Chapter 4 Economics

 
Economics: The study of how people use their scarce resources to satisfy their unlimited wants.
 
Macroeconomics: Study how decisions of individuals coordinated by markets in the entire
economy join together to determine economy-wide aggregates like employment and growth.
They study the performance of the economy as a whole.
 
Market: Means by which individuals interact to buy or to sell; mechanism that coordinates the
independent intentions of buyers and sellers.
 
Before we can go on, it is important to understand what economic actors are interacting in these
markets and their relationships to one another.
 
Four (broadly defined) economic actors are:
 
1. Households
2. Firms
3. Governments
4. "The Rest of the World"
 
I. Households
 
All those people living under one roof are considered a household.
 
Households do two fundamental things vital to the economy.
1.      Demand goods and services from product markets
2.      Supply labor, capital, land, and entrepreneurial ability to resource markets.
 
Economists think of each household acting as a single decision-maker.
 
Householder: The key decision-maker in the household.
 
A.     Evolution of a Households
 
Households have changed considerably in economic history.
 
Earliest households were totally self-sufficient. They made what they consumed and consumed
what they produced to a large extend. Specialization took place within the household.
 
 
Are households self-sufficient today? How are they different?
 
-         Very few people produce their own food. With the increase in agricultural
productivity, fewer people are needed to produce the food to feed a nation.
-         People work away from the home.
 
How have households changed since the 1950s?
 
-         Women working: 1950 15% of married women with children under 18 were in the
labor force. Today more than 1/2 married women with young children are in the labor
force.
-         Higher education among women, growing demand for labor, increased the
opportunity cost of staying at home. Opportunity cost-define.
-         Two-earner households- less production occurs at home, more goods and services
demanded from the market.
 
B.     Households are rational utility maximizers.
 
Economists assume that individuals, and thus households, attempt to maximize their utility.
 
UTILITY: The satisfaction received from consumption; the sense of well being. Utility is
subjective (not objective). One household may have different goals than another.
 
Rational: They act in their own best interest (in the interest of their own goals- maximizing their
utility), would not make choices that would make them worse off.
 
C.     Households as Demanders
 
Personal income is allocated among three uses:
1.      savings
2.      consumption
3.      taxes
 
In US: 80% consumption, 5% savings, and 15% taxes
 
Consumption:
 
1. Durable goods: designed to last three years or more. 13%
2. Nondurable goods: food, clothing, and gasoline 30%
3. Services: childcare, medical care 57%
 
D.     Resource suppliers
 
Households use their limited resources (labor, capital, land, and entrepreneurial ability) to
maximize their own utility.
 
They can use these resources at home, or they can sell these resources in the resource market to
earn money to spend in the product market.
 
You can see that a majority of personal income in the US is from labor earnings, rather than from
ownership of other resources such as capital or land. (Exhibit 1, page 72)
 
Proprietors: People who work for themselves rather than for employers (plumbers,
farmers, and doctors)
 
Transfer payments: Cash (welfare benefits, unemployment, disability) or in-kind benefits (food
stamps - for specific goods/services) given to individuals as outright grants from the government.
 
***Some households have few resources valued in the market. In those cases, the government
provides temporary public assistance.
 
 
II. Firms
 
Firms: Economic units, formed by profit-seeking entrepreneurs who employ resources to
produce goods and services for sale.
 
A.     Firms have evolved as providers of goods and service.
 
-         Prior to the 18th century, Britain had a cottage industry system. Firms supplied raw
materials (lumber, wool) to households that turned raw materials into finished goods.
-         This system still exists in some parts of the world.
-         With the expansion of the economy-more demand for final goods and services-
entrepreneurs organized various stages of production under one roof.
-          Work was organized in factories which 1. Promoted more efficient division of
labor 2. Allowed for direct supervision of laborers 3. Reduced transportation costs 4.
Facilitated use of machines.
-         Around 1750 (start of industrial revolution) the development of large-scale factory
production spread to Europe, North America, and Australia.
 
