Chapter 1: The Central Concepts of Economics
WHY STUDY ECONOMICS  Self-interest of individuals working through
Economics
 Study of how societies use scarce resources to
produce valuable goods and services and
distribute them among different individuals
 Uses
o Examines reasons for trade
o Used for policies
o Behavioral Economics – Explains
behaviors in various branches
 Labor
 International Trade
 Environmental
 Game Theory
Scarcity
 Goods are limited relative to desires
 Refers to the supply of resources
 As long as demand is greater than supply, no
matter how abundant a resource is it is still
considered scarce
Efficiency
 Most effective use of a society’s resources in
satisfying people’s wants and needs
 Biggest “Bang for the Buck”
 Making the most of goods from scarce
resources with the least amount of waste
Optimum
 Most efficient use of resources
Economic Efficiency
 Requires that an economy produce the highest
combination of quantity and quality of goods
and services given its technology and scarce
resources
 No individual economic welfare can be
improved unless someone else is made worse
off
 Welfare Maximization
o Efficiently providing goods and
services to consumers makes them
happy
Microeconomics
 Behavior of individual entities
o Markets
o Firms
o Households
 How the market affects individual entities
Adam Smith – The Wealth of Nations
the competitive market can produce a societal
economic benefit
Macroeconomics
 Overall performance and behavior of the
aggregate economy
 A well-functioning macroeconomic may or
may not have been caused by a well-
functioning microeconomic
Scientific Approach
 Observing economic affairs and drawing upon
statistics and the historical record
Econometrics
 Applies the tools of statistics to economic
problems
Common Fallacies on Economic Reasoning
1. Post hoc Fallacy
o Inference of causality
o Occurs when people assume that,
because one event occurred before
another event, the first event caused
the second event
2. Failure to Hold Things Constant
3. Fallacy of Composition
o Occurs when people assume that what
is true for the part is also true for the
whole
Positive Economics
 Resolving questions of economics by reference
to analysis, empirical evidence, facts of the
economy
Normative Economics
 Involves ethical precepts, norms of fairness,
and value judgments
Cool Heads at the Service of Warm Hearts
 The ultimate goal of economic science is to
improve the living conditions of people in their
everyday lives
 Combine the discipline of the marketplace
with the compassion of social programs
 THE THREE PROBLEMS OF ECONOMIC
ORGANIZATION
Fundamental Questions of Economic Organization
1. What commodities in what quantities
o Goods and Service
2. How are goods produced
o Technology
3. For whom are goods produced
o Question of Equitability and Efficiency
o To the person who needs it the most or
the one who could make the most out
of it
o Distribution of Income and Wealth
Market Economy
 In which individuals and private firms make
the major decisions about production and
consumption
Laissez-Faire Economy
 Extreme case of market economy
 Government keeps its hands off economic
decisions
 Firms produce the commodities that yield the
highest profits based on the law of supply and
demand
 Firms uses techniques of production that least
costly
 Consumption is determined by peso votes
generated by labor and property ownership
Command Economy
 Government makes all important decisions
about production and distribution
 Government owns most of the means of
production
 Government is the employer of most workers
and tells them how to do their jobs
 Government decides how the output of the
society is to be divided among different foods
and services
Mixed Economy
 Government plays an important role in
overseeing the functioning of the market
 Governments pass laws that regulate
economic life, produce educational and police
services, and control pollution
 Government imposes non-compulsory market
policies that shape decisions pursuing a
certain line of behavior
SOCIETY’S TECHNOLOGICAL POSSIBILITIES
Inputs
 Commodities or services that are used to
produce goods and services
 Also termed as “Factors of Production”
1. Land / Natural Resources
2. Labor
o Human time spent in
production
3. Capital / Durable Goods
o Goods produced in order to
produce other goods
o Accumulation of specialized
capital goods is essential to the
task of economic development
Existing Technology
 Used to combine inputs to produce outputs
Outputs
 Useful goods or services that results from the
production process and are either consumed
or employed in further production
Production-Possibility Frontier
 Consumption opportunities of countries are
limited by the resources and the technologies
available to them
 Shows the maximum quantity of goods that
can be efficiently produced by an economy,
given its technological knowledge and the
quantity of available inputs
 Shows the schedule along which society can
choose to substitute one good for another
 Assumes a given state of technology and a
given quantity of inputs
 Points outside the frontier are infeasible or
unattainable
 Any point inside the curve indicates that the
economy has not attained productive
efficiency
 Not a straight line
o Empirically derived
o Magnitude of the trade-off is therefore
not constant
o You give up more as you move away
from the origin, therefore the tradeoff
gets larger because this is not a perfect
substitution
 Friction of Conversion
 Nature of Inputs
Economic Growth
 Increase in inputs and improved technological
knowledge enables a country to produce more
of all goods and services
  Shifts the Production-Possibility Frontier
outward
 Investment for future consumption requires
sacrificing current consumption
 Poor countries must devote most of their
resources to food production while rich
countries can afford more luxuries as
productive potential increases
Single-Sided Growth

