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Economics First Summary

Terms in this set (51)

Scarcity (choice, and costs)
Something is scarce if we want more than is available and, as a consequence, possibilities are limited. Scarcity implies that individuals must make choices. In particular, scarcity forces each of us (1) to choose how we will allocate out time between leisure and works; (2) to choose the mix of things that we will consume; and (3) to choose between consumption now and consumption in the future.
Production Possibilities
An individual's production possibilities depend upon individual skill, the tools available to the individual, training and acquired skills, work effort, and the technology that combines ability, skills, tools, and resources. Because these differ for different individuals, individuals will typically have different opportunity costs.

The ability to produce, the possible choices, and their costs can be represented by a production possibilities frontier. A PPF indicates the maximum amount that can be produced of any particular mix of goods and services.
Scarcity (competition, and coordination)
Scarcity leads to competition among individuals. As a consequence, there is within any economy or society a coordination problem. In this regard, scarcity forces a group of individuals to ask (1) how they will coordinate their possibly competing interests, (2) how they will distribute things among themselves, (3) who will decide, and (4) how disputes will be settled.
Exchange and specialization
If individuals have different preferences, exchanging goods that they value less for goods that they value more increases the well-being of all parties to such exchanges. As long as individuals freely trade, exchange is guided by an invisible hand--both parties to the exchange will be better off. Thus, exchagne is a way of coordinating competing interests.

Exchange allow individuals to specialize. Specialization depends upon relative production costs: the cost to one person of producing something relative to the cost of producing the same thing to someone with whom the person might trade. That is, specialization depends on comparative advanatage. An individual has a comparative advantage in the production of a good if his or her relative costs of producing that good are lower than those of someone with whom the individual might trade.

Specialization consistent with comparative advantage will increase the amount of goods and services available to an economy without using additional resources. Hence, specialization coordinates competing interests in a useful and productive way. Moreover, the gains to an individual from specialization do not depend upon being absolutely better at some activity than other individuals. All that matters is that an individual be relatively better or have a comparative advantage. So long as individuals are different from one another, each will have a comparative advantage.

Exchange and specialization lead to a kind of spontaneous order, in which competing interests are cooridanted in ways that have the potential to beefit all participants.
Aggregate Production Possibilities
An aggregate production possibilities frontier represents the boundary between what an economy can produce, given its resources and available technologies, and what it simply does not have resources to produce. In this sense, an aggregate PPF represents the potential output mixes for an economy when its resources are fully and effectively employed, given the level of technological development of the economy (that is, producing efficiently)

Changes in either the resources or technologies available to an economy will change the economy's production possibilities. When more resources are available or when there are technologies that allow for more to be produced with a given level of resources, the economy's production possibilities will increase.
Relative Prices (and decentralized organization of economic activity)
Aggregate economic activity can be efficiently organized through decentralized individual responses to relative prices. That is, production on an aggregate PPF does not necessarily require centralized direction or control. Rather, individual, self-interested responses to relative prices can lead individuals to specialize in such a way that the economy spontaneously organizes itself and produces at its potential. Moreover, individual, self-interested responses to changes in relative prices can lead to a spontaneous reorganization of economic activity such that an economy produces at its potential, even though its output mix changes.
Increasing relative costs
Because resources are not equally effective in all uses, increasing the production of one commodity will become increasingly costly. That is, an aggregate PPF is generally characterized by increasing relative costs (bows outward) .
Relative prices (and distribution)
Changes in relative prices lead to changes in an economy's production mix. In addition, however, changes in relative prices often change the distribution of income and jobs within an economy. These changes will mater, as we will see later, in the development of public policies and pose important distributional and adjustment problems with which each society must deal.
Production mix (and economic growth)
Different production mixes will will matter not just in terms of their possible effects on the distribution of income but also because a society can influence its rate of growth by choosing to consume less than it produces (thereby, saving), using the remaining resources to build new capital, thereby increasing its aggregate production possibilities through time. The cost of greater potential output in the future is, however, less consumption in the present.
Property Rights (and incentives)
Economic activity can be effectively organized and the gains from exchange and specialization fully realized only if individuals have both present and future interests. Otherwise, resources will be used too intensively and there will be too little investment. Getting incentives right requires property rights, which include the right to exclude, the right to use with minimal restrictions, and the right to transfer.
Contracts
Economic activity can be effectively organized and the gains from exchange and specialization fully realized only if resources can easily move from lower-valued uses to higher-valued uses. Because some trades are complex, however, there is the possibility that the movement of resources from lower-valued to higher-valued uses may be undermined by opportunistic behavior. Hence, an economy has to develop institutional arrangements, rules and enforcement mechanisms that prevent or minimize opportunistic behavior. Chief among these are formal contracts enforceable in a judicial system.
Money
Economic activity can be effectively organized and the gains from exchange and specialization fully realized only if transaction costs, particularly those associated with the problem of coincident wants, are minimized. As a consequence, a commonly traded third commodity, money, has evolved in virtually every economy. Instead of trading goods for goods, individuals trade goods and resources for money and then trade money for goods and resources.
Firms
Teams are often more productive than individuals working alone. However, team production creates opportunities for individual workers to shirk. Shirking can be reduced, and the substantial gains from team production realized, if some people monitor the work effort of others. Since these monitors have, in turn, incentives to shirk ,firms are organized where there is a hierarchy of monitors. Thus, the typical pyramidal organization of a firm evolved to reduce or minimize the shirking problem. Likewise, the rich array of compensation schemes (e.g., wages, salaries, commissions, tips, bonuses, stock options, etc.) evolved as ways to eliminate or reduce the costs of shirking and monitoring.
Intermediaries
Intermediaries are individuals or firms that specialize in facilitating trades between other individuals or firms. Because intermediaries are specialists, the costs of trading through an intermediary are frequently lower than the costs of trading directly. Although intermediaries generally do not produce additional output, they increase individuals well-being by lowering the costs of transacting, thereby facilitating the movement of commodities from lower values to higher valued uses. In the important sense, intermediaries are productive.
Rational choice
While some choices may be based on tradition or others may be random, most choices are assumed to be purposeful or rational. To make rational choices individuals must

