CHAPTER 1

Scarcity
Economics: The study of how people make choices under scarcity and the results of these choices for society.

The Scarcity Principle: People have unlimited wants and limited resources. Having more of one good means having less of
another. Also called No Free-Lunch Principle.

The Cost-Benefit Principle

Take an action if and only if the extra benefits are at least as great as the extra costs. Costs and benefits are not just money

Applying the Cost – Benefit Principle

Assume people are rational: A rational person has well defined goals and tries to fulfill those goals as best they can
Would you walk to town to save $10 on an item? Benefits are clear. Costs are harder to define
Hypothetical auction: Would you walk to town if someone paid you $9? If you would walk to town for less than $10, you gain
from buying the item in town

Cost – Benefit Principle Examples

You clip grocery coupons but Bill and Melinda Gates do not. You speed on the way to work but not on the way to school. At the
ball park, you pay extra to buy a soda from the hawkers in the stands. You skip your regular dental check-up.

Economic Surplus
The economic surplus of an action is equal to its benefit minus its costs.

Opportunity Cost
Opportunity cost is the value of what must be foregone in order to undertake an activity.
Consider explicit and implicit cost. Examples: Give up an hour of babysitting to go to the movies, give up watching TV to walk to
town. Caution: NOT the combined value of all possible activities. Opportunity cost considers only your best alternative.

Economic Models
Simplifying assumptions. Which aspects of the decision are absolutely essential? Which aspects are irrelevant? Abstract
representation of key relationships. The Cost-Benefit Principle is a model, if costs of an action increase, the action is less likely
and if benefits of an action increase, the action is more likely.

Three Decision Pitfalls

Economic analysis predicts likely behavior
Three general cases of mistakes:
1. Measuring costsand benefits as proportions instead of absolute amounts.
2. Ignoring implicit costs.
3. Failure to think at the margin.

Measuring costs and benefits as proportions instead of absolute amount. Would you walk to town to save $10 on a
$25 item? Would you walk to town to save $10 on a $2,500 item?

Ignoring implicit costs. Consider your alternatives, the value of a Frequent Flyer coupon depends on its next best use.
Expiration date. Do you have time for another trip?. Cost of the next best trip. The round-trip airfare to NY is $500. All other cost
is $1000. The most you would be willing to pay for the trip is $1350. You have a frequent-flyer coupon. You can use the coupon
1.go to NY 2.go to Boston(for attending brother’s wedding, your coupon expires shortly thereafter ). The round-trip airfare to
Boston is $400.

Explicit cost + Implicit cost: Economic costs

Failure to think at the margin. Sunk costs cannot be recovered. Examples: Eating at an all-you-can-eat restaurant ($0 or $10)

Marginal Analysis Ideas

Marginal cost is the increase in total cost from one additional unit of an activity.
Average cost is total cost divided by the number of units
Marginal benefit is the increase in total benefit from one additional unit of an activity
Average benefit is total benefit divided by the number of units

Normative and Positive Economics

–Normative economic principle says how people should behave. Building a space base on the moon will cost too much.
–Positive economic principle predicts how people will behave. Building a space base on the moon will cost more than the
shuttle program.
Microeconomics and Macroeconomics
Microeconomics studies choice and its implications for price and quantity in individual markets
Sugar Carpets House cleaning services
Microeconomics considers topics such as Costs of production Demand for a product

Macroeconomics studies the performance of national economies and the policies that governments use to try to improve that
performance •Inflation •Unemployment •Growth
Macroeconomics considers •Monetary policy •Deficits •Tax policy.

CHAPTER 2
Supply and Demand
Every society answers three basic questions
WHATWhich goods will be produced? How much of each?
HOWWhich technology?Which resources are used?
FOR WHOMHow are outputs distributed?Need?Income?

