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Some Economics Concepts
Definition of economics

the study of how individuals and
societies use limited resources to satisfy
unlimited wants.
Fundamental economic problem
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scarcity.
Economics is the study of how
individuals and economies deal with the
fundamental problem of scarcity.
As a result of scarcity, individuals and
societies must make choices among
competing alternatives.
Opportunity Cost
•Economics is all about trade offs
•Because of scarcity our choices require that in
order to get something we must give something
up
•What you give up to get something else is your
opportunity cost.
Rational self-interest
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When an individual makes a choice they
go through a cost-benefit evaluation
This is the idea that an individual
compares the opportunity costs to the
benefits and chooses the option which
benefits them most (rationality)
Positive and normative analysis
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positive economics
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attempt to describe how the economy
functions
relies on testable hypotheses
normative economics
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relies on value judgements to evaluate or
recommend alternative policies.
Economic methodology
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scientific method
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observe a phenomenon,
make simplifying assumptions and
formulate a hypothesis,
generate predictions, and
test the hypothesis.
Efficiency
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Economists strive to achieve 100%
efficiency known as Parato Efficiency
In Parato Efficiency society is 100 $
efficient and there is no way to improve
on persons well being without reducing
another ones.
Microeconomics
Microeconomics vs. macroeconomics
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microeconomics - the study of individual
economic decisions and choices and
how they effect individual markets
Macroeconomics - brings all the
individual markets together and
observes the behavior of the entire
market
Algebra and graphical analysis

direct relationship
Direct relationship
Inverse relationship
Linear relationships

A linear relationship possesses a
constant slope, defined as:
Demand and Supply
Markets
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In a market economy, the price of a
good is determined by the interaction of
demand and supply
A market for a good is comprised of all
the buyers and sellers of that particular
good
Demand
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A relationship between price and
quantity demanded in a given time
period
The quantity demanded is the amount
of good buyers are willing to purchase
at a set price
Demand schedule
Demand curve
Law of demand
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An inverse relationship exists between
the price of a good and the quantity
demanded in a given time period,
Reasons:
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Related goods
Income
Tastes
Expectations
Number of buyers
Income
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If someone's income is lowered they
will be less willing to spend money on
goods and vice versa
Normal goods
Inferior goods
Income and demand: normal goods
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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
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A good is an inferior good if an increase in
income results in a reduction in the demand
for the good.
Price of Related Goods
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Substitutes – a good which causes a
decline in the demand of another good
if its price declines
Complement – a good which causes
an increase in the demand of another
good if its price declines
Change in the price of a
substitute good
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Price of coffee rises:
Change in the price of a
complementary good
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Price of DVDs rises:
Tastes
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The idea that if an buyers perception of
benefits from buying a good changes so
will the buyers willingness to purchase
the good
Expectations
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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.
Number of Buyers
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The market demand curve consists of
all the individual demand curves put
together
So if there are more consumers in the
market the market demand will increase
Change in quantity demanded
vs. change in demand
Change in quantity demanded
Change in demand
Market demand curve
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Market demand is the horizontal summation
of individual consumer demand curves
Supply
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the relationship that exists between the price
of a good and the quantity supplied in a given
time period
Quantity supplied is the amount that a seller
is able to produce for a set price
Supply schedule
Demand curve
Law of supply
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A direct relationship exists between the
price of a good and the quantity
supplied in a given time period
Reason for law of supply
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The law of supply is the
result of the law of
increasing cost.
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As the quantity of a good
produced rises, the marginal
opportunity cost rises.
Sellers will only produce and sell
an additional unit of a good if
the price rises above the
marginal opportunity cost of
producing the additional unit.
