Economics of Consumption: Goods, Taxes, and Market Equilibrium, Summaries of Microeconomics

Download Economics of Consumption: Goods, Taxes, and Market Equilibrium and more Summaries Microeconomics in PDF only on Docsity! lOMoARcPSD|39591929 N. Gregory Mankiw, M. P. Taylor, Microeconomics CHAPTER 1: TEN PRINCIPLES OF ECONOMICS ● economics is the study of how a society manages its scarce resources ● fundamental lessons about individual decision making ○ people face trade-offs among alternative goals ○ decisions are made by comparing costs and marginal benefits ○ ppl change bx in response to incentives ● fundamental lessons about interactions among ppl ○ trade and interdependence can be mutually beneficial ○ gov’t can improve market outcomes ● fundamental lessons abt the economy as a whole ○ productivity is the ultimate source of living standards ○ growth in the quantity of money → inflation ○ Society faces a short-run trade-off btwn inflation and unemployment ● 10 principles ○ how people make decisions ■ People face trade-offs ● I.e.: choosing btwn going to the cinema or working ■ Cost of smtn is what you give up to get it ● i.e.: during the time you were studying, attending classing you could have earned money working ■ Rational ppl think at the margin ● I.e.: when a firm decides whether to produce an extra unit of some good, it will always look at the cost of producing 1 extra unit vs. the benefit ■ Ppl respond to incentives ● I.e.: gov’t imposes a higher tax on cigarettes → ppl would stop smoking ○ how people interact ■ Trade can make everyone better off ● people specialize in the things they are good at so that they can trade with one another ● absolute advantage: ability to produce a good using fewer inputs than another producer ● comparative advantage: ability to produce a good at a lower opportunity cost than another producer ● gains from trade are based on comparative advantage because both parties will benefit when they specialize in smt where both will consume more goods and reach points outside the ppf ● graph: people face trade-offs btwn certain goods b/c their budget is limited so only the points inside and on the production possibility frontier are attainable however with trade, people will specialize and obtain points outside the curve. ● oligopoly: few sellers→ not always aggressive competition ● quantity demanded: ○ change determined by factors such as income, prices of related goods, tastes, expectations and the number of buyers ■ a change in the price of the product → movement along the demand curve ■ a shift in the demand curve ← a factor other than a change in the price ● i.e: suppose new research says ice-cream makes you live longer → demand for ice-cream will increase → demand curve would shift to the right ● i.e: research suggests ice-cream is bad for your health → demand decreases → demand curve shifts to the left→ at any given price, you purchase less than before ■ consumer income: ● as income increases the demand for a normal good will increase ● as income increases the demand for an inferior good will decrease ○ i.e: bus ride ■ price of related goods: ● substitutes: a fall in the price of one good reduces the demand for another good ○ i.e: if the cost for frozen yogurt falls, the law of demand says you will buy more frozen yogurt → now, you will reduce your spending on ice-cream since both goods are similar ○ i.e: hotdogs + hamburgers; movie tickets + DVDs ● complementary goods: a fall in the price of one good increases the demand for another good ○ i.e: DVD and a DVD-player ● quantity supplied: change is determined by a change in anything that alters the quantity supplied at each price ○ a rise in the price → movement along the supply curve ○ change in a determinant other than the price → a shift to the left or right ■ decrease in supply → left ● i.e: input prices → price of sugar rises → producing ice cream is less profitable → supply less ice-cream ● i.e: number of sellers → if ben and jerry's retired from the ice-cream business, the supply of the market would fall ● i.e: expectation: if a firm expects the price of ice-cream to rise in the future → store its current product → sell in the future ■ increase in supply → shift to the right ● i.e: technology → less labour necessary to make ice-cream→ reduce firm’s costs → raise the supply ● equilibrium price : price that balances quantity supplied and quantity demanded ● equilibrium quantity: quantity supplied and quantity demanded at the equilibrium price ● surplus: price > equilibrium price → quantity supplied > quantity demanded ○ suppliers will lower prices to increase sales and move toward equilibrium ● shortage: price <equilibrium price → quantity supplied < quantity demanded ● law of supply and demand: