Semester Outline. A. Objectives: By the end of this chapter, students should understand:

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1 ECON 102 Professor Daneshvary Semester Outline The first three chapters serve as the introduction to the entire text. Chapter 1 introduces ten fundamental principles on which the study of economics is based. The rest of the text is an elaboration on these ten principles. Chapter 2 will develop how economists approach problems. Chapter 3 will explain how individuals and countries gain from trade. Chapter 1: Ten Principles of Economics: 1. that economics is about the allocation of scarce resources. 2. that individuals face tradeoffs. 3. the meaning of opportunity cost. 4. how to use marginal reasoning when making decisions. 5. how incentives affect people s behavior. 6. why trade among people or nations can be good for everyone. 7. why markets are a good, but not perfect, way to allocate resources. 8. what determines some trends in the overall economy. Scarcity: the limited nature of society s resources. Economics: the study of how society manages its scarce resources. Efficiency: the property of society getting the most it can from its scarce resources. Equity: the property of distributing economic prosperity fairly among the members of society. Opportunity cost: whatever must be given up to obtain some item. Marginal changes: small incremental adjustments to a plan of action. Market economy: an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Market failure: a situation in which a market left on its own fails to allocate resources efficiently. Externality: the impact of one person s actions on the well-being of a bystander. 1

2 Market power: the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices. Scarcity: Economics: The Ten Principle fall into three categories Category1: How People Make Decision Principle #1: People Face Tradeoffs (efficiency, equity) Principle #2: The Cost of Something Is What You Give Up to Get It (opportunity cost) Principle #3: Rational People Think at the Margin (marginal changes) Principle #4: People Respond to Incentives Category2: How People Interact Principle #5: Trade Can Make Everyone Better Off Principle #6: Markets Are Usually a Good Way to Organize Economic Activity (market economy) Principle #7: Governments Can Sometimes Improve Market Outcomes (market failure, externality, market power) Category3: How The Economy as a Whole Works (topics of Macroeconomics, will be very briefly mentioned) Principle #8: A Country s Standard of Living Depends on Its Ability to Produce Goods and Services Principle #9: Prices Rise When the Government Prints Too Much Money Principle #10: Society Faces a Short-Run Tradeoff between Inflation and Unemployment Chapter 2: Thinking Like Economists: Economic Models: 1. how economists apply the methods of science. 2. how assumptions and models can shed light on the world. 3. two simple models the circular flow and the production possibilities frontier. 4. the difference between microeconomics and macroeconomics. Circular-flow diagram: a visual model of the economy that shows how dollars flow through markets among households and firms. Production possibilities frontier: a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. 2

3 Positive statements: claims that attempt to describe the world as it is. Normative statements: claims that attempt to prescribe how the world should be. Microeconomics: the study of how households and firms make decisions and how they interact in markets. Macroeconomics: the study of economy-wide phenomena, including inflation, unemployment, and economic growth. Review of Basic Graphs and Understanding Slop of a Line and Curve (Appendix to chapter 2. For your own review, will not be covered in class) The Economist as Scientist i. Economists follow the scientific method. ii. Assumptions make the world easier to understand. iii. Economists use economic models to explain the world around us. iv. Our First Model: The Circular Flow Diagram v. Our Second Model: The Production Possibilities Frontier. The model illustrates concepts of: Efficiency Tradeoffs Opportunity costs, and Economic growth vi. Microeconomics and Macroeconomics Read the rest of the chapter (The Economist as Policy Advisor and Why Economists Disagree). I suggest familiarizing yourself with terms and definitions and summarizing each section or subsection in 1-2 sentences) Chapter 3: Gain From Trade: 1. how everyone can benefit when people trade with one another. 2. the meaning of absolute advantage and comparative advantage. 3. how comparative advantage explains the gains from trade. 4. how to apply the theory of comparative advantage to everyday life and national policy. Absolute advantage: the comparison among producers of a good according to their productivity. Comparative advantage: the comparison among producers of a good according to their opportunity cost. 3

