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Incentives Matter: -People respond in particular ways to incentives of all kinds - Incentive: Something that motivates one to try harder and achieve Rewards and Penalties that motivate behavior Good Institutions Align Self-Interest with social interest. - When markets work well, i...

Incentives Matter: -People respond in particular ways to incentives of all kinds - Incentive: Something that motivates one to try harder and achieve Rewards and Penalties that motivate behavior Good Institutions Align Self-Interest with social interest. - When markets work well, individuals pursuing their own interest also promote social interest - Adam Smith - When markets don't work well, the government can change incentives with taxes, subsidies and regulation. - Trade-Offs - More testing means that approved drugs will have fewer side effects - Drug lag: people are harmed when approval of a safe drug is delayed - Drug loss: higher testing cost may mean a safe drug is never developed - Trade-Off: Sacrifice needed to be made to design a product. - Example of opportunity cost: The choice to attend college means you lose the opportunity to lose working full time. Scarcity - A resource is scarce when there isn't enough of that resource to satisfy our wants. - Great Economic Problem- How to arrange scarce resources to satisfy as many \possible wants as possible Thinking on the Margin - We make choices by considering the benefits and costs of a little more or a little less. - Marginal means one more or one less - Marginal Cost, Marginal Revenue, and Marginal tax rates. - “A little bit slower or a little bit faster” The Power of Trade - The benefits of trade go beyond the benefits of exchange - Trade leads to increased production through specialization (focus of labor on a specific product)  - It also allows us to take advantage of economies of scale - Theory of comparative advantage: When people or nations specialize in goods in which they have a low opportunity cost, they can trade to mutual advantage. The Importance of Wealth and Economic growth: -Economic growth creates wealth. -Wealthier economies enable richer and healthier lives. Institutions Matter - Institutions provide incentives ( a motivation to achieve a desired outcome ) to save and invest in: Physical Capital, Human Capital, Innovation and Efficient Organizations - Institutions foster growth: Property growth, Political stability, Honest government, Dependable legal system and competitive and open markets. Booms and Busts Cannot Be Avoided But Can Be Moderated - Economies do not grow at a constant pace - Booms and Busts are a normal response to changing economic conditions - In a downturn, output (GDP) drops and unemployment increases. - The government can use fiscal and monetary policy to reduce swings in output and unemployment - If used improperly, the tools can make an economy more likely to change. Inflation Is Caused by Increases in the Supply of Money - A countries central bank regulates the supply of money - A sustained increase in supply of money, without an increase in the supply of goods, caused prices to rise. - Inflation: Increase in the general level of prices, happens when money supply goes up. - Inflation can make people poorer. - Unpredictable inflation makes it harder for people to figure out the real values of goods, services and investments. - Excessive inflation can lead to economic disruption. Central Banking Is a Hard Job - U.S Federal Reserve is often called on to combat recessions (period of economic decay) - There are lags between a decision by the Fed and the effects of the decision. - In the meantime, economic conditions may change - “moving target.” CH2 BEGINS Benefits of Trade - Trade makes people better off when preferences are different. - Trade increases productivity through specialization and the division of knowledge. - Trade increases productivity through comparative advantage. Trade creates Value - Trade moves goods from people who value that item less (preference) to people who value them more. Trade Allows Specialization - With no trade, there is no specialization - People will specialize in the production of a single good only when they can trade for other goods. Increased Productivity - We can produce more through trade than by individual production - People who specialize have more knowledge about their field. Division of Knowledge - Without specialization, each person produces their own food, clothing, and so on. - Each person has the same knowledge as everyone else - Combined knowledge is not much more than that of a single person. Absolute and Comparative Advantage - Another reason to trade is to take advantage of differences - Countries