UNIT 1: WHAT IS ECONOMICS? BASIC CONCEPTS.

Economy is the study of the ways in which society manages scarce resources. Scarcity means that the society has limited resources hence cannot produce all the goods people wish to have.

What determines the allocation of resources? Positive question: It asks for the description of how something is. Most goods are allocated through markets. Therefore study of markets is at the core of economics. A market is a place where buyers and sellers freely exchange goods. Is the allocation of resources optimal? Normative question: implies a value judgement (how should something be?). Economists are typically concerned with efficiency. Most commonly employed concept of efficiency is “Pareto efficiency”. A situation is Pareto efficient if it’s impossible to make anyone better off without making someone worst off. Pareto efficiency is a very weak concept of what is desirable. No regard for equity, justice, or liberty. (“I have everything, you have nothing and I don’t care”).

Example 1: “The marriage market”. Until recently, couples met mostly by chance. Now advantages in technology have given us dating websites.

- How do economist answer questions? Economics is a social science that studies decision-making in a world with scarce resources. The scientific approach in economics consist of: - Formulation of theories. - Empirical analysis of data to test these theories.

METHODOLOGY IN ECONOMICS. The development of economic theory. - The departure point is a set of assumptions (a model) - The assumptions are combined (usually using maths or logic)

This delivers predictions, which can lead to: + New Theories+ Empirical analysis

- Every model needs to be a simplification of reality.

Mathematics in economics. - Advantages: Transparency (at least for insiders), logical consistency, and unexpected conclusions. - Disadvantages: Lack of transparency (for outsiders), can become end in itself, and illusion of exactness.

THE PURE EXHANGE MODELA simple model can show how the free exchange can improve the welfare of participants. - Assumptions of the model:

Two people: Nerea and Carlos // Two goods: Oranges and onions - Initial distribution: Nerea has got oranges and Carlos’ got onions.

- Preferences: Nerea likes onions and she’s willing to give up to 5 oranges for each onion. Carlos likes oranges and he’s willing to give up to 4 onions for each orange.

Questions:• Can they improve their situation by trading oranges for onions?• Would they be willing to exchange one onion for one orange?• What’s the interval of relative prices at which they would be willing to trade?

THE COMPARATIVE ADVANTAGE MODEL (CAM): To enrich the previous model we will add some more assumptions. The objective is to be able to understand who produces what. We relax the assumption of the initial distribution and now we assume that both oranges and onions are available in nature. Nerea needs an hour to pick either 10 oranges or 2 onions and Carlos needs an hour to pick either 1 orange or 4 onions.

OPORTUNITY COST. The opportunity cost of an item includes everything you have to give up in order to get that item. E.g.: Examples: going to university or being with your current boyfriend/girlfriend. So we can answer the following questions• What’s the opportunity cost of Nerea (in terms of oranges) of producing 1 onion?• What’s the opportunity cost of Carlos (in terms of onions) of producing 1

orange?• How many oranges would Nerea be willing to produce and trade for 1 onion?• How many onions would Carlos be willing to produce and trade for 1 orange?

- Specialization will be good for both! Nerea will pick only oranges and Carlos onions. What if Carlos is so productive that he produces either 100 oranges or 400 onions per hour? Still, it is better for Carlos to trade onions for oranges!

If an agent has a lower opportunity cost of one good in terms of the other good than the other agent, the first agent has a “comparative advantage” in the production of the first good.

• In our example, Nerea has a comparative advantage in the production of oranges and Carlos in the production of onions.

The main lessons of the CAM are:• Trade can improve the welfare of all the participants• Even in the case in which one very productive person (country)

exchanges with a considerably less productive one• What matters for the PATTERNS OF TRADE are the opportunity costs.

They determine the comparative advantages (vs. absolute advantages)

Questions related to the CAM:• Do you think Einstein should do his own tax declaration?• Is it good for the USA to trade with Ethiopia?• And for Ethiopia to trade with USA?

