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| | Economics consists of making simple observations about complex situations in order to derive powerful results. There may be many things that are unknown or uncertain about a situation, but economics looks at what can be determined and then derives as much as possible from what is known. For example, one might ask an economist what he can say about public school classes. Most people might respond, "I can't say anything about them without knowing more information." But an economist thinks about what can be said despite the lack of knowledge of all the details. The economist might say that we do know this: public school classes censor prayer and avoid discussion of the Bible. From that simple observation, an economist might draw a powerful conclusion: students are completely missing out on the central source of wisdom and comfort. | | Economics consists of making simple observations about complex situations in order to derive powerful results. There may be many things that are unknown or uncertain about a situation, but economics looks at what can be determined and then derives as much as possible from what is known. For example, one might ask an economist what he can say about public school classes. Most people might respond, "I can't say anything about them without knowing more information." But an economist thinks about what can be said despite the lack of knowledge of all the details. The economist might say that we do know this: public school classes censor prayer and avoid discussion of the Bible. From that simple observation, an economist might draw a powerful conclusion: students are completely missing out on the central source of wisdom and comfort. |
| | + | |
| | + | ==Efficiency== |
| | + | |
| | + | Imagine what your day is like as President of the widget factory. You arrive to work earlier than everyone else, because you care the most about the success of your company. During the workday you walk through your factory to see how things are going. You see employees chatting at the water cooler, talking to their friends on the phone, or not showing up for work at all. This irritates you because you are paying for their time. You tell them to get back to work. |
| | + | |
| | + | You also see equipment sitting idle for various reasons. That annoys you too. You paid for the equipment, or you are renting it, but it is not helping your business by sitting idle. You want to return or sell it, or find a way to make it useful. |
| | + | |
| | + | Less easy to see are the wasted opportunity costs. Perhaps your assembly line could be making a different kind of widget that would be more profitable than the one you are making. |
| | + | |
| | + | All your concerns can be summed in one economic term: “efficiency”. Efficiency is the maximum possible productivity at any given time. It consists of the least amount of wasted time, effort or money. There is no wasted opportunity cost in an efficient operation. |
| | + | |
| | + | For once, this is an economic term (“efficiency”) that has the same meaning as its common everyday usage. “It was an inefficient use of my time to sit here all morning waiting for you!” “Try to do your chores more efficiently so that you can finish sooner.” “She finishes her homework faster than you because she works more efficiently.” |
| | + | |
| | + | Generally, maximum efficiency is desired and people want to avoid wasted time, materials, effort, and expense. However, there is a significant obstacle to true efficiency: transaction costs. Recall that “transaction costs” are all the incidental expenses that a consumer must spend to acquire a good. One textbook defines transaction costs as “the time, effort, and expense that go into the purchase of a good.”<ref>Spencer, ''Contemporary Economics'', at p. D-53.</ref> Nobel laureate Ronald Coase, discussed later in this lecture, describes “transaction costs” as simply the “costs of using the market.” |
| | + | |
| | + | If you love the homemade ice cream at your favorite restaurant, then you have to spend the time and money driving there, waiting for a table, tipping the waitress, paying the sales tax, etc. All you wanted was the homemade ice cream, but many transaction costs stand in the way of a perfectly efficient transaction. |
| | + | |
| | + | One day you may want to buy a house. Ideally, you would like to drive up to the house you want and pay the owner directly, and then move in. But in reality, there are transaction costs in buying a house. These include finding what you want, bargaining over the price, paying the real estate broker and attorney, and so on. Those transaction costs drive up the price of the house, and create inefficiencies. Some transaction costs are imposed by governmental regulations. |
| | | | |
| | == Review: Elasticity == | | == Review: Elasticity == |
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| | Keep these different types of elasticity separate: price elasticity is the change in demand due to a change in the price of the good, while income elasticity is the change in demand due to a change in the income of the buyer. | | Keep these different types of elasticity separate: price elasticity is the change in demand due to a change in the price of the good, while income elasticity is the change in demand due to a change in the income of the buyer. |
| | | | |
| − | === Price Elasticity === | + | === Price Elasticity (review) === |
| | | | |
