Shreyas’ Notes

Principles of Economics

ECON 100

fall, freshman year

Economics: study of choice in a world of scarcity

three economic questions:

  1. what to produce
  2. how to produce
  3. for whom to produce

What is Microeconomics? §

individual choices

What is Macroeconomics? §

aggregate, economy-wide

why?

Mankiw’s Ten Principles §

People face trade-offs §

The cost of something is what you give up to get it §

Rational people think at the margin §

Rational people: People who systematically and purposefully do the best they can to achieve their objectives.

Marginal change: small, incremental change in a plan of action.

Rational people compare marginal cost to marginal benefit (profit|utility).

“diamonds vs water”

the more of something you have, the less utility one more unit of that is going to bring you

Compare present options independently of previous choices and losses/profits

Try to make marginal benefit = marginal cost.

People respond to incentives §

Incentive: marginal cost > or < than marginal benefit? Act accordingly.

How can international trade make us better off? Specialization.

Trade can make us all better off* §

Trade: both specialize, break production possibility frontier.

Absolute advantage: ability to produce a good using fewer inputs than another producer

Comparative advantage: ability to produce a good at a lower opportunity cost than another producer. Driving force of specialization.

Having absolute advantage in all goods doesn’t mean one can’t benefit from trade. Trade isn’t driven by absolute advantage.

Price of trade: For both parties to benefit from the trade, the price at which they trade must lie between the two opportunity costs.

  1. Different comparative advantages
  2. Specialize
  3. Trade
  4. Profit

Markets are usually a good way to organize an economy §

Market economy is an economy that allocates resources through the decentralized decisions of many firms/households as they interact in the markets for goods and services.

The Invisible Hand: the ability of free markets to produce desirable outcomes in spite of the self-interest of market participants

As opposed to central economic planning.

Govts can sometimes improve market outcomes §

“facillitate the Invisible Hand”: enforce rules, maintain institutions key to a market economy

facillitate equality.

efficiency/equality trade-off.


A country’s standard of living depends on its ability to produce goods and services §

Productivity: quanatity of goods and services produced fromo each unit of labor input. Depends on:

Price rises when the government prints too much money §

Inflation: increase in overall level of prices in the economy

Hyperinflation:

Society faces a short-run trade-off between inflation and unemployment §

Or does it?

Recession: “two consecutive quarters of negative GDP growth” —BEA

WR=WNPW^R = \frac{W^N}{P}. WNW^N is the nominal wage, PP is the avg price. WRW^R is the real wage.

Real wage >> Nominal wage

Nominal wages are sticky[1]. When prices increased, real wage decreases, marginal cost of labour decreases leading to more employment.

Stimulate employment growth by raising prices

Production Possibilities Frontier §

a graph that shows the combination of output that the economy can produce given the available resources and production tech

downward slope: trade-offs

production possibilities frontier:

opportunity cost of yy: how many xx do we have to give up to produce another yy

bowed out shape because of specialized factors of production[2]. good at making one, bad at another. specialized people taken away from their forte.

opportunity costs increase towards the extremes

Shifts in the frontier §

technological advancements.

more units of a commodity can be produced with the same resources.

graph changes shape. opportunity costs change.

a technological advancement in the production of xx:

Market forces, supply, demand §

Describe the relationship between prices, market demand, market supply

A market is a group of buyers and sellers for a good or service.

Buyers collectively determine demand

Sellers collectively determine supply

Assumption: Markets are perfectly competitive:

Buyers and sellers are price takers. Must accept the price the market determines.

Demand §

Demand: amount of goods buyers are willing and able to purchase.

Law of demand: when prices fall, quantity demanded rises (all other things equal)

Demand curve: Price on yy axis, Quantity Demanded on xx axis. Negative slope.

Demand shifts: translate the demand curve to the left or right.

causes of demand shifts:

Supply §

Quantity of a good that sellers are willing and able to sell

Law of supply: higher the price, higher the supply

Supply curve: Positive slope (Price vs Quantity)

Supply shifts: Increase in supply is rightward, Decrease in supply is leftward

If a firm is FACED WITH this potential price, how much output will it be able to and willing to sell?