Central Planning versus the Market

Central Planning
•Decisions by individuals or small groups Agrarian societies Government programs –Sets prices and goals for the group
•Individual influence is limited
The Market
Buyers and sellers signal wants and costs
•Resources and goods are allocated accordingly –Interaction of supply and demand answer the three basic questions

Buyers and Sellers in the Market

•The market for any good consists of all the buyers and sellers of the good
•Buyers and sellers have different motivations –Buyers want to benefit from the good –Sellers want to make a profit
•Market price balances two forces –Value buyers derive from the good –Cost to produce one more unit of the good

Demand
A demand curve illustrates the quantity buyers would purchase at each possible price
•Demand curves have a negative slope
•Consumers buy less at higher prices
•Consumers buy more at lower prices

Demand Slopes Downward

•Buyers value goods differently
–The buyer’s reservation price is the highest price an individual is willing to pay for a good
•Demand reflects the entire market, not one consumer
–Lower prices bring more buyers into the market
–Lower prices cause existing buyers to buy more

Income and Substitution Effects

•Buyers buy more at lower prices and buy less at higher prices
•What happens when price goes up?
–The substitution effect: Buyers switch to substitutes when price goes up
–The income effect: Buyers' overall purchasing power goes down.

Interpreting the Demand Curve

Horizontal interpretation of demand:
•Given price, how much will buyers buy?
•At a price of $4, the quantity demanded is 8,000 slices/day.

Vertical interpretation of demand:

•Given the quantity to be sold, what price is the marginal consumer willing to pay?
•If 8,000 slices are sold the marginal consumer is willing to pay $4 per slice.

Supply
The supply curve illustrates the quantity of a good that sellers are willing to offer at each price.
–If the price is more than opportunity cost, offer more
•Opportunity cost differs among sellers due to:
-Technology -Different costs such as rent -Skills
•The seller’s reservation price is the lowest price the seller would be willing to sell for:
–Equal to marginal cost

Interpreting the Supply curve

Horizontal interpretation of supply:
•Given price, how much will suppliers offer?
At a price of $2, suppliers are willing to sell 8,000 slices/day.
Vertical interpretation of supply:
•Given the quantity to be sold, what is the opportunity cost of the marginal seller?
If 8,000 slices are sold, the marginal cost of producing the 8,000thslice is $2.

Market Equilibrium
•A system is in equilibrium when there is no tendency for it to change
•The equilibrium price is the price at which the supply and demand curves intersect
•The equilibrium quantity is the quantity at which the supply and demand curves intersect
•The market equilibrium occurs when all buyers and sellers are satisfied with their respective quantities at the market price–At
the equilibrium price, quantity supplied equals quantity demanded
•Quantity supplied equals quantity demanded AND
•Price is on supply and demand curves
•No tendency to change P or Q

Excess Supply and Excess Demand

Excess Supply
–At $4, 16,000 slices supplied and 8,000 slices demanded
Excess Demand
–At $2, 8,000 slices supplied 16,000 slices demanded

Incentive Principle
Excess Supply at $4
–Each supplier has an incentive to decrease the price in order to sell more
–Lower prices decrease the surplus
–As price decreases:
•the quantity offered for sale decreases along the supply curve
•the quantity demanded increases along the demand curve

Excess Demand at $2
–Each supplier has an incentive to increase the price in order to sell more
–Higher prices decrease the shortage
–As price increases:
•the quantity offered for sale increases along the supply curve
•As price increases, the quantity demanded decreases along the demand curve

Rent Controls Are Price Ceilings

–A price ceiling is a maximum allowable price, set by law
–Rent controls set a maximum price that can be charged for a given apartment
–If the controlled price is below equilibrium, then:
•Quantity demanded increases •Quantity supplied decreases •A shortage results

Movement along the Demand Curve

•When price goes up, quantity demanded goes down
•When price goes down, buyers move to a new, higher quantity demanded
•A change in quantity demanded results from a change in the price of a good.

Shift in Demand
•If buyers are willing to buy more at each price, then demand has increased
•Move the entire demand curve to the right
•Change in demand
•If buyers are willing to buy less at each price, then demand has decreased
Movement Along the Supply Curve
•When price goes up, quantity supplied goes up
•When price goes up, sellers move to a new, higher quantity supplied
•A change in quantity supplied results from a change in the price of a good.

