A Short Introduction to Economics

Economics: Part of Social Science
Economics is a social science, which analyzes people’s behavior in economy.

Three Main Branches in Economics

Microeconomics – Study of how households and firms make decisions and how they interact in specific markets
Ex) A microeconomist might study the effects of rent control on housing in New York City, the impact of foreign competition on the U.S. auto industry, or the effects of compulsory school attendance on workers’ earnings.

Macroeconomics – Study of economy-wide phenomena.
Ex) A macroeconomist might study the effects of borrowing by the federal government, the changes over time in the economy’s rate of unemployment, or alternative policies to raise growth in national living standards.

Econometrics – Study of statistical methods for analyses of micro and macro economic theories.

In this class, we study theories in Microeconomics.

What Is Scientific Method?

The scientific method: observation, theory, and more observation
In any science, interplay between theory and observation is important. An observation may motivate a scientist to develop a theory (like Newtown was motivated by his observation that an apple fall from an apple tree to develop a theory of gravity that applies not only to an apple falling to the earth but to any objects in the universe.) Then the theory must be confirmed whether it actually can explain the real world well by additional observations.
Ex) An economist might live in a country experiencing rapid increases in prices and be moved by this observation to develop a theory of inflation. To test this theory, the economist could collect and analyze data on prices and money from many different countries.

Differences between economics and other sciences
Experiments are often difficult in economics, which makes their tasks especially challenging. Physicists studying gravity can drop many objects in their laboratories to generate data to test their theories, but economists studying inflation are not allowed to manipulate a nation’s monetary policy.

The role of assumption and simplification
Like other sciences, economics also make appropriate assumptions and build simplified models in order to understand the world around them.
Ex) Economist sometimes make an extremely unrealistic assumptions such that the world consists of only two contries and that each country produces only two goods.

Examples of Economic Models

1st model: circular-flow diagram: A model that explains how the economy is organized and how participants in the economy interact with one another

Definition of circular-flow diagram: a visual model of the economy that shows how dollars flow through markets among households and firms.

1. There are two decision makers in the model: households and firms.
2. There are two markets: goods market and factor market.
3. Firms are sellers in the goods market and buyers in the factor market.
4. Households are buyers in the goods market and sellers in the factor market.
5. The inner loop represents the flows of inputs and outputs between households and firms.
6. The outer loop represents the flows of dollars between households and firms.

This diagram is a very simple model of the economy.
Note that it ignores the roles of government and international trade.

2nd model: production possibilities frontier: A graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

Suppose a country that produces two goods, cars and computers.
1. If all resources are devoted to producing cars, the economy can produce 1,000 cars and zero computers.
2. If all resources are devoted to producing computers, the economy can produce 3,000 computers and zero cars.
3. If resources are divided between the two industries, the feasible combinations of output are shown on the curve.

This country’s production possibility is given by the following figures.

Production is called efficient at points on the curve.
-This implies that the economy is getting all it can from the scarce resources available.

Production at a point inside the curve is called inefficient.

Production at a point outside of the curve is not possible given the economy’s current level
of resources and technology.

This figure illustrates some basic important economic concepts, such as scarcity, efficiency, tradeoffs, etc.
(Scarcity) Because the resource is scarce, we cannot produce the point D.
(Tradeoff) Suppose the economy is currently producing 600 cars and 2,200 computers.
To increase the production of cars to 700, the production of computers must fall to
2,000.

Economist As Policy Advisor
When an economist makes normative statements, he has crossed the line from scientist to policy advisor

Positive vs Normative Statements

Definition of positive statements:
Claims that attempt to describe the world as it is.
– A statement which is either true or false
Ex) Minimum-wage cause unemployment

Definition of normative statements:
Claims that attempt to prescribe how the world should be.
– A statement which is based on one’s value judgment
Ex) The government should raise the minimum wage.

Positive statements can be evaluated using data, while normative statements involve personal viewpoints.

THE THEORY OF CONSUMER BEHAVIOR

Basic Principles and Concepts in Economics

Scarcity:
Goods or resources are considered scarce if they are not available in sufficient quantity to satisfy everyone’s desires.

Scarcity implies we have to choose, and choice implies cost.
? Having more of one thing requires giving up something else.
Scarcity is a basic fact of life.

Marginal Value: People face tradeoffs and rational people think at the margin
Marginal Value of a good is the value we would be willing to pay to obtain an incremental amount of that good.
Ex) You may consume some steaks per month. You are willing to pay $10 for the first steak.
Suppose that you are also willing to pay $9 for the second steak, or additional steak.
The marginal value of the additional (second) steak is $9.

