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A Definition of Economics
• Economics is the study of how individuals
and societies choose to use the scarce
resources that nature and previous
generations have provided.
Another Definition of Economics
• Economics is the study of how scarce
resources are allocated among conflicting
demands.
1. To Learn a Way of Thinking...
• Three Fundamental Concepts of Economic
Thinking
– Opportunity Cost
– Marginalism
– Information, Incentives, and Market
Coordinations
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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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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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.
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Using Resources Efficiently
–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.
–The marginal benefit curve shows the
relationship between the marginal benefit of a good
and the quantity of that good consumed.
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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
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.
Demand
•
Substitution Effect
• When the relative price (opportunity cost) of a
good or service rises, people seek substitutes for it,
so the quantity demanded decreases.
•
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.
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Substitution Effect of a Price
Change
• The substitution effect of a price change is a change in
consumption of a good or service that results from holding
well-being unchanged.
• When the price of a product falls, that product becomes
more attractive relative to potential substitutes.
• When the price of a product rises, that product becomes
less attractive relative to potential substitutes.
Income Effect of a Price Change
• The income effect of a price change is a change in consumption of
a good or service that results from a change in well-being, other
things being equal.
• When the price of a product falls, a consumer has more purchasing
power with the same amount of income and is better off.
• When the price of a product rises, a consumer has less purchasing
power with the same amount of income and is worse off.
Income as a Determinant of Demand
• 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.
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
$ .50
01
3
7
• When any factor
except price
changes the
relationship
between price and
quantity is
D2 different; there is
a shift of the
D1
demand curve, in
25 30
this case from D1
to D .
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
Market Demand Defined
• 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
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.
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.
Excess Demand
• Excess Demand is the condition that exists
when quantity demanded exceeds quantity
supplied at the current price.
Excess Demand
• 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.
Excess Supply
• 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
Perfectly 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
• 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
• 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
• 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
Other Important Elasticities (cont.)
• 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
• Elasticity of labour supply
– A measure of the response of labour supplied to
a change in the price of labour. Can be negative
or positive
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.
–Efficiency is based on value, which is determined
by people’s preferences.
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Efficiency: A Refresher
•Marginal Benefit
–Marginal benefit is the benefit a person receives
from consuming one more unit of a good or service.
–We can measure the marginal benefit from a good
or service by the dollar value of other goods and
services that a person is willing to give up to get one
more unit of it.
–The marginal benefit from a good or service
decreases as more of that good or service is
consumed—the principle of decreasing marginal
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benefit.
Efficiency: A Refresher
•Marginal Cost
–Marginal cost is the opportunity cost of producing one
more unit of a good or service. The measure of marginal cost
is the value of the best alternative forgone to obtain the last
unit of the good.
–We can measure the marginal cost of a good or service by
the dollar value of other goods and services that a person is
must give up to get one more unit of it.
–The marginal cost of a good or service increases as more of
that good or service is produced—the principle of increasing
marginal cost.
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Efficiency: A Refresher
•Efficiency and Inefficiency
–If the marginal benefit
from a good exceeds its
marginal cost, producing
and consuming more of the
good uses resources more
efficiently.
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Value, Price, and Consumer
Surplus
•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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Value, Price, and Consumer
Surplus
•Consumer Surplus
–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.
–Figure 5.3 on the next slide shows the consumer
surplus for pizza for an individual consumer.
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Value, Price, and Consumer
Surplus
–The price paid is the
market price, which is
the same for each unit
bought.
–The quantity bought is
determined by the
demand curve, and the
blue rectangle shows the
amount
paidtriangle
for pizza.
–The green
shows the consumer
surplus from pizza.
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Cost, Price, and Producer Surplus
•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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Cost, Price, and Producer Surplus
•Producer 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.
–Figure 5.5 on the next slide shows the producer
surplus for pizza for an individual producer.
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Cost, Price, and Producer Surplus
–The price is the market
price, which is the same
for each unit sold.
–The quantity sold is
determined by the supply
curve, and the red area
shows the total cost of
producing pizza.
–The blue triangle shows
the producer surplus
from pizza.
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Is the Competitive Market
Efficient?
•Efficiency of
Competitive Equilibrium
–Figure 5.6 shows that a
competitive market creates
an efficient allocation of
resources at equilibrium.
–In equilibrium, the quantity
demanded equals the
quantity supplied.
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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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