claims that the price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance CHAPTER 4: ELASTICITY AND ITS APPLICATIONS ● Elasticity: ○ measures the responsiveness of buyers and sellers in response to changes in market conditions ● Price elasticity of demand: ○ measures how much the quantity demanded of a good responds to a change in the price of that good ● determinants of price elasticity of demand: ○ Product type: ■ availability of close substitutes: the more substitutes a good has, the more elastic a good is ● i.e: butter and margarine → if butter gets expensive, ppl will switch to margarine so the demand for butter will decrease ■ luxurious → elastic; necessities → inelastic ● i.e: medicine and gasoline → inelastic b/c ppl need it → even if it gets expensive, people will still buy it so demand won’t change much ; sailboats are luxurious → elastic ○ Time horizon: goods tend to be more elastic over a longer period of time ■ i.e: if gas prices rise, it won’t influence ppl that much right away but after some time, ppl will switch to fuel-efficient car or consider the bus ● Midpoint formula: calculate the price elasticity of demand ○ ○ ● Elasticity is always negative because the demand is always downward sloping → disregard the negative sign and refer to its absolute value (but w/ midpoint formula, this problem is gone) ● classification of elasticity: ○ Price elasticity of demand > 1 → elastic→ quantity demanded does respond strongly to price changes ○ Price elasticity of demand < 1 → inelastic → quantity demanded doesn’t respond ” ○ Price elasticity of demand = 1 → unit elasticity→ changes in price = quantity ● 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 : TR = P x Q ○ inelastic demand curves: TR moves in the same direction as the price ○ elastic demand curves: TR moves in the opposite direction as the price ● income elasticity of demand: measures how much the Q demanded for a good changes when income changes by a certain percentage ○ ● Types of goods: ○ Normal goods: goods whose demand rise when consumers’ income rises ■ i.e: LCD tv, organic food, branded clothes ○ Inferior goods: goods whose demand decline when consumers’ income rises ■ i.e: canned vegetables, ramen, use of public transportation ● Price elasticity of supply: measures the change in quantity supplied after a change in price i.e: i.e.: ● perfect complements: 2 goods w/ right-angle indifference curves ○ i.e.: left and right shoes → you only care abt pairs so your happiness would be the same if you had 7 left and 5 right shoes ● Optimization: what the consumer chooses ○ consumer wants to attain the highest indif. curve b/c he’s the happiest there but he also faces a budget constraint so he cannot buy unlimited amts of goods ○ point where the budget constraint is tangent to the indif. curve: point where a consumer’s utility is maximized given the budget constraint → utility maximization ○ if income rises, the budget constraint shifts to the right → we are able to attain a point on a higher indif. curve ■ when income rises, consumers buy more of normal goods ■ when income rises, consumers buy less of inferior goods i.e.: potatoes ○ price change → i.e.: suppose the price of Pepsi drops from $2 to $1/ pint. Consumer can now buy 1000 pints vs. 500 → new budget constraint rotates and has a steeper slope ○ price change has 2 effects on consumption → ■ income effect: consumer can reach a higher indif. curve → consume more pizza and pepsi b/c you’re richer ■ substitution effect: consumer moves along an indif. curve w/ a new, diff MRS→ consume more pepsi b/c it’s cheaper ● demand curves can sometimes slope upward ○ when a consumer buys more of a good when its price rises ○ giffen goods: goods for which an increase in the price increases the quantity demanded ■ they’re pretty rare ● Behavioural approaches to consumer bx: ○ bounded rationality: idea that humans make decisions under the constraints of limited and unreliable info ■ ppl are overconfident ■ give too much weight to a small number of observations ■ are reluctant to change their minds ■ have a tendency to look for examples which confirm their existing view ■ consumers use rules of thumb, common sense → heuristics ■ anchoring: using familiarity to make decisions; a cognitive bias that influences you to rely too heavily on the first piece of info you receive → JCPenney thought it was a smart move to eliminate coupons and instead create “everyday low pricing.” Too bad they weren’t aware of the power of the anchoring effect. When sales slid big time, they got the message. They’ve now reversed their policy and customers are returning. We need that anchor number to inform us that we’re getting a bargain.; ● i.e.2: If a husband is doing ten times more housework