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Table of Contents
BASIC ECONOMIC TERMINOLOGYEconomics| Return to Top |
Microeconomics Vs MacroeconomicsMicroeconomics: the part of economic analysis that studies individual decision making undertaken by individuals (or households) and by firms.
Macroeconomics: the part of economic analysis that studies the behavior of the economy as a whole. It deals with economy-wide phenomena such as changes in unemployment, the general price level, and national income. | Return to Top |Economic behaviorRational Self-Interest – economic assumption that individuals act as if they are motivated by self-interest and respond predictably to opportunities for gain
The Rationality Assumption – the assumption that individuals will not intentionally make decisions that would leave them worse off
Responding to Incentives – the reward for engaging in a given activity … people react to an incentive by making a rough comparison of costs and benefits
Defining Self-Interest – the pursuit of goals that make the individual feel better off … in economic analysis goals are often measured in monetary terms although the pursuit of other goals (prestige, love, power, etc) can be analyzed using this concept | Return to Top |
Economics as a Science
Assumptions – assumptions define the set of circumstances in which a model is most likely to be applicable. Every model, therefore, must be based on a set of assumptions.
The Ceteris Paribus Assumption (All Other Things Being Equal) – assumption that nothing changes except the factors being studied … used to isolate the effect of a change in one variable on another one by assuming that all other variables do not change
Deciding on the Usefulness of a Model – a model is useful if it yields usable predictions and implications for the real world … if a model makes a prediction and factual evidence supports the prediction, the model is useful
Models of Behavior, Not Thought Processes – models relate to the way people act in using limited resources and not to the way they think … normally generalize people’s behavior | Return to Top |Positive Versus Normative EconomicsPositive economics deals with what is. Positive economic statements are “if-then” statements. Since positive economics predicts consequences of actions, it can be used to predict the effects of various policies to see if the policies aid in achieving desired goals. Positive economics cannot provide criteria for choosing which outcomes or goals are best.
Normative economics deals with what some individual thinks ought to be. Normative economic statements involve value judgments and normally have the words “ought” or “should” in them.
Warning – It is easy to define positive economics. It is often difficult to identify unlabeled normative statements. | Return to Top |
RESOURCES factors of production / inputs used in the production of things that people want production – virtually any activity that makes the things that exist and that we use more valuable to us
land – natural resources
labor – all productive contributions made by individuals who work
physical capital or capital good – all manufactured resources used for production
human capital – training & education workers receive that increases their productivity
entrepreneurship – a type of labor that organizes, manages & assembles other factors of production to make business ventures … takes risks associated with introducing new methods and other types of new thinking that could lead to more income | Return to Top |
Goods & Services good – anything from which individuals derive satisfaction or happiness
economic good – good for which the quantity demanded exceeds the quantity supplied at a zero price
service – purchased or used by consumers with no physical characteristics | Return to Top |
wants & needs
| Return to Top |scarcityby definition the supply of economic goods is limited
the things consumers want and need are scarce
scarcity requires that individuals & societies make choices
when one choice is made, another is given up | Return to Top |Opportunity costthe alternative given up when a choice is made - your textbook had a dollar cost of $50 plus an opportunity cost of what you would have bought with that $50 had you not bought your text
in economics cost is always a foregone opportunity | Return to Top |production possibilities curve
| Return to Top |specializationworking at a relatively well-defined, limited activity
leads to an increase in productivity
absolute advantage – ability to produce more units of a good or service using a given quantity of labor or resource inputs … the ability to produce the same quantity of a good or service using fewer units of labor or resource inputs
comparative advantage – ability to produce a good or service at a lower opportunity cost compared to other producers … the basis for specialization
division of labor
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The Law of Demand: the quantities of a good or service that people will purchase at any price during a specified time period, other things being equal. The law of demand states that there is an inverse relationship between relative price and quantity demanded, i.e. when the relative price of a good goes up, people buy less of it and when the relative price of a good goes down, people buy more of it, other things being equal.
The Demand Schedule: The demand schedule is a numerical representation of the inverse relationship between specific prices and quantities demanded of a good measured in terms of constant quality units in a given time period.
The Demand Curve: The demand curve is a graphic representation of the demand schedule. It is a negatively sloped line showing the inverse relationship between the price and the quantity demanded.
Shifts in Demand: A movement of the entire demand curve so that at each price the quantity demanded changes. A leftward shift of the demand curve means the quantity demanded at each price decreases and is called a decrease in demand, while a rightward shift of the demand curve means the quantity demanded at each price increases and is called an increase in demand.
The Other Determinants of Demand: These are non-price factors which determine how much will be bought, other things held constant. A change in any one of these factors will cause a change in demand.
Income: For a normal good, an increase in income leads to an increase in demand, while a decrease in income leads to a decrease in demand. For an inferior good, an increase in income leads to a decrease in demand, while a decrease in income leads to an increase in demand.
