Final Economics 103 Study Guide 4p1610

Copyright Aniket Panjwani 2010

Acing Economics 103 by Aniket Panjwani

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http://www.econhelp.org


Introduction I've lived in Chicago for the last fourteen years of my life, but George Mason University has become my second home. I came to this college because of the stellar economics department, of whom Professor Tom Rustici is one member. I liked economics before coming to GMU, but now my interest has exploded into an obsession. I'm a freshman right now, and I took Rustici's Econ 103 course in the Fall 2009 semester. I got an A in it, which I'm content with, because Rustici is known as the hardest econ professor on campus. I learned an enormous amount from Professor Rustici, and I genuinely respect him – he's incredibly willing to help you. He is a tough professor, and the main reason I got through the class is because I love economics. Because I'm obsessed with economics, some study techniques and ways of tackling economic concepts came naturally to me. I spent a lot of time thinking about the best ways to study economics and used my findings in Rustici's Econ 103 class. The first part of the study guide will help you understand these techniques, which might not come automatically to everyone. Rustici is a tremendous teacher, but he goes over some stuff quickly in order to get everything done. By going quickly over certain parts, Rustici allows room in his class for his humorous stories and also allots time for topics no other teachers cover. It is not easy to understand everything in the class immediately. The second part of the study guide goes through Rustici's course, clarifying everything that is difficult to understand. To make this part of the study guide, I have primarily used my notes and my own thinking on the concepts. I used the Gwartney and Stroup textbook as a reference, along with other textbooks that I own. Part Three includes additional sources for those interested in economics and information for anyone interested in economics tutoring. Good luck with the course – study and you will do well!

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Part One

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Never Get Behind A key to doing well in Rustici's class is to not to get behind in the material, because it won't be too long before you are getting into another difficult topic. Especially horrible times to get behind are the elasticity sections and monopoly sections, which are the most confusing for students. The material before the first test and the material after the third test is the easiest to understand. However, you don't have much time to catch up on the material before the first test, because you soon get into the deadly material on the second test. Similarly, you don't have much time to catch up on the material on the third test if you get behind, because the final is about two weeks after the third test. Better than trying to catch up after getting behind is taking preventative measures to avoid getting behind. These preventative measures include going to class, good note-taking, immediately filling gaps in notes, and immediately filling gaps in understanding. Think in Class A theme you are going to notice in this book is my emphasis on thinking. Economics cannot be actually learned unless you think out everything yourself. You might be able to get by with cramming for one test, but you will have to keep relearning the same material before each test. Thinking something out will allow you to retain material for much longer. Americans have notoriously short attention spans – we get annoyed about having to microwave popcorn for more than three minutes. You are going to have to train yourself to think, and the best time to do this is during class. Most students sit through class, blindly taking notes, but not actually listening or thinking about what the professor is saying. This is a horrible use of your time – it is almost like not coming to class. If you begin to think in class, you will be able to master certain concepts while in class, as opposed to at 3 AM the night before the final exam. Many students haven't thought during class in a while, or ever. Thinking is like lifting weights – you don't start out repping 300 lbs on the bench. Force yourself to think for a manageable, consecutive amount of time during each class - maybe ten minutes of each class. Once you have done this for a week, try fifteen consecutive minutes of each class. Is this too much? Go down to twelve. Eventually, you'll be totally jacked, with bulging, ripped economic muscles. Going to Class If you don't go to class, absolutely nothing I do or say can help you. Rustici's class is not one you can blow off without consequence – his tests are based entirely off lectures. Reading the book alone won't help you because he often lectures on topics that are not in the book, or he elaborates on subjects in more depth than are in the book. Some of the concepts we learn are in the book, but Rustici may teach them differently or emphasize certain things that are not in the book. Rustici gives out important exam information in class. You need to know when the tests are and what they are covering. If Rustici is absent for office hours on a certain day, he will let you know in class. If you don't go to class, you won't be able to get your tests back until office hours, which wastes your time and his time. If you have swine flu, you may have a legitimate reason for missing class. If you are doing keg stands Sunday night and wake up at 2 P.M with a massive headache, you do not have a legitimate reason for 4



missing class. Party all you want, but get to every class. Sober. Good Note-Taking Take notes in pen, so that they are easier to read when you are going back to them. Be very liberal with pages – if you note down a graph incorrectly, cross it out and go on to the next page. You should be sure, at the very least, to be taking down the correct notes. You're not going to come close to filling a 70 page notebook with notes for this class, so you don't have to worry about running out of pages. Not everything needs to be written down. Certainly don't try to write down what Rustici says word for word. Nor should you write down any of Rustici's Rules of Life. When Rustici tells you to write something down, you should write those things down. Once you get to a certain point, you may be able to judge whether or not the things he tells you to write down merit being written down. Until you are confident in your ability to do that, write down everything he tells you to write down. The graphs are the most important things to get down. You want your graphs to be immaculate, with the axes labeled and all important points (i.e. Equilibrium Price) noted. Take down all intermediate steps on the graph, or anything that you feel might enhance your knowledge of the graph in the future. Write down acronyms in full-form at least once, because you may forget what they stand for (i.e. LRATC – Long Run Average Total Cost). You might not have enough time to get the graphs down as perfectly as possible. If this is the case, wait until Rustici begins to tell a story or digresses on some non-economic subject. In that time, go back to the graph and fill in all the blanks. After the graphs, the other crucial element to get down are the lists. Get each list down word for word – the lists often form short answer questions on the tests. The lists are also used in multiple choice questions. Rustici sometimes gives you lists which are related to the graphs. Try to point out on your notes which elements of the lists are related to which parts of the graphs. You usually won't have time to do this, but if you do have time, you should always try to get as much detail into the graphs as possible. Immediately Fill Gaps in Notes Despite your best efforts, there might be gaps in your notes. Maybe Rustici spent the day going straight through difficult material, and there was never a time in the lecture where you could go fill in the blanks. You need to immediately fill the gaps now, or else you will be left confused when going back to your notes later. When there are gaps, go first to a friend after class. Look over their notes – hopefully they were able to get what you missed. If your friends lack what you are missing, or you are lacking in friends, go to your best friend- Tom Rustici. You have to get down to him quickly, because he is high in demand. When Rustici starts talking about something which he is ionate about, he will continue that line of discussion for a while. So get down to him quickly, and ask for help in completing your notes. Be prompt with your question. Rustici cares immensely about his students, so he will spend a lot of time after class elaborating and going further into depth on the lecture for anyone interested. If you're interested in talking to him or listening to what he has to say, wait until he starts moving towards his office so that you can get your 5



question answered. Otherwise, make a beeline towards the office if his office hours are after your class. There is usually a large line outside Rustici's office if you arrive 5-10 minutes after the office hours have begun. He doesn't try to shoo students out as quickly as possible, so you might be waiting for a while outside. Again, the best option to fill gaps in notes is to make friends and get notes from them. If you can't do that, try to get to his office hours at least 10 minutes earlier than they begin; you should be one of the first in line and should get in fairly quickly. Immediately Fill Gaps in Understanding Despite having more than adequate notes, you may not understand a concept or graph. Fill in gaps in understanding immediately – it becomes more difficult to fill them in after each class. You won't understand future concepts well, because many concepts and graphs build on previous ones. The first person you should consult to fill gaps in understanding is yourself. It took me three hours of hard thinking over the span of a week to finally understand why the marginal revenue curve is always below the demand curve on the graph for a single-price monopoly. Spend some time staring at the graph that confuses you. Mark down all the points that you understand and all the points that you do not understand – identify your enemy. Now that you have identified your confusion, spend short periods of time (i.e. 10 minutes, three times in one day) trying to understand the concept. Hopefully, you will now understand the concept. Since you figured it out yourself, it's going to branded into your mind far stronger than if you let somebody else explain it to you. If, after a minimum half-hour of concentrated, hard thinking, you still don't understand the concept, the best thing to do is think some more. Honestly, nothing beats figuring a concept out yourself for true, total understanding. Most people don't have this patience, so they should go to friends after thinking over the problem themselves for a while. It's a better idea to go to friends after thinking about the concept yourself, so that you can be focused in your discussion on the confusing points that you have already identified. Ideally, all problems would be fixed with a friend's assistance, but there are confusing points that absolutely no one understands. It is time to go to Professor Rustici. Follow the previous advice for his office hours; get there ten minutes early. Have the confusing points written down, so that you get out as fast as possible and so that Rustici can help you as efficiently as possible. Get to the point immediately in his office hours – the long line behind you might be annoyed if you are asking inane questions. After Rustici helps you out, nearly every point of confusion should be cleared up. I say nearly, because there are some points that cannot be completely understood until you get past Econ 103. Rustici goes over a lot of stuff which no other teacher covers, because he considers these alternate topics important for students to understand. Since he is brushing over these additional topics, inquisitive students may ask many questions that are answered only in Econ 104, Econ 306, and other higher level classes. If you have worked on a concept/graph yourself, with friends, and with Rustici, but still do not totally understand it, be proud of yourself. You've put in less time than other students will when they cram for the final, but you've spent your time much more efficiently than they have. You have a better understanding of the concept than nearly the entire class, and the understanding you have will be more than sufficient for an 'A'.

