Essentials of Economics

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Essentials of Economics

• Business 502

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Contact

• Instructor Dr. Roger A. McCain
• Office 503 o Matheson Hall
• Best hours for contact MT 130-330 PM
• Phone [phone]
• E-mail mccainra_at_drexel.edu

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Textbook

• W. Baumol and A. Blinder, Economics Principles
  and Policy 11th Edition (Cengage, 2009).
• Optional McCain, Essential Principles of
  Economics, online at http//faculty.lebow.drexel.e
  du/mccainr/top/prin/txt/ecotoc.html

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Evaluation
Students will be evaluated mainly on the basis of
weekly quizzes and an examination. A 93 average
or better will assure you of an A, and an 80
average or better of a B. I will give
plusses but I do not give B-s in graduate
courses.
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What is Economics?

• Thats not as easy as you might think! Notice
  that the main text gives no definition -- only
  examples!
• I personally like Adam Smiths definition. He
  entitled his famous book An Inquiry Into the
  Nature and Causes of the Wealth of Nations
• For many economists, economics is the study of
  the allocation of resources. In this school of
  thought, economics is defined as "The study that
  considers human behavior as a relation between
  scarce means and alternative ends."

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Adam Smith
Adam Smith (1723-90) has been called both the
Adam and the Smith of modern economics. His
Wealth of Nations (1776), has been called
"the most successful not only of all books on
economics but, with the possible exception of
Darwin's Origin of Species, of all scientific
books that have appeared to this day. But no
woman, excepting his mother, ever played a role
in his existence.
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Some Examples

• Opportunity cost
• Trade is a win-win situation
• Thinking at the margin
• Externality
• Fiscal and Monetary Policy
• Labor productivity and growth

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Opportunity Cost

• In general, economists define the "opportunity
  cost" of any good or service as the value of all
  the other goods or services that we must give up
  in order to produce it.
• Some of the costs may not correspond exactly to
  money outlays.
• Consider, for example, taxi driver who is
• Self-employed
• Withdrew savings from his MM account to buy his
  cab
• All the same, his labor and capital are costs --
  opportunity costs.8

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Trade

• Countries trade by exporting the goods for which
  the opportunity cost is lowest in domestic
  production, and import goods for which the
  opportunity cost is highest.
• This is a win for both countries, as each gets
  its imports for a lower opportunity cost than
  they would give up in domestic production.
• This is called the principle of comparative
  advantage.
• We will go into it in more detail 10th week.

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Thinking at the Margin

• How much to charge for an empty seat on an
  airline?
• So long as the seat is empty, the cost of one
  more passenger -- the marginal cost -- is very
  low.
• Much less than average cost.
• So it will probably pay to sell one more seat,
  even at a discount.
• Thats why airlines practice price
  discrimination.
• (Lester Telser, of the University of Chicago,
  thinks thats why they keep going broke, too.)

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Externality

• People may not pay for the goods, services, and
  resources they use. for example, in Equador, the
  loggers polluted water and thus destroyed the
  businesses of the fish-farmers downstream. The
  loggers are using a resource they do not pay for
  -- fresh water -- and thus depriving the
  fish-farmers of it, even though (probably) the
  fish-farmers can make more effective use of it.
  In economics this sort of problem is called an
  "externality.
• In the presence of externalities, markets may
  create inefficiencies.

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Fiscal and Monetary Policy

• Capitalism has never existed without unemployment
  and fluctuations in production and employment.
• Most economists now recognize that government can
  take some steps to mitigate this problem --
  without actual nationalization, in many cases.
• The policies for this purpose are called fiscal
  and monetary policies.

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Productivity and Growth

• In the words of Adam Smith, it is growth of labor
  productivity that leads to that universal
  opulence which extends itself to the lowest ranks
  of the people.
• Unfortunately, we know a lot more about the
  consequences of labor productivity growth than
  about its causes and the means by which it might
  be promoted.

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Microeconomics and Macroeconomics

• In practice, the microeconomist studies the
  working of markets for particular goods and
  services, and the interdependencies among these,
  and the supplies and demands of individual
  enterprises and consumers. The macroeconomist
  studies phenomena which seem to affect or arise
  from the operation of the market system as a
  whole unemployment, inflation, the workings of
  the monetary system, and the determinants of
  economic growth.

