Presentation on theme: "A Definition of Economics"— Presentation transcript:
1 A Definition of Economics Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided.
2 Another Definition of Economics Economics is the study of how scarce resources are allocated among conflicting demands.
3 1. To Learn a Way of Thinking... Three Fundamental Concepts of Economic ThinkingOpportunity CostMarginalismInformation, Incentives, and Market Coordinations
4 Opportunity CostsThe opportunity cost of something is that which we give up when we make that choice or decision.The implication is that all decisions involve trade-offs.“There’s no such thing as a free lunch!!”
5 Margins and Incentives People make choices at the margin, which means that they evaluate the consequences of making incremental changes in the use of their resources.The benefit from pursuing an incremental increase in an activity is its marginal benefit.The opportunity cost of pursuing an incremental increase in an activity is its marginal cost.1-5
6 Production Possibilities and Opportunity Cost The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot.To illustrate the PPF, we focus on two goods at a time and hold the quantities of all other goods and services constant.That is, we look at a model economy in which everything remains the same (ceteris paribus) except the two goods we’re considering.The production possibility frontier (PPF) is the first economic model the students see.Your first challenge is to ensure that the students understand the mechanics of the model. You can provide some help in the classroom, but you main goal must be to get the students working—to develop good work habits. Encourage them to do the end-of-chapter problems, study guide questions, and Economics in Action tutorial and quiz so that they are comfortable with the mechanics of this chapter. Also encourage them to use the diagnostic quizzes on the Web site and follow the “8 steps to success in economics” in reviewing their understanding.2-6
7 Production Possibilities and Opportunity Cost Production EfficiencyWe achieve production efficiency if we cannot produce more of one good without producing less of some other good.Points on the frontier are efficient.2-7
8 Using Resources Efficiently All the points along the PPF are efficient.To determine which of the alternative efficient quantities to produce, we compare costs and benefits.The PPF and Marginal CostThe PPF determines opportunity cost.The marginal cost of a good or service is the opportunity cost of producing one more unit of it.2-8
9 Using Resources Efficiently Preferences and Marginal BenefitPreferences are a description of a person’s likes and dislikes.To describe preferences, economists use the concepts of marginal benefit and the marginal benefit curve.The marginal benefit of a good or service is the benefit received from consuming one more unit of it.We measure marginal benefit by the amount that a person is willing to pay for an additional unit of a good or service.2-9
10 Using Resources Efficiently It is a general principle that the more we have of any good or service, the smaller its marginal benefit and the less we are willing to pay for an additional unit of it.We call this general principle the principle of decreasing marginal benefit.The marginal benefit curve shows the relationship between the marginal benefit of a good and the quantity of that good consumed.2-10
11 Determinants of Household Demand: The price of the product in questionThe income available to the householdThe households amount of accumulated wealthThe prices of other products availableTastes and preferencesExpectations about future income, wealth, and prices
12 Changes in Quantity Demanded vs. Changes in Demand Changes in the price of a product affect the quantity demanded per period. Changes in any other factor, such as income or preferences, affect demand. An increase in income, for instance, tends to increase demand. While a drop in prices will increase the quantity demanded.
13 The Law of DemandThe negative relationship between price and quantity demanded. As price rises, quantity demanded decreases. As price falls, quantity demanded increasesThis is why we observe a negative slope in demand curves.
14 Demand Substitution Effect When the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded decreases.Income EffectWhen the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded decreases.3-14
15 Substitution Effect of a Price Change The substitution effect of a price change is a change in consumption of a good or service that results from holding well-being unchanged.When the price of a product falls, that product becomes more attractive relative to potential substitutes.When the price of a product rises, that product becomes less attractive relative to potential substitutes.
16 Income Effect of a Price Change The income effect of a price change is a change in consumption of a good or service that results from a change in well-being, other things being equal.When the price of a product falls, a consumer has more purchasing power with the same amount of income and is better off.When the price of a product rises, a consumer has less purchasing power with the same amount of income and is worse off.
17 Income as a Determinant of Demand Normal Goods: Goods for which demand goes up when income is higher and for which demand goes down when income is lower.Inferior Goods: Goods for which demand falls when income rises.
