1

MBAD6242 Microeconomics for the Global Economy

Teaching Note

Jiawen Yang

Session 1 Introduction; Supply and Demand

Contents and outlines: 1. Introduction 2. Definition and general concepts of “Economics” 3. Inputs, outputs, technology, and production possibility frontier (PPF) 4. The “invisible hand” and the market economy 5. Basic elements of supply and demand 6. Summary

Required readings: This teaching note Samuelson and Nordhaus, 2010:

Chapter 1: The Central Concepts of Economics Appendix 1: How to Read Graphs (Important background reading) Chapter 2: The Modern Mixed Economy Chapter 3: Basic Elements of Supply and Demand

Supplementary readings (not required, but may help enhance our learning): Perloff, 2012:

Chapter 1: Introduction Chapter 2: Supply and Demand

Topics that require particular attention in this session (as they may be more technical than other topics covered in this session):

• The concept of opportunity cost • Graphs of PPF, supply, and demand (A picture is worth a thousand words!) • Solution for the equilibrium price and quantity given supply and demand

functions Note:

(1) Colors, italics, boldfaced letters, CAPITAL LETTERS, and underlines (and combinations of these) are used in the teaching notes to highlight or emphasize certain key concepts or important ideas.

(2) PowerPoint (PPT) slides are used in the teaching notes to lead the discussions, to highlight and emphasize the main ideas, and to provide data or graphs to facilitate the discussions.

2

1. Introduction Introduction to the course (see syllabus as well) Learning objectives of the course (see syllabus as well) Course requirements (see syllabus for more details) Learning objectives for the first session

Voice over PowerPoint: PPT01-1

Course introduction:

Microeconomics is concerned with the behavior of individual entities such as individuals/households as consumers, firms or enterprises as producers, and individual markets. We first examine how consumers maximize their happiness given the constraint of their income or wealth resources and how firms make investment and production decisions in order to maximize profits and shareholders’ wealth. We then investigate how consumers’ demand and the producers’ supply interact to determine the equilibrium prices and quantities in individual markets. The course provides analysis of market structure and market environment (perfect competition, monopoly, oligopoly, and monopolistic competition). The government’s role in the economy and international trade theories/policies are also discussed in the course.

Course learning objectives:

• To understand the basics of a market economy and the current global market environment.

• To understand how households (consumers) and firms (producers) make decisions to allocate limited resources.

• To understand how demand and supply interact to determine market prices and quantities.

• To analyze the different types of market structure (perfect competition, monopoly, and monopolistic competition) in which firms operate.

• To understand the government’s role in dealing with market failures in the economy. • To understand the benefits of international trade.

Course requirements (see syllabus for more details):

Required Readings: • Lecture notes and PowerPoint slides (PPT) (posted on Blackboard): • Required text: Samuelson and Nordhaus. Economics, 19th edition. McGraw-

Hill/Irwin, 2010. ISBN 978-0-07-351129-0; MHID 0-07-351129-3. • Other materials: Selected articles from various sources may be added to the

readings as the course is in session. Requirements for homework assignments, exams, and grading policies are stated in the course syllabus. See syllabus for specifics and details.

3

Learning objectives for the current session: The objectives of this session are to learn (1) the fundamentals of economics and the roles of markets and government in a modern economy; and (2) the basics of supply and demand in the market. At the completion of this session, you should know/be able to: 1. Describe the definitions of the following terminologies and concepts:

economics, microeconomics, macroeconomics, international economics scarcity of resources, efficiency market economy, command economy, mixed economy production possibility frontier (PPF), constant opportunity cost, increasing opportunity cost the supply function, the demand function, the supply curve, the demand curve, and market equilibrium

2. Understand the major differences between a market economy and a command

economy. 3. Draw the production possibility frontiers (PPFs) with constant opportunity cost

and increasing opportunity cost. 4. Understand the demand and supply flows between product and factor markets. 5. Understand the concept of “the invisible hand” and the basic principles of a

market economy. 6. Understand the benefits (gains) from specialization and trade (exchange). 7. Understand the basic concepts of money, capital, and capitalism. 8. Understand the basic characteristics of the supply and demand curves; understand

supply and demand functions and be able to solve for equilibrium price and quantity for a particular product.

