ppt_ch01

Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank

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Chapter 1Economics and the Market


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Chapter 1: Economics and the Market

• Studying choice in a world of scarcity• Implications of rationality for good decision making• Supply and demand• Simple rules• Markets and social welfare• Microeconomics and macroeconomics


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Economics: Studying Choice in a World of Scarcity

• The Scarcity Principle– Boundless wants cannot be satisfied with limited

resources– Therefore, having more of one thing usually means

having less of another– Because of scarcity we must make choices


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Economics: Studying Choice in a World of Scarcity (cont.)

• Economics is the study of how people make choices under conditions of scarcity and of the results of those choices for society

• Economists assume that people make choices rationally, with a view to maximising the difference between the cost and benefit for them (their net benefit)


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Applying the Cost–Benefit Principle

• Rational Persons– Have well-defined goals who try to meet those goals as

best they can– Seek to maximise their net benefit from the course of

action arising from any decision– When benefits and costs can be measured, net benefit is

called Economic Surplus – the difference between total benefit and cost


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Economics: Studying Choice in a World of Scarcity

• The Cost–Benefit Principle– An individual (or a firm or a society) should take an

action if, and only if, the extra benefits from taking the action are at least as great as the extra costs

– The emphasis is on the EXTRA or MARGINAL benefits and costs

– Following this rule maximises total net benefit


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How Do We Define Cost?

• Opportunity Cost– The value of the next-best alternative that must be

forgone to undertake an activity– So if you value an additional hour of pleasurable leisure

time at $20, this is the opportunity cost of an additional hour of burdensome work or study

– Conversely, if you can earn $20 per hour, this is the opportunity cost of leisure


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Applying the Cost–Benefit Principle

• Should you walk downtown for a half hour to save $10 on a $25 computer game?

• The marginal benefit of the walk is $10• If your time is worth $18 per hour, the marginal

cost of the half hour walk is $9• The marginal benefit ($10) exceeds the marginal

cost ($9) of buying the game downtown


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Cost–Benefit Analysis is a Model or Simplification of How People Think

• C/B analysis assumes that people make decisions consciously and rationally

• What if their decisions are unconscious?• This does not matter as long as their decisions are

consistent with the C/B model• Models are abstract constructs (simplified

descriptions) that allow us to analyse situations in a logical way


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Other Abstract Models

• A computer model of climate change• A road map or building plans• Simulated crash tests using dummies• Analyses of the economy which divide the

community into only three parties:– households (consumers)– firms (producers)– the government


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Four Implications of Rationality

• Cost and benefits are absolute, not proportional• Example which is more valuable:

– saving $100 or 5% on a $2000 international air fare

or– saving $90 or 50% on a $180 domestic bus fare?


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Four Implications of Rationality (cont.)

• Take Account of Opportunity CostsExample: Do frequent flyer points mean that your trip to destination X is costless?

– No, because there may be accommodation costs in excess of those at home

– No, because going to destination X may preclude you from going to destination Y


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Four Implications of Rationality (cont.)

• Costs already incurred or ‘sunk’ are not relevant to your decisions

• The only costs that should influence a decision about whether or not to take an action are those that we can avoid by not taking that action


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Sunk Costs are Irrelevant

• The entry fee to an ‘all you can eat’ restaurant is irrelevant to how much we should eat, once we have entered and paid

• Since the marginal cost is zero, we should eat up to the point where the marginal benefit of eating is zero

• Failure to observe this rule will lead to indigestion and regret (negative marginal benefit) through overeating! Emotion of greed has overcome rational thought!


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Four Implications of Rationality

• The cost of a course of action is what it adds to our total costs, that is its marginal cost

• Marginal, not average, costs are relevant


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Example of the Average–Marginal Distinction

• Should NASA expand the space shuttle program from three launches per year to four?

• Assume average benefit = marginal benefit = $6 billion

• Assume marginal cost exceeds average cost


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The Optimal Number of Launches

0 0 0 0

1 3 3 3

2 7 3.5 4

3 12 4 5

4 20 5 8

5 32 6.4 12

Assume: Average Benefit = Marginal Benefit = $6 billion

Total Cost Average Cost No. of Launches ($ billion) ($ billion/launch) Marginal Cost

What is the optimal number of launches?


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Supply and Demand:An Introduction


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What, How, and for Whom? Central Planning Versus the Market

• Given limited resources and unlimited wants, there are three problems facing all economic systems

– What should be produced?– How should it be produced?– For whom will it be produced?