 Occurs when technology of only one of the

goods in the PPF grows
 Shifts the intercept corresponding the good
having the growth upward

Opportunity Costs

 Value of the next-best good forgone

Efficiency

 Economy is on the frontier rather than inside

the PPF
Productive Efficiency

 Economy cannot produce more of one good

without producing less of another good
 Economy is on the PPF
Economic Inefficiencies
1. Unemployed resources
2. Panics, Bank Failures, Bankruptcies, and
Reduced Spending
3. Markets are failing to reflect true scarcities
o Environmental Degradation
 Chapter 2: The Modern Mixed Economy oFirms maximize profits by keeping
costs at a minimum by adopting the
THE MARKET MECHANISM most efficient methods of production
3. For Whom
Market Economy Decision Making
o Determined by the supply and demand
 No single individual or organization or in the markets
government is responsible for solving the
Factor Markets
economic problems in a market economy
 The economy is invisible coordinated by a  Markets for factors of production
system of prices and markets  Determine “Factor Prices”
o Wage rates
o Land rents
Market Economy System o Interest rates
o Profits
 A system with its own logic
 An elaborate mechanism for coordinating
people, activities, and business through a
Taste
system of prices and markets
 No single individual or organization is  Expressed in the peso votes of consumer
responsible for production, consumption, demands
distribution, or pricing
Technology
Markets
 Limits the candidates for the peso votes of
 Places and mechanisms where buyers and consumers, together with scarce resources
sellers interact, exchange goods and services
or assets, and determine prices
The Invisible Hand
Prices
 Private interest can lead to public gain when it
 Central role of markets
takes place in a well-functioning market
 Value of goods in terms of money
mechanism
 Represent the terms on which different items
can be exchanged Perfectly Competitive Economy
 Signals to producers and consumers
 Most efficiency economy, under limited
 Coordinate the decisions of producers and
conditions
consumers in a market
 Balance wheel of the market mechanism Market Failures
o Higher prices reduce consumer
purchases and encourage production 1. Monopolies
o Lower prices encourage consumption 2. Spillovers / Externalities
and discourage production 3. Politically / Unethically Unacceptable Income
Distribution
Market Equilibrium

