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Full lecture notes: principles of economics
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Notes of all lectures of the course Principles of Economics at the University of Amsterdam
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Principles of Economics – Lecture NotesIndex
Lecture 1..................................................................................................................................................................1
Introduction..........................................................................................................................................................1
Markets, supply, and demand..............................................................................................................................4
Lecture 2................................................................................................................................................................10
Elasticities..........................................................................................................................................................10
Markets, efficiency, and well-being...................................................................................................................15
Lecture 3 - Consumer’s choice..............................................................................................................................17
Consumer choice theory....................................................................................................................................17
Lecture 4 – Producer’s choice................................................................................................................................27
Lecture 5 - Government policies and taxation.......................................................................................................33
Lecture 6 – Monopoly............................................................................................................................................40
Lecture 1
Introduction
What is economics?
There are a lot of different definitions.
“…it’s the study of scarcity, the study of how people use resources, or the study of decision-making.”
(American Economic Association)
“a social science concerned chiefly with description and analysis of the production, distribution, and
consumption of goods and services” (www.merriam-webster.com)
“Economics: the study of how society manages its scarce resources” (Course textbook)
Economics does not look for the perfect solution or ideal outcomes. It wants to find the optimal solution
under certain constraints. If you look for the „perfect” then better to turn to philosophy or mathematics.
Normative vs positive economics
One must make the distinction between normative and positive approaches to economics.
When economists make positive statements, they do not wish to tell others what they should want. They
observe facts, make models, and make predictions. The statements are falsifiable.
o Example: If the government increases taxes on tobacco, then the number of smokers will
decrease.
This statement is based on an economic model of demand, which relies on empirically founded
assumptions regarding the preferences of consumers. A positive statement may, of course, be wrong, but
it should be possible to falsify it, hence it is scientifically testable. (Karl Popper The Logic of Scientific
Discovery, 1934 ).
When economists make normative statements, they express their personal preferences regarding an
issue. This is not part of their scientific work. Beware of this!
o Example: The government should tax tobacco more heavily so that less people smoke.
1
, This statement reflects the economist`s own preferences regarding smoking. There is
nothing to scientifically test here. This is an opinion about the “right” way to deal with
smoking.
“Economics is only concerned about profit and material welfare”
This statement is false, based on a complete lack of understanding of the discipline of economics.
Economists use models to describe what they observe and do not enforce their views on reality.
When profit motive alone describes the behaviour of agents sufficiently, then they will stop there. When
it turns out that profit motive is not enough to account for observed trends and phenomena, then they
will introduce other factors in their models, like altruism, lack of information or beliefs.
Nevertheless, the fact that models based on greed perform quite well empirically does tell more about
the nature of people than about economists.
Economics is not a religion nor a political sect. It is a model-based methodology to analyse any, often
non-economic, phenomenon. Economists have modelled stuff like: elections, spread of religions,
emerging of religious dogmas, survival and spread of languages, demographic changes, trust, and
individualism.
Models
Models: simplified, logically consistent representations of a phenomenon.
“All models are wrong, but some are useful” (George Box, statistician)
The art is to find balance in the number of factors one puts into a model. By increasing the number of
factors in a model, difficulty increases exponentially. Difficulty undermines the usefulness of the model.
o Example: modelling production decisions from profit maximization is chosen because it is
sufficient to understand how the supply of good is determined. It does not mean that economists
believe that people are only interested in profit or production decisions are affected by profit
only.
The ten points of Mankiw
1. People face trade-offs.
2. The cost of something is what you give up to get it.
3. Rational people think at the margin.
4. People respond to incentives.
5. Trade can make everyone better off.
6. Markets are usually a good way to organize economic activity.
7. Governments can sometimes improve market outcomes.
8. A country’s standard of living depends on its ability to produce goods and services.
9. Prices rise when the government prints too much money.
10. Society faces a short-run trade-off between inflation and unemployment.
There is no free lunch! Everything has a price.
Points 1 and 2 basically argue this. Everything has a costs. Costs may be direct and visible or indirect
and invisible. For example, the price of a movie ticket is a direct costs of watching a film. The indirect
costs is what I had to give up to watch the movie: alternative activities.
The opportunity costs of going to a movie is not doing something else instead. For example, talking to
friends, studying or watching another movie instead.
What is the direct cost of your studies? Tuition fee, costs of textbooks.
2
, What is the opportunity cost? All the wages you will not earn because you are a student (foregone
wages). The time you will not spend on something else.
Rational people think at a margin, even if they are unaware of it.
Marginal change: small incremental adjustments to a plan of action.
