Definition of Economics
•Scarcity
–All economic questions arise because we are
unable to satisfy all our wants.
–Our inability to satisfy all our wants is called
scarcity.
–Economics is the social science that studies the
choices that we make as we cope with scarcity and
the institutions that have evolved to influence and
reconcile our choices.
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Definition: Economics
• Economics is the study of how individuals
and societies choose to use the scarce
resources that nature and previous
generations have provided.
• Economics is the study of how scarce
resources are allocated among conflicting
demands.
The Scope of Economics
•Microeconomics
–Microeconomics is the study of choices made by
individuals and businesses, the way these choices
interact, and the influence that governments exert on
them.
•Macroeconomics
–Macroeconomics is the study of the effects on the
national and global economy of the choices that
individuals, businesses, and governments make.
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The Scope of Economics
EXAMPLES OF MICROECONOMIC & MACROECONOMIC CONCERNS
Microeconomics
Production
Prices
Income
Employment
Production/Output in
Individual Industries and
Businesses
Price of Individual
Goods and Services
Distribution of Income
and Wealth
Employment by
Individual Businesses &
Industries
Price of medical care
Price of gasoline
Food prices
Apartment rents
Wages in the auto
industry
Minimum wages
Executive salaries
Poverty
How much steel
How many offices
How many cars
National
Production/Output
Macroeconomics
Total Industrial Output
Gross Domestic Product
Growth of Output
Aggregate Price Level National Income
Consumer prices
Producer Prices
Rate of Inflation
Jobs in the steel industry
Number of employees in
a firm
Number of accountants
Employment and
Unemployment in the
Total wages and salaries Economy
Total corporate profits
Total number of jobs
Unemployment rate
Opportunity Costs
• The opportunity cost of something is that
which we give up when we make that
choice or decision.
• The implication is that all decisions involve
trade-offs.
• “There’s no such thing as a free lunch!!”
•Margins and Incentives
–People make choices at the margin, which means
that they evaluate the consequences of making
incremental changes in the use of their resources.
–The benefit from pursuing an incremental increase
in an activity is its marginal benefit.
–The opportunity cost of pursuing an incremental
increase in an activity is its marginal cost.
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The Theory of Comparative Advantage
• Ricardo’s theory that specialization and free trade will
benefit all trading parties, even those that may be
absolutely more efficient producers.
• A person or country is said to have a comparative
advantage in producing a good if it is relatively more
efficient than a trading partner at doing so. In other words
they have a lower opportunity cost.
Production Possibilities and
Opportunity Cost
–The production possibilities frontier (PPF) is the
boundary between those combinations of goods and
services that can be produced and those that cannot.
–To illustrate the PPF, we focus on two goods at a
time and hold the quantities of all other goods and
services constant.
–That is, we look at a model economy in which
everything remains the same (ceteris paribus)
except the two goods we’re considering.
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Production Possibilities and
Opportunity Cost
•Production Efficiency
–We achieve production
efficiency if we cannot
produce more of one good
without producing less of
some other good.
–Points on the frontier are
efficient.
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Production Possibilities and
Opportunity Cost
–A move from C to D increases
butter production by 1 tonne.
–Guns production decreases from 12
units to 9 units, a decrease of 3
units.
–The opportunity cost of 1 tonne of
butter is 3 units of guns.
–One tonne of butter costs 3 units of
guns.
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Using Resources Efficiently
–All the points along the PPF are efficient.
–To determine which of the alternative efficient
quantities to produce, we compare costs and
benefits.
•The PPF and Marginal Cost
–The PPF determines opportunity cost.
–The marginal cost of a good or service is the
opportunity cost of producing one more unit of it.
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Using Resources Efficiently
•Preferences and Marginal Benefit
–Preferences are a description of a person’s likes and dislikes.
–To describe preferences, economists use the concepts of marginal
benefit and the marginal benefit curve.
–The marginal benefit of a good or service is the benefit received from
consuming one more unit of it.
–We measure marginal benefit by the amount that a person is willing to pay for an
additional unit of a good or service.
–It is a general principle that the more we have of any good or service,
the smaller its marginal benefit and the less we are willing to pay for an
additional unit of it.
•We call this general principle the principle of decreasing marginal benefit.
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– When we cannot produce more of any one good
without giving up some other good that we
value more highly, we have achieved allocative
efficiency, and we are producing at the point on
the PPF that we prefer above all other points.
– The point of allocative efficiency is the point on
the PPF at which marginal benefit equals
marginal cost.
Determinants of Household
Demand:
•
•
•
•
•
•
The price of the product in question
The income available to the household
The households amount of accumulated wealth
The prices of other products available
Tastes and preferences
Expectations about future income, wealth, and
prices
• Population
Changes in Quantity Demanded
vs. Changes in Demand
• Changes in the price of a product affect the
quantity demanded per period. Changes in
any other factor, such as income or
preferences, affect demand. An increase in
income, for instance, tends to increase
demand. While a drop in prices will
increase the quantity demanded.
