Eco 101: Chapter 1 notes
Definition of economics
 The study of how individuals and societies use limited
resources to satisfy unlimited wants.
Fundamental economic problem
 Scarcity - refers to the basic economic problem, the
gap between limited – that is,scarce – resources and
theoretically limitless wants. This situation requires
people to make decisions about how to allocate
resources efficiently, in order to satisfy basic needs
and as many additional wants as possible.
 Individuals and societies must choose among
available alternatives.
Economic goods, free goods, and economic bads
 Economic good (scarce good) - the quantity
demanded exceeds the quantity supplied at a zero
price.
 Free good - the quantity supplied exceeds the
quantity demanded at a zero price.
 economic bad - people are willing to pay to avoid the
item
Economic resources
 land
o natural resources, the “free gifts of nature”
 labor
o the contribution of human beings
 capital
o plant and equipment
o this differs from “financial capital”
 entrepreneurial ability
o It is seen as vital to promoting innovation,
competitiveness and economic growth.
Fostering entrepreneurial spirit supports the
creation of new firms and business growth.
Resource payments
Rational self-interest
 Individuals select the choices that make them
happiest, given the information available at the time of
a decision.
 self-interest vs. selfishness
Positive and normative analysis
 Positive economics
o Attempt to describe how the economy
functions
o relies on testable hypotheses
 Normative economics
o Relies on value judgments to evaluate or
recommend alternative policies.
Economic methodology
 Scientific method
o observe a phenomenon,
o make simplifying assumptions and formulate
a hypothesis,
o generate predictions, and
o Test the hypothesis.
Simplifying assumptions
 ceteris paribus – holding everything else constant
 abstraction in economics
o used to simplify reality
Logical fallacies
 fallacy of composition
o Occurs when it is incorrectly assumed that
what is true for each and every individual in
isolation is true for an entire group.
 post hoc, ergo propter hoc fallacy (association as
causation)
o Occurs when one incorrectly assumes that
one event is the cause of another because it
precedes the other.
Microeconomics vs. macroeconomics
 microeconomics - the study of individual economic
agents and individual markets
 macroeconomics - the study of economic aggregates
Algebra and graphical analysis
Chapter 2: Opportunity costs Marginal benefit

Scarcity  MB generally declines as the level of an activity rises,

ceteris paribus.
 Economics is the study of how individuals and  Consider the MB of time spent studying:
economies deal with the fundamental problem of
scarcity.
 As a result of scarcity, individuals and societies must
make choices among competing alternatives.

Opportunity Cost

 The opportunity cost of any alternative is defined as

the cost of not selecting the "next-best" alternative.
 Example: Suppose that you own a building that is
worth $100,000 today and is expected to be worth
$100,000 one year from today. If the interest rate is Marginal cost
10%, what is the opportunity cost of using this
 For most activities, marginal cost rises as the level of
building for one year?
the activity increases.
Example II

 The opportunity cost of college attendance includes:

o the cost of tuition, books, and supplies,
o foregone income (this is usually the largest
cost associated with college attendance),
and
o Psychic costs.
 What about room and board?

Example III:

 Opportunity cost of attending a movie: Optimal study time

 opportunity cost of tickets
 opportunity cost of time  The optimal amount of study time occurs at the point
at which MB = MC
Marginal analysis

 Marginal benefit = additional benefit resulting from a

one-unit increase in the level of an activity
 Marginal cost = additional cost associated with one-
unit increase in the level of an activity

Net benefit

 Individuals are not expected to maximize benefit; nor

are they expected to minimize costs.
 Individuals are assumed to attempt to maximize the
level of net benefit (total benefit minus total cost) from
Production possibilities curve
any activity in which they are engaged.
 Assumptions:
Marginal analysis o A fixed quantity and quality of available
 MB > MC  expand the activity resources
 MB < MC  contract the activity o A fixed level of technology
 optimal level of activity: MB = MC (Net benefit is o Efficient production (i.e., no unemployment
maximized at this point) and no underemployment)
Example: study time

