Chapter 1 : Scarcity, Trade-offs, and choices
Part 1 : Economic way of reasoning
Economics is a study of how to make choices under scarcity
Economics way of reasoning
1. Economic perspective
a. Scarcity and choice
 Choices must be made under scarce resources
 Every choice has cost involved
 The cost is an opportunity cost
 Opportunity cost is when we want to obtain more of one
thing we have to give up the opportunity of getting next
best thing
b. Purposeful behaviour
 Individual : maximize utility (pleasure from consuming
goods/services)
 Firms : maximize profit
c. Marginal analysis
 Marginal Benefit (MB)
 Marginal cost (MC)
 MB ≥ MC
 When making decision, think at margin only. Do not include
sunk cost (cost the has been incurred)
2. Formulating the ideas
a. Using scientific methods
 Observe
 Formulate a hypothesis
 Test the hypothesis
 Accept, reject, or modify the hypothesis, if necessary
 Theories and principles
- Generalization of economic behaviour that are
true for an average person
- Assume other-thing-equal (held others
constant)
b. Microeconomic and Macroeconomic
 Microeconomics (decision making by individuals or
individual units)
 Macroeconomics (economy as a whole)
c. Positive VS Normative economics
 Positive economics : deal with economic facts
 Normative economics : opinion based : ought to be / should
be)
3. Pitfalls to sound economic reasoning
 Biases (preconceptions that aren’t based on facts)
 Loaded terminology ( in the news to catch audience’s
interest)
Ex. Greedy owners, obscene profits
 Fallacy of composition ( what is true for one doesn’t mean it
is true for others)
 Post hoc fallacy ( A is not necessary the cause of B )
 Correlation but not causation ( events maybe relate without
causal relationship)
Part 2 : Individual’s economizing problem (budget line)
Unlimited want but limited income
Maximize our utility
Use budget line
- Budget line (schedule curve) shows the greatest combination of two
goods that we can purchase with limited income
- To construct a budget line
o Know income
o Price of each goods (A,B)
o Let A be 0 and maximize B
o Continue increasing A and decreasing B (til B is 0)
o Draw straight line by start with x-intercept, y-intercept
What does the budget line tell us?
- Any point on budget line = maximum combination of goods (spend all of
money)
Trade-offs and opportunity costs
-
Budget line is always downward sloping (negative slope)
Opportunity cost remains the same
Opportunity cost = how many B you lose to get A
Slope = Opportunity cost
Part 3 : Society’s economizing problem ( PPC )
- Society needs to make choice because resources scarce
- Resources  factors of production or inputs
Resources in the economy
1.
2.
3.
4.
Land/natural resources
Labour/human resources
Capital/investment goods ( NOT stock, bond, and money (isn’t resource))
Entrepreneurial ability
Production possibilities model
- PPC = Production Possibilities Curve (can be table/frontier) shows the
maximum combination of outputs (products) that can be produced by
input (resources) at a point of time (fixed resources)
Four assumptions for constructing PPC
1.
2.
3.
4.