4 Imports: goods produced abroad and sold domestically. Exports: goods produced domestically and sold abroad. Basic ways that people/nations can satisfy their wants self sufficiency and/or specialization and trade i. Production and consumption under self-sufficiency ii. Production and consumption under specialization and trade iii. Concepts: Absolute Advantage, Comparative Advantage, Terms of Trade, Import, Export iv. Application Outline for Chapters 4-6 Chapter 4 is the first chapter in a three-chapter sequence that deals with supply and demand and how markets work. Chapter 4 shows how supply and demand for a good determines both the quantity produced and the price at which the good sells. Chapter 5 will add precision to the discussion of supply and demand by addressing the concept of elasticity the sensitivity of the quantity supplied and quantity demanded to changes in economic variables. Chapter 6 will address the impact of government policies on prices and quantities in markets. Chapter 4: Market Forces of Demand and Supply 1. what a competitive market is. 2. what determines the demand for a good in a competitive market. 3. what determines the supply of a good in a competitive market. 4. how supply and demand together set the price of a good and the quantity sold. 5. the key role of prices in allocating scarce resources in market economies Competitive market: a market in which there are many buyers and many sellers so that each has a negligible impact on the market price. Quantity demanded: the amount of a good that buyers are willing and able to purchase. Law of demand: the claim that, other things equal, the quantity demanded of a good falls when the price of the good rises. Demand schedule: a table that shows the relationship between the price of a good and the quantity demanded. 4

5 Demand curve: a graph of the relationship between the price of a good and the quantity demanded. Normal good: a good for which, other things equal, an increase in income leads to an increase in demand. Inferior good: a good for which, other things equal, an increase in income leads to a decrease in demand. Substitutes: two goods for which an increase in the price of one good leads to an increase in the demand for the other. Complements: two goods for which an increase in the price of one good leads to a decrease in the demand for the other. Quantity supplied: the amount of a good that sellers are willing and able to sell. Law of supply: the claim that, other things equal, the quantity supplied of a good rises when the price of the good rises. Supply schedule: a table that shows the relationship between the price of a good and the quantity supplied. Supply curve: a graph of the relationship between the price of a good and the quantity supplied. Equilibrium: a situation in which the price has reached the level where quantity supplied equals quantity demanded. Equilibrium price: the price that balances quantity supplied and quantity demanded. Equilibrium quantity: the quantity supplied and the quantity demanded at the equilibrium price. Surplus: a situation in which quantity supplied is greater than quantity demanded. Shortage: a situation in which quantity demanded is greater than quantity supplied. Law of supply and demand: the claim that the price of any good adjusts to bring the supply and demand for that good into balance. Definitions of Market and Competitive Market Demand 5

6 i. Concepts: Quantity Demanded, Law of Demand, Demand Schedule, Demand Curve, and Market Demand ii. Shift in Demand Change in Quantity Demanded versus Change in Demand Curve iii. Factors That Cause a Change in Demand Curve (Income, Price of Related Goods, Tastes, Expectation about Future Income and Prices, and Number of Buyers in the Market) Supply i. Concepts: Quantity Supplied, Law of Supply, Supply Curve, Supply Schedule, and Market Supply ii. Shift in Supply Change in Quantity Supplied versus Change in Supply Curve iii. Factors that Cause a Change in Supply Curve (Input Prices, Technology, Expectations about future prices, and Number of Sellers (produces) in the Market) Market Equilibrium i. Equilibrium Quantity and Equilibrium Price ii. Shortage and Surplus iii. Changes in Equilibrium Price and Quantity 1. Change in Demand 2. Change in Supply 3. Change in Both Demand and Supply Conclusion Chapter 5: Elasticity and Its Application 1. the meaning of the elasticity of demand. 2. what determines the elasticity of demand. 3. what are the implication of demand elasticity for revenue 4. the meaning of the elasticity of supply. 5. what determines the elasticity of supply. 6. the concept of elasticity in various markets. Price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price. Income elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in consumers income, computed as the percentage change in quantity demanded divided by the percentage change in income. Total revenue: the amount paid by buyers and received by sellers of a good, computed as the price of the good times the quantity sold. 6

7 Cross-price elasticity of demand: a measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in the quantity demanded of the first good divided by the percentage change in the price of the second good. Price elasticity of supply: a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price. Definition of Elasticity Demand: Price Elasticity of Demand Determinants of Elasticity of Demand Computation of Elasticity of Demand, Midpoint approach Variety of Demand Curves according to elasticity Total revenue and Elasticity of Demand Income Elasticity and cross-price Elasticity of Demand Supply Price Elasticity of Supply Determinants of Elasticity of Supply Application (OPEC case will be covered in class. Read other applications) OPEC Drug Farming Chapter 6: Supply, Demand, and Government Policies 1. the effects of government policies that place a price ceiling. 2. the effects of government policies that put a price floor. 3. how a tax on a good affects the price of the good and the quantity sold. 4. that taxes levied on buyers and taxes levied on sellers are equivalent. 5. how the burden of a tax is split between buyers and sellers. Price ceiling: a legal maximum on the price at which a good can be sold. It is illegal to sell or buy at higher price than the set ceiling. (Examples include rent control laws and oil price control in 1973.) Price floor: a legal minimum on the price at which a good can be sold. It is illegal to sell at a price lower than the set floor. (Examples include minimum wage laws and agriculture price support by government.) 7

