Economic Methodology: Concepts

Economic Methodology and the Economic Problem

• Positive economics deals with objective and testable statements, while normative economics involves subjective, value-based judgments.
• Value judgments influence economic decision-making by shaping priorities, policies, and resource allocation based on beliefs and ethical considerations.
• Needs are essential for survival, while wants are desires that go beyond basic necessities; the distinction is crucial in economics due to scarcity.
• Opportunity cost represents the potential benefits forgone when choosing one alternative over another; for example, the opportunity cost of attending university is the salary you could have earned working full-time.
• Production possibility frontiers (PPFs) illustrate scarcity by showing the limited amount of resources available, choice by indicating different production combinations, and opportunity cost by demonstrating the trade-offs between producing different goods.
• An outward shift in the PPF can be caused by technological advancements, increased resources, or improved efficiency, while an inward shift can result from natural disasters, decreased resources, or economic decline.
• Free market economies allocate resources through supply and demand, mixed economies combine market mechanisms with government intervention, and command economies rely on central planning.
• Advantages of a free market economy include efficiency, innovation, and consumer choice, while disadvantages include inequality, market failures, and instability.
• Government interventions in a mixed economy address market failures, promote social welfare, and ensure stability.
• Specialization involves focusing on specific tasks, and the division of labor breaks production into smaller, more efficient steps, improving overall economic efficiency.

Price Determination in a Competitive Market

• Equilibrium price and quantity are determined in a market where the demand and supply curves intersect, balancing consumer and producer interests.
• Consumer surplus is the difference between what consumers are willing to pay and what they actually pay (area below the demand curve and above the market price), while producer surplus is the difference between what producers receive and their minimum acceptable price (area above the supply curve and below the market price).
• Factors affecting price elasticity of demand (PED) include availability of substitutes, necessity of the good, proportion of income spent, and time horizon.
• PED affects total revenue; if demand is elastic, a price decrease increases total revenue, while if demand is inelastic, a price decrease reduces total revenue.
• Normal goods have a positive income elasticity of demand (YED), inferior goods have a negative YED, and luxury goods have a YED greater than 1.
• Factors determining price elasticity of supply (PES) include spare production capacity, ease of storage, time to produce, and availability of resources.
• The interaction of supply and demand determines market equilibrium by adjusting prices until the quantity demanded equals the quantity supplied.
• Excess demand occurs when demand exceeds supply, leading to upward pressure on prices, while excess supply occurs when supply exceeds demand, leading to downward pressure on prices.
• Shifts in demand and supply curves affect equilibrium price and quantity; an increase in demand raises both, an increase in supply lowers price and raises quantity, and vice versa.
• Government price controls like price ceilings (maximum prices) can cause shortages and black markets, while price floors (minimum prices) can lead to surpluses and inefficiencies.

Production, Costs, and Revenue

• Short-run production involves at least one fixed input, while long-run production allows all inputs to vary.
• Diminishing marginal returns occur when increasing one input while holding others constant leads to smaller increases in output, affecting a firm’s costs by raising marginal costs.
• Fixed costs do not vary with output, variable costs change with output, and total costs are the sum of fixed and variable costs.
• Average cost (AC) is total cost divided by output, average variable cost (AVC) is variable cost divided by output, and marginal cost (MC) is the change in total cost from producing one more unit; MC intersects AC and AVC at their minimum points.
• Economies of scale reduce costs as output increases, while diseconomies of scale increase costs as output increases.
• The law of diminishing returns affects a firm’s cost curves by causing marginal costs to rise as output increases beyond a certain point.
• Different objectives of firms include profit maximization (maximizing the difference between total revenue and total costs), revenue maximization (maximizing total revenue), and sales maximization (maximizing the volume of sales).
• Total revenue (TR) is price times quantity, average revenue (AR) is total revenue divided by quantity (equal to price), and marginal revenue (MR) is the change in total revenue from selling one more unit.
• Firms might choose to operate at profit maximization rather than revenue maximization because profit maximization ensures the most efficient use of resources and higher returns.
• Normal profit is the minimum profit needed to keep a firm in business (equal to opportunity cost), supernormal profit is profit above normal profit, and economic loss occurs when total costs exceed total revenue.