4

MBAD6242 Microeconomics for the Global Economy

Introduction and Basics

Jiawen Yang, Ph.D.The George Washington University

Introduction We start the course by asking ourselves the following questions: What is economics? What are the major problems that an economy has to solve? What are the alternative economic systems in the world to solve these problems? What are the major branches of economic study? What are the relationships between inputs and outputs? What is a market? What are the main characteristics of a market? How are economic decisions made in a market economy? What are the gains from specialization and trade? What are the economic roles of the government? What are the basic characteristics of supply and demand in the market? We will go over these questions and the fundamental concepts of economics in the first class.

Study guide: Try to answer these questions before and after you read this teaching note and the text.

5

2. Definition and general concepts of “Economics” • Scarcity of resources and unlimited human wants • The three problems of economic organization: What, how, and for whom • Alternative economic systems • Microeconomics, macroeconomics, and international economics

Voice over PowerPoint: PPT01-2

6

What is economics?

n Economics is the study of how societies use scarce resources to produce valuable goods and services and distribute them among different individuals. (Samuelson and Nordhaus, 2010, p.4)

n Resourcesn Scarcity n Efficiency

Different textbooks may define “Economics” somewhat differently, but the essence in the definition is how to use scarce resources efficiently to satisfy people’s wants. At the very beginning of our study of economics, we have to recognize that resources are limited for an individual, for a household, for a company, for a nation, and for the entire mankind. We all have resource constraints! As an individual or household, we are constrained by our income and wealth – we cannot literally do whatever we want and we have to budget. As a company, its investment capital is limited. Therefore, it has to choose its investment project very carefully. As a nation, its economic development is confined by its human resources, capital resources, and land resources. So it has to select a suitable development path to utilize its resources most efficiently. For all mankind, our natural resources are precious and our environment needs to be conserved. Otherwise, we are destroying the planet that we all live on. For producers, resources are often referred to as factors of production. These include land, labor, and capital. Land includes all natural resources: the minerals under the surface, the forests on it, and even the air above it (Mings and Marlin, 2000, p. 9). Seas, inland water, and arable land are, of course, also crucial land resources. Labor refers to all human resources, including manual, clerical, technical, professional, and managerial personnel. Capital refers to the machinery, factories and office buildings used in production. Technology and information, both of which have increasing importance in today’s economy, are also classified as capital resources (Mings and Marlin, 2000, p. 9). While our resources are limited, human wants or desires are unlimited. We always want more of something that can satisfy our need (We call this something a “good”). Given unlimited wants, it is important that an economy functions efficiently – make the best use of its limited resource. Efficiency denotes the most effective use of a society’s resources in satisfying people’s wants and needs (Samuelson and Nordhaus, 2010, p. 4).

Key points in this page: • Resources are limited but

human desires are unlimited; • Efficiency is the most effective

use of the scarce resources to satisfy people’s needs.

7

What is economics?Alfred Marshall (1842-1924): Prin c ip le s o f Ec o n o m ic s , 1890

n Economics is a study of men as they live and move and think in the ordinary business of life.

n A man is likely to be a better economist if he trusts to his common sense, and practical instincts, than if he professes to study the theory of value and is resolved to find it easy.

Economics is a science. The role of common sense in economics may be best stated by Alfred Marshall as follows:

“Economic science is but the working of common sense aided by appliances of organized analysis and general reasoning, which facilitate the task of collecting, arranging, and drawing inferences from particular facts. Though its scope is always limited, though its work without the aid of common sense is vain, yet it enables common sense to go further in difficult problems than would otherwise be possible.” (Principles of Economics: Chapter 4, The Order and Aims of Economic Studies)

Economic analysis may be conducted through intuitive reasoning, graphical illustration, and mathematical modeling.1 We will combine these methods in our course with relatively more applications of intuition and graphs. Economic life is complicated. When considering economics issues, we must carefully distinguish questions of fact from questions of fairness. Positive economics describes the facts of an economy (what it is) while normative economics involves value judgment (what it should be). In economy analysis, we often have to focus on one particular economic variable at a time, holding other things constant (ceteris paribus). For example, will the tax revenue increase or decrease if the income tax rate is raised? We need to hold economic growth and other variables constant in our analysis.

1 Graphs and equations are believed to be two different representations of the same reality. One of our textbook authors, Paul Samuelson, was one of the first economists to generalize and apply mathematical methods to economics.

