Economics

An Introduction to Hell

I. Fundamental Economics Concepts A. Basic Assumptions of Economics 1. Scarcity 2. Trade Offs 3. Opportunity Cost 4. Rationality 5. Gains from Trade B. Models and Economics Theory C. Positive and Normative Economics D. Efficiency as a Goal E. Microeconomics and Macroeconomics

II. Microeconomics A. Perfectly Competitive Markets 1. Markets a. A market = all the buyers and sellers of a particular good/service b. Perfectly Competitive Markets (3 components) i. good/service is highly standardized ii. iii. 2. Demand a. Amount of a good a buyer is willing and able to purchase # of buyers and sellers is large All participants are informed about the market price.

b. Goods Price is most important factor; If price is high, demand is low (vice versa) c. ^This negative relationship of goods price and demand = law of demand

d. On a demand curve graph, a change in market price will lead to an up/down change in the demand curve (leads to new market price). 3. Shifts in the Demand Curve a. Income
i. Reduction of job hours -> reduction of income -> Less buying

ii. For most goods, demand is positively related to income

1. When income rises, quantity demanded rises, and vice versa. These

are called normal goods. a. Gasoline, etc

iii. When income rises but demand falls, these goods are known as inferior

goods
1. For example, when income rises, a person is more willing to buy a

car than ride a bus (bus = inferior service)

b. The prices of related goods

i. When a decline in the price of one good causes a reduction in the quantity

demanded of another, these goods are called substitutes. (same can be applied for increases)
ii. When a decline in the price of one good causes an increase in the quantity

demanded of another, these goods are called complements c. Tastes i. Quantity demanded reflects a comparison of benefits alongside opportunity costs. ii. If perceived benefits change, so will demand d. Expectations i. Changes expected to occur in the future can affect demand.

e. Number of buyers i. Market demand = derived from adding up the demands of individual consumers.
ii. More consumers --> more demand

iii. The growth of a community helps business prosper 4. Supply a. The amount the sellers of a good are willing and able to produce. b. Most important factor is price that suppliers receive. c. The higher the price, the greater the quantity that suppliers will want to make.
d. ^Positive relationship between price and quantity = law of supply

5. Shifts in the Supply Curve a. Input prices i. An input is anything a supplier has to purchase in order to supply a product. ii. The supply curve shifts to the right if supply increases, and shifts to the left if supply decreases (duh) 1. Ex. If the price of gasoline falls, then gas stations will buy more and have a larger supply 2. Input prices range from real estate costs, labor costs, electricity, etc

b. Technology i. Changes in technology affect how businesses operate (and affect supply) ii. Gas Station Example 1: Going from full service to self-service reduces labor costs, keeps some extra cash for gas supply iii. Gas station example 2: Pumps with credit card readers reduce labor costs, leaving more money for gas supply c. Expectations

i. If suppliers expect prices to rise in the future, then they may reduce the

quantity they will supply today and store some of the current inventory in expectation of the higher price. d. Number of sellers i. If there are more sellers entering a market, then quantity will increase (the opposite applies too) 6. Equilibrium a. Point at which all the forces at work in a system are balanced by other forces, resulting in stability. i. In economics, a market is in this stage when no participant in the market has any reason to alter his or her behavior. b. It occurs when supply and demand curves intersect (only one possible point). c. An increase in price will generally lead to excess supply d. A decrease in price will generally lead to excess demand

7. The Characteristics of Competitive Market Equilibrium (CME)

a. A competitive market tends to gravitate toward equilibrium. b. Competitive markets are extremely effective at allocating resources. i. In equilibrium the price gives off two things 1. The value that consumers place on the good 2. The opportunity costs of supplying the good ii. The competitive market equilibrium insures that available supply goes to buyers who value the good most highly, and that it is provided by suppliers who have the lowest costs of supplying the good. c. CME also maximizes the benefits that buyers and sellers receive from exchange d. A consumer surplus is the surplus value that consumers receive
i. Its basically a consumers leftover cash

ii. CS ex. 1: Bob has $100, he buys a ticket costing $60, and his consumer surplus is $40.