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Getting Behind and Catching Up In Rustici's class, earlier concepts need to be understood to grasp later concepts, and each concept can be difficult to understand. Learning earlier concepts incompletely or not learning them altogether cripples you as the semester goes along. I missed four classes last semester because of some sort of flu. The four classes I missed were on elasticity, which is one of the most confusing part of the course. Since I acted immediately upon getting better, I was able to catch up. However, I had to spend about double the time catching up than if I had been well and had gone to class. Avoid getting behind, but if it has already happened, here's what you should do. While You are Sick This may not be the case with everyone, but when I had the flu, I had a short periods of a few hours where I didn't feel too bad. Either the medicine was working well, or my body had successfully fought off some microbial invaders – I don't know. During these hours, I was able to get some work done for classes, but I would soon tire from the work. When you are sick, get focused work done during your better hours. You don't have time to laze around, socializing for five hours while doing something which would take you half an hour on your own. You need to rest, so isolate yourself and get your work done while you're well. Then get better and get back to Rustici's class pronto. Get the Notes Acquire notes from a friend – hopefully you've made one by now. Have your friend explain the notes for you, but don't expect to understand everything immediately, especially if you just missed a difficult section. Put some hard thinking into the concepts that you've missed – at least an hour of cumulative time spent thinking into each concept. You need to double your efforts when behind. Difficult concepts like elasticity or monopoly will require more thinking time than simple concepts like marginal utility or rent controls. The elasticity and monopoly lectures have a lot crammed into a short period of time, where as rent controls are a simple concept that Rustici spends a lot of classes on. Go to Office Hours Tell Rustici that you have missed class – if you were sick, at a funeral, etc., mention why you were sick. If you woke up in your own puke in Georgetown, please, please, do not tell him why you missed class. Show him that you have gotten the notes from a friend already – many students do not even put in the effort to do this. It shows that you care about this class. Ask him about anything that confuses you, but don't expect to completely understand everything during the office hours. Rustici is a busy professor, he teaches triple the classes of most other professors, which means he has a lot of grading to do. If he seems busy, get in and get out quickly. Don't waste his time by staying until you totally understand a concept – he can push you towards understanding something, but he can't understand a concept for you.

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More Thinking It always seems to come down to thinking some more, doesn't it? I had to do more thinking than usual when I was sick, and when you miss classes, you will have to do more hard thinking than when you go to lectures. Suck it up and do it. Talk to Your Friends Again You may still not understand the concept or graph that you missed out on during the lectures. Go back to your friends, who probably have not put in nearly the amount of time you have into thinking, and see if they understand the concept any better than you do. If they do understand the concept better than you do, then acquire their insights. Far more likely is that you understand the concept as well as or better than they do. If this is true, then give yourself a pat on the back. You've successfully recovered and made it back with the rest of the rest of the class.

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Study Techniques The worst way to study for a test is to read through notes over and over, whether these are your notes or my study guide. It's a good way to get a grade below the class average, if that is your intention. Students using much better study techniques will pull up the class average; if you want to be one of them, start using some of the study techniques in this section. 1. Quiz and Recall This isn't a new technique – none of these really are. The person to popularize it is Cal Newport, a blogger and author on college success. Using quiz and recall is simple. You make a list of all the likely topics or questions that will be answered on the test and you answer them. The best application of this method towards Rustici's class is to predict the short answers and answer them. Make sure you can answer all possible short answers off the top of your head. If you can't, go to the next technique. 2. Thinking Thinking is what the good students do that other students do not. Don't go asking for help immediately after finding a concept or graph that confuses you. When studying, spend a cumulative thirty minutes thinking about the concept or graph. After these thirty minutes, if you are still confused, you have two choices: think some more or go on to the next technique. 3. Group Study Group study is a great way to prepare for exams. It is great to think with and bounce ideas off of other students. Most likely, people are finding the same things confusing, and multiple brains working together are more likely to find a solution to a problem. The whole is greater than the sum of the parts – this is both true in Alchian and Demsetz's theory of the firm, and in the case of group study. Also, it can be fun to have someone there with you to joke while studying. Corny economics jokes are a great way to solidify to economic concepts in your head – just make sure the jokes are economically accurate. The primary problem that occurs in group studying is getting off topic. To avoid this, keep the groups small (3-5 people), unless you are certain that you will be able to maintain focus in a larger group. The biggest group I was able to ever handle last semester was eight people. We went through the five most likely short answers. All of us were friends, so it was difficult to keep people on topic sometimes. Also, some people wanted to think about the graphs for far deeper and longer than others did, so there were occasional conflicts of interest, as others only wanted to think up to the level necessary to ace the test. I was essentially the 'monitor' of the 'firm', because I organized and led the study group. I didn't have any paid incentive to keep the study group in check; it was more a matter of pride in seeing the group run well. If you really want a study group to run well, and no one has an intrinsic incentive to see the study group run well, you could give an incentive. Choose a person to be appointed as monitor, and then have each group member give a dollar to the monitor, contingent on the study session having been run smoothly. What will most likely happen is the monitor will refuse payment afterward, having gotten enough payment from the pride of having led the group. Of course, as Rustici says, people are greedy, greedy, greedy, and my prediction is likely wrong. Suck it up, pay a dollar, and get an A on the next exam.

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4. Teaching Teaching is an excellent study option in conjunction with group study. Some people will understand things more quickly than others, so those that have already learned the concept can ingrain the concept into their brain by teaching what they have figured out to others. Some natural econ students will be so far ahead of others that there will be no benefit to them to do group study, but if you study with students that are at the same level as you, then that problem will not occur. This was my favorite way of studying for economics in Econ 103. I was no natural, but I liked helping others and helping myself at the same time. If I could clearly explain a concept to other students, each of whom need it explained differently, I could answer any multiple choice or short answer question on the topic. 5. Previous Exams Studying previous exams is an excellent method for studying. There are ethical considerations to using previous exams, but a friend asked Rustici last year if he approved of studying with previous exams, and he is fine with it. Use the previous exams to go over the short answers – though you can guess them yourself, it's not a bad idea to make sure you're on the right track with the short answers. When doing the multiple choice, make sure you can both pick out the right answer and explain why all the other answers are wrong. If you can't do this, then you don't have a complete enough understanding to do well on Rustici's exams. Approach previous exams with the same methods as with anything else – do it yourself, think about it, and only then think it out in a group. Also go over the past examinations from the current year. Many concepts build on each other and will come back to bite you test after test. Make sure you know why your incorrect answers are wrong. Help others understand why their incorrect answers are incorrect; teaching others helps you.

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How to Think for Economics I didn't teach myself how to think – I learned the skill from far better thinkers than myself. A friend of mine handed me a book called “Thinking as a Science” early in the semester, written by Henry Hazlitt. He's the same guy who wrote the book “Economics in One Lesson”, which is recommended reading for Rustici's Econ 103 classes. That book should be required reading for every college student. Then again, if I had my way, an econ minor would be mandatory for all students at GMU. Unfortunately, I don't get my way too often. Instead, I present an example of how I think by displaying an economics concept which still confuses me: the speculator graphs. These graphs are covered at the end of the information specialist section, right before the third examination.

The first thing that I notice on this graph is that there is a downward sloping demand curve, as usual. Rustici gives a premise to the graph – speculators are expecting a drought in year two. Now, with these two things that I understand, I'll try to figure out the confusing muddle that is this graph. The next thing I notice is a vertical supply curve. Regardless of the price, suppliers will supply the same amount. This doesn't make sense to me – don't suppliers usually want to supply less at a lower price and more at a higher price? The only way suppliers would produce the same supply is if they are getting a constant price … from speculators! That was the whole concept of futures contracts – speculators offer farmers of wheat a constant price for an expected amount of wheat in the future. Rustici mentioned something about the formation of an intertemporal equilibrium price - a stable price between times. Why would prices be stable? Wouldn't there be higher prices when supply is lower and lower prices when supply is higher? So, in year two, when there is a drought, there would be higher prices, right? But speculators are expecting the drought. Speculators in year one must compete with each other, driving futures contracts up to the intertemporal equilibrium price. An assumption of this 11



entire speculator model has to be that speculators are the only ones buying wheat directly from producers. Speculators, by doing all the future predicting, allow farmers to focus on what they are best at – producing wheat. Futures contracts give farmers security of a constant revenue, contingent on their producing the amount specified in the futures contract. If they don't produce the specified amount, crop insurance can cover them by giving them money to buy crops to fulfill their contract. Now, let's look at the “Sold” line. I don't get this. Don't speculators buy up the entire supply? So, sold can't be referring to the speculators then … unless it refers to speculators selling to the consumers!The sold amount is the amount that speculators release into the market. In year two, the supply is less, so the speculators release stored wheat into the market, bringing down the price. This price of speculators in year one is $6, and the price of speculators in year two is $2. I don't understand exactly what the price of speculators is. Is it the price at which speculators are selling wheat to the consumers? If it is the price that speculators are selling wheat to the consumers, what exactly is the point of the speculator? Without speculators, wheat's price would $2 in year one and $6 in year two. All the speculator seems to be doing is switching the prices! The price of speculators and price of no speculators must have something to do with willingness to sell an amount at a certain price. I'm not sure exactly how this applies to the intertemporal equilibrium price formation, but I have a theory of how I can figure it out. When Rustici was teaching about price formation in general, he used the Mengerian auction model. The auction model is a hypothetical market of limited numbers of buyers and their upper willingness to buy, and sellers and their lower willingness to sell. The auction model ends with either a price formed or a bounds of price formation (i.e. $87-$90). I think that if Rustici gave us a hypothetical market with buyers, producers, and speculators, and showed step by step how an equilibrium price is formed, the speculator graphs would make much more sense. So, if I want to understand how the prices are formed, I either need to find or create a model speculator market showing the actions of individual buyers, producers, and speculators that create an equilibrium price. This is how I think in regards to economics. I keep questioning things I don't understand, come up with answers to those questions, and critique my answers. Then, I try to revise those answers, or I at least come up with new avenues I can explore to get a better answer. The way I think can be summed up as extremely critical – adopting the same mindset will help you as well. I don't expect you to understand my thought process for speculators, because you might not have covered it yet in class, and because you are not me. Everyone will think differently. My thinking isn't completely mine either. After thinking myself, I think through things with friends in order to clarify my thoughts and see what their thoughts are on a problem on the graph. When I took the final, there was an exam question on speculators. Though I did not understand everything there was to know about speculators, answering the question was simple. If you have done thinking beyond the level that Rustici is teaching, answering a question that Rustici has taught is easy. Think, and you will succeed.

