haecON: IB 1 Introduction + 2 Micro

An Introduction to Economics

The Foundations of Economics

Economics as a social science

• Explain that economics is a social science.

• Outline the social scientific method.

• Explain the process of model building in economics.

• Explain that economists must use the ceteris paribus assumption when developing economic models.

• Distinguish between positive and normative economics.

• Examine the assumption of rational economic decision-making.

Scarcity

• Explain that scarcity exists because factors of production are finite and wants are infinite.

• Explain that economics studies the ways in which resources are allocated to meet needs and wants.

• Explain that the three basic economic questions that must be answered by any economic system are: “What to produce?”, “How to produce?” and “For whom to produce?”

Choice and opportunity cost

• Explain that as a result of scarcity, choices have to be made.

• Explain that when an economic choice is made, an alternative is always foregone.

• Explain that a production possibilities curve (production possibilities frontier) model may be used to show the concepts of scarcity, choice, opportunity cost and a situation of unemployed resources and inefficiency.

Central themes

• Explain that the economics course will focus on several themes, which include:

–– the extent to which governments should intervene in the allocation of resources

–– the threat to sustainability as a result of the current patterns of resource allocation

–– the extent to which the goal of economic efficiency may conflict with the goal of equity

–– the distinction between economic growth and economic development.

Economic Freedom Index

Economic Models

1.1 Competitive markets: Demand and supply

Markets

The nature of markets

• Outline the meaning of the term market.

Demand

The law of demand • Explain the negative causal relationship between price and quantity demanded.

• Describe the relationship between an individual consumer’s demand and market demand.

The demand curve • Explain that a demand curve represents the relationship between the price and the quantity demanded of a product, ceteris paribus.

• Draw a demand curve.

The non-price determinants of demand (factors that change demand or shift the demand curve)

• Explain how factors including changes in income (in the cases of normal and inferior goods), preferences, prices of related goods (in the cases of substitutes and complements) and demographic changes may change demand.

Movements along and shifts of the demand curve

• Distinguish between movements along the demand curve and shifts of the demand curve.

• Draw diagrams to show the difference between movements along the demand curve and shifts of the demand curve.

review presentation

The law of supply

• Explain the positive causal relationship between price and quantity supplied.

• Describe the relationship between an individual producer’s supply and market supply.

The supply curve

• Explain that a supply curve represents the relationship between the price and the quantity supplied of a product, ceteris paribus.

• Draw a supply curve.

The non-price determinants of supply (factors that change supply or shift the supply curve)

• Explain how factors including changes in costs of factors of production (land, labour, capital and entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations, indirect taxes and subsidies and the number of firms in the market can change supply.

Movements along and shifts of the supply curve

• Distinguish between movements along the supply curve and shifts of the supply curve.

• Construct diagrams to show the difference between movements along the supply curve and shifts of the supply curve.

Market equilibrium

Equilibrium and changes to equilibrium

• Explain, using diagrams, how demand and supply interact to produce market equilibrium.

• Analyse, using diagrams and with reference to excess demand or excess supply, how changes in the determinants of demand and/or supply result in a new market equilibrium.

The role of the price mechanism

Resource allocation

• Explain why scarcity necessitates choices that answer the “What to produce?” question.

• Explain why choice results in an opportunity cost.

• Explain, using diagrams, that price has a signalling function and an incentive function, which result in a reallocation of resources when prices change as a result of a change in demand or supply conditions.

The role of the price mechanism

Resource allocation
• Explain why scarcity necessitates choices that answer the “What to produce?”question.• Explain why choice results in an opportunity cost.• Explain, using diagrams, that price has a signalling function and an incentive function, which result in a reallocation ofresources when prices change as a result of a change in demand or supply conditions.

Market efficiency

Consumer surplus
• Explain the concept of consumer surplus.
• Identify consumer surplus on a demand and supply diagram.

Producer surplus
• Explain the concept of producer surplus.
• Identify producer surplus on a demand and supply diagram.
Allocative efficiency
• Explain that the best allocation of resources from society’s point of view is at competitive market equilibrium, where social (community) surplus (consumer surplus and producer surplus) is maximized (marginal benefit = marginal cost).

