What is the 'Law Of Demand'

The law of demand is a microeconomic law that states, all other factors being equal, as the price of a good or service increases,

consumer demand for the good or service will decrease, and vice versa. The law of demand says that the higher the price, the lower

the quantity demanded, because consumers opportunity cost to acquire that good or service increases, and they must make more

tradeoffs to acquire the more expensive product.

BREAKING DOWN 'Law Of Demand'

The chart below depicts the law of demand using a demand curve, which is always downward sloping. Each point on the curve (A,

B, C) reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1

and the price will be P1, and so on.

The law of demand is so intuitive that you may not even be aware of all the examples around you.

-When shirts go on sale, you might buy three instead of one. The quantity that you demand increases because the price has fallen.

-When plane tickets become more expensive, youre less likely to travel by air and more likely to choose the less expensive options

of driving or staying home. The amount of plane tickets that you demand decreases to zero because the cost has gone up.

The law of demand summarizes the effect price changes have on consumer behavior. For example, a consumer will purchase more

pizzas if the price of pizza falls. The opposite is true if the price of pizza increases. John might demand 10 pizzas if they cost $10

each, but only 7 pizzas if the price rises to $12, and only 4 pizzas if the price rises to $20.

The law of demand is one of the most fundamental concepts in economics. It works with thelaw of supply to explain how market

economies allocate resources and determine the prices of goods and services.
Law Of Supply
What is the 'Law Of Supply'
The law of supply is the microeconomic law that states that, all other factors being equal, as the price of a good or service

increases, the quantity of goods or services that suppliers offer will increase, and vice versa. The law of supply says that as the

price of an item goes up, suppliers will attempt to maximize their profits by increasing the quantity offered for sale.

BREAKING DOWN 'Law Of Supply'

The chart below depicts the law of supply using a supply curve, which is always upward sloping. A, B and C are points on the supply

curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). So, at point A, the quantity

supplied will be Q1 and the price will be P1, and so on.

The law of supply is so intuitive that you may not even be aware of all the examples around you.

-When college students learn computer engineering jobs pay more than English professor jobs, the supply of students with majors in

computer engineering will increase.

-When consumers start paying more for cupcakes than for donuts, bakeries will increase their output of cupcakes and reduce their

output of donuts in order to increase their profits.

-When your employer pays time and a half for overtime, the number of hours you are willing to supply for work increases.
The law of supply summarizes the effect price changes have on producer behavior. For example, a business will make more video

game systems if the price of those systems increases. The opposite is true if the price of video game systems decreases. The

company might supply 1,000,000 systems if the price is $200 each, but if the price increases to $300, they might supply 1,500,000

systems.

The law of supply is one of the most fundamental concepts in economics. It works with the law of demand to explain how market

economies allocate resources and determine the prices of goods and services.
Gregory Mankiw in his Principles of Economics outlines Ten Principles of Economics that we will replicate here, they are:

1. People face tradeoffs

2. The cost of something is what you give up to get it
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.

How People Make Decisions[edit]

People face tradeoffs[edit]
There is no thing such as a free lunch. To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires
trading one goal for another.
Examples include how students spend their time, how a family decides to spend its income, how the government spends revenue, and how regulations may
protect the environment at a cost to firm owners.
A special example of a trade-off is the trade-off between efficiency and equity.
Definition of efficiency: the property of society getting the maximum benefits from its scarce resources.
Definition of equity: the property of distributing economic prosperity fairly among the members of society.
For example, tax paid by wealthy people and then distributed to poor may improve equity but lower the incentive for hard work and therefore reduce
the level of output produced by our resources.
This implies that the cost of this increased equality is a reduction in the efficient use of our resources.
Another Example is guns and butter: The more we spend on national defense(guns) to protect our borders, the less we can spend on consumer goods
(butter) to raise our standard of living at home.
Recognizing that trade-offs exist does not indicate what decisions should or will be made.

The cost of something is what you give up to get it[edit]

Because people face trade off, making decisions requires comparing the costs and benefits of alternative courses of action.
The cost of
going to college for a year is not just the tuition, books, and fees, but also the foregone wages.
seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater
This is called opportunity cost of a resource
Definition of opportunity cost: whatever must be given up in order to obtain some item.
When making any decision, decision makers should consider the opportunity costs of each possible action.

