1 Week One What is economics? Chapter 1 Economics: is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices. How? - Goods and services are produced by using productive resources that economists call factors of production: They are grouped into four categories. Land - rent Labour - wages Capital - interest Entrepreneurship profit Economic way of thinking - Rational choice - Benefit: what you gain - Cost: what you must give up, the opportunity cost of something is the highest valued alternative that must be given up to get it - How much: choosing at the margin, evaluate the consequences of making incremental changes - Choices respond to incentives Economics: a social science and policy tool - An economic model is a description of some aspect of the economic world that includes only those features that are needed for the purpose at hand The Economic problem Chapter 2 Production possibilities and opportunity cost - The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot - We achieve production efficiency if we cannot produce more of one good without producing less of some other good. - Opportunity cost is a ratio - The outward bow means that as the quantity produced of each good increases, so does its opportunity cost - The marginal cost of a good or service is the opportunity cost of producing one more of it - Marginal benefit curve
2 - Allocative efficiency - The point of Allocative efficiency is the point on the PPF at which marginal benefit equals marginal cost Economic growth.. Week 2 Demand and Supply Chapter 3 Markets and Prices - A market is a place where buyers and sellers come together - A competitive market is one with many sellers - Money price of a good is the amount of money needed to buy it - Relative price of a good ratio Demand Supply - Quantity demanded of a good or service is the amount that consumers plan to buy during a particular time period and at a particular price - Substitution effect - Income effect - The term demand refers to the entire relationship between the price of the good and quantity demanded of the good - A 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 - Six main factors that change demand The prices of related goods Expected future prices Income Expected future income and credit Population Preferences - Six main factors that change supply The price of factors of population The prices of related goods produced Expected future prices The number of suppliers
3 Technology State of nature Week 3 & 4 Elasticity Price elasticity of demand The Price elasticity of demand is a units free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buying plans remain the same. Percentage change in quantity demanded in (tri)q/qavex100 etc for price Average price and quantity, get the same elasticity value regardless of whether the price rises or falls Percentages and proportions %Q / %P = Q/Q / P/P The factors that influence the elasticity of demand - The closeness of substitutes: closer = more elastic, necessitites = inelastic - The proportion of income spent on the good : greater proportion larger elasticity - The time elapsed since a price change Cross elasticity of demand is a measure of responsiveness of demand for a good to a change in the price of a substitute or a complement, other things remaining the same. Substitute is positive and a compliment is negative Income elasticity of demand measures how the quantity demanded of a good responds to a change income, other things remaining the same.
4 Elasticity - The price elasticity of demand is a units free measure of the responsiveness of the quantity demanded of a good to change in its price when all other influences on buying plans remain the same - Mid point formula - Point formula - Demand can be inelastic, unit elastic or elastic - The total revenue from the sale of a good or service equals the price of the good multiplied by the quantity sold. - The factors the influence the elasticity of demand: The closeness of substitutes The proportion of income spent on the good The time elapsed since a price change - The cross elasticity of demand: is a measure of responsiveness of demand for a good to a change in the price of a substitute or a complement other things remaining the same - The income elasticity of demand: measures how the quantity demanded of a good responds to a change in income, other things remaining the same - The elasticity of supply: measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same Week 7 Consumer Theory Consumption Possibilities A households consumption choices are constrained by its income and the prices of the goods and services available. The budget line describes the limits to the households consumption choices The Budget Equation The budget equation states that: Expenditure=Income Lisa s budget equation: PsPq+PmQm=Y A households real income is the income expressed as a quantity of goods the household can afford to buy Relative price is the magnitude of the slope of the budget line Change in Prices A rise in the price of the good on the x-axis decreases the quantity of that good and increases
5 the slope of the budget line. The Budget line has become steeper because the relative price of movies has increased A fall in the price of the good on the x-axis increases the affordable quantity of that good and decreases the slope of the budget line. The budget line has become flatter as the price of m has decreased. Change in Income A changes in money income brings a parallel shift to the budget line. Preferences and Indifference curves An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. - All the points above the indifference curve are preferred to all the points on the indifference curve - All the points on the indifference curve are preferred to all the points below the indifference curve A preference map is a series of indifference curves. Marginal rate of substitution The marginal rate of substitution measures the rate at which a person is willing to give up good y to get an additional unit of good x, while at the same time remaining indifferent. The magnitude of the slope of the indifference curve measures the marginal rate of substitution - If the indifference curve is relatively steep, the MRS is high
