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Chapter 1 What is Economics About

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Title: Chapter 1 What is Economics About


1
Chapter 1 What is Economics About
2
Definition of Economics
  • SCIENCE of how individuals and societies deal
    with the fact that wants are greater than
    resources available to satisfy those wants

3
Scarcity
  • Wants are greater than the resources available to
    fill those wants
  • What do you have scarcity of???
  • Money
  • Time
  • What do firms have scarcity of???
  • Labor
  • Land
  • Capital

4
Thus.Economics is the SCIENCE of SCARCITY

5
Normative vs. Positive Economics
  • Normative
  • What ought to be
  • Positive
  • What is

6
Examples Positive or Normative?
  • The government fought inflation during the early
    1980s because it felt the inflation was damaging
    potential long-term economic growth.
  • The government should cut taxes in order to
    stimulate consumption.
  • Increases in consumer spending improved the
    Japanese economy last year.
  • Balancing the federal budget would be good for
    the economy.

7
Micro vs. Macro
  • Microeconomics
  • Study of human behavior and choices
  • Looks at SMALL units (individual, market, single
    firm)
  • Macroeconomics
  • Study of human behavior and choices
  • Looks at LARGE units (aggregated markets, whole
    economy)

8
Economic Way of Thinking
  • Watch
  • An economist is someone that sees something
    working in practice and asks if it would would in
    principle
  • Think
  • Identify

9
Why Study Economics?
  • Social Problems
  • Discrimination
  • Crime
  • Understand why things happen
  • Coupons
  • Minimum Wage
  • Understand the Political Process

10
Homeworkdue Friday April 4th
  • Chapter 1
  • Questions 1 and 2

11
Beginning to Think Like an Economist
  • is this a good thing?

12
Defining Economic Goods
  • Utility
  • Satisfaction you receive from consuming a product
  • Good vs. Bad
  • Tangibility
  • Can the good be touched or is it a service?
  • Resources or factors of production used
  • Land natural resources
  • Labor Physical and mental talents of people
  • Capital produced goods that can be used as
    inputs for further production
  • Entrepreneurship talent of organizing
    resources, seeking new opportunities, and
    developing new ways of doing things

13
Remember Scarcity Runs the Show
  • What was scarcity??
  • Sohow do we make sure that only those who REALLY
    need the good get it??
  • Prices
  • System of rationing of the good
  • Cause people to compete for the item

14
Opportunity Cost
  • Value of the next best alternative foregone
  • Pizza vs CD
  • Pizza for 1.00 per slice CD for 15.00
  • Revolutionary War
  • The British and their red coats
  • Big Macs
  • Big Macs in Japan cost 8.25
  • Highway System
  • Paid for with taxes

15
Summary Statement of Scarcity and Related
Concepts
16
Costs and Benefits at the Margin
  • What is the margin??
  • The last or additional
  • Marginal Cost
  • The cost of the last unit employed
  • Marginal Benefits
  • The benefit of the last unit employed
  • Unintended effects
  • Minimum wage
  • Gun bounties
  • Seat belts

17
Efficiency
  • What is the right amount of time to study?
  • Right amount optimal or efficient amount
  • Marginal Costs Marginal Benefits

18
Economic way of thinking includes
  • Analyzing scarcity
  • Look at opportunity cost of decisions
  • Measure costs and benefits
  • Look at marginal effects
  • Examine unintended effects

19
Economic Thinking Errors
  • Association vs. Causation
  • You hit red lights because you are running late
  • Dont study for a test so you fail
  • Fallacy of Composition
  • What is good for the individual is good for the
    group
  • Forgetting Ceteris Paribus
  • All else remains constant

20
What is this?
21
Model
  • Simplified version of reality
  • Includes only the important aspects
  • Why is a model necessary??

22
Parts of a Theory
  • Variables
  • Magnitudes that can change
  • Assumptions
  • Ideas about event that will not allow to change
  • Hypothesis
  • Educated guess
  • Predictions
  • Based on hypothesis and assumptions

23
Scientific Approach
  • What do you want to predict/explain?
  • What variables are important?
  • State assumptions
  • State hypothesis
  • Test
  • If results are goodYeah You!!
  • If results are badamend or reject theory

24
Building and Testing a Theory
25
How do we judge theories?
  • Look at how well they predict
  • NOT by the assumptions
  • Example Firms try to maximize profits
  • Do they thing about this every second?
  • Probably not
  • Over the course of the yearmake decisions to
    maximize profits

26
Appendix A
  • Working with Diagrams

27
Types of Relationships between variables
  • Direct
  • Positive
  • Inverse
  • Negative
  • No Relationship
  • Variables are independent

28
Two-Variable Diagram Representing an Inverse
Relationship
29
Two-Variable Diagram Representing a Direct
Relationship
30
Two Diagrams Representing Independence between
Two Variables
31
Slope
  • Used to see how a variable changes in response to
    another variable changing

