HE9091

Principles of Economics
Lecture 1
Introduction to Economics

Tan Khay Boon

Email: khayboon@ntu.edu.sg
 Topics
• Scarcity and Cost-Benefit Principles
• Opportunity Cost and Incentive Principle
• Demand and Supply
• Market Equilibrium and Price Control
• Shifts in Demand and Supply
• Efficiency and Equilibrium Principles
• Reference: FBAH or FBL, chapters 1, 3 & 6
 The Scarcity Principle
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

Marginal
Benefits

Marginal
Costs
 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
You take a taxi
grocery
on the way to
coupons but
work but not
your friend
on the way to
Naruto does
school
not

At the
stadium, you
pay extra to You skip your
buy a soft regular dental
drink from the check-up
hawkers in the
stands
 Economic Surplus
• The economic surplus of an action is equal
to its benefit minus its costs

Total Total
Benefits Costs

Economic
Surplus
 Opportunity Cost
• Opportunity cost is the value of what must
be foregone in order to undertake an activity
– Consider explicit and implicit costs
• 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
 Sunk Cost
– Sunk Costs are costs that are beyond
recovery when a decision is made
– Irrelevant to future decision making
– Only costs that influence a decision are
those that can be avoided by not taking
the decision
– Only benefits that influence a decision are
those that would not occur unless the
action were taken.
 Buyers and Sellers
– Cost-Benefit Principle is behind decision making
– Buyers: buy one more unit?
• Only if marginal benefit is at least as great as
marginal cost
– Sellers: sell one more unit?
• Only if marginal benefit (marginal revenue) is at
least as great as marginal cost
– Opportunity Cost also matters
• Buyers: hamburger or pizza?
• Sellers: recycle aluminum or wash dishes?
The Importance of Opportunity
Cost
• Harry can divide his time between two
activities:
– Wash dishes for $6 per hour
– Recycle aluminum cans and earn 2¢ per can
• Harry only cares about the income
• How much labor should Harry supply to each
activity?
– Harry should devote an additional hour to
recycling as long as he is earning at least $6 per
hour
 Economic Models
• Simplifying assumptions
– Which aspects of the decision are absolutely
essential?
– Which aspects are irrelevant?
• Abstract representation of key relationships
– The Cost-Benefit Principle is a model
• If costs of an action increase, the action is less
likely
• If benefits of an action increase, the action is
more likely
 Marginal Analysis Ideas
• Marginal cost is the increase in total cost
from one additional unit of an activity
– Average cost is total cost divided by the number
of units
• Marginal benefit is the increase in total
benefit from one additional unit of an activity
– Average benefit is total benefit divided by the
number of units
 Marginal Analysis: NASA
Space Shuttle
Total Cost Average Cost Marginal Cost
# of Launches
($B) ($B/launch) ($B)
0 $0 $0
1 $3 $3 $3

2 $7 $3.5 $4

3 $12 $4 $5
4 $20 $5 $8
5 $32 $6.4 $12

 If the marginal benefit is $6 billion per launch, how many launches

should NASA make?
 Normative and Positive
Economics
– Normative economic – Positive economic
principle says how principle predicts how
people should behave people will behave
• Gas prices are too • The average price of
high gasoline in May 2010
• Building a space base was higher than in
on the moon will cost May 2009
too much • Building a space base
on the moon will cost
more than the shuttle
program
 Incentive Principle

Incentives are central to people's choices

Benefits Costs
Actions are more likely Actions are less likely
to be taken if their to be taken if their
benefits rise costs rise
 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
 Exchange rates
 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
 Simultaneous Equations
• Two equations, two unknowns
• Solving the equations gives the values of the
variables where the two equations intersect
– Value of the independent and dependent variables
are the same in each equation
• Example
– Two billing plans for phone service
• How many Mbytes make the two plans cost the
same?
 Simultaneous Equations
• Plan 1 B = 10 + 0.04 D
• Plan 2 B = 20 + 0.02 D
– Plan 1 has higher per minute price while Plan 2 has
a higher monthly
fee
• Find B and D
for point A
 Simultaneous Equations
– Plan 1 B = 10 + 0.04 D
– Plan 2 B = 20 + 0.02 D
– Subtract Plan 2 equation from
Plan 1 and solve for D
– Find B when D = 500
B = 10 + 0.04 D
B = 10 + 0.04 (500)
B = $30

B = 10 + 0.04 D OR
– B = – 20 – 0.02 D
0 = – 10 + 0.02 D B = 20 + 0.02 D
B = 20 + 0.02 (500)
D = 500 B = $30
What, How, and For Whom?
• Every society answers three basic questions
WHAT  Which goods will be produced?
 How much of each?

HOW  Which technology?

 Which resources are used?

FOR  How are outputs distributed?

