Economics summary principle of economics

Economics summary principle of economics CHAPTER 1: Thinking like an economist. Economics: The study of how people make choices under conditions of scarcity and of the results of those choices for society. Scarcity Principle (no-free-lunch principle): Although we have boundless needs and wants, the resources available to us are limited. So having more of one good thing usually means having less of another. Hence the cliché, “there ain’t no such thing as a free lunch”, sometimes reduced to the acronym TANSTAAFL. Cost-Benefit Principle: An individual (or a firm, or society) should take an action if , and only if, the extra benefits from taking the action are at least as great as the extra costs. Applying the cost-benefit principle: Rational Person: S.o. with well-defined goals who tries to fulfil those goals as best as he/she can. Economic Surplus: The economic surplus from taking any action is the benefit of taking that action minus its cost. Opportunity Cost: The opportunity cost of an activity is the value of the next-best alternative that must be forgone in order to undertake the activity. Recap: Cost-Benefit analysis Scarcity is a basic fact of economic life. Having more of one good usually implies having less of another good (Scarcity Principle)  Taking one good instead of another which could have been bought. The good which was not bought is called opportunity cost. The cost-benefit principle states that an individual should only take an action, and only if, the benefits from taking the action is at least as great as the cost of taking it. The difference between the cost and the benefit is the economic surplus. Four important pitfalls: 1) Measuring costs and benefits as proportions rather than absolute values. e.g.: saving 100€ on a 2000€ good is equal to saving 100€ on a 10000€ good. 2) Ignoring opportunity costs. e.g.: ignoring the value of the next best alternative which has to be forgone. 3) Failure to ignore sunk costs. Sunk cost: a cost that is beyond recovery at the moment a decision must be made. e.g.: if a ticket of 100€ is already bought, the sunk cost is 100€ and should not influence the decision whether to use the ticket or not! 4) Failure to understand the average-marginal distinction. The question is often to what extent an activity should be pursued rather than if it should be pursued at all. Therefore the focus should be on the benefit and cost of an additional unit of activity. Marginal cost: the increase in total cost that results from carrying out one additional unit of an activity. Marginal benefit: the increase in total benefit that results from carrying out one additional unit of an activity. Average cost: the total cost of undertaking n units of an activity divided by n. Average benefit: the total benefit of undertaking n units of an activity divided by n. The cost-benefit principle tells us that the level of an activity should be increased if, and only if, its marginal benefit exceeds its marginal cost! The not-all-costs-and-benefits-matter-equally Principle: Some costs and benefits (for example, opportunity costs and marginal costs and benefits) matter in making decisions, whereas others (for example, sunk costs and average costs and benefits) do not. ECONOMICS: MICRO AND MACRO. Microeconomics: the study of individual choice under scarcity and its implications for the behaviour of prices and quantities in individual markets. Macroeconomics: the study of the performance of national economies and the policies that governments use to try to improve that performance. CHAPTER 2: Comparative advantage: the basis for exchange. Absolute advantage: One person has an absolute advantage over another if an hour spent in performing a task earns more than the other person can earn in an hour at the task. Comparative advantage: One person has a comparative advantage over another in a task if his or her opportunity cost of performing a task is lower than the other person’s opportunity cost. The principle of comparative advantage: Everyone does best when each person, or each country, concentrates on the activities for which his or her opportunity cost is lower. RECAP: Exchange and opportunity cost. Gains from exchange are possible if trading partners have comparative advantages in producing different goods and services. You have a comparative advantage in producing, say, web pages, if your opportunity cost of producing a web page – measured in terms of other production opportunities forgone – is smaller than the corresponding opportunity costs of your trading partners. Maximum production is achieved if each person specialises in producing the good or service in which he or she has the lowest opportunity cost (the principle of comparative advantage). Comparative advantage makes specialisation worthwhile even if one trading partner is more productive than others, in absolute terms, in every activity. Comparative advantage and production possibilities. Comparative advantage and specialisation allow an economy to produce more than if each person tries to produce a little of everything. The production possibility curve: A graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good. E.g.: a PPC for a one-person economy Attainable point: any combination of goods that can be produced using currently available resources. Unattainable point: any point above the line, so therefore unattainable in terms of the available resources. Inefficient point: any combination of goods for which currently available resources enable an increase in the production of one good without a reduction in the production of the other Efficient point: Any combination of goods for which currently available resources do