8 tax incidence: the manner in which the burden of a tax is shared among buyers and sellers in a market. (Tax laws either affect the demand curve or the supply curve.) Controls on Prices Price Ceiling and Price Floors i. How Price Ceiling Affects Market Outcomes ii. How Price Floor Affects Market Outcomes iii. Evaluating Price Controls Taxes Levied on Buyers and Sellers i. How Taxes on Buyers Affect Market Outcomes ii. How Taxes on Sellers Affect Market Outcomes iii. Elasticities and Tax Incidence Chapter 7: Consumers, Producers, and the Efficincy of Markets Where are we in the course? Chapters 4 through 6 employed supply and demand in a positive (versus normative) framework. That is, we focused on the question of What is equilibrium price and quantity? We also showed how price control creates shortage and surplus in the market. Chapter 7 now addresses the normative question. That is, Is the equilibrium price and quantity in a market the best possible solution to the resource allocation problem or is it simply the price and quantity that balance supply and demand? We will discover that under most circumstances the equilibrium price and quantity is also the one that maximizes economic welfare. The chapter employs the supply and demand model to develop consumer surplus and producer surplus as a measure of welfare and market efficiency. These concepts are then utilized in Chapters 8 to determine the winners and losers from government taxation. 1. the link between buyers willingness to pay for a good and the demand curve. 2. how to define and measure consumer surplus. 3. the link between sellers costs of producing a good and the supply curve. 4. how to define and measure producer surplus. 5. that the equilibrium of supply and demand maximizes total surplus in a market. Welfare economics: The study of how the allocation of resources affects economic well-being. That is, well-being of the society and not public assistance. 8

9 Willingness to pay: The maximum amount that a buyer is willing to pay for a good (not what he/she actually pays). Marginal Buyer: The buyer who would leave the market if price s was any higher. Consumer surplus: A buyer s willingness to pay minus the amount the buyer actually pays. Cost: The value of everything a seller must give up to produce a good, including opportunity cost of time. Marginal Seller: The seller who would leave the market if price s was any lower. Producer surplus: The amount a seller is paid for a good minus the seller s cost. Efficiency: The characteristic of a resource allocation that maximizes the total surplus received by all members of society. Equity: The fairness of the distribution of well-being among the society. members of Total Surplus = Value to Buyers Cost of Sellers. Or Total Surplus = Consumer Surplus + Produces Surplus The Concept of Consumer Surplus o Willingness to Pay Measuring Consumer Surplus o The Surplus for Individual Consumer o The Surplus for All Consumers in the Market o Effect of Price Change on the size of Consumer Surplus The Concept of Producer Surplus o Cost of Producing/Selling Measuring Producer Surplus o The Surplus for Individual Seller o The Surplus for All Sellers in the Market o Effect of Price Change on the size of Producer Surplus Market Surplus as a Measure of Market Efficiency 9

10 Evaluating the Efficiency of Market Equilibrium Chapters 8: The Cost of Taxation Chapter 7 employed the supply and demand model to develop consumer surplus and producer surplus as a measure of welfare and market efficiency. These concepts are then utilized in Chapters 8 to determine the winners and losers from government taxation. 1. Objectives: By the end of this chapter, students should understand: 1. how taxes reduce consumer and producer surplus. 2. the meaning and causes of the deadweight loss from a tax. 3. why some taxes have larger deadweight losses than others. 4. how tax revenue and deadweight loss vary with the size of a tax. deadweight loss: the fall in total surplus that results from a market distortion, such as a tax. The Deadweight Loss of Taxation o Economic Welfare Before Tax o Economic Welfare After Tax o Change in Economic Welfare Due to Tax Determinants of the Size of Deadweight Losses o Price Elasticities of Supply and Demand o Relative Size of Consumer and Producer Surplus Losses and Elasticities o The Effect of Tax Size on the Size of Deadweight Losses and the Size of Tax Revenue Chapters 10: Externalities and Market Inefficiencies Chapter 7 employed the supply and demand model to develop consumer surplus and producer surplus as a measure of economic welfare and market efficiency. Then in chapter 8 we showed that at market equilibrium quantity the total surplus was maximized and deadweight loss was zero. We also showed who to determine the winners and losers (deadweight losses) from government taxation. Chapter 10 is the first chapter in public sector and deals with market externalities and offers some private and public solutions 2. what an externality is. 3. why externalities can make market outcomes inefficient. 4. how people can sometimes solve the problem of externalities on their own. 5. why private solutions to externalities sometimes do not work. 6. the various government policies aimed at solving the problem of externalities. 10