| | '''''Price''''' elasticity of demand is the change in the quantity demanded by the public for a particular good due to a change in its '''''price'''''. Its symbol is "Ped", for "Price elasticity of demand." This term is used to answer this question: if the price of gasoline increases, how does the demand for gasoline change? It decreases due to the Law of Demand, but the '''''price elasticity''''' tells us '''''how much''''' it decreases due to a price increase. Specifically, price elasticity is the percentage change in quantity demanded, divided by the percentage change in the price of the good. If the percent change in quantity demanded is more than the percent change in price, then the good is considered "elastic". If the percent change in quantity demanded is less than the percent change in price, then the good is considered "inelastic". The Law of Demand means that price elasticity is always negative, but for convenience everyone uses the absolute value (positive value) without the minus sign. | | '''''Price''''' elasticity of demand is the change in the quantity demanded by the public for a particular good due to a change in its '''''price'''''. Its symbol is "Ped", for "Price elasticity of demand." This term is used to answer this question: if the price of gasoline increases, how does the demand for gasoline change? It decreases due to the Law of Demand, but the '''''price elasticity''''' tells us '''''how much''''' it decreases due to a price increase. Specifically, price elasticity is the percentage change in quantity demanded, divided by the percentage change in the price of the good. If the percent change in quantity demanded is more than the percent change in price, then the good is considered "elastic". If the percent change in quantity demanded is less than the percent change in price, then the good is considered "inelastic". The Law of Demand means that price elasticity is always negative, but for convenience everyone uses the absolute value (positive value) without the minus sign. |
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| | :<math>Ped = \frac{% \Delta (Quantity-demanded-of-good)}{% \Delta (Price-change-in-good)}</math> | | :<math>Ped = \frac{% \Delta (Quantity-demanded-of-good)}{% \Delta (Price-change-in-good)}</math> |
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| − | === Income Elasticity === | + | === Cross Elasticity === |
| | + | |
| | + | Once you fully understand price elasticity of demand, then it is easy to understand the concept of "cross elasticity of demand." Cross elasticity of demand is the percent change in demand of '''''one good''''' due to a change in the price of a '''''different good'''''. The two goods are either substitutes or complements for each other, which makes their cross elasticity useful. The symbol for cross elasticity of demand is "Xed", with "X" representing the "cross" and "ed" representing the "elasticity of demand." |
| | + | |
| | + | Mathematically, cross elasticity is as follows: |
| | + | |
| | + | :<math>Xed = \frac{% \Delta (Quantity-demanded-of-good-Y)}{% \Delta (Price-change-in-good-X)}</math> |
| | + | |
| | + | '''''Note that cross elasticity is different from price elasticity in that cross elasticity is comparing the change in demand for one good in response to the change in price of another good'''''. |
| | + | |
| | + | If the two goods (X and Y) are complements, then the cross elasticity is negative just as the price elasticity of a good is. Ketchup is a complement for french fries, and if the price of french fries increases, then people will eat fewer french fries and less ketchup. Hence the demand for ketchup will decrease and its cross elasticity with respect to french fries is negative. |
| | + | |
| | + | If the two goods (X and Y) are substitutes, then the cross elasticity is positive. Potato chips are a substitute for french fries, and if the price of french fries increases, then people will eat fewer french fries and more potato chips. Hence the demand for potato chips will increase and its cross elasticity with respect to french fries is positive. |
| | + | |
| | + | Expect a question on an exam which provides two goods and asks whether their cross elasticity is positive or negative. The correct answer will depend on whether the goods are complements (then the answer is "negative") or substitutes (then the answer is "positive"). |
| | + | |
| | + | === Income Elasticity (review) === |
| | | | |
| | '''''Income''''' elasticity of demand is the change in the quantity demanded by the public for a particular good due to a change in '''''income'''''. Stated another way, income elasticity is the responsiveness in demand for a good due to a change in the buyers' income. Its symbol is "Yed", because "Y" is a symbol for income, and "ed" refers to "elasticity of demand." | | '''''Income''''' elasticity of demand is the change in the quantity demanded by the public for a particular good due to a change in '''''income'''''. Stated another way, income elasticity is the responsiveness in demand for a good due to a change in the buyers' income. Its symbol is "Yed", because "Y" is a symbol for income, and "ed" refers to "elasticity of demand." |
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| | :<math>Yed = \frac{% \Delta (Quantity-demanded-of-good)}{% \Delta (Change-in-income-of-buyers-of-good)}</math> | | :<math>Yed = \frac{% \Delta (Quantity-demanded-of-good)}{% \Delta (Change-in-income-of-buyers-of-good)}</math> |
| − |
| |
| − | === Cross Elasticity ===
| |
| − |
| |
| − | Once you fully understand price elasticity of demand, then it is easy to understand the concept of "cross elasticity of demand." Cross elasticity of demand is the percent change in demand of '''''one good''''' due to a change in the price of a '''''different good'''''. The two goods are either substitutes or complements for each other, which makes their cross elasticity useful. The symbol for cross elasticity of demand is "Xed", with "X" representing the "cross" and "ed" representing the "elasticity of demand."
