Lecture 1: September 5, 2012
What is Economics?
All economic questions arise because we want more than we can get.
Our inability to satisfy all our wants is called scarcity.
Because we face scarcity, we must make choices.
The choices we make depend on the incentives we face.
An incentive is a reward that encourages an action or a penalty that discourages an action.
Economics is the social science that studies the choices that individuals, businesses,
governments and entire societies make as they cope with scarcity and the incentives that influence
and reconcile those choices.
Economics divides in to main parts:
Microeconomics: is the study of choices that individuals and businesses make, the way those
choices interact in markets, and the influence of governments.
* An example of a microeconomic question is: Why are people buying more e-books and fewer hard
Macroeconomics: is the study of the performance of the national and global economies.
*An example of a macroeconomic question is: Why is the unemployment in Canada so high?
Two Big questions summarize the scope of economics:
1. How do choices end up determining what, how, and for whom goods and services get produced?
2. When do choices made in the pursuit of self-interest also promote the social interest?
What, How, and For Whom?
Goods and services are the objects that people value and produce to satisfy human wants.
In Canada, agriculture accounts for 2 percent of total production, manufactured goods for 20 percent,
and services (retail and wholesale trade, health care, and education are the biggest one) 78 percent.
In China, agriculture accounts for 11 percent of total production, manufactured goods for 49 percent
and services for 40 percent.
Goods and services are produced by using productive resources that economists call factors of
Factors of production are grouped into four categories:
Capital (including Human Capital)
Who gets the goods and services depends on the incomes that people earn.
Land earns rent Labour earns wages
Capital earns interest
Entrepreneurship earns profit
Lecture 2: September 12, 2012
Two Big Economic Questions
Can the Pursuit of Self-Interest Promote the Social Interest?
Every day, 33 million Canadians and 7 billion people in other countries make economic
choices that result in What, How, and For Whom goods and services are produced.
Do we produce the right things in the right quantities? Do we use our factors of production
in the best way?
Do the goods and services go to those who benefit most from them?
You make choices that are in your self-interest – choices that you think are best for you.
Choices that are best for society as a whole are said to be in the social interest.
It has two dimensions:
Efficiency is achieved when the available resources are used to produce goods and serviced:
1. At the lowest possible price and
2. In quantities that give the greatest possible benefit.
Equity is fairness, but economists have a variety of views about what is fair.
The Big Question
Can choices made in self-interest promote the social interest?
Four topics that generate discussion and that illustrate tension between self-interest and social
The information-age economy
Globalization means the expansion of international trade, borrowing and lending, and
Globalization is in the self-interest of consumers who buy low-cost imported goods and
services and in the self-interest of the multinational firms that produce in low-cost regions
and sell in high-price regions.
But is globalization in the self-interest of low-wage workers in other countries and Canadian
firms that can’t compete with low-cost imports?
Is globalization in the social interest?
The Information Age-Economy
The technological change of the past forty years has been called the Information Revolution.
The information revolution has clearly served your self- interest: It has provided your cell
phone, laptop, loads of handy applications, and the Internet. It has also served the self-interest of Bill Gates of Microsoft and Gordon Moore of Intel, both
of whom have seen their wealth soar.
But did the information revolution serve the social interest?
Every day, when you make self-interested choices to use electricity and gasoline, you
contribute to carbon emissions.
You leave your carbon footprint.
You can lessen your carbon footprint by walking, riding a bike, taking a cold shower, or
planting a tree.
But can each one of us be relied upon to make decisions that affect the Earth’s carbon-
dioxide concentration in the social interest?
Between 1993 and 2007, the Canadian and global economies expanded strongly. Incomes in
Canada increased by 30 percent and incomes in China tripled.
But in August 2007, a period of financial stress began that soon gripped the entire global
The choices of U.S. banks to borrow and lend and the choices of people and business to lend
to and borrow from U.S. banks are made in self-interest.
Does this lending and borrowing serve the social interest?
The Economic Way of Thinking
A choice is a tradeoff.
People make rational choices by comparing benefits and costs.
Benefit is what you gain from something.
Cost is what you must give up to get something.
Most choices are “how-much” choices made at the margin.
Choices respond to incentives.
A Choice Is a Tradeoff
The economic way of thinking places scarcity and its implication, choice, at center stage.
You can think about every choice as a tradeoff—an exchange—giving up one thing to get
On Saturday night, will you study or have fun?
You can’t study or have fun at the same time, so you must make a choice.
Whatever you choose, you could have chosen something else. Your choice is a tradeoff.
Making a Rational Choice
A rational choice is one that compares costs and benefits and achieves the greatest benefit
over cost for the person making the choice.
Only the wants of the person making a choice are relevant to determine its rationality.
The idea of rational choice provides an answer to the first question: What goods and services
will be produced and in what quantities?
The answer is: Those that people rationally choose to buy!
How do people choose rationally?
The answers turn on benefits and costs. Benefit: What you Gain
The benefit of something is the gain or pleasure that it brings and is determined by
Preferences are what a person likes and dislikes and the intensity of those feelings
Cost: What you Must Give Up
The opportunity cost of something is the highest-valued alternative that must be given up to get it.
What is your opportunity cost of going to an AC/DC concert?
