Economic Theory Notes PDF

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Detailing econ theories and concepts...

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While having a basic understanding of economic theory isn't perceived as being as important as balancing a household budget or learning how to drive a car, the forces that underpin the study of economics impact every moment of our lives. At the most basic level, economics attempts to explain how and why we make the purchasing choices we do. Four key economic concepts—scarcity, supply and demand, costs and benefits, and incentives—can help explain many decisions that humans make.

KEY TAKEAWAYS  Four key economic concepts—scarcity, supply and demand, costs and benefits, and incentives—can help explain many decisions that humans make.  Scarcity explains the basic economic problem that the world has limited— or scarce—resources to meet seemingly unlimited wants, and this reality forces people to make decisions about how to allocate resources in the most efficient way.  As a result of scarce resources, humans are constantly making choices that are determined by their costs and benefits and the incentives offered by different courses of action.

Scarcity Everyone has an understanding of scarcity whether they are aware of it or not because everyone has experienced the effects of scarcity. Scarcity explains the basic economic problem that the world has limited—or scarce—resources to meet seemingly unlimited wants. This reality forces people to make decisions about how to allocate resources in the most efficient way possible so that as many of their highest priorities as possible are met. For example, there is only so much wheat grown every year. Some people want bread and some would prefer beer. Only so much of a given good can be made because of the scarcity of wheat. How do we decide how much flour should be made for bread and beer? One way to solve this problem is a market system driven by supply and demand.

Supply and Demand A market system is driven by supply and demand. Taking the example of beer, if many people want to buy beer, the demand for beer is considered high. As a result, you can charge more for beer and make more money on average by using wheat to make beer than by using wheat to make flour. Hypothetically, this could lead to a situation where more people start making beer and, after a few production cycles, there is so much beer on the market—the supply of beer increases—that the price of beer drops.

Although this is an extreme and overly simplified example, on a basic level, the concept of supply and demand helps to explain why last year's popular product is half the price the following year. 5 Economic Concepts Consumers Need To Know

Costs and Benefits The concept of costs and benefits is related to the theory of rational choice (and rational expectations) that economics is based on. When economists say that people behave rationally, they mean that people try to maximize the ratio of benefits to costs in their decisions. If demand for beer is high, breweries will hire more employees to make more beer, but only if the price of beer and the amount of beer they are selling justify the additional costs of their salary and the materials needed to brew more beer. Similarly, the consumer will buy the best beer they can afford to purchase, but not, perhaps, the best-tasting beer in the store. The concept of costs and benefits is applicable to other decisions that are not related to financial transactions. University students perform cost-benefit analyses on a daily basis by choosing to focus on certain courses that they've deemed more important for their success. Sometimes this even means cutting the time they spend studying for courses that they see as less necessary. Although economics assumes that people are generally rational, many of the decisions that humans make are actually very emotional and do not maximize our own benefit. For example, the field of advertising preys on the tendency of humans to act non-rationally. Commercials try to activate the emotional centers of our brain and fool us into overestimating the benefits of a given item.

Everything Is in the Incentives If you are a parent, a boss, a teacher, or anyone with the responsibility of oversight, you've probably been in the situation of offering a reward—or incentive —in order to increase the likelihood of a particular outcome. Economic incentives explain how the operation of supply and demand encourage producers to supply the goods that consumers want, and consumers to conserve on scarce resources. When consumer demand for a good increases, then the market price of the good rises, and producers have an incentive to produce more of the good because they can receive a higher price. ON the other hand, when the increasing scarcity of raw materials or inputs for a given good drive costs up and producers to cut back on supply, then the price they charge for he good rises, and consumers have an incentive to conserve on their consumption of that good and reserve it's use for their most highly valued uses.

In the example of a brewery, the owner wants to increase production so they decide to offer an incentive–a bonus–to the shift that produces the most bottles of beer in a day. The brewery has two sizes of bottles: one 500 milliliter bottle and a one-liter bottle. Within a couple of days, they see production numbers shoot up from 10,000 to 15,000 bottles per day. The problem is that the incentive they provided focused on the wrong thing—the number of bottles rather than the volume of beer. They begin receiving calls from suppliers wondering when orders of the one-liter bottles are going to come. By offering a bonus for the number of bottles produced, the owner made it beneficial for the competing shifts to gain an advantage by only bottling the smaller bottles. When incentives are correctly aligned with organizational goals the benefits can be exceptional. These practices include profit sharing, performance bonuses, and employee stock ownership. However, these incentives can go awry if the criteria for determining if an incentive has been met falls out of alignment with the original goal. For example, poorly structured performance bonuses have driven some executives to take measures that improve the financial results of the company in the short-time—just enough to get the bonus. In the long-term, these measures have then proven detrimental to the health of the company.

