Economics definitions Introduction 1. The Foundation * People respond to incentives ©. Incentives: benefits and costs ‘An improvement in the benefits or a reduction in the costs associated with an activity will cause more people to engage in said activity and vice versa. People respond to incentives. © Types of incentives Moral — Activities that make you feel good about yourself or that align with your moral compass Financial = Money, Material gain etc. Physiological/Emotional - Pleasurable activities Social — Praise and other forms of social approval. Also, shame ostracism ete. © Resources are scarce Scarcity — The basic economic problem of trying to satisfy societies unlimited wants with limited resources, Opportunity Cost - The best alternative forgone by making a choice. © Real values matter Real vs Nominal — Real values account for the quantity of goods and services while Nominal values account for both prices and the quantity of goods. Nominal values = Currency; Real Values = Quantity. © Prices reflect scarcity Markets — An area for commercial trades. ‘The market allows for adjustments in price due to real or expected changes in market conditions (demand/supply) © Returns eventually diminish The Margin - The point where the last unit is produced. Marginal Product - The additional output derived from employing an additional unit of produetion. Marginal Utility — The additional satisfaction derived from consuming an additional unit.Law of diminishing returns — Given all other factors being equal, additions to one factor will eventually result in diminishing retums. The Toolbox 2. The Market Model * Demand © Demand Schedule — A table showing the relationship between quantity demanded and price. © Demand Curve - The line relating price and quantity demanded. It shows how quantity demanded varies with price. © Factors that influence demand Prices of Substitutes and complements Consumer tastes Expectations Number of Buyers * Supply © Supply Schedule ~ A table showing the relationship between quantity supplied and price. © Supply Curve - The line relating price and quantity supplied. It shows how quantity supplied varies with price © Factors that influence supply Technology Expectations Number of Sellers Factor Costs © The Market © Market Clearing Equilibrium — The level at which quantity supplied equals quantity demanded * Special Cases © Fixed Supply (vertical supply curve) — Indicates that the quantity of goods is fixed no matter what price is. (Perfectly inelastic © Constant Cross (horizontal supply curve) — Indicates that the quantity of goods supplied depends on the demand curve. Quantity supplied can scale no matter what. (Perfectly elastic© Price-taking (horizontal demand curve) — (Perfectly elastic demand curve! May occur when there's only one buyer in the market and so a change in price results in 0 demand * Welfare © Consumer Surplus ~ The difference between the market price and the price that a consumer is willing to pay for a product. © Producer Surplus — The difference between the market price and the price that a producer is willing to supply a product for. © Deadweight Loss — A loss of economic efficiency that occurs when equilibrium isn't achieved. © The Optimality of Equilibrium — A state of allocation where it is impossible to reallocate to make someone better off without making someone else worse off. 3. Specialization and Trade * Benefit of Corporation © Comparative Advantage - The ability to produce a good at a lower opportunity cost than another producer. * Production Possibilities Frontier — A curve which shows the possible combinations of two goods that an economy can produce with a fixed amount of resources. * Consumption Possibilities © Gains from Trade - The increase in benefits an economy receives from trading with another economy. © Determinants of Welfare Resources Productivity Terms of Trade © PPF with diminishing returns — Bows Outwards 4. Market Failures * Externalities — A cost or benefit that affects a third party of a transaction. © The tragedy of the Commons — A situation in which a common good is depleted due to individuals acting in their own self-interest and so behave in a way contrary to the collective good of society.* Classification of goods © Excludability ~ Goods can either be excludable or non-excludable. A good is excludable if you can prevent those who haven't paid for the good from consuming it. © Rivalry — Goods can either be rival or non-rival in consumption. A good is rival in consumption if one person's consumption of said good prevents someone else from consuming the good simultaneously. © Common Good - Goods that are rival in consumption but non-excludable. © Public Good ~ Goods that are both non-excludable and non-tival in consumption * Asymmetric information — A situation in which one party to a transaction knows more than the other party. © Adverse Selection — A situation in which because of asymmetric information better quality commodities are driven out of the market. © Screening and Signaling - Activities that can be done to try and reduce the information gap. Screening