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Free Markets vs Central Plans

• In market or capitalist economies these decisions are made by individual households (consumers and owners of factors of production) and firms (producers) who participate in markets as buyers and sellers of factor services and finished goods

• In centrally planned economies these decisions are made by the authorities

• In mixed economies, households, firms and government all play a role in decisions


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Market Demand

As price falls, the quantity demanded rises because:• Substitutes become less attractive• There is a rise in the purchasing power of buyers’

incomes• So existing consumers buy more and new

consumers enter the market

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The Daily Demand Curve for Pizza

Price($ per slice)

Quantity(1000s of slices

per day)

4

2

3

8 12 16

Demand


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Market Supply

• As prices rise, the quantity supplied increases • This is because the benefit to suppliers rises

relative to their costs of production• These costs include their opportunity costs – the

revenue they get from alternative products

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The Daily Supply Curve for Pizza

Price($ per slice)


per day)

4

2

3

8 12 16

Supply


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Market Equilibrium

• Occurs where the demand curve intersects the supply curve: the quantity demanded = the quantity supplied and no pressure for price to change

• At prices above this point the quantity supplied exceeds the quantity demanded (there is excess supply) and prices fall

• At prices below this point there is excess demand and prices rise

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The Equilibrium Price and Quantity of Pizza

Price($ per slice)


per day)

4

2

3

8 12 16

Supply

Demand

Equilibrium at $3

Quantity Demanded =

Quantity Supplied

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Excess Supply: Prices Fall

Price($ per slice)


per day)

4

2

3

8 12 16

Supply

Demand

Excess supply = 8000 slices/day

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Excess Demand: Prices Rise

Price($ per slice)


per day)

4

2

3

8 16

Excess demand = 8000slices per day

Supply

Demand

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Graphing Supply and Demand and Finding the Equilibrium Price and Quantity

Price($ per slice)


per day)

5

2

3

4

1

4

102

Demand

0 6 8

Supply

2.50

5

The Equilibrium Price = $2.50The Equilibrium Quantity = 5


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Predicting and Explaining Changes in Prices and Quantities

• Distinguishing Between– A change in the quantity demanded

(a movement along the demand curve that occurs in response to a change in price)and

– A change in demand

(a shift of the entire demand curve)

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An Increase in Quantity Demanded vs an Increase in Demand

Price($/can)

Quantity(1000s of cans/day)

5

2

3

4

1

4

122

6

0

D

D Increase in quantity

demanded

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An Increase in Quantity Demanded vs an Increase in Demand

Price($/can)


5

2

3

1

4

12

6

0

Increase in demand

D

D

D’

D’


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Predicting and Explaining Changes in Prices and Quantities

• Change in the quantity supplied– A movement along the supply curve that occurs in

response to a change in price

• Change in supply– A shift of the entire supply curve

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An Increase in Quantity Supplied vs an Increase in Supply

Price($/can)


5

2

3

4

1

4

102

6

0 6 8

S

S

Increase in quantity supplied

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An Increase in Quantity Supplied vs an Increase in Supply

Price($/can)


5

2

3

4

1

4

102

6 S

0 6 8

S

S’

S’

Increase in supply


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Factors Changing Demand

• Change in price of complement• Change in price of substitute• Change in income• Change in population of potential buyers• Change in expectations of future prices


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Factors Changing Supply

• Change in cost of inputs• Change in technology• Change in number of suppliers• Change in expectations of future prices• Change in profitability of other industries

competing for resources


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Markets and Social Welfare

• If prices reflect marginal benefits (MB) to buyers and marginal costs (MC) to society, free market equilibrium is good for the community

• This is because Price = MB = MC and consumers are getting as much of the commodity as they are willing to pay for

• Price controls prevent this

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Price Controls in the Pizza Market

Price($ per slice)

Quantity(1000s of

slices per day)

Supply

Demand

Excess demand =8000 slices per day

4

Price ceiling = 2

3

8 12 16


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Price Ceilings

• Price ceiling causes production to fall from 12 to 8, a reduction of 4 units

• On average, these 4 units cost $2.50 each to make, or $10 in total (4 x 2.5)

• On average, consumers value these 4 units at $3.50 each or $14 in total (4 x 3.5)

• So the price ceilings have caused a loss of economic surplus to the community of $4: we saved $10 by not making them, but lost $14!


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Cash on the Table: Buyers

• In the absence of price ceilings, the price is $3 and the quantity is 12 units

• Price ceilings deprive consumers of 4 units, which they value at $3.50 each or $14

• Without price ceilings, consumers would have paid $12 ($3 x 4) for them

• So price ceilings have deprived consumers of a surplus (cash on the table) of $2, or $0.50 per unit


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Cash on the Table: Sellers

• Sellers have also lost profits on 4 units• Without price ceilings they received $3 per unit on

4 units which, on average, cost $2.50 to make, a profit of $0.50 per unit

• They have lost profits (cash on the table) of $2 (4 x $0.50)

• So the price ceilings have imposed a social loss of $4, $2 on buyers and $2 on sellers


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When is the Market Efficient?

• When all of the costs of producing the good or service are borne directly by the seller, so that costs to producers reflect costs to the community

• When all benefits from the good or service accrue directly to buyers, so that benefits to buyers reflect benefits to the community


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When is the Market Inefficient?

• Smart For One, Dumb For All– When some costs of production fall on people other than

those who produce the commodity– When some of the benefits of the commodity fall on

people other than those who consume the commodity


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Inefficient Markets

• Example: Environmental Pollution– The market is in equilibrium: Sellers’ MC = MB– However, sellers’ MC underestimates the cost to society

of producing the good– Therefore, the market produces more than the efficient

amount and there is no incentive for producers and consumers to alter their behaviour


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Inefficient Markets

• Example: Vaccinations– The market is in equilibrium: Buyers’ MB = MC– Buyers’ MB underestimates the benefits to society of

consuming the vaccinations– The market produces less than the efficient amount of

vaccinations and there is no incentive for producers and consumers to alter their behaviour

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