How can we think like an economist? - BulletPoints 1

•  The scarcity principle (also known as the no-free-lunch-principle) means that, despite people having infinite wants, resources available to us are limited, which means that having more of one thing often means having less of another thing. That is where the cliché comes from, there ain’t no such thing as a free lunch, or TANSTAAFL.
• Inherent in the fact that a person must make choices is the cost-benefit principle, which entails that an individual (or a firm, or a society) should only take action when the additional benefits of that actions are at least as great as its additional costs.
• An economic surplus is the benefits minus the costs of an action taken. Say the costs of the 30-minute walk in the example above are 9 euros, that leaves an economic surplus of 1 euro.
• Now say that you could have invested the time you would in studying for a test, instead. In that case we say that the opportunity costs, the value of what you have sacrificed (that is, time to study), are high. This way, you will be less likely to sacrifice that time.
• Microeconomics is the study of individual choice under conditions of scarcity and the implications of this for the behavior of prices and amounts in individual markets. Macroeconomics is the study of how national economies function and how governments use policies in attempt to improve such functioning. The scarcity principle and the fact that resources are limited are very important in both disciplines.

How do markets, specialization, and economic efficiency work? - BulletPoints 2

•  One of the most important insights in the modern economy is that when two people (or countries) have different opportunity costs in executing different tasks, they can always increase their total combined value by trading available goods and services with each other.
• This lead us to conclude that Beth and Paula should specialize, so that they can achieve the highest combined productivity together. This is the reason that we don’t spend 5% of our time on building cars, 10% on producing food, and 25% on building houses, but become fulltime car producers and leave the other tasks to other people.
• Imagine an island where only two goods are produced: coffee and pine nuts. Workers can choose to put all their time in the production of coffee, or all their time in the production of pine nuts, or in any alternative that lies between those options. Al those options taken together are called the production possibilities (PPC).
• Now say that A and B live on an island. A has both an absolute and a comparative advantage in producing pine nuts and B has both an absolute and a comparative advantage in producing coffee. When A and B decide not to specialize, and they both produce coffee as well as pine nuts, that leads to unexploited potential. However, when they do specialize, it still matters how they do it. If they do it in the most efficient way—in this case, when A only produces pine nuts and B only coffee—then that creates a production possibility frontier (PPF) in the graph.
• It is always a trade-off to increase the production of a product’s PPF, because it reduces another product’s PPF. Over time, however, it is possible to increase the PPF of all products in an economy: this is called economic growth.

How do markets, demand, supply, and elasticity work? - BulletPoints 3

• The demand curve is a graph in which the quantity of a product is shown that buyers want to buy per price. For example: at a price of 4 euros per pizza slice, buyers want to buy 8000 pizza slices and at a price of 2 euros per slice, buyers want to buy 16000 slices.
• A fundamental rule of the demand curve is that it is downward-sloping: the lower the price, the higher the demand. An important factor in this is the substitution effect: when buyers can switch to a similar product (in the case of pizza, this can be a chicken and fries), they will do that when the price (of the pizza, in this case) becomes too high. Another important factor is the income effect: when a price becomes higher, consumer can spend less money on other products. There is also the buyer’s reservation price: buyers determine the price they want to pay for a product in advance, so when the price increases, less people will be willing to pay it.
• The notable thing about markets is that they guide the price and quantity of their products toward the market equilibrium. For example, when the price of a pizza slice is 4 euros, then one of the producers will try to raise demand (and take it away from competitors) by selling slices for 3.95 euros. And the other way around: when a buyer cannot buy a pizza slice because the offered quantity is very low at a low price, then she will be willing to pay a higher price to eat pizza anyway. The price will increase because of this.
• Complements are goods that go well with (complement) each other and are worth more together than they are apart. For example: tennis balls and tennis courts. When the price of tennis courts goes down (so it becomes cheaper to play tennis), then the price for tennis balls will go up. Substitutes, by contrast, are goods whereby a lower price of one good leads to a lower price for another good. For example, when the price for internet access goes down, the demand for mail deliverers will go down also (because more people will use electronic mail).
• The price elasticity for the demand of a good is a percentage change in quantity demanded that results from a 1% change in price. Example: when the price of meat goes down with 1%, and the demanded quantity increases with 2%, then meat has a price elasticity of the demand with a value of -2 (namely, -2 / 1 = -2). The outcome of such a calculation is always negative, so we often leave out the minus (-) and say the price elasticity of the demand equals 2.
• One of the most important questions for producers is: do I get a higher revenue when consumers buy many products at a low price, or when consumers buy few products at a high price? The answer strongly depends on the price elasticity.
• Aside from the elasticity of the demand, there is also price elasticity of the supply. This works similar to the elasticity of the demand and can be calculated in the same way.
• Since sellers (producers) and buyers (consumers) exchange in markets, consumer surplus and producer surplus can sometimes occur, which together makes the total surplus. A consumer surplus is the reservation price of the consumer minus the (market) price paid by the consumer. A producer surplus is the received (market) price minus the reservations price.
• Efficiency is an important social goal, because it grows the economic “pie,” which makes it possible for everyone to get a bigger slice.
• A market in equilibrium leaves no unexploited opportunities for individuals, but may not exploit all benefits that are possible through collective action.

