he9091 lecture 1 principles of economics
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HE9091 Lecture 1 Principles of EconomicsTRANSCRIPT
HE9091
Principles of Economics
Lecture 1
Introduction
Tan Khay Boon
Email: [email protected]
Office: HSS-04-25
Topics
• Scarcity and Cost-Benefit Principles
• Opportunity Cost and Incentive Principle
• Demand and Supply
• Market Equilibrium and Price Control
• Shifts in Demand and Supply
• Efficiency and Equilibrium Principles
• Reference: FBLC, chapters 1, 3 & 6
The Scarcity Principle
Economics: The study of how people make choices under scarcity and the results of these choices for society.
The Scarcity Principle: People have unlimited wants and limited resources. Having more of one good means having less of another.
Also called No Free-Lunch Principle
The Cost-Benefit Principle
• Take an action if and only if the extra benefits
are at least as great as the extra costs
• Costs and benefits are not just money
Marginal Benefits
Marginal Costs
Applying the Cost – Benefit
Principle
• Assume people are rational
– A rational person has well defined goals and tries to
fulfill those goals as best they can
• Would you walk to town to save $10 on an
item?
– Benefits are clear
– Costs are harder to define
• Hypothetical auction
– Would you walk to town if someone paid you $9?
– If you would walk to town for less than $10, you gain
from buying the item in town
Cost – Benefit Principle
Examples
You clip grocery
coupons but your friend
Naruto does not
You take a taxi on the way to
work but not on the way to
school
At the stadium, you pay extra to buy a soft
drink from the hawkers in the
stands
You skip your regular dental
check-up
Economic Surplus
• The economic surplus of an action is equal
to its benefit minus its costs
Economic Surplus
Total Benefits
Total Costs
Opportunity Cost
• Opportunity cost is the value of what must
be foregone in order to undertake an activity
– Consider explicit and implicit costs
• Examples:
– Give up an hour of babysitting to go to the
movies
– Give up watching TV to walk to town
• Caution: NOT the combined value of all
possible activities
– Opportunity cost considers only your best
alternative
Sunk Cost
– Sunk Costs are costs that are beyond
recovery when a decision is made
– Irrelevant to future decision making
– Only costs that influence a decision are
those that can be avoided by not taking
the decision
– Only benefits that influence a decision are
those that would not occur unless the
action were taken.
Buyers and Sellers
– Cost-Benefit Principle is behind decision making
– Buyers: buy one more unit?
• Only if marginal benefit is at least as great as
marginal cost
– Sellers: sell one more unit?
• Only if marginal benefit (marginal revenue) is at
least as great as marginal cost
– Opportunity Cost also matters
• Buyers: hamburger or pizza?
• Sellers: recycle aluminum or wash dishes?
The Importance of Opportunity
Cost • Harry can divide his time between two
activities:
– Wash dishes for $6 per hour
– Recycle aluminum cans and earn 2¢ per can
• Harry only cares about the income
• How much labor should Harry supply to each
activity?
– Harry should devote an additional hour to
recycling as long as he is earning at least $6 per
hour
Economic Models
• Simplifying assumptions
– Which aspects of the decision are absolutely
essential?
– Which aspects are irrelevant?
• Abstract representation of key relationships
– The Cost-Benefit Principle is a model
• If costs of an action increase, the action is less
likely
• If benefits of an action increase, the action is
more likely
Marginal Analysis Ideas
• Marginal cost is the increase in total cost
from one additional unit of an activity
– Average cost is total cost divided by the number
of units
• Marginal benefit is the increase in total
benefit from one additional unit of an activity
– Average benefit is total benefit divided by the
number of units
Marginal Analysis: NASA
Space Shuttle
# of Launches Total Cost
($B)
0 $0
1 $3
2 $7
3 $12
4 $20
5 $32
If the marginal benefit is $6 billion per launch, how many launches
should NASA make?
Average Cost
($B/launch)
$0
$3
$3.5
$4
$5
$6.4
Marginal Cost
($B)
$3
$4
$5
$8
$12
Normative and Positive
Economics – Normative economic
principle says how
people should behave
• Gas prices are too
high
• Building a space base
on the moon will cost
too much
– Positive economic
principle predicts how
people will behave
• The average price of
gasoline in May 2010
was higher than in
May 2009
• Building a space base
on the moon will cost
more than the shuttle
program
Incentive Principle
Incentives are central to people's choices
Benefits
Actions are more likely to be taken if their
benefits rise
Costs
Actions are less likely to be taken if their
costs rise
Microeconomics and
Macroeconomics Microeconomics studies
choice and its implications
for price and quantity in
individual markets
Sugar
Carpets
House cleaning services
Microeconomics considers
topics such as
Costs of production
Demand for a product
Exchange rates
Macroeconomics studies
the performance of national
economies and the policies
that governments use to try
to improve that performance
Inflation
Unemployment
Growth
Macroeconomics considers
Monetary policy
Deficits
Tax policy
Simultaneous Equations
• Two equations, two unknowns
• Solving the equations gives the values of the
variables where the two equations intersect
– Value of the independent and dependent variables
are the same in each equation
• Example
– Two billing plans for phone service
• How many Mbytes make the two plans cost the
same?
