BUSS504 Lecture Notes PDF

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Week 1 – Birds Eye View of the EconomyMacroeconomics = the study of the whole economy of a country or region Microeconomics = the study of household and firm decisionsEconomic Groups: the same person can be from multiple groups Households: what to consume, how much to save vs spend, how much to work...

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Week 1 – Birds Eye View of the Economy Macroeconomics = the study of the whole economy of a country or region Microeconomics = the study of household and firm decisions Economic Groups: the same person can be from multiple groups Households: what to consume, how much to save vs spend, how much to work - buy and consume outputs - provide factors of production that firms use to produce outputs eg. Labour - workers, Land - landlords, Capital – shareholders Firms: what to produce, how to produce, what inputs or technology to use, how to finance - produce and sell outputs to households - pay households for the “factors of production” eg. wages to workers, rent to landlord, dividends to shareholders Government: creates the legal environment in which transactions between households and firms take place - decides which public services to provide and how to fund them eg. police, court system, education, medical services etc. - trade-offs such as higher taxes reduce private consumption, borrowing now creates liabilities for future tax payers - The Treasury: sources of funds eg. taxes paid by households and firms, borrowing funds by issuing government bonds (Kiwibonds) Fiscal Policy: decisions that determine the government budget, including the amount & composition of expenditure & revenue New Zealand Commerce Commission: enforces fair trading laws between consumers and firms (Fair Trading Act), enforces competition between firms (Commerce Act), regulates industries which are usually monopolies: electricity lines, telecom, dairy, airports Consumer Guarantees Act: sets minimum guarantees for all goods & services, allows repairs, replacements and refunds for faulty goods eg. match product description, fit for purpose, acceptable quality The New Zealand Reserve Bank: not part of the elected government, statutory independence - issues currency: notes & coins, currencies make buying and selling easier as opposed to trade - supervises the banking system of commercial banks, protects depositors - conducts monetary policy which controls the total amount of money in the economy, aiming to maintain price stability and the macro-environment (low inflation rate 13% per year) - sets The Official Cash Rate (OCR) which is the interest rate that influences all other interest rates (the wholesale rate for borrowing or lending) - GDP (Gross Domestic Product) = measures the total output in the economy and the economic wellbeing, GDP per capita = GDP/population eg. primary 8%, secondary/manufacturing 22% and tertiary/services 70% industries

Markets: the relationship between households and firms where both groups meet and transact (buy & sell) - markets for final goods and services (ready for consumption) eg. supermarket, shopping mall, online retail, restaurants, services etc. - markets for factors of production eg. job market, commercial properties, stock exchange Note: households and firms have to make these decisions because of scarcity (limited resources: time, money/income, physical resources) Scarcity Principle = the gap between limited resources and unlimited wants, having more of one thing means having less of another – scarcity leads to a trade off eg. Households: buy a car or save for a house, Firms: hire more workers or buy more machines, Government: annual budget decisions

Week 2 – Thinking Like an Economist Cost-Benefit Principle = an action should be taken if the extra benefit is at least as big as the extra cost (rational decision making), benefits and costs are not only expressed in dollars, economic decision maker should choose the option that maximises surplus - benefit vs cost = incentive - total benefit – total cost = economic surplus Economic Models: abstract representations of key variables and their relationships - models are not the same thing as the real world, they are a guideline but do not capture all the variables of the real world - models can help predict outcomes eg. cost-benefit principle, we know: if the cost increases  likelihood of the decision decrease / if benefit increases  decision is more likely to be made  The Incentive Principle Pitfall #1: measure cost-benefit proportion, rather than the absolute amount eg. Would you walk 30minutes to save $14 out of a $30 purchase : Would you walk 30minutes to save $14 out of a $300 purchase? Pitfall #2: explicit costs (costs with monetary outlay) vs implicit costs (costs without monetary value) Opportunity Cost = the value of what must be given up in order to undertake an activity, value is made of both explicit and implicit costs – cost of the next best alternative Thinking at the Margin: the next units marginal benefit must be at least as large as the marginal cost - Marginal Cost (MC) = the cost of an additional unit of an activity - Marginal Benefit (MB) = benefit of an additional unit of an activity - If the MC or MB change, then the decision will also have to change eg. all you can eat buffet, the marginal cost would be 0

-

Sunk Cost = costs that cannot be recovered when you make marginal decisions  sunk cost is irrelevant to marginal decisions eg. entry fee to the buffet

Thinking at the Margin Example - Buying Pizza by the Slice Slice

1st

2nd

3rd

Marginal Cost

$5 – explicit cost (physical cost) $8.00 – implicit cost (tangible cost) Y

$5

$5

$6.00

$4.00

Y

N

Marginal Benefit MB > MC

The activity should only be continued up until the 2nd slice for the marginal benefit to be larger than the marginal cost.

