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Economic Principles

3/23/16 1:37 PM

August 7, 2013
Supply
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Changes in supply is a change in the quantity that suppliers plan to
sell when any influence on selling plans other than the price of the
good changes
Factors that effect
o Prices of related goods
§ Substitute in production is a
o Complement in production
o Number of sellers
o Productivity

Equilibrium
• Occurs when the quantity demanded equals the quantity supplied
• Surplus
o Two much
o Price drops
• Shortage
o Not enough
o Price rises
Elasticity
• Price elasticity of demand
o Is a measure of the extent to which the quantity demanded of
a good changes when the price of the good changes
• Percentage change in price
o ((new price-initial price)/((new price+initial price)/2))x100
• elastic demand
o when price percentage increases, demand decreases
• unit elastic demand
• inelastic demand
o when price of gum rise 20%, demand only decreases 10% or
doesn’t change at all
§ like medication
• reached highest revenue when elasticity equals 1
August 15, 2013 (READ LECTURE 3A)

Market Efficiency, Government Action and Taxes
• Production Possibilities Frontier (PPF)
o The boundary between the combinations of goods and
services that can be produced and the combinations that
cannot be produced
• Production efficiency
o When you cant produce more of one good or service without
producing less of something else
o trade off
§ more dvd’s à less cell phones
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opportunity cost changes throughout PPF
o point A à B
§ 1:1 ratio (cellphone:DVD)
o Point D à E

§ 4:1 ratio
• Economic Growth
o Sustained expansion of production possibilities
§ Better technology, better labor lead to better growth
Should price gouging be illegal?
• Resource allocation methods
o In order to produce at more efficient rate
o Resource is always scarce
• Command
o People rank needs and will allocate their needs despite the
price
o Doesn’t matter how many apples you want, I will give you
five
• Tax rate
o Voted on tax rate by majority rules
• First come, first serve
• Sharing equally
Marginal Benefit
• How much you are willing to pay
• Marginal cost
o You have to give up the cost of other things to get something
you want

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Efficient allocation
o Highest valued allocation
Allocative efficiency
o Occurs at intersection of the marginal benefit curve and
marginal cost curve
Demand curve is a marginal benefit curve***
Surplus
o Willingness to pay
§ Willing to pay $15, only costs $10
Consumer Surplus
o Marginal benefit from a good or service minus the price paid
for it, summed over the quantity consumed
o Say you are willing to pay $250, but it only costs $200
§ Consumer Surplus= $50
§ Marginal Benefit= $250

Supply
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Producer surplus
o Say you own a pizza shop and the market price of a pizza is
$10 but you find a way to produce cheaper pizza and would
be able to sell the pizza at a $6 market price, but you still
charge $10
§ Your producer surplus is $4 per pizza
Efficient Market
• Factors
o Market equilibrium
o Marginal cost curve
o Marginal benefit curve
o When marginal cost equals marginal benefit, quantity is
efficient
o Consumer surplus plus…
o Producer surplus is maximized
• Market failure
o Market is not longer efficient
o Too little produced
§ Underproduction
o Too much produced

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Overproduction à price will drop

Deadweight Loss
o Decrease in total surplus and that results from an inefficient
underproduction or overproduction
o Anytime total surplus is a decrease, that decrease is
deadweight loss
o It is a social loss
• Alternatives to the Market
o Remedies are a response to particular reasons for market
inefficiency
Are Markets Fair?
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Equality of opportunity
Rules must be fair in two respects
o The state must enforce laws that establish and protect private
property
o Private property may be transferred from one person to
another only by voluntary exchange
• Big Tradeoff
o Tradeoff between efficiency and fairness that recognizes the
cost of making income transfers
Price Gouging
• Should it be illegal?
o Price of a stove before a storm is raised during a storm
because demand increases
o Government sets a fixed price to avoid gouging
§ Leads to a black market
Price Ceilings
• Government regulation
• Rent ceiling
o Regulation that makes it illegal to charge more than a
specified rent for housing
o Depends on whether it is imposed at a level above or below
the market equilibrium rent
• Price ceiling has to be lower than the equilibrium price
• Black market is broken by a rent ceiling
• Rent ceiling are not efficient
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So why have them?
o Fairness and efficiency to give people apartments who usually
could not afford them
Price Floors
• Minimum wage
o Can pay above wage but not below
o Effect of minimum wage depends on whether it is set above
or below the market equilibrium wage rate
• Not efficient but trying to be fair
Taxes
• Does Congress decide who pays taxes?
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Tax incidence
o Division of the burden of a tax between the buyer and the
seller
Excess burden
o (Tax* demand loss)/2