Rational people think at the margin[edit]

Economists generally assume that people are rational.
Definition of rational: systematically and purposefully doing the best you can to achieve your objectives.
Consumers want to purchase the bundle of goods and services that allows them the greatest level of satisfaction given their incomes and the prices
they face.
Firms want to produce the level of output that maximizes the profits.
Many decisions in life involve incremental decisions: Should I remain in school this semester? Should I take another course this semester? Should I study
an additional hour for tomorrows exam?
 Rational people often make decisions by comparing marginal benefits and marginal costs.
Example: Suppose that flying a 200-seat plane across the country costs the airline 1,000,000, which means that the average cost of each seat is
5000. Suppose that the plane is minutes away from departure and a passenger is willing to pay 3000 for a seat. Should the airline sell the seat for
3000? In this case, the marginal cost of an additional passenger is very small.
Another example: Why is water so cheap while diamonds are expensive? Because water is plentiful, the marginal benefit of an additional cup is
small. Because diamonds are rare, the marginal benefit of an extra diamond is high.

People respond to incentives[edit]

People will make decisions based on benefit or detriment

=[edit]
How People Interact With Each Other[edit]
Trade can make everyone better off[edit]
Trade is not like a sports competition, where one side gains and the other side loses.
Consider trade that takes place inside your home. Your family is likely to be involved in trade with other families on a daily basis. Most families do not build
their own homes, make their own clothes, or grow their own food.
Countries benefit from trading with one another as well.
Trade allows for specialization in products that benefits countries (or families)

Markets are usually a good way to organize economic activity[edit]

Many countries that once had centrally planned economies have abandoned this system and are trying to develop market economies.

Definition of market economy: an economy that allocates resources through the decentralized decisions of many firms and households as they
interact in markets for goods and services.
Market prices reflect both the value of a product to consumers and the cost of the resources used to produce it.
Centrally planned economies have failed because they did not allow the market to work.
Adam Smith and the Invisible Hand
Adam Smiths 1776 work suggested that although individuals are motivated by self-interest, an invisible hand guides this self-interest into promoting
societys economic well-being.

Governments can sometimes improve market outcomes[edit]

There are two broad reasons for the government to interfere with the economy: the promotion of efficiency and equity.

Government policy can be most useful when there is market failure.

Definition of market failure: a situation in which a market left on its own fails to allocate resources efficiently.
Examples of Market Failure
Definition of externality: the impact of one persons actions on the well-being of a bystander. (Ex.: Pollution)
Definition of market power: the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices.
Because a market economy rewards people for their ability to produce things that other people are willing to pay for, there will be an unequal
distribution of economic prosperity.
Note that the principle states that the government can improve market outcomes. This is not saying that the government always does improve market
outcomes.

The Forces and Trends That Affect How The Economy as a

Whole Works[edit]
The standard of living depends on a countrys production[edit]
Differences in the standard of living from one country to another are quite large.
Changes in living standards over time are also quite large.
The explanation for differences in living standards lies in differences in productivity.
Definition of productivity: the quantity of goods and services produced from each hour of a workers time.
High productivity implies a high standard of living.
Thus, policymakers must understand the impact of any policy on our ability to produce goods and services.
To boost living standards the policy makers need to raise productivity by ensuring that workers are well educated, have the tools needed to produce goods
and services, and have access to the best available technology.

Prices rise when the government prints too much money[edit]

Definition of inflation: an increase in the overall level of prices in the economy.
When the government creates a large amount of money, the value of money falls.
Examples: Germany after World War I (in the early 1920s) and the United States in the 1970s

Society faces a short-run trade off between inflation and

unemployment[edit]
Most economists believe that the short-run effect of a monetary injection (injecting/adding money into the economy) is lower unemployment and higher
prices.
An increase in the amount of money in the economy stimulates spending and increases the demand of goods and services in the economy.
Higher demand may overtime cause firms to raise their prices but in the meantime, it also encourages them to increase the quantity of goods and
services they produce and to hire more workers to produce those goods and services. More hiring means lower unemployment.
Some economists question whether this relationship still exists.
The short-run trade-off between inflation and unemployment plays a key role in analysis of the business cycle.
Definition of business cycle: fluctuations in economic activity, such as employment and production.
Policymakers can exploit this trade-off by using various policy instruments, but the extent and desirability of these interventions is a subject of continuing
debate..
 I. Principles of Decision Making
There are four economic principles of individual decision making:

1. People Make Tradeoffs

Economic goods and services are limited, while the need to use services of
these goods and services seem limitless. There are simply not enough goods
and services to satisfy even a small fraction of everyone's consumption
desires. Thus, societies must decide how to use these limited resources and
distribute them among different people. This means, to get one thing that we
like, we usually have to give up another thing that we also like. Making
decision requires trading off one goal against another.

