Production Possibilities; Demand & Supply; Government & Market Failure

Definition of Economics

  • Economics is a social science concerned chiefly with the way society chooses to use or employ its scarce, limited resources, which have alternative uses, to produce, exchange, and allocate goods and services for present and future consumption.
  • Deals with behavior. Scarcity leads to choice which leads to behavior. Choice is driven by value (and often by price). Not all choices are of interest, some are random, some are forced (to eat or not to eat).
  • Choices are between present and future – do you have more now, or later. Produce capital goods, or consumer goods, etc.

    It comes from the Greek word “oikonomia” which means “management of the household”. In ancient Greece, the city states were regarded as an extended family.

  • Per the book’s website, it comes from the French word “economie” meaning “management of a household.” This was adapted from the Latin word “oeconomia” which was derived from the Greek word.

Capital Opportunity Cost

  • Opportunity cost refers to the value or benefit that you give up by choosing 1 choice over another. “You give up watching TV by going to school at night.”
  • Opportunity cost includes accounting costs. Accounting costs are the monetary amounts (pay $300 for class and books), opportunity costs add in non-monetary (can’t work late on Thursday due to this, give up OT hours of work).

Substitute versus complementary goods, inferior goods

  • Substitute goods – 2 goods are said to be substitute when the more you buy of one good, the less you buy of the other. Pepsi and Coke, for example.
  • Complementary goods – 2 goods are said to be complementary when the more you buy of one, the more you buy of the other. Barbie and Barbie accessories, for example.
  • Inferior goods – Cheap goods, such as Raman noodles and SPAM.

P-P curve

  • Production possibilities curve is a graphical representation of a production possibilities table. It shows the possible combinations of two goods that can be produced with the following assumptions:
    • Full employment
    • Fixed resources
    • Fixed technology
    • No international trade
  • Areas inside the curve are attainable, but do not use full employment/resources.
  • Areas outside the curve are unattainable with current resources and technology (see assumptions).

Law of increasing opportunity cost

  • As the production of a particular good increases, the opportunity cost of producing an additional unit rises.
  • This is why the PP curve is bowed and not straight.

Economic growth

  • Removes the assumptions from the PP curvce of fixed resources and fixed technology
  • Increases in resources, and/or better technology, allows for more to be produced.
  • Causes the PP curve to shift out and to the right (more can be produced at each possible combination).
  • Concentration of the future (capital goods - China) over the present (consumer goods – U.S.) allows for faster growth.
  • Extensive growth relaxes assumption resources are fixed
  • Intensive growth relaxes assumption technology is fixed

Factors of production, circular flow

  • Factors of production – Also known as inputs
    • Land – All natural resources used in production such as land, forests, mineral and oil deposits, and water resources.
    • Labor – Physical and mental talents of individuals used in producing goods and services.
    • Capital – Refers to capital goods (goods that make another good, such as ovens that make pizza (consumer good)). Includes tools, machinery, factory, storage, transportation and distribution facilities.
    • Entrepreneurial Ability – Differs from labor. Takes on the risks, is the innovator, combines the other resources, makes strategic and business decisions.
  • Circular flow
    • Resource Market – Households sell, businesses buy
    • Product Market – Businesses sell, households buy
    • Businesses – Sell products, buy resources
    • Households – Sell resources, buy products
    • Government purchases of goods and services
    • Government gives transfer payments (payments made to people for which no contribution is made by the people in return for them).

Command, market economies

  • Market – An established arrangement that brings buyers and sellers together to exchange goods and services
  • Competitive market – A market that has so many buyers and so many sellers such that no single buyer or seller can incluence or control the market price. To the individual buyer or seller, the price is given. They are price takers, not price makers.
  • Command economy – Government answers the three questions (see economic problem) – Cuba, North Korea – Also known as socialism or communism.
    • Centrally planned economies face a coordination problem aligning all the millions of individual decisions by consumers, resource suppliers, and businesses so that production does not entail too much of on eitem but too little of another.
  • Market economy – Market plays a major role in answering the three questions – United States – Also known as capitalism.
    • Marked by private property.
    • Private property and economic freedom are two of the cornerstones of a market system.
    • Laissez-faire – little to no government interference
    • Depends on competition – uses the invisible hand

