Transcript Q 1

Economics
The study of how human beings
coordinate their wants and desires,
given the decision-making
mechanisms, social customs, and
political realities of the society.
Unlimited wants
Limited resources to satisfy wants
Choose between alternatives
Economic reasoning focuses on the
impact of marginal changes.
Decisions will be based on marginal costs
-the cost of buying or making one more unit
and marginal benefits (utility).
- The increase in satisfaction from buying or
making one more unit
MB > MC  Do it!
MC > MB  Don’t do it!
don’t necessarily consider sunk costs.
The use of scarce resources to produce a
good is always costly.
This class?
a. Someone must give up something if we
are to have more scarce goods.
b. The highest valued alternative that must
be sacrificed is the opportunity cost of
the choice.
What must be given up to get one
more unit of another good or service
the price mechanism that guides our actions in a market.
The invisible hand is an example of a market force.
• If there is a shortage, prices rise
• If there is a surplus, prices fall
a. Inductive
Methods
Use facts to develop a model
Take a survey and study the results
b. Deductive
See if the facts support a hypothesis
Start with a theory and see if facts support it
c. Abduction
the combination of deduction and induction
Predicting Behavior
Positive Economic Statements
- relationships that can be tested
- The class is half full
- Unemployment is 6%
- if incomes rise people spend money
Normative Economic Statements
- statements about “what should be” or
make a value judgment
- It is too hot
- Unemployment should be around 4%
- we should raise the minimum wage.
Art of Economics
- application of knowledge learned in
positive economics to the achievement of
goals determined in normative economics.
Economic graphs
1. Direct Relationship
- Graph slopes up from left to right
2. Inverse Relationship
- Graph slopes down from left to right
3. Slope
Rise
Run
The U.S. Economy in Historical Perspective
The U.S. economic system is a market economy
based on private property and the markets in
which individuals decide how, what, and for whom
to produce
• Markets work through a system of rewards and payments
• Individuals are free to do whatever they want as long as it
is legal
• Fluctuations in prices play a central role in coordinating
individuals’ wants in a market economy
Most economists believe the market
is a good way to coordinate economic activity
Capitalism and Socialism
• Capitalism is an economic system based on the market in
which the ownership of the means of production resides
with a small group of individuals (called capitalists)
• Socialism is an economic system based on individuals’
goodwill towards others, not on their own self-interest, and
in which, in principle, society decides what, how, and for
whom to produce
3-13
Evolving Economic Systems
Feudalism is an economic system based on tradition and
dominated the Western world from the 8th to the 15th century
Mercantilism is an economic system in which the government
controls economic activity by doling out the rights to
undertake economic activities and was dominant until the 18th
century
During the Industrial Revolution, technology and
machines rapidly modernized industrial production
Capitalism
Source of income
%
Dividends
1.7
Interest
4.9
Proprietor’s Income
8.4
Rental Income
11.1
Social Security
13.4
Transfer Payments
64.7
Wages and Salaries
-4.3
Savings
84
Spending
15.2
Taxes
1.9
Durable Goods
Non-durable Goods
Services
59
29
12
Type
Number Revenue
proprietorship
72.2
partnership
7.7
7.9
corporation
20.1
87.3
4.8
Business: Forms of Business
Advantages
Disadvantages
• Minimum bureaucratic
hassle
• Direct control by owner
• Limited ability to get funds
• Unlimited personal liability
Partnership
• Ability to share work and
risk
• Relatively easy to form
• Limited ability to get funds
• Unlimited personal liability
(even for a partner's
blunder)
Corporation
• No personal liability
• Increasing ability to get
funds
• Ability to avoid personal
income taxes
• Legal hassle to organize
• Possible double taxation of
income
• Monitoring problems
Proprietorship
Government
The government plays two general roles in the
economy:
1. An actor who collects money in taxes and spends that
money on projects, such as defense and education
3-20
Government
2. A referee who sets the rules that determine relations
between businesses and households
a. Provide a stable set of institutions and rules.
-Enforce contracts and protect property rights
b. Promote effective and workable competition.