Normative Behaviour: how people should behave eg. a dairy farmer should clean up water pollution

vs.

Positive Behaviour: how people will behave eg. a dairy farmer will clean up water pollution, if the government taxes water pollution  if the cost is higher, the action will be done less = less water pollution

Week 3 – Supply and Demand Society must answer 3 questions: - What = what goods to produce, how much of each - How = what combinations of inputs to use, what technology to use - For whom = who gets to consume the outputs To answer these questions = the interaction of supply & demand Central Planning Markets decisions are made high up by a few buyers and sellers signal wants and costs individuals themselves eg. soviet union, North Korea, China eg. market economies, New Zealand

Note: supply & demand have different/opposing motivations - the market price balances this Demand: comes from buyers

-

buyers want economic surplus from the good Buyers Reservation Price = the highest price that an individual buyer is willing to pay based on wants, needs, values etc.

Demand Curve = illustrates the quantity that buyers would purchase at each possible price Note: the demand curve has a negative slope/downward sloping

The Law of Demand: price  consumers buy less consumers switch to another brand/product = substitution effect consumers overall purchasing power decreases, consume less of everything = income effect price  existing consumers buy more & new consumers start to buy  demand increases

The Law of Supply: price  sellers profit increases & seller offers more units existing sellers offer more & new sellers enter the market  quantity supplied increases price  sellers offer less units

Supply: comes from sellers - sellers want profit from the good - Sellers Reservation Price = the lowest price a supplier is willing to sell a good for based on differing input costs (labour, materials, technology etc.)

Supply Curve = illustrates the quantity that sellers would offer at each possible price Note: the supply curve has a positive slope/upward sloping

Market Equilibrium: if the price is above or below equilibrium then buyers and sellers are not satisfied at the same time Buyers Surplus

[

buyers reservation price – market price

+

Sellers Surplus

][

market price – sellers reservation price

= Total Economic Surplus

]

E = Market Equilibrium P = Equilibrium Price Q = Equilibrium Quantity Market Clearing: quantity demanded = quantity supplied Note: if one is upward sloping and the other is downward sloping then they will intersect at some point

“The Invisible Hand” – Adam Smith: the tendency for the market to correct itself and approach equilibrium price Surplus signal for sellers to lower the price Government Influence on Price:

Shortage signal for sellers to increase the price & buyers to bid up the price

Price Ceiling = maximum allowable price VS. Price Floor = minimum allowable price eg. minimum wage eg. rent control If controlled price is above equilibrium If controlled price is below equilibrium demand  quantity supplied  demand  quantity supplied   shortage  surplus Decreased quantity supply results in some More people want to work but less people finding apartments and some not, employers want to hire or provide hours landlords have no incentive to upkeep apartments as they cannot increase the price

Shift in Demand: an external factor (not price) causes consumers to buy more at every price, thus changing the quantity demanded Causes of Demand Shifts: change in preferences, number of buyers in the market, change in income, price of substitutes & complements, buyer’s expectations of future prices eg. demand for ice-cream decreases on a cold day  decrease in demand = shift left eg. substitutes sorbet becomes cheaper than ice-cream  sorbet quantity demanded  ice-cream demanded 

eg. demand for ice-cream increases on a hot day  increase in demand = shift right eg. complements waffle cones become cheaper  waffle cone quantity demanded  ice-cream demand also 

For most things (normal goods eg. eating For some things (inferior goods eg. fast out, shopping, entertainment): food, 2-minute noodles): income increases  demand increases income increases  demand decreases Shift in Supply: an external factor (not price) that causes sellers to change the quantity supplied at every price Causes of Supply Shifts: change in input costs, change in technology, number of sellers, expectations of future prices eg. freezers become more energy efficient supply for ice-cream increases (suppliers profit more from cheaper costs)

eg. milk becomes more expensive supply for ice-cream decreases (suppliers have increased costs)  decrease in supply = shift left

 increase in supply = shift right

Supply and Demand Shifts: the effect on price and quantity (increase or decrease) with each change in supply and demand

