Week 2
Recap

 What is opportunity Cost?
 Why are incentives important to policy makers?
 Why isn’t trade amongst countries a game with
winners and losers?
 Why is productivity important?
 What is the relationship between Marginal Benefit
and Marginal Cost
The Scientific Method

 Economics is a Science
 Economists devise theories, collect data
and analyze it
 Scientific economists make positive
statements
Identify the
problem
Develop a
model based
on simplified
assumptions
Collect data
and test
models
Three Economic Mode

 The Circular Flow Diagram
 The production possibilities frontier
 Market equilibrium
The Circular flow
diagram

 “A visual model of the economy that shows how
money flows through markets amongst households
and firms”
Production Possibilities
Frontier

 A graph that shows the combinations of output that the
economy can possibly produce given the available factors
of production and the available production technology.
 Example




Economy can produce 300 shirts or 100 cakes
Producing at the PPF causes the market to be “efficient”
It is easy to see trade offs and opportunity costs
Opportunity Cost = the slope of the PPF Line
 Slope = Change in Y/ Change in X
 300-0/100/0 = 3
Markets and
Competition

 What happens
 To the price of petrol when war breaks out in Iran
 To the price of mangoes when farmers have an abundant
year
 To the number of tourists when the tsunami hit Sri-Lanka
 All of the above show the workings of Supply and
Demand
 Supply and Demand are the forces that make market
economies work.
 They determine the following
 Quantity of Goods produced
 Price of which goods are sold
What is a Market?

 A group of buyers and sellers of a particular good or
service.
 Characteristics of markets
 Organized markets
 Less Organized markets.
 A competitive market is a market which has many buyers
and sellers so that each has a negligible impact on price.
 For today’s class we will assume that markets are
perfectly competitive.
 The goods offered for sale are exactly the same so that no
single buyer or seller has influence over price.
Demand

 Quantity Demanded – the amount of a good that buyers
are willing and are able to pay.
Law of Demand
The claim that other things equal the quantity
Demanded of a good falls when the price of
The good increases.
 Market Demand – the sum of all individual demand for a
particular good or service
Demand

Price
Quantity
Demanded
0
6
50
5
100
4
150
3
200
2
250
1
300
0
Shifts in the demand curve
Demand curves can shift
• To the RIGHT (A)
• To the LEFT (B)
Shifts to the right means demand has
increased
Shift to the left means demand has
decreased
Variables that cause
Demand Curves to shift

 Income
 Prices of Related goods
 Tastes
 Expectations
 Number of Buyers
Income

 Normal goods
 A good for which other things equal an increase in
income leads to an increase in demand
 Inferior Good
 A good for which other things equal an increase in
income leads to a decrease in demand.
Price of Related Goods

 Substitutes
 Two goods for which an increase in price of one leads
to an increase in demand for the price of the other
 Complements
 Two goods for which an increase in the price of one
leads to a decrease in demand for the other.
Supply

 Quantity Supplied
 The amount of a good that sellers are willing and able
to sell.
Law of Supply
The claim that other things equal the quantity
Supplied of a good increase when the price of
The good increases.
Supply

Price of
cone
Quantity
Supplied
0
0
50
0
100
1
150
2
200
3
250
4
300
5
Shifts in the Supply Curve
• Shifts to the right increase supply
• Shifts to the left decrease supply
Variables that cause the
supply curve to shift

 Input Prices
 Costs of inputs. If they increase production decreases,
if they decrease production will increase
 Technology
 Machinery increases productivity
 Expectation
 Number of Sellers
Market Equilibrium

 Equilibrium – A situation which the market price has
reached the level at which quantity supplied equals
the quantity demanded.
 Equilibrium price – the price that balances Qd and Qs
 Equilibrium quantity – the quantity that balances Pd
and Ps
Law of Supply and Demand
The claim that the price of any good adjusts to
bring the Qd and the Qs for the good into balance.
Surplus and Shortage

 Surplus – A situation where Qs is greater than Qd
 Shortage – A situation where Qd is greater than Qs
No change in
Supply
An increase
in supply
Decrease in
supply
No change in
demand
P.Q No
change
P down
Q up
P up
Q down
Increase in
Demand
P up
Q down
P ambiguous
Q up
P is up
Q ambiguous
Decrease in
demand
P down
Q up
P down
Q ambiguous
P ambiguous
Q down
Elasticity of Supply and
Demand

Price
Elasticity
of Demand
 We use absolute numbers even though Qd is
negatively related to its price.
 |Ped|= △Q/△P
= 20/10 = 2
Different Types of
Demand

 Perfectly Inelastic Demand
 Inelastic Demand
 Unitary Elastic Demand
 Elastic Demand
 Perfectly Elastic Demand
Determinants of Price
Elasticity

 Sustainability
 Nature of the Product
 Proportion of Income
 Definition of Market
 The Possibility of new purchases
 Time Horizons
 Addiction
 Complementary goods
 Price expectations
Income Elasticity of Demand

 A measure of how much the quantity demanded for
a good responds to a change in consumers income.
(Ey)

 Negative elasticity
 Ey>0 – D decreases as I increases
 Zero Income Elasticity
 Ey=0 – D does not change as I rises of falls
 Income Inelastic Demand
 0<Ey<1 – D rises at a smaller proportion than I
 Unit Income Elasticity
 Ey=1 – D rises exactly the same proportion as I
 Income elastic demand
 1<Ey<∞ - D rises at a greater proportion than income
The Cross Price Elasticity of Demand

 The measure of how much the quantity demanded of
one good responds to a change in the price of
another good.
Price Elasticity of Supply

 Es = △Q/Q = △Q x P
△P/P
△P
Q
Determinants of Elasticity of Supply

 Time
 Excess Supply or Unsold Stock
 Factor Mobility
 Natural Constraints
 Risk Taking