-restrict and regulate monopolies
c. Correct for externalities.
-pollution
d. Ensure economic stability and growth.
-Employment Act of 1946
e. Provide public goods.
-Enforce contracts and protect property rights
f. Adjust for undesirable market results.
-drug busts
Factor Markets
Product Markets
Income
Taxes
Goods and
Services
Payments
Goods and
Services
Payments
and Legal
Businesses
Goods and
Services
Resources
Business
Taxes
Resources
Payments $$
Households
Selling
Price
$5
$4
$3
$2
$1
Quantity
Demanded
10
15
25
40
60
Graphing:
-Plot the points
-Connect the dots
Price
$6
$5
Downsloping
to right
$4
$3
left
Demand
$2
$1
0
10
20
30
40
50
60
Quantity
Shifts in Demand versus
Movements Along a Demand Curve
Quantity demanded – is a specific amount that will be
demanded per unit of time at a specific price, other things
constant
Demand refers to a schedule of quantities of a good that
will be bought per unit of time at various prices, other
things constant
• A change in price changes quantity demanded
• A change in price causes a movement along the
demand curve
Why the curve shifts
1 Society’s Income
2 Price of Other Goods
3 Consumer Tastes
4 Consumer Expectations
5 Taxes and Subsidies
6 Number of Consumers
Selling
Price
Quantity
Supplied
$5
$4
$3
$2
$1
60
40
25
15
10
Graphing:
-Plot the points
-Connect the dots
Price
$6
$5
$4
Upsloping
right
to left
$3
Supply
$2
$1
0
10
20
30
40
50
60
Quantity
Selling
Price
$5
$4
$3
$2
$1
Quantity
Demanded Supplied
60
10
40
15
25
25
15
40
10
60
Graphing:
-Plot Demand
-Plot Supply
Price
$6
D
S
$5
$4
$3
$2
$1
0
D
S
10
20
30
40
50
60
Quantity
Why the curve shifts
1 Resource Prices
2 Changes in Technology
3 Prices of other goods
4 Taxes and Subsidies
5 Number of Producers
Economic Examples
1. Cyclone Larry in Australia
• Destroyed 80% of the banana crop.
• Prices went from $1.00 to $2.00 per pound
• Supply or Demand problem??
S2
Price
Banana
Market
S1
$2.00
$1.00
DR
Quantity
Q2 Q 1
Sales of SUVs in the U.S.
Average price fell 10%
SUVs
P
Supply or Demand problem?
S0
Increasing gas costs
causes the demand curve
to shift left
Price for SUVs fell
from P0 to P1 where
Q demanded = Q supplied
P0
P1
D0
D1
Q1
Q0
Q
Coffee Beans
• fell from $2.00/pound in 1997 to $.50 in 2002
Supply or Demand problem?
New growing
techniques and the
entry of new growers
shifted the supply
Price
curve.
S2
Coffee Bean
Market
S1
$2.00
$0.50
Dc
Q1
Q2 Quantity
Increase in the Demand for Foreign
Exchange
• Beginning equilibrium
exchange rate:
(10 cents = 1quetzal).
• An increase in American
demand for Guatemalan
coffee will also increase
the demand for quetzals
• Equilibrium occurs where
the new demand for
quetzals D2 just equals
the supply S – at $.20 per
quetzal with Q2 > Q1
quetzals clearing the
market.
U.S. sales
to
Guatemala
Exchange
rate
S
($ per quetzal)
0.20
0.10
D2
U.S. purchases
from Guatemala
D1
Q1 Q2
Quantity of
quetzal
exchange
1. Price Ceilings
•
Price ceiling is a legally established maximum price that sellers may
charge.
• It stops the price from rising to
the equilibrium level.
•
• Example: rent control
The direct effect of a price ceiling is a shortage: quantity
demanded exceeds quantity supplied.
2. Price Floors
• Price floor is a legally established
minimum price that buyers must pay.
• It stops the price from dropping down
to equilibrium level.
• Example: minimum wage
•
The direct effect of a price floor above the equilibrium price is
a surplus: quantity supplied exceeds quantity demanded.