Opportunity cost has two components:
1. The things you can’t afford to buy if you purchase the AC/DC ticket.
2. The things you can’t do with your time if you go to the concert.
How Much? Choosing at the Margin
You can allocate the next hour between studying and text messaging your friends.
The choice is not all or nothing, but you must decide how many minutes to allocate to each
To make this decision, you compare the benefit of a little bit more study time with its cost—
you make your choice at the margin.
To make a choice at the margin, you evaluate the consequences of making incremental
changes in the use of your time.
The benefit from pursuing an incremental increase in an activity is its marginal benefit.
The opportunity cost of pursuing an incremental increase in an activity is its marginal cost.
If the marginal benefit from an incremental increase in an activity exceeds its marginal cost,
your rational choice is to do more of that activity
Choices Respond to Incentives
A change in marginal cost or a change in marginal benefit changes the incentives that we face
and leads us to change our choice.
The central idea of economics is that we can predict how choices will change by looking at
changes in incentives.
Incentives are also the key to reconciling self-interest and the social interest.
Economics: A Social Science and Policy Tool
Economist as Social Scientist
Economists distinguish between two types of statement:
What is—positive statements
What ought to be—normative statements
A positive statement can be tested by checking it against facts.
A normative statement expresses an opinion and cannot be tested.
Unscrambling Cause and Effect
The task of economic science is to discover positive statements that are consistent with what
we observe in the world and that enable us to understand how the economic world works.
Economists create and test economic models.
An economic model is a description of some aspect of the economic world that includes
only those features that are needed for the purpose at hand.
A model is tested by comparing its predictions with the facts.
But testing an economic model is difficult, so economists also use
Economic experiments Economist as Policy Adviser
Economics is a toolkit for advising governments and businesses and for making personal
All the policy questions on which economists provide advice involve a blend of the positive
and the normative.
Economics can’t help with the normative part—the goal.
But for a given goal, economics provides a method of evaluating alternative solutions—
comparing marginal benefits and marginal costs.
Lecture 3: September 19, 2012
The Economic Problem
Production Possibilities and Opportunity
The production possibilities frontier (PPF) is the boundary between those combinations of goods and
services that can be produced and those that cannot.
We achieve production efficiency if we cannot produce more of one good without producing
less of some other good.
Points on the frontier are efficient.
Tradeoff Along the PPF
Every choice along the PPF involved a tradeoff.
Increasing Opportunity Cost
Because resources are not equally productive in all activities the PPF bows outward
Using Resources Efficiently
To determine which of the alternative efficient quantities to produce, we compare costs and
The PPF and Marginal Cost
The PPF determines opportunity cost.
The marginal cost of a good or service is the opportunity cost of producing one more unit of
Preferences and Marginal Benefit
Preferences are a description of a person’s likes and dislikes.
To describe preferences, economists use the concepts of marginal benefit and marginal
The marginal benefit of good or service is the benefit of a good or service is the benefit
received from consuming one more unit of it.
We measure marginal benefit by the amount that a person is willing to pay for an additional
unit of a good or service.
It is a general principle that:
The more we have of any good, the smaller is its marginal benefit and the less we are willing
to pay for an additional unit of it.
We call this general principle the principle of decreasing marginal benefit Allocative Efficiency
The point of allocative efficiency is the point on the PPF at which marginal benefit equals
This point is determined by the quantity at which the marginal benefit curve intersects the
marginal cost curve.
The expansion of production possibilities and increase in the standard of living is called economic
Two Key factors influence economic growth:
Technological change - the development of new goods and of better ways of producing goods
Capital accumulation - he growth of capital resources, which includes human capital.
The Cost of Economic Growth
To use resources in research and development and to produce new capital, we must
decrease our production of consumption goods and services.
So economic growth is not free.
The opportunity cost of economic growth is less current consumption.
Gains From Trade
A person has an absolute advantage if that person is more productive than others.
Absolute advantages involve comparing productivities while comparative advantage
involves comparing opportunity costs.
Who can do it better, quicker, cheaper?
A person has a comparative advantage in an activity if that person can perform the activity at
a lower opportunity cost than anyone else.
Who has the lowest opportunity cost?
Graphical Proof of Gains from Trade Optional
To reap the gains from trade, the choices of individuals must be coordinated.
To make coordination work, four complimentary social institutions have evolved over the
o Property rights
A firm is an economic unit that hired factors of production and organizations those factors
to produce and sell goods and services.
A market is any arrangement that enables buyers and sellers to get information and do
business with each other. Property Rights are the social arrangements that govern ownership, use, and disposal of
resources, goods or services.
Money is any commodity or token that is generally acceptable as a means of payment.
Circular Flows Through Markets
Factors of production, goods and services flow in one directions
Money flows in the opposite direction.
Markets coordinate individual decisions through price adjustments.
Lecture 4: September 26, 2012
Supply and Demand
Market and Price
A market is any arrangement that enables buyers and sellers to get information and do
business with each other.
A competitive market is a market that has many buyers and many sellers so no single
buyer or seller can influence the price.
The money price of a good is the amount of needed to buy it.
The relative price of a good – the ratio is its money price to the money price of the next best
alternative good0 is its opportunity cost.
When you demand something you want it, can afford and have made a definite plan to buy it.
Wants are the unlimited desires or wishes people have for goods and services. Demand
reflects a decision about which wants to satisfy.