WHOM  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
Mixed economies use both the market and central planning
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 Demand for Donuts
buyers would purchase P
at each possible price
• Demand curves have a $4
negative slope
• Consumers buy less at $2 D
higher prices
8 16 Q
• Consumers buy more
(000s of pieces/day)
at lower prices
 Law of Demand

Law of Demand
Consumers buy less of a product
as the price of the product rises
Price and quantity demanded are inversely related
 Law of Demand
• Cost-Benefit Principle at work
– Do something if the marginal benefits are at least
as great as the marginal costs
• An increase in the market price approaches our
reservation price
– If market price (cost) exceeds the reservation price
(benefit), buy no more
 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
Demand for Donuts
interpretation of
P
demand:
• Given price, how much
$4 will buyers buy?
• At a price of $4, the
$2 D quantity demanded is
Q 8,000 slices/day.
8 16
(000s of pieces/day)
Interpreting the Demand Curve
– Vertical interpretation of
Demand for Donuts
demand:
P • Given the quantity to
be sold, what price is
$4 the marginal consumer
willing to pay?
$2 D • If 8,000 slices are sold
Q the marginal consumer
8 16 is willing to pay $4 per
(000s of pieces/day)
slice.
 The Supply Curve
• The supply curve illustrates the quantity of a
good that sellers are willing to offer at each price
• Producers incur costs in order to obtain resources
to produce output and sell to consumers at the
market price to maximize profits
• The Low-Hanging Fruit Principle explains the
upward sloping supply curve
• The seller’s reservation price is the lowest price
the seller would be willing to sell for
– Equal to marginal cost of production
 Law of Supply

Law of Supply
Producers supply more of a product
as the price of the product rises
Price and quantity supplied are positively related
Interpreting the Supply Curve
• Horizontal
Supply of Donuts
P interpretation of
S supply:
• Given price, how much
$4
will suppliers offer?
$2 • At a price of $2,
suppliers are willing to
8 16 Q sell 8,000 pieces/day.
(000s of pieces/day)
 Interpreting the Supply Curve
– Vertical interpretation of
Supply of Donuts supply:
P • Given the quantity to
S
be sold, what is the
$4 opportunity cost of the
marginal seller?
$2 • If 8,000 pieces are
Q sold, the marginal cost
8 16 of producing the
(000s of pieces/day)
8,000th piece 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
 Market Equilibrium
• Quantity supplied
equals quantity Market for Donuts
demanded AND P
S
• Price is on supply
and demand curves $3
• No tendency to
change P or Q D
• Buyers are on their 12 Q
(000s of pieces/day)
demand curve
• Sellers are on their
supply curve
 Excess Supply and Excess
Demand
Excess Supply
– At $4, 16,000 pieces supplied
and 8,000 slices demanded
Excess Demand
– At $2, 8,000 pieces supplied
16,000 slices demanded

Market for Donuts Market for Donuts

P P
Surplus S S

$4
Shortage
$2
D D
Q 8 16 Q
8 16
(000s of pieces/day) (000s of pieces/day)
 Incentive Principle: Excess
Supply at $4
– Each supplier has an
incentive to decrease the Market for Donuts
price in order to sell more P
– Lower prices decrease the S
surplus $4
– As price decreases: $3.50
• the quantity offered for sale $3 Equilibrium
decreases along the supply D
curve
• the quantity demanded 8 12 16 Q
(000s of pieces/day)
increases along the
demand curve
 Incentive Principle: Excess
Demand at $2
– Each supplier has an
Market for Donuts incentive to increase the
price in order to sell more
P – Higher prices decrease the
S
shortage
– As price increases
$3
Equilibrium • the quantity offered for
$2.50
$2 sale increases along the
D supply curve
8 12 16 Q • As price increases, the
(000s of pieces/day) quantity demanded
decreases along the
demand curve.
Rent Controls Are Price Ceilings
– A price ceiling is a
maximum allowable price, Market for New York City Apartments
set by law
– Rent controls set a maximum P
price that can be charged for S
a given apartment
– If the controlled price is $1,600
below equilibrium, then:
$800
• Quantity demanded D
increases
• Quantity supplied
1 2 3 Q
(millions of apartments/day)
decreases
• A shortage results
Movement along the Demand
Curve
• When price goes up,
quantity demanded Demand for Canned Tuna

goes down P
• When price goes
down, buyers move to
a new, higher quantity $2
demanded $1 D
• A change in quantity Q
8 10
demanded results (000s of cans/day)

from a change in the

price of a good.
 Shift in Demand
• If buyers are willing to
buy more at each price, Demand for Canned Tuna
then demand has P
increased
• Move the entire demand
curve to the right $2
• Change in demand D'
• If buyers are willing to D
8 10 Q
buy less at each price, (000s of cans/day)
then demand has
decreased
 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

