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Micro Econ 101.pdf

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Department
Economics
Course
CAS EC 101
Professor
Michael Manove
Semester
Fall

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Discussion Friday, September 14, 2012 10:57 AM Tanmay B17C, Econ Dept. 264/270Bay State Hours: MTR 9-10 am Buyer and seller both want the transaction: voluntary exchange (market) Buyer does not want to buy at a price, but seller wants to sell: subsidy Buyer wants to buy but the seller does not want to sell at that price: monopoly- break it up Chapter One: Ten Principles of Economics Friday, August 24, 2012 12:37 PM CONTENTS: Chapter Introduction 1-1 How People Make Decisions 1-1a Principle 1: People Face Trade-offs 1-1b Principle 2: The Cost of Something Is What You Give Up to Get It 1-1c Principle 3: Rational People Think at the Margin 1-1d Principle 4: People Respond to Incentives 1-2 How People Interact 1-2a Principle 5: Trade Can Make Everyone Better Off 1-2b Principle 6: Markets Are Usually a Good Way to Organize Economic Activity 1-2c Principle 7: Governments Can Sometimes Improve Market Outcomes 1-3 How the Economy as a Whole Works 1-3a Principle 8: A Country's Standard of Living Depends on Its Ability to Produce Goods and Services 1-3b Principle 9: Prices Rise When the Government Prints Too Much Money 1-3c Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment 1-4 Conclusion Chapter Recap 1-0 CHAPTER INTRODUCTION Economics: management of resources in scarcity,the study of how society manages scarcity Scarcity:society has limited resources and therefore cannot produceall the goods and services people wish to have Basic Areas of Study: - How decisions are made - How people interact - Forces and trends 1-1 HOW PEOPLE MAKE DECISIONS Based on 4 principals of individualdecision making 1-1a People Face Tradeoffs Due to scarcity, tradeoffs must be made to meet the most efficientand useful combinations Efficiency(societal): people are getting themaximum benefits for its scarce resources Equality: those benefits are distributed uniformly amongsocieties members Greater efficiency usually sacrifices equality, andvisa versa At the same time, both can be necessary: hence tradeoffs 1-1b The Cost of Something is What You Give Up to Get It Opportunity cost: the cost of giving upthe next best alternative 1-1c Rational People Think at the Margin Rational people: systematically and purposefullydo the best they can to achieve their objectives, given the available opportunities Marginalchange: incremental adjustment to an existing planof action Marginalvs. average costs 1-1d People Respond to Incentives Incentive: something that induces a person to act (such as the prospect of a punishmentor reward); something to which rationalpeople respond 1-2 HOW PEOPLE INTERACT Based on 3 principles of interaction 1-2a Trade Can Make Everyone Batter Off Trade isn't a contest: it makes both parties better off Allows for specialization Greater varietyat a lower cost 1-2b Markets are Usually a Good Way to Organize Economic Activity Market economy: decisions of a central planner are replaced with the decisions of millions of firms and households; decisions are made by individuals for the individuals (guided by self interest Invisible hand: uses prices to directmarket activity Allocates resources 1-2c Governments Can Sometimes Improve Market Outcomes Enforceproperty rights Property rights:individuals controland own their own scarceresources Micro Econ 101 Page 2 Property rights:individuals controland own their own scarceresources Governments interfere to: 1. promoteefficiency and2. promote equality Efficiency: Market failure: a situationin which the market on its own fails to producean efficient allocation of resources i. Externality: the impact on one person's actionson the well-being of a bystander ii. Market power: ability of a singleperson or group to unduly influencemarket prices Equality: Aim for a more equal distribution of economic well being 1-3 How the Economy as a Whole Works 1-3a A Country's Standard of Living Depends on its Ability to Produce Goods and Services Standardsvery from country to country,as do the rate of changes to average income Largelydue to productivity Productivity:the amount of goods and services produced from each unit of labor input 1-3bPrices Rise When the Government Prints Too Much Money Inflation:increase in the overall level of prices in the economy - Growth in the quantity ofmoney (value falls) 1-3c Society Faces a Short-Run Trade-off between Inflation and Unemployment Short