Introduction to Economics

By Roberta Greene,2014-05-31 19:13
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Introduction to Economics

Introduction to Economics

    Basic Definitions

Definition of social science and Economics

     Social Science: The study of society and the way individuals interact within it.

     Economics: the study of how society employs its finite resources in the attempt to satisfy

    infinite wants.

    Definition of Microeconomics and Macroeconomics

     Microeconomics: The study of individual economic units such as households and firms.

     Macroeconomics: The study of the economy as a whole. (e.g. Inflation)

    Definition of growth, development, and sustainable development

     Economic Growth: An increase in real GDP or an increase in the quantity of resources.

     Economic Development: A qualitative measure of a country's standard of living which takes

    into account numerous factors such as education and health. The Human Development

    Index is normally used to measure a country's economic development.

     Sustainable development: The rate at which a country can develop without compromising

    the needs of future generations.

    'Positive and Normative Concepts

     Normative Economics: Based on opinion. Uses words such as "should". The government

    should make fixing unemployment its number one priority.

     Positive Economics: Based on testable theories. For example, a hike in interest rates leads to

    a fall in aggregate demand can be proven using data.

    Know the concept of Ceteris Paribus.

     Latin for all things being equal. Since Economics is basically the study of society, we have to

    understand that there are thousands of variables present, and to control each one of these

    variables is downright impossible. Thus we make everything else "ceteris paribus" in order to

    see the effect of one aspect.

    Know the concept of Scarcity

     Scarcity is the observation that no resource is infinite.

     Factors of Production

     Factors of production are basic components or inputs which are required in the production of

    goods and services.

     Land: Gifts of nature, this includes everything on the land, under the land, above the land, or

    in the sea. Oil is an example.

     Labour: The human component hired to assist in producing a good or service. Capital: Any man-made aid to production.

     Entrepreneurship: Combines the other factors and takes risks recognizing the possibility of

    gain from employing these factors in a specific way.

     Factors of Payment (FoP):

     Land: Rent

     Labour: Wages

     Capital: Interest

     Entrepreneurship: Profit

    The concept of Choice

Know the concept of Utility

     Utility: The satisfaction gained from the consumption of a good or service. The demand curve

    slopes downward because of the law of diminishing marginal utility. The marginal utility, or

    extra happiness, we gain from buying an extra ice cream decreases with every ice cream we

    buy at a fixed price.

     Know the concept of opportunity cost

     Opportunity cost: The cost of the next best alternative forgone. If I have $5.00 and can either

    buy a tamogotchi or dinner, and I buy the tamogotchi, then the opportunity cost is the dinner I

    could have bought.

     Define Free and Economic Goods

     Free good: A good with no scarcity, that has unlimited supply and therefore no price. A good

    which has no opportunity cost associated with its consumption.

     Economic Good: A good which is scarce and therefore has a possible opportunity cost.

    Production Possibility Curves

    Draw Diagrams showing opportunity cost, actual and potential output

    Draw diagrams showing Economic growth and actual output

Rationing Systems

    What are the basic economic questions?

     What to produce?

     How to produce it?

     For whom to produce?

     Free Market: A market where the forces of supply and demand decide the economic questions

    and therefore where to allocate resources.

     Command Economy: A market where the government or some central authority decides

    where to allocate resources.

     Mixed Economies: An economy consisting of both. Some decisions are made by market

    forces while some other decisions are made by the government or some central authority. Advantages and Disadvantages of the Free Market


     Resources allocated more efficiently by the price mechanism.

     The profit motive is a great incentive, and forces producers to reduce costs and be innovative.

     With no imperfections, the free market maximizes community surplus.



     Market Failure- see Chapter II.

     Monopolies and corruption - The natural goal of all firms is to attain monopoly, as this

    eliminates competition, eliminating the associated costs and thus maximizing profit. If the

    market structure does not include limiting social forces, financial forces will cause firms to

    externalize costs such as pollution to gain monopoly. Union Carbide's gas leak in Bhopal is an

    example of such an externalized cost.

    Advantages and Disadvantages of a Planned Economy


     The government can influence the distribution of income.

     The government can determine which goods are supplied.


     In order to function well, requires an enormous amount of information which is difficult to


     No real incentive for individuals to be innovative. Goods are of poor quality since there is a

    lack of profit motive.

     May NOT lead to allocative efficiency or productive efficiency due to lack of competition and

    profit motives.

     Corruption - the government has the ability to abuse its absolute power.

     The economy does not respond as well to supply and demand, firms are simply told to

    produce a certain number of goods or services

Other important things to remember

Sectors of an economy:

     Primary sector: Natural resources and raw materials.

     Secondary sector: Manufactured goods.

     Tertiary sector: The service sector, things like leisure, health, and sport.