than his dad ever did, he may feel entitled to a “best husband of the year” award from his wife. Imagine his surprise then, when his wife berates him for not doing enough. What’s going on here? Blame it on the anchoring effect. His anchor is what his dad used to do. Her anchor is the amount of housework she does. ■ availability: when assessing relative risk/danger, a mental shortcut that makes fast, but incorrect, judgments→ what is the most dangerous job? high profile police shootings might lead you to think that cops have the most dangerous jobs ■ representativeness: decisions made based on how representative smtn is to a stereotype→ a person accused of abducting a child for ransom may be more likely to be viewed as guilty as someone accused of kidnapping an adult for no ransom. While both crimes represent kidnapping, the first is a more representative example because it fits better with what most people think of when they hear the word "kidnapping." ■ persuasion: attributes a consumer attaches to a product or brand → ‘bandwagon’ effect – if a large number of people go and see a movie and rave about it on FB then there is even more incentive for others to go and see it as well. Firms may look to try and create a bandwagon effect to utilize this persuasion heuristic in their marketing. ■ simulation: visualizing or simulating an outcome of smt → pharmaceutical firms know that consumers are more likely to buy and take medicine that deal with known and experienced symptoms (headaches, strained muscles, sore throats and runny noses) which are easy to visualize and imagine than taking regular medicine for smt like high cholesterol because it is hard to build a mental process for the effects of high cholesterol CHAPTER 6: BACKGROUND TO SUPPLY: FIRMS IN COMPETITIVE MARKETS ● goal of firms is to maximize profit → profit = total revenue - total cost ○ total revenue: amt of money a firm receives for selling its products → ■ TR = PRICE x QUANTITY → 100 balls for $5 each = $500 ○ total cost: sum of explicit and implicit costs ● cost of production: includes all the opportunity costs of output of goods/services ○ explicit costs: out of pocket costs for a firm ■ i.e.: wages a firm pays its workers, materials, rent ○ implicit costs: input costs that don’t require an outlay of money by the firm ■ i.e.: wages the firm owner gives up by working in the firm rather than taking another job; avoiding rent by using the ground floor of a home for business ○ economic profit takes both explicit and implicit costs into account whereas accounting profits doesn’t consider implicit cost such as opportunity costs ● time periods: fixed and variable costs → in the short run, some costs are fixed, in the long run, fixed costs become variable costs ● marginal product of labour: amt of extra output when you hire 1 more worker ○ i.e.: amt of pizzas extra produced if you hire 1 more worker ● production function: shows the relationship btwn labor units (horizontal axis) and the total product on the vertical axis → i.e.: Quantity of workers on the X axis and Quantity of pizzas on Y axis ● diminishing marginal product: marg. product of an input declines as the Q of the input increases ○ i.e.: as more and more workers are hired, each additional worker yields less and less production b/c the firm has a lmtd amt of equipment ○ graph: initially the slope is quite steep, but it declines as you hire more workers→ marginal product declines and the production function becomes flatter ● total cost curve: shows the relationship btwn the Q a firm can produce and its costs ● different kinds of costs related to production: ○ fixed costs: costs which do not depend on the number of goods you produce ■ i.e.: cookie factory → you pay rent every month, rent is a fixed cost→ it doesn’t depend on the amt of cookies produced ○ variable costs: costs that do depend on the number of goods produced ■ i.e.: flour needed to produce cookies → more cookies you produce, the more flour you’ll need ● total costs: ■ i.e.: suppose you like chocolate and your willingness to pay for it is $10 but the price for it’s only $4→difference btwn $10 and $4 is the consumer surplus → $6 ● consumer surplus= buyer’s willingness to pay - actual cost of the good ○ willingness to pay is diff for everyone depending on how much they value that good ○ graph: consumer surplus is the triangle area below the demand curve and above the price and quantity sold/produced ■ as price falls, cons. surplus increases → new customers enter the market b/c of their willingness to pay since price is low enough ○ is consumer surplus a good measure of economic well being? → depends whether consumers are rational or irrational ■ i.e.: heroin addicts may be willing to pay much higher prices for