Full employment ( full production )
Fixed resources ( quality + quantity )
Fixed technology
Two goods
Any points along the curve
- Efficient
- Maximum possible output
Move along the curve  has opportunity cost
Move from inside the curve to point on curve  has no opportunity cost
Optimal allocation
- Depends on society
- Need to compare MB and MC of each goods
Optimal production of any item MB = MC
- MB< MC : good
- MB > MC : bad
Q1: Increase production beyond Q1
Q2: Cut production below Q2
Q3: keep current level of production
Trade-offs and opportunity cost
- PPC always downward slope ( negative slope )
- To increase production of A , society must give up more and more units
of B
- Opportunity cost increases, A/B increases
To find out increasing, constant of decreasing opportunity cost
1. Compare opportunity cost at low and high level of x
2. Find how PPC slopechanges as we move left right
Changes in PPC
When
- Change in technology
- Change in quantity or change in resource
PPC shift
1. Neutral
2. Biased
Neutral
- If change affects both goods equally
Biased shift
- If changes affect one > other
Movement inward, outward
When
- Change in how resources are used (efficient)
- Change in unemployment , factory capacity utilization
Present choice and future possibilities
- Economy produce today  determines amount of economic growth in
the future
- Goods for future = capital , education, research & development
- Satisfy future needs = produce great amount of present goods in the
future
International trade
- Having more and better resource of improved technology
- PPC right shift
Chapter 3 : Demand , supply and market
Demand and supply as an individual face
Market = an institution / merchanism that brings buyers and seller
together
- Have buyers , sellers
- Sell same product
- Price are discovered through the interaction of buyers, sellers
Low of demand
- Inverse relationship
- Price increase, Quantity decease (quantity demanded)
Because
1. Common sense
2. Diminishing marginal utility
 Lower happiness so they buy more only when price
fall
3. Income and substitution effects
 Income effect
 Substitution effect : purchase more unit of goods that
is relatively cheaper
The demand curve
 Quantity demanded = Quantity that you are milling
and to buy
 Demand = Schedule or curve shows quantity
demanded at a specific point in time
Individual and market demand
 Market demand = collection of all individual demand
 Market demand curve describe the relationship
between price and quantity demanded which other
variables remain constant (except price,quantity
demanded)
Determinant of demand
 Number of buyers increase, demand increase
 Consumer tastes and preferences increase, demand
increase
 Consumer income
 Superior or normal goods
Income increase, demand increase
 Inferior goods
Income increase, demand decrease
 Neutral goods
Income increase, demand no change
 Price of related goods
 Substitute
Price A increase, demand B increase
 Complementary goods
Price A increase, demand B decrease
 Unrelated goods
 Price A increase, demand B not change
 Taxes and subsidies on consumers
 Taxes increase, demand decrease
 Subsidies increase, demand increase
 Consumer expectation
 Future income increase, demand increase
today
 Future prices increase, demand increase today
Change in demand VS change in quantity demanded
1. Demand curve shift when changes in determinants of demands
2. Changes in quantity demanded (change in prices)
 Movement along the curve
Law of supply
 Direct relationship between price, quantity supply
 Price increase, quantity increase
 Because common sense and increasing marginal cost
(scarcity of inputs)
The supply curve
Supply = schedule / curve that shows quantity at specific point of
time
Changes in supply
Determinants of supply




Number of sellers increase, supply increase
Cost of production increase, supply decrease
Technological change ( improve ), supply increase
Price of other produced goods
o Production complement goods ( price A increase,
supply A increase, supply B increase)
o Production substitute goods (Price A increase, supply
A increase, supply B decrease_
 Taxes and subsidies on producers
o Taxes increase, supply decrease
o Subsidies increase, supply increase
 Producer expectation
o Future price increase, supply decrease today
o Future cost increase, supply increase today
Change in supply VS change in quantity supplied
- Change in supply (supply curve shifts when there is change in
determinants of supply)
- Change in quantity supplied (movement along the supply curve
when change in prices)
Part 2
Market equilibrium
- Surplus : Qs > Qd (cut price)
- Shortage : Qd > Qs (increase price)
- Market equilibrium = no surplus of shortage by invisible hand
(price)
- Price in a competitive market bring market to reach equilibrium
- Competitive market = efficient
- 2 types of efficiency
 Productive : least costly manner (lowest possible unit cost)
 Allocative : D reflects MB / S reflects MC
 MC = MB; the economy has the output mix that is most
desired by society
The mechanics of market forces
- Graphical analysis
- Market adjustment
 P > Pe  price is too high, surplus of goods, price falls till
reach Pe
 P < Pe  price is too low, shortage of goods, price rises till
reach Pe
Changes in demand, supply, and hence market equilibrium
- ex. Change in income
- to find new equilibrium (which curve shifts, find direction)
- S,D shift same time (either P or Q will be indeterminate)
Part 3
Government market intervention
2 ways
1. Price control : limit on price
1.1.Price ceiling
1.2.Price floor
2. Quantity restriction : limit quantity
Price ceiling = maximum price producers can charge ( Pc) – suppressed price
An effective price ceiling makes – seller lose, buyer win but not all win
because of shortage
Black market = sell in higher price than Pc
Pc distort efficient allocation of resource
Price floor = minimum price producer can charge (Pf) – elevated price
An effective price floor – seller win but surplus, buyer lose
Pf distort the efficient allocation of resources
Quantity Restriction
-
Maximum quantity producers can sell their goods (Qr)
Qr < Qe means products available in market than it should have been
No shortage or surplus because no restriction price
Qr > Qe not effective
- Sell things lower quantity makes market price higher than it should be
Chapter 4 Elasticity
Price elasticity of demand (Ed).
