IE-AC-111-Midterm Reviewer PDF

**CHAPTER 1:**\ \ \"THE AGE OF CHIVALRY IS GONE; THAT OF SOPHISTERS, ECONOMISTS, AND CALCULATORS HAS SUCCEEDED.\" **- EDMUND BURKE** **ECONOMICS -** comes from a Greek word \"OIKONOMIA\" which means \"MANAGEMENT OF THE HOUSEHOLD\" -A social study that deals with the allocation of scarce resources...

**CHAPTER 1:**\ \ \"THE AGE OF CHIVALRY IS GONE; THAT OF SOPHISTERS, ECONOMISTS, AND CALCULATORS HAS SUCCEEDED.\" **- EDMUND BURKE** **ECONOMICS -** comes from a Greek word \"OIKONOMIA\" which means \"MANAGEMENT OF THE HOUSEHOLD\" -A social study that deals with the allocation of scarce resources which have alternative uses to produce and distribute goods and/or services to satisfy unlimited human wants. **SCARCITY**- basic economic problem. It is the limited resources. **ECONOMIC EFFICIENCY-** to acknowledge the reality of scarcity and then figure out how to organize society in a way which produces the most efficient use of resources. MAJOR SUBFIELDS OF ECONOMICS 1\. **MICROECONOMICS** Adam Smith is usually considered the founder of microeconomics, the branch of economics which today is concerned with the behavior of individual entities such as markets, firms, and households. The Wealth of Nations (1776), Smith considered how individual prices are set, studied the determination of prices of land, labor, and capital, and inquired into the strengths and weaknesses of the market machanism. **2. MACROECONOMICS** - Concerned with the overall performance of the economy. It did not even exist in it\'s modern form until 1936, when John Maynard Keynes published his revolutionary General Theory of Employment, Interest and Money. **SOME COMMON FALLACIES ENCOUNTERED IN ECONOMIC REASONING:** 1\. POST HOC FALLACY - The first fallacy involves inference of causality. 2\. FAILURE TO HOLD OTHER THINGS CONSTANT - The second pitfall is failure to hold other things constant when thinking about an issue. 3\. FALLACY OF COMPOSITION - It is assuming that parts on members of a whole will have the same properties as the whole. **POSITIVE ECONOMICS VS. NEGATIVE ECONOMICS** **1. POSITIVE ECONOMICS -** describes the facts of an economy **1. NEGATIVE ECONOMICS -** involves value judgement and involves ethical precept and norms of fairness **THE THREE(3) PROBLEMS OF ECONOMIC ORGANIZATION** **What commodities are produced and in what quantities?** Society must decide the types and quantities of goods/services to produce. - **How are goods produced?** This involves determining who will produce the goods, the resources to use, and the techniques of production. - **For whom are goods produced?** This addresses who benefits from the production, focusing on income and wealth distribution.  **Types of Economies**: - **Market Economy**: Decisions about production and consumption are made by individuals and private firms. - **Command Economy**: The government makes key decisions about production and distribution. - **Mixed Economy**: A blend of market and command economies.  **Technological Responsibilities**: - Every economy has limited resources (labor, knowledge, factories, land, etc.). Deciding what and how to produce reflects how society allocates resources.  **Inputs and Outputs**: - **Inputs** (also called factors of production) include land (natural resources), labor (human work), and capital (durable goods used in production). - **Outputs** are the goods/services produced.  **Production-Possibility Frontier (PPF)**: - The PPF shows the maximum combinations of two goods that can be produced using available resources and technology. - It illustrates **opportunity cost**, which is the value of the best alternative forgone when making a choice between mutually exclusive options.  **Efficiency**: - Productive efficiency occurs when an economy cannot produce more of one good without reducing the production of another. - Inefficiency arises from factors like market failure or environmental degradation. **CHAPTER 2** **MARKET MECHANISM** - The method by which supply and demand interact to set prices and distribute resources in an economy. - Private entities optimize the distribution of commodities and services in free markets by making decisions based on price signals. **Successful Market Mechanisms in Different Countries:** - **European Union Emission Trading System (EU ETS)**: A cap-and-trade system that reduces greenhouse gas emissions by allowing companies to buy and sell emission allowances. - **California Cap-and-Trade Program**: Promotes innovation in clean technologies through a similar cap-and-trade system. **WHAT IS A MARKET?