Economics Basics Quiz

Introduction to Economics

• Economics is the study of how societies allocate scarce resources to satisfy unlimited wants.
• Scarcity is the fundamental economic problem. Resources are limited, but wants are unlimited.
• Economics is a social science. It uses models to understand and predict economic forces.

Session Overview

• Wants are unlimited, but resources are scarce.
• The problem of scarcity leads to the need for choices.
• All economic questions arise from scarcity.
• Economics as a social science provides tools for analysing economic problems.

Learning Objectives

• Understand why economics is studied.
• Know the difference between microeconomics and macroeconomics.

Reading List

• Bade and Parkin (2013) and the 5th Edition of Begg, Dornbusch and Fischer.
• Session slides
• Other economics textbooks

Definition and Questions

• Scarcity is the fundamental economic problem.
• Scarcity requires choices among available options.
  • A scale of preference is necessary to arrange all wants in order.
• Opportunity cost is the value of the next best alternative sacrificed.
• Opportunity cost is divided into explicit and implicit costs.
• Economics is divided into two parts:
  • Microeconomics: the study of individual choices and their interactions, influenced by governments.
  • Macroeconomics: the study of the aggregate effects of these choices on a national and global scale.
• How do choices determine what, how, and for whom goods and services get produced?
• When do choices made in self-interest also promote social interest?
• Questions of What, How, and For Whom are fundamental to understanding economics:
  • What goods and services are produced, and in what quantities?
  • How are goods and services produced?
  • For whom are the various goods and services produced?
• Can the pursuit of self-interest be in the social interest?

Globalization

• Globalization is the expansion of international trade and production by firms.

The Economic Way of Thinking

• Six ideas define the economic way of thinking:
  • Choice is a tradeoff.
  • Cost is what you must give up to get something.
  • Benefit is what you gain from something.
  • People make rational choices by comparing costs and benefits.
  • Most choices are "how much" choices made at the margin.
  • Choices respond to incentives.
• Choice is a tradeoff.
• Cost is what you must give up.
• Benefit is what you gain.
• Rational choice is using resources to best achieve an objective by comparing costs and benefits.
• A choice made at the margin compares all relevant alternatives incrementally.
• Marginal cost: the opportunity cost of a one-unit increase in activity.
• Marginal benefit: what you gain when you get one more unit of something.
• A rational choice is when marginal benefit exceeds or equals marginal cost.
• An incentive is a reward or penalty that encourages or discourages an action.
• Economists use scientific methods to understand and predict economic forces.
• An economic model describes some feature of the economic world.

Economic Models

• The second step for an economist is to use a model to show the potential answer to a question.
• An economic model is a description of some feature of the economic world.
• The third step for an economist is to compare the proposed model to the facts using techniques like natural experiments, statistical investigations, and economic experiments.

Disagreement: Normative versus Positive

• Normative statements discuss what ought to be, and positive statements describe what is.
• Disagreement on economic models can be resolved with further facts.

Economics as Policy Tool

• Economics is useful for government, personal lives, and businesses.

The Economic Problem

• To use the production possibility frontier (PPF).
• To calculate opportunity cost.
• To explain production possibilities expansion.

Production Possibilities

• The maximum combinations of goods and services given available factors and technology .
• The PPF shows scarcity and opportunity cost.

Attainable and Unattainable Combinations

• Points inside the PPF are attainable.
• Points outside the PPF are unattainable.

Efficient and Inefficient Production

• Production efficiency is when producing more of one good requires sacrificing some other good.

Tradeoffs and Free Lunches

• A tradeoff is an exchange. A free lunch is a gift.

Opportunity Cost

• The value of the next best alternative sacrificed to gain something.
• The slope of the PPF illustrates the increasing opportunity cost of producing more of one good.

Opportunity Cost and the Slope of the PPF

• The slope of the PPF tells the opportunity cost of a product.
• The PPF is curved because the opportunity cost of producing one more of a good increases as more of that good is produced.

Opportunity Cost Is a Ratio

• The ratio of quantities of one good sacrificed to gain another.

Increasing Opportunity Cost

• Increasing opportunity cost is the norm.

Demand- Factors Changing Demand

• Demand reflects the quantities of goods and services that consumers are willing and able to buy at various prices.
• Price, related goods, expected future prices, expected future income and credit, number of buyers, preferences.
• Income changes shift the demand curve.
• Price of related goods (substitutes/complements) changes shift the demand curve.
• Expected future prices changes shift the demand curve.
• Related good price increases cause more demand of the good that substitutes the other.

Income

• Normal goods: demand increases with income, and demand decreases with a fall in income.
• Inferior goods: demand decreases with an increase in income.

Prices of Related Goods

• Substitute goods: an increase in the price of one leads to an increase in demand of the other.
• Complement goods: an increase in the price of one leads to a decrease in demand of the other.

Expected future prices

• When prices are expected to rise in the future, current demand increases.

Number of buyers

• More buyers raise demand.