18 Prices of Other Goods and Services as Determinants of Demand Substitutes: Goods that can serve as replacements for one another; when the price of one increases, demand for the other goes up.Perfect substitutes are identical products.Complements: Goods that “go together”; when the price of one increases, demand for the other goes down, and vice versa.
19 Other Determinants of Household Demand: Tastes and Preferences - These are quite subjective and tend to change over time.Expectations - With respect to future income, wealth, prices, and availability.
20 Anna’s Demand for Telephone Calls -A Change in Quantity Demanded $15.0030$10.00$7.50$3.50$ .5025731Quantity demandedPriceThe graph shows a shift in quantity demanded from 3 to 7 caused by a change in price from $7.50 to $3.50.
21 Anna’s Demand for Telephone Calls - A Change in Demand $15.00When any factor except price changes the relationship between price and quantity is different; there is a shift of the demand curve, in this case from D1 to D2.$10.00$7.50$3.503025D1D2$ .50137
22 Changes in Demand: Prices of Related Goods Price of hamburger risesPPQQuantity of hamburger demanded fallsD1D2D2D1Demand for complement good (ketchup) shifts leftQDemand for substitutegood (chicken) shifts rightQ
23 Market Demand DefinedMarket demand may be defined as the sum of all the quantities of a good or service demanded per period by all the households buying in the market for that good or service.
24 Deriving market demand from the individual demand curves: PPP$3.50DA$3.50DCDB$3.50$1.50$1.50$1.5048Qd3Qd49QdPriceMarket Demand$3.50$1.50820Qd
25 SupplyA firm’s decision about what quantity of product to supply depends on:The price of the good or serviceThe cost of producing the product which depends on:The price of required inputs (land, labour, capital)The technologies to be used to produce the productThe prices of related products
26 The Law of SupplyThe positive relationship between price and quantity of a good supplied. An increase in market price will lead to an increase in quantity supplied, and a decrease in market price will lead to a decrease in quantity supplied.
27 Changes in Quantity Supplied vs. Changes in Supply: Changes in quantity supplied imply movement along a supply curve.Changes in supply imply a shift in the entire supply curve.
28 Market SupplyThe sum of all the quantities of a good or service supplied per period by all the firms selling in the market for that good or service.As with market demand, market supply is the horizontal summation of the individual firms’ supply curves.
30 Market EquilibriumThe operation of the market depends on the interaction between suppliers and demanders.An equilibrium is the condition that exists when quantity supplied and quantity demanded are equal.At equilibrium, there is no tendency for the price to change.
31 Excess DemandExcess Demand is the condition that exists when quantity demanded exceeds quantity supplied at the current price.
32 Excess DemandAt $85 per tonne quantity demanded exceeds quantity supplied by 2500 tonnes.Excess demand tends to lead to an increase in prices.
33 Excess SupplyExcess supply is the condition that exists when quantity supplied exceeds quantity demanded at the current price.
34 Excess SupplyAt $150, quantity supplied exceeds the quantity demanded by 2000 tonnes.This causes prices to fall
35 Price Elasticity of Demand The price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in price.Price Elasticity of Demand = % change in quantity demanded % change in price
36 Perfectly Inelastic Demand Perfectly inelastic demand is demand in which quantity demanded does not respond at all to a change in price.An example could be the demand for insulin.
37 Inelastic DemandInelastic demand is demand that responds somewhat, but not a great deal, to changes in price. Inelastic demand always has a numerical value between zero minus one.An example would be the demand for housing or telephone service.
38 Unitary ElasticityUnitary elasticity is a demand relationship in which the percentage change in quantity of a product demanded is the same as the percentage change in price.The elasticity is always equal to minus one.
39 Elastic DemandElastic demand is a demand relationship in which the percentage change in quantity demanded is larger in absolute value than the percentage change in price.The demand elasticity has an absolute value greater than one.An example could be the demand for bananas or any other product for which there are close substitutes.
40 Perfectly Elastic Demand Perfectly elastic demand is demand in which quantity demanded drops to zero at the slightest increase in price.An example could be the demand for wheat on the world market, or any other good that can only be sold at a predetermined price.
