P a= MU b/P b-> maximizing utility/movingfrom this allocation of budget = being worse off • MU a/MU b = Pa/P b Utility-Maximizing Rule - A consumer's total utility is maximizedby the following rule: • Spend all the available income ○ Because more consumption brings more utility, only those choices that exhaust income can maximize utility. maximize utility. ○ Equalize the marginal utility per dollar for all goods (MU a/Pa = MU b/P b) ○ Move$ from good A from good B if doing so ↑ utility from good A by more than it ↓ the utility from good B (possible if MU a/Pa > MU b/P b) ○ Buying moreof good A ↓ its marginal utility; buying less of good B ↑ its marginal utility ○ By moving $ from good A to good B, total utility ↑, but the gap between the marginal utilities per dollar gets smaller. The Power of Marginal Analysis - If the marginal gain from an action exceeds the marginal loss, take the action. • e.g. If the marginal utility per dollar from moviesexceeds the marginal utility per dollar from pop, see more movies& buy less pop. Predictions of Marginal UtilityTheory • Marginal utility theory predicts the law of demand. It also predicts that a ↓ in the price of a substitute of a good ↓ the demand for the good and that for a normal good, a ↑ in income ↑ demand. A Fall in the Price of a Movie Finding the New Quantities of Movies and Pop 1. Determinethe just affordable combinations of movies& pop at the new prices. 2. Calculate the new marginal utilities per dollar from the good whose price has changed. • A person's preferences don't change just because a price has changed (marginal utilities don't change). 3. Determinethe quantities of movies & pop that make their marginal utilities per dollar equal. - Lisa's purchases of moviesresults from a substitution effect (she substitutes the now lower-priced moviesfor pop) & an income effect (she can afford more movies). A Change in the Quantity Demanded - The demand curve traces the quantities that maximizeutility at each price, with all other influences remaining the same. Utility-maximizingchoices generate a downward-sloping demand curve. Utility maximizationwith diminishing marginal utility implies the law of demand. A Rise in the Price of Pop - With different marginal utilities, Lisa might have ↓ or ↑ the quantity of moviesthat she sees when the price of pop changes. A Rise in Income - Demand curves for both moviesand pop shift rightward (↑ in demand for both items) - Larger income = consumer buys more of a normal good The Paradox of Value - How can valuable water be so cheap while a relatively useless diamond is so expensive? The Paradox Resolved - The total utility that we get from water is enormous,but the more we consume of something, the smaller is its marginal utility. - Diamonds have a small total utility relative to water, but because we buy few diamonds, they have a high marginal utility. - The equality of marginal utilities per dollar holds true for diamonds & water: diamonds have a high price and a high marginal utility. Water has a low price and a low marginal utility -> MU d/Pd = MU w/Pw Value and Consumer Surplus - Consumersurplus: the excess of the benefit received from a good over the amount paid for it. - Figure 8.7 (p.191) • Water -> cheap, large consumer surplus; diamonds -> expensive,small consumer surplus New Ways of Explaining Consumer Choices Behavioural Economics - Studies the way in which limits on the human brain's ability to compute& implementrational - Studies the way in which limits on the human brain's ability to compute& implementrational decisions influence economicbehaviourboththe decisions that people make & the consequences of those decisions for the way marketswork - Starts with observed behaviour -> looks for anomalies (choices that do not seem to be rational) - 3 impediments that prevent rational choice: bounded rationality, bounded willpower, & bounded self-interest Bounded Rationality - Rationality that is limited by the computing power of the human brain - Faced with uncertainty, people might use rules of thumb, listen to the views of others, and make decisions based on gut instinct rather than on rational calculation. Bounded Willpower - The less-than-perfect willpower that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret - e.g. Lisa's rational choice is to ignore the temporarythirst and stick to her plan of seeing a movie later this month. But she might not possess the willpower to do so. Bounded Self-Interest - The limited self-interest that results in sometimessuppressing our own interests to help others - e.g. Lisa feels sorry for the victims in Florida after a hurricane hits the coast, and decides to donate $10. The Endowment Effect - The tendency for people to value something more highly simply because they own it - If you have allocated your income to maximizeutility, then the price you would be willing to accept to give up something that you own should be the same as the price you are willing to pay for an identical one. This behaviour contradicts marginal utility theory. Neuroeconomics - uses the ideas & tools of neuroscience to study the effects of economicevents & choices inside the human brain Chapter 9: Possibilities, Preferences, and Choices October-16-12 1:00 PM Consumption Possibilities - Consumption