ECON 130 Full Course Notes PDF

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ECON130 lecture notes for the full course....

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Lecture 1 and 2 - Introduction to Economics GNP: Gross national product, or the total economic activity within a country. There is a correlation between happiness and GNP, but it grows with diminishing returns; an increase of income in a relatively poor country results in an extremely large increase in happiness, but in richer countries an increase in income results in only a slight increase of happiness. The relation between income and life expectancy is very similar; the more income a person earns, the longer they live. As income increases, life expectancy increases with diminishing amounts. “The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.” - Joan Robinson (1903 - 1983) economist. Economics is a way of thinking. A powerful way of thinking. Thinking about choices. What is Economics?: Economics studies how individuals, firms, governments, and other organisations make choices and how those choices determine society's use of its resources. Another way to look at economics is that it is “the study of the way people organize themselves to sustain life and enhance its quality.” - (Goodwin, Nelson and Harris 2009: 3) We begin by looking at three core concepts: 1) Opportunity cost (scarcity and trade-offs) - the cost of choosing one option over another, all resources are scarce and we have to make sure the choice we choose brings the greatest benefit for its relative cost. 2) Incentives and marginal analysis - incentives are the rewards that can be gained from certain actions. Marginal analysis is working out what actions or how many actions will result in the lowest cost and the highest reward 3) Optimising choices and their outcome (equilibrium) - trying to get the greatest net benefit.

Focussing on the micro:

The study of choices: Choice = f(incentives) = f(motivations, resources, technology, information, institutions) Microeconomic theory concerns the behavior of individual economic actors and the aggregation of their actions in different institutional frameworks. [We’ll look at what institutions are a bit more later on.] …an institutional framework… describes what options the individual actors have and what outcomes they receive as a function of the actions of others, traditionally the price mechanism in an impersonal market place. - Kreps (1990:3) Institutions are formal rules or informal conventions that guide and regulate social and economic interactions eg: cultural norms, conventions, legislation Institutions form the incentive structures of societies. - North (1991; 1994) Optimal Choices: Microeconomic analysis involves various simplifying assumptions about how decision makers make choices. A core assumption, or axiom, is that (rational) consumers make optimal choices. Those choices may be constrained by: •A budget or resource constraint (defining an opportunity set) •Information -

incomplete (e.g. maximise expected utility) Imperfect (you know the structure of the world, but not who you are facing)

•Ability to process information (bounded rationality) •Institutions - formal rules or informal conventions that guide and regulate social and economic interactions.

Scarcity forces choices to be made: How do we understand the choices society makes to allocate its scarce resources? How do we describe good choices?

Scarcity: -

Society has limited resources available to satisfy its wants.

Choice: -

weighing up the costs and benefits marginal benefits, marginal costs and when to sleep in…

Opportunity Cost: -

a crucial concept in economic analysis. the quantity of other goods that must be sacrificed to obtain another unit of a good.

The value of the best alternative of the resources used as a result of the choice that is made.

Trade-offs: All choices involve trade-offs: -

Spending more of your budget on one good means you can spend less on other goods

Trade‑offs stem from scarcity: -

You have limited money and time Society (and the globe) has limited resources

Consider the impact of OPEC’s impact on the scarcity of oil.

OPEC - oil producing and exporting companies

Marginal analysis and incentives: Scarce resources can only satisfy a limited set of wants. How do economists determine which option(s) have the highest priority and which have the lowest priority, and which would be the best use of scarce resources? Marginal analysis:

● ●

Focuses on incremental impacts, weighing the costs and benefits that change as a result ignores, or abstracts from, impacts that do not change a result of the decision under analysis

E.g. sunk costs - costs that cannot be altered – would not be weighed into such decision analysis (such as the queen sized bedding that becomes valueless when you upgrade to a king size bed) Value “at the margin”: Consider Adam Smith’s diamond-water paradox: The things which have the greatest value in use have frequently little or no value in exchange; on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any use-value; but a very great quantity of other goods may frequently be had in exchange for it From the perspective of marginal analysis, it is not the total usefulness of diamonds or water that matters, but the value of each additional unit of water or diamond given current scarcity.

Marginal Analysis and OPEC: An increase in the price of oil alters decision makers incentives by affecting the value at the margin and thereby choices over -

What to produce (less oil intensive products) How to produce (less oil intensive techniques) For whom to produce (oil producers have more power buying power, importers have less)

What is the process through which these decisions are made and resources exchanged?