run effects are less cut and dry - More money supply= increased spending and demand - Higher demand= higher prices, butalso more hiring andlarger quantity - More hiring=higher employment This leads to the said tradeoff: more money seems to be good in the short run Business cycle: the irregular andlargely unpredictablefluctuations in economic activity (measured in production of goods and services/number of people employed) How the tradeoffis made by policy makers: 1. Government spending 2. Taxes 3. Money supply (central bank) Micro Econ 101 Page 3 Chapter Two: Thinking Like an Economist Sunday, September 02, 2012 8:38 AM CONTENTS: Chapter Introduction 2-1 The Economist as Scientist2-1a The Scientific Method: Observation, Theory, and More Observation 2-1b The Role of Assumptions 2-1c Economic Models 2-1d Our First Model: The Circular-Flow Diagram 2-1e Our Second Model: The Production Possibilities Frontier 2-1f Microeconomics and Macroeconomics 2-2 The Economist as Policy Adviser2-2a Positive versus Normative Analysis 2-2b Economists in Washington 2-2c Why Economists' Advice Is Not Always Followed 2-3 Why Economists Disagree 2-3a Differences in Scientific Judgments 2-3b Differences in Values 2-3c Perception versus Reality 2-4 Let's Get Going Chapter Recap 2-0 Chapter Introduction Economists use specialized language 2-1 The Economist as a Socialist 2-1a The Scientific Method: Observation, Theory, and More Observation Observe, hypothesize, collect data, analyze, conclude, retest Experiments, however, are not easy to conduct (no lab setting): observations of real events are the only data 2-1b The Role of Assumptions Assumptions simplify without substantially affecting the answer Short and long run have different assumptions, and conditions determine what assumptions can be applied 2-1c Economic Models Omit details so we can examine the crux of the issue 2-1d Our First Model: The Circular Flow Diagram Circular flow diagram: the economy is simplified to include only two types of decision makers- firms who produce goods using labor, land, and capital inputs (factors of production) and households who own the inputs and consume the products - market for goods and services: households buyers, firms sellers - Markets for the factors of production: household sellers, firm buyers The flow of money and the flow of goods/inputs is inverse 2-1e Our Second Model: the Production Possibilities Frontier Production possibilities frontier: model that shows the various combinations of output that the economy can possibly producegiven the available factors of production and the available production technology that firms use to turn these factors into output Scarce resources means that points outside the curve are not possible Points on the line represent maximum (efficient) use of resources Points inside mean the economic is producing less than it could from the resources available Graph represents the tradeoff problem and the opportunity costs of choices (these change over time as the possibilities shift) Outward shift of the curve= growth 2-1f Microeconomics and Macroeconomics Microeconomics: the study of how households and firms make decisions and how they interact in specific markets Macroeconomics: the study of economy-wide phenomena 2-2 the Economist as a Policy Adviser 2-2a Positive vs. Normative Analysis Micro Econ 101 Page 4 2-2a Positive vs. Normative Analysis Positive statements :descriptive- claim on how the world is Normative statements: prescriptive- claim on how the world should be 2-2b Economists in Washington 1. Council of Economic Advisors i. 3 members and a staff of economists 1) Advise the president 2) Write annual Economic Report of the President 2. Office of Management and Budget 1) Design tax policy 3. Department of Labor 1) Analyze data on workers/unemployed 2) Formulate labor-market policies 4. Department of Justice 1) Enforce antitrust laws 5. Congressional Budget Office (independent) 1) Evaluations of policy proposals 6. Federal Reserve (independent) 1) Sets nation's monetary policy 2) Analyze economic developments throughout the world 2-2c Why Economists Advice is Not Always Followed Simply, there is more to it than the test tube 2-3 Why Economists Disagree 1. Because all models are test tubed, they are controversial 2. Because all economists have different values, they have different policy goals 2-3a Differences in Scientific Judgments 1. Different theories for the results 2. Different parameter assumptions 2-3b Differences In Values 2-3c Perception vs. Reality Economists are largely in agreement about certain policies; however, real