     Market: Convenient set of arrangements where buyers and sellers agree to exchange goods.



Definition of markets with relevant, local, national, and international examples

     A place or situation where buyers and sellers communicate with exchange in mind.

    Brief description of perfect competition, monopoly, and oligopoly as different types of market

    structures and monopolistic competition using the characteristic

     Perfect Competition: an industry structure in which there are many firms, none large enough

    to influence the industry, producing homogeneous products. These firms are price takers.

    There are no barriers to entry or barriers to exit.

     Monopolistic Competition: an industry structure in which there are many firms, producing

    slightly differentiated products. There are close substitutes for the product of any given firm.

    Competitors have slight control over price. There are no barriers to entry or exit and success

    invites new competitors.

     Monopoly: an industry structure where a single firm produces a product for which there are

    no close substitutes. Monopolists can set price, but are constrained by market discipline.

    Barriers to entry and exit exist and in order to ensure profits, a monopoly will attempt to

    maintain them.

     Oligopoly: an industry structure in which there are a few firms producing products that range

    from slightly differentiated to highly differentiated. Each firm is large enough to influence

    this industry. Barriers to entry and exit are difficult, but exist.

     Importance of price as a signal and as an incentive in terms of resource allocation


Definition of Demand

     Demand is quantity of a commodity that will be bought at a given period of time at a given

    price. What consumers are willing and able to buy at a price effects the demand for that good. Law of demand with diagrammatic analysis:

     The law of demand states that as a price of good or service rises, the quantity demanded will

    fall. Concurrently, if the price of a good or service falls, the quantity demanded will increase. Determinants of Demand

     Function of demand: Qn= f[Pn, Y, (P1....Pn-1), T]

     Price of a good: A change in the price of a good causes a movement along the demand curve. Price of related goods

     If the price of a substitute rises, demand will increase.

     If the price of a compliment falls, demand will increase.

     Income: An increase in income will cause an increase in demand for normal goods and a

    decrease in demand for inferior goods.


     Other macro factors: Change in the size and composition of a population, advertising,


     Fundamental distinction between a movement along the demand curve and a shift of the

    demand curve

     A movement along the demand curve is caused by a change in price. However, a shift of the

    demand curve means that more is demanded at each price- this is caused by a change in any

    of the determinants of demand (with the exception of price).

     The demand curve is downsloping for several reasons, including the law of diminishing

    marginal utility. The extra utility gained from the consumption of a good falls. Therefore, the

    price must be lower for a person to purchase extra units of a given good. The income effect

    states that as prices fall, real income increases. Consumers can therefore afford to consume a

    greater quantity, providing a second reasons for the downsloping curve. A third reason is the

    "substitution effect," whereby the falling price of a good makes that good cheaper in relation

    to other goods (substitutes).

     (HL) Exceptions to the law of Demand

     Veblen goods: Veblen goods are named after the economist Thornstein Veblen and tie in with

    his theory of conspicuous consumption. If price for a status good rises, then demand for that

    good also rises.

     Giffen goods: Giffen goods are goods which are absolutely vital for a person. This is usually

    refers to staple crops such as rice in some parts of China and potatoes during the Irish potato

    famine. As price for the good increases, individuals will be able to buy little of anything else

    and instead spend their income purchasing staple crops.

     Speculative goods: As share prices increases, so does the quantity demanded of shares, as

    individuals predict further price increases.


Definition of Supply

     Supply is the willingness and ability for producers to produce a good at a given price over a

    given period of time.

     Law of supply with diagrammatic analysis: A higher quantity of a good will be supplied at

    a higher price. This is because producers can afford to supply extra units at a higher price

    because it allows them to produce more before AC is greater than MC.

     Determinants of Supply:

     Function of supply: Qn= f(Pn,Pn1....P(n-1),F1...Fm,G,Tech) + Macro Factors Price of substitute goods

     Costs of the factors of production


     Government Intervention: Taxes/Subsidies

     New firms entering a market

Effect of taxes and subsidies: An indirect tax is a tax placed on each unit of a good.

    Therefore the good become more expensive at every price by a certain value, and the supply

    curve shifts upwards. A subsidy, or tax credit, has the opposite effect, namely it shifts the

    supply curve downwards because the good is cheaper at every price.

     Fundamental distinction between a movement along the supply curve and a shift of the

    supply curve: As with a movement along the demand curve, a movement along the supply

    curve is a change in quantity supplied resulting from a change in the good price. All other

    determinants of supply will change the supply and so will shift the entire supply curve.

    Supply and Demand

     Interaction of Supply and Demand: When a good is placed on a market, it suddenly doesn't

    begin to sell at its equilibrium price. What follows is a game of trial and error. Say a new pair

    of jeans comes out on the market at $20.00 and it instantly becomes a success selling out

    everywhere. Producers decide to produce more and charge it at $30.00. Now they're not

    selling enough and have a surplus of stock. They reduce the price to $25 and they sell as much

    as they make.