e. When market price exceeds opportunity costs, the difference = producer surplus f. A producer surplus is basically the difference between the amount of money that a producer receives from the sale of a good, and the lowest amount that producer is willing to accept for that good. g. Total surplus = consumer + producer surplus h. Maximizing total surplus satisfies Pareto efficiency, since at this point there is no way to make a person better off without reducing the welfare of someone else. B. Applications of the Competitive Market Model 1. Changes in Market Equilibrium 2. Elasticity 3. Using Elasticity C. Evaluating Government Policy: The Impact of Price Controls and Taxes 1. Price Controls a. Efforts to legislate minimum/maximum prices are a fairly common kind of policy intervention b. 2. Taxes a. Taxes are to raise revenue to pay for public expenditures. b. Taxes can prevent beneficial exchange from taking place. c. A tax on suppliers tampers with their revenue and may be lead to the supply curve moving up to accommodate for the lost revenue caused by the tax. d. Tax creates a price wedge between the amount consumers pay and the amount suppliers receive. This price wedge reduces market quantity, and regardless of who legally pays the tax, both consumers and producers share the costs of the tax. e. Deadweight loss of taxation = loss of economic well-being/reduction in social welfare caused by the tax

D. International Trade Gains of trade: When individuals or countries specialize in the activities they do best. Modern economy is highly interdependent 1. An Isolated Economy
a. This paragraph just talks about a highly simplified economy and mentions

production possibility Frontier (PPF): Diagrams that take into account two goods (Look at Figure 20; page 35)
b. Points on a PPF are efficient from the perspective that there is no way that a

person can increase the quantity of one good produced without reducing the quantity of another. 2. Adding the Opportunity to Trade
a. When comparing PPFs, if one persons PPF is both above and to the right of

another persons PPF at every point, that person has an absolute advantage b. Trading can be advantageous 3. Comparative Advantage and Gains from Trade a. Comparative advantage: When a person/company/etc can produce a good at a lower opportunity cost than a competitor. b. If trading partners differ in their comparative advantage, they can improve the overall well being by specializing. 4. The political Economy of Trade a. Free trade expands the overall size of the economy, but also implies shifts in the size of different industries. b. People who experience losses due to trade are usually the ones who oppose free trade (Losers) c. When a country becomes an exporter, producers benefit and consumers suffer d. When a country becomes an importer, consumers benefit and producers suffer

E. The profit Motive and the Behavior of Firms

Firms: Term used to describe the entities responsible for supplying goods and services in the economy. Firms combine labor, capital equipment, raw materials, and other inputs to produce the products. As according to the law of supply, as the price of a good rises, firms are willing supply a greater quantity.
1. Economic Profits and Accounting Profits a. Profits = defined as the difference between a firms total revenue and its total

costs.
b. Total revenue: Total quantity of output that is produced for sale multiplied by the

price the firm receives. 2. Finding the Firms Supply Curve

a. Fixed costs: costs that do not vary with production output b. Variable costs: Expenses that vary with production output

c. Marginal costs: The increase in costs that occur when producing an additional unit of output i. To find the marginal cost, simply divide the increase in costs by quantity produced 1. Ex. 50 to 100 loaves, costs increase from $250 to $350; (350-250) / (100-50) = 2 = marginal cost Diminishing returns to scale: When companys output decreases marginally as it employs more labor
Marginal revenue: Increases in revenue that come with an additional unit of

output

3. Entry, Exit, and the Market Supply Curve

a. The addition of more producers tends to shift the market supply curve outward,

and in return will cause the equilibrium price to fall. b. Entry will only cease when profits = zero

c. If economic profits go below zero due to a shift in preferences that reduced the

demand of a product then they will leave the market, shifting to other activities that offer greater opportunities. (EXIT) d. IN A COMPETITIVE MARKET, business owners earn zero economic profits
i. They will remain CONTENT however, because they are earning their opportunity wage, making this their best alternative e. In addition to their role in rationing scarce goods, PRICES allocate productive resources between different activities.

