Twelve key elements of economics

Common Sense EconomicsCommon Sense Economics

Twelve Key Elements of Economics

1) Incentives Matter.2) There is no such thing as a free lunch. (Milton

Friedman)3) Decisions are made at the margin.4) Trade promotes economic progress.5) Transaction costs are an obstacle to trade.6) Prices bring the choices of buyers and sellers

into balance.

Twelve Key Elements of EconomicsTwelve Key Elements of Economics

7) Profits direct businesses toward activities that increase wealth.

8) People earn income by helping others9) Production of goods and services people value, not just

jobs, provides the source of high living standards.10) Economic progress comes primarily through trade,

investment, better ways of doing things, and sound economic institutions.

11) The “invisible hand” of market prices directs buyers and sellers toward activities that promote general welfare.

12) Too often long-term consequences, or the secondary effects, of an action are ignored.

Twelve Key Elements of EconomicsTwelve Key Elements of Economics

• Economics rest on one simple principle– INCENTIVES MATTER!!!– What costs are associated with decisions?– How do you make decisions?– Why do you make those decisions?

Incentives MatterIncentives Matter

• Two Important functions of incentives are:1) To communicate information on the best things

to do and2) To motivate people to do them.


• How do incentives affect the market?– The Sellers

• An increase in price will cause an increase in amount supplied

– The Buyers• An decrease in price will cause an increase in amount

demanded


• Reality is… “resources are limited, while the human desire for goods and services is virtually unlimited.”– Scarcity is the condition in which human wants

are forever greater than the available supply of time, goods, and resources

• Since we face scarcity, then we must choose our resources wisely.

There is no such thing as a free lunchThere is no such thing as a free lunch

• Opportunity Cost– The best alternative sacrificed for a chosen action,

i.e. the next best alternative.– It is expressed in terms of the most valuable

alternative that is sacrificed.– What are some opportunity costs in your life?


• Example of Opportunity Cost• Please view the YouTube video:


• Decisions are made at the margin• Make choices where the benefits are greater

than the costs.– MB (marginal benefit) > MC (marginal cost)

• Choices are made at the margin.– They involve additions to, or subtractions from,

current conditions– Decisions are made by evaluating “marginal”

effects of change

Decisions are made at the marginDecisions are made at the margin

• Why would we trade?• Why do people agree to trade?

• They expect that it will improve their current situation

Trade Promotes Economic Progress


• Three Major Sources of Gains from trade:1) Trade moves goods from people who value them

less to people who value them more2) Trade makes larger outputs and consumption

levels possible because it allows each of us to specialize more fully in things that we do best.

3) Voluntary exchange makes it possible for lower per-unit costs by adopting mass production methods.



Number Two- How do we get larger outputs???

Number Two- How do we get larger outputs???

Specialize in the task that you do better Law of comparative advantage

Specialize in producing a good IFLower opportunity cost of producing it

Specialization and exchange Better off

Absolute advantage Use fewer resources But does not have the lowest opportunity cost

Law of Comparative Advantage


Example of Comparative and Absolute Advantage

Example of Comparative and Absolute Advantage

• It is about what productive actions you are giving up, not about how good you are at each action.– It is possible that you can be the best at both

goods, but we are interested in the foregone production that may be lost by you doing both actions.



Number Three- lower costsNumber Three- lower costs

• A larger size often allows for larger, more specialized machines and greater specialization of labor.

• A larger scale of operation allows a firm to use larger, more efficient machines to assign workers to more specialized tasks.

• Production techniques such as assembly lines can be introduced only if the rate of output is sufficiently large.

Economies of ScaleEconomies of Scale

Division of labor Specialization; Increased productivity

Individual preferences; natural ability Experience No need to shift between tasks Laborsaving machinery

Downside: Repetitive, tedious Routine tasks - robots

Division of LaborDivision of Labor

• Voluntary exchange promotes cooperation and helps us get more of what we want.

• Is trade costly?• Time, effort, and other resources • Transactions Costs.

Transaction Costs are an Obstacle to Trade

Transaction Costs are an Obstacle to Trade

Transactions Costs???Transactions Costs???

• How does the middlemen help?• Would you like to kill your own meat?• Knit your own sweaters??

• From the youtube video, what were the transaction costs?• Time!!!

Transaction Costs Are an Obstacle to Trade

Transaction Costs Are an Obstacle to Trade

• Market prices will influence the choices of both buyers and sellers

• What happens when the price of a good increases?• The buyer tends to buy less (known as the law of

demand)• The supplier tends to want more (known as the law of

supply)• We will discuss the law of demand and law of

supply in more detail later in the chapter

Prices Bring the Choices of Buyers and Sellers into Balance

Prices Bring the Choices of Buyers and Sellers into Balance

Read I, Pencil and watch the short video describing it!

This is what price does!!!

Read I, Pencil and watch the short video describing it!

This is what price does!!!

• When resources produce valuable good and services then people are better off.