41 Demand Curves and Elasticity PPDDQQPerfectly elasticRelatively elasticDPPDQQPerfectly inelasticRelatively inelastic
42 Elasticity and Total Revenue Effect of a price increase on a product with inelastic demand: P x Qd = TREffect of a price increase on a product with elastic demand: P x Qd = TREffect of a price cut on a product with elastic demand: P x Qd = TREffect of price cut on a product with inelastic demand: P x Qd = TR
43 Relationship Between Elasticity and Total Revenue
44 Determinants of Demand Elasticity Availability of substitutesWhen substitutes are not readily available, demand is likely to be less elastic.The importance of being unimportantWhen an item represents a small proportion of our total budget, demand is likely to be less elastic.The time dimensionIn the longer run, demand is likely to become more elastic, or responsive, because households make adjustments over time.
45 Other Important Elasticities Income elasticity of demandMeasures the responsiveness of demand with respect to changes in incomeCross-price elasticity of demandA measure of the response of the quantity of one good demanded to a change in the price of another good
46 Other Important Elasticities (cont.) Elasticity of supplyA measure of the response of the quantity of a good supplied to a change in the price of that good. Likely to be positive in output marketsElasticity of labour supplyA measure of the response of labour supplied to a change in the price of labour. Can be negative or positive
47 Efficiency: A Refresher An efficient allocation of resources occurs when we produce the goods and services that people value most highly.Resources are allocated efficiently when it is not possible to produce more of a good or service without giving up some other good or service that is valued more highly.Efficiency is based on value, which is determined by people’s preferences.The substance of this section is identical to Chapter 2, pp. 35–37. Send the students back to Chapter 2 to emphasize the fact that they are building on what they’ve learned before. Emphasize that learning economics isn’t memorizing facts, but understanding principles and ideas, and that one idea builds on another. Explain that this section provides an alternative example of the same ideas as those in Chapter 2 and serves as a springboard for going forward. It also illustrates the connection between what they’ve learned about demand, supply, market price, and quantity in Chapter 3 and what they learned about efficiency in Chapter 2.5-47
48 Efficiency: A Refresher Marginal BenefitMarginal benefit is the benefit a person receives from consuming one more unit of a good or service.We can measure the marginal benefit from a good or service by the dollar value of other goods and services that a person is willing to give up to get one more unit of it.The marginal benefit from a good or service decreases as more of that good or service is consumed—the principle of decreasing marginal benefit.5-48
49 Efficiency: A Refresher Marginal CostMarginal cost is the opportunity cost of producing one more unit of a good or service. The measure of marginal cost is the value of the best alternative forgone to obtain the last unit of the good.We can measure the marginal cost of a good or service by the dollar value of other goods and services that a person is must give up to get one more unit of it.The marginal cost of a good or service increases as more of that good or service is produced—the principle of increasing marginal cost.5-49
50 Efficiency: A Refresher Efficiency and InefficiencyIf the marginal benefit from a good exceeds its marginal cost, producing and consuming more of the good uses resources more efficiently.5-50
51 Value, Price, and Consumer Surplus Value, Willingness to Pay, and DemandThe value of one more unit of a good or service is its marginal benefit, which we can measure as maximum price that a person is willing to pay.A demand curve for a good or service shows the quantity demanded at each price.A demand curve also shows the maximum price that consumers are willing to pay at each quantity.The only thing that students sometimes get hung up on is the exact shape of the consumer surplus area—steps versus the complete triangle. The point isn’t worth labouring, but if students raise the matter and are curious, you might explain that we’re assuming that the good (pizza in the example) is finely divisible so that the whole triangle is (approximately) the consumer surplus.[You will look at consumer surplus again if you cover marginal utility theory.]5-51
52 Value, Price, and Consumer Surplus Consumer surplus is the value of a good minus the price paid for it, summed over the quantity bought.It is measured by the area under the demand curve and above the price paid, up to the quantity bought.Figure 5.3 on the next slide shows the consumer surplus for pizza for an individual consumer.5-52
53 Value, Price, and Consumer Surplus The price paid is the market price, which is the same for each unit bought.The quantity bought is determined by the demand curve, and the blue rectangle shows the amount paid for pizza.The green triangle shows the consumer surplus from pizza.5-53
