Chapter 1 Basic Principles of Economics. What is Economics? Scarcity … our wants exceed our...

Chapter 1

Basic Principles of Economics

What is Economics?

• Scarcity … our wants exceed our resources

• Decisions – Consumers– Business– Governments

“Micro”

• Microeconomics relates to specific individuals, companies, industries and markets

• e.g. the price of milk or dvds

“Macro”

• Macroeconomics relates to the whole economy

• e.g. Gov’t decides to raise interest rates to lower inflation

More Macro…

Terms

• Ceteris Peribus• Opportunity Cost• Production Possibilities• Supply and Demand• Price• Elasticity• Economic Profit• Profit Maximum Rule• Costs (marginal, average, minimum, etc.)• Monopoly, Oligopoly, Perfect Competition, etc.• Labour• Globalization

Economists

• David Ricardo

• Adam Smith

• Karl Marx

• John Maynard Keynes

• Frederick Von Hayek

• John Kenneth Galbraith

Theories

• Law of Diminishing Returns

• Law of Increasing Opportunity Costs

• Profit Maximization Rule

• Quantity Theory of Money

• Labour Theory of Value

• Okun’s Law

Formulas

• Total Revenue = Price x Quantity• Total Costs = Fixed Costs + Variable Costs• Average Cost = Total Cost / Quantity• Average Variable Cost = Variable Cost / Quantity• Marginal Revenue = Total Revenue / Total

Quantity• Marginal Cost = Total Cost / Total Quantity• Profit Max. Point where Marginal Revenue =

Marginal Cost• Profit in $ = Total Revenue – Total Costs

Graphs

And more graphs

Quantity

Revenue

D=AR=MRP

MC

AC

AVC

Revenue Rectangle

Cost

Profit

People

Expectations of Teacher

• Excellent knowledge and delivery of content

• Provide multiple opportunities to earn marks in each category

• Create inviting atmosphere of shared experience

Expectations of Student

• Come to class• Come to class on time (1:30pm)• Leave class when it ends (2:45pm)• Do your homework• Participate• Listen• Allow others to learn• Actively review• Come for extra help

Things NOT to do:

• Part time student status• Hand in assignments late• Miss tests• Say “I wasn’t here”• Say “My partner isn’t here”• Waste work periods• Plagiarize or copy• Wine about marks

What is Economics?

• the study of how we make decisions about the use of scarce resources

• a social science because it’s a study of people making decisions

• a self-sustaining system in which independent transactions create distinct flows of money

About Economics

• difficult to predict individual human behaviour it is often possible to predict group behaviour

• Economic decisions should be effective (achieve goal) and efficient (use least amount of resources)

Opportunity Cost

• the sum of all that is lost from taking one course of action over another

• eg. Study or work the night before a big test … opportunity cost is what you give up by taking one course of action

Production Possibilities Model

• a visual model showing the choices faced by people in a simple economy

• Assumptions:

- only two products can be produced … leading to a trade-off

- fixed resources and technology

- full-employment

Production Possibilities Model

• The economy can produce good A or good B (in this case food or clothing)

Production Possibilities Model

• If the economy chooses to produce more of one good over another it can but must shift resources

• resources do not shift easily and it costs progressively more of one good to produce more of the other … this is called the law of increasing relative cost

More “Laws”

• The Law of Diminishing Returns states outputs increase with a particular input but only to a point

• The Law of Increasing Returns to Scale states output can increase if all productive resources are increased at the same time and in the same quantity

Productive Resources

Tangible:• Land (raw

materials) • Labour• Capital – real:

goods used to produce other goods

• Capital – money: funds used

Intangible:• Knowledge • Entrepreneurship• Environment for

enterprise

Three Fundamental Questions

• What to Produce

• For Whom to Produce

• How to Produce

Types of Economy

Traditional:

• Focus on family needs

• Methods handed down

• Use most, trade surplus

Types of Economy

Command:• Central authority

decides what, for whom and how to produce

Types of Economy

Market:• sell popular goods at

best price • keep costs low and be

efficient • consumers are those

that can afford the product

Types of Economy

Mixed:• markets and

governments interact as producers and consumers

• taxes create the desire to cheat, e.g. Hidden Economy

Political Economies

• Democracy means political system involves freely elected government and allows differing political views

• Dictatorship involves a single person or party having authority over a nation

Political Economies

Communism:• the “left” • government owns

control of all means of productions

• no private property rights

• can use violence to retain power

• Marx and Engells

Political Economies

Socialism:• left centre • government control

of means of production

• democracy favoured

• free enterprise is inefficient and wasteful

Political Economies

Capitalism:• moving to the right • freely elected gov’t • private property

encouraged • free market for

consumers and producers

• Adam Smith stressed the “invisible hand”