 The change in quantity purchased relative to the change in price tells us
about how responsive buyers are to price changes.
 A small change in price that results in a large change in quantity
purchased means that buyers are responsive to price changes. That is,
the demand is elastic.
 A large change in price that results in a small change in quantity
purchased means that buyers are insensitive to price changes. That is,
the demand is inelastic.
 Ed is always negative.
o Given the law of demand, Qd always move in opposite direction to
P.
o use absolute value.
lEdl >1  elastic demand  Change in Quantity demand > Change in Price
lEdl <1  inelastic demand Change in Quantity demand < Change in Price
lEdl = 1 unit elastic demand Change in Quantity demand = Change in
Price
How Ed affects total revenue(TR): Elastic demand
 Elastic demand
 Buyers are very sensitive to price change
 Change in Price < change in Quantity demand
 TR loss from lower price < TR gain from larger Quantity demand
 That is, sellers should cut prices to increase total revenue.
 Inelastic demand
 Buyers are very insensitive to price change
 Change in Price > change in Quantity demand
 TR loss from lower Quantity demand < TR gain from higher Price
 That is, sellers should raise prices to increase total revenue
 Unit elastic demand
 Change in Price = Change in Quantity demand
 TR loss from lower Quantity demand = TR gain from higher Price
 Any price change will not increase TR.
 That is, TR is maximized and sellers should not change prices
4 determinants of Elasticity of Demand
1. Availability of substitutes: more elastic, more substitute
2.Price as a proportion of income: more elastic, higher proportion of
income
3. Luxury vs. Necessity goods: more elastic, luxury goods
4. Times: more elastic, longer time
Price elasticity of supply(Es)
Price elasticity of supply tells us about sellers’ responsiveness (or sensitivity) to
price changes
Elastic supply
 Sensitive to price changes
 Large change in quantity even when price changes a little.
Inelastic supply
 Insensitive to price changes
 Small change in quantity even when price changes a lot.
Elastic Supply
lEsl > 1  Elastic Supply  Change in Quantity supply > Change in Price
Unit Elastic Supply
lEsl = 1  Unit Elastic Supply  Change in Quantity supply = Change in Price
Inelastic Supply
lEsl < 1  Inelastic Supply  Change in Quantity supply < Change in Price
Determinant of Elastic Supply
Time : longer time, more elastic supply
Time periods considered
Market Period
 Perfectly Inelastic Supply
Short Run
 More Elastic than Market Period
Long Run
 More Elastic than Short Run
Applications
Antiques (and other non-reproducible commodities)
 Inelastic supply (or sometimes perfectly inelastic)
 This makes their prices highly susceptible to fluctuations in
demand.
 The more inelastic the supply, the greater the changes in price
when demand changes.
Reproductions
 More elastic supply
 Prices tend to remain lower even when there is an increase in
demand.
Volatile gold prices

Inelastic supply

Unstable demand from speculation causes prices to fluctuate
significantly
Cross elasticity of demand (Exy)
Substitutes (Mac vs. PC)
 positive sign  Price of Goods y increases, Quantity demand of Goods x
increases
Complements (iPad and iPad cover)
 negative sign  Price of Goods y increases, Quantity demand of Goods x
decreases
Independent (or unrelated) goods
 Zero Price of Goods y increases, Quantity demand of Goods x doesn’t
change
Applications
Firm’s pricing decision
 determine whether raising the price of one of their products will
affect sales of another of their products.
Government’s merger decision
 determine whether to allow a proposed merger of two
companies or not.
 If there is a high cross-price elasticity between the two
companies’ products (i.e. they are strong substitutes), the
government will likely not allow the merger.
 Being strong substitutes, the merger likely reduces competition in
the market.
Income elasticity of demand (Ei)
Superior/normal goods
 positive sign Income increases, Quantity demand of Goods X increases
Inferior goods
 negative sign Income increases, Quantity demand of Goods X
decreases
Applications
Income elasticity helps us understand which products and industries will
be most affected when household incomes fall during economic downturns.
