Summary
What is economics?
Key issues arising in individual decision-making are that people face trade-offs among alternative goals, that the cost of any action is measured in terms of foregone opportunities, that rational people make decisions by comparing marginal costs and marginal benefits, and that people change their behaviour in response to the incentives they face.
When economic agents interact with each other, the resulting trade can be mutually beneficial. In capitalist economic systems, the market mechanism is the primary way in which the questions of what to produce, how much to produce and who should get the resulting output are answered. Markets do not always result in outcomes that are efficient or equitable and in such circumstances governments can potentially improve market outcomes.
The field of economics is divided into two subfields: microeconomics and macroeconomics. Microeconomists study decision-making by households and firms and the interaction among households and firms in the marketplace. Macroeconomists study the forces and trends that affect the economy as a whole.
Thinking like an economist
Economics is characterized by different methodologies and approaches including neo-classical, feminist, Marxist and Austrian.
Economists make assumptions and build simplified models in order to understand the world around them. Economists use empirical methods to develop and test hypotheses.
Research can be conducted through using inductive and deductive reasoning – no one way is the ‘right way’.
Economists develop theories which can be used to explain phenomena and make predictions. In developing theories and models, economists have to make assumptions.
Using theory and observation is part of the scientific method but economists always have to remember that they are studying human beings and humans do not always behave in consistent or rational ways.
A positive statement is an assertion about how the world is. A normative statement is an assertion about how the world ought to be.
Economists who advise policymakers offer conflicting advice either because of differences in scientific judgements or because of differences in values. At other times, economists are united in the advice they offer, but policymakers may choose to ignore it.
The market forces of supply and demand
Economists use the model of supply and demand to analyze competitive markets. In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price.
The demand curve shows how the quantity of a good demanded depends on the price. According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downwards.
In addition to price, other determinants of how much consumers want to buy include income, the prices of substitutes and complements, tastes, expectations, the size and structure of the population and advertising. If one of these factors changes, the demand curve shifts.
The supply curve shows how the quantity of a good supplied depends on the price. According to the law of supply, as the price of a good rises the quantity supplied rises. Therefore, the supply curve slopes upwards.
In addition to price, other determinants of how much producers want to sell include the price and profitability of goods in production and joint supply, input prices, technology, expectations, the number of sellers and natural and social factors. If one of these factors changes, the supply curve shifts.
The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied.
The behaviour of buyers and sellers drives markets towards their equilibrium. When the market price is above the equilibrium price, there is a surplus of the good, which causes the market price to fall. When the market price is below the equilibrium price, there is a shortage, which causes the market price to rise.
To analyze how any event influences a market, we use the supply and demand diagram to examine how the event affects the equilibrium price and quantity. To do this we follow three steps. First, we decide whether the event shifts the supply curve or the demand curve (or both). Second, we decide which direction the curve (or curves) shifts. Third, we compare the new equilibrium with the initial equilibrium.
In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources. For every good in the economy, the price ensures that supply and demand are in balance. The equilibrium price then determines how much of the good buyers choose to purchase and how much sellers choose to produce.
Elasticity and its applications
The price elasticity of demand measures how much the quantity demanded responds to changes in the price. Demand tends to be more price elastic if close substitutes are available, if the good is a luxury rather than a necessity, if the market is narrowly defined or if buyers have substantial time to react to a price change.
The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If the price elasticity is less than 1, so that quantity demanded moves proportionately less than the price, demand is said to be price inelastic. If the elasticity is greater than 1, so that quantity demanded moves proportionately more than the price, demand is said to be price elastic.
The price elasticity of supply measures how much the quantity supplied responds to changes in the price. This elasticity often depends on the time horizon under consideration. In most markets, supply is more price elastic in the long run than in the short run.
The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. If price elasticity is less than 1, so that quantity supplied moves proportionately less than the price, supply is said to be price inelastic. If the elasticity is greater than 1, so that quantity supplied moves proportionately more than the price, supply is said to be price elastic.
Total revenue, the total amount received by sellers for a good, equals the price of the good times the quantity sold. For price inelastic demand curves, total revenue rises as price rises. For price elastic demand curves, total revenue falls as price rises.
The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to changes in the price of another good.
Background to demand: consumer choices
The analysis of consumer choice looks at how consumers make decisions. There are a number of assumptions underpinning the model which include that people behave rationally to maximize utility from their given resources.
