Econone ReviewerEconomics social science that deals with the allocation of scarce resources to alternative uses to satisfy human wants and needs.3 Fundamental Concepts:1. Opportunity Cost alternative given up when choices are made2. Marginalism weighing of costs and benefits that arise from the decision3. Efficient Markets where profit opportunities are eliminated almost instantaneouslyBasic Questions:1. What to produce?2. How to produce?3. For whom to produce?Economic Resources:1. Natural/Land2. Human/Labor3. Man-made/Capital

FoodEconomic Systems: 1. Command economy govt. Sets2. Free market (laissez-faire) no govt. Market Consumer Sovereignty consumer dictates Free Enterprise players pursue self-interest3. Mixed economy govt. plays major role to: Minimize market inefficiencies Provide public goods Redistribute income Stabilize the macro economy Promote low levels of unemployment and inflationEconomic Policy criteria for judging eco. outcome1. Efficiency production of consumers wants with least possible cost2. Equity fairness3. Growth increase in total output of economy4. Stability condition where national output is growing steadily w/ low inflation and full employment of resourcesScope of Economics:1. Microeconomics individual industries and behavior of decision-making units2. Macroeconomics examines national scale economic behaviorTheory and Models:1. Ockhams Razor irrelevant details should be cut away. Models are simplifications, not complications of reality2. Ceteris Paribus all else equalThe Basic Decision-making Units:1. Firm transforms inputs into outputs2. Entrepreneurs person = firm3. Households consumersThe Circular Flow of Economic Activity

DemandSupplyOutput Market

Goods and services

HouseholdFirm

LLKDemandSupply

Input Market

ClothingProduct Possibility Frontier combination of 2 goods that shows concept of opportunity cost

Demand, Supply and Market EquilibriumThe Law of Demand: There is a negative, or inverse, relationship between price and quantity of a good demanded and its price. (P Qd or P Qd)Violation of Law of Demand:1. Veblen Goods - P Qd -> prada2. Giffen Goods - P Qd -> staple foods during famineFactors of Demand1. Price of the Product - P Qd or P Qd2. Income Available Nominal Goods - Y Qd or Y Qd Inferior Goods - Y Qd or Y Qd3. Amount of Accumulated Wealth4. Prices of other Products Substitutes - Pa Qdb or Pa Qdb Complements - Pa Qdb or Pa Qdb5. Tastes and Preferences6. ExpectationsIncome and Wealth1. Income sum of all wages in a given period2. Wealth total value of what households owns owesThe Law of Supply: There is a positive relationship between price and quantity of a good supplied. (P Qs or P Qs)Factors of Supply1. Price2. Cost of production3. Price of related productsMarket equilibrium1. The operation of the market depends on the interaction between buyers and sellers.2. Equilibrium is the condition that exists when Qs and Qd are equal.3. There is no tendency for price to change.Alternative Rationing Mechanisms1. Price Ceiling max. price that sellers may charge2. Price Floor min. priceTax amount paid by consumers and producers to govt.1. Direct Taxes collected directly Progressive Tax higher income, higher tax2. Indirect Taxes taxes on goods and services Regressive Tax high or low income, same taxEffect of Taxation: Deadweight Loss of TaxationElasticity measure of responsivenessMidpoint Formula = Price elasticity of demand (Epd) = |Epd| > 1 -> elastic luxuries (many subs)|Epd| < 1 -> inelastic necessities (few subs)|Epd| = 1 -> unitaryIncome Elasticity of Demand (Ey,d) = Ey,d > 0 -> normal goodEy,d < 0 -> inferior goodCross Price Elasticity of Demand (Ecross) = Ecross > 0 -> substitutesEcross < 0 -> complementsElasticity of Supply (Eps) = Elasticity of Labor Supply (E) = Extreme ElasticitiesE = -> perfectly elastic ( subs) E = 0 -> perfectly inelastic (0 subs) insulinFactors of Demand Elasticity1. Availability of substitutes2. Importance of item in budget D is more elastic if its significant3. Time Frame D becomes more elastic over timeConsumer BehaviorHousehold Choice in Output MarketsEvery household must make 3 Basic Decisions:1. How much of each product to demand2. How much of labor to supply3. How much to spend today and how much to saveThe Budget Constraint limits imposed on choicesChoice/Opportunity set set of options defined by BCThe Basis of Choice: Utility1. Utility satisfaction a product yields2. Marginal Utility additional satisfaction gained3. The Law of Diminishing Marginal Utility: The more of one good consumed in a given period, the less utility generated by consuming each additional unit of the same good.Indifference Curve representation of 2 goodsPreference Map set of indifference curvesAssumptions:1. more is better2. Diminishing marginal rate of substitution3. Existence of preference relation4. RationalityMarginal Rate of Substitution (MRS) = Ratio at which a household is willing to sub. X for Y Slope of indifference curveUtility Maximizing Condition: =If > then MUx and MUy Diminishing Marginal Utility helps to explain why demand slopes down.Income and Substitution Effect1. Income - consumption changes because purchasing power changes2. Substitution consumption changes because opportunity cost changesConsumer Surplus (CS) = Consumers are willing to pay higherThe Diamond/Water Paradox1. Things with the greatest value in use frequently have little or no value in exchange2. Thing with the greatest value in exchange frequently have little or no value in useHousehold Choice in Input MarketsHouseholds must decide:1. Whether to work2. How much to work3. What kind of job to work atPrice of Leisure1. Substitution Effect - W -> Leisure, Labor Supply2. Income Effect - W -> Purchasing Power, Leisure, Labor SupplySaving and Borrowing: Present vs. Future Consumption1. Substitution Effect - i -> Cost of current consumption, Saving, Consume2. Income Effect - i -> Earn, Saving, ConsumeProduction1. Central to our analysis is production.2. A firm is an org. that comes into being when a person or group of people decide to produce a good/service to meet a perceived demand.Market Structures1. Perfect Competition -> P = MC Many firms Producing virtually identical products No firm is large enough to control price Competitors can freely enter and exitHomogenous Product identical productsCompetitive Firms are Price TakersBehavior of Profit-Maximizing Firms3 Decisions firms must make:1. How much output to supply2. Which production technology to use3. How much of each input to demandProfits and Economic Costs1. Profit = Revenue Cost2. Total Revenue = Q x P3. Total Economic Costa. Out of pocket costs (acctg.)b. Normal rate of return on capital rate of return that is sufficient to keep owners and investors satisfiedc. Opportunity cost of each factor of productionShort-run vs. Long-run Decisions1. Short-run period of time wherein:a. Firm is operating under a fixed scale of productionb. Firms can neither enter nor exit an industry2. Long-run period of time wherein:a. There are no fixed factors of productionsb. Firms can increase or decrease scale of operationc. Firms can may enter and exit

