13: Final Review Intro Econ

1. 13: Final ReviewIntro Econ C.L. Mattoli

2. Intro • This will be a final review of intro econ. • We warn that this is by no means all that might be tested in the final exam. • It is simply meant as a summary of the course, giving it all in one place with tying threads among the concepts. • Study the book, the lecture notes, the tutorials, and the past final exams as a means of studying for the final exam. (C) Red Hill Capital Corp., Delaware, USA 2008

3. Mod 1: intro: Chapters 1,2 & 18

4. Overview • Chapter 1 introduces the idea of economics as a social science that tries to be scientific by employing the scientific method of research, when it can do that. • We talk about scarcity versus unlimited self-interested wants. • In Chapter 2 we look at production possibilities and its frontier (PPF). (C) Red Hill Capital Corp., Delaware, USA 2008

5. Overview • Because resources, including the labor hours available in any given period, are scarce, only a certain amount of one thing could be produced in an economy over a given interval of time. That is maximum production capacity. • If the economy wants to produce 2 goods, the scarce resources will have to be divided among production of the 2 goods. • How that decision is arrived at is a function of opportunity cost considerations. (C) Red Hill Capital Corp., Delaware, USA 2008

6. Overview • The only way to expand a PPF is through investment in new capital. • To do that it will have to give up producing consumer goods to produce more capital goods, which means present sacrifice to get future benefits, another trade-off of opportunities • In Chapter 4, international trade, we also found that an economy can get to a point beyond the PPF by comparative advantage in international trade. (C) Red Hill Capital Corp., Delaware, USA 2008

7. Chapter 1: intro • There is not an unlimited amount of anything in the world, so resources (factors ofproduction) for making things are scarce. • Economics is the study of choice in the allocation of scarce resources. • The resources are land, labor, and capital (equipment). Entrepreneurs, the people who take the risk and burden of doing business, are a particularly scarce resource. (C) Red Hill Capital Corp., Delaware, USA 2008

8. Chapter 1: intro • It uses the scientific method to try to come up with simple theories and equations (models) that are based on simple underlying psychology of human beings. • For example, we would expect that people will be willing to buy more of something, if the price is decreased. • That becomes a demand curve of quantity versus price that is downward sloping. (C) Red Hill Capital Corp., Delaware, USA 2008

9. Chapter 1: intro • Models use ceteris paribus, everything else held constant, many times, so that the affect of one or a few variables at a time can be examined. • Thus, for example, downward-sloping demand assumes that the prices of substitutes does not change. • Problems in theorizing include: causation versus correlation. Things might seem to be related, but it might be only a coincidence. (C) Red Hill Capital Corp., Delaware, USA 2008

10. Chapter 1: intro • Then, there is positive versus normative economics. Positive deals with facts and verifiable true-false statements. Normative is subjective and talks of what it thinks things should be like. • Thus, GDP will increase, if people work more hours is positive. • Poor people should get more money from the rich is normative (C) Red Hill Capital Corp., Delaware, USA 2008

11. Chapter 2: PP & OC • 3 fundamental questions: what, how, and for whom to produce. • That brings us to our first discussion of opportunity costs. • Scarcity means that choices must be made, and to choose one path is to sacrifice taking another path. • Opportunity cost is then defined as the best alternative that was sacrificed in choosing to do what we chose. • For example, give up producing one car to make 20 computers, then, your opportunity cost of producing 1 computer is 1/20 cars. (C) Red Hill Capital Corp., Delaware, USA 2008

12. Chapter 2: PP & OC • Economic analysis also involves marginalthinking. What is important to dynamic analysis of a productive economy is change. Marginal analysis is our first look at change: additions or subtracting, incremental affects, to a current situation. • For example, a farmer figures that he can get $75/acre without fertilizer, and the same land will yield $100/acre with fertilizer. The incremental cost of using fertilizer is $20/acre, so by using it, he will make $100 – $75 – 20 = $5/acre marginal profit by using fertilizer. (C) Red Hill Capital Corp., Delaware, USA 2008

13. Chapter 2: PP & OC • Then, we can finally look at the PPF. The PPF is the plot of maximum capacity simultaneous production of 2 (or more) goods or services (G&S). • With limited resources, we will have different combinations of producing different numbers of the pair of good, together. • Those maximums are the PPF (see slide below), it is an outer boundary line on the production possibilities set, which are the points inside the outer boundary (not max capacity). (C) Red Hill Capital Corp., Delaware, USA 2008

