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Introduction To Economics 2 PDF
Introduction To Economics 2 PDF
Introduction To Economics 2 PDF
We present to you some basic study notes for the subject economics. As you all know that
the course for the economics is very vast and not possible to cover it fully. So we have
compiled a few basic concepts of economics. Go through them to get a hang of the subject.
These notes have been compiled using various sources.
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INTRODUCTION TO ECONOMICS:
Definition of Economics
Economists study the economy. In the economy, goods
and services are produced, exchanged, and consumed.
So, economics is the study of the production, exchange,
and consumption of goods and services.
The subject matter of economics can be approached
from two levels of analysis: macroeconomics and
microeconomics. Microeconomics looks at the
production, exchange, and consumption of goods and
services at the level of an individual producer of the
good or the market in which a single good or service is
exchanged or an individual consumer of the product.
The key word is individual; microeconomics deals with
the behavior of the individual entities that make up the
economy.
Macroeconomics deals with the entire national
economy. Rather than being concerned with the
production of a single good or service, say, vacuum
cleaners, macroeconomics looks at the total production
of all goods and services including vacuum cleaners,
coffee makers, and frozen pizza. Rather than worrying
about why the price of gasoline has risen or fallen over
the last several weeks macroeconomics is concerned
with the inflation rate, a measure of how the average
price of all goods and services has changed.
Scarcity
Economics isthe study of the allocation of scarce
resources among competing and insatiable needs so
as to maximize welfare.
Economists assume that people do not act randomly.
Instead, people's behavior has a purpose. We assume
that people act in their own rational self-interest.
People make the choices they believe leave them best
off.
Economics resources are used to produce goods and
services. There are three categories of economic
resources:
1.
land - raw materials and natural resources
2.
labor - workers
3.
capital - buildings, machinery, factories,
equipment
4.
Each of the resources exists in a finite, limited
quantity.
We assume that people have unlimited wants. There is
always something that people want more of. Since we
have a limited amount of resources, we can produce a
limited amount of goods and services. No matter how
large that amount is, we cannot produce enough to
satisfy everyone's unlimited wants. This is known as
scarcity and much of economics looks at how people
cope with scarcity.
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Opportunity Costs
Because resources are scarce, people must make
choices. A choice is a comparison of alternatives. For
example, suppose I had a choice of having Kix, Cheerios,
or Lucky Charms for breakfast, and I decided to eat the
Lucky Charms. When I chose to eat the Lucky Charms I
was simultaneously choosing not to eat Cheerios and
not to eat Kix. I gave up the chance to eat the Cheerios
or the Kix. What I gave up has a value. This value is
called the opportunity cost.
Every choice has an opportunity cost. Opportunity cost
is the value of the next best alternative. Since I chose the
Lucky Charms, my opportunity cost is the Cheerios or
the Kix, whichever I most prefer.
For an accountant, the cost of an activity is the out-ofpocket expenses, all of the money paid to undertake the
activity. For an economist, the cost of an activity is
everything given up for it, including opportunity costs.
For example, what are the total costs of a college
education?
Tuition
$44,000
Books
3,200
beer costs
4,800
transportation
4,800
opportunity costs
56,000
total costs
$112,800
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2.00
2.51
$5.26
$2.00
0.25
1.00
2.00
$5.25
marginal benefits
Knowledge
higher lifetime income due to better
economics gradeearned because you
learned about opportunity costs in class
today
were able to socialize with other students
total marginal benefits
$0.50
0.25
2.00
$2.75
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$0.50
0.25
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Financial Sector
The financial sector acts as an intermediary between
savers and investors. The financial sector includes
financial markets such as stock and bond markets and
financial intermediaries like banks, mutual funds, and
insurance companies.
International Sector
The American economy has extensive interactions with
the rest of the world. Trade in goods, services, and
income is one such interaction. Exports are products
made in this country and sold abroad; imports are
foreign made products purchased by Americans.
Supply and Demand, Part 1
The three basic economic questionsmarkets and
pricesdemandsupply
The Three Basic Economic Questions
All societies must deal with scarcity and, therefore,
must have some way of answering 3 basic economic
questions:
1. What goods and services are produced and in what
quantities?