8

The Three Problems of Economic Organization

n What? What commodities are produced (choice of products) and in what quantities (choice of quantity)?

n How? How are goods produced? Division of labor among different people; production techniques

n For whom? For whom are goods produced? Income and wealth distribution among different households; the role of government

Every economy has to deal with three fundamental questions: What commodities are produced and in what quantities? Since our resources are limited, we cannot produce everything we want. We have to make a choice in production at any point in time. That is, we have to decide what to produce and what NOT to produce. We also have to decide how much to produce for each commodity we select to produce. The answer to this question is our preference. How are goods produced? We can use manual labor to grow crops. We can also use machines. How goods are produced depends on resources (whether or not machines are available) and technology (whether or not we can make machines). Technology refers to the body of skills and knowledge that comprises the process used in production (Mings and Marlin, 2000, p. 9). For whom are goods produced? This is an income/wealth distribution issue. It involves the compensation for the factors of production: land, labor, and capital.

9

Alternative Economic Systems

n Market economyq Individuals and private firms make major

decisions about production and consumption (Samuelson and Nordhaus, 2010, p.8).

n Command economyq Government makes all important decisions about

production and distribution.n Mixed economy

q Most societies today operate as mixed economies.

There are a number of alternative economic systems that a society can choose from. A market economy is one in which individuals and private enterprises make major decisions on the “what, how, and for whom” questions (the “trio of economic problems”) That is, individuals and private enterprises make major decisions in investment, production, and consumption. On the other hand, a command economy is one in which the government makes major decisions about investment, production, and distribution of the products. These are two extremes. Most societies today operate mixed economies with elements of both market and command. The main difference between societies today lies in which element dominates the economy. The United States and other advanced economies such as Japan, Germany, France, the United Kingdom, Italy, and Canada are considered market economies.2 So are many other countries. The former Soviet Union and China before 1978, the year when it started its economic reform, were often referred to as command economies, or centrally-planned economies (since the economic decisions were made through central government planning). The judgment of a country’s economic system has significant implications in the world trading system. The “market economy” status is an important consideration for membership of the world trading organization, the World Trade Organization (WTO). The U.S. antidumping laws and regulations treat import products differently from countries that are regarded as “non-market” economies. The nature of the Chinese economy is a case in point. China claims itself as a “socialist market economy.” However, as of September 2011, the United States and the European Union (EU) had not recognized China’s full market economy status in evaluating trade issues with China.3 2 These seven countries are often referred to as the “Group of Seven” countries, or G7, representing the seven largest economies among developed countries in the world. 3 See Stoler (2003) for a discussion of the implications of treatment of China as a non-market economy for antidumping and countervailing measures.

10

Microeconomics and Macroeconomics

n Microeconomicsq Householdsq Firmsq Markets

n Macroeconomicsq Money and financeq Employmentq Inflationq Economic growth

n International Economicsq International trade

theoryq International trade

policiesq International Balance of

paymentsq Foreign exchange

marketsq International monetary

systems

There are two major branches of economic studies: microeconomics and macroeconomics. Microeconomics is concerned with the behavior of individual entities such as individuals/households as consumers, firms or enterprises as producers, and individual markets (the labor market, the market for automobiles, the market for petroleum oil, or the market for healthcare services, etc.). In examining the behavior of consumers, we will focus on how consumers maximize their happiness given the constraint of their income or wealth resources. In studying the behavior of firms, we will look at how firms make investment and production decisions in order to maximize profits and shareholders’ wealth. We will also investigate how consumers’ demand and the producers’ supply interact to determine the equilibrium prices and quantities in individual markets. One major aspect of microeconomics deals with different market structures – perfectly competitive markets, monopolies, oligopolies, and monopolistic competition. Macroeconomics is concerned with the overall performance of the economy. The overall performance or health of an economy is often measured on three dimensions: unemployment, inflation, and economic growth. Macroeconomics examines a wide variety of areas, such as how the total production of an economy is spent – private and government consumption, investment, and net exports, and how the monetary authority – the central bank manages money, interest rates, and prices. International economics covers the international aspects of economics. Its extension to microeconomics includes international trade theories and government trade policies. On the macroeconomic side, international economics covers the international balance of payments (a statistical summary of a country’s international transactions with the rest of the world), the foreign exchange markets, and the international monetary systems (such as fixed or floating exchange rate regimes).