14. Chapter 2: PP & OC • Points inside the PPF are also possibilities, but they are not efficient because you could have produced more of both with your capacity and trade-offs. • If we produce 2 goods, we have to allocate some of the fixed resources to both. • For example, we start with 100% of production in good A, then we begin to allocate a larger and larger percentage to good B until we have all of our production in good B. (C) Red Hill Capital Corp., Delaware, USA 2008

15. Production Possibilities, Graphically • The graph describes the production possibilities for 2 goods or services, with production of each on the separate axes. • The Production possibilities set is contained to the left of the PPF. • Thus, Points A,B,C,D, and F are part of the set, while E is unattainable. • A, C, and F are on the frontier, which represents maximum production, although of different mixes of goods and services. • Point E is beyond the possibilities, given the resources and technology of the economy in the period described in the graph. A A C C Units of Good 2 Units of Good 2 E E B B D D F F Units of Good 1 Units of Good 1 (C) Red Hill Capital Corp., Delaware, USA 2008

16. Chapter 2: PP & OC • We get our first chance to look at marginal analysis. • That reallocation from only one to 2, in various proportions, will involve opportunity cost considerations. • To get that PPF plot, we assume fixed, fully utilized resources and unchanged technology. (C) Red Hill Capital Corp., Delaware, USA 2008

17. Chapter 2: PP & OC • As happens in cases of other costs, marginal opportunity costs change. • Thus, PPF is a concave curve because of the law of increasing opportunity costs. • The more we move from producing one good to producing more of a second and less of the first, the sacrifices become larger and larger. (C) Red Hill Capital Corp., Delaware, USA 2008

18. Increasing Opportunity cost example • Consider the choice between producing automobiles or university degrees (U.D.). At point A all production is devoted to autos. • Auto production requires a large amount of purpose-built equipment, computers, and some moderately educated labor • University degree production requires some buildings, computers, and highly-educated personnel. (C) Red Hill Capital Corp., Delaware, USA 2008

19. Increasing Opportunity cost example • To move from A to B we move some buildings, computers and educated personnel from auto production to U.D. production, and sacrifice one grid-unit of autos to produce about 2 1/3 grid-units of U.D.’s. • However, to move from B to C we sacrifice the same amount of autos as in the first step to produce less U.D.’s. • Even less, in steps from C to D and D to E (see next slide). (C) Red Hill Capital Corp., Delaware, USA 2008

20. Autos vs. University Degree production • Recall that on the PPF, all factors of production are fully employed, so that by the time we have gone from A to E all of the capital and laborers have been moved from autos to university degrees. • However, some of those resources, like unskilled labor and robots, were better suited to auto making than U.D. production. • Thus, at first those well-suited to U.D. production were moved. • However, more and more resources that were better suited to autos are moved to U.D.’s and we have to sacrifice more auto production for incremental U.D. production. A B C D Autos U.D.’s E (C) Red Hill Capital Corp., Delaware, USA 2008

21. Law of increasing opportunity cost explained • In this example, because the factors of production are not equally suited to autos and U.D.’s, the marginal addition of U.D. production for each equal decrease of auto production decreases. • In another way of looking at it, the slope of the line ΔA/ΔU is negative and becomes more negative as we move down the curve. (C) Red Hill Capital Corp., Delaware, USA 2008

22. Law of increasing opportunity cost explained • We give up producing cars (negative) to make more U.D.’s (positive), so slope is negative • In fact, in a case where the factors of production were equally suited to production two outputs, the PPF would be a straight line and a straight line has a constant slope (Constant opportunity costs). (C) Red Hill Capital Corp., Delaware, USA 2008

23. Chapter 2: PP & OC • To move the PPF out (expand it) means investing in capital because newer better capital will allow greater productive capacity. • New technology is particularly helpful in moving PPF’s outward. • Another means is by increasing resources, like finding gold or having an influx of employable population. (C) Red Hill Capital Corp., Delaware, USA 2008

24. Chapter 2: PP & OC • A means of reaching a point above the PPF is by using comparative advantage in the production of one good to trade for another from another economy, in foreign trade. • Comparative advantage means that one country can produce a good at a relatively lower opportunity cost than other nations. (C) Red Hill Capital Corp., Delaware, USA 2008

25. Trade and the PPF • Assume 2 countries that produce the same 2 goods: agricultural products and electronics. • Further assume, for simplicity, that their resources are equally suited for both industries, so that the PPF’s of each are linear, i.e., straight lines instead of curves. • Econ 1 starts at B, producing 60,000 tons of agricultural goods and 20,000 tons of electronics. Econ 2 starts at D, producing 30,000 tons agricultural goods and 10,000 tons electronics. (C) Red Hill Capital Corp., Delaware, USA 2008