Excise Taxes
• Government impacts markets through taxation
• An excise tax is a tax that is levied on
a specific good
• A tariff is an excise tax on an imported good
• The result of taxes and tariffs is an increase in
equilibrium prices and reduce equilibrium quantities
5-41
The Effect of an Excise Tax
P
Government imposes a
$10,000 luxury tax on the
suppliers of boats
Luxury Boats
S1
S0
Tax = $10,000
$70,000
The supply curve shifts up by
the amount of the tax
$65,000
$60,000
D0
420
510
Q
The price of boats rises by
less than the tax to
$70,000
Quantity Restrictions
• Government regulates markets with
licenses, which limit entry into a market
• Many professions require licenses, such as doctors,
financial planners, cosmetologists, electricians, or
taxi cab drivers
• The results of limited number of licenses in a
market are increases in wages and an increases in
the price of obtaining the license
5-43
The Effect of a Quantity Restriction
NYC Taxi Drivers
P(wage)
Successful lobbying by taxi cab
drivers in NYC resulted in quantity
restrictions (medallions)
QR
D1
$15
D0
12,000
When the demand for taxi
services increased, because
the number of taxi licenses was
limited, wages increased
Q(of drivers)
Application: The Effect of a Quantity Restriction
P
NYC Taxis Medallions
QR
The demand for taxi
medallions also increased
because wages were
increasing. But because the
number of taxi licenses was
limited, the price of a
medallion also increased
$400,000
D1
Initial Fee
D0
12,000
Q(of medallions)
Third-Party-Payer Markets
• In third-party-payer markets, the person
who receives the good differs from the
person paying for the good
• Under a third-party-payer system, the person who
chooses how much to purchase doesn’t pay the entire
cost
• Equilibrium quantity and total spending can be much
higher in third-party-payer markets
• Goods from a third-party-payer system will be rationed
through social and political means
5-46
Third-Party-Payer Markets
P
With a co-payment of $5,
consumers demand 18 units
Health Care
Sellers require $45 per unit
for that quantity
S0
$45
Total expenditures for 18
units of health care
$25
…are greater than when…
$5
D0
10
18
Q
The consumer pays
the entire cost
CHAPTER 6
Thinking Like a Modern Economist
Economics is what economists do.
— Jacob Viner
Teach a parrot the words ‘supply’ and
‘demand’ and you have an economist
Thomas Carlyle
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Economic Models
• Mathematical e = mc2
• or heuristic
expressed informally in words
Characteristics
• more often use more of an inductive,
as opposed to deductive, approach
Behavioral vs Traditional
Economics
• Traditional –more reliance on relatively simple
algebraic or graphical models such as the supply
and demand model
-provide simple and clear results, which can
highlight issues that behavioral models cannot
Behavioral vs Traditional
Economics
• Behavioral - use a broader set of building blocks
than rationality and self-interest
• Seem to use real-life situations to explain and
illustrate economic concepts
• People behave purposefully - reflecting
reasoned but not necessarily rational judgment
• Act with enlightened self-interest people
care about other people as well as themselves
Empirical Work in Modern
Economics
• Modern economics is highly empirical
• Both traditional and modern behavioral
economic building blocks rely on experiments
and statistical analysis of real world
observations
• An empirical model is a model that statistically
discovers a pattern in the data
• Econometrics is the statistical analysis of
economic data
Modern Traditional and Behavioral
Economists
Modern Economics
Earlier
Modern Behavioral
Economics Economists
Assumptions
Approach
Types of
Models
Modern Traditional
Economists
Rationality
Purposeful behavior
Rationality
Self-Interest Enlightened self-interest Self-Interest
Deduction
Induction and
Induction and
deduction: emphasis on deduction: emphasis
experimental economics empirical models
and on empirical models
Simple S/D
models
All types including
complex mathematical
models and ACE
models
All types including
complex mathematical
models and ACE
models
the responsiveness of the amount
purchased to a change in price.
