The fundamental lessons about individual decision making are that people face
trade-offs among alternative goals, that the cost of any action is measured in terms
of forgone opportunities, that rational people make decisions by comparing
marginal costs and marginal benefits, and that people change their behavior in
response to the incentives they face.
The fundamental lessons about interactions among people are that trade and
interdependence can be mutually beneficial, that markets are usually a good way
of coordinating economic activity among people, and that the government can
potentially improve market outcomes by remedying a market failure or by
promoting greater economic equality.
The fundamental lessons about the economy as a whole are that productivity is
the ultimate source of living standards, that growth in the quantity of money is
the ultimate source of inflation, and that society faces a short-run trade-off
between inflation and unemployment.
There are two ways to compare the ability of two people to produce a good. The
person who can produce the good with the smaller quantity of inputs is said to
have an absolute advantage in producing the good. The person who has the
smaller opportunity cost of producing the good is said to have a comparative
advantage. The gains from trade are based on comparative advantage, not
absolute advantage.
Decisions are made by households and firms. Households and firms interact in
the markets for goods and services where households are buyers and firms are
sellers and in the markets for the factors of production where firms are buyers and
households are sellers.
The demand curve shows how the quantity of a good demanded depends on the
price. According to the law of demand, as the price of a good falls, the quantity
demanded rises. Therefore, the demand curve slopes downward.
In addition to price, other determinants of how much consumers want to buy
include income, the prices of substitutes and complements, tastes and preference,
future expectations, and the number of buyers. If one of these factors changes,
the demand curve shifts.
The supply curve shows how the quantity of a good supplied depends on the price.
According to the law of supply, as the price of a good rises, the quantity supplied
rises. Therefore, the supply curve slopes upward.
In addition to price, other determinants of how much producers want to sell
include input prices, technology, expectations, and the number of sellers. If one
of these factors changes, the supply curve shifts.
The intersection of the supply and demand curves determines the market
equilibrium. At the equilibrium price, the quantity demanded equals the quantity
supplied.
The behavior of buyers and sellers naturally drives markets toward their
equilibrium. When the market price is above the equilibrium price, there is a
surplus of the good, which causes the market price to fall. When the market price
is below the equilibrium price, there is a shortage, which causes the market price
to rise.
Elasticity is a measure of how much buyers and sellers respond to changes in
market conditions.
The price elasticity of demand measures how much the quantity demanded
responds to changes in the price. Demand tends to be more elastic if close
substitutes are available, if the good is a luxury rather than a necessity, if the
market is narrowly defined, or if buyers have substantial time to react to a price
change.
The price elasticity of supply measures how much the quantity supplied responds
to changes in the price. This elasticity often depends on the time horizon under
consideration. In most markets, supply is more elastic in the long run than in the
short run.
The income elasticity of demand measures how much the quantity demanded
responds to changes in consumers’ income.
The cross-price elasticity of demand measures how much the quantity demanded
of one good responds to changes in the price of another good.
Inelastic demand means a change in the price of a good, will not have a
significant effect on the quantity demanded.
The Determinants of Price Elasticity:
The price elasticity of demand depends on:
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the extent to which close substitutes are available.
whether the good is a necessity or a luxury
how broadly or narrowly the good is defined.
the time horizon: elasticity is higher in the long run than the short run.
The Determinants of Supply Elasticity
• The more easily sellers can change the quantity they produce, the greater
the price elasticity of supply.
• For many goods, price elasticity of supply is greater in the long run than
in the short run, because firms can build new factories, or new firms may
be able to enter the market.
Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.