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Chapter 1. About Economics. About Economics. Economics is often referred to as the “dismal science.” Purpose of this Chapter: Introduction to field of economics. Defining economics and the questions economics address Discussing how economists think

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chapter 1

Chapter 1

About Economics

about economics
About Economics
  • Economics is often referred to as the “dismal science.”
  • Purpose of this Chapter: Introduction to field of economics.
    • Defining economics and the questions economics address
    • Discussing how economists think
    • Presenting five important lessons of economics
  • Economics is broadly defined as the study of the allocation of scarce resources.
    • Agricultural economics is the area of economics that specializes in agriculture and food issues
examples of economics
Examples of Economics
  • Cows and Buffalo
    • How have cows never gone extinct but buffalo nearly have?
  • Elephants in Africa
    • To keep elephants from being extinct, Zimbabwe allows farmers and herdsmen to own them.
  • Exxon Valdez Oil Spill
    • Lawsuits against the tanker oil spill
fields of economics
Fields of Economics
  • Macroeconomics: Study of large economies
  • Microeconomics: Study of individual behavior
  • Environmental and Resource Economics: Study of the environment and resources
  • Behavioral Economics: Study of economics and psychology
  • Labor Economics: Measuring the income gap between men and women, whites and blacks, and trying to understand the gap.
  • Agricultural Economics: Economics specializing in agriculture and food issues.
economic forces
Economic Forces
  • Economics is not always exact, but it is a pervasive and important force.
    • Economic forces are general rules for economics.
        • Compare the economic forces to a thermostat. A thermostat is not an absolute truth. If you set a thermostat to 72 degrees, no place in the room will it be exactly 72 degrees. But the thermostat—like economic laws—is a pervasive and important force. This is the reason we prefer the term ECONOMIC FORCES.
      • The Three I’s of Economic Theory: Incentives, Interactions, and Indifference.
incentives
Incentives
  • People respond to incentives:
    • If the government taxes more of people’s income, people will work less.
    • If gas prices rise, people will (eventually) drive less.

For example: 1960’s—Numerous automobile safety regulations, including the mandatory use of seat beats, padded dashboards, and penetration-resistant windshields were issued.

    • This made driving safer giving people the INCENTIVE to drive more recklessly.
interactions
Interactions
  • When people follow incentives, and in the process interact with others, this interaction often changes those incentives.
    • Check out line in a grocery store
    • Congress taxing yachts
indifference
Indifference
  • Indifference Principle: except when people have unusual tastes or unusual talents, all actions must be equally desirable.
    • It describes an equilibrium where there are no incentives for people to modify their actions.
      • Example: Wal-Mart Check Out Line:: If a person is ready to check out and all of the lines are the same length, that person is indifferent to which line he or she has to wait.
does farm aid benefit farmers
Does Farm Aid Benefit Farmers?
  • Farmers’ incomes depend on the weather and the price farmers receive can fall without warning.
    • Government has responded to the tough times with subsides.
      • Some say subsides are due to the fact that farmers are a powerful lobbying group.
      • Others say that government research aimed at an inexpensive food supply hurts the farmer by lowering the prices they receive, so the government give the extra payments to make up the difference.
slide11

Figure 1.3. Wren is indifferent between farming and industry labor

  • Think Economically…
  • Wren is renting her crop land from a landowner for $5,000.
  • Wren grows wheat and makes $40,000 before paying the rent payment.
  • After paying rent, she has made $35,000.
  • The alternative to farming is working in industry that pays $40,000.
  • Wren is willing to forgo $5,000 in profits per year to farm because she enjoys it.
  • She is now indifferent between being a farmer and an industry worker.
slide12

Figure 1.4. With the government subsidy, Wren prefers being a farmer

  • Suppose the government feels that Wren deserves more money, giving her subsides of $5,000 per year.
    • This causes the benefits of farming to be greater than she could earn in industry.
    • However, this gives negotiating power over to the landowner.
slide13

Figure 1.5. The government subsidy raises land rent, leaving Wren indifferent once again.

  • In some way or another the subsides given to the farmers will eventually get back to the landowners.
    • In this case, in the form of rent. If Wren was getting the subsides the landowner could raise the rent to $10,000.
      • This would make being a farming and being a industry worker indifferent again.
    • The landowner is better off by $5,000 and is indifferent between being a landowner and not being a landowner.
does genetically modified seed benefit farmers
Does Genetically Modified Seed Benefit Farmers?
  • Genetically modified seeds could lower production costs and food prices for consumers.
    • However, most genetically modified seeds are patented by a seed company. This allows the seed company act as a monopoly, charging higher costs for the modified seed than the regular seed.
  • For example: Monsanto’s Bt Cotton
the force of one price
The Force of One Price
  • Full Price paid for an item can be broken into two components: transaction price and transaction cost.
    • Transaction Price: refers to the money the buyer gives to the seller.
    • Transaction Cost: refers to any other costs the buyer or seller incurs in the transaction.