There are two fields in the economic science:

• MICROECONOMICS studies the behavior of the individual units in each economy (households and firms) and how they interact in markets. E.g.: Each household decides what to consume, how much to work; each firm decides what to produce, how many workers to hire. They interact in the market of each good and in the labor market

• MACROECONOMICS studies the interactions between the different markets in an overall economy and the processes that affect the economy as a wholeTypical questions in macroeconomics are:- What are the consequences of a higher government spending?- What would be the evolution of unemployment?- Why there is inflation (or deflation)?- How does the average…?

Summary: 1) Economics tries to understand how people choose and deal with scarcity2) Study of markets central to economics3) Positive vs. normative analysis4) Pareto efficiency5) Opportunity cost is the relevant way to measure the cost of something6) Trade can make everyone better off7) Comparative advantages are important in determining who produces what8) Micro and macroeconomics

UNIT 2: THE DEMAND.

The market. A market refers to an institution in which buyers and sellers freely exchange a good. It’s got two sides:

- Buyers determine the demand for the good. - Sellers determine the supply of the good.

º Perfect competition. The perfect competition model assumes that buyers as well as seller are price takers:A buyer (or a seller, but specially buyers) is a price taker if s/he cannot influence the price of the good that is bought/sold.

- When can we expect buyers and sellers to be price takers?When there are many buyers and sellers interested in the same good (an homogenous good). • We call this type of market a competitive market.

Other market structures: • Monopoly: single seller.• Oligopoly: few sellers.• Monopolistic Competition: many sellers but with slightly different products.

The demand. The demand curve. • The quantity demanded is the quantity of a good that buyers are willing (and

able) to buy in each possible circumstance determined by various factors such as prices, availability of other goods etc.

• The demand curve is a function (or a graph) that shows us the demand as a function of the price. (So it shows us when it changes)

Example of a demand curve:

Price (x10€)

Nº of delivers

Price Quantity100€ 190€ 280€ 270€ 360€ 450€ 540€ 8… …

“Ceteris Paribus” The demand curve is constructed under the assumption of ceteris paribus, which comes from Latin, “other things being equal”.• This means that the demand curve is constructed only by looking at the effects of

changes in price. We keep all other factors such as prices of other goods, tastes constant.

The law of the demand. The law of the demand states that there is an inverse relation between the price and the quantity demanded, i.e. the demand curve has a negative slope.

- Individual and market demand. To understand how the demand curve works we have to consider two levels: · Individual demand· Market demandWhich is the sum of the individual demands of all the buyers in a market.

The individual demand corresponds to a particular person. Price (x10€)

Nº of delivers

Marginal utility. The increase in the welfare of an individual resulting from an additional unit of a good is called the marginal utility of the good. We will measure this welfare increase in monetary units, i.e. euros. E.g.: What is the marginal utility for an oyster?

CLUE: What do you prefer right now, X euros or an oyster?

Decreasing marginal utility. For most of the goods, the welfare increase resulting from the consumption of a good decreases as we consume more of that good.

- Your first oyster is very tempting. If you have already eaten 10 oysters, an additional one is going to add less to your welfare.That is, the marginal utility of an oyster is decreasing in the number of oysters you have eaten already. This property (decreasing marginal utility) holds for the majority of goods.

Price Quantity

100€

1

90€ 180€ 170€ 260€ 350€ 340€ 3… …

We can express the marginal utility as a decreasing function of the quantity of oysters.

MgU (in €’s)

Nº ofDelivers

For each price, an individual would compare the price with the marginal utility generated by that unit. Price and MgU (in €’s)

Number of oysters

The MgU curve is the demand curve of a price taker individual. Price and MgU(In €’s)

Number of oysters

(Review graphics, not completed)

Number of oysters

MgU

1 10€

2 7€

3 6€

4 3€

5 3€

6 1€

Number of oyster

MgU

1 10€

2 7€

3 6€

4 3€

5 3€

6 1€

Number of oysters

MgU

1 10€

2 7€

3 6€

4 3€

5 3€

6 1€

CONCLUSIONIf the Marginal Utility is decreasing, the individual demand will be decreasing.The law of demand will hold. Price and MgU (in €’s)

Number of oysters

The market demand. The market demand is the total demand of all buyers in a market. This can be calculated by summing all the individual demands at each price level. This type of addition is called horizontal summation.

