Lecture 1-2 Materials
Key Economic Concepts, Intro to Demand and Supply
Textbook: Mankiw, chapters 1-3
LECTURE NOTES
Chapter 1: What Economics is About
Economics is the study of how society manages its scarce resources. All resources are scarce to a certain
extent. In market economies these resources are allocated through the interaction of buyers and sellers,
households and firms, employers and employees, as well as policies implemented by governments.
“Ten Principles of Economics”
1. People face tradeoffs
2. Opportunity cost
3. Rational people think at the margin
4. People respond to incentives
5. Trade can make everyone better off
6. Markets are usually a good way to organize economic activity
7. Governments can sometimes improve market outcomes
8. A country’s standard of living depends on its ability to produce goods and services
9. Prices rise when the government prints too much money
10. Society faces a short run tradeoff between inflation and unemployment
They are the standard principles that economists rely on. Throughout this course, we will be defining, applying
and, at times, questioning these principles. Among these principles, there are three that are considered key to
the way economists think: opportunity cost, incentives and marginal analysis.
(1) Opportunity cost = the opportunity cost of something is what you give up in order to get it. Economic cost
= direct cost + opportunity cost. Economists recognize that the cost of a good or service includes not only the
money you part with to acquire it, but also the time involved in looking for it, learning how it works, and what
else you would have been doing your time.
Example: Economic Cost of the LIUC degree:
Cost of tuition (direct cost) + lost income if you had gone directly to work rather than spent three years pursuing
the degree (opportunity cost).
Suppose that if you had not come to LIUC, you believe you would have found a job (lucky you!) earning
15,000 euros per year with a raise of 1,000 each year thereafter.
Then economic cost of LIUC degree = 6,000+6,000+6,000 + 15,000+16,000+17,000 = 66,000 euros. That is,
it is far greater than just the cost of the three-year tuition.
Actually, this calculation is not quite correct because you need to discount euros spent or earned in future years.
If your discount rate (rate at which you are willing to trade euros next year for euros today) = 5%, then
economic cost of LIUC degree =
6,000 + 6,000/(1.05) + 6,000/(1.05)2 + 15,000 + 16,000/(1.05) + 17,000/(1.05)2 = 62,814 euros.
Should you pursue the LIUC degree?
To decide whether it is worthwhile to pursue the degree, we need to compare the sum of the discounted
stream of costs/income (called the net present value or NPV) with and without the degree. To do so, we must
make an assumption regarding how much you expect to earn with the degree. Assume that you believe that the
LIUC degree will allow you to get a more interesting and better-paying job than without the degree: 25,000
euros/year with a raise of 2,000 euros/year thereafter. Remember that without the degree you assumed you
would earn 15,000 euros/year with a 1,000 euro raise each year.
If you compare the discounted stream for the first 10 years, you obtain the following1:
With
Degree
(6,000)
(6,000)
(6,000)
25,000
27,000
29,000
31,000
33,000
35,000
37,000
Year
1
2
3
4
5
6
7
8
9
10
NPV
€
136,666
Without
Degree
15,000
16,000
17,000
18,000
19,000
20,000
21,000
22,000
23,000
24,000
€ 147,478
Thus, based on the first 10 years, you would conclude that the degree is not worth pursuing since the NPV is
lower with the degree than without the degree.
However, if you take a 20 year perspective, the two streams are as follows:
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
NPV
With
Degree
(6,000)
(6,000)
(6,000)
25,000
27,000
29,000
31,000
33,000
35,000
37,000
39,000
41,000
43,000
45,000
47,000
49,000
51,000
53,000
55,000
57,000
€ 360,408
Without
Degree
15,000
16,000
17,000
18,000
19,000
20,000
21,000
22,000
23,000
24,000
25,000
26,000
27,000
28,000
29,000
30,000
31,000
32,000
33,000
34,000
€ 285,422
The values in parentheses are negative. Standard excel NPV function assumes each year’s entries occur at the end of the year. If we
assume that they occur at the beginning of the year, then the first year entry should not be discounted.
1
Thus, based on a 20 year analysis, the degree is worth pursuing since the NPV with the degree is higher than
without the degree.
Class discussion: why may this approach be wrong or incomplete?
a. Future salaries are difficult to estimate with accuracy ex ante
b. You may decide to retire at a different age with or without the degree
c. What discount rate r should you use
d. There may be non monetary rewards to pursuing the degree: more interesting and rewarding
job/life/colleagues.