have different climates, levels of human capital and so on. - Different countries are therefore suited to produce different goods. - To benefit from trade, a country doesn't need to have an absolute advantage. Absolute Advantage: The ability to produce the same good using fewer inputs then another producer and creating more of that same good. Comparative Advantage: Producing goods at the lowest opportunity cost. Comparative Advantage and Wages - Difference in wages reflect differences in productivity - Wages will be higher in high-productivity countries than in low-productivity countries - Trade raises wages to the highest levels allowed by a country's productivity. Globalization and Wages -Wages will rise in high-demand industries and fall in low-demand industries -Workers will move from low-wage industries to high-wage industries until wages equalize. -The transition isn't always quick or easy. CH2 ENDS LECTURE NOTES 9/26: CH3 SUPPLY and DEMAND Supply, Demand and equilibrium are the important tools in econ as they explain how prices are determined Demand Curve: A function that shows the quantity demanded at different prices Quantity Demanded: The quantity that buyers are willing and able to buy at a particular price. A Demand Curve Can Be Read: - Horizontally: At a given price, how much are people willing to buy? Right and Down: Start to Finish - Vertically- End to Finish Up and left. Law of Demand - A demand curve is negatively sloped - The lower the price, the quantity demanded increases. - Demand summarizes how consumers choose to use a good including preference and substitution. - If one substitute goes up, the other follows. They are similar. - (OIL IS AN EXAMPLE) Consumers will buy more oil at lower prices than at higher prices - Ex. Go to Costco to get cheaper gas. - When the price is high, consumers will use it in its most valuable use. - As the prices fall, consumers will also use oil in its less valued uses. Consumer Surplus: The consumers gain from exchange; difference between max price a consumer is willing to pay for a certain quantity and the market price. Ex: I want to buy a SENTRA for 8,000 while the tagged price is 10k. I got the car for 9k. The consumer surplus is 1k Total Consumer Surplus: The area beneath the demand curve and above the price. (IMPORTANT) Shifting the Demand Curve - An increase in demand, shifts the demand curve to the RIGHT - At each price, people are willing to buy more - At each quantity, people are willing to pay a higher price. - DECREASE IN DEMAND- shifts the demand curve to the left - AT EACH PRICE, people are willing to buy for less - At each quantity, people are willing to pay a lower price. Factors That Shift Demand 1. Income -When people get richer, they buy more stuff - a normal good is a product or service that sees an increase in demand when a consumer's income increases - Most goods are normal goods -Inferior goods is a product whose demand decreases when a consumer's income increases. 2. Population - An increase in population will increase demand generally - A shift in subpopulations will change the demand for specific goods and services. 3. Prices of Substitute -Substitute is a good that can be consumed instead of another good. - A decrease in the price of a substitute will decrease the demand for the other goods. 4. Prices of Complement - Complements are things that go well together - A drop in the price of a complement will increase demand for the other complementary goods. 5. Expectations - The expectation of a reduction in future supply increases the demand today. Ex: I better buy oil right now as it will get expensive when the war starts. 6. Tastes - Changes in tastes caused by fads, fashions and advertising can all increase or decrease demand. SUPPLY - Supply Curve is positively sloped. - Horizontally: At a given price, how much are suppliers willing to sell  - Vertically: Represents the price of a good. - Supply Curve: A function that shows the quantity supplied at different prices - Quantity Supplied: Quantity that sellers are willing to be able to sell. - Law of Supply: As the price of an item rises, the quantity supplied increases. - Producer Surplus: Difference between market price and the minimum price at which a producer would be willing to sell a particular quantity - Total Producer Surplus: Area above the supply curve and below the price. SHIFTING THE SUPPLY CURVE - An increase in supply- shifts the curve to the right - At each price producers are willing to sell more - At each quantity, producers are willing to accept a lower price. - Decrease in supply- shifts the supply curve to the left. - Higher price required for same quantity - Smaller Quantity supplied at the same price than before. Factors that affect supply - Technological Innovations: Improvements in tech can reduce costs, thus increasing supply. - A reduction in input prices also reduces costs. Taxes and Subsidies - A tax on a output has the same effect as an increase in costs - A subsidy is the reverse of a tax. 3. Expectations - Suppliers who expect prices to increase will store goods for future sale and sell less today - The expectation of future prices increases therefore decreases current supply — Supply curve shifts left. 4. Entry or Exit of Producers - New producers increase supply, shifting the curve down and to the right. 