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Chapter 1: The four core principles of economics P ROF ESSO R M I K A L S KU T ERU D ECO N 1 0 1 – FA L L 2 0 2 4 U N I V ERSITY O F WAT ER LO O What is an economy? “Lord of the Flies” by William Golding published in 1954. Airplane...

Chapter 1: The four core principles of economics P ROF ESSO R M I K A L S KU T ERU D ECO N 1 0 1 – FA L L 2 0 2 4 U N I V ERSITY O F WAT ER LO O What is an economy? “Lord of the Flies” by William Golding published in 1954. Airplane crashes on a remote Pacific island. Survivors are a group of boys aged 6 to 12. Scarce resources available on the island for survival. What to produce (hunt and gather)? How to produce? Who does what? Who gets what? Examples of economic systems 1. Tribal hunter-gatherer societies (“Dances with Wolves”) Tribal members hunt wild animals and search for edible grains and plants Production shared equally 2. Slavery (“Gladiator”) Technological advances (e.g., iron replaces wooden plough) result in surplus production (above subsistence) Incentive for powerful individuals to enslave workers through violence/war 3. Feudalism (“Braveheart”) Nobility seized land, re-allocated it to serfs, who worked small plots to produce for themselves, and were taxed in exchange for protection 4. Market capitalism (most of the world today, including Canada) Industrial revolution brought farmers into factories Production and distribution of goods and services through competitive markets The principled approach to economics Economics is the study of economies or economic systems. Economists are people who do economics. 250 years of economic thought has led to some core ideas or “principles of economics.” The goal of this course is not to memorize definitions or facts about the economy. The goal is to learn how to “do economics” by thinking like an economist. At the core of economics are four principles. As you’ll see, these principles are highly relevant to your everyday life. They will help you to make better decisions in your personal and professional life. The “atoms” of economics are individual decisions. In understanding how people make choices, we begin to understand what gets produced, who produces it, and who gets what. 1. Cost-Benefit Principle Only pursue options when the benefit is at least as big as the cost. But how to compare costs and benefits that don’t have explicit dollar values (“nonfinancial”)? What is the most that you’d be willing to pay to obtain the benefit or to avoid the cost? But not everything is about money. But sometimes the benefit goes to someone else. But costs and benefits are sometimes uncertain. But sometimes there are framing effects. Costs and benefits are the economic incentives that lead people to make the choices they do. Economic surplus The difference between the benefit you receive and the cost you incur is the economic surplus. It is a measure of how much your choice has raised your economic well-being. Every time we buy something, we receive some economic surplus, but what about the seller of the good? The selling price is a benefit to the seller. If the cost of producing the good is less than the selling price, they also receive a surplus. Both the buyer and seller are better off. This mutual gain from voluntary exchange lies at the heart of all economic transactions. Economic transactions are not “zero-sum games.” 2. Opportunity Cost Principle The true cost of something is what you must give up to get it. What you give up is the next best alternative. This is the opportunity cost of a choice. Sometimes the opportunity cost of a choice is much bigger than the direct cost. What is the cost of every hour spent gaming? The biggest cost isn’t the gaming hardware and software. The biggest cost is the loss of time that could have been spent doing something else. 2. Opportunity Cost Principle What is the cost of attending today’s ECON 101 lecture? Full-time tuition is $9,000 per year. With 10 courses, that’s $900 per course. With 24 lectures per lecture, that’s $37.50 per lecture. For international students, the cost is $237.50 per lecture. Should this out-of-pocket cost affect your decision of whether to attend a lecture? No, because you must pay it whether you attend today’s lecture. It’s an example of a sunk cost. The cost that matters for your decision is the 90 minutes of time that could have been spent doing something else such as earning a wage in the labour market. Choices require resources, whether its our income, time, or energy. But these resources are scarce. The scarcity of resources means that whenever we choose to do something, we are necessarily giving up (“foregoing”) doing something else. When asking yourself whether to make a particular choice, always include “or” followed by the next best alternative in your question. Four important lessons about opportunity costs 1. Some out-of-pocket costs are opportunity costs. ◦ Your rent costs at university are a cost if you otherwise would have lived at home rent-free. 2. Sometimes the biggest opportunity costs are not out-of-pocket costs. The cost of acquiring a four-year degree are four years of foregone earnings in the best job you could have got with your high school diploma. 3. Not all out-of-pocket costs are opportunity costs. ◦ Your food costs at university are not an opportunity cost, since you would still have needed to eat. 4. Some nonfinancial costs are not opportunity costs. ◦ Studying and passing university exams requires hard work, but if the next best alternative is a job that also requires equally hard work, then this cost should not be included. Economic phenomena consistent with the opportunity cost principle 1. Most Canadians have romantic relationships during their teen years but why do so few get married during their teen years? 