Consider a society that decides to spend more on national defense to protect

its shores from foreign aggressors: the more the society spends on the
national defense, the less it can spend on personal goods to raise its standard
of living at home. Or consider the trade-off between a clean air environment
and a high level of income. Laws that require firms to reduce pollution have
the cost of reducing the incomes of the firm's owners, workers, and
customers, while pollution regulations give the society the benefit of a
cleaner environment and the improved health that comes with it.

Another trade off society faces is between efficiency and equity. Efficiency
deals with a society's ability to get the most effective use o its resources in
satisfying people's wants and needs. Equity denotes the fair distribution of
benefits of those resources among society's members.

2. When People Choose One Thing They Give Up Something Else

Scarcity of economic resources forces people to make tradeoffs. That is,

people must always consider how to spend their own limited incomes or time
because resources are limited to satisfy their unlimited needs and wants.
Tradeoffs or choosing a one thing means giving up something else. When we
give up an item, we lose the benefits of its services to us or incur costs to
obtain the benefits of the thing we decided to choose. Thus, making
decisions requires comparing the costs and benefits of alternative courses of
action. In economics, the term used to reflect whatever must be given up to
obtain some item is called opportunity cost.

3. Rational People Think at the Margin

In many situations, decisions in life are made in small incremental or

decremental adjustments to the existing plan of action or status quo.
Economists call these marginal changes. Imagine a student who is pondering
whether she should add one more course next semester. She, as a rational
decision-maker, will add the extra course as long as her marginal benefits
from carrying one more course exceeds her expected marginal costs.
Generally speaking, an individual can make better decisions by thinking at
the margin. Likewise, a rational decision-maker takes an action if and only if
the marginal benefit of the action exceeds the marginal cost.

4. People Respond to Incentive

Since individuals make decisions by comparing costs or benefits, their

behavior may change when the costs or benefits change. That is, people
respond to incentives. As an example of this, consider public policy toward
seat belts and auto safety. In the 1960s, Ralph Nader's book (Mr. Nader is a
well-known personality as an advocate for a consumer's interest and a Green
Party presidential candidate in 2000 ) Unsafe at Any Speed influenced the
Congress to pass a legislation requiring car companies to make seat belts
standard equipment on all cars. The direct effect of this law is to save lives.
It is this direct impact that motivated Congress to require seat belts.

II. HOW PEOPLE INTERACT

It is so obvious that individuals' decisions affect not only themselves but

other people as well. The following three principles state how people interact
with one another.

5. Trade Can Make Everyone Better Off

Consider a situation in which a family isolates itself from all other families.
That particular
family would need to grow its own food, make its own clothes, and build its
own home. Clearly
any family gains much from its ability to trade with others. Trade allows
each person to
specialize in the activities he or she does best, whether it is farming, sewing,
or home building.
By trading with others, people can buy a greater variety of goods and
services at lower cost.

Just as a family would not be better off isolating itself from all other
families, a country too would not be better off if it does not exchange goods
and services with the rest of nations. Trade allows countries to specialize in
what they do best and to enjoy a greater variety of goods and services.

6. Markets Are Usually a Good Way to Organize Economic Activity

The market possesses the power of resource allocation. Most nations of the
world have adopted the use of the market power as a tool for allocating
resources rather than other alternatives such as central planning. This is
because the market allocates resources through the decentralized decisions of
many firms and households as they interact in markets for goods and
services.

Under a market economy, firms decide whom to hire and what to make.
Households decide which firms to work for and what to buy with their
incomes. These firms and households interact in the marketplace, where
prices guide their decisions. Prices reflect both the values of a good to
society and the cost to society of making the good. Because households and
firms look at prices when deciding what to buy and sell, prices guide these
individual decision makers to reach outcomes that, in many cases, promote
general economic well-being by allocating resources efficiently.

In a centrally planned economy, for example, prices are not determined in

the marketplace, but are gauged by central planners. Central planners,
however, lack the information that effectively reflects either the value of a
good to the society or the cost of the good to the society that gets reflected in
prices under market forces. Thus, the pricing mechanism under a central
planning system does not take into account the social benefits and costs
when exchanging goods and services. As a result, resources are not
effectively allocated in a way that maximizes the welfare of society as a
whole.

7. Governments Can Improve Market Outcomes

Markets cannot effectively respond to some key societal questions, such as

how to protect our precious environment for future generations, or how
much of our resources should be devoted to educating the young, or how to
correct the extreme imbalances and the unfair sharing of national wealth that
exists between the rich and the poor, or how to reduce unemployment in a
deep recession.

