Fundamentals of Economics

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Fundamentals of Economics

The focus of this lecture is the basic concepts of economics. Students will learn to
think like an economist by applying some economic models to practical examples.


OBJECTIVES

1. Define the term “Economics”

2. Explain the role of government in a mixed economy

3. Understand Production Possibility Frontier

4. Illustrate market equilibrium using supply and demand curves

5. Explain the relationship between market and aggregate supply and demand.


TOPICS

Please read all the following topics.


ECONOMIC ESSENTIALS

PRODUCTION POSSIBILITY FRONTIER


ECONOMIC SYSTEMS

INTERNATIONAL TRADE



DEMAND

SUPPLY

MARKET EQUILIBRIUM

Economic Essentials

Economics is a social science. It studies how to efficiently allocate the limited
resources to satisfy unlimited human wants. Since resources are scarce, but
wants are unlimited, we learn to make choices. When choices are made,
certain wants must be sacrificed. For example, when you decided to take this
class, you are prepared to give up some of your leisure time. The leisure time
you give up in order to finish this class plus what you would have otherwise
used the tuition money for is your opportunity cost for this class. Since every
one of you has decided to take this class, that means you valued the benefit of
this class more than the cost (which is the time you give up and what you
would have used the tuition money for). Economists are making wise choices
by comparing the extra benefit to the corresponding extra cost at each
decision. The extra benefit is called Marginal benefit (MB); the extra cost is
called Marginal cost (MC). You should only choose an item when its MB is
greater or equal to its MC.



Marginal Rule: MB> or = MC, then do it; MB < MC, then don’t do it.


Production Possibility Frontier

In any society, people have to deal with limited resources by
comparing their opportunity costs. If a country choose to produce
more weapons, then this country must give up some of the other
goods, say food. It is because resources like labor or capital must be
relocated to produce weapons. In other words, an economy
producing only weapons and food can only increase its weapons
output by reducing its food output. (Under the assumption of fixed
technological level, full employment and full efficiency).


The combinations of weapons and food can be illustrated by using
a production possibility frontier (PPF) or called production
possibility curve (PPC). Most of the PPF curves are concave due to
the inadaptability of the resources
. The law of increasing
opportunity cost states: as the production of one good rises, the
opportunity cost of producing that good increases. However, this
country can have more weapons and food at the same time by a)
improving its technological level, b) having economic growth, C)
trading with another country.


Production Possibility Frontier

PRODUCTION ALTERNATIVES

TYPE OF PRODUCTS

PIZZAS(in

thousands
)

ROBOTS

A

0

10

B

1

9

C

2

7

D

3

4

E

4

0

The PPC curve shown in the graph is constructed using
the above data. Assuming this country produced only two
products: pizzas and robots; this country's resources are
fixed in quantity and quality; this country's technology level
is fixed and production cost is at its minimum.


Every point on the curve is an
efficient

point. The purple
area is the
attainable

area where this country is capable
of reaching, but worse off than any point on the PPC. The
grey area is the
unattainable

area where this country is
not capable of reaching at this point, but the country will be
better off by moving into this area.

Economic Systems

Capitalism and socialism:


From the PPF, we understand that it is impossible to produce as much of every good as we might
want, so choices must be made. Different economic systems will make different choices. There are
two major economic systems: capitalism and socialism, but most countries use some combination
of the two known as a mixed economy.



In pure or laissez
-
faire capitalism, there is private ownership, and markets and prices coordinate
and direct economic activity. In socialism, there is public (state) ownership, and central
government planning coordinates economic activity. Socialists believe that government decision
makers are persons who promote the best interests of society as a whole and make every effort to
obtain the information needed to make the right decision. However, capitalists think that
government is more likely to respond to producers who have the political power to lobby congress
than to consumers who do not lobby. Central government planning may favor special

interest
groups at the expense of the rest of the society. Therefore, government’s role should be limited to
order maintenance. Pure capitalism is an abstract model. The economy is self
-
regulating.



