The Basic Principles

The Basic Principles

Business economics is defined as the study of how businesses manage scarce resources. Microeconomics is the study of the decisions of individuals, households, and businesses in specific markets, whereas macroeconomics is the study of the overall functioning of an economy such as basic economic growth, unemployment, or inflation. Scarcity in microeconomics is not the same as poverty. It arises from the assumption of very large (or infinite) wants or desires, and the fact that resources to obtain goods and services are limited.

• wants exceed resources necessary to obtain them
• therefore we must make choices
• every choice leads to a cost

Principles of Economics:

1. People face trade-offs.Every decision involves choices, and more of one good means less of another good. Income and wealth are not limitless, since there is only so much time available. Trade-offs apply to individuals, families, corporations and societies.
2. Cost of something is what you give up to get it.When we make a decision we implicitly compare the costs and benefits of our choices. Opportunity cost is whatever must be given up to obtain something. Some costs are obvious – out-of-pocket expenses; other costs are less obvious but must be included in total opportunity cost.
3. Rational people think at the margin.Basic economics assumes that people act rationally and try to act so as to gain the most benefit for themselves compared to the associated costs. Microeconomics focuses on small or marginal) changes, and it is often rational to consider the marginal rather than the average effects of decisions.
4. People respond to incentives.If rational people compare costs and benefits, then changes in either one may change decisions. An example of an incentive that people respond to, are changes in prices. In general, people are more likely to buy something if it is cheaper. If an action becomes more costly, then there is an incentive to switch to other choices. Note that all actions have substitutes.
Sometimes people will encounter emergencies with costs that are beyond the cash they have available. In these situations, they may consider getting a cash advance to ease the pressure of liquidity in the present.

Explicit costs vs. Implicit costs

The cost of something, say a business, includes both the explicity cost (usually the price) and the implicit costs. One major implicit cost is the opportunity cost. Opportunity costs includes the next best opportunity given up. Only actions have costs; if there are no choices, then there are no costs. Be aware that cost is subjective. For example, compare the psychological benefit of a new computer. Decide whether you would rather have the a vacation to Europe, or a brand new computer.
Another example is in credit card comparison. Some people might only compare the annual fees, but you should compare the added benefits and features too. Certain features may be more valuable to you and be worth the cost, while others may be more valuable to another individual.

Disagreement in Economics

Business economics is both a science and a study of policy – united by a common “way of thinking”. As a science, economists develop models and deliberately simplify accounts of how cause and effect work in some part of the economy. Based on assumptions of what is important, models are created and used to make suggestions about policy and improve basic economic outcomes. Policy involves decisions about scientific theories, personal values and particular circumstances.
Positive statements are claims about what the world is like, although they may be false. For example, "Minimum wage laws cause unemployment". Normative statements are claims about how the world ought to be, and are based on values as well as positive knowledge. For example, "The government should raise minimum wage". Economists may disagree over either positive or normative statements or both, but the great majority tend to agree over basic positive propositions. As such, most disagreements are over normative/policy issues.

Public Goods

Public goods include things such as fireworks displays, and basic research. According to basic economics, a free market is unlikely to provide enough public goods, due to the “free rider” problem. A free-rider is a person who consumes a good without paying for it. Public goods create a free-rider problem because the quantity consumed is not directly related to the amount paid. As a result:

• there may not be enough incentive to pay for public goods through individual action;
• you cannot be prevented from consuming the good even if you do not pay for it and;
• it creates an external benefit on those not involved.

Business economics state that we can decide how much of a public good to produce, by considering a cost-benefit analysis of public goods. The total benefit is equal to the total dollar value that an individual places on a given level of production of a public good. Total Cost is what we must give up to get more of the public good. These are often difficult to calculate - especially the benefits. For example, what is the benefit of saving a human life, and what is the benefit of more flowers in the downtown?
Once we decide on the benefits, then we want to provide enough of the public good to maximize net benefits. That is, total benefits - total costs. The private market will usually not produce enough of a public good. However, it is often done by government because it can compel everyone to contribute through taxes.
The problem is not that people are selfish, per se, but the free-rider problem. If some people do not voluntarily contribute, others who do contribute will feel that it is unfair and may stop contributing as well.

Common Property Resources

These resources include clean air, oil pools, congested roads, fish, whales and other wild life. The problem here is that it is hard to exclude people, but one person’s use reduces that of others'. Over-use of these resources is sometimes dramatically referred to as, "Tragedy of the Commons". This tragedy refers to the common grazing rights in medieval England, in which:

• all families could graze sheep on the common land which was collectively owned and;
• as population and number of sheep increased, common land became over-grazed.

People did not reduce their use, because social and private incentives differed. Each individual’s best move is to get as much of the resource as possible before it is gone. The social optimum is to restrict use. The problem is that each individual creates a negative externality by reducing amount available to others. A few possible solutions were:

1. Custom or regulations could put a maximum on how much each family could use the resource;
2. They could have internalized the externality by auctioning off rights to graze and;
3. They could have created private property rights.

Property Rights

Economists realize that property rights are very important for efficient use of resources. When an individual owns and controls the resource, they have an incentive to increase its value. When everyone owns a resource, or rather, no one owns the resource, there is no one to charge for use, or who can attach a price. An example of such, is air that we breath.
For some goods we can establish property rights, like the pollution permit. For other goods, like national defence or clean air, the government can improve the outcome by regulating or providing the product.

Monopolistic Competition

Monopolistic competition has characteristics of both competition and monopoly. Similar to competition, it has many firms, and free exit and entry. Similar to monopoly, the products are differentiated and each company faces a downward sloping demand curve. Since the company has a differentiated product, it is like a monopolist and faces a negatively-sloped demand curve. In the short-run,

• marginal revenue is always less than demand
• profit is maximized where MR = MC
• profit = (price - average total cost) x quantity

The short-run equilibrium in monopolitic competition is the same as for a monopolist, and businesses may make positive, zero, or negative profits in the short run.