Political Economies

Facism:• extreme right • free market economy • non-democratic/

authoritarian gov’t • private property

ownership encouraged if gov’t dictates followed

Adam Smith(1723 –1790 The Wealth of Nations)

• laissez-faire term meaning leaves things alone

• individual self-interest and wealth creation good for all individuals

• “invisible hand” is the market competition and will serve the common good

• division of labour

Adam Smith• division of labour (specialization of

workers) led to increased production, increased profits for investors, more consumer goods for workers and greater economic efficiency for society

• law of accumulation meant profits would be reinvested and create more prosperity for investors and workers

Adam Smith

• law of population implies increased capital requires more workers, leading to higher wages, improved living conditions, reduced mortality, increase in population and labour force … keeping wages low

Thomas Robert Malthus (1766-1834 Population)

• predicted inevitable poverty and famine for the masses

• Industrial Revolution meant farm to urban change• Population doubles every 25 years if unchecked,

geometric progression• but food can only grow in an arithmetic progression,

Positive checks include war, famine, disease, epidemics and reduce pop. Growth rate

• preventative checks include late marriage, sexual abstinence (and now birth control)

• tech. breakthroughs in food production were not imagined

Thomas Robert Malthus

• Positive checks include war, famine, disease, epidemics and reduce pop. Growth rate

• preventative checks include late marriage, sexual abstinence (and now birth control)

• tech. breakthroughs in food production were not imagined

David Ricardo (1772-1823 Rent)

• three groups: working class, industrialist class, landlords

• one group could only prosper at the expense of others

• Iron Law of Wages implied higher reproduction kept wages low

• Trade – absolute advantage meant a nation could produce a product more efficiently than another nation

• but Trade could still exist if each nation produced the product it had a comparative advantage in and traded the surplus

David Ricardo

• Trade – absolute advantage meant a nation could produce a product more efficiently than another nation

• but Trade could still exist if each nation produced the product it had a comparative advantage in and traded the surplus

Karl Marx (1818-1883 Communist Manifesto)

• believed workers – the proletariat – would always be exploited by the ruling class

• workers in urban areas endured no labour laws and children were abused

• believed all workers would eventually unite to overthrow the ruling class

• Labour Theory of Value – means labour receives only a portion of its worth; the rest being surplus value

• e.g. cost of sweater is $10 in materials, $40 in labour and sold for $80 … surplus value is $30

Karl Marx

• Labour Theory of Value – means labour receives only a portion of its worth; the rest being surplus value

• e.g. cost of sweater is $10 in materials, $40 in labour and sold for $80 … surplus value is $30

John Maynard Keynes (1883-1946 Gov’t intervention)

• gov’t could and should intervene in economy to smooth the effects of business cycles methods

• include control of interest rates and gov’t spending

• critics suggest his policies lead to high inflation rates and massive public debts

John Kenneth Galbraith (1908 Social Balance)

• in good times consumer goods such as tv’s and cars produced in abundance but public goods such as hospitals and parks not a priority

• believed corporate managers held real decision-making power (not shareholders or consumers)

• argued for more gov’t involvement and regulation

Milton Friedman (1912 Monetarism)

• argued gov’t involvement worsened economy • also it put individuals more dependent on

gov’t • pro-laissez-faire, self-sufficiency and work

ethic • replace gov’t welfare programs with a

guaranteed income (negative income tax)• advocated voucher system for schools • Monetarist School of Thought – gov’t should

only manage the economy by guaranteeing a constant money supply and yearly increase (3-5%)

The Market

• can be a location, network of buyers and sellers for a product, demand for a product or a price-determination process

• the interaction of buyers and sellers determines what the price will be for a good or service

Demand

• the quantity of a good or service buyers will purchase at various prices during a given period of time

• the law of demand states the quantity demanded varies inversely with price (Ceteris Paribus – all other things remain the same)

Demand

Reasons supporting the law of demand:

• Substitution Effect – we buy different goods when prices rise or fall

• Income Effect – we can more if price falls or less if it rises

Demand

• the demand schedule is the entire relationship between each price and quantity demanded

• the demand is downward-sloping

Demand

• the sum of all individual consumer demand curves for a good is the market demand curve

• “demand” is the entire set of price and quantity relationships while “quantity demanded” is the amount demanded at one price

Supply

• the quantities sellers will offer for sale at various prices during a given period of time

• law of supply states the quantity supplied will increase if price increases and fall if price falls

• “supply” is the entire set of price and quantity relationships while “quantity supplied” is the amount offered at one price