make informed comparisons
have consistent orderings
choose the most preferred or best option
Marginal Analysis
The marginal benefit associated with a choice is the additional benefit obtained by increasing the activity level a small amount. The marginal cost associated with a choice is the additional choice incurred when the activity level is increased by a small amount. Thus, marginal utility is the additional satisfaction obtained when consumption of some good or service is increased by a small amount. Similarly, marginal revenue is the additional revenue obtained by the sales some output are increased by a small amount.
(The best or) optimal choices
The best or optimal level of activity is where the marginal benefit associated with a particular choice is just equal to the marginal cost of the choice. When there are a number of different activities from which to choose, marginal opportunity costs must be considered. In this case, the best or optimal mix of choices is the one where the marginal benefit per additional dollar cost is the same over all choices made.

Best or optimal choices are unaffected by sunk costs. That is, the only things that can matter when trying to find the best or optimal choice are those that can actually be affected by the choice. As a consequence, past expenditure cannot matter.

In short, to optimize:
Equate the marginal benefit per additional dollar cost for each choice across all possible choices, and Ignore past expenditures or sunk costs.
Markets
Some individuals have money that they wish to exchange for goods, services, or resources; others have goods, services, or resources that they wish to exchange for money. The former are demanders; the latter, suppliers. A market is created when suppliers exchange with demanders. More formally, a market is a set of related transactions for a specific commodity, usually sing money as a medium of exchange.
Demand
Demanders, in general, will purchase more if the price is lower. The maximum amount that demanders wish to purchase at all possible market prices is the market demand. The quantity demanded, by contrast, is the amount that demanders are willing to purchase at a specific market price. Quantity demanded is inversely related to the relative price, ceteris paribus. This relationship is often called the First Law of Demand
Supply
Suppliers, in general, will provide more to a market if the price is higher. The maximum amount that suppliers wish to sell at all possible market prices is the market supply. The quantity supplied is the amount that suppliers will prove to the market at a specific market price. Quantity supplied is directly or positively related to the relative price, ceteris paribus.
(Demand, supply, and) equilibrium
If the quantity demanded is greater than the quantity supplied at a particular price, there is excess demand. If the quantity demanded is less than the quantity supplied at a particular price, however, there is excess supply. If the market price increaes when there is excess demand, and decreases when there is excess supply, a market coordinates the differing interests of demanders and suppliers. Specifically, the price moves to equate the quantity that suppliers willingly provide to the market with the quantity that demanders want to purchase. When the price is such that there is neither excess demand nor excess supply, the amount that demanders wish to purchase will be equal to the amount that suppliers wish to sell: the market is in equilibrium at that price.