• Plan 1 B = 10 + 0.04 D
• Plan 2 B = 20 + 0.02 D
– Plan 1 has higher per minute price while Plan 2 has
a higher monthly
fee
• Find B and D
for point A
Simultaneous Equations
– Find B when D = 500
B = 10 + 0.04 D
B = 10 + 0.04 (500)
B = $30
OR
B = 20 + 0.02 D
B = 20 + 0.02 (500)
B = $30
Simultaneous Equations
– Plan 1 B = 10 + 0.04 D
– Plan 2 B = 20 + 0.02 D
– Subtract Plan 2 equation from
Plan 1 and solve for D
B = 10 + 0.04 D
– B = – 20 – 0.02 D
0 = – 10 + 0.02 D
D = 500
What, How, and For Whom?
• Every society answers three basic questions
WHAT Which goods will be produced?
How much of each?
HOW Which technology?
Which resources are used?
FOR
WHOM
How are outputs distributed? Need?
Income?
Central Planning versus the Market
Central Planning
• Decisions by
individuals or small
groups
• Agrarian societies
• Government programs
– Sets prices and goals for the
group
• Individual influence is
limited
The Market
• Buyers and sellers
signal wants and costs
• Resources and goods are
allocated accordingly
– Interaction of supply and
demand answer the three
basic questions
Mixed economies use both the market and central planning
Buyers and Sellers in the
Market
• The market for any good consists of all the
buyers and sellers of the good
• Buyers and sellers have different motivations
– Buyers want to benefit from the good
– Sellers want to make a profit
• Market price balances two forces
– Value buyers derive from the good
– Cost to produce one more unit of the good
Demand
• A demand curve
illustrates the quantity
buyers would purchase
at each possible price
• Demand curves have a
negative slope
• Consumers buy less at
higher prices
• Consumers buy more at
lower prices
$4
$2
8 16 Q
P
D
Demand for Donuts
(000s of pieces/day)
Law of Demand
Law of Demand
Consumers buy less of a product
as the price of the product rises
Price and quantity demanded are inversely related
• Cost-Benefit Principle at work
– Do something if the marginal benefits are at least
as great as the marginal costs
• An increase in the market price approaches our
reservation price
– If market price (cost) exceeds the reservation price
(benefit), buy no more
Law of Demand
Demand Slopes Downward
• Buyers value goods differently
– The buyer’s reservation price is the highest price
an individual is willing to pay for a good
• Demand reflects the entire market, not one
consumer
– Lower prices bring more buyers into the market
– Lower prices cause existing buyers to buy more
Income and Substitution Effects
• Buyers buy more at lower prices and buy less at
higher prices
• What happens when price goes up?
– The substitution effect: Buyers switch to
substitutes when price goes up
– The income effect: Buyers' overall purchasing
power goes down
Interpreting the Demand Curve
• Horizontal
interpretation of
demand:
• Given price, how much
will buyers buy?
• At a price of $4, the
quantity demanded is
8,000 slices/day.
$4
$2
8 16 Q
P
D
Demand for Donuts
(000s of pieces/day)
Interpreting the Demand Curve
– Vertical interpretation of
demand:
• Given the quantity to
be sold, what price is
the marginal consumer
willing to pay?
• If 8,000 slices are sold
the marginal consumer
is willing to pay $4 per
slice.
$4
$2
8 16 Q
P
D
Demand for Donuts
(000s of pieces/day)
The Supply Curve
• The supply curve illustrates the quantity of a
good that sellers are willing to offer at each price
• Producers incur costs in order to obtain resources
to produce output and sell to consumers at the
market price to maximize profits
• The Low-Hanging Fruit Principle explains the
upward sloping supply curve
• The seller’s reservation price is the lowest price
the seller would be willing to sell for
– Equal to marginal cost of production
Law of Supply
Law of Supply
Producers supply more of a product
as the price of the product rises
Price and quantity supplied are positively related
Interpreting the Supply Curve
• Horizontal
interpretation of
supply:
• Given price, how much
will suppliers offer?
• At a price of $2,
suppliers are willing to
sell 8,000 pieces/day.