11

3. Inputs, technology, outputs: Opportunity cost • Input, technology, and output • Production possibility frontier (PPF) • Opportunity cost • Constant opportunity cost • Increasing opportunity cost • Marginal cost

Voice over PowerPoint: PPT01-3

12

Inputs, Outputs, and Production Possibility Frontier (PPF)

n Limited resources and trade-offsn Production possibility frontier (PPF): all

combinations of amounts of different products that an economy can produce with full employment of its resources and maximum feasible productivity of these resources (Pugel, 2004, p.43)

Inputs(Resources or

Factors of production)

Outputs(Goods or servicesfor consumption or

Investment)

Technology

The scarcity of resources sets limitations on what a society can produce given the relevant technology at any particular time. So the capacity of our production is determined by the amount of resources and technology. The resources we use in our production are called “inputs,” or factors of production. These include land, labor, and capital. The useful results of our production, either goods or services, are called “outputs.” Outputs that are consumed concurrently are referred to as “consumption.” Outputs that are not consumed concurrently are employed or “saved” for further production. We call them “investments.” Since we cannot produce ALL what we want, we have to make trade-off decisions in our production – to select what to produce given our limited resources and the technology available to us. Before we make this selection, we need to look at all the production opportunities, or possibilities. For simplicity, suppose there are only two commodities in the world – wine and cloth, and only one factor of production – labor. It takes 6 minutes to produce a bottle of wine and 12 minutes to produce a yard of cloth. This labor (or resource) requirement remains constant. That is, it always takes twice the amount of time to produce a yard of cloth. The entire society has only 100 man-hours of labor resources. What are the production possibilities then? If we employ the entire labor resources to produce wine, the most we can produce is 1,000 bottles of wine (since 100 hours = 6,000 minutes and each bottle of wine takes 6 minutes). On the other hand, if we spend all our man-hours on cloth, we will be able to produce a maximum of 500 yards of cloth. Or if we spend half of the labor resources on each product, we should be able to produce 500 bottles of wine and

Labor requirements

Wine Cloth6 minutes 12 minutes

Total labor resources: 100 hours

13

250 yards of cloth. These are just a few possible combinations. In fact, there are an unlimited number of combinations – See the graph on the next page.

14

PPF with constant opportunity cost

Cloth

Wine

500

1000

300

?

12 minutes6 minutesClothWine

PPF

Labor requirements

Total labor hours: 100 hoursA

0 K

E

The following table shows some possible production combinations. These combinations are plotted as the red line in the graph above. A, E, and K are production possibility points representing combinations illustrated in the table.

Combinations Wine Cloth A 0 500 B 100 450 C 200 400 D 300 350 E 400 300 F 500 250 G 600 200 H 700 150 I 800 100 J 900 50 K 1,000 0

The diagram in the PowerPoint slide above represents these combinations. This diagram measures wine along the horizontal axis and cloth on the vertical one. The red line that represents all possible production combinations is called the production possibility frontier (PPF). It shows the maximum amounts of production that can be obtained by an economy, given its technological knowledge and quantity of inputs available. The PPF represents the menu of goods and services available to society (Samuelson and Nordhaus, 2010. p. 10). Moving from point A to point B, we gain 100 bottles of wine, but give up 50 yards of cloth. So the cost of 100 bottles of wine is 50 yards of cloth. This trade-off is often

15

called the opportunity cost: the cost of forgone opportunities or the next-best alternatives. In real life, we have to make choices all the time. Go to a movie tonight or stay home to study? The opportunity cost of going to a movie is a few hours’ study at home. Moving from point B to point C, we again gain 100 bottles of wine and give up another 50 yards of cloth. So the opportunity cost does not change. For every two bottles of wine, we have to give up one yard of cloth. This is true for all other movements along the red line. This situation is regarded as constant opportunity cost. The PPF with constant opportunity cost is represented by a straight line (the red line in the graph on the previous page). The slope of the PPF represents the opportunity cost. In our example, if we choose to produce 1000 bottles of wine, we have to give up 500 yards of cloth (moving from Point A to Point K in the graph). The slope is:

where C: change in cloth production; W: change in wine production500 1

1000 2CW

Δ ΔΔ −

= = −Δ

This means that the opportunity cost of 1000 bottles of wine is 500 yards of cloth, or the opportunity cost of one bottle of wine is half a yard of cloth! Moving from Point A to Point E of the graph, we give up 200 yards of cloth and produce 400 bottles of wine. The slope is again – ½ (–200/400). So the opportunity cost is constant – no change. Constant opportunity cost means that the PPF is a straight line and the slope of the line is the same at any point along the line. Note that – ½ is the opportunity of cost of WINE, that is, how much it costs to produce one additional unit of WINE. It costs ½ yard of cloth to produce one more bottle of wine. So it is a relative price, wine relative to cloth: one unit of wine costs half a unit of cloth. What is the opportunity cost of cloth then? It is 2 WINE, the inverse of ½. It costs two bottles of wine to produce one additional yard of cloth.