Long Run Equilibrium

In the long run, entry and exit are both possible. If profit is greater than zero, businesses will enter, and each company's market share will fall because of more variety. As a result, each company’s demand curve will decrease, along with price and quantity. If profit is less than zero, businesses will exit, and each company’s market share will increase. This will cause the remaining companies' demand curves to increase, along with the price and quantity.
If profit is equal to zero, there will be no entry into or exit from the industry. In the long run, all the companies' economic profits must be zero.

Monopolistic Competition and Welfare

Let's compare a company in monopolistic competition with a company in perfect competition, where both are in a long-run equilibrium. In both cases, profit equals zero. The two main differences between the two are:

1. Excess Capacity
   • companies in perfect competition produce where ATC is at a minimum (efficient scale)
   • companies in monopolistic competition produce where quantity of output is smaller, and on a downward sloping part of ATC (excess capacity)
   • could increase capacity and lower average costs
2. Make-up Over Marginal Cost
   • for a competitive firm, price = marginal cost
   • for a monopolistic competition firm, price > marginal cost
   • there is a mark-up above MC even though the firm makes zero profits

Efficient Outcomes and Externalities

When price is greater than marginal cost, the value that consumers place on the last unit is greater than the cost, so the good is under-produced. This leads to a deadweight loss like a monopolist. The number of businesses in the industry may be inefficient, and each time a new business enters, it creates externalities such as,

• Product Variety Externality - consumers get a wider choice of products, and an increase in consumer surplus which is a positive externality
• Business-Stealing Externality - this is a negative externality whereby other businesses lose customers

Since companies do not take these into account, there are no guarantees that there is an optimum number of them in the industry. This means that there may be too few or too many products available on the market.

Product Differentiation through Advertising

Companies that wish to differentiate products often use advertising. Advertising is common with differentiated consumer products, and much less common with homogeneous goods. Forms of advertising include television, radio, direct mail, billboards, etc. Advertising has a wide range of costs and benefits.
One cost of advertising, is that it may be mostly aimed at manipulating tastes of consumers without conveying any useful information. Advertising may also try to create differentiation within products that are actually very similar. Also, advertising tries to make demand curves less elastic, and impedes competition. This then leads to a high markup over marginal cost.
Some benefits to advertising, is that it does convey some useful information such as prices, new products, locations, etc. Advertising may also foster competition by giving more information on pricing and availability. Advertising may also be a “signal of quality”, because willingness to spend money to advertise products may be a sign that the company has confidence in its quality. This makes it rational for consumers to try such products even if content of ads is minimal.

Oligopoly Market Structure

Between the definitions of perfect competition and pure monopoly lie oligopolies and monopolistic competition. An oligopoly is where there are a few sellers with similar or identical products, such as hockey skates (Bauer, CCM). Monopolistic competition has many companies with similar but not identical products. Each firm has monopoly power over what it produces, but products are close substitutes, such as cigarettes, CDs, and computer games. Examples of oligopolies include crude oil businesses and auto manufacturers.
The main key to behaviour in an oligopoly, is that companies must take into account what other companies will do. In perfect competition, firms are price-takers and can ignore other firms. In a monopoly, there is only one firm, and it does not take into account what competitors will do. Oligopolists are torn between:

1. cooperating to increase profits by obtaining the monopoly outcome, or;
2. competing to try to gain an advantage over competitors.

Duopolies and Cartels

A duopoly is when there are only two businesses in a market. Their best outcome is to cooperate and agree to restrict output to the monopoly quantity, where price is greater than margical cost, and profit is maximized. A great example of a duopoly is Coca-Cola and Pepsi Co. Usually, a duopoly trying to maximize profits will produce more than a monopolist but less than a competitive industry. Duopolies come from collusion where firms agree to share output and set prices such as in a cartel.
A cartel is a group of companies acting in unison, such as OPEC. If the competing companies cannot agree, then they may end up with the competitive position with profits equal to zero. Cartels are known to restrict output quantities in order to raise prices, and consequently profits.

Size of an Oligopoly and the Market Outcome

Generally, the more companies in the industry, the harder it is to form a cartel and to enforce it. As the number of companies increases, the more the industry resembles a competitive outcome, since each company has a smaller effect on the outcome. The mentality where each company tends to think only of its own profits and strategic behaviour is reduced. Each company will increase production as long as price is greater than marginal cost. As the number of companies increases, we tend to move towards a perfectly competitive outcome.

Game Theory and Prisoners' Dilemma

Game theory is the study of how people behave in strategic situations (i.e. when they must consider the effect of other people’s responses to their own actions). In an oligopoly, each company knows that its profits depend on actions of other firms. This gives rise to the "prisoners’ dilemma".
The prisoners' dilemma is a particular game that illustrated why it is difficult to cooperate, even when it is in the best interest of both parties. Both players select their own dominant strategies for shortsighted personal gain. Eventually, they reach an equilibrium in which they are both worse off than they would have been, if they could both agree to select an alternative (non-dominant) strategy.

Monopoly Companies

A monopoly is a single producer of a product which does not have close substitute. A monopoly is characterized bybarriers to entry. Sources of a monopoly include:

• Ownership/Control of a Key Resource - rainforests, rare minerals (DeBeers diamond monopoly).
• Exclusive Right Given by Government - patents, copyrights, franchises (pharmaceutical companies, research, authors).
• Falling Average Total Cost - making one company more efficient than others (also known as a natural monopoly), arising from economies of scale over the relevant range of output.
• Public Utilities - electricity, cable television. and water provision.

Pricing and Production Decisions

A monopoly is a large enough business to influence its own price, such that it is the price setter rather than taker, unlike a perfectly competitive market where each firm faces a perfectly elastic demand curve. A monopoly faces a downward-sloping demand curve and the market demand is the company’s demand. Monopolists are still constrained by the negative relationship between price and quantity demanded. With fraud becoming more widespread, it's important to do a criminal background check prior to engaging in business activities.