F. Imperfect Competition Markets with one or only a few suppliers are imperfectly competitive. A firm in an imperfectly competitive market can make decisions that affect the price at which its products can be sold. Its demand curve is downward sloping; if it chooses to increase supply, the price it receives will be lower. Market power: firms that face a downward sloping demand curve; meaning: instead of taking prices as given, they have the ability to choose market prices (this is slightly exaggerated). They are not entirely free to choose any price due to constrain by combinations of price and demand. 1. Monopoly a. Single supplier
b. Monopolies arise from the existence of Barriers to Entry: Obstacles that prevent

competitors from entering the market. c. Most important sources of Barriers to Entry: i. The ownership of a key resource ii. Government created monopolies
iii. Natural Monopolies: Where a single firm can supply the market at a lower

cost than two or more firms. 2. Monopoly Supply a. Look at this individually, its basically a long example illustrating supply in a monopoly 3. Welfare Consequences of Monopoly

a. ^Read on your own.

4. Dealing with Monopolies

a. Mergers and Acquisitions (M&A) : Bringing separate companies together to form

larger ones. b. Sherman Anti-Trust Act (1890): the federal government has sought to use legislation to increase market competition. i. As a result, large M&As must be reviewed by government regulations to insure that they do not reduce competition in key markets.
ii. Antitrust regulations can also break up companies, such as when AT&T

split up in 1984, or take steps to restrict anti-competitive practices, such as when Microsoft was required to unbundle Internet Explorer from Windows. c. Regulations are put on monopolies (many natural monopolies are regulated) i. Public utilities such as electricity, cable television. d. Public Ownership of services (sewer, local water, sanitation) also helps reduce the influence of monopolies.

5. Price Discrimination
a. Price discrimination: Separating customers into groups who value their product

differently. Example: Movie tickets for children differ from movie tickets with adults b. Price discrimination increases monopoly profits by allowing the monopoly to capture a greater fraction of the benefits produced by each transaction. It also increases social welfare by moving the market closer to the socially efficient quantity.

6. Oligopoly a. System where a small number of producers/firms supply the bulk of the market. b. Cartels: Suppliers cooperating to behave like a monopoly, maximizing total industry profits. However, this is illegal in the U.S under anti-trust law.

c. OPEC: Organization consisting of the worlds major oil-exporting nations. It was founded in 1960,and is a cartel that aims to manage the supply of oil in an effort to set the price of oil on the world market, in order to prevent fluctuations that might occur between the differing economies of both producing and purchasing nations.

7. Monopolistic Competition a. Most common form of imperfect competition b. Market where firms produce similar but differentiated products i. Books, restaurants, clothing, cereal c. Downward sloping demand curve d. Each firm chooses its output by finding the point where marginal revenue = marginal cost. e. Because price exceeds marginal costs, there is social inefficiency f. The diversification of products that results from the efforts of firms to create a distinctive identity for their product creates benefits for consumers by increasing the range of choices available. G. Creative Destruction: the profit motive and the sources of Economic Changes Producers in a competitive market are satisfied with earning zero profits. The definition of economic profits factors in the opportunity cost of all the resources employed, including the business owners time. Innovation is an important route that firms take to establish market power Entrepreneurs: individuals who take on the risk of attempting to create new products or services, establish new markets, or develop new methods of production. Innovation helps to create barriers to entry that reward the innovator with profit, but also serves to break down the existing market imperfections because the existence of profits encourages efforts to invent around the barriers. Ex. Development of satellite television competing with cable television, and mobile phone companies trying to imitate apples iphone. Joseph Schumpeter called entrepreneurs as a type of creative destruction. The essential catalyst for creative destruction is the opportunity to earn economic profits.