Study guide: Relative price is often a confusing concept. Go over this simple numerical example and make sure you understand opportunity cost and relative price.

16

PPF with increasing opportunity cost

The graphs above show PPF with increasing opportunity cost. The graphs are taken from the Samuelson and Nordhaus textbook (2010, p. 10-11). Point F shows one extreme, where all butter and no guns are produced, while A depicts the opposite extreme, where all resources go into guns. In between these extremes, at B, C, D, and E, increasing numbers of guns are given up in return for each additional unit of butter. For example, moving from Point A (0 butter and 15 thousand guns) to Point B (1 million pounds of butter and 14 thousand guns), the initial one million pounds of butter is produced at the cost of one thousand guns. Moving from B to C, the addition one million costs two thousand guns. … So the opportunity cost keeps increasing. As shown in the graph, the PPF with increasing opportunity cost is no longer a straight line; it is concave.

Possibilities Butter Guns(Millions of pounds) (Thousands)

A 0 15B 1 14C 2 12D 3 9E 4 5F 5 0

17

PPF with increasing opportunity cost

111

−=−

=⎟⎠

⎞⎜⎝

⎛Δ

Δ

BG

butter of productionin Change :B

gun of productionin Change :

Δ

ΔG

This PPT slide above illustrates the opportunity costs of butter. Moving Point A to Point B, the slope is

It means we have to give up one unit of guns to produce the first unit of butter. Can you verify the slope (or the opportunity cost) at other points?

Quick summary of the key points: • Inputs + technology = outputs; • Production possibility frontier (PPF); • Trade off and opportunity cost; • Constant opportunity cost; • Increasing opportunity cost • The slope of the PPF measures the opportunity cost

1 11

GB

Δ −⎛ ⎞ = = −⎜ ⎟Δ⎝ ⎠

18

4. The “invisible hand” and the market economy • Market, price, and equilibrium • The market system • Adam Smith and the “invisible hand” concept • Division of labor, specialization, and exchange • Private ownership and capitalism • The role of the government Voice over PowerPoint: PPT01-4

19

Market, Price, and Equilibrium

n A market is a mechanism through which buyers and sellers interact to determine prices and exchange goods and services (Samuelson and Nordhaus, 2010, p.26).

n Prices coordinate the decisions of producers and consumers in a market.q Product pricesq Factor pricesq Signals of scarcity; resource allocation

n A market equilibrium represents a balance among all the different buyers and sellers.

The focus of this course is on the market economy. What is a market? How does the market function? Let us now look at some basic ideas. A market is a mechanism through which buyers and sellers interact to determine prices and exchange goods and services (Samuelson and Nordhaus, 2010, p.26). In a market economy, every good or service has a price. Prices represent the terms on which people and firms voluntarily exchange different commodities or services. Prices also serve as signals to producers and consumers. If the demand for a particular product is strong, its price will go up and producers would like to produce more. The market reaches equilibrium when supply and demand are balanced (or buyers and sellers reach an agreement on the price and quantity). The prices we often observe in the shopping malls or centers are called product prices, such as the prices for shirts, shoes, TV sets, etc. There is another set of prices, called factor prices, which represent the market-determined values for factors of production. These prices include the price for labor (wages and salaries), rent for land use, and interest rate for the use of funds.

20

The Market System

The graph above is a circular flow of goods and inputs, showing how the what, how, and for whom problems are solved in the market system (If the graph is too small or unclear, please see the same picture in the Samuelson Nordhaus textbook (2010, p. 29)). The factor owners provide labor, land, and capital inputs (supply) to meet the demand for these factors from the producers or employers. The factors prices (wages, rents, and interest) are determined through interaction between supply and demand in the factor markets. Similarly, the consumers and producers (businesses) interact to determine the product prices in the product markets. Consumer demand has to dovetail with business supply of goods and services to determine what is ultimately produced. Businesses are driven by profit motives. Not all businesses are profitable, however. In fact, many businesses fail in the market competition. How things are produced is determined by the competition among different producers in the product markets. For whom things are produced depends largely on the supply and demand in the factor markets. Factor owners obtain their income through wages, stock dividends, rent from a property, or interest on a bond. The level of income (or wealth which is past income) determines an individual’s or a household’s purchasing power in the market place – what and how much the individual or the household can buy and consume.