Change in supply vs. change
in quantity supplied
Change in supply
Change in quantity supplied
Individual firm and market
supply curves
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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
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Price received by supplier
Input price
technology
the expectations of producers
the number of producers
Relative Goods
Price Received by Supplier
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This is the law of supply
The more money the supplier receives
for the good he’s selling the more
willing he/she will be to sell it
Price of resources (Input
Price)
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Inputs are the goods
the supplier has to
purchase in order to
produce the supply
As the price of a
resource rises,
profitability declines,
leading to a
reduction in the
quantity supplied at
any price.
Technological improvements
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Technological improvements (and any
changes that raise the productivity of labor)
lower production costs and increase
profitability.
Expectations and supply
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An increase in the expected future price
of a good or service results in a
reduction in current supply.
The supplier will hold off on selling his
goods if he can sell them for a greater
profit later.
Increase in the Number of
Sellers
Prices of other goods
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More than one firm produces and sells the
same good or a relative good
Because of this firms compete with each
other to sell more goods and in order to do
so they have to lower their prices below that
of their competition
Without this effect all markets would be
monopolistic and we would all be screwed
Equilibrium…the fun never
stops
Market equilibrium
Price above equilibrium
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If the price exceeds the equilibrium price, a
surplus occurs:
Price below equilibrium
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If the price is below the equilibrium a
shortage occurs:
Consumer and Producer
Surplus
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Consumer surplus – the utility (or level of
satisfaction) a buyer receives by being able
to purchase a product for a price less then
the maximum they were willing to pay
Producer surplus – the amount that
producers benefit by selling at a market
price which is greater than the minimum
they would be willing to sell for
Consumer/Producer Surplus
Visualized
Consumer surplus
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Individuals buy an item only if they
receive a net gain from the purchase
(i.e., total benefit exceeds opportunity
cost.)
This net gain is called “consumer
surplus.”
Example
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Suppose that an individual buys 10 units of a
good when the price is $5
Benefits and cost of first unit
• Benefit = blue + green rectangles (=$9)
• Cost = green rectangle (=$5)
• Consumer surplus = blue rectangle (=$4)
Total benefit to consumer
Total cost to consumer
Consumer surplus
Demand rises
Demand falls
Supply rises
Supply falls
Price ceiling
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Price ceiling - legally mandated
maximum price
Purpose: keep price below the market
equilibrium price
Price ceiling (continued)
Price floor
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price floor - legally mandated minimum
price
designed to maintain a price above the
equilibrium level
Price floor (continued)
Elasticity
Elasticity
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A measure of the responsiveness of one
variable (quantity demanded or
supplied) to a change in another
variable (price)
Most commonly used elasticity: price
elasticity of demand, defined as:
Price elasticity of demand =
Price elasticity of demand
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Demand is said to be:
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elastic when Ed > 1,
unit elastic when Ed = 1, and
inelastic when Ed < 1.
Perfectly elastic demand
Perfectly inelastic demand
Elasticity & slope
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a price increase from $1 to $2 represents a 100%
increase in price,
a price increase from $2 to $3 represents a 50%
increase in price,
a price increase from $3 to $4 represents a 33%
increase in price, and
a price increase from $10 to $11 represents a 10%
increase in price.
Notice that, even though the price increases by $1 in
each case, the percentage change in price becomes
smaller when the starting value is larger.
Elasticity along a linear demand
curve
Elasticity along a linear
demand curve
Determinants of price
elasticity
Price elasticity is relatively high when:
 close substitutes are available
 the good or service is a large share of
the consumer's budget (necessities)
 a longer time period is considered (time
horizon)
Price elasticity of supply
Perfectly inelastic supply
Perfectly elastic supply
Determinants of supply
elasticity
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Ease of Entry and Exit
Scarce Resources
Time Horizon
Elasticity and total revenue
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Total revenue = price x quantity
What happens to total revenue if the
price rises?
Price elasticity of demand =
Elasticity and TR (cont.)
Price elasticity of demand =
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A reduction in price will lead to:
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an increase in TR when demand is elastic.
a decrease in TR when demand is inelastic.
an unchanged level of total revenue when
demand is unit elastic.
