intro to ecnomics Flashcards
what is economics?
“Economics is the study of how we the people engage ourselves in production, distribution and
consumption of goods and services in a society.”
“The science which studies human behavior as a relationship between ends and
scarce means which have alternative uses.”
BRANCHES OF ECONOMICS
Normative economics:
Normative economics is the branch of economics that incorporates value judgments about what the
economy should be like or what particular policy actions should be recommended to achieve a desirable
goal.known as statements of
opinion which cannot be proved or disproved, and suggests what should be done
Positive economics:
Positive economics, by contrast, is the analysis of facts and behavior in an economy or “the way things
are.” Positive statements can be proved or disproved, and which concern how an economy works,
factors of production
- Land includes the land used for agriculture or industrial purposes as well as natural resources
taken from above or below the soil. - Capital consists of durable producer goods (machines, plants etc.) that are in turn used for
production of other goods. - Labor consists of the manpower used in the process of production.
- Entrepreneurship includes the managerial abilities that a person brings to the organization.
Entrepreneurs can be owners or managers of firms.
Scarcity
does not mean that a good is rare; scarcity exists because economic resources are unable to
supply all the goods demanded
rationing
a process by which we limit the supply or amount of some economic factor which is
scarcely available. It is the distribution or allocation of a limited commodity
ECONOMIC SYSTEMS
Dictatorship:
Dictatorship is a system in which economic decisions are taken by the dictator which may be an individual or a group of selected people.
Command or planned economy:
A command or planned economy is a mode of economic organization in which the key economic functions – for whom, what, how to produce are principally determined by government directive.
Free market/capitalist economy:
A free market/capitalist economy is a system in which the questions about what to produce, how to produce and for whom to produce are decided primarily by the demand and supply interactions in the
market.
Islamic economic system:
This system is based on Islamic values and Islamic rules i-e zakat, ushr, etc.
of wealth and this strikes at the root of capitalism.
Pakistan case: A mixed economy
In Pakistan, there is mixed economic system. Resources are governed by both government and individuals. Some resources are in the hand of government and some are in the hand of public. Optimal mix of resources is decided by the price mechanism.
CIRCULAR FLOW OF GOODS & INCOME
There are two sectors in the circular flow of goods & services. One is household sector and the other is the business sector which includes firms. Households demands goods & services, Firms supply goods & services. An exchange takes place in an economy.
In monetary economy, firms exchange goods & services for money. Firms’ demands factors of production and households supply factors of production.
Firms pay the payment in terms of wages, rent, etc. This is circular flow of goods. On the other hand, household gives money to firms to purchase the goods & services from firms, and firms’ gives money to households in return for factors of production.
DISTINCTION BETWEEN MICRO & MACRO ECONOMICS
Micro Economics:
The branch of economics that studies the parts of the economy, especially such topics as markets, prices, industries, demand, and supply. It can be thought of as the study of the economic trees. studies how individuals, households, and firms make decisions to allocate limited resources typically in markets where goods or services are being bought and sold.
Macro Economics:
The branch of economics that studies the entire economy, especially such topics as aggregate production, unemployment, inflation, and business cycles. It can be thought of as the study of the economic forest. involves the “sum total of economic activity, dealing with the issues of growth,
inflation, and unemployment and with national economic policies relating to these issues” and the effects of government actions (e.g., changing taxation levels) on them.
HOW PRODUCERS DECIDE ABOUT OPTIMAL CHOICE
Costs:
will be additional labor employed, additional raw material and additional parts & components that have to be bought.
Benefits:
will be additional revenue that the firm will get by selling the additional number of cars.
It will be profitable to invest if revenue is greater than the cost.
MARGINAL COST AND MARGINAL BENEFIT
Marginal cost:
is the additional costs of producing an additional unit of some good or service.
Marginal benefit:
is the additional benefit derived from consuming an additional unit of good or service.
PRODUCTION POSSIBILITY FRONTIER (PPF)
Production possibility frontier (PPF):
is the curve which joins all the points showing the maximum amount of goods and services which the country can produce in a given time with limited resources.
GOODS MARKET AND FACTORS MARKET
Goods/product/commodity markets:
Markets used to exchange final good or service. Product markets exchange consumer goods purchased by the household sector, capital investment goods purchased by the business sector, and goods purchased by government and foreign sectors.
Factors markets:
Markets used to exchange the services of a factor of production: labor, capital, land, and entrepreneurship. Factor markets, also termed resource markets, exchange the services of factors, NOT
the factors themselves
types of goods
Normal goods:
are goods whose quantity demanded goes up as consumer income increases.
Inferior goods:
are goods whose quantity demanded goes down as consumer income increases.