The demand function in practice. What happens when we study demands in an environment with many units?

Number of oysters

MgU

1 10€

2 7€

3 6€

4 3€

5 3€

6 1€

What happens when we study demands in an environment with many units? We approximate the demand with a curve.

Market demand. Does the law of demand hold in the case of market demand?In general, the market demand is a decreasing function of its own price for two reasons:

• Individual demands are decreasing functions of price.• At a lower price, there are more individuals demanding the good.

Factors that affect the demand: market price, consumer’s income, prices of other goods…

Quantity demanded and demand function. If there’s a change in demand due to the change in the price of a good, ceteris paribus… there will be a movement along the demand curve!

Change in the quantity demanded:

Shifts in demand. If there is a change in a factor that affects the demand other than the price of the good. There is a shift in demand. Graphically, it looks like a shift in the demand curve (left or right).

The demand and consumer’s income. Given an increase in income, the demand of a normal good increases.Given an increase in income, the demand of an inferior good decreases.

Normal good:

Inferior good:

Demand and the prices of other goods. - When a decrease in the price of a good reduces the quantity demanded of another good, these two goods are called substitutes.- When a decrease in the price of a good increases the quantity demanded of another good, these two goods are called complements.

Complements or substitutes? Determine if the following items are complements or substitutes.

• Movies and theatre plays.• Movies and popcorn.• Cigarettes and cigars.• Computers and printers• Restaurant food and wine.• Goalkeepers and strikers.

Summary: 1) Introduction:

• The market: Supply and demand• Competitive markets: price-taking.

2) Individual demand:• Marginal utility• From marginal utility to individual demand

3) From individual to aggregate demand4) Movements and shifts:

• Normal versus inferior goods.• Complements versus substitutes

UNIT 3: THE SUPPLY

What to outline? • The law of supply• Goals of a firm

- Firms as profit-maximizers• Different types of costs and individual supply• From the supply of the firm to the aggregate supply.• Shifts of the supply function.• The elasticity of supply (and elasticity of demand).

The quantity supplied: it’s the quantity of a good that sellers are willing (and able) to sell in every possible circumstance (price of the good, price of factors of production…). Supply curve: function (or graph) that gives the supply for each price.

The law of supply states that there is a positive relationship between the price and the quantity supplied,E.g.: the supply curve has a positive slope.

Ceteris paribus: • The supply curve is drawn under the assumption ceteris paribus (remember,

from latin, “other things equal”).• It means that the supply curve is drawn keeping constant all the other things that

can influence the quantity supplied.

- Derivation of a supply curve: In what follows we will study in detail the derivation of a supply curve. The first step is to study the supply of an individual firm. Then, we will analyse the relationship between the individual supply and the aggregate supply (or market supply).

- Firm as profit-maximizers: Economists typically assume that firms seek to maximize profits. This assumption is not always satisfied, especially in the short run (Maximization of market share, Maximization of revenue, or Maximization of CEO ego).

Example: “For years, investors have complained that Amazon is chronically unprofitable.”“As long as the company can grow its revenues, it can spend any profit it makes on new lines of business that throw off more revenues.”

- Economic vs. Accounting profit

- Fixed and variable costs: Fixed costs are those costs that do not vary with the quantity of output produced.Variable costs are those costs that do vary with the quantity of output produced.

- Total costs:

- Marginal and average costs: The marginal cost is the increase in cost associated to producing one extra unit. Average cost is the total cost for producing a number of units divided by the number of units.

- Marginal cost and decreasing marginal returns:The curve of marginal cost is usually increasing because of the law of decreasing marginal returns. If production is expanded by increasing the use of some resources while others are kept constant, the LDMR is reasonable. There is a point at which the fixed resources are overexploited and marginal costs start to increase. In reality marginal cost curves often U-shaped.