32
To calculate slope
  • Find two points on any straight line

33
What sign do you expect the slope to have?
  • Direct relationship
  • Positive
  • Inverse relationship
  • Negative
  • No Relationship
  • 0 or infinity

34
Calculating Slopes
35
Calculating Slopes
36
The 45 Line
37
Appendix B
  • Should you major in Economics??

38
Five myths about economics and an economics major
  • Economics is all mathematics and statistics
  • Economics is only about inflation, interest
    rates, unemployment, and other such things
  • People become economists only if they want to
    make money
  • Economics wasnt very interesting in high school,
    so it isnt going to be interesting now
  • Economics is a lot like business, but business is
    more marketable

39
Chapter 2 Economic Activities Producing and
Trading
40
Efficiency
  • Efficiency of Production is goal
  • If a firm is producing the max possible given
    available resources and technology

41
Production Possibility Frontier(PPF)
  • Shows all possible combinations of goods for a
    particular economy at a particular point in time,
    given its resources and technology constraints

42
Production Possibilities Frontier for Grades
43
Production Possibilities Frontier for Grades
44
Where are we on the PPF?
  • Can we be on the PPF?
  • Yes!
  • efficient
  • Can we be under the PPF?
  • Yes!
  • Inefficient
  • Can we be over the PPF?
  • NO

45
Two types of Production Possibility Frontiers
  • Constant Opportunity Costs
  • STRAIGHT LINE
  • DOWNWARD SLOPED (inverse relationship)
  • 1 to 1 relationship (slope constant)

46
Production Possibilities Frontier (Constant
Opportunity Costs)
47
Production Possibilities Frontier (Constant
Opportunity Costs)
48
Second Type of PPF
  • Changing Opportunity Costs
  • BOWED OUT PPF
  • Real world PPF
  • Changing slope with every point

49
Production Possibilities Frontier (Changing
Opportunity Costs)
50
Production Possibilities Frontier (Changing
Opportunity Costs)
51
Law of Increasing Opportunity Costs
  • Goes along with CHANGING OPPORTUNITY COSTS
  • As more of a good is produced the opportunity
    cost to produce that good increases.

52
A Summary Statement about Increasing Opportunity
Costs and a Production Possibilities Frontier
That Is Bowed Outward (Concave Downward)

53
Economic Concepts illustrated by PPF
  • Scarcity
  • Choice
  • Opportunity Costs
  • Law of Increasing Opportunity Costs

54
Examples of Law of Increasing Opportunity Costs
  • Armed Services
  • WWI, WWII and Korean War draft was irrelevant of
    job or education level Civil War education and
    job level mattered
  • Home Improvements
  • Swedish men make more improvements themselves
    compared to US men

55
Economic Growth
  • Increase in resources
  • Increase in technology
  • Shift of PPF outward

56
How would each of the following affect the US PPF?
  • A rise in the unemployment rate
  • The invention of the computer
  • An increase in the number of birth in the United
    States
  • An increase in the number of births in Russia

57
Economic Growth within a PPF Framework
58
Production Possibilities Frontier for Grades
59
Production Possibilities Frontier for Grades
60
More Hours of Study Shifts the Production
Possibilities Frontier
61
EfficiencyAgain
  • Produce max amount possible given resources and
    technology
  • ON PPF EFFICIENT
  • UNDER PPF INEFFICIENT
  • OVER PPF NOT POSSIBLE

62
Unemployment
  • Economy is not producing the maximum output given
    the resources and technology available
  • Efficient?
  • On, over, or under PPF?

63
Efficiency Criterion
  • Will alternate arrangements of resources or goods
    make at least one person better off without
    hurting someone else?
  • Yes? Inefficient
  • No? Efficient

64
Efficiency, Inefficiency, and Unemployment
Resources, within a PPF Framework
65
Trade or exchange
  • Process of giving up one thing for something else
  • Why would you trade?
  • Make yourself better off
  • Give up something that you value less for
    something you value more
  • Example a leather jacket is 100what does this
    show??
  • Value the 100 less than you value the jacket

66
Periods relevant to trade
  • Before the trade takes place
  • Ex ante
  • Decision takes place ? 2000 of other goods or
    the 2000 television set?
  • Which makes me better off?
  • At the point of the trade
  • The 2000 changing hands
  • After the trade
  • Ex post
  • No guarantee that trade will meet expectations
  • Buyers remorse

67
Benefits of Trade
  • Compare the consumers and producers point of
    views
  • Consumer Surplus
  • Maximum buying price price paid
  • Satisfaction gained by not having to pay as much
  • Producer Surplus
  • Price received minimum selling price
  • Satisfaction gained by getting more than
    anticipated for the good

68
Which makes you better off?
  • Increases in Consumer or Producer Surplus?
  • Consumer
  • Why?
  • Price that you pay will be lower

