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Economics is a social science that deals with the study of how human’s allocate scarce resources. Allocation means distribution. Scarce means limited. If the resources is not scarce then human’s would not fight over it. Since there is a limited quantity, then we have to figure out as a society how we are going to distribute those scarce resources.
Scarcity is the state of limited nature of society’s resources.
Resources can be any number of things like land, water, food, oil, gas etc.
We need to understand economics so we avoid things like civil unrest and wars. Countries tend to go to war over a number of these resources.
The first principle we need to take note of is that people behave rationally. While human beings oftentimes do not behave rationally, we make an assumption that people tend to behave rationally for purposes of this course.
The second principle is that people respond to incentives. For example, if there was a tax on cigarettes, leads to less smoking
Microeconomics – the study of how individual households and firms make decisions and how they interact with one another
- focuses on the actions of individual agents within the economy, like households, workers, and businesses.
Macroeconomics – the study of the economy as a whole. The goal is to explain the economic changes that affect many households, firms, and markets simultaneously
- It is the branch of economics that focuses on broad issues such as growth, unemployment, inflation, and trade balance.
- Fiscal policy – economic policies that involve government spending and taxes. It is determined by a nation’s legislative body
- Monetary policy – policy that involves altering the level of interest rates, the availability of credit in the economy, and the extent of borrowing. It is determined by a nation’s central bank
Economists play two important roles:
Economist as Scientist
- They must rely on observations and data
- They cannot run experiments
- Economist make assumptions to simply things
- Economists use models to explain theories
Economist as Policy Adviser
- of Treasury, Office of Management and Budget, Council of Economic Advisers, Congressional Budget Office
Division of Labor
Adam Smith – wrote “The Wealth of Nations” 1776. Adam Smith introduced the idea of dividing labor into discrete tasks, in his famous 1776 book, titled The Wealth of Nations.
- Division of Labor– the production of a good or service is divided into a number of tasks performed by different people
- the way in which different workers divide required tasks to produce a good or service. The workers on an assembly line are an example of the divisions of labor
- Dividing and subdividing the tasks involved with producing a good or service, produces a greater quantity of output.
- Specialization– workers concentrate on one part of the production process where they have an advantage
- When workers or firms focus on particular tasks for which they are well-suited within the overall production process.
- Specialization allows businesses to take advantage of economies of scale, which means that for many goods, as the level of production increases, the average cost of producing each individual unit declines
- Economies of Scale– As the level of production increases, the cost of producing each unit declines
Circular Flow Diagram
- The circular flow diagram is a very basic model.
- It shows how households and firms interact in the goods and services market, and in the labor market.
- The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them.
- In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.
- In this model, there are households which represent the consumers and the firms which represent the producers. The goods and services are supplied by the firms. The household pay for those goods and services.
- The household supplies their time, energy, skills and education. In turn, the firms pay for the labor in terms of wages and salaries.
Economists Use Theories and Models to Understand Economic Issues
- One of the most influential economists in modern times was John Maynard Keynes.
- Keynes thought that economics teaches you how to think, not what to think.
- A theory is a simplified representation of how two or more variables interact with each other.
- A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying.
Two Types of Markets:
- The Market for Goods and Services
- Households demandgoods and services
- Firmssupply goods and service
- The Labor Market
- Firmsdemand labor
- Households supplylabor
The Invisible Hand
Adam Smith – coined the term “The Invisible Hand”, a natural phenomenon that guides the market economy
- It describes how consumers and producers interact in the economy
- Self-interest can lead to positive social benefits
Sometimes market economies have inefficiencies or market failures (monopolies, income inequality, pollution, etc) Government is often needed to correct for market failures
- Regulations define the “Rules of the game” in an economy
- Regulations enforce private property laws, protect people, prevent fraud, collect taxes
Underground economy (black market) – buyers and sellers make transactions without government approval
Traditional Economy– these economies organize their affairs the same way they have always done
- typically an agricultural economy where things are done the same as they have always been done.
