Notes on Principles of Economics

2023-02-04

This are my notes from my studies on microeconomic theory. I am watching the lectures from this link. Also reading two books, Principles of Economics, by Mankiw, and Basic Economics, by Sowell.

Introduction

Comparative Advantage: Refers to the ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than another individual, firm, or country. Opportunity cost is the value of the next best alternative that must be given up in order to engage in a certain activity. The concept of comparative advantage is central to international trade theory and suggests that countries or individuals should specialize in the production of goods and services for which they have a comparative advantage and trade with others for goods and services for which they have a comparative disadvantage.

By doing so, all parties can benefit from increased efficiency and higher standards of living. The theory of comparative advantage is based on the idea that trade can increase the overall welfare of both countries or individuals, even if one country has an absolute advantage in producing all goods.

Temporal Preferences: Refer to an individual's preference for consuming goods or services now versus in the future. Temporal preferences can be thought of as a trade-off between immediate and delayed satisfaction, as individuals who prefer immediate satisfaction may be willing to consume goods or services now at the expense of sacrificing satisfaction in the future, while individuals who prefer future satisfaction may be willing to delay consumption in order to increase their future satisfaction.

Temporal preferences play an important role in various aspects of economic behavior, including saving and investment decisions, borrowing and lending decisions, and the consumption of goods and services over time.

Economic models often assume that individuals have inter temporal preferences that are consistent and stable over time, and that individuals make decisions that maximize their expected utility over time. However, in practice, temporal preferences can vary based on a variety of factors, such as income, age, and risk tolerance, and may change over time as individuals' circumstances and preferences change.

Understanding temporal preferences is important for policymakers and economists as they can impact a wide range of economic outcomes, such as consumption patterns, savings and investment decisions, and the overall functioning of the economy. Thus, it is important to consider temporal preferences when designing and evaluating economic policies, such as those related to savings and retirement, debt management, and consumption taxes.

Risk: Refers to the uncertainty associated with future outcomes. In the context of economics, risk refers to the uncertainty surrounding economic decisions, such as investment, consumption, and production.

Risk can impact economic behavior in many ways, as individuals and firms must take into account the likelihood of different outcomes when making decisions. For example, in the case of investment decisions, individuals and firms must consider the risk of losing money, and must weigh this against the potential reward of higher returns.

Utility: Refers to the satisfaction or happiness that an individual derives from consuming goods or services. Utility is a subjective concept that cannot be measured directly, but is instead inferred from observed behavior and preferences.

Economic models often assume that individuals make decisions that maximize their utility, meaning they choose to consume goods or services that they expect will provide the greatest level of satisfaction. The total utility that an individual derives from consuming a good or service is influenced by a variety of factors, such as the individual's tastes and preferences, the price of the good or service, and the availability of other goods or services.

Utility is a key concept in microeconomics, as it is used to explain consumer behavior and to analyze market outcomes. For example, the law of diminishing marginal utility states that as an individual consumes more of a good or service, the additional satisfaction that they derive from each additional unit decreases. This concept is used to explain the downward-sloping demand curve for goods and services.

Overall, the concept of utility is central to economic analysis, as it provides a framework for understanding how individuals make decisions about what to consume and how much to consume, and how these decisions affect market outcomes and the overall functioning of the economy.

Supply, Demand, and Equilibrium

Supply: Refers to the quantity of a good or service that a producer is willing and able to offer for sale at a given price in a given time period. In economics, supply is a function of price and other factors that affect the production of the good or service, such as technology, resource availability, and government policies.

An increase in the price of a good or service will typically lead to an increase in supply, as producers will be incentivized to produce more in order to earn higher profits. Conversely, a decrease in the price of a good or service will typically lead to a decrease in supply, as producers will be less motivated to produce at lower prices. The relationship between price and supply is usually represented graphically as a supply curve, which slopes upward to the right, indicating that higher prices lead to higher levels of supply.