How does the demand side of the market work? - BulletPoints 4

• The law of demand goes as follows: people do less of an action when they costs of that action increase. This is a direct result of the cost-benefit principle, as taking an action is only done when the marginal benefits are larger than the marginal costs.
• Wants (also called preferences or tastes) play an important role in determining the price of a product. These wants can change over time: many books came out on the Titanic disaster of 1912, but they only started selling well after the 1998 film became so successful.
• The goal of people to fulfill their wants as well as possible is also called utility maximization. Goods have a certain utility. The utility of most goods rises with a diminishing rate at additional consumption. Example: eating ice cream serves the purposes of feeling happier. However, the amount with which we become happier by eating ice cream becomes smaller with each additional unit of ice cream, until we actually become less happy (as we become noxious, for instance).
• Of course, people have to achieve utility maximization from many different goods. As someone consumes more of good A, the marginal utility of good A goes down, creating an incentive to start consuming good B, because the marginal utility is higher here (low-hanging fruit principle). Eventually people have to look for the optimal combination, which leads to the highest total utility. This optimal combination comes from the rational spending rule: expenses should be divided over goods so that the marginal utility per euro is the same for every good. This rule only goes for goods that are easily to divide, such as milk and gasoline. Some goods, however, are not, as with cars and televisions. The rational spending rule follows directly from the cost-benefit principle, and is therefore not a basic principle (though it is important).

How does the supply side of the market work? - BulletPoints 5

• The answer to the question in which way you want to earn money depends on the opportunity costs. The first hour you search for cans you earn (600 x 0.02) = 12 euros. The second hour you earn (400 x 0.02) = 8 euros. The third hour you earn (300 x 0.02) = 6 euros. And the fourth hour you earn (200 x 0.02) = 4 euros. The alternative is to wash dishes, which earns you 6 euros per hour. In other words, the best strategy is to clean up cans for three hours, because after that, the marginal benefits are lower than the opportunity costs.
• The supply curve has an upward slope because of the low-hanging-fruit principle: in the case of cleaning up cans, you will first go looking for the cans that are most easily found, which makes your first hour of work the most effective. In addition, sellers respond to their opportunity costs: they stop offering a product a certain point, because they can choose for more profitable alternatives.
• As it works with cleaning cans, so does it work with hiring employees: eventually there will be a point that the output of each employee goes down. This is called the law of diminishing returns. Oftentimes this stems from a form of congestion. Example: it’s better to work with three people behind a bar, because with, say, ten people, you will only get in each other’s way.
• An important concept for the supply side of the market is fixed costs, costs that are not dependent on the output. In the example of the bottle company this is the bottle-making machine: the rent is always the same, whether you use it to produce 80 bottles per day, or 350. Aside from these costs, there are also variable costs, costs which are dependent on the output. With the bottle company these are the employees, because it requires more employees to make 350 bottles than it does to produce 80. Together the fixed costs and variable costs make up the total costs. The marginal costs, finally, are the costs in the difference in output.
• The bottle company was an example in the short run. In the long run, it is possible for a company to replace labor (the employees) and capital (the machines) and to make use of technological development to create a more efficient (at lower cost) output. This means that the law of diminishing returns isn’t so important. Besides, a company can expand and benefit from economies of scale in the long run, which can bring the price down (for example because they can acquire their input, or factors of production, more cheaply).
• When talking about profit-seeking companies, it is often assumed that they operate in a market with perfect competition, which means that no seller has any influence on the market price of the product (as a seller in a monopoly would). When this is the case, such firms are called price takers.