| |
| − |
| |
| − | Mathematically, cross elasticity is as follows:
| |
| − |
| |
| − | :<math>Xed = \frac{% \Delta (Quantity-demanded-of-good-Y)}{% \Delta (Price-change-in-good-X)}</math>
| |
| − |
| |
| − | '''''Note that cross elasticity is different from price elasticity in that cross elasticity is comparing the change in demand for one good in response to the change in price of another good'''''.
| |
| − |
| |
| − | If the two goods (X and Y) are complements, then the cross elasticity is negative just as the price elasticity of a good is. Ketchup is a complement for french fries, and if the price of french fries increases, then people will eat fewer french fries and less ketchup. Hence the demand for ketchup will decrease and its cross elasticity with respect to french fries is negative.
| |
| − |
| |
| − | If the two goods (X and Y) are substitutes, then the cross elasticity is positive. Potato chips are a substitute for french fries, and if the price of french fries increases, then people will eat fewer french fries and more potato chips. Hence the demand for potato chips will increase and its cross elasticity with respect to french fries is positive.
| |
| − |
| |
| − | Expect a question on an exam which provides two goods and asks whether their cross elasticity is positive or negative. The correct answer will depend on whether the goods are complements (then the answer is "negative") or substitutes (then the answer is "positive").
| |
| | | | |
| | === Supply Elasticity === | | === Supply Elasticity === |
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| | If the supply elasticity (Pes) is inelastic (less than 1), then it is difficult for suppliers to react quickly to a change in price. If Pes is elastic (more than 1), then suppliers can react quickly to a change in price, as in supplying more goods when the price increases. | | If the supply elasticity (Pes) is inelastic (less than 1), then it is difficult for suppliers to react quickly to a change in price. If Pes is elastic (more than 1), then suppliers can react quickly to a change in price, as in supplying more goods when the price increases. |
| − |
| |
| − | ==Efficiency==
| |
| − |
| |
| − | Imagine what your day is like as President of the widget factory. You arrive to work earlier than everyone else, because you care the most about the success of your company. During the workday you walk through your factory to see how things are going. You see employees chatting at the water cooler, talking to their friends on the phone, or not showing up for work at all. This irritates you because you are paying for their time. You tell them to get back to work.
| |
| − |
| |
| − | You also see equipment sitting idle for various reasons. That annoys you too. You paid for the equipment, or you are renting it, but it is not helping your business by sitting idle. You want to return or sell it, or find a way to make it useful.
| |
| − |
| |
| − | Less easy to see are the wasted opportunity costs. Perhaps your assembly line could be making a different kind of widget that would be more profitable than the one you are making.
| |
| − |
| |
| − | All your concerns can be summed in one economic term: “efficiency”. Efficiency is the maximum possible productivity at any given time. It consists of the least amount of wasted time, effort or money. There is no wasted opportunity cost in an efficient operation.
| |
| − |
| |
| − | For once, this is an economic term (“efficiency”) that has the same meaning as its common everyday usage. “It was an inefficient use of my time to sit here all morning waiting for you!” “Try to do your chores more efficiently so that you can finish sooner.” “She finishes her homework faster than you because she works more efficiently.”
| |
| − |
| |
| − | Generally, maximum efficiency is desired and people want to avoid wasted time, materials, effort, and expense. However, there is a significant obstacle to true efficiency: transaction costs. Recall that “transaction costs” are all the incidental expenses that a consumer must spend to acquire a good. One textbook defines transaction costs as “the time, effort, and expense that go into the purchase of a good.”<ref>Spencer, ''Contemporary Economics'', at p. D-53.</ref> Nobel laureate Ronald Coase, discussed below, describes “transaction costs” as simply the “costs of using the market.”
| |
| − |
| |
| − | If you love the homemade ice cream at your favorite restaurant, then you have to spend the time and money driving there, waiting for a table, tipping the waitress, paying the sales tax, etc. All you wanted was the homemade ice cream, but many transaction costs stand in the way of a perfectly efficient transaction.