Tastes and Preferences: If consumer tastes change in favor of a good, then there is an increase in demand for it. If consumer tastes move against the good, then there is a decrease in demand for it.
Prices of Related Goods (Substitutes and Complements): When two goods are related a change in the price of one of them changes the demand for the other. Substitutes are goods that can be used to satisfy a similar want. If the price of one changes, demand for the other changes in the same direction. Complements are goods that are consumed together. If the price of one changes, the demand for the other changes in the opposite direction.
Expectations: Expectations of future increases in the price of a good, increases in income, and reduced availability lead to an increase in demand now. Expectations of future decreases in the price of a good, decreases in income, and increased availability lead to a decrease in demand now.
Market Size (Number of Buyers): An increase in the number of buyers in the market causes an increase in demand. A decrease in the number of buyers causes a decrease in demand.
Changes in Demand Vs Changes in Quantity Demanded: A change in demand refers to a shift of the entire demand curve to the right or left if there is a change in a determinant of demand other than price. A change in quantity demanded refers to a movement along a given demand curve caused by a change in price.
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The Law of Supply: the relationship between price and quantity supplied at different prices in a specified time period, other things being equal. The law of supply states that the higher the price of a good, the larger the quantity sellers will make available over a specified time, other things being constant.
The Supply Schedule: The supply schedule is a table that shows a direct relationship between price and quantity supplied at each price in a given time period.
Supply Curve: This is a graphic representation of the supply schedule that is an upward sloping line showing a direct or positive relationship between price and quantity supplied.
Shifts in Supply: A change in supply is a shift of the entire supply curve so that at each price the quantity supplied changes. A leftward shift of the supply curve means that the quantity supplied at each price decreases and is called a decrease in supply, while a rightward shift of the supply curve means that quantity supplied at each price increases and is called an increase in supply.
Other Determinants of Supply: These are factors other than price which determine how much will be produced and are held constant when identifying supply. A change in one of these factors will cause the supply curve to shift.
Cost of Inputs Used to Produce the Product: An increase (decrease) in the price of one or more inputs will cause a decrease (increase) in supply.
Technology and Productivity: An improvement in technology will cause an increase in supply.
Taxes and Subsidies: Increases (decreases) in indirect taxes have the same effect as raising (lowering) costs and, thus, decreases (increases) supply. A subsidy is a negative tax.
Price Expectations: An expected increase (decrease) in the relative price of a good can lead to a decrease (increase) in supply.
Number of Firms in the Industry: If the number of firms increases (decreases), supply will increase (decrease).
Changes in Supply Vs Changes in Quantity Supplied: A change in quantity supplied refers to a movement along a given supply curve caused by a change in price. A change in supply refers to a shift of the entire supply curve to the right or left caused by a change in a non-price determinant of supply.
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Putting Demand and Supply Together: Understanding how demand and supply interact is essential to understanding how prices are determined in our economy and other economies.
Demand and Supply Schedules Combined: When the supply and demand schedules are combined, an equilibrium or market-clearing price is determined. This is a price at which quantity demanded equals quantity supplied. There is neither an excess quantity supplied (surplus) nor an excess quantity demanded (shortage).
Equilibrium: Equilibrium is a stable point. When equilibrium is reached, there is no tendency for change unless supply and/or demand change. Equilibrium is a situation where quantity supplied equals quantity demanded at a particular price. Equilibrium occurs where the supply and demand curves intersect.
Shortages: A shortage is a situation in which quantity demanded is greater than quantity supplied. At a price below the equilibrium price there is a shortage which is corrected when price increases. Quantity demanded will fall and quantity supplied will increase until equilibrium is reached. Surpluses: A surplus is a situation in which quantity demanded is less than quantity supplied. At a price above the equilibrium price there is a surplus that is corrected when price decreases. Quantity demanded will rise and quantity supplied will fall until equilibrium is reached.
An economic system in which relative prices constantly change to reflect changes in demand and supply. Prices act as signals of relative scarcity to everyone in the system. The Rationing Function of Prices:
Prices are indicators of relative scarcity and ration goods to those who are willing to pay the most. Because of scarcity, it is not possible for everyone to have everything they want.
Rationing by a freely functioning price system is the most efficient because all gains from mutually beneficial trade will be exhausted.
Goods can also be rationed on a “first-come, first-served” basis, by the use of political power, by physical force, by lotteries, by coupons, and by cultural, physical, and religious differences.
Government-Imposed Price Controls: The rationing function of prices is often not allowed to operate when government sets price controls called price floors (minimum legal prices) and price ceilings (maximum legal prices).
Price Floors
When a surplus develops in agriculture, the government buys the surplus and stores it or sells it to foreign countries at a reduced price.
A minimum wage is a price floor legislated by government below which it is usually illegal to pay workers. The effect is to cause unemployment for some low skill workers and depressed wages in areas not covered by the minimum wage.
Price Ceilings:
When a price ceiling is below the market-clearing price a shortage occurs. The result is fewer exchanges.