The quantity demanded of a good or service is the amount that consumers plan to buy
during a particular time period, and at a particular price.
The Law of Demand states:
Other things remaining the same, the higher the price of a good, the smaller is quantity
demanded; and the lower the price of a good, the larger is the quantity demanded.
The law of demand results from:
o Substitution effect: When the relative price (opportunity cost) of a good or service
rises, people seek substitutes for it, so the quantity demanded of the good or service
o Income effect: When the price of a good or service rises relative to income, people
cannot afford all the things they previously bought, so the quantity demanded of the
good or service decreases.
Demand Curve and Demand Schedule
The term demand refers to the entire relationship between the price of the good and
quantity demanded of the good.
A demand curve shows the relationship between the quantity demanded of a good and its
price when all other influences on consumers’ planned purchases remain the same. A rise in the price, other things remaining the same, brings a decrease in the quantity
demanded and a movement up along the demand curve.
A fall in the price, other things remaining the same, brings an increase in the quantity
demanded and a movement down along the demand curve.
Willingness and Ability to Pay
A demand curve is also a willingness-and-ability-to- pay curve.
The smaller the quantity available, the higher is the price that someone is willing to pay for
Willingness to pay measures marginal benefit.
A Change in Demand
When some influence on buying plans other than the price of the good changes, there I a
change in demand for that good.
That quantity of the good that people plan to buy changes at each and every price, so there is
a new demand curve.
When demand increases, the demand curve shifts rightward.
When demand decreases, the demand curve shifts leftward.
Six main factors that change demand are:
The prices of related goods
Expected future prices
Expected future income and credit
Prices of Related Goods
A substitute is a good that can be used in place of another good.
A complement is a good that is used in conjunction with another good.
When the price of substitute for an energy bar rises or when the price of a complement of an
energy bar falls, the demand for energy bars increases.
Expected Future Prices
If the expected future price of a good rises, current demand for the good increases and the
demand curve shifts rightward.
When income increases, consumers buy more of most goods and the demand curve shifts
A normal good is one for which demand increases as income increases.
An inferior good is a good for which demand decreases as income increases.
Expected Future Income and Credit
When expected future income increases or when credit is easy to obtain, the demand might
The larger the population, the greater is the demand for all goods.
People with the same income have different demands if they have different preferences. Movement Along the Demand Curve
When the price of the good changes and everything else remains the same, the quantity
demanded changes and there is a movement along the demand curve.
A Shift of the Demand Curve
If the price remains the same but one of the other influences on buyers’ plans changes,
demand changes and the demand curve shifts.
If a firm supplies a good or service, then the firm:
1. Has the resources and the technology to produce it,
2. Can profit from producing it, and
3. Has made a definite plan to produce and sell it.
Resources and technology determine what is is possible to produce. Supply reflects a
decision about which technologically feasible items to produce.
The quantity supplied of a good or service is the amount that producers plan to sell during
a given time period at a particular price.
The Law of Supply
Other things remaining the same, the higher the price of a good, the greater is the quantity
supplied; and the lower the price of a good, the smaller is the quantity supplied.
The law of supply results from the general tendency for the marginal cost of producing a
good or service to increase as the quantity produced increases (Chapter 2, pg. 33)
Producers are willing to supply a good only if they can at least cover their marginal cost of
Supply Curve and Supply Schedule
The term supply refers to the entire relationship between the quantity supplied and the
price of a good.
The supply curve shows the relationship between the quantity supplied of a good and its
price when all other influences on producers’ planned sales remain the same.
Minimum Supply Price
A supply curve is also a minimum-supply-price curve.
As the quantity produced increases, marginal cost increases.
The lowest price at which someone is willing to sell an additional unit rises.
This lowest price is marginal cost.
A Change in Supply
When some influence on selling plans other than the price of the good changes, there is a
change in supply of that good.
The quantity of the good that producers plan to sell changes at each and every price, so there
is a new supply curve.
When supply increases, the supply curve shifts rightward.
The five main factors that change supply of a good are
The prices of factors of production
The prices of related goods produced
Expected future prices
The number of suppliers Technology
State of nature
Prices of Factors of Production
If the price of a factor of production used to produce a good rises, the minimum price that a
supplier is willing to accept for producing each quantity of that good rises.
So a rise in the price of a factor of production decreases supply and shifts the supply curve
Expected Future Prices
If the expected future price of a good rises, the supply of the good today decreases and the
supply curve shifts leftward.
The Number of Suppliers
The larger the number of suppliers of a good, the greater is the supply of the good. An
increase in the number of suppliers shifts the supply curve rightward.
Advances in technology create new products and lower the cost of producing existing
So advances in technology increase supply and shift the supply curve rightward.
The State of Nature
The state of nature includes all the natural forces that influence production—for example,
A natural disaster decreases supply and shifts the supply curve leftward.
Movement Along the Supply Curve
When the price of the good changes and other influences on sellers’ plans remain the same,
the quantity supplied changes and there is a movement along the supply curve
A Shift of the Supply Curve
If the price remains the same but some other influence on sellers’ plans changes, supply
changes and the supply curve shifts
Equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market
occurs when the price balances the plans of buyers and sellers. A state of stability.
The equilibrium price is the price at which the quantity demanded equals the quantity
The equilibrium quantity is the quantity bought and sold at the equilibrium price.
Price regulates buying and selling plans.