54 Cost, Price, and Producer Surplus Cost, Minimum Supply-Price, and SupplyThe cost of one more unit of a good or service is its marginal cost, which we can measure as minimum price that a firm is willing to accept.A supply curve of a good or service shows the quantity supplied at each price. A supply curve also shows the minimum price that producers are willing to accept at each quantity.A similar issue about the shapes of the areas arises here too. You might want to emphasize that the total revenue of the producer is the rectangle whose corners are (0, 0) and (P, Q). This total revenue divides into cost and producer surplus, and the supply = marginal cost curve marks the boundary for the division.The issue is not likely to arise at this point in the course, but you might like to keep the relationship between producer surplus and economic profit up your sleeve for later. The textbook doesn’t spend any time on this relationship because for most students, it is too esoteric. But, a few thoughtful students may want to know. You can explain that producer surplus = total revenue minus total variable cost; economic profit = total revenue minus total cost; so producer surplus = economic profit plus total fixed cost. Don’t try to explain this now. Wait until you get a question when you’re in Chapter 9, 10, 11, or 12.5-54
55 Cost, Price, and Producer Surplus Producer surplus is the price of a good minus the marginal cost of producing it, summed over the quantity sold.Producer surplus is measured by the area below the price and above the supply curve, up to the quantity sold.Figure 5.5 on the next slide shows the producer surplus for pizza for an individual producer.5-55
56 Cost, Price, and Producer Surplus The price is the market price, which is the same for each unit sold.The quantity sold is determined by the supply curve, and the red area shows the total cost of producing pizza.The blue triangle shows the producer surplus from pizza.5-56
57 Is the Competitive Market Efficient? Efficiency of Competitive EquilibriumFigure 5.6 shows that a competitive market creates an efficient allocation of resources at equilibrium.In equilibrium, the quantity demanded equals the quantity supplied.Although done just with words and a diagram, this section explains the astonishing so-called “first fundamental theorem of welfare economics” that, under appropriate conditions, competitive equilibrium is Pareto efficient (what this textbook calls an efficient allocation).You might want to provide your students with more background to this result. It begins with Adam Smith’s invisible hand conjecture. Some progress was made by Vilfredo Pareto (1848–1923), an Italian economist (see who defined an efficient allocation as one in which it is not possible to rearrange the use of resources an make someone better off without making someone else worse off. But Adam Smith’s conjecture did not receive formal proof until the 1950s. John Hick, Kenneth Arrow, and Gerard Debreu are credited with the major contributions to welfare economics and received the Nobel Prize in Economic Sciences for their work (see Lionel McKenzie (University of Rochester) is also credited with a major independent statement of the theorem and some economists refer to it as the Arrow-Debreu-McKenzie theorem.Continued on the notes page of slide 39.5-57
58 Is the Competitive Market Efficient? At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the efficient quantity.The sum of consumer and producer surplus is maximized at this efficient level of output.The A-D-M proof is deeper and more restricted that the arm waving words and diagrams of a principles text. But we do not mislead our students by being enthusiastic and amazed at the astonishing proposition. Selfish people all pursuing their own ends and making themselves as well off as possible end up allocating resources in such a way that no one can be made better off (qualified by the exceptions that we quickly note in the chapter).Don’t get hung up on the mechanics of how the obstacles to efficiency work. Just note at this stage that they bring either underproduction or overproduction and emphasize the deadweight loss that they generate. You will go into the details in later chapters. The list is a guide to what is coming.In the overproduction case, you might like to bring the PPF back into the story and point out that the overproduction of one good means the underproduction of some other good. If you’re brave, you might want to explain that in the two-goods world of the PPF, you get the complete efficiency analysis by looking at only one of the markets. If you use guns and butter again, the overproduction of guns implies the underproduction of butter. You can measure the deadweight loss in either the market for guns (overproduction like Figure 5.7b) or in the market for butter (underproduction like Figure 5.7a). Make this extension only with bright students in an honours section.5-58
59 Is the Competitive Market Efficient? Obstacles to EfficiencyMarkets are not always efficient. Obstacles to efficiency are:Price ceilings and floorsTaxes, subsidies, and quotasMonopolyPublic goodsExternal costs and external benefits5-59