Giffen goods:
are the sub category of inferior good.a change in price causes quantity demanded to change in the same direction.
demand analysis effects
substitution effect:
occurs because a change in the price of a good makes it higher or lower than the prices of other goods that might act as substitutes.
The income effect:
results because a change in price gives buyers more real income, or the purchasing
power of the income, even though money or nominal income remains the same.
Price effect = Income effect + Substitution effect
law of demand
The law of demand states that holding all other factors constant, if the price of a certain commodity rises, its quantity demanded will go down, and vice-versa. Other factors are income, population, tastes, prices of all other goods etc.
demand function
A demand function is an equational representation of demand as a function of its many determinants. Equation of demand function is Qd= a – b P
a= slope pf demand curve
b=unit price
p= intercept
Shifts in the demand curve
normal goods: (increase in income): rightwards
normal goods: decrease: leftwards
inferior goods: increase: leftwards
inferior goods: decrease: rightwards
substitute: increase in price: rightwards
substitute: decrease: leftwards
law of supply
The law of supply states that the quantity supplied will go up as the price goes up and vice versa.
supply function
A supply equation is QS = c + d P
Determinants of supply
- Costs of production
- Profitability of alternative products (substitutes in supply) ( favour more profitable good)
- Profitability of goods in joint supply
- Nature and other random shocks
- Aims of producers(maximise short run profit)
- Expectations of producer(increase or decrease predictability maybe wrong)
ALGEBRAIC REPRESENTATION OF EQUILIBRIUM
Qd = Qs
price ceiling
A price ceiling is the maximum price limit that the government sets to ensure that prices don’t rise above that limit (medicines for e.g.).
price floor
A price floor is the minimum price that a Government sets to support a desired commodity or service in a society (wages for e.g.)
RATIONING & SUPPLY SHOCKS (ALTERATION OF EQUILIBRIUM PRICE BY THE
GOVT)
- Through Tax :
Tax (to be paid by the producer) will increase the Supply Price, Supply Curve shifts left ward, Price
increases & quantity decreases. - Through Subsidy :
Subsidy (given to the producer) will decrease the Supply Price, Supply Curve shifts rightward, Price
decreases & quantity increases.
IMPORTANCE OF ELASTICITY IN OUR TODAY’S LIFE
The firm which uses advertising to change prices uses the concept of elasticity of demand of its
product.
Mostly firms set the prices of their product by viewing at the elasticity of demand of their
product.
The government collects revenues by imposing taxes. The good tax imposed by the government on the products is one for which either demand is inelastic or the supply is inelastic.
So if the government wants to put tax burden on the consumers then it will choose the product to tax with low price elasticity of demand.
And if government wants to panelize the producers then it must choose the product with low price elasticity of supply.
elasticity
“responsiveness of one variable to changes
in another.”
TYPES OF ELASTICITY
Price Elasticity of Demand:
is the percentage change in quantity demanded with respect to the percentage change in price.
PЄd = Percentage change in Quantity Demanded ÷ Percentage change in Price.
Price elasticity of supply:
is the percentage change in quantity supplied with respect to the percentage
change in price.
PЄs = Percentage change in Quantity Supplied ÷ Percentage change in Price.
Income elasticity of demand:
is the percentage change in quantity demanded with respect to the
percentage change in income of the consumer.
YЄd = Percentage change in Quantity Demanded ÷ Percentage change in Income
Cross price elasticity of demand:
is the percentage change in quantity demanded of a specific good, with respect to the percentage change in the price of another related good.
PbЄda = Percentage change in Demand for good a ÷ Percentage change in Price of good b
WHY WE USE PERCENTAGE CHANGE RATHER THAN ABSOLUTE CHANGE IN
ELASTICITY?
we can avoid the problem of comparison in two different quantitative variables
avoid that of what size of units to be changed
how to define big or small changes
TOTAL REVENUE AND ELASTICITY
Total revenue (TR) = Price x Quantity (P x Q)
Elastic demand means when price of any product increases, its demand decreases more than the
increase in price. As price increases total revenue decreases in case of elastic demand.
Inelastic demand of any product means that if price of that product increases there is very small effect
on its quantity demanded. As price increases, total revenue also increases in case of inelastic demand.
point elasticity
Point elasticity is used when the change in price is very small.
Є= ∆Q/∆ P x P/Q
If elasticity = zero then demand curve will be vertical.
If elasticity is infinity then the demand curve will be horizontal.
DETERMINANTS OF PRICE ELASTICITY OF DEMAND
- Number of close substitutes within the market.
- Percentage of income spent on a good.
- Time period under consideration.
