Review Materials and Worksheets for Managerial Economics (Adkisson), Page 1

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Principles of Economics Review and Worksheets
The purpose of this packet is to provide a review of some basic math concepts and materials taught in
Principles of Economics that are essential background knowledge for students in Economics 371. Most
of the economics concepts and models reviewed here are discussed in the first four or five chapters of
any good Principles of Economics textbook. The math concepts come from algebra and beginning
calculus. Make sure you understand this material within the first few days of class. Ask the instructor
about anything you don't understand.
WHAT IS ECONOMICS?
Economics, as it is treated in this class, is the study of how societies deal with the problem of scarcity.
Scarcity is evident when a society wants to consume more goods and services than it has the capacity to
produce. The shorthand way of defining scarcity is to say that societies have unlimited wants but
limited resources. To decide how to allocate scarce resources among alternative uses is often referred to
as the economic (or economizing) problem.
Resources fall into four categories: land (natural resources), labor (self explanatory), capital (goods used
to produce other goods), and entrepreneurial ability (the ability to organize resources into new
productive activities and the willingness to take the risk of doing so). Owners of each type of resource
receive payments when they allow their resources to be used in production. Land owners receive rent,
laborers receive a wage, capital owners receive interest (capital rental), and entrepreneurs receive a
profit.
To understand how economic choices are made is an important issue in economics. Since societies lack
sufficient resources to produce everything they want, they must have a systematic way to decide how to
use the resources they do have. A society's system for making these choices is called its economy. Any
economy must provide a systematic way to answer the three fundamental questions.
What to produce? Since no society can produce everything that its members want, the economy
must provide a systematic way to decide which things the society will produce? (resource
allocation problem)
How to produce? Most things can be produced using any of several methods. The economy
must provide a systematic way to decide which method to use. (technological choice problem)
For whom to produce? Since everyone cannot have everything they want, some or all members
of society will receive less of the things produced than they would like to have. The economy
must provide a systematic way to decide who gets what. (income distribution problem)
History provides examples of at least three basic types of economies that societies have used to deal
with these questions. They are classified by the method used to answer the three fundamental questions.
Traditional Economies Answer the three questions in the same way they have been answered in
the past. (example: feudal societies)
Command Economies A central authority answers the three questions on behalf of society.
(example: centrally planned economies of former USSR)

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Market Economies The answers to the three questions evolve from the interaction of
independent buyers and sellers in the marketplace. (example: U.S. and other capitalist oriented
nations)
Although it is useful to discuss these classifications, in reality, all economies are mixed
economies. That is to say, they use some elements of all three methods of economic decision
making. For example, we might say that the U.S. has a mixed economy where many (but not all)
economic decisions are made in markets.
In this course, as in many other economics courses, it is assumed that all economic decisions are made
in markets. This assumption simplifies the analysis we will do and allows us to focus on the forces
thought to be the most influential in modern economies.
A COMMENT ON ECONOMIC INTERDEPENDENCE
All modern economies are characterized by a great degree of economic interdependence. Few (really
none) of the people of the world produce all the things they consume. Most depend on others to produce
a large portion of the things they consume while they produce many things that they will never
consume. In other words, there is a great deal of specialization and exchange that occurs in modern
economies. People, towns, states, and countries specialize in certain types of production, producing far
more than they wish to consume, and exchange their surplus production for goods produced by other
people, towns, states and countries. People are willing to become economically interdependent because
specialization and exchange leads to a more efficient use of resources and results in a higher material
standard of living. At the same time, specialization and exchange creates a coordination problem, the
decisions of what to produce and what to consume are made separately. Without a good method to
coordinate production and consumption decisions, resources will be poorly used. One of the main
purposes of this course is to explain how individual decisions work together in markets to solve the
coordination problem.
ECONOMIC MODELS
One of the things economists do is try to create models of economic behavior. Economic models are
simplified representations of real economic phenomena. Economic models can be expressed in at least
three different ways. They can be expressed in words, graphs or equations. In this class, most of the
models we will explore will be in graphical form. Each model we discuss will be built upon a set of
simplifying assumptions about economic behavior. For example, we will assume that "more is better"
meaning that, other things equal, people prefer to have more stuff to less stuff. Another important
assumption that is often used in economics is that economic actors (people) are self interested and will
make economic decisions that serve their self interest, firms will seek to maximize profits and
consumers will seek to get the most possible satisfaction from their consumption of goods and services.
We will mention many other assumptions during the semester. The use of assumptions helps to narrow
the focus of our analysis and thus makes it possible to focus on the things we are most interested in.
However, be warned. The assumptions of the model define the context (real world situation) to which
the model applies. Before using an economic model to analyze a real situation, one should always ask,
"how well does the real world situation match the assumptions of the model?" Economic models can be
useful and important decision making tools, but only if care is taken in their application.
It is important in economics to understand the concept of cause and effect. Economists rely heavily on