2. How are they produced?
3. Who gets the goods and services that are produced?
There are two extreme systems for answering these
questions. In a communist economy, the government
decides all the answers. In a capitalist economy, the
questions get answered through the interaction of
buyers and sellers in the market.
Communist economy:
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$5
4
3
2
1
Supply
Supply is the amount producers are willing to offer for
sale at each possible price. The amount sellers are
willing to offer at a particular price is called quantity
supplied. The supply schedule for pizza would be
constructed by adding up the quantities that each
producer offers for sale at each price, holding constant
everything else that affects the supply of pizza.
Price Quantity Supplied
($/slice) (number of slices)
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18
15
8
2
1
$5
4
3
2
1
18
15
8
2
1
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2. inferior goods
changes in income
1. normal goods
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o
o
2. complements
o
o
o
o
Elasticity
We want to measure the magnitude by which
consumers change the quantity demanded in response
to a change in the price of the product. The more elastic
demand is, the more responsive it is to price changes.
percentage change in quantity demanded
price elasticity of demand = ---------------------------------percentage change in price
The price elasticity of demand
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4.
5.
Heating oil prices rose because the cold winter increased the demand for heating
oil. Heating oil suppliers hold very little inventory, so the supply curve is very
steep: the supply of heating oil responds very little to changes in price.
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Accounting costs consist of businesses direct, out-ofpocket costs. However, the time and funds invested in a
firm could have been used in some other business. The
foregone return on the entrepreneur's time and money
that could have been used in another business is an
opportunity cost. This opportunity cost is part of the
costs of doing business so we add it to accounting costs
to get economic cost. A business can earn an accounting
profit yet have zero economic profits. Remember that
from now on, costs always include these opportunity
costs and that cost always means economic cost.
In the short-run, the size of a firm's capital stock is fixed.
They are unable to change it. Other resources, such as
labor, are variable inputs in the short run. In the longrun, all input levels can be changed.
Assume that a firm uses two resources, labor and
capital, to produce a good or service. Capital is a fixed
resource while labor can be used in varying quantities.
Total Output
Total output is the maximum output that can be
produced when variable resources are added to a fixed
amount of capital.
0
0
1
15
15
2
34
19
3
48
14
4
60
12
5
62
2
6
60
-2
The table above exhibits the law of diminishing
returns: the addition of resources increases output but
eventually does so at a decreasing rate. In other words,
the extra output of the group must eventually fall.
Costs in the Short Run
There are two types of costs in the short-run:
1.
fixed costs: those costs that do not change as
output increases and are incurred even if no output is
produced at all, e.g. interest, depreciation, fire insurance
2.
variable costs: those costs that do increase as
output increases
Total Costs (TC) = Total Fixed Costs (TFC) + Total
Variable Costs (TVC)
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Q
0
1
2
3
4
5
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TFC
35
35
35
35
35
35
TVC
0
24
40
60
85
116
TC
35
59
75
95
120
151
AFC
AVC
ATC
35
17.5
11.7
8.8
7
24
20
20
21.2
23.3
59
37.
31.
30
30.
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Profit Maximization
demand curve facing the firmbarriers to entryfinding
profits graphically
Demand Curve Facing the Firm
We assume that firms choose the price and quantity
produced so as to maximize profits. A firm's choices for
the price and quantity produced depend on the
environment in which it operates. One important factor
is the demand curve facing the firm.
With
perfectly
elastic
demand the
firm has no
control over
price. It only
chooses the
quantity to
produce.
profits for a long time and can raise prices without fear
of immediate new competition.
Facing a perfectly
inelastic
demand
curve, the firm only
chooses the price
since the quantity is
determined by how
much
consumers
want.
Firms would prefer to face the most inelastic demand
curves possible. Firms can reduce elasticity by reducing
the availability of substitutes. One way is to distinguish
or differentiate your product from those of your
competitors. Differentiation can occur through
advertising, price, service, quality, location, et cetera.
Barriers to Entry
A firm's environment not only depends on the demand
for its product but also on the ease of entry into the
market.A barrier to entry is anything that makes it
difficult or costly for a firm to enter a market. Some
barriers to entry are created by the government:
patents and copyrights, zoning, and licensing are
examples. Other barriers to entry are economic in
nature. One such barrier to entry is fixed or sunk costs.