Supply

• Supply curve is upward sloping to the right

Market Equilibrium

• the interaction of buyers and sellers, of demand and supply

• equilibrium price is the result of supply and demand forces

• a price above the equilibrium leads to a surplus which can only be cleared by a drop in price

• a price below equilibrium leads to a shortage and can only be cleared with a price increase

Market Equilibrium

• The intersection of demand and supply

Demand Determinants(changes in Demand)

• Non-price factors shifting the entire curve (at every price)

1. Income – more leads to increased demand

2. Population – more leads to increased demand

3. Tastes/Preferences – various reasons, reports, advertising

4. Expectations – of a future event may lead to more or less demand now

5. Price of Substitute Goods – if a compliment, demand shifts in the same direction; if substitute the opposite direction; eg. bread price increase, demand for butter decreases (compliment); e.g. steak price increases, hamburger demand increases

Supply Determinants(changes in Supply)

1. Costs – increase/decrease in production costs decrease or increase supply

2. Number of Sellers – new producers increase market supply

3. Technology – usually decreases costs and increases supply

4. Nature – weather or disaster can affect supply 5. Prices of related outputs – if another good has

higher price, producers may shift production

Movement along Demand curve

• Can only be caused by change in price

Movement along Supply Curve

• Can only be caused by price change

Shortage

• decrease in price, away from equilibrium

• Excess will be cleared with an increase in price and shrinking quantity demanded

Surplus

• Increase in price, causing excess quantity supplied

• Cleared by lowering prices and reducing quantity demanded

Change in Demand

• Can only be caused by a demand determinant (no price change)

• The whole demand curve shifts

Change in Supply

• Caused by change in supply determinant (no price change)

Profit & the Firm

• The “Bottom Line”• Incentive and reward for risks• Leads to better decision making and greater productivity• Accounting profit = revenue – costs• Revenue = price x quantity• Costs = Fixed Costs + Variable Costs• Short Run – at least one resource can’t be changed• Long Run – all costs , including buildings, can be

variable

Production

• Marginal Revenue is the additional revenue earned producing one more unit of output

• Marginal Cost is the additional cost of that unit

• Profit maximized where MR = MC• Productivity – maximize output from

resources used• Efficiency – producing at lowest cost

Productivity factors

• Skills, education, experience of workforce• Quantity and quality of resources• State-of-the-art machinery• Aim to lower cost per unit• Capital-intensive (using machines) vs. Labour-

intensive• Economies of scale relates to the efficient use of

machinery• Producing more output lowers the cost per unit

Useful Formulas

• Total Revenue = Price x Quantity

• Total Costs = Fixed Costs + Variable Costs

• Average Cost = Total Cost / Quantity

• Average Variable Cost = Variable Cost / Quantity

• Marginal Revenue = Total Revenue / Total Quantity

• Marginal Cost = Total Cost / Total Quantity

• Profit Max. Point where Marginal Revenue = Marginal Cost

• Profit in $ = Total Revenue – Total Costs

Perfect Competition

• Many buyers and sellers

• identical product

• price taker … no control over price

• no barriers to entry

• little non-price competition

• may not actually exist

Perfect CompetitionProfit Maximization

Quantity

Revenue

D=AR=MRPAC

AVC

Revenue Rectangle

Cost

Profit

MC

Profit Max

Profit Max Quantity

Monopolistic Competition

• Many firms

• Similar product

• Some influence over supply and price

• Easy entry

• Non-price competition high

Monopolistic CompetitionProfit Maximization

Quantity

Revenue

D=ARMR

MC

ACProfit

Cost

P

Q

Oligopoly

• Few firms dominate

• Products may be similar or different

• Influence over price varies

• Barriers to entry high

• Non-price competition high

OligopolyProfit Maximization

Quantity

Revenue

D=AR

AC

MC

MR

MR

P

Q

Cost

Profit

“Kink”

Monopoly

• One firm dominates

• Unique product

• Price maker and control over supply

• Barriers to entry very high

• No need for non-price competition

MonopolyProfit Maximization

Quantity

RevenueMC

ACProfit

Cost

P

Q

D=AR

MR

Profit max

Note: Similar to Mono. Comp. but more inelastic demand curve

Issues• Natural Monopoly – where high fixed costs make one

firm the choice (e.g. utilities, public transit)• Deregulation – allow competition• Privatization – sell public assets to private interests• Fewer bigger firms may mean collusion• Third-party costs – social costs such as pollution are

borne by others• Public-Private Balance – gov’t as a provider of goods

and services (health, education, etc.) increased in last 40 years as deficits soared

• Regulation – firms may prefer less but gov’t must balance with needs of individuals