SCARCITY
We make choices because we cannot satisfy all our WANTS. There are limited resources making it impossible to satisfy all the wants, regardless of the wealth and money one can possess. For example, you cannot get your daily tasks accomplished and sleep all you want at the same time. Time here is your limited resource. Economists call this limited resource a scarce resource.
In this world, our wants are greater than the resources available to satisfy them. This is SCARCITY and Economics stems from scarcity. Economics studies how people deal with limited resources to satisfy their unlimited wants.
Supply, demand and market equilibrium
These two concepts are extremely important economics concepts to understand how economists interpret and analyze things. If you sell goods and/or services, you are on the supply side. And since we all of us consume goods and services, we are always on the demand side. Demand is simply our willingness to buy different quantities of goods and services at different prices.
If the meal you buy every day for lunch at school or work increases from $6 to $8, you might not buy one everyday as you used to, maybe 3 or 4 times a week instead of 5. Here is what happened: the price of your meal has increased and as a result your quantity demanded decreases. You buy LESS of that meal at HIGHER PRICES. This fundamental relationship defines the LAW of DEMAND. The Law of Demand states that “At higher prices, the quantity demanded of a good falls and at lower prices, the quantity demanded of a good rises, when everything else remains the same”.
Supply is simply the willingness of producers to sell different quantities of goods and services at different prices. The higher the price of a good, the higher the quantities sellers are willing to sell. This leads us to the LAW OF SUPPLY which states “At higher prices, the quantity supplied of a good increases while at lower price the quantity supplied of a good decreases, when everything else remains the same.”
When you put supply and demand together, you get a market, i.e. when buyers with the willingness and the ability to buy goods and services meet producers with the ability to sell goods and services.
Opportunity costs
If you are reading this terminology now, then you have given up on something else you could have been doing. This decision you made to be here is the OPPORTUNITY COST of anything else you could have been doing.
The higher the opportunity costs the costlier the choice you make. For example if skipping an additional day at work can get you fired, then you are less likely to do it because the costs are high. So you will make a decision to to go to work.
Substitute and complements
Two goods are complements if they are consumed altogether, jointly. From an economic perspective, two goods are complements if the demand for one increases as the price of the other good drops. Example: coffee and creamer. If the price of coffee decreases, then you are more likely to buy more coffee creamer because at the new lower price, you can purchase more coffee.
Two good are substitute of they satisfy similar needs and can be substituted for each other. From an economic perspective, two goods are substitute if the demand for one increases as the price of the other goods increases. Example : Coke and Pepsi. If the price of Coke increases, then you are more likely to buy more Pepsi because at the new higher price, Coke is more expensive to buy so you switch to Pepsi.
Production Possibilities curve and trade
The same way individuals make choice for themselves, societies also make choices and must choose what maximizes benefits for the whole society. Economists have illustrated this concept using a graph called the Production Possibilities Frontier (PPF). The PPF graphically shows the maximum amount of goods and services a society can produce given the available resources. An economy cannot produce as much as it wants because of scarcity. So, it must choose a combination goods and services that will maximize efficiency. This combination is shown by the PPF, an outward bowed curve.
If the costs of producing one good are lower for one economy compare to another economy, then this economy is said to have a comparative advantage in the production of that good. In more formal terms, you have a lower opportunity costs in that good. In this specific case, an economy will specialize in the production of that good.
To summarize, you specialize in a good in which you have a comparative advantage, i.e. lower costs of production.
Price elasticities
Measures the responsiveness of goods and services due to a change in price. It is calculated as the percentage change in quantity demanded divided by the percent change in price. Only the absolute value is considered. If absolute values are less than 1, equal to 1 and greater than 1, elasticities are respectively inelastic, unit elastic and elastic.
Income elasticity of demand percentage is calculated as the change in quantity demanded – at specific price- divided by the percentage change in income. If it is positive then income and demand are positively related and we face a normal good. If it is negative, income and demand are inversely related and we face an inferior good.
The cross price elasticity of demand percentage is the change in the demand of good X due to a change in the price of good Y. It is calculated as the change in quantity demanded of one good (good X)- at specific price- divided by the percentage change in price of a related good (good Y). It is positive for substitute goods and negative for complements goods.
The price elasticity of supply is calculated as the percentage change in quantity supplied of a good divided by the percentage change in price. If it is less than 1, equal to 1 and greater than 1, elasticity is respectively inelastic, unit elastic and elastic.
Consumer choice
Consumers buy goods and services for their own satisfaction or pleasure. Each consumer gained her own utility with a goal of maximizing such utility within the boundaries of a set budget- called budget constraint. In other words, consumer will use their budget to allocate money to buy a combination of goods and services that maximize their satisfaction. Hence utility is the satisfaction derived from the consumption of a good or service. Total utility is the total satisfaction derived from consuming a specific level of goods and services. Each additional unit of goods or service consumed increases total utility up to a certain level beyond which satisfaction declines. This is the marginal utility.
The Law of Diminishing Marginal Utility states that the marginal utility declines beyond a certain level of consumption, all else being equal.