$4
$2
8 16 Q
P S
Supply of Donuts
(000s of pieces/day)
Interpreting the Supply Curve
– Vertical interpretation of
supply:
• Given the quantity to
be sold, what is the
opportunity cost of the
marginal seller?
• If 8,000 pieces are
sold, the marginal cost
of producing the
8,000th piece is $2.
$4
$2
8 16 Q
P S
Supply of Donuts
(000s of pieces/day)
Market Equilibrium
• A system is in equilibrium when there is no
tendency for it to change
• The equilibrium price is the price at which the
supply and demand curves intersect
• The equilibrium quantity is the quantity at
which the supply and demand curves intersect
• The market equilibrium occurs when all buyers
and sellers are satisfied with their respective
quantities at the market price
– At the equilibrium price, quantity supplied equals
quantity demanded
Market Equilibrium
• Quantity supplied
equals quantity
demanded AND
• Price is on supply
and demand curves
• No tendency to
change P or Q
• Buyers are on their
demand curve
• Sellers are on their
supply curve
12 Q
P S
Market for Donuts
(000s of pieces/day)
D
$3
Excess Supply and Excess
Demand Excess Supply
– At $4, 16,000 pieces supplied
and 8,000 slices demanded
Excess Demand
– At $2, 8,000 pieces supplied
16,000 slices demanded
$4
8 16 Q
P S
Market for Donuts
(000s of pieces/day)
D $2
8 16 Q
P S
Market for Donuts
(000s of pieces/day)
D
Surplus
Shortage
Incentive Principle: Excess
Supply at $4 – Each supplier has an
incentive to decrease the
price in order to sell more
– Lower prices decrease the
surplus
– As price decreases:
• the quantity offered for sale
decreases along the supply
curve
• the quantity demanded
increases along the
demand curve
$4
8 16 Q
P S
Market for Donuts
(000s of pieces/day)
D
$3.50 $3
12
Equilibrium
Incentive Principle: Excess
Demand at $2 – Each supplier has an
incentive to increase the
price in order to sell more
– Higher prices decrease the
shortage
– As price increases
• the quantity offered for
sale increases along the
supply curve
• As price increases, the
quantity demanded
decreases along the
demand curve.
$2.50 $2
8 16 Q
P S
Market for Donuts
(000s of pieces/day)
D
$3
12
Equilibrium
Rent Controls Are Price Ceilings
– A price ceiling is a
maximum allowable price,
set by law
– Rent controls set a maximum
price that can be charged for
a given apartment
– If the controlled price is
below equilibrium, then:
• Quantity demanded
increases
• Quantity supplied
decreases
• A shortage results
2 Q
P S
Market for New York City Apartments
(millions of apartments/day)
D
$1,600
$800
3 1
Movement along the Demand
Curve • When price goes up,
quantity demanded
goes down
• When price goes
down, buyers move to
a new, higher
quantity demanded
• A change in quantity
demanded results
from a change in the
price of a good.
$2
$1
8 10 Q
P
D
Demand for Canned Tuna
(000s of cans/day)
Shift in Demand
• If buyers are willing to
buy more at each price,
then demand has
increased
• Move the entire demand
curve to the right
• Change in demand
• If buyers are willing to
buy less at each price,
then demand has
decreased
$2
8 10 Q
P
D
Demand for Canned Tuna
(000s of cans/day)
D'
Causes of Shifts in Demand
• Price of complementary goods
– Tennis courts and tennis balls
• Price of substitute goods
– Internet and overnight delivery are substitutes
• Income: normal or inferior goods?
• Preferences
– Dinosaur toys after Jurassic Park movie
• Number of buyers in the market
• Expectations about the future
Price changes never cause a shift in demand
Movement Along the Supply
Curve • When price goes up,
quantity supplied
goes up
• When price goes up,
sellers move to a
new, higher quantity
supplied
• A change in quantity
supplied results from
a change in the price
of a good.