5. Changes in Opportunity Costs - An increase in supply costs shifts the supply curve up and to the left. - If the Price of wheat increases, the opportunity cost of growing soybeans increases - Some farmers will shift away from producing soybeans and move to producing wheat as it makes more money. Elasticity of Demand - Measures how responsive the equanimity demanded is to change in price. - More responsive = more elastic - Elascity is not the same as a slope, but they are related - Elasticity rule: If two linear demand curves run through a common point, then the curve that is flatter is more elastic.  Determinants in finding substitutes -Ease in finding substitutes/ Easier to substitute = Greater Elascity -Time to adjust to price change/ More time = More substitutes = greater elasticity - The definition of the commodity/ Narrow definition brand = More substitutes = greater elasticity. Necessities vs Luxuries - Luxuries = greater elasticity/ Necessities are inelastic - Share of budget devoted to the good -Large share- greater elasticity FORMULA FOR ELASTICITY OF DEMAND Usually in Iterpret using the absolute value (drop the minus) Greater than 1 is Elastic Less than 1 Is Inelastic A firm's revenue = price per unit x quantity sold Revenue = Price x Quantity Elasticity measures how much Q goes down when P goes up. Relationship between elasticity and revenue - If the demand curve is inelastic, then revenues goes up when price increases - If the demand curve is elastic, then revenue goes down when price increases. ELASTICITY OF SUPPLY - Measures how responsive the quantity supplied is to a change in price. - Elasticity rule: If two linear supply curves run through a common point, then the curve that is flatter is more elastic. - Inelastic = Less responsive. - Elastic = More Responsive - Perfect Inelastic Supply = Perfectly Steep Slope - Perfectly Elastic Supply = Perfectly Straight LINE —--------------- Calculating the Elasticity of Supply  SAME AS DEMAND BUT S INSTEAD OF Q Applications of Supply - When policy buys guns measures how responsive the quantity demanded is to a change in price. - Elasticity of demand also tells you revenues Equilibrium: Price at which the quantity demanded is equal to the quantity supplied. Equilibrium occurs at the intersection of the demand and supply curves Equilibrium price and quantity are the only ones that are stable in a free market. Surplus: A situation in which quantity supplied is greater than quantity demanded. Shortage: When quantity demanded is greater than quantity supplied. A free market maximizes the gains from trade - Available goods are bought by buyers with the highest willingness to pay. - Goods are sold by the sellers with the lowest cost. - Between buyers and sellers, there are no exploited gains from trade or wasteful trades. - These three conditions ABOVE imply the gains from trades are maximized.  Demand and Quantity Demanded - A change in quantity demanded is a movement along a fixed demand curve - A change in demand is a shift of the entire demand curve. Supply and Quantity Supplied - A change in supply is a shift to entire a supply curve - A change in quantity supplied is a movement along a fixed supply curve Prices Are the key force integrating markets and motivating entrepreneurs Create rich connections between markets by conveying important information Create an incentive to respond to that information in socially useful ways Enable societies to mobilize vast amounts of knowledge toward common ends, Markets link to each other -Shift in supply and demand in one market ripple across the worldwide market -Entrepreneurs are constantly looking for ways to lower costs - These cost-cutting measures link markets that seem like they are a world away. Example: Oil and Candy Bars - Higher energy costs increase the cost of producing most products, including candy bars. Great Economic Problem: How do we arrange our limited resources to satisfy our unlimited wants? Suppose the supply of oil decreases. We should economize on oil by: Shifting oil out of low-valued uses, where we can do without or where there are good substitutes One option