1. An increase in demand will lead to an increase in equilibrium price and quantity

2. A both

decrease in demand will lead to a decrease in equilibrium price and quantity

3. An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity

4. A decrease equilibrium

in supply will lead to an increase in the price and a decrease in the equilibrium quantity

Week 4 –

Elasticity

Price Elasticity of Demand ( ℇ ): consumer responsiveness to a price change - the percentage change in quantity demanded from a 1% change in price ℇ

=

% ∆Qd %∆P

eg. price of beef has decreased by 1% and consumers respond by increasing their quantity demanded by 2% 2 ℇ = =2 1

ε >1 demand is elastic (consumers are quite responsive) % ∆Qd >% Δ P ε MC for more units to be produced MR > MC  increase production MR < MC  decrease production MR = MC  optimum quantity to maximise profit ∆ TC ∆Q eg. market price = $0.40, Price = Marginal Revenue, Marginal Revenue = Marginal Cost for Profit Maximisation  P = $0.40 = MR = MC Marginal Cost =

Minimising Loss: - when profit < 0, firms can choose to continue operating or to shut down (Q = 0, VC = 0) - if revenue (PxQ) does not cover variable costs (TR < VC) then the firm should shut down as Profit = - Fixed Cost - continuing to sell in an unfavourable environment will increase variable costs where the firm will lose money on every unit it produces, whereas shutting down in the short run only equates the loss of fixed costs - if revenue does cover variable costs (TR > VC) then firms are safe to continue operating as each unit covers the variable cost and losses will be less than fixed costs Shut down when

P < AVC

(AVC =

VC ) Q

P > ATC

Profitable Firms = TC (ATC = ) Q

Week 6 – Monopoly -

most markets in the real world are not perfectly competitive imperfect firms have some ability to set their own price (price setters) usually one firm, product has no close substitutes

Note: Oligopoly = small number of large firms eg. petrol, supermarkets, telecommunications Note: Monopolistic Competition = many firms producing slightly different products eg. fashion Market Power: the firm’s ability to raise price without losing all customers Sources of Power: 1. Exclusive control over input eg. diamonds 2. Patent: for inventions, usually lasts 20yrs & Copyrights: original work, for the author’s lifetime + 50-70yrs 3. Government Licenses – can have a cap eg. taxis, casino 4. Natural Monopoly/Economies of Scale – most economical to have only one firm supplying the market, large FC and small VC eg. electricity supply, water supply 5. Network Economies – when the value of the platform increases based on the number of users, market is dominated by the network with the most users eg. Facebook, TradeMe Note: monopolies must exist for the above reasons Monopoly’s Profit Maximisation: all profit maximising firms produce in line with MR = MC - the monopoly firm serves the entire market  to sell more units it must lower the price MR = ∆ TR MR ≠ P (current price) MR < P Monopoly vs. Perfect Competition: - monopoly price > competitive price - monopoly quantity < competitive quantity - monopoly results in a Deadweight Loss (DWL) = loss of consumer & producer surplus, caused by the difference between the monopoly price and the marginal cost (the triangle of 3 points MR/MC, D, D/MC)

Public Policy: aim to maximise total surplus (consumer surplus + firm surplus) - Government ownership and operation of the monopoly firm eg. water care, postal service - Regulation from NZ Commerce Commission: cost-plus regulation = setting price to explicit cost + implicit cost (cost + mark-up), no incentive for firms to reduce costs eg. pipelines, airports, dairy - Competitive Bids for Natural Monopoly Services: government decides who to give the contract to eg. construction, rubbish collection Competition Law - The Commerce Act: promotes competition to benefit consumers through penalties for misbehaviour -

Cartel/Collusion = firms agree to not compete, usually by all raising prices - Anti-Competitive Behaviour = trying to restrict entry of new firms into the market or eliminate other firms - Bid Rigging = firms agree who will win the bid and at what price, forcing the price to increase

Monopoly Profit: TR−TC  P× Q – ATC ×Q  Q (P – ATC)

