Econ 191 Part 1: Introduction to the Economic Approach Microeconomics how individual workers, consumers and firms act and interact in markets -an act is a choice (made under free will) -choice is subject to constraints -fundamental constrain is scarcity leads to trade-offs One of the biggest trade-offs in an economy is efficiency (maximising yield from resources) vs. equality (distributing benefits uniformly among society's members) Basic Building Blocks 1: Choice -Economics is about how individuals make choice (choice theory); sociology is about how individuals don't have choices to make (class theory) BBB2: Scarcity 1) Time constraints 2) Resource constraints 3) Spatial constraints: can't be in two places at once 4) Human constraints: limits to our individual physical and psychological capacities The notion of rational choice Economics relies upon the powerful but limited concept of rational behaviour A rational agent (EcMan) is a decision maker who: 1) can figure out the likely consequences of their actions 2) has a well established set of tastes 3) wants to use their figuring competency to make the choice that will maximise personal utility (best satisfy their tastes) Opportunity Cost The next best alternative foregone when making a decision. If X>Y, choose X, otherwise EcMan is being irrational. Sunk costs Sunk costs have no opportunity cost. The results of past decisions that you cannot change now are called sunk costs Normative vs positive Normative: 'what you should do' Positive: 'this is how people actually behave' Summary of the Economic Problem Need to answer: WHAT to produce, HOW to produce it and FOR WHOM to produce Specialisation Absolute advantage: when you can produce more of a good than another party Comparative advantage: when you have a lower opportunity cost of producing a good than another party, meaning you are RELATIVELY better at producing it; op cost calculated by sacrifice/gain Just because you are better at something doesn't mean you should COMPLETELY specialise. Specialising leads to the production of MORE, which is unambiguously better. However there must be trade for this to be useful, otherwise they will be worse off.
What will be done with the surplus produce depends on the tastes and the bargaining power of the two parties. Product possibility frontier -over time we can invest in more 'capital' -over time we can discover better ways of doing things This increases productivity, and the PPF shifts out Productivity gains from specialisation The statement that there won't be gains from specialisation without comparative advantage relies on the assumption that productivity is constant. In many real world production situations, specialisation will lead to increases in productivity. Gains from division of labour Part 2: Supply and Demand: How markets work Demand Demand as price increases, quantity demanded of a good increases, ceteris paribus, vica versa Quantity demanded the amount of a good/service that customers are willing and able to purchase at a given price Demand schedule table showing the relationship of price and QD Demand curve a graphed line or curve showing the same Market demand the demand by all the consumers of a good/service Demand a movement along the demand curve -change in price of a good will lead to a change in QD -such a change represents a MOVEMENT along the curve Demand shifts in the curve -caused by any change that alters the quantity demanded at each price Caused by: -consumer income (assuming the good is normal, as Y increases, D increases) -prices of related goods -tastes -expectations (e.g. demand would fall if prices are expected to fall in the future) -number of buyers Why does the law of demand hold true? As we consume more of something the 'utility' (the pleasure/satisfaction derived from consuming it) decreases. We call additional units marginal units. The law depends on diminishing marginal utility, and as consume more, we are not willing to pay as much for each marginal unit. Supply The basic idea: if the price of a good is higher, then producing it will be more profitable, so more firms will enter the market, and each will wish to expand production. The law of supply is often interfered with. A change in price leads to a change in the quantity supplied, i.e. movement along the curve. A shift of the curve left or right is due to a change in a determinant of supply OTHER than price.
