Chapter 1: The Ten Lessons in Economics

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1 Textbook Notes Page 1 Chapter 1: The Ten Lessons in Economics Saturday, 25 May :09 PM Economics: The study of how society manages its scarce resources Individual Decision-Making Lesson 1: People Face Trade-Offs Efficiency: society getting the most it possibly can from its scarce resources Equity: distributing economic prosperity fairly among all members of society Examples High income V clean environment Defense (guns) V living standards (butter) Lesson 2: Opportunity Cost Whatever must be given up to obtain some item. The cost of something is what you give up to get it Lesson 3: Rational people think at the margin Economics assume people are rational. Marginal Change: a small incremental adjustment to a plan of action A rational decision maker takes an action only if the marginal benefit of the action exceeds the marginal cost. Lesson 4: People respond to incentives Inducing a person to act through the prospect of punishment or reward. Because people are rational and make decisions by comparing costs and benefits, they respond to incentives. Economic Interactions Lesson 5: Trade can make everyone better off By trading with others, people can buy a greater variety of goods and services at lower cost Lesson 6: Markets are usually a good way to organise economic activity Market Economy: an economy that allocates resources through the decentralised decisions of many firms and households as they interact in markets for goods and services. Invisible Hand: the idea that buyers and sellers who freely interact in a market economy will create an outcome that allocates goods and services to those people who value them most highly, making the best use of scarce resources Lesson 7: Governments can sometimes improve market outcomes Market Failure: when a market, left on its own, fails to allocates resources efficiently Externality: the uncompensated impact of one person's actions on the wellbeing of a bystander (positive or negative) Market Power: the ability for a single/small group of economic actors to have a substantial influence on market prices The Economy as a Whole Lesson 8: A country's standard of living depends on its ability to produce goods and services Almost all variation in living standards is attributable to differences in countries' productivity Productivity: the quantity of goods and services produced from each hour of a worker's time Lesson 9: Prices rise when the government prints too much money

2 Textbook Notes Page 6 Chapter 4: The market forces of supply & demand Saturday, 25 May :18 PM Markets & Competition Market: A group of buyers and sellers of a particular good or service Competitive Market: a market where there is many seller and many buyers so that each has a negligible impact on the market price Demand Quantity Demanded: the amount of a good that buyers are willing and able to purchase Law of Demand: the claim that, other things being equal, the quantity demanded of a good falls when the price of the good rises Demand Schedule: a table that shows the relationship between the price of a good and the quantity that is demanded Demand Curve: a graph of the relationship between the price of a good and the quantity demanded Types of Goods Normal good: an increase in income leads to an increase in quantity Inferior good: an increase in income leads to a decrease in quantity demanded Substitutes: two goods for which a decrease in the price of one leads to a decrease in the demand for the other Complements: two goods for which a decrease in the price of one leads to an increase in the demand for the other good Supply Quantity Supplied: the amount of a good that sellers are willing and able to sell Law of Supply: the claim that, other things being equal, the quantity supplied of a good rises when the price of the good rises Supply Schedule: A table that shows the relationship between the price of a good and the quantity that is demanded Supply Curve: a graph of the relationship between the price of a good and the quantity supplied Other Terms Equilibrium: a situation in which supply and demand have been brought into balance Equilibrium price: the price that balances supply and demand Equilibrium quantity: the quantity supplied and the quantity demanded when the price has adjusted to balance supply and demand Surplus: a situation in which quantity supplied is greater than quantity demanded Shortage: a situation in which quantity demanded is greater than quantity supplied Law of Supply & Demand: the claim that the price of any good adjusts to bring the supply and demand for that good into balance

