- Created by: Lydia Stein
- Created on: 14-04-15 11:18
the ten principles
- decision making involves trade offs
- the cost of something is what you give up to get it (opportunity cost)
- rational people and businesses think at the margin
- people and businesses respond to incentives
- trade can make everyone better off
- allows countries to specialise in what they do best but still enjoy a wide range of goods and services
- markets are usually a good way to organize economic activity
- governments can sometimes improve market outcomes
- prevent market failure
- an economy's standard of living depends on its ability to produce goods and services
- can be measured by GDP
- bUT countries like china have a very high GDP and still very low living standards
- prices rise when the government produces too much money (inflation)
- economies face a short-run trade off between inflation and unemployment
- the more people are employed, the more demand. cost-push inflation.
Supply and demand
The market forces of supply and demand determine the quantity and price of each good sold in the market. they are most influential in perfectly competitive markets.
The law of demand
The law of demand states that when the price of a good rises, the demand falls. Shifts in the demand curve will arise because of factors other than price, like income, complimentary/substitute goods, tastes, population etc.
The law of supply
The law of supply states that when the price of a good rises, the supply will also rise. Shifts in the supply curve will happen because of competition, technology, input prices, availability of raw materials etc.
The equilibrium point will be reached when the price has reached the level where quantity supplied = quantity demanded. If the market price was higher than the equilibrium, there would be a surplus. If it was below, there would be a shortage.
Types of markets
A perfectly competitve markets will have many different buyers and sellers with mainly homogenous goods. The companies in this market will be price takers, as in they have very little influence over the market price. There will usually be perfect/near perfect knowledge and easy exit/entrance for firms
There are also oligopolies, monopolistic competition and monopolies/monopsonies.
Monopoly markets will have one seller (with more than 25% market share). There are high barriers to entry in the market. They are created either through sole ownership of a resource, external growth, the government or occur naturally. They will maximize profit by choosing the quantity where marginal revenue equals marginal cost.
This is either the % change in quantity supplied or demanded, divided by the % change in price. It measures how responsive the supply/demand is to changes in price. The closer the value is to zero, the more inelastic the product is and perfect inelasticity will be represented by a vertical curve. The price elasticity of demand will be affected by things like substitutes, neccessity vs luxury and proportion of income devoted to the product.
This is the % change in quantity demanded divided by the % change in income. It measures the responsiveness of demand to changes in income
Cross price elasticity
This is the % change in demand of X divided by the % change in the price of Y
Rational people and businesses think at the margin. Marginal changes describe small incremental adjustments.
Marginal cost and revenue
This is the change in total costs divided by the change in output. It is seen as the additional cost from producing one more unit. Marginal revenue is the additional revenue gained from selling one extra unit.
This is the increase in the quantity of output achieved from one additional unit of an input. Diminishing marginal product is the decrease in output.
Margin of safety
This is the distance between the break even output and the level of current production. The break even output is calculated as fixed costs divided by contribution (the selling price of one unit - the average variable costs)
To reach profit maximization, marginal revenue should equal marginal costs.
Exits and market failure
Shut downs vs exits
A shut-down is a short run decision to stop producing for a period, usually due to market conditions. If total revenue is less than variable costs then production will be halted. Fixed costs will still be incurred during this period, however. An exit is a long-run decision to leave the market, usually because the total revenue is less than the total costs.
This is when the market fails to allocate resources efficiently. It may happen because of external costs (the effect of a transaction on a third party), information asymmetry etc. The pareto efficient outcome is where it isnt possible to make someone better off without making someone worse off, and indeed the scarcity of our resources and rivalry from them means that consumption from one person implies others cant consume.
Consumer surplus is the amount a buyer is willing to pay for a good minus the amount they actually pay for it, while producer surplusis the amount a seller is paid minus the cost of production. Deadweight loss is a fall in total surplus arising from a tax or another policy.
Economic fluctuations are irregular and unpredictable and most macroeconomic quantities fluctuate together. As output falls, unemployment rises. The model of aggregate supply and aggregate demand is the model that most economists use to explain short run fluctuations in economic activity around its long-run trend.
The aggregate demand curve is one that shows the quantity of goods and servies that households, firms and the government want to buy at each price level. Y (GDP) = C + I + G + Exports - imports.
The price level
- and consumption; a decrease in price level makes consumers wealthier, so they spend more
- and investment; a decrease in price level means consumers have more disposable income to invest
- and net exports; a decrease in price level leads to a fall in interest rates, leading to a fall in the value of the currency. this depreciation increases net exports
The aggregate demand curve might shift due to increased saving, a stock market boom, taxes and money supply. the effect of a shift in ad will be for prices to fall, this leads to a fall in supply, increasing unemployment. The government should increase spending to combat the fall in ad.
The fiscal policy can be summed up as government policy on spending and taxation. The fiscal policy has an impact on aggregate demand. It can be used (like monetary) to stablilize the economy from shifts in AD that cause fluctuations in output and employment. Increases in government spending shifts AD to the right. Expasionary fiscal policy raises the interest rate, reducing spending, shifting the AD curve to the left.
The keynesian cross
- full employmnt is the point where people who want to work at the going market wage level can find a job
- planned spending/saving/investment is the desired/intended actions of households and firms
- actual spending/saving/investment: the realized outcome from actions of households and firms
Planned expenditure = consumption + investment + government
Government raises autonomous expenditure (spending not dependent on income, e.g. government spending) and taxation dampens the relationship btw income and consumption.
The multiplier effect is the additional shift in AD that result when expansionary fiscal policy increases income and therefore consumer spending. The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves.
Monetary policies are a set of actions taken by the central bank to affect the money supply and interest rates. Their main weapon are the interest rates set by the central bank. It can be used to help stabilize the economy from shifts in AD, causing fluctuations in output and employment.
Buying bonds increases money supply (selling decreases) and they can lend to commercial banks to influence money supply.
The central bank controls money supply so its not dependent on interest rates (MS must be vertical on diagrams).
An increase in price levels increases the demand for money, shifting the money demand curve to the right and interest rates rise. The increase in the interest rate then reduces the quantity of goods and services demanded
This is the total supply of goods and services in an economy. The aggregate supply curve will experience shifts because of changes in the workforce population, an increase in an economy's capital, natural reources and technologial knowledge. An increase in the price level tends to raise the quantity of goods and services supplied.
The effects of a fall in as would be for the scarcity of goods to rise, causing the price level to rise (stagnation (period of falling output and rising prices) and inflation).