The U.S. system is a mixed economy, but closer to pure capitalism. There are two major markets
(product and resources market), and three major sectors (household, business, government) in the
domestic economy.


In the product market,


goods and services are produced in the business
sector and sold to households. In return, businesses get revenue from the household as they pay
for the goods and services. In the resources market, resources are supplied by the households.
Businesses pay for the desired resources, which produce good and services. In return, households
get income, which they will use to pay for the goods and services. U.S. government collects taxes
from both sectors, buys goods and services from the businesses, pays for resources they
employed, provides services and will intervene by their policies according to different market
situations.

International Trade


From the PPF curve, we understand that trading can expand PPF outward.
Domestic trading is comparatively simpler than international trading. Since
different countries have different standards and regulations on various products,
exporters and importers have to learn to cope with them. International trading has
to involve customs, and quota, tariffs, and some other barriers limiting producers’
right.



A large number of producers are engaged in international trading because of the
comparative advantages. Look around your household, you probably have a lot of
imported items.



Why did you choose to buy foreign goods instead of


U.S. goods? The answer is
very simple: imports are cheaper. Producers decided to move production to other
countries for the same reason. Countries with abundant labor resources have
comparative advantage on labor intensive goods, such as clothing, shoes, and
most of the consumer goods. Therefore these countries will produce consumer
goods and export them to the U.S. The U.S. has comparative advantage on many
capital goods (tools and equipment used to produce consumer goods), therefore
the U.S. exports capital goods and imports consumer goods. Through international
trading, the PPF of U.S. can expand outward.

Demand

Demand


(D
) is a schedule that shows the various amounts of product consumers are willing and able to buy

at each specific price in a series of possible prices during a specified time period.

Quantity demanded

(
Qd
)
is the amount of a good or service that individuals are willing and able to buy

at a particular price at a particular time.


In another words, demand is the quantity demanded at all prices during a specific time period. A change in

price will change the quantity demanded, not the demand. Any other factors other than price change will

change the demand.


The law of demand:
As price of a good increases, the quantity demanded of the good falls, and as the price
of a good decreases, the quantity demanded of the good rises, ceteris paribus.

Restated: there is an inverse relationship between price (P) and quantity demanded (
Qd
).

Explanation of Law of Demand:

1.Substitution Effect
: As the price of product A increases, product A is comparatively more expensive than

product B if B's price remain constant. Therefore, consumers will substitute B for A, causing the

consumption of A to decrease.

2. Income Effect
: higher price will lower the consumption power of your income and decrease the

quantity demanded.

3. Law of diminishing marginal utility
: As a person consumes more of a good, the additional utility of


consuming more will eventually decreases. This means that to encourage additional consumption, price


must fall.


Demand Curve


It is the graphical of presentation of the relationship
between the quantity demanded of a good and the
price of the good. It is a downward sloping curve.



The demand curve shown here is drawn according
to the following data:



Price =P Quantity demanded=
Qd



P


$2


4


6




8


10


Qd

40


30


20


10


0



Price and quantity demanded are
negatively related.


Individual Demand Vs Market Demand:

Market demand is the summation of all of the individual demand curves for a particular item.


The transaction
from an individual to a market demand schedule is accomplished by summing individual quantities at various
price levels. Aggregate demand (AD) is not the same as market demand. AD is a schedule that shows the
various amount of real domestic output (GDP) which domestic and foreign buyers will desire to purchase at
each possible price level.



Determinants of Demand

When price changes, quantity demanded will change. That is a movement along the same demand curve. When
factors other than price changes, demand curve will shift. These are the determinants of the demand curve.


1
.

Incom
e
: A rise in a person’s income will lead to an increase in demand (shift demand curve to the right), a fall will
lead to a decrease in demand for normal goods. Goods whose demand varies inversely with income are called
inferior goods (e.g. Hamburger Helper).


2
.
Consumer Preferences
: Favorable change leads to an increase in demand, unfavorable change lead to a decrease.


3
.
Number of Buyers
:
the more buyers lead to an increase in demand; fewer buyers lead to decrease.