 Tennis Market
– If rent for tennis court decreases, demand for tennis
balls increases
• Tennis courts and tennis balls are complements

Tennis Court Rentals Tennis Ball Sales

P P
$10 S
$1.40
$7 $1.00
D D'
D
4 11 Q 40 58 Q
(00s rentals/day) (millions of balls/day)
 Demand for Apartments
• If income rise, demand for
apartments increases
Apartments • Demand increases
P D D' S – Price increases
– Quantity increases
• Demand for a normal
P' good increases when
income increases
P • Demand for an inferior good
increases when income
decreases
Q
Q Q'
(units/month)
Movement Along the Supply
Curve
• When price goes up,
quantity supplied Supply
P of Donuts
goes up S
• When price goes up,
$4
sellers move to a
new, higher quantity
supplied $2
• A change in quantity Q
8 16
supplied results from (000s of pieces/day)
a change in the price
of a good.
 Shift in Supply
• Supply increases when • Supply decreases when
sellers are willing to offer sellers are willing to offer
more for sale at each less for sale at each
possible price possible price
• Moves the entire supply • Moves the entire supply
curve to the right curve to the left

Supply of Supply of
P Donuts S P Tuna
S' S*
S
$2
$2
8 9 Q 8 9 Q
(000s of pieces/day) (000s of cans/day)
 Causes of Shifts in Supply
• A change in the price of an input
– Steel for bicycles, skill workers’ 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: Bicycles
• Costs of production affect the supply of a
product
• Cost of steel for bicycles increases
– Supply decreases
Supply of Bicycles
• With no change in demand,
the price of bicycles P S'
S
increases to $80 and quantity $80
decreases to 800 $60
D

600 800 1,000

Q
(bicycles/month)
 Shift in Supply: Handmade
Carpets
• Cost of labor used to produce handmade
carpets decreases
– Supply increases The Market for Handmade Carpets

• Demand is constant P S
• The price of handmade $120 S'
$90
carpets decreases to
D
$90,000 per carpet
• Quantity increases to 50 40 50 Q
(carpets/
month)
 Supply and Demand Shifts:
Four Rules
An increase in demand will lead to an increase in
both equilibrium price and quantity

P
S
P'
P
D'
D
Q Q' Q
 Supply and Demand Shifts:
Four Rules
An decrease in demand will lead to a decrease
in both equilibrium price and quantity

P
S

P
P'
D
D'
Q
Q' Q
 Supply and Demand Shifts:
Four Rules
An increase in supply will lead to a decrease in the
equilibrium price and an increase in the equilibrium
quantity.
P S
S'
P
P'

Q Q' Q
 Supply and Demand Shifts:
Four Rules
An decrease in supply will lead to an increase in
the equilibrium price and a decrease in the
equilibrium quantity.

P S'
S
P'
P
D

Q' Q Q
 Supply and Demand Both
Change: Tortilla Chips
• Oils used for frying are harmful AND the price of
harvesting equipment decreases

S
S'
Price ($/bag)

P'
D
D'

Q' Q
Millions of bags per month
Changes in Supply and Demand

Supply

Demand Increases Decreases

P Depends P Increases
Increases
Q Increases Q Depends

P Decreases P Depends
Decreases
Q Depends Q 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
 Efficiency and Equilibrium
• Markets communicate
information effectively
– Value buyers place on the
product Market
– Opportunity cost of P S = MPC
producing the product
• Markets maximize the
difference between private
benefits and costs PE
• Market outcomes are the best
D = MPB
provided that
– The market is in
QE Q
equilibrium AND
– No external costs or
benefits are shared with
the public MPC = Marginal Private Cost
MPB = Marginal Private Benefit
 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
• No cash 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
 Efficiency and Equilibrium
• Equilibrium Principle:
a market in equilibrium
leaves no unexploited Market
opportunities for P S = MPC = MSC
individuals
• Only when the seller
pays the full cost of PE
production and the
D = MPB = MSB
buyer captures the full
Q Q
benefit of the good is E

the market outcome

socially optimal MSC = Marginal Social Cost
MSB = Marginal Social Benefit
 From Graphs to Equations …
• Sample equations

P = 16 – 2 Qd
is a straight-line demand curve with intercept 16
on the vertical (P) axis and a slope of – 2

P = 4 + 4 Qs
is a straight-line supply curve with intercept 4
and a slope of 4
 … To Equilibrium P and Q
• Equilibrium is where P and Q are the same for
demand and supply
– Set the two equations equal to each other (P = P)
and solve for Q (Qs = Qd = Q*)
16 – 2 Q* = 4 + 4 Q*
6 Q* = 12
Q* = 2
• Use either the supply or demand curve and Q* =
2 to find price
P = 16 – 2 Q* P = 4 + 4 Q*
P = $12 P = $12