Demand: Refers to the quantity of a good or service that a consumer is willing and able to purchase at a given price in a given time period. In economics, demand is a function of price, income, preferences, and other factors that affect the consumer's willingness and ability to purchase the good or service.

An increase in the price of a good or service will typically lead to a decrease in demand, as consumers will be less willing to pay the higher price. Conversely, a decrease in the price of a good or service will typically lead to an increase in demand, as consumers will be more willing to purchase the good or service at the lower price. The relationship between price and demand is usually represented graphically as a demand curve, which slopes downward to the right, indicating that higher prices lead to lower levels of demand. The intersection of the supply and demand curves determines the market price and the quantity of the good or service that will be produced and consumed.

Market Equilibrium: Refers to a state where the supply of a good or service is equal to the demand for that good or service. In other words, the market is in balance, and there is no excess supply or excess demand. At this point, the market price has reached a level where the quantity of the good or service that producers are willing to supply is equal to the quantity that consumers are willing to purchase.

Equilibrium is a dynamic concept and can change in response to changes in the factors that affect supply and demand, such as price, income, preferences, technology, and government policies. The market will continue to adjust until a new equilibrium is reached. Equilibrium can be represented graphically as the point where the supply and demand curves intersect. The market price at this point is called the market-clearing price, and the quantity of the good or service produced and consumed is called the market-clearing quantity.

Elasticity: Refers to the responsiveness of demand or supply to changes in price or other factors that affect the market. The concept of elasticity is used to measure the degree to which changes in price (or other factors) result in changes in the quantity demanded (or supplied) of a good or service. There are several different types of elasticity, including price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross-price elasticity of demand.

Price elasticity of demand measures the responsiveness of the quantity demanded of a good or service to changes in its price. A good or service is considered to be price elastic if a small change in price leads to a relatively large change in the quantity demanded. If a good or service is price inelastic, a small change in price leads to a relatively small change in the quantity demanded.

Price elasticity of supply measures the responsiveness of the quantity supplied of a good or service to changes in its price. A good or service is considered to be price elastic if a small change in price leads to a relatively large change in the quantity supplied. If a good or service is price inelastic, a small change in price leads to a relatively small change in the quantity supplied.

Taxes and Subsidies

Commodity taxes: also known as excise taxes, are taxes imposed on specific goods or services. They are often used by governments to raise revenue, as well as to discourage the consumption of certain goods or services deemed to be harmful to society, such as tobacco or alcohol. Commodity taxes are different from sales taxes, which are levied on all goods and services purchased, and income taxes, which are levied on individuals and businesses based on their income.

Commodity taxes can impact the price of the taxed good or service, as the tax is typically passed on to consumers in the form of higher prices. This can result in changes in demand for the taxed good or service, as consumers may choose to reduce their consumption or switch to substitute goods or services that are not taxed.

Commodity taxes can also impact the behavior of producers, as they may adjust their production processes or choose to shift production to another location to avoid the tax.

Overall, commodity taxes can play an important role in shaping the economy, as they can influence the behavior of both consumers and producers. It is important for governments to carefully consider the impact of commodity taxes on the economy, as well as their impact on the welfare of individuals and society as a whole, when designing and implementing tax policies.

Subsidy: is a payment or other support provided by a government to an individual, company, or sector in order to support a specific activity, product, or service. The goal of subsidies is to encourage the production and consumption of goods and services deemed to be of value to society, or to support the development of certain industries or regions.

Subsidies can take many forms, including direct payments, tax breaks, low-interest loans, or the provision of goods or services at below-market prices. They are often used to address market failures, such as externalities, or to support industries or regions that are seen as struggling.

However, subsidies can also lead to unintended consequences, such as creating a distorted market and encouraging inefficiency, reducing the competitiveness of unsubsidised firms, or leading to the overproduction of goods or services that may not be in demand.