life decisions usually ignore the advice 2-4 Let's Get Going Micro Econ 101 Page 5 Microeconomic Analysis: Introduction Sunday, September 02, 2012 10:29 AM Outline Notes Lectures 1 and 2 Thinking Like an Economist: 1. Think about goods and services , not money a. Black Monday 1987 i. 20% stock market loss ii.Material wealth did not change 1) Changes in investors beliefs in the value of those goods changed a) Bad for sellers of assets b) Buying is better though iii. Long run effect on production 2. Everything has a cost a. Opportunity cost i. Embodies the economic concept of cost ii.The opportunity that has to be sacrificed in order to get something or do something 3. Compare benefits and costs a. Need to outweigh the costs b. When benefits come after the costs, its an investment 4. Think at the Margin a. The last unit you buy, sell, or use i. Benefits: those provided by the last unit (not the sum) ii.Costs: opportunity costs of last unit (again, not sum) 5. People Respond to incentives a. Not always as expected i. Renting to the elderly, if there are restrictions on evicting the elderly, so landlords are less likely to rent to them ii.Congress passes law limiting paper use: doesn't necessarily mean that there will be more trees (trees are grown by farmers, so they don't have incentive to grow trees if they can't make money off them) 6. Prices that reflect all costs provide the best incentives a. Highway toll money is best used to reduce congestion (maintenance and law enforcement are covered by taxes) 7. Statistics are often misleading Definition of Economics Economics is the scientific study of human behavior associated with the production and distribution of the “necessities and conveniences of life" Adam Smith 1. Production a. Transformation of some goods and services into other goods and services i. Inputs ii.Outputs 2. Distribution a. Primitive economies i. Make and consume most of your own production b. Complex economies i. Large quantities of inputs= large quantities of outputs ii.Outputs are distributed to consumers iii.Inputs are distributed to producers Human behavior 1. Economics is not production technology 2. Not about material objects 3. Its about how people organize themselves for the production and distribution of goods and services 4. It is about what people do in order to create the necessities Micro Econ 101 Page 6 4. It is about what people do in order to create the necessities 5. Its about patterns of human behavior Scientific Study a. Not how to manage a business b. Not how to make money c. Its an observational science d. Experiments are uncommon e. Models are the basic tool a. Similar to real world objects in details that are important to the intended analysis b. There are simpler, irrelevant details Micro Econ 101 Page 7 Chapter Three: Independence and the Gains from Trade Thursday, September 06, 2012 11:10 AM Contents: Chapter Introduction 3-1 A Parable for the Modern Economy 3-1a Production Possibilities 3-1b Specialization and Trade 3-2 Comparative Advantage: The Driving Force of Specialization 3-2a Absolute Advantage 3-2b Opportunity Cost and Comparative Advantage 3-2c Comparative Advantage and Trade 3-2d The Price of the Trade 3-3 Applications of Comparative Advantage 3-3a Should Tom Brady Mow His Own Lawn? 3-3b Should the United States Trade with Other Countries? 3-4 Conclusion Chapter Recap 3-0 Introduction A web of interdependence: how did this happen? 3-1 A Parable for the Modern Economy Not only is trade good for specialization andvariety,but also for when productionwould be at too great a cost 3-1a Production Possibilities The productionpossibilities frontier is a graph of what a producercan produce given the set resources andcapital he has (not bowed out for an individual producer) Any point along the curve is an efficient combination of amounts of goods to produce Producers can consume more if they specialize In the product in whichthey have comparativeadvantage 3-1b Specialization and Trade A simple graph can illustrate the most economical use of time for production andthe best trades:whatever maximizes consumption 3-2 Comparative Advantage: The Driving Force of Specialization The slopeof the new line after trade representsthe producttrade rate To create the new trade line,begin at the unit at which the producer is producingthe productin which he has comparative advantage Go down the axis to the amount he keeps, or subtract what istraded Then, go across to the amount of the OTHER product whichthe producertraded for. The line that runs through this point and the production unit isthe new trade line. The new points indicate thenew rates of consumption. 