Economics Study Guide PDF

Economics as a Study of Human Behaviour 1. Introduction to Economics Economics is the study of how societies allocate scarce resources to satisfy human needs and desires. The term comes from the Greek word "oikonomia," meaning "household management." The discipline explores decision-making at variou...

Economics as a Study of Human Behaviour 1. Introduction to Economics Economics is the study of how societies allocate scarce resources to satisfy human needs and desires. The term comes from the Greek word "oikonomia," meaning "household management." The discipline explores decision-making at various levels, from individuals to entire nations. Economics arises because people have unlimited needs but limited resources. It studies how societies allocate scarce resources to produce goods and services and distribute them. 2. Economic Systems Economic systems determine how resources are allocated:  Market Economy: Resources are allocated through decentralized decisions of firms and households interacting in markets.  Centrally Planned Economy: The government makes decisions on production, distribution, and prices. Also, the government, contributes correcting market failures, redistributing income and implementing macroeconomics policies.  Mixed Economy: A combination of both systems where markets operate freely, but the government intervenes to correct market failures and redistribute income. 3. Economics Models Inside of the economists, we distinguish two roles:  Scientists: Explain the economy through theories and models. (explain world)  Consultants: Provide solutions to economic issues. (improve world) Economics employs the scientific method: 1. Observation: Identifying economic patterns and behaviours. 2. Theory Development: Formulating hypotheses about economic interactions. 3. Empirical Testing: Using historical data and experiments to validate theories. Economic models are simplified representations of reality, helping to predict economic outcomes. These 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) Those economic models have many characteristics: manageable and understandable; based on realistic assumptions and testable with empirical analysis. These models include two types of analysis:  Positive Analysis: Describes economic consequences without judgment and use the economic model based on certain assumptions.  Normative Analysis: Evaluates policies based on societal goals. 4. The Circular-Flow Model This model illustrates the movement of resources and money in an economy:  Households: Provide labour and consume goods.  Firms: Produce goods and services, paying wages to households.  Government: Regulates taxes and redistributes income.  Financial Markets: Facilitate saving and investment.  Foreign Sector: Represents international trade and capital flows. The main economic flows:  Factor Services: Households supply labour, capital, and land to firms.  Wages, Rents, Interest, and Profits: Firms pay households for factor services.  Personal Consumption: Households spend earnings on goods and services 5. Microeconomics vs. Macroeconomics Economics is divided into two main branches:  Microeconomics: Focuses on individual decision-making, market structures, and price formation.  Macroeconomics: Examines aggregate economic indicators such as GDP, inflation, unemployment, and government policies. While both fields use similar concepts, microeconomics studies specific agents (e.g., firms, consumers), whereas macroeconomics analyses overall economic performance and policy impacts. 6. Fundamental Questions in Economics: 1. What is produced and in what quantity? Goods and services are produced based on available resources and consumer demand. In a market economy, production is guided by supply and demand, while in a planned economy, the government decides what and how much to produce. 2. How are these goods produced? Goods are produced using various factors of production, including labor, capital, and natural resources. The production method depends on technology, efficiency, and economic structure. 3. For whom are they produced? Goods and services are distributed based on purchasing power in a market economy, while in a planned economy, the government allocates resources to meet societal needs. 4. Who makes economic decisions? In a market economy, firms and households make economic decisions through decentralized interactions. In a planned economy, a central authority, such as the government, determines production and distribution.  The Market Forces of Supply and Demand 1. Introduction to Market Forces Markets are platforms where buyers and sellers interact to exchange goods and services. The forces of supply and demand determine the price and quantity of goods in a competitive market. The key objective of market analysis is to understand how these forces allocate scarce resources efficiently. 2. Market Types Markets can be classified into different types based on competition levels:  Perfectly Competitive Market: Many buyers and sellers, homogeneous products, no single entity influences the price, and perfect information availability.  Monopoly: A single seller dominates the market.  Oligopoly: A few large firms control the market.  Monopolistic Competition: Many sellers offer differentiated products. 3. Market Demand Demand is determined by consumers' willingness and ability to purchase goods at various prices.  Law of Demand: As price increases, quantity demanded decreases (ceteris paribus). So, the price of a product is determinant to the quantity demanded. Shifts in the Demand Curve: if we analyse one variable, we only focus on that variable. If one of all these factors change, the demand curve will shift. 