1.2 Elasticity

Price elasticity of demand (PED)

Price elasticity of demand and its determinants

• Explain the concept of price elasticity of demand, understanding that it involves responsiveness of quantity demanded to a change in price, along a given demand curve.

• Calculate PED using the following equation.

PED = percentage change in quantity demanded / percentage chang e in price

• State that the PED value is treated as if it were positive although its mathematical value is usually negative.

• Explain, using diagrams and PED values, the concepts of price elastic demand, price inelastic demand, unit elastic demand, perfectly elastic demand and perfectly inelastic demand.

• Explain the determinants of PED, including the number and closeness of substitutes, the degree of necessity, time and the proportion of income spent on the good.

• Calculate PED between two designated points on a demand curve using the PED equation above.

• Explain why PED varies along a straight line demand curve and is not represented by the slope of the demand curve.

Applications of price elasticity of demand

• Examine the role of PED for firms in making decisions regarding price changes and their effect on total revenue.

• Explain why the PED for many primary commodities is relatively low and the PED for manufactured products is relatively high.

• Examine the significance of PED for government in relation to indirect taxes.

explanation why elasticity varies along a straight line demand curve

Cross price elasticity of demand (XED)

Cross price elasticity of demand and its determinants

• Outline the concept of cross price elasticity of demand, understanding that it involves responsiveness of demand for one good (and hence a shifting demandcurve) to a change in the price of another good.

• Calculate XED using the following equation.

XED = percentage change in quantity demanded of good x/ percentage change in price of good y

• Show that substitute goods have a positive value of XED and complementary goods have a negative value of XED.

• Explain that the (absolute) value of XED depends on the closeness of the relationship between two goods.

Applications of cross

price elasticity of

demand

• Examine the implications of XED for businesses if prices

of substitutes or complements change.

Income elasticity of demand (YED)

Income elasticity of demand and its determinants

• Outline the concept of income elasticity of demand, understanding that it involves responsiveness of demand (and hence a shifting demand curve) to a change in income.

• Calculate YED using the following equation.

YED = percentage change in quantity demanded / percentage change in income

• Show that normal goods have a positive value of YED and inferior goods have a negative value of YED.

• Distinguish, with reference to YED, between necessity (income inelastic) goods and luxury (income elastic) goods.

Applications of income elasticity of demand

• Examine the implications for producers and for the economy of a relatively low YED for primary products, a relatively higher YED for manufactured products and an even higher YED for services.

Price elasticity of supply (PES)

Price elasticity of supply and its determinants

• Explain the concept of price elasticity of supply, understanding that it involves responsiveness of quantity supplied to a change in price along a given supply curve.

• Calculate PES using the following equation.

PES = percentage change in quantity supplied/ percentage change in price

• Explain, using diagrams and PES values, the concepts of elastic supply, inelastic supply, unit elastic supply, perfectly elastic supply and perfectly inelastic supply.

• Explain the determinants of PES, including time, mobility of factors of production, unused capacity and ability to store stocks.

Applications of price elasticity of supply

• Explain why the PES for primary commodities is relatively low and the PES for manufactured products is relatively high.

1.3 Government intervention

Subsidies
Explain why governments provide subsidies, and describe examples of subsidies.
• Draw a diagram to show a subsidy, and analyse the impacts of a subsidy on
market outcomes.
• Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government.

Price controls

Price ceilings (maximum prices): rationale, consequences and examples

Explain why governments impose price ceilings, and describe examples of price ceilings, including food price controls and rent controls.
• Draw a diagram to show a price ceiling, and analyse the impacts of a price ceiling on
market outcomes.
• Examine the possible consequences of a price ceiling, including shortages, inefficient resource allocation, welfare impacts, underground parallel markets and non-price
rationing mechanisms.
• Discuss the consequences of imposing a price ceiling on the stakeholders in a market, including consumers, producers and the government.