Input PricesProduction TechniquesPrice of outputDetermining the Optimal Method of Production

Determines total revenueDetermines total cost and optimal method of prod.

Total Profit = Total revenue Total cost with optimal method

Production Techniques can be labor-intensive or capital-intensive.The Production Function numerical expression of a relationship between inputs and outputsLabor UnitsTotal ProductMPLAPL

00

1101010.0

2251512.5

3351011.7

440510.0

54228.4

Marginal Product and Average Product1. Marginal Product additional output that can be produced by adding one more unit of a specific unitMPL = 2. Average Product average amount produced by each unit of a variable factor of productionAPL = Law of Diminishing Marginal Returns: When additional units of a variable input are added to fixed inputs, the marginal product of the variable input declines.Total Average and Marginal Product1. Marginal product is the slope of the total product function2. As long as marginal product rises, ave. product rises3. When average product is max., marginal product equals average productProduction Functions with 2 Variable Factors of Production1. In many production processes, inputs work together and are viewed as complementary.2. Given the tech. Available, the cost-minimizing choice depends on input prices.Cost-minimizing Choice Among Alternative TechnologyTech.Units of CapitalUnits of LaborCost when PK =1, PL = 1Cost when PK = 1, PL = 5

A2101252

B36933

C44824

D63921

E1021220

Cost per unitIsoquants and Isocosts (TC = PL x L + PK x K)1. Isoquant graph that shows all the combinations of capital and labor that can be used to produce a given amount of output2. Isocost Line graph that shows all the combinations of capital and labor available for a given total costFor output to be constant, the loss of output from using less capital must be matched by the added output produced by using more labor.

(MRTS)(Slope of isoquant)K x MPK = -L x MPL

SRACSRMCCost per unit = -

SRACSRMCCost-minimizing Equilibrium Condition

SRACSRMC =

LRACIf > -> L K

QCosts in the Short-run TC = TFC + TVCATC = AFC +AVC1. Fixed cost (or sunk costs) costs that dont depend on level of output. These costs are incurred even if the firm produces nothing. AFC = AFC falls as output rises (spreading overload)2. Variable cost cost that depends on the level of production chosen Total Variable Cost Curve graph that shows the relationship between total variable cost and the level of a firms output. It also shows the cost of production using the best available technique at each output level, given current factor prices. Total Variable Cost derived from production requirements and input prices AVC = 3. Marginal Cost increase in the total cost that result from producing one or more units of output. It also reflects changes in variable costs. MC = MR = MCThe Slope of the Marginal Cost Curve in the Short-run1. The fact that in the short-run every firm is constrained by some fixed input means that:a. Firm faces diminishing returns to variable inputsb. Firm has limited capacity to produce output2. As a firm approaches that capacity it becomes increasingly costly to produce successively.