Non-price factors affecting supply Input prices anything that goes into the production process (e.g. labour, electricity, materials) Technology generally will shift curve to the right Expectations if the prices of inputs is expected to rise, you will purchase them now and increase supply Number of sellers WHY would the supply curve slope upwards? Because additional 'marginal' units of output may cost more to produce, meaning a higher price is needed to justify putting them on the market. This is because after a while, it costs more to produce a unit (e.g. paying workers overtime). Therefore to get that money back (make the same profit), price must increase. Rising marginal costs Rising prices Inflation this does not always occur however... Economies of scale As the size of the business increases, the AVERAGE COST PER UNIT may decrease. At a certain stage, diseconomies may occur. -purchasing/marketing economies -technological -risk-bearing -managerial -financial The price mechanism The market price is found where supply and demand meet; that is Q.d. = Q.s. We know this will MOST LIKELY happen, as both supply and demand are affected by price, and they slope in opposite directions Surplus When P > Ep; therefore Qs > Qd Naturally, suppliers will lower the price to increase sales, moving towards equilibrium Shortage When P < Ep; therefore Qs < Qd Naturally, suppliers should raise the price, moving towards equilibrium Law of supply and demand The claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded into balance. This will happen naturally, by individual suppliers and demanded making the profitable response to the supply/demand inbalance THE INVISIBLE HAND Independent suppliers and demanders can respond in turn to 'mistakes' such that the mistakes get smaller and smaller; the process is mediated by changes in the market clearing price. The market clearing rule: short side wins The tatonnement process diagram on page 17 of Part 2 of coursebook
Essentially, this shows the 'cobweb' effect of initially a price that is too high, which is then dropped, then raised, and dropped, until an equilibrium is found, without a surplus or shortage Market equilibrium In reality, supply and demand are always changing, so equilibrium will never last forever. Equilibrium is broken by a change in either supply and/or demand Three steps to analysing the changes in equilibrium 1)Decide whether the event shifts the supply or demand curve, or both 2)Decide which direction the curve shifts 3)Use the diagram to see how the shift effects Pe and Qe. The affect of price when demand or supply shift If both curves move to the right, then the amount traded unambiguously rises, however the effect on price, we cannot be certain about. S=D is not guaranteed Having demand slope downwards and supply slope upwards is helpful. But 1)it can occur with a downward sloping supply curve 2)it cannot occur if supply and demand do not intersect Elasticity -measures the strength of the relationship of any two variables -one variable has a causal (not casual) effect on the other Price Elasticity of Demand % Q.d./% P Note: the midpoint method can be used, which uses the average of the changing values e.g. Original Q.d. Is 10, new q.d. Is 8; original price is 2.00, new price is 2.20 [10-8/(10+8)/2] / [2.2-2/2.2+2]/2] Inelastic demand Where q.d. Does not respond strongly to a change in price; PED <1 Elastic demand Where q.d. Does strongly respond to a change in price; PED >1 Perfectly inelastic q.d. Does not respond at all to price changes; vertical graph Perfectly elastic q.d. Goes to infinity or zero with any change in price Unit elastic % in Q.d. = % in P Because PED measures the responsiveness of q.d. To price, it is closely related to the demand curve, BUT IT IS NOT THE SAME THING AS SLOPE. This curve is relatively INELASTIC, due to its steep slope.
Halfway along the curve, at the midpoint, the PED is 1. Elastic is above, inelastic is below. Application of PED PED is used to calculate TR, which is price x the quantity Inelastic and TR If PED is inelastic, increase the price to increase TR. Consumers are willing to pay more as the good is a need/necessity. If you have INELASTIC DEMAND, increasing prices will ALWAYS increase profits. Elastic and TR If PED is elastic, lower the price to increase TR. Consumers are price sensitive, and their quantity demanded will increase. [Note: in the long run, PED is MORE elastic, as people are able to find alternatives/substitutes] Income Elasticity of Demand Measures the change in Q.d. in response to a change in incomes. % Q.d./% Y Normal goods regarded as necessities are income inelastic, and have an elasticity of between 0 and 1. Normal goods regarded as luxuries are income elastic, and have an elasticity of greater than 1. Inferior goods have a negative YED.
Cross Price Elasticity of Demand Measures the response of Q.d. Of one good changes when the price of another good changes. % Q.d. of good X/% P of good Y. Substitutes can be used in place of each other, therefore their XED will probably be positive. Complements can be used together, therefore their XED will probably be negative. Price Elasticity of Supply The responsiveness of the quantity supplied to a change in price. % in Qs/% in P [Note, the PED will always be positive for an upward sloping supply curve] What determines the PES: -the ability of sellers to change the amount they produce -time period (time to adjust); for almost every good, supply is more elastic in the long run Applications of Elasticity e.g. Can good news for farming be bad news for farmers? If new crops are found that can increase a farmers yield, this may actually be harmful to them, if supply and demand curves are relatively INELASTIC, leading to a FALL in TR. e.g. Why did OPEC fail to keep the price of oil rise? In the short term, the demand for oil is relatively INELASTIC. However, in the long term it is relatively more elastic as people can look for substitutes Part 3: Firms & The Organisation of Markets Assume a firms single goal is to maximise profits Profit = (PxQ) (ACxQ) or Profit = Q(P-AC) and: 1. we know from the law of demand that P and Q will move in opposite directions 2. But we don't know the relationship between AC and Q; could be positive or negative So we can immediately deduce that profit maximising does not in general mean: 1. maximising profit margins (P-AC) 2. maximising quantity sold (Q) 3. maximising sales revenue (TR) 4. minimising total costs (TC) Costs Costs are a function of output. They can be explicit (cash) or implicit (e.g. opportunity cost) TC = wn (where w is the daily wage rate, and N is the number of employees) The Production Function we link N to Q through the production function: Q = f(n) [we will be implicitly assuming what economists call technical efficiency - meaning the value of Q given by the function is the maximum achievable for each level of N]