Revenue for a Monopoly

A monopoly may raise its price, but it will lose sales. In order to sell more, it must lower its price. There are two effects on total revenue (profit x quantity):

1. Output effect - gains more revenue because it sells more.
2. Price effect - gains less revenue because it gets less from each unit sold because of the lower price.

Marginal revenue (MR) can even turn negative if price falls enough to reduce total revenue, even though the company sells more. What determines value of MR? It depends on whether the fall in price is larger than the increase in quantity. In other words, it depends on the elasticity of demand. Note that MR = P [1-1/abs. E].
When E > 1, MR > 0 because output effect > price effect
When E < 1, MR < 0 because price effect > output effect
When E = 1, MR = 0 because price effect = output effect
Therefore, the monopolist will never produce in the inelastic portion of the demand curve since MR < 0. A straight-line demand has elasticity that varies from zero to infinity. Assuming a linear demand curve P = a-bQ, the MR curve for a straight line will:

• be a straight line with the same intercept and;
• have twice the slope of the demand curve (i.e. it is zero at the halfway point of the demand curve).

Profit Maximization

Recall that the objective of a business is to maximize profits. As such, a company should produce where profit is at a maximum. In marginal terms,

1. If MC < MR, producing 1 more unit will add more to TR than to TC, so the monopoly should increase quantity.
2. If MC > MR, producing 1 more unit will add more to TC than to TR, so the monopoly should decrease quantity.
3. Only when MR = MC (and MC cuts MR from below) is profit maximized.

A monopolist will generally produce less than a socially efficient level of output, and charge too high a price. Are the above normal profits of monopoly a social cost? Not usually, since profit is still part of surplus but has been transferred from consumers to producers. Social cost arises from inefficiently low output which leads to the dead weight loss. However, if the monopolist uses some of its normal profits to lobby in order to maintain a monopoly (rent seeking), then this can be a welfare cost to society.

Price Discrimination

Price discrimination is selling the same good to different customers/markets at different prices. Examples include movie tickets, airline tickets, and discount coupons. In order to practice price discrimination, there must be easy to separate customer into groups. These groups are determined based on their elasticities to demand. The company must also be able to prevent resales between groups, as well as arbitrage, which is buying where a good is cheap and selling where it is expensive.
Price Discrimination can increase the profit of monopolies, since they can charge a higher price to those with less elastic demand, and a lower price to those with more elastic demand. In this manner, a business does not have to lower prices to all buyers in order to sell more goods.

Perfect Competition

In competitive markets there are:

1. Many buyers and sellers - individual firms have little effect on the price.
2. Goods offered are very similar - demand is very elastic for individual firms.
3. Firms can freely enter or exit the industry - no substantial barriers to entry.

Competitive firms have no market power. Recall that businesses are trying to maximize profits, and Profit = Total Revenue (TR) - Total Cost (TC).

Revenue in a Competitive Business

Businesses in competitive markets take the market price (P) as given (price takers). How much does the business receive for a typical unit is known as the "average revenue" (AR) and is equal to TR/Q = (P x Q)/Q = Price. So average revenue is equal to price, and is constant. How much additional revenue does the firm get if it sells one additional unit? To answer this question, we take a look at "marginal revenue" (MR) which is equal to the change in TR divided by the change in quantity. Note that this too is equal to price, so the marginal revenue is constant as well, and is equal to average revenue.

Profit Maximization

To maximize profit, we need to know the revenue and costs of the business. Profit is maximized when marginal revenue = marginal cost, and marginal cost is rising. To see why, recall that marginal revenue is the additional revenue from 1 additional unit. Marginal cost is the additional cost from 1 additional unit.
When MR > MC, revenue is increasing faster than costs and the firm should increase production. When MR < MC, revenue from the additional unit is less than additional cost, and the firm should decrease production. As such, A firm maximizes profits when MR = MC.
So what happens to output at various prices? Since MC is upward sloping, as price increases, quantity produced will increase too. As price falls, quantity produced falls. In each case, the marginal cost curve determines how much the firm is willing to produce at each price, so it translates into the supply curve.

Shutting Down a Company (temporary)

A company is considered to have shut down, if it temporary ceases production but keeps fixed capital. A company has exit the industry when it has made a permanent decision to leave the industry. The decision to temporarily shut down a business depends on a few factors. Recall that ATC = AVC + AFC. So average fixed cost is the vertical distance between average variable cost and average total cost.
Now if a business shuts down, its total revenue becomes zero, and its total cost equals the fixed cost. So the company should continue producing its product, as long as it covers its variable costs. This way, total revenue is greater than total variable cost, because losses are then less than TFC. Basically, shut down when P (AR = MR) < AVC, to minimize the losses and so the company's short-run supply curve = MC curve above AVC. The firm therefore produces where profit equals marginal cost.
Another way to put this is that sunk costs are sunk. Fixed costs are sunk, and therefore cannot be recovered by shutting down in the short run. The decision to continue producing depends on revenues and variable costs. If average revenue is greater than average variable cost, then the business should continue to produce. It is rational to continue producing, so long as AVC < P < ATC.

When to Leave An Industry (permanent)

A business should leave the industry when revenue is less than cost of operating in the long run. In other words, exit if total revenue is less than total cost (P < ATC). In competitive markets, a company will make zero economic profits in the long run. If companies are making more than zero economic profits, it will encourage other firms to enter the industry to share in these profits. In other words, enter if total revenue is greater than total cost (P > AC). If companies are making zero economic profits, there is no entry and no exit, which is a long run condition.