Elasticity and TR (cont.)
Price elasticity of demand =
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In a similar manner, an increase in price will
lead to:
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a decrease in TR when demand is elastic.
an increase in TR when demand is inelastic.
an unchanged level of total revenue when demand
is unit elastic.
…...Let’s Stick to the Nonconfusing Example
Everyone's Favorite…Taxes!!!!
Tax incidence
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distribution of the burden of a tax
depends on the elasticities of demand
and supply.
When supply is more elastic than
demand, consumers bear a larger share
of the tax burden.
Producers bear a larger share of the
burden of a tax when demand is more
elastic than supply.
Costs and production
Production possibilities curve
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Assumptions:
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A fixed quantity and quality of available
resources
A fixed level of technology
Specialization and trade
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Adam Smith – economic growth is
caused by increased specialization and
division of labor.
Specialization and trade
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As noted by Adam Smith, specialization
and trade are inextricably linked.
Adam Smith used this argument to
support free trade among nations.
Absolute and comparative
advantage
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Absolute advantage – an individual (or
country) is more productive than other
individuals (or countries).
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
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Suppose the U.S. and Japan produce
only two goods: CD players and wheat.
Absolute advantage?
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Who has an absolute advantage in
producing each good?
Comparative advantage?
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Who has a comparative advantage in
producing each good?
Gains from trade
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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.
Gains from trade (continued)
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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?
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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 is increased.
Robinson and Crusoe? Really
USAD……Really?
Profit Motive and Behavior of
Firms
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Profit = total revenue – total cost
(costs will likely only include only
monetary expenses)
Total cost is comprised of expenses plus
all monetary opportunity costs
Different Costs
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The costs that do not depend on
production and can’t change in the
short run are called fixed costs
However costs that can be varied in the
short run are called variable costs
Marginal Cost
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Notice in figure 23 that when you go
down 1 row there are 50 more loaves of
bread produced; however, there is an
additional cost for producing more
goods
This increase in cost when producing an
additional unit of output is called the
marginal cost
How to find marginal cost
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(increase in total cost)
MC = ------------------------------------(increase in quantity produced)
Law of Diminishing Returns
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Next notice that the maximum profit is
made when marginal cost is equal to
marginal revenue
Think of the marginal cost as the
opportunity cost for making an extra
unit of good and the marginal revenue
as the profit for making that extra unit
Law of Diminishing Returns
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as the level of a variable input rises in a
production process in which other
inputs are fixed, output ultimately
increases by progressively smaller
increments
So this means that at some point it’s no
longer productive to make that extra
unit of good
Imperfect Markets
Monopolies
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A monopoly is an extreme case in
which there is a market with only one
producer
Ownership Monopolies
Government-Created Monopolies
Natural Monopolies
Why Monopolies Are Bad?
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Because the supplier can charge
whatever amount he/she wants for the
product and there is no competition to
force the supplier to lower the prices on
goods
Price discrimination
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different customers are charged
different prices for the same product,
due to differences in price elasticity of
demand
higher prices for those customers who
have the most inelastic demand
lower prices for those customers who
have a more elastic demand.
Price discrimination (cont.)
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customers who are willing to pay the
highest prices are charged a high price,
and
customers who are more sensitive to
price differentials are charged a low
price.
Next up…Oligopolies
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An oligopoly is a market with very few
suppliers
Not quite as bad as a monopoly but still
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Example: OPEC (Organization of
Petroleum Exporting Countries)
Creative Destruction
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A term coined by the Australian
economist Joseph Schumpeter
“creative destruction” states that as
new industries surged, older industries
grow more slowly, stagnate, and shrink
Market failures
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Not all markets are perfect and
sometimes a market failure will occur
when externalities or breakdowns in the
system of private property cause
markets to deviate from the socially
efficient outcome
Oh the Government
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Pork Barrel Politics – elected officials
introduce projects that steer money into
their of pockets
Logrolling – vote trading within
legislation