A consumer’s budget constraint shows the possible combinations of different goods they can buy given their income and the prices of goods. The slope of the budget constraint equals the relative price of the goods.
The consumer’s indifference curves represents their preferences. An indifference curve shows the various bundles of goods that make the consumer equally happy. Points on higher indifference curves are preferred to points on lower indifference curves. The slope of an indifference curve at any point is the consumer’s marginal rate of substitution – the rate at which the consumer is willing to trade one good for the other.
The consumer optimizes by choosing the point on their budget constraint that lies on the highest indifference curve. At this point, the slope of the indifference curve (the marginal rate of substitution between the goods) equals the slope of the budget constraint (the relative price of the goods).
When the price of a good falls, the impact on the consumer’s choices can be broken down into an income effect and a substitution effect. The income effect is the change in consumption that arises because a lower price makes the consumer better off. The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper. The income effect is reflected in the movement from a lower to a higher indifference curve, whereas the substitution effect is reflected by a movement along an indifference curve to a point with a different slope.
The theory of consumer choice can be applied in many situations. It can explain why demand curves can potentially slope upward, why higher wages could either increase or decrease the quantity of labour supplied, and why higher interest rates could either increase or decrease saving.
Background to supply: firms in competitive markets
When analyzing a firm’s behaviour, it is important to include all the opportunity costs of production. Some, such as the wages a firm pays its workers, are explicit. Others, such as the wages the firm owner gives up by working in the firm rather than taking another job, are implicit.
A firm’s costs reflect its production process. A typical firm’s production function gets flatter as the quantity of an input increases, displaying the property of diminishing marginal product. As a result, a firm’s total cost curve gets steeper as the quantity produced rises.
A firm’s total costs can be divided between fixed costs and variable costs. Fixed costs are costs that are not determined by the quantity of output produced. Variable costs are costs that directly relate to the amount produced and so change when the firm alters the quantity of output produced.
Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost changes if output increases (or decreases) by one unit.
For a typical firm, marginal cost rises with the quantity of output. Average total cost first falls as output increases and then rises as output increases further. The marginal cost curve always crosses the average total cost curve at the minimum of average total cost
Many costs are fixed in the short run but variable in the long run. As a result, when the firm changes its level of production, average total cost may rise more in the short run than in the long run.
Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firm’s average revenue and its marginal revenue.
One goal of firms is to maximize profit, which equals total revenue minus total cost.
To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost. Thus, the firm’s marginal cost curve is its supply curve.
In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost.
In a market with free entry and exit, profits are driven to zero in the long run. In this long-run equilibrium, all firms produce at the efficient scale, price equals the minimum of average total cost, and the number of firms adjusts to satisfy the quantity demanded at this price.
Changes in demand have different effects over different time horizons. In the short run, an increase in demand raises prices and leads to profits, and a decrease in demand lowers prices and leads to losses. But if firms can freely enter and exit the market, then in the long run the number of firms adjusts to drive the market back to the zero-profit equilibrium.
Consumers, producers and the efficiency of markets
Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it, and it measures the benefit buyers get from participating in a market. Consumer surplus can be computed by finding the area below the demand curve and above the price.
Producer surplus equals the amount sellers receive for their goods minus their costs of production, and it measures the benefit sellers get from participating in a market. Producer surplus can be computed by finding the area below the price and above the supply curve.
An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. Policymakers are often concerned with the efficiency, as well as the equity, of economic outcomes.
The equilibrium of supply and demand maximizes the sum of consumer and producer surplus. That is, the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently.
Supply, demand and government policies
A price ceiling is a legal maximum on the price of a good or service. An example is rent control. If the price ceiling is below the equilibrium price, the quantity demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must in some way ration the good or service among buyers.
A price floor is a legal minimum on the price of a good or service. If the price floor is above the equilibrium price, the quantity supplied exceeds the quantity demanded. Because of the resulting surplus, buyers’ demands for the good or service must in some way be rationed among sellers.
When the government levies a tax on a good, the equilibrium quantity of the good falls. That is, a tax on a market shrinks the size of the market.
A tax on a good places a wedge between the price paid by buyers and the price received by sellers. When the market moves to the new equilibrium, buyers pay more for the good and sellers receive less for it. In this sense, buyers and sellers share the tax burden. The incidence of a tax (that is, the division of the tax burden) does not depend on whether the tax is levied on buyers or sellers.
