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Review Guide: ECONONE

Economics in Perspective
Economics as a social science
It is a systematic study that focuses in the activities of man in relation to his environment. It studies
the societys allocation of scarce resources to meet unlimited needs and wants. Scarcity is a general
characteristic of resources, basically due to a resources alternative uses.
Economics as the science of choice
From the households choice to purchase goods to the firms choice of production, everything in our
world now is a result of the many decisions individuals made in the past. Economics studies these choices
and how and why these choices are made.
The concept of Opportunity Cost
In economics, the full cost of making a certain choice includes the value of what we give up by
not choosing the alternative choice. For example, the opportunity cost of studying in college is the
time you could have used to do other things or the money you could have earned if you decided to
work as a high school graduate.
Ceteris Paribus
Translated to English, this means all else equal. This concept allows one variable to change as
other variables are held constant.
Three basic questions in economics:
What to produce?
How is it produced?
For whom is it produced?
Microeconomics
The branch of economics that examines the behaviour of an individual decision-making units, e.g.
the household and the firms.
Macroeconomics
The branch of economics that deals with the behaviour of aggregates (income, employment,
output etc.) on a national level.
*ECONONE is a course that serves as an introduction to Microeconomics.

In a market economy, individual consumers make plans of consumption and individual firms make plans of
production based on the changes in market prices.

Analysis of Demand and Supply

The Law of Demand


It shows the negative relationship between price and quantity demanded. As price of a commodity
increases, demand for it decreases and vice-versa.
For a better understanding of the concept, refer to Table 1.1 and Figure 1.1

A demand schedule is a table showing the quantities of a good that a consumer would buy at all
different prices. Below is an example of a demand schedule.
Table 1.1 Demand Schedule for Candy
Price
0
1
2
3
4

Quantity Demanded
20
15
10
5
0

In mathematics, price & quantity demanded have a functional relationship. (In a demand function,
price is called the independent variable and quantity demanded the dependent variable). A demand
curve shows the above relationship in a graph.
Figure 1.1 Demand Curve for Candy
P
4.00
3.00
2.00
1.00
0
5

10

15

20

Qd

Demand curves are downward-sloping due to the negative relationship of price and demand, thus
the Law of Demand applies.

Factors affecting a change in demand: A Shift of Demand Curve

Prices of Related Goods


When the price of a good (X) rises, it does not only affect its Qd, but also the Qd of another related
good (Y).
If a rise in price of good X leads to a in demand of good Y, these 2 goods are called
substitutes in economics. (There involves a movement along the demand curve of X and
a shift of the demand curve of Y.)
If a rise in price of good X leads to a fall in demand of good Y, these 2 goods are called
complements or complementary goods. They are in joint demand.

Income
A rise in income leads to a higher purchasing power or ability to buy of the consumers.
( If nominal income and prices increase by the same percentage, the real income is unchanged.)
If a rise in income leads to a rise in demand of a good by a consumer, the good is called a
normal good or superior good.
If a rise in income leads to a fall in demand of a good, the good is called an inferior
good. Inferior does not refer to the quality of the good.

Summary:
Table 1.2
Type of Good
Normal
Inferior

Income
Increases
Decreases
Increases
Decreases

Demand
Increases
Decreases
Decreases
Increases

Price of good 1
Increases
Decreases
Increases
Decreases

Demand for good 2


Increases
Decreases
Decreases
Increases

Table 1.3
Type of Good
Substitute
Complement

Movement along a demand curve:


Changes in price of a commodity

Change in quantity demanded.

Shift of a demand curve


Changes in income, tastes & preferences, prices of other goods

Change in demand.

The Law of Supply


It shows the positive relationship between price and quantity supplied. An increase in market
price would increase quantity supplied, and vice-versa.

A supply schedule is a table showing the quantities of a good that a firm or producer would
produce (sell) at all different prices within a time period, ceteris paribus.
Table 2.1 Supply Schedule for candy
Price
2
4
6
8
10

Quantity Supplied
0
1
2
3
4

A supply curve shows the relationship of price and quantity supplied in graph, in a similar manner
with the demand curve.

Figure 2.1 Supply Curve for Candy


P
10
8
6
4
2
0

Movement along a supply curve


Whenever the market price changes, a firm or supplier will change its quantity supplied
accordingly.
Change in price of a good

Change in quantity supplied

Shift of a supply curve


Change in costs, input prices, technology,
weather, or prices if related goods

Change in supply

Market Equilibrium

Equilibrium is achieved when Quantity Demanded = Quantity Supplied. (Qd = Qs)

Shortage or Excess demand is a condition wherein Qd > Qs at the current price.


Surplus or Excess supply is a condition wherein Qs > Qd at the current price.

