Economics The study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society.

1. What and how much to produce. 2. How to produce it. 3. For whom to produce it. 4. Can the system adjust?

Limited resources to satisfy wants Unlimited wants Limited resources to satisfy wants Choose between alternatives

Economic reasoning focuses on the impact of marginal changes. Decisions will be based on marginal costs -the cost of buying or making one more unit and marginal benefits (utility). - The increase in satisfaction from buying or making one more unit MB > MC  Do it! MC > MB  Don’t do it! don’t necessarily consider sunk costs.

The use of scarce resources to produce a good is always costly. Someone must give up something if we are to have more scarce goods. b. The highest valued alternative that must be sacrificed is the opportunity cost of the choice. This class? What must be given up to get one more unit of another good or service

The Invisible Hand the price mechanism that guides our actions in a market. The invisible hand is an example of a market force. If there is a shortage, prices rise If there is a surplus, prices fall

Methods a. Inductive Use facts to develop a model b. Deductive Take a survey and study the results b. Deductive See if the facts support a hypothesis Start with a theory and see if facts support it c. Abduction the combination of deduction and induction

Predicting Behavior Positive Economic Statements - relationships that can be tested - The class is half full - Unemployment is 6% - if incomes rise people spend money

Normative Economic Statements - statements about “what should be” or make a value judgment - It is too hot - Unemployment should be around 4% - we should raise the minimum wage.

Art of Economics - application of knowledge learned in positive economics to the achievement of goals determined in normative economics.

Economic graphs Direct Relationship - Graph slopes up from left to right Inverse Relationship - Graph slopes down from left to right 3. Slope Rise Run

The U.S. Economy in Historical Perspective The U.S. economic system is a market economy based on private property and the markets in which individuals decide how, what, and for whom to produce Markets work through a system of rewards and payments Individuals are free to do whatever they want as long as it is legal Fluctuations in prices play a central role in coordinating individuals’ wants in a market economy Most economists believe the market is a good way to coordinate economic activity

Capitalism and Socialism Capitalism is an economic system based on the market in which the ownership of the means of production resides with a small group of individuals (called capitalists) Socialism is an economic system based on individuals’ goodwill towards others, not on their own self-interest, and in which, in principle, society decides what, how, and for whom to produce 3-13

Evolving Economic Systems Feudalism is an economic system based on tradition and dominated the Western world from the 8th to the 15th century Mercantilism is an economic system in which the government controls economic activity by doling out the rights to undertake economic activities and was dominant until the 18th century During the Industrial Revolution, technology and machines rapidly modernized industrial production Capitalism

Household Income Sources Source of income % Dividends 1.7 Interest 4.9 Proprietor’s Income 8.4 Rental Income 11.1 Social Security 13.4 64.7 Transfer Payments Wages and Salaries -4.3

Household Expenditures Savings 84 Spending 15.2 Taxes 1.9

Household Expenditures Durable Goods 59 Non-durable Goods 29 Services 12

Businesses Type Number Revenue proprietorship 72.2 4.8 partnership 7.7 7.9 corporation 20.1 87.3

Business: Forms of Business Advantages Disadvantages Proprietorship Minimum bureaucratic hassle Direct control by owner Limited ability to get funds Unlimited personal liability Partnership Ability to share work and risk Relatively easy to form Unlimited personal liability (even for a partner's blunder) Corporation No personal liability Increasing ability to get funds Ability to avoid personal income taxes Legal hassle to organize Possible double taxation of income Monitoring problems

Government The government plays two general roles in the economy: An actor who collects money in taxes and spends that money on projects, such as defense and education 3-20

Government 2. A referee who sets the rules that determine relations between businesses and households a. Provide a stable set of institutions and rules. -Enforce contracts and protect property rights b. Promote effective and workable competition. -restrict and regulate monopolies c. Correct for externalities. -pollution d. Ensure economic stability and growth. -Employment Act of 1946 e. Provide public goods. -Enforce contracts and protect property rights f. Adjust for undesirable market results. -drug busts

The Circular Flow of Goods and Services Factor Markets Resources Payments and Legal Resources with Government Involvement Business Taxes Income Taxes Goods and Services Goods and Services Businesses Households Goods and Services Payments Product Markets Payments $$

The Law of Demand Other things being equal*, as price increases, the corresponding quantity demanded falls (*price is the only variable that is changed)

Selling Quantity Price Demanded The Demand Table Selling Quantity Price Demanded $ 5 10 $ 4 15 $ 3 25 $ 2 40 $ 1 60

The Demand Curve Graphing: Price Quantity -Plot the points -Connect the dots $6 $5 Downsloping left to right $4 $3 Demand Demand $2 $1 10 20 30 40 50 60 Quantity