Changes in the desires of either suppliers or demanders will lead to predictable changes in price:

1. An increase in demand, if nothing else happens, will lead to an increase in the market price.

2. An increase in supply if nothing else happens will lead to a decrease in the market price.

3. A decrease in demand, if nothing else happens, will lead to a decrease in the market price.

4. A decrease in supply, if nothing else happens, will lead to an increase in the market price.
Demand Change
Demand will change with changes in the following:

The income of demanders
The prices of other, related commodities
Transaction costs
Property rights
Expectations about the future
Population, and
Demander's preferences.
Supply Change
Supply will change with the following:
Changes in the prices of inputs
Technological innovations
Organizational innovations
Changes in the prices of other, related outputs
Changes in transaction costs
Changes in expectations about the future, and
Changes in the number or size of firms.
Price (and quantity demanded)
When the price of a commodity or activity increases, less will be demanded because individuals will substitute other commodities or activities for the one whose price has increased; conversely, when the price of a commodity or activity decreases, more will be demanded because individuals will substitute this commodity or activity for other things that have become relatively more expensive. Thus, there is an inverse relationship between relative price and quantity demanded. This is known as the First Law of Demand.
Substitution
Central to the inverse relationship between relative price and quantity demanded is the ability to substitute. Identifying some goods as substitutes may be obvious: Pepsi is a substitute for Coke, and vice versa. Some substitutes may be not as obvious: time devoted to planning shopping trips when the price of gasoline increases is a substitute for higher-priced gasoline. Or, perhaps, even more subtle: if expenditures on a wide variety of commodities are cut back when the price of a good that is more necessary increases in price, it implies that individuals are substituting as well.
Demand (two interpretations)
A demand schedule or demand curve can be interpreted in two ways. First, it represents the maximum quantity that demanders wish to purchase at each price. Second, it represents the maximum amount of money that individuals would be willing to pay for any additional amounts, given the current level of purchases.
Effects of change (other than price)
Anything that changes the environment within which individuals make decisions will also affect market demand. These include changes in individual incomes, changes in the prices of other goods, changes in the number of persons desiring to purchase some commodity, changes in transaction costs, changes in expectations, and changes in tastes or preferences. These changes will increase or decrease demand, shifting the demand curve either to the right or the left.
Substitution (and income effects of a price change)
A change in the relative price also changes the real income of consumers. For normal commodities, the substitution effect of a price change and the income effect of the real income change reinforce each other, leading to an inverse relationship between price and quantity demanded. For inferior commodities, however, the substitution effect and the income effect go in opposite directions. Thus, there will be an inverse relationship between price and quantity demanded for inferior goods only if the substitution effect is more important than the income effect. Empirical evidence suggests that this is so.
Elasticity of demand
The elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price. If the percentage change in quantity demanded is small relative to the percentage change in price, this ratio will be less than one and demand is said to be inelastic. If the percentage change in quantity demanded is large relative to the percentage change in price, the ratio will be greater than one and demand is said to be elastic.
Substitution
The price elasticity of demand reflects the responsiveness of quantity demanded to a change in the market price. Or, in other words, it reflects the ease of substitution of other things for the commodity whose price has changed. A high elasticity of demand indicates that there are many substitutes for a particular commodity; a low elasticity of demand indicates that substitution is more difficult.
(Elasticity of demand and) total expenditures
Total expenditures are equal to the market price multiplied by the amount bought and sold in the market. Changes in total expenditures when the market price chnages are closely related to the elasticity demand: if demand is elastic, total expenditures will increase when the price decrease and total expenditures will decrease when the price increases. If, however, demand is inelastic, total expenditures will move with the price change. If demand is elastic for a particular commodity, that is ed>1, total expenditures will move in a direction opposite to a price change. On the other hand, if demand is inelastic, that is e<1, total expenditures will move in the same directions as a price change.
Size (of the price elasticity)
The "size" of the elasticity of demand depends upon three things: (1) the ease of substitution, (2) the proportion of typical person's income spent on the commodity, and (3) the period of time since the price change. The elasticity of demand will be higher when substitution is easier, when expenditures on a particular commodity represent a larger fraction of a person's income; and when the period of adjustment to the price change is longer (the Second Law of Demand)
Income elasticity (and cross-price elasticity)
The concept of elasticity can be used to measure the responsiveness of demand to the change of anything that affects consumer's decisions. We considered two changes that affect consumers' decisions: (1) changes in income, and (2) changes in the prices of other commodities. The elasticity associated with the latter is called the cross-price elasticity of demand and for the former, the income elasticity of demand. A positive cross-price elasticity indicates that two commodities are substitutes; a negative cross-price elasticity indicates that two commodities are complements. The income elasticity of demand is positive for normal commodities and negative for inferior commodities.
Short run
A firm must often make short-run decisions about production without being able to change its capital stock. Because the capital stock in these circumstances is fixed, the firm finds that its marginal cost increase as it increases production and decrease as it decreases production.
Profits
Profits are total revenues minus total costs, where revenues are equal to the amount sold multiplied by the market price. Total costs are equal to the explicit and implicit costs of production, including the explicit costs associated with payments to input owners, the implicit costs associated with the use of previously purchased intermediate goods and resources, the value of depreciation, and the normal rate of return to the owners of the firm.
Perfectly Competitive Market
If a firm sells its output in a perfectly competitive market, then it will find that no decision it makes about how much to produce will affect the price at which it can sell its output.
Short-run (competitive supply for a firm)
When a firm finds its capital is fixed and that it sells in a competitive market, the marginal cost schedule (or curve) for the firm becomes the firm's short-run competitive supply schedule (or curve) as long as the market price is greater than average variable cost. If the market price is below the firm's average variable cost, the firm will shut down.

