Economics

The study of how human beings coordinate their wants and

desires, given the decision-making mechanisms, social customs, and political realities of the society.

Unlimited wants

Limited resources to satisfy wants

Choose between alternatives

Economic reasoning focuses on the impact of marginal changes.

Decisions will be based on marginal costs

-the cost of buying or making one more unit

and marginal benefits (utility).

- The increase in satisfaction from buying or making one more unit

don’t necessarily consider sunk costs.

MB > MC Do it!

MC > MB Don’t do it!

a. Someone must give up something if we are to have more scarce goods.

b. The highest valued alternative that must be sacrificed is the opportunity cost of the choice.

The use of scarce resources to produce a good is always costly.

What must be given up to get one more unit of another good or

service

This cla

ss?

the price mechanism that guides our actions in a market. The invisible hand is an example of a market force.

• If there is a shortage, prices rise• If there is a surplus, prices fall

a. InductiveMethods

Use facts to develop a modelTake a survey and study the results

b. DeductiveSee if the facts support a hypothesisStart with a theory and see if facts support it

c. Abduction the combination of deduction and induction

Predicting BehaviorPositive Economic Statements

- relationships that can be tested

- The class is half full

- Unemployment is 6%

- if incomes rise people spend money

Normative Economic Statements

- statements about “what should be” or make a value judgment

- It is too hot

- Unemployment should be around 4%

- we should raise the minimum wage.

Art of Economics

- application of knowledge learned in positive economics to the achievement of goals determined in normative economics.

2. Inverse Relationship - Graph slopes down from left to

right

1. Direct Relationship - Graph slopes up from left to right

Economic graphs

3. Slope Rise Run

The U.S. Economy in Historical Perspective

The U.S. economic system is a market economy based on private property and the markets in which individuals decide how, what, and for whom to produce

• Markets work through a system of rewards and payments

• Individuals are free to do whatever they want as long as it is legal

• Fluctuations in prices play a central role in coordinating individuals’ wants in a market economy Most economists believe the market

is a good way to coordinate economic activity

Capitalism and Socialism• Capitalism is an economic system based on the

market in which the ownership of the means of production resides with a small group of individuals (called capitalists)

• Socialism is an economic system based on individuals’ goodwill towards others, not on their own self-interest, and in which, in principle, society decides what, how, and for whom to produce

3-13

Evolving Economic SystemsFeudalism is an economic system based on tradition and

dominated the Western world from the 8th to the 15th century

Mercantilism is an economic system in which the government controls economic activity by doling out the

rights to undertake economic activities and was dominant until the 18th century

During the Industrial Revolution, technology and machines rapidly modernized industrial production

Capitalism

Dividends

Interest

Proprietor’s Income

Rental Income

Transfer Payments

Wages and Salaries

1.7

4.9

8.4

11.1

13.4

64.7

Source of income %

Social Security

-4.3

Savings

Spending

Taxes

84

15.2

1.9

Services

Durable Goods

Non-durable Goods

59

29

12

proprietorship

partnership

corporation

72.2

7.7

20.1

4.8

7.9

87.3

Type Number

Revenue

Business: Forms of Business

Advantages Disadvantages

Proprietorship

• Minimum bureaucratic hassle

• Direct control by owner

• Limited ability to get funds• Unlimited personal liability

Partnership• Ability to share work and

risk• Relatively easy to form

• Limited ability to get funds• Unlimited personal liability (even for a partner's blunder)

Corporation

• No personal liability• Increasing ability to get funds

• Ability to avoid personal income taxes

• Legal hassle to organize• Possible double taxation of income

• Monitoring problems

Government

1. An actor who collects money in taxes and spends that money on projects, such as defense and education

The government plays two general roles in the economy:

3-20

Government2. A referee who sets the rules that determine

relations between businesses and householdsa. Provide a stable set of institutions and

rules.b. Promote effective and workable

competition.c. Correct for externalities.

e. Provide public goods.

f. Adjust for undesirable market results.

-Enforce contracts and protect property rights

-restrict and regulate monopolies

-pollution

-Enforce contracts and protect property rights

-Employment Act of 1946

-drug busts

d. Ensure economic stability and growth.