How does economic efficiency work? - BulletPoints 6

•  When we say a market equilibrium is efficient, it means that when price and quantity are anything other than the equilibrium value, then there will always be a transaction possible whereby some people are better without others being off worse. This is also known as Pareto efficiency. In a sense there is something as a “free lunch.” This is not good, because this way the largest possible economic surplus is not achieved.
• Say that in a market for a product the equilibrium price is too high for many poor people. In such a scenario, economists will not necessarily think that a price ceiling is a good idea, because this results in a situation wherein transactions are possible where no one is worse off. Economists would rather see that the market price reaches the equilibrium, and that we give money to poor people, so that they can use the product as well. Thinking back on the economic “pie” again: it is better to make the pie as large as possible and then split it in a fair way.

How does the “invisible hand” work? - BulletPoints 7

• Firms want to maximize their profits. There are three kinds of profit.
• Accountants will define profit as the difference between the revenue and the explicit costs, the actual payments a firm makes for the factors of production, for example. Accounting profit, then, is total revenue minus total costs.
• Economists, by contrast, define profit as the difference between revenue and the implicit costs plus explicit costs. Implicit costs are the resources that a firm produces, even when no money is paid for them. These are the opportunity costs of all resources that are used by the owners of the firms. Such profit is called economic profit, or sometimes supernormal profit or excess profit.
• Market prices have two distinct functions: distributive and allocative. The distributive function of price is to distribute scarce goods in a way that those who attach the highest value to them also receive them. The allocative function of price is to drive productive means to different sectors of the economy. Both functions are important for the theory of the invisible hand by Adam Smith, which says that the actions of independent, self-interested sellers and buyers will often result in the most efficient allocation of resources. The reward of economic profit and punishment of economic loss would ensure this.
• Economic rent, or in economics simply “rent,” is the part of a payment for a factor of production that is higher than the owner’s reservation price. The difference between economic rent and economic profit is that the latter is driven towards zero by the invisible hand, while that does not happen with economic rent. Why doesn’t that happen? Because in cases of economic rent the seller has unique capabilities that are not easily imitated. This prevents supply from going up and, thus, the price from being driven towards zero.

How does imperfect competition work and what are the consequences of market power? - BulletPoints 8

• There are different kinds of forms that these sorts of markets can take. A pure monopoly is the first. This is a market wherein one single firm is the sole seller of a unique product. It is the exact opposite of a perfectly competitive market. An oligopoly is a market structure with only a few sellers. An example would be mobile network providers: in the Netherlands there are only 4 mobile networks. A monopolistic competition, finally, is a market wherein relatively many firms are present who each differentiate their product slightly by selling in different locations for example. We use the term monopolist to describe all three of these forms, so not just to describe a pure monopoly.
• Firms with downward-sloping demand curves have a certain market power, the possibility to increase prices without losing their entire sales. This market power can stem from five different factors, of which economies of scale is the most important.
• Fixed costs play a crucial role in the constitution of certain economies of scale. When two firms compete with each other and the fixed costs are very low, then trying to increase the scale of production helps very little: it does not help to bring down the size of the variable costs, because these are dependent on the output. The fixed costs were already low, so the firms cannot outcompete each on the basis of these. However, when fixed costs are high, then increasing the scale of production does work. The fixed costs become relatively lower with each extra product that is produced. So, by producing more products than the competition, a firm in a market with high fixed costs can bring down the marginal costs of production (and, thus, increase the marginal benefits).
• The invisible hand works to make market more efficient. However, when the monopolist goes past a certain amount of production, the price will go down, whereas this would stay the same in a perfectly competitive market. This ensure that the social optimal amount is not reached, and that the monopolist becomes socially inefficient, which in turn ensures that the economic surplus will not reach its highest potential. The problem, here, is that the marginal benefits are not equal to what people want to pay for the next product, but to the new price for all produced goods.