4.
Price of related good
s:

a. Substitute goods (those that can be used to replace each other): price of substitute and demand for the other
good are directly related.

Example: If the price of coffee rises, the demand for tea should increase.

b. Complement goods (those that can be used together): price of complement and demand for the other good are
inversely related.

Example: if the price of ice cream rises, the demand for ice
-
cream toppings will decrease.


5. Expectation of future
:

a. Future price: consumers’ current demand will increase if they expect higher future prices; their demand will
decrease if they expect lower future prices.

b. Future income: consumers’ current demand will increase if they expect higher future income; their demand will
decrease if they expect lower future income.



Review
:

A change in quantity demanded is caused by a change in its own price of the good.

A change in demand is caused by a change in determinants.


Supply




Supply (S) is a schedule, which shows amounts of a product a producer is willing and able
to produce and sell at each specific price in a series of possible prices during a specified
time period.


Quantity supplied (Qs) is the amount of a product that producers are willing and able to
produce and sell at a particular price at a particular time.

In another words, supply is the quantity supplied at all prices during a specific time period.
A change in price will change the quantity supplied, not the supply. Any other factors other
than price change will change the supply.


The law of supply

Law of supply states: As price of a good increases, the quantity supplied of the good rises,
and as the price of a good decreases, the quantity supplied of the good falls, ceteris paribus.

Restated: there is a direct relationship between price (P) and quantity supplied (Qs).


Explanation of Law of Supply

If the product cost is given, a higher price means greater profits and thus an incentive to
increase the quantity supplied.


Price and quantity supplied are directly related.

Supply Curve

Supply curve is the graphical representation of the

relationship between the quantity supplied of a good and

the price of the good. It is an upward sloping curve.


The supply curve shown here is drawn with


the following

Data: Price = P Quantity Supplied=Qs


P


$ 2


4


6


8


10

Qs


0


10


20


30


40




Price and quantity supplied are positively related.






Individual Firm’s Supply Vs Market Supply

Market supply is the summation of the individual firm’s entire supply curve for a
particular item. The transaction from an individual to a market supply schedule is
accomplished by summing individual firm’s quantities at various price levels.


Aggregate supply (AS) is not the same as market supply. AS is a schedule showing level
of GDP available at each possible price level.

Determinants of Supply


When price changes, quantity supplied will change. That is a movement along the same supply curve. When
factors other than price changes, supply curve will shift. Here are some determinants of the supply curve.



1. Production cost:

Since most private companies’ goal is profit maximization. Higher production cost will lower profit, thus hinder
supply. Factors affecting production cost are: input prices, wage rate, government regulation and taxes, etc.



2. Technology:

Technological improvements help reduce production cost and increase profit, thus stimulate higher supply.



3. Number of sellers:

More sellers in the market increase the market supply.



4. Expectation for future prices:

If producers expect future price to be higher, they will try to hold on to their inventories and offer the products
to the buyers in the future, thus they can capture the higher price.



Review
:

A change in quantity supplied is caused by a change in its own price of the good.

A change in supply is caused by a change in determinants.

Market Equilibrium

When the supply and demand curves intersect, the market is in equilibrium.


This is
where the quantity demanded and quantity supplied are equal.


The corresponding
price is the equilibrium price or market
-
clearing price, the quantity is the equilibrium
quantity.

Putting the supply and demand curves from
the previous sections together. These two
curves will intersect at


Price = $6, and Quantity = 20.




In this market, the equilibrium price is $6 per
unit, and equilibrium quantity is 20 units.


At this price level, market is in equilibrium.
Quantity supplied is equal to quantity
demanded ( Qs = Qd).



Market is clear.

Surplus and Shortage

If the market price is above the equilibrium price, quantity supplied is greater than quantity
demanded, creating a surplus.


Market price will fall.


Example: if you are the producer, you have a lot of excess inventory that cannot sell. Will you
put them on sale? It is most likely yes. Once you lower the price of your product, your
product’s quantity demanded will rise until equilibrium is reached. Therefore, surplus drives
price down.