** - A market is a structure or meeting place where vendors and consumers exchange goods and services. It could be virtual (like an internet platform) or physical (like a retail store). - Prices are set by supply and demand, which also helps in resource allocation. **MARKET EQUILIBRIUM** - Occurs when the quantity supplied equals the quantity demanded at a certain price (equilibrium price). - Market forces naturally correct prices. If prices are too high, supply exceeds demand, leading to a price decrease. - Equilibrium represents efficient resource use in a competitive market. **HOW MARKETS SOLVE THE 3 ECONOMIC PROBLEMS** 1. **What to Produce**: Consumer preferences signal what to produce based on demand, ensuring supply meets demand. 2. **How to Produce**: Efficiency is encouraged as producers seek cost-effective methods, leading to innovation and better production techniques. 3. **For Whom to Produce**: Goods are distributed according to purchasing power, reflecting consumer demand and income levels. **THE INVISIBLE HAND** - A metaphor by Adam Smith describing the self-regulating nature of a free market, where individuals pursuing their own interests contribute to society's economic well-being. **TRADE, MONEY, AND CAPITAL** - Modern economies involve trading goods and services globally. - Trade networks depend on specialization and division of labor, with extensive use of money and large stocks of capital. **GLOBALIZATION** - An example is Apple\'s iPod, which is designed by Apple but assembled in China. Its components come from around the world, illustrating how trade involves multiple countries. **MONEY: THE LUBRICANT OF EXCHANGE** - Money facilitates trade by acting as a matchmaker between buyers and sellers. It's a medium of exchange beyond just currency. **CAPITAL** - Capital refers to durable goods produced by the economy and used in further production (e.g., factories, machinery). **GROWTH FROM THE SACRIFICE OF CURRENT CONSUMPTION** - Economic growth often requires sacrificing current consumption for future prosperity. **CAPITAL AND PRIVATE PROPERTY** - The relationship between capital and private property is fundamental in capitalist economies, where ownership incentivizes investment. **PROPERTY RIGHTS OF CAPITAL AND POLLUTION** - The legal and economic frameworks that define ownership of capital (like factories) and externalities (such as pollution). **WHAT IS THE INVISIBLE HAND OF GOVERNMENT?** - Governments have three main economic functions: - Increase efficiency by promoting competition and addressing externalities (e.g., pollution). - Promote equity by redistributing income through tax and expenditure programs. - Foster macroeconomic stability and growth by reducing unemployment and inflation through fiscal and monetary policies. **EFFICIENCY** - Refers to the optimal allocation of resources to maximize output and minimize waste. **COMPETITION** - The rivalry between businesses to attract customers and increase market share. **PERFECT AND IMPERFECT COMPETITION** - **Perfect Competition**: No firm or consumer is large enough to affect market prices. - **Imperfect Competition**: One or more conditions of perfect competition are not met, and a buyer or seller can affect the price. **EXTERNALITIES** - Costs or benefits for a third party not involved in the production or consumption of a good or service. - **Positive Externality**: When production or consumption benefits a third party. - **Negative Externality**: When it imposes costs on a third party. **PUBLIC GOODS** - Goods that everyone can enjoy, and no one can be excluded from using (e.g., public parks). - **Non-rivalrous**: The supply doesn't dwindle as more people use it. - **Non-excludability**: Everyone has access to the good. **TAXATION** - A financial charge imposed by governments to fund public expenditures, and a crucial source of revenue at all levels of government. **EQUITY** - Refers to ownership in a company or asset. It's the difference between what a company owns and what it owes. **MICROECONOMIC GROWTH AND STABILITY** - Growth and stability are intertwined, but policies that boost growth can sometimes reduce stability, and vice versa. **THE RISE OF THE WELFARE STATE** - The welfare state has evolved over time and is now interpreted and implemented differently across various countries. **THE MIXED ECONOMY TODAY** - Combines elements of capitalism and socialism, balancing individual freedom with social responsibility. - **Advantages**: Efficiency, social welfare, and stability. - **Disadvantages**: Bureaucratic inefficiency, high taxes, and political influence. **CHAPTER 3** *A man who knows the price of everything and the value of nothing.*\ ---Oscar Wilde **.DEMAND SCHEDULE** Both common sense and scientific observation show that the amount of a commodity people buy depends on its price. The higher the price of an article, the fewer units consumers are willing to buy, holding other factors constant. Conversely, as the price decreases, consumers buy more. **THE DEMAND SCHEDULE:** There exists a definite relationship between the market price of a good and the quantity demanded. This relationship between price and quantity bought is called the demand schedule or demand curve. **Law of Downward-Sloping Demand:** 1. **Substitution Effect:** When a good's price rises, consumers substitute it with cheaper alternatives.