Price

Discrimination: charging different buyers a different price for essentially the same thing Perfect Price Discrimination = a monopoly firm tries to gauge the exact reservation price of each customer and charges that exact price, capitalising on consumers’ willingness to pay Price Discrimination vs. Monopoly: price discrimination increases firms profit and increase the quantity suppled  decreasing DWL

Worked Example: Carla edits student essays, with the cost of her time valued at $29 and 7 potential customers each with different reservation prices

Competitive Market – Carla edits essays in line with Price > Cost 6 customers (exclu. G) at price $30 Revenue = 30 x 6 = $184 Cost = 29 x 6 = $174 Profit = 184 – 174 = $6

Monopoly – Carla edits essays in line with MR > MC 3 customers (ABC) at price of Student C Reservation Price $36 Revenue = 36 x 3 = $108 Cost = 29 x 3 = $87 Profit = 108 – 87 = $21

Price Discrimination – Carla edits essays at the reservation price of each student 6 customers (exclu. G as reservation price is below Carla’s cost) Revenue = 40 + 38 + 36 + 34 + 32 + 30 = $210 Cost = 29 x 6 = $174 Profit = 210 – 174 = $36

Week 7 – Externality Externality: benefit or cost of an action that falls on a person other than the individual pursing the action External Benefit = Positive Externality External Cost = Negative Externality eg. Bee Farmer – produces and sells honey – & lives next to an apple orchard Bees provide free pollination = Positive Externality Private Benefit (bee farmer) + External Benefit (XB – apple orchard) = Social Benefit Without intervention, Bee Farmer produces to the point of: Positive Benefit = Private Cost  Social Benefit > Social Cost  to maximise social economic surplus, quantity should increase to the point of: Social Benefit = Social Cost

eg. Bee farmer lives next to a school & students are bothered = Negative Externality Private Cost (bee farmer) + External Cost (XC – school students) = Social Cost Without intervention, Bee Farmer produces to the point of: Positive Benefit = Private Cost  Social Benefit < Social Cost  to maximise social economic surplus, quantity should decrease to the point of: Social Benefit = Social Cost

Remedying Externalities: private market outcomes do not achieve the largest possible economic surplus eg. Dairy Farmer dumps waste into Waikato River – Tainui Tribe can no longer fish from the river because of the pollution – Dairy Farmer could install a filter to reduce harmful waste Party Benefits Dairy Farmer Tainui Total

Install Filter 100 100 200

1. Dairy Farmer does not communicate with Tainui:

No Filter 130 50 180

Compares only private benefit vs. without filter  130 > 100 filter is not installed  social welfare is not maximised 180 < 200 2. Parties communicate and negotiate to reach a compromise: Cost to Farmer to install filter (130-100) = 30 Benefit to Tainui of clean water (100 – 50) = 50 Benefit > Cost  socially optimal to install filter Tainui pays Farmer $40 to install the filter  social welfare is maximised Party Benefit Install Filter Dairy Farmer 100 + 40 = 140 Tainui 100 – 40 = 60 Total 200

No Filter 130 50 180

Coase Theorem: if private parties can negotiate costlessly, they can efficiently solve the externality problem - the affected party can pay the other party to stop - the party can pay the affected party a compensation to allow the right to continue their actions (dependant on whether the cost or benefit is larger) 3. Law makes Dairy Farmer liable for the pollution Dairy Farmer will therefore install the filter to avoid private consequences (blunt tool) 4. Law prohibits pollution, unless local iwi agrees Dairy Farmer would offer compensation to local iwi Cost to Dairy Farmer $30 < the amount to compensate local iwi $50  filter will be installed as it is less costly for the Dairy Farmer to install than to negotiate with the local iwi

 If negotiation is costless (no law required), private solution is therefore adequate – the party with the lowest cost makes the adjustment, that party offers compensation  If negotiation is not easy, law may be used to correct externalities –falling on the person committing the act Legal Remedies = Noise Regulations – Car Emission Standards – Zoning Laws Transaction Costs Prohibit Private Negotiation: taxes and subsidies are used to shift the market to a socially optimal outcome Negative Externality Positive Externality Tax = XC Subsidy = XB  quantity decreases  quantity increases eg. tobacco eg. flu shot

Tragedy of the Commons: when the use of a communal resource has no cost (private cost = 0), the resource will b...