their habit than they actually do → creates larger consumer surplus (in this case, not a good measure) ● but usually, consumer surplus is a good measure of economic well being especially if policymakers want to respect the preferences of buyers ● producer surplus: measures economic welfare from the seller’s side ○ producer surplus = amt a seller pays for a good - the cost of providing it ○ cost: value of everything a seller must give up to produce a good ○ consumers want a lower price whereas the producers would prefer a higher price ○ graph: the area btwn the equilibrium price, equilibrium Q and the origin ○ just like a decreasing price is good for consumer surplus, increasing price is good for producer surplus → conflicting interests: consumers want lower prices and producers want higher prices ● total surplus = consumer surplus + producer surplus → ○ TOTAL SURPLUS= VALUE TO BUYERS - COST TO SELLERS ● Market Efficiency ○ economic efficiency and waste → consumes spend money on goods which don’t have value; producers spend money on producing a good which consumers don’t want to buy ■ to reduce waste → consumers need to adjust their buying habits; producers adjust their production methods ○ allocative efficiency → an allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient ○ efficiency: if an allocation of resources maximizes total surplus, that allocation exhibits effic. ○ equality: distributing economic prosperity uniformly among members of society ○ Pareto efficiency: is said to occur when it’s impossible to make one individual better off without making someone worse off (a state where pareto improvement can occur) ■ i.e.: An economy contains two people and two goods, apples and bananas. Person 1 likes apples and dislikes bananas (the more bananas she has, the worse off she is), and person 2 likes bananas and dislikes apples. There are 100 apples and 100 bananas available. The only allocation that is Pareto efficient is that in which person 1 has all the applies and person 2 has all the bananas. For any other allocation, one of the persons has some units of the good she does not like, and would be better off if the other person had those units. ○ Pareto improvement: is said to occur when at least one individual becomes better off w/out harming another individual ■ i.e.: a group of people do not have electricity but overtime were able to install a small solar farm which brought electricity to their village. The electricity would allow the village to cook and heat their homes with electricity instead of charcoal which has harmful effects on the respiratory systems of the users. Assuming the electricity is accessible to everyone and the farm does not interfere with anyone in the village, it would be a Pareto improvement because the village is made better off without anyone being made worse off ● Efficiency and Equity: ○ equity: fairness of the distribution of well-being among various buyers and sellers ○ social welfare function: collective utility of society which is reflected by consumer and producer surplus CHAPTER 8: SUPPLY, DEMAND AND GOV’T POLICIES ● in a free, unregulated market system, market forces establish equilibrium prices and exchange quantities ○ while equilibrium conditions may be efficient, it may be true that not everyone is satisfied therefore the Pareto efficiency principle is said to be weak b/c of equity issues ● Control Prices -- usually enacted when policymakers believe the market price is unfair to buyers/sellers → results in govt created price ceilings and floors ○ price ceiling: a legal maximum on the price → price is not allowed to rise above a certain amt, which is beneficial for customers ○ price floor: a legal minimum on the price at which a good can be sold ● Outcomes of price ceiling: ○ if price ceiling is set above the equilibrium price, then nothing will happen b/c market forces drive the price to the equilibrium level → price ceiling is not binding ○ price ceiling is binding if set below the equilibrium price → leads to a shortage ■ a binding price ceiling creates shortages b/c QD > QS ○ i.e.: rent control→ local govt can limit how much a landlord can charge a tenant or by how much the landlord can increase prices annually. Rent control aims to ensure the quality and affordability of housing on the rental market. New York and San Francisco have famous rent control laws. Over the long-run, however, rent control decreases the availability of apartments, since suppliers do not wish to spend the money to build more apartments when they cannot charge a profitable rent. Landlords not only do not develop any more apartments, but they also do not maintain the ones that they have, not just to save costs but also because they do not have to worry about