Econ 104 Term 1 notes - for the whole semester PDF

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Utility: means satisfaction (happiness) Rational things that you do makes you the happiest e. a man on heroine is acting 'rationally', he's maximizing his utility. Different people derive utility (or happiness) from different things_. e. different leisure activities, different work activities._ Howe...

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Utility: means satisfaction (happiness) Rational things that you do makes you the happiest e.g. a man on heroine is acting 'rationally', he's maximizing his utility. Different people derive utility (or happiness) from different things. e.g. different leisure activities, different work activities. However, we are limited in how much utility we can generate for ourselves. People face trade-of 1. Because of scarcity of resources such as time or money. e.g. work-leisure trade off. The leisure-work trade-off is an example of this when facing a trade-off between more free time and more income. Helps to explain differences in the hours that people work in different countries and also the changes in our hours of work through history. 2. The true cost of any choice includes the opportunity cost. The next best alternative foregone when deciding. e.g. if you need more money you may need to work longer hours and give up some leisure activities. Opportunity cost is the benefit you would have received from more leisure. 3. People response to incentives. Understanding economic incentives is crucial in explaining the behavior of individuals and groups. (If benefit is too high it messes with incentive. But it needs to be high enough to live off. So, there is the balance of how high or low it is, so they still are looking for work). 4. Markets are usually a good way to organize economic activity. The free interaction of buyers and sellers (via markets) is most often the best way to achieve an efficient allocation of scarce resources. 5. There can be a role for government to improve market outcomes. On occasions where the market process does not lead to an efficient allocation of resources then the Government can sometimes improve the outcome. e.g. alcohol, and cigarettes has taxes. *the govt does not always get it right* 6. The role of information. Information is important in the efficient allocation and use of scarce resources. To make the best decisions, economic agents need good information. Therefore, firms spend money on market research. The more complete information is, the more likely it is that resources will be allocated and used efficiently. Production Possibility Model: Assumptions of the PPF model: - There is no change in the general level of technology e.g. Machines, skill level of labor. - The quantity of resources available is fixed. - The boundary of the PPF illustrates the limit of production given scarce resources. - To increase the production of one of the commodities means giving up some of the production of the other. Efficiency and the PPF: -

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Only points on the PPF are considered “production efficient” where all available resources are being used to their maximum potential (Point B). Points outside the PPF are “production unattainable” given current resources and technology (Point C). Points inside are labeled “production inefficient”, where resources are not being used to their maximum potential (Point A).

Shape of the PPF: -

When resources are not usually perfect substitutes and to get another unit of one commodity means giving up larger and larger quantities of the other. This is known as increasing opportunity costs and leads to a concave PPF.

 From point B to point C, 300 cabinets are gained, and 200 cushions are given up. Opportunity cost is 200/300 equals 0.67 of a cushion given up for every cabinet. From point C to point D, 300 cabinets are gained, and 500 cushions are given up. Opportunity cost is 500/300 equals 1.67 cushions given up for every cabinet. 

From B to C: The firm switches workers from cushions to cabinets who are good at producing cabinets, but not very good at producing cushions - Few cushions lost

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From C to D: The firm switches workers who are relatively better at producing cushions than cabinets -More cushions lost for the same gain in cabinets

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If resources are perfectly interchangeable then we have constant opportunity costs and the PPF is a straight line.

 The ratio of 3 wool for 1 cotton is constant along the PPF Where on the PPF do we produce? The role of markets and prices is crucial in getting as close to the boundary of the PPF as possible. -

Prices provide a clear signal to producers of what to produce more or less of. There would be one point on the PPF which consumers would direct producers to (through demand), which represents the combination society demands.

Gains from Trade: Absolute Advantage Tribe two has an absolute advantage in the collection of fish and coconuts. They can collect more coconuts than tribe one, and they can collect more fish than tribe one. NOTE: Tribe One can collect 27 coconuts and zero fish, 9 fish and zero coconuts, or some combination in between. Likewise, for Tribe Two at their ratios.