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Part Two

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Assumptions of Economics 1) Scarcity - Limited supply of goods 2) Methodological Individualism - Economics is built on the assumption that only individuals act, not groups. 3) Rational Choice - Humans first allocate scarce goods to their highest needs. 4) Unlimited Wants - We never stop wanting. Positive vs. Normative Questions Positive - deals with causation Example Q: If I raise the minimum wage, will there be greater unemployment? A: Yes Normative - deals with policy Example Q: Should we raise minimum wage? A: Yes, because I'm a sadist and take pleasure in human pain History of Price Theory 1) Aristotle (300 BC): Equality of Exchange - Believed that we exchange things because they have equal value. - There is no incentive to trade in this theory, because you come out no better than before. 2) Scholasticism: St. Thomas Aquinas (Catholic theologian) - Believed that there was a certain just price to certain goods: Just Price Doctrine. - JPD is a normative theory, but we are trying to find a positive theory of price. 3) Mercantilism (1500 - 1776) - Believed that gold and silver bullion were the wealth of nations. - Hoarded gold bullion, limited imports and increased exports - Policy of : "The people may be poor, but the country is rich!" - Who cares how much gold the nation has when all the people are starving? 4) Physiocrats - First to consider that a spontaneous order may occur in a free market; a planned social order is not necessary - Made no advancements to price theory 5) Classicals - Adam Smith's "Wealth of Nations" (1776) - Exchange benefits both sides, because they have inverse valuation of goods being exchanged - "Invisible hand": unseen market forces allocate resources efficiently - Problematic price theory 1) Infinite regress in value 2) Labor theory of value 3) Objective theory of value 4) Relevant quantities are wrong

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Conditions for a Good 1) A human need - If there are no needs, there can be no good to fulfill it. 2) Properties of object that satisfy that need - If there are needs, the object must be able to fulfill that need. 3) Knowledge of causal connection between properties (2) and need (1) - We need to know whether or not an object fulfills our need. 4) Sufficient command (accessibility) - Can I acquire the object? Do I own it? - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 5) Scarcity (turns a non-economic good into an economic good) Menger's Principles 1) Value of goods of higher order is dependent on command of corresponding complementary goods. - If you need flour, water, and yeast to make bread, but there is no available flour, water and yeast lose some of their value, since their value comes from the consumer good - bread. 2) Value of goods of higher order is derived from corresponding goods of lower order. 3) Value of generalized factors of production are net exclusively dependent on satisfying any one particular human need. - For example, land, a generalized factor of production, is dependent on no one particular need for it to have value. It can be allocated in different proportions to fulfill many needs.

Prerequisites for Exchange 1) Inverse valuation - We both value what the other has more than what we have. 2) Both parties recognize inverse valuation - Similar to third condition for a good 3) Perceived ability to deliver goods (execute ownership) - Similar to fourth condition for a good 4) Perceived cost of trade is less than the perceived benefits (net benefits despite transaction costs) - When you sell something on eBay, the company takes a commission out of your sale. This commission is the transaction cost. Structure of Production The goods used to create the consumer good are called the factors of production or capital goods. One and two are goods of the second order, the next row up are goods of the third order, and the next row are goods of the fourth order. Consumer goods are goods of the first order.

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The Classicals believed that value went down the structure of production, meaning that the consumer good has value because valuable things went into its creation. According to Menger, value moved up the structure of production. The only reason the capital goods have value is because they go into the creation of something that has direct use value to consumers. The Classicals and Menger both knew that production went down the structure of production - bread doesn't create flour.

Menger's Auction Model Principles of the Auction Model 1) Consumer desiring the good most must exclude consumers desiring goods least. - Overbidding: consumers compete with consumers 2) Producer valuing goods least exclude producers that value the goods the most - Competitive undercutting (sellers compete with sellers) 3) Final exchange prices set between limits, defined by the maximum buying and minimum selling values at the margin 4) As more buyers and sellers enter the auction, the limits on price become narrower and narrower. Auction Model

Seller

Minimum Selling Price

Buyer

Maximum Buying Price

1

$100

1

$200

2

$125

2

$190

3

$148

3

$170

4

$165

4

$168

5

$172

5

$160

6

$175

6

$155

If you are given the above set of data, how do you figure out what the bounds of price formation are going to be? The price will be formed at the point that quantity supplied meets quantity demanded. How do you figure out that point? Good ol' guess and check.

Go through every possible marginal price (all the minimum and maximum prices above). Find what quantity is supplied and what quantity is demanded at each price. This has been done below.

$100

$125

$148

$155

$160

$165

$168

$170

Qs = 1 Qs = 2 Qs = 3 Qs = 3 Qs = 3 Qs = 4 Qs = 4 Qs = 4 Qd = 6 Qd = 6 Qd = 6 Qd = 6 Qd = 5 Qd = 4 Qd = 4 Qd = 3

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In this case, the bounds of price formation are going to be between $165 and $168. We can call these bounds the margin, as the least capable sellers and least capable buyers will be located in this area. Where the price occurs in these bounds depends on the bargaining skills of the buyers and sellers. If there were more buyers and sellers, the bounds would be narrowed into an exact price with dollars and cents. The auction model can get more complicated when we introduce buyers or sellers that want to buy or sell multiple units of goods. Buyers will want a lower price for their second unit, and sellers will want a higher price for their second unit. Keep with the same methods as before for figuring out the bounds of price formation, but make sure you are getting the correct quantity demanded and supplied. ---------------------------------------------------------------------------------------------------------------------------Normal vs. Inferior Goods Normal: As income goes up, demand for good goes up. (Rustici: Twinkies are normal goods.) Inferior: As income goes up, demand for good goes down. (Rustici: Ramen is an inferior good.) ---------------------------------------------------------------------------------------------------------------------------

Bill has five units of water. Because Bill is a rational being, he is going to allocate his units of water to his highest need first, and then to his lower needs. Bill's highest use for the water is to keep himself alive - he values this use of water more than anything else. After this use, he will use water for plants, to provide food for himself. The next unit goes to bathing, the fourth unit goes to washing dishes, and the fifth goes to keeping his car clean. If Bill lost one unit of water, or his fifth unit, he would have to give up keeping his car clean. Therefore, the fifth unit of water is the marginal unit. The use that this unit is put to - cleaning his car is the marginal utility of the fifth/marginal unit. The benefit that Bill gets out of having the marginal unit is the marginal benefit. As Bill gives up more units of water, he has to give up more important uses on his value scale. There is an increasing opportunity cost as Bill gives up more units of water. The opportunity cost is the value of the next best choice. Right now, the opportunity cost is the value that Bill puts to the health of his goldfish. However, if Bill gives up one unit of water, his opportunity cost becomes the value he puts to a clean car.

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Bill always allocates his units of water to his highest needs. Therefore, when he sells a unit of water, he will give up the least important need towards which water was being put towards. He might sell the unit of water that was allocated towards watering plants, but water currently being put towards his least important use would be reassigned towards the watering of plants. So, Bill's lower willingness to sell at a certain price is defined by the use which Bill has to give up to sell the unit of water. Since Bill has to give up progressively higher uses, his lower willingness to sell will increase with each additional unit of water sold. We have now arrived at the the Law of Supply, which states that as the price of the good goes up, the seller is willing to supply greater quantities of the good.

Imagine a consumer named Mary. Since Mary values her life higher than any other use of water, she is willing to pay one million dollars for the first unit of water. The second unit of water still has an important use to her - the watering of plants to satisfy her need for food. She is willing to pay $30,000 for water. The third unit of water is used to bathe, and Mary would be willing to pay up to $80 for the satisfaction of this need. If the price of water is $80, Mary is willing to buy three units of water. If the price of water is $81, Mary is willing to buy only two units of water. The money is worth more to her than the marginal benefit of an additional unit of water. As the price decreases, Mary, and all consumers are willing to buy greater quantities of the good - this is the law of demand. The graph on the right illustrates a demand curve. Demand curves are always downward sloping because of the diminishing marginal utility of each additional unit of a good. When I have more of something, it is put to a less and less important use. When you see demand curves for markets, think of them as the demand curves for many individuals and firms added together into one big demand curve. All those individuals' values are impounded into one demand curve.