The Law of Demand
• The negative relationship between price and
quantity demanded. As price rises, quantity
demanded decreases. As price falls, quantity
demanded increases
• This is why we observe a negative slope in
demand curves.
Substitution Effect
When the relative price (opportunity cost) of a good or service rises, people seek substitutes
for it, so the quantity demanded decreases.
When the price of a product falls, that product becomes more attractive relative
to potential substitutes.
Income Effect
When the price of a good or service rises relative to income, people cannot afford all the
things they previously bought, so the quantity demanded decreases.
When the price of a product falls, a consumer has more purchasing power with
the same amount of income and is better off.
Income as a Determinant of
Demand
Income: The total of all earnings received by a
household in a given period of time
• Normal Goods: Goods for which demand
goes up when income is higher and for
which demand goes down when income is
lower.
• Inferior Goods: Goods for which demand
falls when income rises.
Prices of Other Goods and Services as
Determinants of Demand
• Substitutes: Goods that can serve as
replacements for one another; when the
price of one increases, demand for the other
goes up.
– Perfect substitutes are identical products.
• Complements: Goods that “go together”;
when the price of one increases, demand for
the other goes down, and vice versa.
Other Determinants of Household
Demand:
• Tastes and Preferences - These are quite
subjective and tend to change over time.
• Expectations - With respect to future
income, wealth, prices, and availability.
Shift of Demand vs. Movement
Along Demand Curve
• Shift of a demand curve is the change that
takes place in a demand curve when a new
relationship between the quantity demanded
of a good and the price of that good is
brought about by a change in the original
conditions.
• Movement along the demand curve is
what happens when a change in price causes
quantity demanded to change.
Anna’s Demand for Telephone Calls -A Change in Quantity Demanded
Price
• The graph shows a
shift in quantity
demanded from 3
to 7 caused by a
change in price
from $7.50 to
$3.50.
$15.00
$10.00
$7.50
$3.50
$ .50
01
3
7
25 30
Quantity demanded
Anna’s Demand for Telephone Calls - A Change in Demand
$15.00
$10.00
$7.50
$3.50
D1
$ .50
01
3
7
25 30
D2
• When any factor
except price changes
the relationship
between price and
quantity is different;
there is a shift of the
demand curve, in this
case from D1 to D2.
Changes in Demand: Prices of Related Goods
P
Price of
hamburger rises
P
P
Q
D2
Demand for complement
good (ketchup) shifts left
D1
Q
Quantity of
hamburger
demanded
falls
D1 D2
Demand for substitute
good (chicken) shifts right
Q
From Household to Market
Demand
• Demand for a good or service can be
defined for an individual household, or for a
group of households that make up a market.
• Market demand may be defined as the
sum of all the quantities of a good or service
demanded per period by all the households
buying in the market for that good or
service.
Deriving market demand from the individual
demand curves:
P
P
$3.50
DA
$1.50
0
P
$3.50
DB
$1.50
4
8 Qd
DC
$3.50
$1.50
0
3
Price
Qd
0
4
9
Market Demand
$3.50
$1.50
0
8
20
Qd
Qd
Supply
• A firm’s decision about what quantity of product
to supply depends on:
– The price of the good or service
– The cost of producing the product which depends on:
• The price of required inputs (land, labour, capital)
• The technologies to be used to produce the product
– The prices of related products
– Expected future prices
– The number of suppliers
Quantity Supplied and The Law of
Supply
• Quantity Supplied : The amount of a particular
product that a firm would be willing and able to
offer for sale at a particular price during a given
time period.
• The Law of Supply : The positive relationship
between price and quantity of a good supplied. An
increase in market price will lead to an increase in
quantity supplied, and a decrease in market price
will lead to a decrease in quantity supplied.
Changes in Quantity Supplied vs. Changes in Supply: Changes
in quantity supplied imply movement along a supply curve.
Changes in supply imply a shift in the entire supply curve.
P
P
S
S1
S2
Q
An increase in the
quantity supplied
An increase in supply
Q
From Individual Firm to Market
Supply: Market Supply
• The supply of a good or service can be defined for an
individual firm, or for a group of firms that make up
a market or an industry.
• Market Supply : The sum of all the quantities of a
good or service supplied per period by all the firms
selling in the market for that good or service.
• As with market demand, market supply is the
horizontal summation of the individual firms’
supply curves.
From Individual Firm to Market Supply
Market Equilibrium
• The operation of the market depends on the
interaction between suppliers and
demanders.
• An equilibrium is the condition that exists
when quantity supplied and quantity
demanded are equal.
• At equilibrium, there is no tendency for the
price to change.
Market Equilibrium
P
PE
S
E
D
QE
Q
Excess Demand: is the condition that exists when quantity demanded
exceeds quantity supplied at the current price.
• At $85 per tonne
quantity demanded
exceeds quantity
supplied by 2500
tonnes.
• Excess demand tends
to lead to an increase
in prices.