Market Structures-Costs and Production

Firms are defined as economic organizations that purchase inputs and sell outputs. We will assume that a firm's objective is to maximize profits. Let's take a look at some equations relating to costs.
Profit = Total Revenue (TR) - Total Costs (TC)
Total Revenue = Price x Quantity Sold
Total Costs = Sum of all opportunity costs related to the production process
Opportunity Costs = Explicit Costs + Implicit Costs
Explicit costs of production include:

• wages and salaries to employees
• costs of raw materials
• taxes

Implicit costs of production include:

• value of time of owner/entrepreneur
• opportunity cost of financial capital invested in the firm i.e. interest rate foregone

"Economic profit" is the difference between total revenue and total cost, where total cost includes both explicit and implicit costs. In contrast, "accounting profit" is the difference between total revenue and explicit cost. For example: A dancer gives dancing lessons for $20 per hour. Instead, he could be performing on stage for $30 per hour. What is the economic profit of performing on stage?
Total costs = $0 (explicit cost) + $20 (implicit cost)
Economic Profit = $30 (TR) - $20 (TC)
Recall that supply is primarily determined by the productivity of inputs, and the cost of the inputs. The production functions show the relationship between quantity of inputs and the quantity of output.
The short run refers to a period in which at least one input (usually capital) is fixed. The short run production function shows a relationship between total output and inputs, when one input is varied and one is fixed. This is also referred to as the total product (TP). Average product (AP) is the average production per unit of variable input, and is equal to TP/L, where L is labour (the variable input). Marginal product (MP), shows the change in total output when input changes by one unit. Therefore, MP is the slope of the total product curve, and thus shows the productivity of labor.

Total Product Function

A very key assumption, is that of the diminishing marginal product (or diminishing marginal returns). If we add more and more of the variable input(s) and there is at least one fixed input, then eventually the MP of the variable input will decline. The TP curve will flatten out as the quantity of the variable input increases. Therefore, MP may rise initially, but it must fall (TP is increasing but at a decreasing rate).

Product and Cost curves

To go from production to cost, we assume that the costs of inputs are fixed (i.e. a firm can hire all the labour it wants at the going wage). Cost are divided into two broad categories:

• Fixed costs - costs that do not vary with output, such as cost of plant or some fixed inputs
• Variable costs - costs that vary with output, such as cost of labour or other variable inputs.

Total costs (TC) is the sum of Total Fixed Costs (TFC) and Total variable Costs (TVC). Graphically, TFC is represented by a horizontal line since costs are fixed. The total cost eventually gets steeper as more is product is produced. Average cost (AC) is how much a typical unit costs and is equal to TC divided by number of units produced. Mathematically we have,
AC = (TFC + TVC)/Q = AFC + AVC
AFC: average fixed costs
AVC: average variable costs
Note that AFC will constantly fall as output increases. AVC will fall and then increase due to diminishing returns. Marginal Cost (MC) is the change in total cost divided by change in output, and addresses the question: how much will it cost to produce one additional unit of output?

Market Failures and Externalities

Principle of Economics #7: Governments can sometimes improve market outcomes. Markets do many things well. With competition and no externalities, markets will allocate resources so as to maximize the surplus available. However, if these conditions are not met, markets may fail to achieve the optimal outcome. This is also known as "market failure".

Externalities

In previous analysis, we assumed that all goods consumed or produced have been private, in the sense that one individuals consumption or production of a good does not affect the other. When our actions impact on those not directly involved, an externality exists. As one individual's behaviour increases or decreases, another's satisfaction or profit changes as well. It can have a positive or negative effect on a third-party not directly involved with the buyer or seller of the transaction. These costs (or benefits) are not included in the cost curve faced by the decision makers.
Examples of externalities:

• A smoker annoys others with second hand smoke.
• A gardener delights a neighbour with his beautiful garden.
• A pulp mill pollutes the air and water in town.
• A perfume wearer gives a friend an allergic reaction.

Negative Externalities

When economic agents not directly involved, negative externalities can exist, such as pollution. A free market tends to over-produce the good which produces a negative externality, and under produce those with positive externality. If we include costs borne by everyone, then we get social costs, which are the total costs of production no matter who bears them. We say that the total cost is equal to private costs plus external costs.
Negative externalities result in a lower free-market output. In order to make the market produce the optimal amount, we must impose a tax. This is called "internalizing the externality", and forces those involved to account for external costs. There are also externalities in "consumption", when consumption has costs for persons other than those actually consuming the product. Examples of these are cigarettes and second-hand smoke, and drinking alcohol and car accidents.

Positive Externalities

Not all externalities are negative. Some create benefits to those not directly involved. Such is the case with "technology spillover", where new inventions benefit those beyond the inventors.
Some have argued that governments should subsidize research and development, since it will have positive externalities to everyone else. Another method is to allow patents to give monopoly rights to new inventions for a period of time, and encourage such activity. Without this method, there could be an under investment in research. Positive externalities in production means that social cost is less than private cost, and more of the good should be produced than will occur in a free market.
There may also be positive externalities in consumption, such as education. In this case, the social value is greater than the private value

Solution to Externalities

Externalities lead to an inefficient quantity of production and consumption. This can be remedied by either private arrangements or public policy. Externalities can be dealt with by:

1. Moral codes and social sanctions
2. Voluntary organizations - charitable groups, lobby groups
3. Internalization - when activities with complementary externalities are merged into one firm, thus eliminating the externality
4. Contracts - parties through negotiation can agree as to how to regulate the externality

Coase Theorem

If parties can bargain without cost over the allocation of resources, then the private market can always solve the problem of externalities. It can allocate resources efficiently, irrespective of how the law assigns responsibility for damages. Earlier before Coase, it was argued that the source of the externality should be penalized. It is now recognized that the party that can deal with the externality at least cost should do exactly that.

International Business and Trade

The main determinant of whether a country imports or exports a product is price. World price is the price prevailing in world markets and is the price at which we can sell or buy goods. Domestic price is the price in our country without trade. Ignoring transportation costs, if the world price is greater than domestic price before trade, then we will export the good. If the world price is less than domestic price before trade, then we will import the good.
Trade allows us to buy goods more cheaply from international businesses and sell them at a higher price than if we were restricted to the domestic market.

Winners and Losers from Trade

To analyze the welfare effects of trade, we begin by assuming we are dealing with a small country, and that its actions have a very small effect on world markets. In general, the economy benefits from trade because we can import goods more cheaply than we can produce them, and can sell our exports for more than people would pay. However some groups will be hurt.