 Balance among all the different buyers and

sellers by simultaneously meeting the desires TRADE, MONEY, AND CAPITAL
of buyers and sellers
Features of a Modern Economy
1. Elaborate network of trade depending on
Markets Solving the Three Economic Problems specialization and division of labor
2. Extensive use of money, measuring economic
1. What
values
o Determined by peso votes of
3. Industrial technologies and vast stocks of
consumers in their daily purchase
capital transforming human labor into a much
decisions
more efficient factor of production
o Firms are motivated by the desire to
maximize profits
 Profits – net revenues or the
Specialization
difference between total sales
and total costs  People and countries concentrate their efforts
2. How on a particular set of tasks
o Determined by competition among  Use to best advantage the specific skills and
different producers resources that are available
  Become highly productive in a very narrow
field of expertise
Division of Labor
 Dividing production into a number of small
specialized steps or tasks
Gains from Trade
 Since countries tend to specialize in certain
areas, they can engage in the voluntary
exchange of what they produce for what they
need
 Increase in the range and quality of
consumption and having the potential to raise
everyone’s living standards
Globalization
 Denote an increase in economic integration
among nations
 Steady increase in the share of national output
devoted to imports and exports
 Financial-market integration
o Dismantling of restriction on capital
flows among nations, cost reductions,
and innovations in financial markets
 Consequence of economic integration
o Unemployment
o Lost profits
 Consequence of no economic integration
o Loss on possible prices
o Caused by “Protectionism”
 Tariffs
 Quotas
Money
 Allows people to trade their specialized
outputs for the vast array of goods and
services produced by others
 Means of payment in the form of currency and
checks used to buy things
 Facilitates exchange
o Only when everyone trusts and
accepts money as a payment for goods
and services
 Supply is controlled by the government
through central banks
Capital
 Produced and durable input which is itself an
output of the economy
 Its use involves time-consuming, roundabout
methods of production
o Indirect and roundabout production
techniques often are more efficient
than direct methods of production
Sacrifice of Current Consumption
 Abstaining from present consumption and
wait for future consumption by devoting
resource to new capital goods pushing out the
PPF
 Poor countries are caught in the vicious cycle
of a “Poverty Trap”
o They have low incomes and few
productive outlets for their savings,
they save and invest little, they grow
slowly, and as a consequence they fall
further behind in the economy
standing of nations
Property Rights
 Ability to use, exchange, paint, dig, drill, or
exploit their capital goods
 Capitalism
o Ability of individuals to own and profit
from capital
 Enforced through the legal framework, which
constitutes the set of laws within which a
society operates
THE VISIBLE HAND OF GOVERNMENT
Government Functions
 Operate by requiring people to pay taxes, obey
regulations, and consume certain collective
goods and services
 Main economic functions
1. Increase Efficiency
o Promoting competition
o Curving externalities
o Providing public goods
2. Promote Equity
o Using tax and expenditure
programs to redistribute
income toward particular
groups
3. Foster Macroeconomic Stability and
Growth
o Reducing unemployment and
inflation
o Encouraging economic growth
through fiscal and monetary
policy
Government Coercion
 Increases the freedoms and consumptions of
those who benefit while reducing the incomes
and opportunities of those who are taxed or
regulated
Perfect Competition Macroeconomic Growth and Stability

 No firm or consumer is large enough to affect
the market price
Imperfect Competition
 Monopoly / Duopoly / Oligopoly elements
o Monopoly – a single supplier who
alone determines the price of a
particular good or service
 A buyer or seller can affect a good’s price
 Society may move inside its PPF
 Lead to prices that rise above cost and to
consumer purchases that are reduced below
efficient levels
Externalities
 Involuntary imposition of costs or benefits on
others outside the marketplace
 Government regulations are designed to
control externalities
Public Good
 Careful use of fiscal and monetary policies
o Affect output, employment, and
inflation
 Fiscal Policies
o Taxing
o Spending
 Monetary Policies
o Determination of Money Supply
o Determination of Interest Rates
Welfare State
 Markets direct the detailed activities of day-to-
day economic life while government regulates
social conditions and provides pensions,
health care, and other necessities for poor
families

 Polar case of a positive externality

 Can be enjoyed by everyone and from which
no one can be excluded
 Non-rival
o Cost of extending the service to an
additional person is zero
 Nonexcludable
o It is impossible to exclude individuals
from enjoying it
 Not necessarily publicly provided, but often,
provided by no one
Taxes