HouseholdsBusinesses

Product Markets

Factor Markets

Resources

Payments $$

Goods and

Services

Business Taxes

Goods and

Services

Income Taxes

Paym

en

ts an

d L

eg

al

Reso

urce

sP

aym

en

ts

Good

s an

d

Serv

ices

Selling Quantity Price Demanded

$ 3$ 2$ 1

$ 410

254060

15$ 5

Price

Quantity

$6

$5

$4

$3

$2

$1

10 20 30 40 50 600

Demand

Downsloping left

-Plot the pointsGraphing:

-Connect the dots

to right

Demand

Shifts in Demand versus Movements Along a Demand

CurveQuantity demanded – is a specific amount that will be demanded per unit of time at a specific price, other things constant

• A change in price changes quantity demanded

• A change in price causes a movement along the demand curve

Demand refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant

1

Why the curve shifts

2345

Consumer TastesPrice of Other Goods

Society’s Income

Number of Consumers

Consumer ExpectationsTaxes and Subsidies

6

Selling Quantity Price Supplied

$ 3$ 2$ 1

$ 460

251510

40$ 5

Price

Quantity

$6

$5

$4

$3

$2

$1

10 20 30 40 50 600

Upsloping right

-Plot the pointsGraphing:

-Connect the dots

to left

Supply

Selling Quantity Price Demanded Supplied

$ 3$ 2$ 1

$ 410

254060

15$ 5 60

251510

40$ 3 25 25

Price

Quantity

$6

$5

$4

$3

$2

$1

10 20 30 40 50 600

D

-Plot DemandGraphing:

-Plot Supply

D

S

S

1 Resource PricesWhy the curve shifts

2 Changes in Technology3 Prices of other goodsTaxes and Subsidies

45 Number of

Producers

Economic Examples1. Cyclone Larry in Australia

•Destroyed 80% of the banana crop.•Prices went from $1.00 to $2.00 per pound•Supply or Demand problem??

BananaMarket

Quantity

$2.00

DR

S1

Price

Q1Q2

S2

$1.00

Sales of SUVs in the U.S.

P0

Q1

P1

Increasing gas costs causes the demand curve

to shift left

Average price fell 10%

Price for SUVs fell

from P0 to P1 where

Q demanded = Q supplied

S0

D0

P

QQ0

SUVs

D1

Supply or Demand problem?

Coffee Beans• fell from $2.00/pound in 1997 to $.50 in 2002

Supply or Demand problem?

Price

Coffee BeanMarket

Q1

Dc

Q2

S1

Quantity

S2

$2.00

$0.50

New growing techniques and the entry of new growers shifted the supply curve.

Increase in the Demand for Foreign Exchange

0.20

Q1 Q2

Exchange rate($ per quetzal)

Quantity of quetzal exchange

S

D1

U.S. sales to

Guatemala

U.S. purchasesfrom Guatemala

D20.10

• Beginning equilibrium exchange rate: (10 cents = 1quetzal).

• An increase in American demand for Guatemalan coffee will also increase the demand for quetzals

• Equilibrium occurs where the new demand for quetzals D2 just equals the supply S – at $.20 per quetzal with Q2 > Q1 quetzals clearing the market.

• It stops the price from rising to the equilibrium level.

• Example: rent control• The direct effect of a price ceiling is a shortage:

quantity demanded exceeds quantity supplied.

1. Price Ceilings• Price ceiling is a legally established maximum price that sellers

may charge.

• Price floor is a legally established minimum price that buyers must pay.

• It stops the price from dropping down to equilibrium level.

• Example: minimum wage• The direct effect of a price floor above the equilibrium price is

a surplus: quantity supplied exceeds quantity demanded.

2. Price Floors

Excise Taxes

• An excise tax is a tax that is levied on a specific good

• A tariff is an excise tax on an imported good

• The result of taxes and tariffs is an increase in equilibrium prices and reduce equilibrium quantities

• Government impacts markets through taxation

5-41

The price of boats rises by less than the tax to

$70,000

The Effect of an Excise Tax

S0

D0

P

Q

$65,000

510420

The supply curve shifts up by the amount of the tax

Government imposes a $10,000 luxury tax on the

suppliers of boatsS1

Tax = $10,000

Luxury Boats

$60,000

$70,000

Quantity Restrictions• Government regulates markets with licenses,

which limit entry into a market

• Many professions require licenses, such as doctors, financial planners, cosmetologists, electricians, or taxi cab drivers

• The results of limited number of licenses in a market are increases in wages and an increases in the price of obtaining the license

5-43

The Effect of a Quantity Restriction

QR

D0

12,000

When the demand for taxi services increased, because

the number of taxi licenses was limited, wages increased

Successful lobbying by taxi cab drivers in NYC resulted in quantity

restrictions (medallions)

NYC Taxi Drivers

$15

P(wage)

Q(of drivers)

D1

Application: The Effect of a Quantity Restriction

QR

D0

12,000

The demand for taxi medallions also increased

because wages were increasing. But because the number of taxi licenses was

limited, the price of a medallion also increased

NYC Taxis Medallions

$400,000

P

Q(of medallions)

D1Initial Fee

Third-Party-Payer Markets• In third-party-payer markets, the person who receives

the good differs from the person paying for the good

• Equilibrium quantity and total spending can be much higher in third-party-payer markets

• Under a third-party-payer system, the person who chooses how much to purchase doesn’t pay the entire cost

• Goods from a third-party-payer system will be rationed through social and political means

5-46

Third-Party-Payer Markets

D0

10

Health Care

$25

P

Q

$45

$5

S0

18

The consumer pays the entire cost

Total expenditures for 18 units of health care

With a co-payment of $5, consumers demand 18 unitsSellers require $45 per unit for that quantity

…are greater than when…

Thinking Like a Modern Economist

Economics is what economists do.