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Price Equilibrium

When we put the supply curves and demand curves on the same graph, we are able to visualize the point where the quantity supplied equals the quantity demanded. This point is called the equilibrium point. What if the price isn't at the equilibrium point? On the above graph, if the price was $2, eighty units of the good would be demanded, but producers would supply 150 units of the good. This creates a surplus of 70 units. Sellers will undercut each other at this price. With the lowering of prices, consumers will be willing to buy additional units of the good. Eventually, we reach an equilibrium at a price of $1 and 100 units demanded. Conversely, if the price was 50 cents, eighty units of the good would be supplied, consumers would demand 150 units. This creates a shortage of 70 units. Consumers will overbid each other - as price increases, sellers will be wishing to supply additional units of the good. Again, we get back to equilibrium. The key understanding to acquire from the above graph is that price changes the quantity demanded and quantity supplied. A change in price does not shift the supply or demand curve in any direction. Only factors other than price can shift the curve itself from its current position.

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Shifting the Curves Every single Rustici exam will have a section which tests you on the forces that shift supply and demand curves. You will be presented with a scenario and asked to depict graphically what occurs to the supply or demand curves when this scenario occurs. For example, if the premier textbook producer in the world shuts down all its factories, what will happen to either the supply or demand for textbooks? This section of the test is supposed to be a complete gimme - you really should not lose a single point on this section in any of the exams. Some parts of this section can be confusing, but I will clarify them. It's important to understand the forces that are at work behind the shifting of the curves.

Imagine that the surgeon general has declared that bread cures cancer. What will happen to either the supply or demand for bread? Consumers will want much more bread, won't they? Since this scenario affects consumers, we can forget about the supply curves - it must have to do with demand. Now, we have to figure out whether the demand curve to shift to the right or to the left. A shift to the right is an increase in demand, and a shift to the left is a decrease in demand. Clearly, there will be an increase in demand due to the surgeon general's statement. The demand curves will shift before prices change. Therefore, there will be a temporary shortage of bread. Consumers demand 180 units of bread at the previous equilibrium price, while suppliers are only willing to supply 100 units of bread. As producers increase their price, the marginal buyers will be removed from the market, and there will be a new equilibrium point. There is a change in the quantity demanded and quantity supplied after the demand has shifted. When demand shifts, there is either greater or lesser quantity demanded at the same price as before. On curve D, 100 units are demanded at a price of $1, but on D prime, 180 units are demanded at that same price. A change in quantity demanded moves along the same demand curve, to a different price and different quantity demanded. The same rules hold for change in supply vs. change in quantity supplied. 20



One thing to keep in mind with these curve shifts is that they assume ceterus paribus - all other things are equal. In reality, multiple forces are moving at once. Economists isolate these forces to see what each individual one does. Adding these forces together and trying to judge their relative importance is beyond the bounds of an introductory economics course. This is primarily the domain of econometrics, where economists attempt to quantify these same principles that you learn in basic economics. For now, let us isolate the forces that shift supply and demand, and understand their effects. Changes in Demand Values of Buyers The example curve shift fits under this category. Bread moved up buyers' value scales after the announcement that it cures cancer. Scenarios in this category are pretty much common sense. If buyers value a good more, then the demand curve shifts to the right. If buyers value a good less, then the demand curve shifts to the left. Number of Buyers in Market If there are more buyers in the market, there will be a greater quantity demanded at the same price as before. Therefore, the demand curve will shift to the right. Conversely, if there are less buyers in the market, the demand curve will shift to the left - a decrease in demand. Income of Buyers If the good is a normal good, then as income of buyers increases, demand will increase. If the good is an inferior good, then as income of buyers increases, demand will decrease. A good way to the difference is that normal goods go along with the norm - in the same direction. For inferior goods, think inferior-inverse. Demand and income go in inverse directions go for inferior goods. Price of Substitutes If the price of cookies increases, then the marginal buyers of cookies will look to the substitutes of cookies in order to fulfill their needs. More consumers will look to buy brownies, increasing demand for brownies since there are now more buyers in the brownie market. If the price of cookies decreases, then the demand for brownies will fall, since consumers of brownies will shift consumption to cookies. The price of substitutes always moves in the same direction. Price of Complements Certain goods, like tea and sugar, go together. These goods are called complements. Imagine that the price of sugar goes up. Most people put sugar in their tea. Will they be more or less likely to buy tea now that the price of the complement has gone up? Since it is costing them more to consume tea and sugar together, they will be less willing to buy tea at the current equilibrium price. The price of complements always moves in opposite directions.

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Changes in Supply Number of Sellers in Market If there are more sellers in the market, the supply will increase - a shift of the supply curve to the right. On the other hand, if there are fewer sellers in the market, the supply will decrease - a shift of the supply curve to the left. Easy schmeezy. Technology New technology increases workers' productivity and decreases costs of production. It enables to suppliers to supply more of a good at the same price - an increase in supply, or a rightwards shift of the supply curve. Input Prices If the price of higher order goods (inputs) goes down, the costs of creating the consumer good (output) will go down. Therefore, producers will be able to supply a greater amount of the good at the same price, shifting the supply curve to the right. Conversely, if the price of higher order goods goes up, then the supply curve will shift to the left. Taxes and Subsidies Taxes and subsidies can be a bit more confusing than the other market forces, and more ambiguous as well. Therefore, they merit their own section. A tax is a punishment for taking a certain action. Imagine Farmer Joe, quietly producing his pumpkins. Then, the government enters and tells Farmer Joe they want a portion of his earnings - a tax. Farmer Joe will no longer be willing to sell as many pumpkins at the previous equilibrium price. Taxes shift the supply curve to the left. Subsidies are rewards for taking a certain action. If Farmer Joe, instead, was paid additional money by the government for producing pumpkins, he would have an incentive to sell more pumpkins than he was at the previous equilibrium price. The supply curve shifts to the right due to subsidies. Taxes and subsidies aren't always supply side - if the government offers a rebate on the purchase of textbooks, the demand for textbooks will rise. Most often, on exams, you will be tested on supply-side taxes and subsidies, but keep your eyes open for a demand-side tax or subsidy. In the previous example, it might seem like the benefits only go to the consumers buying the textbook, since they receive the subsidy. However, the benefits of this subsidy would go both to the consumers, with their cheaper textbooks, and to the textbook retailer, due to the higher prices from an increase in demand for textbooks. that the money for subsidies has to come from taxing something else. Subsidies are almost always wasteful and politically driven - a minority lobbies for a subsidy, getting major benefits while the costs are distributed throughout society. While one subsidy has little effect on Joe Plumber, hundreds of subsidies add up to exorbitant taxes.

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Price Controls

Minimum wages are minimum price controls - also known as price floors. You can't go below the floor/minimum. 1) We start out fine, at the equilibrium price. Markets are cleared, which means that the quantity that sellers are willing to sell equals the quantity that consumers are willing to buy. The supply curve and demand curves meet. 2) The government sets a minimum price control above the equilibrium price. 3) At the higher government set price, fewer people / businesses demand labor. 4) However, at the government set price, more people are willing to supply labor than before. 5) Since consumers are less willing to buy at a higher price, less quantity is demanded than before. The consumers are the short side of the market, the party that first stops trade. 6) These gains from trade could have been made without price controls, but now they have been taken away. This is called dead weight loss. 7) The consumer's surplus after price controls. 8) The producer's surplus after price controls. 9) Surplus of labor (unemployed laborers): the difference between quantity of people who are willing to work (quantity supplied) and the quantity of people willing to hire laborers (quantity demanded)

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The other type of price control is a maximum price control, or a price ceiling. You can't go above the ceiling/maximum. Rent controls are one type of maximum price control: the most famous case of rent controls is in New York City, though they are present in various forms around the United States and the rest of the world. 1) Markets cleared. 2) Government sets a maximum rent control below the equilibrium price. 3) At this lower price, fewer people are willing to supply the good. 4) But more people are willing to buy the good at the lower price. 5) Since suppliers are less willing to let go of their goods at a lower price, less quantity is supplied. In maximum price controls the supplier is the short side of the market. 6) Dead weight loss from maximum price controls. 7) Producer's surplus after price controls. 8) Consumer's surplus after price controls. 9) People that can't find housing anymore, but want it at the current price (housing shortage).

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The Law of Comparative Advantage - first described by the classical economist David Ricardo in 1817 - ability to produce something at a lower opportunity cost than others - opportunity cost: option sacrificed when taking a certain action/making a certain transaction - absolute advantage: ability to produce more than others, with the same amount of resources (greater productivity)

Example Smith Lawn Garden

40 min. + 60 min.

Jones Lawn

120 min. +

Garden

100 min.

Isolation = 100 min.

Isolation

= 220 min.

2 Lawns

- 80 min.

2 Gardens - 200 min.

Gains

=20 min.

Gains

=20 min.

This hypothetical scenario has two laborers, Smith and Jones. Assume that one lawn equals one garden. In this example, Smith can be said to have an absolute advantage in mowing lawns and gardening. Given the same resources and amount of time as Jones, Smith could produce more mowed lawns and well kept gardens. However, gardening has a higher opportunity cost for Smith than mowing the lawn does. Therefore, Smith will elect to mow lawns and trade mowed lawns for garden maintenance. Jones has a comparative advantage in gardening, so he will elect to garden. He trades maintained gardens for mowed lawns. In doing this, both Smith and Jones acquire gains from the transaction: 20 minutes in saved time. The gains from trade are not always equal; it just turned out that way this time. Sometimes the exchange ratio of one good to another is not the same. If one mowed lawn was worth two gardens, then you would need to double the amount of gardening done. Smith Lawn

40 min. +

Jones Lawn

120 min. +

2 Gardens 120 min.

2 Gardens 200 min.

Isolation = 160 min.

Isolation

2 Lawns

- 80 min.

4 Gardens - 400 min.

Gains

=80 min.

Gains

= 320 min. = -80 min.

In this new case, Jones would no longer have an incentive to trade, because he loses eighty minutes from trade. Jones would elect to work in isolation, though Smith would rather exchange services.

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Trade Always Balances

Don't expect to totally understand this section - you go far more in depth on it in Econ 104 and other upper-level macro classes. I will try to explain what I understand, but I have an incomplete understanding of the topic. In later editions of this study guide, I will expound on the topics based on what I have learned. As long as you can regurgitate this section on the test, you will be fine. There are two primary s that the government keeps track of - the current and the capital . The current adds up the value of goods and services moving through customs. The capital adds up foreign investment in the United States and U.S. investment in other countries to get net foreign investment. The sum of the current and capital should be zero, but there can be statistical errors. Current deficits are not necessarily harmful, because they imply that there is a capital surplus. Also, countries with current surpluses are not necessarily well off. The current doesn't properly take into some services. The USA has an enormous service industry healthcare, entertainment, advertising, financial, education, healthcare - but not all of these services are properly considered in the current . The underground economy isn't taken into either, because people avoid reporting these transactions. The underground economy includes explicitly illegal transactions (i.e. heroin) or under the table trade aiming to avoid taxes. Looking above, Japan and USA are trading cars and wheat. Japan sends greater real assets to the USA, so the United States gives $4 Billion of money, an IOU, to Japan, who can use this IOU for foreign investment. In this transaction, the current would stand at $4 Billion and the capital would stand at negative $4 billion, adding up to zero. The holders of IOUs have everything to lose because their property can be seized by the country where the IOU holders are investing their money. For example, foreign investment after the Soviet Communist Revolution was likely seized 'for the people', with the foreign investors getting nothing.

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Arguments Against Free Trade Protecting High Wages Argument: If we allow free trade, cheap foreign labor will undercut our higher wages! Answer: Wages are based off productivity, and the reason that we make more than cheap foreign labor is because we are more productive than they are. Our capital accumulation is the primary reason for this productivity. We have more human capital (i.e. knowledge/education), more resource capital (i.e. factories), and more social capital (i.e. roads). Our (relatively) strong protection of property rights allows for this productivity to go on unhampered. Think of it this way. An American laborer makes $10/hour and produces 5 shoes per hour. A Brazilian laborer makes $2/hour and produces 1 shoe per hour. If there is free trade with Brazil, American wages will not get chopped down to $2/hour. American and Brazilian laborers are receiving wages commensurate with their productivity. Saving Jobs Argument: Since we are losing all these jobs to other countries, we need tariffs on imports. Answer: The tariffs are always ed by special interest groups who derive benefits to their industries from the increased demand for their goods. The average person loses out due to increased prices and lessened competition. Also tariffs will cause dead weight loss, because some trades can no longer be made at the higher prices. This dead weight loss far outweighs the benefits to the special interest group. Dumping Argument: Those darn foreigners are selling their goods cheaper here than they do in their own countries (rough definition of dumping)! They're driving down our prices! Answer: Dumping is a gift. Special interest groups may suffer concentrated consequences from dumping, but these consequences add up to far less than the diffused benefits that go to all consumers of the dumped product. But since these consequences are so concentrated, special interest groups have an incentive to ban or restrict dumping. Reciprocal Trade Argument: We're buying their goods, but they won't buy ours! Answer: If you want "them" to buy your goods, then make a product worth buying! Unhampered trade is win-win, but if you force them to buy your goods, it will be a win-loss transaction.

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National Security Argument: Trading with foreigners is a danger to our country! Answer: What could be more dangerous to our country than to restrict free trade? If there are US firms in Iran, and Iranian capital stored in US banks, how badly will those countries want to go to war? Not at all, unless they want their property to suddenly vanish. Besides, you would have to go to extreme lengths to avoid a country from getting a certain good. Many goods will land up at transshipment ports before arriving at their end destination. From transshipment ports, goods go off in different directions. Transshipment can easily be used to smuggle goods into other countries and disguise the destination country of the good. You could stop trade altogether to avoid transshipment, but that has costs that far outweigh the relatively miniscule benefits. Costs 1. Sunk Costs - irrelevant, historical, past costs of production. 2. Total Fixed Costs - costs that do not vary depending on the level of production (i.e. rent) 3. Average Fixed Costs - Total Fixed Costs divided by Quantity 4. Total Variable Costs - costs that vary depending on the level of production (i.e packaging) 5. Average Variable Costs - Total Variable Costs divided by Quantity 6. Total Cost - Total Fixed Cost + Total Variable Costs 7. Average Total Cost - Total Cost divided by Quantity 8. Marginal Cost - Change in Total Cost divided by Change in Quantity Note on this Section: Rustici keeps the costs section simpler than most professors. He mentions the costs curves and spends a few minutes on them. If you are an economics major or minor, read Chapter 8 in depth. It covers the cost curves. If you have the workbook, do the exercises for Chapter 8. They help tremendously in understanding the cost curves. If you aren't an economics major, skim through chapter 8, because there may be multiple choice questions mentioning cost curves on the examination. Rustici may differ slightly in what he covers each semester, so if he covers cost curves, go to the book for help. In Fall of 2009, he barely mentioned cost curves. The Firm Ronald Coase held that the firm existed to reduce transaction costs. By organizing contracts under one central person - the owner of the firm / entrepreneur - there would be fewer transaction costs than under the price system, or market. Armen Alchian and Harold Demsetz agreed that firms reduce transaction costs, but they did not think this was the primary reason for their existence. They believed that firms existed for team-production the ability to create a whole that is greater than the sum of its parts. Two men working together can do more than when they work separately. Under team-production, however, it is difficult to see how one individual contributes to the output of the firm. Therefore, laborers have an incentive to shirk their duties. When they shirk, they are getting paid for more than their productivity. A monitor is hired to limit shirking. The monitor can also renegotiate contracts (hire and fire). The monitor's pay is at least partly tied to the good of the group as a whole. If the monitor shirks, the group won't do well, and he won't get paid very much. If he keeps everything efficient and limits shirking, he will make more money, due to the firm's success.

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Interest Rates Interest rate multiple choice questions confuse most everyone. Let's look at a previous exam, and how your thought process should go on this sort of question. 4. Suppose the exchange rate between dollar and yen is 1 dollar to 100 yen and then Japan runs a lower interest rate than America. Before the exchange rate adjusts, which of the following is true? A. The interest rate will fall in America. B. There will be an excess supply of yen in Japan relative to dollars. C. There will be a surplus of dollars in Japan relative to dollars. D. There will be a surplus of yen in America relative to dollars. E. The relative price of goods in Japan will fall compared to American goods. that we are looking at what is true before the exchange rate adjusts. As soon as people start trading currencies, the exchange rate will adjust. So we are looking at what is true before there is any exchange of currencies. Ceterus paribus, people would rather have a higher interest rate - they get more for their time. The higher interest rate is in America, where dollars are the currencies. Therefore, people would rather have dollars. So, there will be a surplus of yen in America relative to dollars. Couldn't we also say there is a shortage of dollars in Japan relative to yen? This is not an option on this multiple choice question, but it could have been a choice. You could say this, but there would actually be a shortage of all currencies in Japan relative to yen. If Japan suddenly runs a lower rate of interest, it will have lessened the demand for yen relative to all currencies. So, saying that there is a shortage of dollars in Japan relative to yen is true but incomplete. The better answer is to say there is a surplus of yen in America relative to dollars - Answer D.

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Elasticity Elasticity is a ratio between the percent change of one variable and the percent change of another variable. Those two variables can technically be anything, as long as they are quantifiable. For example, you could have the percent change in Mississipi population growth rates and percent change in number of wins by the NFC Central division champion. We tend to appreciate elasticities that are actually useful, however, and the aforementioned elasticity is pretty much useless.

One type of elasticity that is actually useful is the price elasticity of demand. It measures the sensitivity of quantity demanded to changes in prices. When the absolute value of the coefficient of the elasticity of demand is greater than one, we say that demand is elastic over the range being observed. When the absolute value of the coefficient is less than one, we say that demand is inelastic. In the above scenario, we are looking at a change in the price of a good from $12 to 10. This change in pice causes a change in quantity demanded from 50 to 100. This is a 100% change in quantity demanded and a -16.66% change in price. When you crunch the numbers, you get a -6 coefficient of elasticity of demand. For every -1% (or 1%) change in price, there is a 6% or (-6%) change in quantity demanded. Demand is elastic over the range being studied, since the absolute value of the coefficient of elasticity is greater than one. The negative sign merely means that you are looking at a demand curve. When demand is elastic, revenue increases with reduction of price and decreases with increases in price. The opposite holds when demand is inelastic.

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Income elasticity is calculated the same way as price elasticity of demand, except that percent change in price is replaced with percent change in income. Income elasticity of demand shows us whether a good is normal or inferior. If the good is normal, an increase in income should increase the quantity demanded, and a decrease in income should decrease the quantity demanded. If the income elasticity coefficient is positive, then the good is normal. If the good is inferior, a decrease in income should increase the quantity demanded, and an increase in income should decrease the quantity demanded. If the income elasticity coefficient is negative, then the good is inferior.

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Cross-price elasticity compares the percent change in the quantity demanded of a good to the percent change in price of another good. Cross-price elasticity shows us whether a good is a substitute or a complement to another good. substitutes always move in the same direction, meaning if the price of one goes up, the quantity demanded of the other goes up. But if the price of one goes down, the quantity demanded of the other goes down. Since the change in quantity and change in price of the other good will always have the same sign, the cross-price elasticity of substitutes is always positive. Complements always move in opposite directions, so if the price of one goes up, the quantity demanded of the other goes down. This is because it more expensive to consume the two goods which usually go together (i.e. tea and sugar). Since the change in quantity and change in price of the other good will always have different signs, the cross-price elasticity of substitutes is always negative.