 Government revenues used to pay for its

public goods and for its income-redistribution
programs

Equity

 Markets do not necessarily produce a fair

distribution of income
 Incomes are determined by a wide variety of
factors, including effort, education,
inheritance, factor prices, and luck
 Market mechanism
o Putting goods in the hands of those
who have the peso votes
o Efficiency doesn’t necessarily comply
with equity
 Possible Solution
o Progressive Taxation
o Transfer Payments
 Chapter 3: Basic Elements of Supply and Demand o More goods will be bought at every
price
Theory of Supply and Demand
 Caused by changes in factors other than a
 Shows how consumer preference determine good’s own price which affect the quantity
consumer demand for commodities, while purchased
business costs are the foundation of the supply
Movement Along the Demand Curve
of commodities
 Occurs when quantity demand changes due to
THE DEMAND SCHEDULE change in price
 No increase / decrease in demand for the same
Demand Schedule
price occurs
 Relationship between price and quantity
bought
THE SUPPLY SCHEDULE
Demand Curve
Supply Schedule
 Graphical representation of the demand
schedule  Relationship between its market price and the
amount of that commodity that producers are
Law of Downward-Sloping Demand willing to produce and sell, other things held
 Quantity and price are inversely related constant
 Reason  Things held constant:
o Substitution Effect o Input Prices
o Income Effect o Prices of Related Goods
o Government Policies
Upward-Sloping Supply Curve
Market Demand
 Law of Diminishing Returns
 Represents the sum total of all individual o Additional labor, considering limited
demands land, will add lesser and lesser product
 Individual preference is the fundamental
building block
Market Demand Curve Forces Behind the Supply Curve

 Found by adding together, horizontally,  Cost of Production

quantities demanded by all individuals at each o When production costs for a good are
price low relative to the market price, it is
profitable for producers to supply a
great deal
o When production costs are high
Forces Behind the Demand Curve
relative to price, firms produce little,
 Average Income of Consumers switch to the product of other
 Size of the Market products, or may simply go out of
 Prices and Availability of Related Goods business
 Tastes or Preferences  Prices of Inputs
o Cultural Influence o Labor - Wages
o Historical Influence o Energy - Rent
o Psychological Need o Machinery - Rent
o Physiological Need  Technological Advances
o Artificially Contrived Cravings o Changes that lower the quantity of
o Tradition inputs needed to produce the same
o Religion quantity of output
 Special Influences o Examples
o Weather  Scientific Breakthroughs
o Location  Better Application of Existing
Technology
 Reorganization of the Flow of
Shifts in Demand Work
 Prices of Related Goods
 Increase in Demand o Prices of alternative outputs of the
o Net effect of the changes in underlying production process
influences
 o If the price of one production
substitute rises, the supply of another
substitute will decrease
 Government Policy
o Environmental and Health
Considerations
o Taxes
o Minimum-Wage Laws
o Free Trade Agreements
 Special Influences
o Weather
o Spirit of Innovation
o Market Structure
o Expectations about Future Prices

Shifts in Supply

 Caused by changes in factors other than a

good’s own price affecting the quantity
supplied

EQUILIBRIUM OF SUPPLY AND DEMAND CURVE

Market Equilibrium

 Caused by supply and demand interaction

 Comes at a price and quantity where the forces
of supply and demand are in balance
 At this point, there is no reason for price to rise
or fall, as long as other things remain
unchanged
Equilibrium Price

 Also called the “Market-Clearing Price”

 Denotes that all supply and demand orders are
filled, the books are “cleared” of orders, and
demanders and suppliers are satisfied
Surplus

