Economic Principles and Applications – Lecture Notes PDF

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Economic Principles and Applications – 22nd September        

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Economics by Mankiw and Taylor, 3rd Edition Microeconomics – studies the decisions made by individual consumers and firms Macroeconomics – studies the economy as a whole Economics is based around the notion of scarcity (there are fewer resources than we would like to use) When faced with scarcity, important decisions must be made Economics is the study of how individuals and society as a whole manage their scarce resources Principle 1 – people face trade-offs Efficiency vs Equity (how equally split up is society’s income) [big pie shared equally] Principle 2 – the cost of something is what you give up to get it I invite you to lunch and offer to pay. Is lunch free? Yes but you give up your time Opportunity cost of something is the value of the next best thing you are foregoing e.g. money in pocket = loss of interest Principle 3 – rational people think at the margin A marginal is a small incremental increase e.g. buying one more cup of coffee Thinking at the margin entails comparing the costs and benefits of one more incremental adjustment Keep doing the same action so long as the marginal benefit outweighs the marginal cost i.e. Marginal Benefit > Marginal Cost Principle 4 – people respond to incentives People make decisions y comparing costs and benefits Policy makers can change people’s behaviour by altering the costs or benefits Incentive schemes don’t always work i.e. People don’t give blood nearly enough. It has been suggested that we pay blood donors. Bad as giving blood is moral Principle 5 - trade can make everybody better off Trade allows people to specialise in what the do best and people can enjoy more goods at a better cost. Same with countries i.e. Germany makes cars, France makes wine, France and Germany trade wine for cars Principle 6 – markets are usually a good way to organise economic activity A market economy is an economy that allocates resources through the decentralized decisions in the market place i.e. consumers what they want and firms make what they want Key feature behind this principle is price – price of good reflects its value and its cost of production. Resulting price is a very good reflection of how much a good is worth and how much society values it In a centrally planned economy the government must estimate how much society values a good Principle 7 – governments can improve market outcomes Government should still have a role Markets can fail to allocate scarce resources Markets might fail to function properly when a firm has market power allowing them to set prices way above the cost of production There are many levers at government’s disposal e.g. max price, promote competition, minimum standard of service If the market is functioning properly, the government should still step in to improve equity Principle 8 – an economy’s standard of living depends on its ability to produce goods and services Gross domestic product (GDP) per capita is defined as the total value of all the goods and services produced in a county divided by how many people live there Productivity determines a country’s GDP per capita GDP is not only a measure of how rich a country is, it is also a measure of how well educated, how safe, how clean a country is Human development index looks at education, life expectation, GDP per person. Each country gets a score based on there

Principle 9 – prices rise when the government prints too much money

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Inflation is an increase in the overall level of prices in the economy most common cause of inflation is growing money supply Principle 10 – society faces a short-run trade-off between inflation and unemployment When government increases money supply, there is inflation. But at the same time, more money reduces unemployment First 7 principle’s are microeconomic, last 3 are macroeconomic

Economic Principles and Applications – 25th September

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If you want to produce more of something you have to give up something else A positive statement is a statement about how the world is e.g. “The unemployment rate is 9%” A normative statement is a statement about how the world should be e.g. “The unemployment rate is too high” Economists may disagree over facts or their values An equilibrium occurs when competing forces are balanced and stability is achieved (quantity demanded equals quantity supplied) Once equilibrium is reached, the system will stay right there unless outside conditions change. e.g. Price of petrol and how much people drive. What happens when a new tram system is put in? Omitted Variables = You think that x causes y, but in fact both x and y are caused by some third factor z e.g. As ice cream sales increase, the rate of drowning deaths increases sharply. Therefore, ice cream consumption causes drowning Reverse Causality = You think that x causes y, but in fact y causes x e.g. The more firemen fighting a fire, the bigger the fire is observed to be. Therefore, firemen cause fire Coincidence = x and y have nothing to do with each other e.g. With a decrease in the number of pirates, there has been an increase in global warming over the same period. Therefore, global warming is caused by a lack of pirates Constrained optimisation is a situation in which an objective is maximised or minimised subject to some restriction (maximise x, subject y)

Economic Principles and Applications – 29th September  The model of Supply and Demand can be used to answer a number of questions

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A market is a group of buyers and sellers of a particular good or service Model of Supply and Demand assumes the market is competitive (i.e. when there are a huge number of buyers and sellers and the product is very similar) Demand is dependant on a number of variables (tastes, population, expectations, income)  When the price of something rises, people will want less of it. This is the Law of Demand The demand curve plots how much ice cream consumers wish to buy for various prices holding everything else constant Market demand is the sum of everyone’s demand Price  in one good = Demand  in other good = Substitutes Price  in one good = Demand  in other good = Complements Normal Good = higher demand when people are richer Inferior Good = less demand when richer e.g. public transport

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Several factors determine how much is supplied (wages, subsidises, tax, selling price) A Supply Curve shows how much of something a seller is willing to sell Equilibrium Price and Quantity in a market can be found by putting the demand and supply curves together  This occurs where quantity supply exactly equals quantity demanded i.e. the point of intersection  When at equilibrium, them market will stay the same until some other external factor changes

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At this price, sellers want to sell 7 units and buyers only want to purchase 3 units There is a surplus equal to 4 units Firms have unsold inventory and they will begin to decrease their production and lower the price. A price of £0.90, therefore, is not an equilibrium because it is not stable When the price is above the equilibrium price, the price will begin to decrease

 At this price, sellers want to sell only 1 unit and buyers want to purchase 9 units There is a shortage equal to 8 units Th ill b i t th d Th

price of ice cream will gradually increase until supply is equal to demand.