69
Terms of Trade
  • Trade is where things are given up to get
    something else
  • What things?
  • Money, goods, services
  • Terms of trade is how much is given up
  • Which part does buyers remorse fit into?
  • terms of trade
  • Where the money usually comes in

70
Costs of Trade
  • Transaction costs
  • Time and effort needed to search out, negotiate,
    and consummate a trade
  • May cause trades to not take place
  • Dont know about the good
  • Shipping costs are too high
  • Dont like to work with salesperson
  • Third-party effects
  • Impacts of trade on parties not immediately
    involved
  • Second hand smoke (negative externality)

71
Producing and trading
  • Two people Elizabeth and Brian
  • Each produce two goods Bread and Apples
  • Elizabeth ? 10 loaves of bread and 10 apples
  • Brian ? 5 loaves of bread and 15 apples

Elizabeth Apples Elizabeth Bread
20 0
10 10
0 20
Brian Apples Brian Bread
0 10
15 5
30 0
72
Comparative Advantage
  • Should both produce apples and bread or should
    they specialize?
  • What does specialize mean?
  • Produce the good that you do best
  • Produce at a lower costs than other person(s) can
  • Called comparative advantage
  • Looks at opportunity cost
  • What was that?
  • What you have to give up
  • Give up less?? Have the comparative advantage

73
What are the opportunity costs?
  • Elizabeth
  • If give up 10 apples how much more bread can she
    produce?
  • 10 units
  • If give up 10 loaves of bread how many more
    apples can she produce?
  • 10 units
  • Opportunity Costs
  • 10 Bread 10 Apples
  • 1 Bread 1 Apple

Elizabeth Apples Elizabeth Bread
20 0
10 10
0 20
74
What are the opportunity costs?
  • Brian
  • If give up 15 apples how much more bread can he
    produce?
  • 5 units
  • If give up 5 loaves of bread how many more apples
    can he produce?
  • 15 units
  • Opportunity Costs
  • 5 Bread 15 Apples
  • 1 Bread 3 Apples
  • 1/3 Bread 1 Apple

Brian Apples Brian Bread
0 10
15 5
30 0
75
Should we specialize?
  • Elizabeth
  • 1 Bread 1 Apple
  • Brian
  • 1 Bread 3 Apples
  • 1/3 Bread 1 Apple
  • Who produces apples cheaper?
  • What does cheaper mean?
  • Lower opportunity cost (give up less)
  • Brian!!! Give up only 1/3 loaves of bread
  • Who produces bread cheaper?
  • Elizabeth!!! Give up only 1 apple

76
Here is the deal
  • Elizabeth produces only bread (20 loaves)
  • Brian produces only apples (30 apples)
  • Trade 8 loaves of bread for 12 apples
  • Breakdown of end result
  • Elizabeth Bread?
  • 12 loaves (20 - 8 traded)
  • Elizabeth Apples?
  • 12 apples (0 12 traded)

77
  • Brian Bread
  • 8 loaves (0 8 traded)
  • Brian Apples
  • 18 apples (30 -12 traded)
  • Are they better off??

78
Are they better off??
No Specialization or Trade Specialization and Trade Gains from trade
Elizabeth Bread
Elizabeth Apples
Brian Bread
Brian Apples
79
Are they better off??
No Specialization or Trade Specialization and Trade Gains from trade
Elizabeth Bread 10
Elizabeth Apples 10
Brian Bread 5
Brian Apples 15
80
Are they better off??
No Specialization or Trade Specialization and Trade Gains from trade
Elizabeth Bread 10 12
Elizabeth Apples 10 12
Brian Bread 5 8
Brian Apples 15 18
81
Are they better off??
No Specialization or Trade Specialization and Trade Gains from trade
Elizabeth Bread 10 12 2
Elizabeth Apples 10 12 2
Brian Bread 5 8 3
Brian Apples 15 18 3
82
Are they better off??
No Specialization or Trade Specialization and Trade Gains from trade
Elizabeth Bread
Elizabeth Apples
Brian Bread
Brian Apples
83
Both are Better off!!

84
Economic System
  • The way in which a society decides to answer key
    economic questions
  • What goods will be produced?
  • How will the goods be produced?
  • For whom will the goods be produced?
  • Where on the PPF will the economy operate?
  • What is the nature of trade?
  • What function do prices serve?