A subsidy given to sellers lowers the cost of production and encourages firms to expand output. Buyers benefit from lower prices.
The incidence of a tax or subsidy depends on the price elasticities of supply and demand. The burden tends to fall on the side of the market that is less elastic because that side of the market can respond less easily to the tax (and more easily to the subsidy) by changing the quantity bought or sold.
Public goods, common resources and merit goods
Goods differ in whether they are excludable and whether they are rival. A good is excludable if it is possible to prevent someone from using it. A good is rival if one person’s use of the good reduces other people’s ability to use the same unit of the good. It can be argued that markets work best for private goods, which are both excludable and rival. Markets do not work as well for other types of goods.
Public goods are neither rival nor excludable. Examples of public goods include fireworks displays, national defence and the creation of fundamental knowledge. Because people are not charged for their use of a public good, they have an incentive to free ride if the good was provided privately. Therefore, governments provide public goods, making their decision about the quantity based on cost-benefit analysis.
Common resources are rival but not excludable. Examples include common grazing land, clean air and congested roads. Because people are not charged for their use of common resources, they tend to use them excessively. Therefore, governments try to limit the use of common resources.
Merit goods such as education and health might be under-consumed if left to the market and so the state can step in to help provide services which provide social as well as private benefits.
De-merit goods are goods which are over-consumed and which confer both private and social costs. Governments might intervene in the market to reduce consumption in some way either through the price mechanism (levying taxes on these goods, for example), or through regulation and legislation.
Market failure and externalities
When a transaction between a buyer and seller directly affects a third party, the effect is called an externality. Negative externalities, such as pollution, cause the socially optimal quantity in a market to be less than the equilibrium quantity. Positive externalities, such as technology spillovers, cause the socially optimal quantity to be greater than the equilibrium quantity.
Those affected by externalities can sometimes solve the problem privately. For instance, when one business confers an externality on another business, the two businesses can internalize the externality by merging. Alternatively, the interested parties can solve the problem by negotiating a contract. According to the Coase theorem, if people can bargain without cost, then they can reach an agreement in which resources are allocated efficiently. In many cases, however, reaching a bargain among the many interested parties is difficult, so the Coase theorem does not apply.
When private parties cannot adequately deal with external effects, such as pollution, the government often steps in. Sometimes the government prevents socially inefficient activity by regulating behaviour. At other times it internalizes an externality using Pigovian taxes. Another public policy is to issue permits. For instance, the government could protect the environment by issuing a limited number of pollution permits. The end result of this policy is largely the same as imposing Pigovian taxes on polluters.
Government intervention to correct market failure might be subject to its own failures. This is because minority groups are able to exercise political power to influence decision-making of politicians and bureaucrats to gain benefits which might be outweighed by the costs imposed on the majority.
Firm’s production decisions
The use of isoquants and isocosts helps to conceptualize the reasons why firms make decisions to change factor combinations used in production and how the prices of factor combinations can also influence those decisions.
The least-cost input combination occurs where the isoquant curve is tangential to the isocost line. At this point, the producer cannot reorganize existing resources, given their budget constraint, to increase output any further.
Changes in productivity of factors will alter the shape of the isoquant curve and changes in factor prices can alter the shape of the isocost curve.
Monopoly
A monopoly is a firm that is the sole seller in its market. A monopoly arises when a single firm owns a key resource, when the government gives a firm the exclusive right to produce a good, or when a single firm can supply the entire market at a smaller cost than many firms could.
Because a monopoly is the sole producer in its market, it faces a downwards sloping demand curve for its product. When a monopoly increases production by 1 unit, it causes the price of its good to fall, which reduces the amount of revenue earned on all units produced. As a result, a monopoly’s marginal revenue is always below the price of its good.
Like a competitive firm, a monopoly firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost. The monopoly then chooses the price at which that quantity is demanded. Unlike a competitive firm, a monopoly firm’s price exceeds its marginal revenue, so its price exceeds marginal cost.
A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus. That is, when the monopoly charges a price above marginal cost, some consumers who value the good more than its cost of production do not buy it. As a result, monopoly causes deadweight losses similar to the deadweight losses caused by taxes.
Policymakers can respond to the inefficiency of monopoly behaviour in four ways. They can use competition law to try to make the industry more competitive. They can regulate the prices that the monopoly charges. They can turn the monopolist into a government-run enterprise. Or, if the market failure is deemed small compared to the inevitable imperfections of policies, they can do nothing at all.