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conditional (if-then) statements, if this happens, then that happens. For example, an economist might
use a model of supply and demand for pizza to analyze the pizza market and conclude that if the price
of pizza goes up, ceteris paribus, consumers will buy less pizza. Ceteris paribus means holding other
things constant (other things like the price of soft drinks, the price of tacos, the income of consumers,
etc...). Because economists must make many assumptions in their analyses, the list of ifs can be rather
large (if this, this, this, this, this, this, this, this, and this, then that). Sometimes many of the ifs are
implied rather than explicitly expressed. For this reason, it is important to know the assumptions that
are behind each model.
Economic models fall into two basic categories. Partial equilibrium models incorporate only one market
at a time. They ignore how changes in one market affect other markets. The typical supply and demand
model (reviewed below) falls into this category. General equilibrium models incorporate two or more
markets into the analysis at the same time. They try to capture the interrelationships among markets and
will always involve at least two goods and two prices. In this course, most, but not all, analysis is of the
partial equilibrium type..
There are two approaches to studying economics, microeconomics and macroeconomics. Both are
important but we focus on microeconomic issues in this class.
Microeconomics is concerned with analyzing and explaining the behavior of the components of
the economic system (households, firms, industries). For example, we might want to explain
how individual consumers/households make consumption choices, how firms decide what to
produce and how much to produce, or how markets produce price signals that help coordinate
the decisions producers and consumers .
Macroeconomics is concerned with analyzing and explaining the behavior of the economic
system as a whole. For example, we might want to measure how much output is being produced
in a year or what is happening to the price level (inflation, deflation). In addition,
macroeconomics explores ways that the government might be able to influence the performance
of the economy through its fiscal policy (government policy on taxing and spending) and its
monetary policy (central bank policy toward money supply and interest rate).
REVIEW OF GRAPHS AND GRAPHING
Some of the graphical models used in this class are simply expansions of the models you should be
familiar with from your study of principles of economics. Others will be new, but easy to understand, if
you have a good grasp of basic graphing principles. Below you will find reviews of basic graphing and
two basic economic models. The first model reviewed is the production possibilities curve (frontier)
model. The second model reviewed is the simple model of a market (supply and demand).
GRAPHS
If you remember how you used the Cartesian coordinate system in algebra, you should have little
problem understanding the graphical models we use here. This system is no more than two
perpendicular number lines on a two-dimensional plane and can be used to show relationships between
two variables, X and Y. Typically, values of the X variable are shown on the horizontal (flat number
line) axis and values of the Y variable are shown on the vertical (upright number line) axis of the graph.
See Figure 2.

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Each point on this two dimensional plane represents an ordered pair, (X, Y). For example, the point H
represents the ordered pair (2, 4) where X=2 and Y=4. The point C represents the ordered pair (-3, -3)
where X= -3 and Y= -3. Note the characteristics of the ordered pairs in each quadrant.
Quadrant I
Quadrant II
Quadrant III
Quadrant IV

Both X and Y are positive

X is negative, Y is positive
Both X and Y are negative
X is positive, Y is negative