Full Price = Transaction Price + Transaction Cost

  • Law of One Price: If transaction costs are zero, the transaction price of identical goods should be the same across regions.
law of one price
Law of One Price
  • Law of One Price: If transaction costs are zero, the transaction price of identical goods should be the same across regions.

For example: Purchasing a car in Raleigh (your hometown) or Charlotte, North Carolina.

    • The transaction price may or may not be the same but the transaction cost is not. It costs money and time to travel to Charlotte, making the transaction costs greater than in Raleigh.
      • If the transaction costs are zero and the price of cars is lower in Charlotte than Raleigh, everyone will purchase cars from Charlotte.
      • Charlotte dealers will increase their prices due to the demand and Raleigh dealers will lower the prices to entice buyers.
      • This continues until the prices are the same in all regions and people are indifferent between purchasing in Charlotte or Raleigh.
slide17

Figure 1.6. Price differences for wheat in selected Midwest states. All differences are relative to river ports in Eastern Kansas and Oklahoma ( a negative difference means the price is lower relative to river ports).

  • The price difference shown is due to the fact that most wheat is sold near river ports in eastern Kansas and eastern Oklahoma.
  • The price of wheat purchased from Dodge City (western Kansas) to resale in Kansas City (eastern Kansas) will be considerably lower than directly sold in Kansas City.
    • This is due to the added transaction costs of transporting the wheat across the state.

Map made available by Agmanager, Department of Agricultural Economics at Kansas State University. Available at http://www.agmanager.info. Accessed September 20, 2005.

indifference principle wheat sales
Indifference Principle: Wheat Sales
  • The Indifference Principle states that wheat buyers should be indifferent between buying wheat in Kansas City and Dodge City.
    • To make this principle true:
      • Transaction price in Dodge City must fall just enough to offset the transportation costs.
          • If prices are $0.50 lower in Dodge City compared to Kansas City, you can bet the cost of hauling wheat across the state of Kansas is around $0.50 per bushel.
can you profit from price difference situation
Can you Profit from Price Difference Situation?
  • If the Indifference Principle is not true in this situation:
    • Suppose it costs $0.50 per bushel to haul wheat from Dodge City to Kansas City.
    • Price in Dodge City is $3.00 and the price in Kansas City is $4.00.
    • YOU CAN PROFIT FROM THIS!!!
      • Purchase wheat from Dodge City for $3.00, transport it to Kansas City for $0.50, and receive $4.00 per bushel.
      • You will profit $0.50 per bushel.
      • This is called ARBITRAGE: profiting from price differences across markets.
arbitrage
Arbitrage
  • Definition: Profiting from price differences across the markets.
    • Many businesses seek these arbitrage profits.
      • For example: Long-Term Capital Management
        • Keep track of the price of similar investments. If investments are similar, they should sell for similar prices.
        • However, if prices diverge, they would purchase the cheap asset. They anticipate prices to converge again. (Due to the Force of One Price)
        • The investment they purchases would rise in value, after which they would sell it to make a profit.
      • Some businesses and companies have started using this method or profiting with “robo-traders” (computers that trade things like commodities and stock).
arbitrage indifference principle and force of one price wheat sales
Arbitrage, Indifference Principle, and Force of One Price: Wheat Sales
  • Given: Transportation costs = $0.50 per bushel, Price in Dodge City = $3.00, Price in Kansas City = $4.00.
    • Buying wheat in Dodge City and selling to Kansas City will continue as long as the price difference is great than the transportation costs.
      • Continually buying more and more wheat from Dodge City bids up the price of wheat in Dodge City.
      • Continually selling more and more wheat to Kansas City bids down the price of wheat in Kansas City.
      • Dodge City price increases & Kansas City price decreases: no longer allowing for arbitrage profiting.
      • The price difference in Dodge City must be exactly $0.50 per bushel less than the price in Kansas City, due to the $0.50 transportation cost.
  • As long as people are pursuing profits, the Indifference Principle ensures that the Force of One Price holds.
price differences for wheat
Price Differences for Wheat
  • Indifference Principle allows price differences to differ, but only by so much.
    • Never exceeding the transportation cost between two regions.
    • If they do, arbitrage opportunities arise.
    • People follow their incentives, which lead to interactions causing prices to quickly change, and soon the price differences are less than transportation costs and once again the Indifference Principle holds.
price of grain between harvests
Price of Grain Between Harvests
  • Most crops are available one time a year.
    • Storing grain is not done by the government and many people do not store grain unless they think they can make a profit.
      • If storing the grain for a couple of months will allow you to receive more money per bushel than selling it at harvest time, there is an incentive to store grain because it is profitable. (Example of Arbitrage: profiting from price differences across time.)
price of grain between harvests1
Price of Grain Between Harvests
  • The Indifference Principle implies that the price difference of a storable crop in different time periods should equal the cost of storing the crop between those time periods, so long as there is no new harvest.
    • Once a new harvest arrives, there is little incentive to store the crop.
  • The Indifference Principle can also be used to articulate how prices for crops in different time periods should change as storage costs rise or fall.
    • If storage costs rise, the price difference for corn in May and June should be larger compared to when storage cost were lower. Then prices must rise throughout the crop year by a greater amount than before to compensate people for storing the crop.
slide25

