Transcript Chapter 1 - McGraw Hill Higher Education

Chapter 1
Economics and the Market
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Chapter 1: Economics and the Market
•
•
•
•
•
•
Studying choice in a world of scarcity
Implications of rationality for good decision making
Supply and demand
Simple rules
Markets and social welfare
Microeconomics and macroeconomics
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Economics: Studying Choice
in a World of Scarcity
• The Scarcity Principle
– Boundless wants cannot be satisfied with limited
resources
– Therefore, having more of one thing usually means
having less of another
– Because of scarcity we must make choices
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Economics: Studying Choice
in a World of Scarcity (cont.)
• Economics is the study of how people make
choices under conditions of scarcity and of the
results of those choices for society
• Economists assume that people make choices
rationally, with a view to maximising the difference
between the cost and benefit for them (their net
benefit)
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Applying the Cost–Benefit Principle
• Rational Persons
– Have well-defined goals who try to meet those goals as
best they can
– Seek to maximise their net benefit from the course of
action arising from any decision
– When benefits and costs can be measured, net benefit is
called Economic Surplus – the difference between total
benefit and cost
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Economics: Studying Choice
in a World of Scarcity
• The Cost–Benefit Principle
– An individual (or a firm or a society) should take an
action if, and only if, the extra benefits from taking the
action are at least as great as the extra costs
– The emphasis is on the EXTRA or MARGINAL benefits
and costs
– Following this rule maximises total net benefit
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How Do We Define Cost?
• Opportunity Cost
– The value of the next-best alternative that must be
forgone to undertake an activity
– So if you value an additional hour of pleasurable leisure
time at $20, this is the opportunity cost of an additional
hour of burdensome work or study
– Conversely, if you can earn $20 per hour, this is the
opportunity cost of leisure
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Applying the Cost–Benefit Principle
• Should you walk downtown for a half hour to save
$10 on a $25 computer game?
• The marginal benefit of the walk is $10
• If your time is worth $18 per hour, the marginal
cost of the half hour walk is $9
• The marginal benefit ($10) exceeds the marginal
cost ($9) of buying the game downtown
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Cost–Benefit Analysis is a Model or
Simplification of How People Think
• C/B analysis assumes that people make decisions
consciously and rationally
• What if their decisions are unconscious?
• This does not matter as long as their decisions are
consistent with the C/B model
• Models are abstract constructs (simplified
descriptions) that allow us to analyse situations in
a logical way
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Other Abstract Models
•
•
•
•
A computer model of climate change
A road map or building plans
Simulated crash tests using dummies
Analyses of the economy which divide the
community into only three parties:
– households (consumers)
– firms (producers)
– the government
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Four Implications of Rationality
• Cost and benefits are absolute, not proportional
• Example which is more valuable:
– saving $100 or 5% on a $2000 international air fare
or
– saving $90 or 50% on a $180 domestic bus fare?
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Four Implications of Rationality (cont.)
• Take Account of Opportunity Costs
Example: Do frequent flyer points mean that your trip to
destination X is costless?
– No, because there may be accommodation costs in
excess of those at home
– No, because going to destination X may preclude you
from going to destination Y
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Four Implications of Rationality (cont.)
• Costs already incurred or ‘sunk’ are not relevant to
your decisions
• The only costs that should influence a decision
about whether or not to take an action are those
that we can avoid by not taking that action
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Sunk Costs are Irrelevant
• The entry fee to an ‘all you can eat’ restaurant is
irrelevant to how much we should eat, once we
have entered and paid
• Since the marginal cost is zero, we should eat up
to the point where the marginal benefit of eating is
zero
• Failure to observe this rule will lead to indigestion
and regret (negative marginal benefit) through
overeating! Emotion of greed has overcome
rational thought!
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Four Implications of Rationality
• The cost of a course of action is what it adds to our
total costs, that is its marginal cost
• Marginal, not average, costs are relevant
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Example of the
Average–Marginal Distinction
• Should NASA expand the space shuttle program
from three launches per year to four?
• Assume average benefit = marginal benefit
= $6 billion
• Assume marginal cost exceeds average cost
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The Optimal Number of Launches
Total Cost
No. of Launches ($ billion)
Average Cost
($ billion/launch)
Marginal Cost
0
0
0
0
1
3
3
3
2
7
3.5
4
3
12
4
5
4
20
5
8
5
32
6.4
12
What is the optimal number of launches?
Assume: Average Benefit = Marginal Benefit
= $6 billion
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Supply and Demand:
An Introduction
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What, How, and for Whom?
Central Planning Versus the Market
• Given limited resources and unlimited wants, there
are three problems facing all economic systems
– What should be produced?
– How should it be produced?
– For whom will it be produced?