Figure 1
A variable is something that can take on different values. For example, in economics, price is a variable
that can take on many values. When variables are related to one another, they are usually classified as
being either a dependent variable or an independent variable. The value of a dependent variable
depends upon the value of the independent variable (or of a set of independent variables). For example,
a persons weight (dependent variable) depends on many things (independent variables) like caloric
intake, height, activity level, etc. When variables are related, a function can be used to describe the
relationship between the variables. A function is a mathematical rule (equation) that relates one set of
variables to another set of variables and assigns one unique value of the dependent variable to each
value of the independent variable. Discrete variables take on specific values, for example whole
numbers, 1, 2, 3, etc... within a range of numbers. Continuous variables can take on any value within a
range, for example, 1, 1.1, 1.11, 1.111, 1.111, etc. Most variables used in this class are assumed to be
continuous and can therefore be represented by a continuous function. When a continuous function is
graphed, there will be no gaps in the graph.
Functional relationships with two variables (one dependent, usually Y, and one independent, usually X)
can be easily graphed on the Cartesian coordinate system. For example, the line through points C and B
is the graph of the function, Y= aX - 2. This equation, or function, defines a positive (or direct), linear
relationship between the variables X and Y, as the value of X increases (decreases) the value of Y
increases (decreases). The line through points I and A is the graph of the function, Y=-X+1. This
function defines a negative (or inverse), linear relationship between the variables X and Y, as the value
of X increases (decreases) the value of Y decreases (increases). The curve through points D, E, F, G,

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and H is a graph of the function Y=X2. Note that in this case the relationship between X and Y is
nonlinear. Note that for linear functions, the slope is a constant (it doesnt change over the range of the
function). For nonlinear functions the slope is a variable. The slope of a nonlinear function can be
found by using simple calculus. The first partial derivative of a function (MY/MX) can be used to find the
slope of a nonlinear function at any particular point. The second partial derivative of a function
(M2Y/M2X) can be used to find whether the slope is increasing or decreasing at a particular point.
In addition to graphing relationships between variables (functions), we will sometimes divide the two
dimensional plane (graph) into sets of points. For example, we could define the set of points in quadrant
I (including the points on the axes) as the set of ordered pairs (X, Y) where X$0 and Y$0. We might
want to divide this set into two subsets, one where X$0 and Y<3 and another where X$0 and Y$3. The
reason we might want to do this will become obvious later.
Having reviewed the general concept of graphing, it is important to point out several things about the
use of graphs in this class.
Because almost all of the variables discussed in economics have positive values, economists
often use (and draw) only Quadrant I of the Cartesian coordinate system.
Often, the variables X and Y are renamed to represent more specific economic variables. For
example, if we are interested in the relationship between the price of a good and the quantity
demanded of a good, the values on the horizontal axis will represent quantities of the good and
the values on the vertical axis will represent prices of the good.
In economics the actual numbers on the axes are often not as important as the type of
relationship between the variables being discussed. For this reason, we will often draw a line or
curve to represent a functional relationship but will not show any particular values on the axes of
the graph. Neither will we always define the specific equation that defines the relationship.
Graphs of linear functions are also called curves.
REVIEW OF BASIC ECONOMIC MODELS
PRODUCTION POSSIBILITIES CURVE
The production possibilities (frontier) curve is a basic economic model that captures the concepts of
scarcity, efficiency, opportunity cost, and economic growth. As mentioned above, the model uses
quadrant I from the Cartesian coordinate system. In this model we assume that a society produces only
two goods, good X and good Y. When we label the axes in this way, we can think of the two
dimensional space represented as a commodity space where each point in the space represents a
combination (ordered pair) of some quantity of X and some quantity of Y. Note that an infinite number
of combinations of goods X and Y can be represented in this space.
Think of the production possibilities frontier as a constraint on society. Of all the (mathematically)
possible combinations of the two goods, only some are possible to produce. After all, it takes resources
to produce goods and services (in this case goods X and Y) and resources are limited. Therefore, think
of the combinations of X and Y on, and below, the PPF as a society's production opportunity set (more
generally its feasible set). Because of limited resources, society cannot produce just any combination of

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X and Y. They must produce a combination in their production opportunity set (thus the model captures
the concept of scarcity).