\ Example: As beef prices rise, people buy more chicken. 2. **Income Effect:** A price increase makes consumers feel poorer, reducing their purchasing power for other goods. **MARKET DEMAND CURVE:** The market demand curve is obtained by summing the quantities demanded by all individuals at each price. The law of downward-sloping demand applies here as well. **Forces Behind the Demand Curve:** 1. **Average Income:** As incomes rise, people tend to buy more goods, even if prices remain constant. 2. **Market Size:** A larger population increases demand. For example, California's 40 million people buy more cars than Rhode Island's 1 million. 3. **Prices of Related Goods:** The demand for a product depends on the prices of substitutes. As the price of computers fell, demand for typewriters decreased. 4. **Tastes and Preferences:** Cultural, psychological, or traditional factors can influence demand. For example, beef is popular in the US but taboo in India. 5. **Special Influences:** Weather or specific local conditions affect demand. For example, air conditioner demand rises in hot weather. **Shifts in Demand:**\ Changes in factors other than price cause demand curves to shift. When income, population, or preferences change, demand increases or decreases accordingly. **MOVEMENTS ALONG CURVES VS. SHIFTS OF CURVES:** A movement along the demand curve refers to a change in quantity demanded due to price changes, while a shift of the curve represents changes in demand itself due to external factors. **THE SUPPLY SCHEDULE (OR SUPPLY CURVE):** Shows how much of a product will be supplied at different price levels. It is determined by production costs, technological advancements, and other external factors. **Forces Behind the Supply Curve:** 1. **Production Costs:** The cost of inputs like labor and energy directly affects supply. 2. **Technological Advancements:** Innovations reduce input costs and increase supply. 3. **Government Policies:** Environmental regulations and trade agreements can impact supply. 4. **Special Influences:** Weather conditions or market structures also affect supply. **Shifts in Supply:**\ A shift in supply occurs when factors other than price affect the quantity supplied. For example, technological improvements or changes in input prices can shift the supply curve. **C. EQUILIBRIUM OF SUPPLY AND DEMAND:** - **Equilibrium Price:** The price at which the quantity demanded equals the quantity supplied. - **Equilibrium Quantity:** The quantity at which both supply and demand are balanced. **Movements in the Market:** - **Surplus:** Occurs when the quantity supplied exceeds the quantity demanded, causing prices to drop. - **Shortage:** Occurs when the quantity demanded exceeds the quantity supplied, causing prices to rise. **CHAPTER 4** **PRICE ELASTICITY OF DEMAND AND SUPPLY** **LAW OF SUPPLY AND DEMAND:**\ This law says that a price increase will increase supply and decrease consumer demand, but a price decrease will decrease supply and increase demand. **ELASTICITY**\ Elasticity measures how changes in one variable affect changes in another variable. **PRICE ELASTICITY OF DEMAND:**\ Price elasticity of demand focuses on how percentage changes in price affect the percentage change in demand. The formula for calculating elasticity is: **ELASTIC DEMAND:**\ Occurs when a minor price change has a significant effect on demand. **INELASTIC DEMAND:**\ Occurs when a minor price change does **NOT** have a significant effect on demand. **UNITARY ELASTIC DEMAND:**\ Occurs when price and demand change at the **SAME** rate. **PRICE ELASTICITY OF SUPPLY:**\ Price elasticity of supply focuses on how percentage changes in price affect the percentage change in supply. The formula for calculating elasticity is: **APPLICATION TO MAJOR ECONOMIC ISSUES:** **AGRICULTURE:**\ Agricultural technology increases supply, but demand grows slower, leading to lower prices. **Government Action:**\ Governments use crop restrictions and other programs to stabilize farm incomes. - Example: Price drops in crops like wheat or rice due to surplus supply. **COMMODITY TAXES:**\ Taxes shift the supply-demand balance. **Impact on Consumers or Producers:**\ When demand is inelastic, consumers bear more of the tax burden. - Example: A tax on gasoline where most consumers still buy it despite higher prices. **PRICE CONTROLS:** **PRICE CEILINGS:**\ Set a maximum price (e.g., rent control). - Result: Excess demand, leading to shortages. - Example: Rent control in big cities causing a housing shortage. **PRICE FLOORS:**\ Set a minimum price (e.g., minimum wage). - Result: Excess supply, leading to surpluses. - Example: Minimum wage causing unemployment if employers can\'t hire as many workers. **SUMMARY:**\ Price drops due to supply increases. **CHAPTER 5** **Choice and Utility Theory** **Choice Theory** - **Choice theory explains how individuals make decisions when faced with various options. People select the option that provides the greatest benefit or satisfaction.