choices are limited by income & by prices. - budgetline -> describes the limits to its consumption choices - Figure 9.1 (p.204) Divisible and Indivisible Goods - Divisible goods: can be bought in any quantity desired (e.g. gasoline & electricity) • Consumption possibilities refer to specific points on & intermediate points that form the budget line. Affordable & Unaffordable Quantities - Budget line = constraint on choices (boundary between affordable & unaffordable) - The constraint on consumptiondepends on the prices and one's income, and the constraint changes when the price of a good or one's income changes. Budget Equation - Expenditure = Income - Expenditure = (Priceof A Quantity of A) + (Price of B Quantity of B) Real Income - A household's income expressed as a quantity of goods that the household can afford to buy - e.g. Expressed in terms of pop, Lisa's real income is Income/P p ($40/$4= 10 cases). - Point at which the budget line intersects the y-axis in terms of the good measured on that axis Relative Price - The price of one good divided by the price of another good - Is the magnitude of the slope of the budget line • Slope of budget line = Δy/Δx = - Income/P y÷ Income/P x = -Px/P y A Change in Prices - Figure 9.2 (a) (p.206) • The lower the price of the good measured on the x-axis, the flatter is the budget line (rotates outward). • The higher the price of the good measured on the x-axis, the steeper is the budget line (rotates inward). A Change in Income - A change in money income changes real income but does not change the relative price. The budget line shifts, but its slope does not change (due to same relative prices). - Figure 9.2 (b) (p.206) • ↑ money income, ↑ real income, shifts budget line rightward • ↓ money income, ↓ real income, shifts budget line leftward Preferences and Indifference Curves - A preference map helps people sort all the possible combinations of goods into 3 groups: preferred, not preferred, & indifferent. It is a series of indifference curves that resemble the contour lines on a map. - Figure 9.3 (p.207) - Indifferencecurve: a line that shows combinations of goods among which a consumeris indifferent - The assumption of a regular indifference curve: 1. Two goods world, good x &good y 2. More is preferred to less 3. Diminishing MU 4. Transitivity (being logical) - Indifference curves farther from the origin represent higher levels of satisfaction. - Indifference curves never intersect. - Slope of the indifference curve (rise/run) = -Δy/Δx = MU x/Mu y= MRS Marginal Rate of Substitution (MRS) - The rate at which a person will give up good y (measured on y-axis) to get an additional unit of good x measured on x-axis) while remaining indifferent (remaining on the same indifference curve) x measured on x-axis) while remaining indifferent (remaining on the same indifference curve) - The magnitude of the slope of an indifference curve measures the MRS. • If the indifference curve is steep, the MRS is high. The person is willing to give up a large quantity of good y to get an additional unit of good x while remaining indifferent. • If the indifference curve is flat, the MRS is low. The person is willing to give up a small amount of good y to get an additional unit of good x while remaining indifferent. - Figure 9.4 (p.208) -> straight line/tangent on curve -> MRS = Quantity of Good Y ÷ Quantity of Good X - DiminishingMRS: a general tendency for a person to be willing to give up less of good y to get one more unit of good x, while at the same time remaining indifferent as the quantity of x ↑ • key assumption about preferences Your Diminishing Marginal Rate of Substitution - The shape of a person's indifference curves incorporates the principle of the diminishing MRS because the curves are bowed towards the origin. The tightness of the bend of an indifference curve tells us how willing a person is to substitute one good for another while remaining indifferent. Degree of Substitutability - Figure 9.5 (p.209) • Indifference curves of perfect complementsare L-shaped. • The closer the 2 goods are to perfect substitutes, the closer the MRS is to being constant (straight line, sloping downward), rather than diminishing (curved line). Indifference curves for poor substitutes are tightly curved and lie between the shapes of those shown in Figure 9.5 (a) & (c). PredictingConsumer Choices Best Affordable Choice - Intersection of budget line & highest attainable indifference curve (Figure 9.6 (p.210)) - For every point inside the budget line, there are points on the budget line that one prefers. - Every point on the budget line lies on an indifference curve. - MRS = relative price (e.g. willingness to pay for a movie= opportunity cost of a movie) A Change in Price - Price effect: the effect of a change in the price of a good on the quantity of the good consumed • Price Effect = Substitution Effect + Income Effect - Figure 9.7 (p.211) -> lower price, movementto the right along demand curve A Change in Income - Incomeeffect: the effect of a change in income on buying plans. - Figure 9.8 (p.213) -> income ↓ -> consumersbuy less of both normal goods, ↓ demand Substitution Effect and Income Effect - Normal good -> price ↓
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