Figure 2
A society has the opportunity to produce any combination of goods in its production opportunity set
but, because of the "more is better" assumption mentioned above, we assume that a society not will
purposely choose to produce at a point below its PPF. To produce at a point below the PPF is to say that
a society is either not using all of its resources, or it is not using its best (most efficient) technology. If
more really is better, a society will seek to produce as much with its resources as possible. That is, it
will choose to produce one of the combinations of X and Y on its PPF. The PPF shows all of the
various combinations of two goods that can be produced assuming that society is using all its resources
and its most efficient technology (thus the concept captures the concept of efficiency).
Once a society is producing at a point on its PPF it cannot increase the output of one good without
decreasing the output of the other good. Thus, this model also captures the concept of opportunity costs.
The opportunity cost of good X is the amount of good Y that must be given up to produce one more X.
The opportunity cost of good Y is the amount of good X that must be given up to produce one more Y.
The absolute value of the slope of the PPF at the point of production is the opportunity cost of good X in
terms of good Y. For example, if society was producing at a point on the PPF where the slope was -2,
this would indicate that society must give up two units of Y to get one more unit of X. The reciprocal of
the absolute value of the slope of the PPF gives the opportunity cost of Y in terms of X. In this
example, society would have to give up 1/2 unit of X to get one more unit of Y.
We can talk of opportunity costs in three ways.
Constant Opportunity Costs - The opportunity cost of producing one more of good X (or good
Y) is the same regardless of how much is already being produced (constant returns to scale).
When there are constant opportunity costs the PPF will be linear (straight).
Increasing Opportunity Costs (shown in Figure 2) - The opportunity cost of producing a good
increases as more and more of the good is produced (decreasing returns to scale). When there
are increasing opportunity costs the PPF will be concave to the origin of the graph (bowed out)

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as in the graph above.
Decreasing Opportunity Costs - The opportunity cost of producing a good decreases as more and
more of the good is produced (increasing returns to scale). When there are decreasing
opportunity costs the PPF will be convex to the origin of the graph (bowed in).
Any time a society increases (or decreases) its resource endowment, or develops a more efficient
technology, its PPF will shift to reflect the society's new production opportunity set. A shift out
indicates that society's choices have expanded. A shift inward indicates that society's choices have
contracted. Outward movements of the PPF indicate economic growth and inward movements imply
economic contraction.
Hopefully, by the end of this course, you will understand how a set of well-functioning markets will
lead a society to the best possible choice when it chooses what to produce (from its limited choices
represented by its production opportunity set).
RESOURCE ALLOCATION THROUGH MARKETS
There are many different kinds of markets but, to keep things simple, we will concentrate on two basic
markets, product markets and resource markets. Product markets are markets where finished goods and
services are bought by households and sold by firms. Resources markets are markets where land, labor,
capital, and entrepreneurial ability are bought by firms and sold by households. The simplest model of a
market economy is the basic two sector, two market circular flow model.1 The diagram below is an
expression of this model.

Remember, this is a very simple model. Notice that there is no government, financial,
or external (international) sector. The purpose here is to gain an appreciation of how prices are
generated and their role as economic signals.

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Households are economic decision making units. They may contain a single person, family, or other
group. The key is that they operate as a unit when making economic decisions. Households have two
basic decisions to make (a third will be discussed in class). Household members own resources and
must decide what quantity of resources they are willing to provide to firms (hours of labor, etc...). They
must also decide what goods and services they are willing to consume and in what quantities they will
consume them. Households make supply decisions in the resource market and demand decisions in the
product market.
Production takes place in firms. Entrepreneurs in firms have two basic economic decisions to make.
They must decide what quantity (and what mix) of resources they are willing to buy. They must also
decide what goods and services they are willing to produce and in what quantities to produce them.
Firms make demand decisions in the resource market and supply decisions in the product market.
The prices of resources (wages, interest, etc...)are determined when buyers and sellers interact in
resource markets. The prices of goods and services (PX and PY) are determined when buyers and sellers
interact in the product market. In turn, prices provide information to market participants that help them
make production and consumption decisions.
Refer to the circular flow diagram above. Households sell their resources in the resource market to earn
incomes with which they buy the goods and services they wish to consume. When they pay for the
goods and services, firms receive revenue which they use to pay for the resources used when they
produced the goods and services which they sell to the households. This is an example of economic
interdependence. There is a basic conflict here in that both households and firms behave in a self
interested way. Utility maximizing households want high incomes (resource prices) and low prices for
goods and services. Profit maximizing firms want low costs (resource prices) and high revenues (prices
of goods and services). This conflict is what makes markets work.