Market Equilibrium §

Equilibrium: a situation in which the market price has reached the level where the \textrm{quantity_{supplied}} = \textrm{quantity_{demanded}}.

if price > equilibrium:
	supply > demand
	supply - demand: surplus

else if price < equilibrium:
	demand > supply
	demand - supply: shortage

Pressure towards equilibrium. Market forces. Adjustment. Equilibrium.

Shifts:

When both shift, magnitude.

No changes in supply Increase in supply Decrease in supply
No change in demand PP, QQ: same PP down, QQ up PP up, QQ down
Increase in demand PP, QQ: up PP ambiguous, QQ up PP up, QQ ambiguous
Decrease in demand PP, QQ: down PP down, QQ ambiguous PP ambiguous, QQ down

Elasticity and its applications §

Calculate and interpret elasticity coefficient

What is Elasticity? §

Elasticity: measure of the responsiveness of a quantity to a change in its determinants

Price elasticity of demand: a measure of how the quantity demanded responds to change in price

Inelastic: tough to ditch

Elastic: easy to ditch

Determinants of elasticity of demand:

when inelastic demand, raise price to raise revenue

when elastic demand, raise quantity to raise revenue

Price elasticity of demand §

\textrm{Price elasticity of demand} = \frac{\textrm{% change in demand quantity}}{\textrm{% change in price}}

Issue with this naive formula: elasticity from AA to BB is different from the elasticity from BB to AA according this formula. That’s false. Denominator is causing the trouble.

Price elasticity of demand=Q2Q1(Q1+Q2)/2P2P1(P1+P2)/2\textrm{Price elasticity of demand} = \frac{\frac{Q_2 - Q_1}{(Q_1 + Q_2)/2}}{\frac{P_2 - P_1}{(P_1 + P_2)/2}}

Midpoint method

Elasticity changes from region-to-region on the demand curve.

In the inelastic region:

In the elastic region:

Unit elastic is neither inelastic nor elastic. total revenue=constant\textrm{total revenue} = \textrm{constant}

Total revenue: price×quantity\textrm{price} \times \textrm{quantity}

Constant slope but different elasticity? Elasticity depends on percentages. Different denominators.

Other demand factors §

Supply, demand, govt policies §

Price ceiling §

Make something more affordable

Effective only when below the equilibrium price. Creates a shortage (demand > supply)

non-binding (above EP) vs binding (below EP)

short-run/long-run effects may differ.

Price floors §

Goods market: households demand, firms supply

Labor market: firms demand, households supply

If minimum wage is above the equilibrium wage, unemployment (labor surplus)

Taxes §

Who pays? How much?

Cause change in behaviour.

Goods market §

tax on seller: leftward shift in supply curve: upward shift in prices, seller receives lower: tax wedge. passed-on from seller to buyer

tax on buyer: leftward shift in demand curve: lower prices. passed-on from buyer to seller.

tax=pricebuyers paypricesellers receive\textrm{tax} = \textrm{price}_{\textrm{buyers pay}} - \textrm{price}_{\textrm{sellers receive}}

Labor market §

flipped: firms demand, households supply

tax=wagefirms paywageworkers receive\textrm{tax} = \textrm{wage}_{\textrm{firms pay}} - \textrm{wage}_{\textrm{workers receive}}

Always split regardless of who is taxed.

Tax incidence is the manner in which the burden of tax is shared among participants. Doesn’t depend on who is taxed.

Whoever has the (relatively) less elastic curve, pays more of the tax:

Whoever is more desperate pays more of the tax

Consumers, producers, and efficiency of markets §

consoooom product

wtf is market efficiency

Welfare economics §

welfare economics: study of how the allocation of resources affects economic well-being

maximize total surplus

consumer surplus: max willing to pay - actually pay

consumer surplus1price\textrm{consumer surplus} \propto \frac{1}{\textrm{price}}

producer surplus: amount received by sellers - cost to sellers

profit = producer surplus - fixed cost[3]

producer surplusprice\textrm{producer surplus} \propto \textrm{price}


peak stonks (maximum total surplus) when consumer surplus = producer surplus

total surplus: consumer surplus - producer surplus

value to buyers - cost to sellers

“value to the marginal buyer = cost to the marginal seller” s/marginal/next/g

social planners may care about more than just efficiency (i.e. equality). economists are cold number-crunchers tho

deadweight loss (DWL): [inefficiency]. surplus we lose that we do not get back as tax revenue.

some people who value the product more than its price aren’t in the market anymore because of the tax wedge. DWL region.

when a tax is levied, the more elastic the S/D curves:

if the curves are more elastic, then it’ll be easier for people to move to a different market, so the deadweight loss will be greater, and because of that, the tax revenue will be smaller

—Alia

DWLtax size2\textrm{DWL} \propto \textrm{tax size}^2

Tax revenue first increases, reaches a max, then decreases with increase in tax size.