August 20, 2013
Income Tax and Social Security Tax
• Taxable income
o Total income minues a personal exemption and a standard
deduction
• Marginal tax rate
o Percentage of an additional dollar of income that is paid in tax
• Average tax rate
o Percentage of income that is paid in tax
• Progressive tax
o Tax whose average rate increases as income increases
• Proportional tax
o Tax whose average rate is constant at all income levels
• Regressive tax
o Tax whose average rate decreases as income increases
• Tax on labor income
• Taxes on capital income
o Taxing the income from capital works like taxing the income
from labor

o Difference
§ Capital is internationally mobile and so the supply of
capital is highly elastic
ú Perhaps perfectly elastic
ú Invest in a country where there are no capital tax,
you can increase gains greatly
o Supply of capital is perfectly elastic
o With a 40 percent tax on capital income, the interest rate
rises
o The firm pays the entire tax
§ Producing a large deadweight loss
Taxes on income from land and unique resources
o The supply of land is highly inelastic
o Tax goes up, causing rent to go up
§ Money from increase of rent is used to pay tax through
the landowner
• Social Security Tax
o Says that the tax is to be shared equally by workers and
employers
Fairness and the Big Tradeoff
• Two conflicting principles
o Benefits principle
§ Proposition that people should pay tax equal to the
benefits they receive from public good and services
§ People that benefit the most must pay the most
ú Living in a place with better school system or a
safer location
o Ability-to-pay principle
§ Proposition that people should pay taxes according to
how easily they can bear the burden
ú Rich person can more easily bear the burden of
higher tax
• Horizontal equity
o Taxpayers with same ability to pay should pay the same taxes
• Vertical equity
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o Requirement that taxpayers with greater ability to pay bears
a greater share of tax
• Marriage tax problem
o Married couple is considered a single taxpayer
• Big tradeoff
o Question of fairness or efficiency
Classifying Goods and Resources
• Excludable
o Good, service, or resource is excludable if it is possible to
prevent a person from enjoying its benefits
§ Fish in a fish farm
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§ Live concert paying for ticket
Nonexcludable
o Impossible to prevent a person from benefiting from it
§ Fish in the pacific ocean
§ Concert on television
Rival
o Goods or services… if its use by one person decreases the
quantity available to someone else
§ Seat at a live concert
Nonrival
o If its use by one person does not decrease the quantity
available to someone else
§ Concert on network television
Private good
o Good or service that can be consumer by only one person at a
time and only by those people who have bought it or own it
o Both rival and excludable
§ Can of coke
Public good
o Consumed simultaneously and doesn’t take away from other
and available to all
o Nonrival and nonexcludable
§ Flood control levee
Common resource

o Resource that can be used only once but no one can be
prevented from using what is available
§ Rival and nonexcludable
ú Fish in the pacific ocean
• Natural monopoly goods
o Good or service that is nonrival but excludable is produced by
a natural monopoly
o Firm that produces at lower cost than two or more firms can
§ A low cost postal service
Public goods and the free-rider problem
• Free-rider problem
o Person who enjoys the benefits of a good or service without
paying for it
§ Investing in apple and the price going up
o To produce efficient quantity, government action is required
§ Nobody want to pay for a bridge on their own
• Marginal social benefit from a public good
o (MSB) similar to demand
o sum of the marginal benefits of all the people in the economy
at each quantity
o abstract numbers that really cant be determined
§ like eating a fish that was cost
• Marginal social costs of a public good
o (MSC) similar to supply
o abstract numbers
§ like pollution costs of fishing in the ocean
• rational ignorance
o decision not to acquire information because the marginal cost
of doing so exceeds the expected marginal benefit
Common Resources
• Tragedy of the commons
o Absence of incentives to prevent the overuse and depletion of
a commonly owned resource
§ Atlantic ocean cod stocks, south pacific whales
• Property rights