85
Two major economic systems
  • Capitalism
  • An economic system based on private ownership of
    capital
  • Market economy
  • Socialism
  • An economic system based on state ownership of
    capital
  • Most use pieces of each ? mixed capitalism

86
How do they differ
  • PPF
  • Capitalist Buying behavior of consumers signal
    for producers to produce more/less
  • Socialist Government sets up how much to
    produce
  • What good to produce?
  • Capitalist Consumers and producers decide
  • Socialist Government decides

87
  • How goods will be produced?
  • Capitalist producers decide
  • Socialist government decides
  • For whom to produce?
  • Capitalist Consumers decide if they are able
    and willing to purchase the good
  • Socialist Government may redistribute funds to
    get certain people certain items
  • Trade
  • Capitalist view Trade benefits both sides
  • Socialist view Trade benefits one side at the
    expense of the other

88
  • Prices
  • Capitalism views
  • Rations goods and services
  • Conveys information
  • Serves as an incentive to respond to information
  • Socialism views
  • Price is set by greedy businesses with much
    economic power
  • Price controls (cant charge more or less than a
    certain price)

89
Now we want to use these questions for the next
chapter as we look at
  • What a market is and how is it established.

90
Chapter 3Supply, Demand Theory
91
Market
  • Market is an arrangement by which people exchange
    goods and services including money
  • Two sides
  • Buyer
  • Seller

92
Starting with the Buyer Side
  • Quantity demanded
  • Amount of a good people are willing and able to
    buy at a particular price at a particular point
    in time

93
Important parts of definition
  • Willing
  • Able
  • Particular Price
  • Particular point in time

94
Demand
  • Quantity demanded over all prices during a
    specific point in time
  • Important parts
  • Quantity demanded
  • All prices
  • Specific point in time

95
So.
  • So.

96
Who does what in the Market?
  • Consumers
  • Buy goods
  • Sell Labor
  • Firms
  • Sell goods
  • Buy Labor

97
Circular Flow
  • Depiction of how the market works in the economy
  • Includes both buyers and sellers
  • Shows the flow of goods and services between
    consumers and firms

98
(No Transcript)
99
Law of Demand
  • As price of a good (decreases) increases the
    Quantity demanded of that good (increases)
    decreases

100
Demand Schedule
  • Numerical table of quantity demanded at different
    prices

101
Demand Curve
  • Graphical representation of the demand schedule
  • Used to represent the relationship between price
    and quantity
  • Why type of relationship do you expect price and
    quantity to have?

102
Demand Schedule and Demand Curve
103
Market Demand Curves
  • Previous demand curve was for an individual
  • Single buyer
  • How can we get the market curve from individual
    demand curves?
  • All buyers
  • Sum the individual Demand curves

104
Therefore.

105
Deriving a Market Demand Schedule Curve
106
Deriving a Market Demand Schedule Curve
107
Determinants of Demand
  • Income
  • Normal good
  • Inferior good
  • Preferences
  • Prices of Related Goods
  • Substitutes
  • Compliments

108
Determinants Continued
  • Number of Buyers
  • Expectations of Future

109
Change in Demand vs. Change in Quantity Demanded
  • Change in Demand
  • SHIFT OF CURVE
  • Due to any non-price determinate
  • Change in Quantity demanded
  • MOVEMENT ON ORIGINAL CURVE
  • Due only to a change in price

110
Change in Demand versus Change in Quantity
Demanded
111
Change in Demand
  • SHIFT OF CURVE
  • SHIFT LEFT??
  • DECREASE IN DEMAND
  • SHIFT RIGHT??
  • INCREASE IN DEMAND

112
Shifts in the Demand Curve
113
Shifts in the Demand Curve
114
Change in price of related goods
  • Substitutes
  • Something used in replace of another good
  • Price of Coke increases...
  • Compliments
  • Something used with another good
  • Price of Tennis Rackets increase

115
Substitutes and Complements
116
Substitutes and Complements
117
SELF TEST-Do we understand??
  • Substitutes
  • Coke vs. Pepsi --- what happens if the price of
    Coke increases?
  • Qd of Pepsi?
  • NOTHING
  • Qd of Coke?
  • DECREASES
  • Demand for Coke?
  • NOTHING
  • Demand for Pepsi?
  • INCREASES

118
  • Compliments
  • Tennis Balls and Tennis Rackets --- what happens
    if the price of Tennis Rackets increase?
  • Qd of Tennis Balls?
  • NOTHING
  • Qd of Tennis Rackets?
  • DECREASES
  • Demand for Tennis Balls?
  • DECREASES
  • Demand for Tennis Rackets?
  • NOTHING

119
Examples
  • The housing market Consumers income increases
  • The sugar market Saccharine is found to lead to
    cancer
  • The jelly market The price of peanut butter
    increases
  • The beer market The price of beer decreases

120
Does the Law of Demand Hold?
  • The price of eating out increases from 10 to 15
    and the quantity demanded of restaurants
    increases from 10 to 14 meals.

121
The Law ofDemand Holds
122
The other sidesupply
  • Quantity supplied
  • Amount of a good that producers are willing and
    able to sell at a particular point in time at a
    particular price

123
Important Parts
  • Able
  • Willing
  • Particular price
  • Particular point in time

124
Supply
  • Quantity Supplied at all prices during a specific
    time period
  • Thus

125
Law of Supply
  • As the price of a good increases (decreases) the
    quantity supplied of that good increases
    (decreases)

126
Supply Schedule
  • Numerical table of quantity supplied at different
    prices

127
Supply Curve
  • Supply Curve
  • Graphical representation of the relationship
    between price and quantity supplied
  • What type of relationship do we have between
    price and quantity supplied?

128
Supply Curve Exhibit 7
129
Stuff continued
  • Change in supply
  • SHIFT OF SUPPLY CURVE
  • Change in quantity supplied
  • MOVEMENT ALONG ORIGINAL SUPPLY CURVE
  • Increase in supply --- shift right
  • Decrease in supply --- shift left

130
Change in Supply versus Change in Quantity
Supplied
131
Shifts in the Supply Curve
132
Shifts in the Supply Curve
133
Question???
  • Can the supply curve ever be vertical?
  • Firstwhat does a vertical curve indicate about
    the relationship between price and quantity
    supplied?

134
Supply Curves When There Is No Time to Produce
More or No More Can Be Produced
135
Determinants of Supply
  • Price of inputs
  • Technology
  • Number of sellers
  • Price expectations
  • Taxes and subsidies

136
Examples
  • The computer market The price of computer chips
    decreases
  • The fast food market McDonalds opens three new
    stores in Bakersfield
  • The pencil market The price of pencils
    increases
  • The gasoline market A tax is imposed on gas
    station owners for each gallon of gas pumped out
    of their station

137
Market Supply Curves
  • Previous supply curve was for an individual
  • Single seller
  • How can we get the market curve from individual
    supply curves?
  • All sellers
  • Sum the individual supply curves

138
Therefore.

139
Deriving a Market Supply Schedule Curve
140
Deriving a Market Supply Schedule Curve
141
Next Step.
  • Putting Supply and Demand Together

142
Auction Model
  • Can think of supply and demand as an
    auction where buyers bid the price down
    and sellers bid the price up until Qs and Qd
    are equal at the same price

143
But
  • There is only one price where QsQd
  • This is called the equilibrium price
  • The market is always working towards this price

144
Scissors and economics?
  • Alfred Marshall compared Supply and demand to a
    pair of scissors
  • It is impossible to say which blade is actually
    doing the cutting just like it is impossible to
    say whether demand or supply is responsible for
    the price

145
What determines the price?
  • The interaction of supply and demand

S
Price
D
Quantity
146
Equilibrium
  • Also called the market clearing price
  • When QsQd
  • Disequilibrium
  • When QsQd

147
At Disequilibrium can have
  • Shortage (excess demand)
  • Qd gt Qs
  • Price too low
  • Price must increase to rid shortage
  • Surplus (excess supply)
  • Qd lt Qs
  • Price too high
  • Price must decrease to rid surplus

148
Moving to Equilibrium
149
Moving to Equilibrium
  • If we have a surplus, price must _______ to get
    to equilibrium.
  • Decrease
  • If we have a shortage, price must _______ to get
    to equilibrium.
  • Increase

150
Do Shortage and Scarcity refer to the same
thing???
  • NO!!
  • Shortage is only when price is less than the
    equilibrium price
  • Scarcity is always present (at all prices)

151
Applications of Supply and Demand
  • Romanee-Conti Wine
  • Dated back to 1990 and sells for 800 a bottle or
    8 a sipwhy?
  • Ticket scalping
  • Why would people pay higher prices to see an
    event?
  • Prices must have been below equilibrium.
  • Freeway
  • Why would people be willing to pay a toll to use
    a road?

152
Remember..
  • Equilibrium price and quantity are determined by
    the INTERACTION of supply and demand
  • A change in supply, demand, or both will change
    the equilibrium price
  • Exception If supply and demand move in same
    direction and magnitude so changes are offset

153
Change in Supply and Demand but no change in
equilibrium price

Price
S
S'
P
D'
D
Q1
Q2
quantity
154
What Happens???
  • Increase D and S constant?
  • Decrease D and S constant?
  • D constant and increase S?
  • D constant and decrease S?
  • D increase and S decreases by equal amounts?
  • D decrease and S increases by equal amounts?
  • D increases more than S decreases?
  • D increases less than S decreases?

155
A Summary Exhibit of a Market
156
Price Controls
  • Produces a barrier to which the economy can no
    longer operate freely
  • Cant get to equilibrium price
  • Two types
  • Price ceiling
  • Price Floor

157
Price Ceiling
  • Government mandated maximum price above which
    legal trades cannot be made
  • Price ceiling is below equilibrium price.