11 Externality: the uncompensated impact of one person s actions on the well-being of a bystander. It can be negative or positive. Internalizing an externality: altering incentives so that people take account of the external effects of their actions. Coase theorem: the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own without government intervention. Transaction costs: the costs that parties incur in the process of agreeing and following through on a bargain. Pigouvian tax: a tax enacted to correct the effects of a negative externality. The Concept Externalities o Negative Externality o Positive Externality Social versus Private Costs; Social versus Private Values; Socially Optimal quantity Externalities and market Inefficiencies o Negative Externality o Positive Externality Solutions to Externalities o Private Solutions Coase Theorem o Public Solutions Regulations Pigovian Tax Tradable Pollution Permits Chapters 11: Public Goods and Common Resources Chapter 11 addresses public goods and common resources goods for which it is difficult to charge prices to users. 1. The defining characteristics of public goods and common resources. 2. Why private markets fail to provide public goods. 3. Why the cost benefit analysis of public goods is both necessary and difficult. 11

12 4. Why people tend to use common resources too much. Excludability: the property of a good whereby a person can be prevented from using it. Rivalry: the property of a good whereby one person s use diminishes other people s use. Private goods: goods that are both excludable and rival. Public goods: goods that are neither excludable nor rival. Common resources: goods that are rival but not excludable. Characteristics of Goods Excludability and Rivalry Kinds of Goods: o Private Goods o Some goods that are produced by natural monopoly are excludable but not rival o Public Goods The Free-Rider Problem Cost-Benefit Analysis of Public Goods o Common Resources Conclusion Chapters 13: The Economic Costs of Production Chapter 13 develops the cost curves on which firm behavior is based. Chapters utilize these cost curves to develop the behavior of firms in a variety of different market structures competitive and monopolistic. B. Objectives: By the end of this chapter, students should understand: 1. what items are included in a firm s costs of production. 2. the link between a firm s production process and its total costs. 3. the meaning of average costs and marginal cost and how they are related. 4. the shape of a typical firm s cost curves. 5. the relationship between short-run and long-run costs. Explicit costs: input costs that require an outlay of money by the firm. Implicit costs: 12

13 input costs that do not require an outlay of money by the firm. Economic profit: total revenue minus total cost, including both explicit and implicit costs. Accounting profit: total revenue minus total explicit cost. Production function: the relationship between quantity of inputs used to make a good and the quantity of output of that good. Average Product: of an input is total product divided by the amount of the input employed. Marginal product: of an input is the increase in output that arises from an additional unit of input. Diminishing marginal product: the property whereby the marginal product of an input declines as the quantity of the input increases. Total Fixed costs: costs that do not vary with the quantity of output produced. Total Variable costs: costs that do vary with the quantity of output produced. Average total cost: total cost divided by the quantity of output. Average fixed cost: fixed costs divided by the quantity of output. Average variable cost: variable costs divided by the quantity of output. Marginal cost: the increase in total cost that arises from an extra unit of production. Efficient scale: the quantity of output that minimizes average total cost. Economies of scale: the property whereby long-run average total cost falls as the quantity of output increases. diseconomies of scale: the property whereby long-run average total cost rises as the quantity of output increases. constant returns to scale: the property whereby long-run average total cost stays the same as the quantity of output changes. Concepts: Total Revenue, Total Cost, Economic Profit, Explicit Costs, Implicit Costs, Accounting Costs 13

14 Production and Costs 1. The Production Function Average Product (AP) and Marginal Product (MP) of factors of Production 2. Diminishing Marginal Product 3. Production Curves 4. From Production Curves to Cost Curves The Various Measures of Cost 1. Total Fixed Cost (TFC), Total Variable Cost (TVC), Total Cost (TC) 2. Average Fixed Cost (AFC), Average Variable Cost (AVC), Marginal Costs (MC) 3. Cost Curves and Their Shape Costs in the Short Run and Long Run (LR-ATC) Chapters 14: Firms in a Competitive Market Chapter 14 examines the behavior of competitive firms firms that do not have market power and are price takers. The cost curves developed in the previous chapter shed light on the decisions that lie behind the supply curve in a competitive market. C. Objectives: By the end of this chapter, students should understand: 1. What characteristics make a market competitive. 2. How competitive firms decide how much output to produce. 3. How competitive firms decide when to shut down production temporarily. 4. How competitive firms decide whether to exit or enter a market. 5. How firm behavior determines a market s short-run and long-run supply curves. Competitive market: A market with many buyers and sellers trading identical products so that each buyer and seller is a price taker. Average revenue: Total revenue divided by the quantity sold. Marginal revenue: The change in total revenue from an additional unit sold. Sunk cost: A cost that has been committed and cannot be recovered. D. Outline Introduction to Market Structure What Is a Competitive Market The Revenue of a Competitive Market Profit Maximization/Loss Minimization 14