Taste and preferences

• Changes in taste and preferences shift demand.
• The most important factors influencing consumer tastes and preferences are the information available to the consumers, the number of options available, consumer's culture and religion.

Changes in Quantity Demanded

• A change in the quantity demanded is caused by a change in the product's price. It causes a movement along the same demand curve.

Changes in Demand

• A change in demand results when factors change other than the product price. This results in a shift of the demand curve.

Supply

• Supply is the quantities of a good or service that producers are willing and able to put on the market at various prices for a given period.
• Price is a major factor that influences supply.
• The law of supply states that the higher the price of a product, the greater the amount that is put on the market for sale, All other things equal.
• The lower the price of a product, the smaller the quantity that is put on the market for sale, All other things equal.

Supply Schedule and Supply Curve

• A supply schedule shows a relationship between the quantities supplied and their respective prices, when all other factors are constant.
• A supply curve illustrates the relationship between the quantities supplied and their respective prices on a graph.
• A supply function depicts the relationship between the quantities supplied and their respective prices in the form of an equation, holding other factors constant.

Individual Supply and Market Supply

• Market supply is the horizontal summation of individual supply curves.

Other Factors Influencing Supply

• Cost of production: higher costs reduce supply
• Prices of related products: substitutes are related, and the price of one impacts the supply of the other
• Technology: advances in technology increase supply, and obsolete technology reduces supply.

Changes in Supply

• A change in any factor, other than price, affecting supply shifts the supply curve.

Market Equilibrium

• The equilibrium price is the price where quantity demanded equals quantity supplied.
• The equilibrium quantity is the quantity demanded and supplied at the equilibrium price.

Effects of Changes in Demand

• When tap water is unsafe, demand for bottled water increases and the demand curve shifts rightward.

Effects of Changes in Supply

• When European water bottlers buy springs and open plants in Ghana, the supply of bottled water increases, and the supply curve shifts rightward.

Effects of Changes in Both Demand and Supply

• When both demand and supply increase, the effect of equilibrium quantity is definite increase; but price might rise or fall.

Effects of Changes in Both Demand and Supply (decrease)

• When both demand and supply decrease, the effect of equilibrium quantity is decrease; but price might rise or fall.

Effects of Changes in Both Demand and Supply (increase in one, decrease in the other)

• When demand increases, and supply decreases, the equilibrium price rises, and the effect of quantity is unpredictable (might increase or decrease).
• When demand decreases, and supply increases, the equilibrium price falls, and the effect of quantity is unpredictable (might increase or decrease).

Price Control

• Minimum price (price floor): a price set above the market equilibrium price. A common example is a minimum wage.
• Maximum price (price ceiling): a price set below the market equilibrium price.

Minimum Price

• A minimum price is set above the market price to protect suppliers.
• Minimum price policies lead to excess supply.

Elasticity of Demand and Supply

• Elasticity measures responsiveness of quantity demanded/supplied to changes in price.
• Price elasticity of demand measures the responsiveness of quantity demanded to a change in price.
• Price elasticity of supply measures the responsiveness of quantity supplied to a change in price.
• The law of demand states that quantity demanded and price are inversely related; the law of supply states that quantity supplied and price are directly related.
• Point and arc elasticity are used to measure price elasticity.

Income Elasticity of Demand

• Income elasticity of demand measures the responsiveness of quantity demanded to a change in income.
• Normal good: income elasticity is positive.
• Inferior good: income elasticity is negative.

Cross Price Elasticity of Demand

• Cross-price elasticity of demand measures the responsiveness of quantity demanded of one good to a change in the price of another good.
• Substitute goods: cross-price elasticity is positive.
• Complement goods: cross-price elasticity is negative.

Determinants of Elasticity of Demand

• Existence, number, and quality of substitutes: The availability and quality of other products affects the price elasticity of demand
• Percentage of consumer's total income devoted to the purchase: The proportion of the consumer's income spent on a good impacts price elasticity.
• Length of time allowed for price adjustment: Elasticity of demand is greater in the long run than in the short run.

Determinants of Elasticity of Supply

• Time period allows manufacturers to adjust factors like capacity, inputs, etc.
• Availability of raw materials
• Elasticity is greater in the long run because firms can adjust factors.

The Concept of Elasticity

• Elasticity refers to responsiveness.
• Elasticity of demand/supply is the measure of the responsiveness of a good's quantity demanded/supplied to changes in price.
• This refers to percentage change in quantity demanded/supplied relative to percentage change in price, all other factors held constant.

Theory of Consumer Behaviour

• Consumers buy goods for satisfaction.
• Utility is the satisfaction a consumer derives from consuming various units of a commodity.
• Cardinalist approach measures utility in units called "utils".
• Ordinalist approach ranks preferences without quantifying utility.

The Budget Constraint

• The budget is the amount of money available to consumers to buy goods.
• The budget constraint shows the possible bundles of goods a consumer can afford given their income and the prices of the goods.
• The slope of the budget line represents the relative price of the two goods.