is central planning. - Problems of information and incentives Another option is the price system  - Each user of oil compares the value in their use with values in their use with the value in alternative uses. - Each user has an incentive to give up the oil if it has a lower value in their use. - A buyer compares the value of the good to its opportunity cost - Because markets linked, the price reflects information about many other markets - The market collapse all relevant information into a single number- the price. Main Concepts: 1. Price Signals: ○ Prices communicate information about supply and demand. ○ High prices signal shortages and encourage suppliers to produce more. ○ Low prices indicate less demand or oversupply, discouraging further production. 2. Profit and Loss: ○ Profits guide entrepreneurs to expand industries that are in demand. ○ Losses signal areas where resources should contract, leading uncompetitive firms to exit the market. 3. Market Efficiency and Competition: ○ A successful economy allows inefficient firms to fail, ensuring only strong competitors survive. ○ Competition drives firms to innovate and reduce costs. 4. Speculation and Futures: ○ Speculation is the act of profiting from future price changes. ○ Futures markets help companies hedge against risks, like fluctuating oil prices or harvest yields. ○ Farmers and airlines use futures to stabilize prices in unpredictable markets. 5. Prediction Markets: ○ Prediction markets allow people to bet on future events, such as elections, with prices reflecting probabilities. ○ Similar markets, like the Hollywood Stock Exchange, predict movie revenues. Examples and Applications: Hurricanes and Price Gouging: ○ Post-hurricane, prices rise to signal increased demand and incentivize production. ○ Politicians often impose price controls to prevent excessive price hikes. Futures Contracts in Business: ○ Airlines buy oil futures to lock in fuel costs, avoiding price hikes. ○ Farmers secure future crop prices to manage weather-related risks. Economic Speculation: ○ If one predicts oil prices will rise, they can buy oil today and sell it in the future for a profit.  ○ Futures contracts enable speculation without taking possession of physical goods. Key Takeaways: Prices act as signals wrapped in incentives, guiding economic decisions across time, goods, and markets. Successful firms capitalize on market signals, while uncompetitive ones naturally fail. Speculation and futures help smooth price fluctuations and improve predictions of future events. Commodity Taxes: Taxes on goods such as those on fuel, cigarettes and liquor. The government can collect a tax in one of two ways: - It can tax sellers for every unit sold - It can tax buyers for every unit bought -The tax has exactly the same effects whether it is “paid” for by sellers or buyers. - Who ultimately pays a tax is determined by the relative elasticities of supply and demand. Tax question: If the government imposes a new tax on every car sold, most of the tax will be paid by: Buyers or Sellers or it depends? It DEPENDS! Who ultimately pays the tax depends on the relative elasticity of supply and demand. More elastic side of the market can have time to escape more of the tax, as there is easily enough time to identify substitutes. Firms can escape the tax several ways: - Can substitute more capital (machines) for labor - Move overseas - Shut down Workers have fewer options: - Costs of leaving the labor force is to high. Demand is therefore more elastic than supply Result: More tax is paid by the workers If supply is more elastic than demand, most of the tax is paid by buyers. When demand is more elastic than supply, producers bear most of the cost of the tax. Subsidy: a reverse tax, the government gives money to producers or consumers. A subsidy creates a deadweight loss because some non beneficial trade occurs The supply curve tells us the cost of producing. The demand curve tells us the value of buyers Producing goods for which the cost exceeds the value creates waste. Whoever receives burden of tax receives benefit of subsidy Cotton Subsidy In some states, there are very large subsidies for water used in agriculture. (They pay 20-30 per acre of water, when it actually costs 200-500. Demand for cotton in California has gotten up in elasticity, as there are perfect other substitutes in other states. Supply is much more inelastic, meaning farmers get the majority of the benefit from subsidy. A subsidy might be beneficial if it increased something of importance. Edmund Phelphs suggested wage subsidies to increase employment of low wage workers Offsetting benefits include: Reduced crime, welfare payments, drug dependence and culture of rational defeatism.