Topic 3: Economic Principles

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Topic 3 Economic Principles
David Letson Marine Affairs/Economics University
of Miami
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Seven Principles of Economics

• People face tradeoffs.
• The cost of something is what you give up.
• People think at the margin.
• People respond to incentives rationally.
• Trade can make everyone better off.
• Markets are usually a good way to organize
  economic activity.
• Governments can sometimes improve market outcomes.

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Principle 1 Tradeoffs

• In a world of scarcity, every choice is a
  tradeoff.
• Scarcity exists whenever there is a limited
  availability of things that we want.
• Almost all resources can be used many different
  ways.
• Resources are factors of production that are used
  to produce the goods and services we want.
• Most resources can be put to only one use.
• Therefore, choosing to use a resource in a
  particular way means we have also chosen not to
  use it any other way.

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Principle 2 Opportunity Cost

• The cost of something is the value to you of what
  you must do without because you have to give up
  other things.
• The value of the things that you do without
  refers to opportunity cost.
• The opportunity cost of something is the highest
  valued alternative that has been given up.

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Principle 3 At the Margin

• Decision making takes place at the margin.
• The marginal costs and marginal benefits are the
  extra, or additional, costs and benefits.
• Decisions are rarely made on an all-or-nothing
  basis.
• Rather, we view our situation and decide to have
  a little more or less of something. Trial and
  error allows us to find optimal behavior.
• We constantly think about the marginal benefits
  from a little more or less of something and
  compare these benefits to their marginal costs.

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Principle 4 Rationality

• Incentives influence our behavior and choices.
• Incentives are changes in costs or benefits.
• To get the most from life, people respond in
  predictable ways to incentives.
• Incentives can be both monetary or nonmonetary.
• People are (fairly) rational.
• When benefits are increased (decreased), more
  (fewer) people will seek that activity.
• When costs are increased (decreased), fewer
  (more) people will seek that activity.

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Principle 5 Gains from Trade

• Voluntary exchange makes both parties to exchange
  better off.
• People have different tastes and preferences and
  incur different opportunity costs in the
  production of goods.
• Trade enables both parties to exchange goods of
  lesser value for goods they value more highly.
• The assumption that people behave rationally
  suggests that voluntary trade will not occur
  unless both parties expect to gain from the
  transaction.

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Principle 6 Markets

• Markets are an efficient way to organize economic
  activity.
• Efficiency is when something is produced at the
  lowest possible opportunity cost and it reaches
  those who value it most.
• Market prices reflect scarcity and provide
  important signals to potential traders about the
  perceived value of resources.
• These prices provide useful information about how
  resources should be used in order to satisfy
  peoples wants and needs.

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Markets

• A market is an institution, mechanism, or
  arrangement to facilitate the voluntary exchange
  of goods and services.
• Buyer and sellers are exchanging private goods.
• A place where traders can buy or sell goods and
  services.
• Competitive markets have many buyers and sellers,
  homogeneous products, and free entry and exit.

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Demand

• Demand is the amount of a good that buyers are
  willing and able to purchase at various prices.
• Law of Demand Other things equal, when the
  price of a good rises (falls), the quantity
  demanded of the good falls (rises).

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Demand Schedule
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Demand Curve
Price
Changes in price lead to changes in quantity
demanded.
D
Quantity
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Factors that affect demand

• Income normal and inferior goods
• Prices of related goods substitutes and
  complements
• Tastes and preferences
• Expectations
• Number of buyers

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Changes in Demand
Price
D1
Quantity
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Decrease in Demand
Price
D1
D2
Quantity
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Increase in Demand
Price
D1
D3
Quantity
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Supply

• Supply is the amount of a good that sellers are
  willing and able to make available for sale at
  various prices.
• Law of Supply Other things equal, when the
  price of a good rises (falls), the quantity
  supplied of the good rise (falls).

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Supply Schedule
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Supply Curve
Price
S
Changes in price lead to changes in quantity
supplied.
Quantity
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Factors that affect supply

• Resource prices
• Technology
• Expectations
• Number of sellers

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Changes in Supply
Price
S1
Quantity
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Decrease in Supply
Price
S1
S2
Quantity
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Increase in Supply
Price
S1
S3
Quantity
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Markets Supply and Demand Together
Price
S
D
Quantity
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Market Surplus
Price
S
P1
D
Quantity
surplus
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Market Shortage
Price
S
P2
D
Quantity
shortage
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Market Equilibrium
Price
S
P
D
Q
Quantity
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Decrease in Demand
Price
S
P2
D1
D2
Q2
Quantity
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Increase in Demand
Price
S
P3
D3
D1
Q3
Quantity
30
Decrease in Supply
Price
S2
S1
P4
D1
Q4
Quantity
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Increase in Supply
Price
S1
S3
P5
D1
Q5
Quantity
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Gains from Trade
? ACP is Consumer Surplus
Price
? BCP is Producer Surplus
A
S
C
P
D
B
Q
Quantity
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Elasticities

• How much would higher gasoline taxes reduce
  consumption?
• Q How responsive are Supply Demand to price
  changes?
• Available substitutes?
• Time to respond?
• Cost of good as a proportion of income?
• Permanence of the price change?
• Prices of complementary goods?
• Example of gasoline prices
• Prices rose 55 from Sept 2004-Sept 2005, yet
  consumption fell just 3.5.
• Prices rose 53 from 1998 to 2004, yet
  consumption rose 10.
• Big changes in income (up) and car prices (down)
  during these periods.

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Principle 7 Market Failures

• Sometimes government (nonmarket) action is
  necessary to improve market outcomes.
• People seldom take into account the costs and
  benefits their choices have on others.
• If there are substantial spillover benefits and
  costs, then there can be inefficiency when viewed
  from societys point of view.
• Spillover benefits and costs are those that
  affect others without compensation.
• In these cases, it may be possible for government
  to intervene and correct these inefficiences.

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Market Failure

• Private goods are excludable and rival.
• Excludability people can be prevented from
  using it.
• Rival one persons use diminishes another
  persons use
• Market outcomes are efficient when the good is
  private.
• Market outcomes are inefficient if the good is
  either a public good or a common property
  resources.
• Other examples of market failure are
  externalities and market power.

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Public Goods

• Public goods are neither excludable nor rival.
• Example the Coast Guard
• Since public goods are not excludable, it is
  possible for free riders to receive the benefit
  but not pay for it.
• If no one is forced to pay for the good, the
  market may not supply it since it would not be
  profitable for the seller.
• Government can solve the problem by providing for
  the good, paid for out of tax revenue.

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Common Property Resources

• A common property resource is a good that is not
  excludable but is rival.
• Government can solve problems created by
  non-excludability with regulation, taxes, and/or
  fees.
• Example the tragedy of the commons.
• There is a water body where fishers are free to
  catch all they can (nonexcludable).
• Eventually, as each additional fish is caught,
  there are fewer for others (rival).
• No individual angler has an incentive to reduce
  their catch of fish.

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Externalities

• Externalities are the uncompensated (spillover)
  effects (benefits or costs) that the production
  or consumption of goods have on third parties.
• Example Water Pollution. Business firms that
  discharge wastes into water reduce fish
  populations and hurt commercial and recreational
  fishers.
• Taxes, subsidies, and tradeable permits are
  economic incentive approaches that have been
  suggested to solve the externality problem.

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Seven Principles of Economics

• People face tradeoffs.
• The cost of something is what you give up.
• People think at the margin.
• People respond to incentives rationally.
• Trade can make everyone better off.
• Markets are usually a good way to organize
  economic activity.
• Governments can sometimes improve market outcomes.