Econone Reviewer

Economics social science that deals with the allocation of

scarce resources to alternative uses to satisfy human
wants and needs.
3 Fundamental Concepts:
1. Opportunity Cost alternative given up when choices
are made
2. Marginalism weighing of costs and benefits that arise
from the decision
3. Efficient Markets where profit opportunities are
eliminated almost instantaneously
Basic Questions:
1. What to produce?
2. How to produce?
3. For whom to produce?
Economic Resources:
1. Natural/Land
2. Human/Labor
3. Man-made/Capital
Economic Systems:
1. Command economy govt. Sets
2. Free market (laissez-faire) no govt.
Market
Consumer Sovereignty consumer dictates
Free Enterprise players pursue self-interest
3. Mixed economy govt. plays major role to:
Minimize market inefficiencies
Provide public goods
Redistribute income
Stabilize the macro economy
- Promote low levels of unemployment and inflation
Economic Policy criteria for judging eco. outcome
1. Efficiency production of consumers wants with
least possible cost
2. Equity fairness
3. Growth increase in total output of economy
4. Stability condition where national output is growing
steadily w/ low inflation and full employment of
resources
Scope of Economics:
1. Microeconomics individual industries and behavior
of decision-making units
2. Macroeconomics examines national scale economic
behavior
Theory and Models:
1. Ockhams Razor irrelevant details should be cut
away. Models are simplifications, not complications of
reality
2. Ceteris Paribus all else equal
The Basic Decision-making Units:
1. Firm transforms inputs into outputs
2. Entrepreneurs person = firm
3. Households consumers
The Circular Flow of Economic Activity






Product Possibility Frontier
combination of 2 goods that
shows concept of opportunity
cost


Demand, Supply and Market Equilibrium
The Law of Demand: There is a negative, or inverse,
relationship between price and quantity of a good
demanded and its price. (P Qd or P Qd)
Violation of Law of Demand:
1. Veblen Goods - P Qd -> prada
2. Giffen Goods - P Qd -> staple foods during famine
Factors of Demand
1. Price of the Product - P Qd or P Qd
2. Income Available
Nominal Goods - Y Qd or Y Qd
Inferior Goods - Y Qd or Y Qd
3. Amount of Accumulated Wealth
4. Prices of other Products
Substitutes - Pa Qdb or Pa Qdb
Complements - Pa Qdb or Pa Qdb
5. Tastes and Preferences
6. Expectations
Income and Wealth
1. Income sum of all wages in a given period
2. Wealth total value of what households owns owes
The Law of Supply: There is a positive relationship
between price and quantity of a good supplied. (P Qs or
P Qs)
Output Market
Household Firm
Input Market
Supply
Demand
Demand
Supply
Goods and services
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Food
Factors of Supply
1. Price
2. Cost of production
3. Price of related products
Market equilibrium
1. The operation of the market depends on the
interaction between buyers and sellers.
2. Equilibrium is the condition that exists when Qs and Qd
are equal.
3. There is no tendency for price to change.
Alternative Rationing Mechanisms
1. Price Ceiling max. price that sellers may charge
2. Price Floor min. price
Tax amount paid by consumers and producers to govt.
1. Direct Taxes collected directly
Progressive Tax higher income, higher tax
2. Indirect Taxes taxes on goods and services
Regressive Tax high or low income, same tax
Effect of Taxation: Deadweight Loss of Taxation
Elasticity measure of responsiveness
Midpoint Formula =

Price elasticity of demand (Epd) =

|Epd| > 1 -> elastic luxuries (many subs)
|Epd| < 1 -> inelastic necessities (few subs)
|Epd| = 1 -> unitary
Income Elasticity of Demand (Ey,d) =

Ey,d > 0 -> normal good
Ey,d < 0 -> inferior good
Cross Price Elasticity of Demand (Ecross) =

Ecross > 0 -> substitutes
Ecross < 0 -> complements
Elasticity of Supply (Eps) =

Elasticity of Labor Supply (E) =

Extreme Elasticities
E = -> perfectly elastic ( subs)
E = 0 -> perfectly inelastic (0 subs) insulin
Factors of Demand Elasticity
1. Availability of substitutes
2. Importance of item in budget D is more elastic if its
significant
3. Time Frame D becomes more elastic over time
Consumer Behavior
Household Choice in Output Markets
Every household must make 3 Basic Decisions:
1. How much of each product to demand
2. How much of labor to supply
3. How much to spend today and how much to save
The Budget Constraint limits imposed on choices
Choice/Opportunity set set of options defined by BC
The Basis of Choice: Utility
1. Utility satisfaction a product yields
2. Marginal Utility additional satisfaction gained
3. The Law of Diminishing Marginal Utility: The more of
one good consumed in a given period, the less utility
generated by consuming each additional unit of the
same good.
Indifference Curve representation of 2 goods
Preference Map set of indifference curves
Assumptions:
1. more is better
2. Diminishing marginal rate of substitution
3. Existence of preference relation
4. Rationality
Marginal Rate of Substitution (MRS) =