— Jacob Viner

CHAPTER

6

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Teach a parrot the words ‘supply’ and ‘demand’ and you have an economist

Thomas Carlyle

Economic Models• Mathematical e = mc2

• more often use more of an inductive, as opposed to deductive, approach

• or heuristic

expressed informally in wordsCharacteristic

s

Behavioral vs Traditional Economics

• Traditional –more reliance on relatively simple algebraic or graphical models such as the supply and demand model

-provide simple and clear results, which can highlight issues that behavioral models cannot

Behavioral vs Traditional Economics

• Behavioral - use a broader set of building blocks than rationality and self-interest

• Act with enlightened self-interest people care about other people as well as themselves

• People behave purposefully - reflecting reasoned but not necessarily rational judgment

• Seem to use real-life situations to explain and illustrate economic concepts

Empirical Work in Modern Economics

• Modern economics is highly empirical• Both traditional and modern behavioral

economic building blocks rely on experiments and statistical analysis of real world observations

• Econometrics is the statistical analysis of economic data

• An empirical model is a model that statistically discovers a pattern in the data

Modern Traditional and Behavioral Economists

Earlier Economics

Modern Economics

Modern Behavioral Economists

Modern Traditional Economists

AssumptionsRationalitySelf-Interest

Purposeful behaviorEnlightened self-interest

RationalitySelf-Interest

Approach Deduction

Induction and deduction: emphasis on experimental economics and on empirical models

Induction and deduction: emphasis empirical models

Types of Models

Simple S/D models

All types including complex mathematical models and ACE models

All types including complex mathematical models and ACE models

the responsiveness of the amount purchased to a change in price.

Price Elasticityof demand =

% Q

% P=

% Change in quantity demanded% Change in Price

- or put more simply -

=

PED > 1 Elastic < 1 Inelastic

= 1 Unit Elastic

)()(

0

10

0

10

P

PP

Q

QQ =

)()(

0 1

0

0

10

P PP

Q

QQ

X

Quan 1

2

3

4

5

6

7

8

Price 8

7

6

5

4

3

2

1

Elasticity

___

___

___

___

___

___

___

Total Revenue

___

___

___

___

___

___

___

___

=

=

=

=

=

=

=

X

X

X

X

X

X

X

X

(b)

Price

Quantity/time

(a)

Price

Quantity/time

Mythicaldemandcurve

• Perfectly inelastic: An increase in Price

results in no change in Quantity

Different Elasticities

• Relatively inelastic: A percent increase in Price

results in a smaller % reduction in Quantity

Demand for Cigarettes

(c)

Price

Quantity/time

• Unitary elasticity: The percent change in

quantity demanded due to an increase in price is equal to

the % change in price.

Demand curve of unitary elasticity

= 1

(d)

Price

Quantity/time

• Relatively elastic: A % increase in Price

leads to a larger % reduction in Quantity.

Elasticity of Demand

(e)

Price

Quantity/time

• Perfectly elastic: Consumers will buy all of Farmer Hollings’s wheat at the market price, but none

will be sold above the market price.

Demand for Granny Smith Apples

Demand for Farmer Hollings’s wheat

2. Necessity vs Luxury

What affects Elasticity???

3. Proportion of Income

1. Available Substitutes

4. Time to shop around

a. Market Period

What affects Supply Elasticity???

b. Short Run

1. Time

c. Long Run

Income Elasticity• the responsiveness of a product’s

demand to a change in income.

Income Elasticityof demand =

% Change in quantity demanded

% Change in Income

• A normal good has a positive income elasticity of demand.– As income increases, the demand

for normal goods increases.• Goods with a negative income

elasticity are inferior goods.– As income expands, the demand

for inferior goods will decline.

Cross Price Elasticity• the responsiveness of a product’s

demand to a change in the price of another good.

Cross Price Elasticity =

% Change in Qx

% Change in Py

• A complement has a negative cross price elasticity.

– As Py increases, the demand for Y decreases, and demand for goods that are consumed with Y also decreases.

• A substitute has a positive cross price elasticity– As Py increases, the demand for Y decreases,

and demand for goods that can be consumed instead of Y also decreases.

Consumer SurplusThe total difference between what a consumer is willing to pay and how much they actually have to pay.