3-2a Absolute Advantage Absolute advantage:the producerthat requires a smaller quantity of inputs to produce a good (and therefore can produce more of it with the available resources) 3-2b Opportunity Cost and Comparative Advantage The slopeof the PPF line indicateshow many units of the lower (x axis) product must be given up to produce one more unit of the y axis product This is the opportunitycost of each unit of production. The producerwith the lowest opportunitycost in a good has the comparativeadvantage,and therefore should specialize inthat good, then trade for the goods he needs, for higher consumption. 3-2c Comparative Advantage and Trade Trade can benefit everyonein society becauseit allows people to specialize in activities in whichthey have a comparativeadvantage. 3-2d The Price of the Trade For both partiesto gain from trade, the price at which they trade must lie between the two opportunity costs. David Ricardo's developedcomparativeadvantagein Principles of a Political Economy and Taxation (1817) 3-3 Applications of Comparative Advantage 3-3a Should Tom Brady Mow His Lawn? Who has the comparativeadvantage(lower opportunitycost of mowing lawns) 3-3b Should the United States Trade with Other Countries? Micro Econ 101 Page 8 3-3b Should the United States Trade with Other Countries? Imports: goods producedabroadand sold domestically Exports: goods produceddomestically andsold abroad Comparative advantage conceptstillapplies Internationaltrade, however,can make some individuals worse off even as it makes the country as a whole better off 3-4 Conclusion Micro Econ 101 Page 9 Free Markets, Exchange, and Money Tuesday, September 11, 2012 10:58 AM Lecture Outline Important Economic Concepts 1. Wealth a. Capacity to create valued goods and services b. Many forms: i. Buildings ii.Roads iii.Machines iv. Ships v. Cars vi. Stores vii.Warehouses viii.Education and training 1) Productivity ix. Governmental institutions x. Productive social and economic organizations 1) Private 2) Public c. Economists want to understand why some societies have far more wealth than others 2. Economic agents a. Person or group who plays an active role in economy i. Households 1) Individuals 2) Small groups living together ii. Firms 1) Individuals producing alone 2) Groups in joint production iii. Governments 1) Groups of people who regulate households and firms 2) Viewed as specialized firms with regulatory functions 3) Provide public goods b. Many of the same people playing different roles 3. Economics systems a. Different cultures have different systems i. Different codes of behavior 1) Army: orders passed from top a) Feudalism/serfdom- social hierarchy b) command b) command 2) Decentralized: businesses run any way they want a) Free market system 3) Etc… 4. Basic Economic Choices a. Production decisions i. What to produce ii. How to produce b. Distribution decisions i. Who gets the outputs ii. Who provides the inputs c. Choices are made depending on the economic system Free Market System 1. Most economic activity is voluntary a. Economic incentives b. Production- voluntary activity of private firms c. Distribution- voluntary exchange 2. Free market model a. Most countries b. Highly simplified representation of a free market economy i. All firms private and unregulated ii. Real world 1) How do markets deviated from the model? 2) Taxes must be paid in exchange for services (involuntary exchange) 3) Regulations on operations (involuntary production activity) 4) Restrictions (involuntary) c. Voluntary Exchange i. Used to distribute inputs and outputs in free market ii. Fundamental aspect of the system iii. Households, firms, and governments sell and buy goods and services iv. Usually increases welfare of both parties (or at least neutral) 1) Exceptions a) Poor information b) Gullibility c) Temptation v. mechanisms 1) Barter a) Direct exchange b) "double coincidence of wants" c) Needs FAR more markets d) No medium of exchange needed d) No medium of exchange needed 2) Selling and buying a) Sell products b) Buy other products c) Eliminates a and b needs for barter i) Easier to find the right market ii) Medium of exchange needed One. Commodity money First. Universal value to everyone in the market Two. Fiat money First. Construct with no intrinsic value Second. Declared to be money by state or authority Third. Paper or as notations in computers d. Markets i. Meeting places for voluntary exchange 1) Traditional markets 2) Supermarkets 3) NASDAQ: virtual ii. Some are diffuse and exist in many places simultaneously 1) Petroleum 2) US labor market Chapter 4: The Market Sources of Supply and Demand Tuesday, September 11, 2012 6:21 PM Outline Chapter Introduction 4-1 Markets and Competition 4-1a What Is a Market? 