Econ 100.

LESSON 1: What Economics Is All About

Scarcity: the limited nature of society’s resources

Economics: the study of how society manages its scarce resources, e.g.

 how people decide what to buy, how much to work, save, and spend
 how firms decide how much to produce, how many workers to hire
 how society decides how to divide its resources between national defense, consumer goods,
protecting the environment, and other needs

How People Make Decisions

Principle # 1: People Face Tradeoffs

 All decisions involve tradeoffs.

 Society faces an important tradeoff: efficiency vs. equality
 Efficiency: when society gets the most from its scarce resources
 Equality: when prosperity is distributed uniformly among society's members
 Trade off: to achieve greater equality, could redistribute income from wealthy to poor. But this
reduces incentive to work and produce, shrinks the size of the economic “pie”.

Principle # 2: The Cost of Something is What You Give Up to Get it

 Making decisions requires comparing the costs and benefits of alternative choices.
 The opportunity cost of any item is whatever must be given up to obtain it, different from what
we mean by ’cost’ in everyday language.
 It is the relevant cost for decision making.
 OC of action or good (x) = the value of the next-best alternative that must be given up to do
action or purchase good (x).

Principle #3: Rational People Think at the Margin

 Rational people
– systematically and purposefully do the best they can to achieve their objectives.
– make decisions by evaluating costs and benefits of marginal changes – incremental
adjustments to an existing plan.

Principle #5: Trade Can Make Everyone Better Off

 Rather than being self-sufficient, people can specialize in producing one good or service and
exchange it for other goods.

Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

 “Organize economic activity” means determining – what goods to produce, how to produce
them, how much of each to produce, who gets them
 Market: a group of buyers and sellers (need not be in a single location) – for a certain defined
good
  A market economy allocates resources through the decentralized decisions of many households
and firms as they interact in markets.
 Each of these households and firms acts as if “led by an invisible hand” to promote general
economic well-being.
 The invisible hand works through the price system:
– The interaction of buyers and sellers determines prices.
– Each price reflects the good’s value to buyers and the cost of producing the good.
– Prices guide self-interested households and firms to make decisions that, in many cases,
maximize society’s economic wellbeing.

Principle #7: Governments Can Sometimes Improve Market Outcomes

 Important role for govt: enforce property rights (with police, courts)
 People are less inclined to work, produce, invest, or purchase if large risk of their property being
stolen.
 Market failure: when the market fails to allocate society’s resources efficiently
 Causes:
– Externalities, when the production or consumption of a good affects bystanders (e.g.
pollution)
– Market power, a single buyer or seller has substantial influence on market price (e.g.
monopoly)
 In such cases, public policy may promote efficiency
 Govt may alter market outcome to promote equity
 If the market’s distribution of economic well-being is not desirable, tax or welfare policies can
change how the economic “pie” is divided.

The Economist as Scientist

 Economists play two roles:

1. Scientists: try to explain the world
2. Policy advisors: try to improve it
 In the first, economists employ the scientific method, the dispassionate development and
testing of theories about how the world works.
– Use theory and observation
– Observation: Natural experiments – “historical episodes” and “Experiments”

Assumptions & Models

 Assumptions simplify the complex world, make it easier to understand.

– Challenge: What assumptions to make?
– May depend on time horizon (long vs. short-term) and Relationship being investigated
 Model: a highly simplified representation of a more complicated reality. Economists use models
to study economic issues.
– Mostly diagrams and equations
– Economic models assume away some details that may be irrelevant for studying the question
at hand
The Circular-flow diagram of the Economy

 Diagram represents transactions between households and firms in the economy.

 Two types of decision makers (agents): Households (consumers) and Firms (producers)
 Firms produce goods and services using factors of production/inputs: labor, land, capital
 Households own factors of production and buy goods and services.

The Production Possibilities Frontier

 Production Possibilities Frontier (PPF): a graph that shows the combinations of two goods the
economy can possibly produce given the available resources and the available technology
 Points along the PPF: possible and efficient
 Points under the PPF: possible and inefficient
 Points above the PPF: impossible

The PPF and Opportunity Cost

 Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to
the other.
 Society faces a tradeoff: Getting more of one good requires sacrificing some of the other.
 The slope of the PPF tells you the opportunity cost of one good in terms of the other.
 The steeper the slope, the higher the opportunity costs.

The Shape of the PPF

 The PPF could be a straight line, or bow-shaped

 Depends on what happens to opportunity cost as economy shifts resources from one industry to
the other.
– If opp. cost remains constant, PPF is a straight line.
– If opp. cost of a good rises as the economy produces more of the good, PPF is bow-shaped.
 PPF is bow-shaped when different workers have different skills, different opportunity costs of
producing one good in terms of the other.
  The PPF would also be bow-shaped when there is some other resource or mix of resources with
varying opportunity costs (e.g., different types of land suited for different uses, different types of
labor suited to different jobs).