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Example of Microeconomics

• In Seattle, Washington, there was an initiative
  in the early 00s to place a tax on espresso
  coffee drinks to finance preschool programs. (It
  was rejected by the electorate). Had it been
  passed, what would its impacts have been on
• prices and trading in espresso coffee?
• prices and trading in regular coffee?
• prices and trading in beer?
• Compared to other taxes (yielding the same
  revenue) would this proposal have been more or
  less inefficient?

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Example of Macroeconomics
Don't Worry About Inflation By FREDERIC S.
MISHKIN http//online.wsj.com/article/SB1221693365
38749851.html (2007) The Federal Reserve is
facing a major challenge because high commodity
prices, especially oil, have produced high
headline inflation. But the Fed should not
overreact. The outcome of such a policy would
be a more pronounced fall in inflation, with a
decline in employment. It would increase
volatility in inflation and employment, which is
the opposite of what a central bank should be
trying to achieve as it seeks to promote price
stability and maximum sustainable employment.
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Which is This?
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Schools of Thought

• Economists can be grouped by schools of thought
  -- groupings that stress the same principles and
  share theories -- as well as by specialization.
  Among the most important schools of thought are
• Neoclassical
• Keynesian
• Marxist
• Austrian
• For modern economics, the neoclassical school is
  the most important.

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Some Neoclassical Themes

• Neoclassical economists have been leaders in
  putting special stress on
• Rationality
• Models
• Scarcity
• as key aspects of economics.

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Rationality
Neoclassical economists usually assume that human
beings make the choices that give them the best
possible advantage, given the circumstances they
face. Circumstances include the prices of
resources, goods and services, limited income,
limited technology for transforming resources
into goods and services, and taxes, regulations,
and similar objective limitations on the choices
they may make.
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Rationality footnote
I should modify that a little right away.
Strictly speaking, neoclassical economics does
not assume that real, concrete human beings are
rational and self-interested. Rather, most
economists assume that economic systems work as
if they consisted of rational, self-interested
persons.
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Models
Economists rely on models to simplify the real
complexity of the economy. In economics, a model
is most likely to take the form of a list of
variables and one or more relationships among the
variables. These variables and relationships
describe the interdependence among the people and
activities in the economic system or subsystem,
and the way these activities change as time
passes.
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Model Footnote
The term "model" is sometimes used in two
different ways. The most common usage in
economics can be expressed as "a model of." This
is the usage just described a "model of" is
descriptive. However, we may also hear of a
"model for," as in "the economy of Taiwan
provides a model for all of China to emulate." In
economics, "model of" is the primary meaning, and
nothing more will be said here about "models
for."
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Idealization
This method ... idealizes. like the ideal
picture which the geographer draws in his map, as
a means not to deception but to more effective
guidance, he meanwhile assuming, that they who
are to profit by the map will know how to read
it, i.e. to interpret it in accordance with
nature. From The Austrian School and the
Theory of Value, by Friedrich von Wieser
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A Model Illustrating Scarcity
For our model, let us think of an economy that
produces just two kinds of goods "machines" and
food. At any given time, a country cannot produce
more machines without producing less of something
else. (In this case, the country produces less
food). Table 1 on the next slide shows, for the
model country, how much food they can produce
given each respective output of machines. For
example, to increase machine output from 7000 to
8000, they would have to cut food output from
1020 to 720.
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Production Possibilities for Machines and Food
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In Diagram Form
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Opportunity Cost
A key point here is the trade-off between
machines and food. Whenever we increase the
output of machines we must decrease the output
of food. This is a cost it is the "opportunity
cost" of the increase in production of machines.

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Opportunity Cost in the Example

• For example, going from 3000 to 4000 machines, we
  give up 1820-1680 140 carloads of food. This is
  the opportunity cost of the 1000 machines.
• Thus, the opportunity cost of one machine
  averages about 0.14 carloads of food over this
  range.