H. Market Failures 1. Externalities a. Type of market failure

b. The actions of one person affect the well being of someone else, but neither party

pays nor is paid for these effects i. Positive: when the effect of these actions are beneficial ii. Negative: when harm is done c. Public goods: goods or services in which it is impossible to establish private property rights d. Example of externality: When bees pollinate apple trees, they increase the size and value of the apple. However, the value of the apple does not figure into the beekeepers costs or benefits, its considered an externality. Because the farmer benefits from the beekeepers actions, this externality is positive. e. Negative externality example: When your neighbor doesnt take care of his house, creating an ugly environment and thus affecting the value of your own home. f. Pollution is a negative externality too. 2. The Effect of Externalities on resource Allocation a. Read on your own 3. Private Responses to Externalities a. Externalities create incentives for market participants to attempt to solve the problems they create
b. In this case of the beekeeper example, total revenue will increase if the beekeeper

expanded his production c. In this case of the homeowner, trying to get your neighbor to start maintaining their house will benefit both you and your neighbor in terms of the value of the houses.
d. The Coase Theorem: Insight reached by Ronald Coase; As long as the parties

involved can negotiate with each other, the private market should be able to resolve the inefficiencies created by externalities.

4. Government Regulation of Externalities a. When private bargaining fails, governments can sometimes step in to resolve the matter. b. Taxes were used to address externalities i. Example: congestion charge in London (2003) 1. At the time, London had the worst traffic congestion of any city in Europe. 2. Estimated that drivers spent nearly fifty percent of their time idling and that the economic value of time lost was between 3 and 6 million each week. 3. The introduction of the fee reduced the congestion by over 20 percent ii. Using taxes is effective if it is possible to estimate the value of the externality. iii. It may be more effective to approach a negative externality by establishing a quota limiting the activity that produces the externality. 1. The EPA used this approach to deal with sulfur dioxide emissions 5. Property Rights a. Read on your own 6. The Effects of Private Ownership
a. Tragedy of the commons: If a resource is held in common for use by all, then ultimately that resource will be destroyed. No one takes account of the negative externalities caused by the overuse.

b. Read on your own 7. Public and Private Goods There are two dimensions to differentiate between public and private. 1st dimension: Rivalry of consumption- Characteristic that one persons consumption will reduce the amount available for others

2nd dimension: Excludability- the ability to control who consumes the good. National Defense is a non excludable good.

a. Private Goods i. Conventional private goods are characterized by a high degree of rivalry in consumption and a high degree of excludability. b. Common resources i. Goods with a high degree of rivalry but a low degree of excludability ii. Suffer from tragedy of the commons iii. Subject to externalities c. Collective Goods i. Low degree of rivalry but high degree of excludability ii. They can be easily privatized, but they are often national monopolies because non rivalry in consumption means marginal cost of production is close to zero.

d. Public Goods
i. Non rivalry in consumption with non excludability <- true public goods.

ii. Provided by the government I. Institutions , Organizations, and Government Collective decision making begins with institutions Institutions are both formal and informal rules that structure human interaction. Most markets are institutions.

Organizations help to organize human interaction via formal rules and structures. Government possesses two powers: Ability to tax citizens Legal monopoly on the legitimate use of force o Power used to restrain criminals, protect national security

1. Pork Barrel Politics a. Government officials introducing projects to steer money to their communities b. Projects are popular with voter who matter to that particular legislator c. Combined effect of these projects is to increase the cost of government
d. Logrolling: The practice of exchanging favors, esp. in politics by reciprocal voting for each other's proposed legislation. e. Wasteful spending

2. Rent-Seeking a. Socially unproductive activities that seek simply to direct economic benefits to one set of actors rather than another 3. What is the Proper Role for Government? a. Government is not essential to the establishment of a market economy, but it can help b. We are willing to accept the small loss of individual autonomy for the protection of property and security III. MACROECONOMICS Branch that studies the performance of national economies 1st concern: the factors that determine the long run growth in the size of economies, the standard of living that they provide for their participants, and the price level. 2nd concern: the causes and consequences of short run fluctuations in the level of economic activity, unemployment, and inflation

1. Economic Growth and Living Standards a. GDP (Gross Domestic Product): Measure of the total quantity o goods and services produced in the economy, adjusted to remove effects of inflation. b. Since 1900, the total real output of the U.S economy has increased by a factor of 32. c. Decline in output occurs during Great Depression and expansion of output during WWII d. More people can produce more output e. Since 1900, the U.S population has increased by a factor of 4 f. GDP per capita: Growth of output per person, per capita meaning per head, which is used to denote averages calculated for an entire population
g. Average labor productivity: economys total output divided by total number of

workers employed. This measures how much the typical worker can produce. h. The average output per person in the U.S economy in 2008 was $43, 000. i. Human happiness depends on more than just the material level of consumption.