Wellbeing through trade §

Exporter §

World price is higher than the domestic price.

Increase the price.

Consumer surplus decreases, producer surplus increases[4].

supply - demand exported.

Importer §

World price is lower than the domestic price.

Reduce prices

Consumer surplus increases[5], producer surplus decreases

demand - supply imported


In both cases, total surplus increases.

Tariff: tax on imported goods

After tariffs: producers 📈, but consumers 📉

tax revenue, deadweight loss.

Other benefits of trade §

Arguments for restricting trade §

Externalities, public goods, common resources §

effects of externalities, related policies, relation to different types of goods.

externalities: uncompensated impact of one’s actions on the well-being of a bystander. e.g. pollution.

producers don’t consider externalities in their decision.

public policy

market forces don’t account for externalities. social cost may be higher than market cost (social optimum quantity less than the market optimum quantity). “invisible hand needs guidance”

“make the private market internalize the externality”

DWL becomes social benefit.

want the tax to equal the external cost.

Subsidies §

Tradable pollution permits §

When optimal level known.

Types of goods §

Public goods and common resources §

public goods: usually related to positive externalities. people receive sth without paying for it.

common resources: associated with negative externalities. tragedy of the commons. sustainability issues.

role for govt. encourage/discourage behaviors with taxes/subsidies.

free rider problem with public goods. person who receives benefits of a good but avoid paying for it. social value > private value. taxes, subsidies.

public goods:

common resources:

Coase theorem: as long as bargaining costs are low, property rights to one party will solve the externality problem (regardless of who has the property rights)L

in the absence of govt:

Costs of production §

Total revenue, cost, profit §

profits:

profit=revenuecost\mathrm{profit} = \mathrm{revenue} - \mathrm{cost}

costs:

accountants: only explicit cash flows.

economists: indirect opportunity costs too. about decision-making. include implicit costs.

economic profit: total revenue minus total cost. accounting profit: total revenue minus explicit cost.

Types of costs §

fixed costs: costs that don’t vary with quantity

variable costs: costs that vary with quantity


average variable cost rises midway due to diminishing marginal returns.

marginal cost: change in variable cost

Average cost §

Efficient scale: intersection of ATC and MC

Rising marginal costs §

…because of diminishing returns. Size of increases gets smaller as quantity increases.

Cost curves §

Why is ATC U-shaped?

at low Q, AFC is rel. high and AVC is rel. low

initially, ATC declines because AFC decreases faster than AVC increases

then, ATC increases because AVC increases faster than AFC decreases for higher Q

MC and ATC: if the MC at a point is above the ATC, that sale increases the ATC. if the MC is below the ATC, that sale decreases the ATC. where MC=ATCMC = ATC, efficient scale. MC intersects ATC at the minimum ATC.

teamwork effect \rightarrow logistical constraints \rightarrow

Short-term vs long-term ATC §

Economies of scale LT ATC falls as quantity rises

Constant returns to scale LT ATC remains const as quantity rises

Diseconomies of scale LT ATC rises as quantity rises

Firms in competitive markets §

Meaning of competition §

competitive market: many buyers and sellers with identical products. so many, that nobody has undue effect on the price. free entry and exit. everyone is a price taker.

market pressures towards zero-loss, zero-profit.

temp assumption: identical operating costs

price same regardless of quantity

average revenue=price\textrm{average revenue} = \mathrm{price} (as long as there’s no price discrimination). not unique to competitive market

marginal revenue=price\textrm{marginal revenue} = \textrm{price}. unique to competitive market.

price always equal to avg revenue (unless we price discriminate)

unique to perfectly competitive markets:

Visualizing competition §

stop when marginal cost eq marginal revenue

in the short run: MC curve is the supply curve (shows quantity supplied for any price). competitive.

shutdown short-run decision to halt production temporarily due to current market conditions. sunk fixed costs

if revenue >= variable cost (short run):
	stay in the market
else if revenue < variable cost (short run):
	shut down

exit long-run decision to leave the market.

if revenue > total cost (long run):
	exit (can get rid of fixed costs)

sunk cost: cost that has already been committed and can’t be recovered.