Economic fallacies, scientific method

  • Fallacies – Errors in reasoning.
    • Fallacy of criticizing the man (Argumentum ad hominem) – Personal attacks, instead of criticizing a position, criticizing the person.
    • Fallacy of appeal to the people – Just because everyone says something doesn’t make it so. “Most people use tide, therefore Tide is the best.” “75% think gun control laws are good, therefore gun control laws are good.”
    • Fallacy of false cause (Post hoc ergo propter hoc) – Whenever A occurs, B occurs (this is correlation not causation). It could be that B causes A, or C causes both.
    • Fallacy of composition – Assuming that what is true or characteristic of the parts of a whole is also true of the whole in its entirety. Paradox of thrift (example).
    • Fallacy of division/decomposition – Assuming that what is true of the whole is also true for its parts. Reverse of fallacy of composition.
  • Scientific method – A process of formulating theories, collecting data, testing, and then revising/or tentatively confirming your theories using two mental processes.
    • Induction – reasoning from particular observations to general conclusions. Leads to a simplified picture called a theory or model.
    • Deduction – reasoning from general statements to particular observations (then you try to verify your conclusions by going back to the facts)
  • Scientific truths are capable of being disproven.

Production efficiency

  • Any point on the production possibilities curve. It is production efficient because of the assumptions that you have full employment, and are utilizing all resources.

Allocative efficiency

  • A specific point on the production curve. Society wants the results of production efficiency at this specific point, and that’s what it gets. Any other point on the pp curve is still production efficient, but is not allocative efficient.

Macro vs microeconomics

  • Macro focuses on being production efficient – utilizing all resources, full employment, etc.
  • Micro focuses on being allocative efficient – having the “perfect” mix: society wants a specific mix (as represented on the pp curve), and that’s what it gets.

Concept of demand/supply

  • Concept of demand – A relation that shows the various amounts of a commodity that buyers would be willing and able to purchase at possible alternative prices during a given period of time, ceteris paribus.
    • A relation: ? P changes Qd (this is buyer behavior)
    • Willing means want the product, able means have the money to buy.
    • Law of Demand – Quantity demanded of a good varies inversely with its price
    • Income effect – As price falls, you can afford to buy more of it
    • Substitution effect – As price of good falls, it becomes a better bargain relative to the other good
    • Decreasing marginal utility – The more you have of a good, the less you’re willing to pay for another unit of it.
  • Concept of supply – A relation that shows various amounts of a commodity (good or service) that sellers would be able to make available for sale at possible althernative prices for a given period of time, ceteris paribus
    • A relation: ? P changes Qs (this is seller behavior)
    • Able means then can make a profit at that price
    • Law of Supply – Quantity supplied of a good varies directly with its price
    • Law of Increasing Costs – As production increases, unit costs rise.

Demand and supply shifters

  • Demand shifters
    • Change in income
      • For normal goods, increase in income results in increase in demand
      • For inferior goods, increase in income results in decrease in demand
    • Change in price of related goods
      • Substitute goods – Rise in price of Pepsi decreases quantity demanded of Pepsi, but could increase demand for Coke.
      • Complementary goods – Rise in price in Barbie causes decrease in quantity demanded for Barbie, and decrease in demand for accessories.
    • Change in the number of buyers
      • Deals with the difference between an individuals demand curve and a market demand curve
      • Market demand curve is sum of individual demand curves.
      • An increase in number of buyers will cause increase in market demand.
    • Change in consumer taste
      • This deals with fads
    • Change in consumer expectations about future prices/quantities
      • If you think prices will fall in the future, you will buy less today, causing a decrease in demand.
      • If you think there will be less available in the future, you will buy more today, causing an increase in demand.
  • Supply shifters
    • Changes in technology
      • If technology lowers production costs, this results in an increase in supply.
    • Changes in resource prices – The price you pay for the factors of production
      • If prices drop, there will be an increase in supply (less costs, more you can make at that price).
    • Changes in price of related goods
      • Substitute goods – If corn prices increase, corn qty supplied increases, causing decrease in wheat supply. It becomes more profitable to supply the other good.
    • Change in the number of sellers
      • Deals with the difference between individuals supply curve and a market supply curve
      • Market supply curve is sum of individual supply curves.
      • An increase in number of sellers will cause increase in market supply.
    • Change in producer expectations about future prices/quantities
      • If you think prices will fall in the future, you will produce more today (to try and sell now and maximize profits) causing an increase in supply.
    • Taxes and Subsidies
      • Taxes increase costs, cause a decrease in supply
      • Subsidies (taxes in reverse) decrease costs, cause an increase in supply