Example 1: you have to decide how much time you will spend on preparing for your EMO I exam. You
know that any additional day you spend with preparations will increase you chance of a better grade.
Every day you will need to face a decision: do the possible gains from spending this day with studying
outweigh the loss from not being able to do something else (opportunity cost)? This is thinking happens
at the margin.
Example 2: why do you think that a poor person is willing to take a job as sandwich man while the rich
are not? After all, they would be paid the same wage.
People respond to incentives
Global warming is a serious issue. How could you reduce the emission of greenhouse gasses?
Choose: which one is more effective?
1. Convince people that they should use their cars and fly less. Also, they should eat more plant-based
food and less meat. You can organize meditation sessions and make documentaries.
2. You introduce a carbon tax on agriculture and transport industries so that their costs increase and will
produce less at a higher price.
Trade can make everyone better off
It can but will not.
Trade (or transaction) between two agents can be beneficial if they are both perfectly informed and can
negotiate freely without any transaction costs.
Example 1: you go to the market to buy cheese. Then you can try to haggle, and you will see if it works
out. If you buy 2kg cheese, I bet it will.
Example 2: you live next to a factory whose chemical waste slowly flows over to your estate. You can
again try to tell that to the manager. Do you think it will work?
International trade: there are a lot of misunderstandings regarding the theories of absolute and
comparative advantage. International trade improves average welfare statically (now) but can have
negative dynamic effects (in the future).
Also, free trade and protectionism creates winners and losers within a society. So not everyone is better
off.
Markets are usually a good way to organize economic activity
We have just seen examples when markets work well and cases when they do not.
The market mechanisms can nicely go towards a solution if agents are free to negotiate and well
informed. You know the quality of cheese and could bargain without cost. There is no need for
government here.
In case of pollution you alone are clearly not powerful and rich enough to be able to negotiate with a
firm. You cannot even sue them: they have more money and lawyers than you would ever have. Clearly
negotiation has a very high costs for one of the agents (you) so it is good if the government (or a
community) can step in and equal the field by, for example, giving an incentive to the firm to reduce its
pollution.
Market failure: when markets do not create a solution with the highest possible welfare.
3
, Macro vs microeconomics
Microeconomics is concerned with the choices made by individuals, such as consumers (households)
and firms.
o Example: if the tax on tobacco increases, how would the demand for cigarettes react? How much
should a firm produce to achieve the highest possible profit, with given costs?
Macroeconomics is about economy-wide phenomena. Like economic growth, welfare, inflation,
unemployment, or business cycles.
o Example: How would aggregate consumption change if the government increased income tax by
5 percentage points (p.p.)? How would GDP be affected if taxes were halved?
Markets, supply, and demand
Market structures: competitive market
Market: a group of buyers and sellers of a particular good or service.
A competitive market will serve as our baseline case. It is a market in which there are many buyers and
many sellers so that each has a negligible impact on the market price.
Assumptions of a perfectly competitive market:
1. All firms produce a single identical good (homogeneous good).
2. All firms are so small that their individual decisions on how much they produce has no effect on the
total supply of that good.
3. As a result, firms cannot influence price, they are price-taker.
4. Buyers are perfectly informed about the supply of each firms.
5. It is free and costless to enter or exit the market.
Examples of a competitive market
Perfectly competitive market is a theoretical construct. There are some markets that can be classified as
competitive markets, albeit they do not fulfil all the conditions. Some come quite close though.
Agriculture: production of homogeneous goods by many farmers. No farmer has enough market power
to affect prices. They produce standardized goods (crop is divided into exactly defined quality
categories, so they are comparable). But: barriers to entry often exist
Online or e-commerce: many traders, free entry and exit, easy comparability of prices.
Foreign exchange market: many buyers and sellers, quick flow of information.
Other market structures
Monopoly: a single firm produces a single good. So, the supply of the firm is the total supply of that
good. By changing its output, the firm can effectively set the price at the market. Entry to the market is
barred either by law or by costs. We will study this market structure in the 3rd week.
Market structures not discussed in this course:
(a) Monopolistic competition: many smaller producers produce slightly different (differentiated) goods.
No major barriers to entry. Example: Restaurants, hotels, consumer services like hairdressing, food and
beverage. Producers have some power to affect price. Characteristics: tough competition, marketing.
This is perhaps the most common market structure.
(b) Oligopoly: a few firms share the same market, producing either homogenous or differentiated goods.
Producers can affect prices. Example: car industry, telecommunication providers, pharmaceuticals,
airlines, banks. Characteristics: tough competition, marketing, brands, innovations.
Demand
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