Economics Full Subject PDF

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ECONS101 - Full Subject Notes1: Introduction to EconomicsLearning Outcomes:● Apply selected models and the 'economic way of thinking' to explain and solve economic problems; ● Use elasticities and game theory to anticipate how buyers, sellers, and competitors will react to changes in prices and othe...

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ECONS101 - Full Subject Notes 1: Introduction to Economics Learning Outcomes: ● Apply selected models and the 'economic way of thinking' to explain and solve economic problems; ● Use elasticities and game theory to anticipate how buyers, sellers, and competitors will react to changes in prices and other variables; ● Use descriptive and graphical models to explain the behaviour and decision-making of firms that sell a differentiated product and have some market power; ● Apply the model of supply and demand to analyse market problems in markets with perfect competition; ● Use descriptive and graphical models to explain how NZ's GDP, employment and overall price level are determined, and how changes in the macroeconomy may influence the behaviour of buyers and firms; and ● Apply your knowledge to problems arising within the general business environment.

Economics & Data Errors Extrapolation Error: Extrapolating data and causing error is when you look at a past trend and assume that trend is going to continue into the future. Causation & Correlation: To observe two variables that change together and conclude that a change in one variable causes a change in the other variable. - Often, this leads to the ‘faulty causation fallacy’, where we mix up correlation with causation. - Causation refers to a cause-and-effect relationship between two variables, i.e. where a change in one variable produces a change in the other, ceteris paribus (all else being equal). - Correlation refers to an assessment that two variables have moved together, so that they appear to be related. This might be because of a cause-and-effect relationship, but not necessarily. Causation vs Correlation: When two variables (A and B) move together in the same direction (positive correlation) or opposite directions (negative correlation), it might be because A causes

B. However, it might also be because: B causes A (reverse causation). Alternatively a third variable (C) could cause (A and B) to appear related. Spurious: It just happens because the data says it happens, however there is no relationship at all.

Examples: Consider the following three situations. Are these relationships causal (does a change in the first variable cause the change in the second variable)? ● Students who brush their teeth get higher grades in school - The data shows this however it is a correlation, brushing teeth is not causal to better grades, there is likely to be a third variable causing better grades in the sample. ● Players who play violent video games are more likely to commit acts of violence - This is no causal either, this is reverse causation - people who are naturally more violent are more likely to play violent video games. ● In years where per capita cheese consumption is higher, more people have died by becoming tangled in their bedsheets - This is not causal, this is an example of spurious correlation. Where the data shows the accuracy of the statement however there is no relation between the two variables.

Economic Models How do we avoid making simple extrapolation and faulty causation errors? - By using an appropriate model to extrapolate, or to explain relationships A model is an abstraction or simplification of reality, e.g. - A map - A model aircraft - A mathematical or theoretical model An economic model is an explanation of how the economy, or part of the economy, works, e.g. - We will use our first simple model of production shortly A good model: ● Is clear: it helps us better understand something important ● Predicts accurately: its predictions are consistent with evidence ● Improves communication: it helps us to understand what we agree (and disagree) about ● Is useful: We can use it to find ways to improve how the economy works

Basic Economic Concepts ● Economics is about using models, and most models are about explaining choices. Before describing economic choices, we need to have some basic concepts in mind: ● Ceteris paribus is an assumption we make in economic models. It translates as “other things being equal” and it means that when we look at a change in the model, we are assuming that everything else (including things that are not in the model) doesn’t change. Everything else being equal. ● Incentives are economic rewards or punishments that influence the benefits and costs of the alternatives that a decision-maker can choose. Influence our decision making - costs go up we do less of it, benefits go up we do more of it. ● The relative price is the price of one good compared to another, which helps us to compare alternatives. ● Economic rent is a payment or other benefit that a decision-maker receives above and beyond what they would have received in their next best alternative. The profit that they received by choosing the best option - how much better is A than B. Opportunity Cost: ● When we choose one alternative we are also choosing to set aside (or forego) the other alternatives we could have chosen. ● The opportunity cost is the cost of not pursuing the opportunity of doing something else any time you choose one thing, there is a cost to it - the cost of what you have given up. ● We can measure the opportunity cost of a decision as its’ cost measured in terms of the best possible alternative foregone (i.e. we measure the opportunity cost as the value of the best alternative we didn’t choose).