21

The Invisible Hand and Efficiency

n Adam Smith and the Wealth of Nations (1776)n The Invisible hand

q Every individual “intends only his own security, only his own gain, … he is led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.”

n Under perfect competition and with no market failures, markets will squeeze as many useful goods and services out of the available resources as is possible. But where monopolies or pollution or similar market failures become pervasive, the remarkable efficiency properties of the invisible hand may be destroyed. (Samuelson and Nordhaus, 2010, p.30)

To understand the market economy, we have to understand the basic principles of such an economy. The most important principle of the market economy is the recognition of self-interest and market competition. Adam Smith, the founding father of economics, maintained that in pursuing their own self-interest, people would be guided by an invisible hand to maximize their personal contribution to the economy (Mings and Marlin, 2000, p. 115). According to Adam Smith, every individual “intends only his own security, only his own gain, … he is led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.” The essence of Adam Smith’s idea is that product prices and quantities should be determined by the supply and demand forces in the market; Government should not interfere or intervene. This laissez-faire (“leave me alone”) system is believed to be the most efficient economic system because it promotes competition among businesses and factor owners. Under perfect competition and with no market failures, markets will squeeze as many useful goods and services out of the available resources as possible. Perfect competition refers to a market in which no individual firm or consumer is large enough to affect the market price. But where monopolies or pollution or similar market failures become pervasive, the remarkable efficiency properties of the invisible hand may be destroyed. (Samuelson and Nordhaus, 2010, p.30)

22

Division of Labor, Specialization, and Traden Division of labor – dividing production into a

number of small specialized steps or tasks.n Specialization occurs when people and countries

concentrate their efforts on a particular set of tasks.n Trade or exchange: Different people or countries

tend to specialize in certain areas; they then engage in the voluntary exchange of what they produce for what they need.

n Gains from trade form one of the central insights of economics.

Specialization and free exchange are major characteristics of a modern market economy. Imagine yourself to be Robinson Crusoe on an uninhabited island. You will have to make everything you need by yourself. In a modern economy, we are all specialized in different professions such as doctors, nurses, secretaries, farmers, etc. This specialization is made possible by the division of labor. There are thousands, if not more, of industries or professions in today’s world. Jobs are divided so that each one of us can be more focused and productive in one particular profession. So division of labor and specialization lead to efficiency.

Specialization is not possible without a market for trade or exchange. In a market economy, people are free to choose how they want to specialize in (choose their career or profession) and trade their products and services in the markets. Trade or exchange allows one to sell his or her own products/services for others’ products/services, vastly increasing the range and quantity of consumption. The gains from trade form one of the central insights of economics (Samuelson and Nordhaus, 2010, p. 31).

23

Money, Capital, and Capitalism

n Money: The lubricant of exchangen Capital: a produced factor of production, a

durable input which is itself an output of the economy

n Private property: The ability of individuals to own and profit from capital is what gives capitalism its name.

Trade is carried out through the use of money. When we sell something, we get paid in money; when we buy something, we pay money for it. So money is the lubricant of exchange. Of course, trade can be carried out without the use of money. This is barter trade, which consists of exchange of goods for other goods. In a modern economy, money is almost indispensable in either domestic or international trade.

As we mentioned earlier, capital is one of the three major factors of production (land, labor, and capital). Unlike labor or land, whose supplies are mainly determined by non-economic factors such as fertility rate and natural endowment, capital has to be produced before it can be used. Capital includes physical capital and human capital. Buildings and machinery are examples of physical capital. Human capital includes quality of education and technical knowledge. Capital is normally accumulated through savings, or forgone consumption. People in rich countries can afford to save more out of their production and tend to accumulate more capital than people in poor countries. This is why rich countries are capital abundant while poor countries are capital scarce.

Private ownership of capital is a fundamental characteristic of a market economy. The deed for a house or a piece of land and the title of an automobile represent ownership and property rights. The owners have the right to use and exchange their capital goods. The ability of individuals to own and profit from capital is what gives capitalism its name.