2. Why are there fewer stay-at-home moms? 3. Why are more Canadians born in September and October than in February and March? 4. Why are terminally ill people more willing to take unproven experimental drugs? 5. Why are there often leftover snacks at business meetings? Production possibilities frontier (PPF) You have 3 hours/night to study economics or psychology. Each hour spent studying increases your grade but by more in economics than psychology. The PPF shows the possible improvements in your grades. Notice it impossible to improve one grade without reducing the other. What is the opportunity cost of a one percentage point increase in your psychology grade? Features of PPFs 3. The Marginal Principle Up to now, we have only considered binary choices (either/or choices). But many choices in life involve decisions about “how many” or “how much”? The marginal principle says decisions about quantities are best made incrementally. We should break them down into a series of marginal decisions comparing the incremental benefits and costs of buying one more. The rational rule The rational rule says we should continue doing something as long as the marginal benefit of doing a little more exceeds the marginal cost. Following the rational rule ensures that economic surplus is maximized. The rational rule The rational rule says we should continue doing something as long as the marginal benefit of doing a little more exceeds the marginal cost. Following the rational rule ensures that economic surplus is maximized. The rational rule The rational rule says we should continue doing something as long as the marginal benefit of doing a little more exceeds the marginal cost. Following the rational rule ensures that economic surplus is maximized. 4. The Interdependence Principle Your best choice in any situation doesn’t happen in a vacuum but depends on: 1. Your other choices ◦ You have limited resources (income, time, attention, productive/cognitive capacity, wealth) so your choice in any situation affects the availability of resources in other situations. 2. The choices of other decision makers ◦ The resources available to you depend on the resources used by others. This scarcity results in competition between economic agents (people, business, governments) and your decisions. 3. Dependencies between markets ◦ Your choice in any market (labour, housing, credit) depend on what is happening in other markets. 4. Dependencies over time ◦ Your choice today is affected by your choices yesterday and your expected future choices. Chapter 2: Demand and Consumer Choice P ROF ESSO R M I K A L S KU T ERU D ECO N 1 0 1 – FA L L 2 0 2 4 U N I V ERSITY O F WAT ER LO O Darren’s demand for gasoline Darren owns a car and uses it to commute to work and school, go shopping, and visit friends and family. Darren was surveyed about his demand for gasoline at various hypothetical prices. The chart shows the results. Darren’s individual demand curve A Price is on the vertical axis and quantity demanded is on the horizontal axis. B When the price is $1.80 per litre, Darren will use 1 litre of gas per day, but when the price is $1.20 per litre, he will use 5 litres per day. C The individual demand curve shows the quantity demanded at each price. Law of demand The law of demand says that our demand for a good increases when its price decreases, and vice-versa. In other words, individual demand curves are downward sloping. The demand curve shows what happens to demand when the price changes holding everything else constant (“ceteris paribus”). What’s behind Darren’s demand curve? $1.80 If the price of gas is $1.39 per litre, how much gas should Darren buy each day, on average? Use the marginal principle to get the answer. The rational rule for buyers The rational rule says to keep buying more until the marginal benefit equals the marginal cost. Since the marginal cost is the price of a litre of gas, we should buy until the marginal benefit is equal to the price. The law of demand is a consequence for consumption to provide us with diminishing marginal benefit. From individual to market demand From surveying a random sample of 3,000 consumers, we can determine the market demand for gas in the population of 30 million people. Market demand curve The market demand curve is downward sloping. Movements along the market demand curve reflect changes in the quantity demanded of existing customers and the entry/exit of new/old customers from the market. Shifts in the market demand curve What happens to the market demand curve if income tax rates were reduced leaving consumers with more income to spend? Six factors that shift the demand curve 1. Income ◦ A higher income allows individuals to buy more of everything. ◦ A normal good is one that we demand more of when our income increases. An inferior good is one that we demand less of when our income increases. 2. Preferences ◦ A marketing campaign that convinces us that we need to wear a certain brand of clothing to be “cool.” 3. Prices of related goods ◦ A change in the price of a related good. ◦ When a decrease in the price of a related good increases our demand for a good, the related good is a complementary good. When the price decrease of a related good decreases our demand for a good, the related good is a substitute good. Six factors that shift the demand curve 4. Expectations ◦ Beliefs about whether future prices will be higher or lower affect our demand today. 