3 Textbook Notes Page 8 Chapter 6: Supply, Demand & Gov't Policies Wednesday, 5 June :01 PM Controls on Prices Price Ceiling: a legal maximum on the price at which a good can be sold Price Floor: a legal minimum on the price at which a good can be sold Consider Rent Wages Products Taxes All governments (at all levels) use taxes to raise revenue for public purposes The question to ask is, 'Who bears the burden of a tax?' Tax incidence refers to the question of tax burden distribution (the study of who bears the burden of the tax) How does a tax on buyers affect market outcomes? (the three steps) 1) Does the law affect the supply or demand curve? 2) Which way does the curve shift? 3) How does the curve shift affect the equilibrium? Implications Taxes discourage market activity as the quantity sold is smaller in the new equilibrium Buyers and sellers share the burden of taxes -> Buyers pay more; sellers receives less How does a tax on sellers affect market outcomes? (same three steps) 1) Does the law affect the supply or demand curve? 2) Which way does the curve shift? 3) How does the curve shift affect the equilibrium? Implications Taxes on buyers and taxers on sellers are equivalent (both situations affect the price buyers pay and sellers receive) Buyers and sellers share the burden regardless of how the tax is levied Elasticity and Tax Incidence The incidence of a tax depends on the price elasticities of supply and demand. The burden tends to fall on the side of the market that is less elastic because that side of the market can respond less easily to the tax by changing the quantity purchased/sold

4 Textbook Notes Page 12 Chapter 22: Consumer Choice Sunday, 9 June :45 PM The theory behind the demand curve Trade-Offs (one of the 10 lessons from economics - chapter 1) A consumer who spends more income in the present and saves less of it must accept a lower level of consumption in the future A consumer who buys more of one good can afford less of other goods A consumer who spends more time enjoying leisure and less time working has a lower income and can afford less consumption The Budget Constraint: What the consumer can afford The link between income and spending The budget constraint is the limit on the consumption bundles that a consumer can afford Eq. quantity of pizza vs quantity of pepsi There are many different combinations the consumer can choose to add to the fixed total/income If pizza is $10 and Pepsi is $2 then the trade-off is 1 pizza for 5 Pepsi's Preferences: What the consumer wants If two bundles are equally satisfying, the consumer is considered indifferent between the two bundles. Indifference curve: a curve that shows consumption bundles that give the consumer the same level of satisfaction The slope at any point on an indifference curve equals the rate at which a consumer is willing to substitute one good for the other. This is called the marginal rate of substitution Marginal Rate of Substitution (MRS): the rate at which a consumer is willing to trade one good for another The indifference curve is not represented by straight lines, therefore the MRS is not the same at all points. The MRS depends on the amounts of the goods already being consumed A higher indifference curve shows the preferred point - more of one good may be enough to justify less of another good. By seeing which point is higher on the indifference curve, we can use the set of indifference curves to rank any combinations of the two goods Four Properties of Indifference Curves Higher indifference curves are preferred to lower ones Consumers usually prefer more of something rather than less of it Indifference curves are downward-sloping The slope reflects the rate at which a consumer is willing to substitute one good for the other If the quantity of one good is reduced, the quantity of the other good must increase in order for the consumer to be equally happy (assuming the consumer likes both goods) Indifference curves do not cross It is not possible as it assumes equal happiness between a bundle of more of both goods and a bundle of less of both goods Indifference curves are bowed inwards Because a consumer is more willing to trade away goods of which they have an abundance of and less of goods that he/she has little of, the indifference curves are bowed inwards There is a greater willingness to give up a good that a consumer already has in large quantity Extreme Examples (rarely, if ever, is a good a perfect match to either of these) Perfect Substitutes: two goods with straight-line indifference curves Willing to trade the same amount at any bundle quantity (eg. 2x10c coins for 1x20c coin)