Shifts in Demand versus Movements Along a Demand Curve Quantity demanded – is a specific amount that will be demanded per unit of time at a specific price, other things constant Demand refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant A change in price changes quantity demanded A change in price causes a movement along the demand curve

Consumer Expectations Taxes and Subsidies 5 6 Number of Consumers Shifting the Demand Curve Why the curve shifts 1 Society’s Income 2 Price of Other Goods Consumer Tastes 3 4 Consumer Expectations Taxes and Subsidies 5 6 Number of Consumers

The Law of Supply Other things being equal*, as price increases, producers will be willing to supply more (*price is the only variable that is changed)

Selling Quantity Price Supplied The Supply Table Selling Quantity Price Supplied $ 5 60 $ 4 40 $ 3 25 $ 2 15 $ 1 10

The Supply Curve Graphing: Price Quantity -Plot the points -Connect the dots $6 Upsloping right $5 to left $4 $3 Supply $2 $1 10 20 30 40 50 60 Quantity

Equilibrium Where it is possible for buyers and sellers to realize their choices simultaneously

Selling Quantity Price Demanded Supplied The Demand and Supply Tables Selling Quantity Price Demanded Supplied 60 $ 5 10 $ 4 40 15 25 $ 3 $ 3 25 25 25 $ 2 15 40 $ 1 10 60

Together!! Graphing: Price Quantity -Plot Demand -Plot Supply D S D S $6 D S $5 $4 $3 $2 D $1 S 10 20 30 40 50 60 Quantity

Why the curve shifts 1 Resource Prices 2 Changes in Technology 3 Shifting the Supply Curve Why the curve shifts 1 Resource Prices 2 Changes in Technology 3 Prices of other goods 4 Taxes and Subsidies 5 Number of Producers

Economic Examples 1. Cyclone Larry in Australia Destroyed 80% of the banana crop. Prices went from $1.00 to $2.00 per pound Supply or Demand problem?? Banana Market Price S2 S1 $2.00 $1.00 DR Quantity Q2 Q1

Sales of SUVs in the U.S. S0 D0 P Q Q0 D1 P0 P1 Q1 Average price fell 10% S0 D0 P Q Q0 SUVs Supply or Demand problem? Increasing gas costs causes the demand curve to shift left D1 P0 P1 Price for SUVs fell from P0 to P1 where Q demanded = Q supplied Q1

Coffee Beans S2 S1 Dc fell from $2.00/pound in 1997 to $.50 in 2002 Supply or Demand problem? New growing techniques and the entry of new growers shifted the supply curve. Coffee Bean Market S2 Price $2.00 S1 $0.50 Dc Q1 Q2 Quantity

Increase in the Demand for Foreign Exchange U.S. sales to Guatemala Exchange rate ($ per quetzal) Beginning equilibrium exchange rate: (10 cents = 1quetzal). D2 S An increase in American demand for Guatemalan coffee will also increase the demand for quetzals 0.20 Equilibrium occurs where the new demand for quetzals D2 just equals the supply S – at $.20 per quetzal with Q2 > Q1 quetzals clearing the market. U.S. purchases from Guatemala 0.10 D1 Quantity of quetzal exchange Q1 Q2

1. Price Ceilings Price ceiling is a legally established maximum price that sellers may charge. It stops the price from rising to the equilibrium level. Example: rent control The direct effect of a price ceiling is a shortage: quantity demanded exceeds quantity supplied.

2. Price Floors Price floor is a legally established minimum price that buyers must pay. It stops the price from dropping down to equilibrium level. Example: minimum wage The direct effect of a price floor above the equilibrium price is a surplus: quantity supplied exceeds quantity demanded.

Excise Taxes An excise tax is a tax that is levied on a specific good Government impacts markets through taxation An excise tax is a tax that is levied on a specific good A tariff is an excise tax on an imported good The result of taxes and tariffs is an increase in equilibrium prices and reduce equilibrium quantities 5-41

The Effect of an Excise Tax Government imposes a $10,000 luxury tax on the suppliers of boats Luxury Boats P S1 S0 Tax = $10,000 $70,000 The supply curve shifts up by the amount of the tax $65,000 $60,000 The price of boats rises by less than the tax to $70,000 D0 Q 420 510

Quantity Restrictions Government regulates markets with licenses, which limit entry into a market Many professions require licenses, such as doctors, financial planners, cosmetologists, electricians, or taxi cab drivers The results of limited number of licenses in a market are increases in wages and an increases in the price of obtaining the license 5-43