- Aside: sunk costsSunk costs are costs that are irretrievable and therefore should not influence any future decisions, whether in business of private life.

• Example:You have booked two trips for one weekend by accident, one for 50€ and one for 100€. The trip for 50€ would be slightly more fun.Which one would you pick? How much each trip costs does not matter as you already paid the price!

- Aggregate supply: • The aggregate supply is the total quantity that all the firms or individuals want

to sell at a given price.

In general the market supply curve has a positive slope because: The individual supply curves have positive slope. When the price increases, more firms enter the market.

The market supply with many units:

- Determinants of supply: • Market price• Input Prices• Technology• Expectations• Number of producers

- Changes in the quantity supplied or movements along the supply:Changes in the quantity supplied or movements along the supply curve arise when there is a change in the market price of the product, other things equal.

- Supply shifts or changes in the supply (to the left or to the right) are caused by one of the other determinants (not the price).

- Changes in the quantity supplied and shifts in the supply curve:

Variables that affect the quantity supplied

A change in this variable . . .

Price Produces a movement along the supply curve

Price of inputs Shifts the supply curve

Technology Shifts the supply curve

Expectations Shifts the supply curve

Number of sellers Shifts the supply curve

- Shifts in the supply curve: Discuss how the following changes affect the supply curve of deliveries:

• The government puts a new tax on petrol.• Ikea limits the number of vans allowed in its parking lot.• There is a rise in the salary of van drivers.• A new bio fuel is invented which increases the efficiency of engines.

- Price elasticity of supply (and demand): The price elasticity of supply is the percentage change in the quantity supplied when the price changes by 1 %. It measures the response of the quantity supplied of a good to a change in its own price. Everything we say about the price elasticity of supply can be applied to the price elasticity of demand.

Price elasticity The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in the price.

p r icein ch ang e P ercen tag esu p p liedq uan tity in ch ang e P ercen tag e=su p p ly o f e las tic ity P rice

The price elasticity of demand is calculated analogously.

- (Absolute) values elasticity’s: • Perfectly elastic

ES = ∞• Relatively elastic

ES > 1• Unit elastic

ES = 1• Relatively inelastic

ES < 1• Perfectly inelastic

ES = 0

1. Perfect inelastic supply:• An inelastic supply is equivalent to elasticity equal to zero:

• An inelastic supply is equivalent to an elasticity smaller than one:

2. Unit elastic supply: is equivalent to an elasticity equal to one:

3. Elastic supply: is equivalent to an elasticity larger than one:

4. Perfectly elastic supply: is equivalent to an elasticity equal to infinity.

Determinants of the elasticity supply: - The elasticity of supply depends on the ability of the producers to change the quantity they produce.- The supply of land just in front of the beach is inelastic.- The supplies of books, cars and industrial goods are elastic.- Time horizon: the supply is in general more elastic in the long run (oil, etc.).

| Exercise: What determines the price elasticity of demand?

Application of elasticity concept:What is the relationship between revenues of a firm and the price elasticity of the demand of the good it produces?

- Example: Why can Wal-Mart reduce its prices and earn more money?

Summary: • The law of supply• Goals of a firm: firms as profit-maximizers• Different types of costs and individual supply• From the supply of the firm to the aggregate supply.• Shifts of the supply function.• The elasticity of supply (and elasticity of demand)

UNIT 4: MARKET EQUILIBRIUM

- Supply and demand together: • Equilibrium Price: price that equates the supply and the demand.• Equilibrium Quantity: quantity supplied and demanded at the equilibrium

price.

• Supply function: Qs = 1 + (4/5) p• Demand function: Qd= 10 - p

- Market equilibrium: Is the market equilibrium a reasonable prediction? Excess supply puts downward pressure on prices.

- The price mechanism: Tendency of the price to move towards a situation where supply and demand are equal is known as the price mechanism. The price mechanism coordinates millions of individual decisions.