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Real Numbers
Here is the Production Possibility Frontier for
capital good (vertical) and consumption goods
(horizontal) for the United States in 1996.
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Summary of Model

• There is scarcity whenever we have to make a
  choice between different uses to which resources
  can be put
• Our limited resources and technology set a limit
  to how much of any good or service that we can
  produce, but we can still "trade off" one kind of
  good (food in the model) for another (machinery
  in the model)
• We can increase the production of one good only
  by diverting resources from another good, so that
  we suffer an "opportunity cost," that is, the
  loss of the opportunity to enjoy the other good.

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Positive versus normative economics
According to Milton Friedman, positive economics
has to do with "what is," while normative
economics has to do with "what ought to be."
Positive economics is a social science, and as
such is subject to the same checks on the basis
of evidence as any science. By contrast,
normative economics has a moral or ethical
aspect, and as such goes beyond what a science
can say.
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Critical Reasoning in Economics

• Like any profession, economics relies on critical
  reasoning, with its own emphases.
• Critical reasoning includes, for example, the
  avoidance of fallacies, that is, confused forms
  of reasoning.
• A fallacy that can be especially confusing in
  economics is the fallacy of composition, so it
  will serve well as an example.

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Example of the Fallacy

• If a tobacco company advertises, its sales will
  increase.
• All tobacco companies advertise.
• Therefore, prohibition of advertising would
  reduce sales of tobacco.
• BUT this assumes hat the tobacco industry as a
  whole sells more tobacco than it would sell in
  the absence of advertising. Taint necessarily
  so.

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Counterargument

• An individual company might be able to sell more
  by advertising and taking customers away from the
  other companies. But they all can't do that at
  the same time. It's possible that, when they all
  advertise, those advertisements just cancel out
  -- leaving the same total sales as before.

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Interim Conclusion

• This is a sampling of the kinds of data and
  pragmatic issues we are concerned with in
  economics.
• This course will attempt to survey both
  microeconomics and macroeconomics, with
  macroeconomics (mainly) first.

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Lets Take a Break!
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Exchange
As we have seen, one of the key words in
economics is "allocation." To allocate resources
is to determine who gets the use of what
resources.
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Allocation and Exchange

• An obvious case of allocation of resources is
  when the government decides who will get the use
  of the resources. But market processes of
  bidding, buying and selling can also determine
  who gets the use of what resources. That is, in
  effect, markets can allocate resources.
• Accordingly, economics is centrally concerned
  with the workings of markets, and with the
  question, how do markets allocate resources? One
  answer to that question is expressed in the
  familiar phrase, "Supply and Demand."

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Economists Are a Joke?

• A smarty-pants old story says that if you want a
  "learned economist," all you have to do is get a
  parrot and train the bird to squawk "supply and
  demand" in response to every question.
• Not fair, but ... It's true that the "theory of
  supply and demand" is a central part of
  economics. It is widely applicable, and also is a
  model of the way economists try to think most
  problems through, even when the theory of supply
  and demand is not applicable.

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Analysis of Markets

• The theory of supply and demand is a theory of
  price and output in competitive markets. We use
  the analytic approach
• demand
• supply
• equilibrium of demand and supply

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Demand

• Definition Demand
• Demand is the relationship between price and
  quantity demanded for a particular good and
  service in particular circumstances. For each
  price the demand relationship tells the quantity
  the buyers want to buy at that corresponding
  price. The quantity the buyers want to buy at a
  particular price is called the Quantity Demanded.

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Relationship

• A relationship such as demand can be expressed in
  at least three ways
• As a table of numbers showing prices and
  quantities demanded that correspond
• As a diagram
• As a mathematical equation or function.