4-1b What Is Competition? 4-2 Demand 4-2a The Demand Curve: The Relationshipbetween Price and Quantity Demanded 4-2b Market Demand versus Individual Demand 4-2c Shifts in the Demand Curve 4-3 Supply 4-3a The Supply Curve: The Relationshipbetween Price and Quantity Supplied 4-3b Market Supply versus Individual Supply 4-3c Shifts in the Supply Curve 4-4 Supply and Demand Together 4-4a Equilibrium 4-4b Three Steps to Analyzing Changes in Equilibrium 4-5 Conclusion: How Prices Allocate Resources Chapter Recap 4-0 Chapter Introduction Supply and demand are the forces that make a market economy work Determine the quantity of each good produced and the price at which it is sold 4-1 Markets and Competition 4-1a What is a Market? Market: a group of buyers and sellers of a particular good or service Buyers determine demand Seller determine supply 4 -1b What is Competition? Because of competition, the market is decided by the collective decisions of the buyers and the collective decisions of the sellers Competitive market: a market in which there are so many buyer and so many sellers that each has a negligible impact on the market price Perfectly competition markets have: 1. identical products and 2. many buyers and sellers with no influence on the price as individuals (price takers) Monopoly: a market with only one seller 4-2 Demand 4-2a The Demand Curve: the Relationship between Price and Quantity Quantity demanded: the amount of the good that buyers are willing and able to purchase Law of demand: all other things equal, when the price of a good rises, the quantity demanded of the good falls, and visa versa Demand schedule: a table that shows the relationship between the price of a good and the quantity demanded Demand curve: the down sloping line relating price and quantity demanded 4-2b Market Demand vs. Individual Demand The sum of all individual demands 4-2c Shifts in the Demand Curve Demand: the difference between the price per unit and the quantity demanded May not be stable Anything that alters the "all other things equal" assumption will change the curve Replaces the original curve Change in the amount purchased due to price is a change in quantity demanded, not demand Micro Econ 101 Page 13 Change in the amount purchased due to price is a change in quantity demanded, not demand There are several determinants of demand Income Normal good: a good whose demand falls when income falls Inferior good: the reverse Prices of Related Goods Substitutes: the fall in the price of one good reduces the demand for another good Complements: when the fall of one means the RISE of the other Tastes Expectations Future predictions anticipate today's purchases Number of buyers 4-3 Supply Only competitive markets Law of supply: Price and quantity are inverse Revenue must exceed the cost to sell 4-3a The Supply Curve: the Relationship between Price and Quantity Supplied Same exact concepts as demand 4-3b Market Supply vs. Individual Supply 4-3c Shifts in the Supply Curve Determinants of supply: Input prices Technology Expectations Numbers of Sellers 4-4 Supply and Demand Together 4-4a Equilibrium Intersection of demand and supply curve Determines price and quantity Stays until something shifts The system as a whole adjusts to eq. Model assumes free, competitive market Surplus: price is too high, and too much is produced Shortage: price too low, and too little is produced Law of supply and demand: the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance 4-4b Three Steps to Analyzing Changes in Equilibrium 1) which curve does it shift? And is it a shift or a movement in the first place? 2) which way does it shift? 3) figure out the new eq. based on the model 4-5 Conclusion: How Prices Allocate Resources Micro Econ 101 Page 14 Production Specialization Thursday, September 13, 2012 10:52 AM Lecture Outline The production process The entire population process is a series of transformations in which the primary factors of production (inputs) gradually become the final goods and services 1. Primary factors of production a. Services provided by households (outside the productive sphere) i. Labor 1) Productive work from humans beings ii.Capital services (capital goods) 1) Productivity increasing tools a) Buildings b) Machines c) training iii.Land services 1) Resources provided by nature b. Availability of Primary Factors i. Population of available workers determines available labor (studied by demographers) ii.Availability of land determines by nature 1) Exception: land creation iii. Capital formation 1) Creation of tools 2) Investment a) Committing time, labor, inputs to create capital 3) Saving a) Sacrificing some of her consumption 4) Returns to capital a) Rise in consumption because of investment and capital gain c. Decisions i. How should inputs be used? ii. What combinations of final goods should be produced? 