The Economist as Policy Advisor

 As scientists, economists make positive statements, which attempt to describe the world as it is
(describes a relationship).
 As policy advisors, economists make normative statements, which attempt to prescribe how the
world should be (value judgment)
 Positive statements can be confirmed or refuted, normative statements cannot.
 Govt employs many economists for policy advice.

Why Economists Disagree

 Economists often give conflicting policy advice.

 They sometimes disagree about the validity of alternative positive theories about the world.
 They may have different values and, therefore, different normative views about what policy
should try to accomplish.
 Yet, there are many propositions about which most economists agree.

LESSON 2: The Law of Demand and Supply

Markers and Competition

 A market is a group of buyers and sellers of a particular product.

 A competitive market is one with many buyers and sellers, each has a negligible effect on price.
 In a perfectly competitive market:
- All goods exactly the same.
- Buyers & sellers so numerous that no one can affect market price – each is a “price taker”

This lesson is under the assumption that the markets are perfectly competitive:

Demand

 The quantity demanded of any good is the amount of the good that buyers are willing and able
to purchase.
 Law of Demand: the claim that the quantity demanded of a good falls when the price if the
good rises, other things equal (ceteris paribus)

The Demand Schedule

 Demand schedule: a table that shows the relationship between the price of a good and the
quantity demanded
 Demand curve: plots the points in the demand schedule into a graph

Market Demand

 The quantity demanded in the market is the sum of the quantities demanded by all buyers at
each price.
Demand Curve Shifters

 The demand curve shows how price affects quantity demanded, other things being equal
 These “other things” are non-price determinants of demand (i.e., things that determine buyers’
demand for a good, other than the good’s price)
A. Number of Buyers
- increase in the number of buyers increase the quantity demanded at each price (shift to the
right); decrease (shift to the left)
B. Income
- Demand for a normal good is positively related to income. Increase in income causes
Increase in the quantity demanded at each price, shifts the curve to the right. Normal good
– higher quality.
- Demand for an inferior good is negatively related to income. An increase in the income
shifts the curve for the inferior goods to the left. Inferior good – lower quality.
C. Price of Related Goods
- Two goods are substitutes if an increase in the price of one causes an increase in the
demand for the other.
- Two goods are complements if an increase in the price of one causes a fall in the demand of
for the other.
D. Taste
- Anything that causes a shift in tastes toward a good will increase demand for that good and
shift its curve to the right.
E. Expectations
- It affects consumer’s buying decisions.
- Examples: (1) If people expect their incomes to rise, their demand for meals at expensive
restaurants may increase now; and (2) If the economy sours and people worry about their
future job security, demand for new autos increase.

Note: Price causes a movement along the curve (not shifting of the curve). When the variable can be
found on one of the axes, it only moves along the curve.

Supply

 The quantity supplied of any good is the amount that sellers are willing and able to sell.
 Law of Supply: the claim that the quantity supplied of a good rises when the price of the good
rises, other things equal.

The Supply Schedule

 Supply Schedule: A table that shows the relationship between the price of a good and the
quantity supplied.
 Supply curve: plots the points in the supply schedule into a graph

Market Supply

 The quantity supplied in the market is the sum of the quantities supplied by all sellers at each
price.
Supply Curve Shifters

 The supply curve shows how price affects quantity supplied, other things being equal
 The other things are non-price determinants of the supply.
A. Input Prices
- A fall in input prices makes production more profitable at each output price, so firms supply
a larger quantity at each price and the curve shifts to the right
B. Technology
- Technology determines how much inputs are required too produce a unit of output
- A cost-saving technological improvement has the same effect as a fall in input price, shifts
the curve to the right.
C. Number of Sellers
- An increase in the number of sellers increases the quantity supplied at each price, shifts the
supply curve
D. Expectations
- Sellers may adjust supply when their expectations of future prices change

Alfred Marshal – “Supply and demand determine the market prices.”