• What ensures that restaurants receive fresh ingredients every day?• Why are there enough people who are willing to collect rubbish, grow

rice, bury the dead, clean toilets…

- The invisible hand: The Scottish philosopher Adam Smith (1723-1790) was the first to describe the price mechanism. In his book “An Inquiry into the Nature and Causes of the Wealth of Nations” in 1776 Smith referred to an “invisible hand” that guides participants in the market.

- Market outcomes: Market equilibrium determines how markets assign scarce resources, like how much of each good is produced or who will consume each good and how much. A very important question: is the resource allocation determined by the market desirable?

- Is the market equilibrium efficient? Pareto-efficiency?There are two ways to make consumers better off: Sell additional units at a sufficiently low price or sell existing units at a lower price.There are two ways to make sellers better off: Buy additional units at a sufficiently high price or buy existing units at a higher price.

• Is the market equilibrium efficient in the sense that we cannot increase the total welfare of buyers and sellers? (Even if this would require making some buyers/sellers worse off):

- Consumer surplus is a measure of the gains of buyers thanks to the existence of the market.- Producer’s surplus is a measure of the gains of sellers thanks to the existence of the market.

- Consumer surplus: We return to the market for deliveries and assume a price of 50€. The number of deliveries is three. But each delivery is worth more than the price. The difference between the value of the good and what is paid for it is the consumer surplus.

If we are interested in the surplus of all consumers, we can make a similar computation, but summing the surplus of all consumers:

Computations are simpler with linear demand functions:

- Producer’s surplus (or profit): Let’s again consider the example of deliveries and a price of 50€. The quantity of deliveries is three. The area between the price and the horizontal axis gives us total revenue.

The area under the cost curve (MgC) gives us the costs:

The area between the price and the marginal cost (MgC) curve is the producer surplus. If the supply is the market supply, this area is the total producer surplus.

With linear supply functions the computations are simpler:

- TOTAL SURPLUS: Consumer surplus = value for the buyers – amount paid by the buyers Producer surplus = amount received by the sellers – cost for the sellers

Total surplus = consumer surplus + producer surplus Total surplus = value for the buyers – cost for the sellers

- Efficiency in the market: Total surplus is the sum of consumer and producer surplus.

If the quantity produced decreases some units that before generated surplus cease to be produced there’s a reduction in total surplus:

If the quantity produced increases additional units are not valued highly enough to relative cost. There’s a reduction in total surplus:

- Market outcomes: From previous points we can conclude that free competitive markets

1) Assign the goods supplied to the buyers that value the most, which is measured by their willingness to pay.2) Assign the demand for the goods to the sellers that can produce at the lowest cost. 3) Induce a quantity of goods that maximizes the total sum of consumer and producer surplus.

- Criticism of maximisation of total surplus:Willingness to pay and marginal utility are not the same.Does a rich person get more joy out of a something just because they are willing to pay more for it?Consumers may not understand what they are buying. (Use of medication often decided by doctor, who may have other interests apart from patient welfare.)It’s possible to sell more units without any buyer paying more than they want to and without any seller selling below costs. (See exercise on problem set 1)

- Comparative statics: How does a change in the exogenous conditions in the model affect the equilibrium variables? For example, changes in consumer income, changes in technology, changes in the prices of substitute goods…

- Shifts of the curves versus movements along the curves: • A shift in the supply curve is called a change in supply.• A movement along a supply curve is called a change in the quantity supplied.• A shift in the demand curve is called a change in demand.• A movement along a demand curve is called a change in the quantity demanded.

- The changes in equilibrium: The three main steps to analyse changes in equilibrium are: 1) Determine if the change leads to a shift in the demand or supply curve (or both).2) Determine if the curve/s shift/s to the right or towards the left.3) Check if these shifts affect the equilibrium price and quantity.

How does an increase in the demand affect the equilibrium?

How does a decrease in supply affect the equilibrium?

What happens to price and quantity if the supply and demand shift?

- Summary: 1) What outcomes does the market produce?

• Market equilibrium• Excess supply or demand and the price mechanism

2) Are market outcomes “good”?• Pareto efficiency• Consumer surplus and producer surplus

3) Changes in equilibrium