1. Consider if we export a good such as wheat
   • domestic price will rise to the world price since less of the product will be available for domestic consumption
   • domestic producers benefit from higher prices
   • domestic consumers are worse off because of higher prices
2. For goods which we import, domestic prices fall and consumers benefit while producers are hurt.

Importing Goods

Lowering the price reduces producer surplus, which is transferred to consumers while consumer surplus is extended. Thus with imports, domestic consumers are made better off while domestic producers are hurt, but overall surplus is increased. Since the gains of the “winners” are larger than the losses of the “losers”, this would allow the winners to compensate the losers and still be better off. In practice, this compensation may not happen, but can be a justification for government intervention to help those groups hurt, by taxing those groups who benefit.

Tariffs and Quotas

Tariffs are taxes levied on businesses for imported goods. Tariffs raise the domestic price above the world price by the amount of the tariff. The increase in the domestic price will lead to a decrease in domestic quantity demanded, and an increase in domestic quantity supplied. Before the tariff, the domestic price is the same as world price. After the tariff, the domestic price rises.
Quotas are restrictions on the maximum amount that may be imported, and have a similar effect as do tariffs. They restrict the amount available to domestic consumers and push up the price, resulting in a deadweight loss similar to that of a tariff. The main difference is the distribution of the surplus. A tariff raises revenue for the government, whereas import quota creates surplus for licence holders. The government could capture surplus from import quotas by charging a fee for the licences. If licence fee equals difference in prices, then import quota works same as tariffs.
How is the quota distributed?

1. It can be auctioned off to the highest bidder - In this case, the revenue goes to the government and the result is exactly like that of an equivalent tariff.
2. It can distribute quota without payments - The extra surplus goes to those who get the quota, and may lead to large expenses for lobbying the government for the quotas. In this case, the deadweight loss is usually larger than a tariff due to cost of lobbying.

Arguments for Restricting Trade

1. The Jobs Argument
   • jobs are created as well as eliminated
   • not possible that a country can be out-competed in all products owing to comparative advantage
2. National Security Argument
   • products such as weapons and military equipment should be produced domestically
3. Infant-Industry Argument
   • temporary protection while firms have a chance to learn to compete
   • economists are skeptical that govt can pick “winners” and argue that industry with real promise does not need protection
4. Unfair-Competition Argument
   • if firms sell at below cost, they are subsidizing our consumption
5. Protection as a Bargaining Chip Argument
   • restricting trade can be used for leverage in other foreign affairs

Tax and Deadweight Loss

We saw earlier how taxes on goods and services of businesses can change the demand by citizens, supply, and equilibrium price and quantity. Taxes provide revenues to the government and are usually paid by both buyers and sellers. To see the welfare effect of taxes, we need to compare the revenue received by the government, and the dead weight loss (also known as "excess burden" or "distortionary cost") to the consumers and producers.

Deadweight Loss of Taxation

Recall that in a competitive market, a given tax surcharge added to the price of each unit of a particular good (gasoline tax, food tax, federal tax) will:

• lower the price received by the seller and;
• increase the price paid by the buyer.

This allows us to use supply and demand diagram to analyze the effects of a tax on total surplus. We see that the tax places a wedge between the gross price and net prices, and the equilibrium quantity will fall as a result of the tax. What are the gains and losses as a result of a tax? The government receives tax revenue of T x Q, where T is the amount of tax per unit, and Q is the quantity sold. This is a benefit to those on whom the government spends the tax revenue.
To see the welfare losses, consider the total surplus before and after the tax. Deadweight loss, also known as "excess burden", is a pure loss to society. It represents lost value to consumers and producers due to the reduction in the sales of the good, but not captured by government revenue. In other words, the loss to consumers and producers from the tax is larger than the size of the tax revenue.

Determinants of Deadweight Loss

How large will the deadweight loss be from a particular tax? It depends on how much a given tax reduces the amount that:

• consumers are willing to purchase and;
• producers are willing to supply.

What determines how much the market will shrink? Reduction in quantity supplied as a result of a tax depends on the elasticity of supply. Generally, the more inelastic the supply, the smaller the reduction in quantity, and the smaller the deadweight loss. Reduction in quantity demanded depends on the elasticity of demand. Generally, the more elastic the demand, the more quantity demanded decreases and the greater the deadweight loss.
In general, the smaller the decrease in quantity, the smaller the deadweight loss. This occurs since the main cost of a tax is that it shrinks the size of a market below its optimum level. Overall, the more elastic the supply and demand, the larger the dead weight loss of a tax.

Deadweight Loss and Tax Revenue

For the most part, tax revenue will first increase as we raise taxes but as the gross price keeps rising, the quantity decreases more and more. Eventually, the tax revenue will also begin to decrease. the more inelastic the demand, the slower the tax revenue falls. This helps to explain why governments often put taxes on goods in inelastic demand like tobacco and gasoline. Overall, taxes on specific items will:

1. Influence people’s behaviour by inducing them away from the goods that are taxed.
2. Raise revenue for the government to spend, making those who receive the expenditures better off.
3. Create a dead weight loss.

Efficiency of Markets

Welfare economics is the study of how the allocation of scarce resources affects the well-being of every participant in a given economy and efficiency of markets. As such, welfare economics is a normative idea rather than a positive one. Keep in mind that free markets allocate goods in a desirable way, since they maximize total surplus (consumer surplus + producer surplus). Consider that:

1. Consumer Surplus = Value to buyers - amount paid by buyers
2. Producer Surplus = Amount received by producers - cost to sellers
3. Total Surplus = Value to buyers - amount paid by buyers + amount received by sellers - cost to sellers
4. But since amount paid and received are the same, Total Surplus = Value to buyers - Cost to sellers

An allocation that maximizes surplus is said to be efficient. Unfortunately, an efficient system does not necessarily correspond to a fair one. Whether or not free market allocations are fair is known as division of equity.
While it is not uncommon for markets to surge upwardly or fall off a cliff, there are methods by which to mitigate these drastic fluctuations, such as certificates of deposits. The interest rates offered by these financial products are generally the same, but you can find the best CD rates by searching online. Certificates of deposit are generally secure as well, since the principal is normally guaranteed. This means that you will never lose money by buying a CD.