o With property rights over fish, the marginal private cost of
fishing equals the marginal social cost
o Supply=MC=MSC
• Individual transferable quota
o Is a production limit that is assigned to an individual who is
free to transfer the quota to someone else
§ Say I can catch 100 fish, I can sell that quota to
another fisherman so he can catch 200 fish
Lemons problem and its solution
• Lemons problems
o Arises when it is not possible to distinguish reliable products
from lemons, there are too many lemons
• Wants to buy a good car for 20,000 and avoid buying a lemon
o He can fix the car himself and will buy a lemon for 10,000 if
he can fix it himself
• Adverse selection
o Tendency for people to enter into transactions that bring
them benefits from their private information and impose costs
on the uninformed party
o Someone who is old and goes to get insurance because they
know they are sick and insurance company doesn’t know
about previous health conditions
• Signaling
o Occurs when an informed person takes actions that send
information to uninformed persons
o Makes the buyer not want to buy if car has no insurance
because they now know the car is a lemon if the seller doesn’t
want to insure the car
Insurance markets
• Pay the premium
• Auto collision insurance
• Moral hazard
o Tendency for a person with private information to use it in
ways that impose costs on an uninformed party with whom
they have made an agreement

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Drive with full collision coverage has less incentive than
a driver with little or no collision coverage to drive
carefully

Screening
o Occurs when an uninformed person created an incentive for
an informed person to reveal relevant private information
§ Insurance companies use the “no-claim” bonus and the
deductible as screens to separate high-risk aggressive
drivers and low-risk careful drivers and set premiums in
line with the risk arising from the two types of drivers
No claim bonus

o Ex
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Circular flows in the U
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economy
o Consumption
§ Expenditure by households on consumption goods and
services
o Investment
§ The purchase of new capitals goods and additions to
inventories
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o Government expenditure
§ The expenditure by all levels of government on goods
and services
o Net exports of goods and services
§ The value of exports of goods and services minus the
value of imports of goods and services
§ Exports vs
...
expenditure approach may give similar
numbers but they are still different
Real GDP
o Value of the final goods and services produced in a given year
expressed in the prices of the base year
o Used to:
§ Compare the standard of living over time
§ To track the course of the business cycle
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To compare the standard of living among countries
The standard of living over time
ú To compare living standards we calculate real
GDP per person
ú Overall GDP/number of people
o Omits illegal transactions, volunteer work, and household
production
• Nominal GDP
o The value of the final goods and services produced in a given
year expressed in the prices of that same year
• National Bureau of Economic Research Business Cycle Dating
Committee determines the dates of US business cycle turning
points
o If GDP goes down, it is considered a recession
How long does it take to find a job?
• Working age population
o Total number of people aged 16 years and over who are not
in a jail, hospital, or some other form of institutional care or
in the U
...
Armed Forces
o Divided into those in the labor force and those not in the labor
force
• Labor Force
o Number of people employed plus the number of unemployed
• Unemployment rate
o = (number of people unemployed/labor force) x 100
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Labor force participation rate
o The percentage of the working-age population who are
members of the labor force
o = (labor force/working-age population) x 100
marginally attached worker
o person who does not have a job, is available and willing to
work, had not made specific efforts to find a job within the
previous four weeks, but has looked for work sometime in the
recent past
Discouraged worker
o Marginally attached worker who has not made specific efforts