26. Trade and the PPF • We assume that points along the PPF’s also describe the consumption possibilities of the country in a closed self-sufficient system without trade. • If each specializes, Econ 1 producing only agriculture, and 2 producing only electronics, they can trade the excesses and each can go beyond their PPF’s. • Then, econ 1 will produce 100, 000 tons of agricultural goods and economy 2 will produce 50,000 tons of electronics. (C) Red Hill Capital Corp., Delaware, USA 2008

27. International Trading PPF’s • Econ 1 trades 30,000 tons of agricultural goods for 20,000 tons electronics from Econ 2. • Economy 1 ends up with 70,000 tons of agricultural goods and 20,000 tons of electronics, more than they would have had on their own. • Similarly, economy 2 ends up with 30,000 ton of agricultural goods and 20,000 tons of electronics, again, beyond what they could have done on their own • Both move beyond their PPF’s to B’ and D’. See figure, below Econ 1 Econ 2 A Ag. 20,000 tons/day B’ with trade B without trade C D without trade D’ with trade (C) Red Hill Capital Corp., Delaware, USA 2008 Electronics 10,000 tons/day

28. Chapter 18: Int’l. Trade • We all specialize in something, and the economy benefits from specialization: we produce more than we would, if we all did everything for ourselves. • We saw that nations can gain from the use of comparative advantage in international trade. • There is also the concept of absolute advantage. • Absolute advantage means that a nation can produce something using fewer resources than any other country. • However, even a nation with absolute advantage in a number of goods can benefit from trading. (C) Red Hill Capital Corp., Delaware, USA 2008

29. Mod 2: Markets

30. Chapter 3: market analysis • One efficient and effective means of allocation is by markets. • In markets, there is consumer sovereignty: the consumer decides what to buy, which ultimately should determine what will be produced. • The law of demand says that the quantity of a good that consumers will purchase is an inversefunction of price (quantity demanded decreases with increasing price) in a given period of time, ceteris paribus (which means that prices of substitutes, for example, remain unchanged). (C) Red Hill Capital Corp., Delaware, USA 2008

31. Chapter 3: market analysis • It is based on the behavioral fact that consumers have a marginal utility for things that is decreasing. • From all of the individual demand schedules, intentions to buy, we add up all quantities at each price to get the total demand curve for something. • Quantity demanded changes with changing price, that is a move along a demand curve. (C) Red Hill Capital Corp., Delaware, USA 2008

32. Chapter 3: market analysis • Demand curves can be transformed (shifted) into new demand curves by non-price factors, like prices of substitutes, change in number of buyers, income, tastes and preferences, and expectations. • The law of supply says that sellers are willing to offer more goods at a higher price, ceteris paribus. It is upward sloping (C) Red Hill Capital Corp., Delaware, USA 2008

33. Chapter 3: market analysis • Changes in the supply curve come from non-price: number of sellers, technological change, input prices, taxes/subsidies, expectations, and prices of competing goods. • Note: new curves, i.e., new demand or new supply, always come from non-price factors. The curves we draw show quantify as a function of price only. (C) Red Hill Capital Corp., Delaware, USA 2008

34. Chapter 3: market analysis • Finally, we need to put supply and demand together to find out, through working out surpluses and shortages, an actual equilibrium price and quantity that the price system mechanism has used the forces of the market to ultimately efficiently determine. • Then, society has maximized the benefits of some scarce resources. (C) Red Hill Capital Corp., Delaware, USA 2008

35. Chapter 4: markets in action • Now that supply and demand have met, we look at what happens when either the supply or demand curve changes. • We get new equilibrium price and quantity, as shown in the next 2 slides. • We can look at what happens when governments try to fix prices. • We also look at how markets can fail and lead to not good outcomes. (C) Red Hill Capital Corp., Delaware, USA 2008

36. Effects of demand shifts on equilibrium • Diagrams and causal chains Increase in Equilibrium price Increase in Quantity supplied Decrease in Equilibrium price Decrease in Quantity supplied Decrease in demand Increase in demand When Haircut demand rises When SUV demand falls P S P S D1 D2 D2 D1 Q Q (C) Red Hill Capital Corp., Delaware, USA 2008

37. Supply Changes • Causal chain and graphs. • Note there is a mistake in the arrow for price in the graph in the book on page 92 for decrease in supply Decrease in Equilibrium price Increase in Quantity demanded Increase in Equilibrium price Decrease in quantity demand Increase in supply Decrease in supply P P S1 S2 D D S2 S1 Q Q (C) Red Hill Capital Corp., Delaware, USA 2008