B.     Kinds of Firms
 
1. Sole Proprietorships: A firm with a single owner who has the right to all profits and who bears
unlimited liability for the firm's debts. (plumber, doctor)
-         Must raise all the money to start business, is solely responsible for all debts.
-         Account for 73% of all US businesses (6% of all US business sales)
 
2. Partnerships: A firm with multiple owners who share the firm's profits and each of who bears
unlimited liability for the firm's debts.
 
-         Two or more people agree to contribute resources in return for a share of the profit
or loss. (law, accounting, medical partnerships)
-         Account for 7% of all firms (5% of all US business sales)
 
3. Corporations: A legal entity owned by stockholders whose liability is limited to the value of
their stock.
 
 -         Owners issued stocks that entitle them to profits in proportion to their stock
ownership.
-         Many individuals pool money (1000s even millions)
-         Easy to amass large funds, limited liability
-         stockholder has little influence over corporate policy
-         corporate income taxed twice
 
 
C.     Household production still exists.
 
Name some forms of household production that still exist.
- Cooking, cleaning
- Fixing own cars
- Paint own home
 
Why?
 
If a householder's opportunity cost of performing a task is below the market price of the task,
then the householder usually performs that task.
 
Opportunity cost: the value of the next best alternative.
 
Example:
 
1.      Consider my decision to mow the lawn or pay someone else to do it.
 
What is my next best alternative to mowing the lawn? I would probably watch read, watch TV or
play game; value to me $10. Preparing an extra hour isn't my next best alternative, because I'm
well enough prepared, and I won't get any extra salary from over-preparing. Opportunity cost =
~$10
 
Suppose the market price of getting someone to mow my lawn $25. What would I do?
 
 
2.      What about a Dr. making the same decision. His next best alternative is working an extra
hour. He makes about $100 after taxes. Working is hard -$20.  Opportunity cost = ~$80.
 
Suppose the market price of getting someone to mow his lawn $25. What would the doctor do?
 
Some Reasons for household production:
 
1.      No skills or specialized resources are required
2.      Household production avoids taxes
3.      Household production reduces transaction costs: Transaction costs-the costs of time and
information required to carry out market exchange.
4.      Household production allows for more control over the final product.
5.      Technological Advances Increase Household Productivity
 
 
III. The Government
 
 
A.     MARKET FAILURE: A condition that arises when unrestrained operation of markets
yields socially undesirable results.
 
In the case of market failure, intervention could improve society's overall welfare.
 
B.     The Role of the Government
 
 
1. Establishing and Enforcing the Rules of the Game.
 
2. Promoting Competition
 
3. Regulating Natural Monopolies
 
4. Producing public goods.
 
Public good: A good that, once produced, is available for everyone to consume, regardless of
who pays and who doesn't.
 
5. Externality: A cost or benefit that falls on third parties and is therefore ignored by the two
parties to the market transaction.
 
6. Income Distribution
 
7. Full employment, Price stability, Economic Growth
 
 
C.     Government is a unique Problem for Economists
 
 
1. What is the goal of government?
 
-         Households maximize utility
-         Firms maximize profits
-         It might be said that government officials maximize the number of votes they will
get in the next election.
 
2. Voluntary exchange vs. Coercion
 
Market is based on voluntary exchange.
Unless there is 100% agreement--government decisions involve some degree of coercion
 
3. No Market Prices
 
Selling price of public output is often zero or well below the cost of production.
In government budget/expenditure does not directly link cost/benefit of a public program.
 
D.     Size of Government
 
- If we measure government spending as % of GDP (total value of all goods/services produced in
US.)
 
Prior to 1926 never exceeded 3%
1929 (year Great Depression began) 10%
Depression, WWII-- Change in Macroeconomic thought.
 
By 1998 32% of GDP
 
Compared to:
 
Japan 36%
U.K 39%
Canada 42%
Germany 47%
Italy 50%
France 54%
 

E.      Government Revenue
 
Taxes: provide bulk of revenue. (Exhibit 3, page 81)
 
Tax Principles: principles on which tax often justified.
 