What is the role of game theory in economics? - BulletPoints 9

• Every game has three basic elements: the players, the list of possible actions (or strategies), and the potential pay-off of these strategies.
• When a player has a strategy that delivers a higher pay-off, regardless of what the other players do, then that is called a dominant strategy. If both Lufthansa and Alitalia don’t spend anything on marketing, then that would be a dominated strategy.
• When all players have chosen their best strategy, and so there will be no incentives for players to deviate from their strategy, then we have reached a (Nash) equilibrium. This can also be reached when not all players have a dominant strategy.
• A solution has been found for the problem when playing the prisoner’s dilemma repeatedly, namely the tit-for-tat strategy: the first time you play, you choose cooperation, and from that moment on you only choose what the other player chose in the previous turn. That way, when someone cooperated, you will continue to cooperate, and when someone betrayed you, you return the favor. It is the fear of this repercussion that will prevent players from “cheating.”
• In our society we often have certain feelings that make us more focused on cooperation: moral aversion against hurting another, sympathy for the people we work with, and anger at injustice.

How does game theory work in practice? - BulletPoints 10

• A cartel is a coalition of firms or producers that collude to limit production with the goal of reaching economic profit through price setting. Oftentimes agreements that cartels make are instable, because they have to deal with the prisoner’s dilemma: participants cheat. The problem with cartels is that they can artificially increase price, which allows participants to cheat by secretly lowering price and, thus, making a higher profit. A solution for this would be the tit-for-tat strategy from Chapter 9, as this makes punishments for deviating players more effective, but that strategy really only works with two players.
• There are three important factors in determining the prices and output in a market, and they are categorized as follows:
• Market structure. By this we mean to what extent players in a market differ from one another and how many players there are.
• Convictions. In a prisoner’s dilemma the outcome depends on what is the conviction of what other players will do. What determines one firm’s conviction about another firm is determined by many factors.
• Competition. Firms differ in the way they compete with each other, often depending on the product they produce. Example: a car producer can mainly influence the quantity of cars produced. This is called “Cournot competition.” A life insurance provider, by contrast, differentiates by price setting. This is called “Betrand competition.
• The first, and possible the most important, model is the “Cournot model.” This model assumes that firms compete by determining how much they should produce and it was created by Augustin Cournot in the early nineteenth century. Examples of Cournot markets are cement- and car production. The second model is the “Bertrand model.” This model assumes that firms compete by setting the price. Examples of Bertrand markets are insurance companies and restaurants. We use these models to analyze competition and the effects of cooperation.