Equilibrium

 When the market price has reached the level where quantity supplied equals quantity
demanded
 Equilibrium price: The price that equates quantity supplied with quantity demanded
 Equilibrium quantity: The quantity supplied and quantity demanded at the equilibrium price

Surplus (excess supply)

 When quantity supplied is greater than the quantity demanded

 Facing a surplus, sellers try to increase sales by cutting price
 Prices continue to fall until market reaches equilibrium (pressure)

Shortage (excess demand)

 When the quantity demanded is greater than the quantity supplied

 Facing a shortage, sellers raise the price
 Prices continue to rise until market reaches equilibrium (pressure)

Three Steps to Analyzing Changes in Equilibrium

To determine the effects of any event,

1. Decide whether event shifts S curve, D curve, or both.

2. Decide in which direction the curve shifts.

3. Use supply-demand diagram to see how the shift changes equilibrium P and Q.

Terms for Shift vs. Movement Along Curve

 Change in supply: a shift in the S curve occurs when a nonprice determinant of supply changes
 shifts to the right: results in a lower equilibrium price (rise in the demand, fall in the prices)
  Change in the quantity supplied: a movement along a fixed S curve occurs when P changes
 Change in demand: a shift in the D curve occurs when a nonprice determinant of demand
changes
 shifts to the right: results in higher equilibrium price (rise in the supply, rise in the supply)
 Change in the quantity demanded: a movement along a fixed D curve occurs when P changes

How Prices Allocate Resources

 One of the 10 principles: “Markets are usually a good way to organize economic activity.”
 In market economies, prices adjust to balance supply and demand. These equilibrium prices
are the signals that guide economic decisions and thereby allocate scarce resource.

LESSON 3: Elasticity and Its Application

Elasticity

 Basic idea: Elasticity measure how much one variable responds to changes in another variable
 It is a numerical measure of the responsiveness of Qd or Qs to one of its determinants.

Price Elasticity of Demand

 measures how much Qd responds to a change in P

 It measures the price-sensitivity of the buyers’ demand
% change ∈Qd
 Formula: Price elasticity of demand=
% change ∈ price
end value−start value
 Midpoint method: x 100 %
midpoint of end∧start value
What determines Price Elasticity

The price elasticity depends on:

 the extent to which close substitutes are available (higher when close substitutes are available)
 whether the good is a necessity or a luxury (higher on luxury than necessity)
 how broadly or narrowly the good is defined (higher for narrowly defined than broadly
defined)
 the time horizon – elasticity is higher in the long run than the short run

The Variety of Demand Curves

 The price elasticity of demand is closely related to the slope of the demand curve.
 Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the
smaller the elasticity.

Five different classifications of D curves

1. Perfectly inelastic demand (one extreme case)

- D curve: vertical, Consumers’ price sensitivity: none, Elasticity = 0
2. Inelastic demand
- D curve: relatively steep, Consumers’ price sensitivity: relatively low, Elasticity < 1
 3. Unit elastic demand
- D curve: intermediate slope, Consumers’ price sensitivity: intermediate Elasticity = 1
4. Elastic demand
- D curve: relatively flat, Consumers’ price sensitivity: relatively high, Elasticity > 1
5. Perfectly elastic demand
- D curve: horizontal, Consumers’ price sensitivity: extreme, Elasticity = infinity

Elasticity of a Linear Demand Curve

 The slope of a linear demand curve is constant but its elasticity is not.

Price Elasticity and Total Revenue

% change ∈Q s
 Formula: Price elasticity of supply=
% change ∈ price
 Revenue=P x Qs while ∆ Revenue=old ( P x Qs )−new ( P x Qs)
 A price increase has two effects on revenue:
1. Higher P means more revenue on each unit you sell
2. But you sell fewer units (lower Q), due to Law of Demand
 Which of these two effects is bigger? It depends on the price elasticity of the demand
 If demand is elastic, then price elasticity of demand > 1, % change in Q > % change in P
 When D is elastic, a price increase causes revenue to fall.
 If demand is inelastic, then the price elasticity of demand < 1, % change in Q < % change in P
 When D is inelastic, a price increase causes revenue to increase.

Price Elasticity of Supply

 measures how much Qs responds to a change in P

 It measures the price-sensitivity of the sellers’ supply
% change ∈Q s
 Formula: Price elasticity of supply=
% change ∈ price
end value−start value
 Midpoint method: x 100 %
midpoint of end∧start value
The Variety of Supply Curves

 The price elasticity of demand is closely related to the slope of supply curve.
 Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the
smaller the elasticity.

Five different classifications of S curves

1. Perfectly inelastic supply (one extreme case)

- S curve: vertical, Sellers’ price sensitivity: none, Elasticity = 0
2. Inelastic supply
- S curve: relatively steep, Sellers’ price sensitivity: relatively low, Elasticity < 1
3. Unit elastic supply
- S curve: intermediate slope, Sellers’ price sensitivity: intermediate Elasticity = 1
4. Elastic supply
 - S curve: relatively flat, Sellers’ price sensitivity: relatively high, Elasticity > 1
5. Perfectly elastic supply
- S curve: horizontal, Sellers’ price sensitivity: extreme, Elasticity = infinity

The Determinants of Supply Elasticity

 The more easily sellers can change the quantity they produce, the greater the price elasticity of
supply.
 For many goods, price elasticity of supply is greater in the long run than in the short run,
because firms can build new factories, or new firms may be able to enter the market.