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THE MODEL OF A MARKET, SUPPLY AND DEMAND IN PRODUCT MARKETS
Resource markets are just as important as product markets but, because we primarily focus on product
markets in this class, we will examine only product markets here. In market economies, prices are
determined by the interaction of supply and demand. Consider the following definitions of supply and
demand.
Supply (expressed as a graph, an equation, or a table) tells us the various quantities of a particular good
or service that firms (sellers) are willing and able to sell at each price in a set of prices, other things
equal. Mathematically, supply is a function (rule) that maps (relates) a set of quantities to a set of
prices, assuming that other variables (non price determinants of supply) are held constant.
Note: Several things (variables) will affect a producers willingness and ability to sell a good or
service in the market. For example:
Price of the good under consideration
Prices of other goods that the producer could produce
Prices of resources (inputs)
Technology
Producers expectations
Taxes and subsidies
Number of producers in the market
Etc. . .
All of these (except price of the good under consideration) are called non price determinants of
supply or shift factors of supply.
In order to concentrate on the supply (price-quantity) relationship discussed above we must
assume that none of the non price determinants of supply change at the same time we examine
the price quantity relationship we refer to as supply. If one of the non price determinants does
change it will change the price-quantity relationship. We call this a change in supply.
Graphically, a change in supply will shift the supply curve to the left (decrease in supply) or to
the right (increase in supply).
A decrease in supply (leftward shift of supply curve) indicates that suppliers are willing and able
to sell fewer of the good or service at any price. For example, if the prices of resource inputs
increases, producers costs would increase and, at any given price, they would no longer be
willing and able to sell the same amount that they were selling before at the same price.
An increase in supply (rightward shift of the supply curve) indicates that suppliers are willing
and able to sell more of the good or service at any price. For example, if they gain access to a
new technology that allows them to use fewer resources in production, they will be willing and
able to sell more goods than they were before, even at the same price.
Demand (expressed as a graph, an equation, or a table) tells us the various quantities of a particular good
or service that households (buyers) are willing and able to buy at each price in a set of prices, other
things equal. Mathematically, demand is a function (rule) that maps (relates) a set of quantities to a set
of prices, assuming that other variables (non price determinants of demand) are held constant.

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Note: Several things (variables) will affect a consumers willingness and ability to buy a good or
service in the market. For example:
Price of the good under consideration
Consumers tastes and preferences
Incomes of consumers (normal goods and inferior goods)
Prices of other related goods (substitutes and complements)
Consumer expectations
Number of consumers in the market
Etc. . .
All of these (except price of the good under consideration) are called non price determinants of
demand or shift factors of demand.
In order to concentrate on the demand (price-quantity) relationship discussed above we must
assume that none of the non price determinants of demand change at the same time we examine
the price quantity relationship we refer to as demand. If one of the non price determinants does
change it will change the price-quantity relationship. We call this a change in demand.
Graphically, a change in demand will shift the demand curve to the left (decrease in demand) or
to the right (increase in demand).
A decrease in demand (leftward shift of demand curve) indicates that buyers are willing and able
to buy fewer of the good or service at any price. For example, if consumer incomes decrease,
consumers would be willing and able to buy less of a good at any given price (assuming the good
is a normal good, see below).
An increase in demand (rightward shift of the demand curve) indicates that buyers are willing
and able to buy more of the good or service at any price. For example, if there is a successful
advertising campaign that convinces consumers that consumption of a good will improve their
love life, consumers might become willing to buy more of the good at any given price.
IMPORTANT When we talk about a change in demand (or supply) we are talking about a
response to one of the non price determinants of demand (or supply). A change in demand (or
supply) will be evident by a shift of the demand (or supply) curve. A change in quantity
demanded (or supplied) occurs when consumers (producers) respond to a change in the price of
the good under consideration. Changes in quantity demanded (or quantity supplied) are simply
movements from one point to another point on the same demand (or supply) curve.

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GRAPHICAL MODEL OF A MARKET (SUPPLY AND DEMAND)
The graph below models the market for Good X.