Economics Is the Dismal Science Scarcity is what underpins all of economics, which is one interpretation of why economics is sometimes referred to as the dismal science. Humans are constantly making choices that are determined by their costs and benefits. On a personal level, scarcity means that we have to make choices based on the incentives we are given according to different courses of action. On a market level, the impact of millions of people making choices creates the forces of supply and demand.

What Is the Law of Supply and Demand? The law of supply and demand is a theory that explains the interaction between the sellers of a resource and the buyers for that resource. The theory defines the relationship between the price of a given good or product and the willingness of people to either buy or sell it. Generally, as price increases, people are willing to supply more and demand less and vice versa when the price falls. The theory is based on two separate "laws," the law of demand and the law of supply. The two laws interact to determine the actual market price and volume of goods on a market.

KEY TAKEAWAYS  The law of demand says that at higher prices, buyers will demand less of an economic good.

 The law of supply says that at higher prices, sellers will supply more of an economic good.  These two laws interact to determine the actual market prices and volume of goods that are traded on a market.  Several independent factors can affect the shape of market supply and demand, influencing both the prices and quantities that we observe in markets.

Understanding the Law of Supply and Demand The law of supply and demand, one of the most basic economic laws, ties into almost all economic principles in some way. In practice, people's willingness to supply and demand a good determines the market equilibrium price, or the price where the quantity of the good that people are willing to supply just equals the quantity that people demand. However, multiple factors can affect both supply and demand, causing them to increase or decrease in various ways. Law of Supply and Demand

Law of Demand vs. Law of Supply Demand The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

Supply Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. From the seller's perspective, the opportunity cost of each additional unit that they sell tends to be higher and higher. Producers supply more at a higher price because the higher selling price justifies the higher opportunity cost of each additional unit sold. For both supply and demand, it is important to understand that time is always a dimension on these charts. The quantity demanded or supplied, found along the horizontal axis, is always measured in units of the good over a given time interval. Longer or shorter time intervals can influence the shapes of both the supply and demand curves.

Supply and Demand Curves

At any given point in time, the supply of a good brought to market is fixed. In other words, the supply curve in this case is a vertical line, while the demand curve is always downward sloping due to the law of diminishing marginal utility. Sellers can charge no more than the market will bear based on consumer demand at that point in time. Over longer intervals of time, however, suppliers can increase or decrease the quantity they supply to the market based on the price they expect to be able to charge. So over time, the supply curve slopes upward; the more suppliers expect to be able to charge, the more they will be willing to produce and bring to market. For all time periods, the demand curve slopes downward because of the law of diminishing marginal utility. The first unit of a good that any buyer demands will always be put to that buyer's highest valued use. For each additional unit, the buyer will use it (or plan to use it) for a successively lower-valued use.

Shifts vs. Movement For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very different market phenomena. A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa. Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.

Shifts Meanwhile, a shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though the price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is affected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.

How Do Supply and Demand Create an Equilibrium Price? Also called a market-clearing price, the equilibrium price is the price at which the producer can sell all the units he wants to produce and the buyer can buy all the units he wants. With an upward-sloping supply curve and a downward-sloping demand curve, it is easy to visualize that at some point the two will intersect. At this point, the market price is sufficient to induce suppliers to bring to market the same quantity of goods that consumers will be willing to pay for at that price. Supply and demand are balanced, or in equilibrium. The precise price and quantity where this occurs depend on the shape and position of the respective supply and demand curves, each of which can be influenced by a number of factors.

Factors Affecting Supply Supply is largely a function of production costs such as labor and materials (which reflect their opportunity costs of alternative uses to supply consumers with other goods); the physical technology available to combine inputs; the number of sellers and their total productive capacity over the given time frame; and taxes, regulations, or other institutional costs of production.