Comparative Advantage If we calculate the opportunity cost of coconuts and fish for each tribe, we see that trade is worthwhile for both tribes.  We say tribe one has a comparative advantage in coconuts, as their opportunity cost is lower (they give up fewer fish (0.33) to produce a coconut than tribe two (0.5))  We say tribe two has a comparative advantage in fish, as their opportunity cost is lower than tribe one (2 coconuts given up compared to 3). Opportunity Cost For Tribe One: The ratio of coconuts collected to fish collected is 3 to 1 In the time taken to collect one coconut, the tribe could have collected 0.33 of a fish. (Opportunity cost). Or simply 9/27=0.33 In the time taken to collect one fish, the tribe could have collected 3 coconuts (Opportunity cost)

Or simply 27/9=3 For Tribe Two: The ratio is 2 coconuts to 1 fish, so their opportunity costs are 0.5 fish for every coconut collected (18/36=0.5), and 2 coconuts for every fish collected (36/18=2). Trade with Comparative Advantage For tribe one, 1 fish = 3 coconuts, and for tribe two, 1 fish = 2 coconuts. If trade occurs where 1 fish = 2.5 coconuts, both tribes win:  Tribe one can produce 27 coconuts, trade 5 of them for 2 fish, and end up with 22 coconuts and 2 fish (as opposed to 21 coconuts and 2 fish without trade).  Tribe two can produce 18 fish, trade 2 of them for the 5 coconuts, and end up with 5 coconuts and 16 fish (as opposed to 4 coconuts and 16 fish without trade). Both tribes benefit from trade, even though one tribe has an absolute advantage in the collection of both goods. Trade verses No Trade

Consuming outside the PPF: If a country can consume outside their PPF due to trade, they must be better off, as they are able to consume a bundle of goods that they previously could not. From our survivor example  Consumption Possibility Frontier: -

Shows the possible combinations of goods able to be consumed. Allows for easy comparison with the PPF to see the gains from trade.

Trade Calculations: Comparative Advantage In the following example, Australia has an absolute advantage in producing both wheat and apples (i.e. takes less labor to produce either than New Zealand does). - The producer that requires the smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. -

To produce wheat, New Zealand must transfer some resources -from apples – in this case 3 hours’ worth. In 3 hours, NZ could have produced 3/5 of a unit of apples. Hence the opportunity cost (or

what you have given up) of producing another unit of wheat is 0.6 (3/5) units of apples. -

New Zealand has the comparative advantage in apples because it only must give up 1.667 units of wheat to produce another unit of apples compared to Australia’s 2.

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Australia has the comparative advantage in wheat because it only has to give up 0.5 units of apples to produce another unit of wheat, compared to New Zealand’s 0.6. NZ specialises in apples, and Aussie specialises in

wheat. So, if each country had, say, 300 hours to contribute to either or both goods: - NZ would produce 300/5=60 units of apples - Australia would produce 300/2=150 units of wheat Trade would occur at a price between the two opportunity costs. - Between 1.667 and 2 units of wheat for a unit of apples. - Between 0.5 and 0.6 units of apples for a unit of wheat. When a country trades, there will be some winners and some losers, but overall the wins outweigh the losses and the country as a whole is better off. There are some limitations to our model, such as ignoring transportation costs. However, the important points about free international trade are that it leads to: - an increase in the standard of living of all those who trade (including inefficient and low wage countries) because countries can consume outside of their PPF. - an efficient use of resources. Supply and Demand: Markets: A market is any place or situation in which buyers and sellers exchange goods or services e.g. market for apples, money, insurance A Situation: A situation does not require the buyer and seller to physically meet. More common with the advent of the internet and sites such as trade me and eBay. Demand Schedule - A table showing the quantity of a commodity a consumer is willing and able to buy (demand) at various prices. Other factors such as income, tastes and the price of substitutes are held constant for the moment (Ceteris Paribus). e.g. Supply schedule is a table showing the quantity of a commodity a producer is willing and able to provide at certain prices. Other things such as input costs and technology are held constant for the moment (Ceteris Paribus).

