Lecture 1 Introduction & Basics of Economics

1. Lecture 1 Introduction & Basics of Economics Dr. Rajeev Dhawan Director Given to the EMBA 8400 Class March 19, 2010

2. Course Objective & Teaching Philosophy • Practical Course to Comprehend the Economic Environment so that Managers can make their Decisions • Philosophy is that Micro Sectors Add Up to a Macro Environment • Optimal Blend of Economics and Real World Experience/Common Sense • Train You to Critically Evaluate and Interpret Business Press Writings

3. Course Layout • Week 1 – Basic Economic Concepts and Microeconomics I • Week 2 – Microeconomics II and Basics Macroeconomics I • Week 3 – Macroeconomics II

4. Grading Policy • TWO RULES: • No Early or Makeup Exams • All Exams are Open Book • 20% Quiz #1 (30 minutes) • 30% Quiz #2 (45 minutes) • 50% Final Comprehensive Exam (2 hours)

5. Macro Framework • Households: Consume & Work • Firms: Production & Investment • Government: Money Supply, Taxes, Expenditures • Foreign Sector: Exports, Imports & Exchange Rate

6. Introduction The 10 Principles of Economics

7. What is Economics? • Economics is the study of how we use our scarce productive resources for consumption, now or in future. • Paul Samuelson • Resources are scarce: • Society has limited resources and therefore cannot produce all the goods and services people wish to have • Example: clean air & water • Scarcity is not poverty

8. Basic Questions • What to produce in what quantity? • How to produce them? • When and where to produce? • For whom? • Who makes economic decisions and by what process?

9. Basic Concepts • Opportunity Cost: Things are Scarce • Next Best Alternative • Ex: Party on Friday night vs. study for exams • Cost of Time • Ex: 1 hour wait time at the dentist

10. Basic Concepts • Marginal Concept: At the Margin • Utility: Level of Satisfaction (here, drunkenness)

11. Basic Concepts • Sunk/Fixed Costs: Expenditures Made that Cannot be Recovered • Example: • You bought a computer laptop for $1500 • A newer, upgraded model costs $1200 • The dealer will accept a trade in + $400 • What do you do?

12. Winnick’s Voyage to the Bottom of the Sea WSJ; by Andy Kessler • First Mover, FCC regulated + fixed costs • Regulated utility • Price protection • You can’t lose • Traffic / use was of low economic value or cashless • Global Crossing couldn't cut prices without running the risk of either failing to cover its debt or being unable to raise more capital • Accounting Tricks…….

13. 10 Principles of Economics • People face tradeoffs : • “No such thing as free lunch” • Give up one thing to get another –Opportunity Cost (OC) • Everything has an OC – whatever must be given up to get that item • People make decisions at the margins – increments matter • People respond to incentives – e.g. cigarette laws, communism • Free Trade is good (for everybody)

14. 10 Principles of Economics • Markets organize economic activity - Adam Smith “Invisible Hand” • Governments can sometimes improve market outcome • A country’s standard of living depends upon its production power (productivity) • Prices rise when government prints too much money • Phillips curve – short run tradeoff between inflation and unemployment

15. Branches of Economics • Micro: The Study of One Entity (firm, business, people) • Macro: The Study of a Collection of Things (national, aggregate)

16. How are Theories Developed? • Decision-Makers • Firms, governments • Markets • Place where exchange takes place

17. Winnick’s Voyage to the Bottom of the Seaby Andy Kessler (p.14) • First Mover, FCC regulated + fixed costs • Regulated utility • Price protection • You can’t lose • Traffic / use was of low economic value or cashless Global Crossing couldn't cut prices without running the risk of either failing to cover its debt or being unable to raise more capital • Accounting Tricks…….

18. Chapter 2 Production

19. Production • What is production? • The activity by which we convert inputs (labor, land & capital) into goods and services • What limits production? • Inputs (resources) • Technology • Government interference

20. MARKETS FOR GOODS AND SERVICES • Firms sell Goods and Goods • Households buy services and services bought sold HOUSEHOLDS FIRMS • Buy and consume • Produce and sell goods and services goods and services • Own and sell factors • Hire and use factors of production of production MARKETS Labor, land, Factors of FOR and capital production FACTORS OF PRODUCTION • Households sell Wages, rent, • Firms buy and profit Circular Flow Diagram Circular Flow Diagram Revenue Spending Income = Flow of inputs = Flow of inputs and outputs and outputs = Flow of dollars = Flow of dollars

21. Production Possibilities Frontier • Definition: the amount of goods a firm or society can produce given a fixed amount of land, labor and other inputs.

