1 Eco 101: Chapter 1 notes Definition of economics the study of how individuals and societies use limited resources

s to satisfy unlimited wants. Fundamental economic problem scarcity. individuals and societies must choose among available alternatives. Economic goods, free goods, and economic bads economic good (scarce good) - the quantity demanded exceeds the quantity supplied at a zero price. free good - the quantity supplied exceeds the quantity demanded at a zero price. economic bad - people are willing to pay to avoid the item Economic resources land natural resources, the free gifts of nature labor the contribution of human beings capital plant and equipment this differs from financial capital entrepreneurial ability Resource payments Economic Resource Resource payment land rent labor wages capital interest entrepreneurial ability profit Rational self-interest individuals select the choices that make them happiest, given the information available at the time of a decision. self-interest vs. selfishness Positive and normative analysis positive economics attempt to describe how the economy functions relies on testable hypotheses normative economics relies on value judgements to evaluate or recommend alternative policies. Economic methodology scientific method observe a phenomenon, make simplifying assumptions and formulate a hypothesis, generate predictions, and test the hypothesis. Simplifying assumptions ceteris paribus holding everything else constant abstraction in economics used to simplify reality Logical fallacies fallacy of composition occurs when it is incorrectly assumed that what is true for each and every individual in isolation is true for an entire group. post hoc, ergo propter hoc fallacy (association as causation) occurs when one incorrectly assumes that one event is the cause of another because it precedes the other.

2 Microeconomics vs. macroeconomics microeconomics - the study of individual economic agents and individual markets macroeconomics - the study of economic aggregates Algebra and graphical analysis Direct relationship

Inverse relationship

Linear relationships A linear relationship possesses a constant slope, defined as: If an equation can be written in the form: Y=mX+b, then: m = slope, and b = Y - intercept.

Chapter 2: Opportunity costs Scarcity Economics is the study of how individuals and economies deal with the fundamental problem of scarcity. As a result of scarcity, individuals and societies must make choices among competing alternatives. Opportunity Cost The opportunity cost of any alternative is defined as the cost of not selecting the "next-best" alternative. Example: Suppose that you own a building that is worth $100,000 today and is expected to be worth $100,000 one year from today. If the interest rate is 10%, what is the opportunity cost of using this building for one year? Marginal analysis Marginal benefit = additional benefit resulting from a one-unit increase in the level of an activity Marginal cost = additional cost associated with one-unit increase in the level of an activity Net benefit Individuals are not expected to maximize benefit; nor are they expected to minimize costs. Individuals are assumed to attempt to maximize the level of net benefit (total benefit minus total cost) from any activity in which they are engaged. MB > MC expand the activity MB < MC contract the activity optimal level of activity: MB = MC (Net benefit is maximized at this point) Marginal benefit MB generally declines as the level of an activity rises, ceteris paribus. Consider the MB of time spent studying:

3 Optimal study time The optimal amount of study time occurs at the point at which MB = MC Production possibilities curve Assumptions: A fixed quantity and quality of available resources A fixed level of technology Efficient production (i.e., no unemployment and no underemployment) Example: study time 4 hours left to study for two exams: economics and calculus Output = grades on each exam Alternative uses of time: Fixed resources? Fixed technology? No unemployed nor underemployed resources?

Law of diminishing returns Law of diminishing returns: output will ultimately increase by progressively smaller amounts when the use of a variable input increases while other inputs are held constant. Does this apply in this example? What are the fixed inputs? Production possibilities curve

Marginal opportunity cost Marginal opportunity cost = the amount of another good that must be given up to produce one more unit of a good. Calculating marginal opportunity cost In the interval between points A and B, the marginal opportunity cost of 1 point on the economics exam is 1/3 of a point on the calculus exam. Law of increasing cost Law of increasing cost marginal opportunity cost rises as the level of an activity increases

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Reasons for law of increasing cost

Law of diminishing returns Specialized resources (heterogeneous labor, land, capital, etc.) Specialized resources in farming Some land, labor, and capital is better suited for wheat production and some is better suited for corn production

Points outside of the PPC

Economic growth

Commodity-specific technological change

Specialization and trade Adam Smith economic growth is caused by increased specialization and division of labor. Gains from specialization and division of labor specialization in areas that match the skills and talents of workers learning by doing increase in productivity from task repetition less time lost while switching from task to task As noted by Adam Smith, specialization and trade are inextricably linked. Adam Smith and David Ricardo used this argument to support free trade among nations. Absolute and comparative advantage Absolute advantage an individual (or country) is more productive than other individuals (or countries). Comparative advantage an individual (or country) may produce a good at a lower opportunity cost than can other individuals (or countries). Countries always expand their consumption possibilities by engaging in trade (since they acquire goods at a lower opportunity cost than if they produced them themselves). Free trade? If each country specializes in the production of those goods in which it possesses a comparative advantage and trades with other countries, global output and consumption in increased. Chapter 3: Demand and Supply Barter vs. monetary economy Barter goods are traded directly for other goods Problems: requires double coincidence of wants large number of trading ratios: N(N-1)/2 (high information costs) Monetary economy has lower transaction and information costs Relative and nominal prices Relative price = price of a good in terms of another good Nominal price = price expressed in terms of the monetary unit Relative price is a more direct measure of opportunity cost