not allow an increase in the production of one good without a reduction in the production of the other. Points that lie either along the PPC or within it are attainable. Whereas the one inside it is inefficient. The ones on the curve are said to be efficient. Outside the curve, the points are unattainable! A PPC for a many-person economy:  Bow shaped instead of a straight line. The Principle of Increasing Opportunity cost (called the low-hanging-fruit principle): In expanding the production of any good, first employ those resources with the lowest opportunity cost, and only afterwards turn to resources with higher opportunity costs. RECAP: Comparative advantage and production possibilities. For an economy that produces two goods, the PPC describes the maximum amount of one good that can be produced for every possible level of production of the other god. Attainable points are those that lei on or within the curve, and efficient points are those that lie along the curve. The slope of the PPC tells us the opportunity cost of producing an additional unit of the food measured along the horizontal axis. The Principle of Increasing Opportunity Cost, or the Low-Hanging-Fruit Principle, tells us that the slope of the PPC becomes steeper as we move downward to the right. The greater the differences among individual opportunity costs, the more bow-shaped the PPC, the greater will be the potential gains from specialisation. Factors that shift the Production Possibility Curve (PPC): Economic Growth: An outward shift in the Economy’s PPC: Increases in productive resources (such as labour and capital equipment) or improvements in knowledge and technology cause the PPC to shift outward. They are the main factors that drive economic growth. Other reasons for economic growth:  population growth  knowledge and technology  specialisation increases productivity! Why have some countries been slow to specialise? The reason for this is the population density! In some regions in the past the markets were simply too small and fragmented. A low population density was a definite obstacle to gains from specialisation. Other reasons for a slow specialisation or no specialisation at all are, for example, laws and customs of regions. In addition, specialisation is limited by the size of the market! Can there be too much specialisation? Yes. Specialisation also entails costs! It needs to be considered whether the extra goods produced by specialisation are too costly. However, a failure of specialisation entails costs as well. Comparative advantage and international trade. RECAP: Comparative advantage and international trade. Nations, like individuals, can benefit from exchange, even though one trading partner may be more productive than the other in absolute terms. The greater the difference between domestic opportunity costs and world opportunity costs, the more a nation benefits from exchange with other nations. But expansion in exchange does not guarantee that each individual citizen will do better. In particular, unskilled workers in high-wage countries may be hurt in the short run by the reduction of barriers to trade with low-wage nations. CHAPTER 3: Supply and Demand: An Introduction Central Planning: the allocation of economic resources is determined by a political and administrative mechanism that gathers information as to technology, resource availability and end demands for goods and services. Capitalist economies/ Free-Market economies: In these economies or markets people decide for themselves which careers to pursue and which products to produce or buy. In fact, there are no pure free-market economies today! Mixed economies: Goods and services are allocated by a combination of free markets, regulation and other forms of collective control. However, these systems are referred to as market economies! Buyers and Sellers in a market. Market: The market for any good consists of all buyers or sellers of that good. Demand curve: A schedule or graph showing the quantity of a good that buyers wish to buy at each price. The demand curve for any good is a downward- sloping function of its price. x-axis: quantity demanded; y-axis: price Substitution effect: the change in the quantity demanded of a good that results because buyers switch to substitutes when the price of the good changes. (i.e. when pizza prices rise, people buy sandwiches for example!) Income effect: the change in the quantity demanded of a good that results because of a change in real income of purchasers arising from the price change. (i.e. when prices increase less people can afford a good!) Buyer’s reservation price: the largest euro amount the buyer would be willing to pay for a good. Supply curve: a curve or schedule showing the quantity of a good that sellers wish to sell at each price. This curve is upward-sloping. Seller’s reservation price: the smallest money amount for which a seller would be willing to sell an additional unit, generally equal to marginal cost. RECAP: Demand and supply curves: The market for a good consists of the actual and potential buyers and sellers of that good. For any given price, the demand curve shows the quantity that demanders would be willing to buy, and the supply curve shows the quantity that suppliers of the good would be willing to sell. Suppliers are willing to sell more at higher prices and demanders are willing to buy less at higher prices. Market Equilibrium Equilibrium: a system is in equilibrium when there is no tendency for it to change. Equilibrium Price and Equilibrium Quantity: The values of price and quantity for which quantity supplied and quantity demanded are equal. Market Equilibrium: It occurs in a market when all buyers and sellers are satisfied