Shift in Supply
•Supply increases when sellers are willing to offer more for sale at each possible price
•Moves the entire supply curve to the right

•Supply decreases when sellers are willing to offer less for sale at each possible price
•Moves the entire supply curve to the left

Tennis Market
–If rent for tennis court decreases, demand for tennis balls increases
•Tennis courts and tennis balls are complements
Causes of Shifts in Demand
•Price of complementary goods
–Tennis courts and tennis balls
•Price of substitute goods
–Internet and overnight delivery are substitutes
•Income: normal or inferior goods?
•Preferences
–Dinosaur toys after Jurassic Park movie
•Number of buyers in the market
•Expectations about the future

Price changes never cause a shift in demand

Apartments Near DC Metro

•If government wages rise, demand for apartments near Metro stations increases
•Demand increases
–Price increases
–Quantity increases
•Demand for a normal good increases when income increases
•Demand for an inferior good increases when income decreases

Causes of Shifts in Supply

•A change in the price of an input–Fiberglass for skateboards, construction wages
•A change in technology
–Desktop publishing and term papers
–Internet distribution of products (e-commerce)
•Weather (agricultural commodities and outdoor entertainment)
•Number of sellers in the market
•Expectation of future price changes

Price changes never cause a shift in supply

Shifts in Supply: Skateboards

•Costs of production affect the supply of a product
•Cost of fiberglass for skateboards increases
–Supply decreases
•With no change in demand, the price of skateboards increases to $80 and quantity decreases to 800

Supply and Demand Shifts: Four Rules

1. An increase in demand will lead to an increase in both equilibrium price and quantity

2. An decrease in demand will lead to a decrease in both equilibrium price and quantity

3. An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity

4. An decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity.
Supply and Demand Both Change: Tortilla Chips
•Oils used for frying are harmful AND the price of harvesting equipment decreases
Efficiency and Equilibrium
•Markets communicate information effectively
–Value buyers place on the product–Opportunity cost of producing the product
•Markets maximize the difference between benefits and costs
•Market outcomes are the best provided that
–The market is in equilibrium AND
–No costs or benefits are shared with the public.

Cash on the Table

•Buyer's surplus: buyer's reservation price minus the market price
•Seller's surplus: market price minus the seller's reservation price
•Total surplus = buyer's surplus + seller's surplus–Total surplus is buyer's reservation price – seller's reservation price
•Nocash on the table when surplus is maximized
–No opportunity to gain from additional sales or purchases

Efficiency Principle
•The socially optimal quantity maximizes total surplus for the economy from producing and selling a good
–Economic efficiency – all goods are produced at their socially optimal level
•Efficiency Principle: equilibrium price and quantity are efficient if:
–Sellers pay all the costs of production –Buyers receive all the benefits of their purchase
•Efficiency: marginal cost equals marginal benefit–Production is efficient if total surplus is maximized

Smart for One, Dumb for All

•Producers sometimes shift costs to others
–Pollution is like getting free waste disposal services
–Total marginal cost = seller's marginal cost plus marginal cost of pollution
–When costs are shifted, supply is greater than socially optimal
•Buyers may create benefits for others
–Marginal benefit is less than the full social benefit
–Vaccinations, my neighbor's landscaping
–The demand for these goods is less than socially optimal

Equilibrium Principle: a market in equilibrium leaves no unexploited opportunities for individuals

–BUT it may not exploit all gains achievable through collective action
–Only when the seller pays the full cost of production and the buyer captures the full benefit of the good is the market outcome
socially optimal
•Regulation, taxes and fines, or subsidies can move the market to optimal level.

Chapter 4
Demand and Elasticity

Free Ice Cream – Or Is It?•The cost of a good extends beyond its monetary cost –
Waiting in line•"Free" ice cream attracts so many consumers that the time spent waiting in line
acts as the price of the good•Demand curves relate the quantity demanded to ALL costs, not
just monetary costs.

Law of DemandPeople do less of what they want to do as the cost of doing it rises

Law of Demand-2•Cost-Benefit Principle at work–Do something if the marginal benefits

1A-7

are at least as great as the marginal costs•An increase in the market price approaches our
reservation price–If market price exceeds the reservation price, buy no more–Costs include ALL
costs – money, time, reputation•Consider implicit and explicit costs

Origins of Demand•Reservation price–Individual tastes and preferences differBiological

needs■ Cultural influencesPeer behavior■ Individual differencesPerceived quality■ Expected benefits–Tastes may
change over time•Macaroni and cheese•Spinach•New goods get incorporated into priorities
Needs versus Wants•Some goods are required for subsistence –These are
needs•Beyond subsistence, behavior is driven by wants –Kidneys or hamburger–Oatmeal or toaster
pastries•Wants depend on price –Water in California•Regulations or price mechanism–Regulations are cumbersome
and expensive–Price changes are fast and effective