Figure 1.8. Price of winter wheat in Kansas City

  • Price differences from different time periods reflect the storage costs.
    • The price difference will pay for the wages and salaries of workers involved in maintaining storage facilities as well as other storage costs.
  • Arbitrage and the seeking of profits ensure an adequate supply of food throughout the year.
slide26

Figure 1.9. A Few Words From the Father of Economics

Adam Smith is considered the Father of Economics

Image made available by the Adam Smith Institute. Available at http://www.adamsmith.org/.

when will we run out of oil
When Will We Run Out of Oil?
  • The world consumes approximately 29 billion barrels or oil each year.
    • Experts seem to think that we will out of oil in 44 years.
    • For example, in the mid-1970’s, there were only 650 billion barrels of proven oil reserves, but today there are more than 1.2 trillion barrels on reserves.
  • Three reasons that oil will always exist:
    • Oil explorers respond to incentives.
      • It is profitable to locate the hard-to-find reserves when prices rise.
    • As oil becomes scares, there are incentives for people to invent and invest in technology.
      • Example: Fuel efficient vehicles.
    • Oil is not the only source of energy.
      • Alternative energy sources, like wind energy, will one day become indifferent to oil.
six economic lessons
Six Economic Lessons
  • Think Toys, Not Dollars
  • Beware the Law of Unintended Consequences
  • Markets Work Well (If Prices Reflect All Costs and Benefits)
  • The Only Scientific Definition of “Value” is People’s Maximum Willingness-to-Pay
  • People’s Actions Are Largely Driven by Opportunity Costs
  • The Time Value of Money
lesson 1 think toys not dollars
Lesson 1: Think Toys, Not Dollars
  • Toys are considered to be anything that you get pleasure from consuming, like Playstation, Houses, high-definition TV, etc.
  • Terms toys = goods and services
  • Broken Window Fallacy: represents an ill-founded confusion on the importance of toys and dollars.
    • For example: If a hail-storm destroyed your roof and you have to replace it, the money you would have to pay to fix the damage would help to stimulate the economy. However, it will not necessarily make you happy.
      • You would not be better off because you will not have your old roof AND the new roof. You have to make more money to replace the old roof. Because you had to do this involuntarily indicates that it will not make you happier.
lesson 1 think toys not dollars1
Lesson 1: Think Toys, Not Dollars
  • For an individual business exporting more than one imports means the business is turning a profit.
  • In International trade, exporting more than one imports does not mean the country is turning a profit.
    • Normally, a country will export as much as it imports.
      • Example: Cars and bananas with Belize
  • As desire for more exports than imports is confusing dollars with toys.
lesson 1 think toys not dollars2
Lesson 1: Think Toys, Not Dollars
  • Inflation: The price of all goods and services has risen each year, so a dollar purchases less each year.
    • Consumer Price Index (CPI): U.S. Government maintained statistic that measures inflation.
      • Can be used to take dollars in one year and calculate its equivalent purchasing power in another year.
lesson 1 think toys not dollars3
Lesson 1: Think Toys, Not Dollars
  • Using CPI for dollars can help you to understand the true situation.
    • For Example: Job in Tulsa at $40,000 vs. Job in New York at $55,000.
      • Use CPI to compare the options (apples to apples).
      • The Salary in New York would be the same as getting paid $23,000 when you consider how much it costs to live in the area.
      • The Job in Tulsa is the better opportunity, giving the most “toys.”
lesson 1 think toys not dollars4
Lesson 1: Think Toys, Not Dollars
  • Parity Price: a price in one time period that provides the same purchasing power as another time period.
    • 1910-1914 was a good time to be a farmer. The price of agricultural commodities was higher than it had ever been. In the 1930’s farmers wanted the government to enact programs so that one bushel of corn could buy as many toys as it did during the 1910-1914 era. Farmers knew that the price calculation should take inflation into account. In 1910-1914 a bushel of corn was $1.50, due to inflation, the price of corn in 1930 would have to be higher than $1.50.
lesson 2 beware the law of unintended consequences
Lesson 2: Beware the Law of Unintended Consequences
  • Governments impose regulations with the best intentions, but those regulations can change people’s incentives, leading to an undesirable outcome.
    • Policymakers tend to consider how regulations alter incentives.