Consumer and Producer Surplus

The difference between how much the consumer values the good (their maximum price) and how much the consumer ends up paying, is known as the consumer surplus. Graphically, consumer surplus is the area under the demand curve but above the price. It represents the net benefit received by purchasers as the purchasers themselves perceive it. This surplus is a good measure of economic well-being if we respect the choices of the buyers.
Cost is the value of everything that the producer must give up in order to produce the good. The supply curve shows the cost of producing additional units, and hence the minimum price that the producer should and will accept. The difference between the cost and the amount received is known as theproducer surplus, which is sometimes referred to as profit. It is the amount the buyer pays the seller, minus the seller's cost of production. Graphically, it is the area above the supply curve and under the price.

Free Markets and Equilibrium

A free market in equilibrium will:

1. Allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.
2. Allocate the demand for goods to the sellers who can produce them at least cost.
3. Produce the quantity of goods that maximizes the total surplus.

If there is competition in the market but no significant externalities (or outside effects) of a transaction, the free market result is efficient and benefits both the producer and the buyer. It may or may not be fair since it depends on the existing distribution of income and wealth.
Note that it does take time for a free market to reach equilibrium (especially markets with new businesses), and projected equilibrium prices and quantities can change due to externalities.

Tax & Market Failure-Price Controls and Tax

We will now analyze government policy with respect to price controls, and its effects using the supply and demand microeconomic model. Principle of Economics #6: Markets are usually a good way to organize, track, and analyze economic activity.
Governments often wish to influence the market outcome by imposing price ceilings or floors. A price ceiling is the maximum price that businesses may be charged for a product due to external influences, and usually limits the price of a good to reach its free market equilibrium price. Examples can be found in rent controls, gasoline prices, and caps on doctor fees. If the ceiling price is below the equilibrium, it will result in:

1. Lower quantity supplied
2. Higher quantity demanded

This will create a shortage equal to quantity demanded (QD) minus quantity supplied (QS). This effect is larger in the long run because supply is more elastic. If the product is not rationed by price, we must find some other means to allocate. One possible result to this is the black market.
Price floors are minimum prices that artificially raise the equilibrium price of products above the free market point. Examples of price floors are minimum wages, and agricultural marketing boards. If price floors are binding, then it will tend to reduce quantity demanded by citizens, and increase quantity supplied. Naturally, this will cause a surplus in the market since supply will exceed demand.
Most economists believe that minimum wage laws cause some unemployment, especially among teenagers, since businesses need to pay higher wages. It is estimated that a 10% increase in minimum wage generally leads to a 1-3% decline in employment of teenagers.

Taxes and Their Incidence

Who pays taxes levied on products? What happens to the equilibrium price? It depends on the shape of the demand and supply curves, but generally price does not rise as much as the tax rises. Tax drives a wedge between the price paid by the consumer (gross price) and the price received by the producer (net price). Note that "net price" equals "gross price" minus "tax per unit".
Incidence of tax again depends on the relative shape of the curves and is calculated by:

1. Consumers pay gross price - original price.
2. Producers pay original price - net price.

In a perfectly competitive market, it makes no actual difference whether the tax is levied on the consumer or the producer. So what determines the distribution of the tax? If consumers can easily substitute away from the good which is taxed, they will avoid the tax and the producer will pay more (demand is elastic). If consumers cannot easily substitute away from the good which is taxed, they will be forced to buy it anyway and will pay the bulk of the tax (demand is inelastic).
Generally speaking, when demand is more elastic than supply, the producer pays more. When demand is less elastic than supply, the consumer will pay more.

Elasticity of Supply and Demand

What happens to the quantity demanded when the price of a good changes? If quantity changes a lot, we say that demand is elastic and stretches. If quantity changes only a little, demand is inelastic and the quantity does not stretch much. The "price elasticity (E)" of demand is equal to "% change in quantity demanded" divided by "% change in price".
When the value of E is equal to zero, demand is perfectly inelastic. If E is between 0 and 1, then demand is inelastic. When the value of E is equal to one, demand is unit elastic. If E happens to be greater than one, then demand is elastic. If E is equal to infinity, then demand is perfectly elastic. Note that although price and quantity demanded move in opposite directions, elasticity will always be positive by convention.

Determinants of Elasticity

Many factors influence elasticity, some of which include:

1. Necessities versus Luxuries - It is harder to find substitutes for necessities so quantity demanded will change less.
2. Availability of Close Substitutes - If there are close substitutes, buyers will move away from more expensive items and demand will be elastic.
3. Definition of the Market - The more broadly we define an item, the more possible substitutes and the more elastic the demand.
4. Time Horizon - The longer the time available, the easier to find substitutes and the more elastic the demand.
5. Relative Size of Purchase - Purchases which are a very small portion of total expenditure tend to be more inelastic, because consumers are not worried about the extra expenditure.

Total Revenue and Elasticity

Raising the price will have two effects: more revenue per unit sold and; fewer units sold. In order to increase total revenue, we must decide which of the two effects is greater. When demand is inelastic, total revenue is more influenced by the higher price and increases as price increases. When demand is elastic, total revenue is more influenced by the lower quantity and decreases as price increases.

Income Elasticity of Demand

There are factors other than price that influence the demand for a product. Income elasticity of demand is calculated as the percent change in quantity demanded divided by percent change in income, ceteris paribus. There are two possible relationships. If demand increases when income increases, elasticity is positive and good is normal. If demand decreases when income increases, elasticity is negative and good is inferior.
The main influence on income elasticity of demand is whether a good is a luxury or a necessity. When goods are luxuries, elasticity is usually highly positive (greater than one). When goods are necessities, elasticity is usually lower (less than one). When goods are very basic, they can even be inferior (less than zero), such that demand falls when income rises.