Indifference Curve

• An indifference curve shows the combination of goods that yield the same level of satisfaction to a consumer.
• Higher indifference curves represent higher levels of satisfaction.
• Indifference curves are negatively sloped.
• Indifference curves do not intersect.

Slope of the Indifference Curve

• The slope of the indifference curve is the marginal rate of substitution.

Consumer Equilibrium

• A consumer is in equilibrium when the marginal rate of substitution equals the relative prices of the goods being consumed.

Price Consumption Curve (PCC)

• The locus of tangents from budget lines to indifference curves.
• Positively sloping for complements; negatively for substitutes.

Income Consumption Curve

- The income consumption curve (ICC) is the set of optimum bundles when income changes, while preferences and prices remain constant.
- The Engel curve graphs the relationship between the quantity of one good purchased and a consumer's income.

Income and Substitution Effect

- Income effect on consumption reflects the change in quantity demanded as income changes.
- Substitution effect reflects the change in quantity demanded as the price of one good changes.
- The total effect is the sum of the income and substitution effects.

The Theory of Cost

• Firms incur various costs.
• Economists interpret costs in terms of opportunity costs, which is the value of the next best alternative foregone, whereas accountants' measures are different.
• Accounting cost measures the explicit cost borne by the firm in its business operation; whereas economic costs include implicit costs not explicitly counted.

Short Run Costs

• Fixed cost: cost of fixed factors independent of output.
• Variable cost: cost of variable factors that fluctuate with output.
• Total cost: sum of fixed and variable costs; TC = TFC + TVC
• Average cost: cost per unit of output; AFC, AVC, ATC.
• Marginal cost: change in total cost from producing one more unit.

Relationship between Short-Run Production and Cost

• The firm's cost curves are related to product quantities.
• An increase in production, up to a certain point, shows diminishing returns that impact the marginal & average costs in a U shape.
• The output at which the marginal cost is minimum is where the marginal product is maximum.

Short-Run Costs, Technology, and Input Prices

• Changes in technology and input prices shift cost curves (up or down).
• Changes in technology shift output-related costs.
• Changes in input prices shift all costs except fixed costs.

Market Types- Perfect Competition

• Many firms produce undifferentiated goods.
• Firms have no ability to influence market price; they are price takers.
• There are no barriers to entry in the market.

Revenue Function- Competitive Firm

• Total revenue (TR) is calculated as P x Q.
• Average revenue (AR) is calculated as TR / Q.
• Marginal revenue (MR) is the extra revenue gained by increasing output; MR = ATR / AQ or ΔTR/ΔQ
• In a competitive market, price = MR = AR.

A Firm's Profit-Maximizing Choices- Competitive Firm

• A firm maximizes profits at the output where price (AR) = MC(=MR)
• The firm makes a normal profit in the short run or a loss.
• A shutdown point is where price is less than AVC, the firm shuts down to minimize loss.

Output, Price, Profit in the Short Run

• Market equilibrium for a competitive firm occurs where the market price equals the firm's marginal cost.
• The quantity supplied in the market is the sum of the quantities supplied by each firm.
• The firm earns a normal profit, zero economic profit, in the long run if price = ATC.

Output, Price, Profit in the Long Run

• The long-run equilibrium for a competitive firm occurs where the market price equals both the firm's marginal cost and average total cost.
• The long-run supply curve of a competitive market is perfectly elastic if input prices don't change, meaning that the price of each product is consistent with the marginal cost, and firms are free to enter or exit the market easily
• Changes in demand impact the price in the long run.
  • Increase in demand leads to greater supply and more economic profits, hence more firms enter until new equilibrium is reached, bringing price to its original level.
  • Decrease in demand leads to smaller supply and more economic losses until the new equilibrium is reached, bringing price to its original level.

Monopoly

• One firm controls the supply of a unique product, making it a price maker.
• Barriers to entry prevent other firms from competing.

Monopoly versus Perfect Competition

• In perfect competition, price = marginal cost.
• In a monopoly, price > marginal cost.

Monopoly's Profit

• Profit = (P-ATC) x Quantity.
• Economic Profit is the surplus of price over average total cost.
• Economic profit attracts entry; economic loss attracts exit.

Monopolistic Competition

• Many firms compete in a market.
• Firms produce differentiated products.
• Firms compete on price, product quality, and marketing.
• There is free entry and exit.
• In the long run, monopolistic firms earn zero economic profit.
• Excess capacity (produce below efficient scale) and markup ( price > MCL) are typical in this structure.

Measuring Profit

• Profit is Total Revenue(TR) - Total Cost(TC).
• Divide both sides of the equation by quantity (Q)
  • Profit = [(TR)/Q - (TC)/Q)] x Q
  • Profit = [(P - ATC)] x Q

Other factors influencing supply

• Changes in technology;
• Input prices;

Summary

• These notes summarise the content of the provided documents.