(2) Incentives: Economic agents respond to incentives. Surprisingly enough, many non economists forget how
important this principle is in explaining behavior. Identifying and understanding the effect of incentives on the
behavior of market participants (buyers, sellers, firms and governments) is extremely important for economic
analysis and for effective government regulation.
Examples: (i) If we want to promote investment in more fuel efficient cars: we can offer positive incentives
(tax rebates or special traffic lanes for fuel efficient cars) or negative incentives (increase tax on gasoline,
luxury tax on Hummers.) (ii) Is we want to improve worker efficiency we can offer various types of incentives:
pay for performance (higher salaries, bonuses), promotions/demotions, benefits (amenities such as cars, first
class travel, low interest loans), equity in the firm (stock option plans). (iii) As we will see later in the course,
cartel-like behavior is very common in many industries and countries even though it is illegal because the
profit incentives associated with it are so high. Government regulators need to take this into account in
investigating and fining cartels.
(3) Marginal Analysis: Rationale decisions are made at the margin by comparing the marginal (or
additional) cost with the marginal benefit associated with a decision or action.
Examples: See lecture slides for examples of marginal analysis applied to employment (how many workers do
you hire), consumption (how many pastries do you produce) and consumption (how many slices of pizza di you
eat).
Chapter 2: What Economists Do or “Thinking Like an Economist”
Economists approach their field of study using a fairly scientific approach: i.e. gathering data, making
assumptions, developing theories, testing those theories, developing models, etc. In fact economists love
theories, assumptions and models.
The value of an economic model depends on how good the tools are that go into building it (i.e. the data and the
structure). But remember always that it is a model, not reality. See lecture slides “What is a Model”.
Two general good rules for models:
(1) garbage in  garbage out;
(2) always have some idea of the direction you expect the results to go in. If you get what seem to be
strange results, the reason may be that: the model is not very good; the data is not very good; you do not have
good enough insight into the underlying reality that you are trying to model; the underlying reality may not be
amenable to modeling.
LECTURE READINGS
Note: To access posted readings from within LIUC (in Ateneo) or outside, click on the link and input
your library user name and password.
1. Alistair Osborne, “MS Accepts $225 m for Brooks Brothers,” Telegraph, November 24, 2001
http://www.telegraph.co.uk/finance/2743194/MandS-accepts-225m-for-Brooks-Bros.html
2. Robert H. Frank, The Opportunity Cost of An Economics Education, New York Times, September 1, 2005
http://www.biblio.liuc.it:2248/lnacui2api/api/version1/getDocCui?lni=4H0Y-3220-TW8FG37V&csi=6742&hl=t&hv=t&hnsd=f&hns=t&hgn=t&oc=00240&perma=true
3. “Why the Oil Price is Falling,” The Economist, December 8, 2014.
http://www.economist.com/blogs/economist-explains/2014/12/economist-explains-4
SAMPLE PROBLEMS
1. Suppose we are analyzing the market for hot chocolate. What will be the impact on the equilibrium price and
quantity as a result of each of the following events on the market for hot chocolate? In deriving your answer:
- explain which curve shifts in what direction
- explain why the curve shifts (i.e. give a rationale for the shift)
- determine whether the resulting equilibrium price and quantity will be higher or lower. You may use graphs
to illustrate your answer (but you don’t have to).
a. the weather turns sharply colder
b. the price of coffee falls (for some consumers, coffee and hot chocolate are substitutes)
c. the price of whipped cream falls (hot chocolate is sold with whipped cream as a topping for consumers
who want it—at no extra charge)
d. the price of cocoa beans increases
e. consumer income falls because of a recession
f. the Surgeon General of the US announces that hot chocolate cures acne
g. there is a population increase in the market
h. a better (less expensive) method of harvesting cocoa beans is introduced
Answer
a. People demand more hot chocolate in colder weather. The demand curve will shift outwards, and
equilibrium market price and quantity will both increase.
b. For these consumers, a decrease in the price of coffee will reduce their demand for hot chocolate, causing
the overall demand curve for hot chocolate to shift inwards. Equilibrium price and quantity of hot chocolate
will fall.
c. If the price of whipped cream falls, this reduces costs for suppliers of hot chocolate, causing the supply
curve to shift out. The resulting equilibrium price will decrease and equilibrium quantity will increase.