- Oldest economic system
- Used in parts of Asia, Africa, and South America
- Occupations tend to stay in the family
- What you produce is what you consume
- Little economic progress or development
Command Economy– the government decides what goods and services will be produced and what prices will be charged, what methods of production will be used and how much workers will be paid.
- an economy where economic decisions are passed down from government authority and where the
government owns the resources.
- Government decides what goods and services will be produced and what prices it will charge for them.
- The government decides what methods of production to use and sets wages for workers.
- The government provides many necessities like healthcare and education for free.
Market Economy– decision-making is decentralized. Market economies are based on private enterprise: the means of production (resources and businesses) are owned and operated by private individuals or groups of private individuals
- An economy where economic decisions are decentralized, private individuals own resources, and businesses supply goods and services based on demand.
Real World Economies
- Most economies in the real world are mixed. They combine elements of command, traditional, and market systems.
- The U.S. economy is positioned toward the market-oriented end of the spectrum.
- Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than the U.S. economy.
- China and Russia, while they have moved more in the direction of having a market-oriented system, remain closer to the command economy end of the spectrum.
The Rise of Globalization
- Globalization – the trend in which buying and selling in markets have increasingly crossed national borders.
- Exports – the goods and services that a nation produces domestically and sells abroad.
- Imports – the goods and services that are produced abroad and then sold domestically.
- Gross domestic product (GDP)– measures the size of total production in an economy.
Choices and Tradeoffs
Opportunity Set – all the possible opportunities for spending on two goods or services
Budget Constraint – all the combination of two goods that one can afford when the budget is exhausted
Opportunity cost – what must be given up to obtain something that is desired
Opportunity cost = Explicit cost + Implicit cost
Sunk costs – costs incurred in the past that cannot be recovered
Law of Diminishing Marginal Utility
Utility – the satisfaction one gains from a good or service
Law of Diminishing Marginal Utility – as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines
Production Possibilities Frontier
Just as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either.
Law of Increasing Opportunity Cost
The law of increasing opportunity cost – holds that as production of a good or service increases, the marginal opportunity cost of producing it increases as well
- Economists make the careful distinction between positive statements and normative statements.
- When economics analyzes the gains and losses from various events or policies, and thus draws normative conclusions about how the world should be, the analysis of economics is rooted in a positive analysis of how people, firms, and governments actually behave, not how they should behave.
Law of Demand
market – a group of buyers and sellers of a particular good or service
competitive market – a market in which there are many buyers and sellers so that each has little to no impact on the market price.
The goods offered for sale are identical
Buyers and sellers are price takers
Law of Demand
Ceteris paribus, when the price of a good rises, the quantity demanded falls, and when the price falls, the quantity demanded rises
- There is a negative relationship (inverse relationship) between price and quantity demanded.
Quantity demanded – the amount buyers are willing and able to purchase
Increase in Demand – demand curve shifts right
Decrease in Demand – demand curve shifts left
Normal and Inferior Goods
How Changes in Income Affect Demand
Normal good – a good for which, other things being equal, an increase in income leads to an increase in demand
Inferior good – a good for which, other things being equal, an increase in income leads to a decrease in demand
Substitutes and Complements
How Prices of Related Goods Affect Demand
Substitutes – two goods for which an increase in the price of one leads to an increase in the demand for the other
Complements – two goods for which an increase in the price of one leads to a decrease in demand for the other
Law of Supply
Ceteris paribus, the quantity supplied of a good rises when the price of the good rises.