Price floors (minimum prices): rationale, consequences and examples

Explain why governments impose price floors, and describe examples of price floors, including price support for agricultural products and minimum wages.
• Draw a diagram of a price floor, and analyse the impacts of a price floor on market
outcomes.
• Examine the possible consequences of a price floor, including surpluses and government measures to dispose of the surpluses, inefficient resource allocation and welfare impacts.
• Discuss the consequences of imposing a price floor on the stakeholders in a market, including consumers, producers and the government.

1.4 Market failure

Market failure as a failure to allocate resources efficiently

Analyse the concept of market failure as a failure of the market to achieve allocative efficiency, resulting in an over allocation of resources (over provision of a good) or an under-allocation of resources (under-provision of a good)

Types of market failure

Problems of a Free Market
"Capitalism is the astounding belief that the most wickedest of men, will do the most wickedest of things for the greatest good of everyone."
John Maynard Keynes, as quoted in Moving Forward: Programme for a Participatory Economy (2000)

A free market has various problems. This is a silly mnemonic to help you remember them. PIMM FACED.

P - Public Goods are not provided in a free market. A public good is a good with the characteristics of non rivalry and non excludability. Examples include street lighting and national defence.

I - Inequality. A free market provides no social security net for those who are unemployed or on low income. Furthermore the nature of a free market is that the benefits tend to accrue to a small number of people who have the advantage of property and monopoly power

M - Monopoly. In an unchecked free market, monopolies can easily develop. This means the owners are in a position to set high prices and exploit both consumers and workers.

M - Merit Good - Education and health care. Under-provided because people underestimate the benefits of going to school e.t.c.

F - Factor immobility. Geographical unemployment. Occupational unemployment through lack of skills

A - Agrictulture. - Agriculture is prone to market failure e.g. weather can harm crops C - Cyclical Instability - economic recessions and the corresponding unemployment

E - Externalities - Over-consumption of goods like tobacco with negative externalities

D - De merit goods - Overconsumption of goods like alcohol, where people overestimate the personal benefits, underestimate the costs of getting drunk.

The meaning of externalities

Describe the concepts of marginal private benefits (MPB), marginal social benefits (MSB), marginal private costs (MPC) and marginal social costs (MSC).
Describe the meaning of externalities as the failure of the market to achieve a social optimum where MSB = MSC.

Negative externalities of production and consumption

Explain, using diagrams and examples, the concepts of negative externalities of production and consumption, and the welfare loss associated with the production or consumption of a good or service.
Explain that demerit goods are goods whose consumption creates external costs.

Evaluate, using diagrams, the use of policy responses, including market-based policies (taxation and tradable permits), and government regulations, to the problem of negative externalities of production and consumption

Positive externalities of production and consumption

Explain, using diagrams and examples, the concepts of positive externalities of production and consumption, and the welfare loss associated with the production or consumption of
a good or service.
Explain that merit goods are goods whose consumption creates external benefits.
Evaluate, using diagrams, the use of government responses, including subsidies, legislation, advertising to influence behaviour, and direct provision of goods and services

Should We Tax People for Being Annoying? nyt 8 jan 2013

What are externalities?

back to basics: IMF externality introduction

Public Goods and Commons Goods

The Tragedy of the Commons

G Hardin in Science (1968)

Microeconomics Revision Material:

Markets

Linear Demand Functions

Supply Functions

Finding Equilibrium

Consumer and Producer Surplus

Allocative Efficency

Government Intervention

Taxes

Subsidy

Price Controls

Information Failure

For markets to work, there needs to be symmetric information i.e. consumers and producers have the same level of knowledge about the products, and they know everything there is to know about them.

Asymmetric information occurs when somebody knows more than somebody else in the market. This can make it difficult for the two people to do business together.

Examples include the following:

Warranties: The miss-selling of extended warranties by high street retailers on domestic electrical goods such as televisions and dishwashers

Sub-prime mortgages: A lender does not know how likely a borrower is to repay their loan.

Insurance: A car insurance company cannot tell the risks associated with each single driver

Market for used cars: A used-car seller knows more about the quality of the car being sold than do buyers. The mini case study below on the Market for Lemons covers this example!