Excess Supply: Excess supply is the condition that exists
when quantity supplied exceeds quantity demanded at the
current price.
• At $150, quantity
supplied exceeds the
quantity demanded by
2000 tonnes.
• This causes prices to
fall
Price Elasticity of Demand
• The price elasticity of demand is the ratio of
the percentage change in quantity demanded
to the percentage change in price.
• Price Elasticity of Demand = % change in quantity
demanded
% change in price
Inelastic Demand
• Perfectly inelastic demand is demand in which
quantity demanded does not respond at all to a
change in price.
• An example could be the demand for insulin.
• Inelastic demand is demand that responds
somewhat, but not a great deal, to changes in
price. Inelastic demand always has a numerical
value between zero minus one.
• An example would be the demand for housing or telephone
service.
Unitary Elasticity
• Unitary elasticity is a demand relationship
in which the percentage change in quantity
of a product demanded is the same as the
percentage change in price.
• The elasticity is always equal to minus one.
Elastic Demand
• Elastic demand is a demand relationship in which the percentage
change in quantity demanded is larger in absolute value than the
percentage change in price.
• The demand elasticity has an absolute value greater than one.
• An example could be the demand for bananas or any other product for
which there are close substitutes.
• Perfectly elastic demand is demand in which quantity demanded
drops to zero at the slightest increase in price.
• An example could be the demand for wheat on the world market, or
any other good that can only be sold at a predetermined price.
Demand Curves and Elasticity
P
P
Perfectly elastic
P
D
D
Q
Q
Relatively elastic
D
P
D
Q
Perfectly inelastic
Relatively inelastic
Q
Elasticity and Total Revenue
• Effect of a price increase on a product with
inelastic demand: P x Qd = TR
• Effect of a price increase on a product with
elastic demand: P x Qd = TR
• Effect of a price cut on a product with
elastic demand: P x Qd = TR
• Effect of price cut on a product with
inelastic demand: P x Qd = TR
Relationship Between Elasticity and Total Revenue
Determinants of Demand Elasticity
• Availability of substitutes
– When substitutes are not readily available, demand is
likely to be less elastic.
• The importance of being unimportant
– When an item represents a small proportion of our total
budget, demand is likely to be less elastic.
• The time dimension
– In the longer run, demand is likely to become more elastic,
or responsive, because households make adjustments over
time.
Other Important Elasticities
•
Income elasticity of demand
– Measures the responsiveness of demand with respect to changes in income
• If the income elasticity of demand is greater than 1, demand is income elastic and the
good is a normal good.
• If the income elasticity of demand is greater than zero but less than 1, demand is income
inelastic and the good is a normal good.
• If the income elasticity of demand is less than zero (negative) the good is an inferior
good.
•
Cross-price elasticity of demand
– A measure of the response of the quantity of one good demanded to a change in the
price of another good
• The cross elasticity of demand for a substitute is positive.
• The cross elasticity of demand for a complement is negative.
•
Elasticity of supply
– A measure of the response of the quantity of a good supplied to a change in the
price of that good. Likely to be positive in output markets
Efficiency: A Refresher
–An efficient allocation of resources occurs when
we produce the goods and services that people value
most highly.
–Resources are allocated efficiently when it is not
possible to produce more of a good or service
without giving up some other good or service that is
valued more highly.
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Value, Willingness to Pay, and Demand
–The value of one more unit of a good or service is
its marginal benefit, which we can measure as
maximum price that a person is willing to pay.
–A demand curve for a good or service shows the
quantity demanded at each price.
–A demand curve also shows the maximum price
that consumers are willing to pay at each quantity.
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Cost, Minimum Supply-Price, and Supply
–The cost of one more unit of a good or service is
its marginal cost, which we can measure as
minimum price that a firm is willing to accept.
–A supply curve of a good or service shows the
quantity supplied at each price. A supply curve also
shows the minimum price that producers are willing
to accept at each quantity.
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Producer Surplus, Consumer surplus
–Producer surplus is the price of a good minus the marginal
cost of producing it, summed over the quantity sold.
•Producer surplus is measured by the area below the price and above
the supply curve, up to the quantity sold.
–Consumer surplus is the value of a good minus the price
paid for it, summed over the quantity bought.
•It is measured by the area under the demand curve and above the price
paid, up to the quantity bought.
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Is the Competitive Market Efficient?
–At the equilibrium
quantity, marginal benefit
equals marginal cost, so the
quantity is the efficient
quantity.
–The sum of consumer
and producer surplus is
maximized at this
efficient level of output.
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Is the Competitive Market Efficient?
•Obstacles to Efficiency
– Markets are not always efficient. Obstacles to
efficiency are:
– Price ceilings and floors
– Taxes, subsidies, and quotas
– Monopoly
– Public goods
– External costs and external benefits
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Is the Competitive Market Efficient?
–Figure shows the
effects of
underproduction.
–The efficient quantity is
10,000 pizzas a day.
–If production is
restricted to 5,000 pizzas
a day, a deadweight loss
arises from
underproduction.
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