2. Recessions and Expansions a. Rate of U.S output is not steady. b. Once again, huge decline in output during the Great Depression (1929-1933), and huge increase during WWII (1941-1945). c. Periods of rapid growth of output are called expansions d. Periods of slow growth are called recessions i. Severe recessions = depressions ii. Recessions are associated with declining employment and slower wage growth e. The alternation of periods of expansion and recession is referred to as the business cycle 3. Unemployment

a. The unemployment rate is the percentage of the labor force that would like to work but cannot find work b. Labor force = employed + unemployed individuals c. The unemployment rate is never zero, people are always searching for jobs 4. Inflation a. When all prices rise together = inflation b. Everything becomes expensive c. It reduces purchasing power and makes people worse off d. Macroeconomic policy must keep inflation low e. Inflation was high during WWI and WII and in the 1970s f. Inflation has been quite low since the early 1980s g. Prices have risen since WWII, but before 1940, prices were very low 5. International Trade a. Trade Surplus: When exports exceed importants b. Trade deficit: When imports exceed exports c. Up until the late 1950s, the U.S has generally exported more than imported d. Since the 1970s, imports are greater than exports B. Macroeconomic Measurement 1. Measuring Total Output: GDP GDP: the market value of all final goods and services produced within a country during a specified period of time. a. Market value i. To combine all the different types of things that a country produces, we use their dollar value ii. Remember that the market price of a good reflects the value that a consumer has on that good b. Final goods and services

i. Intermediate goods: goods used up in the production of a final good ii. We exclude intermediate goods from GDP, because this insures that our measure is not affected by vertical integration.
iii. Final Goods: goods that are ultimately consumed. iv. Capital Goods: Long Lived goods that are themselves produced and are

used to produce other goods and services but are not used up in production. Ex. Machinery and factory building v. Capital Goods are included in GDP during the year they are produced c. Within a country i. The word domestic indicates that we count only goods produced within the borders of the country discussed. ii. U.S GDP includes the values of all automobiles produced in the U.S, whether or not the auto manufacturer is an American company or a foreign owned one d. During a specified period i. We only include items that are produced between the beginning and end of the period in question ii. Sales of goods produced in earlier periods is not included in the GDP 1. Ex. A 20 year old house sold this year is not included in the current GDP, because it was produced 20 years ago. This house was included in the GDP of the year it was made. 2. However real estate services that occurred with the selling of the house are included in the GDP, because they occurred during that year

2. Understanding what GDP Measures a. One of the earliest efforts to measure national output was undertaken by Sir William Petty in the mid 1600s. b. In 1932 the U.S Department of Commerce commissioned the economist Simon Kuznets to develop a system to measure national output.

c. GDP excludes goods that are not bought and sold in markets i. Ex. Unpaid housework d. GDP ignores activities that deplete a countrys stock of natural resources or pollute the environment 3. Other ways to measure GDP: Expenditures Equal Production a. We can also think of GDP as a measure of the total value of expenditures within a country b. Household expenditures are called consumption expenditures, or consumption for short i. Consumer durables: long lived consumer goods such as cars ii. Consumer nondurables: goods used u quickly like cereal iii. Services: Intangible goods like education iv. Investment: Spending by firms on final goods and services, along with household purchases. 3 parts to it 1. Business Fixed Investment: Business purchases of factories, offices, machinery, and equipment
2. Residential Fixed Investment: purchase of new homes and

apartment buildings 3. Inventories: consists of additions of unsold goods to company inventories v. Economists use of investment is different than typical use 1. Its reserved for the purchase of new capital goods, such as building and equipment, and not just describing the purchase of general financial assets like stocks. vi. Government purchases: all goods and services purchased by federal, state, and local governments.
vii. Net Exports: Difference between the values of domestically produced