Producer SurplusThe total difference between what a supplier is willing to provide a good or service and how much they actually get for it.

S

D

P

Q

Consumer surplus = area of red triangle =

½($5)(5) = $12.5

Producer surplus = area of green triangle =

½($5)(5) = $12.5

Producer and Consumer Surplus

The combination of producer and consumer surplus is maximized at

market equilibrium

CS

PS

$10987654321

0 1 2 3 4 5 6 7 8

8-64

The Burden of a Tax

Tax Incidence

• Who pays a tax is called the incidence.

BuyerSeller

Price

# of used carsper month(in thousands)

D

500 750

$6,400

S plus tax

$7,000

$7,400

S

$1000 tax

Impact of a Tax Imposed on Sellers• If in the used car market a price

of $7,000 would bring the quantity of used cars demanded

into balance with the quantity supplied.

• When a $1,000 tax is imposed on sellers of used cars, the supply curve shifts vertically by the amount of the tax.• The new price for used cars is $7,400 …

• Consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden. • Sellers end up receiving $6,400 (after taxes) instead of $7000 and bear $600 of the tax burden.

sellers netting $6,400 ($7,400 - $1000 tax).

Price

# of used carsper month(in thousands)

D

500 750

$6,400

$7,000

$7,400

S

$1000 tax

Impact of a Tax Imposed on Buyers

• In the same used car market:

• When a $1,000 tax is imposed on buyers of used cars, the demand curve shifts vertically by the amount of the tax.• The new price for used cars is $6,400 …

• Consumers end up paying $7,400 (after taxes) instead of $7,000 and bear $400 of the tax burden. • Sellers end up receiving $6,400

instead of $7000 and bear $600

of the tax burden.

buyers then pay taxes of $1000 making the total $7,400.

D minus tax

• The actual burden of a tax depends on the elasticity of supply and demand.

• As supply becomes more inelastic, then more of the burden will fall on sellers.

• As demand becomes more inelastic, then more of the burden will fall on buyers.

Elasticity and Incidence of a Tax

ED ES

ED + ES ED + ES

110

D

Luxury boatmarket

194

80

Gasoline

market

S

$1.60

$1.50$1.45

Quantity(thousands of boats)

Quantity(millions of gallons)

Price

Price(thousand $)

Tax Burden and Elasticity

90

100

5 10 15 20

D

S plus tax

200

$1.55

$1.65S

S plus tax• Consider the market for Gasoline and Luxury Boats individually.

• In the gas market, the demand is relatively more inelastic than its supply; hence, buyers bear a larger share of the burden of the tax.

• In the luxury boats market, the supply curve is relatively more inelastic than its demand; hence, sellers bear a larger share of the tax burden.

• We begin in equilibrium.

• If we impose a $.20 tax on gasoline suppliers, the supply curve moves vertically the amount of the tax. Price goes up $.15 and output falls by 6 million gallons per week.

• If we impose a $25K tax on Luxury Boat suppliers, the supply curve moves vertically the amount of the tax. Price goes up by $5K and output falls by 5 thousand units.

S

D

P

Q

P0

Q0

A price ceiling transfers surplus from producers to consumers,

generates deadweight loss, and reduces equilibrium quantity

Q1

Price ceilingP1

Shortage

• An effective price ceiling is a government set price below the market equilibrium price

• It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation

S

D

P

Q

P0

Q0

A price floor transfers surplus from consumers to producers,

generates deadweight loss, and reduces equilibrium quantity

Q1

Price floorP1

Surplus

• An effective price floor is a government set price above the market equilibrium

• It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers

The Difference Between Taxes and Price Controls

• Taxes leave people free to choose how much to supply and consume as long as they pay the tax

• Price ceilings create shortages and taxes do not

• Shortages may also create black markets

Rent Seeking, Politics, and Elasticities

• Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus

• Lobbying for price controls, which transfer surplus from one group to another, is an example of rent-seeking behavior

• Public choice economists argue that when all rent seeking and tax consequences are netted out, there is often not a net gain to the public

• The possibility of transferring surplus from one set of individuals to another causes people to spend time and resources on doing so.

A

C

B

Inelastic Demand and Incentives to Restrict Supply

S0

D

P

Q

S1

P0

P1

Q0Q1

Revenue gained When demand is

relatively inelastic, suppliers have incentive

to restrict quantity to increase total revenue

Revenue lost

Inelastic Supplies and Incentives to Restrict Prices

• When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls

• When supply is inelastic, consumers have incentives to restrict prices

• Rent control in New York City is an example

Application: Price Floors and Elasticity

S

D

P

Q

P0

P1

S

D

P

Q

P0

Q0Q1

The surplus created by a price floor is larger if demand and supply are elastic

Q0Q1

Surplus

Price floor

Surplus

P1