Economics

Topics To Be Covered
Introduction
Definition of Economics
Market Definition
Demand Schedule, Curve, and Functions
Supply Schedule, Curve, and Functions
 Topics To Be Covered
Change in Quantity Demanded versus
Change in Demand
Change in Quantity Supplied versus
Change in Supply
Equilibrium of Supply and Demand
Price Ceiling
Price Floor
 What is economics ?

Economics is the study of how societies

choose to use scarce productive
resources that have alternative uses, to
produce commodities of various kinds,
and to distribute them among different
groups.
 Why should we study
economics?
To understand how society manages its
scarce resources, e.g.
 howpeople decide what to buy,
how much to work, save, and spend
 howfirms 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
 Human Development Index
(HDI)
The Human Development Index (HDI) is
a composite statistic of life expectancy,
education, and per capita income
indicators, which are used to rank
countries into four tiers of human
development. A country scores higher
HDI when the lifespan is higher, the
education level is higher, and the GDP
per capita is higher
 Scarcity vs. Efficiency
Economic goods are scarce or limited in supply.
Free goods like air exist in such large
quantities. Thus, their market price is zero.
Scarcity is a situation in which the amount of
something available is insufficient to satisfy
everyone’s desire for it.
Efficiency refers to the use of economic
resources to maximize satisfaction with the
given inputs and technology.
 Microeconomics vs.
Macroeconomics
Microeconomics is the study of how
individual households and firms make
decisions and how they interact with one
another in markets.
Macroeconomics is the study of the
economy as a whole with respect to
output, price level, employment, and
other aggregate economic variables.
 Adam Smith & John
Maynard Keynes
Smith authored The Wealth of Nations in
1776.
 Founder of modern economics.
 Research into pricing of land, labor, and
capital.
 Invisible hand.

Keynes authored General Theory of

Employment, Interest and Money in 1936.
 What, How, and For Whom

What is the problem of decision to produce

possible goods or services.
How is the choice of the particular technique
by which each good of the what shall be
produced.
For whom refers to the distribution of
consumption goods among the members of
that society.
 Resources are anything that
can be used directly or indirectly
to satisfy human wants.

We sometimes call resources

factors of production

because they are utilized

to produce the goods and services

we use for consumption.

Three types of resources
land, which is physical space together
with the natural resources found above
or beneath it

labor, which is the time

human beings spend producing
goods and services
capital, which is a long-lasting resource
(not used up in the process) used to
produce goods and services

physical capital, which is tools, machines,

buildings, terraces

human capital, which is the natural

abilities, skills, and training of labor
 Production systems,
goods, services, and factors
A production system or technology
is a description of the set of outputs

that can be produced by a given set of

factors of production (or inputs) inputs

using a given method of production

or production process.
A factor of production (input) is a good or
service that is employed in the production
process.

A product is a good or service that is

the output of a particular production
process.
There are three types of factors of production (inputs)

Expendables

Capital

Capital Services
Expendable factors of production

Expendable factors of production are

raw materials or produced factors
that are completely used up or
consumed during a single production
period.
 Capital is a stock that is not used up
during a single production period,

provides services over time,

and retains a unique identity.

 Capital services are the flow of
productive services that can be obtained
from a given capital stock during a
production period.

They arise from a specific item of capital

rather than from a production process.

It is usually possible to separate the

right to use services
from ownership of the capital good.
The economic environment and “outcomes”
of the economic system

Actions taken by any agent depend on the

opportunities presented to that agent.

These opportunities depend on the

economic environment of the agent.
The economic environment and “outcomes”
of the economic system

Actions taken by any agent depend on the

opportunities presented to that agent.

These opportunities depend on the

economic environment of the agent.
Outcomes for each Agent in the System

Outcomes are the things that happen

in an economic system.

Receive paycheck, buy a bike wheel, get wheel

Quit job, move, get new job, get fired

 Given a particular economic
environment and a set of choices for
each agent,

we can determine the outcome

for each agent,

depending on the actions
of all the agents in the system.
 Positive, Normative and
Conditionally Normative Economics
Positive economics
Positive economics deals with how
(why) the economy works.
Positive economic analysis is the process
of under-standing, describing,
and predicting economic behavior.
 Examples

Price of gasoline

What happens to corn supply when the

price of corn rises?