Elasticity of Supply

This is a measure of how much quantity supplied (QS) reacts to a change in prices. Elasticity of Supply is equal to "percent change of QS" divided by "percent change in price". This value can range from zero to infinity. When elasticity is less than one, supply is inelastic. If elasticity is greater than one, then supply is elastic. The main determinant of supply elasticity is length of time. The shorter the time period, the more inelastic the supply, because it is harder to get the additional inputs to increase production. It also depends on whether the firm is near its capacity.

Theory of Consumer Choice

Consumers face trade-offs in their purchase decisions, since their income is limited and choices are numerous. In order to make choices, consumers must combine budget constraints (what they can afford), and preferences (what they would like to consume).
A budget contraint, means what a consumer can purchase is constrained by income. The slope of the budget constraint measures the rate at which one consumer can trade off one good for another, and the relative prices of the two goods. Budget constraints are determined by both the income of the consumers, and the relative prices.
If a consumer equally prefers two product bundles, then the consumer is indifferent between the two bundles. The consumer will get the same level of satisfaction (utility) from either bundles. Graphically speaking, this is known as the indifference curve. This curve shows that all bundles are equally preferred, or have the same utility or same level of satisfaction. The slope of indifference curve is the rate at which a consumer is willing to trade one good for another, which is also known as the marginal rate of substitution (MRS).

Properties of Indifference Curves

1. Higher indifference curves are preferred to lower ones, since more is preferred to less (non-satiation).
2. Indifference curves are downward sloping. If the quantity of one goods is reduced, then you must have more of the other good to compensate for the loss.
3. Indifference curves do not cross (intersect), since this would imply a contradiction.
4. Indifference curves are bowed inward (in most cases). The slope of indifference curves represent the MRS (rate at which consumers are willing to substitute one good for the other). People are usually willing to trade away more of one good when they have a lot of it, and less willingto trade away goods which are in scarce supply. This implies that MRS must increase as we get less of a good.

Nota bene that two extreme examples exist. Perfect substitutes have straight-line indifference curves. As we get more of the good, we trade off with the substitute at a constant rate because we are indifferent between them (i.e. Coke and Pepsi). Perfect complements have right-angled indifference curves. If goods can only be used together, there is no satisfaction in having more of A without additional amounts of B (i.e. left and right shoe). In general, the better substitutes goods are, the straighter the indifference curve.

Consumers' Optimal Choice

We must combine what a consumer can obtain (budget constraint) and the preferences (indifference curve). The optimum is the highest point on the indifference curve that is still within the budget constraint. This will usually occur where the indifference curve is tangent to budget constraint. At the optimum point, MRS = relative prices of goods since MRS = slope of indifference curve, and relative price = slope of budget constraint. The marginal rate of substitution is the rate at which consumers are willing to trade-off, and is equal to rate at which they can trade.
Changes in income will undoubtedly affect the optimal choice. The budget constraint will shift parallel to the original - upwards for an increase in income, and downwards for a decrease in income. The new equilibrium for a higher income will be on a higher indifference curve, and since income is higher, more of both products could be consumed. For normal goods, as income increases, more of the good will be preferred. For inferior goods, as income increases, less of the good will be chosen.

Changes in Prices

A change in price will change the slope of the curve. A fall in price will rotate the budget constraint outwards, and an increase in price will rotate the budget constraint inwards. Thus a change in price will change both the relative prices of the two products and also the amount that can be bought, ceteris paribus (income). Changes in price has two effects:

1. Substitution Effect
   • arises from the tendency to buy less of goods which are more expensive
   • can be measured by keeping satisfaction constant (stay on same indifference curve and finding where MRS = new relative prices
2. Income Effect
   • arises from change in price effect on total amount that can be purchased
   • change in consumption when we shift to a new indifference curve as a result of the price change

Supply and Demand

A market is defined as a group of buyers and sellers of a particular product or service. Competitive markets are markets with many buyers and sellers, so that each has a very small influence on the price. Supply and demand is the most useful model for a competitive market, and shows how buyers (citizens) and sellers (businesses) interact in that market.


Quantity Demanded & Supplied


The demand for a product is the amount that buyers are willing and able to purchase. Quantity demanded is the demand at a particular price, and is represented as the demand curve. The supply of a product is the amount that producers are willing and able to bring to the market for sale. Quantity supplied is the amount offered for sale at a particular price. The main determinant of supply/demand is the price of the product.


Law of Demand


The Law of Demand states that other things held constant, as the price of a good increases, the quantity demanded will fall. Other factors that can influence demand include:


Income - Generally, as income increases, we are able to buy more of most goods. When demand for a good increases when incomes increase, we call that good a "normal good". When demand for a good decreases when incomes increase, then that good is called an inferior good.
Price of related products - Related goods come in two types, the first of which are "substitutes". Substitutes are similar products that can be used as alternatives. Examples of substitute goods are Coke/Pepsi, and butter/margarine. Usually, people substitute away to the less expensive good. Other related products are classified as "complements". Complements are products that are used in conjunction with each other. Examples of complements are pencil/eraser, left/right shoes, and coffee/sugar.
Tastes and preferences - Tastes are a major determinant of the demand for products, but usually does not change much in the short run.
Expectations - When you expect the price of a good to go up in the future, you tend to increase your demand today. This is another example of the rule of substitution, since you are substituting away from the expected relatively more expensive future consumption.
Demand Curves and Schedules


Demand curves isolate the relationship between quantity demanded and the price of the product, while holding all other influences constant (in latin: ceteris paribus). These curves show how many of a product will be purchased at different prices. Note that demand is represented by the entire curve, not just one point on the curve, and represents all the possible price-quantity choices given the ceteris paribus assumptions. When the price of the product changes, quantity demanded changes, but demand does not change. Price changes involve a movement along the existing demand curve.


Market demand is the summation of all the individual demand curves of those in the market. It is the horizontal sum of individual curves and add up all the quantities demanded at each price. The main interest is in market demand curves, because they are averages of individual behaviour tend to be well-behaved.


When any influence other than the price of the product changes, such as income or tastes, demand changes, and the entire demand curve will shift (either upward or downward). A shift to the right (and up) is called an increase in demand, while a shift to the left (and down) is called a decrease in demand. In example, there are two ways to discourage smoking: raise the price through taxes or; make the taste less desirable.