goods sold to foreigners and the value of foreign produced goods purchased by domestic buyers. c. IMPORTANT EQUATION: GDP = C + I + G + NX

i. C = CONSUMPTION ii. I = INVESTMENT iii. G = GOVERNMENT SPENDING iv. NX = NET EXPORTS

4. Yet Another way to Measure GDP: Income Equals Protection Equals Expenditures a. GDP can also be thought of as income b. GDP = Production =Expenditures = Income 5. Real GDP a. GDP = calculated by adding up the market value of all the goods and services produced in a country during a specified time period b. The size of the resulting sum depends on both the quantity of the goods and services produced and their prices. c. Between 200 0 and 2005, the GDP tripled, rising from $750 to $2250 d. Real GDP is used to isolate the effects of changes in production from changes in prices by using prices from a single year to value production in each year. i. This year is called the base year. 6. Measuring Inflation a. Consumer Price Index (CPI) : measures the cost of purchasing a market basket of goods and services intended to represent the consumption of a typical consumer b. The Bureau of Labor Statistics conducts periodic surveys of consumer expenditures c. CPI can overstate the effect of rising prices i. First Factor is substitution bias: Going from expensive goods to less costly ones ii. Second Factor is Unmeasured quality Change: Goods and services getting better or worse
iii. 3rd Factor is the introduction of new goods and services.

d. 1996, the Boskin Commission headed by Michael Boskin reviewed the methods used to calculate the CPI e. Nominal GDP = (GDP Deflator/ 100) x (Real GDP) f. GDP Deflator = 100 x (Nominal GDP/Real GDP) 7. Unemployment Unemployment rate: defined as the percentage of the labor force unable to find a job. Employed: If that person worked for pay either full or part time during the previous week or is on vacation or sick leave from a regular job Unemployed: If that person did not work during the previous week but made some effort to find paid employment during the past four weeks Out of Labor Force: if that person did not work during the past week and did not actively seek work during the previous four weeks.

a. Frictional unemployment i. Refers to the portion of the unemployed who are currently not working because of the normal process of matching employees and employers. b. Structural unemployment i. The portion of total unemployment attributable to the mismatch between job openings and job seekers. c. Cyclical unemployment i. Additional unemployment that occurs from circumstances during recessions and just the normal business cycle C. Economic Growth, Productivity, and Living Standards 1. The Circular Flow Model of the Economy
a. It traces the flow of dollars through the economy, this diagram illustrates

schematically the complex set of interactions between the major sets of economic actors in our economy: households, firms, and the government.

b. Households receive income by providing factors of production (labor, capital, land) to firms c. Even though firms purchase many capital goods in our economy, these goods are indirectly owned by households through their ownership of the firms, and these households provide this capital to firms in exchange for rent. d. Households use their income to purchase goods, pay taxes, and save through financial markets. e. The government receives income from households in the form of taxes, and the government borrows from financial markets. It uses these sources of income to purchase goods and services. f. Just look at the damn cycle (p. 73)

2. What Determines How much an Economy Produces? a. An economys output depends on the total quantity of goods and services that firms are able to produce. b. D. Savings and Investments and the Financial System 1. Financial Markets a. The bond market b. The stock market

2. Financial Intermediaries a. Banks b. Mutual Funds c. Saving and investment in Aggregate d. International capital Flows in an Open Economy e. How Financial Markets Coordinate Saving and Investment Decisions E. Money and Prices in the Long Run 1. What is Money? 2. Measuring money 3. The Federal reserve, Banks, and the Supply of Money 4. Bank Runs 5. Money and Inflation in the Long Run 6. Why worry about inflation? F. Short Run Economic Fluctuations 1. Characteristics of Short Run Fluctuations 2. Potential Output, the Output Gap, and the Natural Rate of Unemployment 3. Expaining Short Run Fluctuations in Output a. Wealth effects b. Interest rate effects c. Foreign Exchange Effects d. The Aggregate Supply Curve e. The Keynesian Model of Short Run Fluctuations f. Inflation in the Keynesian Model g. Using Fiscal and Monetary Policy to Stabilize the Economy IV