1. Ability to pay: Those with a greater ability to pay should pay more. (income tax)
 
2. Benefits-received: Those who receive more benefits from government program funded by tax
should pay more. (tax on gasoline funds highway construction)
 
Tax Incidence: The distribution of tax burden among taxpayers. (Indicates who bears the tax
burden.)
 
Marginal tax rate: percentage of each additional dollar that goes to taxes.
 

 
Kinds of Taxes:
 
1. Proportional tax (flat-rate tax): The tax as a % of income remains constant as income
increases.
 
2. Progressive tax: the tax as a % of income increases as income increases.
 
3. Regressive tax - the tax as a % of income decreases as income increases.
 
 
IV. The rest of the World: Households, firms, and governments in over 200 countries around the
world.
 
 
Circular Flow Model

Chapter 5 Supply and Demand

Supply and demand,

in economics, relationship between the quantity of a commodity that producers wish to sell at
various prices and the quantity that consumers wish to buy. It is the main model of price
determination used in economic theory. The price of a commodity is determined by the
interaction of supply and demand in a market. The resulting price is referred to as the
equilibrium price and represents an agreement between producers and consumers of the good. In
equilibrium the quantity of a good supplied by producers equals the quantity demanded by
consumers.

Demand Curve,

The quantity of a commodity demanded depends on the price of that commodity and potentially
on many other factors, such as the prices of other commodities, the incomes and preferences of
consumers, and seasonal effects. In basic economic analysis, all factors except the price of the
commodity are often held constant; the analysis then involves examining the relationship
between various price levels and the maximum quantity that would potentially be purchased by
consumers at each of those prices. The price-quantity combinations may be plotted on a curve,
known as a demand curve, with price represented on the vertical axis and quantity represented on
the horizontal axis. A demand curve is almost always downward-sloping, reflecting the
willingness of consumers to purchase more of the commodity at lower price levels. Any change
in non-price factors would cause a shift in the demand curve, whereas changes in the price of the
commodity can be traced along a fixed demand curve.
Supply Curve,

The quantity of a commodity that is supplied in the market depends not only on the price
obtainable for the commodity but also on potentially many other factors, such as the prices of
substitute products, the production technology, and the availability and cost of labour and other
factors of production. In basic economic analysis, analyzing supply involves looking at the
relationship between various prices and the quantity potentially offered by producers at each
price, again holding constant all other factors that could influence the price. Those price-quantity
combinations may be plotted on a curve, known as a supply curve, with price represented on the
vertical axis and quantity represented on the horizontal axis. A supply curve is usually upward-
sloping, reflecting the willingness of producers to sell more of the commodity they produce in a
market with higher prices. Any change in non-price factors would cause a shift in the supply
curve, whereas changes in the price of the commodity can be traced along a fixed supply curve.

Market Equilibrium,

It is the function of a market to equate demand and supply through the price mechanism. If
buyers wish to purchase more of a good than is available at the prevailing price, they will tend to
bid the price up. If they wish to purchase less than is available at the prevailing price, suppliers
will bid prices down. Thus, there is a tendency to move toward the equilibrium price. That
tendency is known as the market mechanism, and the resulting balance between supply and
demand is called a market equilibrium.

As the price rises, the quantity offered usually increases, and the willingness of consumers to buy
a good normally declines, but those changes are not necessarily proportional. The measure of the
responsiveness of supply and demand to changes in price is called the price elasticity of supply
or demand, calculated as the ratio of the percentage change in quantity supplied or demanded to
the percentage change in price. Thus, if the price of a commodity decreases by 10 percent and
sales of the commodity consequently increase by 20 percent, then the price elasticity of demand
for that commodity is said to be 2.