24

The Visible Hand of Government

n Governments increase efficiency by promoting competition, curbing externalities like pollution, and providing public goods.

n Governments promote equity by using tax and expenditure programs to redistribute income toward particular groups.

n Governments foster macroeconomic stability and growth – reducing unemployment and inflationwhile encouraging economic growth – through fiscal policy and monetary regulation.

n Governments also conduct international economic policy.

An economy has two hands. In addition to the “invisible hand,” we also have a “visible hand” – the government. Even a market economy needs the government. The invisible hand works in perfectly competitive market. But there are market failures such as monopolies and pollution. We need the government to regulate them. We need the government to help provide public goods such as national and social security, police, and infrastructure. Governments also deal with social equity issues. We will discuss these issues and the roles of the government in a separate session.

How big a role should the government play in the economy? This is a recurring issue. Do we want the government to “leave us alone” (laissez-faire economy) or do we want the government to make all the economic decisions for us? More specifically, should the government spend a lot of money to stimulate the economy? Should the government bail out troubled financial institutions? The debate about the U.S. debt ceiling in the Congress before the August 2, 2011 deadline was a case in point.4 There are no clear or unique answers to these questions. However, we should have a better idea of what these arguments are based on when we study economics.

4 The U.S. Congress raised the debt ceiling on August 2, 2011, when the deadline was reached.

25

5. Supply, Demand, and Equilibrium • The supply function and the supply curve • The demand functions and the demand curve • Equilibrium price and quantity

Voice over PowerPoint: PPT01-5

26

6.

Supply, Demand, and Market Equilibrium

P

QO

S

D

6

4

Supply function:

QS = – 2 + P

è P = 2 + QS

Demand function: QD = 10 – P

è P = 10 – QD

Equilibrium:

P = $6 (or $600)

Q = 4 (million)

How does a market work? What moves the market prices up and down? Supply and Demand! Consumer preferences (tastes) determine consumer demand for commodities (We will explore this topic further in Session 2 of our course – “Consumer Behavior”). On the other hand, business (firm) costs (prices of inputs and technology advances) are the foundation of the supply of commodities (we will explore this topic further in Session 3 of our course – “Production and Costs”).

The downward-sloping demand curve (also called demand schedule). When the price of a commodity is raised, we demand less for the commodity for two reasons. First, we switch to something similar but less costly. This is the substitution effect. Second, given our income constraint, we can afford less of the commodity when the price is higher. This is the income effect.

The upward-sloping supply curve (or supply schedule). The supply curve for a commodity shows the relationship between its market price and the amount of that commodity that producers are willing to produce and sell, other things held constant (Samuelson and Nordhaus, 2010, p. 51). Given firms’ resource constraints, the cost of producing additional units of the commodity rises, thus requiring a higher price to cover the additional costs.

Market equilibrium. When supply meets demand, the market is in equilibrium. This is shown in the graph in the PPT slide above. The intersection between the supply and demand curves determines the equilibrium price and equilibrium quantity of the commodity in the market.

27

Mathematical expressions of supply, demand, and market equilibrium. The supply and demand curves are often expressed as supply and demand functions:

Supply function: ( , , )SQ f P C T= ; Demand function: ( , , )D SQ f P P I=

DQ is the quantity demanded for a particular commodity; P is the price of the commodity; PS is the price of the substitute for the commodity; and I is the consumer’s income. This expression reads as follows: The quantity demand for a particular product is a function of its own price, the price of its substitute, and the income level.

SQ is the quantity supplied for a particular commodity; P is the price of the commodity; C is the production cost for the commodity; and T represents the technology level. This expression reads as follows: The quantity supplied of a particular commodity is a function of its own price, the firm’s production cost, and the firm’s technology level.

The market is in equilibrium when supply equals demand: D SQ Q=

The demand and supply functions described above are in general forms. That is, they are not specified in a particular mathematic expression. Let us now see a pair of hypothetical specific supply and demand functions for a particularly product (for simplicity, we assume the supply and demand depend only on price):

Supply function: QS = – 2 + P; Demand function: QD = 10 – P

These supply and demand functions are illustrated in the graph in the previous page. We set supply equals demand and solve for the equilibrium price:

QS = QD è – 2 + P = 10 – P è 2P = 12 è P = 6

So the equilibrium price is 6 (dollars). Put the equilibrium price into either the supply or the demand function, we obtain the equilibrium quantity:

QS = – 2 + P = – 2 + 6 = 4 and QD = 10 – P = 10 – 6 = 4

Note that these supply and demand functions can also be expressed as the price being a function of quantity as follows:

Supply function: P = 2 + QS; Demand function: P = 10 – QD

We set the above supply and demand functions equal and solve for the equilibrium quantity (Q = QD = QS):

2 + Q = 10 – Q è 2Q = 8 è Q = 4 (the same as before)

And the equilibrium price is 6, the same as before.