MCMarginal Cost and Average Cost1. MCWhen MC < AVC -> AVC is declining2. AVCWhen MC > AVC -> AVC is rising3. QRising MC intersects AVC at the minimum point of AVC

Long-run

1. Economies of scale = Returns to scale 2. Increase returns to scale -> Q, LRAC 3. Constant returns to scale -> Q, LRAC remains constant4. Decrease returns to scale -> Q, LRACExample:f(2L, 2K) > IRTS = 4Q, DRTS = 1.5Q, CRTS = 2Q

Market Failures:1. Externality (Spill-overs/Neighborhood Effects) cost/benefit resulting from some activity/transaction that is imposed upon parties outside the activity/transaction Positive benefit -> underproduction (cheating) Negative suffer -> overproduction (smoking) When external costs are not considered in economic decisions, we may produce products that are not worth it. When external benefits are not considered, we may fail to do things that are indeed worth it which result to inefficient allocation of resources.Marginal Social Cost and Marginal Cost Pricing Marginal Social Cost (MSC) total cost to society of producing an additional unit of a good and service MSC = Marginal Private Cost (MPC) + Marginal Damage to SocietyPrivate Choices and External Effects Marginal Benefit (MB) benefit derived from each successive hour of music Marginal Damage Cost (MDC) add. harm done by increasing the level of an externality Marginal Social Cost (MSC) total cost to society of playing an add. hour of music PCondition to Maximize utility:i. MDCMB = MC -> Privateii. MB = MC + MD -> Social

MPCInternalizing Externalities MBQA tax per unit equal to MDC is imposed on the firm. The firm will weigh the tax and thus the damaged costs in its decisions.The Coase Theorem Govt. Need not to be involved in every case of externality Private bargains and negotiations are likely to lead to an efficient solution in many social damagesIndirect and Direct Regulations Subsidy govt. should pay firmSMBPMBMCMB/MCQTaxes, subsidies, legal rules and public auction are all methods of indirect regulations designed to induce firms and households to weigh the social costs of their actions against the benefits.

MSB > MPC

2. Public Goods (Social/Collective Goods) goods that are non-rival in consumption and/or their benefits are non-excludable. (roads, education) Public goods have characteristics that make it difficult for the private sector to produce them profitably

Characteristics of Public Goods: Non-rival in consumption when As consumption does not interfere with Bs consumption. The benefits of the good are collective they accrue to everyone. Non-excludable if once produced, no one can be excluded from enjoying its benefits (lamp posts) Free-rider problem people can enjoy the benefits of public goods whether they pay for them or not, they are usually unwilling to pay for them.3. Imperfect Information and Adverse Selection Most voluntary exchanges are efficient, but in the presence of imperfect information, not all exchanges are efficient Adverse Selection when buyer/seller enters into an exchange with another party who has more information -> hidden info. (health insurance) Moral Hazard when one party to a contract passes the cost of his or her behavior on to the other party to the contract. -> hidden action (car insurance) The Moral Hazard problem is an information problem, in which contracting parties cannot always determine the future behavior of the person with whom they are contracting.Market Solutions1. As with any other good, there is an efficient quantity of information production.

Market Structures (continuation)1. Monopoly Only one firm Barriers to Entry: extremely high, scale and scope economies or legal barriers Type of Product: unique, no close substitutes Firms control over price: considerable or regulated Profit Point: MR = MC MR > MC -> inc. output to inc. profit MR < MC -> dec. output to inc. profit will suspend operations in the short run if P < AVC will shut down permanently if revenue is not likely to equal or exceed all costs in the long run.Source of Monopoly PowerEconomic Barriers Economies of scale Capital Requirements Technological Superiority No substitute goods Control of natural resources Network externalities

Legal Barriers Property rights give firms exclusive control to the production and selling of goods, and sometimes even the control of materials. Examples: copyrights, patents, govt. franchise (public transportation)

2. Monopolistic Competition Many firms No barriers to entry Product differentiation3. OligopolyCollusion Model MR = MC P > MC Cartel agreements are made Tacit Collusion agreements are impliedPrice-Leadership Model Dominant firm sets prices for small firms to followKinked-Demand Curve: Rivals will not follow price increase Rivals will follow price decrease