Figure 4
Notice that demand is downward sloping indicating a negative (inverse) functional relationship between
the price of X and the quantity demanded of X (as the price of X goes down, consumers are willing and
able to buy more of X, and vice versa). This is because of the income effect and the substitution effect.
The income effect is part of the reason for the inverse relationship between price and quantity
demanded. As a price goes down (other things staying the same) consumers real incomes (the
amount of goods and services that can be purchased from ones money income) increase. This
increase in income causes consumers to buy more of the good X because now they can afford
to.2
For example, suppose you have an income of $250 per week and you have been spending it all on
consumption. If you are buying 10 gallons of gasoline every week and the price of gasoline drops by
$.25 (everything else stays the same price) you will be able buy everything you bought before the price
change and have $2.50 left to spend, part of which you may spend on more gasoline.
The substitution effect is another part of the reason for the inverse relationship between price and
quantity demanded. As the price goes down (other things equal) the good becomes cheaper not
only in the dollar amount paid but it also becomes cheaper relative to (compared to) other goods.
Because of this, consumers may buy more of the now relatively cheaper good and buy less of
some substitute for the good. For example, if the price of hamburgers increases (decreases) you

This assumes that X is a normal good. For normal goods, an increase (decrease) in
income will cause the consumer to buy more (less) of the good. For inferior goods, an increase
(decrease) in income will cause the consumer to buy less (more) of the good. For many people,
shrimp or steak might be normal goods while Ramen noodles or frozen burritos might be inferior
goods.

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might buy fewer (more) hamburgers and more (less) tacos or pizzas.
The demand curve in the graph above indicates that at price P1, quantity demanded is Q1. At price P3,
quantity demanded is Q5 and at price P2, quantity demanded is Q4. Important: Remember that this
assumes that nothing else except price is changing. A change in any of the non price determinants of
demand will change demand (shift the demand curve) and a new price-quantity relationship will be
established. Other things equal, an increase in demand will drive the equilibrium price up and a
decrease in demand will drive the equilibrium price down.
Notice that supply is upward sloping indicating a positive (direct) relationship between the price of X
and the quantity supplied of X (as the price of X goes up, producers are willing and able to sell more of
X, and vice versa). The main reason for this is explained by the law of diminishing marginal product.
To understand this, consider that there are two types of inputs in any productive process.
Fixed inputs are inputs which are used in the same quantity regardless of the level of output. For
example, a factory building is a fixed input. Regardless of the level of output, the same building
is used (and paid for). Because some inputs are fixed (at least in the short run) firms have fixed
costs that must be paid regardless of output.
Variable inputs are inputs that are used in different quantities as the level of output changes. For
example, for most productive processes, labor is a variable input. As more (less) goods are
produced, more (less) labor is used. To the extent that a firm uses variable inputs, it will have
variable costs. Variable costs change with the level of output.
Realize that in the short run, the only way to increase the production of a good or service is to add more
variable inputs to the available fixed inputs.
And remember the following definitions.
Marginal product: the amount of extra output produced when one more input is added to a
productive process.
Marginal cost: the increase in total costs when one more unit of a good or service is produced.
The law of diminishing marginal product states that as more and more variable inputs are added to a set
of fixed inputs, the marginal product of each additional variable input will eventually decline. For
example, as more and more workers (variable inputs) are put to work in a given factory building (fixed
input), the first workers hired will add more to production than the last workers hired. The factory is
getting crowded, more difficult to manage, etc... Assuming that each worker is paid the same wage, the
marginal cost of producing a good will increase as more and more is produced in the short run.
Producers will be willing and able to sell a unit of a good in the market any time the extra revenue they
receive from doing so (marginal revenue, often the price of the good) is enough to cover the marginal
cost of producing the good. Because of the law of diminishing marginal product, marginal costs
increase as output increases. For this reason, producers will increase their output only when they are
offered a higher price, which will cover their higher marginal costs. Thus, we expect a positive
relationship between price and quantity supplied (upward sloping supply curve).