It is important for governments to carefully consider the impact of subsidies, as well as alternative policy options, when designing and implementing economic policies. This can involve evaluating the costs and benefits of subsidies, considering their impact on the economy and society as a whole, and ensuring that subsidies are well-targeted and transparent, in order to maximize their effectiveness and minimize any potential negative effects.

The Price System

Invisible Hand: is a term used by Adam Smith to describe the unintended beneficial consequences of individuals pursuing their own self-interest in a market economy. Smith, widely considered the father of modern economics, believed that the pursuit of self-interest by individuals in the market would lead to an efficient allocation of resources, even without the intervention of the government or any other central authority.

Smith argued that in a market economy, individuals who are motivated by their own self-interest will make decisions about production and consumption that are best for society as a whole. For example, a manufacturer who wants to maximize profits will produce goods that are in high demand, and consumers who want to maximize their own satisfaction will buy goods that are of high quality and low price. According to Smith, these mutually beneficial transactions between buyers and sellers result in an efficient allocation of resources and a general increase in prosperity for society as a whole.

The concept of the invisible hand is often used to describe the power of the market to coordinate the actions of millions of individuals and to produce outcomes that are in the best interest of society as a whole. However, it is important to note that the invisible hand is not a guarantee of a perfectly efficient market or a perfectly just society. There are many cases in which market failures can occur, such as when there are externalities or when information is asymmetrical, and in these cases, government intervention may be necessary to correct market inefficiencies. Despite this, the invisible hand remains an important concept in economics, and it continues to be used to describe the power of the market to allocate resources in a way that is beneficial for society.

Signal: in economics is any information that is used by individuals or firms to make decisions. Signals can take many forms, including prices, wages, and advertising. For example, the price of a good is a signal that provides information about its scarcity and the level of demand for it. By observing the price of a good, individuals can make decisions about whether to buy or sell it.

Incentives: are rewards or punishments that are used to influence the behavior of individuals and firms. Incentives can take many forms, including profits, losses, bonuses, and taxes. For example, the profit motive is an incentive that encourages individuals and firms to produce goods and services that are in high demand. By observing the potential for profit, individuals and firms are motivated to produce goods and services that are of high quality and low price.

Signals and incentives are critical components of a market economy, and they play a central role in determining the allocation of resources and the distribution of goods and services. By providing information about the relative scarcity of goods and services, signals help to coordinate the actions of buyers and sellers, and by providing rewards and punishments, incentives help to motivate individuals and firms to make decisions that are in the best interest of society as a whole. Together, signals and incentives help to ensure that the market operates efficiently and effectively, producing outcomes that are in the best interest of society.

Price Ceilings and Price Floors

Shortages: Refers to a situation where the demand for a good or service exceeds the available supply. This results in some buyers not being able to purchase the quantity they would like to at the current market price. In such a scenario, the price of the good or service is likely to increase as a result of competition among buyers for the limited available supply.

The extent of the shortage, and the resulting price increase, will depend on the size of the supply shortfall and the elasticity of demand for the good or service.

Misallocation of Resources: Refers to the allocation of economic resources (such as labor, capital, and land) to uses that are less efficient or less valuable than alternative uses. This can occur due to market failures, government intervention, or other factors that cause prices to deviate from their true market-clearing levels.

As a result of misallocation, some firms may produce goods or services that are less in demand, while other firms may be unable to produce the goods or services that consumers want. This leads to a suboptimal allocation of resources and a reduction in overall economic efficiency and welfare.

Deadweight Loss: Refers to the reduction in economic welfare or surplus that results from market inefficiencies. It is the value of the goods and services that could have been produced or consumed but are not because of market failures such as monopolies, price controls, taxes, or other factors that prevent prices from reaching their market-clearing levels.

Deadweight loss is a measure of the efficiency loss to society from these market failures and can be represented graphically as the area between the supply and demand curves and the market price. The larger the deadweight loss, the greater the inefficiency in the market and the lower the overall level of economic welfare.