California Water Shortages•Problem: California has a large population and relatively

low annual rainfall, so some argue that water shortages are inevitable•Analysis –New Mexico
has less rainfall per person and fewer shortages–California's water price is low–Low price
discourages careful use•Rice is grown because water is cheap•Water-intensive home landscaping

Substitution at Work•Substitution has powerful effects on our choices –New car or used
one–Car pool or bus–French restaurant, Chinese restaurant, cook at home–Soccer game or TV or
read a book–Go to movies or join Netflix or get cable TV–Turn on the heat or put on a hoodie

Example: Smaller Homes in Manhattan•Observation: Wealthy people in Seattle

have larger homes than wealthy people in Manhattan –Seattle houses twice the size of Manhattan
houses•Analysis–Housing prices are higher in Manhattan•Land is more expensive•Construction costs are higher –
New Yorkers buy less housing and spend more on other goods such as vacation homes, travel, restaurant
meals, and theater tickets

Nominal and Real Prices•Nominal price: the absolute price of a good in terms of
dollars–The price you see on a good in a store•Real price: the nominal price of a good relative
to the average dollar price of all other goods –Real prices are adjusted for inflation

Example: How Many Cylinders in Your Car?

Observation: People bought 4-cylinder cars in the 1970s, returning to 6- and 8-cylinder cars in the 1990s
•Analysis
-1973 gas price was higher in real terms than in 1999
–$1.40 in 1999 bought more other goods than $0.38 bought in 1973
-With lower real gas prices, people bought bigger cars
–SUV market boomed in the 1990s
–High gas prices in 2004 reversed the trend again

Income Differences Matter

•Income is one of the determinants of demand
–"Free goods" have more takers in lower income neighborhoods than in higher income areas
•The wait to get the free good is the price
–Waiting times in lower income areas will be longer »Lower opportunity cost of the residents' time
–Stores in higher income areas have lower waiting times to pay for purchases
-The higher value of time causes these people to be willing to pay for more store staff

Individual and Market Demand Curves

•The market demand is the horizontal sum of individual demand curves
–At each possible price, add up the number of units demanded by individuals to get the market demand

Identical Individual Demand Curves

•In the special case where all buyers demand exactly the same quantity at each price
–Multiply the individual quantity demanded by the number of buyers to get the market demand
Drug Enforcement and Local Theft•Hypothesis–Drug users steal to buy drugs–Increasing
drug enforcement will decrease theft•Analysis–Increased enforcement reduces supply of drugs•Price of drugs
increases•Quantity demanded decreases –Theft goes down ONLY IF total expenditure on drugs decreases •How
responsive is quantity demanded to price?

Price Elasticity of Demand•Price elasticity of demand is defined as the percentage change

in quantity demanded from a 1% change in price–Measure of responsiveness of quantity demanded to
changes in price•Example:–Price of beef decreases 1%–Quantity of beef demanded increases 2%–Price elasticity of
demand is – 2

Calculate Price Elasticity•Symbol for elasticity is ε–Lower case Greek letter epsilon•For small
percentage changes in priceε = Percentage change in quantity demandedPercentage change in pricePrice
elasticity of demand is always negativeIgnore the sign

Elastic Demand
If price elasticity is greater than 1, demand is elastic–Percentage change in quantity is greater than percentage
change in price–Demand is responsive to price

Inelastic Demand
If price elasticity is less than 1, demand is inelastic–Percentage change in quantity is less than percentage
change in price–Quantity demanded is not very responsive to price

Unit Elastic Demand

If price elasticity is 1, demand is unit elastic–Price and quantity change by the same percentage
Taxes And Teen Smoking
•Hypothesis
:–Teens’ demand for cigarettes is inelastic
•Demand is driven by peers
•But, teens also lack income
•Analysis:
–Cigarette taxes increase the price of cigarettes
•Some teens will smoke less or quit altogether
–These teens will influence others to quit
–Higher taxes are likely to reduce teen smoking

Unintended Effects of the Yacht Tax

•Hypothesis
–Luxury tax on yachts over $100,000 will yield $31 million in tax revenue
•Analysis
–Price elasticity of demand is high
–Actual tax revenue $16.6 million
–People bought yachts outside US to avoid tax
•7,600 jobs in US boating industry lost
•Outcome: tax repealed after 2 years