The output provided to the market (market supply) is the sum of the amount each competitive firm is willing to produce at each possible market price. Short-run competitive market supply is positively related to the market price--sloping upward to the right--because in the short run each firm will find that, as it attempts to increase production in response to higher market prices, marginal cost increases. Short-run market supply is also positively related to the market price because as the market price increases, firms that chose not to produce when the market price was below their average variable cost and left their capital idle, now find that it is once again profitable to use their capital. In doing so, they reenter the market.
Profits (losses and incentives)
If all firms in an industry earn economic profits, there will be incentive for new firms to enter the market and for existing firms to expand. Entry or expansion brings new capital to the market. If, on the other hand, most firms in an industry incur economic losses, there will be an incentive for existing firms to leave the market or to contract. Exit or contraction moves capital away from the market and toward other activities.
Long-run equilibrium
A market is in long-run equilibrium when the profits that any potential entering firm expects to earn are zero and when firms within the industry can expect to earn a normal rate of return. This means that a perfectly competitive market cannot be in long-run equilibrium unless any existing firm earns profits equal to what the owners of the firm's capital might earn if they used their capital elsewhere in the economy.
(The effects of) exit and entry
As firms exit or enter, the market supply changes. With entry and expansion, market supply increases, and the market price falls from its short-run level. With exit and contraction, market supply decreases, and the market price increases from its short-run level.
Long-run supply
The long-run supply curve is perfectly elastic if there are constant long-run costs; it slopes downward if there are decreasing long-run costs; and it slopes upward if there are increasing long-run costs. These correspond to constant returns to scale, increasing returns to scale, ad decreasing returns to scale, respectively. What the long-run supply curve for any particular industry looks like is an empirical matter that depends on the specific characteristics of that industry.
(the importance of) long-run adjustments
The important point of this chapter is that the market price can adjust so that the quantity supplied to the market is exactly equal to the quantity demanded--a short-run equilibrium--yet market adjustments continue. This is because profits and losses create incentives for additional market adjustments. If, at a short-run equilibrium, both old and new firms can expect to make profits, entry will occur and the market price will decline. Or if at a short-run equilibrium firms are incurring losses, they will exit as soon as they can dispose of their capital and the market price will increase. Thus, market prices will no longer change only when both the quantity supplied is exactly equal to the quantity demanded and expected profits are zero for any firm that enters or leaves the market. That is, a market is in long-run equilibrium only when supply is equal to demand and profits are zero.
Economic rents
If there are unique, scarce inputs whose supply cannot be easily increased and if there is competition for the use of these inputs, economic rents will be created. Generally, competition among firms employing these inputs will mean that the economic rents will go to the owners of the unique inputs.
Prices and Profits
Price ration scarce commodities among competing interests. Prices convey information. Prices and profits provide incentives to move or reallocate resources from activities of lesser value to activities of greater value, where value is determined by the willingness of individuals to pay. Prices and profits also link markets together through substitution and arbitrage.