Price adjusts when plans don’t match.
Appendix to Chapter 3
Algebra of Demand and Supply Lecture 5: October 3, 2012
Price Elasticity of Demand
The contrast between the two outcomes in Figure 4.1 highlights the need for:
o A measure of the responsiveness of the quantity demanded to a price change.
The price elasticity of demand is a units-free measure of the responsiveness of the quantity
demanded of a good to a change in its price when all other influences on buying plans
remain the same.
Calculating Price Elasticity of Demand
The price elasticity of demand is calculated by using the formula:
Percentage change in quantity demanded
Percentage change in price
To calculate the price elasticity of demand:
We express the change in price as percentage of the average price – the average of the initial
and new price, and we express the change in the quantity demanded as a average of the
initial and new quantity
A Units-Free Measure
Elasticity is a ratio of percentages, so a change in the units of measurement of price or
quantity leaves the elasticity value the same.
Minus Sign and Elasticity
The Formula yields a negative value, because price and quantity move in opposite directions.
But it is the magnitude, or absolute value, that reveals how responsive the quantity change
has been to a price change.
Inelastic and Elastic Demand
Demand can inelastic, unit elastic, or elastic, and can range from zero to infinity.
If the quantity demanded doesn’t change when the price changes, the price elasticity of
demand is zero and the good as perfectly inelastic demand.
If the percentage change in the quantity demanded equals the percentage change in price
The price elasticity of demand equals 1 and the good has unit elastic demand.
If the percentage change in the quantity demanded is smaller than the percentage change in price,
The price elasticity of demand is less than 1 and the good has inelastic demand.
If the percentage change in the quantity demanded is greater than the percentage change in price,
The price elasticity of demand is greater than 1 and the good has elastic demand.
If the percentage change in the quantity demanded is infinitely large when the price barely changes
The price elasticity of demand is infinite and the good has a perfectly elastic demand.
Total Revenue and Elasticity
The total revenue from the sale of good and service equals the price of the good multiplied
by the quantity sold.
When the price changes, total revenue also changes.
But a rise in price doesn’t always increase total revenue
The change in total revenue due to a change in price depends on the elasticity of demand:
If demand is elastic a 1 percent price cut increases the quantity sold by more than 1 percent,
and total revenue increases If demand is inelastic a 1 percent price cut increases the quantity sold by less than 1 percent
and total revenue decreases
If demand is unit elastic the price and quantity stay the same and total revenue stays the
The total revenue test is a method of estimating the price elasticity of demand by observing the
change in total revenue that results from a price change (when all other influences on the quantity
sold remain the same).
If a price cut increases total revenue, demand is elastic.
If a price cut decreases total revenue, demand is inelastic.
If a price cut leaves total revenue unchanged, demand is unit elastic.
Your Expenditure and Your Elasticity
If your demand is elastic, a 1 percent price cut increases the quantity you buy by more than 1
percent and your expenditure on the item increases.
If your demand is inelastic, a 1 percent price cut increases the quantity you buy by less than
1 percent and your expenditure on the item decreases.
If your demand is unit elastic, a 1 percent price cut increases the quantity you buy by 1
percent and your expenditure on the item does not change.
The Factors That Influence the Elasticity of Demand
The elasticity of demand for a good depends on:
The closeness of substitute
The proportion of income spent on the good
The time elapsed since a price change
Closeness of Substitutes
The closer the substitutes for a good or service, the more elastic are the demand for the good
Necessities, such as food or housing, generally have inelastic demand.
Luxuries, such as exotic vacations, generally have elastic demand.
Proportion of Income Spent on the Good
The greater the proportion of income consumers spend on a good, the larger is the elasticity
of demand for that good.
Time Elapsed Since Price Change
The more time consumers have to adjust to a price change, or the longer that a good can be
stored without losing its value, the more elastic is the demand for that good.
Cross Elasticity of Demand
The cross elasticity of demand is a measure of the responsiveness of demand for a good to a change
in the price of a substitute or a complement, other things remaining the same.
The Formula for calculating the cross elasticity is:
Percentage change in quantity demanded
Percentage change in price of substitute of complement
The cross elasticity for:
A substitute is positive.
A complement is negative. Income Elasticity of Demand
The income elasticity of demand measures how the quantity demanded of a good responds to a
change in income, other things remaining the same.
The Formula for calculating the income elasticity of demand is:
Percentage change in quantity demanded
Percentage change in income
If the income elasticity of demand is greater than 1, demand is income elastic and the good is
a normal good.
If the income elasticity of demand is greater than zero but less than 1, demand is income
inelastic and the good is a normal good.
If the income elasticity of demand is less than zero (negative) the good is an inferior good
Elasticity of Supply
The elasticity of supply measures the responsiveness of the quantity supplied to a change in the
price of a good when all other influences on selling plans remain the same.
Calculating the Elasticity of Supply
The elasticity of supply is calculated by using the formula:
Percentage change in quantity supplied
Percentage change in price
Supply is perfectly inelastic if the supply curve is vertical and the elasticity of supply is 0.
Supply is unit elastic if the supply curve is linear and passes through the origin. (Note that
slope is irrelevant.)