How do externalities and property rights work? - BulletPoints 11

• Many activities have unintended costs and benefits for people who have nothing to do with the activity. Such effects are called external costs (or negative externalities) and benefits (or positive externalities), or externalities. A good example is found in vaccinations: it is an individual choice when someone has their child vaccinated, but it also has the external benefit that other people will be further protected from sickness. We sometimes call this the spillover effect. In general the following is true: where there are positive externalities, individual choice behavior will ensure a shortage on the socially optimal quantity of these activities. In other words, since the people executing the activity do not experience the positive effect themselves, they will not bring enough of the positive effects. These effects can be very important: Adam Smith forgot to include them in his theory of the “invisible hand,” which was a significant error.
• The tragedy of the commons means that there is a tendency to exploit a resource that has no price (a common good or service) so much that its marginal benefits decrease all the way toward zero. Example: with American fisheries they have concluded that there is a lower output per person with oyster fisheries that were publicly owned than oyster fisheries that were privately owned. This was due to overexploitation of the bio mass. When there is no price for a product, meaning that the product is collectively owned, negative externalities will occur.
• A positional externality means that when a pay-off depends on a rival’s performance, that every step to enhance one’s performance automatically means that the rival’s performance is worsened. This way, positional externalities can lead to an escalating positional arms race. Since this can lead to a lot of inefficiency, societies often have positional arms race agreements, agreements that limit an arms race. One example is starting with school: older children perform better in school, so it can be advantageous to parents to wait a year before sending their kid to school, since her performance will be better. However, we don’t want parents waiting two or three years before sending their kid to school. That is why we have compulsory education from a certain age.

What is the role of information in the economy? - BulletPoints 12

• It is better to have more information than to have less information. However, actually acquiring information costs time and energy. Therefore, gathering information has a point where it is most efficient. We, again, use the cost-benefit principle: the marginal benefits of gathering information have to outweigh the marginal costs.
• There is an essential component here: there is always insecurity involved, because you can never know all information. There’s always a small gamble. You just have to gamble rationally. You can do this by calculating the expected value of a gamble, the sum of all possible outcomes of the gamble, weighed by the likeliness of their happening.
• A frequent problem is that people do not possess the same information. For example, when a car owner knows that a car is in good condition, but the potential buyers does not. We call this asymmetrical information. Usually sellers are better informed than buyers, but it can happen the other way around as well.
• This problem can lead to George Akerlof’s lemon model: uncertainty about the quality of a product will lead to an inefficient market, because sellers of good products cannot prove that their products are good, resulting in in buyers only accepting lower prices. This will ensure a decline in the quality of a market’s goods since the sellers of good products will exit the market.
• In some markets there can also be a lack of information. In such cases, firms often employ statistical discrimination: they try to ascertain the lacking information through statistics. An example can be found in the insurance industry: young men statistically cause more accidents than women or young women. This will result in higher premiums for young men.

How does the labor market work? - BulletPoints 13

• It is important for employers to try to quantify the labor (/the production) of employees, so that the marginal physical product (or marginal product, MP) can be calculated. An employee’s MP is the extra output that the firm receives as a result of hiring the employee. When we multiply an employee’s MP with the net price of every individual unit, then we get the value of marginal product (VMP). Generally, in competitive markets, workers’ wage in the long run will be equal to the VMP, which is the net contribution that she makes to an employer’s revenue.
• The human capital theory provides us with an answer here. This theory tells us that someone’s VMP (and so, her wage) is equal to their share in human capital, which is a mix between education, experience, training, intelligence, energy, etcetera. This theory says that some vocations are payed more because they require more human capital than others. The demand for different forms of human capital can change over time, and so too can wages.
• Differences in wages can also exist because one employee is with a union and another is not. A union is an organization through which employees attempt to negotiate collectively with employers for better wages and working conditions. Unions are controversial in economics. Some think they are a positive protection of employees, and of fair wages and human working conditions. Others, however, believe that unions have the same effect on the labor market as do cartels on the production market. In other words, they think that unions stop markets form being efficient.
• Differences in wages also occur through different working conditions. We expect that someone who works in poor conditions is better compensated than someone who works in relatively good conditions. This compensation is called compensating wage differences.
• Differences in wages can also occur as a result of discrimination (for example, racism and sexism). When this is proven, this forms a deep critique on the functioning of competitive markets, as discrimination leads to inefficiency.
• An important measure of income differences it the Gini coefficient. This measures to what extent an observed distribution differs from a hypothetical perfectly equal distribution. Graphically represented as cumulative percentages of wealth (on the y-axis) and population (on the x-axis), the Gini coefficient is the difference between a straight line from the bottom-left to the top-right and the Lorenz curve, the representation of the cumulative wealth per part of the cumulative population. For example: 50% of the people have 10% of the wealth.
• The philosopher John Rawls would say inequality is a moral problem. He reasoned as follows: when people would create a system of distribution from behind a veil of ignorance, which means that they don’t know how their skills would be valued in the system under creation, then they would implement as many rules as possible that would ensure they would be treated fairly. In other words, people would create a fully egalitarian system. One reason for this lies in the fact that most people are risk-averse. We can conclude from this that anything that deviates from the system that would be created form behind the veil of ignorance is, in principal, ethically inferior.
• Economists would point out to Rawls that small forms of inequality can be desirable to give people certain incentives, such as the incentive to work hard and be on the good side of inequality. However, they would mostly agree with his statement that fairness at least requires attempts to reduce inequality.
• There are two methods of reducing inequality: the first is to remove the underlying factors that produce inequality and the second is to offer compensation for the outcome. An example of the first would be to give better education to children from poorer families and an example of the second would be to give certain households money. Redistribution takes place in two ways, namely by a progressive tax system (higher incomes pay more taxes than lower incomes, both absolutely and relatively) and by spending more public money on lower incomes than on higher incomes.