158
Price Ceiling
159
Impacts of Price Ceilings
  • Shortage sustained
  • Fewer exchanges
  • Non-price rationing schemes
  • First come first served
  • Buying selling at prohibited prices
  • Black markets
  • Tie in Sales
  • Pay certain amount for rent of the house and an
    amount for renting the refrigerator
  • Distort normal economic information and
    incentives
  • Lower prices is supposed to mean greater
    availability

160
Price Floor
  • Government mandated minimum price below which
    legal trades cannot be made
  • Price floor is above equilibrium price

161
Price Floor
162
Impacts of Price Floors
  • Sustained surpluses
  • Fewer exchanges
  • Example Minimum wage

163
Minimum Wage
  • In California the minimum wage is 6.75 per hour
  • Increased from 6.26 on January 1, 2002
  • Government mandated minimum wage is 5.15
  • Last increase was on September 1, 1997

164
Impacts of Minimum Wage
  • Surplus of unskilled
  • Fewer workers overall employed
  • Supply and Demand would determine wage
  • Minimum wage doesnt guarantee better standards
    of living for low wage employees

165
Effects of the Minimum Wage
5.75
4.25
166
Chapter 5Elasticity
You are responsible for reading Chapter 4!!!
167
What have we done?
  • Chapter 3 gave us downward sloping demand curves
  • Law of demand
  • Now want to see how Qd changes when price changes

168
Elasticity
  • Response of one variable to a change in another
    variable
  • Price elasticity of demand
  • Measure of the responsiveness of Qd of a product
    to a change in the price of that product

169
or rewrite as
170
So
  • What if Ed 3?
  • If price was increased from the prevailing point
    the change in Qd would be 3 times the change in
    price
  • Shouldnt it be negative?
  • So price increases and Qd decreases?
  • Yes!!
  • For ease we look at the absolute value, but know
    that the law of demand holds

171
Point elasticity
  • Measures the change between two observed points.

172
example
  • P1 10
  • P2 12
  • Q1 100
  • Q2 50
  • Elasticity??
  • Which is Point A???
  • Big Problem!!!

173
Problem
  • Answers vary depending on where you start
  • Becomes more important the larger the change

174
Arc Elasticity
  • To avoid the endpoint problem take elasticity at
    the midpoint (average) of the two points

175
Differences
  • With arc elasticity it is clear which points are
    used
  • P1 is the first price
  • P2 is the second price
  • Qd1 and Qd2 are the first and second quantity
    demanded respectively

176
Price elasticity of demand can yield 5 basic
results
  • Numerator gt Denominator
  • Numerator lt Denominator
  • Numerator Denominator
  • Numerator 0
  • Denominator 0
  • Each has a specific name and result

177
Elastic Demand
  • Ed gt 1
  • change in quantity demanded gt change in price
  • FLATTER CURVE
  • What are some examples of an elastic good???

178
Inelastic Demand
  • Edlt1
  • change in the price gt percent change in
    quantity demanded
  • STEEPER CURVE
  • What are some examples of an inelastic good?

179
Price Elasticity of Demand
180
Unit Elastic Demand
  • Ed1
  • change in price change in quantity demanded
  • Change in price brings a proportionate change in
    quantity demanded
  • CURVE

181
Price Elasticity of Demand
182
Perfectly Elastic Demand
  • Ed (denominator 0)
  • change in quantity demanded is A LOT in
    response to a change in price
  • Price increases and quantity demanded goes to 0
  • Totally flat --- horizontal
  • Extreme
  • Examples???

183
Perfectly inelastic demand
  • Ed 0
  • change in quantity demanded DOESNT CHANGE in
    response to a change in price
  • Totally steep --- vertical
  • Extreme
  • Examples???

184
Price Elasticity of Demand
185
Arent demand curve downward sloping?
  • Because the extremes (perfectly inelastic and
    perfectly elastic) are not.
  • Use as points of reference only

186
How does a change in price affect Total Revenue
of a Firm?
  • Revenue depends on elasticity
  • Michael Jordan and Nike shoes
  • No substitutes -- inelastic demand
  • What happens to Qd if price increases?
  • Substitutes elastic demand
  • What happens to Qd if price increases?

187
What is total revenue??
  • Total revenue pricequantity
  • Firm uses to decide if to produce more or less

188
examples
  • Elastic demand
  • Price increase
  • Price decrease
  • Inelastic demand
  • Price increase
  • Price decrease
  • Unit elastic demand
  • Price increase
  • Price decrease

189
Elasticities, Price Changes, and Total Revenue
190
Important to look at because
  • Elasticity of the demand determines if with a
    price increase
  • Total revenue increases
  • Total revenue decreases
  • Total revenue remains the same

191
Price elasticity of demand and a straight line
  • Demand is downward sloping
  • Along the line elasticity varies from highly
    elastic to highly inelastic
  • Butremember SLOPE is constant

192
Point P Qd
A 8 3
B 7 4
C 6 5
D 5 6
E 4 7
F 3 8
G 2 9
P
A
B
C
D
E
F
G
Q
Find Total Revenue and Elasticity of Demand
193
Price Elasticity of Demand along a Demand Curve
194
Summary
  • Upper end of Demand Curve
  • Qd is low and price is high
  • One unit change in demand is much larger in terms
    of percent than change in price
  • Lower end of Demand Curve
  • Qd is high and price is low
  • One unit change in demand is much smaller in
    terms of percent than change in price