Income and substitution effect
The income effect is the change in the consumption of a good or service from a change in income. Can also due to an indirect change in income resulting from a price change. For a price change that takes up a significant amount of the income, the income effect is larger and vice versa.
The substitution effect is the change in consumption of a good or service when a change in the price of that good or service adjusts the consumer’s income. The substitution effect occurs when the change in consumption is in opposite direction to the change in price. In other words, a drop in prices triggers an increase in the purchase of that good and a decrease in the purchase of the other good.
Diminishing marginal returns
Diminishing Marginal Returns occur when the consumption of every additional unit of a good or service decrease the satisfaction received from its consumption. Who doesn’t get excited to get a sweet treat? The first treat consumed makes you very happy, the second one even more and so does the third one. By the time you get the fourth unit, you’re like “why not?” You feel reluctant to eat the fifth unit and by the time you receive the sixth one, you say no thanks. For you, the fifth unit was the maximum and that’s where your satisfaction reached a plateau. However, the sixth unit decreases your satisfaction. This is the reason why the graph of marginal returns is bell shaped. Satisfaction from consumption increases, plateaus, then starts decreasing. This is true for any marginal concept in economics.
Market structures
In a perfectly competitive market, hundreds, or even thousands, of firms sell a homogeneous product. Each firm is such a small part of the market that it takes the market price as given: Each firm is a price taker. A perfectly competitive market has the following features: many sellers, many buyers, homogeneous product, no barriers to market entry and both buyers and sellers are price takers.
The firm’s objective is to maximize economic profit, which equals total revenue minus economic cost. Perfectly competitive firms maximizes profit at the point where their price is equal to their marginal costs. (P=MC). If P<MC, then profits will decrease. If P>MC, profits will increase, so firms can increase levels of production
A monopoly is a market structure where only one seller makes the industry and for which goods it produces have no close substitutes. A monopolist’s price is higher than the market price and its output is lower than the market output.
A monopoly can be due to barriers to entry, government regulations, specific location, economies of scale or natural monopoly – lower per unit costs of production.
Monopolies maximize output at the point where their marginal revenue equals their marginal costs (MR=MC)
Market structure where few firms make up the industry. They compete among each other and are interdependent in their actions, i.e. the actions of one firm affect the outcome of other firms. For these reasons, oligopoly firms make strategic choices called game theory. Each firm’s economic outcome depends on the strategic choice of the firm itself and the other firms in the industry. They are strategically interdependent. The best know game theory model is called the prisoner’s dilemma. The prisoner’s dilemma is an analytical framework where firms choose to act in their own self interest though cooperating with each other will have produce a better outcome.
Competing among many other firms. They have some of the perfect competition characteristics -many firms, very limited barriers to entry except that they make differentiated products.
Production costs
Costs for a given firm depends on its level of production and the prices of the resources needed for production. These costs are divided into variable and fixed costs. Variable costs (VC) are associated with the level of production while fixed costs (FC) are somehow independent of these levels. They include costs such as rent of facilities, insurance, salary of some employees, etc. in other words, whether or not the firm is producing, those costs are incurred.
Total costs is the sum of variables and fixed costs. TC=VC+FC.
Any average costs is the corresponding costs divided by quantity.
- AVC=VC/Q
- AFC=FC/Q
- ATC=TC/Q. It’s also equal to the sum of AFC+AVC
Marginal costs are the costs associated with the production of one additional unit. The sum of all marginal costs is equal to the total costs
Breakeven price and shutdown rule
While Break-even price is the price at which the economic profit is zero, a firm’s shut-down price is the price at which it is indifferent between operating and shutting down. The rule is to operate if Price is greater than Average Variable Costs (P>AVC) and to shut down if Price is less than Average Variable Costs (P<AVC).
Long run costs
A firm’s long-run total cost (LTC) is the total cost of production when the firm is perfectly flexible in choosing its inputs, including its production facility. The firm’s long-run average cost (LAC) equals the long-run cost divided by the quantity produced. As the quantity produced increases, the average cost doesn’t change, so the average-cost curve is horizontal over this range of output. This is the case of constant returns to scale: As a firm scales up its operation, costs increase proportionately with output, so average cost is constant. A firm’s long-run marginal cost (LMC) is the change in long-run cost resulting from producing one more unit of output.
Budget deficits and effects on trade
When the government borrows money, the real interest rate goes up, hence offering a higher return on U.S. securities. This makes investments on U.S. securities more attractive to foreign investors. As a result, the demand for U.S. dollars increases in the foreign exchange market. This increase in demand makes the U.S. dollar stronger. There is a currency appreciation. On the domestic side, the stronger dollar allows U.S. residents to purchase more goods from abroad as they are now cheaper. This raises the level of imported goods. At the same time, the stronger dollar makes U.S. goods more expensive for foreign buyers who decreases the level of exported goods. Greater imports and smaller exports decrease net exports, resulting in a decrease in GDP. Deficits ultimately affects output and foreign trade.