is done by the ignorant side (buyers test driving a car, employers conducting interviews). Signalling is done by the knowledgeable side (employees getting certification] 5. Interfering in the Market * Taxes © Market model with taxes ~ Tax drives a wedge (that is the size of the tax) between supply and demand © Incidence of a tax - The incidence of a tax refers to how the burden of a tax is distributed among the people who make up an economy. It falls more heavily on the side of the market that is less elastic. © Welfare effect of taxation — A deadweight loss occurs between the wedge the tax creates and the equilibrium point. * Price Restrictions © Price Ceiling — A price ceiling is a legal maximum placed on a price. Itis binding when it occurs below the equilibrium price. © Price Floor — A price floor is a legal minimum place on a price. It is binding when it occurs above the equilibrium price.* Quantity Restrictions © Restrictions on Supply ~ This makes prices artificially high and the quantity supplied artificially low. © Restrictions on Demand - This makes prices artificially low and the quantity demanded artificially low. The Macroeconomy 6. Output and Growth * Building Blocks © Physical Capital - Physical capital refers to tangible items that are used to produce goods. © Human Capital - Human capital refers to intangible items such as human skills and intelligence. Improvement in human capital allows for the greater production of goods. © The technology of production — Technology of production refers to the means of production, i.e. the methods of production or the way production is organized. (Not necessarily machinery used for production) © Economic institutions — The laws, regulations and unwritten codes of conduct that govern economic activity. © Nominal and Real GDP — Nominal GDP refers to the production of goods and services valued at current prices. Real GDP refers to the production of goods and services valued at constant prices. © GDP Per Capita — GDP divided by the population © Economic Growth - The annual percentage change of real GDP per capita. * Economic Growth © Accumulating Capital - Economic growth by accumulating capital is possible, however, it is subject to diminishing returns and further limited by capital depreciation. This is shown on the Solow Growth model by a movement along the output curve. © Capital Depreciation — The reduction of the productive value of capital due to wear and tear and obsolescence. This is shown on the Solow Growth model by the Depreciation Curve._ © Innovation — Economic growth by developing or copying new technology of production. This is shown on the Solow Growth model by a shift of the output curve. © Institutional Reform - Economic growth by reforming institutions is possible by making investments more attractive or lucrative by improving propertyrights or making them more secure, impartially enforcing laws, allocating opportunities based on merit, having a speedy independent justice system, constitutionally limit the arbitrary exercise of power, implement an independent competent central bank and implementing social safety nets * Solow Growth Model © Production Function — The Production function consists of the output curve, the savings curve and the depreciation curve. Both the output and savings curve flatten out as capital increases due to diminishing returns. Output increases to the point where savings is equal to depreciation. Prices and Inflation * Inflation © Price Level - This refers to the average of prices across the entire spectrum of goods in the economy or the price or cost of a product. Inflation causes price levels to rise. © The value of money ~ 1/P (Price Level). Inflation causes the value of money to decrease, © Inflation — This refers to the reduction in the value of money over time. © Hyperinflation — Inflation that exceeds 50% per month, * The Market for Money — The value/price of money is determined in the market for money. The money supply is determined by the central bank and so is fixed (curve vertical) (© Demand for money — This reflects how much wealth people want to hold in. liquid form. The motives for holding money (determinants of demand) are transactions and precautions Liquidity — Refers to how easy an asset is to turn into cash. Why people hold money - Transactions, Precaution Variables that affect money demand - Demand, Price Levels, Interest Rates. ‘Supply of Money — Money supply is fixed since it is set by the central bank/government eo 000 * In-Depth © How excess money raises prices — An increase in money supply reduces the value of money which manifests in higher prices. © How excess money comes about ~ Money demand grows as the economy expands and shrinks as payment habits change. Furthermore, underestimating money supply strangles the economy so central banks prefer to increase money supply. Alternatively, some governments printmoney to pay their debts. © The inflation tax — The revenue government gains from printing money. (The government printing money and causing 25% inflation decreases purchasing power by 25% which has the same