If the market price is below the equilibrium price, quantity supplied is less than quantity
demanded, creating a shortage. The market is not clear. It is in shortage. Market price will rise
because of this shortage.


Example: if you are the producer, your product is always out of stock. Will you raise the price
to make more profit? Most for
-
profit firms will say yes. Once you raise the price of your
product, your product’s quantity demanded will drop until equilibrium is reached.


Therefore,
shortage drives price up.


If a surplus exist, price must fall in order to entice additional quantity demanded and reduce
quantity supplied until the surplus is eliminated.


If a shortage exists, price must rise in order
to entice additional supply and reduce quantity demanded until the shortage is eliminated.

Surplus and shortage

Government Regulations

Government regulations
will create surpluses and shortages in the market.


When a price ceiling is set,
there will be a shortage. When there is a price floor, there will be a surplus.


Price Floor
: is legally imposed
minimum

price on the market. Transactions
below

this price is prohibited.
Policy makers set floor price
above

the market equilibrium price which they believed is too low. Price
floors are most often placed on markets for goods that are an important source of income for the sellers,
such as labor market.

Price floor


generate
surpluses

on the market. Example: minimum wage.


Price Ceiling
: is legally imposed
maximum

price on the market. Transactions
above

this price is
prohibited. Policy makers set ceiling price
below

the market equilibrium price which they believed is too
high. Intention of price ceiling is keeping stuff affordable for poor people. Price ceiling generates
shortages

on the market. Example: Rent control.


If the market price (P) is higher than $6 (where
Qd

= Qs),

for example,


P=8, Qs=30, and
Qd
=10.

Since


Qs>Qd, there are excess quantity supplied


in the

market, the market is not clear. Market is in surplus.

THE PRICE WILL DROP BECAUSE OF THIS SURPLUS.

If the market price is lower than equilibrium price,


$6,

for example,


P=4, Qs=10, and
Qd
=30.

Since Qs<
Qd
, There are excess quantity demanded in the market.
Market is not clear. Market is in shortage
.


THE PRICE WILL RISE DUE TO THIS SHORTAGE

Changes in equilibrium price and quantity


Equilibrium price and quantity are determined by the intersection of supply and demand. A
change in supply, or demand, or both, will necessarily change the equilibrium price,
quantity or both. It is highly unlikely that the change in supply and demand perfectly offset
one another so that equilibrium remains the same.


Examples: These examples are based on the assumption of Ceteris Paribus.


1) If there is an exporter who is willing to export oranges from Florida to Asia, he will
increase the demand for Florida’s oranges. An increase in demand will create a shortage,
which increases the equilibrium price and equilibrium quantity.





2) If there is an importer who is willing to import oranges from Mexico to Florida, he will
increase the supply for Florida’s oranges. An increase in supply will create a surplus, which
lowers the equilibrium price and increase the equilibrium quantity.




3) What will happen if the exporter and importer enter the Florida’s orange market at the
same time? From the above analysis, we can tell that equilibrium quantity will be higher.
But the import and exporter’s impact on price is opposite. Therefore, the change in
equilibrium price cannot be determined unless more details are provided. Detail
information should include the exact quantity the exporter and importer is engaged in. By
comparing the quantity between importer and exporter, we can determine who has more
impact on the market.

Changes in Equilibrium Price and Quantity

In the first graph, supply is constant, demand increases. As the new
demand curve (Demand 2) has shown, the new curve is located on
the right hand side of the original demand curve.


The new curve intersects the original supply curve at a new point. At
this point, the equilibrium price (market price) is higher, and
equilibrium quantity is higher also.

In the second graph, demand is constant, and supply increases.
As the new supply curve (SUPPLY 2) has shown, the new curve
is located on the right side of the original supply curve.


The new curve intersects the original demand curve at a new
point. At this point, the equilibrium price (market price) is lower,
and the equilibrium quantity is higher.

In this last graph, the increased demand curve and
increased supply were drawn together.


The new
intersection point is located on the right hand side of the
original intersection point.