Economics: Introduction

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1 Economics: Introduction Study notes for the Introduction To Economics (section 1) and introduction to Miceconomics (section 2) By Nils Österberg for nilsnotes

2 On HL paper two there are usually three out of six questions that reffer to section 1 and 2 of the syllabus, i.e. introduction to economics and microeconomics. It is therefore important to understand the essential concepts of these syllabus sections. This document aims to cover the first section of IB economics. In addition, an introduction to microeconomics is given through some very basic but essential concepts. Table of Contents PRODUCTION POSSIBILITY FRONTIER (PPF) 4 POSITIVE AND NORMATIVE STATEMENTS IN ECONOMICS 5 GROWTH 5 MARKETS 7 DEMAND 7 SUPPLY 9 SHIFTING DEMAND & SUPPLY CURVES 9 EXCEPTIONS TO THE LAW OF DEMAND VEBLEN GOODS GIFFEN GOODS 12 ELASTICITIES 12 PRICE ELASTICITY OF DEMAND 12 CROSS ELASTICITIES OF DEMAND 14 INCOME ELASTICITY OF DEMAND 15 Please note that nilsnotes and the author reserves themselves against any wrong, missing, or misleading content. It is however our goal to produce high quality study notes and we therefore ask you to contact us in the case of any questions or comments. 2

3 Introduction to Economics Scarcity is the relation between infinite wants and finite resources. Economics builds on the core problem scarcity. In the world there exist infinite wants. However, resources are limited, or, finite. As a result, choices have to be made and resources have to be allocated. Scarcity leads to the three basic economic questions: 1. What to produce? 2. How to produce? 3. For whom to produce? The Four Factors of Production are Land, Labor, Capital, and Enterprise. The reward of taking a risk to produce goods or services is called profit. The finite, and thus scarce resources are called the Four Factors of Production and are listed below. Land: are natural resources Labor: are human resources Capital: are goods that are used to manufacture other goods Enterprise: human resources that organize the other factors of production or who take the risk of producing goods and services to gain profit. This factor is sometimes also referred to as entrepreneurship Investments are additions to the capital, or education that improves labor or capital. *An economy is an area where goods and services are produced. They vary in size and are often referred to as regional, national, or international. An economy consists of three sectors: - Primary sector - Manufacturing sector - Tertiary sector Allocation of resources can be made and organized by using three kinds of economic systems. All economies* use more or less of every system. The systems are listed below. Free market: individuals own the Four Factors of Production and answer the Three Basic Economic Questions Centrally planned: the government owns the Four Factors of Production and answer the Three Basic Economic Questions Traditional: people answer the Three Basic Economic Questions in the same way as their predecessors. All economies are based on a mixed of all economic systems. However, all economies lean more towards one or two systems. For example, many poor Less Developed Countries (LDCs) tend to lean towards having economies based on Traditional systems, while these are less common among most Developed and Developing Countries. 3

4 Since choices have to be made, at least one option has to be rejected. The next best alternative forgone is called the opportunity cost. In HL paper 2, 3 of the 6 questions relate to the introduction and microeconomics. The PPF is probably the only diagram in the introduction section and can be used efficiently in development questions too, so take your time to learn the PPF fully. Remember to choose labels for the axis carefully. *recession is a decrease of an economy s output during two succeeding quarters Production Possibility Frontier (PPF) The PPF curve illustrates the quantity of two goods that can be produced with the available resources. This diagram is useful to illustrate opportunity cost, growth and recession*, development, more efficient allocation of resources or vice versa, etc. Diagram 1: PPF Agricultural goods 0 A Military goods Moving between different point on the curve represents opportunity costs, as an amount of one good has to be given up to increase the amount of the other good. Depending on the labels on the axis, development can also be illustrated by moving between points on the curve. Moving from point C to A in Diagram 1 illustrates an increase in agricultural goods and a decrease in military goods, which may be regarded as development, being a general increase of a population s standard of living. D B E C If production is at any point on the curve, all Four Factors of Production are used at optimum. However, in reality, an economy almost never use all resources at optimum, which is represented by point D in Diagram 1. If the curve is shifted outwards from B to E an increase of the total output of the economy is illustrated and hence growth. The shift 4