Explaining the Industrial Revolution

Observations of the Industrial Revolution ● For most of history income was flat and consistent. ● Suddenly GDP per capita skyrockets. Explain why the Industrial Revolution happened in Britain (rather than France or China or somewhere else), using a model. A simple model of production, can show how changes in relative prices create incentives for innovation and ultimately created the conditions underlying the Industrial Revolution.

A model of production to explain the Industrial Revolution Consider a simple model involving the choice between two inputs into production – with the amount of one input (labour = L) measured on the x axis, and the amount of the other input (capital = K) measured on the y axis Different combinations of the two inputs (L,K), which we can refer to as “different production technologies”, will produce different amounts of output However, some production technologies will produce the same amount of output How can we decide which production technology we should use?

The Production Decision Let’s say that the firm wants to produce a total amount of production equal to X, and has several production technologies (combinations of labour and capital) to choose from We can easily eliminate any combination of L and K which requires more of both inputs than some other technology We say the eliminated combination is dominated by the better production technology How do we decide among the remaining options? Let’s assume the firm is trying to maximise its profits (profits are the firm’s economic rent from this production decision) The profit-maximising production technology will be the one that has the lowest cost to produce X

Iso-Cost Line An iso-cost line is a line that links all of the combinations of the inputs that have the same total cost. Consider our simple two input model. The equation for total cost is: = × + × We can rearrange this into the equation for a straight iso-cost line with total cost equal to TC: 𝐾=𝑇𝐶/𝑝−𝑤/𝑝. With a y-intercept of TC/p and a slope of -w/p

● All iso-cost lines have the same slope (equal to -w/p, which is the relative price of the two inputs) - The only difference between them is the total cost (TC) ● When the relative price is high (wages are high and/or price of capital is low), the iso-cost lines will be steep. When the relative price is low (wages are low and/or price of capital is high), the iso-cost lines will be flat ● Regardless of their slope, iso-cost lines closer to the origin (down and to the left) will have lower total cost - So, the lowest cost production technology will be the one that sits on the lowest iso-cost line

What Happened in the Industrial Revolution? The two resources in our model of the Industrial Revolution are labour and coal, and the output is cloth ● To make things simple, let’s assume there are only two production technologies available: A labour-intensive production technology (A) A coal-intensive production technology (B) ● Prior to the Industrial Revolution, wages were relatively low and coal was relatively expensive. - The labour-intensive production technology was the lowest cost way to produce cloth. ● During the Industrial Revolution, there was an increase in wages relative to the price of coal. - So, w/p increased and the iso-cost lines became steeper. The labour-intensive production technology is no longer the lowest cost technology for producing cloth & this created the incentive for firms to shift to the coal-intensive (and less labour-intensive) production technology. So why was Britain first to experience the Industrial Revolution? ● Because in Britain, wages were higher than elsewhere and the price of coal was lower (the relative price favoured the use of coal more in Britain than it did elsewhere)

2: A Model of Choices Objective ● Describe the features of the constrained optimisation model and/or the consumer choice model

● Use the consumer choice model to explain consumer behaviour when prices or income changes ● Explain the income and substitution effects of a change in relative price ● Use the constrained optimisation model to explain leisure-consumption decisions by workers, and/or to explain savings behaviour