Supply is perfectly elastic if the supply curve is horizontal and the elasticity of supply is
The Factors That Influence the Elasticity of Supply
The elasticity of supply depends on :
Resource substitution possibilities
Time frame for supply decision
Resource Substitution Possibilities
The easier it is to substitute among the resources used to produce a good or service, the greater is its
elasticity of supply.
Time Frame for Supply Decision
The more time that passes after a price change, the greater is the elasticity of supply.
Momentary supply is perfectly inelastic. The quantity supplied immediately following a price
change is constant.
Short-run supply is somewhat elastic.
Long-run supply is the most elastic.
Efficiency and Equity
Resources Allocation Methods
Scarce resources might be allocated by:
Majority Rule Contest
First-come, first serve
When a market allocates a scarce resource, the people who get the resource are those who
are willing to pay the market price.
Most of the scarce resources that you supply get allocated by market price.
You sell your labour services in a market, and you buy most of what you consume in
For most goods and services, the market turns out to do a good job.
Command system allocates resources by the order (command) of someone in authority.
For example, if you have a job, most likely someone tells you what to do. Your labour time is
allocated to specific tasks by command.
A command system works well in organizations with clear lines of authority but badly in an
Majority rule allocates resources in the way the majority of voters choose.
Societies use majority rule for some of their biggest decisions.
For example, tax rates that allocate resources between private and public use and tax dollars
between competing uses such as defense and health care.
Majority rule works well when the decision affects lots of people and self-interest must be
suppressed to use resources efficiently.
A contest allocates resources to a winner (or group of winners).
The most obvious contests are sporting events.
Contest works well when the efforts of the “players” are hard to monitor and reward
A first-come, first-served allocates resources to those who are first in line.
Casual restaurants use first-come, first served to allocate tables. Supermarkets also uses
first-come, first- served at checkout.
First-come, first-served works best when scarce resources can serve just one person at a
time in a sequence.
Lotteries allocate resources to those with the winning number, draw the lucky cards, or
come up lucky on some other gaming system.
State lotteries and casinos reallocate millions of dollars worth of goods and services each
But lotteries are more widespread. For example, they are used to allocate landing slots at
Lotteries work well when there is no effective way to distinguish among potential users of a
scarce resource. Personal Characteristics
Personal characteristics allocate resources to those with the “right” characteristics.
For example, people choose marriage partners on the basis of personal characteristics.
But this method gets used in unacceptable ways: allocating the best jobs to white males and
discriminating against minorities and women.
Force plays a role in allocating resources.
For example, war has played an enormous role historically in allocating resources.
Theft, taking property of others without their consent, also plays a large role.
But force provides an effective way of allocating resources—for the state to transfer wealth
from the rich to the poor and establish the legal framework in which voluntary exchange can
take place in markets.
Benefit, Cost, and Surplus
Demand Willingness to Pay, and Value
Value is what we get, price is what we pay.
The value of one more unit of a good or service is its marginal benefit.
We measure value as the maximum price that a person is willing to pay.
But willingness to
pay determines demand.
A demand curve is a marginal benefit curve.
Individual Demand and Market Demand
The relationship between the price of a good and the quantity demanded by one person is
called individual demand.
The relationship between the price of a good and the quantity demanded by all buyers in the
market is called market demand.
Consumer surplus is the excess of the benefit received from a good over the amount paid for
We can calculate consumer surplus as the marginal benefit (or value) of a good minus its
price, summed over the quantity bought.
It is measured by the area under the demand curve and above the price paid, up to the
Supply and Marginal Cost
Firms are in business to make a profit.
To make a profit, firms must sell their output for a price that exceeds the cost of
Firms distinguish between cost and price.
Supply, Cost, and Minimum Supply-Price
Cost is what the producer gives up, price is what the producer receives.
The cost of one more unit of a good or service is its marginal cost.
Marginal cost is the minimum price that a firm is willing to accept.
But the minimum supply-price determines supply.
A supply curve is a marginal cost curve.
Individual Supply and Market Supply
The relationship between the price of a good and the quantity supplied by one producer is
called individual supply.
The relationship between the price of a good and the quantity supplied by all producers in
the market is called market supply. Producer Surplus
Producer surplus is the excess of the amount received from the sale of a good over the cost of
We calculate it as the price received for a good minus the minimum-supply price (marginal
cost), summed over the quantity sold.
On a graph, producer surplus is shown by the area below the market price and above the
supply curve, summed over the quantity sold.
Efficiency of Competitive Equilibrium
A competitive market creates an efficient allocation of resources at equilibrium.
In equilibrium, the quantity demanded equals the quantity supplied.
Is the Competitive Market Efficient?
When production is:
Less than the equilibrium quantity, MSB > MSC.
Greater than the equilibrium quantity, MSC > MSB.
Equal to the equilibrium quantity, MSC = MSB
Resources are used efficiently when marginal social benefit equals marginal social cost.
When the efficient quantity is produced, total surplus (the sum of consumer surplus and
producer surplus) is maximized.
The Invisible Hand
Adam Smith’s “invisible hand” idea in the Wealth of Nations implied that competitive
markets send resources to their highest valued use in society.
Consumers and producers pursue their own self-interest and interact in markets.
Market transactions generate an efficient—highest valued—use of resources.
Markets don’t always achieve an efficient outcome.
Market failure arises when a market delivers in inefficient outcome.
Market failure can occur because:
o Too little of an item is produced (underproduction) or
o Too much of an item is produced (overproduction).