| |
| − |
| |
| − | One day you may want to buy a house. Ideally, you would like to drive up to the house you want and pay the owner directly, and then move in. But in reality, there are enormous transaction costs in buying a house. These include finding what you want, bargaining over the price, paying the real estate broker and attorney, and so on. Those transaction costs drive up the price of the house, and create inefficiencies.
| |
| − |
| |
| − | Some transaction costs are imposed by governmental regulations. In many areas, homeowners must receive permission to chop down trees on their yards or build an addition to their house. The time and expense in obtaining that approval by the local zoning board are transaction costs.
| |
| | | | |
| | == Marginal Cost and Marginal Revenue == | | == Marginal Cost and Marginal Revenue == |
| | | | |
| − | Two of the most important concepts in economics are '''''marginal cost''''' and '''''marginal revenue'''''. We introduce these concepts now, and will use them throughout the remainder of this course. | + | Two of the most important concepts in economics are '''''marginal cost''''' and '''''marginal revenue'''''. |
| | | | |
| − | '''''Marginal cost''''' is the additional cost to produce '''''one more unit'''''. It includes only the additional cost, and not any costs to produce anything else. If, for example, you drove to the grocery store and then saw another store 100 feet up the road, the marginal cost of driving to that store would be only the gas and time and wear and tear on the car for going the extra 100 feet. The marginal cost would not include the overall cost of the car, or your taking off a day from work, or anything other than the cost of going that extra 100 feet. | + | '''''Marginal cost''''' is the additional cost to produce '''''one more unit'''''. It includes only the additional cost, and not any costs to produce anything else. If, for example, you drove to the grocery store and then saw another store a half mile up the road, the marginal cost of driving to that store would be only the additional gas and time and wear and tear on the car for going the extra half mile. The marginal cost would not include the original cost of the car, or taking off time from work, or anything other than the extra cost of going that extra half mile. |
| | | | |
| − | Similarly, the '''''marginal revenue''''' is the additional revenue received by a business for selling '''''one more unit'''''. It is the same as the price of the unit, because revenue is '''P x Q''', where Q (quantity) is 1. | + | Similarly, the '''''marginal revenue''''' is the additional revenue received by a business from selling '''''one more unit'''''. It equals the price of the unit, because revenue is '''P x Q''', and for one more unit Q (quantity) is 1. |
| | | | |
| | Imagine yourself as an owner of a business. As long as marginal revenue is larger than marginal cost, then you will want to sell more and more units. But once marginal revenue falls just below your marginal cost, then you lose money for each additional unit. You will lose money in selling more goods at that point. | | Imagine yourself as an owner of a business. As long as marginal revenue is larger than marginal cost, then you will want to sell more and more units. But once marginal revenue falls just below your marginal cost, then you lose money for each additional unit. You will lose money in selling more goods at that point. |
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| | ==The Coase Theorem== | | ==The Coase Theorem== |
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| − | The most-cited paper in all of economics<ref name="Coase article">http://www.boston.com/globe/search/stories/nobel/1991/1991i.html</ref> is “The Problem of Social Cost,” published by Professor Ronald H. Coase in 1960. It describes what later became known as the “Coase theorem,” a fundamental conservative insight about entitlements and property rights. Though criticized for thirty years by professors who disliked its implications, this theorem was finally recognized by the 1991 Nobel Prize of Economics, of which Professor Coase was the sole recipient. (An unshared Nobel Prize awarded to only one recipient is rare.) | + | The most-cited article in all of economics<ref name="Coase article">http://www.boston.com/globe/search/stories/nobel/1991/1991i.html</ref> is “The Problem of Social Cost,” published by Professor Ronald H. Coase in 1960. It describes what later became known as the “Coase theorem,” a fundamental conservative insight about entitlements and property rights. Though criticized for thirty years by professors who disliked its implications, this theorem was finally recognized by the 1991 Nobel Prize of Economics, of which Professor Coase was the sole recipient. (An unshared Nobel Prize awarded to only one recipient is rare.) |
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| | But few economics courses explain this theorem, and those that do unfortunately teach distorted interpretations of it. Professor Coase himself has endured unfair academic disdain and criticism, including being called a “dinosaur” by one colleague.<ref name="Coase article"/> | | But few economics courses explain this theorem, and those that do unfortunately teach distorted interpretations of it. Professor Coase himself has endured unfair academic disdain and criticism, including being called a “dinosaur” by one colleague.<ref name="Coase article"/> |