The Budget Constraint ● Of course, consumers can not buy everything that they want. They are constrained by the amount of income they have. This is what we call the budget constraint ● Consider our simple two goods model. If the consumer spends all their income, then income = expenditure, i.e. = + We can rearrange this into the equation for a straight line: = / − / With y-intercept M/Py and slope -Px/Py (the relative price of the two goods) ● Notice that this is similar to the iso-cost line from Topic 1 – all bundles of goods on the budget constraint have the same total cost (M) Key ● An easier way of remembering how to draw the budget constraint is to find the two end points (where you spend all of your income on good x, or all of your income on good y), and draw a line passing through those two points. ● Using the two end points and the slope (-Px/Py) you can easily describe what happens to the budget constraint when there is a change in the price of either good, or a change in income. The Budget Constraint & Relative Prices ● The slope of the budget constraint is the relative price (-Px/Py) of the two goods ● The slope of the budget constraint also shows the opportunity cost of each good ● If the budget constraint is steep, then the opportunity cost of Good X is high (since a consumer would have to give up lots of Good Y to get more of Good X) and the opportunity cost of Good Y is low ● The slope of the budget constraint is also called the marginal rate of transformation: Because it shows what it would ‘cost’ you (in terms of opportunity cost) to transform Good Y into one more unit of Good X How is the budget line affected by the following situations? ● Price discounts – e.g. buy one pizza slice and additional slices at half price (block pricing – Topic 6)

● Connection fees (two-part pricing – Topic 6) – e.g. internet $30 per month base fee and $3 a gigabyte ● Quantity constraints and rationing – e.g. a maximum of three drinks per person ● Combinations of these – e.g. text messaging at $25 a month, which gives you 1000 ‘free’ texts, then 20c each text after that

Comparing Bundles of Goods ● The first thing to recognise is that the budget constraint separates the bundles of goods into those that the consumer can afford and those they cannot afford ● The bundles of goods they can afford are those that are on, or below, the budget constraint is called the feasible set ● However, we then need some way of showing the preferences of consumers (their likes and dislikes among different consumption bundles in the feasible set, or more generally their ranking of the consequences of a decision)

Utility ● Utility is a measure of satisfaction or happiness ● The goal of the consumer is to maximise their utility (satisfaction, or happiness) ● One way to compare bundles of goods is then to compare the amount of utility that they provide to the consumer. A bundle that provides higher utility will be preferred to a bundle that provides lower utility Diminishing Marginal Utility: ● Let’s assume that consuming more of a good is always better than consuming less ● However, our consumption of goods is subject to diminishing marginal utility ● Marginal utility is the additional utility a consumer receives by consuming one additional unit of a good ● Marginal utility decreases as we get more and more of a good (because of satiation) Indifference Curves ● An indifference curve (or iso-utility curve) shows all the combinations of goods that provide the consumer with the same level of satisfaction (utility) ● The consumer would be equally happy with any of the bundles of goods on the same indifference curve. If asked to choose between bundles of goods on the same indifference curve, we say that they are indifferent between them Properties of Indifference Curves ● There are an infinite number of indifference curves (every possible combination of Good X and Good Y will be on some indifference curve). To make our life simpler, we will

only draw the indifference curves that go through bundles of goods that we are interested in ● If both goods are desirable, then higher indifference curves (that provide more utility) occur to the right and above lower indifference curves: Because we always prefer to have more of one good with the same amount of the other good. Essentially, the consumer is trying to get to the highest indifference curve (to maximise their utility) ● Indifference curves cannot cross.

Marginal Rate of Substitution ● The amount of good y a consumer is willing to give up to get one additional unit of good x (and remain just as satisfied) is called the marginal rate of substitution (MRS) ● The MRS is the slope of the indifference curve, and is equal to the ratio of the marginal utility of the two goods, i.e. ●

Special Cases of Indifference Curves Indifference curves are not necessarily parallel, and while the standard shape of an indifference curve is a curve, there are also some special cases: ● Perfect substitutes (goods that are essentially identical to the consumer) ● Perfect complements (goods that must be consumed together in some specific ratio) The Best Affordable Choice Using the budget constraint and indifference curves, we can then describe what the consumer will choose to buy. ● The best affordable choice (or the consumer’s optimum) is the bundle of goods that the consumer can afford (under or on their budget constraint) that provides them with the highest utility (is on the highest indifference curve that they can get to). ● At this bundle, the marginal rate of substitution is usually equal to the relative price (i.e. the slope of the indifference curve is the same as the slope of the budget constraint; MRS = MRT). ● There are some exceptions to this, when the budget constraint isn’t a simple straight line (think about the quantity constraint we discussed earlier, for example)