5 Markets In a market economy, the price of a good is determined by the interaction of demand and supply Demand A relationship between price and quantity demanded in a given time period, ceteris paribus. Demand schedule Demand curve

Law of demand An inverse relationship exists between the price of a good and the quantity demanded in a given time period, ceteris paribus. Reasons: substitution effect income effect Change in quantity demanded vs. change in demand Change in quantity demanded Change in demand

2 Market demand curve Market demand is the horizontal summation of individual consumer demand curves

Determinants of demand tastes and preferences prices of related goods and services income number of consumers expectations of future prices and income

Tastes and preferences

Prices of related goods

Effect of fads:

substitute goods an increase in the price of one results in an increase in the demand for the other. complementary goods an increase in the price of one results in a decrease in the demand for the other.

Change in the price of a substitute good

Change in the price of a complementary good

Price of coffee rises:

Price of DVDs rises:

Income and demand: normal goods

Income and demand: inferior goods

A good is a normal good if an increase in income results in an increase in the demand for the good.

A good is an inferior good if an increase in income results in a reduction in the demand for the good.

Demand and the # of buyers

Expectations

An increase in the number of buyers results in an increase in demand.

A higher expected future price will increase current demand. A lower expected future price will decrease current demand. A higher expected future income will increase the demand for all normal goods. A lower expected future income will reduce the demand for all normal goods.

International effects

International effects (continued)

exchange rate the rate at which one currency is exchanged for another. currency appreciation an increase in the value of a currency relative to other currencies. currency depreciation a decrease in the value of a currency relative to other currencies.

Domestic currency appreciation causes domestically produced goods and services to become more expensive in foreign countries. An increase in the exchange value of the U.S. dollar results in a reduction in the demand for U.S. goods and services. The demand for U.S. goods and services will rise if the U.S. dollar depreciates.

Supply

Supply schedule

the relationship that exists between the price of a good and the quantity supplied in a given time period, ceteris paribus.

Law of supply

Reason for law of supply

A direct relationship exists between the price of a good and the quantity supplied in a given time period, ceteris paribus.

The law of supply is the result of the law of increasing cost.

As the quantity of a good produced rises, the marginal opportunity cost rises. Sellers will only produce and sell an additional unit of a good if the price rises above the marginal opportunity cost of producing the additional unit.

Change in supply vs. change in quantity supplied

Change in supply Change in quantity supplied

Individual firm and market supply curves

The market supply curve is the horizontal summation of the supply curves of individual firms. (This is equivalent to the relationship between individual and market demand curves.)

Determinants of supply

Price of resources

the price of resources, technology and productivity, the expectations of producers, the number of producers, and the prices of related goods and services

As the price of a resource rises, profitability declines, leading to a reduction in the quantity supplied at any price.

note that this involves a relationship in production, not in consumption

Technological improvements

Expectations and supply

Technological improvements (and any changes that raise the productivity of labor) lower production costs and increase profitability.

An increase in the expected future price of a good or service results in a reduction in current supply.

Increase in # of sellers

Prices of other goods

Firms produce and sell more than one commodity. Firms respond to the relative profitability of the different items that they sell. The supply decision for a particular good is affected not only by the goods own price but also by the prices of other goods and services the firm may produce.

International effects

Market equilibrium

Firms import raw materials (and often the final product) from foreign countries. The cost of these imports varies with the exchange rate. When the exchange value of a dollar rises, the domestic price of imported inputs will fall and the domestic supply of the final commodity will increase. A decline in the exchange value of the dollar raises the price of imported inputs and reduce the supply of domestic products that rely on these inputs.

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Price above equilibrium

Price below equilibrium

If the price exceeds the equilibrium price, a surplus occurs:

If the price is below the equilibrium a shortage occurs:

Demand rises

Demand falls

Supply rises

Supply falls

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Price ceiling

Price ceiling (continued)

Price ceiling - legally mandated maximum price Purpose: keep price below the market equilibrium price Examples:

rent controls price controls during wartime gas price rationing in 1970s

Price floor

Price floor (continued)

price floor - legally mandated minimum price designed to maintain a price above the equilibrium level examples:

agricultural price supports minimum wage laws