Monopolists can often raise their profits by charging different prices for the same good based on a buyer’s willingness to pay. This practice of price discrimination can raise economic welfare by getting the good to some consumers who otherwise would not buy it. In the extreme case of perfect price discrimination, the deadweight losses of monopoly are completely eliminated. More generally, when price discrimination is imperfect, it can either raise or lower welfare compared to the outcome with a single monopoly price.
Monopolistic competition
A monopolistically competitive market is characterized by three attributes: many firms, differentiated products and free entry.
The equilibrium in a monopolistically competitive market differs from that in a perfectly competitive market in two related ways. First, each firm in a monopolistically competitive market has excess capacity. That is, it operates on the downwards sloping portion of the average total cost curve. Second, each firm charges a price above marginal cost.
Monopolistic competition has the standard deadweight loss of monopoly caused by the mark-up of price over marginal cost. In addition, the number of firms (and thus the variety of products) can be too large or too small. In practice, the ability of policymakers to correct these inefficiencies is limited.
The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names. Critics of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition. Defenders of advertising and brand names argue that firms use them to inform consumers and to compete more vigorously on price and product quality.
The theory of contestable markets suggests that firm behaviour may be directed at pricing strategies designed to prevent new entrants or to exploit the value in markets. Public policy, therefore, might be more directed at focusing on keeping barriers to entry as low as possible so that prices are driven down towards average cost. Low barriers to entry provide a constraint on firms seeking to adopt strategies to prevent competition.
Oligopoly
Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. Yet, if oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome. The larger the number of firms in the oligopoly, the closer the quantity and price will be to the levels that would prevail under competition.
The prisoners’ dilemma shows that self-interest can prevent people from maintaining cooperation, even when cooperation is in their mutual interest. The logic of the prisoners’ dilemma applies in many situations, including advertising, common-resource problems and oligopolies.
Policymakers use competition law to prevent oligopolies from engaging in behaviour that reduces competition. The application of these laws can be controversial, because some behaviour that may seem to reduce competition may in fact have legitimate business purposes.
Interdependence and the gains from trade
Production possibilities frontiers provide a model to show potential output of goods and services in an economy and the opportunity cost ratios of diverting resources to different uses.
The PPF can shift outwards if countries find ways of improving their factor productivity or exploit factor endowments more effectively.
The shape and position of a PPF is dependent on the productivity of factor inputs and degree of specialization involved in the country in different industries.
Each person consumes goods and services produced by many other people both in their country and around the world. Interdependence and trade are desirable because they allow people to enjoy a greater quantity and variety of goods and services.
There are two ways to compare the ability of two people in producing a good. The person who can produce the good with the smaller quantity of inputs is said to have an absolute advantage in producing the good. The person who has the smaller opportunity cost of producing the good is said to have a comparative advantage. The gains from trade are based on comparative advantage, not absolute advantage.
Trade can make everyone better off because it allows people to specialize in those activities in which they have a comparative advantage.
The effects of free trade can be determined by comparing the domestic price without trade to the world price. A low domestic price indicates that the country has a comparative advantage in producing the good and that the country will become an exporter. A high domestic price indicates that the rest of the world has a comparative advantage in producing the good and that the country will become an importer.
When a country allows trade and becomes an exporter of a good, producers of the good are better off, and consumers of the good are worse off. When a country allows trade and becomes an importer of a good, consumers are better off, and producers are worse off. In both cases, the gains from trade exceed the losses.
A tariff – a tax on imports – moves a market closer to the equilibrium that would exist without trade and, therefore, reduces the gains from trade. Although domestic producers are better off and the government raises revenue, the losses to consumers exceed these gains.
An import quota – a limit on imports – has effects that are similar to those of a tariff. Under a quota, however, the holders of the import licences receive the revenue that the government would collect with a tariff.
There are various arguments for restricting trade: protecting jobs, defending national security, helping infant industries, preventing unfair competition and responding to foreign trade restrictions.
Critics of the theory of comparative advantage argue that the assumptions of the theory do not hold in real life, that the development of the theory was based on a particular historical context which does not exist anymore, and that developing countries investing in higher value industries, rather than those in which they have the factor endowments which provide comparative advantage, have seen greater economic benefits.
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