• What does profit and losses tell us about how resources are allocated?• The higher the marginal value, the greater the

amount supplied.

Profits Direct Businesses Toward Activities That Increase Wealth

Profits Direct Businesses Toward Activities That Increase Wealth

• High earnings come from providing goods and services that others value.• How does Wal-mart help the average household?

• People seeking wealth notice people’s wants for goods and services.

• Read the article “Profit-Friend or Foe” to help understand this concept.

People Earn Income by Helping OthersPeople Earn Income by Helping Others

• Often government spending “crowds out” private spending and no net increase in employment is seen

Production of Goods and Services People Value, Not Just Jobs, Provides the Source of High Living

Standards

Production of Goods and Services People Value, Not Just Jobs, Provides the Source of High Living

Standards

• The article entitled “Profit, Friend or Foe” describes how the Key Points-7-9 relate to the economy.

• Please read the article!!

Summary of Key Points 7-9Summary of Key Points 7-9

• How does this happen?• Technological changes• Better machines, roads, and communication• Agricultural society, now service based

Economic Progress Comes Primarily Through Trade, Investment, Better Ways of Doing Things,

and Sound Economic Institutions



• What’s important:• Investments in productive assets and in the skills

of workers enhance our ability to produce goods and service.

• Improvements in Technology spur economic progress.

• Improvements in economic organization can promote growth.





• “Self-interest” will further the general prosperity of a community or nation. • How does this work?

• The “invisible hand” of market prices to promote the goals of others.

• “…Adam Smith contends that pursuing one’s own advantage creates an orderly society in which demands are routinely satisfied without a central plan.

The Invisible HandThe Invisible Hand

• The market price of a particular good or service provides buyers and sellers with what they need to know to bring their actions into harmony with the actions and preferences of others.

• What does the price tell about consumers and sellers?• Preferences, Sellers’ costs, location, and

circumstances in the market

The Invisible HandThe Invisible Hand

Discussion of Demand and SupplyDiscussion of Demand and Supply

The Law of Demand

• Law of Demand: the inverse ( or negative) relationship between the price of a good and the quantity consumers are willing to purchase, other things held constant (ceteris paribus). As the price of a good rises, consumers buy less.

The Law of DemandThe Law of Demand

The Law of Demand

• The demand curve allows you to find the quantity demanded by a buyer at different selling prices by moving along the curve

The Law of DemandThe Law of Demand

The Substitution Effect of a Price Change

• What explains this “Law of Demand?”– Lower Price= Greater Amount Consumer… Why?– Substitution effect: The consumer will substitute a

cheaper good for a more expensive good.

Substitution EffectSubstitution Effect

• Income Effect: A fall in the price of the good increases the consumers purchasing power.– The consumer can now buy more with NO change

in their income level.

Income EffectIncome Effect

The Demand

• Demand: a curve or schedule showing the various quantities of a product consumers are willing to purchase at possible prices during a specific period of time, other things held constant.– Demand is the quantity consumers are both

willing and able to buy at each possible price.

The Demand Schedule and Demand Curve

The Demand Schedule and Demand Curve

Market Demand ScheduleMarket Demand Schedule

• A demand schedule is simply a table listing the various quantities of something consumers are willing to purchase prices– Example of the demand schedule

Example of a Market ScheduleExample of a Market Schedule

• Demand of Hula Hoops

Price (in Dollars) Quantity Demanded (Hula Hoops)

$10.00 0

8.00 10

6.00 20

4.00 30

2.00 40

The Demand Curve Using the ScheduleThe Demand Curve Using the Schedule

• The demand curve is the plots of this table– Example of demand curve using the demand

schedule

Demand Curve of Hula Hoops

Price of the Hula Hoops (measured in dollars)

Quantity Demanded of Hula Hoops

Market Demand

• The transition from the individual to the market demand curve is done by totaling or summing the individual demand schedules (this is known as the horizontal summation of demand).– Example of horizontal summation

Horizontal Summation of Demand

+

= Market Demand of Hula Hoops

Market Demand of Hula Hoops

• The market demand of hula hoops, is the horizontal summation of the two individuals demand for hula hoops (i.e. the summation of quantity demanded at each individual price).

Market Demand of Hula Hoops

Price (measured in

dollars)

Quantity Demanded of Hula Hoops

Changes in demand vs. changes in quantity demanded

• A movement along the curve- CHANGES IN PRICE ONLY

• Changes in quantity demanded– Example of movement

Movement along the Curve

A movement from $8 to $6 represents an

increase in quantity demanded

A movement from $8 to $10 represents an decrease in

quantity demanded

The distinction between changes in Quantity Demanded and Changes in Demand

• Remember that price and quantity variables in our model are subject to the ceteris paribus assumption (other things held constant).– IT IS VERY IMPORTANT TO REMEMBER THE

FOLLOWING:– If you are dealing with price of the item it is a

movement along the curve, a change in quantity demanded not DEMAND, NO SHIFT!!!!!!