Supply curves for firms §

Monopolies §

price order:

  1. monopoly
  2. oligopoly
  3. monopolistic competition
  4. perfect competition

What and how §

A monopoly is a firm that is the only seller of a product without close substitutes.

Barriers to entry for firms:

  1. monopoly resources

    a key resource required for production is owned by a single firm

  2. govt-created (regulations)

    govt gives a single firm exclusive rights. patents or copy rights. incentivize R&D.

  3. natural monopoly (production process)

    one firm can supply at lower costs than two or more can.

    happens when there’s high fixed costs, low variable costs.

    larger the market, higher the demand, more lucrative.

Monopoly vs competition §

Competitive firm Monopoly
Price takers. Can’t increase or decrease price.
Horizontal demand curve. Can’t increase (lose all demand). Can’t decrease (loss). Downward sloping demand curve. Power over the price.
P=MRP=MR P>MRP> MR
P=MR=MCP=MR=MC P>(MR=MC)P>(MR=MC)

With an increase in output:

  1. output effect: tends to increase TR

    revenue gained from the sale of additional units

  2. price effect: tends to decrease TR

    decrease in the price of each unit due to the increased quantity

alt terminology for elasticity

if we want to sell one more unit, we have to lower the price. thus MR<ARMR < AR.

no supply curve for monopolies

When a monopoly is a monopoly no longer §

MR flattens out, collapses into D.

Qmono<QcompQ_{mono} < Q_{comp}

Pmono>PcompP_{mono} > P_{comp}

monopoly: deadweight loss

Price discrimination §

price discrimination: selling the same good at different prices to different people

demand curve: marginal revenue curve

zero consumer surplus.

total surplus = profit.

some profit is better than no profit

e.g. movie tickets, airline prices, online advertising profiles, discount coupons, fin aid

Monopolistic competition §

Oligopoly: few sellers offering identical products

Monopolistic competition: many sellers offer differentiated products (similar, but not identical)

Monopolistic competition §

Curves §

Mono Comp: no in the long run. profit/loss possible in the short run.

Welfare §

“it’s complicated”

inefficient because Price > MC. regulation challenges:

  1. too many firms
  2. will have to offset firms’ losses with tax-funded subsidies
  3. no profit motive: no incentive to lower costs

number of firms may not be ideal wrt societal welfare. firms only consider profits when entering, ignoring externalities:

inefficient. hard to measure, hard to fix.

Advertising §

is it worth it? or are we wasting resources?

brand names:

Oligopolies §

oligopoly: a market structure in which few firms sell identical products

duopoly: two-firm oligopoly

at nash equilibrium nobody has any incentive to deviate

Game theory §

Prisoner’s dilemma

“incentive to cheat”

cooperation difficult

Antitrust §

resale price maintenance

predatory pricing

tying: selling one product/service as a mandatory addition to another product/service

Consumer choice §

Affordance §

Budget constraint: limit on the consumption bundles a consumer can afford

Indifference curves §

Indifference curve: curve of consumption bundles that give the consumer the same level of satisfaction

Marginal rate of substitution: rate at which the consumer is willing to trade one good for another. slope of the indifference curve.

  1. higher indiff curves > lower indiff curves

    higher total satisfaction

  2. downward sloping

    one increase, other decrease. same level of satisfaction in total.

  3. don’t cross

  4. bowed inward

    diminishing marginal utility. MRS.

extremes:

Consumer’s optimal choices §

at optimum point, budget constraint tangent to indifference curve.

Slope=MRS\mathrm{Slope} = \mathrm{MRS}

PAPB=MUAMUB\frac{P_A}{P_B} = \frac{MU_A}{MU_B}

MUAPA=MUBPB\frac{MU_A}{P_A} = \frac{MU_B}{P_B}

Labor vs leisure §

leisure is a normal good

wage increase:

GDP §

GDP and GNP §

GDP: market value of final goods, services produced within a country’s borders during a specified time period.