Due to what is known as market failure, which are the characteristics of the
free market system, some times the market on its own fails to allocate
resources efficiently. Under these circumstances, intervention by a
government into the economy becomes both a desirable and an inevitable
outcome. Consider three situations of market failures: externality, market
power and unequal distribution of income. A government in a market
economy can promote efficiency and equity eliminating problems
unresolved or caused by market failure.

An externality is an activity that affects others for better or worse, without

those others paying or being compensated for the activity. It exists when
private costs or benefits do not equal social costs or benefits. The
unregulated market may produce too much air pollution and too little
investment in public health or knowledge. Government may use its influence
to control harmful externalities. For example, if a chemical factory does not
bear the entire cost of smoke it emits, the government can raise economic
well-being through environmental regulation. Or it can subsidize activities
that are socially beneficial such as education or prenatal care.

The second example of market failure, a market power, reflects the degree of
control that a firm or group of firms has over the price and production
decisions in an industry. When monopolies or oligopolies, for example,
collude to reduce rivalry or drive firms out business, government may apply
antitrust policies or regulations to enhance economic efficiency.

The last example refers to the manner in which the total wealth of a nation
and income is unfairly and unequally distributed among individuals. Even
when a market works to maintain efficiency, it does not ensure that everyone
has sufficient food, decent clothing, and adequate health care. People end up
being rich or poor depending on their inherited wealth, or on their talents and
efforts, and on their gender or the color of their skin. The government can
achieve a more equitable distribution of economic well being through public
policies, such as the income tax and the welfare system.

III. How the Economy Works

All the decisions that are made by individuals and the interactions they
make with one another together make up "the economy". The last three
principles reflect the workings of the economy as a whole.

8. A Country's Standard of Living Depends on Its Ability to Produce

Goods and Services

The differences in the living standards around the world are astounding.
People in countries with the lowest average incomes earn only about one-
twentieth as much as people in high-income countries. The average life
expectancy is four-fifths that of the average person in an advanced country.
Birth rates are high, particularly for the families where women receive no
education, but mortality rates are also much higher there than in countries
with good health-care systems. A typical works with but one-sixtieth the
horsepower of a prosperous industrialized worker. The people in the 40
poorest countries constitute 55 percent of the world population but must
divide among each other only 4 percent of the world income.
What explains these large differences in living standards among countries
and over time? Almost all variation in living standards is attributable to
differences in countries' productivity. Broadly defined, productivity is the
quantity of goods and services produced from each hour of a worker's time.
In nations where workers can produce large quantities of goods and services
per unit of time, most people enjoy a high standard of living; in nations
where workers are less productive, most people must endure a more meager
existence. Similarity, the growth rate of a nation's productivity determines
the growth rate of average income.

The relationship between productivity and living standard also has profound
implications for public policy. To boost living standards, policymakers need
to raise productivity by ensuring that workers are well educated, have the
tools needed to produce goods and services, and have access to the available
technology.

The relationship between productivity and living standard also has profound
implications for public policy. To boost living standards, policymakers need
to raise productivity by ensuring that workers are well educated, have the
tools needed to produce goods and services, and have access to the available
technology.

9. Price Rise when the Government Prints Too Much Money

When an average price increases consistently for a long period of time in the
economy, it causes an inflationary condition. Average price increases in the
economy are mainly affected by growth in the quantity of money in the long
run situation. Therefore, inflation is associated with rapid growth in the
quantity of money in the long run circumstances.

10. Society Faces a Short-Run Tradeoff between Inflation and

Unemployment

The tradeoff between inflation and unemployment is called the Phillips

curve, after the economist who first examined this relationship.

The tradeoff arises because in the short run, prices respond to the quantity of
money changes very slowly. Suppose, for example, that the government
reduces the quantity of money in the economy. All prices will not be reduced
immediately as a result of this change for many reasons. It may take several
years before all firms issue new catalogs or all unions make wage
concessions. That is prices are said to be sticky in the short run. On the other
hand, when the government reduces the quantity of money in the economy, it
reduces the amount that people spend. Lower spending, together with prices
that are stuck too high, reduce the quantity of goods and services that firms
sell. Lower sales, in turn, cause firms to lay off workers. Thus, the reduction
in the quantity of money raises unemployment in the short run until prices
have fully adjusted to the change.

Policymakers can exploit this tradeoff using various policy instruments. For
example, by changing the the amount it spends, the amount it taxes, and the
amount of money it prints, Policymakers can influence the combination of
inflation and unemployment the economy experiences.