Economics: Principles, Concepts, and Applications

Posted on Feb 11, 2025 in Economy

Economics Summary

Week 1: Introduction to Economics

According to Michael Mandel, economics is the study of how individuals, businesses, and governments make decisions and tradeoffs in the face of scarce resources.

Today, the economy occupies significant space in newspapers and news, often making headlines due to the continuing crises that several countries experience. Companies that produce outputs (goods and services) have existed since ancient times.

The first economist, Adam Smith (considered the father of economics), published “The Wealth of Nations” in 1776. The Industrial Revolution prompted this philosopher to study national and international economies. Smith argued that the market is guided by an “invisible hand,” where individuals working for their own interest unintentionally benefit society.

Later, the philosopher Karl Marx (a socialist) argued that a capitalist economy was fatally flawed and would not survive. He believed that shared ownership would eliminate workers’ incentives because, regardless of effort, everyone would receive the same amount of money.

Microeconomics and Macroeconomics

  • Microeconomics: Focuses on how individuals and businesses make decisions about using scarce resources.
  • Macroeconomics: Examines economy-wide phenomena such as inflation, price levels, economic growth rate, national income, gross domestic product (GDP), and changes in unemployment.

Private Property

Private property is fundamental to capitalism. Karl Marx noted that capitalism presents societies with an immense collection of commodities that are privately owned and operated for profit in a free market.

Types of Property:

Property encompasses everything from material goods to intellectual property.

Material property has been organized in three different ways:

  1. Everything can be held in common and used by everyone, such as in tribal economies.
  2. Property can be held and used collectively; this is the essence of the communist system.
  3. Property can be held privately; this is the heart of capitalism.

Aristotle argued that “property should be private.” When property is held in common, no one takes responsibility for maintaining and improving it. People can only become generous if they have something to give away.

A Right to Property

In the 17th century, land and housing in Europe were owned by monarchs.

  • John Locke advocated for individual rights, believing that we have dominion over the things we create.
  • Kant argued that private property is a legitimate expression of the self.
  • Marx claimed that private property is a device by which capitalism expropriates the labor of the proletariat, keeping them in slavery and excluding them.

What is a Just Price?

The price of anything is the market price—the price people are prepared to pay. For market economists, pricing is simply an automatic function of supply and demand. Market economists consider the marketplace to be the only way to establish price.

  • Markets need goods. Traders only supply goods if there is a profit.
  • But there is a moral dimension to avoid unjust prices. Profit shouldn’t be excessive.
  • The buyer must freely accept the price.

Thomas Aquinas stated that a merchant may charge a just price, which includes a decent profit but excludes excessive profiteering. This just price is the price the buyer freely agrees to pay. Aquinas also said, “No man should sell a thing to another man for more than it’s worth.”

  • The issues of price and morality are very much alive today.

Week 2: Supply and Demand

Factors Affecting Demand:

  • Price: As price rises, demand falls; as it falls, demand increases (Law of Demand). For example, what happens if Netflix doubles its prices?
  • Personal Income:
    • If personal income increases:
      • For normal goods, demand increases (e.g., clothing, restaurants).
      • For inferior goods, demand decreases (e.g., less McDonald’s, more nice restaurants).
    • If personal income decreases:
      • For normal goods, demand decreases (e.g., less meat).
      • For inferior goods, demand increases (e.g., more pasta).
  • Prices of Related Goods:
    • Substitute goods satisfy the same needs. If the price of butter goes up, the demand for margarine will increase.
    • Complementary goods are consumed together. If demand increases for cars, it will also increase for gasoline.
  • Tastes: Influenced by marketing, celebrities, etc. (e.g., What does Kylie Jenner like?).
  • Expectations: Influenced by media, rumors of recession, falling interest rates, weather, war, peace, and international trade. Prices may rise or fall.

Factors Affecting Supply (Production):

  • Price of a Good or Service: If the price goes up, suppliers will compete to produce more. For example, if prices for condos on the Costa del Sol are rising, developers build more condos.
  • Price of Production Factors: Costs of land, labor, or capital. If interest rates fall, the supply of new homes increases.
  • Technology: The amount of media has exploded due to lower production costs for digital media. The supply of cameras has dropped as smartphones have replaced them.
  • Price of Related Goods: If the price of a good rises, the supply of the substitute good drops (because everyone is producing the one with the higher price). If the price is rising for big SUVs, manufacturers will supply more SUVs and fewer small economy cars. If the price of a good increases, the supply of the complementary good increases.
  • Expectations: If a producer expects demand or prices to increase, they will increase supply. If they expect demand or prices to fall, they will decrease supply (leading to deflation).

Week 3: Economic Man and Elasticity

Man is a Cold, Rational Calculator

All humans are self-interested. This is Homo Economicus, or “Economic Man.” This concept suggests that women and men make decisions designed to maximize their personal well-being, based on a level-headed evaluation of all the facts. They make decisions by collecting information and calculating which actions will help them achieve their aims without being too costly. This idea was first expounded by Adam Smith in his book “The Wealth of Nations.”