 High income elasticities
o Most affected by a recession
 Low or negative income elasticities
o Least affected by a recession
Chapter 9: Consumers Decision
1. How does an individual make a choice?
- Ask yourself how much pleasure of satisfaction you would get from
going with each choice and how much you will have to spend
(Maximize pleasure subject to price and budget constraint)
2. Utility
- Utility means the pleasure or satisfaction people get from consuming
or doing something.
- Util means a unit of satisfaction, happiness
- 2 methods of measuring utility
1. Cardinal Utility : quantitative evaluation of satisfaction
2. Ordinal Utility: qualitative assessment of satisfaction
- Total Utility : total amount of satisfaction from consuming a curtain
amount of a goods or services. Ex. The satisfaction of consuming 8
units
- Marginal Utility: the additional satisfaction from consuming and
additional unit of goods or services. Ex. The satisfaction of consuming
8th unit
∆𝑇𝑈
𝑀𝑈=
∆𝑄
TU: Increases at a diminishing rate, reaches a maximum and then decline
MU: reflects the change total utility, MU diminishes with increased
consumption, MU=0 when TU is maximizes
3. Theory of consumer behavior
- Three Theory of consumer behavior
1. Rational Behavior: use their income to maximize satisfaction ( TU )
2. Preferences
3. Budget Constraint: Consumer’s money is limited. (𝐼 ≡ 𝑃𝑥 𝑋 + 𝑃𝑦 𝑌)
4. Price: unaffected by amounts purchased by consumer
: Scarce relative to demand
: Consumer is price taker
- Consumer’s objective
 Total approach
: All income maximize total utility
: Max. 𝑇𝑈𝑥 + 𝑇𝑈𝑦 subject to 𝐼 = 𝑃𝑥 𝑋 + 𝑃𝑦 𝑌
 Marginal approach
: Allocate all income so when last $ spent on each goods, it will
yield the same MU per $
𝑀𝑈𝑥 𝑀𝑈𝑦
=
𝑃𝑥
𝑃𝑦
- Equilibrium is achieved
- Equal opportunity cost
- Maximize TU at this point
𝑀𝑈𝑥 𝑀𝑈𝑦
>
𝑃𝑥
𝑃𝑦
Consume an additional unit of x
𝑐
𝑀𝑈𝑥 𝑀𝑈𝑦
<
𝑃𝑥
𝑃𝑦
Consume an additional unit of y
𝑀𝑈𝑥 𝑀𝑈𝑦
=
𝑃𝑥
𝑃𝑦
Utility is maximized (consumer equilibrium)
4. Utility maximization and the demand curve
- Reason why demand curve is downward sloping
 Diminishing MU
 Income and substitution effects
 DMU: price rises, consumer will increase TU by consuming less
amount of that things
5. Applications and extensions
- Opportunity cost of time
- Medical care purchase
- Cash and non-cash gift
6. Prospect theory
- Losses & shrinking packages
- Framing effects and advertising
- Anchoring and credit card bills
- Mental accounting and warranties
- The endowment effect and market transaction
- Nudging people toward better decisions
Chapter 10: Producer Decision
Goal of firm = Maximize Profit
Profit = TR – TC
- TR = amount that get from setting goods or services + any increase in
value of asset
- TC = explicit payment + opportunity cost (by owner)
Firm maximizing profit
- Accounting profit = explicit revenue – explicit cost
- Economic profit = explicit and implicit revenue + explicit and implicit
cost
Economic cost: Payment that must be made to obtain and retain the
service of a resource
1. Explicit cost ( Production cost, salary, labor, raw material)
2. Implicit cost
 Value of next best use (opportunity cost)
 Self-owned resources
 Include normal profit ( opportunity cost, depreciation,
forgone interest/rent/wages/entrepreneurial income)
Economic cost = Explicit cost + Implicit cost + Profit of entrepreneur
Accounting Profit and Normal Profit
- Accounting Profit
- Economic Profit
= Revenue – Explicit cost
= Accounting profit – Implicit cost
= TR – Economic cost
= TR – Explicit cost – Implicit cost
- Economic profit always smaller than accounting profit
The Production Process
Short Run
- Firm is constrained in regard to what production decision it can
make.
