Key Principles and Concepts in Economics
Four Core Principles of Economics
The four core principles are:
- Cost-Benefit
- Opportunity Cost
- Marginal
- Interdependence
Interdependency can be broken down into four types:
- Interdependency is between each of my individual choices.
- Interdependency is between people or businesses in the same market.
- Interdependency is between markets.
- Interdependency occurs over time; the choices I make today affect my future.
Rational Rule in Economics
Rational Rule for Buyers: Individuals use their self-interests to make choices that will provide them with the greatest benefit.
Rational Rule for Suppliers: Produce more if the price you could receive is greater than the marginal costs to produce.
Marginal Cost and Benefit
Marginal Cost = Change in total cost / Change in quantity
Marginal Benefit = Change in total benefit / Change in quantity
Law of Demand and Supply
Law of Demand: The law of demand states that the quantity purchased varies inversely with price.
Law of Supply: The law of supply in economics states that as the price of a good or service increases, the quantity of goods or services increases and vice versa.
Inferior and Normal Goods
Inferior Good: When an individual’s income rises, they buy less of that good.
Normal Good: When an individual’s income rises, they buy more of that good.
Shifting Supply Indicators
- Input Prices: The costs that go into producing a good or service.
- Productivity and Technology: If productivity and technology improve, supply will shift up.
- Prices of related outputs
- Expectations
- Type and number of sellers
Elasticity in Economics
Elasticity: An economic concept used to measure the change in the aggregate quantity demanded of a good or service in relation to price movements of that good or service.
Midpoint Formula for Percentage Changes
Percentage change in demand: Change in quantity / Average quantity
Percentage change in price: Change in price / Average price
Price Elasticity of Demand
Price Elasticity of Demand: Change in demand / Change in price
Important Measures of Elasticity
Elastic: Price goes DOWN = Revenue goes UP
Inelastic: Price goes DOWN = Revenue goes DOWN
Income Elasticity of Demand
Change in quantity demanded as income changes:
- Inferior goods: Income elasticity is negative.
- Necessities: Income elasticity is less than 1.
- Luxuries: Income elasticity is greater than 1.
Cross-Price Elasticity of Demand
Change in quantity demanded for one good as the price of another good changes.
- Complements: Cross-price elasticity is negative.
- Substitutes: Cross-price elasticity is positive.
Price Elasticity of Supply
Taxes in Economics
Taxes: When some dollar amount is paid to a government by consumers or producers per unit bought or sold.
Tax Wedge: The difference between the tax on buyers and the tax on sellers, which would equal how much is needed to be taxed.
Tax on Buyers
- The demand curve shifts left, as the quantity sold decreases.
- The tax increases the price buyers pay and decreases the price sellers receive.
- Both buyers and sellers bear the economic burden.
Tax on Sellers
- The supply curve shifts up and left, as the price increases.
- The tax leads to a decline in the quantity sold.
- The tax increases the price buyers pay and decreases the price sellers receive.
- Both buyers and sellers bear the economic burden.
Tax Incidence and Tax Burden
Tax Incidence: The manner in which the tax burden is divided between buyers and sellers, depending on the price elasticity of demand and supply.
Tax Burden: The true economic effect of the tax.
Who Pays for CPP: Both the employee and employer split the tax burden for the CPP.
Economic Efficiency
Efficiency: When all goods and factors of production in an economy are distributed or allocated to their most valuable uses, and waste is eliminated or minimized.
- Efficient Production: There are many firms in the market.
- Efficient Allocation: There are many consumers in the market.
- Efficient production occurs when a given level of output is produced at the lowest possible cost.
- Firm level: Producing output at the lowest possible cost.
- Efficient production: Lowest Marginal Costs.
- Efficient allocation of goods: Highest Marginal Benefit.
- Efficient quantity produced: Largest possible economic surplus.
Absolute and Comparative Advantage
Absolute Advantage: The ability of a party to produce a good or service more efficiently than its competitors.
Comparative Advantage: An economy’s ability to produce a particular good or service at a lower opportunity cost than its trading partners.
Production Possibilities Frontier
Production Possibilities Frontier: A curve on a graph that illustrates the possible quantities that can be produced of two products if both depend upon the same finite resource for their manufacture.
Trade and Tariffs
Import Tariffs: Tax on imported goods, to collect revenue.
Import Quotas: Limits on the quantity of imports.
Autarky: Economic independence.
Public Good: A good that is both non-excludable and non-rivalrous.
Club Good: Products that are excludable but non-rival.
Tragedy of the Commons
Tragedy of the Commons: A situation in which individuals with access to a public resource (also called a common) act in their own interest and, in doing so, ultimately deplete the resource.
Marginal Costs and Benefits
Marginal Costs:
- Marginal Private Cost: Extra costs that are paid for by the seller.
- Marginal External Cost: The extra costs imposed on bystanders from producing one extra unit.
- Marginal Social Cost: Stays above the supply curve. MSC = MPC + MEC
Marginal Benefits:
- Marginal Private Benefits: Marginal gains that buyers enjoy.
- Marginal External Benefits: Extra external benefits enjoyed by bystanders.