If you're finding this all difficult, here is a simple acronym that should help with elasticity. 32



Elasticity Graphs

Elastic graphs have a slope with an absolute value under one, and inelastic graphs have a slope with an absolute value greater than one. But the coefficient of elasticity has an absolute value of greater than one for elastic graphs, and less than one for inelastic graphs. To the left is one of the lesser known stepchildren of economics - unitary elasticity. When the absolute value of the coefficient of elasticity is equal to one, you have a unitary elasticity In the unitary elastic portion of a graph, an increase or decrease in price will do absolutely nothing to revenue.

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While unitary elasticity is the unknown stepchild, these are the the genetically mutated monsters of economics. Very rarely actually present in reality, but still important to know. On the perfectly inelastic demand curve, people will keep buying the same quantity regardless of price. With the perfectly elastic graph, even the slightest increase in price will cause all demand to disappear. For example, if you charged $1.01 for one U.S. Federal Reserve Note (dollar bill), you would have zero quantity demanded. On the other hand, someone requiring a heart transplant with otherwise immediately assured death might have something very close to a perfectly inelastic demand curve for heart transplants. Determinants or Variables of Price Elasticity of Demand 1. Number of Available Substitutes - If there are more substitutes, a good will be more elastic, because you have more options to go to if the good you are currently using incurs an increase in price. But if you decrease the price of a good with lots of substitutes, many buyers of the substitutes will begin to use your good instead. If there are less substitutes, the good will be more inelastic, because there are fewer options for buyers. 2. % of Consumer's Budget Spent on Good - When a greater portion of your budget is spent on a good, your demand curve tends to be more elastic. While you may not notice a ten cent increase in the price of bread, a $1000 hike in the price of a car may stop you from buying it. 3. Time - Over time, all demand curves will become elastic. More substitutes and better technologies become available. If the price of gasoline goes up significantly, the demand for gasoline may be inelastic for a while. Eventually, people will look to alternative transportation - train, bike, bus - and alternative fuels - ethanol, hydrogen fuel cell, electricity. They also may create new technologies to fill their transportation needs, making the demand for gasoline elastic once again.

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The Law of Diminishing Marginal Returns - With the fixed input and the successive additions of a variable input to that fixed factor, at some point, the rate of output growth of the variable input begins to decline. Fixed Input Variable Input Total Output

Marginal Returns

1 acre

1 worker

10 Bushels of Wheat 10 Bushels

1 acre

2 workers


1 acre

3 workers


1 acre

4 workers


1 acre

5 workers


1 acre

6 workers

32 Bushels of Wheat -5 Bushels

1 acre

7 workers

30 Bushels of Wheat -2 Bushels

From 0 to 2 workers, there are increasing marginal returns. Firms will tend to expand when there are increasing marginal returns. From 3 to 5 workers, there are diminishing positive returns. Firms like to be somewhere in this area, at the point where marginal revenue equals marginal cost. From 6 to 7 workers, there are negative marginal returns. Firms will downsize once in this area, since there can be no benefits to producing additional units of a good.

Perfect Price Competition Model Learn this, and learn this well. Every exam after the first exam will have multiple choice and perhaps short answer questions on perfect price competition. The PPC model is something which never occurs in reality, but helps economists better understand reality. By relaxing the assumptions of the PPC model one at a time, we can explore entire new vistas in economics. Six Assumptions 1) Large numbers of buyers and sellers - as opposed to a monopoly or oligopoly 2) Free entry and free exit into the industry - no barriers to entry (regulation, licensing, etc.) 3) Everyone is a price taker; the market sets the price - as opposed to a price searcher market, where firms have to find point where MR=MC 4) Perfect and costless information - in real world, information search always has an opportunity cost, but not in PPC model 5) Perfect and costless mobility of resource inputs and outputs (zero transaction costs) - i.e. commission to broker when selling stocks 6) Homogenous goods - all goods are the same; no substitutes

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Here are two graphs - one for an individual firm in the perfect price competition model and one for the entire industry in the perfect price competition model. The firm is a price taker. Because there are so many buyers and sellers, no one firm's actions can effect the price - the firm must accept the price. If the firm decides to charge above the price, even by one cent, then it will sell no goods whatsoever, because it will be off the demand curve altogether. Since the price is $5 for everyone, the marginal revenue of each additional unit sold will be $5 as well. Also, average revenue (total revenue divided by quantity) will be $5. If the entire industry changes its price, it will not lose all its demand. Only a few of the marginal buyers will be lost. The equilibrium price for the industry in perfect price competition is the price that firms have to take. In the real world, there are price taker markets, where there are many buyers and sellers with the same price through the market. However, in the real world, there are costs, barriers to entry, and there are not necessarily homogenous goods. So, by reducing costs and offering better substitutes, sellers can compete in price taker markets. Implications of 6 Assumptions 1. Productive efficiency - goods are produced at least possible costs 2. Allocative efficiency - correct volume of output is being produced: no over or underproduction - there is a unit of the good for all buyers willing to buy at the market price (no shortage), but there are no extra units that buyers are not willing to buy at the market price (no surplus) 3. All the gains from trade are exhausted - no dead weight loss (because there is a unit of the good for all willing buyers) 36



Monopoly Most of the time, if there is one firm in an industry, or even one main large firm, we assume that they must be a monopoly. This is false - what identifies monopolies are their behavior, not their appearance. Monopolies vs. Competition 1. Monopolies restrict output. 2. Monopolies raise prices. 3. By raising the prices and restricting output, monopolies harm the consumer surplus (the area under the demand curve and above the equilibrium price). 4. Monopolies earn abnormally high profits. 5. Monopolies are inefficient (Dead Weight Loss) Single Price Monopolies Three Assumptions 1. High barriers to entry 2. No close substitutes available to the monopolized good. 3. Monopolist cannot sell all they want at the market price without changing the market price (price maker, as opposed to the price taker of perfect price competition).

The marginal revenue curve is always underneath the demand curve for a single price monopoly. If a single price monopolist wants to increase output, he will have to give lower prices to the buyers who were willing to pay higher prices. For example, at a price of twelve, buyers demand one unit of the good. At a price of eleven, buyers demand two units of the good. However, the marginal revenue of the additional unit is only ten, not eleven, because the buyer that was willing to buy at a price of twelve earlier now only has to pay 37



eleven.

This is the graph of the single price monopoly. Just like in the previous graph, the marginal revenue curve is under the demand curve. - in perfect price competition, the marginal revenue curve is the demand curve. If the marginal revenue curve is the demand curve, there is no dead weight loss, but whenever the marginal revenue curve is under the demand curve, there is dead weight loss. The single price monopolist restricts output from Q PPC to Q SPM and raises prices from P PPC to P SPM , which is the indicative behavior of any single price monopoly. By raising his price above the point where MR = MC, the single price monopolist can make abnormal profits. However, these profits cut into the consumer surplus. Note that the marginal cost curve is a flat line. The marginal cost curve is the same thing as the supply curve. Rustici's graph of the single price monopoly has the marginal cost curve horizontal, but you can make it upward sloping as well. Just realize that the supply curve is not missing in this example - it is the same thing as the marginal cost curve. Think of it this way - if there are certain costs to production (resources, information, transaction, bribes, etc.), you are going to need to be compensated at least as much as it costs you if you are going to be willing to produce any more units. The marginal cost curve is both the costs of producing an additional unit and the minimum willingness to sell of the seller. If he gets anything more than his minimum willingness to sell, that is a gain. As the marginal cost curve is flat, there would be no producer's gain in perfect price competition. However, the single price monopolist makes a monopoly profit. 38



Perfect Price Discriminating Monopoly Assumptions 1, 2, 3. Same as single price monopoly 4. Monopolist must be able to separate buyers (market segmentation). 5. Monopolist can prevent resale of the product.

This is the graph of a perfect price discriminating monopoly, as opposed to a price discriminating monopoly, because the monopoly is able to make every buyer pay up to his upper willingness. This type of monopolist takes all the gains from trade away from the buyer and to himself in the form of monopoly profits. A big difference between the single price monopolist and the perfect price discriminating monopolist is that there is no dead weight loss in a PPD monopoly. All the possible gains from trade are made, but none of those gains from trade go to the consumer. In a PPD monopoly, the marginal revenue curve equals the demand curve. Perfection rarely occurs in economic reality. However, price discriminating does occur - the best example is found in the airline industry. Airlines are able to roughly separate people into executive class, business class, and economy class, with little cost to themselves. Airline tickets can't be resold, 39



since you need to present an ID to get through security. Cartel A cartel is an explicit agreement between competitive firms, usually to raise prices and restrict output (like a monopoly). In the long run, cartels can only exist with the threat of force, courtesy of the state. Four Reasons Cartels Fail on a Free Market 1. Cartels have to stop the internal prisoner's dilemma and the incentive to cheat. 2. Cartels have to take on the policing and monitoring costs of catching cheaters 3. Cartels have to stop people from outside the industry from entering the industry. 4. Cartels have to stop all methods of non-price competition (i.e. buy an apple, get an orange free!). Below is a graph which illustrates a firm within a cartel.