5. Congestion and network effects ◦ Our value for a good depends on other people’s demand for the same good. ◦ A network effect occurs when a good becomes more valuable to us when more other people are using it. A congestion effect occurs when a good becomes less valuable when more other people are using it. 6. The type and number of buyers in the market ◦ Market demand is the sum of individual demand, an increase in the number of consumers in the market will increase market demand. ◦ Unlike the first five factors, this factor shifts the market demand curve, but not individual demand curves. Movements along vs shifts of the demand curve Chapter 3: Supply and Producer Choice P ROF ESSO R M I K A L S KU T ERU D ECO N 1 0 1 – FA L L 2 0 2 4 U N I V ERSITY O F WAT ER LO O Shell’s individual supply curve A When the price is $0.80 per litre, Shell supplies 8 million litres per day to the market. If the price rises to $1.00 per litre, the quantity supplied increases to 9 million litres per day. B At price below $0.80 per litre, Shell will stop supplying gas. C The individual supply curve shows the quantity supplied by Shell at each price. Law of supply The law of supply says that our supply of a good decreases when its price decreases and increases when its price increases. In other words, individual supply curves are upward sloping. The supply curve shows what happens to supply when the price changes holding everything else constant (“ceteris paribus”). Perfect competition In modelling the market demand for gasoline in Chapter 2, we assumed that Darren and all the other buyers in the market do not choose the price they pay. Analogously, in this chapter we assume that gas suppliers are price-takers (not price-makers). How do we justify this assumption? A market is perfectly competitive if: 1. all firms in the market are selling an identical product 2. many buyers and sellers (each small relative to the overall size of the market) and no barriers to entry/exit 3. perfect information 4. zero mobility costs (costs nothing to switch from one seller to another) In a perfectly competitive market, there’s no incentive for firms to sell at a price that deviates from their competitors’ price. Why? Because if they sell at a higher price, nobody will buy from them, and if it was possible to sell at a lower price and still make profit, a competitor would already have exploited that opportunity. In the real world, not all markets are perfectly competitive, but it simplifies the theoretical analysis.  Choosing the best quantity to supply The marginal benefit of selling one more litre of gas is the market price. To calculate the marginal cost of selling one more unit, Shell needs to apply the opportunity cost principle – how do costs compare in next best alternative when extra litre isn’t produced? The marginal cost of production includes variable costs which vary with the quantity of output produced (e.g., labour and raw materials), but not fixed costs, which do not vary with the quantity of output (e.g., buildings and equipment). Sell one more unit if the price is greater than (or equal to) the marginal cost. The rational rule for sellers The rational rule says to keep selling more until the marginal benefit equals the marginal cost. Since the marginal benefit is the price of a litre of gas, Shell should sell until the marginal cost is equal to the price. The law of supply is a consequence of diminishing marginal product and rising input costs. Diminishing marginal product Marginal cost tends to increase with as more output is produced. Why? As a firm uses more of a variable input (e.g., labour) with a given quantity of fixed inputs (e.g., kitchen equipment), the marginal product of the variable input diminishes. Diminishing marginal product means that marginal increases in output become increasingly difficult to achieve and so the marginal cost of production increases. Mathematical example Y = L× K (" production function") L (“labour”) K (“capital”) Y (“output”) MPL 0 4 0 -- 1 4 2 2 2 4 2.83 0.83 3 4 3.46 0.64 4 4 4.00 0.54 5 4 4.47 0.47 6 4 4.90 0.43 Mathematical example Y2 If Y = L × K , then L = K Y K L TC MC (wage=$15) 0 4 0 0 -- 1 4 0.25 3.75 3.75 2 4 1 15 11.25 3 4 2.25 33.75 18.75 4 4 4 60 26.25 5 4 6.25 93.75 33.75 6 4 9 135 41.25 From individual to market supply Movements along the supply curve A change in the price causes movement along the supply curve yielding a change in the quantity supplied. A higher price leads existing firms to expand their production and new firms to enter the market. Both factors serve to increase the quantity supplied in the market. Shifts in the market supply curve What happens to the market supply curve if the market price of crude oil increases? Five factors that shift the supply curve 1. Input prices ◦ An increase in the price of the inputs used to produce output increases the marginal cost of production and reduces the number of units supplied at every price. 2. Productivity and technology ◦ Productivity gains occur when businesses learn how to produce more using same inputs. May reflect technological change (new machinery or equipment), new management techniques or production processes, or learning by doing. 3. Prices of related outputs ◦ Substitutes-in-production are alternative outputs produced using the same inputs, whereas complements-in-production are produced together. ◦ An increase in the price of a substitute-in-production causes a supply to decrease, whereas an increase in the prices of a complement-in-production causes supply to increase. Five factors that shift the supply curve 4. Expectations ◦ A belief that the price of the output will increase in the future incentivizes firms to store the output instead of selling it, thereby reducing supply. ◦ More relevant for outputs that are non-perishable (gasoline versus fresh fish). 