- There is a positive relationship between price and quantity supplied
Quantity supplied – the amount of a good that sellers are willing and able to sell
Shift In supply
Increase in supply – supply curve shifts right
Decrease in supply – supply curve shifts left
Equilibrium – a situation in which the market price has reached the level at which quantity supplied equals quantity demanded
Equilibrium price P* – the market-clearing price, buyers have bought all they want to buy and sellers have sold all they want to sell
Equilibrium quantity Q* – where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied)
consumer surplus – the amount that individuals would have been willing to pay, minus the amount that they actually paid
producer surplus – the amount that a seller is paid for a good minus the seller’s actual cost
Markets Not in Equilibrium
- Surplus– a situation in which quantity supplied is greater than quantity demanded. Excess supply
- Shortage– a situation in which quantity demanded is greater than quantity supplied. Excess demand
Price Ceiling – a legal maximum price; prevents price from climbing “too high”
Example: rent control
Price Floor – a legal minimum price; prevents price from falling “too low”
Example: minimum wage
Four Steps for Analyzing Changes in Equilibrium
- Draw the demand and supply model before the change took place.
- Decide whether the event shifts the supply or demand curve (or both)
- Decide in which direction the curve shifts
- Use the supply and demand diagram to see how the shift changes the equilibrium price and quantity
Practice drawing the following demand and supply curves. Starting with the market in equilibrium, show how the event shifts the demand and/or supply curve. Then explain how the equilibrium price and quantity changes
- The surgeon general reports that e-cigarettes increases the risk of certain cancers, how does this affect the market for e-cigarettes?
- S. geologists have developed a new technology for extracting oil, how does this affect the market for oil?
- The price of peanut butter drops, what happens to the market for jelly?
- Pepsi and Coke are substitutes. If the price of Coke increases, what happens to the market for Pepsi?
Solutions: Four Steps for Analyzing Changes in Equilibrium
- The surgeon general reports that e-cigarettes increases the risk of certain cancers
The demand for e-cigarettes would decrease. The demand curve will shift left, price will fall from P1 to P2, and quantity will decrease from Q1 to Q2.
- S. geologists have developed a new technology for extracting oil. What happens to the market for oil?
The supply of oil will increase. The supply curve will shift right, price will fall from P1 to P2, and quantity will increase from Q1 to Q2.
- The price of peanut butter drops, what happens to the market for jelly?
Peanut butter and jelly are complements. A drop in the price of peanut butter will cause the demand for peanut butter to rise. Since these two items are consumed together, the demand for jelly will also rise. The demand curve will shift right, price will rise from P1 to P2, and quantity will rise from Q1 to Q2
- Pepsi and Coke are substitutes. If the price of Coke increases, what happens to the market for Pepsi?
When the price of Coke increases, demand for Coke will fall and consumers will switch to Pepsi. The demand for Pepsi increases causing the demand curve to shift right, price increases from P1 to P2, and quantity increases from Q1 to Q2.
- a demand for a commodity, service, etc. which is a consequence of the demand for something else
- For example, a high demand for coffee leads to an increased demand for coffee baristas
Other examples of derived demand:
- The demand for chefs is dependent on the demand for restaurant meals
- The demand for pharmacists is dependent on the demand for prescription drugs
- The demand for attorneys is dependent on the demand for legal services
Shifts in Labor Demand
Factors that Shift the Demand Curve
- Demand for Output – When the demand – When the demand for the good produced (output) increases, both the output price and profitability increase. As a result, producers demand more labor to ramp up production
- Education and Training – well-trained and educated workforce causes an increase in the demand for that labor by employers. Increased levels of productivity within the workforce will cause the demand for labor to shift to the right.
- Technology – Technology changes can act as either substitutes for or complements to labor; When technology acts as substitute, it replaces the need for the number of workers an employer needs to hire; Technology that acts as a complement to labor will increase the demand for certain types of labor, resulting in a rightward shift of the demand curve.
- Number of Companies – An increase in the number of companies producing a given product will increase the demand for labor resulting in a shift to the right ; A decrease in the number of companies producing a given product will decrease the demand for labor resulting in a shift to the left.