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The supply curve in the graph above indicates that at price P1, quantity supplied is Q1. At price P3,
quantity supplied is Q4 and at price P2, quantity demanded is Q5. Important: Remember that this
assumes that nothing else except price is changing. A change in any of the non price determinants of
supply will change supply (shift the supply curve) and a new price-quantity relationship will be
established. Other things equal, an increase in supply will drive the equilibrium price down and a
decrease in supply will drive the equilibrium price up.
EQUILIBRIUM PRICE AND QUANTITY
Notice that in our previous example, at price P1, producers of X are willing and able to sell exactly the
quantity of X that consumers of X are willing and able to buy at that price. The quantity supplied at P1
equals the quantity demanded at P1. We call P1 the market-clearing price. At this price everyone who
is willing and able to sell X sells all they want and everyone willing and able to buy X buys all they
want (at the market price). The market clearing price is also referred to as the equilibrium price because
there is a tendency for the market price to move toward the equilibrium price whenever the market price
is different than the equilibrium price. Once the market price equals the equilibrium price, it tends to
stay there until one of the non price determinants of demand or supply change. Consider the following
cases.

Figure 5
(See Figure 5) At price P2 we find a surplus (excess supply) of X in the market because, at this price,
quantity supplied is greater than quantity demanded. At P2, sellers are willing and able to sell more of
X than buyers are willing and able to buy. As the surplus becomes evident to producers, they will begin
to offer X for sale at a lower price and, at the same time, bring less to market (reduction in quantity
supplied). As the price drops, consumers who were not willing and able to pay price P2 begin to buy X
as the price drops (increase in quantity demanded). This adjustment will continue as long as there is a
surplus of X in the market. The adjustment will stop when the market price has dropped to P1, the
equilibrium price.

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Richard V. Adkisson 2007

Figure 6
(See Figure 6) At price P2 we find a shortage (excess demand) of Y in the market because, at this price,
quantity supplied is less than quantity demanded. At P2, sellers are willing and able to sell less of Y
than buyers are willing and able to buy. As the shortage becomes evident to producers, they will begin
to ask a higher price for Y and, at the same time, bring more to market (increase in quantity supplied).
As the price increases, consumers who were willing and able to pay price P3, but not a higher price, stop
buying Y as the price increases (decrease in quantity demanded). This adjustment will continue as long
as there is a shortage of Y in the market. The adjustment will stop when the market price has increased
to P1, the equilibrium price.
IMPORTANT P1 will only be the equilibrium price for the case shown in the graph. If one of the non
price determinants of supply or demand change (shifting the supply or demand curve) there will be a
new equilibrium price. For example, if demand increases (demand curve shifts right) because of a
change in tastes and preferences, the equilibrium price will increase. As the price of X adjusts upward
toward the new equilibrium, producers increase their quantity supplied. The price increase sent a signal
to producers that consumers wanted more Y.
PUTTING THINGS TOGETHER
Refer again to Figure 4 above. The prices shown in this graph (P1, P2, P3) were generated in markets
by the interactions of households (consumers) and producers. As prices change, consumers and
producers both transmit and receive important signals. Increasing prices tell producers to produce more
and consumers to consume less. Decreasing prices tell them the opposite. Besides clearing markets,
changes in relative prices (Py/Px or Px/Py) signal the need to reallocate resources. For example,
suppose consumer tastes and preferences changed such that the demand for X increased (price increases)
and the demand for Y decreases (price decreases). The changing relative prices would tell producers to
reallocate resources from Y production and toward X production.

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Richard V. Adkisson 2007
Production Possibilities Curve Review (two pages)
Refer to the graph below and answer all of the questions that follow.
1.

What two factors determine the position of a

societys production possibilities curve?

2.

Graphically, where is the societies

production/consumption opportunities set?

3.

Define opportunity cost.

4.

By looking at the production possibilities

frontier on the graph you can tell that this
economy experiences _______________
opportunity costs. What does this mean?

5.

If the PPF were straight instead of concave to the origin of the graph, we would say that this economy
experiences ___________________ marginal opportunity costs. What does this mean?

6.

Which of the labeled points on the graph are included in the feasible production/consumption
opportunity set?

7.

Which of the labeled points are not included in the feasible production/consumption opportunity set?

8.

What is true at points A, B, C, D, and E that is not true at point H?

9.