Whenever the price system is not allowed to work, non-price rationing devices will evolve to ration the affected goods and services. An obvious example is queuing.
Typically, an effective price ceiling leads to a black market in which the price-controlled good is sold at an illegally high price.
Rent control is the placement of price ceilings on rents in particular municipalities.
Quantity Restrictions: Governments can impose quantity restrictions on a market, such as a ban on ownership or trading of goods (human organs and certain psychoactive drugs). The most common quantity restrictions in international trade are import quotas. A quota is a quantity restriction that prohibits the importation of more than a specified quantity of a particular good in a one-year period. The United States has had import quotas on tobacco, sugar, and immigrant labor. The beneficiaries of quotas are importers who get the quota rights and the domestic producers of the restricted good.
The benefits of a price system are high levels of economic efficiency, the existence of consumer sovereignty, promotion of personal freedom, and prevention of coercion of buyers and sellers by the existence of competition. A price system can also produce market failures for which government interventions may be wanted.
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Correcting for Externalities: An externality is a situation in which a benefit or a cost associated with an economic activity spills over to third parties, i.e., parties who are not direct participants in the market transaction. How Government Corrects Negative Externalities
Special Taxes: Taxes on output would reduce output, but would not provide an incentive to reduce pollution per unit of output. Taxes on the amount of pollutants emitted would provide an incentive to reduce pollution per unit of output.
Regulation: The government could specify a maximum allowable rate of pollution.
How Government Corrects Positive Externalities
Government Financing and Production: When positive externalities are large (e.g. public goods), government may finance and produce the good or service.
Subsidies: A subsidy is a negative tax: a payment to the consumer or producer of a good or service for consuming or producing a good or service
Regulation: Government can require that certain actions be undertaken, e.g. inoculations of school children.
Providing a Legal System: All relationships among consumers and businesses are governed by legal rules. Much of the legal system is involved with defining and protecting property rights.
Promoting Competition: Promoting competition is a way of increasing the efficiency of the economy. Antitrust legislation is used to reduce the power of monopolies and to discourage certain activities that restrain trade.
Providing Public Goods: Public goods are goods to which the principle of rival consumption does not apply and are jointly consumed by many individuals simultaneously. This is in contrast to private goods that can be consumed by only one person at a time.
Characteristics of Public Goods
Public goods can be used by more and more people at no additional cost and without depriving others of any services of the goods.
It is difficult to design a collection system for a public good on the basis of how much individuals use it.
Free Riders
The free rider problem is a situation associated with public goods when individuals presume others will pay for public goods, so they can escape paying for their portion without causing a reduction in production.
Ensuring Economy-wide Stability: The federal government is charged under the Employment Act of 1946 to stabilize the economy at high levels of employment.
Merit and Demerit Goods: The government defines certain goods and services as desirable or undesirable. A merit good is a good that has been deemed socially desirable by the political process, and will be provided by government or subsidized. A demerit good is a good that has been deemed socially undesirable by the political process. It will be prohibited, taxed, or regulated to reduce consumption.
Income Redistribution: Government explicitly redistributes income by progressive taxation and by transfer payments and transfers in kind. Transfer payments are money payments made to individuals for which no services or goods are concurrently rendered. Transfers in kind are payments in the form of goods and services for which no goods or services are concurrently rendered.
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Collective Decision-Making: Theory of Public Choice
Collective decision-making is how voters, politicians, and other interested parties act to influence non-market decisions. The theory of public choice is the study of collective decision-making.
Similarities in Market and Public Sector Decision-Making
There is an assumption of self-interest being the motivating force in both sectors.
Scarcity: Because resources are fixed, there is a scarcity constraint for both sectors. At any point in time if government gets more goods, there are then fewer goods for the private sector. Every government action has an opportunity cost.
Competition in Both Sectors: In the public sector the competition is between bureaucrats, elected representatives, and appointed officials for available funds. Economists assume that they will compete and act in their own interest not that of society.
Similarity of Individuals: Persons in government face a different incentive structure, i.e. the system of rewards and punishments individuals face with respect to their own actions. They are no different than persons who hold similar jobs in the private sector.
Differences Between Market and Collective Decision-Making
Government Goods at Zero Price: Most goods and services governments produce or provide are provided to the user free of charge and are paid for by general tax revenues. Rarely does government adopt a user charge system whereby the consumer pays more or less directly for these goods and services by specific fees or taxes.
Use of Force: Governments can legally use force in the regulation of economic affairs, but those in the private sector cannot.
Voting Versus Spending: In the market sector a dollar voting system exists and differs from the voting system in the public sector in three ways:
In the political system one person equals one vote. In the market system one dollar equals one vote.
The political system is run by majority rule. The market system is run by proportional rule.
Dollars can indicate intensity of want, whereas because of the all-or-nothing nature of political voting, a vote cannot.
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Copyright © 1996 Amy S. Glenn |