What is the role of the government in the market economy? - BulletPoints 14

•  There are two kinds of goods that are produced through government activities: public goods and merit goods. Public goods are goods that, at least to some extent, are both non-rival and non-excludable. Oftentimes these cannot be efficiently produced by the market. Merit goods are goods that are produced under non-market circumstances by the state for political reasons. These can be produced by the market, but for political reasons, they aren’t. Examples of such goods include health care and education.
• An important difference between private goods and public goods is that with the former people are free to consume as much of it as they want, whereas with the latter, they can’t. For instance, when a government would implement a poll tax, then there wouldn’t be enough money for public goods such as parks, which are used more by high-income people than low-income people. This is an important reason for the fact that many countries have a progressive tax, whereby the proportion of the income that is taxed increase as income increases.
• Regulation is the legal intervention in markets for the purpose of influencing the way firms and consumers behave. This can be necessary in markets wherein firms have a lot of market power, which creates economic inefficiency. However, in preventing market failure governments can also allow regulatory failure. This has to be prevented.
• Regulations are supposed to counter market failure. However, there is no free lunch: when regulations are applied, this exposes the economy to potential regulatory failure. This can come in two shapes: (1) regulation is badly designed or (2) regulation is employed for different goals (regulatory capture). When the latter occurs, forms of regulation are actually used to protect companies—from competition, for instance. Another example: a supplier of alcohol who fights for limits on the number of bars to counter excessive consumption of alcohol.

What are the micro foundations for a macroeconomic crisis? - BulletPoints 15

• It is important to remember that the crisis was not solely caused by the mortgage crisis in the US. That was the “tipping point,” but the underlying causes were much broader. After all, in the 1980s there already was a subprime mortgage crisis, the S&L crisis, but the impact of this crisis was nowhere near that of the 2008 crisis (even though there was a recession).
• The international financial crisis had a big part in the global economic crisis, so it is useful to find out what the underlying causes were. The two most important were regulatory failure and information asymmetry.
• At first, people thought the bankruptcy of Lehman Brothers was a liquidity problem, a shortage of funds that they could easily sell to manage their long-term obligations. When people take a lot of money off bank A, then bank A has to borrow money from bank B, so that bank B is now also at risk to have to few liquid funds. The shortage in liquidity ensure that banks had to pay off their loans, which ensured that money that was destined for the short term was used for the long term payments. If this perception of the crisis were true, then that implied two things: (1) that there mostly was a crisis of faith that needed to be restored and (2) that the provision of liquidity and the reducing of uncertainty would offer the required solutions.
• The solution could be to go back to the time from before 1986, when banks only lend out money and accepted small risks and other intermediaries did the large investments. That way even the biggest financial institutes would not become “too big to fail.” However, there are two problems here: (1) when would we be back at that “level”? and (2) we would lose economic surplus, because deregulation has led to profits from efficiency. However, perhaps this is a price we should want to pay.