Point G represents a combination of beans and franks that has both more beans and more franks than are
represented by point C. Suppose that, even though this is true society chooses to produce and consume
the combination represented by point C. If more is better, why would a society choose to do this?

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Richard V. Adkisson 2007
10.

Given the assumptions we talked about briefly in class, would a society ever voluntarily choose to
produce at point H? Why or why not?

11.

If the slope of the PPF is - at point B, what is the marginal opportunity cost of franks at this point?
What is the marginal opportunity cost of beans at this point?

12.

If the slope of the PPF is -2 at point D, what is the marginal opportunity cost of franks at this point?

What is the marginal opportunity cost of beans at this point?

13.

Suppose that a NMSU researcher develops, and makes public, a new method to raise cattle and hogs
which allows them to gain weight with less feed. Describe what will happen to the PPF in this case.

14.

Suppose that an NMSU researcher develops, and makes public, a new method for controlling the
weather. Describe what will happen to the PPF in this case.

15.

Suppose that this is the United States PPF and a large earthquake causes California to fall into the
ocean. Describe what will happen to the PPF in this case.

16.

Describe societys resource allocation decision at point A.

Describe societys resource allocation decision at point E.

Is it likely that a society would voluntarily choose to produce and consume at either of these points?
Why or why not?

17.

We discussed the economic problem in class. What is it and how does it relate to the PPF model?

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Richard V. Adkisson 2007
Market Review Worksheet (two pages)
The graph below represents a simple graphical model of the market for shoe polish. The ticks on the vertical
axis are in intervals of one, the ticks on the horizontal axis are in intervals of 10. Add the proper labels for the
X and Y axes (not the numbers on the ticks), the downward sloping curve, and the upward sloping curve.

What is the equilibrium price and quantity of shoe polish?

Why is it called an equilibrium and what condition is met at the equilibrium price that is not met at any other
price?

What condition exists in the shoe polish market when the price is above equilibrium? Then what happens?

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Richard V. Adkisson 2007
What condition exists in the shoe polish market when the price is below equilibrium? Then what happens?

What is the difference between a change in demand and a change in quantity demanded?

What is the difference between a change in supply and a change in quantity supplied?

How would each of the following affect demand or supply and the equilibrium price and quantity? In each
case, identify which determinant of demand or supply has changed.
The price of leather shoes decreases (what kind of good is this?)
The price of canvas shoes decreases (what kind of good is this?)
Consumer incomes increase and shoe polish is a normal good (incomes decrease?)
Consumer incomes increase and shoe polish is an inferior good (incomes decrease?)
A famous and popular movie star says that men (or women) with shiny shoes drives him or her wild
Scientists at NMSU discover that shiny shoes cause skin cancer
The wage for factory workers increases (decreases?)
The price of tin decreases (increases?)
There is massive unemployment and many unemployed workers start shoe shine stands to make ends
meet.
A machine is invented that blends wax with dye faster and uses less energy to operate than the older
machines
The price of moustache wax increases substantially

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Richard V. Adkisson 2007
Circular Flow and the Role of Markets, Review Worksheet (two pages)

Each number on the graph above indicates a sector, market, real flow, or monetary flow. If any two of
them have been identified, you should be able to identify the other 10. I have identified two of the
elements of the model below. Identify the others and note whether it is a sector, a market, a real flow, or
a monetary flow.

1.

____________________

______________________

2.

____________________

______________________

3.

____________________

______________________

4.

____________________

______________________

5.

____________________

______________________

6.

____________________

______________________

7.

_Households__________

____Sector_____________

8.

____________________

______________________

9.

____________________

______________________

10.

__Goods and Services__

_Real Flow_____________

11.

____________________

______________________

12.

____________________

______________________

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Richard V. Adkisson 2007
The circular flow model on the other side of this sheet is the simplest representation of a market system. It
ignores many important things like government, financial markets, flows of intermediate goods between firms,
household production, and international markets. Still, it is useful as a starting point to talk about the role and
functions of markets. The graph below has the government added. Think about it and try to identify the
additional flows.
A.

____________________

B.

____________________

C.

____________________

D.

____________________

E.

____________________

F.

____________________

G.

____________________

H.

____________________

III

What is the role of markets in a market economy?