The Effect of a Quantity Restriction NYC Taxi Drivers P(wage) Successful lobbying by taxi cab drivers in NYC resulted in quantity restrictions (medallions) QR When the demand for taxi services increased, because the number of taxi licenses was limited, wages increased D1 $15 D0 Q(of drivers) 12,000

Application: The Effect of a Quantity Restriction NYC Taxis Medallions P The demand for taxi medallions also increased because wages were increasing. But because the number of taxi licenses was limited, the price of a medallion also increased QR $400,000 D1 Initial Fee D0 Q(of medallions) 12,000

Third-Party-Payer Markets In third-party-payer markets, the person who receives the good differs from the person paying for the good Under a third-party-payer system, the person who chooses how much to purchase doesn’t pay the entire cost Equilibrium quantity and total spending can be much higher in third-party-payer markets Goods from a third-party-payer system will be rationed through social and political means 5-46

Third-Party-Payer Markets With a co-payment of $5, consumers demand 18 units P Health Care S0 Sellers require $45 per unit for that quantity $45 Total expenditures for 18 units of health care $25 …are greater than when… $5 The consumer pays the entire cost D0 Q 10 18

Teach a parrot the words ‘supply’ and ‘demand’ and you have an economist Thomas Carlyle McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Economic Models Mathematical e = mc2 or heuristic expressed informally in words Characteristics more often use more of an inductive, as opposed to deductive, approach

Behavioral vs Traditional Economics Traditional –more reliance on relatively simple algebraic or graphical models such as the supply and demand model -provide simple and clear results, which can highlight issues that behavioral models cannot

Behavioral vs Traditional Economics Behavioral - use a broader set of building blocks than rationality and self-interest Seem to use real-life situations to explain and illustrate economic concepts People behave purposefully - reflecting reasoned but not necessarily rational judgment Act with enlightened self-interest people care about other people as well as themselves

Empirical Work in Modern Economics Modern economics is highly empirical Both traditional and modern behavioral economic building blocks rely on experiments and statistical analysis of real world observations An empirical model is a model that statistically discovers a pattern in the data Econometrics is the statistical analysis of economic data

Modern Traditional and Behavioral Economists Earlier Economics Modern Economics Modern Behavioral Economists Modern Traditional Economists Assumptions Rationality Self-Interest Purposeful behavior Enlightened self-interest Approach Deduction Induction and deduction: emphasis on experimental economics and on empirical models Induction and deduction: emphasis empirical models Types of Models Simple S/D models All types including complex mathematical models and ACE models

Price Elasticity of demand % Change in quantity demanded the responsiveness of the amount purchased to a change in price. Price Elasticity of demand = % Change in quantity demanded % Change in Price = % Q % P - or put more simply - ( Q - Q ) ( P - P ) ( Q - Q ) P = 1 1 = 1 X Q P - Q ( P P ) 1 PED > 1 Elastic < 1 Inelastic = 1 Unit Elastic

Elasticity and Total Revenue ___ Quan 1 2 3 4 5 6 7 8 Price 8 7 6 5 4 X =

Different Elasticities Price Quantity/ time Perfectly inelastic: An increase in Price results in no change in Quantity Mythical demand curve (b) Price Quantity/ time Relatively inelastic: A percent increase in Price results in a smaller % reduction in Quantity Demand for Cigarettes

(c) Price Quantity/ time Unitary elasticity: The percent change in quantity demanded due to an increase in price is equal to the % change in price. Demand curve of unitary elasticity = 1

Elasticity of Demand (d) Price Quantity/ time Relatively elastic: A % increase in Price leads to a larger % reduction in Quantity. Demand for Granny Smith Apples (e) Price Quantity/ time Perfectly elastic: Consumers will buy all of Farmer Hollings’s wheat at the market price, but none will be sold above the market price. Demand for Farmer Hollings’s wheat

2. Necessity vs Luxury 4. Time to shop around Elasticity What affects Elasticity??? 1. Available Substitutes 2. Necessity vs Luxury 3. Proportion of Income 4. Time to shop around

a. Market Period c. Long Run Elasticity What affects Supply Elasticity??? 1. Time a. Market Period b. Short Run c. Long Run

Income Elasticity of demand % Change in quantity demanded the responsiveness of a product’s demand to a change in income. Income Elasticity of demand = % Change in quantity demanded % Change in Income A normal good has a positive income elasticity of demand. As income increases, the demand for normal goods increases. Goods with a negative income elasticity are inferior goods. As income expands, the demand for inferior goods will decline.

Cross Price Elasticity the responsiveness of a product’s demand to a change in the price of another good. Cross Price Elasticity = % Change in Qx % Change in Py A complement has a negative cross price elasticity. As Py increases, the demand for Y decreases, and demand for goods that are consumed with Y also decreases. A substitute has a positive cross price elasticity As Py increases, the demand for Y decreases, and demand for goods that can be consumed instead of Y also decreases.

Consumer Surplus Producer Surplus The total difference between what a consumer is willing to pay and how much they actually have to pay. Producer Surplus The total difference between what a supplier is willing to provide a good or service and how much they actually get for it.

Producer and Consumer Surplus Consumer surplus = area of red triangle = ½($5)(5) = $12.5 $10 9 8 7 6 5 4 3 2 1 S Producer surplus = area of green triangle = ½($5)(5) = $12.5 CS PS The combination of producer and consumer surplus is maximized at market equilibrium D Q 0 1 2 3 4 5 6 7 8 8-64

The Burden of a Tax Tax Incidence Buyer Seller Who pays a tax is called the incidence. Buyer Seller

Impact of a Tax Imposed on Sellers If in the used car market a price of $7,000 would bring the quantity of used cars demanded into balance with the quantity supplied. Price S plus tax S When a $1,000 tax is imposed on sellers of used cars, the supply curve shifts vertically by the amount of the tax. $7,400 $1000 tax $7,000 The new price for used cars is $7,400 … sellers netting $6,400 ($7,400 - $1000 tax). $6,400 Consumers end up paying $7,400 instead of $7,000 and bear $400 of the tax burden. D Sellers end up receiving $6,400 (after taxes) instead of $7000 and bear $600 of the tax burden. # of used cars per month (in thousands) 500 750

Impact of a Tax Imposed on Buyers Price In the same used car market: When a $1,000 tax is imposed on buyers of used cars, the demand curve shifts vertically by the amount of the tax. S $7,400 The new price for used cars is $6,400 … D minus tax buyers then pay taxes of $1000 making the total $7,400. $7,000 $1000 tax $6,400 Consumers end up paying $7,400 (after taxes) instead of $7,000 and bear $400 of the tax burden. D Sellers end up receiving $6,400 instead of $7000 and bear $600 of the tax burden. # of used cars per month (in thousands) 500 750

Elasticity and Incidence of a Tax The actual burden of a tax depends on the elasticity of supply and demand. As supply becomes more inelastic, then more of the burden will fall on sellers. As demand becomes more inelastic, then more of the burden will fall on buyers. ED ES ED + ES ED + ES

Tax Burden and Elasticity Consider the market for Gasoline and Luxury Boats individually. Price Gasoline market S plus tax $1.65 We begin in equilibrium. S $1.60 If we impose a $.20 tax on gasoline suppliers, the supply curve moves vertically the amount of the tax. Price goes up $.15 and output falls by 6 million gallons per week. $1.55 $1.50 $1.45 D Quantity (millions of gallons) If we impose a $25K tax on Luxury Boat suppliers, the supply curve moves vertically the amount of the tax. Price goes up by $5K and output falls by 5 thousand units. 194 200 Price (thousand $) S plus tax Luxury boat market 110 S In the gas market, the demand is relatively more inelastic than its supply; hence, buyers bear a larger share of the burden of the tax. 100 90 D In the luxury boats market, the supply curve is relatively more inelastic than its demand; hence, sellers bear a larger share of the tax burden. 80 Quantity (thousands of boats) 5 10 15 20

An effective price ceiling is a government set price below the market equilibrium price It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation P A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity S P0 P1 Price ceiling Shortage D Q Q1 Q0

An effective price floor is a government set price above the market equilibrium It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers P Surplus S P1 Price floor P0 A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity D Q Q1 Q0

The Difference Between Taxes and Price Controls Price ceilings create shortages and taxes do not Taxes leave people free to choose how much to supply and consume as long as they pay the tax Shortages may also create black markets

Rent Seeking, Politics, and Elasticities The possibility of transferring surplus from one set of individuals to another causes people to spend time and resources on doing so. Lobbying for price controls, which transfer surplus from one group to another, is an example of rent-seeking behavior Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus Public choice economists argue that when all rent seeking and tax consequences are netted out, there is often not a net gain to the public

Inelastic Demand and Incentives to Restrict Supply Revenue gained P When demand is relatively inelastic, suppliers have incentive to restrict quantity to increase total revenue S1 S0 P1 C P0 Revenue lost A B D Q Q1 Q0

Inelastic Supplies and Incentives to Restrict Prices When supply is inelastic, consumers have incentives to restrict prices When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls Rent control in New York City is an example

Application: Price Floors and Elasticity The surplus created by a price floor is larger if demand and supply are elastic P P S Surplus Surplus S P1 P1 Price floor P0 P0 D D Q Q Q1 Q0 Q1 Q0