$4
$2
8 16 Q
P S
Supply of Donuts
(000s of pieces/day)
Shift in Supply
• Supply increases when
sellers are willing to offer
more for sale at each
possible price
• Moves the entire supply
curve to the right
• Supply decreases when
sellers are willing to offer
less for sale at each
possible price
• Moves the entire supply
curve to the left
$2
8 Q
P S
Supply of
Donuts
(000s of pieces/day)
S'
9
$2
8 Q
P S*
Supply of
Tuna
(000s of cans/day)
S
9
Causes of Increase in Supply
• More output, fewer resources Technology
• Decreases costs Input Prices
• More suppliers in the market Number of Suppliers
• Lower prices in the future Expectations
• Lower prices for alternative products Price of Other
Products
Tennis Market
– If rent for tennis court decreases, demand for tennis
balls increases
• Tennis courts and tennis balls are complements
P
Q
Tennis Court Rentals
$7
$10
D
(00s rentals/day)
4 11
$1.40
Tennis Ball Sales P
Q
$1.00
D
(millions of balls/day)
40 58
D'
S
Apartments Near Washington
Subway
• If government wages rise,
demand for apartments
near subway stations
increases
• Demand increases
– Price increases
– Quantity increases
• Demand for a normal
good increases when
income increases
• Demand for an inferior good
increases when income
decreases
Convenient Apartments
P
Q
(units/month)
D' D S
P
P'
Q Q'
Causes of Shifts in Supply
• A change in the price of an input
– Steel for bicycles, skill workers’ wages
• A change in technology
– Desktop publishing and term papers
– Internet distribution of products (e-commerce)
• Weather (agricultural commodities and outdoor
entertainment)
• Number of sellers in the market
• Expectation of future price changes
Price changes never cause a shift in supply
Shifts in Supply: Bicycles
• Costs of production affect the supply of a
product
• Cost of steel for bicycles increases
– Supply decreases
• With no change in demand,
the price of bicycles
increases to $80 and quantity
decreases to 800
(bicycles/month)
$80
800
$60
P S
Supply of Bicycles
1,000
D
S'
600 Q
Shift in Supply: Handmade
Carpets
• Cost of labor used to produce handmade
carpets decreases
– Supply increases
• Demand is constant
• The price of handmade
carpets decreases to
$90,000 per carpet
• Quantity increases to 50
$120
40
$90
Q
P S'
The Market for Handmade Carpets
50
D
S
(carpets/
month)
Supply and Demand Shifts:
Four Rules
An increase in demand will lead to an increase in
both equilibrium price and quantity
Q
P
D D'
S
Q' Q
P
P'
Supply and Demand Shifts:
Four Rules
An decrease in demand will lead to a decrease
in both equilibrium price and quantity
Q
P
D
D'
S
Q' Q
P
P'
Supply and Demand Shifts:
Four Rules An increase in supply will lead to a decrease in the
equilibrium price and an increase in the equilibrium
quantity.
Q
P
D
S
Q' Q
P
P'
S'
Supply and Demand Shifts:
Four Rules An decrease in supply will lead to an increase in
the equilibrium price and a decrease in the
equilibrium quantity.
Q
P
D
S
Q' Q
P
P'
S'
Supply and Demand Both
Change: Tortilla Chips
• Oils used for frying are harmful AND the price of
harvesting equipment decreases
P
rice ($
/ba
g)
Millions of bags per month
P
Q
S
D
P'
Q'
D'
S'
Changes in Supply and Demand
Supply
Demand Increases Decreases
Increases P Depends
Q Increases
P Increases
Q Depends
Decreases P Decreases
Q Depends
P Depends
Q Decreases
Efficiency and Equilibrium
• Markets communicate information effectively
– Value buyers place on the product
– Opportunity cost of producing the product
• Markets maximize the difference between
benefits and costs
• Market outcomes are the best provided that
– The market is in equilibrium AND
– No costs or benefits are shared with the public
Cash on the Table
• Buyer's surplus: buyer's reservation price
minus the market price
• Seller's surplus: market price minus the seller's
reservation price
• Total surplus = buyer's surplus + seller's
surplus
– Total surplus is buyer's reservation price – seller's
reservation price
• No cash on the table when surplus is
maximized
– No opportunity to gain from additional sales or
purchases
Efficiency Principle
• The socially optimal quantity maximizes total
surplus for the economy from producing and
selling a good
– Economic efficiency -- all goods are produced at
their socially optimal level
• Efficiency Principle: equilibrium price and
quantity are efficient if:
– Sellers pay all the costs of production
– Buyers receive all the benefits of their purchase
• Efficiency: marginal cost equals marginal
benefit
– Production is efficient if total surplus is maximized
Equilibrium Principle
• Equilibrium Principle: a market in equilibrium
leaves no unexploited opportunities for
individuals
• Only when the seller pays the full cost of
production and the buyer captures the full
benefit of the good is the market outcome
socially optimal
From Graphs to Equations …
• Sample equations
P = 16 – 2 Qd
is a straight-line demand curve with intercept 16
on the vertical (P) axis and a slope of – 2
P = 4 + 4 Qs
is a straight-line supply curve with intercept 4
and a slope of 4
… To Equilibrium P and Q
• Equilibrium is where P and Q are the same for
demand and supply
– Set the two equations equal to each other (P = P)
and solve for Q (Qs = Qd = Q*)
16 – 2 Q* = 4 + 4 Q*
6 Q* = 12
Q* = 2
• Use either the supply or demand curve and Q* =
2 to find price P = 16 – 2 Q*
P = $12
P = 4 + 4 Q*
P = $12