     Diagrammatic analysis of changes in demand and supply to show adjustment of a new


    Price Control

     Maximum Price: a maximum price that sellers may charge for a good or service. This is

    usually set by the government. For example, concert tickets may have maximum prices. To be

    effective, the maximum price (or price ceiling) must be set below the market clearing price. Minimum Price a minimum price (or price floor) that sellers may charge for a good or

    service. This again is usually set by the government. To be effective, it must be set above the

    market clearing price.

     Buffer stock scheme: A scheme in which the government tries to relegate the price level of a

    good or service by buying the good up when demand is too low or selling off any surplus

    when supply is too low. In the free market, commodities tend to fluctuate in price. Buffer stock schemes tend to be very expensive. There are storage costs, the goods in question

    might be perishable, and there is an opportunity cost made by the government in

    implementing them.

     Commodity agreements: Agreements between countries to attempt to stabilise commodity

    prices. This may be done by a buffer stock scheme or placing a tariff on foreign goods. OPEC

    is a good example of such an agreement.

    Why do governments intervene in Agricultural markets

     There has been a downward trend in agricultural markets: Thanks to more efficient

    technology, there has been an increase in supply. The result has been lower prices as demand

    has increased a bit. Moreover, the income elasticity of demand for food is inelastic. Someone

    does not buy more apples because he has more money.

     Agricultural prices are subject to fluctuations because of harvests, time lags in supply, and the

    price elasticity of demand is very low. There are thousands of substitutes which are available.

    If the price of beef goes up, individuals will switch to chicken instead. Governments may wish to subsidize to prevent cheap imports from abroad in an effort to

    protect domestic jobs.

     Governments may wish to intervene by using buffer stocks, subsidies, or high fixed prices.

    Price Elasticity of Demand


     %Change in Quanity Demanded of Good A / %change in Price of Good A Definition

     The responsiveness of the quantity demanded of a good to a change in its price. Possible range of values

     PED > 1: Demand is elastic

     PED < 1: Demand in inelastic

     PED = 1: Demand is unit elastic

     PED = 0: Demand is perfectly inelastic

     PED = : Demand is perfectly elastic

     Diagrams illustrating the range of values of elasticity

     Varying elasticity along a straight-line Demand curve

     Determinants of Price Elasticity

     Closeness of substitutes

     Luxury or necessity

     Percentage of income spent on the good

     Time Period


    Cross Elasticity of Demand


     The responsiveness of the quantity demanded of one good to a change in price of another.


     %Change in QD of Good A / %Change in the Price of Good B

     Significance of signs with respect to compliments and substitutes

     A positive value signifies that the two goods are substitutes.

     If the goods are complements, the value will be negative.

    Income Elasticity of Demand


     The responsiveness of the quantity demanded of a good to a change in income.


     %Change in QD / %Change Y

     Normal goods: When income increases, demand for normal goods increases as well. Positive


     Inferior goods: When income increases, demand for this good falls. Negative YED.

    Price Elasticity of Supply


     The sensitivity of supply to a change in price.


     %Change QS / %Change in Price.

     Possible range of values:

    PES > 1: Supply is elastic

    PES < 1: Supply is inelastic.

Diagrams illustrating the range of values of elasticity:

     Determinants of price elasticity of supply

     Number of producers.

     Spare capacity

     Ease of storage

     length of production period

     time period of training

     Factor mobility

     How costs react

    Applications of concepts of elasticity

PED and business decisions: the effect of price changes on total revenue.

     PED may be important for businesses attempting to distinguish how to maximize revenue. For

    example, if a business finds out its PED is very inelastic, it may want to raise its prices. If a

    business finds that its PED is very elastic, it may wish to lower its prices. PED may be important for a government to find the impact of a tax or subsidy. PED and taxation

     Governments may wish to know how a tax or subsidy will affect a good. Cross-elasticity of demand:

     Competitors may wish to know what will happen if there is a change in compliments, or


     Significance of income elasticity for sectoral change (primary> secondary > tertiary) as

    economic growth occurs.

     Primary sector is generally income elasticity of demand inelastic. Just because a person's

    income changes does not mean he will buy more tomatoes. However, secondary and tertiary

    sectors tend to be income elasticity of demand elastic. A change in income will have a big

    impact on quantity demanded of cars, or the demand for personal massages.


Flat rate and ad valorem taxes

     A flat rate tax is a tax which is the same rate regardless of price or income. Ad valorem taxes is a tax which is a percentage of the price of a good. The United States has

    an ad valorem tax of ten percent.

     Incidence of indirect taxes and subsidies on the producer and consumer

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