A deadweight loss equals the decrease in total surplus—the grey triangle.
This loss is a social loss.
Sources of Market Failure
In competitive markets, underproduction or overproduction arise when there are
Price and quantity regulations
Taxes and subsidies
High transactions costs
Price and Quantity Regulations
Price regulations sometimes put a block of the price adjustments and lead to
underproduction. Quantity regulations that limit the amount that a farm is permitted to produce also leads to
Taxes and Subsidies
Taxes increase the prices paid by buyers and lower the prices received by sellers.
So taxes decrease the quantity produced and lead to underproduction.
Subsidies lower the prices paid by buyers and increase the prices received by sellers.
So subsidies increase the quantity produced and lead to overproduction.
An externality is a cost or benefit that affects someone other than the seller or the buyer of a
An electric utility creates an external cost by burning coal that creates acid rain.
The utility doesn’t consider this cost when it chooses the quantity of power to produce.
*An apartment owner would provide an external benefit if she installed a smoke detector. But she
doesn’t consider her neighbor’s marginal benefit and decides not to install the smoke detector.
The result is underproduction.
Public Goods and Common Resources
A public good benefits everyone and no one can be excluded from its benefits.
It is in everyone’s self-interest to avoid paying for a public good (called the free-rider
problem), which leads to underproduction.
A common resource is owned by no one but can be used by everyone.
It is in everyone’s self interest to ignore the costs of their own use of a common resource that
fall on others (called tragedy of the commons).
The tragedy of the commons leads to overproduction.
A monopoly is a firm that has sole provider of a good or service.
The self-interest of a monopoly is to maximize its profit. To do so, a monopoly sets a price to
achieve its self- interested goal.
As a result, a monopoly produces too little and underproduction results.
High Transactions Costs
Transactions costs are the opportunity cost of making trades in a market.
To use the market price as the allocator of scarce resources, it must be worth bearing the
opportunity cost of establishing a market.
Some markets are just too costly to operate.
When transactions costs are high, the market might underproduce. October 17, 2012
Government Actions in Market
A Housing Market with a Rent Ceiling
Price ceiling or price cap
Rent ceiling or Rent
Price ceiling < Equilibrium price
At the rent ceiling, the quantity of housing demanded exceeds the quantity supplied.
There is a shortage of housing
Increase Search Activity
The time spent looking for someone with whom to do business is called search activity (costly).
A Black Market
A black market is an illegal market that operates alongside a legal market in which a price ceiling or
other restriction has been imposed.
Inefficiency of a Rent Ceiling
A rent ceiling set below the equilibrium rent leads to an inefficient underproduction of
The marginal social benefit from housing services exceeds its marginal social cost and a
deadweight loss arises.
A rent ceiling decreases the quantity of housing supplied to less than the efficient quantity.
A deadweight loss arises.
Producer surplus shrinks.
Consumer surplus shrinks.
There is a potential loss from increased search activity.
Are Rent Ceilings Fair?
A rent ceiling decreases the quantity of housing and the scarce housing is allocated by
A Labour Market with a Minimum Wage
Price floor > Equilibrium price
Inefficiency of a Minimum Wage
A minimum wage set above the equilibrium wage decreases the quantity of labour
A deadweight loss arises.
The potential loss from increased job search decreases both workers’ surplus and firms’
The full loss is the sum of the red and grey areas.
Everything you earn and most things you buy are taxed.
Who really pays these taxes? Income taxes and the social security taxes are deducted from your par, HST (or GST) is
added to the price of the things you buy, so isn’t it obvious that you pay these taxes?
Tax incidence is the division of the burden of a tax between buyers and sellers
When an item is taxed its price might by the full amount of the tax by a lesser amount, or not
If the price rises by the full amount of the tax, buyers pay the tax.
If the price rises by a lesser amount than the tax, buyers and sellers share the burden of the
If the price doesn’t rise at all, sellers pay the tax.
Tax incidence doesn’t depend on tax law!
The law might impose a tax on buyers or sellers, but the outcome will be the same.
Tax incidence is the same regardless of whether the law says sellers pay or buyers pay.
Tax Incidence and Elasticity of Demand
The Division of the tax between buyers and sellers depends on the elasticities of demand and supply.
Perfectly inelastic demand: Buyers pay the entire tax. –
o Demand for this good is perfectly inelastic—the demand curve is vertical.
o When a tax is imposed on this good, buyers pay the entire tax.
Perfectly elastic demand: Sellers pay the entire tax.
o The demand for this good is perfectly elastic—the demand curve is horizontal.
o When a tax is imposed on this good, sellers pay the entire tax.
The more inelastic the demand, the larger is the buyers’ share of the tax.
Tax Incidence and Elasticity of Supply
To see the effect of the elasticity of supply on the division of the tax payment, we again look at two
Perfectly inelastic supply: Sellers pay the entire tax.
The supply of this good is perfectly inelastic—the supply curve is vertical.
When a tax is imposed on this good, sellers pay the entire tax.
Perfectly elastic supply: Buyers pay the entire tax.
The supply of this good is perfectly elastic—the supply curve is horizontal.
When a tax is imposed on this good, buyers pay the entire tax.
The more elastic the supply, the larger is the buyers’ share of the tax.