effect as a 25% income tax) 8. Interest Rates and Finance * Savings and Investment © Consumption ~The utilization of resources to satisfy current wants. Savings — Current production not consumed. Investment — The utilization of resources to satisfy future consumption. Foreign Savings — Exports — Imports/(M-X, Fiscal Balance, Fiscal Deficit - Governments revenue less expenditure. Deficit when expenditure > revenue, surplus when revenue > expenditure. © National Income Identity — © Savings-Investment Identity — * Financial Institutions and Markets © Purpose of the Financial System ~ It serves an in intermediate for the flow of funds from savers to borrowers (investors) © Financial Institutions — Corporations that serves as a financial intermediary ( stock market, bond market, credit unions banks etc) © Stock Market — A market in which companies and/or individuals can exchange money for equity (shares in companies) © Bond Market — A market in which individuals/companies can lend companies money in exchange for receiving their principal and interest at a later date. eo 000 © The Market for Loanable Funds © Nominal and Real interest Rate — Nominal interest rate inflation rate. © Supply of funds — Brought about from savings. (Reduced by fiscal deficits) © Demand for funds - Brought about from investments real interest rate + * The Harm from Inflation © Relationship between prices and wages - Wages are earned by selling labour. During inflationary periods people sell their labour for more and so wages keep up with prices. © Whyis inflation harmful Resource Misallocation — Inflation makes it difficult to compare prices and so resources get misallocated,‘Shoe leather costs - The costs associated with reducing money holdings during inflationary periods. Menu Costs - The costs associated with changing prices Arbitrary redistribution — Inflation favours debtors because their debt repayments are less valuable. Deflation favours creditors because their receivables are more valuable. 9. The Exchange Rate and External Linkages Nominal and Real Exchange Rate ~ The nominal exchange rate is the price of one currency in relation to another. The real exchange rate is the price of one country’s products in relation to another © Currency appreciation/depreciation — An appreciation represents domestic, goods becoming more expensive in relation to foreign goods. (Smaller number on the formula above and lower nominal exchange rate). A. depreciation represents domestic goods becoming cheaper in relation to foreign goods. (Larger number on the formula above and larger nominal exchange rate) © Effect on imports/exports — Appreciation increases imports and decreases exports. Depreciation increases exports and decreases imports. Balance of Payments ~ The official record of a country’s international transactions ‘© Current Account — Payment for the trade in goods, services and factors. Includes the Goods and Services Balance (Net Imports and Exports) and Net Transfers, © Capital Account - Payments for the acquisition of assets and liabilities, Includes Net FDI flows, Net Portfolio flows and Net International Reserves. © Trade Balance — The Goods and Services Balance (Exports — Imports) © Net Capital Inflows - The Net Portfolio flows (Capital Inflows ~ Capital Outflows) © Foreign Direct Investments — Investments made by foreigners in the country The Market for Foreign Exchange © Foreign Exchange — The exchange rate is the price of consuming foreign goods. © Demand for foreign exchange — Derived from the outflows in the balance of payments. © Supply for foreign exchange — Derived from the inflows in the balance of payments. Exchange Rates in the long run© Arbitrage — The act of exploiting price differences of a commodity in different markets, © The Law of One Price — This states that a commodity can only have one price. Price differences between markets are arbitraged away. © Purchasing Power Parity — The PPP dictates the nominal exchange rate in the ong run. It is the ratio of the cost of goods in the local market to the cost of, goods in a foreign country. 10. Economic Statistics Measuring Production © Circular flow of income — A model of the economy that shows how expenditure and income are distributed in an economy. © GDP-The market value of all final goods and services produced within a country in a given time. © Double Counting — The value-added approach OR the final goods approach is taken. Imports are also subtracted from the GDP calculation because their value is already included in consumption, Measuring Inflation © Household expenditure survey ~ Surveys in which households are asked to provide data of the amounts they spend on goods and services for a given period of time. This is used to determine CPI © Consumer Price Index — This is a measure of the overall goods or services bought by typical consumers. Inflation can be measured by calculating the change between the index between years © GDP Deflator — The GDP Deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP. Inflation can be measured by calculating the change between the deflator between years.