to find a job within the previous four weeks because previous
unsuccessful attempts were discouraging
• Full-time workers
• Part-time workers
o Less than 35 hours a week
• Part-time for economic reasons
o People who work 1 to 34 hours per week but are looking for
full-time work
o Also called involuntary part-time workers
• Frictional unemployment
o The unemployment that arises from normal labor turnover
o From people entering and leaving the labor force and from
the ongoing creation and destruction of jobs
• Structural unemployment
o Unemployment that arises when changes in technology or
international competition change the skills needed to perform
jobs or change the location of jobs
• Cyclical unemployment
o The fluctuating unemployment over the business cycle that
increases during a recessions and comes back when it is over
Consumer Price Index
• Measure of the average of the prices paid by urban consumers for a
fixed market basket of consumer goods and services
• Reference based period
o Period for which CPI is defined for 100

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Cost of
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Constructing the CPI
o Selecting the CPI basket
o Conducting monthly price survey
o Finding the CPI
Deflation
o Situation in which the inflation rate is negative
o Inflation is a negative number
living index
Measure of changes in the amount of money that people would
need to pend to achieve a given standard of living
Sources
o New goods bias
o Quality change bias
o Commodity substitution bias
§ Price of beef rises faster than the price of chicken,
people buy more chicken and less beef
GDP price index
o Uses the prices of all the goods and services in GDP
§ CPI uses prices of consumption goods and services
o GDP price index weights each item using information about
current as well as past quantities
§ CPI weights each item using information from a past
consumer expenditure survey
PCE price index
o Average of current prices of all the goods and services
included in the consumption expenditure component of GDP
expressed as a percentage of base-year prices
o Core inflation rate
§ Percentage change in the PCE price index excluding
food and energy
o Excluding food and energy
GDP price index is the broadest measure
PCE price index contains goods and services in GDP that households
buy in the current year
CPI basket contains only good and services that urban consumers
buy in the base year

Nominal wage rate and real wage rate
• Real wage takes inflation into account
• Real interest rate
o Nominal interest rate-inflation rate
o Nominal interest rate is the dollar amount of interest
expressed as a percentage of the amount loaned
August 28, 2013
Why is recession so difficult to predict?
• Shadow Banking
o Not a bank

Federa
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o They can lend money to firms or individuals but are not
regulated by Federal Reserve to do this
o They can be a partner with big banks, like citi bank, and
invest in loans by the bank
o Systemic risk
§ If one big bank is going into distress, a lot of banks
related to this bank will be in risk
Budget
Annual statement of the revenues, outlays, and surplus or deficit of
the gov
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Taxes are the income of gov
Outlays are the deficit of government
Budget surplus in the late 1990’s and early 2000’s
o 24 million jobs added in 10 year after 1990-91 recenssion
o ten year expansion
o increased taxes
o Budget enforcement act
§ Limit on annual federal expenditure
§ Required that any revenue or spending legislation that
would increase the deficit (or decrease the surplus) by
offset by a reduction in expenditures or an increase in
revenue elsewhere in the budget

Spent more on military, spend less (in equal amount) in
education
Government borrows to finance a budget deficit and repays its debt
when it has a budget surplus
National debt
o Amount of debt outstanding that arises
Transfer payments
o Social security benefits, medicare and medicaid benefits, and
other cash benefits paid to individuals and firms
o Social security is a government debt
o Revenue will never be able to pay back debt
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Options by gov
o Raise income taxes
o Raise social security taxes
o Cut social security benefits
o Cut other federal government spendin
Keynasian View
o Fiscal stimulus
§ An increase in government outlays
New classical view of fiscal policies
o Increase tax rate now, decrease tax rate later
Mainstream view
o If government invest in a state, then investment in that state
will decrease
§ If you own an airport and you want to add on, but
governemtn is willing to pay for it, then you don’t need
to invest more money
§ “crowds out”
how to curb the deficit
o democrats want to spend more than we can afford
o republicans want to tax more than we can afford
§ what policy will change aggregate demand the most:
Democrats agreeing to cut the budget outlays or
Republicans agreeing to raise taxes?
§ Increase in taxes will decrease aggregate demand (tax
multiplier)

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3/23/16 1:37 PM

3/23/16 1:37 PM



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