Demand Curve - The information forms the demand schedule can be shown graphically on a demand curve. - The law of demand states that the quantity demanded of a good fall as the price rises. Two main reasons for this are that as the price rises:

 real incomes of consumers fall and consumption of all goods falls  the relative price of substitutes falls, and consumers consume less of the more expensive good.  Thus, the demand curve slopes downwards to the right. Supply Curve -

The information forms the supply schedule can be shown graphically on a supply curve. The law of supply states that the quantity supplied of a good rise as the price rises. Two main reasons for this are that as the price rises:

 Higher prices offer higher profits which gives existing producers an incentive to produce more and others not currently in the market an incentive to enter.  Secondly, since a firm’s plant size is fixed in the short-run costs tend to rise as production increases (overtime rates, less efficient production etc). Firms will therefore require a higher selling price before they are prepared to produce more.  Thus, the supply curve slopes upwards to the right. Market Demand and Supply -

In economics we are most often interested in the interaction of all buyers and sellers. The demand schedules of all individual consumers can be added together to find the total Market Demand and the supply schedules of all individual firms can be added together to find the total market supply (called horizontal addition). The market demand and supply curves can then be drawn.

Market Equilibrium - A state in which the quantity of a good/service demanded by consumers is matched exactly by the quantity sellers wish to sell. Shown as the intersection of the market supply and demand curves. -

This equilibrium is stable. The market will not move away from the equilibrium price and quantity unless there is a change in demand, supply, or some sort of intervention in the market.

Excess Demand -

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At P there is an excess demand or a shortage as Qd > Qs. To remove the shortage consumers bid up the price: quantity demanded decreases, quantity supplied increases until Qs = Qd at the equilibrium Pe. There is upward pressure towards equilibrium

Excess Supply

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At P there is an excess supply or a surplus as Qs > Qd. To remove the surplus the firms cut the price: quantity demanded increases, quantity supplied decreases until Qs = Qd at the equilibrium Pe. There is downward pressure towards equilibrium.

Shifts and Movement -

If the price of the good itself changes, there will be a movement along the existing supply or demand curve. If factors other than a change in the price of the good itself occur, there is a shift of the supply or demand curve.

Demand Curve Shifts -

The demand curve will shift position when any of the following changes: Price of substitutes eg: butter / margarine Price of complements eg; cars / petrol Tastes and preferences, eg: clothing Incomes - Any change in the above factors that increases demand shifts the demand curve to the right. e.g. consumers become convinced of the health benefits of apples. - Any factor that decreases demand shifts the curve left. e.g. a fall in the price of pears (a substitute). Supply Curve Shifts -

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The supply curve will shift position when any of the following changes: Technology eg: automatic pruning machines Input costs eg: higher wages, cheaper raw materials the number of sellers in the market. Climatic events can also change supply e.g. a colder than normal winter reduces the apple crop. When the supply or demand curve shifts, the new equilibrium forms at the intersection of the new and existing curves. Any change in the above factors that increases supply shifts the supply curve to the right. e.g. Costs of production decrease. Any factor that decreases supply shifts the curve left. e.g. a storm wipes out vegetable crops.

When a curve shifts An increase in demand -

Original equilibrium at Pe and Qe Demand increases, shifting D to D’ At Pe, there is now a situation of excess demand

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As price increases, there is a movement up the original supply and new demand curves until a new equilibrium forms at P’ and Q’ A decrease in demand -

Original equilibrium Demand curve shifts left Excess supply at original equilibrium price Price falls, movement down original supply and new demand curves New equilibrium where new demand curve intersects original supply curve at a lower price and a smaller quantity than at the original equilibrium A decrease in supply -

Original equilibrium Supply curve shifts left Excess demand at original equilibrium price Price rises, movement up original demand and new supply curves New equilibrium where new supply curve intersects original demand curve at a higher price and a smaller quantity than at the original equilibrium Increase in supply -

Original equilibrium Supply curve shifts right Excess supply at original equilibrium price Price falls, movement down original demand and new supply curves New equilibrium where new supply curve intersects original demand curve at a lower price and a greater quantity than at the original equilibrium

Shifts of verses move along -

The terms “change in demand” or “change in supply” refer to a shift of the supply or demand curve. The terms “change in quantity demanded” or “change in quantity supplied” refer to a movement along the supply or demand curve.