5. The type and number of sellers ◦ A change in the number of sellers in the market affects market supply. ◦ A ruling by the Competition Bureau to allow or disallow a corporate merger affects the number of sellers in the market and potentially supply and, in turn, the market price. ◦ Unlike the first four factors, this factor shifts the market supply curve, but not individual supply curves. Movements along vs shifts of the supply curve Chapter 4: Equilibrium - Where Supply Meets Demand P ROF ESSOR MI KA L S KU T ERU D ECON 1 0 1 – FA L L 2 0 2 4 U N I V ERSITY OF WAT ER LOO Market economy vs planned economy Who decides what is produced in the Canadian economy, who and how it’s produced, and who gets what? In a market economy, individuals make their own choices about what to produce and consume through their market transactions. For example, they sell their labour in labour markets and buy their food in food markets. In a planned economy, decisions about production and distribution are centralized. Nearly all countries in the world today rely on some mixture of markets and public provision of goods and services. In Canada, we mostly rely on governments to provide health and education, but private markets to distribute food and housing. What is a market? A market is a setting that brings together buyers and sellers to engage in transactions. The terms of trade in most markets is determined by a price which incentivize sellers to adjust their supply and buyers to adjust their demand. But some markets do not have prices. 1. Market for votes 2. Marriage market 3. Grades market 4. PR status market In markets with prices, who sets the price? Where does the price come from? Equilibrium An equilibrium is a situation in which competing forces – demand and supply in our case – are balanced so there is no tendency to change. The equilibrium price is the price at which the quantity supplied equals the quantity demanded in the market. The equilibrium quantity is the quantity that is bought and sold at the equilibrium price. Equilibrating mechanism A surplus exists when the price is such that the quantity supplied exceeds the quantity demanded. Gas station owners offer gas at a lower price to attract new customers. A lower price increases demand and decreases supply bringing the market back to equilibrium. A shortage exists when the price is such that the quantity demanded exceeds the quantity supplied. Gas station customers offer to pay a higher price to get to the front of the queue. A higher price increases supply and lowers demand bringing the market back to equilibrium. Symptoms of out-of-equilibrium markets 1. Unusual changes in prices ◦ Where there is a shortage, we should see prices increasing fast relative to other prices in the economy. Where there is a surplus, prices should be decreasing relatively fast. 2. Queuing ◦ When there is a shortage, we need to find a way other than the price to allocate the good. Queuing (“first-come first-served“) is a common alternative. 3. Secondary markets ◦ Where the price is kept artificially high in a market by limiting entry of new suppliers in the “official” or legal market, there is a surplus and an incentive for sellers to supply the good at a lower in a secondary or illegal market. The diamond-water paradox Water is essential for life, while diamonds are mostly used for decoration. But the price of water is low, and the price of a diamond is very high. This is the, so called, paradox of value. The principle of diminishing marginal benefit and the fact that prices are determined at the margin provides an answer to this paradox. Effect of an increase in demand On Friday afternoon before a long summer weekend, the demand for gas increases because drivers need to get to their cottages. The increase in demand moves the market to a new equilibrium at B. The equilibrium price increases from $1.40 per litre to $1.60 per litre. The equilibrium quantity bought and sold increases from 100 million litres to 125 million litres. Effect of an increase in demand What is the dynamic price adjustment process? 1. With more drivers filling their tanks, the quantity demanded increases at every price causing demand curve to shift to the right. 2. Price doesn’t adjust instantaneously, so immediate effect is a shortage. 3. Gas sellers respond by increasing price, which increases supply and decreases demand and brings market to new equilibrium. 135 Effect of a decrease in demand Suppose the federal government decides to make all expenditures on public transportation income tax deductible. The lower marginal cost of taking the bus or a train lowers the demand for gas moving the market to a new equilibrium at B. The equilibrium price decreases from $1.40 per litre to $1.20 per litre. The equilibrium quantity decreases from 100 million litres to 75 million litres per day. Effect of an increase in supply A technological innovation in the process used to refine crude oil to produce gasoline results in an increase in the quantity of gas supplied at every price. The increase in supply initially leads to a gas surplus but competition between sellers incentivizes price reductions and pushes the economy toward a new equilibrium at B. The equilibrium price decreases from $1.40 per litre to $1.20 per litre. The equilibrium quantity increases from 100 million litres to 120 million litres per day. Effect of a decrease in supply A war in the Middle East disrupts the extraction of crude oil thereby decreasing its supply and increasing the world price crude oil. The higher price of crude oil increases the marginal cost of refining gasoline which shifts the market supply curve for gas to the left and leads to a new market equilibrium at B. The equilibrium price increases from $1.40 per litre to $1.60 per litre. The equilibrium quantity decreases from 100 million litres to 80 million litres per day. COVID effect on deodorant market Data from Statistics Canada suggests that the COVID pandemic caused a decrease in the market price of deodorant. What explains this effect? When both supply and demand shifts Which case best captures the COVID effect on the price of deodorant?