28

6. Summary

In this lecture, we have covered the following major topics:

1. The definition of economics and the scarcity of resources. Economics is the study of how scarce resources are used to produce goods and how the goods are distributed among different groups in the society. There are two major branches of economics: microeconomics that is concerned with the behavior of individual households, firms, and markets, and macroeconomics that is concerned with overall performance of the economy. Based on these two branches, we have also introduced international economics, which extends the major aspects of economics beyond the national border.

2. The three problems of economic organizations and how alternative economic systems solve them. Every society must answer three fundamental questions: what, how, and for whom? What kinds and quantities are produced among the wide range of all possible goods and services? How are resources used in producing these goods? And for whom are the goods produced? Societies answer these questions in different ways. The command economy is directed by centralized government control; a market economy is guided by an informal system of prices and profits in which most decisions are made by private individuals and firms. All societies have different combinations of command and market; all societies are mixed economies.

3. Production possibility frontier (PPF). With given resources and technology, the production choices between two goods such as butter and guns can be summarized in the production-possibility frontier (PPF). The PPF shows how the production of one good (such as guns) is traded off against the production of another good (such as butter). In a world of scarcity, choosing one thing means giving up something else. The value of the good or service forgone is its opportunity cost. Constant opportunity cost refers to a situation in which there is constant tradeoff between the two commodities. Increasing opportunity cost, on the other hand, refers to a situation in which we have to give up an increasing amount of one commodity in order to get one more unit of the other commodity. The shape of PPF with constant opportunity cost is a straight line while the shape of the PPF with increasing opportunity cost is bowed out from the origin.

4. Market and the invisible hand. Adam Smith proclaimed that the invisible hand of markets would lead to the optimal economic outcome as individuals pursue their own self-interest. And while markets are far from perfect, they have proved remarkably effective at solving the problems of how, what, and for whom. The market has a mechanism to determine prices, which lead to the efficient allocation of resources. The product and factor markets interact to determine the prices in both markets and the distribution of income.

5. Specialization, exchange, money, and capital. Division of labor and specialization improve productivity and increase efficiency in production. Exchange allows each individual to consume beyond his/her own productive capacity in isolation. Money is used to facilitate trade in the economy. The right to own and profit from capital is the essence of capitalism.

29

6. Supply, demand, and market equilibrium. Consumer preferences determine the demand for a particular commodity and the production costs determine the supply of it. The market reaches equilibrium when supply equals demand. The supply and demand functions are mathematical expressions of the supply and demand. Equilibrium price and quantity can be obtained through the interaction of supply and demand.

What we do in our next class session:

Now that we have discussed the basic structures and fundamental concepts of economics, we are ready to look at the major players in the market – the consumers, producers, and the government and how they behave in the market. Since households are the basic elements of an economic society and represent the demand side of a market, we will focus on the consumer behavior and demand in our next class session.

References cited in this teaching note: (Not required reading except for statements included in the teaching note):

Mings, Turley and Matthew Marlin. 2000. The Study of Economics – Principles, Concepts & Applications, 6th edition. McGraw Hill Custom Publishing (Boston).

Further readings (For interested readers only; nor required or tested):

Roger E. Backhouse and Steven G. Medema, “Retrospectives: On the Definition of Economics,” Journal of Economic Perspectives, Volume 23, Number 1(Winter 2009), pages 221–233.

Mary Anastasia O'Grady, “The Weekend Interview with Gary Becker: Now Is No Time to Give Up on Markets,” Wall Street Journal (Eastern edition). New York, N.Y.: Mar 21, 2009. Page A.9.

Robert H. Frank, “Supply, Demand and Marriage,” New York Times, August 6, 2011.

Andrew L. Stoler, “Treatment of China as a Non-Market Economy: Implications for Antidumping and Countervailing Measures and Impact on Chinese Company Operations in the WTO Framework,” Presentation to Forum on WTO System & Protectionism: Challenges China Faces After WTO Accession, Shanghai WTO Affairs Consultation Center, December 1-2, 2003.