Factors Affecting Demand Consumer preferences among different goods are the most important determinant of demand. The existence and prices of other consumer goods that are substitutes or complementary products can modify demand. Changes in conditions that influence consumer preferences can also be important, such as seasonal changes or the effects of advertising. Changes in incomes can also be important in either increasing or decreasing quantity demanded at any given price.

What Is Demand-Side Economics? Because Keynesian economists believe the primary factor driving economic activity and short-term fluctuations is the demand for goods and services, the theory is sometimes called demand-side economics. This perspective is at odds with classical economic theory, or supply-side economics, which states the production of goods or services, or supply, is of primary importance in economic growth.

Economist John Maynard Keynes developed his economic theories in large part as a response to the Great Depression of the 1930s. Before the Great Depression, classical economics was the dominant theory, with the belief that through the market forces of supply and demand, economic equilibrium would be restored naturally over time. However, Keynes believed that the Great Depression and its long-running, widespread unemployment defied classical economic theories, and his theories try to explain why the mechanisms of the free market were not restoring balance to the economy.

KEY TAKEAWAYS  Demand-side economics refer to Keynesian economists' belief that demand for goods and services drive economic activity.  A core characteristic of demand-side economics is aggregate demand.  Government can generate demand for goods and services if people and businesses are unable to.

Insufficient Demand Causes Unemployment Keynes maintained that unemployment is the result of inadequate demand for goods. During the Great Depression, factories sat idle, and workers were unemployed because there was not enough of a demand for those products. In turn, factories had insufficient demand for workers. Because of this lack of aggregate demand, unemployment persisted and, contrary to classical theories of economics, the market was not able to self-correct and restore balance. One of the core characteristics of Keynesian or demand-side economics is the emphasis on aggregate demand. Aggregate demand is composed of four elements: consumption of goods and services; investment by industry in capital goods; government spending on public goods and services; and net exports. Under the demand-side model, Keynes advocated for government intervention to help overcome low aggregate demand in the short-term, such as during a recession or depression, to reduce unemployment and stimulate growth.

How the Government Can Generate Demand If the other components of aggregate demand are static, government spending can mitigate these issues. If people are less able or willing to consume, and businesses are less willing to invest in building more factories, the government can step in to increase government spending to generate demand for goods and services. Keynesian economics supports heavy government spending during a national recession to encourage economic activity. Putting more money in the pockets of the middle and lower classes has a greater benefit to the economy than saving or stockpiling the money in a wealthy person's account.

Central banks can also achieve this goal by altering interest rates or selling or buying government-issued bonds. This type of intervention is known as monetary policy. These policies, such as changing interest rates, can be used to increase the total money supply in the economy or the velocity of money flowing through the economy. Increasing the flow of money to lower and middle classes increases the velocity of money or the frequency at which $1 is used to buy domestically-produced goods and services. Increased velocity of money means more people are consuming goods and services and, thus, contributing to an increase in aggregate demand.

What Is Supply-Side Theory? The supply-side theory is an economic concept whereby increasing the supply of goods leads to economic growth. Also defined as supply-side fiscal policy, the concept has been applied by several U.S. presidents in attempts to stimulate the economy. Comprehensively, supply-side approaches target variables that bolster an economy’s ability to supply more goods and services.

KEY TAKEAWAYS:  Supply-side economics holds that increasing the supply of goods translates to economic growth for a country.  In supply-side fiscal policy, practitioners often focus on cutting taxes, lowering borrowing rates, and deregulating industries to foster increased production.  Supply-side fiscal policy was formulated in the 1970s as an alternative to Keynesian, demand-side policy.

Understanding Supply-Side Theory Supply-side economic theory is commonly used by governments as a premise for targeting variables that bolster an economy's ability to supply more goods. In general, supply-side fiscal policy can be based on any number of variables. It is not limited in scope but seeks to identify variables that will lead to increased supply and subsequent economic growth. Supply-side theorists, historically, have focused on corporate income tax reductions, capital borrowing rates, and looser business regulations. Lowerincome tax rates and lower capital borrowing rates provide companies with more cash for reinvestment. Moreover, looser business regulations can eliminate lengthy processing times and unnecessary reporting requirements that can stifle production. Comprehensive...