5 would either be caused by an increased efficiency or increased amount of resources, or both. The opposite is also true causing the curve to shift inwards representing recession. Diagram 2 B Agricultural goods C A An outwards shift represents growth. An inwards shift represents recession. 0 Military goods Positive and normative statements in economics A positive statement is a statement that may be tested. A normative statement on the other hand is a statement that cannot be tested, i.e. proved correct or wrong. Positive economics is economics that can be tested right or wrong. In contrast, normative economics cannot be tested and is, therefore, open for discussions and opinions. Growth National income may be defined as the total value of all the goods and services produced in an economy during a given period of time. By convention, this period is usually one year. There are several different measures for this, such as Gross Domestic Product and Gross National Product. The idea is that these measures should be about equal and in reality they differ somewhat. However, it is not very important which one you use, as long as you the difference between the measures by definition, 5

6 and as long as term corresponds with the method used to obtain the value. The total amount produced by an economy is called the output. If the output of an economy increases, the economy is said to experience growth. Growth is a major aim in macroeconomics. 6

7 Microeconomics Monopoly: 1 producer has 100% of market shares Oligopoly: 4 producers have 80%, or more, of market shares Monopolistic competition: very many small firms with no barriers to entry or exit Perfect competition: very many small firms, no barriers, perfect information, perfect factor mobility, perfect customer mobility Markets A market is an area where goods and services are exchanged. There are both buyers and sellers present, which allows demand and supply to interact. The interaction between demand and supply sets the price and quantity of a good or service and hence determines the allocation of resources. A market can be local/regional, national, and international. Markets can be of four different market structures. These are monopoly, oligopoly, monopolistic competition, and perfect competition. These market structures have several unique characteristics that will be further discussed later. They are briefly defined in the left margin, but the definitions will be discussed later. Demand Definition: demand is the quantity bought of a good or service at a certain price at a given time. It measures the willingness and the capability to buy a good or service. Law of Demand: The law of demand states that demand and price are inversely related. As price increases, demand lowers. As a result, the demand curve is sloping downwards as shown in Diagram 3. A movement along the demand curve is any change in demand caused by a change in price. This is illustrated below in Diagram 3. Diagram 3: movement along the demand curve 6 Price 5 Movement along the demand curve D Quantity 7

8 *Real income is how much can be bought with the income. The scenario in the main text also illustrates a basic principal of inflation, or rather the opposite, i.e. deflation. This may therefore be a useful connection between micro and macroeconomics. If the price of any product falls, the costumer has more money left. Hence the real income* has increased. As people now can buy more of the product, by definition, people also become more likely to buy the product, hence being an increase of demand. This is called the income effect. If the price of a product falls it becomes relatively cheaper in comparison to other products at the market** and the demand for the product will as a result increase. This is called the substitution effect. There are several factors which affect the demand; price and income are only some of them. These factors are called determinants of demand and are listed on page 8. 8

9 Supply Definition: supply is the quantity sold of a good or service at certain price during at a given time. It measures producers /sellers willingness and capability to sell a good or service. Law of supply: usually, as the price of a good or service increase, the supply of the good or service will increase. Therefore, it can be said that supply and price positively related. S Price increase in price 0 Increase in quantity Quantity The diagram above illustrates a movement along the supply curve. Likewise a movement of the demand curve, a movement of the supply curve is due to change in price. Note that the movement also can be in the opposite direction of what is shown above. Shifting demand & supply curves In difference to a movement of a curve, which is caused by a change in price, any shift of a demand curve or a supply curve is caused by a change in any other factor that affects demand or supply. These factors are called determinants and are listed below. Determinants of Demand: ü Income ü The price of other products ü Tastes ü Other factors like: o Seasons and weather 9

10 o o o Population size and demographics Income distribution Government policies Determinants of Supply: Costs of the four factors of production Productivity Prices of other products which the supplier could produce instead 10

11 Exceptions to the law of demand There are two major exceptions of the law of demand that you should know about. 1. Veblen goods Veblen goods are said to experience an increased demand as their price increases. This is due to that they have snob value. As they become more expensive it becomes more status filled to own the good. Veblen goods can be illustrated by diagrams as below. Diagram 4: Veblen good Veblen good Price D 0 Quantity Diagram 5: Veblen good D Price 0 Quantity Sometime the lower part of the demand curve (Diagram 4) of a Veblen good is taken away, resulting in a diagram looking as Diagram 5. 11