** **Utility Theory** - **Utility theory quantifies preferences, where utility represents the satisfaction or happiness derived from a particular choice.** **Marginal Utility and the Law of Diminishing Marginal Utility** **Marginal Utility** - **Refers to the additional satisfaction a person receives from consuming one more unit of a good or service.** **Law of Diminishing Marginal Utility** - **As a person consumes more units of a good or service, the additional satisfaction (marginal utility) decreases.** **Total Utility** - **The overall satisfaction derived from consuming a certain quantity of goods or services.** **Relationship of Total Utility and Marginal Utility** - **Total utility increases as long as marginal utility is positive but at a decreasing rate due to the law of diminishing marginal utility. When marginal utility becomes zero or negative, total utility stops increasing or declines.** **Equimarginal Principle** - **States that consumers maximize satisfaction when the marginal utility per dollar spent on each good is equal.** **An Alternative Approach: Substitution Effect and Income Effect** **Substitution Effect** - **When the price of a good changes, consumers substitute it with similar goods, holding utility constant.** **Income Effect** - **Refers to the change in the quantity of a good demanded due to a change in the consumer\'s purchasing power caused by a change in the price of the good.** **Indifference Curve** - **A graphical representation showing different combinations of two goods that provide the same level of satisfaction.** **Law of Substitution (Marginal Rate of Substitution)** - **The rate at which a consumer is willing to exchange one good for another while maintaining the same level of utility.** **Budget Line (Budget Constraint)** - **Represents all possible combinations of two goods that a consumer can purchase given their income and the prices of the goods.** **Changes in Income and Price** **Income Change** - **Affects purchasing power, shifting the budget line outward or inward based on income increases or decreases.** **Single Price Change** - **Affects only one good, rotating the budget line to reflect the new relative price.** **From Individual to Market Demand** - **The market demand curve is obtained by summing the quantities demanded by all consumers.** **Demand Shift** - **Occurs when the entire demand curve shifts due to changes in income, preferences, or prices of related goods, affecting the quantity demanded at every price level.** **Substitutes and Complements** - **Goods are substitutes if an increase in the price of one increases the demand for the other.** - **Goods are complements if an increase in the price of one decreases the demand for the other.** - **Goods are independent if a price change for one has no effect on the demand for the other.** **Empirical Estimates of Price and Income Elasticities** - **Estimates show wide variation. Goods with readily available substitutes, like tomatoes or peas, tend to have high price elasticities.** **The Economics of Addiction** - **Examines how the consumption of addictive goods (e.g., drugs, alcohol, cigarettes) is influenced by prices, income, and policies, and how addiction affects future decisions and welfare.** **Paradox of Value** - **Also known as the diamond-water paradox, it highlights the discrepancy between the high market value of non-essential goods (e.g., diamonds) and the low market value of essential goods (e.g., water).** **Consumer Surplus** - **The additional benefit consumers receive when they purchase goods at prices lower than their maximum willingness to pay.** **Application of Consumer Surplus** - **Helps evaluate government decisions and highlights the privilege of modern consumers who can access valuable goods at low prices.** **CHAPTER 6** **The Role of Foreign Investment in Economic Growth** **A. THEORY OF PRODUCTION AND MARGINAL PRODUCTS** **PRINCIPLES OF ECONOMICS** **BASIC CONCEPTS** **Economy involves many different activities.** - **Farms use fertilizer, seeds, and labor.** - **Factories use energy, machinery, labor.** **Produce goods like tractors, DVDs, toothpaste.** - **Airlines use planes, fuel, and labor.** - **Provide fast travel through routes.** **TOTAL, AVERAGE, AND MARGINAL PRODUCTS** **Total Product (TP):\ **Refers to the total output produced using a specific number of inputs, such as labor. It increases as more labor is applied but eventually reaches a maximum. **Marginal Products:\ **The extra output from adding one additional unit of labor, holding other inputs constant. MP initially rises, then diminishes as more labor is added. **Average Product (AP):\ T**otal output divided by the total number of input units (labor). AP decreases as more labor is added. **THE LAW OF DIMINISHING RETURNS** **Adding more input (e.g., labor) reduces output.