What happens to the supply of housing

if rent controls are imposed?
Normative economics

Normative economics concerns itself

with what should be.
Normative economic analysis is the
process of determining what "ought to
be" or how to use resources optimally
so as to achieve the maximum well-
being for individuals in society.
 Examples
Should we build a bridge over the Snake River?

Should a tariff on textiles be removed?

Should the government pay workers

displaced by mechanical tomato harvesters?

Should Farmer Oleson plant wheat or oats?

Conditional normative analysis

Conditional normative economics concerns

itself with under-standing, describing
and predicting economic behavior . . .
by assuming that agents make choices
according to some rule, determining their
optimal response given that rule,
and then using these derived expressions
to test various positive hypotheses.
 Examples
Chocolate content assumption

Which food is chosen?

Distance from campus assumption?

Which apartment is chosen?

 Economic Models

A model is an abstract representation of reality.

A model represents the real world.

We follow the principle that a model should be
as simple as possible
to accomplish its purpose.

The model should contain necessary details,

but no unnecessary ones.

We call this “no fat’ modeling.

 Assumptions are things that we

take to be true in forming a model,

without necessarily providing

evidence that they are true.

 simplifying assumption –
any assumption that makes a model simpler
without affecting any of its important
conclusions.

critical assumption -
any assumption that affects the conclusions of
a model in an important way.
Two fundamental assumptions in economics

Every economic agent tries to make the

best out of any situation.
(Maximization hypothesis)

Every economic agent faces constraints.

The principles of
HOW PEOPLE
MAKE DECISIONS
 HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs

All decisions involve tradeoffs. Examples:

 Going to a party the night before your midterm
leaves less time for studying.
 Having more money to buy stuff requires working
longer hours, which leaves less time for leisure.
 Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.
 HOW PEOPLE MAKE DECISIONS
Principle #1: People Face 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
 Tradeoff: 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.”
 HOW PEOPLE MAKE DECISIONS
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.
It is the relevant cost for decision making.
 HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It

Examples:
The opportunity cost of…
…going to college for a year is not just the tuition,
books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.
 HOW PEOPLE MAKE DECISIONS
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.
 HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the
Margin
Examples:
When a student considers whether to go to
college for an additional year, he compares the
fees & foregone wages to the extra income
he could earn with the extra year of education.
When a manager considers whether to increase
output, she compares the cost of the needed labor
and materials to the extra revenue.
 HOW PEOPLE MAKE DECISIONS
Principle #4: People Respond to Incentives

Incentive: something that induces a person

to act, i.e. the prospect of a reward or
punishment.
Rational people respond to incentives.
Examples:
 When gas prices rise, consumers buy more
hybrid cars and fewer gas guzzling SUVs.
 When cigarette taxes increase,
teen smoking falls.
The principles of
HOW PEOPLE
INTERACT
 HOW PEOPLE INTERACT
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.
Countries also benefit from trade &
specialization:
 Get a better price abroad for goods they produce
 Buy other goods more cheaply from abroad than
could be produced at home
 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity

Market: a group of buyers and sellers

(need not be in a single location)
“Organize economic activity” means
determining
 what goods to produce
 how to produce them
 how much of each to produce
 who gets them
 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity

A market economy allocates resources

through the decentralized decisions of many
households and firms as they interact in
markets.
Famous insight by Adam Smith in
The Wealth of Nations (1776):
Each of these households and firms
acts as if “led by an invisible hand”
to promote general economic well-being.
 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
 The invisible hand works through the price system:
 Theinteraction of buyers and sellers
determines prices.
 Eachprice reflects the good’s value to buyers
and the cost of producing the good.
 Pricesguide self-interested households and firms
to make decisions that, in many cases, maximize
society’s economic well-being.
 HOW PEOPLE INTERACT
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.
 HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
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.
 HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes

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 principles of
HOW THE
ECONOMY
AS A WHOLE
WORKS
HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living
depends on its ability to produce goods &
services.