Prices and profits coordinate competing interests also to allow an economy to capture the gains from specialization and exchange. In particular, competitive markets allocate goods and services to the highest-valued users and resources to their most productive use.
Allocative Efficiency
A market is allocatively efficient when the maximum amount that individuals are willing to pay for any additional production is equal to the marginal cost of producing any additional goods. Alternatively, a market is allocatively efficient when the sum of consumer plus producer surplus is maximized. Competitive markets are allocatively efficient.
(Other notions of) efficiency
Three additional notions of efficiency are important: adjustment efficiency, informational efficiency, and dynamic efficiency. For the first, the important question is whether markets adjust to changes and shocks more quickly than can alternatives. For the second, the important question is whether markets gather and transmit information about demands and supplies more quickly than can alternatives. For the third, the important question is whether markets stimulate and reward individual initiative to change and innovate.
(consumer and) producer surplus
Consumer surplus is the difference between the amount that individuals are willing to pay for what they currently purchase minus the amount that they actually have to pay. Because the market price is determined by the amount that individuals are willing to pay for the last or marginal unit purchased, markets create a consumer surplus.

Producer surplus is the difference between what firms receive for producing a certain output and what they would have been willing to receive and still make the same production decision. Because the market price is determined by the minimum price that firms must recieve to produce the last or marignal unit provided to the market, markets create a producers' surplus as well.

Competitive markets maximize the sum of consumer surplus plus producer surplus. Thus, given scarce resources, competitive markets make consumers and producers, taken together, as well as off possible.
Specialization (and comparative advantage)
If the price of a commodity is higher outside of an economy than inside, domestic firms have an incentive to export part or all of what they produce. Conversely, if the world price for a commodity is lower than the domestic price, individuals have an incentive to import part or all of what they consume. Responding to differences in prices will lead to nations to specialize consistent with comparative advantage. International trade and domestic specialization between economies consistent with comparative advantage increases the overall level of output available to each economy. These gains do not come without consequences, however. International trade and domestic specialization imply interdependence and integration in an international or global economy. In addition, since changes in relative prices sometimes alter the distribution of economic rewards within an economy and the allocation of jobs across an economy, international trade and domestic specialization will also have income distributional effects.
Exports and imports
Sales abroad by domestic firms are exports. Purchases abroad by domestic firms or individuals are imports. Exports from one country are imports to other countries with whom they trade. For a single economy, net exports are the difference between the value of its exports and the value of its imports. In symbols, net exports = x-m (where x is the "value of exports" and m is the "value of imports").
Markets (markets for foreign currencies)
because there is not a single currency that is accepted for transactions everywhere in the world, trade between nations leads to markets for foreign exchange in which individuals and firms buy and sell the currencies of other countries. The exchange rate is the price of one currency in terms of another currency. Exchange rates are determined by interactions of supply and demand in foreign exchange markets, although governments sometimes intervene to manipulate the foreign exchange value of their currencies.

Changes in the foreign exchange value of a currency change the price of imports from the perspective of domestic importers. Changes in the exchange rate also change the price of exports from the perspective of foreigners. More precisely, if the dollar appreciates relative to the yen, each dollar will purchase more yen. The prices of imports from Japan to the United States decrease from the perspective of US consumers and the prices of exports from the United States to Japan increase from the perspective of Japanese consumers. If the dollar purchases fewer yen (the dollar depreciates), the opposite occurs.
(Changes in) net exports
An appreciation of an economy's currency in foreign exchange markets will make its exports appear more costly to foreigners and, generally, its exports will fall. Also, as just noted, an appreciation also makes imports from abroad appear less costly to domestic citizens, and, as a consequence, imports will increase. The combined effects of an appreciation, then, is that net exports will fall. If a country has balanced trade--that is, net exports are zero--then it will find itself with a trade deficit (net exports will be less than zero). If a country has a trade surplus--that is, its net exports are positive--the effect of the appreciation will be to reduce the size of the surplus.

A depreciation of an economy's currency in foreign exchange markets will have the opposite effect: net exports will increase. In this case, an economy with balanced trade will find that now has a trade surplus; one with a trade deficit will find that the deficit falls or is eliminated.

It follows that if a country's currency appreciates when it is running a trade surplus, the appreciation will tend to eliminate the surplus and if depreciation occurs when there is a trade deficit, the depreciation will tend to eliminate the deficit. For this reason, net exports can be persistently different from zero (e.g., negative) only if individuals in one economy choose to hold the currency or assets of another economy.
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