Eco 101: Chapter 1 notes

Economics

- the study of how individuals and societies use limited resources to satisfy unlimited wants.

Fundamental economic problem

 scarcity.

 individuals and societies must choose among available alternatives.

Economic goods, free goods, and economic bads

1. economic good (scarce good) - the quantity demanded exceeds the quantity supplied at a zero
price.
2. free good - the quantity supplied exceeds the quantity demanded at a zero price.
3. economic bad - people are willing to pay to avoid the item

Economic resources

1. land
- natural resources, the “free gifts of nature”
2. labor
- the contribution of human beings
3. capital
- plant and equipment
 this differs from “financial capital”

4. 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.

Microeconomics vs. macroeconomics

1. microeconomics - the study of individual economic agents and individual markets

2. 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?

Example II

The opportunity cost of college attendance includes:

 the cost of tuition, books, and supplies,

 foregone income (this is usually the largest cost associated with college attendance), and
 psychic costs.

What about room and board?

Example III:

Opportunity cost of attending a movie:

 opportunity cost of tickets

 opportunity cost of time

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.

Marginal analysis

 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
 Marginal cost
 For most activities, marginal cost rises as the level of the activity increases.

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:  Fixed technology?

economics and calculus  No unemployed nor underemployed
 Output = grades on each exam resources?
 Fixed resources?

Alternative uses of time

Law of diminishing returns

- Used to refer to a point at which the level of profits or benefits gained is less than the amount of
money or energy invested.
 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.

Production possibilities curve

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.

 In the interval between points B and C, the marginal opportunity cost of one point on the
economics exam equals 4/3 of a point on the calculus exam.

Law of increasing cost

- marginal opportunity cost rises as the level of an

activity increases

Reasons for law of increasing cost

 Law of diminishing returns

 Specialized resources (heterogeneous labor, land, capital, etc.)

Specialized resources in farming

1. Some land, labor, and capital is better suited for wheat production and some is better suited for
corn production
2. Unemployed or underemployed resources

3. Points outside of the PPC

4. Economic growth
 5. Commodity-specific technological change

Specialization and trade

o Adam Smith – economic growth is caused by increased specialization and division of labor.

Gains from specialization and division of labor

1. specialization in areas that match the skills and talents of workers

2. “learning by doing” – increase in productivity from task repetition
3. less time lost while switching from task to task

Specialization and trade

o As noted by Adam
Smith, specialization and trade
are inextricably linked
o Adam Smith and David
Ricardo used this argument to
support free trade among
nations.

Absolute and comparative advantage

1. Absolute advantage – an individual (or country) is more productive than other individuals (or
countries).

2. Comparative advantage – an individual (or country) may produce a good at a lower opportunity
cost than can other individuals (or countries).

Example: U.S. and Japan

 Suppose the U.S. and Japan produce only two goods: CD players and wheat.
 Who has an absolute advantage in producing each good?
 Who has a comparative advantage in producing each good?

Gains from trade

o Opportunity cost of CD player in U.S. = 2 units of wheat

o Opportunity cost of CD player in Japan = 4/3 unit of wheat
o If Japan produces and trades each CD player to the U.S. for more than 4/3 of a unit of wheat but
less than 2 units of wheat, both the U.S. and Japan gain from trade and can consume more
goods than they could produce by themselves.
 o Note that the U.S. has a comparative advantage in producing wheat.
o 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

1. Barter – goods are traded directly for other goods

2. Problems:
 requires double coincidence of wants
 large number of trading ratios: N(N-1)/2 (high information costs)
3. Monetary economy has lower transaction and information costs

Relative and nominal prices

1. Relative price - price of a good in terms of another good

2. Nominal price - price expressed in terms of the monetary unit
 Relative price is a more direct measure of opportunity cost

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

- Is a tabulation of the quantity of a good that all consumers in a market will purchase at a given
price.
Demand curve

- Is a graphical representation of the relationship between the price of a good or service and the
quantity demanded for a given period of time.

Law of demand

- The higher the price, the lower the quantity demanded. The lower the price the higher the
quantity demanded.
- An inverse relationship exists between the price of a good and the quantity demanded in a given
time period, ceteris paribus.

Ceteris Paribus- all other things being equal.

Reasons:

o substitution effect
o income effect

Change in quantity demanded vs. change in demand

Change in quantity demanded Change in demand

Market demand curve

o Market demand is the horizontal summation of individual consumer demand curves

Determinants of Demand

1. tastes and preferences

2. prices of related goods and services
3. income
4. number of consumers
5. expectations of future prices and income

1. Tastes and preferences

Effect of fads:

2. Prices of related goods

1. substitute goods – an increase in the price of one results in an increase in the demand for the other.

2. 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

Price of coffee rises:

Change in the price of a complementary good

Price of DVDs rises:

3. Income and demand

Normal goods

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

Inferior goods

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

4. Demand and the # of buyers

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

5. Expectations

o A higher expected future price will increase current demand.

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

International effects

1. exchange rate – the rate at which one currency is exchanged for another.
2. currency appreciation – an increase in the value of a currency relative to other currencies.
3. currency depreciation – a decrease in the value of a currency relative to other currencies.
4. Domestic currency appreciation causes domestically produced goods and services to become
more expensive in foreign countries.
5. An increase in the exchange value of the U.S. dollar results in a reduction in the demand for U.S.
goods and services.
6. The demand for U.S. goods and services will rise if the U.S. dollar depreciates.

Supply

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

Supply schedule

- is a table view of that presents the different quantities of a product that a seller is willing to sell
at different price.
Law of supply

- as the price of a good or services increases, the quantity of goods that suppliers offer will
increase.
- A direct relationship exists between the price of a good and the quantity supplied in a given time
period, ceteris paribus.

Reason for law of supply

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

o As the quantity of a good produced rises, the marginal opportunity cost rises.
o 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

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

1. the price of resources,

2. technology and productivity,
3. the expectations of producers,
4. the number of producers, and
5. the prices of related goods and services

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

1. Price of resources

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

2. Technological improvements

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

3. Expectations and supply

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

4. Increase in # of sellers

5. Prices of other goods

o Firms produce and sell more than one commodity.

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

International effects

1. Firms import raw materials (and often the final product) from foreign countries. The cost of
these imports varies with the exchange rate.
2. 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.
3. 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.
Market equilibrium Demand rises

Price above equilibrium Demand falls

- If the price exceeds the equilibrium

price, a surplus occurs:

Supply rises

Price below equilibrium

- If the price is below the equilibrium a

shortage occurs:
Supply falls - designed to maintain a price above the
equilibrium level

examples:

o agricultural price supports

o minimum wage laws

Price ceiling

1. Price ceiling - legally mandated

maximum price

Purpose: keep price below the market

equilibrium price

Examples:

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

Price floor

1. Price floor
- legally mandated minimum price