 4 hours left to study for two exams: economics and

calculus
 Output = grades on each exam
  Fixed resources?
 Fixed technology?
 No unemployed nor underemployed resources? Law of increasing cost
Alternative uses of time
 Law of increasing cost – marginal opportunity
cost rises as the level of an activity increases

Law of diminishing returns

 Law of diminishing returns: output will ultimately
increase by progressively smaller amounts when
the use of a variable input increases while other
inputs are held constant.
 Does this apply in this example? What are the
fixed inputs?
Reasons for law of increasing cost

 Law of diminishing returns

 Specialized resources (heterogeneous labor,
land, capital, etc.)

Specialized resources in farming

 Some land, labor, and capital is better suited for

wheat production and some is better suited for
corn production
Marginal opportunity cost

 Marginal opportunity cost = the amount of

another good that must be given up to produce
one more unit of a good.

Calculating marginal opportunity cost

 In the interval between points A and B, the .
marginal opportunity cost of 1 point on the
economics exam is 1/3 of a point on the calculus
exam.

 In the interval between points B and C, the

marginal opportunity cost of one point on the
economics exam equals 4/3 of a point on the
calculus exam.

Specialization and trade
o Adam Smith – economic growth is caused by
increased specialization and division of labor
Gains from specialization and division of labor
o specialization in areas that match the skills and
talents of workers
o “learning by doing” – increase in productivity from
task repetition
o less time lost while switching from task to task
Specialization and trade
o As noted by Adam Smith, specialization and
trade are inextricably linked.
o Adam Smith and David Ricardo used this
argument to support free trade among nations.
Absolute and comparative advantage
o Absolute advantage – an individual (or country) is
more productive than other individuals (or
countries).
o Comparative advantage – an individual (or
country) may produce a good at a lower
opportunity cost than can other individuals (or
countries).
Example: U.S. and Japan
o Suppose the U.S. and Japan produce only two
goods: CD players and wheat.
Absolute advantage?
 Who has an absolute advantage in producing
each good?
Comparative advantage?
 Who has a comparative advantage in producing
each good?
Gains from trade
 Opportunity cost of CD player in U.S. = 2 units of
wheat
 Opportunity cost of CD player in Japan = 4/3 unit
of wheat
 If Japan produces and trades each CD player to
the U.S. for more than 4/3 of a unit of wheat but
less than 2 units of wheat, both the U.S. and
Japan gain from trade and can consume more
goods than they could produce by themselves.
 Note that the U.S. has a comparative advantage
in producing wheat.
 Countries always expand their consumption
possibilities by engaging in trade (since they
acquire goods at a lower opportunity cost than if
they produced them themselves).
Free trade?
 If each country specializes in the production of
those goods in which it possesses a comparative
advantage and trades with other countries, global
output and consumption in increased.
Chapter 3: Demand and Supply Law of demand

Barter vs. monetary economy
 Barter – goods are traded directly for other goods
 Problems:
o requires double coincidence of wants
o large number of trading ratios: N(N-1)/2
(high information costs)
 Monetary economy has lower transaction and
information costs
 An inverse relationship exists between the price
of a good and the quantity demanded in a given
time period, ceteris paribus.
o Reasons:
o substitution effect
o income effect
Change in quantity demanded vs. change in demand

Relative and nominal prices

 Relative price = price of a good in terms of

another good
 Nominal price = price expressed in terms of the
monetary unit
 Relative price is a more direct measure of
opportunity cost

Markets

 In a market economy, the price of a good is Market demand curve

determined by the interaction of demand and
supply  Market demand is the horizontal summation of
individual consumer demand curves
Demand

 A relationship between price and quantity

demanded in a given time period, ceteris paribus.

