economics session1

8/9/2019 Economics Session1

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Anke N Richter, CFA LSBF - Economics

ECONOMICS




ECONOMICS - INTRODUCTION




Economics Definition

• Economics: is the social science thatstudies the production, distribution,and consumption of goods and

services• The term economics comes from the

Ancient Greek οἰ κονομία (oikonomia,"management of a household,administration")




Economics Basics

• Key assumption: scarcity of goods

• Types of market participants: – Households: maximize consumption

– Businesses: maximize profit

• Market participants offer production factors on themarket : capital, labor, land

• The challenge for households and businesses toreach their goals while resources are scare




Economics Basics

• Economics looks at some key questions:

• Production: how could input factors be usedefficiently for production and which goods should beproduced

• Distribution: how to distribute the goods betweenhouseholds and how to distribute the income for theproduction factors

• Coordination: of plans of households andbusinesses to produce and consume (planed ormarket-based economy)




Areas of Economics

• Microeconomics – Production theory

– Market and Price theory

• Macroeconomics – Growth, Inflation, Unemployment

– Monetary/Fiscal Policy

• International Trade




ECONOMICS – ECONOMIC SYSTEM




Economic system

• An economic system is defined by the way a society decidesand organizes the ownership and allocation of economicresources

• Market based economy: private ownership and free allocation

over the market

• Planned economy : usually limited ownership and coordinationvia gov’t plans

• Mixed economy: most economies today have elements fromthe market and planned system, however, the degree varies




Market-based coordination

• Adam Smith (1723-1790): concept of invisiblehand – Pursuit of self-interest by individuals will lead to the

most efficient allocation of resources for the whole

economy – Central view of free market economist

• Market coordination over price• Function of price

– Signaling: where are resources required? – Transmitting preferences – Rationing




Mixed economic systems

• Based on believe that the market is notalways leading to the best results (marketfailure)

• Gov’t intervention is required• Various schools of thought:

– Ordoliberalism: gov’t needs to create the framework for the

market to work (legal framework, competition laws, fiscal

discipline, limited gov’t intervention) – Active intervention in various areas by the gov’t (EU agriculture

policy)




ECONOMICS – MICROECONOMICS




Demand and Supply




Demand and Supply

Price

QuantityDemand

Supply

P

Q




Demand

Demand: quantity of a good or service thatconsumers are willing and able to buy at a givenprice in a given time period

Marginal Benefit: benefit from consuming anadditional unit of a good or service. It is the most aconsumer is willing to pay for one more unit of agood

Principal of Decreasing Marginal Utility: additionalutility from consuming each additional unit of agood decreases as more units are consumed




Supply

Supply: the quantity of a product that aproducer is willing and able to supply ontothe market at a given price in a given timeperiod

Marginal cost: addition to total cost fromproducing one additional unit of output




Consumer and Producer Surplus

Price

QuantityDemand

SupplyConsumerSurplus

Producer

Surplus




Efficient Resource Allocation

Efficient resource allocation happenswhen marginal benefit equals marginal

cost for the last unit produced andconsumed

The sum of producer surplus andconsumer surplus is maximized at thatquantity




Competitive Equilibrium

Equilibrium in a competitive market: where supplyand demand meet

The quantity supplied at the equilibrium price equals

the quantity demanded at that price

The equilibrium changes over time with shifts indemand and supply

There is a ST and a LT equilibrium




Obstacles to Efficient Allocation

Price controls – ceilings, floors

Taxes and trade restrictions

Monopolies – restrict quantity

External costs and external benefits

Public goods – national defense




Externalities

Externalities:arising from production and consumption of goods andservices for which no appropriate compensation is paid

Externalities cause market failure if the pricemechanism does not take account of the social costsand benefits of production and consumption

Negative: air pollution

Positive: vaccination

Internalization of external effects: pricing ofexternal effects (carbon emission trading),intervention required – market fails




Public and private goods

Private goods –Excludability: not everybody has access

–Rivalry: consumption reduces good –Rejectability: does not need to be consumed

Public goodsNon-excludability: “free-rider” problem

Non-rival consumption

Usually public goods are not provided by theprivate sector but require gov’t intervention




Market Mechanism




Market Equilibrium and Shocks




Price Ceiling




Price Ceiling

Long-Run Impact:

– Price does not promote efficient allocation

– Long waiting period to purchase

– Sellers discriminate

– Sellers take bribes

– Sellers lower quality

– Often leads to a black market

• Examples: rent control




Price Ceilings/Black Markets

A black market is economic activity thattakes place outside the legal system

– Black market prices > ceiling prices

– Example: Currency in countries with fixedexchange rates

Black markets are inefficient

– Contract enforcement costs

– Prices increase along with legal risk

– Quality deteriorates




Demand/Supply of illegal Goods

Expected penalties on sellers and consumerswill shift demand and supply:

Penalties on sellers supply decreased

Penalties on buyers demand decreased

Price factors compensation to sellers in for

potential penalties




Price Floors




Price Floor

Long-run effects: Excess supply of the good

Substitution in consumption away from the

price controlled good

Example: minimum wage

Excess supply of labor increasedunemployment

Producers substitute capital for labor




Elasticity of demand and supply




Price Elasticity of Demand

As the price of a good increases usuallydemand (quantity) decreases

– Elastic demand: Percentage increase inprice leads to a larger percentage decreasein demand

– Inelastic demand: Percentage increase in

price leads to a smaller percentage decreasein demand




Price Elasticity of Demand

Elastic

Price

DD

D

D

PricePrice

Quantity

InelasticPerfectlyInelastic/Elastic

Elastic

Inelastic

Quantity Quantity




Determinants of Demand Elasticity

Necessity of the product

Availability of substitutes

Switching cost

Relative amount of budget spent on theitem

Time since price change




Calculating Elasticity of Demand

price elasticity of demand

% change in quantity demanded

% change in price

change in valuewhere % change

average value

If price elasticity = 0, not elasticIf price elasticity between 0 and 1, inelastic

If price elasticity = 1, % changes are equally

If price elasticity >1, elastic




The price increases from $7 to $9, quantitydemanded decreases from 12 to 8 units.Calculate and interpret the demand elasticity

% change in demand: (8-12)/10= -40%

%change in price: (9-7)/8= 25%

price elasticity= =-40%/25%= -1.6

Demand Elasticity – Problem

Absolute value greater than 1, so elastic

- 3




Cross Elasticity of Demand

Cross elasticity

% in quantity demanded% in price of substitute or complement




Cross Elasticity of Demand -substitutes

Price of coffee went up 12% and demand fortea increased 9%

Cross Elasticity > 0: tea and coffee are substitutes

0.759%

Cross elasticity of demand12%




Cross Elasticity of Demand - complements

Price of scones went up 20% and demandfor tea decreased 13%.

Cross elasticity < 0: the goods are complements

=-0.65-13%

Cross elasticity of demand20%




Income Elasticity of Demand

The sensitivity of quantity demanded tochanges in income

Normal good: Income↑ Demand↑ Elasticity > 0

Necessity: 0 < Income elasticity < 1

Luxury good: Income elasticity > 1

Inferior good: Income↑ Demand↓ Elasticity < 0(e.g., bus travel, camping holidays)

%change in quantity demandedIncome elasticity

%change in income




Income Elasticity of Demand- Example

Income went up 7% and annual demand forcars went up 15%. Calculate the incomeelasticity of demand and determine the type ofgood.

Because elasticity > 1, cars are luxury goods

- 2

2.14Income elasticity of demand15%

7%




Elasticity of Supply

elasticity of supply

% change in quantity supplied% change in price

When > 1, then supply is price elasticWhen < 1, then supply is price inelasticWhen = 0, supply is perfectly inelasticWhen = infinity, supply is perfectly elastic following a change in demand




Elasticity of Supply

The price of oranges increased 11.11%, andorange growers increased quantity supplied

by 9.09%

= 0.81 =9.09%

Elasticity of supply inelastic11.11%




Determinants of Elasticity of Supply

Availability of resource substitutes

Spare production capacities

Ease/cost of substitution

Time of production process

LT vs ST




Elasticity on a Straight-line Demand Curve

The slope of the

price-demandline ≠ priceelasticity




Price Elasticity of Demand and TotalRevenue

• Greatest total revenue (P × Q) at the pointwhere elasticity = –1

• Inelastic range: Price increase will increase totalrevenue; percentage decrease in quantitydemanded < percentage increase in price

• Elastic range: Price increase will decrease totalrevenue; percentage decrease in quantitydemanded > percentage increase in price

economics session1

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