Basic Principles of Economics 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 = rTotal Revenue / rTotal Quantity Marginal Cost = rTotal Cost / rTotal Quantity Profit Max. Point where Marginal Revenue = Marginal Cost Profit in $ = Total Revenue – Total Costs

Graphs

And more graphs Quantity Revenue MC AC D=AR=MR P Profit AVC Cost Revenue Rectangle

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) Income – more leads to increased demand Population – more leads to increased demand Tastes/Preferences – various reasons, reports, advertising Expectations – of a future event may lead to more or less demand now 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) Costs – increase/decrease in production costs decrease or increase supply Number of Sellers – new producers increase market supply Technology – usually decreases costs and increases supply Nature – weather or disaster can affect supply 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 = rTotal Revenue / rTotal Quantity Marginal Cost = rTotal Cost / rTotal 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 Competition Profit Maximization Quantity Revenue MC Profit Max AC D=AR=MR P Profit AVC Cost Revenue Rectangle Profit Max Quantity

Monopolistic Competition Many firms Similar product Some influence over supply and price Easy entry Non-price competition high

Monopolistic Competition Profit Maximization Quantity Revenue D=AR MC MR P AC Profit Cost Q

Oligopoly Few firms dominate Products may be similar or different Influence over price varies Barriers to entry high Non-price competition high

Oligopoly Profit Maximization Quantity Revenue “Kink” D=AR MR MC P Profit AC Cost Q

Monopoly One firm dominates Unique product Price maker and control over supply Barriers to entry very high No need for non-price competition

Monopoly Profit Maximization Quantity Revenue D=AR MR MC P AC Profit Profit max Cost Q 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