Figure 3.1 Shortage

Figure 3.2 Surplus

P
3

P
3.5

2.5

20 25

40

10

30

35

(Fig. 3.1) The equilibrium point e is when P = 3. When P= 2, a shortage or excess demand of 20 units is
present.
(Fig. 3.2) The equilibrium point e is when P = 2.5. When P=3.5, a surplus or excess supply of 25 units is
present.

Solving for Equilibrium Price & Equilibrium Quantity


Demand function: Qd = 100 2P

Supply Function: Qs = 20 + 2P

Since Qd = Qs when e
100 2P = 20 + 2P
P = 20

Qs = 20 + 2(20) = 60
Qd = 100 2(20) = 60

Consumption is based on utility


Utility is the satisfaction a product yields.
Marginal Utility is the additional utility gained from additional consumption.

Law of Diminishing Marginal Utility


As the consumer increases consumption, overall utility increases while marginal or
additional utility obtained from every consumption decreases.

Indifference Curves
A set of points that shows different combinations of consumption of commodities that gives
the consumer the same level of satisfaction.
Fig. 4.1 Indifference Curves for Chips and Juice
Curves
Chips

Fig. 4.2 Intersecting Indifference


Good 1

CA

A
A

CB

D
B
C
E

CC

JA

JB

JC

U1
U2

Juice

Good 2

(Fig. 4.1) In this indifference curves, the combinations A (CA amount and JA), B and C will give the
same level of total utility. The curve has a negative slope implying that in order for the individual to
have the same total utility, he has to reduce consumption of chips to increase consumption of juice.
The curve is convex because of the diminishing marginal rate of substitution. This means that the
rate at which Chips is being replaced by Juice is decreasing.

(Fig. 4.2) U1 and U2 intersect at point B. Points A, B and C are indifferent along U1 while points D, B
and C are indifferent along U2. If B is indifferent to both U1 and U2, then applying the assumption of
transitivity in consumption, then A is indifferent to D and so on. This does not hold however because
U2 has a higher level of Total Utility. Therefore, indifference curves should not intersect.

The Budget Line


The various combinations of the amount of goods an individual can consume given his
budget and the price of commodities.

Consumer Equilibrium When the slope of the indifference curve and the budget line are equal,
then the marginal utility per amount of money derived from good1 is equal to the marginal utility per
amount of money derived from good2.

Substitution Effect & Income Effect


Table 3 Income & Substitution Effect
*This summarizes the effect of price increases and decreases for each type of good.
Type of Good
Normal

Price
Increases
Decreases
Increases
Decreases

Inferior

Substitution Effect
- (buy less)
+ (buy more)
- (buy less)
+ (buy more)

Income Effect
- (buy less)
+ (buy more)
+ (buy more)
- (buy less)

Consumer Surplus
The excess utility derived by an individual when consuming a good or service. It is the
difference between the amounts he/she is willing to pay from the actual amount he/she paid for the
good or service.
Fig. 4.3 Consumer Surplus

Price
A
P1

Q1

(Fig. 4.3) If market price is set at P1


and quantity demanded is at Q1,
there are still consumers willing to
but at less than Q1 and pay a higher
price than P1. These consumers
therefore gain a consumer surplus
equal to triangle AP1B when they
buy at price P1 and get quantity Q1 .

Quantity

Price elasticity of demand


- Responsiveness of demand for a good due to a change in its price.
Inelastic Demand:

Demand that responds slightly to a change in price.


Absolute value < 1
Producers will benefit from an increase in price because it will
increase revenue, as the % decline in demand is less than the
increase in price.

Perfectly Inelastic Demand:

Qd does not respond at all to a change in price.

Elastic Demand:

% change in Qd > % change in price


Absolute value is > 1
Producers will benefit from a decrease in price because it will
increase demand and revenue.

Perfectly Elastic Demand:

Qd drops to zero at an increase in the change in price.

Cross elasticity of demand


Responsiveness of demand for a good due to changes in the price of other goods.
When cross elasticity is:
Positive

Negative

substitute goods (e.g. an increase in the price of beef will increase the
demand for pork.)
complementary goods (e.g. price increase in sugar would decrease the demand
for coffee.)

Income elasticity of demand


- The change in quantity demanded brought due to a percentage change in the income of the
consumer.
When income elasticity is:
Positive

Negative

normal good
superior good
inferior good

The Production Function


- This shows the relationship the quantities of inputs and the maximum quantities of outputs
produced. Below illustrates the concept in a table.