Huge variation in living standards across

countries and over time:
 Average income in rich countries is more than
ten times average income in poor countries.
 The U.S. standard of living today is about
eight times larger than 100 years ago.
HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living
depends on its ability to produce goods &
services.

The most important determinant of living

standards: productivity, the amount of goods
and services produced per unit of labor.
Productivity depends on the equipment, skills,
and technology available to workers.
Other factors (e.g., labor unions, competition
from abroad) have far less impact on living
standards.
HOW THE ECONOMY AS A WHOLE WORKS
Principle #9: Prices rise when the
government prints too much money.

Inflation: increases in the general level of

prices.
In the long run, inflation is almost always
caused by excessive growth in the quantity of
money, which causes the value of money to
fall.
The faster the govt creates money,
the greater the inflation rate.
HOW THE ECONOMY AS A WHOLE WORKS
Principle #10: Society faces a short-run
tradeoff between inflation and unemployment

In the short-run (1 – 2 years),

many economic policies push inflation and
unemployment in opposite directions.
Other factors can make this tradeoff more
or less favorable, but the tradeoff is always
present.
 Normative vs. Positive
Economics
Normative economics considers
“what ought to be”—value
judgments, or goals, of public policy.
Positive economics, by contrast, is
the analysis of facts and behavior in
an economy, or “the way things are.”
 Market Definition

A market is an arrangement
whereby buyers and sellers
interact to determine the prices
and quantities of a commodity.
Demand and Supply Cycle
Supply Market for Demand
Goods
Goods & Goods &
Services sold and Services
Services
bought

Firms Households

Inputs for Labor, land,

production Market for and capital
Factors
Demand Supply
of Production
 Demand

Quantity demanded
is the amount
of a good that buyers are
willing and able
to purchase.
The Law of Diminishing Demand

The law of demand states

that there is an inverse
relationship between price
and quantity demanded.
Demand Schedule
Price Quantity
$0.00 12
0.50 10
1.00 8
1.50 6
2.00 4
2.50 2
3.00 0
 Demand Curve
P
Price Quantity
$3.00
$0.00 12
0.50 10
2.50 Qd=12 – 4P 1.00 8
1.50 6
2.00 2.00 4
2.50 2
1.50 3.00 0
1.00

0.50

Qd
0 1 2 3 4 5 6 7 8 9 10 11 12
Determinants of Demand

Market price (P)

Consumer income (M)
Prices of related goods (Pr)
Tastes (T)
Expectations (Pe)
Number of consumers (N)
 Demand Functions

Qd = f (P, M, Pr, T, Pe, N)

Qd = a + bP + cM + dPr+ eT
+ fPe + gN
Qd = f (P, M’, Pr’, T’, Pe’, N’)
Qd = f (P)
Qd = a + bP
 Ceteris Paribus
Ceteris paribus is a Latin phrase that
means all variables other than the
ones being studied are assumed to be
constant. Literally, ceteris paribus
means “other things being equal.”
The demand curve slopes downward
because, ceteris paribus, lower prices
imply a greater quantity demanded!
 Market Demand
Market demand refers to the sum of
all individual demands for a
particular good or service.
Graphically, individual demand
curves are summed horizontally to
obtain the market demand curve.
Change in Quantity Demanded
versus Change in Demand

Change in Quantity Demanded

Movement along the demand curve.
Caused by a change in the price of
the product.
Changes in Quantity Demanded
P

C
$4.00

2.00 A

D1
0 12 20
Qd
Change in Quantity Demanded
versus Change in Demand
Change in Demand
A shift in the demand curve, either
to the left or right.
Caused by a change in a
determinant other than the price.
 Changes in Demand
P

Increase in
demand

Decrease in
2.00 demand A B
D2
D1
D3
0 20 30 Qd
 Consumer Income

As income increases the demand

for a normal good will increase.
As income increases the demand
for an inferior good will decrease.
 Consumer Income
Normal Good
Price

