Discussion 1
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BUSN 201 Supplemental Economics Notes: Week 1
Introduction to Economic Modeling and Objective Analysis
Economic Methods and Modeling: Economics is an important part of social and political debate. As a field of study, economic thinking strives to be objective and accurate in its methods, predictions and prescriptions. The following are common issues in assessing the soundness of economic reasoning and analysis:
Normative statement: Includes judgment as to what is good or bad.
Positive statement: Statement of fact.
Fallacy of composition: Assumption that fact about one element of the economy is true of the whole.
Fallacy of causation: Assumption when there is an association between two events, that one event caused the other.
Model: A model is a simplification of reality specifying factors and processes to be considered in analysis. The concept behind the use of models is to strip away all unnecessary information to focus on the essential elements of an issue. Yet, because models limit factors considered and the way in which they interact – and because we must use proxies (substitutes) for the data we would really like to consider – models and economic analytical tools have “blind spots.” The user and consumer of economic analysis must consider these blind spots when evaluating analytic data and conclusions.
Theory: A theory is a statement about how the world works. Theories represent thoughts that are organized toward answering selected questions.
Ceteris Paribus: Literally, in Latin, the term ceteris paribus means “all things being equal.” In economic analysis, ceteris paribus is a blanket assumption that all other factors that might influence the market outcome, other than those specifically stipulated (often meaning Price and Quantity, in supply and demand analysis), are assumed to be unchanging, for the sake of examining one relationship and set of conditions at a time. The purpose for setting such a stringent restriction on the scope of analysis is to provide a tractable scope to analyses, by focusing on a very limited set of factors. This limitation does not reflect likely real world conditions, but does allow us to more closely study the influence of the factors under investigation. It is important in “consuming” economic analysis to evaluate whether this restriction is acceptable for the circumstances under investigation, or whether it is too restrictive to adequately represent the issues being modeled.
Comparative Static Analysis: Comparative statics analyzes equilibrium positions of the market, but does not include the transition or the adjustment process by which the market moves from one equilibrium to another. Most economic analysis uses comparative static techniques.
Dynamic Analysis: Dynamic analysis attempts to include consideration of how markets adjust to changing conditions.
Partial Equilibrium Analysis: Partial equilibrium analysis focusses on the behavior of individual decisions and individual markets, without considering the broader economy. Most economic analysis is partial equilibrium analysis.
General Equilibrium Analysis: General equilibrium analysis looks at the behavior of individuals and individual markets taken together simultaneously.
It is important to carefully consider the foundations and assumptions of economic arguments and analysis. Every economic model, theory or argument has implicit assumptions that do not fully mesh with reality. The most valuable lesson you can get out of this class is to be a thoughtful and cautious consumer of economic reasoning.
Factors of Production: Resources are required for satisfying human wants. They are necessary inputs for the production of goods and services. Economics refers to resources as the factors of production and divides them into four groups:
Land: Land encompasses all free gifts of nature and all resources in their natural state (mineral ores, water, and soil). The “return” to land is called “rent.”
Labor: Labor is the human element of production or people’s capacity to work. “Returns” to labor include wages, salaries, tips, benefits and commission.
Capital: Capital is the human-made factor of production. This is physical capital, and does not include financial capital such as financial instruments. Capital includes human capital, improvements in labor’s capacity to produce. The “return” to capital is referred to as interest.
Entrepreneurship (enterprise): Entrepreneurship combines the other factors of production into a functioning whole. Combining resources requires technology or techniques of production. As technology changes, the resource mix also changes. The return to entrepreneurship is profit.
The Sources of Economic Theory and Models
While many theorists have contributed to our body of economic knowledge and insight, a few stand out as chief architects of how we understand and approach economic issues today. While all of these are long since dead and most lived and wrote over 150 years ago, they continue to define the field of economic understanding and debate.
American economic theory, as we study it in the U.S. today, has its roots in Adam Smith’s seminal work Wealth of Nations (published in 1776). Adam Smith (1723 - 1790) first described how the behaviors of individuals pursuing their own interests in a marketplace come together collectively to form a market, with predictable economic and social outcomes. Adam Smith’s work still defines the approach we take to understanding how markets behave today.
Other important theorists that followed closely on Adam Smith’s work were David Ricardo (1772 – 1823; who wrote on the economic ramifications of international trade and competition), Thomas Malthus (who wrote about the economic limitations imposed by exhaustible resources), and Karl Marx (1818 - 1883; Capital, 1867; who wrote not only on controversial political theory, but extensive analysis on the inherent tensions in capitalist markets).
Later were to come Alfred Marshall (who first applied mathematical analytic tools to economics, including the supply and demand graphs commonly used in economics coursework), and John Maynard Keynes (1883 - 1946; The Economic Consequences of the Peace; The General Theory of Employment, Interest and Money; who first diagnosed and developed prescriptive measures to address issues of market failure and government intervention in a depression).
The work of these theorists continues to define how economic issues are presented, analyzed and understood today. Some understanding of the historical context and intent of these theoretical contributions and analytical tools gives greater insight into the economic models we use today.