 Excess of quantity supplied over quantity

demanded
 Prices tend to move down
Shortage

 Excess of quantity demanded over quantity

supplied
 Competition among buyers for limited goods
causes the price to rise
 Chapter 4: Supply and Demand – Elasticity and
Applications
PRICE ELASTICITY OF DEMAND AND SUPPLY
Elasticity
 Describes how much supply and demand
respond to changes in prices
 Quantitative relationship between price and
quantity
Price Elasticity of Demand
 How much the quantity demanded of a good
changes when its price changes
 Percentage change in quantity demand
divided by the percentage change in price
Elastic
 High price elasticity
 Quantity demand responds greatly to price
changes
Inelastic
 Low price elasticity
 Quantity demanded responds little to price
changes
Factors Affecting Price Elasticity of Demand
 Substitutes
o Elastic = Goods with Substitutes
o Inelastic = Goods without Substitutes
 Length of Time to Respond to Price Changes
o Elastic = Long-run
o Inelastic = Short-run
 Necessities v. Luxuries
o Elastic = Luxuries
o Inelastic = Necessities
Calculating Elasticities
 For convenience we drop the minus sign, so all
elasticities are positive
 Price Elasticity of Demand = ED
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝐷
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃
𝑄2 − 𝑄𝑧
𝑄2 + 𝑄1
2 demand curve and the specific price and
𝑃2 − 𝑃1
𝑃2 + 𝑃1
2
≜ 𝑄 𝑃0
( )( )
≜ 𝑃 𝑄0
 Categories
o 1% Change in P = >1% Change in QD
 Price Elastic Demand
o 1% Change in P = 1% Change in QD
 Unitary Elastic Demand
o 1% Change in P = <1% Change in QD
 Price Inelastic Demand
 Use percentage changes in price and demand
rather than absolute changes
 Changes in the units of measurements does
not affect elasticity
Completely Inelastic Demands
 Quantity demanded responds not at all to
price changes
 Vertical Demand Curve
 Slope = Infinity
 Elasticity = 0
Completely Elastic Demand
 A tiny change in price will lead to an
indefinitely large change in quantity
demanded
 Horizontal Demand Curve
 Slope =0
 Elasticity = Infinity
Elasticity of a Straight Line at a Point
 Ratio of the length of the line segment below
the point to the length of the line segment
above the point
 Categories when the point is at midline
o At Midline = Unitary Elastic
o Above Midline = Elastic
o Below Midline = Inelastic
Elasticity of a Nonlinear Demand Curve
 Draw a tangent line at the point
 Take the ratio of the length of the straight-line
segment below the point to the length of the
line segment above the point
Algebra of Elasticities
 Q = a – bP
≜ 𝑄 𝑃0
( )( )
≜ 𝑃 𝑄0
𝑃0
(𝑏) ( )
𝑄0
 Elasticity depends upon the slope of the
quantity pair
Elasticity v. Slope
 A straight line has a constant slope, however
elasticity varies along the line from zero to
infinity
  A curved line has varying slope, but may show
constant elasticity
 Slope depends on the changes in P and Q
 Elasticity depends on the percentage changes
in P and Q
Total Revenue
 Price X Quantity (P x Q)
 Inelastic Demand
o Price Decrease reduce Total Revenue
 Elastic Demand
o Price Decrease increase Total Revenue
 Unitary Elastic Demand
o Price Decrease has no change in Total
Revenue
 Equal to the area of a rectangle which is a
product of its base times its height
Price Discrimination
 Separate customers into groups with different
elasticities
 Charge different prices for the same service to
different customers
o Elastic Demand = Price Lower
o Inelastic Demand = Price Higher
Paradox of Bumper Harvest
 Since demand for necessities are inelastic, a
bountiful harvest that increase quantity
supplied would only decrease prices without
increasing quantity demanded by much
 Farmers as a whole receive less total revenue
when the harvest is good than when it is bad
Price Elasticity of Supply
 Responsiveness of the quantity supplied of a
good to its market price
 Percentage change in quantity supplied
divided by the percentage change in price
Completely Inelastic Supply
 Quantity supplied is fixed
 Example: Perishable goods are sold to the
market at whatever price they will fetch
 Zero Elasticity
 Vertical Supply Curve
Completely Elastic Supply
 A tiny cut in price will cause the amount
supplied to fall to zero
 A slightest rise in price will coax out an
indefinitely large supply
 Infinite Elasticity
 Horizontal Supply Curve
Price Elasticity of Supply v. Demand
 Supply – the quantity response to a price is
positive
 Demand – the quantity response to a price is
negative
Three Important Cases of Supply Elasticity
 Vertical Supply Curve
o Completely Inelastic Supply
 Horizontal Supply Curve
o Completely Elastic Supply
 Straight-Line Through the Origin
o Unitary Elastic Supply
o Percentage quantity and price changes
are equal
Factors Influencing Supply Elasticity
 Ease of Production
o Inputs can be readily found
 Production capacity is severely limited
o Inelastic Supply
o Example: Gold Mining
 Sharp increases in price won’t
call forth an increase in
production
 Time period under consideration
o Short-run = Inelastic Supply
 Unable to increase their inputs
of labor, materials and capital
o Long-run = Elastic Supply
 Businesses can hire more
labor, build new factories and
expand capacity
APPLICATIONS TO MAJOR ECONOMIC ISSUES
Economics of Agriculture
 Demand for food increases slowly because
basic foods are necessities
 Demand shift is consequently modest in
comparison to growing average incomes
 Productivity has grown more rapidly in
agriculture than in most other industries
 Sharp increases in supply outpaced modest
increases in demand, producing a downward
trend in farm prices
 Possible Solution: Crop Restriction
o Raised prices through price supports
o Curb imports through tariffs and
quotas
o Send checks to farmers who agreed
not to produce on their land
 o Supply curve will shift leftward raising
prices