Market Structures

• Perfect competition features many small firms, homogeneous products, no barriers to entry, and price-taking behavior; monopolistic competition involves many firms, differentiated products, and low barriers to entry; oligopoly consists of few dominant firms, and high barriers to entry; monopoly involves a single firm with complete market control.
• Firms in perfect competition are price takers because they are too small to influence market price; in the long run, profitability is driven to normal profit due to easy entry and exit.
• Monopolists set prices by choosing the output level where marginal cost equals marginal revenue, leading to higher prices and lower output compared to competitive markets, resulting in welfare losses.
• Product differentiation allows firms in monopolistic competition to have some control over price and build brand loyalty.
• Key barriers to entry include economies of scale, patents, high start-up costs, and government regulations, which limit competition.
• Firms in an oligopoly compete through price competition (e.g., price wars) and non-price competition (e.g., advertising, product differentiation).
• Game theory analyzes strategic interactions among interdependent firms; in an oligopoly, firms’ decisions are based on expectations about rivals’ actions.
• Price discrimination involves charging different prices to different customers for the same product; conditions include market power, ability to segment markets, and prevention of resale.
• The contestability of a market influences firm behavior by threatening potential entry, encouraging firms to act more competitively, and reducing prices.
• Perfect competition is the most efficient market structure, while monopolies are the least efficient, with monopolistic competition and oligopoly falling in between.

The Labor Market

• The demand for labor is derived from the demand for the final product; factors influencing it include wage rates, productivity, technology, and product demand.
• Factors determining the supply of labor include wage rates, education and skills, working conditions, job satisfaction, and demographic factors.
• Elasticity of labor demand and supply impacts wages; if labor demand is inelastic, wage changes have a smaller effect on employment, and vice versa.
• Wage determination in competitive labor markets occurs where the supply of labor equals the demand for labor, establishing the market wage rate.
• Causes of wage differentials include differences in skills, education, experience, risk, and compensating differentials, while effects include income inequality and labor mobility.
• Trade union activity can increase wages for union members but may also lead to decreased employment if wages are raised above competitive levels.
• Monopsonies, or single buyers of labor, can lower wage levels and employment by exercising their market power.
• Minimum wage sets a price floor on wages, potentially benefiting low-wage workers but also risking job losses if set above the market equilibrium.
• Discrimination in the labor market can lead to lower wages and fewer opportunities for certain groups, reducing overall economic efficiency.
• Government policies aimed at improving labor market outcomes include education and training programs, anti-discrimination laws, and unemployment benefits.

Market Failure and Government Intervention

• Key causes of market failure include externalities, public goods, information asymmetry, and monopolies.
• Public goods are non-excludable and non-rivalrous (e.g., national defense), while private goods are excludable and rivalrous.
• Externalities, such as pollution (negative) or education (positive), lead to market failure because the market price does not reflect the full social costs or benefits.
• Policies to correct negative externalities include taxes, regulations, and tradable permits; effectiveness varies based on the specific context and implementation.
• Subsidies can correct market failure caused by positive externalities by lowering the cost of beneficial activities, while taxes can correct negative externalities by raising the cost of harmful activities.
• Government failure occurs when government intervention leads to a less efficient allocation of resources than the free market; examples include bureaucratic inefficiency and unintended consequences.
• Asymmetric information, where one party has more information than another, can lead to market failure; for example, in the market for used cars.
• Tradable pollution permits allow firms to buy and sell permits to pollute, creating a market-based incentive to reduce pollution efficiently.
• Behavioral economics concepts like bounded rationality (limited cognitive ability) explain market failures by showing how individuals make irrational decisions.
• Regulation and competition policy can correct market failure by setting rules and promoting competition, but their effectiveness depends on design and enforcement.

Government Intervention and Its Failure

• Key government interventions in markets include taxes, subsidies, price controls (maximum and minimum prices), and regulations.
• Indirect taxes decrease both consumer and producer surplus by raising prices and reducing quantity traded.
• Advantages of subsidies include encouraging production of beneficial goods and services, while disadvantages include potential inefficiencies and misallocation of resources.
• Price controls (maximum and minimum prices) create unintended consequences such as shortages, surpluses, and black markets because they interfere with market equilibrium.
• Main causes of government failure include lack of information, bureaucratic inefficiencies, political interference, and unintended consequences.
• Public choice theory explains that government intervention may fail because policymakers may act in their own self-interest rather than the public interest.
• Regulatory capture occurs when regulatory agencies are unduly influenced by the industries they regulate, leading to policies that favor those industries rather than the public.
• Buffer stock schemes stabilize prices by buying surplus output when prices are low and selling from reserves when prices are high; effectiveness depends on accurate forecasting and storage capabilities.
• Government provision of public goods corrects market failure by ensuring these goods are available to all, as the private market would under-provide them.
• Unintended consequences can make government intervention worse than the original market failure by creating new problems or exacerbating existing ones.