% Change in
% Q
Price Elasticity quantity demanded
of demand = % Change in Price = % P
- or put more simply -
=
(Q0 - Q1 )
Q0
( P0 - P1 )
P0
=
(Q0 - Q1 )
Q0
X
P0
( P0 - P1 )
PED > 1 Elastic
< 1 Inelastic
= 1 Unit Elastic
Quan Price
1 X 8
2
3
4
5
6
7
8
X
X
X
X
X
X
X
7
6
5
4
3
2
1
Total
Revenue
Elasticity
=
___
=
___
=
___
=
___
=
___
=
___
=
___
___
___
___
___
___
___
___
___
Different Elasticities
• Perfectly inelastic:
An increase in Price results
in no change in Quantity
Mythical
demand
curve
(a)
Quantity/
time
• Relatively inelastic:
A percent increase in Price
results in a smaller % reduction
in Quantity
Demand for
Cigarettes
(b)
Quantity/
time
• Unitary elasticity:
The percent change in quantity
demanded due to an increase in
price is equal to the % change in
price.
Demand curve of
unitary elasticity
(c)
Quantity/
time
=1
Elasticity of Demand
Demand for
Granny Smith
Apples
(d)
• Relatively elastic:
A % increase in Price
leads to a larger %
reduction in Quantity.
Quantity/
time
• Perfectly elastic:
Consumers will buy all of
Farmer Hollings’s wheat at the
market price, but none will be
sold above the market price.
Demand for Farmer
Hollings’s wheat
(e)
Quantity/
time
What affects Elasticity???
1. Available Substitutes
2. Necessity vs Luxury
3. Proportion of Income
4. Time to shop around
What affects Supply Elasticity???
1. Time
a. Market Period
b. Short Run
c. Long Run
Income Elasticity
• the responsiveness of a product’s
demand to a change in income.
% Change in
Income Elasticity quantity demanded
of demand = % Change in Income
• A normal good has a positive
income elasticity of demand.
– As income increases, the demand
for normal goods increases.
• Goods with a negative income
elasticity are inferior goods.
– As income expands, the demand
for inferior goods will decline.
Cross Price Elasticity
• the responsiveness of a product’s demand
to a change in the price of another good.
Cross Price
Elasticity
=
% Change in
Qx
% Change in Py
• A complement has a negative cross
price elasticity.
– As Py increases, the demand for Y decreases,
and demand for goods that are consumed
with Y also decreases.
• A substitute has a positive cross price
elasticity
– As Py increases, the demand for Y decreases,
and demand for goods that can be consumed
instead of Y also decreases.
Consumer Surplus
The total difference between what a consumer is willing to pay and how
much they actually have to pay.
Producer Surplus
The total difference between what a supplier is willing to provide a good or
service and how much they actually get for it.
Producer and Consumer Surplus
P
$10
9
8
7
6
5
4
3
2
1
Consumer surplus =
area of red triangle =
½($5)(5) = $12.5
S
Producer surplus =
area of green triangle =
½($5)(5) = $12.5
CS
PS
D
0 1 2 3 4 5 6 7 8
Q
The combination of
producer and consumer
surplus is maximized at
market equilibrium
8-64
The Burden of a Tax
Tax Incidence
•
Who pays a tax is called the incidence.
Buyer
Seller
Impact of a Tax Imposed on Sellers
Price
• If in the used car market a price
of $7,000 would bring the
quantity of used cars demanded
into balance with the quantity
supplied.
• When a $1,000 tax is imposed on
sellers of used cars, the supply
curve shifts vertically by the
$7,400
amount of the tax.
S plus
tax
S
$1000 tax
$7,000
• The new price for used cars is
$7,400 … sellers netting $6,400
($7,400 - $1000 tax).
$6,400
• Consumers end up paying
$7,400
instead of $7,000 and bear $400
of the tax burden.
• Sellers end up receiving $6,400
(after taxes) instead of $7000
and
bear $600 of the tax burden.
D
500
750
# of used
cars
per month
(in
thousands)
Impact of a Tax Imposed on Buyers
Price
• In the same used car market:
• When a $1,000 tax is imposed
on
buyers of used cars, the
demand
curve shifts vertically by the
$7,400
amount of the tax.