195
So
  • As move down the demand curve from higher prices
    to lower the price elasticity of demand goes from
    elastic to inelastic

196
Determinants of price elasticity of demand
  • Number of substitutes available
  • Increase substitutes increases elasticity
  • More narrowly defined goods have more substitutes
    (compared to broadly defined)
  • Example Fords vs all cars

197
More Determinants
  • Percentage of ones budget that is spent on the
    good
  • More expensive??? More elastic
  • More affected by price (even small changes)

198
Final Determinants
  • Amount of time that passed since price change
  • Increase time passed gives more opportunity to
    change behavior or react to price change
  • Overtime can look for substitutes
  • Increase time increases elasticity
  • More elastic in long term than short

199
Cross Elasticity of Demand
  • Measures the responsiveness of quantity demanded
    to a change in price of ANOTHER good

200
When would you use Cross Price Elasticity?
  • To determine if goods are substitutes or
    compliments
  • Ecgt0 substitutes
  • change in quantity demanded and price move in
    same direction
  • Eclt0 compliments
  • change in quantity demanded and price move in
    opposite directions
  • Ec0 goods unrelated

201
Income elasticity of demand
  • Measures the responsiveness of quantity demanded
    to the change in income

202
Why use income elasticity of demand?
  • Use to determine if a good is normal or inferior
  • Eygt0 normal good
  • As income increases Qd increases
  • Eylt0 inferior good
  • As income increases Qd decreases

203
Can also say
  • If Ey gt 1
  • change in Qd gt change in Y
  • Income elastic
  • If Ey lt 1
  • change in Qd lt change in Y
  • Income inelastic
  • If Ey 1
  • change in Qd change in Y
  • Income unit elastic

204
Can we use income elasticity in the real world??
  • If invest in the stock market do you want to
    invest in a normal or inferior good?
  • Normal
  • Why
  • Increase income would increase quantity bought
    and increase stock prices

205
Price Elasticity of Supply
  • Measures the responsiveness of quantity supplied
    of a good to the change in the price of that good

206
Classification is like demand
  • Es gt 1
  • Elastic
  • Es lt 1
  • Inelastic
  • Es 1
  • Unit elastic
  • Each of these will result in a normal upward
    sloped supply curve

207
Any extreme elasticities???
  • Yes!!
  • Es
  • Perfectly elastic or horizontal
  • Es 0
  • Perfectly inelastic or vertical

208
Price Elasticity of Supply
209
Price Elasticity of Supply
210
Price Elasticity of Supply
211
Does time play a role in elasticity of supply?
  • Yes!!
  • Overtime producers are able to adjust their
    behavior and production patterns
  • Supply becomes more elastic as time passes

212
Elasticity and taxes
  • If government levies a tax on a product who pays
    the tax??
  • Producers?? Consumers?? Share??
  • Depends on the elasticity of demand and supply

213
How find??
  • Find equilibrium price
  • Supply shifts left in the amount of the tax
  • Find new equilibrium
  • Find point of second equilibrium on ORGINAL
    supply curve
  • Shows the actual price realized by firm or
    equilibrium price tax point in question
  • Difference between points determines how much of
    tax you pay

214
Who Pays the Tax?
215
Who pays more of the tax??
  • Perfectly inelastic demand
  • Perfectly elastic demand
  • Demand more elastic than supply
  • Supply more elastic than demand

216
Different Elasticities and Who Pays the Tax
217
Summary
  • Ed gt Es producer bears most of the tax burden
  • Ed lt Es consumer bears most of the tax burden
  • Ed Es equally share the tax burden

218
Chapter 6Consumer Choice Maximizing Utility
and Behavioral Economics
219
Diamond-Water Paradox
  • Why is water (necessary to life) so cheep while a
    diamond (not necessary to life) is so expensive?

220
Two types of value for a good
  • Value of Exchange
  • Price
  • Utility
  • Satisfaction or wellbeing

221
How do you measure utility?
  • Construct an artificial measure called a UTIL
  • Remember we assume people are rational
  • What does it mean to be rational?
  • Will not consume a bad voluntarily
  • All consumed goods have utility or you would not
    consume it.

222
Total Utility
  • Amount of satisfaction or use value you receive
    from consuming a particular good
  • Thus

Total Utility
Utility gained from consuming each unit
223
Marginal Utility
  • Additional utility gained from consuming an
    additional unit of a good
  • Change in total utility brought about by the
    additional consumption

224
Thus

TU
Marginal Utility
Q
225
Calculate the Marginal Utility
Quantity Pizza Slices Total Utility
1 10
2 16
3 18
4 19
226
Law of Diminishing Marginal Utility
  • The more units of a good we consume during a
    period of time the less additional satisfaction
    we get from the additional units

227
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228
Does the law always hold?
  • Some goods have increasing MU initially then
    decreasing later, but the law says satisfaction
    should begin to decrease with the second unit
  • Tennis
  • As you get better you like it more, so the 10th
    game may be more enjoyable

229
Soften the Law
  • Principle of Diminishing Returns
  • For a given period of time the MU gained from
    consuming equal successive units of a good will
    eventually decline as the amount consumed
    increases.