1) What can be produced with our available inputs? d. Labor i. How should people be allocated to different productive processes 2. Absolute advantage a. A person or firm that needs less time or resources to produce a good b. Graph of "commodity space" i. Each axis represents one of the commodities ii. Production possibilities curves 1) Shows the possible efficient combinations of products 3. Specialization a. Allows for truly maximum production b. Comparative advantage i. The producer with the lowest opportunity cost of production c. Joint production possibilities curve i. Joint PPC without specialization 1) Added production possibilities of producers ii. Specialization is outside that curve 1) Must plot different distributions based on each distribution of labor Micro Econ 101 Page 15 Markets and Demand Tuesday, September 18, 2012 11:01 AM Lecture Outline A. Money a. Barter needs no special tools b. Buying and selling need a medium of exchange i. Selling: obtaining money in exchange for goods ii. Buying: obtaining good in exchange for money c. Types i. Commodity 1) Salt 2) Gold ii. Fiat money 1) No intrinsic value 2) Declared money by a state or other authority 3) Exists only as paper (currency) 4) or in computers a) The system works because everyone agrees to accept the currency B. Competition a. The driving force of any free market economic system C. Prices a. Prices are defined when money is used for selling and buying i. Not used in barter 1) Uses exchange ratio 2) Not useful as a standard measure of value b. The price of a good is the amount of money exchanged for one unit of the good c. They indicate the value that markets place on a good 1. Perfect competition A. A model, doesn't exist in the real world a. Some markets are close i. One homogeneous good ii. Many buyers and sellers iii. Voluntary exchange iv. Full information v. Perfect foresight vi. Everyone is rational and self interested vii. Free entry B. Law of one price a. At any given time, in a perfectly competitive market, identical goods must have the same price i. Full information: "losers" need to find each other and compromise ii. Rational self-interest: they both wan to do better iii. "losers" decide to trade with each other iv. At the compromise price, both would be better off iv. At the compromise price, both would be better off 1) The original prices wouldn't go through b. Arbitrage i. Buy low and sell high 1) Takes advantages of price differences to make a profit 2) Makes prices closer together 3) Extends the law of one price 2. Supply and Demand A. Demand a. How much would each buyer buy at each price b. Demand schedule i. Specifies how much of a good a person is willing to buy at various prices ii. Demand curve 1) These values put into a graph 2) Downward sloping a) Independent variable (price) b) Dependent variable (quantity demanded) c) Higher price means lower QD i) Lower prices justify putting the milk to less important uses Supply and Market Equilibrium Thursday, September 20, 2012 11:01 AM Lecture Outline A. Ask the suppliers the right questions a. How much would you want to sell at each price i. Makes an upward sloping curve 1) Sells more at higher prices ii. Higher prices justify higher costs (to increase the quantity) A. Market demand a. Add all the quantities demanded at each price b. Market demand curve i. Price is on the vertical axis ii. Graphed the same way as individual curves B. Market supply a. Total of all SELLERS b. Same system to create graph C. Market clearing price a. When the quantity supplied is equal to the QD in the market b. Competitive market equilibrium i. Price and quantity supplied at equilibrium ii. Hits eq. because 1) Above a) Excess supply b) Sellers cannot sell as much as they want c) Offer a lower price 2) Below a) Excess demand b) Buyers can't buy all they want c) They offer more money 1. Government intervention a. Large groups unhappy with the eq. price b. Government tries to intervene to put limits (upper or lower) i. Rent controls 1) May help poor find housing 2) BUT: excess demand because the control forces the p
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