Taxes in Practice
Taxes usually are levied on goods and services with an inelastic demand or an inelastic
Alcohol, tobacco, and gasoline have inelastic demand, so the buyers of these items pay most
the tax on them.
Labour has a low elasticity of supply, so the seller—the worker—pays most of the income
tax and most of the social security tax.
Taxes and Efficiency
Except in the extreme cases of perfectly inelastic demand or perfectly inelastic supply when
the quantity remains the same, imposing a tax creates inefficiency.
With no tax, marginal social benefit equals marginal social cost and the market is efficient.
Total surplus (the sum of consumer surplus and producer surplus) is maximized.
The tax decreases the quantity, raises the buyers’ price, and lowers the sellers’ price.
Marginal social benefit exceeds marginal social cost and the tax is inefficient.
The tax revenue takes part of the total surplus.
The decreased quantity creates a deadweight loss. Taxes and Fairness
Economists propose two conflicting principles of fairness to apply to a tax system:
The benefits principle
The ability-to-pay principle
The Benefits Principle
The benefits principle is the proposition that people should pay taxes equal to the benefits
they receive from the services provided by government.
This arrangement is fair because it means that those who benefit most pay the most taxes.
The Ability-to-Pay Principle
The ability-to-pay principle is the proposition that people should pay taxes according to how
easily they can bear the burden of the tax.
A rich person can more easily bear the burden than a poor person can.
So the ability-to-pay principle can reinforce the benefits principle to justify high rates of
income tax on high incomes.
Production Quotas and Subsidies
Intervention in markets for farm products takes two main forms:
A production quota is an upper limit to the quantity of a good that may be produced during a
A subsidy is a payment made by the government to a producer.
At the quantity produced,
marginal social benefit equal market price, which has increased.
marginal social cost has decreased.
Production is inefficient and producers have an incentive to cheat.
At the quantity produced:
marginal social benefit equals the market price, which has fallen.
marginal social cost has increased and exceeds marginal social benefit.
Penalties on Both Sellers and Buyers
With both sellers and buyers penalized for trading in the illegal drug, both the demand for
the drug and the supply of the drug decrease.
Legalizing and Taxing Drugs
An illegal good can be legalized and taxed.
A high enough tax rate would decrease consumption to the level that occurs when trade is
Arguments that extend beyond economics surround this choice.
October 24, 2012
Global Markets in Action
How Global Markets Work What Drives International Trade?
o The Fundamental force that generates trade between nations is comparative
o The basis for comparative trade is divergent opportunity costs between countries.
o National comparative advantage is the ability of a nation to perform an activity or
produce a good or service at a lower opportunity cost than any other nation.
Winners, Losers, and the Net Gain from Trade
International trade lowers the price of an imported good and raises the price of an exported
Buyers of imported goods and benefit from lower and prices and sellers of exported goods
benefit from higher prices.
But some people complain about international competition: not everyone gains.
International Trade Restrictions
Governments restrict international trade to protect domestic producers from competition.
Governments use four sets of tools:
Other Import Barriers
A tariff is a tax on a good that is imposed by the importing country when an imported good
crosses its international boundary
An import quota is a restriction that limits the maximum quantity of a good that may be
imported in a given period.
Other Import Barriers
Thousands of detailed health, safety, and other regulations restrict international trade.
An export subsidy is a payment made by the government to a domestic producer of an
Export subsidies bring gains to domestic producers, but they result in overproduction in the
domestic economy and underproduction in the rest of the worlds and so create a deadweight
The Case Against Protection
Other common arguments for protection are that it
Allows us to compete with cheap foreign labour.
Penalizes lax environmental standards.
Prevents rich countries from exploiting developing countries.
The idea that buying foreign goods costs domestic jobs is wrong.
Free trade destroys some jobs and creates other better jobs.
Free trade also increases foreign incomes and enables foreigners to buy more domestic
Protection to save particular jobs is very costly. Allows Us to Compete with Cheap Foreign Labour
The idea that a high-wage country cannot compete with a low-wage country is wrong.
Low-wage labour is less productive than high-wage labour.
And wages and productivity tell us nothing about the source of gains from trade, which is
Penalizes Lax Environmental Standards
The idea that protection is good for the environment is wrong.
Free trade increases incomes and poor countries have lower environmental standards than
These countries cannot afford to spend as much on the environment as a rich country can
and sometimes they have a comparative advantage at doing “dirty” work, which helps the
global environment achieve higher environmental standards.
Prevents Rich Countries from Exploiting Developing Countries
By trading with people in poor countries, we increase the demand for the goods that these
countries produce and increase the demand for their labour.
The increase in the demand for labour raises their wage rate.
Trade can expand the opportunities and increase the incomes of people in poor countries.
Utility and Demand
The Choices you make as a buyer of goods and services is influenced by many factors, which
economists summarize as:
Consumption possibilities are all the things that you can afford to buy.
A Consumer’s Budget Line - Consumption possibilities are limited by income, the price of a
movie, and the price of pop.
The choice that Lisa makes depends on her preferences – her likes and dislikes
Her benefit or satisfaction from consuming a good or service is called utility.
Total utility is the total benefit a person gets from the consumption of goods. Generally, more
consumption gives more total utility.
Marginal utility from a good is the change in total utility that results from a unit-increase in
the quantity of the good consumed.
As the quantity consumed of a good increases, the marginal utility from it decreases.