Shifts of the Demand Curve:1) Changes in consumer income

• Normal goods• Inferior goods

2) Changes in the price of a related good• Substitutes• Complements

3) Changes in expectations- prices, income, or availability of goods.

4) Changes in the number of consumers in the market5) Changes in consumer tastes and preferences

Examples

• Income– Normal goods: direct relationship– Inferior goods: inverse relationship

Changes in Demand

• Most of us would consider steak to be a normal good. Since, steak is a more expensive meat as income increases then more consumption of steak should occur.

• Thus, when consumer income increases, the demand for steak increases.

Normal Good

D1

D2

Inferior Goods

• However, we could argue that Ramon Noodles would be an inferior good, meaning as income increases then the demand for Ramon Noodles would decline.

• Thus, when income increases, then the demand of Ramon Noodles will decrease.– This would be a leftward shift of the demand

curve

Examples

• Related goods– Substitute good: if the price of the substitutable

good decreases, then demand decreases for the good of interest

– Complementary good: if the price of the complement good increases, then demand decreases for the good of interest.

Substitute goods

• Let’s assume that Pepsi and Coke are substitute goods for one another.

• If the price of Pepsi increases, then what happens to the demand of Coke?– The demand for Coke will increase, because now

consumers will substitute Coke for Pepsi

Graph of CokePrice

(measured in dollars)

Quantity Demanded of Coke (in millions)

D1

D2

Complementary Goods

• Complementary goods are goods that we buy together, I think it is safe to say that peanut butter and jelly are bought together.

• Thus, what would happen to the demand of jelly, if the price of peanut butter increased?– The demand for jelly would decrease.

• This is a leftward shift of the demand curve

Demand for Jelly

D1D2

Supply

• Supply indicates how much producers are willing and able to offer for sale per period at each possible price, other things held constant.

Law of Supply

• There is a direct (positive) relationship between the price of a good or service and the amount of it that suppliers are willing to produce.– Example of the supply curve– When price increases, then the amount supplied

will increase.– Why are sellers willing to sell more at a higher

price? Does this make sense?

Market Supply

• Again, it is the horizontal summation of the quantity produced by the sellers– Example of Horizontal Summation

Changes in Supply VS. Changes in Quantity Supplies

• Increase or decrease in the price of the good is a movement along the curve

• This is a change in “quantity supplied”– Example here

Shifts of the Supply Curve

1) Changes in Technology2) Changes in the Prices of Relevant resources

– Inputs into production.

3) Changes in the Price of Alternative Goods– Other goods that the producer could produce

4) Changes in Producer Expectations5) Changes in the Number of Producers

Markets

• A market is any arrangement in which buyers and sellers interact to determine the price and quantity of goods and services exchanged.– Markets reduce transaction costs

Market Equilibrium

• The market is where the buyers and sellers come together

• Equilibrium is no conflict between demand and supply– Quantity supplied= Quantity demand– Example of the equilibrium

• This is the theory of how the price system operates and it is the cornerstone of microeconomic analysis

Equilibrium in the Pizza Market

Millions of pizzas per Week

Price per

pizza

Quantity

Demanded

Quantity

Supplied

Surplus or

Shortage Effect on Price

$15

12

9

6

3

8

14

20

26

32

28

24

20

16

12

Surplus of 20

Surplus of 10

Equilibrium

Shortage of 10

Shortage of 20

Falls

Falls

Remains the same

Rises

Rises

(a) Market schedules

Exhibit 5(a)

Equilibrium in the Pizza Market(b) Market curves

S

24201614

Millions of pizzas per week

26 0

9

6

3

12

Pric

e pe

r pi

zza

$15

D

c

Shortage

SurplusMarket equilibrium occurs at:Price where QD=QS; Point c

Above the equilibrium price:QS>QD; Surplus; Downward pressure on P

Below the equilibrium price:QD>QS; Shortage; Upward pressure on P

Exhibit 5(b)

Economic Efficiency

• When a market reaches equilibrium, all the gains from trade between the buyer and seller have been fully realized and Economic efficiency is met

• When the short-term benefits are greater than the longer-term consequences.• Policy• Secondary Effects

Too Often Long-Term Consequences, or the Secondary Effects, of an Action Are IgnoredToo Often Long-Term Consequences, or the Secondary Effects, of an Action Are Ignored

Price Floors Set above equilibrium P Minimum selling P Surplus Distort markets Reduce economic welfare

Price FloorsPrice Floors

Price Ceilings Set below the equilibrium P Maximum selling P Shortage Distort markets Reduce economic welfare

Price CeilingsPrice Ceilings

Price Floors and Price Ceilings

Exhibit 11

S

D

(a) Price floor for milk (b) Price ceiling for rent

$2.50

1.90

Pric

e pe

r ga

llon

1914Millions of gallons per month

0 24

S

D

$1,000

600

Mon

thly

ren

tal p

rice

5040Thousands of rental units per month 0 60

Surplus

Shortage

No effect if price floor is

set at or below equilibrium P

No effect if price ceiling is

set at or above equilibrium P