Impact of a Tax on Price and Quantity

 Incidence
o Ultimate economic effect of a tax on
the real incomes of producers and
consumers
 Elastic Demand
o It is better for producers to absorb
most of the tax effect so that with
lower price increase, quantity
demanded will also respond less
 Inelastic Demand
o It is better for producers to shift the
burden of tax to the consumers
 In essence, taxes lower both quantity supplied
and quantity demanded

Subsidies

 The opposite of taxes

 Used to encourage production
 Shifts supply curve downward lowering prices

Minimum-Wage Controversy

 Labor demand is inelastic for low-skilled

workers such that an increase in minimum
wage will not affect quantity of labor
demanded that much

Energy Price Ceilings

 Result to supply rationing because of shortage

Chapter 5: Demand and Consumer Behavior
Choice and Utility Theory
 People choose those goods and services they
value most highly
 Assumes that people make decisions that give
them the greatest satisfaction or utility
Equimarginal Principle
 Assumes consumers are reasonably consistent
in their tastes and actions
Utility
 Denotes satisfaction
 How consumers rank different goods and
services
 Subjective pleasure or usefulness that a
person derives from consuming a good or
service
 A scientific construct (how rational consumers
make decisions) rather than a psychological
function or feeling that can be observed or
measured
Theory of Demand
 Assume that people maximize their utility
 Choose the bundle of consumption goods that
they most prefer
Marginal Utility
 Increment to one’s utility
 Additional utility one gets from the
consumption of an additional unit of
consumption Marginal Utility of Income
Law of Diminishing Marginal Utility
 The amount of extra or marginal utility
declines as a person consumes more and more
of a good
 As one consumes more and more, one’s total
utility will grow at a slower and slower rate
 As the amount of a good consumed increases Leisure and the Optimal Allocation of Time
the marginal utility of that good tends to
decline
Total Utility
 Equal to the sum of the marginal utilities up to Ordinal Utility
that point
Marginal Utility Curve
 Its area is equal to the height of the total utility
curve Substitution Effect
Principle of Utility (Jeremy Bentham)
 Property in any object … to produce pleasure,
good, or happiness or to prevent … pain, evil,
or unhappiness
Calculus of Pleasure and Pain (Stanley Jevons)
 Rational people would base their consumption
decisions on the extra or marginal utility of
each good
 Assume that consumers maximize utility
o Consumers chooses the most
preferred bundle of goods what is
available given a certain income and
facing given market prices of goods
 Fundamental condition of maximum
satisfaction or utility
 Consumers will achieve maximum satisfaction
or utility when the marginal utility of the last
dollar spend on a good is exactly the same as
the marginal utility of the last dollar spent on
any other good
 Formula:
𝑀𝑈𝑋 𝑀𝑈𝑌
=
𝑃𝑋 𝑃𝑌
 A higher price for a good reduces the
consumer’s desired consumption of that
commodity which shows why demand curves
slope downward
 Assumed that goods can be divided into
indefinitely small units
o When indivisibility matters, the
equality rule for equilibrium can be
restated as an inequality rule
 Common marginal utility per dollar of all
commodities in consumer equilibrium
 Measures the additional utility that would be
gained if the consumer could enjoy an extra
dollar’s worth of consumption
 Law of rational choice
 Determine only their preference ranking of
bundles of commodities
 When the price of a good rises, consumers will
tend to substitute other goods for the more
expensive good in order to satisfy their desires
more inexpensively
 Buying a given amount of satisfaction at a
lower cost
Income Effect Complements

 Real income  An increase in the price of good A causes a

o Actual quantity of goods that one’s decrease in the demand for its complement
money income can buy good B
 When a price rises and money income is fixed,
Independent Goods
real income falls because the consumer cannot
afford to buy the same quantity of goods as  A price change for one has no effect on the
before demand for the other
 Change in the quantity demanded that arises
because a price change lowers consumer real
incomes Merit Goods