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Free Markets vs Central Plans
• In market or capitalist economies these decisions
are made by individual households (consumers
and owners of factors of production) and firms
(producers) who participate in markets as buyers
and sellers of factor services and finished goods
• In centrally planned economies these decisions
are made by the authorities
• In mixed economies, households, firms and
government all play a role in decisions
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Market Demand
As price falls, the quantity demanded rises because:
• Substitutes become less attractive
• There is a rise in the purchasing power of buyers’
incomes
• So existing consumers buy more and new
consumers enter the market
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The Daily Demand Curve for Pizza
Price
($ per
slice)
4
3
Demand
2
8
12
16
Quantity
(1000s of slices
per day)
1–22
Market Supply
• As prices rise, the quantity supplied increases
• This is because the benefit to suppliers rises
relative to their costs of production
• These costs include their opportunity costs – the
revenue they get from alternative products
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The Daily Supply Curve for Pizza
Price
($ per
slice)
Supply
4
3
2
8
12
16
Quantity
(1000s of slices
per day)
1–24
Market Equilibrium
• Occurs where the demand curve intersects the
supply curve: the quantity demanded = the quantity
supplied and no pressure for price to change
• At prices above this point the quantity supplied
exceeds the quantity demanded (there is excess
supply) and prices fall
• At prices below this point there is excess demand
and prices rise
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The Equilibrium Price and Quantity of Pizza
Price
($ per
slice)
Supply
Equilibrium at $3
Quantity Demanded =
Quantity Supplied
4
3
2
Demand
8
12
16
Quantity
(1000s of slices
per day)
1–26
Excess Supply: Prices Fall
Price
($ per
slice)
Excess supply = 8000 slices/day
Supply
4
3
2
Demand
8
12
16
Quantity
(1000s of slices
per day)
1–27
Excess Demand: Prices Rise
Price
($ per
slice)
Supply
4
Excess demand = 8000
slices per day
3
2
Demand
8
16
Quantity
(1000s of slices
per day)
1–28
Graphing Supply and Demand and Finding the
Equilibrium Price and Quantity
Price
($ per
slice)
Supply
5
4
The Equilibrium Price = $2.50
The Equilibrium Quantity = 5
3
2.50
2
1
0
Demand
2
4
6
5
8
10
Quantity
(1000s of slices
per day)
1–29
Predicting and Explaining Changes in
Prices and Quantities
• Distinguishing Between
– A change in the quantity demanded
(a movement along the demand curve that occurs in
response to a change in price)
and
– A change in demand
(a shift of the entire demand curve)
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An Increase in Quantity Demanded vs
an Increase in Demand
Price
($/can)
6
D
Increase in
quantity
demanded
5
4
3
2
1
0
D
2
4
12
Quantity
(1000s of cans/day)
1–31
An Increase in Quantity Demanded vs
an Increase in Demand
Price
($/can)
6
D’
D
5
4
Increase in
demand
3
2
D’
1
0
D
12
Quantity
(1000s of cans/day)
1–32
Predicting and Explaining Changes in
Prices and Quantities
• Change in the quantity supplied
– A movement along the supply curve that occurs in
response to a change in price
• Change in supply
– A shift of the entire supply curve
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An Increase in Quantity Supplied vs
an Increase in Supply
Price
($/can)
S
6
5
Increase in
quantity supplied
4
3
2
S
1
0
2
4
6
8
10
Quantity
(1000s of cans/day)
1–34
An Increase in Quantity Supplied vs
an Increase in Supply
Price
($/can)
6
S
S’
5
4
3
Increase in supply
2
1
S’
S
0
2
4
6
8
10
Quantity
(1000s of cans/day)
1–35
Factors Changing Demand
•
•
•
•
•
Change in price of complement
Change in price of substitute
Change in income
Change in population of potential buyers
Change in expectations of future prices
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Factors Changing Supply
•
•
•
•
•
Change in cost of inputs
Change in technology
Change in number of suppliers
Change in expectations of future prices
Change in profitability of other industries
competing for resources
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Markets and Social Welfare
• If prices reflect marginal benefits (MB) to buyers
and marginal costs (MC) to society, free market
equilibrium is good for the community
• This is because Price = MB = MC and consumers
are getting as much of the commodity as they are
willing to pay for
• Price controls prevent this
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Price Controls in the Pizza Market
Price
($ per slice)
Supply
4
Excess demand =
8000 slices per day
3
Price
ceiling = 2
Demand
8
12
16
Quantity
(1000s of
slices per day)
1–39
Price Ceilings
• Price ceiling causes production to fall from 12 to 8,
a reduction of 4 units
• On average, these 4 units cost $2.50 each to
make, or $10 in total (4 x 2.5)
• On average, consumers value these 4 units at
$3.50 each or $14 in total (4 x 3.5)
• So the price ceilings have caused a loss of
economic surplus to the community of $4:
we saved $10 by not making them, but lost $14!
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Cash on the Table: Buyers
• In the absence of price ceilings, the price is $3 and
the quantity is 12 units
• Price ceilings deprive consumers of 4 units, which
they value at $3.50 each or $14
• Without price ceilings, consumers would have paid
$12 ($3 x 4) for them
• So price ceilings have deprived consumers of a
surplus (cash on the table) of $2, or $0.50 per unit
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Cash on the Table: Sellers
• Sellers have also lost profits on 4 units
• Without price ceilings they received $3 per unit on
4 units which, on average, cost $2.50 to make, a
profit of $0.50 per unit
• They have lost profits (cash on the table) of
$2 (4 x $0.50)
• So the price ceilings have imposed a social loss of
$4, $2 on buyers and $2 on sellers
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When is the Market Efficient?
• When all of the costs of producing the good or
service are borne directly by the seller, so that
costs to producers reflect costs to the community
• When all benefits from the good or service accrue
directly to buyers, so that benefits to buyers reflect
benefits to the community
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When is the Market Inefficient?
• Smart For One, Dumb For All
– When some costs of production fall on people other than
those who produce the commodity
– When some of the benefits of the commodity fall on
people other than those who consume the commodity
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Inefficient Markets
• Example: Environmental Pollution
– The market is in equilibrium: Sellers’ MC = MB
– However, sellers’ MC underestimates the cost to society
of producing the good
– Therefore, the market produces more than the efficient
amount and there is no incentive for producers and
consumers to alter their behaviour
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Inefficient Markets
• Example: Vaccinations
– The market is in equilibrium: Buyers’ MB = MC
– Buyers’ MB underestimates the benefits to society of
consuming the vaccinations
– The market produces less than the efficient amount of
vaccinations and there is no incentive for producers and
consumers to alter their behaviour
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