These are costs which must be paid before any output is
even produced.
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1.50
1.00
7.50
2.50
-1.50
Price QD TR TC
MR MC
Profits
11
-2
3.50
-7.00
$5
$0
$3
$-3
15.50 -1
4.50
-15.50
3.50
$4
$0.50 0.50
When the firm can produce fractional units of the good, profits are
maximized at the quantity at which MR = MC. Graphically, this occurs
where the marginal revenue and marginal cost curves intersect. Drop
straight down from the point of intersection to find the profit
maximizing quantity of output, Q*. To find the profit maximizing price,
follow Q* up to the demand curve and over to the vertical axis.
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3.
entry is impossible
A monopolist faces the market demand curve. Since
entry is impossible a monopolist can earn an economic
profit over the long run.
Monopolistic Competition
1.
many buyers and many sellers
2.
slightly different products
3.
free entry and exit
Monopolistic competitors tend to compete on the basis
of product differentiation and by introducing new
products, for example, light beer, then ice beer, then low
carb beer.
Oligopoly
1.
many buyers and just a few sellers
2.
identical or slightly different products
3.
entry is difficult
Oligopolists need to take into account how the other
firms in the industry will react to their business
decisions. For example, Ford will consider what it
thinks General Motors will do when Ford is making its
styling and pricing decisions for its new cars.
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Financial Markets
The interest rate is the fee for using money, expressed in annual
percentage terms. The interest rate is determined by the supply and
demand for money. The demand for money comes from those with a
shortage of funds, borrowers or investors. The supply of money
comes from those with a surplus of funds, lenders or savers.
The interest rate is determined by the equilibrium of money supply
and money demand.
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primary v. secondary
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o
o
Business Cycles
The American economy experienced increasing material
wealth and productivity over the century.
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underground economy
unreported income from legal sources
income from illegal sources
Nominal and Real GDP
Nominal GDP is the sum of this year's output valued at
this year's prices. The problem is that nominal GDP
changes when prices change and when the quantity of
output changes. We want to separate the desirable
increase in the quantity of output from the undesirable
increase in prices.
Real GDP is the sum of this year's output valued at base
year prices. Prices from the base year are used to
calculate real GDP for all years.
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Macroeconomic Equilibrium
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input prices
o
higher input prices AS curve shifts up to the left
o
lower input prices AS curve shifts down to the
right
productivity
o
higher productivity AS curve shifts down to the
right
o
lower productivity AS curve shifts up to the left
government regulation
o
more regulation AS curve shifts up to the left
o
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Causes of Inflation
1.
demand-pull inflation - increase in aggregate
demand
2.
Causes of a Recession
1.
a fall in aggregate demand
2.
Fiscal Policy
Expansionary and Contractionary Fiscal Policy
Fiscal policy involves the taxing and spending policies of
the government.
expansionary fiscal policy (to fight a recession by
increasing aggregate demand)
1. increase government spending
2. cut taxes
contractionary fiscal policy (to deal with inflation by
reducing aggregate demand)
1. decrease government spending
2. raise taxes
The Tax System
Federal Government
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excise taxes
State and Local Governments
sales taxes
income taxes
property taxes
progressive tax
tax is a higher percentage of income for those with
higher incomes than those with lower incomes
proportional tax
tax is the same percentage of income for those with
higher incomes as those with lower incomes
regressive tax
tax is a lower percentage of income for those with
higher incomes than those with lower incomes
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Average
Pre-tax
Income
Total
Government
Taxes Paid
Taxes as a
Percentage
of Income
$7,946
$1,449
18%
$20,319
$2,847
14%
$35,536
$5,622
16%
$56,891
$9,835
17%
$116,666
$21,623
19%
Medicare 297.4 b
Medicaid 176.2 b
Budget deficit = Revenues - Outlays = 1880.1 b - 2292.2
b = $412.1 billion
National Debt
When the government overspends, the U.S.
Treasury must borrow to finance the difference
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And then came World War II, the Korean War, and the
postwar military-industrial buildup associated with the
Cold War.