6 - If the indifference curve is relatively flat, the MRS is low A diminishing marginal rate of substitution is 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 remain indifferent ad the quantity of good x increases Degree of suitability The shape of the indifference curve reveals the degree of suitability between two goods. (ordinary goods, perfect substitutes, and perfect compliments) Predicting consumer choices Best affordable price The consumers best affordable choice: - On the budget line - On the highest attainable indifference curve - Has a marginal rate of substitution between two goods equal to the relative price of the two goods Predicting: A change in price The effect of a change in the price of a good on the quantity of the good consumed is called the price effect. Predicting: a change in income The effect of a change in income on the quantity of a good consumed is called the income effect. As income decreases the budget line shifts leftwards The substitution effect and income effect
7 The Substitution effect is the effect of a change in price on the quantity bought when the consumer remains on the same indifference curve The direction of the substitution effect varies: - When the relative price falls, the consumer always substitutes more of that good for other goods - The substitution effect is the first reason why the demand curve slopes upward The Income Effect. DIAGRAMS Inferior goods For an inferior good, when income increases, the quantity bough decreases The income effect is negative and works against the substitution effect So long as the substitution effect dominates, the demand curve still slopes downward Week 8 Producer Theory A firm and its economic problem A firm is an institution that hires factors of production and organises them to product and sell goods and services A firms goals is to maximise profit. Accounting profit: accountants measure a firms profit to ensure that the firm pays the correct amount of tax and to show its investors how their funds are being used. Economic profit: economists measures a firms profit to enable them to predict the firms decisions, and the goal of these decisions is to maximise economic profit (equals a firms total revenue minus its total opportunity cost of production) A firms opportunity cost of production: a firms opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production. - Resources bought in the market: the amount spent by a firm on resourced bough in the market is an opportunity cost of production because the firm could have bought different resources to product some other good or service - Resources owned by the firm: - Resources supplied by the firms owner Profit constraints Two features of a firms environment impose constraints that limit the profit that it can make: - Technology constraints - Market constraints Decision time frames The Short run is a time frame in which the quantity of one or more resources used in production is fixed
8 The Long Run is a time frame in which the quantities of all resource, including the plant size, can be varied. - A Sunk cost is a cost incurred by the firm and cannot be changed, eg if a firms plant has no resale value. Short run technology constraint To increase output in the short run, a firm must increase the amount of labour employed. Three concepts describe the relationship between output and the quantity of labour employed: 1. Total product is the total output produced in a given period 2. Marginal product of labour is the change in total product that results from a one unit increase in quantity of labour employed, with all other inputs remaining the same 3. Average product of labour is equal to total product divided by the quantity of labour employed Product curves: show how the firms total product, marginal product and average product change as the firm varies the quantity of labour employed. - The total product curve shows how total product changes with the quantity of labour employed - Separates attainable and unattainable output levels in the short run - The height of each bar measures the marginal product of labour Almost all production processes are like the ones shown and have: increasing marginal returns initially and diminishing marginal returns eventually The law of diminishing returns state that, as a firm uses more of a variable input with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes. Short run cost Three concepts and three types of cost curves are: 1. Total cost- a firms total cost is the cost of all resources used. TC=TVC+TFC 2. Marginal cost- is the increase in total cost that results from a one unit increase in total product. 3. Average cost- measures can be derived from each of the total cost measures.atc=afc+avc
9 The position of a firms cost curves depend on two factors: technology and prices of factors of production Long run cost The behaviour of long run cost depends upon the firms production function. The firms production function is the relationship between maximum output attainable and the quantities of both capital and labour - Diminishing marginal product of capital: is the increase in output resulting from a one unit increase in the amount of capital employed, holding constant the amount of labour employed - Long run average cost curve: is the relationship between the lowest attainable average total cost and output when both the plan and labour are varied. This is a planning curve and tells the firm the plan that minimises the cost of producing a given output range. Economies and diseconomies of scale Economies of scale, are features of a firms technology that lead to falling long run average cost as output increases Diseconomies of scale are features of a firms technology that lead to rising long run average cost as output increases Constant returns to scale are features of a firms technology that lead to constant long run average cost as output increases
10 Minimum efficient scale A firm experiences economies of scales up to some output level Minimum efficient scale is the smallest quantity of output at which the long run average cost reaches its lowest level Week 9 Perfect Competition What is perfect competition - Many firms sell identical products to many buyers - There are not restrictions to entry into the industry - Established firms have no advantages over new ones - Sellers and buyers are well informed about prices Price takers In perfect competition each firm is a price taker: - A price taker is a firm that cannot influence the price of a good or service. It must take the equilibrium market price. - Each firms output is a perfect substitute for the output of the other firms so the demand for each firms output is perfectly elastic.
