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Ec102 Notes

Economics Notes > EC102 - Economics B Notes

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EC102: Economics B

SECTION A: INTRODUCTION Lecture 1: The Market Economy Scarcity & Economics

* All resources (natural, human, capital) are scarce ---> people and societies among a limited set of possibilities

* Economics: study of how people and societies deal with scarcity

* All societies must answer 3 questions: (1) What is to be produced? ---> consider opportunity cost (value of the most highly valued forgone alternative) when making decision (2) How is it to be produced?
(3) Who gets the output?
- Questions answered through allocation of resources (how society's resources are divided up among various output, among the different organisation that produce these outputs, and among the members of society)

* Study how economies work using models (simplified description of some aspect of the economy, often using equations and graphs), which are used to create theories. Theories must satisfy 2 requirements (1) Must accurately describe large set of observations on basis of a model that contains only few arbitrary elements (2) Must make definite predictions about result of future observations

* Two Levels of Analysis: Positive & Normative
- Positive: Statements of cause & effect ---> why things go the way they do
- Normative: Statements that embody value judgements ---> are things going the right way

* Scarce resources can be allocated in 3 specific ways: (1) Centrally planned/command economy (e.g. North Korea) (2) Market economy (e.g. UK): Buyers bring demands to market, sellers bring supplies, prices adjust to supply meets demand controlled by market mechanism
- Market mechanism works through price adjustment ('invisible hand')
- Role of Prices: convey information; ration scarce resources; determine income (3) Mixed economy (e.g. China)

* The Circular Flow Model: Representation of how business and household sectors are linked
- 2 Sectors: Households & Businesses
- 2 Circles: Inner circle shows physical flows (flows of G&S and of inputs); outer circle shows monetary flows (expenditures that households make for G&S and that businesses make for inputs)
- Indicates markets somehow regulate flows between the two sectors
- Model amalgamates all firms into single sectors
---> ignores transactions taking place among firms
- Assumes all production takes place within business
- Ignores government

EC102: Economics B

SECTION B: THE HOUSEHOLD Lecture 2: Consumer Choices - Tastes & Constraints Consumer Choice 3 steps involved in understanding consumer behaviour: 1) Consumer's preferences (tastes) --->
knowing what customer wants 2) Budget constraint ---> knowing what customer can do given limited income and prices 3) Combining 1&2 ---> determine which feasible choice maximise well-being Economics cannot judge whether an individual's goals are sensible; they can only say whether or not an individual is attempting to attain his or her goals in a rational fashion Preferences/Tastes

* Although millions of commodities exist to keep things simple assume only 2 exist --->
makes problem simple without losing essential aspect

* 2 commodities can be combined in different quantities to obtain different bundles which give different utility to the consumer

* Consumer tastes satisfy 3 assumptions ('axioms'): 1) Completeness: When confronted with any 2 bundles, consumer can tell which one they prefer or whether they are indifferent (able to rank them) 2) Transitivity: Preferences are consistent in sense that if bundle x is preferred to y, and bundle y is preferred to z, then x is preferred to z 3) Non-Satiation: More is better 4) Diminishing MRS: MRS falls as we move down along indifference curve Indifference Curves

* If axioms satisfied, preferences can be graphed as indifference curves (set of bundles among which a consumer is indifferent because they give the same utility) --->
indifference curve for each utility

* Indifference Map: Collection of indifference curves

* Axioms and Shapes 1) Completeness: Any bundle is on an indifference curve ---> no blind spots 2) Transitivity: Curves do not cross (but do not have to be parallel) 3) Non-Satiation: Curves are downward sloping 4) Diminishing MRS: Look like smiles from origin
- Curves lying to the NE represent higher levels of satisfaction
- Shows what customers want to do Budge Constraints

* Shows feasible consumption bundles when income and prices are given

* Accounting identity stating that consumer can spend no more than income ---> feasible bundles (x,y) must satisfy Px [?] x + Py [?] y = I , therefore: I [?] Px [?]
y=x Py [?][?] Py [?][?]

EC102: Economics B

* Budge Constraint: Relative Price Change (left)
- An increase in the price of a commodity moves the budget line in along the axis of the good whose price has increased

* Budge Constraint: Change in Income (right)
- A decrease in income, other things being the same, induces a parallel shift of the budget constraint towards the origin Relative Price Change

Change in Income

Non-Linear Budget Constrains

* Linear budge constraints assume consumer is price take, however not always the case; non-linear in times of: Quantity Rationing: Feasible bundles in shaded area

Quantity Discounts: When price per unit of a commodity depends on the number of units purchased

EC102: Economics B

Lecture 3: Consumer Choices - Demand Consumer Equilibrium:

* Indifference map shows what a consumer wants to do, budget constraint shows what a consumer can do ---> consumer chooses bundle where budget constraint is tangent to indifference curve (i.e. the bundle of commodities that for the maximum level of utility given income and price)

* Blue curve unfeasible as it lies above budget constraint

* Yellow curve does not use whole income --->
involves throwing away money

* Example of interior solution (where equilibrium bundle contains some amount of each good)

* At equilibrium bundle MRSyx = px/py (i.e. if consumer's MRS is not equal to the price ratio, then income could be better reallocated between 2 goods, as MRS shows rate at which consumer is willing to trade one good for another and the slope of the budget constraint is that rate at which the consumer is able to trade one good for another ---> in equilibrium must be equal)