- Ratio at which a household is willing to sub. X for Y
- Slope of indifference curve
Utility Maximizing Condition:

If

>

then MUx and MUy

Diminishing Marginal Utility helps to explain why demand
slopes down.
Income and Substitution Effect
1. Income - consumption changes because purchasing
power changes
2. Substitution consumption changes because
opportunity cost changes
Consumer Surplus (CS) =

- Consumers are willing to pay higher
The Diamond/Water Paradox
1. Things with the greatest value in use frequently have
little or no value in exchange
2. Thing with the greatest value in exchange frequently
have little or no value in use
Household Choice in Input Markets
Households must decide:
1. Whether to work
2. How much to work
3. What kind of job to work at
Price of Leisure
1. Substitution Effect - W -> Leisure, Labor Supply
2. Income Effect - W -> Purchasing Power, Leisure,
Labor Supply
Saving and Borrowing: Present vs. Future Consumption
1. Substitution Effect - i -> Cost of current
consumption, Saving, Consume
2. Income Effect - i -> Earn, Saving, Consume
Production
1. Central to our analysis is production.
2. A firm is an org. that comes into being when a person
or group of people decide to produce a good/service
to meet a perceived demand.
Market Structures
1. Perfect Competition -> P = MC
Many firms
Producing virtually identical products
No firm is large enough to control price
Competitors can freely enter and exit
Homogenous Product identical products
Competitive Firms are Price Takers
Behavior of Profit-Maximizing Firms
3 Decisions firms must make:
1. How much output to supply
2. Which production technology to use
3. How much of each input to demand
Profits and Economic Costs
1. Profit = Revenue Cost
2. Total Revenue = Q x P
3. Total Economic Cost
a. Out of pocket costs (acctg.)
b. Normal rate of return on capital rate of return that
is sufficient to keep owners and investors satisfied
c. Opportunity cost of each factor of production
Short-run vs. Long-run Decisions
1. Short-run period of time wherein:
a. Firm is operating under a fixed scale of production
b. Firms can neither enter nor exit an industry
2. Long-run period of time wherein:
a. There are no fixed factors of productions
b. Firms can increase or decrease scale of operation
c. Firms can may enter and exit
Determining the Optimal Method of Production






Production Techniques can be labor-intensive or capital-
intensive.
The Production Function numerical expression of a
relationship between inputs and outputs
Labor Units Total Product MPL APL
0 0
1 10 10 10.0
2 25 15 12.5
3 35 10 11.7
4 40 5 10.0
5 42 2 8.4

Marginal Product and Average Product
1. Marginal Product additional output that can be
produced by adding one more unit of a specific unit
MPL =

2. Average Product average amount produced by each
unit of a variable factor of production
APL =

Law of Diminishing Marginal Returns: When additional
units of a variable input are added to fixed inputs, the
marginal product of the variable input declines.
Total Average and Marginal Product
1. Marginal product is the slope of the total product
function
2. As long as marginal product rises, ave. product rises
3. When average product is max., marginal product
equals average product
Production Functions with 2 Variable Factors of
Production
Price of
output
Production
Techniques
Input
Prices
Determines
total revenue
Determines total cost and
optimal method of prod.
Total Profit = Total revenue Total
cost with optimal method
1. In many production processes, inputs work together
and are viewed as complementary.
2. Given the tech. Available, the cost-minimizing choice
depends on input prices.
Cost-minimizing Choice Among Alternative Technology
Tech. Units of
Capital
Units of
Labor
Cost when
PK =1, PL = 1
Cost when
PK = 1, PL = 5
A 2 10 12 52
B 3 6 9 33
C 4 4 8 24
D 6 3 9 21
E 10 2 12 20

Isoquants and Isocosts (TC = PL x L + PK x K)
1. Isoquant graph that shows all the combinations of
capital and labor that can be used to produce a given
amount of output
2. Isocost Line graph that shows all the combinations of
capital and labor available for a given total cost
For output to be constant, the loss of output from using
less capital must be matched by the added output
produced by using more labor.
K x MPK = -L x MPL

= -

Cost-minimizing Equilibrium Condition

If

>

-> L K
Costs in the Short-run
TC = TFC + TVC
ATC = AFC +AVC
1. Fixed cost (or sunk costs) costs that dont depend on
level of output. These costs are incurred even if the
firm produces nothing.
AFC =

AFC falls as output rises (spreading overload)
2. Variable cost cost that depends on the level of
production chosen
Total Variable Cost Curve graph that shows the
relationship between total variable cost and the
level of a firms output. It also shows the cost of
production using the best available technique at
each output level, given current factor prices.
Total Variable Cost derived from production
requirements and input prices
AVC =

3. Marginal Cost increase in the total cost that result
from producing one or more units of output. It also
reflects changes in variable costs.
MC =