For example: After Exxon Valdez, many states created laws placing unlimited liability on tanker operations. This caused many companies to cease shipping oil across seas or hiring other companies to do it for them.

lesson 2 beware the law of unintended consequences1
Lesson 2: Beware the Law of Unintended Consequences
  • Economic Model: a simplified version of the real world where many complexities are assumed away to concentrate on a single question.
    • Example: Floodville and Highville
      • People have the same preferences and the only difference between the two towns is that Floodville experiences a huge flood about once every 50 years and Highville never floods.
      • For the Indifference Principle to hold true, it must cost $20,000 less to live in Floodville. However, when it floods the $20,000 must just offset the reconstruction costs, for the people to remain indifferent.
      • When the flood occurs, if the government decides to provide relief by taxing the residents in Highville and giving the money to Floodville citizens. Now, people prefer to live in Floodville because the cost of living is lower and they are compensated for flood damage.
lesson 2 beware the law of unintended consequences2
Lesson 2: Beware the Law of Unintended Consequences
  • Example Continue: Floodville and Highville
    • People are indifferent between living in Floodville or Highville before and after the government decides to compensate flood victims.
    • There are more people living in Floodville so there are more homes destroyed by floods.
      • A portion of people’s incomers that were spent on toys is now spent on compensating more flood victims.
    • No one benefited from the governments compensation plan. Overall, society loses toys.
lesson 2 beware the law of unintended consequences3
Lesson 2: Beware the Law of Unintended Consequences
  • Agricultural Economists can spend their career writing about this law.
    • Example: Regulation of Swine Manure
      • The State of North Carolina was considering law limiting the amount of swine manure that could be applied to crops. To reduce phosphorous runoff that pollutes the rivers and streams.
      • Economists discovered that if the law was passed, the farmers’ incentives were to substitute chemical fertilizers for the manure in a way that the water pollution would actually increase.
lesson 3 markets work well if prices reflect all costs and benefits
Lesson 3: Markets Work Well (If Prices Reflect All Costs and Benefits)
  • Markets are nothing more than a collection of buyers and sellers who negotiate transactions and prices.
    • Markets operate based on the profit motive.
    • Markets allow buyers and sellers to work together in a voluntary fashion to find deals that make both better off.
lesson 3 markets work well if prices reflect all costs and benefits1
Lesson 3: Markets Work Well (If Prices Reflect All Costs and Benefits)
  • Market failure: a market transaction made the buyer and seller better off but harmed a third party.
    • Externality: the harm to the third party.

For example: Poultry Production

Poultry production produces water pollution. When you purchase chicken at the grocery store, it makes you better off. The sale of the chicken makes the grocery better off. However, the users of the surface waters are made worse by the raising of chicken leads to water pollution. THIS IS CALLED A NEGATIVE EXTERNALITY, because of the negative harm to the third party.

lesson 3 markets work well if prices reflect all costs and benefits2
Lesson 3: Markets Work Well (If Prices Reflect All Costs and Benefits)
  • Poultry example continued:
    • Several remedies for this type of market failure.
      • Example: Tax chicken producers by an amount to equal the cost of the pollution.
        • Tax money can be used to compensate water users or to clean up the pollution.
lesson 3 markets work well if prices reflect all costs and benefits3
Lesson 3: Markets Work Well (If Prices Reflect All Costs and Benefits)
  • Positive Externality: market transactions that make the buyer and seller better off, and benefit a third party.
    • Example: Pharmaceutical Research

A researcher sells her services to a pharmaceutical company, both the buyer and seller are better off. The researcher discovers a better means of health care, down the road it will benefit the third party—society. Because the pharmaceutical company can not capture all the benefits to the third party, the end result is too little research. The solution is to have the government subsides research.