Taxes kept pace--and the underlying growth of the
American economy steadily reduced the outstanding
national debt as a share of GDP. (The debt to GDP ratio
went down from 112% at the end of WWII to about
25% in the mid-1970s.)
Since the end of the 1970s the debt-to-GDP ratio has
doubled and there has been an almost steady increase
in share of GDP devoted to spending while revenues
have been relatively constant as a share of GDP).
Three reasons for persistent budget deficits in the
1980s and 1990s and their recent reemergence:
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excise taxes
State and Local Governments
sales taxes
income taxes
propoerty taxes
progressive tax
tax is a higher percentage of income for those with
higher incomes than those with lower incomes
proportional tax
tax is the same percentage of income for those with
higher incomes as those with lower incomes
regressive tax
tax is a lower percentage of income for those with
higher incomes than those with lower incomes
The overall tax system (including income, sales, and
property taxes at all levels of government) in the United
States is nearly proportional.
Income
Group
bottom
20%
second
20%
middle
20%
fourth
20%
top 20%
Average
Pre-tax
Income
Total
Government
Taxes Paid
Taxes as a
Percentage
of Income
$7,946
$1,449
18%
$20,319
$2,847
14%
$35,536
$5,622
16%
$56,891
$9,835
17%
$116,666
$21,623
19%
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Medicare 297.4 b
Medicaid 176.2 b
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capitalist
well
developed
transportation
and
communication systems
Characteristics of Poor Nations
medium of exchange
store of value
unit of account
Why Money?
Money was created to reduce the costs of exchange.
Specialization in the production process increases
output. But, while each individual may specialize as a
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customary exchanges
indirect exchange
Searches by potential barterers for some double
coincidence of wants will be extremely time consuming
in a large, highly specialized economy with millions of
products and people. Barter was abandoned and a
system of indirect exchange was adopted instead.
Indirect exchange significantly reduces the time spent
on any one transaction.
In spite of widely different tastes within a society, there
will be a small number of commodities most everybody
is will to accept for exchange purposes. Everyone will
maintain an inventory of the generally accepted
commodities and virtually all exchanges will be made
with these commodities. We then have a medium of
exchange and a store of value. Prices will be listed in
terms of these generally accepted commodities, making
them units of account. These generally accepted
commodities take on the functions of money.
Desirable Characteristics of Money
divisible
durable
transportable
easily recognizable
Monetary Aggregates
M1
M1 = currency + checking deposits
M2
M2 = M1 + small savings deposits
M3
M3 = M2 + large savings deposits
Monetary Policy
Federal Reservetools of monetary policyexpansionary
monetary policycontractionary monetary policy
Federal Reserve
Monetary policy involves control of the quantity of
money in the economy. The Federal Reserve is
responsible for monetary policy in the United States.
organization:
1.
District Banks
2.
Board of Governors (chairman is Alan
Greenspan)
3.
Federal Open Market Committee
Tools of Monetary Policy
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2.
the decrease in interest rates causes
consumption and investment spending to rise and so
aggregate demand rises
3.
the increase in aggregate demand causes real
GDP to rise
2. discount rate
When the Federal Reserve makes a loan to a member
bank, the loan is called a discount loan. The interest rate
on a discount loan is called the discount rate.
Lowering the discount rate encourages banks to take
out more discount loans while raising the rate
discourages banks from borrowing from the Fed.
Therefore, lowering the discount rate puts money into
the economy; raising the discount rate takes money out
of the economy.
3. reserve ratio
The reserve ratio is the percentage of deposits banks
are required to hold as vault cash and not loan out..
Lowering the reserve ratio allows banks to loan out a
greater fraction of deposits and the money supply
would increase. Raising the reserve ratio would cause
the money supply to shrink.
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food
5
3
clothing
3
1
Suppose the table above shows output per worker per day in the food and clothing sectors of the American and Chinese
economies. Also, suppose that there are 16 workers in each country and that both countries prefer equal amounts of
food and clothing.
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For an import good, the price falls to the world price, making
consumers better off. Domestic producers are worse off
because the lower price leans less profits. Domestic production
of the good falls.
Tariffs
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Import Quotas
export subsidies
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