The demand for products that have readily available substitutes is likely to be elastic, which
means that it will be more responsive to changes in the price of the product. That is because
consumers can easily replace the good with another if its price rises. The demand for a product
may be inelastic if there are no close substitutes and if expenditures on the product constitute
only a small part of the consumer’s income. Firms faced with relatively inelastic demands for
their products may increase their total revenue by raising prices; those facing elastic demands
cannot. Supply-and-demand analysis may be applied to markets for final goods and services or to
markets for labour, capital, and other factors of production. It can be applied at the level of the
firm or the industry or at the aggregate level for the entire economy.
Sample problems:

 1. Consider the following data for the market for pizzas in a small town:

a) Plot and label the demand and supply curves in the grid below:

Quantity
Quantity
Pric Supplied
e Demanded
1 10
2 25
3 40
4 55
5 70
6 85
7 100
8 115
9 130
10 145

b) What is the equilibrium price and quantity of pizza sold in this market?
Price: $6 Quantity: 85
Market for
Pric 11 Pizza
e
10

2
Deman1
1 d
Deman0
0
d
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 180 190 200
Quantity of
Pizzas
c) List four different examples of a scenario that would shift the demand curve.

___Change in preferences for pizzas_________________________

___Changes in the price of a substitute good________________________

___Change in incomes_______________________

___Expectation of a future
shortage/surplus_________________________________

d) List two different examples of a scenario that would shift the supply curve.

____Changes in the price of resources______________________

_____Change in technology_____

e) Suppose incomes increased by such an amount that the quantity demanded at

every price increased by 30 pizzas. Draw the new demand curve above. How
much does the equilibrium price and quantity change? Why doesn’t the supply
curve shift when incomes change?

P=$7, Q=100; A change in income does not shift the supply curve. Doesn’t
change the behaviour of suppliers on consumers.

f) Suppose there was a massive increase in the supply of flour causing the price of
flour and hence the price of dough to fall massively. Suppose the fall in the price
of dough is exactly enough to restore the market to the original equilibrium price.

i. What is the new quantity demanded and supplied in this market?

The supply curve would intersect the new demand curve at Q=115
and P=6

ii. Why doesn’t the demand curve shift when there is a change in the cost of
production?

Changes in factor prices do not affect the behaviour of consumers –

they still have the same demand preferences.

g) Re-plot the demand and supply curves from the data in a) in the grid below:
 Market for Pizza
Price 11
Supply
10
Surplus
9

4
Shortage
3

1
Demand
0
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170
Quantity of Pizzas

i. Indicate in the diagram the consequence of the following scenarios:

a. All pizzerias were forced to charge a price of $8 by the

government.
b. All pizzerias were forced to charge a price of $2 by the
government.

2. Consider the following data:

Given: Quantity Demanded = 80–6P
Quantity Supplied = 40+10P

Prices

1.50 4.00 8.50 10.00

a) Compute to show the equilibrium price and equilibrium quantity using.

b) Plot the result.
c) Indicate your analysis.

2. Complete the grey shaded cells in the following table:

 Change in New Equilibrium

Demand Supply Price Quantity

No change

No change

No Change

No Change

Uncertain

Uncertain

3. “Technological improvements over the last five years have so reduced the costs of producing
tablet computers that, although they have greatly increased in popularity, the average price has
dropped.” Illustrate the changes in the tablet market below:
 4. Suppose that both the quantities demanded and supplied of an exclusive French perfume
called Eau de Biere increase with its price.

a) If a price above equilibrium results in a surplus, what can you say about the slope of
the two curves?
b) What will happen to price if it is currently above equilibrium?

c) What will happen to the surplus?

 
2. In the diagram below (which represents the market for chocolate bars), the initial equilibrium is at
the intersection of S1 and D1. What curves represent the new equilibrium if there is an increase in
cocoa (an input to making chocolate) prices?
S2 and D1

3. In the table below, if the government set a minimum price of £6 and agreed to buy any resulting
surplus to stockpile it, how many pounds would they have to spend in the first year?

400 x 6 = £2,400