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No matter what the initial price is, prices will adjust until the price of ice cream is eventually equal to £0.80 and 5 units are sold.

Economic Principles and Applications – 2nd October  Equilibrium can be found algebraically  Qd = 100 – 10p Qs = 40 + 20p

Equilibrium can be calculated by setting Qs = Qd  i.e. Equilibrium: 100 – 10p = 40 + 20p 60 = 30p p=2 40 + 20(2) =80 Equilibrium Price is £2 and Equilibrium Quantity is 80 The equilibrium price and quantity are always changing in the market i.e. Government policies shifting supply and demand 

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The Supply Curve has shifted to the left due to a raised cost of production i.e. sugar workers going on strike

The price elasticity of demand is a very important concept to understand Price elasticity of demand is the percentage change in quantity demanded that results from a percentage change in price If the price elasticity of demand is 2, a 1% increase in price leads to a 2% drop in quantity demanded If price elasticity of demand is more than 1, the good we are considering is elastic If price elasticity of demand is between 0 and 1, the good we are considering is inelastic Price elasticity of demand is determined by:  Disposable income  Availability of substitutes  Definition of the market (shoes versus Adidas shoes)  Time horizon  Most goods are more price elastic in the long run. However, for certain types of goods known as durable goods, the reverse is true  Necessities versus luxuries The price elasticity of demand is related to the slope of the demand curve Suppose the price increases from £10 to £11 (a 10% increase). A large change in quantity demanded and a high price elasticity of demand will result in a flat curve A small change in quantity demanded and a low price elasticity of demand will result in a steep curve

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If demand for a good does not change at all when the price changes, it is perfectly inelastic If demand for a good drops to zero when the price increases by 1P, it is perfectly elastic

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If the price of a product increases, people will buy less. The amount is determined by the elasticity Total Spending = Price x Quantity  If a good is price inelastic, an increase in price actually increases total spending  Fewer units being purchased but each good is more expensive so expenditure rises The price elasticity of supply measures the responsiveness of supply to price The price elasticity of supply is driven by how easily a firm can adjust to price changes. This is determined by:  The time horizon  Productive capability of the firm  Size of the firm/industry  Mobility of factors of production  Ease of storing stock If the price elasticity of supply is greater than 1, supply is said to be elastic e.g. 1% price increase = more than 1% increase in supply If the price elasticity of supply is less than 1, supply is said to be inelastic e.g. 1% price increase = less than 1% increase in supply

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Total Revenue = Price x Quantity Supplied  If the price increases, business’s will supply more of the good in order to increase their revenue VAT shifts the supply to the left  Very elastic = not a big impact on the market price, but it will have a huge effect on quantity

 Very inelastic = a big impact on the market price, but it will not have a huge effect on quantity

Economic Principles and Applications – 6th October  Rational consumers choose the affordable bundle that maximises utility subject to the Budget Constraint Optimal bundle occurs at the point of  tangency Where gradients are equal i.e. Can be rearranged to: h

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th

t

tilit

£ that

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earned by eating one more of either If > Then you are

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If income is increased from £40 to £60: Both goods are normal

axim

g utility

Hamburgers inferior

The Income Expansion Path shows how a rational consumer responds to income changes. The curve connects all the optimal bundles for different levels of income

p between the quantity of a good consumed and income

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If the price of a hamburger were to decrease from £4 to £2:

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The Price Consumption Curve is similar to the Income Expansion Path in that it shows the optimal bundles as the price of a good changes

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We can use the Price Consumption Curve to derive the Demand Curve  As long as we know how the optimal consumption of one good changes as the price changes

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Income Effect + Substitution Effect  Substitution Effect = when the price of a good decreases and become relatively less expensive than other goods, consumers will substitute towards the cheaper good  Always works in this way (consumers tend to consume more of the cheaper good)  Income Effect = when the price of a good decreases, consumers have a higher purchasing power as money that was spent on the higher cost is now freed up – as if income has increased. This increase purchasing power changes the optimal bundle consumption

 Direction of Income Effect will depend on whether the good is normal or inferior (less if inferior, more if normal)  If a good is normal, both Substitution Effect and Income Effect will cause consumption to increase so total Effect is an increase in consumption  If a good is inferior, the Substitution Effect increases consumption whereas the Income Effect decreases consumption so the Total Effect is dependant on what Effect is stronger  When a price decrease results in a fall in demand the good is called a Giffen Good (a good that violates the Law of Demand)