$3.00 An increase
2.50 in income...
Increase
2.00 in demand

1.50

1.00

0.50
D2
D1
Quantity
0 1 2 3 4 5 6 7 8 9 10 11 12
 Consumer Income
Inferior Good
Price

$3.00

2.50 An increase
2.00
in income...
Decrease
1.50 in demand
1.00

0.50

D2 D1
Quantity
0 1 2 3 4 5 6 7 8 9 10 11 12
 Prices of Related Goods
When a fall in the price of one good
reduces the demand for another good,
the two goods are called substitutes.
When a fall in the price of one good
increases the demand for another
good, the two goods are called
complements.
Change in Quantity Demanded
versus Change in Demand
Variables that A Change in
Affect Quantity
Demanded This Variable . . .
Price Represents a movement
along the demand curve
Income Shifts the demand curve
Prices of related Shifts the demand curve
goods
Tastes Shifts the demand curve
Expectations Shifts the demand curve
Number of Shifts the demand curve
buyers
 Supply

Quantity supplied
is the amount of a good
that sellers are
willing and able
to sell.
 Law of Supply

The law of supply states that

there is a direct (positive)
relationship between price
and quantity supplied.
Supply Schedule
Price Quantity
$0.00 0
0.50 0
1.00 1
1.50 2
2.00 3
2.50 4
3.00 5
 P
Supply Curve
Qs = - 1 + 2P
$3.00

2.50 Price Quantity

2.00 $0.00 0
0.50 0
1.50 1.00 1
1.50 2
1.00 2.00 3
2.50 4
0.50
3.00 5
Qs
0 1 2 3 4 5 6 7 8 9 10 11 12
 Determinants of Supply

Market price (P)

Input prices (PI)
Related goods prices (Pr)
Technology (T)
Expectations (Pe)
Number of firms (F)
 Supply Functions

Qs = g (P, PI, Pr, T, Pe, F)

Qs = h + kP + l PI + mPr+ nT
+ rPe + sF
Qs = g (P, PI’, Pr’, T’, Pe’, F’)
Qs = g (P)
Qs = h + kP
 Market Supply

Market supply refers to the sum of

all individual supplies for all sellers
of a particular good or service.
Graphically, individual supply
curves are summed horizontally to
obtain the market supply curve.
Change in Quantity Supplied
versus Change in Supply

Change in Quantity Supplied

Movement along the supply curve.
Caused by a change in the market price
of the product.
Change in Quantity Supplied
P
S
C
$3.00 A rise in the price
results in a
movement along
the supply curve.

A
1.00

Qs
0 1 5
Change in Quantity Supplied
versus Change in Supply

Change in Supply
A shift in the supply curve, either to the
left or right.
Caused by a change in a determinant
other than price.
 Change in Supply
P S3
S1 S2
Decrease in
Supply

Increase in
Supply

Qs
0
 Change in Quantity Supplied
versus Change in Supply
Variables that
Affect Quantity Supplied A Change in This Variable . . .
Price Represents a movement along
the supply curve
Input prices Shifts the supply curve
Technology Shifts the supply curve
Expectations Shifts the supply curve
Number of sellers Shifts the supply curve
Supply and Demand Together
Equilibrium Price
The price that balances supply and
demand. On a graph, it is the price at
which the supply and demand curves
intersect.
Equilibrium Quantity
The quantity that balances supply and
demand. On a graph it is the quantity at
which the supply and demand curves
intersect.
Supply and Demand Together
Demand Schedule Supply Schedule

Price Quantity Price Quantity

$0.00 19 $0.00 0
0.50 16 0.50 0
1.00 13 1.00 1
1.50 10 1.50 4
2.00 7 2.00 7
2.50 4 2.50 10
3.00 1 3.00 13

At $2.00, the quantity demanded is

equal to the quantity supplied!
 Equilibrium of
P
Supply and Demand
Qd=19 – 6P Supply
$3.00

2.50 Equilibrium

2.00 Qd= Qs

1.50

1.00

0.50 Qs = - 5 + 6P Demand
Q
0 1 2 3 4 5 6 7 8 9 10 11 12
 Three Steps To Analyzing
Changes in Equilibrium

Decide whether the event shifts the

supply or demand curve (or both).
Decide whether the curve(s) shift(s) to
the left or to the right.
Examine how the shift affects
equilibrium price and quantity.
 How an Increase in Demand
Affects the Equilibrium
Price 1. Hot weather increases
the demand for ice cream...