lesson 4 the only scientific definition of value is people s maximum willingness to pay
Lesson 4: The Only Scientific Definition of “Value” is People’s Maximum Willingness-to-Pay
  • Whatever definition of “value” economists adopt, we must be able to measure it.
  • Economists often measure the “value of a statistical life” for use in setting government policies.
    • Environmental Protection Agency uses it to estimate the value of lowering carcinogens in food.
    • Department of Transportation uses it to determine how speed limits should be set.
    • Currently, the value of a statistical life used is around $3-$7 million, depending on the government agency.
lesson 4 the only scientific definition of value is people s maximum willingness to pay1
Lesson 4:The Only Scientific Definition of “Value” is People’s Maximum Willingness-to-Pay
  • Our nation regulates food production to ensure that food is safe but is also not too expensive.
    • Defined this value as “consumers’ maximum willingness-to-pay for safer food”
    • For example: Traceable Beef
      • The government has considered establishing a system to track where beef originated. This to ensure that the beef was raised on farms using safe production practices. This system will cost money, making beef prices rise. But how much are consumers willing to pay for “traceable beef” relative to other beef?
lesson 5 people s actions are largely driven by opportunity costs
Lesson 5: People’s Actions are Largely Driven by Opportunity Costs
  • Opportunity Cost: The value of the next best alternative
    • Example: Running a Store vs. Teaching
      • The store makes $100,000 in revenues each year.
        • Accounting Costs (wages, cost of beverages and food, rent, energy bills, taxes, etc.) = $50,000
      • Teaching salaries is $40,000
      • If you didn’t run the store, the next best option would be to teach.
      • Accounting profits for running the store are $100,000 - $50,000 = $50,000.
      • To run the store you forgo the salary you could have earned as a teacher. The value of the next best alternative is the $50,000 that you would save in accounting costs plus your $40,000 teacher salary.
        • Opportunity Costs are $50,000 + $40,000 = $90,000
      • Economic Profit from running the store are revenues minus opportunity costs: $100,000 - $90,000 = $10,000
lesson 6 the time value of money
Lesson 6: The Time Value of Money
  • The value of money depends on when that money will be received.
    • A dollar today is worth more than a dollar tomorrow because money has an opportunity cost.

Example: If you were offered $100 today or $101 in one year, you would take the $100 today. You could take the $100 today and invest it in a interest-earning instrument and have more than $101 in one year.

You could put that $100 in a CD or savings account at the bank that pays i = 3% interest. At the end of the year you will have your $100 plus earn $100 x i = $100 x 0.03 = $3. (This can be written as $100(1+i) = $100(1+0.03) = $103)

This means that $100 today is worth more than $101 next year, but $100 today is worth the same as $103 next year, at the interest rate of 3%.

lesson 6 the time value of money1
Lesson 6: The Time Value of Money
  • Interest Rates: is usually associated with loans and investments.
  • Discount Rate: the rate of return on money that makes one indifferent between money today and money tomorrow.
    • Best interpreted as the opportunity cost of money.
lesson 6 the time value of money2
Lesson 6: The Time Value of Money

Example: You have the choice of $1,000 today or $1,050 next year and you choose $1,000 today. Then give you the choice of $1,00 today or $1,100 next year, and you say you are indifferent. You are given the choice of $1,000 today or $1,101 next year, you prefer the money next year.

The discount rate (r) that makes you indifferent between money today and next year is then $1,000(1+r)=$1,100. Solve for r. r=1100/1000-1= 0.1 or 10%. The rate at which you discount money in the future is 10%.

lesson 6 the time value of money3
Lesson 6: The Time Value of Money

The discount rate of 10% means that as long as you can use money today to purchase a financial instrument that yields 10% or more in interest you will forgo the money today , purchasing the instrument, and earning interest.

In the example: $1,000 today is the Present Value (money today). $1,100 next year is the Future Value (money paid out later).

The discount rate is just a number that converts present values to future values.

(Present Value)(1+r)=Future Value OR Present Value=(1+r)-1(Future Value)

(1,000)(1+0.10)=(1,100) (1,000)=(1+0.10)-1(1,100)

lesson 6 the time value of money4
Lesson 6: The Time Value of Money
  • More complicated investment problem:
    • We can upgrade a vegetable processing plant, incurring costs of $150,000 today. The upgrade will yield extra profits of $70,000 for the next 3 years.
    • To determine which is worth more, $150,000 today or $70,000 in extra money for the next 3 years, we must “discount” the $70,000 in years 1, 2, and 3. We must convert them to their present value.
slide50

Figure 1.11. Discounting Example (discount rate = 10%)

It is clear the upgrade should be made. Accounting for the opportunity costs of money, the expenditure of $150,000 today yields more profits than investing in the next best alternative.