Economics: Scarcity, Systems, and Models

• Economics is how societies allocate scarce resources to fulfill unlimited needs and desires
• The word "economics" comes from "oikonomia," which means "household management" in Greek
• Economics studies decision-making from individual to national levels
• Economics studies how societies allocate scarce resources to produce and distribute goods and services

Economic systems

• Economic systems determines resources allocation
• Market economy: Resources allocated through firms' and households' decentralized decisions
• Centrally planned economy: The government decides on production, distribution, and prices
• In centrally planned economies the government corrects market failures, redistribute income and implement macroeconomic policies
• Mixed economy: Combines free markets with government intervention to correct failures and redistribute income

Economic Models

• Economists can be scientists, they use theories and models
• Economists can be consultants, they provide solutions to economic issues
• Economics uses the scientific method which is
  • Observation: Identifying behaviors and patterns
  • Theory Development: Hypotheses on economic interactions
  • Empirical Testing: Using data and experiments to validate theories
• Economic models simplify reality to predict economic outcomes
• Economic models include variables
  • Endogenous variables: Determined within the model (e.g., consumer spending)
  • Exogenous variables: Determined outside the model (e.g., population growth)
  • Flow variables: Measured over time (e.g., income)
  • Stock variables: Measured at a specific moment (e.g., wealth)
  • Nominal variables: Expressed in current prices (e.g., nominal GDP)
  • Real variables: Adjusted for inflation (e.g., real GDP)
• Economic models should be manageable, understandable, realistic, and testable
• Economic models include two analyses:
  • Positive analysis: Describes economic consequences based on assumptions without judgement
  • Normative analysis: Evaluates policies based on societal goals

Circular Flow Model

• Circular-flow model illustrates resource and money movement in an economy including:
  • Households: Supplies labor and consumes goods
  • Firms: Produces goods/services, paying wages to households
  • Financial markets: Facilitates saving and investment
  • Government: Regulates, taxes and redistributes income
  • Foreign sector: Represents international trade and capital flows
• Main economic flows:
  • Households supply factor services to firms
  • Wages, rents, interest: Firms pay to households for factor services
  • Personal Consumption: Households spend earnings on goods/services

Micro vs Macro

• Microeconomics focuses on individual decisions, market structures, and price formation
• Macroeconomics examines aggregate indicators like GDP, inflation, unemployment, and policies
• Microeconomics studies agents, macroeconomics analyzes performance and policy impacts

Fundamental Questions in Economics

• What is produced and in what quantity?
  • Production relies on available resources and demand
  • In a market economy, it is guided by supply and demand
  • In a planned economy, the government decides
• How are goods produced?
  • Goods are produced using labor, capital, and natural resources
  • The production method adapts to technology, efficiency, and economic structure
• For whom are goods produced?
  • Goods distributed based on purchasing power in a market economy
  • In planned economies, the government allocates to meet needs
• Who makes economic decisions?
  • Firms/households make decisions through decentralized interactions in a market economy
  • In a planned economy, a central authority decides production and distribution

Market Forces

• Markets allow interactions of buyers and sellers exchanging goods and services
• Supply and demand determine goods' price/quantity in a competitive market
• Market analysis aims to understand how market forces efficiently allocate resources

Types of Markets

• Perfectly competitive market: Many buyers/sellers, homogenous products, no single entity impacting price, plus perfect information
• Monopoly: Single seller dominates the market
• Oligopoly: A few large firms control the market
• Monopolistic competition: Many sellers offering differentiated products

Market Demand

• Demand determined by consumers' willingness/ability to purchase goods at various prices
• Law of demand: As price increases, quantity demanded decreases
• Shifts in demand curve if there is change in the analyzed variable:
  • Price: Higher price → Lower quantity demanded
  • Income:
    • Normal goods (demand ↑ with income)
    • Inferior goods (demand ↓ with income)
  • Related goods:
    • Substitutes: Price increase in one good → Demand increase for the other.
    • Complements: Price increase in one good → Demand decrease for the other.
  • Tastes and preferences: Favorable changes → Demand increase.
  • Expectations: Future price decrease expectations → Current demand decrease.
  • Number of buyers: More buyers → Higher demand.

Market Supply

• Supply depends on producers to sell goods at different prices, is the most important determinant
• As price increases, quantity supplied increases
• Shifts in supply curve:
  • Price: HIgher price → More quantity supplied
  • Input prices: Lower production costs → More supply
  • Technology: Improvements increase supply
  • Expectations: Expected future price rise → Reduced current supply
  • Sellers: More sellers → Increased supply
• The market supply curve is the horizontal sum of all supply curves

Market Equilibrium

• The point where quantity demanded equals quantity supplied, determining the market-clearing price
  • Equilibrium price: Where supply meets demand
  • Equilibrium quantity: Quantity exchanged at equilibrium price.
• Surplus occurs when supply exceeds demand, causing downward pressure on prices
• Shortage occurs when demand exceeds supply, causing upward pressure on prices
• Comparative statics analyses equilibrium changes when supply/demand shifts

Elasticity

• Elasticity measures how quantity demanded or supplied responds to price changes
• Price elasticity of demand (PED): Responsiveness of quantity demanded to price changes including:
  • Elastic demand (PED > 1): Consumers react significantly to price changes
    • Inelastic demand (PED < 1): Consumers react minimally.
    • Unit elastic demand (PED = 1): Proportional change in demand to price.
    • Perfectly inelastic/elastic demand (PED = 0) One extreme case.
• Price elasticity depends on available substitutes, necessity, how broadly defined, and time
• Total revenue is equal to Price x Quantity
• Elastic demand (PED > 1): % change Q > % change P.
• Inelastic demand (PED < 1): % change Q <% change P.
• Income elasticity of demand determines how much the quantity demanded shifts
• Cross-price elasticity of demand measures how one goods demanded quantity shifts with another good
• Price elasticity of supply (PES): Measures how responsive quantity supplied reacts to price changes
• Elastic (PES > 1): The prices rise, and the quantities rise more
• Inelastic (PES < 1): The prices rise, and the quantities rise less
• Perfectly inelastic/elastic price elasticity have extreme cases

Surplus

• Consumer surplus: Buyer's willingness to pay (maximum they will). The the difference between willingness to pay/actual payment
• Producer surplus: Seller's cost to produce good. This is difference between received price/production costs
• Total surplus: Total welfare by adding surplus by consumer with producer

Imposed Taxes

• Tax revenue is [T x Q], where Q is the quantity sold, and T is the size of the tax
• Occurs because buyers pay more, but seller receive less
• The deadweight loss includes all deficits due to the market
  • Diminishes quantity sold
  • Larger loss of tax
  • Burden lightens on agent
• Tax incidence determines the amount the tax is shared between buyers and sellers
• Taxes increase costs, reducing equilibrium quantities
• Deadweight loss: Efficiency loss occurs with reduced trade volume due to taxation

Economics studies how societies allocate limited resources to satisfy unlimited wants. Economic systems like market, centrally planned, and mixed economies determine resource distribution. Economists use models to analyze decisions and provide solutions.