Supply

$2.50 New equilibrium

2.00
2. ...resulting Initial
in a higher equilibrium
price...
D2

D1
0 7 10 Quantity
3. ...and a higher
quantity sold.
 Shifts in Curves versus
Movements along Curves
A shift in the supply curve is called a
change in supply.
A movement along a fixed supply curve is
called a change in quantity supplied.
A shift in the demand curve is called a
change in demand.
A movement along a fixed demand curve is
called a change in quantity demanded.
 How a Decrease in Supply
Affects the Equilibrium
Price
1. An earthquake reduces
the supply of ice cream...
S2
S1

New
$2.50 equilibrium

2.00 Initial equilibrium

2. ...resulting
in a higher
price...
Demand

0 1 2 3 4 7 8 9 10 11 12 13 Quantity
3. ...and a lower
quantity sold.
 What Happens to Price and
Quantity When Supply or
Demand Shifts?
No Change An Increase A Decrease
In Supply In Supply In Supply
No Change P same P down P up
In Demand Q same Q up Q down
An Increase P up P ambiguous P up
In Demand Q up Q up Q ambiguous
A Decrease P down P down P ambiguous
In Demand Q down Q ambiguous Q down
 Excess Supply
P
Supply
$3.00 Surplus

2.50

2.00

1.50

1.00

0.50 Demand
Q
0 1 2 3 4 5 6 7 8 9 10 11 12
 Surplus
When the price is above the equilibrium
price, the quantity supplied exceeds the
quantity demanded. There is excess supply
or a surplus. Suppliers will lower the price
to increase sales, thereby moving toward
equilibrium.
 Excess Demand
Price

Supply

$2.00

$1.50

Shortage Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity
 Shortage
When the price is below the equilibrium
price, the quantity demanded exceeds the
quantity supplied. There is excess demand
or a shortage. Suppliers will raise the price
due to too many buyers chasing too few
goods, thereby moving toward equilibrium.
Price Ceilings & Price Floors

Price Ceiling
A legally established maximum price at
which a good can be sold.
Price Floor
A legally established minimum price at
which a good can be sold.
 A Price Ceiling That
Creates
P
Shortages

Supply

Equilibrium
price

$3

2 Price
ceiling
Shortage
Demand

0 75 125
Q
Quantity Quantity
supplied demanded
Effects of Price Ceilings

 Shortages
 Non-price rationing
 Black market
 Corruption
 Rent Control
Rent controls are ceilings placed on the
rents that landlords may charge their
tenants.
The goal of rent control policy is to help
the poor by making housing more
affordable.
One economist called rent control “the
best way to destroy a city, other than
bombing.”
Rent Control in the Short Run
Rental
Price of
Apartment Supply and
Supply demand for
apartments
are relatively
inelastic

Controlled rent

Shortage

Demand

0 Quantity of
Apartments
Rent Control in the Long Run
Rental Because the
Price of supply and
Apartment
demand for
apartments are
more elastic...

Supply

…rent control Controlled rent

causes a large
shortage
Shortage
Demand

0 Quantity of
Apartments
 A Price Floor That
P
Creates Surplus

Supply
Surplus

$4 Price floor

$3

Equilibrium
price

Demand
Q
0 80 120
Quantity Quantity
demanded supplied
 The Minimum Wage

An important example of a price

floor is the minimum wage.
Minimum wage laws dictate the
lowest price possible for labor that
any employer may pay.
 The Minimum Wage
A Free Labor Market
Wage
Labor
supply

Equilibrium
wage

Labor
demand
0 Equilibrium Quantity of
employment Labor
 The Minimum Wage
A Labor Market with a
Wage
Minimum Wage
Labor
Labor surplus supply
(unemployment)
Minimum
wage

Labor
demand
0 Quantity Quantity Quantity of Labor
demanded supplied
Thanks