Income Change and Consumer Choice ● When a consumer’s income changes, they might increase the quantity of a good they buy, or they might decrease the quantity they buy ● When a consumer buys more of the good as their income increases, economists call that a normal good ● When a consumer buys less of the good as their income increases, economists call that an inferior good

Indifference Curves in Practice ● So, how do we know what shape the consumer’s indifference curves are? We don’t! So, if we don’t know that, what use is this model? ● It’s useful because it can help us explain what will happen when prices or incomes, or something else changes, for an ‘average’ (representative) consumer ● We can also look at what happens when we have different types of consumers (say, high demand and low demand consumers) ● How can we tell if we have one group of very similar customers (homogeneous demand), or different groups of customers (heterogeneous demand)?

The Income and Substitution Effect ● The substitution effect of a price change – consumers substitute away from the relatively more expensive good towards the relatively less expensive good. ● However, there is also an income effect of a price change. A price increase decreases a consumer’s purchasing power (real income). If the good is a normal good, they will buy less of it. But if the good is an inferior good, they will buy more of it. ● Note that these two effects both occur when there is a change in relative price. If there is a change in income, there is only an income effect and no substitution effect

3: Game Theory Objectives ● Structure a simple game in both matrix form (normal form) and tree form (extensive form) ● Define and identify dominant strategies in simultaneous games ● Define and identify Nash equilibriums in simultaneous and sequential games

● Explain how players can use or alter the structure of the game to their own advantage

Game Theory ● Game theory is the general analysis of strategic interaction; originated with John von Neumann in the 1920s. Psychologists refer to game theory as the “theory of social situations”, which pretty accurately describes what we are interested in ● We study optimal strategic decision making assuming: all decision makers act rationally, & each decision maker attempts to anticipate the actions of their rivals ● In this paper we will start by considering non-cooperative games ● Negotiation and enforcement of binding contracts is not possible Some Definitions: ● A game is a set of interactions between players that results in a payoff to each player ● The rules determine how the game is structured and played ● A player is one of the decision-makers in the game ● A strategy is a potential choice that the player could make ● An outcome is the combination of strategies that the players choose ● A payoff is what the player receives from the game (their economic rent). Simultaneous, non-repeated games: ● A game is a simultaneous game if both players’ decisions about strategy are revealed at the same time, so they make their decision without knowing the strategy choice of the other player ● A game is a non-repeated game if it is played only once ● We will also assume that both players have full information about the game (including the possible strategies and payoffs) and that all of the benefits (and costs) are summarised in the payoff to each player

Normal Form (See Diagram) ● We can describe simultaneous, non-repeated games with a payoff table (referred to as normal form). The table identifies the players, the strategies available to them, and the payoffs as a function of the strategies selected by both players. ● 4 outcomes with payoffs for each player.

Dominant Strategy (The Prisoner's Dilemma) ● A strategy is a dominant strategy for a player if it gives that player a payoff that is higher than the payoff the player could receive from any other strategy, regardless of the

strategy played by the other player. A player will always choose to play a dominant strategy. ● A dominant strategy equilibrium occurs where both players play a dominant strategy.

Nash Equilibrium ● In the absence of a dominant strategy, Nash equilibrium may predict the outcome ● A Nash equilibrium is a set of strategies in which each player is doing the best they can, given the actions of their rivals. An outcome is a Nash equilibrium if no player could be better off by changing their strategy. ● We can find any Nash equilibriums using the “best response” method. ● A dominant strategy equilibrium is a Nash Equilibrium, but not all Nash equil...