38. Chapter 4: markets in action • Given those basic facts, what will happen if the government tries to fix the price of something, either above or below, floor (lowest allowed sale price) or ceiling (highest allowed price), this natural equilibrium price. • A common example of a ceiling is on rents. The government might be concerned that its citizens be able to afford rent, so they put caps (ceilings) on rental prices. (C) Red Hill Capital Corp., Delaware, USA 2008

39. Chapter 4: markets in action • That will lead to a shortage, that will lead to bad behavior, like black market renting and subletting, bribes, and, ultimately, inefficiency and market failure. • Minimum wages is a common floor, leading to surplus, to market failure, to unemployment. (C) Red Hill Capital Corp., Delaware, USA 2008

40. Chapter 4: markets in action • Markets can also have failures, even without the interference of the government in natural markets affairs. • First, a market might lack competition. Maybe only one company ever found that a particular good was profitable, and it grew into a huge percentage of the market. What if there is market that no on cares about, supply-wise? Any sort of lack of competition is a failure. (C) Red Hill Capital Corp., Delaware, USA 2008

41. Chapter 4: markets in action • Governments get involved in trying to solve these other failures. • For lack of competition, governments might act to make the few people in the industry act as though they are in a competitive market. • For example, that is done with electric and water utility companies that have to be necessarily large and cannot easily exist in great multiplicity. (C) Red Hill Capital Corp., Delaware, USA 2008

42. Chapter 4: markets in action • It would be difficult to offer citizens of a town an option to buy water from 100 companies, because there would have to be 100 main water lines running through the whole town. • Externalities are external affects by or on markets. They can be good or bad. • Pollution is an example of bad. A steel producer pollutes the atmosphere. People get sick, everything, including the water, gets dirty, and there is a large cost to society. (C) Red Hill Capital Corp., Delaware, USA 2008

43. Chapter 4: markets in action • By taxing bad or regulating that the producer must buy and install pollution control, the cost will rise, the offer price will rise, and the market price and quantity will be a new equilibrium, with higher price and lower quantity, as the supply curve is shifted against a fixed demand curve. • A positive externality is something that benefits people who do not buy the product. (C) Red Hill Capital Corp., Delaware, USA 2008

44. Chapter 4: markets in action • Inoculation of children against bad diseases benefits the people whose children go to school with them. Since most are inoculated, the others are fairly well protected against being with someone with the disease. • Those who benefit are free-riders. • Free rides give the government another reason to get involved in the economy. (C) Red Hill Capital Corp., Delaware, USA 2008

45. Chapter 4: markets in action • Public works is a function performed by a government wherein without intervention, the things would likely not get done. • These are things, like interstate highways, national defense, or community parks. • If you asked people to contribute to such things as they saw fit, most would probably try to get away with paying nothing and still getting the benefit of everyone else's payment. (C) Red Hill Capital Corp., Delaware, USA 2008

46. Chapter 4: markets in action • It is another general behavior of human beings. • A debatable failure is the income inequality issue. • Some argue that markets are inefficient in that people’s incomes vary so widely; others would argue that that is just the market making efficient use an pricing of what it has got. (C) Red Hill Capital Corp., Delaware, USA 2008

47. Chapter 5: Elasticity • So, since we have talked about how supply and demand relate quantities to prices, and that both curves can change, it would be nice to know how things might change. • Percentage change of one thing with unit percentage change of another variable is called elasticity. • Price elasticity of demand tells how demand will change with price changes. That will be interesting information for producers. (C) Red Hill Capital Corp., Delaware, USA 2008

48. Chapter 5: Elasticity • It is always a negative number (downward sloping curve), so we usually just drop the minus sign. • A downward sloping demand curve will show ranges of the different types of elasticity, with elastic towards higher prices and with inelastic range towards the bottom of price. • Income elasticity of demand looks at how demand varies with a person’s income. (C) Red Hill Capital Corp., Delaware, USA 2008

49. Chapter 5: Elasticity • There is a division: inferior goods have negative elasticity, while normal good have a positive elasticity. • Inferior goods, formerly called necessities, have e negative change versus income. As income rises, people buy better food, and buy a car instead of taking a bus. • Normal goods, formerly called luxuries, have an increase when people earn more money. (C) Red Hill Capital Corp., Delaware, USA 2008

50. Chapter 5: Elasticity • Price elastic of demand has to do with substitutes and budgets versus wants and needs. • If something is elastic, that means that changes in price will lead to bigger changes in quantity demanded. • Inelastic means that there is no choice, we have to have the good or we don’t care much about the price. (C) Red Hill Capital Corp., Delaware, USA 2008