1. Price: Higher price → Lower quantity demanded. 2. Income: Normal goods (demand ↑ with income), Inferior goods (demand ↓ with income). And the other way around. demand increases [ \ → \ ]; [ \ ⃪⃪⃪ \ ] demand decreases. 3. Prices of Related Goods: o Substitutes: Price increase in one good → Demand decrease for the other. o Complements: Price increase in one good → Demand increase for the other. 4. Tastes and Preferences: Favourable changes → Demand increase. 5. Expectations: Future price decrease expectations → Current demand decrease. Maybe in the future people will consume less or not. Those expectations are about: future income, future prices or economy 6. Number of Buyers: More buyers → Higher demand. [ \ → \ ] Market Demand Curve: The quantity demanded between two companies is the horizontal sum of all individual demand curves. 4. Market Supply Supply is determined by the willingness and ability of producers to sell goods at different price levels. The price is the most important determinant of the quantity supplied.  Law of Supply: As price increases, quantity supplied increases. Shifts in the demand curve: if one of all these factors change, the supply curve will shift. 1. Price: Higher price → More quantity supplied. 2. Input Prices: Lower production costs → More supply. [ / → / ] As prices of the raw materials are low, the firms supply a larger quantity at each price. 3. Technology: Improvements increase supply. As machines to produce are cheaper, we can save some costs and improve in other aspects. 4. Expectations: Expected future price rise → Reduced current supply. 5. Number of Sellers: More sellers → Increased supply. Market Supply Curve: The horizontal sum of all individual supply curves. 5. Market Equilibrium Equilibrium is reached when quantity demanded equals quantity supplied, determining the market-clearing price.  Equilibrium Price: The price where supply meets demand.  Equilibrium Quantity: The quantity exchanged at equilibrium price.  Surplus: Occurs when supply exceeds demand, leading to downward pressure on prices.  Shortage: Occurs when demand exceeds supply, leading to upward pressure on prices.  Comparative Statics: Analysing how equilibrium changes when supply or demand shifts. 6. Elasticity Concept Elasticity measures how quantity demanded or supplied responds to price changes.  Price Elasticity of Demand (PED): Measures responsiveness of quantity demanded to price changes. o Elastic demand (PED > 1): Consumers react significantly to price changes. o Inelastic demand (PED < 1): Consumers react minimally. o Unit elastic demand (PED = 1): Proportional change in demand to price. o Perfectly inelastic demand (PED = 0): One extreme case. o Perfectly elastic demand (PED = 0): The other extreme case. Price elasticity of demand depends on extent to which close substitutes are available, if the good is necessity or not, how broadly or narrowly the good is defined and the time horizon. Although the total revenue is the amount paid by buyers and received by sellers of the good [Revenue = P x Q] o Elastic demand (PED > 1): % change Q > % change P. o Inelastic demand (PED < 1): % change Q < % change P. The income elasticity of demand measures how much the quantity demanded of a good respond to change in customers income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to a change in the price of another good. Whether the result is positive or negative, depends on whether the two goods are complements or substitutes.  Price Elasticity of Supply (PES): Measures responsiveness of quantity supplied to price changes. The price depends on the flexibility of sellers to change the amount of the good they produce when price changes. o Inelastic (PES < 1): The prices rise, and the quantities rise less. o Unit elastic (PES = 1): The prices and the quantities rise in equilibrium.  o Elastic (PES > 1): The prices rise, and the quantities rise more. o Perfectly inelastic (PES = 0): One extreme case o Perfectly elastic (PES = 0): The other extreme case 7. Consumer and Producer Surplus  Consumer Surplus: The buyer´s willingness to pay for a good (the maximum that the buyer pays). Although is the difference between willingness to pay and actual payment. We calculate the areas of the consumer surplus using two formulas: triangle ( ½ x b x h) and the rectangle (b x h)  Producer Surplus: The cost is the value of everything a seller must give up to produce a good. Although is the difference between the price received by producers and their production costs. We calculate the areas of the producer surplus using two formulas: triangle ( ½ x b x h) and the rectangle (b x h)  Total Surplus: The sum of consumer and producer surplus, representing overall economic welfare. 8. The Impact of Taxes The tax revenue is [T x Q], where Q is the quantity sold, and T is the size of the tax. Although all if formed by the price buyers pay less the price sellers receive. A tax is a deadweight loss, because is the fall in total surplus that results from a market distortion. The dimension of the tax depends on how the quantity demanded or supplied respond to changes. Also depends on the price elasticities of supply and demand. The greater elasticities of demand and supply derivates on: o The larger will be the decline in equilibrium quantity o The greater the deadweight loss of a tax o The lower the tax burden for those agents  Tax Incidence: Determines how tax burdens are shared between buyers and sellers.  Effect on Market: Taxes increase prices for consumers and reduce sellers’ received prices, leading to lower equilibrium quantities.  Deadweight Loss: The efficiency loss due to reduced trade volume caused by taxation.