\ Marginal product decreases with extra input.\ Fixed resources like land or machinery limit output.\ Overcrowding or overuse causes decline.** **DIMINISHING RETURNS IN FARM EXPERIMENTS** **Farmer Tilly adds more labor.\ Initial increase in productivity (seeding, weeding).\ After a point, extra labor less effective.\ Overcrowding reduces productivity.** **RETURNS TO SCALE** **Returns to scale refer to how output responds to proportional increases in all inputs (e.g., labor, land, capital). There are three key types:** **Constant Returns to Scale:\ When all inputs are increased proportionally, and output increases by the same proportion. This is typical in industries like handicrafts.** **Increasing Returns to Scale (Economies of Scale):\ When an increase in all inputs results in a more-than-proportional increase in output. This is common in industries like manufacturing, where larger-scale production allows for more efficiency and specialization.** **Decreasing Returns to Scale:\ When a proportional increase in inputs results in a less-than-proportional increase in output. This can occur due to inefficiencies in large operations, such as in electricity generation or natural resource industries.** **SHORT RUN AND LONG RUN** **In production, time plays a crucial role. We distinguish between the short run and the long run based on a firm\'s ability to adjust inputs:** **Short Run:\ **A period where firms can only adjust variable factors like labor and materials, but fixed factors such as capital (e.g., machinery, factories) remain unchanged. For example, a steel company can increase production by working employees overtime but cannot quickly expand plant capacity. **Long Run:\ **A period long enough for firms to adjust all factors, including capital. Over time, a firm can build new factories, install new equipment, or adopt more efficient processes to meet sustained demand increases, leading to higher output and efficiency. **TECHNOLOGICAL CHANGE** - Is a major driver of increased output and higher living standards in the U.S. economy over the past century. **Sources of Growth:\ **While part of the economic growth comes from increased labor and machinery, a significant portion is due to technological advancements. **Examples of Technological Change:** - **Wide-body jets increased efficiency in air travel by 50%.** - **Fiber optics improved telecommunications by lowering costs and enhancing reliability.** - **Computer technologies have increased computational power by over 1000 times in three decades.** **Types of Technological Change:** - **Process Innovation: Improves production techniques, allowing firms to produce more with the same or fewer inputs, shifting the production function upward.** - **Product Innovation: Introduces new or improved products to the market, which are harder to quantify but may have an even greater impact on living standards.** **Impact of Technological Change:** **Technological advances lead to substantial productivity gains, such as a 48% improvement in output over a decade, based on a 4% annual growth in productivity. Both process and product innovations play critical roles in boosting productivity and improving living standards.** **BUSINESS ORGANIZATIONS** **The Nature of the Firm:** - **Firms reduce transaction costs.** - **Organize production efficiently.** - **Allocate resources.** - **Employ labor and capital.** - **Exist to profit from goods/services.** - **Make decisions under uncertainty.** - **Compete in markets.** **Big, Small, and Infinitesimal Businesses:** - **Big businesses have more resources.** - **Small businesses have flexibility.** - **Micro-businesses include freelancers.** - **Size affects market influence.** - **Regulation varies by size.** - **Economies of scale benefit larger firms.** - **Small firms can innovate quickly.** **Individual Proprietorship:** - **One-person ownership.** - **Simple setup.** - **Full control.** - **Unlimited liability.** - **All profits go to the owner.** - **Limited lifespan.** - **Personal income tax.** **The Partnership:** - **Owned by two or more people.** - **Shared profits and risks.** - **Requires a partnership agreement.** - **Joint decision-making.** - **Unlimited liability for partners.** - **Dissolves upon partner exit.** - **Personal taxation for partners.** **The Corporation:** - **Legal entity separate from owners.** - **Limited liability for shareholders.** - **Can raise capital through shares.** - **Board of directors oversees it.** - **Perpetual existence.** - **Subject to corporate tax.** - **More regulations to follow.** **Ownership and Control:** - **Shareholders own the corporation.** - **Board of directors elected by shareholders.** - **Separation of ownership and management.