Property rights: A property right is often referred to as a bundle of rights: •the right to use the good •the right to earn income from the good •the right to transfer the good to others

The strength of a property right “is measured by its probability and costs of enforcement which depend on the government, informal social actions, and prevailing ethical and moral norms.” – Alchian A, New Palgrave Dictionary of Economics, Second Edition (2008). A primary function of property rights is that of guiding incentives to achieve a greater internalization of externalities (third party effects) (in other words, it is making sure that people are taking into account the effects their actions have on other people) - Demsetz (1967: 348) Defining and enforcing property rights: Property rights are central to the functioning of a modern market economy. “A private-enterprise system cannot function properly unless property rights are created in resources, and, when this is done, someone wishing to use a resource has to pay the owner to obtain it. Chaos disappears; and so does the government except that a legal system to define property rights and to arbitrate disputes is, of course, necessary.” - Coase (1959: 14) Markets are one way that property rights may be exchanged. Markets: A market is an environment - or institution - through which a voluntary exchange takes place A market need not be a physical location. •E.g. a fruit and vege market, the NZSX, TradeMe. With competitive markets, consumers have a choice of alternatives. New Zealand has a mixed economy where most exchanges take place in a market. But the government plays a critical role in other aspects of the economy. Markets and decisions: Markets are a process by which decisions… of households about consumption of alternative goods of firms about what and how to produce of workers about how much and for whom to work … are all reconciled by adjustment of prices. The “price mechanism” is a central concept of the market-based trade

Markets and distribution: “The success of our economy has always depended not just on the size of our Gross Domestic Product, but on the reach of our prosperity.” - US President Barrack Obama, January 2009 Markets determine who gets which goods according to the demand and supply of goods, labour (and its embodied knowledge), and capital. How do economists build this understanding of demand and supply across an economy’s markets? How do we rationalise consumption choices? Consumption now versus consumption in the future (via investment in to capital goods)? The economic method: “The whole of science is nothing more than the refinement of everyday thinking” – Albert Einstein Economists approach the subject as a scientist. The scientific method involves developing and testing theories about how the world works. There is an interplay between observation and theory. Having observed something interesting, an economist forms a theory about what is going on. The theory is then tested using data. Does the data confirm the hypothesised relationship(s)? One step in testing a theory, is to develop the ‘story’ into a model. A model describes how key parts are related. Assumptions make the relationships easier to understand and focus our attention on the key parts. Data can then be used to test the theory. Does the data support the theory, i.e. is it actually a good explanation of the world around us? Economists are rarely able to do lab experiments. We use natural experiments instead. -

E.g. to see how a cut in oil supply affects its price, we might look at what happened when suppliers imposed quotas.

A Cartoon is a model:

•It makes an observation about human behaviour. •It strips away unnecessary detail – it is simplified. •It provides an insight that we might otherwise miss. •It can allow us to look at something in a new way.

The production possibility curve: Our first model – the production possibility curve (PPC). For each level of the output of one good, the PPC shows the maximum amount of the other good that can be produced. The PPC demonstrates the concepts of: -

Scarcity Feasibility Efficiency Opportunity cost Transferability

•A simple 2 good economy. •The goods are food and clothing. The country is better at farming than making clothes Production of goods and measuring productivity: X = 1.5 x square root of labour (L) Point v is not efficient - you can increase the amount of food or clothing being produced without decreasing the amount of the other. Points on the frontier are the most efficient as they are maximising resource use to create the most food/clothing possible. However, we cannot know whether it is better to produce food or clothing until we know what the consumer demand for each is. Changes in relative prices will lead to changes in production levels. Equilibrium is a market state of predicting what will happen across an economy.

Markets home and abroad The PPC describes a set of possibilities that are efficient, but does not predict which one will occur. For market economies to allocate resources efficiently, firms and individuals must be informed and have incentives to act on available information in order to make good choices. We need to understand how consumers behave, how firms behave and how they interact… …in domestic or international markets. …specialisation, exchange and relative (comparative) advantage. The Competitive Model The competitive model assumes that rational decision makers are: -

utility maximising customers profit maximising firms.

(Perfectly) competitive markets Note: government is ignored for now (ie we assume an economy where there is no government) Rationality: a rational decision is one where a decision maker chooses the option that gives them the best possible payoff subject to constraints they face (which define their opportunity set) Sometimes the individual’s ability to make a good decision is impaired by their circumstances (eg people drinking on a friday night, always want another drink whether it is good or not) When looking at a certain market, all the goods within that market are seen as homogenous (or the same) The main characteristics of a competitive market are: -

Many firms Selling identical products Too many consumers

Perfectly competitive markets also have: -

Free entry or exit to the industry Participants who have perfect information

In competitive markets, • firms and consumers are price takers. • all firms in the industry charge the same price. If firms charge a price higher than the market price, they lose all their customers. • firms provide as much output as consumers will buy. • each firm can sell as much as it wants: the size of the firm is small compared to the size of the market.

Rational customers: Scarcity forces consumers to make choices. Economists assume individuals (and firms) make choices rationally: Pursue what they see as their own self‑interest Weigh costs and benefits as they see them If benefits ≥ costs, take the action However, different people have different interests Prices provide information about the relative scarcity (availability vs desire) of different goods.