- Marginal Social Benefit: Stays above the demand curve since MSB = MPB + MEB
Monopsony and Intergenerational Mobility
Monopsony: A market situation where there is only one buyer.
Intergenerational Mobility: The relationship between the socio-economic status of parents and the status their children will attain as adults.
Absolute and Relative Poverty
Absolute: When a person or household does not have the minimum amount of income needed to meet the minimum living requirements needed over an extended period of time.
Relative: The level of poverty that changes based on context—it is relative to the economic climate.
Progressive and Regressive Tax
Progressive Tax: Involves a tax rate that increases (or progresses) as taxable income increases.
Regressive Tax: A tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases.
Discount and Output Effects
Discount Effects: Makes current costs and benefits worth more than those occurring in the future because there is an opportunity cost to spending money now, and there is a desire to enjoy benefits now rather than in the future.
Output Effects: Relates to the change in the demand for labor, an input in the production process, due to changes in the demand for a company’s goods or services, the outputs in the production process.
Collusion: A non-competitive, secret, and sometimes illegal agreement between rivals which attempts to disrupt the market’s equilibrium.
Firm, Monopoly, and Oligopoly
Firm: A business organization, such as a corporation, that produces and sells goods and services with the aim of generating revenue and making a profit.
Monopoly: A type of monopoly in an industry or sector with high barriers to entry and start-up costs that prevent any rivals from competing.
Oligopoly: A market in which the industry is dominated by a few companies that are each influential participants in the market.
Regulatory and Deterrence Barriers
Regulatory Barriers: The costs of compliance deter new products or firms from entering the market.
Deterrence Barriers: A strategy adopted by incumbent firms to prevent or discourage potential competitors from entering the market.
Variable and Fixed Costs
Variable Costs: Change based on the amount of output produced. Labor, commissions, and raw materials.
Fixed Costs: Remain the same regardless of outputs produced.
Reservation Price
Reservation Price: A limit on the price of a good or a service.
- On the demand side, it is the highest price that a buyer is willing to pay.
- On the supply side, it is the lowest price a seller is willing to accept for a good or service.
Hurdle Method
Hurdle Method: Separates buyers with low minimum buying prices from buyers with higher so-called reservation prices.
Price Discrimination and Group Pricing
Price Discrimination: A sales strategy of selling the same product or service to different customers for different prices.
Group Pricing: To establish different prices for different groups or customer segments.
Product Differentiation: A process used by businesses to distinguish a product or service from other similar ones available in the market.
Informative Advertising and Hold Up Problems
Informative Advertising: Conveys information to uninformed consumers regarding a product’s characteristics, price, or even existence.
Hold Up Problems: Central to the theory of incomplete contracts and shows the difficulty in writing complete contracts.
Five Forces Framework
Five Forces Framework:
- Competitive Rivalry
- Threat of New Entry
- Threat of Substitution
- Supplier Power
- Buyer Power
Simultaneous and Sequential Games
Simultaneous Games: Played with each player making their decision at the same time.
Sequential Games: Involves multiple players who do not make decisions simultaneously, and one player’s decision affects the outcomes and decisions of other players.
Best Response: The best strategy is given what you think the other player will do.
Backward Induction: An iterative process of reasoning backward from the end of a problem or situation to solve finite extensive-form and sequential games and infer a sequence of optimal actions.
Repeated Interactions: A situation in which the same stage game (strategic form game) is played at each date for some duration of T periods.
Nash Equilibrium: A decision-making theorem within game theory states a player can achieve the desired outcome by not deviating from their initial strategy. Each player’s strategy is optimal when considering the decisions of other players.
Prisoner’s Dilemma
Prisoner’s Dilemma: A situation where individual decision-makers always have an incentive to choose in a way that creates a less than optimal outcome for the individuals as a group. Prisoner dilemmas occur in many aspects of the economy.
Collusion and Grim Trigger Strategy
Collusion: The collaboration between companies that seek to gain an extensive competitive advantage in the marketplace. Typically, illegal.
Grim Trigger Strategy: One episode of cheating by one player triggers the grim prospect of a permanent breakdown in cooperation for the remainder of the game.
Adverse Selection
Adverse selection: In economics, adverse selection is a market situation where buyers and sellers have different information. The result is the unequal distribution of benefits to both parties, with the party having the key information benefiting more.
Moral Hazard
Moral Hazard: In economics, a moral hazard is a situation where an economic actor has an incentive to increase their exposure to risk because it does not bear the full costs of that risk.
Actuarially Fair Economics: The price of the insurance policy exactly equals the expected monetary losses.
Marginal Utility: The added satisfaction a consumer gets from having one more unit of a good or service.
Risk Neutral, Averse, Loving
- Risk-averse individuals: Risk premium is positive.
- Risk-neutral persons: It is zero.
- Risk-loving individuals: Their risk premium is negative.
Risk Aversion: The tendency to avoid risk.
Diversification: The process of allocating capital in a way that reduces the exposure to any one particular asset or risk.
Expected Utility VS Fair Bet
The expected utility of some bet is higher than the utility she gets from the utility of the expected value. A fair bet is a wager with an expected value of zero.
Utility Function:
