1c Handout Economic Actors and Markets
Spring 2007
1. The Economic Way of Thinking The economic way of thinking was an expression coined by the late Paul Heyne. The economic way of thinking is choice. We make choices in response to scarcity unlimited wants and limited resources. According to the economic way of thinking, every choice or action involves a foregone opportunity or cost. This is what we refer to as an opportunity cost. As a result, an individual compares the benefits of each action to its opportunity cost when making a decision. An individual does not compare the total benefit and total cost cost, but rather the additional or marginal benefit and marginal cost. The economic way of thinking tells us that an individual will keep doing something so long as the marginal benefit exceeds the marginal cost. Once the marginal cost equals the marginal benefit, an individual will stop his or her activity. In making a decision, an individual considers the relative price of an action. You decide what to buy in the grocery story by considering the price of an item relative to other items. You make this calculation implicitly because you know what a dollar can buy. For instance, a price of $10 for a candy bar appears expensive because $10 could buy you a CD or a t-shirt or lunch! An increase in a relative price will induce two effects. The substitution effect is that if the price of an activity or good rises relative to another then an individual will substitute out of the moreexpensive activity or good into the less-expensive activity or good. The income effect, on the other hand, is the effect of the relative price increase on the well-being or income of the individual. Consider an increase in the price of a Mars bars while all the prices of all other candy stays the same. The increase in the price of a Mars bar relative to a Snickers bar will lead consumers to substitute out of Mars bars and into Snickers bars substitution effect. Furthermore, the increase in the price of a Mars bar makes consumers worse off so they will consume less Mars bars and Snickers bars income effect. 2. The Economic Actors There are two main economic actors: the households and firms. Households are individuals and families who work, save and spend. The objective of each household is to maximize utility or happiness. Each household maximizes utility by making three decisions: (1) What to buy in the goods and services markets: demand decision (2) How much to work in the labor market: labor supply decision (3) How much to save in the capital markets: savings decision Firms are businesses and companies who produce goods and services by hiring labor and renting capital. The objective of each firm is to maximize economic profit, which is defined as total revenue (price quantity) minus economic costs (wage labor + interest rate capital). Each firm maximizes economic profits by making three 1 decisions:
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Handout 1c Economic Actors and Markets
Spring 2007
(1) How much to produce in the goods and services markets: supply decision (2) How much to hire in the labor market: labor demand decision (3) How much to borrow in the capital markets: borrowing decision 3. Markets A market is an institutional construct under which economic exchange occurs. For instance, buying coffee at Ralph's is participating in the retail coffee market. Similarly, working for the Outpost is participating in the labor market. Moreover, selling your Leif Garrett record collection on EBay is participating in the 1970 collectables market. In each market, there is a relative price. This relative price is paid by the buyer or what we call the demander in economics and is received by the seller or what we call the supplier. For instance, the price of coffee is the price paid by the shopper (demander) and the price received by Ralph's (supplier). The hourly wage rate at the Outpost is the price paid by CSU-LB (demander) and the price received by the worker (supplier). The winning bid on EBay is the price paid by the buyer (demander) and the price received by the seller (supplier). There are three types of markets: goods and services market, labor market, and capital market. The goods and services market is where economic goods such as food, furniture, automobiles and services such as banking and insurance are bought and sold. The households demand the goods and services and the firms supply them. The relative price in the goods and services market is the price of those goods and services or what we call a price index. The labor market is where households are employed by firms. The firms demand the labor and the households supply it. The relative price in the labor market is the real wage rate: the real price paid by firms and received by households. We will talk more about the labor market later in the course. The capital market is where excess savings of households is transferred to firms for capital accumulation. Capital accumulation is where firms acquire new plant, machinery and equipment to increase their productive capacity. The firms demand the capital by borrowing and the households supply the capital by essentially lending. The relative price in the capital market is the real interest rate: the real price paid by firms to borrow and households to lend. We will talk more about the capital market later in the course. 4. Circular Flow Diagram The following circular flow diagram shows the interactions of the three economic actors in the three markets. The blue lines on the outside represent the flow of the goods and services themselves, while the red lines on the inside represent the flow of monetary payments.
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Handout 1c Economic Actors and Markets
Fall 2007
Households
Labor market
Goods & services market
Capital market
Firms
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