Profit maximising firms: To have incentives to make the best use of their resources, i.e. maximise profits, businesses need to be able to own, use and sell their resources. That is, there must be private property and corresponding property rights. Property rights means it is rational for a business to aim to maximise profits.

When dividing products into markets, the products should be looked at as if they are homogenous (or the same). This means that Iphone and samsung smartphones are in the same market, but landline phones and other cell phones are not. They are part of the same market if they can be seen as reasonable substitutes to each other.

The competitive model - a benchmark: This model combines self‑interested consumers, profit maximising firms, and competition. Tested by comparing predictions with actual markets. An economy is a set of markets or decision making firms that have organised themselves into a similar geographical location. Economists believe this model can provide answers to the four basic questions: What is produced, and in what quantities? How are goods produced? For whom are those goods produced? Who decides the answers to the first three questions, and how?

Government is not needed to answer these questions in the basic competitive model.

General Equilibrium Initially we will examine a single market. Our prediction of what will happen in this market is called equilibrium. Think of the economy as a set of markets. When all markets are in equilibrium, the economy is said to be in general equilibrium (GE) An interesting question is what are the properties of a general equilibrium? Is GE allocation - in some sense - a good outcome? One specific question that economists have focussed on: is an economy made up of a set of perfectly competitive markets efficient (when an economy is in a GE)? Efficiency in the basic competitive model Jumping to a conclusion - the allocation of resources predicted in the competitive model is efficient ie: -

Scarce resources are not wasted It is not possible to produce more of one good without producing less of another good It is not possible to make one person better off without making someone else worse off

An allocation with such properties is allocatively efficient: Production efficiency (at minimum cost) + output efficiency (what consumers want) = Allocative efficiency

Pareto Efficiency We can also draw on the idea of the pareto efficiency to think about the allocation in a competitive economy. An economy is pareto efficient if: -

No mutually beneficial trading opportunities are unexploited Equally, it is not possible to make someone better off without making someone else worse off

When a perfectly competitive economy reaches a general equilibrium, there is no alternative allocation where at least one person can be made better off (and no one is made worse off) ie the incentives are such that all mutually beneficial trades have been made Incentives and efficiency

Providing appropriate incentives is a fundamental economic problem. -

Profits provide incentives for firms to produce the goods individuals want Wages provide incentives for individuals to work Property rights provide people with important incentives, to invest, save, and to put their assets to the best possible use

Property rights may be poorly defined, fail or be non-transferable. (eg Can you sell yourself into slavery?). Inappropriate incentives cause problems with the efficient allocation of resources, consequently affecting welfare.

Lecture 2 and 3 - Consumer Choice Part 1 Differences in consumer choice can be formed by the scarcity of resources like money and time (high income households order more takeaways because time is very scarce for them, while low income households buy cheaper food from supermarkets as money is more scarce for them). The theory of consumer choice helps us to understand and explain consumers’ choices. Four elements used to build this theory are: ● ● ● ●

Consumer’s income Prices of goods Consumer preferences (want do consumers want?) Rationality (The assumption is that consumers choose options as to maximise their utility (satisfaction).

The budget set: People have limited incomes. A larger income, ceteris paribus, (all other things the same) allows people to purchase more. The quantity a person can purchase depends on: Their income and product prices Income and prices together determine the possible bundles of goods that a consumer can afford The budget set is all the different bundles of goods a consumer can afford.

It can be shown graphically as an area. Points within the line are within the budget, but are not maximising the possible resources they can get. Only points along the line are the best choices.

The budget line It separates the affordable bundles from the unaffordable bundles. It represents the limit or constraint a consumer has on their spending. For this reason, the BL is also sometimes called the budget constraint (BC). Assume there are two goods, X and Y. If a person spends all their income M on one good, they can purchase: M/Px units of good X; or, M/Py units of good Y. Suppose they currently spend all their income on good X. If they decided to purchase one unit less of good X, how much good Y could they buy? The slope of the BC (-Px/Py) is called relative price of good X, that is, the quantity of good Y that is traded per unit of good X

The yellow diamond is affordable but not efficient, and the blue diamond is not affordable. To work out the best possible mix of goods, we need to know the preferable mix of goods that the consumer desires

Expands the consumers’ opportunity set Means they can buy ore goods Makes consumers better off

The effect of a change in income When income increases, consumers choose a new point on a new budget constraint farther from the origin. The consumer’s new choice (the point they choose on the BL) depends on their own tastes or preferences. When income rises, consumption: -

Rises for normal goods (inner city apartment and high quality food) Falls for inferior goods (mouldy aro valley flat and cheap takeout food)

The quantity demanded of each good increases There is a positive response to an income increase

Qm falls and Qf increases

Inferior goods Inferior goods commonly occur where there are cheap goods and expensive (and better) goods that both perform the same basic function, for example sausages vs. steak, or Hyundai vs. BMW. Consider food, for example. The amount of food a person consumes is usually fixed; as...