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Demand Schedule Beer, 1960
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Demand Diagram for Beer
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Terminology
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The "Law of Demand"
Notice that, in this example, the demand curve is
downward sloping. That's a common-sense point
the higher the price, the less people will want
to buy. In this case, common-sense has it 100
right. Economists call this the Law of Demand
At a higher price, the quantity demanded will
be less, ceteris paribus.
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Footnote
"Ceteris paribus" is a Latin phrase often used by
economists, literally meaning "other things
equal." Used in the context of an economic model,
it means all the variables that might affect the
model are held constant unless we explicitly say
otherwise. Only the ones we say are changing are
allowed to change -- others are held steady by
assumption.
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Demand for Cigarettes
As an equation Qdabp
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Supply
We treat supply much as we do demand supply is
a relationship between the price and the quantity
supplied. Lets look at the supply of beer.
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Supply of Beer 1
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Supply of Beer 2
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Long and Short Run

• For supply, we need to distinguish between the
  long and short run
• In the short run the plant and equipment
  (productive capacity) of the industry are fixed
• In the long run sellers can change the productive
  capacity, in response to the price

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Equilibrium of Supply and Demand

• Equilibrium exists when the price is just high
  enough so that the quantity supplied just equals
  the quantity demanded.
• If we superimpose the demand curve and the supply
  curve in the same diagram, we can easily
  visualize this "equilibrium" price.
• It is the price at which the two curves or lines
  cross.

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Equilibrium of Estimated Supply and Demand for
Beer
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Excess Demand
With a price of 30, quantity supplied is 500,
while quantity demanded is about 1200.
Thus, demanders will compete against one another,
offering higher prices for the limited supply,
and the price will rise.
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Excess Supply
Quantity supplied is 2000 at a price of 40, while
quantity demanded is only 600.
Thus, suppliers will compete to sell what they
can by cutting the price.
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Forces Opposing Competition

• We have seen that competition forces the market
  into equilibrium. However, this might fail if
• There is only one seller or buyer, hence no
  competition
• Sellers or buyers agree ("conspire") not to
  compete in this way
• It is illegal to compete by offering a higher or
  lower price
• People are unable to compete by price offer --
  for example, they do not know who else buys or
  sells the item, or are unsure of the quality of
  the good or service offered by other traders.

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Change in Demand and Supply

• In order to use these concepts for practical
  purposes, we need to think about the ways in
  which demand and supply can change, and what
  happens when they do change.
• Remember that economists think of "a change in
  demand" as a shift of an entire demand curve.
• Likewise supply.
• By the way, always think of a shift in supply as
  "leftward" or "rightward," not "up" or "down."
  Thinking in terms of "up" and "down" will cause
  confusion!

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Shifts in Demand
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Shift Factors for Demand 1

• Here are some things that would cause the demand
  curve to shift
• A change in income for the average consumer.
• If an increase in income causes an increase in
  the demand for a particular good, that good is
  called a "normal" good. Example steak.
• If an increase in income causes a decrease in the
  demand for a particular good, that good is called
  an "inferior" good. Example red beans.

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Shift Factors for Demand 2

• A change in the population.
• Changes in the prices of other goods.
• Complements.
• Substitutes.
• Changes in consumer tastes.

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Changes of Supply
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Shift Factors for Supply

• Here are some things that would cause the supply
  curve to shift
• Changes in the prices of input goods.
• Labor
• Raw materials
• A change in technology.
• Changes in natural conditions.
• Rainfall
• Environmental Conditions

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A Change in Demand
In the early stages of industrialization, in
Britain, new jobs in industry made people better
off -- for the first time, they had enough money
income to buy food and improve their nutrition.
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A Change in Supply
Agriculture is very sensitive to the weather,
and bad weather can cause a reduction in the
supply of food from normal levels.
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The Incidence of an Excise Tax
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Subsidy 1

• Subsidy
• A subsidy is a payment from the government to a
  firm or individual in the private sector, usually
  on the condition that the person or firm that
  receives the subsidy produce or do something, or
  to increase the income of a poor person.

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Subsidy 2
In this example, we will look at the subsidy from
the point of view of the buyers. From their point
of view, the subsidy is an increase in supply.
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Summary
We have defined "demand" as a relation between
the price of the good and the quantity consumers
want to buy. Similarly, we have defined "supply"
as the relation between the price and the
quantity that producers want to sell. When we put
these two concepts together, we identify the
market "equilibrium" with the price and quantity
at the intersection of the demand and supply
relations -- that is, a price just high enough
that quantity demanded is equal to quantity
supplied, and the quantity corresponding to that
price.