Quality Reduction: Refers to a decrease in the quality of a good or service due to market factors or production decisions. In some cases, firms may choose to lower the quality of their products in order to lower costs and increase profits. For example, a manufacturer may use lower-quality materials or reduce the number of features on a product in order to lower its price.

Quality reduction can also occur as a result of competition in the market, as firms try to undercut each other on price. This can lead to a reduction in the overall quality of goods and services available to consumers. The result is a reduction in consumer surplus, as buyers are not able to purchase the high-quality goods they would prefer at the current market price.

Search Costs: Refer to the costs associated with finding information about goods or services that a consumer is interested in purchasing. These costs can include the time and effort required to find information about the product, the cost of physically searching for the product, and the cost of evaluating the quality of the product.

High search costs can reduce the number of transactions that occur in a market and can prevent consumers from finding the best deal or the best-quality product. This can lead to a reduction in consumer surplus and a less efficient allocation of resources in the market. In some cases, high search costs can also create barriers to entry for new firms, leading to reduced competition and higher prices for consumers.

Trade

Tariffs and Protectionism: Refer to government policies aimed at restricting imports and promoting domestic production. A tariff is a tax on imported goods that raises the price of imported goods relative to domestically produced goods. The goal of tariffs is to make imported goods less competitive with domestic goods, thus increasing demand for domestic goods and protecting domestic producers.

Protectionism is a broader term that encompasses a range of policies aimed at promoting domestic production and protecting domestic producers from foreign competition. In addition to tariffs, protectionist policies can include quotas, subsidies, and other measures designed to limit imports and promote domestic production.

Protectionist policies are often motivated by the desire to protect domestic jobs and industries, as well as to maintain control over key industries. However, protectionist policies can also have negative consequences, such as reducing economic efficiency, limiting consumer choice, and increasing the cost of goods for consumers.

In addition, protectionist policies can lead to retaliation from other countries, as they may respond by imposing their own tariffs and other restrictions on imports from the protecting country. This can result in trade wars, in which countries engage in a series of tit-for-tat measures aimed at protecting their own producers and limiting imports from other countries.

Overall, tariffs and protectionism are controversial economic policies that are often used by governments to promote domestic production and protect domestic producers. While they can provide short-term benefits to domestic producers, they can also have negative consequences for the economy and for consumers, and can lead to trade conflicts, lower product quality, and other economic disruptions.

Externalities

Externalities: are costs or benefits associated with a market activity that are not reflected in the market price. In other words, externalities are effects of a market activity that are experienced by third parties who are not directly involved in the transaction.

Externalities can be positive or negative. Positive externalities occur when a market activity generates benefits for third parties, such as when a factory creates jobs in the local community. Negative externalities occur when a market activity generates costs for third parties, such as when a factory pollutes the air and water.

The presence of externalities can result in market inefficiencies, as the market price does not reflect the full cost or benefit of a market activity. For example, if a factory is generating negative externalities in the form of pollution, the market price for the goods produced by the factory will be lower than the true cost of the pollution. This can result in too much of the activity being produced from the perspective of society as a whole.

To address externalities, governments may intervene in the market through regulation, taxes, subsidies, or other measures. The goal of these policies is to internalize the externality, meaning to make the cost or benefit of the market activity part of the market price.

Overall, externalities are an important concept in economics, as they demonstrate how market activities can generate costs or benefits for society as a whole, and how government intervention may be necessary to address these effects and ensure that markets function efficiently.

Costs and Profit Maximization Under Profit

Competition and the Invisible Hand

Monopoly

Price Discrimination

Price Discrimination: Refers to the practice of charging different prices to different customers for the same good or service. This can occur when a seller is able to distinguish between different market segments and charge different prices based on the willingness of each segment to pay.

There are several forms of price discrimination, including first-degree price discrimination, second-degree price discrimination, and third-degree price discrimination.