The Invisible Hand

Every individual acts out of self-interest. This might lead to a chaotic mix of products and prices, but other self-interested people provide competition and take advantage of each other’s greed. If one seller charges too much, another will undercut their price, and the first seller’s products will fail to sell. If one employer pays wages that are too low, another will take their employees, and their firm will fail. Businesses will fail unless they pay market wages and make products the market demands, at the price people are willing to pay.

Elasticity of Demand

Elasticity of demand quickly became one of the most widely used tools of economic analysis. Marshall had been one of the first to formalize the idea that demand fell as prices rose. He also saw that when prices changed for necessities such as bread, demand changed very little. On the other hand, demand for luxuries might be much more responsive to price (“price-elastic”).

  • According to Engel, demand for food is “income-inelastic.” He studied the budgets of 199 households in Belgium and showed that while demand for necessities such as food grew less quickly as income rose, demand for luxuries – such as holidays – grew at least as quickly as the increase in income.

Week 4: Market Failures and Externalities

Provision of Public Goods and Services

A perfectly competitive market is one in which there are many buyers and sellers of identical goods, so that the market power of each one is insignificant, and there are no barriers to entry for competitors.

  • All participation is voluntary.
  • Businesses choose to produce and sell because they make the most profit possible.
  • Buyers make purchases because the value of the goods is greater than the prices they pay.
  • All purchases and all sales are mutually beneficial.
  • All buyers and all sellers are price takers; that is, they accept the market price.
  • A market failure occurs when the normal market forces of supply and demand don’t apply. Positive or negative externalities (outside forces) disrupt the equation.
  • Examples include monopolies, pollution, education, research, regulations, and crime.

Sometimes, there are areas in which markets fail. One important example of market failure is in the provision of public goods, which are non-rival (one person’s consumption of the good does not diminish the ability of others to consume it) and non-excludable. They increase the well-being of people who don’t pay for them: Parasites. Some examples of public goods are education, national defense, and social security.

There is another type of good: shared resources. These are non-excludable but rival; their use reduces the enjoyment of other users, and the users don’t pay for them. Examples include water, parking spaces, and air traffic.

Perfect Competition Requires Efficient Exchange

  • Exchangeability in markets: Public goods and common resources are difficult to price and exchange, leading to imperfect competition.
  • Equal market power: No monopolies or oligopolies.
  • Equal access to information: No asymmetry.
  • No externalities: All value is within the exchange between buyer and seller. The price reflects the true costs.

A competitive market is one in which there are many buyers and sellers of identical goods, so that the market power of each one is insignificant, and there are no barriers to entry for competitors.

  1. All participation is voluntary.
  2. Businesses choose to produce and sell because they make the most profit possible.
  3. Buyers make purchases because the value of the goods is greater than the prices they pay.
  4. All purchases and all sales are mutually beneficial.
  5. All buyers and sellers are price takers; that is, they accept the market price.

Negative and Positive Externalities

  1. Alcohol consumption affects neighbors and the social welfare system (negative).
  2. Pollution: Value for the producer destroys value for others (negative).
  3. Education: Not only the student but society benefits (positive).
  4. Research and development: Drug companies’ patents, chip manufacturers, computer makers (positive).

Make the Polluter Pay: External Costs

Taxing Polluters

  • This is a market failure: The factory doesn’t have to face the true social costs of its actions; it will create too much pollution relative to what would be socially efficient.
  • Carbon taxes imposed by Obama were intended to reflect the true cost of the product to society.
  • According to Arthur Pigou, “In general, industrialists are interested, not in the social, but only in the private, net product of their operations.”

Monopolies

  • In many countries, a firm is said to have a monopoly if it controls more than 25 percent of a market.
  • Competition between producers increases output and drives down prices. But monopolies, like some telephone companies, have no competition. They can produce less and charge higher prices. Phone calls are dearer without competition.
  • Monopolies are inefficient users of production factors.
  • Monopoly strategy: Grow as fast as possible, grab market share, and put the competition out of business.

Market Failure of Natural Monopolies

  • These industries have high capital costs. Having multiple providers compete would be inefficient. Some countries nationalize them. Non-payers can be excluded. Rates must be regulated.
  • Examples:
    1. Electricity service (this is changing)
    2. Cable television, fiber-optic internet
    3. Water systems

Week 5: Money and Inflation

The Function of Money

  • Money remains at the heart of all our transactions. The disturbing effects of money are well known, inciting everything from miserliness to crime and warfare.

A man might offer to mend his neighbor’s broken door in return for a few hours’ babysitting, for instance. Yet it is hard to imagine these personal exchanges working on a larger scale.

Money solves all these problems. There is no need to find someone who wants what you must trade; you simply pay for your goods with money.

  • Money is transferable and deferrable – the seller can hold on to it and buy when the time is right. Many argue that complex civilizations could never have arisen without the flexibility of exchange that money allows.

Fiduciary Money

  • In the Middle Ages, goldsmiths and jewelers accepted deposits of gold, silver, and jewels for safekeeping and gave receipts. These receipts became instruments of exchange.
  • Fiduciary money: Money that depends for its value on confidence that it is an accepted medium of exchange. It originated as a paper certificate that was a promise to pay a certain amount of gold or silver to the bearer.
  • Type 1: Fiat money or legal money, issued by a government’s central bank.
  • Type 2: Bank money: Checks, transfers, debits, and credit.