EFFECTS OF ADVERTISING ON DEMAND CURVE
Advertising aims to:
* Change the slope of the demand curve – make it more inelastic. This is done by generating brand loyalty;
* Shift the demand curve to the right by tempting the people’s want for that specific product.
price elasticity of supply
The relative response of a change in quantity supplied to a relative change in price.
DETERMINANTS OF PRICE ELASTICITY OF SUPPLY
- If costs increases, lower will be the supply. Lower the costs the more will be the supply.
- Amount of time given to quantity respond to a price increase or decrease. There may be immediate time period, short term and long term time period.
income elasticity of demand
The relative response of a change in demand to a relative change in income.
Єdy = ∆ Q/Q ÷ ∆ Y/ Y
Less income elastic Єdy < 1
More income elastic Єdy > 1
ΔQ represents the change in quantity demanded of a good or service.
Q is the initial quantity demanded.
ΔY represents the change in income.
Y is the initial income
DETERMINANTS OF INCOME ELASTICITY OF DEMAND
- Degree of necessity of good.
- The rate at which the desire for good is satisfied as consumption increases
- The level of income of consumer.
short run/long run
Short run is a period in which not all factors can adjust fully and therefore adjustment to shocks can only be partial.
Long run is a period over which all factors can be changed and full adjustment to shocks can take place.
Cross price elasticity of demand
Cross price elasticity of demand is the percentage change in quantity demanded of a specific good, with
respect to the percentage change in the price of another related good.
PbЄda = ∆ Qa/Qa ÷ ∆ Pb/ Pb
Goods are substitutes (sign is positive). Demand is cross price elastic | є | > 1.
THREE CORE RULES OF ELASTICTY
1- Price elasticity:
Inelastic (less than 1)
Elastic (greater than 1)
2- income elasticity
normal goods (positive)
inferior goods(negative)
3- cross elasticity
substitute (positive)
complementary (negative)
CARDINAL VS. ORDINAL APPROACH
MARGINAL UTILITY ANALYSIS OR CARDINAL APPROACH
Marginal utility approach involves cardinal measurement of utility, i.e., you assign exact values or you
measure utility in exact units, while the indifference curve approach is an ordinal approach, i.e., you
rank possibilities or outcomes in an order of preferences, without assigning them exact utility values.
Utility is the usefulness, benefit or satisfaction derived from the consumption of goods and services.
Total utility (TU) is the entire satisfaction one derives from consuming a good or service.
Marginal utility (MU) is the additional utility derived from the consumption of one or more unit of the
good.
supply side and demand side
Economists like recordo and Karl Marx focused on the supply side of the economics. In their opinion
any good produced, its value is equal to the labor content used in its production. For example, if workers
are working 8 hours a day to produce bicycles then their time multiplied is the value of that bicycle.
This is labor content. On the other hand, economists like Adam smith focused on the demand side of the
economics.
UNCERTAINTY IN THE CONSUMPTION DECISION ANALYSIS
A consumer’s response to uncertainty depends upon her attitude to risk: whether she is:
a. Risk averse
b. Risk-loving
c. Risk neutral
The odds ratio (OR) is the ratio of the probability of success to the probability of failure
. If it is equal to 1 we call it fair odds, if less then 1 unfavorable
odds, and if greater 1 then favorable odds.
A risk neutral person is one who buys a good when OR > 1. He is indifferent when OR = 1 and will
not buy when OR < 1.
A risk averse person will not buy if OR < 1. He will also not buy if OR = 1. He might also not decide
to buy if OR > 1.
A risk loving person will buy if OR > 1 or = 1, but he might also buy when OR is < 1.
The degree of risk aversion increases as your income level falls
indifference curve
An indifference curve is a line which charts out all the different points on which the consumer is
indifferent with respect to the utility he derives.
marginal rate of substitution
. MRS states how much unit of a good you have to give up in order get an additional
unit of another good.
dY/dX = MUx/ MUy = MRS
THE OPTIMUM CONSUMPTION POINT FOR THE CONSUMER
is where the budget line is
tangent to the highest possible indifference curve. At such a point, the slopes of the indifference curve
and the budget line are equal. In other words: MRS = Px/Py = ∆Y/∆X = MUx/MUy.
THE INCOME CONSUMPTION CURVE (ICC)
can be used to derive the Engel Curve, which shows the
relationship between income and quantity demanded.
Engel curve shows the positive relationship between income & quantity demanded of normal good. As
income increases, quantity demanded for normal goods also increases.
PRICE CONSUMPTION CURVE (PCC)
traces out the optimal choice of consumption at different prices.
The PCC can be used to derive the demand curve, which shows the relationship between price &
quantity demanded.