12 2. Giffen goods The principle of Giffen goods is based on that poor people spend a very large portion of their income on few types of goods. Suppose that you earn 5 a week and that food prices rise as in the table below. It is enough to define these using the formulae. Remember that Y = income Meat Potatoes Before 3 1 After 6 2 Given the low income, it can be seen that after the price increase Meat cannot be afforded. Therefore the cheaper kind of food will have to be switched over to, in this case potatoes. Hence, in the example illustrated above, the demand for potatoes has increased, even if the price also has risen, making it an exception to the law of demand. Elasticities Elasticites measure how much a dependent variable is changed as a reaction to a change of an independent variable. The four elasticities that you should know are: Price Elasticity of Demand (PED) Cross Elasticity of Demand (XED) Income Elasticity of Demand (YED) Price Elasticity of Supply (PES) It is important to know elasticities in various kinds of decision making. For a government it is important when trying to limit uses and during policy making. Private companies will have to use elasticities to maximize total revenue. Price elasticity of demand PED measures the responsiveness of the quantity demanded to a change in price. %!h!"#$!"!"#$%&%'!"#$%!"!!"# = %!h!"#$!"!"#$% The equation above is the most commonly used and will be accepted as definition on any IB economics paper. However, since calculations are often based on percentages but real numbers, the equation below is often more convenient. 12

13 !"# =!!!!!! If the formula produces a negative answer, the negative sign is ignored. PED>1 è the good or service is price elastic PED<1 è the good or service is price inelastic PED=1 è the good or service is unit elastic PED=0 è the good or service is perfectly price inelastic PED= è the good or service is perfectly elastic If a good is price elastic, a small price change affects the demand greatly. A perfectly elastic good will not be demanded at all if the price is changed. The extremes of price elasticity of demand are useful for illustration. However, they are purely hypothetical, as they never exist in reality. If a good is price inelastic, a large price change has little affect on the demand. A perfectly inelastic good s demand is not affected by a price change at all. If a good is unit elastic, a change in price causes a proportional change in quantity. In diagrams, the price elasticity of a good or service changes along the demand curve. N.B. since there is usually no scale indicated on the axis of the diagrams, price elasticities cannot be illustraued in diagrams simply by drawing a less sloping demand curve. However, one demand curve can be shown to be more or less elastic than another that is drawn on the same axis. IF indication of the scale on the axis, elasticities may be illustrated. Often the extremes are used to illustrate different price elasticities. D perfectly inelastic Price D perfectly elastic D unit elastic 0 Quantity 13

14 Cross Elasticities of Demand Is the measurement of the responsiveness of the change of demand for product x caused by a change of the price of product y. Again, XED can be defined using the formula: %!h!"#$!"!"#$%&%'!"#$%!"!!"!""#! %!h!"#$!"!h!!"#$%!"!""#! It is often more convenient to use the below formula for actual calculations.!"# =!!!!!!!!!! If the equation produces a positive value the two goods are said to be substitutes. This means that the goods compete for the same demand. If the equation produces a negative value the two goods are said to be complementary goods, or complements, which means that they are often sold together. The magnitude of the value produced by the equation tells how strong the relationship is. 14

15 Income elasticity of demand YED measures the responsiveness of demand to a change of income. %!h!"#$!!!"#$%&%'!"#$%!"! %!h!"#$!"!"#$%& The above equation will do well as a definition. However, the below equation may be preferred in certain situations. The demand of an inferior good is increased if the income is increased. In contrast, the demand of an inferior good falls if the income is increased. Form the result of the formula it can be told whether a good is normal or inferior. If the value derived at using the formula is positive, the good is a normal good If the value is negative, the good is an inferior good. If the value is greater than 1, i.e. if the change in quantity is greater than the change in income, the good is said to be income elastic. If the YED is between 0 and 1, the good is said to be income inelastic. Note that the sign of YED must be ignored throughout this analysis. 15

SHORT QUESTIONS AND ANSWERS FOR ECO402

SHORT QUESTIONS AND ANSWERS FOR ECO402 Question: How does opportunity cost relate to problem of scarcity? Answer: The problem of scarcity exists because of limited production. Thus, each society must make