• The new price for used cars is
$6,400 …buyers then pay taxes $7,000
of $1000 making the total
$7,400.
$6,400
• Consumers end up paying
$7,400
(after taxes) instead of $7,000
and bear $400 of the tax burden.
• Sellers end up receiving $6,400
instead of $7000 and bear $600
of the tax burden.
S
$1000 tax
D
D minus tax
500
750
# of used
cars
per month
(in
thousands)
Elasticity and Incidence of a Tax
• The actual burden of a tax depends on the
elasticity of supply and demand.
• As supply becomes more inelastic,
then more of the burden will fall on
sellers.
• As demand becomes more inelastic,
then more of the burden will fall on
buyers.
ED
ED + E S
ES
ED + ES
Tax Burden and Elasticity
• Consider the market for Gasoline
and Luxury Boats individually.
• We begin in equilibrium.
• If we impose a $.20 tax on gasoline
suppliers, the supply curve moves
vertically the amount of the tax.
Price goes up $.15 and output falls
by 6 million gallons per week.
• If we impose a $25K tax on Luxury
Boat suppliers, the supply curve
moves vertically the amount of
the tax. Price goes up by $5K and
output falls by 5 thousand units.
• In the gas market, the demand is
relatively more inelastic than its
supply; hence, buyers bear a larger
share of the burden of the tax.
• In the luxury boats market, the
supply curve is relatively more
inelastic than its demand; hence,
sellers bear a larger share of the
tax burden.
Price
S
$1.65
$1.60
$1.55
$1.50
$1.45
Gasolin
e
plus tax
market
S
D
Quantity
(millions
of
gallons)
19 20
4 0
Price
(thousand $)
S plus tax
S
110
Luxury boat
market
100
90
D
80
Quantity
5
1
0
15
(thousand
20 s
of boats)
• An effective price ceiling is a government set price
below the market equilibrium price
• It acts as an implicit tax on producers and an
implicit subsidy to consumers that causes a
welfare loss identical to the loss from taxation
P
S
A price ceiling transfers surplus
from producers to consumers,
generates deadweight loss, and
reduces equilibrium quantity
P0
P1
Price ceiling
Shortage
Q1
Q0
D
Q
• An effective price floor is a government set price above
the market equilibrium
• It acts as a tax on consumers and a subsidy for
producers that transfers consumer surplus to
producers
P
Surplus
S
P1
Price floor
P0
D
Q1
Q0
Q
A price floor transfers surplus
from consumers to producers,
generates deadweight loss, and
reduces equilibrium quantity
The Difference Between Taxes and Price Controls
• Price ceilings create shortages and taxes do not
• Taxes leave people free to choose how much to
supply and consume as long as they pay the tax
• Shortages may also create black markets
Rent Seeking, Politics, and Elasticities
• The possibility of transferring surplus from one set of
individuals to another causes people to spend time and
resources on doing so.
• Lobbying for price controls, which transfer surplus from
one group to another, is an example of rent-seeking
behavior
• Individuals spend money and use resources to lobby
governments to institute policies that increase their own
surplus
• Public choice economists argue that when all rent
seeking and tax consequences are netted out, there is
often not a net gain to the public
Inelastic Demand and Incentives to Restrict Supply
Revenue gained
P
When demand is relatively
inelastic, suppliers have
incentive to restrict
quantity to increase total
revenue
S1
S0
P1
P0
C
Revenue lost
A
B
D
Q1 Q 0
Q
Inelastic Supplies and Incentives to Restrict Prices
• When supply is inelastic, consumers have incentives to
restrict prices
• When supply is inelastic and demand increases, prices
increase causing consumers to lobby for price controls
• Rent control in New York City is an example
Application: Price Floors and Elasticity
The surplus created by a price floor is larger if
demand and supply are elastic
P
P
Surplus
S
Surplus
S
P1
P1
P0
P0
Price floor
D
D
Q1
Q0
Q
Q1 Q0
Q