In competition, the firm is willing to produce up until the point where Long Run Marginal Cost, the upward sloping curve, meets Long Run Average Total Cost, the u-shaped curve. After this point, LRATC begins to increase. In the above graph, this point is at Q quantity and 5 dollars. But now, the cartel wishes to raise prices to $8. Obviously, this will be impossible if they maintain the same level of production. So, the firms in the cartel collude to restrict output. However, at a price of $8, the firms within the cartel wish to produce up to quantity X. The firms in the cartel are placed into a prisoner's dilemma. They can be noble and uphold the promise to restrict output, but then everyone else might be cheating - producing more than the allotted amount. The 'noble' firms will lose out, and the cheaters will win. Most firms will elect to cheat, but since everyone is producing past what they would

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produce in a competitive market, prices will dip below the competition price. Looking at the graph, an obvious question presents itself: to what amount will the firms in the cartel have to restrict production? Rustici never answered this question, but after months of pondering, I may have an answer. The cartel graph has no demand curve for the firm. If there was a demand curve, we would just have to look for the point on the demand curve where price equals eight. The quantity demanded at $8 is the quantity to which this particular firm has to restrict output. Other firms in the cartel have to restrict output to the quantity demanded at $8 on their own demand curves. Contestability The idea of contestable markets comes from the economist William Baumol. While a market may have only one firm, that firm will lower price and increase output if there is the threat of other firms entering the market. If the single firm raises its prices and restricts output, other firms will quickly jump into the market. In order for a market to be contestable, there must be low barriers to entry into the market. Otherwise, it would take firms a while to jump into the market. If there is a single pencil manufacturer and many pen manufacturers, the pencil market may still be contestable. It would not be too difficult for the pen manufacturers to shift production from pens to pencils. You can't infer anything on the level of competition from the number of suppliers - monopolies are defined by behavior, not number of sellers.

41



Economics of Information

When we lift the assumption of perfect and costless information in the perfect price competition model, a new world opens up - the economics of information. Time is scarce, so while you might not have to directly give up money all the time to get information, you will have to give up time, and the opportunity cost of that time may be high. The above graph shows the basics of economics of information. You will search for information as long as the marginal benefit of searching is higher than the marginal cost. There may be more information after time Q, but it is no longer worthwhile to search for information at this point. The economist George Stigler came up with this insight.

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Middlepersons Just like one person might specialize in teaching, carpentry, or engineering, middlepersons specialize in acquiring and disseminating scarce information. Just because middlepersons do not produce anything tangible does not make them leeches on society. Go through the list of middlepersons below, and see how well anyone could function without them. Brokers These information specialists coordinate buyers and sellers. Stock brokers coordinate buyers and sellers of stocks. If you want to sell stocks, you don't have to get on the exchange yourself, shouting and screaming in the melancholy. You just have to make some clicks on your computer, and your broker sells stocks for you. The real estate broker allows you to pursue your comparative advantage instead of selling a house yourself. If you were to try to sell the house yourself, you wouldn't have to pay a commission, but you would have lost out in all the hours you otherwise could have spent at other work. The real estate broker has a comparative advantage in what he does - quickly selling your house at a sufficient price. Retailers You don't have to go to the grocery store to purchase mangoes. You could buy a plane ticket to India, buy the mangoes for cheaper than at your grocery store, and bring them back home. Thing is, you had to pay for the plane ticket and you lost out on time that could have been spent on other endeavors. If you take those costs into consideration, how expensive are your mangoes? Retailers bring information and goods closer to your proximity, and then charge a for this service Financial Intermediaries (Banks) Their service is to coordinate buyers of loanable funds (borrowers) and suppliers of loanable funds (savers). Without the bank, it would be difficult to find a decent interest rate as a borrower or saver. Banks can give borrowers and savers better interest rates than they would find alone.

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The bank's coordination of borrowers and savers is illustrated in the above graph. Without the bank, savers may only be able to acquire a meager 2% interest rate. Borrowers would have to put up with a 10% interest rate without the bank. The bank can coordinate these two parties - giving the borrower a much better 8% interest rate and the saver a 4% interest rate. The consumer's surplus/borrower's gain and producer's surplus/saver's gain increases due to the actions of the bank. The bank takes some of the interest for istrative costs and for it's own gain. Advertising What would happen if we got rid of advertising? We would probably have many more monopolies, for one. This connection may be hard to see if you don't understand the purpose of advertising - to provide scarce information. If a firm is acting like a monopoly, increasing price and restricting output, new firms can their cheaper prices to the public, reducing the costs to the consumer of searching for a cheaper product. If the customer doesn't have advertising, they won't know what their options are. Speculators (I go more in depth on this in the Part 1 section titled How to Think for Economics) 1. Acquire scarce information about future. 2. Stabilize price through time. 3. Shift risk liability from producers to themselves with a futures contract. 4. Allow others to pursue their comparative advantage

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Economics of Income Determination This section is a very simple overview of how income is determined for three groups: entrepreneurs, workers, and savers. You are not expected to have more than a basic understanding, so don't stress too much if this section confuses you after you have reviewed it - some things still confuse me. Entrepreneurs An entrepreneur's income is determined by profits or losses. ing profits are measured as revenue minus expenses of the firm. An entrepreneur may have ing profits, but if his opportunity cost is greater than his ing profits, then he has economic losses. When you calculate economic profits, you consider the opportunity cost of the entrepreneur's capital. This includes alternate uses for physical resources (i.e. lumber, ore, etc.) and human capital (i.e. the entrepreneur's labor). Imagine three industries: apples, oranges, and mangoes. The rate of return on investment in the three industries is 10%. Everyone is making ing profits, but nobody is making economic profits, since the rate of return is equal in all industries. Now, imagine that Indians begin to flock to the United States, raising demand for mangoes. The rate of return on investment for mangoes becomes 14%. Now, mango entrepreneurs are earning economic profits, since their opportunity cost - investing in apples and oranges - is less than their ing profits. On the other hand, apple and orange entrepreneurs will now be taking economic losses, but they still have ing profits. Apple and orange entrepreneurs will want in on the juicy mango action, so they will dash to the mango industry. The rate of return in the mango industry will fall back as the additional producers undercut each other. With fewer producers, the rates of return on investment in the apple and orange industries will rise, until all three industries arrive at a general equilibrium once again. Workers Workers receive real wages (wages adjusted for inflation) commensurate with their productivity. If one of your workers is making less than his productivity, a competitor will offer him a higher wage which is commensurate with his productivity. However, someone's productivity isn't going to suddenly go up when you give them higher wages - they'll just pocket the extra money and laugh at your stupidity. The clearest example of this is in baseball. Bad contracts occur when someone is paid far more than their productivity. If you offer a mediocre pitcher 45 million for four years, he isn't suddenly going to become a number one or number two pitcher. He'll still be mediocre. What really got rid of child labor was education and technology. Human capital and resource capital improved workers' productivity, which therefore increased their wages. So now, children don't have to work, because most parents are able to make enough to feed their families without the kids' help.

45



Unions best show how productivity is solely what increases the overall real wage. Unions purport to raise the wage for all workers - union and non union. This is completely false. They limit the supply of union workers through certification, licensing, regulation, and simply not allowing people to the union. Then, through the state, they force producers to employ union workers. By limiting the supply, they have increased the wages for union workers. However, all the people who want to the union but are barred from doing so the non-union labor force. The increased supply of non-union labor depresses the wages of non-union labor. Union workers largely get paid more than their productivity, while non-union workers, on average, get paid less than their productivity. Income Effect and Substitution Effect In the short run, as real wage goes up, the quantity of labor supplied goes up as well. If my boss calls me and asks me to do overtime on Friday for triple pay, I'm probably going to do it. But in the long run, I might start working less if I have triple pay. When I have more money, I begin to put more value to leisure. The short run effect is the substitution effect - as real wage goes up, quantity of labor supplied goes up, and as real wage goes down, the quantity of labor supplied goes down. The long run effect is the income effect - as real wage goes up, quantity of labor supplied goes down, and as real wage goes down, the quantity of labor supplied goes up. The reason we have shorter work weeks and more leisure time than our ancestors is because of the increases in productivity and real wage.

46



Savers The income of savers is based on the value of time. As usual, this is more easily seen on the graphs.

The good presented above is loanable funds. The people that demand loanable funds are the borrowers, while the people that supply loanable funds are savers. People always have time preference - they prefer a good now rather than later. So, how much of a good in the future is needed for someone to give up the good now? Everyone has their own answer to this question. One person might need ten percent more of a good in a year in order to give it up now, while another may only need two percent. When you take all these preferences together, you get the supply curve for loanable funds. The demand for loanable funds works in a similar way. How much is a person willing to pay in the future in order to get the good now? When you take everyone's different willingness to pay in the future, you will get the demand curve for loanable funds. The equilibrium price that forms is the interest rate. People who value time at more than the interest rate are the borrowers. People who value time at less than the interest rate will be savers. Outside events can shift people's tendencies to be borrowers or savers. For example, if a meteor was expected to strike tomorrow with 99% certainty, demand for present goods would increase crazily. Interest rates would accordingly shift to insanely high levels.

47



The PV Formula is a way of calculating the present value of future goods. Above, the present value of $80,000 payed over the course of 3 years is calculated. The first installment is payed immediately, the second after a year, the third after 2 years, and the last after 3 years. If there is a higher interest rate, the future good will have less worth in the present. In the above example, the present value comes out to $74, 463.