5 Textbook Notes Page 13 Perfect Complements: two goods with right-angle indifference curves When two goods are strongly complementary Eg. Any quantity of right shoes would be useless without a bundle that offers the same number of left shoes Optimisation: What the consumer chooses The consumer must consider the budget constraint they are held back by. They must end up on the budget curve or below it. The point at which the indifference curve and budget constraint touch is called the optimum The optimum point offers the best combination of the products available Effect of Consumer Income on Consumption Choices A higher income means that the consumer can afford more of both goods This shifts the budget constraint outwards The slope of the next budget constraint is the same as the previous as the relative prices of the goods have not changed A new optimum combination is set An increase in income does not require an increase in consumption however this is most common (normal goods). Inferior goods may not increase as a result of higher income Effect of Product Prices on Consumption Choices The budget constraint shifts and changes slope when prices change. A new optimum is formed which changes the purchasing quantities of both products. Income & Substitution Effects Income effect: the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve Substitution effect: the change in consumption that results when a price change moves the consumer along a given indifference curve to a paint with a new marginal rate of substitution Applications of Consumer Choice Theories Do all demand curves slope downwards? Demand curves can sometimes slope upwards however this is unusual Example of Meat versus Potatoes This means consumers buy more of a good when the price rises (potatoes) This may be if the good is strongly inferior and the price rise makes the consumer poorer. This income effect makes the consumer want to buy less meat and more potatoes. At the same time, the substitution effect makes the consumer want to buy more meat (cheaper in comparison) but the income effect is so strong it exceeds the substitution effect A good that violates the law of demand is called a Giffen good Giffen Good: a [rare] good for which an increase in the price raises the quantity demanded Inferior good Substitution effect is dominated by the income effect How do wages affect labour supply? To do with time-allocation: trade-off between leisure and consumption The indifference curve can be applied to this theory - leisure and consumption being the goods Higher wages gives a consumer more money. The decision between leisure and consumption decides upon labour supply How do interest rates affect household saving? Consumer decision to save money is influenced by the interest rate their savings will earn A higher interest rate rotates the budget constraint outwards resulting in lower consumption at present and higher saving A higher interest rate rotates the budget constraint outwards resulting in higher consumption at present and lower saving

6 WK1;S1 Page 18 The Lessons Tuesday, 14 May :14 AM People Face Trade-Offs a. True costs of actions - giving up something for something else. Eg. i. Clothes vs holiday ii. Leisure time vs work iii. Clean environment vs income iv. Efficiency vs equity 1) Efficiency: society gets the most that it can from its scarce resources 2) Equity: means the benefits of those resources are distributed fairly among the members of society Opportunity Cost (links into 1) a. Decisions require comparing costs and benefits of alternatives. Eg. i. Go to university or work? ii. Study or movies? iii. Lecture or sleep? Rational People Think at Margin a. Many decision problems can be addressed using marginal analysis. Eg. b. Stopping studying and going to bed when the benefit of an extra minute of studying is no longer greater tha the cost of losing that minute's sleep c. This is rational behaviour People respond to incentives a. We do not think of people as having purely hard-wired behaviour Trade can make everyone better off a. Individual transaction b. Both parties must have expected to gain from the transaction otherwise they wouldn't have agreed to it c. Ex ante: both must see transaction as good idea beforehand d. Ex post: one party may decide/realise the transaction wasn't a good idea Markets are usually a good way to organise economic activity a. Market economies allocate resources through decentralised decisions. Eg. i. Firms decide who to hire and what to produce ii. Households decide what to buy and who to work for b. Works as the result of the idea of the 'invisible hand' Governments can sometimes improve market outcomes a. Market failure occurs when the market fails to allocate resources efficiently b. When the market fails we have a rationale for government intervention c. It's possible that government intervention can worsen situations d. Market failures can be caused by: i. Externalities (impact of one person/firm's actions on wellbeing of a bystander) ii. Market power (ability for a single person/firm to have substantial influence on market prices) 1) Eg. Telecommunications industry 2) One solution is for gov't to require providers to split retail operations from its wholesale network The standard of living depends on a country's productive ability a. Large differences exist in living standards (between different countries) b. Incomes may converge over time (different growth rates) Prices rise when the Government prints too much money a. This is an example of a macroeconomic issue Society faces a short-term trade-off between inflation and unemployment a. This is an example of a macroeconomic issue

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