- Government Regulations – Complying with government regulations can increase or decrease the demand for labor at any given wage; In the heatlhcare industry, government rules may require that nurses be hired to carry out certain medical procedures. This will increase the demand for nurses.
- Price and Availability of Other Inputs – Labor is not the only input into the production process. For example, a salesperson at a call center needs a telephone and a computer terminal to enter data and record sales. If prices of other inputs will become profitable, and suppliers will demand more labor to increase production. This will cause a rightward shift in the demand curve for labor.
Price Floors in the Labor Market
- minimum wage – a price floor that makes it illegal for an employer to pay employees less than $7.25 per hour
- if you work 40 hours a week earning $7.25 per hour for 50 weeks a year, your annual income is $14,500, which is less than the official U.S. government definition of what it means for a family to be in poverty.
- living wage– a higher minimum wage that ensures that full-time workers can afford the essentials of life: food, clothing, shelter, and healthcare
- Price Elasticity of Demand – measures how much the quantity demandedresponds to a change in price
- Price Elasticity of Supply – measures how much the quantity suppliedresponds to changes in the price
- Income Elasticity of Demand – measures how the quantity demandedresponds to changes in the price
Price Elasticity of Demand
- Elasticity is the measurement of how responsive an economic variable is to a change in another
- Price Elasticity of Demand measures how much the quantity demanded responds substantially to changes in the price.
Factors Affecting Price Elasticity of Demand
- The availability of substitutes – The more substitutes available, the more elastic the demand will be
- Necessities vs. Luxuries
- Necessities tend to have inelastic demands
- If the price of insulin rises, diabetic patients cannot use less insulin or another substitute
- Luxuries tend to have elastic demands
- If the price of a BMW rises, quantity demanded of BMW’s will fall
Calculating Price Elasticity of Demand
Practice calculating Price Elasticity of Demand:
- The price of a good rises from $6 to $10, and the quantity demanded falls from 200 to 150, calculate the elasticity.
- The price elasticity of demand for cigarettes is 0.3. If the price of a pack of cigarettes rises from $6 to $9, what happens to the quantity demanded?
Factors Affecting Price Elasticity of Supply
- The price elasticity of supply depends on the flexibility of producers to change the amount of good they produce
- Manufactured or mass produced goods like toasters, t-shirts, and phones have elasticsupplies
- Custom goods or goods with a limited supply have inelasticsupplies
Income Elasticity of Demand
Income Elasticity of Demand measures how changes in quantity demanded responds to changes in income
Some possible changes to income:
- economic boom (high economic growth)
- raising minimum wage
Income Elasticity = % change in quantity demanded / % change in income
- Normal goods have positiveincome elasticities, quantity demanded and income move in the same direction
- Inferior goods have negativeincome elasticities, quantity demanded and income move in opposite directions
Calculating Income Elasticity of Demand
Calculate the income elasticity of demand for good X if quantity demanded changes from 450 to 430 as income rises from $65,000 to $70,000
To find percent change in Q:
(430 – 450) /( (430 + 450)/2)
= -20 / 440
= – 0.045
To find percent change in I:
(70000 – 65000) / ((70000 + 65000) / 2)
= 5000 / 67500
To find the elasticity:
E = -0.045 / 0.074
The negative sign tells us the good is inferior and because |E| is <1, the demand is inelastic. In other words, these consumers are not that sensitive to changes in income.
- A 7.4% change in income leads to a 4.5% change in quantity demanded.
Gross Domestic Product
GDP – the market value of all final goods and services produced within a country in a given period of time.
- It measures total income and total expenditure
Y = C + I + G + NX
What is included:
- Final goods
- Market value of housing (rent)
What is not included:
- Intermediate goods
- Illegal goods and services
- Items produced at home
- Used goods
- Goods produced outside of the country
Example: Tires sold in a store are considered final goods. Tires sold to a car manufacturer are considered intermediate goods. The car would be considered the final good in this case.
