Introduction to Economics

Introduction to Economics Two branches of economics 

Microeconomics: the behaviour of individual units o Rational decision-making of people and firms o Supply and demand

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Macroeconomics: the behaviour of the whole system o The activity of economic institutions, e.g. government o Measurement of a whole economy

Some key concepts The economic problem 

We have unlimited wants… but limited resources!

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This gives rise to constant scarcity. o Some kind of constraint on consumption is therefore required.

The market 

Markets bring together: o Individuals (who consume goods and services) o Firms (which sell goods and services)

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Under ideal conditions, the market produces and allocates goods and services efficiently (i.e. with minimal waste).

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The market appears to be so efficient at doing this that Adam Smith talked of an “invisible hand”. “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”

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The economy is made up of many interacting markets. Chemical extraction

Plastics Ink

Pens

Solvents Labour Books Dyes

Writers

Money 

Bartering has to get over the problem of the double coincidence of wants.

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The use of money overcomes this.

Types of economic system   

Planned Competitive / Market / Laissez-faire Mixed

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Government intervention can take many forms: o Ownership o Regulation o Taxation / subsidy

Tradeoffs 

Individual: o 15 minutes sleep or 15 minutes earlier to work o Economics class or lunch

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Societal: o Efficiency or equity o Health of education

Opportunity cost 

This is the cost of one activity considered in terms of the best alternative (which has to be foregone), e.g. buy a house, or put money in the bank

Decisions at the margin 

Marginal means (roughly) considering the effects of one more. o E.g. the marginal benefit of building a bridge is the extra benefit accrued just due to that extra bridge (i.e. not the average benefit).

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Diminishing marginal returns mean that we tend not to spend all our money on one thing. o E.g. you are much less likely to buy a chocolate bar if you have already eaten 3.

Rational Agency 

Both individuals and firms are rational, in theory. o Individuals seek to maximise utility. o Firms seek to maximise profits.

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Incentives can therefore affect people’s behaviour.

Supply and Demand Quantity 

Quantity demanded refers to the quantity that buyers are willing to purchase.

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Quantity supplied refers to the quantity of a good that sellers are willing to offer.

Determinants of demand      

Price of the product in question Price of competing products Consumer income Tastes Expectations Size of the market

The Law of Demand 

Ceteris paribus the quantity demanded of a good is inversely related to price. Price

Quantity demanded

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NB while economic examples are typically stated in terms of price affecting demand (and therefore you would expect price to be on the x-axis), in reality the variables are interdependent. High demand can have a price reducing effect(?)

Determinants of Supply     

Price of the product in question Input price Production technology Expectations Size of the market

The Law of Supply 

Ceteris paribus the quantity supplied of a good is rises with price. Price

Quantity supplied

Economic efficiency 

A system is Pareto-optimal when there is minimum waste, i.e.: o There is no redundant capacity: you can’t make anyone better off without making someone else worse off. o Productive and allocative efficiency come into this.

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Maximum efficiency may not always be desirable; e.g. it may cause gross inequality.

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Under normal conditions, the market should reach an equilibrium point of maximum efficiency.

Equilibrium of Supply and Demand The Equilibrium Point Price Supply curve

Equilib rium price Demand curve

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Quantity

Equilib rium quantit y equilibrium

When price and quantity reach this point, we say that the market has cleared. This equilibrium point is the point of maximum efficiency.

Changes in Supply and Demand   

Increased demand (e.g. ice-cream in the summer): the demand curve moves right. Increased supply (e.g. cheaper milk): the supply curve moves right. Normally, both curves will move at the same time (e.g. in a heatwave, higher demand will give rise to more production, but also higher maintenance cost of machines).

Price Distortion as a cause of inefficiency  

Artificially high prices (e.g. through purchase tax) mean that demand won’t meet supply because the price as perceived by producers and consumers will be different. This leads to inefficiency. Producers are producing less than is economical at a given price, and consumers are consuming less than is utility-optimal. Price Supply curve

Equilib rium price

Demand curve without tax Demand curve with tax

Equilib rium quantit y

Quantity

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An analogous effect is produced by price subsidy.

Elasticity Price Elasticity of demand 

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This means the extent to which the price of a good/service affects the quantity demanded. The more price-elastic it is, the greater the effect of price. o Price-elastic: all normal goods and most inferior goods o Price-inelastic: necessities, e.g. petrol For the purposes of raising revenue, it is clearly better to tax goods which are priceinelastic of demand. NB: Price Elasticity of demand is not the same as the slope of the demand curve. The technical definition of elasticity refers to percentage change => log-log relationship.

Income Elasticity of demand  

This means the extent to which consumer income affects demand for a good/service. You may imagine that the relationship is always a positive one, but it isn’t! o Positively (0-1) income-elastic: normal goods o Very positively (>1) income-elastic: luxury goods. As incomes rise, the demand for luxury goods increases disproportionately. o Negatively income-elastic: inferior goods. As incomes rise, demand switches to higher-quality goods.

Income and Substitution effects   

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These effects relate to individual preferences and how these relate to work and pay. Increasing someone’s salary can motivate them to: (i) work more hours (ii) work fewer hours Why? Let’s examine the two effects: o Substitution effect: an increase in pay causes an individual to work more hours, because their work is worth more (autrement dit the opportunity cost of leisure is higher). o Income effect: an increase in pay causes an individual to work fewer hours, because they have already reached their target level of income. It can be hard to tell which effect will predominate! Consider: Price (i.e. wages)

Supply curve

Incom e effect predo minant Substituti on effect predomin ant Demand curve Quantity (i.e. hours)

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We call this a backward-bending supply curve.