** - **Managers handle daily operations.** - **Conflict between owners and managers possible.** - **Agency problem may arise.** - **Shareholders influence through voting.** **Executive Compensation:** - **Executives are top managers.** - **Pay includes salary, bonuses, stock options.** - **Compensation often linked to company performance.** - **High compensation can be controversial.** - **Aims to motivate top talent.** - **Stock options align executive interests with shareholders.** - **Can create incentives for short-term performance.** **CHAPTER 7** **Economic Analysis of Costs** **I. Total Cost: Fixed and Variable** - **Fixed Costs:** Do not change with output (e.g., rent, salaries). - **Variable Costs:** Vary with the level of production (e.g., materials, wages). - **Total Cost Formula:**\ **Total Cost = Fixed Costs + Variable Costs** **B. Marginal Cost (MC)** - The additional cost incurred from producing one more unit of output. **C. Production and Cost Relationship** - **U-Shaped Cost Curves:**\ Initially, production increases reduce costs; eventually, diminishing returns raise costs. - **Short Run vs. Long Run:** - **Short Run:** Some inputs are fixed (e.g., equipment). - **Long Run:** All inputs can be adjusted, allowing cost optimization. **D. Firm\'s Input Choices** 1. **Least-Cost Rule:** Allocate resources to equalize marginal product per dollar spent. 2. **Substitution Rule:** When input prices change, firms switch to cheaper alternatives. **II. Economic Costs and Business Accounting** **A. Income Statement** - Shows revenue, expenses, and profits during a specific period. **B. Balance Sheet** - **Assets:** Divided into current (cash, inventory) and fixed (equipment, buildings). - **Liabilities:** Current (due within a year) and long-term (bonds, loans). - **Net Worth:**\ **Net Worth = Total Assets - Total Liabilities** - **Fundamental Identity:**\ **Total Assets = Total Liabilities + Net Worth** **III. Opportunity Cost** - **Definition:** The benefit foregone when choosing one option over another. - **Application Beyond Markets:** Helps in decision-making for non-marketed goods like health or recreation. **CHAPTER 8** **A. Supply Behavior of the Competitive Firm** - **Profit Maximization** **Rule for a Firm's Supply under Perfect Competition:** - A firm will **maximize profits** when it produces at the level where:\ **Marginal Cost (MC) = Price (P)** **B. Entry and Exit of Firms in Competitive Industries** - **Entry and Exit** are important factors that affect the evolution of a market economy. - Firms **enter an industry** either when: 1. They are newly formed. 2. An existing firm decides to start production in a new sector. - **Firms exit** when: 3. They stop producing. 4. They go bankrupt. - **Free Entry and Exit:** 1. This occurs when there are **no barriers to entry or exit**. 2. **Barriers to Entry:** - **Government regulations** - **Intellectual property rights** (e.g., patents, software). **C. Special Cases of Competitive Markets** - This section focuses on **supply and demand analysis**. **Economic Equilibrium** - **Definition:** - A condition in which **economic forces are balanced**. - When in equilibrium, **supply and demand remain unchanged**, unless external factors intervene. - **Variables in Equilibrium:** - Typically involve **price** and **quantity**. - Normal economic processes naturally drive the economy toward this state. **Marginal Cost as a Benchmark for Efficiency** - Marginal cost plays a **key role** in efficient resource allocation. - **Example:** - Producing **100 car tires** costs **\$100**. - Making **one more tire** costs **\$80**. - This additional \$80 is the **marginal cost**. **Market Failures in Competitive Markets** - **Market Failures** arise from: 1. **Imperfect competition** (e.g., monopolies). 2. **Externalities** (unintended side effects on third parties). 3. **Imperfect information** (when market participants lack complete knowledge). - **Imperfect Competition Example:** 1. When a **firm has market power** (e.g., a monopoly). **D. Efficiency and Equity of Competitive Markets** - **Equity-Efficiency Tradeoff:** - Maximizing **market efficiency** can sometimes lead to **inequitable outcomes**. - **Inequity** can result in: 1. Unequal access to **wealth** and **income**. 