with their respective quantities at the market price. It is the intersection point of the supply and demand curve. Excess supply: The amount by which quantity supplied exceeds quantity demanded when the price of a good exceeds the equilibrium price. Excess demand: The amount by which quantity demanded exceeds quantity supplied when the price of a good lies below the equilibrium price. Price controls Price ceiling: A maximum allowable price, specified by law. RECAP Market Equilibrium: Market Equilibrium, the situation in which all buyers and sellers are satisfied with their respective quantities at the market price, occurs at the intersection of the supply and the demand curve. The corresponding price and quantity are called the equilibrium price and equilibrium quantity. Unless prevented by regulation, prices and quantities are driven toward their equilibrium values by the actions of buyers and sellers. If the price is initially too high, so that there is excess supply, frustrated sellers will cut their prices in order to sell more. If the price is initially too low, so that there is excess demand, competition among buyers drive the price upward. This process continues until the equilibrium is reached. Predicting and explaining changes in prices and quantities. Change in the quantity demanded: a movement along the demand curve that occurs in response to a change in price. Change in demand: a shift of the entire demand curve. Change in the quantity supplied: a movement along the supply curve that occurs in response to a change in price. Change in supply: a shift of the entire supply curve. Shifts in demand. Complements: two goods are complements in consumption if an increase in the price of one causes a leftward shift in the demand curve for the other (or if a decrease causes a rightward shift.) Substitutes: two goods are substitutes in consumption if an increase in the price of one causes a rightward shift in the demand curve for the other (or if a decrease causes a leftward shift) Normal good: one whose demand curve shifts rightward when the incomes of buyers increase and leftward when the incomes of buyers decrease. Inferior good: one whose demand curve shifts leftward when the incomes of buyers increase and rightward when the incomes of buyers decrease. Shifts in the supply curve. Any shifts in the supply curve will result in a new equilibrium quantity and price, just as any shifts in the demand curve. RECAP Factors that shift supply & demand.  Factors that cause an increase (rightward or upward shift) in demand: 1. a decrease in the price of complements to the good or service. 2. an increase in the price of substitutes for the good or service. 3. an increase in income (for a normal good) 4. an increased preference by demanders for the good or service. 5. an increase in the population of potential buyers- 6. an expectation of higher prices in the future.  Factors that cause an increase (rightward or downward shift) in supply: 1. a decrease in the cost of materials, labour or other inputs used in the production of the good or service. 2. an improvement in technology that reduces the cost of producing the good or service. 3. an improvement in the weather (especially for agricultural products). 4. an increase in the number of suppliers 5. an expectation of lower prices in the future. Markets and social welfare. Buyer’s surplus: the difference between the buyer’s reservation price and the price he or she actually pays. Seller’s surplus: the difference between the price received by the seller and his or her reservation price. Total surplus: the difference between the buyer’s reservation price and the seller’s reservation price. (i.e. the sum of the buyer’s surplus and the seller’s surplus) “Cash on the table”: economic metaphor for unexploited gains from exchange. Smart for one, dumb for all. Socially optimal quantity: The quantity of a good that results in the maximum possible economic surplus from producing and consuming the good. Economic efficiency: (also called efficiency) occurs when all goods and services are produced and consumed at their respective socially optimal levels. The efficiency principle: Efficiency is an important social goal, because when the economic “pie” grows larger, everyone can have a larger slice. RECAP Markets and social welfare. When the supply and demand curves for a good reflect all significant costs and benefits associated with the production and consumption of that good, the market equilibrium price will guide people to produce and consume the quantity of the good that results in the largest possible economic surplus. CHAPTER 4: Elasticity. PRICE ELASTICITY OF DEMAND: Price elasticity defined. Price elasticity of demand: percentage change in quantity demanded that results from a 1 per cent change in price.  Basically, it is a measure of the responsiveness of the quantity demanded of that good to changes in its price. Calculus: percentage change in consumption = price elasticity of demand. Percentage change in price Elastic: demand is elastic with respect to price if the price elasticity of demand is greater than 1. a change in price results in a proportionally higher change in consumption. Inelastic: demand is inelastic with respect to price if the price elasticity of demand is less than 1. A change in prices does affect consumption, but not too much! Unit elastic: demand is unit elastic with respect to price if the price elasticity of demand equal 1. the percentage change in price is equal to the one in consumption. The negative sign which is always there, since price changes are always in the opposite direction from changes in quantity demanded, is dropped! Determinants of price elasticity of demand.