First-degree price discrimination, also known as perfect price discrimination, occurs when a seller is able to charge each customer the maximum price that they are willing to pay for a good or service. This type of price discrimination requires the seller to have complete information about the willingness to pay of each customer, which is usually not possible in real-world market situations.

Second-degree price discrimination occurs when a seller charges different prices based on the quantity of the good or service that is purchased. For example, a seller may offer discounts for bulk purchases.

Third-degree price discrimination occurs when a seller charges different prices based on demographic characteristics, such as age or income. For example, a movie theater may charge a lower ticket price for senior citizens or students.

Price discrimination can have both benefits and drawbacks. On the one hand, it allows firms to capture additional revenue from customers who are willing to pay more, which can increase profits. On the other hand, price discrimination can create market inefficiencies and lead to unfair treatment of customers who are charged a higher price for the same good or service. Additionally, price discrimination can lead to a reduction in consumer surplus, as consumers who are charged a higher price for a good or service are worse off than they would be if the price were the same for everyone.

Price discrimination is a controversial topic, and the practice is subject to regulation in many countries to ensure that it does not harm consumers or result in market inefficiencies.

Tying: is a business practice in which a firm requires a customer to purchase one product as a condition for purchasing a different product. For example, a software company may require customers to purchase a computer operating system in order to purchase a productivity software package.

Tying can create a number of economic and competition issues. For example, tying can limit competition in the market for the tied product, as customers may feel forced to purchase the tied product even if they would prefer a different product. This can result in higher prices and reduced quality for the tied product.

Additionally, tying can limit the ability of customers to choose the products that best meet their needs, as they are forced to purchase products in a bundle. This can result in a reduction in consumer surplus, as customers are worse off than they would be if they were able to purchase the products they want separately.

In many countries, tying is subject to regulation to ensure that it does not harm competition or result in market inefficiencies. For example, in the United States, tying arrangements are subject to scrutiny under the antitrust laws, and may be illegal if they result in harm to competition.

Tying can also be used in certain circumstances to promote efficiency or to support complementary products. For example, a software company may require customers to purchase a computer operating system in order to purchase a productivity software package because the software package is designed to work best with the operating system. In such cases, tying can benefit both the seller and the customer by promoting efficiency and improving the quality of the products.

Bundling: Refers to the practice of selling two or more products together as a single combined package. This can be seen in many different industries, including software, consumer goods, and entertainment.

Bundling can provide several benefits to both firms and consumers. For example, bundling can reduce the costs of production and distribution for firms, as they are able to sell multiple products in a single transaction. This can result in lower prices for consumers, who benefit from the economies of scale.

Additionally, bundling can help firms to cross-sell complementary products, as customers are more likely to purchase additional products when they are sold as part of a bundle. For example, a software company may offer a bundle that includes a computer operating system and several productivity software packages, in order to encourage customers to purchase the software packages along with the operating system.

Bundling can also create certain challenges, as it can limit competition in the market for the bundled products. For example, if a firm offers a bundle that includes a computer operating system and several productivity software packages, this may limit the ability of other software companies to compete in the market for productivity software.

In many countries, bundling is subject to regulation to ensure that it does not harm competition or result in market inefficiencies. For example, in the United States, bundling arrangements are subject to scrutiny under the antitrust laws, and may be illegal if they result in harm to competition.

Overall, bundling can be a useful marketing strategy for firms, as it allows them to offer multiple products to customers at a lower cost, while also promoting the sale of complementary products. However, it is important to carefully consider the potential benefits and drawbacks of bundling in order to ensure that it does not harm competition or result in market inefficiencies.

Labor Markets

Human Capital: Refers to the knowledge, skills, and abilities that individuals acquire through education, training, and work experience, which increase their productivity and earning potential.

In the context of the labor market, human capital is seen as an important factor in determining an individual's value as an employee. For example, a person with a high level of human capital, such as a advanced degree or specialized training, may be more valuable to an employer than an individual with a lower level of human capital, as they are more likely to have the skills and knowledge needed to perform well in a job.