2. Lack of a **basic minimum of goods and services** for everyone. **Evaluating the Market Mechanism** - **Market Mechanism (Price Mechanism):** - Decisions on **price** and **quantity** are determined by **supply and demand alone**. **Concept of Efficiency** - **Definition:** - The ability to **achieve goals** with **minimal waste, effort, or energy**. **Efficiency of Competitive Equilibrium** - **Competitive Equilibrium Efficiency** occurs when: - **Supply equals demand** for a product. **CHAPTER 9** - Perfect competition is an idealized market of atomic firms that are price-takers. These firms are easily analyzed but hard to find. - For a given technology, prices are higher, and outputs are lower under imperfect competition compared to perfect competition. However, imperfect competitors also have virtues, such as exploiting economies of scale and driving innovation, which are key to long-term economic growth. - If a firm can affect the market price of its output, it is considered an imperfect competitor. This includes **monopoly**, **oligopoly**, and **monopolistic competition**. - In a modern economy, many forms of imperfect competition exist. The price elasticity of demand varies across industries. - A monopoly exists when a single firm controls an entire industry, producing no close substitutes. True monopolies are rare and often maintained through government regulation or protection. - An oligopoly exists when there are a few sellers, such as 2 to 15 firms, each of which can affect the market price. In the airline industry, for instance, fare changes by one airline can lead to a price war. - In monopolistic competition, many sellers produce differentiated products. Products are not identical, which allows firms to charge slightly different prices. - Imperfect competition often occurs in markets with few firms, such as the airline industry, where price wars are common. Rivalry in these markets includes advertising, price cuts, and research to improve product quality or develop new products. - The cost structure of an industry determines the number of firms it can support. If economies of scale exist, larger firms will have a cost advantage, leading to imperfect competition. - Barriers to entry, such as legal restrictions, high costs, and product differentiation, prevent effective competition. Examples include patents and franchise monopolies in utilities like water and electricity. - Advertising creates product loyalty, making it difficult for new entrants to compete. Product differentiation increases market power by appealing to a wide range of consumers. - Monopoly behavior leads to inefficiently high prices and low outputs, reducing consumer welfare. **Marginal revenue (MR)** is the additional revenue generated by selling one more unit. For perfect competitors, price and marginal revenue are identical. **CHAPTER 10\ ** **A. Behavior of Imperfect Competitors** - **Perfect Competition:** - Found when a large number of firms produce identical products. - **Monopolistic Competition:** - Occurs when many firms produce slightly differentiated products. - **Oligopoly:** - An intermediate form of imperfect competition where an industry is dominated by a few firms. - **Monopoly:** - A single firm produces the entire output of an industry. **Measures of Market Power** - **Market Power:** - Degree of control a firm or a few firms have over price and production in an industry. - **Concentration Ratios:** - **Four-firm concentration ratio:** - Measures the market share of the four largest firms. - **Eight-firm concentration ratio:** - Measures the market share of the top eight firms based on sales, output, or shipments. - **Herfindahl-Hirschman Index (HHI):** - Calculated by summing the squares of each firm\'s market share. **The Nature of Imperfect Competition** - **Costs:** - When efficient operation requires a significant portion of industry output, only a few firms can profitably survive, resulting in oligopoly. - **Barriers to Competition:** - Large economies of scale or government restrictions reduce the number of competitors. - **Strategic Interaction:** - A firm's strategy depends on its rivals\' behavior. **Theories of Imperfect Competition** - **Industrial Organization:** - Studies market power, product differentiation, and industrial policy affecting firms. - **Collusive Oligopoly:** - Example: Two airlines on the same route---if one raises its fare, the other must decide whether to match or undercut it. **Cooperative vs. Non-Cooperative Behavior** - **Non-Cooperative:** - Firms act independently without agreements. - **Cooperative:** - Firms reduce competition by working together. - **Collusion:** - Firms cooperate by setting prices or dividing markets. - **Cartel:** - A group of independent firms that work together to raise prices and restrict output. **Monopolistic Competition and Oligopoly** - **Monopolistic Competition:** - Many buyers and sellers, easy entry/exit, and firms take prices as given. - **Small-Number Oligopoly:** - Few dominant firms with interdependent decisions leading to strategic behavior. - **Rivalry Among the Few:** - Competition between a small number of firms where decisions consider competitors\' reactions. - **Duopoly:** - Industry dominated by only two firms. **Price Discrimination** - Selling the same product at different prices to different consumers. **Game Theory** - **Definition:** - Analyzes how two or more players' strategies affect each other. - **Developed by:** - John von Neumann (1903--1957), a Hungarian-born mathematician. - **Applications:** - Used to study oligopolies, trade policies, and environmental agreements. - **Payoff Table:** - A tool to show strategies and payoffs between two players. - **Dominant Strategy:** - A strategy that is the best for a player regardless of the opponent's actions. - **Nash Equilibrium:** - Named after John Nash, occurs when no player can gain by changing strategy alone. **Games Everywhere** - **Strategic Thinking:** - Outdoing an adversary, knowing they are doing the same. - **Credibility:** - Must be consistent with incentives to build trust. **C. Public Policies to Combat Market Power** - **Monopolies:** - Reduce output, raise prices, and waste resources. - Antitrust laws promote competition by reducing entry barriers and supporting small firms. - **Imperfect Competition:** - Policies promote competition, regulate monopolies, and correct market failures. **Regulating Economic Activity** - **Historical Regulation:** - U.S. economic regulation started with the **Interstate Commerce Commission (ICC)** in 1887. - Later spread to banks, electric power, communications, and air travel in the 20th century. **Reasons for Regulation:** 1. **Correcting Market Failures** 2. **Protecting Consumers** 3. **Promoting Fairness** 4. **Protecting Public Interest** **Antitrust Policy** - **Goals:** - Promote competition and prevent monopolies. - **Key Laws:** - **Sherman Act** and **Clayton Act** prevent anti-competitive practices. - **FTC Act:** Focuses on consumer protection. - **\"Rule of Reason\" Approach:** - Evaluates practices based on their impact on competition. **Market Power and Externalities** - **Market Power:** - Ability to influence prices. - **Externalities:** - Costs or benefits affecting third parties (can be positive or negative). - **Information Failures:** - When one party has more information than the other, leading to suboptimal decisions. **CHAPTER 11\ ** **A. Economics of Risk and Uncertainty** 1. **Speculation: Shipping Assets or Goods Across Space and Time** **Speculation** - Involves buying and selling to make profits from fluctuations in prices.\ Example: A speculator buys low and sells high, aiming to profit from price changes, rather than the goods themselves. **Arbitrage** - The purchase of a good or asset in one market for immediate resale in another to profit from price discrepancies.\ **Arbitrage and Geographic Price Patterns** - Variations in prices of the same goods across locations due to transportation costs, taxes, and supply-demand differences. Example: A product cheaper in one country can be sold in a more expensive one for profit, narrowing the price difference. **Speculation and Price Behavior Over Time** Speculation leads to definite price patterns over time and space. **Shedding Risks through Hedging**\ Speculative markets allow people to shed risks.\ **Hedging** - Reduces risks by making an offsetting sale of an asset. Example:\ A wheat farmer hedges the risk of price drops by entering into a futures contract to sell wheat at a fixed price, avoiding fluctuations. **Impacts of Speculation**\ Speculation improves price and allocation patterns across time and space, transferring risks. 2. **Risk and Uncertainty**\ When people avoid risks, they are risk-averse.\ Example: Gambling raises economic issues, unlike speculation, which improves welfare. Markets handle risks through **risk spreading**. Insurance is a major form of risk spreading, a kind of gambling in reverse. **B. The Economics of Insurance** **Capital Markets and Risk Sharing** - Risk sharing in capital markets is achieved through corporate financial ownership. **Market Failures in Information** - **Moral Hazard:** Risk-taking because one is protected from consequences (e.g., reckless driving with car insurance). - **Adverse Selection:** One party in a transaction has more information, leading to higher risks for others (e.g., unhealthy individuals buying health insurance, raising costs). **C. Health Care: The Problem That Won't Go Away** Health care must be rationed due to limited supply, regardless of a country's health care equality. **D. Innovation and Information** **Schumpeter's Radical Innovation** - Innovators introduce \"new combinations\" and gain entrepreneurial profits. **The Economics of Information** - The ability of firms to capture the value of inventions is called **appropriability**. - Case studies show the gap between the **social return** (value to society) and the **private return** (monetary value to inventors). **Intellectual Property Rights** - Protect owners from unauthorized copying and use (patents, copyrights, trade secrets). **The Dilemma of the Internet** Inventions in communication raise the issue of incentivizing information creation. - New technologies have high upfront costs but nearly zero marginal costs, making competition unsustainable with zero-price services.