We call these decreases in marginal utility as the quantity of the good consumed increases
the principle of diminishing marginal utility. The Utility-Maximizing Choice
The key assumption of marginal utility theory is that the household chooses the consumption
possibility that maximized total utility.
A Spreadsheet Solution
The direct way to find the utility-maximizing choice is to make a table in a spreadsheet and
do the calculations.
o Find the just-affordable combinations
o Find the total utility for each just-affordable combination
o The utility-maximizing combination is the consumer’s choice
Utility Maximization Choice
A more natural way of finding the consumer equilibrium is to use the idea of choices made at
Choosing at the Margin
Having made a choice, would spending a dollar more or a dollar less on a good bring more
Marginal utility is the increase in total utility that results from consuming one more unit of
The marginal utility per dollar is the marginal utility from a good that results from
spending one more dollar on it
The marginal utility per dollar equals the marginal utility from a good divided by its price.
Calling the marginal utility from movies Mand the price of a movie P , then the marginal
utility per dollar from movies is MU /P.
Calling the marginal utility of pop MU and the price of pop P , then the marginal utility per
dollar from pop is MU /P .
By comparing MU /P and MU /P , we can determine whether Lisa has allocated her
M M P P
budget in the way that maximizes her total utility
Following the rule maximizes a consumer’s total utility:
Spend all available income
Equalize the marginal utility per dollar for all goods
Predictions of Marginal Utility Theory
A Fall in the Price of a Movie
When the price of a good falls the quantity demanded of that good increases—the demand
curve slopes downward.
For example, if the price of a movie falls, we know that MUM/PM rises, so before the
consumer changes the quantities bought, MUM/PM > MUP/PP.
To restore consumer equilibrium (maximum total utility), the consumer increases the
movies seen to drive down the MUM and restore MUM/PM = MUP/PP. A change in the price of one good changes the demand for another good
You’ve seen that if the price of a movie falls, MUM/PM rises, so before the consumer changes
the quantities consumed, MUM/PM > MUP/PP.
To restore consumer equilibrium (maximum total utility), the consumer decreases the
quantity of pop consumed to drive up the MUP and restore MUM/PM = MUP/PP.
The Paradox of Value
The paradox of value “Why is water, which is essential to life, far cheaper than diamonds,
which are not essential?” is resolved by distinguishing between total utility and marginal
We use so much water that the marginal utility from water consumed is small, but the total
utility is large.
We buy few diamonds, so the marginal utility from diamonds is large, but the total utility is
The paradox is resolved by distinguishing between total utility and marginal utility.
For water, the price is low, total utility is large, and marginal utility is small.
For diamonds, the price is high, total utility is small, and marginal utility is high.
But marginal utility per dollar is the same for water and diamonds.
Value and Consumer Surplus
The supply of water is perfectly elastic, so the quantity of water consumed is large and the
consumer surplus from water is large.
In contrast, the supply of diamonds in perfectly inelastic, so the price is high and the
consumer surplus from diamonds is small.
Predictions of Marginal Utility Theory
Temperature: An Analogy
Utility is similar to temperature. Both are abstract concepts, and both have units of
measurement that are arbitrary.
The concept of utility helps us make predictions about consumption choices in much the
same way that the concept of temperature enables us to predict when water will turn to ice
The concept of utility helps us understand why people buy more of a good when its price
falls and why people buy more of most goods when their incomes increases. November 7, 2012
Possibilities, Preferences and Choices
Household consumption choices are constrained by its income and the prices ..
The budget line describes the limits to the household’s consumption choices.
The Budget Equation
We can describe the budget line by using a budget equation. The budget equation states that:
Expenditure = Income
Call the price of pop PP, the quantity of pop QP, the price of a movie PM, the quantity of
movies QM, and income Y. Lisa’s budget equation is:
PPQP + PMQM = Y
PPQP + PMQM = Y
Divide both sides of this equation by PP, to give:
QP + (PM/PP)QM = Y/PP
Then subtract (PM/PP)QM from both sides of the equation to give:
Y/PP is Lisa’s real
income in terms of pop.
PM/PP is the relative price of a movie in terms of pop.
A Change in Prices
A rise in the price of a good on the x-axis decreases the affordable quantity of that good and
increases the slope of the budget line.
A Change in Income
A change in the income brings a parallel shift to the budget line.
Preferences and Indifference Curves
An indifference curve is a line that shows combination of goods among which a consumer
Points on the indifference curve are preferred to all the points below the indifference curves
And all the points above the indifference curve will be preferred rather than the points on
the indifference curve.
A preference map is a series of indifference curves
Marginal Rate of Substitution
The marginal rate of substitution, (MRS) measures the rate at which a person is willing to
give up good y to get an additional unit of good x while at the same time remain indifferent
(remain on the same indifference curve).
If the indifference curve is relatively steep, the MRS is high.
The person is willing to give up a large quantity of y to get a bit more of x.
If the indifference curve is relatively flat, the MRS is low.
In this case, the person is willing to give up a small quantity of y to get more of good x.
Diminishing Marginal Rate of Substitution
A diminishing marginal rate of substitution is the key assumption of consumer theory.
A diminishing marginal rate of substitution is a general tendency for a person to be willing to
give up less of good y to get one more unit of good x, while at the same time remain
indifferent as the quantity of good x