Investment in human capital can lead to a range of benefits for individuals, including increased earning potential, improved job security, and greater career mobility. For society as a whole, investment in human capital can lead to economic growth and development, as individuals with high levels of human capital are more productive and contribute more to the economy.

However, investment in human capital can also lead to certain challenges, such as information asymmetry, which can result in unequal access to education and training opportunities. Additionally, investment in human capital can be costly and time-consuming, which may result in barriers to entry for certain individuals, such as those who are unable to afford the costs of education and training.

Overall, human capital is a critical component of the labor market, and plays a significant role in determining an individual's earning potential and career opportunities. It is important for individuals to invest in their human capital in order to improve their chances of success in the labor market, and for society to invest in human capital to promote economic growth and development.

Compensating Differentials: Refer to differences in wage rates that compensate workers for differences in the non-monetary aspects of their jobs. Non-monetary aspects of a job can include things like working conditions, job security, and the level of stress associated with the job. The idea behind compensating differentials is that workers will accept lower wage rates for jobs that have undesirable non-monetary characteristics if the wage rate is high enough to compensate them for those characteristics.

For example, workers who have to work in dangerous or unpleasant conditions might demand higher wage rates to compensate them for the risks they face on the job. Conversely, workers who have jobs that are less stressful and more secure might accept lower wage rates because they value those non-monetary aspects of their jobs. The concept of compensating differentials is based on the idea that workers make rational decisions about the trade-offs between wage rates and the non-monetary aspects of their jobs, and that these trade-offs result in wage differentials that reflect the value of those non-monetary aspects.

Marginal Product of Labor: Refers to the additional output produced by one additional unit of labor, holding all other factors of production constant. MPL is used to describe the relationship between the quantity of labor input and the corresponding change in output, and is an important concept in the analysis of production and labor market decisions.

The MPL is calculated as the change in total output (i.e., the increase in total production) divided by the change in the number of workers. In other words, it measures the amount of additional output produced by the last unit of labor added to the production process. As more and more units of labor are added, the MPL will initially increase, but eventually, it will start to decline as the law of diminishing returns takes effect.

The MPL is important for firms because it provides information about the marginal cost of producing additional units of output. If the MPL is high, then adding an additional unit of labor will result in a large increase in output and a relatively low increase in costs, making it more attractive for firms to hire additional workers. On the other hand, if the MPL is low, then adding an additional unit of labor will result in a small increase in output and a relatively high increase in costs, making it less attractive for firms to hire additional workers. The MPL is also important for workers because it provides information about the marginal benefit of working an additional hour, which is represented by the increase in output produced by that additional hour of work.

On signaling

Signaling in the context of the labor market refers to the use of information about an individual's characteristics, such as education or experience, to indicate their quality or value as an employee. This information is often used by employers to screen job applicants, and by employees to demonstrate their skills and abilities to potential employers.

For example, a person with a high-quality education, such as a degree from a prestigious university, may signal to potential employers that they are a highly qualified and skilled individual. Similarly, prior work experience may signal to potential employers that an individual has the relevant skills and knowledge to perform well in a particular job.

Signaling can play an important role in the labor market by helping employers to identify the most qualified and capable individuals for a given job. It can also help employees to demonstrate their skills and abilities to potential employers, which may increase their chances of being hired.

However, signaling can also lead to certain inefficiencies in the labor market. For example, individuals who are unable to obtain a high-quality education or work experience may be disadvantaged in the labor market, even if they have the necessary skills and abilities to perform well in a job. Additionally, the use of signaling can result in information asymmetry between employers and employees, which can lead to inefficiencies in the market.

Overall, signaling is an important factor in the labor market, and can play a significant role in determining who gets hired and how much they are paid. It is important for both employers and employees to understand the role of signaling in the labor market in order to make informed decisions about their careers and job opportunities.

Public Goods and the Tragedy of the Commons

Asymmetric Information

Consumer Choice

Game Theory