REMEMBER – a price change (which is observed) is a result of a supply or demand shift and NOT a cause. It will however cause a movement along the curve which hasn’t shifted, as a result of the change in price Elasticity: Price Elasticity -

Price elasticity of demand is the responsiveness of quantity demanded to change in price. It is defined as:

This formula tells us that elasticity has two parts: - the first term is the slope of the demand curve - the second is a point on the demand curve. Note - that we ignore the minus sign and express the PED as an absolute number -

If the demand response to a price change is less than proportionate, we refer to demand as being inelastic. e.g. necessity type goods.

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If the demand response to a price change is more than proportionate, we refer to demand as being elastic. e.g. luxuries.

Determinants of Elasticity In general, price elasticity of demand is smaller (more inelastic) when: - the number of substitutes is small - there is a high degree of necessity associated with the good - the proportion of income spent on the good is small - the time period is short Slope of the Curve: -

A change in price of $-2, results in a change in quantity demanded of 4 Therefore, for every $1 change in price, quantity demanded changes by 2 The slope of the curve is thus -2

e.g. can check using the formula:

Deriving the Demand Curve: -

Linear Demand Function A demand equation or demand function expresses quantity demanded Qd as a function of the price per item (P). A linear demand function has the form Qd = a + b(P)

Interpretation of b The (usually negative) slope b, measures the change in demand per unit change in price. Interpretation of a The x-intercept a gives the demand if the items were given away (P=0). -

= a – bP or -

If the equation of the direct demand curve is given by: Qd = 600 – 3P (or more generally as Qd Qd=a+(-b)) Then we know that at P = 80, Qd = 360. We can see that ΔQd= b = -3 ΔP

Calculating Price Elasticity: Therefore, the elasticity of demand is calculated as:

(2dp and usually expressed as an absolute value, in other words, ignore the negative sign). Price Elasticity of Demand -

If the coefficient comes out as exactly1, this means there is unit elasticity (or unitary elasticity). A price change will result in an exactly proportionate change in quantity demand, and total revenue will remain unchanged.

Impact of Price Changes on Revenue -

We can summarize the impact on revenue for different elasticities:

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If price and revenue move in the same direction, then demand is inelastic.

Elasticity along the Curve -

Elasticity varies along a demand curve. In this graph the price and quantity changes are the same at both points A and B (i.e the slope is the same) but the elasticities are much different. • A 1.87 B

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0.4

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A $5 change from $10 to $15 is a much bigger % change, than a $5 increase from $30 to $35. - Demand curves are more elastic further up the demand curve and more inelastic nearerthe bottom. Price Elasticity of Demand -

Ignoring the negative sign on the coefficient: ∞ Perfectly Elastic >1 1

% change in quantity is infinite. % change in price

Perfectly Inelastic

A vertical demand curve is known as perfectly inelastic. Change in quantity is always zero. =>

% change in quantity is zero. % change in price

Price Elasticity of Supply -

Price Elasticity of Supply is similar in construction to PED. It has the same formula as price elasticity of demand, except it is quantity supplied rather than quantity demanded. It is measuring how responsive quantity supplied by producers is to a change in price. Time is the main determinant for supply elasticity: Short run = more inelastic Long run = more elastic

The Supply Function -

Last lecture we showed how the demand curve can be derived from the demand function. The same can be done for the supply curve from the supply function.

Linear Supply Function -

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A supply equation or supply function expresses Qs (the number of items suppliers are willing to make available) as a function of the price per item (P). A linear supply function has the form Qs = b(P) + a

Interpretation of b The (usually positive) slope b measures the change in supply per unit change in price. Interpretation of a The x-intercept a gives the number of items suppliers would be willing to supply for free (P=0), and is usually negative, as firms will not give goods away for free.

A function ...