230
Examples
  • Car rides
  • Fads
  • eating

231
Thusthe law says
  • At some point successive units of a good consumed
    by the SAME individual will become less valuable
    to that individual
  • What about to someone else or the interpersonal
    utility?
  • Cant do because we dont know with certainty
    another persons preferences

232
Example
  • Who would value a dollar more a poor person or
    a millionaire?
  • Money hungry millionaire?
  • Answer would be millionaire
  • Dollar is not much of a million
  • Answer would be a poor person
  • Dont guess at utility

233
Diamond-Water Paradox revisited
  • Goods have Total and Marginal Utility values
  • Water
  • TU?
  • High because need it to live
  • MU?
  • Low because it is plentiful and we consume it in
    large quantities

234
Diamond-Water Paradox continued
  • Diamonds
  • TU??
  • Low because not really necessary to live
  • MU??
  • High because very limited supply and consume in
    small quantities

235
Solution to Diamond-Water Paradox
  • Things with great value in use have little value
    in exchange
  • Those with little use value have higher exchange
    value
  • Prices (value of exchange) are most often
    determined by
  • Marginal Utility

236
Is gambling worth it?
  • If only want to win??? NO!!
  • If gain pleasure from the gambling process???
    YES!!

237
How do we compare MU of different units?
  • Example What is the MU of an apple vs. an
    orange?
  • Relative Marginal Utility of the good
  • MU per dollar of purchase price

238
Decision Making Process
  • If the MU of good A relative to its price is
    greater than the MU of good B relative to its
    price we should buy more of A and less of B
  • Compare of each good

239
Example
  • MUorange 30
  • MUapple 20
  • Income 20
  • Buy 10 oranges for 1 each and 10 apples for 1
    each
  • Good??

240
Not Good
  • We could do better by buying more oranges because
    per dollar it brings more satisfaction
  • Buy one more orange and one less apple increases
    TU
  • What happens to the MU of oranges?
  • Decreases MU of oranges
  • Why?
  • Diminishing MU when buy more
  • What happens to the MU of apples?
  • Increases MU of apples
  • Why?
  • Increasing MU when buy less
  • When do we stop?

241
Consumer Equilibrium
  • The combination of goods where our income cant
    be redirected to improve our situation
  • Therefore

242
ExamplePM2 Pc1 Income60

muffins MUM cookies MUc
5 11 44 6
6 8 46 5
7 6 48 4
8 3 50 3
243
What if the price of a good changes?
  • Must recalculate

244
Pa1Pb1? Pa0.50Pb1?Income 7.00

a MUa b MUB
1 12 1 22
2 11.5 2 20
3 11 3 18
4 10 4 16
5 9 5 14
6 8 6 12
7 7 7 10
245
Consumer Equilibrium and a Fall in Price
246
So
  • As price decreases relative MU increases so
    consumers buy more to gain consumer equilibrium
    again
  • Shows a negative relationship between price and
    amount people buy
  • JUST LIKE THE DEMAND CURVE

247
Do RATS understand the inverse relationship
between price and quantity?
  • Choice between two liquids
  • Root beer
  • Collins mix
  • Given 300 pushes (each liquid had a different
    number of pushes to get it price)
  • Found rats switched to the cheaper liquid when
    the price changed

248
Why isnt education and medical care free?
  • If cost 0 when do we stop using it?
  • When MU 0
  • Thus we will see a lot of frivolous use of
    programs. It costs you nothing so use it.

249
Consumer Surplus
  • The difference between the actual price buyers
    pay for a good and the maximum amount they are
    WILLING and ABLE to pay for it
  • Dollar measure of benefit gained from a price
    decrease

250
Consumer Surplus cont.
  • Triangle under the demand curve and above the
    equilibrium price out to the equilibrium quantity

251
Consumers' Surplus
252
Changes in Supply affect Consumer Surplus
  • Decrease in the number of sellers
  • Advance in technology
  • Increase in the price of relevant resources
  • A per-unit subsidy placed on producers/seller

253
Consumers' Surplus
254
Sales schemes
  • Consumer is willing to buy
  • One pair of shorts for 40
  • Second pair of shorts for 30
  • Store has a choice
  • Sell shorts for 30
  • Have sale where buy first for 40 get 10 off
    second pair?
  • Which has more CS??? (hint only use the demand
    curve)

255
Consumers Surplus and Two Pricing Schemes
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