Law of Diminishing Marginal Value
For all individuals and all goods, the marginal value of goods decreases, as more of that good is consumed, holding other things constant.
Ex) (Continuation of steak example.) Suppose you’ve already purchased 2 steaks. You
may buy an additional steak, but would not be willing to pay as much as for the second
steak since you’ve already purchased enough; the value of the third steak for you would
be less than $9, say $8. Like this, the value of an additional good is decreasing as you
have more of that good. This is called law of diminishing marginal value.

Demand
The Demand Curve: The plots of the marginal values of a good (measured by money) versus quantities of that good, which expresses the relationship between price and quantity demanded.
Ex) Demand schedule for coffee
Price (P) $4.0 $3.0 $2.0 $1.5 $1.0
Quantity demanded (Q)

The Law of Demand: With other things equal, when the price of a good rises, the quantity demanded of the good falls. When the price falls, the quantity demanded rises.
? Thus, demand curve is negatively slopped
This is a corollary of the law of diminishing marginal value.

Market Demand vs. Individual Demand
The quantity demanded in a market is the sum of the quantities demanded by all the buyers at each price. Thus, the market demand curve is found by adding horizontally the individual demand curves

Ex) If there are only two consumers of coffee,
i) Demand schedule of Tom for coffee:
Price (P) $3.0 $2.5 $2.0 $1.5 $1.0
Quantity demanded (Q) 0 1 2 3 4
ii) Demand schedule of Mary for coffee:
Price (P) $3.0 $2.5 $2.0 $1.5 $1.0
Quantity demanded (Q) 1 2 3 4 5

Market Demand schedule
Price (P) $3.0 $2.5 $2.0 $1.5 $1.0
Quantity demanded (Q)

Factors influence demand other than its own price

Income, Prices of related goods, Tastes, Expectations, Number of buyers, etc.

Income: Increase (or decrease) in income will result in increase (or decrease) in consumption of a good.

Normal good: the demand for a good falls (increases) when income falls (increases)
Ex) Car, CDs, etc.

Inferior good: the demand for a good increases (falls) when income falls (increases)
Ex) Bus ride

Price of related goods: Price of other goods can influence the demand of a good.

Substitute: Goods that are similar in use or two goods that satisfy similar wants
Two goods for which an increase in the price of one leads to an increase in the demand for
the other
Ex) Coca cola vs. pepsi, coffee vs. tea,

Complements: Goods that tend to be used together
Two goods for which an increase in the price of one leads to a decrease in the demand for
the other
Ex) Coffee beans and coffee maker, or cars and gasoline

Q. Ketchup is a complement (as well as a condiment) for hot dogs. If the price of hot dogs rises, what happens to the market for ketchup? For tomatoes? For tomato juice? For orange juice?

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Details of Normal, Inferior, Substitute, and Complement Good.

PARAMETERS OF DEMAND (CURVE)
Demand curve expresses a relationship between prices of a good and quantities demanded at those prices. However demand would be affected by many other factors other than its own price, such as income and prices of other goods.

(For example, suppose that you occasionally go to a teriyaki restaurant, where you can eat chicken teriyaki, beef teriyaki, and pork teriyaki. It is natural to think that your demand for chicken teriyaki would depend on its own price; if its price is low you would eat it frequently and if the price is high, you rarely order it. But your demand for chicken teriyaki would also depends on other factors such as prices of beef teriyaki and pork teriyaki; if the price of pork teriyaki becomes lower you would reduce eating chicken teriyaki and eat pork teriyaki more frequently. These other factors affecting the demand for chicken teriyaki are called parameters of demand)

Definition: Normal good & inferior goods
If demand for one good increases (decreases) when the income increases, the good is called NORMAL GOOD (INFERIOR GOOD). That is

Normal goods: income ? ? Q ?
Inferior goods: income ? ? Q ?,

where Q represents the quantity of the good.
For example, beef teriyaki is a normal good for me; as my income goes up I will eat beef teriyaki more frequently. But it may be inferior good for someone else; as his income goes up he may reduce eating beef teriyaki but rather go to an expensive restaurant more frequently.

Another example of inferior goods may be bus ride. As you have more income, you may afford to buy a car, then your demand for bus ride would be reduced.

Definition: Substitutes
If an increase (decrease) in price of one good leads to an increase (decrease) in demand of other good, the former good is called SUBSTITUTE of the latter good.

Denote the price of good X by and the demand for good X by .
If X is a substitute of Y, then
? ? ?,
where denotes the demand of good Y

In teriyaki example, pork teriyaki would be a substitute of chicken teriyaki and vice verse.
Note: when ? the demand for X itself ? (The law of demand)

The definition of complements is just opposite to the definition of substitutes.