GDP per capita: GDP ÷\div population

GNP: GDP + domestically-owned factors located overseas - foreign-owned located domestically

GDP Components §

Consumption §

70% of US GDP apparently

consumption: spending by households on goods and services. doesn’t include new structures|home purchases

Investment §

Spending on:

when inventory is sold, consumption positive and inventory negative

diff. from intermediate goods.

Government §

government purchases: spending by local state and national governments

doesn’t include transfer payments e.g. health care, social security, …

Net Imports §

Exports minus imports

exports: spending on domestically produced products

imports: spending on foreign products by domestic residents

imports cancel out with part of purchased household goods

Shortcomings §

Calculating GDP §

Nominal GDP=current prices×current quantity\textrm{Nominal GDP} = \textrm{current prices} \times \textrm{current quantity}

Real GDP=constant prices×current quantity\textrm{Real GDP} = \textrm{constant prices} \times \textrm{current quantity}

GDP Deflator §

measure of price level. ratio of nominal gdp to real gdp.

GDP Deflator=Nominal GDPReal GDP×100\textrm{GDP Deflator} = \frac{\textrm{Nominal GDP}}{\textrm{Real GDP}} \times 100

Inflation Ratet=ΔGDP DeflatorGDP Deflatort1\textrm{Inflation Rate}_t = \frac{\Delta \textrm{GDP Deflator}}{\textrm{GDP Deflator}_{t-1}}

CPI §

consumer price index.

Inflation: increase in the overall price levels

Core inflation: Inflation from CPI minus food, energy

CPI=currentbase×100\textrm{CPI} = \frac{\textrm{current}}{\textrm{base}} \times 100

Measuring the CPI §

  1. fix the basket
  2. find the prices
  3. compute basket

Indexing §

indexing: increasing nominal quantity by an amount equal to % increase in some price index

RP=NPIncome\textrm{RP} = \frac{\textrm{NP}}{\textrm{Income}}

Shortcomings §

overstates inflation

Costs of inflation §

  1. shoe leather costs

  2. distortions in the tax system

  3. unexpected redistribution of wealth

    i=r+πe    r=iπi = r + \pi_e \implies r = i - \pi

  4. noisy signal

Too much inflation §

Excessive money supply.

Money printer go brrr

Price level \propto Money supply

Unemployment §

Defining measures §

UR=UU+E=ULFUR= \frac{U}{U+E} = \frac{U}{LF}

UUR=EER\frac{U}{UR} = \frac{E}{ER}

PR=LFWAPPR = \frac{LF}{WAP}

Types of Unemployment §

Natural unemployment rate: “normal” rate of unemployment. long-term.

NR=Structural Rate+Frictional Rate\textrm{NR} = \textrm{Structural Rate} + \textrm{Frictional Rate}

Cyclical unemployment rate

CR=Actual RateNatural Rate\textrm{CR} = \textrm{Actual Rate} - \textrm{Natural Rate}

Shortcomings §

Duration of unemployment §

Costs of unemployment §

Direct §

Indirect §

§

Evolving Standards of Living §

yt=y0(1+g)ty_t = y_0 (1 + g)^t

Factors of Growth §

Neo-classical or Solow model §

Y=Af(K,L,H,R)Y = Af(K,L,H,R)

y=Ypop=average labor productivity×PRy = \frac{Y}{pop} = \textrm{average labor productivity}\times PR

participation rate problems:

Y=AKαL1αY = AK^\alpha L^{1-\alpha}, 0<α<10 < \alpha <1

y=Akαy = Ak^\alpha (popLpop \approx L, k=KLk=\frac{K}{L})

Where does physical capital come from? §


  1. Contentious. How sticky are they really? If nominal wages adjust quickly enough, the real wage remains the same. Thus no improvement in employment. High inflation, high unemployment = oops. aka Stagflation. ↩︎

  2. if no specialized factors of production, constant slope aka constant opportunity cost. straight line. no specialization. everyone’s equally good at producing everything. ↩︎

  3. fixed cost is the yy-intercept of the supply curve ↩︎

  4. includes quantity exported ↩︎

  5. includes quantity imported ↩︎