22. 4,000 D 3,000 C 2,200 E 2,100 2,000 Production A possibilities frontier B 1,000 300 600 700 750 1,000 Production Possibilities Frontier Quantity of Pretzels Produced a b d . c Quantity of 0 Beer Produced

23. Production Function I Y (Production) = F (Inputs) Y = I Marginal Product: it is the increase in output that arises from an additional unit of input. Marginal Product (MP) = ∆ Output / ∆Input

24. Production Function II Y = I2 Marginal Product (MP) = ∆ Output / ∆Input

25. Production Function III Y = √I Marginal Product (MP) = ∆ Output / ∆Input

26. Returns to Scale • Returns to Scale: the property of the production function that when you double your inputs, your output either doubles, more than doubles, or less than doubles. DRS Y=F MP ↑  IRS MP ↓  DRS CRS Y = √F Y=F2 IRS

27. Chapter 4 Demand & Supply

28. Some Basic Definitions • Market: a group of buyers and sellers of a particular good or service • E.g. Warren Buffet has been buying up junk bonds • E.g. Bars, parties – informal market Stock market – organized market

29. Example of Supply & Demand • Hong Kong chicken flu scare? Price of chicken  • Mad cow disease in US? Price of beef  • Oprah bad mouths beef? Price of beef  • Amarillo farmers sue her. • SARS? (Macro issue…)

30. Pints of Beer P QD $10.00 0 7.00 1 5.00 3 4.00 6 2.00 11 0.00 19 Demand Quantity demanded (Q): the amount of a good that buyers are willing and able to purchase at a given price (P).

31. Graph Results • Demand curve/schedule is downward sloping and shows the relationship between price of a good and the quantity demanded • Why downward sloping? • Law of demand: Ceteris Paribus (all other things being equal) the quantity demanded falls when price rises

32. Other Determinants of Demand • Income (I) : • I  , D   Normal Goods: car, Ferrari • I  , D   Inferior goods: bus rides, potatoes • Price of related goods • Substitutes (inversely correlated) • Compliments (directly correlated)

33. Other Determinants of Demand • Tastes – taken as above • You get old and prefer Lincoln Town cars to sports cars • Expectations – about future • Income potential with EMBA degree  • Loss of jobs, layoffs prospects • Market Demand • More players  Increase in demand • Buy IPO’s in 90’s

34. Shifts in Demand Curve • Variables that shift the demand curve:

35. Increase in demand Decrease in demand Demand curve, D 2 Demand curve, D 1 Demand curve, D 3 Shifts in the Demand Curve Price of Beer Quantity of 0 Beer

36. Supply Quantity supplied (Q): the amount of a good that sellers are willing and able to sell at a given price (P). Pints of Beer P QS $10.00 12 7.00 7 5.00 4 4.00 3 2.00 1 0.00 0

37. Supply • Supply graph for another bar Pints of Beer P QS $10.00 8 7.00 5 5.00 4 4.00 3 2.00 1 0.00 0

38. Determinants of Supply • Your own Price • Input Prices • Cost of bottle of beer: labor, capital, rent • Technology • Smoking laws  separation of smoking & drinking • Expectations • Future outlook

39. Shifts in The Supply Curve • Variables that shift the supply curve:

40. Supply curve, S 3 Supply curve, S 1 Supply curve, S Decrease 2 in supply Increase in supply Shifts In Supply Curve Price of Beer Quantity of 0 Beer

41. Equilibrium • Equilibrium: the price where quantity supplied is equal to quantity demanded Equilibrium 6

42. Supply Surplus $6.50 4.00 Demand 2 6 10 Quantity Quantity demanded supplied Markets Not In Equilibrium Excess Supply Price of Beer 0 Quantity of Beer

43. Supply $4.00 2.50 Shortage Demand 2 6 10 Quantity Quantity supplied demanded Markets Not In Equilibrium Excess Demand Price of Beer 0 0 Quantity of Beer

44. Changes in Equilibrium • Decide whether the event shifts the supply or demand curve (or both). • Decide whether the curve(s) shift(s) to the left or to the right. • Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity.

45. An increase in the An increase in wealth price of hops reduces increases demand for beer the supply of beer S2 S1 Supply New New equilibrium $6.50 equilibrium $6.50 4.00 4.00 Initial equilibrium 2 D Demand 1 D 6 10 6 2 Changes in Equilibrium Price of Price of Beer Beer Initial equilibrium Pints of Beer 0 Pints of Beer 0

46. S1 S2 One bar closes… New Equilibrium $5.00 4

47. Chapter 6 Controls on Prices

48. Controls on Prices • Price Ceiling (e.g. rent control) • A legal maximum on the price at which a good can be sold. • If the price ceiling is set below the equilibrium price, it leads to a shortage. • Price Floor (e.g. minimum wage) • A legal minimum on the price at which a good can be sold. • If the price ceiling is set above the equilibrium price, it leads to a surplus.

49. Supply Equilibrium price $3 2 Price ceiling Shortage Demand 75 125 Quantity Quantity supplied demanded Price Ceiling: Beer Shortage …RentControl Too Beer 0 Pints

50. Supply Surplus Equilibrium $4 price Price floor $3 Demand 75 125 Quantity Quantity supplied demanded Price Floor: Beer Surplus Price of Beer Quantity of 0 Beer