* Corner solutions: an equilibrium bundle in which the consumption of some commodity is zero; consumer's choice problem is characterised by an inequality between MRS and the price ratio where MRSyx [?] px/py

* Equilibrium with Composite Commodities: Divide budge between desired commodity (e.g. DVDs) and a composite of all goods other than DVDs ---> each point on indifference curve shows how much income the consumer is willing to give up on bundle of 'all other goods' for one extra DVD

* Equilibrium can also be characterised in terms of marginal utility (change in total utility associated with consumption of one additional unit of a good) where MUx/MUy = px/py Comparative Statistics

* Process of comparing two equilibria (when consumers adjust behaviour) after income and relative prices changes ---> important for firms/policy makers to understand

* 3 step strategy to compare: (1) Determine equilibrium before change (2) Find equilibrium after change (3) Compare bundles

* 3 Cases: (1) Own Price Changes: Impact of changes in the price of a good on its QD (moves the budget line in along the axis of the good whose price has increased)
- From this can derive individual demand curve using price-consumption curve (set of commodity bundles traced out as commodity price varies, cetaris paribus)

EC102: Economics B

(2) Cross-Price Change: Impact of change in price of one good on the QD of another
- Substitutes: Two goods that satisfy similar wants ---> increase of price of one good leaders to increase in QD of substitute
- Complements: Two goods that tend to be used together ---> increase in price of one leaders to decrease in QD of complement (3) Income Changes: Impact of change in income
- Decrease in income (represented by parallel shift of budget constraint inwards) usually results in a decrease in consumption and vice versa ---> normal goods
- However possible for increase in income to result in decrease of consumption --->
inferior good
- Can be used to derive income-consumption curve (set of equilibrium commodity bundles traced out as consumer's income varies) ---> used to derive Engel curve Elasticities of Demand (1) Own-Price Elasticity: % change in QD of good when price changes by 1% = -(1/s)(P/x)
- Considered inelastic when PED < 1; elastic when PED > 1; Unitary when PED = 1
- Linear Demand Function: X = a - b * p ---> PED = -(1/s) * (p/X) = b * (p/x)
- Therefore elasticity varies along demand curve: PED < 1 below midpoint, > 1 above midpoint, = 1 at midpoint (2) Cross-Price Elasticity: % change in QD of good x when price of good y change by 1%
- Substitute if XED > 1; Complement if XED < 1; No relation if XED = 1 (3) Income Elasticity: % change in QD of good when income changes by 1%

EC102: Economics B

Lecture 4: Household Choice - Consumption, Labour Supply and Welfare Household as Consumer-Worker

* The single most important source of income for households is labour

* Individuals have only a certain amount of time at their disposal per week, some time is devoted to work and the remainder to non work activities (leisure)

* An individual derives utility from leisure and consumption of goods:
- To buy goods the individual has to earn income; to earn income the individual has to give up some leisure ---> trade-off between leisure and consumption

* The problem the consumer worker solves is to find the combination of leisure and consumption that maximises utility ---> consider consumption and leisure is commodities and use indifference curves Price of Leisure

* Individual has T hours of time available per week and allocates them between n hours of leisure and I = T - n hours of work
- Time endowment: the upper limit of time that can be dedicated to labour or leisure by an individual in a specified period

* For each hour worked the individual earns hourly wage w; equivalently, for each hour of leisure the individual foregoes hourly wage w

* The hourly wage w is the opportunity cost and therefore the price of one hour of leisure

* Feasible bundles of leisure and consumption (n,c) must satisfy:
- W * n + Pc * c = Income = W *T

* Comparative statistics within the consumption leisure model
- Wage reductions reduce opportunity cost for an hour of leisure
- Depending on person, individual will either work more to make up for loss of wage, work less as opportunity cost of leisure is lower, work the same
- When wages go down, the consumption of goods and services becomes more expensive. This means the worker has to give up more leisure for each unit of consumption. Hence there is a tendency to substitute leisure for consumption, that is, to decrease labour supply. Labour Supply Curve

* Shows relationship between quantity of labour supplied and wage rate; has ambiguous slope due to :
- Substitution Effect: As leisure become more expensive, the individual reduces leisure and increases consumption
- Income Effect: As full income increases, the individual can afford more leisure even if it now more expensive
- Therefore effect of wage decrease depend on individual and whether income effect dominates substitution effect (downward sloping curve) or substitution effect dominates income effect (upward-sloping curve)
- Curve can also be backward bending (when substitute effect dominates at low levels and income effect at high ones) Welfare

* Normative analysis requires definition of some measure of welfare to evaluate alternative scenarios ---> can be represented on demand and supply curves

* It is based on the concepts of consumer surplus and producer surplus
- Consumer Surplus: Difference between what a consumer is willing and able (found using demand curve) to pay and what they actually pay (going price)

EC102: Economics B

- Producer Surplus: Amount of income an individual receives in excess of what they would require in order to supply a given number of unity ---> are below going price and above supply curve
- When price increase consumer surplus decreases and producer surplus increase
- Application: Trade Quotas ---> result in losses of consumer surplus which is transferred to overseas produces ('quote rents') and dead weight losses
- Compensated Demand Curve: Shows how QD of a commodity varies with price, holding utility constant; gives exact measure of how much consumer is willing to pay (differs from original demand curve in that it only show substitution effect ---> not observed response to price change)

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