d. Since cocoa beans are an important input in making hot chocolate, an increase in the price of cocoa beans
will cause the supply curve of hot chocolate to shift inwards. Equilibrium price will increase and
equilibrium quantity will decrease.
e. Assuming that hot chocolate is a normal good, when consumer income falls, the demand curve for hot
chocolate will shift inwards. Equilibrium price and quantity will decrease.
f. The announcement from the Surgeon General will cause consumers to prefer more hot chocolate and the
demand curve will shift outwards. Equilibrium price and quantity will increase.
g. When population increases, the number of buyers of hot chocolate increases, causing the demand curve to
shift outwards. Equilibrium price and quantity will increase.
h. This technological improvement will cause the supply curve for cocoa beans to shift to the right, lowering
the equilibrium price of cocoa beans, an input in hot chocolate. The supply curve of hot chocolate will shift
outwards, lowering equilibrium price and raising equilibrium quantity.
2. Suppose the market for the English version of Mankiw’s Principles of Microeconomics textbooks in the
Italian market is given by the following equations:
Qd = 300 – 6P
Qs = P/4
Where Q is measured in number of copies (in thousands/year) and P is in euros.
a) Plot the demand and supply curves on a graph.
b) Solve for the equilibrium price and quantity and show them on the graph.
Suppose that, in the interest of reducing the cost of university education, the Italian Minister of Education sets a
price ceiling of $40 on the price of the textbooks.
c) How many Mankiw textbooks will be sold and purchased in Italy under the price ceiling? Will there be a
shortage or surplus of textbooks?
d) On the same graph, illustrate the outcome with the price ceiling and the equilibrium outcome with no price
ceiling (from b above).
e) Will fewer or more books be sold under the price ceiling compared to the equilibrium outcome?
f) Class discussion: was the effect of the price ceiling consistent with the intentions of the Minister of
Education?
Answer:
a) To plot the curves first find the curves’ horizontal and vertical intercepts (that is where they intercept the
horizontal and vertical axes.
Demand curve:
To find the horizontal intercept (i.e. where the demand curve intercepts the horizontal or x or quantity axis),
set P = 0
Qd = 300 – 6P
Qd = 300 – 6(0) = 300
x-intercept = 300
To find the vertical intercept (ie. Where the demand curve intercepts the vertical or y or price axis),
set Q = 0
Qd = 300 – 6P
(0) = 300 – 6P
300 = 6P
P = 300/6 = 50
y-intercept = 50
Supply curve:
To solve for the horizontal intercept, set P = 0
Qs = P/4
Qs = (0)/4 = 0
x-intercept = 0
To solve for the vertical intercept, set Q = 0
Qs = P/4
(0) = P/4
P = 0*4 = 0
y-intercept = 0
Thus, the supply curve originates at point 0. For the moment don’t worry about the slope (tilt) of the supply
curve. That will become clear when you solve for the market equilibrium below.
$/copy
Supply
50
Demand
0
300 Copies(000s)
(b) To find the equilibrium price P*, set Qd = Qs and solve for P:
Qd = Qs
300-6P = P/4
4(300-6P) = P
1200 – 24P = P
1200 = 25P
*
P = 48 euro
To find the equilibrium quantity Q*, substitute P* into the demand or supply function.
Using the supply function:
Qs = P/4
Qs* = (48)/4
Qs* = 12
Using the demand function:
Qd = 300 – 6P
Qd* = 300 – 6(48)
Qd* = 12
*
*
So, the market equilibrium is P = 48 euros Q = 12,000 copies of the textbook.
Supply
$/copy
50
Market Equilibrium
48
Demand
300
12
Copies (000s)
c) If P is set at $40/textbook, then Qd and Qs become:
Qd = 300 – 6P = 300 – 6*40 = 300 – 240 = 60
Qs = P/4 = 40 / 4 = 10
Thus Qd = 60,000 textbooks but Qs= 10,000 textbooks
That is, quantity demanded exceeds quantity supplied by 50,000 textbooks.
Thus, 10,000 textbooks will be sold at the price of $40 each.
(Note: even though 60,000 are demanded at the price of $40/textbook, the amount that will be sold will
be only 10,000 since that is the quantity that suppliers in the market are willing to sell at that price.)
There will be a shortage of 50,000 textbooks.
d)
Supply
$/copy
50
48
Price ceiling $40
40
Demand
10 12
60
300
Copies(000s)
Shortage = 50
e) 2000 fewer textbooks will be sold under the price ceiling than under the free market equilibrium.