 Consumption is through intrinsically

worthwhile
Income Elasticity
Demerit Goods
 Quantitative measure of the income effect
 Percentage change in quantity demanded  Consumption is deemed harmful
divided by the percentage change in income Addiction
 Formula:
 Pattern of compulsive and uncontrolled use of
≜ 𝑄𝐷 a substance
𝐸𝑀 =
≜𝑀
Addictive Substances
High Income Elasticity
 Casual Consumers = Elastic Demand
 Demand for these goods rises rapidly as
 Hard-Core Users = Inelastic Demand
income increases
 Luxuries
Low Income Elasticity Paradox of Value

 Denote a weak response of demand to increase  Total utility does not determine the price or
in income demand
 Necessities  The marginal utility of the last good
determines the price of a good
Negative Income Elasticity
o Scarce resources are more expensive,
 Denote a negative or opposite response of even if they are not useful
demand to increase in income o Abundant resources are cheaper, even
 Inferior Goods if they are useful

Unitary Income Elasticity

 Demand grows proportionately with income Consumer Surplus

 Staple Commodities  Gap between the total utility of a good and its
total market value
 Since earlier units are worth more to people,
Water and Electricity Consumption Formula considering that they only pay the same
amount based on the last consumption for all
 (Population in Year X)(Population Growth
consumptions, there is a surplus of utility on
Factor)(Per Capita Use)[1+(Income
each of the earlier units
Growth)(Income Elasticity)]
 Extra value that consumers receive above
what they pay for a commodity
 Helps determine whether or not to construct a
Market Demand Curve
public good
 Obtained by summing up quantities o If the consumer surplus is greater than
demanded, at each price, by all consumers the cost of the good, a public good
horizontally should be built

Substitutes Indifference Curve

 If an increase in the price of good A will  Points on the curve represent consumption
increase the demand for substitute good B bundles among which the consumer is
indifferent
  All points in this curve are equally desirable
 Bowl-Shape Curve
o The scarcer a good, the greater its
relative substitution value.
o The scarce good’s marginal utility rises
relative to the marginal utility of the
other good that has become plentiful
Effects of Changes in Income and Prices
 Its slope is the measure of the goods’ relative
marginal utilities
 Shape and slope will vary from one consumer
to the next
 Slope Formula:
𝑀𝑈𝑋
𝑀𝑈𝑌
Substitution Rations / Marginal Rates of Substitution
 Slope of the resulting tangent lines from points
in the indifference / utility curve
 As the size of the movement along the curve
becomes very small, the closer the substitution
ratio comes to the actual slope of the
indifference curve
o Which is equal to the Equimarginal
Principle
𝑀𝑈𝑋 𝑀𝑈𝑌
=
𝑃𝑋 𝑃𝑌
 Income Increase
o Budget Constraint Shift Right
 Income Decrease
o Budget Constraint Shift Left
 Price Increase of Product X
o Tilt Inwards from the Bottom
 Price Decrease of Product X
o Tilt Outwards from the Bottom
 Price Increase of Product Y
o Tilt Inwards from the Top
 Price Decrease of Product Y
o Tilt Outwards from the Top

Indifference Map

 Contour of varying indifference curves

 As we increase both goods and move, we can
reach higher and higher levels of satisfaction

Budget Line / Constraint

 Sums up all the possible combinations of the

goods that would just exhaust the consumers’
income
 Slope Formula:
𝑃𝑋
𝑃𝑌

Equilibrium Position of Tangency

 Highest indifference curve attainable with

fixed income shown by the budget line
 Substitution Ratio = Price Ratio
 All goods’ marginal utilities are proportional
to their prices, with the marginal utility of the
last dollar spent on every good being
equalized
Consumer Equilibrium

 Attained at the point where the budget line is

tangent to the highest indifference curve
 Consumer’s Substitution Ratio = Slope of the
Budget Line
𝑀𝑈𝑋 𝑃𝑋
=
𝑀𝑈𝑌 𝑃𝑌