11 Economic profit and revenue A firms total revenue is PxQ A firms marginal revenue is the change in total revenue that results from one unit increase in the quantity sold A firms output decision Profit maximising output A perfectly competitive firm chooses the output that maximises its economic profit One way to find the profit maximising output is to look at the firms total revenue and total cost curves Marginal analysis and supply decision Temporary shutdown decision decide whether to stay in the market. If the firm makes an economic loss it must If the firm decides to stay in the market, it must decide to produce something or to shut down temporarily. The decision will be the one that minimises the firms cost Loss comparisons Economic loss = TFC + TVC TR or = TFC + (AVC P) x Q The shutdown point
12 A firms shutdown point is the price and quantity at which it is indifferent between producing and shutting down This point is where AVC is at its minimum, and where the MC curve crosses the AVC curve The firms supply curve This shows how the firms profit maximising output varies as the market price varies, and other things remain the same. Output, price and profit in the short run The short run market supply shows the quantity supplied by all firms in the market at each price when each firms plant and the number of firms remain the same Entry and exit Competition and efficiency Week 10 Monopoly Market power Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale Monopoly is an industry that produces a good or service for which no close substitutes exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms - legal or natural constraints that protect a firm from potential competitors are called barriers to entry - Legal barriers to entry create a legal monopoly, a market in which competition and entry are restricted by the granting of a 1. Monopoly franchise 2. Government license 3. Patents and copyright - Natural barriers create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can. Government regulates the price of monopoly - There are two types of monopoly price setting strategies: 1. Price discrimination is the practice of selling different units of a good or service for different prices. 2. A Single price monopoly is a firm that must sell each unit of its output for the same price to all its customers Marginal revenue and elasticity Single price monopoly marginal revenue is related to the elasticity of demand for its good.
13 A profit maximising monopoly never produces an output in the inelastic range of its demand curve Price and output decisions A monopoly sets its price and output at the levels that maximise economic profit that is where MR = MC Monopoly restricts output and charges a higher price Product innovation - Patents and copyrights provide protection from competition and lets the monopoly enjoy the profits stemming from innovation for a longer period of time Economies of scale - Where economies of scale exist, a monopoly can product at a lower average total cost than what a large number of competitive firms could achieve Week 11 - Monopolistic competition Monopolistic competition This is a market structure where: - A large number of firms compete - Each firm produces a differentiated product - Firms compete on product quality, price and marketing - Firms are free to enter and exit the industry firms cannot make an economic profit in the long run Large number of firms mean that each firm has a small market share Each firm is sensitive to the average market price, but no firm pays attention to the actions of others Product differentiation enables a firm to compete on price, quality and marketing - Quality: design, reliability and service Firms short run output and price decision Comparison & is it efficient
14 Week 12 Oligopoly What is oligopoly? Natural or legal barriers prevent the entry of new firms There is a small number of firms Small number of firms - Because an oligopoly market has only a few firms, they are interdependent and face a temptation to cooperate Oligopoly games Game theory is a tool for studying strategic behaviour, which is behaviour that takes into account the expected behaviour of others and the mutual recognition of interdependence. 1. Rules 2. Strategies 3. Payoffs payoff matrix is a table that shows the payoffs for every possible action by each party 4. Outcome nash equilibrium A collusive agreement is an agreement between two or more firms to restrict output, raise the price and increase profits. Week 13 Trade Gains from trade A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else A person has an absolute advantage if that person is more productive than others Absolute advantage involves comparing productivities while comparative advantage involves comparing opportunity costs Terms of trade = ToT