When the price of one good change
- One the purchasing power of consumer changes i.e., the budget line shifts (leads to income
effect). - Secondly, the slope of budget line changes due to a change in the relative price ratio (leads to
substitution effect)
LIMITATION OF INDIFFERENCE APPROACH
a. Indifference curve analysis is only possible for 2 or at best for 3 goods.
b. It is almost impossible to practically derive indifference curves.
c. The consumer may not always behave rationally.
d. The consumer may not always realize the level of utility (ex-post) from consumption, that she
originally expected (ex-ante).
e. Indifference curve analysis can not help when one of the goods (X or Y) is a durable good
TRADITIONAL THEORY OF THE FIRM
The traditional theory of the firm says that the firm’s basic goal is to maximize profits. Profit is the
difference between the total revenue & total cost.
π = TR – TC
Types of firms:
sole proprietorship (one-person ownership), partnership (a limited number of owners) or a
limited company (a large number of changing shareholders).
production function
PRODUCTION FUNCTION
A mathematical relation between the production of a good or service and the inputs used.: Q = f(L, K), where Q = quantity of production output,
L = quantity of labor input, and K = quantity of capital input.
COBB DOUGLAS PRODUCTION FUNCTION
Cobb-Douglas functional form of production functions is widely used to represent the relationship of an output to inputs. It was proposed by Knut Wicksell, and tested against statistical evidence by Paul Douglas and Charles Cobb in 1928.
Q = A K^α L^1–α
Where:
Q = output
L = labor input
K = capital input
A, α and 1 – α are constants determined by technology
law of diminishing marginal returns
The law of diminishing marginal returns states that as you increase the quantity of a variable factor
together with a fixed factor, the returns (in terms of output) become less and less.
The total physical product (TPP)
refers to the total quantity or output of goods or services produced by a firm, business, or individual. In simpler words, it’s the total amount of stuff or products that are made or provided.
Average physical product (APP)
tells us the average amount of output or production per unit of input. Specifically, it’s the total physical product (TPP) divided by the quantity of the variable input, such as labor or capital.. APP can be represented by the
following formula, APP = TPPF/QF
(f= factor)
Marginal physical product (MPP)
is the addition to TPP brought by employing an extra unit of the variable factor. More generally,
MPPF = ∆TPPF/∆QF
RELATIONSHIP BETWEEN APP AND MPP
- If the marginal physical product equals the average physical product, the average physical
product will not change. - If the marginal physical product is above the average physical product, the average physical
product will rise. - If the marginal physical product is below the average physical product, the average physical
product will fall.
TWO THEORIES OF PRODUCTION
- Short run productivity theory or the law of diminishing marginal returns. This theory states that as we increase the amount of a variable factor with the fixed factor, initially the output will increase but afterwards there will come a point when each extra unit of the variable factor produces less extra output than the previous unit. In this theory, we take one factor as fixed therefore; it applies only in the short run.
- Long run productivity theory or returns to scale theory. In long run, all factors are variable. This theory includes constant, increasing & decreasing returns to scale.
ISOQUANT
An isoquant represents different combinations of factors of production that a firm can employ to
produce the same level of output. Isoquant can be used to illustrate the concepts of returns to scale and
returns to factor.
MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS)
The slope of an isoquant is called marginal rate of technical substitution (MRTS). It is analogous to the term marginal rate of substitution (MRS) in consumer analysis. MRTS is the amount of one factor, e.g. capital, that can be replaced by a one unit increase in the other factor e.g. labor, if output is to be held constant.
cost analysis
VARIABLE COST (VC)
Costs, which vary with the level of activity (or output), are called variable costs. Variable cost is a cost of labor, material or overhead that changes according to the change in the volume of production units.
Fixed Cost (FC)
Costs, which do not vary with the level of activity or output, are called fixed costs.
Total Cost (TC)
Total cost (TC) is the sum of all fixed and variable costs. It plot as a vertical summation of the horizontal line total fixed cost (TFC) curve and the upward sloping total variable cost (TVC) curve.
TC = FC + VC
Average Cost or Average total cost (AC or ATC)
Total cost per unit of output, found by dividing total cost by the quantity of output.
Average cost (AC) is the vertical summation of the AFC & AVC. Average variable cost plus average fixed cost equals average total cost.
AVC + AFC = ATC or AC
Average variable cost (AVC)
AVC is an economics term to describe the total cost a firm can vary (labor, etc.) divided by the total
units of output.
AVC = TVC/Q
Average fixed cost (AFC)
AFC is total; fixed cost divided by the total units of output.
AFC = TFC/Q
MARGINAL COST (MC)
The change in total cost (or total variable cost) resulting from a change in the quantity of output produced by a firm in the short run.MC = ∆TC/∆Q