Changes in demand/supply versus changes in the quantity demanded/supplied

  • Changes in demand
    • The demand curve shifts, caused by demand shifters
      • “An increase in demand” – Purchase more at the same price – at any given price, the buyer purchases more.
      • “A decrease in demand” – Purchase less at the same price – at any given price the , the buyer purchases less.
  • Changes in quantity demanded
    • A movement along the same curve – affected by price only.
      • “An increase in the quantity demanded” – Price went down
      • “A decrease in the quantity demanded” – Price went up
  • Changes in supply
    • The supply curve shifts, caused by supply shifters
      • “An increase in supply” – More is made available for sale at any given price.
      • “A decrease in supply” – Less is made available for sale at any given price.
  • Changes in quantity supplied
    • A movement along the same curve – affected by price only.
      • “An increase in the quantity supplied” – Price increases
      • “A decrease in the quantity supplied” – Price decreases

Other terms and items

  • Utility
    • The pleasure, happiness, or satisfaction obtained from consuming a good or service.
    • The power of a good to satisfy a want.
  • Marginal analysis
    • Comparisons of marginal benefits and marginal costs, usually for decision making. Marginal means “extra”.
  • Ceteris Paribus
    • Other things equal assumption. This means that only those factors (such as price) are assumed to change, and everything else is kept constant.
  • Positive economics vs normative economics
    • Positive – focuses on facts and cause-and-effect relationships
    • Normative – includes value judgements and what “should” be.
  • Economizing problem
    • The need to make choices because economic wants exceed economic means.
  • Economic assumption
    • People are rational, trying to maximize profits and/or minimize costs.
  • Economic problem
    • How to use limited resources to satisfy unlimited wants. Three fundamental questions.
    • What goods and services should society produce?
    • How shall it be produced? How should the resources be organized for production?
    • For whom shall the goods be produced? Who gets it?
  • Optimal allocation
    • The point where marginal benefit meets marginal cost.
  • Equity
    • Refers to fairness and justice. This is a moral issue.
  • Specialization
    • Division of labor – assembly line
    • Increases output by enabling workers to take advantage of differences in their skills.
  • Economic profit
    • The difference between total receipts and total economic cost.
  • Equilibrium
    • The point where supply and demand curves meet – there is no shortage and no surplus
    • In the below, this is at $2.50 (Qs = Qd)
    • Area above equilibrium is a surplus, tendency for price to fall
    • Area below equilibrium is a shortage, tendency for price to rise
  • Sources of market failure
    • Economic instability – unemployment, recession
      • The govt response is monetary and fiscal policy
    • Equity (fairness) – The govt has a safety net (unemployment, welfare, food stamp)
    • Market power – Lack of competition – Monopoly
      • Govt response is anti trust laws
    • Public goods – The private sector will not provide these goods
      • Not subject to the exclusion principle (ability to exclude the non-payers from getting it) – Free rider
      • Non-rival in consumption – Your consumption does not reduce my benefit
      • Some public goods are because private sector won’t (libraries)
    • Externalities
      • Negative – outcome that are paid for by third party without compensation (pollution)
      • Positive – outcome that benefits third party without paying for it (education, immunizations)
  • Graphs
    • Y axis is Price, X axis is Quantity.
    • 0,0 is called point of origin.
    • Slope is ? Y/? X
    • Negative slope – curve points down (demand), P and Q are inversely related
    • Positive slope – curve points up (supply), P and Q are directly related.
      • Example: Qs = f(P) : Quantity supplied is a function of the price. Qs is the dependent variable, P is the independent variable
    • Independent variable cause. Dependent variable changes because of the independent variable (the effect).
    • Vertical intercept is the point of the curve that it meets the Y axis (x = 0).
  • Shift in supply and demand