Definition: Complements
If X is a complement of Y, then
? ? ? or ? ? ?
How do we express changes in parameters on the demand diagram?
Suppose my demand curve for chicken teriyaki and pork teriyaki are given as follows, respectively. (For example here demand may be measured by the number of times that I eat chicken teriyaki per week)

How will this diagram change when the price of pork teriyaki goes up, say by $1?

When the price of pork teriyaki increases, we expect that the demand for pork teriyaki would be decreased by the law of demand.

(Demand for pork teriyaki)

The demand for pork teriyaki is decreased from 2 to 1.
This is the law of demand (increase in price causes in decrease in the demand.)

What about the demand for chicken teriyaki?
The demand for chicken teriyaki would increase since it is thought to be a substitute of pork teriyaki. The diagram would change like below.

Point: Price of chicken teriyaki does not change, but the demand increases (Shift of Demand Curve)

If the price of substitute of a good becomes higher, then we expect that the demand of the good will increase even the price of the good itself remains. To express this in the diagram, the demand curve shifts toward right.

Similarly suppose that chicken teriyaki is a normal good, then if my income goes up, what would happen to my demand curve on the diagram? It would be

So the demand curve would shit toward right (or upward).

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Difference Between Change of Quantity Demanded and Change of Demand

Change of quantity demanded: Change caused by its own price change
? Movement along the demand curve

Change of Demand: Change caused by factors other than its own price
? Shift of the demand curve

Ex: Two ways to reduce the quantity of smoking demanded
Public policy makers often want to reduce the amount that people smoke.
There are two ways for this objective:

1. Shift the demand curve for cigarettes and other tobacco products.
Ex) Mandatory health warnings on cigarette packages
? Reduce the quantity of cigarettes demanded at any given price.

2. Raise the price of cigarettes (movement along the demand curve.)
Ex) Tax manufacture of cigarettes
? Cigarette companies pass much of this tax on to consumers in the form of higher prices.
? Smokers will reduce the numbers of cigarettes they smoke.

How much does the amount of smoking respond to changes in the price of cigarettes?
Economists have found that a 10 percent increase in the price causes a 4 percent reduction in the quantity demanded. Teenagers are found to be sensitive to the price of cigarettes: A 10% increase in the price causes a 12% drop in teenagers’ cigarettes.

Total Value: sum of marginal values. On the demand diagram it is the area under the demand curve, that is,

This represents the total values of gaining D0 of this good.
Ex) Marginal value (MV) of the 1st steak is $10, MV of the second steak is $9, then total value of obtaining 2 steaks is $19. You are willing to pay $19 to get 2 steaks.

Consumer Surplus,
Suppose the actual price is given by $P0. The shaded area is called consumer surplus.

The consumer surplus represents the gains of consumers from purchasing D0 goods at price P0. It is given by total value (the total amount of money you are willing to pay) minus actual payment ($P0 �¯�¿�½ D0).
Ex) Suppose your MV of steaks are
$10 for the first steak
$ 9 for the second steak
$ 8 for the third steak
$ 7 for the fourth steak etc.
When the actual price of one steak is $8, you will purchase 3 steaks (why?.)
The consumer surplus of purchasing the steaks is
$(10+9+8) (Total Value of three steaks) – $ 8 (price) Ã?¯Ã?¿Ã?½ 3 (quantity) (Actual payments)
= $27 – $24 = $3
This amount is thought to be your gain from purchasing 3 steaks

Sample Question for Quiz1

A certain consumer is willing to pay $14 per month for 1 steak per month, $12 for the 2nd, $10 for the 3rd, etc. This same consumer is willing to pay $18 per month for 1 pizza per month, $15 for a 2nd, $12 for a 3rd, etc. This consumer’s preference is summarized in the following demand curve for steaks and pizza per month:
(Demand curve for steaks)
P($) 14 12 10 8 6 4 2 0
Q 1 2 3 4 5 6 7 8
(Demand curve for pizzas)
P($) 18 15 12 9 6 3 0
Q 1 2 3 4 5 6 7
The market price of steaks is $6. The market price of pizzas is also $6.

(1). How many steaks and pizzas does this consumer purchase per month, and how much
does she spend on each?

(2). Which good provides the consumer with the greatest net benefits? Would your answer
be the same if pizza costs $9?

(3) How much would this consumer have to be paid per month so that she would voluntarily
accept the higher price of $9 for pizza rather than the original price of $6?