How the Price Elasticity of Supply Can Vary

 Supply often becomes less elastic as Q rises due to capacity limits.

Elasticity and changes in equilibrium

 When supply is inelastic, an increase in demand has a bigger impact on price than on quantity.
 When supply is elastic, an increase in demand has a bigger impact on quantity than on price.

Other elasticities

 Income elasticity of demand: measures the response of Qd to a change income

% change ∈Q d
 Formula: Income elasticity of demand=
% change ∈income
 For normal goods, income elasticity > 0. For inferior goods, income elasticity < 0.
 Cross-price elasticity of demand: measures the response of demand for one good to changes in
the price of another good
% change∈Qd for Good 1
 Formula: Cross− price eslasticity of demand=
% change∈ price of Good 2
 For substitutes, cross-price elasticity > 0. For complements, cross-price elasticity < 0.

LESSON 4: Government Policies That Alter the Private Market Outcome

Price Controls

 Price Ceiling a legal maximum on the price of a good or service

 Price floor: a legal minimum on the price of a good or service

Taxes

 The government can make buyers or sellers pay a specific amount on each unit bought/sold.

Price Ceiling

 The price ceiling above the equilibrium price is not binding - has no effect on the market
outcome.
 When the equilibrium price is above the ceiling, it is illegal. The ceiling is a binding constraint
on the price, causes a shortage. In the long run, supply and demand are more price-elastic.

Shortage and Rationing

  With a shortage, sellers must ration the goods among buyers.
 Some rationing mechanisms: (1) Long lines (2) Discrimination according to sellers’ biases
 These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the
buyers who value them most highly.
 Moreover – there could be hidden costs – e.g. waiting time
 In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go
to the buyers that value them most highly) and impersonal (and thus fair).

Price Floor

 The price floor below the equilibrium price is not binding -has no effect on the market
outcome.
 When the equilibrium price is below the floor, it is illegal. The floor is a binding constraint on
the price, causes a surplus.
 The price floor below the equilibrium price is not binding -has no effect on the market
outcome.

Evaluating Price Controls

 Prices are the signals that guide the allocation of society’s resources. This allocation is altered
when policymakers resist prices.
 Price controls often intended to help the poor but may hurt more than help.

Taxes

 The government levies taxes on many goods & services to raise revenue to pay for its
expenditures on public services like national defense, public schools, etc.
 The government can make buyers or sellers pay the tax.
 The tax can be a percentage (%) of the goods price (value taxes) or a specific amount for each
unit sold (quantity tax)
 For simplicity, we analyze per unit taxes only
A Tax on Buyers

 The price buyers pay is now Php x higher than the market price P
 P would have to fall by Php x to make buyers willing to buy same Q as before
 Hence, a tax on buyers shift the D curve down by the amount of the tax. This means that there
will be two curves where the lower is how much the buyer is willing to pay given that they still
have to pay the tax (upper curve).
 A new equilibrium will result into a lower quantity and price. Ps (sellers receive) is the
intersection between the new D curve (lower curve). Pb (buyers pay) is point directly above
the new equilibrium from the previous D curve (upper curve).

A Tax on Sellers

 The tax effectively raises sellers’ cost by Php x per unit.

 Sellers will supply the same quantity only if the price rises to Php x per unit to compensate for
the increase in cost.
 Hence, a tax on sellers shift the S curve up by the amount of the tax.
  A new equilibrium will result into a lower quantity and price. Ps (sellers receive) is the
intersection between the new D curve (lower curve). Pb (buyers pay) is point directly above
the new equilibrium from the previous D curve (upper curve).

The Incidence of a Tax

 How the burden of a tax is shared among market participants.

- The difference between the Pb and the equilibrium price from the free market is what the
buyers’ share (pay more) while the difference between the Ps and the equilibrium price
from the free market is what the sellers’ share (get less).
- The effects on P and Q, and the tax incidence are the same whether the tax is imposed on
buyers or sellers
- A tax drives a wedge between the price buyers pay and the price sellers receive.

Elasticity and Tax Incidence

Case 1: Supply is more elastic than demand

- It is easier for sellers than buyers to leave the market. So, buyers bear most of the burden of
the tax.

Case 2: Demand is more elastic than supply

- It is easier for buyers than sellers to leave the market. So, sellers bear most of the burden of
the tax.

Government Policies and the Allocation of Resources

- Each of the policies discussed here affects the allocation of society’s resources.
- With less production, resources will become available to other industries
- It is important for policymakers to apply such policies very carefully.