Components of GDP
Consumption (C) – spending by households on goods and services, except new housing
- Durable goods: cars, refrigerators, furniture, etc.
- Nondurable goods: food, clothing, magazines, newspapers
- Services: medical treatments, massages, dry cleaners, lawyers
Investment (I) – spending on capital equipment, inventories, and structures, including new housing
- Business Investment: purchases of goods used in the production process, construction of offices or factories, machinery, computers, and equipment
- Residential Construction: the actual construction of new housing
- Changes in inventories: produced goods held in storage for later sales. Inventories are counted in the year they are produced, not the year sold
Government Purchases (G) – spending on goods and services by local, state, and federal governments
- Includes: salaries of government workers, expenditures on public works.
- Does notinclude: Social security payments, transfer payments, and interest payments on the debt
Net Exports (NX) – The foreign purchases of domestically produced goods (exports) minus the domestic purchases of foreign goods (imports)
NX = Exports – Imports
NX = X – M
When a domestic household buys an imported good, it reduces net exports, but it also raises consumption. It does not affect GDP
Trade surplus: NX > 0, X > M
Trade deficit: NX < 0, X < M
Balanced trade: NX = 0, X = M
Nominal and Real GDP
Nominal GDP – the production of goods and services valued at current prices
Real GDP – the production of goods and services valued at constant prices
GDP deflator – measures the current level of prices relative to the level of prices in the base year
GDP growth rate = [(GDP new – GDP old) / GDP old] x 100
GDP per capita = GDP/population
GDP deflator = [Nominal GDP / Real GDP] x 100
inflation rate – the percentage increase or decrease in prices during a specified period, usually a month or a year
inflation rate = [(GDPdef new – GDPdef old) / GDPdef old] x 100
- two quarters (6 months) of negative GDP growth
Calculating Nominal and Real GDP and GDP Deflator
- Fill in the missing values
- What is the GDP growth rate from 2015 to 2016?
- What is the inflation rate from 2017 to 2018?
- The population in Australia is roughly 25.2 million people. What is the GDP per capita in 2018?
Limitations of GDP as a Measure of the Standard of Living
- GDP focuses on production that is bought and sold in markets
- “Standard of living” is a broader term than GDP.
- standard of living includes all elements that affect people’s well-being, whether they are bought and sold in the market or not
- While GDP includes spending on recreation and travel, it does not cover leisure time
- The GDP per capita of the U.S. economy is larger than the GDP per capita of Germany, but it is also true that the average U.S. worker works several hundred hours more per year more than the average German worker.
- Calculating GDP does not account for the German worker’s extra vacation weeks.
- While GDP includes what a country spends on environmental protection, healthcare, and education, it does not include actual levels of environmental cleanliness, health, and learning
- GDP includes production that is exchanged in the market, but it does not cover production that is not exchanged in the market. For example, hiring someone to mow your lawn or clean your house is part of GDP, but doing these tasks yourself is not part of GDP
- GDP has nothing to say about the level of inequality in society. GDP per capita is only an average
Are We Better Off?
- the typical workweek for a U.S. worker has fallen over the last century from about 60 hours per week to less than 40 hours per week.
- Life expectancy and health have risen dramatically, and so has the average level of education.
- Since 1970, the air and water in the United States have generally been getting cleaner.
- Companies have developed new technologies for entertainment, travel, information, and health.
- A much wider variety of basic products like food and clothing is available today than several decades ago
- crime rates, traffic congestion levels, and income inequality are higher in the United States now than they were in the 1960s
GDP is Rough, but Useful
Real and Nominal Interest Rates
- Nominal interest rate – the current interest rate
- Real interest rate – the interest rate corrected for the effects of inflation
Real interest rate = Nominal interest rate – inflation
The interest on a savings account is 0.01%. If the inflation rate is 2%, what is the real interest rate?
Real interest = 0.01% – 2%
= – 1.99%
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Economics 102 – Principles of Macroeconomics