Law of Supply


As the price of a product rises, ceteris paribus, suppliers will offer more for sale. This implies that price and quantity supplied are positively related. The major factor that influences supply is the "cost of production", and includes:


Input prices - As the prices of inputs such as labour, raw materials, and capital increase, production tends to be less profitable, and less will be produced. This leads to a decrease in supply.
Technology - Technology relates to methods of transforming inputs into outputs. Improvements in technology will reduce the costs of production and make sales more profitable so it tends to increase the supply.
Expectations - If firms expect prices to rise in the future, may try to product less now and more later.
Supply Curves and Schedules


The relationship between the price of a product and the quantity supplied, holding all other things constant is generally sloping upwards. Supply is represented by the entire curve and not just one point on the curve. When the price of the product changes, the quantity supplied changes, but supply does not change. When cost of production changes, supply changes, and the entire supply curve will shift.


Market Supply is the summation of all the individual supply curves, and is the horizontal sum of individual supply curves. It is influenced by the factors that determine individual supply curves, such as cost of production, plus the number of suppliers in the market. In general, the more firms producing a product, the greater the market supply.


When quantity supplied at a given price decreases, the whole curve shifts to the left as there is a decrease in supply. This is generally caused by an increase in the cost of production or decrease in the number of sellers. An increase in wages, cost of raw materials, cost of capital, ceteris paribus, will decrease supply. Sometimes weather may also affect supply, if the raw materials are perishable or unattainable due to transportation problems.


Reaching Equilibrium


We can analyze how markets behave by matching (or combining) the supply and demand curves. Equilibrium is defined as the intersection of supply and demand curves. The equilibrium price is the price where the quantity demanded matches the quantity supplied. The equilibrium quantity is the quantity where price has adjusted so that QD = QS. At the equilibrium price, the quantity that buyers are willing to purchase exactly equals the quantity the producers are willing to sell. Actions of buyers and sellers naturally tend to move a market towards the equilibrium.


Excess Supply/Demand


Excess Supply is where Quantity supplied > Quantity demanded, and results in surpluses at the current price. A large surplus is known as a "glut". In cases of excess supply:


price is too high to be at equilibrium
suppliers find that inventories increase
suppliers react by lowering prices
this continues until price falls to equilibrium
Excess Demand occurs when Quantity demanded > Quantity supplied, and results in shortages at current prices. In cases of excess demand:


buyers cannot buy all they want at the going price
sellers find that their inventories are decreasing
sellers can raise prices without losing sales
prices increase until market reaches equilibrium
Law of Supply and Demand


In free markets, surpluses and/or shortages tend to be temporary and obey the law of supply and demand, since actions of buyers and sellers tend to match prices back toward their equilibrium levels.

Production Possibilities Frontier

An example of a model is the Production Possibility Frontier (PPF). PPF is a graph/table that shows the maximum possible combinations of outputs that can be produced from given inputs. Simplifying assumptions:


Assume the economy produces just 2 goods
Assume that technology and the quantity of factors (inputs such as labour, capital, & raw materials) are fixed


Example: A farmer has a 10 acre field and can grow either wheat or barley on it. The only input is land. He has the following possible combinations:


Wheat 40 30 20 10 0
Barley 0 5 10 15 20


Draw the PPF with Wheat on vertical axis. Note that this is a straight line. Any point on the Production Possibility Frontier is said to be "efficient". The economy is getting the most it can given the fixed resources & technology, and there are many possible efficient combinations.


Inside the PPF is considered inefficient, since the business can produce more of one good without producing less of the other. Inefficiencies arise from unemployed resources or inefficient management. Points outside the PPF are currently unavailable. The PPF can be increased by economic growth which shifts the curve outward. Growth can come from more/better inputs like capital & labour, or from better technology/organization. PPF shows the trade-off between quantities of the two goods (is always downward or negatively sloped).


Production Possibilities Frontier and Opportunity Costs


PPF illustrates the opportunity cost of gaining more of one good. Opportunity cost is equal to "loss" divided by "gain". Opportunity cost of good on vertical axis = 1/absolute slope of PPF. Opportunity cost of good on horizontal axis = absolute slope of PPF. Therefore, when the PPF is a straight line, opportunity cost is constant. What is the opportunity of Barley and Wheat in the example above? One good can be traded off for the other at a constant rate, and inputs are equally good at producing either good.


When the Production Possibilities Frontier is a curve (bowed out from the origin), the opportunity cost increases as we want more of a good. Inputs become specialized, and it becomes more efficient to produce one good than the other.


Trade and Production Possibilities


Trade is another way we can increase the combinations of outputs that we can consume. Principle of Economics #5: Trade can make everyone better off. Assume that we have 2 individuals with different PPFs. With no trade/exchange, each must consume what each produces; however, with trade, each can specialize in the good they are better at and trade for the other good. So in general, both can benefit from the exchange.


To understand why, let's define some terms. Absolute advantage occurs when one party is more productive than the other, and can produce an amount with fewer inputs. Comparative advantage occurs when one party has a lower opportunity cost than the other in producing some good. In other words, one is relatively more productive in producing one of the two goods.


In terms of trade, comparative advantage is the important factor. Trade can benefit both parties if they specialize in the good in which they have a comparative advantage. This is still the case, even if one has an absolute advantage in producing both goods.


Example: A worker in the United States can produce either 15 computers or 5 tonnes of wheat per month. Suppose a worker in China can produce either 4 computers or 4 tonnes of grain in a month.


computers grain
United States
China
Which country has an absolute advantage for each product, and which country has a competitive advantage for each product?


Quick Summary


Comparative Advantage determines specialization and trade.
Comparative advantage means that countries have different opportunity costs to produce goods.
Countries will tend to specialize in goods in which they have the lower opportunity costs.
Price at which trade occurs is between the original trade-offs in the two countries
Trade allows countries to consumer more than they would if they produced everything themselves.