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Economics of the Environment The economist A.C. Pigou was the first to articulate the concept of negative externalities. When a firm produces something, many of the costs of production go to the firm, but not all of the costs. For example, a factory emits pollutants which harm the air quality of surrounding areas. These extra costs are called social costs. Pigou said that when you take social costs into consideration, the socially optimal quantity of production is less than the free market quantity. According to Pigou, we should see the failure to take negative externalities into consideration as a failure of the market. Pigou believed that taxing the producers up to the socially optimal level would fix this failure of the market.

On the graph, the social costs curve is higher than the private costs curve. The area between the private cost curve and the social cost curve is the negative externalities - the costs that aren't considered in the private cost curve. The socially optimal quantity is less than the free market quantity. The free market price is below the socially optimal price. The economist Ronald Coase countered Pigou's conclusion that negative externalities are a market failure. Instead of being a market failure, Coase showed that negative externalities are a failure of the government. The government is who we look to in order to enforce property rights. If someone treses, they can be fined in the government's courts. However, since no one owns the water or the air, anyone can do what they want with it. The term for publicly owned air, water, and land is 'the commons'. No one has a strong incentive to look after the commons, since the costs of taking care of it go to few and the benefits go to many; there is no residual claimant on the commons. Garret Hardin, an ecologist, called this 'the tragedy of the commons' in his identically titled paper. 49



Public Choice: The Economics of Politics Just like there is a dichotomy between economic and non-economic goods, there is a dichotomy between public and private goods. The economists Paul Samuelson and Francis Bator were the first to define public goods. Four Characteristics of Public Goods 1. Non-rivalrous consumption: one person's consumption of the good does not leave less of the good for others to consume. 2. Good tly consumed - people consume the good together; they don't take turns consuming it. 3. Chronic freeriding - consumers strategically do not pay producers for their output 4. Not economically feasible or viable to exclude the freerider If a good has the above four characteristics, the idea is that it will be under produced by the free market. Therefore, it has to be produced by the government - making it a public good for all. For example, national defense fits the above criterion. Everyone consumes the good together, one person's use of national defense doesn't leave less for others, people can benefit from national defense without paying for it, and it is not feasible to exclude those free riders. Since it is under produced on the market, the argument goes, this is a market failure and should be fixed by the government. This argument has some critical problems. Problems with Public Goods Theory 1. While market failure may be a necessary condition for government action, it is not a sufficient condition. Just because the market has failed does not give the government license to do whatever it desires. The government is not some angelic nirvana. It is composed of humans, who are at least as fallible as the individuals in the market. 2. Just because underproduction leads to market failure, the government does not necessarily produce the optimal level. Too often, the government overproduces - the arms race between the USSR and the USA is a perfect example of this. The opportunity cost of all the capital that was put into creating nukes is immense. Often, overproduction is far more dangerous than underproduction. 3. If you tie a private good to a public good, you have a private good. Radio is a public good, but radio stations put ments onto the radio broadcast. This turns it into a private good, because radio stations capture some of the gains from people's free listening of radio. Modern Public Choice Public choice is the application of economics to political science. In 1907, the economist Knut Wicksell was the first to recognize the need for a theory of politics. Anthony Downs wrote An Economic Theory of Democracy, which was the first positive look at democracy (as opposed to normative). Most important among the founders are James Buchanan and Gordon Tullock. These two former George Mason economists wrote the book The Calculus of Consent, which is now considered a classic work in public choice.

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Three Primary Political Players Type

Maximum Incentive

Rule

Politicians

Vot es

50% + 1

Voters

Gain/Rent-seeking

What have you done for me lately?

Bureaucracy

Budget

Use it or lose it

Politicians To see how politicians are driven by incentive, we look at one of the most important models in public choice - the rational voter model. Five Assumptions 1. Single issue (not health care and war in Iraq - one or the other) 2. Two political parties 3. Parties want to maximize the vote for their candidates 4. Spacial mobility over the political spectrum - you can change your position on the issue 5. Single peaked preferences (one mode)

There are two parties in the graph to the right : the left and the right. 'D' represents the winner of the Democratic primary while 'R' represents the winner of the Republican primary. During the primaries, candidates will try to position their views in the middle of their party, in order to capture the most votes. However, since the Republican shifts his position to R prime after the primary, he will likely win the overall election by claiming some of the rightward leaning Democrats. Some of the assumptions can be seen on the graph. There is one mode (point with most number of votes), only two parties, spacial mobility (Republican shifts views). 51



Five Implications 1. Candidates will label their opponents as extremists - radicals can not get much of the vote. 2. Each candidate claims to be the moderate - the closer you are to the middle, the better your chance of getting elected. 3. If you're behind in the polls, you start sounding like your opponent (because you are trying to get closer to the middle). 4. Primaries are more ideologically driven than the general elections, because candidates only try to get the votes of one party in primaries, where as they cater to both parties in general elections. 5. Candidates will speak in generalities and avoid all specifics, in order to avoid polarizing voters. Voters While the incentive that drives politicians is votes, the incentive that drives voters is gains from politicians. The specific term for this is rent-seeking. Rents are gains above opportunity cost through the political means. It does not necessarily always make sense for voters to vote. This can be seen through the returns to voting equation. In the example equation, there are two candidates and the benefits to a certain voter of voting for candidate A is $1000 (difference between benefits of Candidates A and B). However, because of the miniscule chance that the voter's vote actually effects the election results, the returns to voting are -$19.99 and civic pride. Voter A has to have significant civic pride to make it worth his while to vote. Also, the voter will often not bother to educate himself on an issue, since the costs of doing so are greater than the benefits. Special interest group form to reduce the rational ignorance of voters. For example, the AFL-CIO, a federation of labor union with millions of , can collect dues from all its . Then with its money, it can set up shop in DC, hire high-profile lawyers, and leverage its clout to increase the benefits to its union . Then, they can get back to their and tell them which candidates to vote for based on which ones offered them the greatest benefits. Special interest groups are powerful because the benefits are concentrated to their , but the costs are diffused through the general population. One thousand biologists will vote for a candidate offering them $25,000 in straight cash, but 100 million taxpayers will be rationally ignorant about the 25 cents they are each giving up to the biologists.

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Bureaucracy Bureaucrats work nothing like entrepreneurs. While firms on the market want to minimize costs, bureaucrats work to maximize costs. Bureaucrats want as much money as possible allocated to their department, but if they don't spend all that money, less money will be allocated to them the next year. Since there is no owner or residual claimant of a government department, nobody has an incentive to minimize costs. Bureaucrats are rewarded for inefficiency and punished for efficiency. Differences between Private and Political Markets Private

Political

Bait-n-switch (punished)

Bait-n-switch (rewarded)

Every penny counts (profits) Not every vote s Individualised purchases

Bundled purchases

Return policy (easy)

Re election cycle: 2, 4, 6 years

Acquire information

Rational Ignorance

In private markets, if you promise your customers a price on a good and then renege on that promise, but offer a supposedly excellent substitute, you get arrested for fraud. If you lie in political markets, you get elected and stay in office for four years. In private markets, every penny counts. But in political markets, all that matters is half the vote and one more in most elections. In other cases, other percentages of votes counts, but rarely does every vote count. In private markets, you can buy your goods separately. You don't have to buy sugar, thermometers, and highlighters when you want an apple. In political markets, you have to vote for candidates with many different positions on issues, depending on which lobbyists are influencing him. In private markets, the return policy is easy. Go to the store, show your receipt, get a refund. In political markets, it is almost impossible to impeach a politician, and you have to wait many years to re elect someone. In private markets, there is a great incentive to acquire information. But in political markets, your vote has such a small chance of affecting your life that voters choose to be rationally ignorant.

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Part Three Tutoring Last semester, I offered free economics tutoring to anyone who wanted it. I tutored students taking Econ 103 with Bennett, Gillepsie, and Rustici, so I had to learn microeconomics as it was taught by all professors. This gave me a more complete understanding of microeconomic principles, since not all professors cover the same things or in the same depth. This semester, I am no longer offering free tutoring. I have a variable rate per concept. After getting through the class, I've figured out which concepts require more time to understand and which require less time, so I adjust my rates accordingly. If you are interested in tutoring, you can find information at http://econhelp.org/tutoring/ . Obsessive Economics Majors I am always looking to meet up with people that are obsessed with economics. If you're one of the students who reads Principles of Economics, dreams about indifference curves, or is seriously considering economics graduate school, please send me a message through the form at http://econhelp.org//. I'll make time to get lunch or meet up with you. Additional Suggested Economics Resources Mises.org : This website has an absolute wealth of knowledge on economics. There are hundreds of free books, podcasts, and instructional videos online. If any topic in economics interest you, this website probably has something on it. One particularly interesting essay on the website is called Jonesin' for a Soda, which explains why Jones Soda is as expensive as it is. Thinking as a Science : I mentioned this book before, and I'll mention it again, because it is that important. It was written by Henry Hazlitt, the same man who wrote Economics in One Lesson. It provides an entirely new outlook on learning - emphasizing the importance of thinking over regurgitating. The book gives practical advice on becoming a better thinker - which is crucial to learning economics. Econhelp.org I created this website to help others learn economics. There are new articles every Thursday and Sunday. The articles on the website fit into three categories: explanation of economic concepts, tips and tricks for learning economics, and miscellaneous. The miscellaneous category includes some of the more interesting econ-related things that I see in life. The economic concept category will evolve as I get closer to becoming an economist - so keep checking back on that for future classes. And the econ learning section will also keep being advanced, because I'm obsessed with figuring out the most efficient ways to learn economics.

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