Table 4.1 TP, AP and MP in production of a good


Machine (Capital)
K
1
1
1
1
1
1
1

Labor
L
1
2
3
4
5
6
7

Fixed Input:
Machine
Variable Input
Variable Input: Labor L
1st Stage of Production:
2nd Stage of Production:

Total Product
TP
15
40
75
90
85
85
77
K

Average Product
AP
15
20
25
22.5
17
14.17
11

Marginal Product
MP
15
25
35
15
5
0
-8

Average Product = Total Product /


Marginal Product = TP2 TP1 / L2 L1

K is underutilized so MP is increasing up to the 3rd labourer being added.


K is fully utilized so MP is decreasing (diminishing marginal productivity)
until it reaches 0.
3rd Stage of Production:
K is over-utilized so MP is negative meaning additional labourers
decrease production.

Costs of Production

Table 4.2 Costs and Average Costs exhibit


Total
Product
TP
0
20
30
40
50
60
70

Total Fixed
Cost
TFC

Total
Variable Cost
TVC

Total Cost
TC

Average
Fixed Cost
AFC

Average
Variable Cost
AVC

Average
Total Cost
ATC

100
100
100
100
100
100
100

0
50
75
115
170
210
240

100
150
175
215
270
310
340

5.00
3.33
2.50
2.00
1.67
1.43

2.50
2.43
2.88
3.40
3.50
3.43

7.50
5.83
5.38
5.40
5.17
4.86

TC = TFC + TVC
AFC = TFC/TP

AVC = TVC/TP
ATC = TC/TP

Isoquants
- A curve showing different combinations of variable inputs that will give the same level of
production.
Marginal Rate of Technical Substitution : Rate at which capital is being substituted for labor.

Isocosts
- A locus of points showing combinations of variable inputs that will result in the same total cost for
the firm.

Condition for efficient production:


Fig. 5 Efficient Production
Capital K
A
K*

E
Q1
B
L*

Q2
Labor L

(Fig. 5) At point E, the isoquant line Q 1 is tangent to the isocost line. This is the condition for efficient
production. It means that the marginal productivity of capital per amount spent and marginal
productivity of labor per amount spent will give the same marginal productivity. The firm should
therefore produce at K* and L*. Production at isoquant Q2 will not be efficient because at point A nor
at point B where it meets the isocost line.

Market Structures

Perfectly competitive market


- No single firm has market power. Firms are price takers.
- Many buyers and sellers.
- Homogenous products are being sold in the market.
- There is a free entry/exit in the market.
Profit Maximization is attained when Marginal Revenue = Marginal Cost
In a perfectly competitive market, it is attained when MR=Price=MC
The demand curve of a perfectly competitive firm is perfectly elastic.
The supply curve in a perfectly competitive market is its MC curve from the point where it is
equal to the AVC curve. The firm should not produce below this point.

Monopoly
- Single producer of a product or service in the market.
- Product sold is differentiated/unique.
- Barriers to entry in the market are present.
The market demand curve is the AR curve, and since there is only one producer, it is also the firms
demand curve.
Profit Maximization in a monopoly is when MR=MC.
The monopolist will produce where MR=MC. There is an incentive to gain profit if it produces at
MC<MR while losses will be incurred if it produces at MC>MR.
Discriminating Monopolist is a firm that gives the same output or service at different price levels,
by dividing its market to maximize profit.
Consumers with an inelastic demand curve will be charged a higher price while those with an elastic
demand curve will be charged a lower price.

Oligopoly
- Price and output of one firm is based on the actions of competitors in the market.
- Few sellers present in the market.
Reaction of Competitors and Kinked Demand Curve
Fig. 6.1 Market Reaction Function

Fig. 6.2 Kinked Demand Curve

Qty.

Price

XA1

XA2

B
P1
J

XAC
RFA

Quantity

XB1 XB2 XBC

RFB

Qty.

Q1
MR

(Fig. 6.1) If firm A produces at quantity XA1 firm B reacts to this and produces at X B1 to maximize its
profit based on its reaction function. In turn, firm A adjusts to production level XA2, and firm B
produces at XB2. The intersection of RFA and RFB is the equilibrium amount to be supplied by each
firm in the market, XAE and XBE.

(Fig. 6.2) The kinked demand curve BCD is broken at point N. At this point, market price is at P1. If
prices are set above P1, the portion of the demand curve is more elastic, thus if one firm increases
price others will not follow, and that firm will lose consumers. If one firm decreases price it is on the
portion wherein the demand curve is more inelastic, meaning that % increase in demand < %
decrease in price.

Monopolistic Competition
- Numerous sellers present in the market.
- Products are differentiated through advertising, packaging, etc.
The most efficient production level cannot be achieved because of the firms ability to influence price
through product differentiation. Price is set where it is higher than the MC of the firm. It cannot
operate on the lowest AC because its demand curve has an negative inclination.
-END-

Prepared by:
The Academics Committee
Economics Organization