You will be introduced to each of these theorists in our first and second class sessions. They will resurface throughout our nine weeks, as their insights still form the core of current economic methods and thought.
MARKET PRICES: SUPPLY & DEMAND
1. Supply and Demand Analysis
Economic analysis relies heavily on the offsetting concepts of supply, demand, price and cost to explain and predict much of economic activity. These market forces are examined using theories expressed as algebraic formulas and are visually illustrated using graphs. This section introduces the basic economic relationships and interactions that shape the market.
To answer questions about the what, how and why of economic events, the concepts of supply and demand are used. Supply and demand are both defined as relationships between price and quantity. Supply relates the quantity offered for sale to each possible price. Demand is the relationship between the price and the quantity demanded of a good.
Demand: The demand function for a product gives the specific quantity that consumers will purchase for each possible price, over some period of time, other things being equal (ceteris paribus). Demand is a continuum expressing the relationship between price and demand, rather than a single price or quantity. The quantity of a good that consumers will buy for a specific price is the quantity demanded. Demand can also be referred to as a demand schedule or demand curve.
The ceteris paribus condition means that all other factors are assumed to be unchanging, for the sake of examining one relationship and set of conditions at a time. This restriction makes the scope of analysis manageable. It is important in “consuming” economic analysis to evaluate whether this restriction is acceptable for the circumstances under investigation, or whether it is too restrictive to adequately represent the issues being modeled.
The law of demand states that quantity demanded will fall as price rises, and that the quantity demanded will rise as price falls. Price and quantity demanded have an inverse relationship. This means that the demand for a product is represented graphically by a downwardly sloping (negative) line. Determining the quantity demanded of a product as price changes requires moving along the demand curve.
Changes in factors other than price of the good will change the relationship between price and quantity demanded for the good. These changes will, therefore, shift the demand curve and are referred to as shift factors. Factors that influence demand are:
· personal income
· personal tastes
· the price of other goods (especially substitute and complementary goods)
· number of consumers (population)
· consumer expectations about future prices
An increase in demand is a change that causes the demand curve to shift to the right. A decrease in demand is a shift in the demand curve to the left. A change in the price of the good can neither increase nor decrease demand – instead, it causes a move along the existing demand curve and a change in the quantity demanded.
Changes in shift factors will result in the following changes in demand:
· An increase in consumer income will:
· Increase demand (shift to the right) for normal goods
· Decrease demand (shift to the left) for inferior goods
· Increases in the price of substitute goods will increase demand (shift right)
· Increases in the price of complementary goods will decrease demand (shift left)
· Population increase will increase demand, and vice versa
· Consumer expectations of future price decreases or increases can change consumption & demand for the good in the near term
Supply: Supply defines the quantity of a good that will be offered for sale at each possible price, over a set period of time, ceteris paribus. The specific quantity that will be offered for sale at a given price is the quantity supplied. As price changes, the quantity supplied changes, but supply does not.
In contrast to demand, the supply curve slopes upward to the right, reflecting that the quantity supplied increases with price. This is known as the law of supply.
Factors that can shift the supply curve are:
· prices of inputs
· technological change
· government or union restrictions on how production is conducted
· prices of by-products
· supplier expectations of future prices
A decline in input prices will increase supply, shifting the supply curve to the right.
Technological change can decrease the cost per unit and increase supply.
Government restrictions can increase costs, decreasing supply (shift supply to the left).
Price increases of by-products will increase supply (shift supply to the right).
Change in price reflects movement up or down the supply curve. Increased or decreased supply at every price reflects a shift in the supply curve.
Equilibrium – The Balance Between Supply and Demand: The economic analysis of supply and demand can be applied to an individual, a firm, an industry or a market. Therefore, we can draw demand and supply curves and calculate equilibrium points for individuals or entire economies. Market demand and supply are the summation of all individual demand and supply schedules in that market.
The market price for a good is the price where quantity supplied and quantity demanded are equal. This price is said to clear the market because the amount produced and purchased are equal, leaving no unmet demand and no surplus goods.
The price and quantity where quantity demanded and supplied are equal is referred to as the market equilibrium, because there is a tendency for price and quantity to remain stable (unchanging) at this level. Graphically, the market equilibrium is the intersection of the demand and supply curves. An asterisk is used to distinguish the equilibrium price and quantity (P*, Q*).
To examine why this price and quantity level tends to remain stable, consider what would happen if price rose above P*. Suppliers would produce more of the product than consumers would want, creating a surplus on the market. Suppliers would tend to lower price to dispose of the surplus, moving price back toward the equilibrium price. Conversely, a price below P* would result in an insufficient supply to satiate demand (shortage). Scarcity would create bidding wars among consumers, moving back price up toward the equilibrium point. This seemingly automatic movement of market forces toward equilibrium and cleared markets is what Adam Smith termed the “invisible hand” of the free market, guiding market interactions toward efficient outcomes.
Note: Since demand and supply are influenced by different factors, a shift in demand does not mean that supply will shift. However, a shift in demand will move the intersection of the demand and supply curves. The new equilibrium price and quantity will be at a new point on the same supply curve.