Economic Principles and Applications – 9th October  How do consumers decide what to buy?  Market prices  Income  Preferences  Standard Economic Model of Consumer Behaviour assumes:  Buyers = rational

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 More > Less  Consumers are selfish (want to maximise their utility and don’t care about other’s utility) Utility refers to a measure of personal satisfaction derived from consuming a certain quantity of a product  It is an abstract measure on an ordinal scale Ordinal = I prefer X to Y Cardinal = I prefer X 10 times more than Y Bundle = a combination of goods and services you may buy A Budget Constraint shows all possible combinations that can be purchased if you spend all of your income  The slope of a Budget Constraint is a measure of the rate at which the consumer can trade one good for another  Calculated from the negative price ratio (x-axis ÷ y-axis)

 The Budget Line will shift out if there is an increase in income Slope will stay the sae as the price hasn’t changes For example, £40 (red) to £60 (blue)

 The Budget Line will swivel in if there is an increase in price For example, £4 per burger (red) to £8 per burger (blue) Assuming the price per hotdog remains constant Note the vertical intercept has not changed

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ows all bundles that give the consumer the same level of

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Consumers are indifferent between bundles A, B and C as they provide the same utility. However, consumers would choose B as consumers prefer averages to extremes.

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Indifference Curves:  Curves which are further from the origin have more utility (as more is preferred to less)  Two curves cannot cross  Bow towards the origin  Downward sloping  The slope is the Marginal Rate of Substitution  The number of goods on the vertical axis that consumers are willing to give up to get more of the good on the horizontal axis (holding utility constant)  The rate is not constant (driven by the concept of diminishing marginal utility, i.e. after a certain amount of something you get less utility)  MRS = Marginal Utility (x-axis) ÷ Marginal Utility (y-axis) An Axiom is a fundamental rule/premise

Economic Principles and Applications – 13th October  Short run = period of time in which at least one input is fixed Long run = period of time in which all inputs can be adjusted  The marginal product of labour measures the increase in production that results from a one unit increase in the amount of labour used  Production Function: Q = l x k  Decreasing slope (typical of nearly every short-run production function)  The slope of the production function is given by the marginal product of labour

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 The slope measures how output changes as the quantity of labour changes  This property of the production function (that it has a decreasing slope) is driven the concept of diminishing marginal product Fixed costs are independent of the amount that is produced Variable costs are determined by the amount that is produced The marginal cost of production is measured as the increase in total cost for every one additional unit of output. It is given by: Δ Total Cost ÷ Δ Q Or for very small changes in output, marginal cost can be expressed as: d Total Cost ÷ d Q By convention, Δ is used to denote an incremental change and d is used to note a very small change e.g. If Δ Total Cost ÷ Δ Q = 2, the total cost increases by twice as much as output Economists are able to identify some basic features that are common to most firms in the economy  The first common feature is an increasing marginal cost in the short run  The second common feature is a U-shaped average total cost  The average total cost first decreases and then it begins to increase as more is produced

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At first the average total cost is high because the fixed cost of production is spread over only a small number of units. As more donuts are produced, the fixed cost gets spread out and the average total cost decreases Eventually, however, the marginal product of labour will decline by enough that the average total cost starts decreasing again

Notice that marginal cost curve intersects the average total cost curve at the minimum of the average total cost curve. Once the marginal cost is exactly equal to the average total cost, the average total cost neither rises or falls. Average total costs are minimised at this point. This is called the Efficient Scale (the quantity of output that minimises average total cost) In the long run, you will always choose the least-cost input requirement In the short run, however, an organisation is not free to choose the optimal amount of capital as they are stuck using some level of capital that was chosen in the past.

Economic Principles and Applications – 16th October Average Total Cost Lowers as more is produced (i.e. fixed cost of capital is

It then rises again due to a diminishing marginal product of labour 

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Economies of Scale = Long-run ATC of Production falls as more is produced  Workers can specialise  Lower cost input due to bulk buying discounts Diseconomies of Scale = Long-run ATC of Production rises as more is produced  More complex, too many layers of management, bad communication  No bulk buy discount = higher input cost Competitive Markets  No barrier for entry or exit  New firms can join, old ones can leave  Buyers and sellers are well informed (buyer knows price set by all sellers)  Sellers have o influence over price Profit (π) = Total Revenue (TR) – Total Cost (TC) ↳ Price per Unit (P) x Quantity Sold (Q) Marginal revenue measures the increase in total revenue resulting from an incremental increase in production Marginal cost measures the increase in total cost resulting from an incremental increase in production If MR > MC, produce more If MR < MC, produce less If MR = MC, then profit made is maximised

 Marginal Revenue Curve is flat because MR is simply market price, which is constant Therefore, Max Profit occurs when Marginal Costs = Price  Marginal Cost Curve is the firms supply curve However, if the market price is too low then a firm may prefer to produce nothing  

You cannot fully exit a market in the short-run as you still need to pay fixed costs  A frim should ignore their fixed costs when deciding whether to produce or not, they need only consider their variable costs...