15 o Total Approach o Marginal Approach o Measuring Profits/Losses Using Marginal Approach o The Marginal-Cost and the Competitive Firm s Supply Curves o The Firm s Short-Run Decision to Shut Down o The Firm s Long-Run Decision to Exit or Enter a Market The Supply Curve in a Competitive Market (the Industry) o The Short-Run Supply o The Long-Run Supply For a Constant-Cost Industry For an Increasing-Cost Industry Chapters 15: Monopoly Firms In Chapter 14 examines the behavior of competitive firms-firms that do not have market power and are price takers. In this chapter we examine monopoly markets. A monopolist firm is the sole seller of a product without close substitutes. As such, it has market power because it can influence the price of its output. That is, a monopolist is a price maker as opposed to a price taker. 1. Why some markets have only one seller. 2. How a monopoly determines the quantity to produce and the price to charge. 3. How the monopoly's decisions affect economic well-being. 4. The various public policies aimed at solving the problem of monopoly. Monopoly: A firm that is the sole seller of a product without close substitutes. Natural monopoly: A monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. price discrimination: The business practice of selling the same good at different prices to different customers, when the difference in price is not justified by a difference in cost. 15

16 B. Outline Introduction to Monopoly as a "Price Maker" Why Monopoly Arise - Types of Monopoly o Monopoly Resources o Government- Created Monopolies o Natural Monopolies o Other Forms of Monopolies How a Monopoly Determines Price and Output o Demand and Marginal Revenue (MR) Curves o Profit Maximization o Why Monopoly Does Not Have a Supply Curve The Welfare Cost of Monopoly o Deadweight Loss of Monopoly Public Policy Towards Monopolies o Regulations Marginal Cost Pricing Average Cost Pricing Chapters 16: Monopolistic Competition Firms Chapters 14 and 15 developed the two extreme forms of market structure competition and monopoly. The market structure that lies between competition and monopoly is known as imperfect competition. There are two types of imperfect competition oligopoly and monopolistic competition. Monopolistic competition is the topic of the current chapter. The analysis in this chapter is again based on the cost curves developed in Chapter Competition among firms that sell differentiated products. 2. How the outcomes under monopolistic competition and under perfect competition compare. 3. the debate over the effects of advertising. 4. the debate over the role of brand names. Monopolistic competition: a market structure in which many firms sell products that are similar but not identical. Characteristics of Monopolistic Competition 16

17 The Monopolistically Competitive Firm in the Short Run The Long-Run Equilibrium Monopolistic Versus Perfect Competition Excess Capacity Markup over Marginal Cost Monopolistic Competition and the Welfare of Society The Debate over Advertising Chapters 18: Markets for the Factors of Production The purpose of Chapter 18 is to provide the basic theory for the analysis of factor markets the markets for labor, land, and capital. As you might expect, we find that the wages earned by the factors of production depend on the supply and demand for the factor. What is new in the analysis is that the demand for a factor is a derived demand. That is, a firm s demand for a factor is determined by its decision to supply a good in another market. 1. The labor demand of competitive, profit-maximizing firms. 2. The household decisions that lie behind labor supply. 3. Why equilibrium wages equal the value of the marginal product of labor. 4. How the other factors of production land and capital are compensated. 5. How a change in the supply of one factor alters the earnings of all of the factors. Factors of production: the inputs used to produce goods and services. Production function: the relationship between the quantity of inputs used to make a good and the quantity of output of that good. Marginal product of labor: the increase in the amount of output from an additional unit of labor. Diminishing marginal product: the property whereby the marginal product of an input declines as the quantity of the input increases. Value of the marginal product: the marginal product of an input times the price of the output (the dollar value of marginal productivity of input). Capital: the equipment and structures used to produce goods and services. D. Outline The Nature of Demand for Inputs (Derived Demand) Demand for Labor 17

18 o The Competitive Profit-Maximizing Firm o The Production Function and the Marginal Product of Labor o Diminishing Marginal Product o The Value of Marginal Product and the Demand for Labor o Input Demand and Output Supply o Shifts in Demand for Labor Causes The Supply of Labor o Work and Leisure tradeoffs Shifts in Supply of Labor Causes Equilibrium in the Labor Market o Marginal Product in Equilibrium o Shifts in Supply o Shifts in Demand Case Study: Productivity and Wage in the U.S. The Other Factors of Production: Land and Capital 18