MR = MC
The Slope of the Marginal Cost Curve in the Short-run
1. The fact that in the short-run every firm is constrained
by some fixed input means that:
a. Firm faces diminishing returns to variable inputs
b. Firm has limited capacity to produce output
2. As a firm approaches that capacity it becomes
increasingly costly to produce successively.
Marginal Cost and Average Cost
1. When MC < AVC -> AVC is
declining
2. When MC > AVC -> AVC is
rising
3. Rising MC intersects AVC
at the minimum point of AVC


Long-run

1. Economies of scale = Returns to scale
2. Increase returns to scale -> Q, LRAC
3. Constant returns to scale -> Q, LRAC remains
constant
4. Decrease returns to scale -> Q, LRAC
Example:
f(2L, 2K) > IRTS = 4Q, DRTS = 1.5Q, CRTS = 2Q








(MRTS)
(Slope of
isoquant)
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Q
MC
AVC



Q
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SRMC

SRMC
SRMC

SRAC

SRAC
SRAC

LRAC

MC
Market Failures:
1. Externality (Spill-overs/Neighborhood Effects)
cost/benefit resulting from some activity/transaction
that is imposed upon parties outside the
activity/transaction
Positive benefit -> underproduction (cheating)
Negative suffer -> overproduction (smoking)
When external costs are not considered in economic
decisions, we may produce products that are not
worth it.
When external benefits are not considered, we may
fail to do things that are indeed worth it which result
to inefficient allocation of resources.
Marginal Social Cost and Marginal Cost Pricing
Marginal Social Cost (MSC) total cost to society of
producing an additional unit of a good and service
MSC = Marginal Private Cost (MPC) + Marginal
Damage to Society
Private Choices and External Effects
Marginal Benefit (MB) benefit derived from each
successive hour of music
Marginal Damage Cost (MDC) add. harm done by
increasing the level of an externality
Marginal Social Cost (MSC) total cost to society of
playing an add. hour of music
Condition to Maximize
utility:
i. MB = MC -> Private
ii. MB = MC + MD -> Social
Internalizing Externalities
A tax per unit equal to MDC
is imposed on the firm. The
firm will weigh the tax and
thus the damaged costs in
its decisions.
The Coase Theorem
Govt. Need not to be involved in every case of
externality
Private bargains and negotiations are likely to lead
to an efficient solution in many social damages
Indirect and Direct Regulations
Taxes, subsidies, legal
rules and public auction
are all methods of
indirect regulations
designed to induce firms
and households to weigh
the social costs of their
actions against the
benefits.

MSB > MPC

2. Public Goods (Social/Collective Goods) goods that
are non-rival in consumption and/or their benefits are
non-excludable. (roads, education)
Public goods have characteristics that make it
difficult for the private sector to produce them
profitably

Characteristics of Public Goods:
Non-rival in consumption when As consumption
does not interfere with Bs consumption. The
benefits of the good are collective they accrue to
everyone.
Non-excludable if once produced, no one can be
excluded from enjoying its benefits (lamp posts)
Free-rider problem people can enjoy the benefits
of public goods whether they pay for them or not,
they are usually unwilling to pay for them.
3. Imperfect Information and Adverse Selection
Most voluntary exchanges are efficient, but in the
presence of imperfect information, not all exchanges
are efficient
Adverse Selection when buyer/seller enters into
an exchange with another party who has more
information -> hidden info. (health insurance)
Moral Hazard when one party to a contract passes
the cost of his or her behavior on to the other party
to the contract. -> hidden action (car insurance)
The Moral Hazard problem is an information
problem, in which contracting parties cannot always
determine the future behavior of the person with
whom they are contracting.
Market Solutions
1. As with any other good, there is an efficient quantity of
information production.

Market Structures (continuation)
1. Monopoly
Only one firm
Barriers to Entry: extremely high, scale and scope
economies or legal barriers
Type of Product: unique, no close substitutes
Firms control over price: considerable or regulated
Profit Point: MR = MC
MR > MC -> inc. output to inc. profit
MR < MC -> dec. output to inc. profit
will suspend operations in the short run if P < AVC
will shut down permanently if revenue is not likely
to equal or exceed all costs in the long run.
Source of Monopoly Power
Economic Barriers
Economies of scale
Capital Requirements
Technological Superiority
No substitute goods
Control of natural resources
Network externalities






Q
P
MPC
MB
MDC



Q
MB/
MC
MC
SMB
PMB
Subsidy govt. should pay firm
Legal Barriers
Property rights give firms exclusive control to the
production and selling of goods, and sometimes
even the control of materials.
Examples: copyrights, patents, govt. franchise
(public transportation)




2. Monopolistic Competition
Many firms
No barriers to entry
Product differentiation
3. Oligopoly
Collusion Model
MR = MC
P > MC
Cartel agreements are made
Tacit Collusion agreements are implied
Price-Leadership Model
Dominant firm sets prices for small firms to follow
Kinked-Demand Curve:
Rivals will not follow price increase
Rivals will follow price decrease