Demand schedule

Determinants of demand

 tastes and preferences

 prices of related goods and services
 income
 number of consumers
 expectations of future prices and income

Demand curve Tastes and preferences

 Effect of fads:

Prices of related goods

 Substitute goods – an increase in the price of

one result in an increase in the demand for the
other.
  Complementary goods – an increase in the price
of one results in a decrease in the demand for
the other.
Change in the price of a substitute good
 Price of coffee rises:
Change in the price of a complementary good
 Price of DVDs rises:
Income and demand: normal goods
 A good is a normal good if an increase in income
results in an increase in the demand for the
good.
Income and demand: inferior goods
 A good is an inferior good if an increase in
income results in a reduction in the demand for
the good.
Demand and the # of buyers
 An increase in the number of buyers results in an
increase in demand.
Expectations
 A higher expected future price will increase
current demand.
 A lower expected future price will decrease
current demand.
 A higher expected future income will increase the
demand for all normal goods.
 A lower expected future income will reduce the
demand for all normal goods.
International effects
 Exchange rate – the rate at which one currency
is exchanged for another.
 Currency appreciation – an increase in the value
of a currency relative to other currencies.
 Currency depreciation – a decrease in the value
of a currency relative to other currencies.
 Domestic currency appreciation causes
domestically produced goods and services to
become more expensive in foreign countries.
 An increase in the exchange value of the U.S.
dollar results in a reduction in the demand for
U.S. goods and services.
 The demand for U.S. goods and services will rise
if the U.S. dollar depreciates.
Supply
 the relationship that exists between the price of a
good and the quantity supplied in a given time
period, ceteris paribus.
Supply schedule
Law of supply
 A direct relationship exists between the price of a
good and the quantity supplied in a given time
period, ceteris paribus.
Reason for law of supply
 The law of supply is the result of the law of
increasing cost.
o As the quantity of a good produced rises,
the marginal opportunity cost rises.
o Sellers will only produce and sell an
additional unit of a good if the price rise
above the marginal opportunity cost of
producing the additional unit.
Expectations and supply
Change in supply vs. change in quantity supplied
Prices of other goods
Individual firm and market supply curves
 The market supply curve is the horizontal
summation of the supply curves of individual
firms. (This is equivalent to the relationship
between individual and market demand curves.)
Determinants of supply
International effects
 the price of resources,
 technology and productivity,
 the expectations of producers,
 the number of producers, and
 the prices of related goods and services
 note that this involves a relationship in
production, not in consumption
Price of resources
 As the price of a resource rises, profitability
declines, leading to a reduction in the quantity
supplied at any price.
Technological improvements
 Technological improvements (and any changes
that raise the productivity of labor) lower
production costs and increase profitability.
 An increase in the expected future price of a
good or service results in a reduction in current
supply.
 Firms produce and sell more than one
commodity.
 Firms respond to the relative profitability of the
different items that they sell.
 The supply decision for a particular good is
affected not only by the good’s own price but also
by the prices of other goods and services the firm
may produce.
 Firms import raw materials (and often the final
product) from foreign countries. The cost of these
imports varies with the exchange rate.
 When the exchange value of a dollar rises, the
domestic price of imported inputs will fall and the
domestic supply of the final commodity will
increase.
 A decline in the exchange value of the dollar
raises the price of imported inputs and reduces
the supply of domestic products that rely on
these inputs.
Market equilibrium Supply rises

Supply falls

Price above equilibrium

 If the price exceeds the equilibrium price, a

surplus occurs:

Price ceiling

 Price ceiling - legally mandated maximum price

 Purpose: keep price below the market equilibrium
price
 Examples:
 rent controls
Price below equilibrium  price controls during wartime
 gas price rationing in 1970s
 If the price is below the equilibrium a shortage
occurs:

Demand rises

Price floor

 price floor - legally mandated minimum price

 designed to maintain a price above the
equilibrium level
 examples:
 agricultural price supports
 minimum wage laws

Demand falls