Fiat Money, Legal Money

Money issued by a government that is not convertible into gold or silver and has no intrinsic value.

It derives its purchasing power and value from the authority and reputation of the government that issues it.

Modern-day notes and coins are fiat money.

Make Money from Money

Basic Concepts

  • Economies of scale is an economics term that describes a competitive advantage that large entities have over smaller entities. It means that the larger the business, non-profit, or government, the lower its costs. For example, the cost of producing one unit is less when many units are produced at once.
  • Diversification of risk consists of spreading risk out into numerous areas to ensure that the potential negative effects of exposure to any one variable are limited.
  • Transformation of assets: Asset transformation is the process of creating a new asset (loan) from liabilities (deposits) with different characteristics by converting small-denomination, immediately available, and relatively risk-free bank deposits into loans—new, relatively risky, large-denomination assets—that are repaid following a set schedule.

“All finance is about connecting people with more money than they need with people who need more money than they have.” (Econ Book, location 480)

Inflation

  • Inflation is when money loses its value, so you need more money to pay for the same thing. Money circulates at a constant speed. If more money is put into the system, people have more money in their pockets and wish to buy more goods and services. This results in too much money chasing too few goods, leading to price rises. Money causes inflation.

(Buy the house now; next year, it will cost more. The expectation is that prices will keep rising.)

  • Hyperinflation is inflation that is very high and out of control; prices increase so fast and by enormous amounts.

The Main Monetary Policy Tools

  • Control over short-term interest rates.
  • Direct lending to banks and other financial institutions.
  • Changes in the reserve requirement and other financial regulations.

Money Supply

  • The demand for money can be predicted by looking at people’s behavior. The supply of money can be controlled by the government. Money should grow at a modest, constant rate in order to keep inflation low. Governments should do nothing but control the money supply.
  • Government spending cannot reduce unemployment below its natural rate without causing inflation. Inflation damages economic efficiency and should be avoided. Money should grow at a modest, constant rate in order to keep inflation low. Governments should do nothing but control the money supply.

Week 6: Economic Policies and Ideologies

Austerity

  • Austerity was imposed by the European Central Bank. They ordered countries to control their spending, increase taxes, and save money in order to reduce their debt. Austerity causes unemployment, which brings with it a risk for deflation. The United States and the United Kingdom, on the other hand, ran deficits to stimulate the economy.

GDP

GDP is a calculated number that measures the cash flow of a country, not its resources. How does it affect us? The more money flow, the more jobs. This leads to more wages and salaries, which is more money in the pockets of the consumers. In the end, there is more consumerism. In the United States, the GDP is measured by the Bureau of Economic Analysis; in Spain, the GDP is measured by the Instituto Nacional de Estadística. Also, the International Monetary Fund, the World Bank, and other monetary organizations make their estimates. China’s data is not believable, mainly because its numbers are shady. For more info, check the Khan Academy video on Circular Flow.

Capitalism and Socialism (Again)

  • Adam Smith – Capitalism: Free markets and trade keep goods flowing; greed fuels ambition, which leads to innovation and greater riches, but also to inequality.
  • Karl Marx – Socialism: Shared ownership, uniform wages, command economy; workers don’t have any incentives to work because, regardless of what you do, you receive the same amount of money. This leads to economic stagnation.
  1. Socialism is irrational economics
    • There is a demand for different types of footwear in the economy—for example, some people wanted sneakers.
    • The central planning committee sees only a demand for footwear—not for types of footwear.
    • The committee tells the factories to produce sensible, long-lasting footwear: boots.
    • Everyone ends up with boots, even if some people wanted sneakers.
    • Planned economies lack basic market information about demand, so a central planning committee must guess the type and level of demand for any item. Their ideas about what people want or need are unlikely to be accurate.

Neoliberalism

Neoliberalism was an economic wave of thinking applied in Brazil, Peru, Chile, Mexico, and Venezuela in the 1980s and 1990s, mainly due to the poverty, high unemployment, and violence that the countries suffered. It consisted of fiscal austerity (which is another name for raising taxes and less government spending), having free trade, a free market, fewer tariffs, and privatizing national industries.

Central Banks and Supply-Demand

  1. Central banks try to stimulate demand and the economy by lowering the interest rates they charge to other banks. That makes capital cheaper.
  2. They try to slow down demand and the economy by raising the interest rates they charge to other banks. That makes capital more expensive.

Mario Draghi’s plan to stimulate the Eurozone:

  1. Keep interest rates low, avoid price deflation.
  2. Buy bonds from banks—the policy is called ‘quantitative easing.’
  3. Give banks more money to lend.
  4. When banks lend, businesses hire and expand.

John Maynard Keynes

  1. Most sources of poverty are outside a person’s control.
  2. The poor have no private property.
  3. In many countries, education must be paid for, and the poor cannot afford it. This leads to poor job prospects and bad health.

The poor are unlucky, not bad.

  • In a depression, the government should spend more to create jobs and stimulate the economy. The government should also borrow more in order to spend more.