- Some inputs are fixed
- Less flexible
- Can increase labor, increase material
Long Run
-
Firm chooses from all possible production technique
All inputs are variable
More flexible
Variable plant
Firms enter and exit
Short run production relationship
- Total product (TP)
- Marginal Product (MP) =
∆𝑇𝑃
∆ 𝑖𝑛 𝑙𝑎𝑏𝑜𝑟 𝑖𝑛𝑝𝑢𝑡
- Average Product (AP) =
𝑇𝑃
𝑈𝑛𝑖𝑡𝑠 𝑜𝑓 𝑙𝑎𝑏𝑜𝑟
Law of Diminishing Return (short run)
-
Resource are equal quality
Technique fixed
Variable resources are added to fixed resources
At some point MP will fall
Increasing Marginal Return: MP increases, TP increases
Diminishing Marginal Return: MP decreases, TP increases
Negative Marginal Return: MP decreases, TP decreases
- AP intersect MP at Max Point
- MP = 0 when TP is at its highest point
The cost of production
TC = FC + VC
(FC = only in short run = sunk cost)
Short Run Production Cost
- Average Fixed Cost (AFC) =
𝐹𝐶
𝑄
- Average Variable Cost ( AVC) =
- Average Total Cost (ATC) =
- Marginal Cost (MC) =
𝑇𝐶
𝑄
𝑉𝐶
𝑄
or AFC + AVC
∆𝑇𝐶
∆𝑄
Per-unit of average cost
Marginal cost: relationship of MC to ATC and AVC
-
FC increases then AFC,ATC increase
VC increases then AVC,ATC,MC increase
MC below ATC  ATC decreases
MC above ATC ATC increases
MC intersect ATC, AVC at their minimum point
Mirror Image
The Shape of cost curve
- The variable and total cost curves have same shape
Increase output, increase VC, TC
- The fixed cost curve is always constant
- The average fixed cost curve is downward sloping
Increase output, AFC decreases
- MC,AVC,AFC are U-shape
Increase output lead to decrease in MC, AVC,ATC but lastly they
increase
- The U-shape of ATC, AVC
 Increase output in short run, it can only be done by increasing
input (variable)
 Law of diminishing return cause MP, AP decrease
 As AP, MP decrease  AC, MC increase
Relationship between MC and average cost
-
MC>ATC  ATC increases
MC>AVC  AVC increases
MC<ATC  ATC increases
MC<AVC  AVC increases
 If MC=AVC and MC=ATC then AVC and ATC are at their
minimum point
Long Run Product Cost
- Firm can change all inputs amount (plant size)
- No fixed cost
- No diminishing returns because fixed input
Firm size and cost
- Long run ATC curve just envelopes the short run ATC
Economic and Diseconomic of scale
1. Economic of scale
 Labor specialization
 Managerial specialization
 Efficient capital
 Other factors
2. Diseconomic of scale
 Control and coordinate problems
 Communication problem
 Worker alienation
 Shirking (avoiding work is easier in large firm)
- Constant returns to scale
 Occur when ATC is constant over a variety of plant sizes when
there are constant returns to scale, and increase in input will
result in a proportionate increase in output
A typical long-run ATC curve
- ATC falls because of economic of scale
- ATC is constant because of constant return to scale
- ATC rises because of diseconomic of scale
MES and Industry structure
- Minimum Effective Scale (MES)
 Lowest level of output where long run average cost are
minimize
 Can determine the structure of the industry
These industries will be populated by firms of many different sizes
- Industries with economic of scale over a wide range of output will led
to a few large scale firms
- ATC curve is lowest only when there is a large output
This is a ATC curve where economic scale exist, are exhausted quickly
and turn back up substantially
- Here minimum effective scale occurs at very low level of output
- This results in a large number of small producers
Application and Illustration
1.
2.
3.
4.
Rising gasoline price
Successful start up firms
Daily newspaper
Aircraft and concrete plant
Don’t cry over the sunk cost
- Sunk cost: cost that have already been incurred and irrecoverable
- Rule: don’t engage in any activity where MB<MC
- Rule: ignore sunk costs because they are they are irrecoveable