market demand since there is excessive demand for rent-controlled apartments. Hence, excess demand and limited supply lead to a massive shortage. ■ rent control in the short run: number of flats are given and we can’t change that → we assume the supply is given ■ rent control in the long run: can be adjusted to increase the supply ○ non- price rationing: process by which the market system allocates goods and services to consumers when QD > QS. Whenever there’s a need to ration a good (when a shortage exists) in a free market, the price of the good will rise until QS = QD → until market clears ■ queuing: a non price rationing mechanism → waiting in line as a means of distributing goods and services ● the cost of a product = price of product + waiting time ● i.e.: doctor queues (USSR) ■ discrimination by sellers: favored customers who receive special treatment from dealers during situations of excess demand ● outcomes of price floor: ○ price floor is not binding if set below the equilibrium price ○ price floor is binding if set above the equilibrium price → surplus→ QS > QD ○ i.e.: minimum wage→ if min. wage is set above equilibrium level → companies are less willing to hire ppl and unemployment occurs ● Taxes affect the outcome of a market → govts levy taxes to raise revenue for public projects ○ H/e → taxes discourage market activity (can have a negative effect on bx) and result in a change in market equilibrium; when a good is taxed, the Q sold is smaller; ● graph: consumer surplus decreases (now only the triangle above TR); producer surplus has decreased (now only the triangle below the TR) → consumer and producer surplus decreased more than the increase of tax revenue → this loss of potential is called deadweight loss ○ deadweight loss: fall in total surplus that results from a market distortion such as a tax ○ so a society as a whole is worse off w/ tax than w/out tax b/c in a free market, resources are allocated efficiently but w/ gov’t interference, price rises for buyers and is lower for producers → incentive for buyers to buy less and for producers to make less → market outcome is not optimal anymore hence, the DEADWEIGHT LOSS ● Determinants of the deadweight loss: ○ the size of the deadweight loss depends on the price elasticities of supply and demand ■ let’s assume demand is relatively elastic, which means it responds more to changes in price → if the govt levies a tax, price will change and QD will shrink even more thus, there’s more loss of potential (AKA deadweight loss) ○ the greater the price elasticities of demand and supply → the larger will be the decline in equilibrium quantity → greater the deadweight loss of tax ● Deadweight loss DEBATE: ○ i.e.: labour taxes: some economists argue that labor taxes are not very distorting as to them, labour supply is fairly inelastic (labour supply curve almost vertical) so, ■ most ppl would work full-time regardless of the wage ■ if so, the tax on labour has a small deadweight loss ○ other economists argue that labor taxes are highly distorting b/c labor supply is more price elastic → for instance, some workers who may respond more to incentives: ■ workers who can adjust the # hrs they work ■ families w/ second earners ■ elderly who can choose when to retire ■ illegal workers in the underground economy ● Deadweight loss & tax revenue as taxes vary ○ taxes rarely stay the same for long period time b/c policymakers in govts are always considering raising or lowering taxes ○ higher tax rate causes a higher deadweight loss ○ w/ each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax ■ small tax → TR is small → small deadweight loss ■ as the size of the tax increases → TR grows → deadweight loss also gets larger ■ but, as the size of the tax continues to rise → TR first rises w/ the size of the tax but then, eventually falls b/c higher tax reduces the size of the market ● Laffer Curve: shows the relationship btwn tax rates and tax revenue ● supply-side economics: refers to the views of Arthur Laffer and other economists who proposed that by lowering taxes and decreasing regulation, consumers will benefit from a greater supply of goods and services at lower prices → employment will increase ○ lower tax rates when tax level is too high will actually boost gov’t revenue b/c of higher economic growth CHAPTER 10: PUBLIC GOODS, COMMON RESOURCES AND MERIT GOODS ● When classifying goods, 2 characteristics should be examined: ○ Excludability: refers to the property of a good whereby a person can be prevented from using it ○ Rivalry in consumption: refers to the property of a good whereby one person’s use diminishes other people’s use ● (using these 2 characteristics, goods can be divided into 4 categories: ○ Private goods: both excludable and rival ■ i.e.: ice cream cone: it’s rival in consumption b/c if you eat an ice-cream cone, someone else cannot eat the same cone. It’s excludable b/c it’s your ice cream. ○ Public goods: neither excludable nor rival ■ i.e.: tornado siren in a small town no one is being excluded from hearing the siren and the fact that someone else benefits of hearing the siren does not mean that your benefit is being reduced so there’s no rivalry; i.e.: fireworks ■ free-riding: since ppl cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it → you benefit from smt without paying for it ● i.e.: wikipedia : a free encyclopedia → millions of people use it and benefit from it but only a tiny fraction contribute to its upkeep ● i.e.: national defense (army); basic research (program that aims to develop medicine against cancer → society benefits); fighting poverty (welfare programs → give $ to low-income families) ■ Cost-benefit analysis: before deciding to fund a public good, the gov’t must compare the costs and benefits of a public good ● before providing a public good, the benefits of using the good must be compared to the costs of providing and maintaining the public good ● Not easy → how to measure how much individuals will value a good? ○ Common resources: rival but not excludable ■ i.e.: fish in the ocean : rival b/c when one person catches fish, there are fewer fish for the next person to catch. It’s not excludable b/c we can’t just exclude certain people from fishing in a public place (ocean, lake) ■ i.e: littering: govt has laws prohibiting it but it’s not always enforced but still, some still don’t litter b/c it’s against their moral standards. ■ i.e: charity: ppl donate money to non-profit organizations b/c they care abt a cleaner envt. ● alumni donating $$$ to universities and schools b/c they believe school is important! ○ ppl can also negotiate directly w/ each other to solve externalities → ■ Coase theorem: if ppl can bargain w/ each other abt the allocation of resources, they can always reach an efficient outcome on their own ● i.e: suppose your friend plays the piano. She has a piano at home and practices every day. Unfortunately, her neighbor does not like piano music at all → a classic example of a negative externality. Playing the piano is worth $100 to your friend. Her neighbor values his peaceful silence $150. In this case, the neighbor can ask your friend to stop playing the piano and compensate her with $110 (or any amount between $100 and 150) instead. This way, both of them are happy. Your friend is happy because she is compensated adequately for the lack of playing and her neighbor is happy because he ensured his silence for less than he would have been willing to pay. Both parties are better off, so we have an efficient outcome. ○ sometimes, both parties fail to solve an externality problem b/c of transaction costs → ■ transaction costs: costs that parties incur in the process of agreeing to and following through on a bargain ● i.e (cont. from example above): your friend values playing the piano at $140. Her neighbor might be willing to pay her $150 if she stops playing the piano. In that scenario she wins $10. What if she could have used the time they spent bargaining to go to work and make $20 instead. In that case, she is better off not bargaining ● i.e: suppose you’re in a dispute w/ your neighbor over smt and you’re trying to resolve it → you and your neighbour speak different languages so to reach an agreement, you need to hire a translator → if the benefit of solving the problem is less than the cost of the translator, you and your neighbor might choose to leave the problem unsolved thus, the transaction costs are the expenses of the translators… ○ transaction costs could also be lawyers required to draft and enforce contracts,etc. → to resolve disputes Transaction Costs sFTe-c ly od Policing & Teo a) Pelee aol CeCe Cee tn Ere CR) ae Ieee parties sick to the eeu Ee a ee eae Dead ey Ce Cul Letra UC Red ca PCL Rey iy Cee os ely Transaction Cost : Search and information costs : are costs such as those incurred in determining that the required good is available on the market, which has the lowest price, etc. Bargaining costs are the costs : required to come to an acceptable agreement with the other party to the transaction, drawing up an appropriate contract and so on. In game theory this is analyzed for instance in the game Of chicken, On asset markets and in market microstructure, the transaction cost is some Function of the distance between the bid and ask. Policing and enforcement costs; are the costs of making sure the other party sticks {0 the terms of the contract, and taking appropriate action (often through the legal system) if this tums out not to be the case.