BSB 113 – ECONOMICS NOTES
LECTURE 1: THE BARE BONES OF ECONOMICS
At the heart of economics lies the problem of scarcity!
What is economics?
The application of rigorous, often mathematical thinking to understand how scarce resources are best
Tries to understand how scarce resources are used in the real world
Positive vs. normative theory: how are resources used and what is the best way to use resources in the
Theory of how to run a business ie. how to improve efficiency by making better use of resources and to
make a profit without incurring extra costs.
The basic economic problem
All decision-makers (consumers, firms and gov) want more than is possible ie. demand is larger than
what is possible to produce/supply
Issue of scarcity (Insufficiency of amount or supply; shortage)
All of the groups have infinite needs and only finite resources
Demand vs. supply
People are concerned only for their own interests ie. they look after themselves/their own needs or
People always care about their material welfare – all strive to increase it.
Economics: how to best use limited resources in a way which is beneficial for the people (a majority?)
Economists: claim everyone is selfish
A short history of economic thought
“What government should care about is the combined welfare of all inhabitants” – Adam Smith
The role of economists
“To find out what is in the best interests of all and to relay this information to the benevolent decision maker.”
Economics is implicitly idealistic ie. it is for the common good
But … whose welfare should be maximised
The welfare of the poor? Or the welfare of the average?
„Average‟ is found through GDP or the average income which is often seen as a measure of a successful
Economics contains a lot of idealisms and therefore doesn’t tell you want to do immediately. Therefore, it is not
practical in some situations.
Eight Basic Ideas of Economics
2. Functioning Markets
Jessica King BSB113 - Economics Semester 1, 2009 2
3. Benevolent Markets
4. Homo Economicus
6. Money Circulation
7. Creative Destruction
Prices ensure that individuals specialise in what they do relatively best
Business want to sell goods to make profit but increasing competition limits prices and ensures
consumers get the lowest possible price.
Stores therefore have an incentive to provide goods to ensure customers return to their store
Specialise: reduces costs, produce more and arguably goods of better quality (occurs as a result of
The use of scarce resources efficiently ensures a business will earn an optimum profit
Economics of scale eg. car makers merge which allows them to cut production costs and therefore
2. Functioning Markets
Competition only works when a situation of many sellers exists
Only 1 seller (monopoly or no competition) means prices rise
Functioning market – where competition can occur
Buyers have access to price from all sellers and can purchase from anyone ie. they can chose the best
product for their needs
Ownership is honoured.
3. Who sets market rules?
Believe that the rule setter is interested
In the common good (not always!) eg. the government, rule setters: competition boards (eg. ACCC),
courts with impartial judges, government or those with independent power ie. a king
4. Homo Economicus
People maximise their own individual material gain and act highly rational in doing so
Eg. Cultural inhibitions against eating cows in India – the standard explanation from economists is that
this prevents people when times are bad from eating their productive future capacity ie. keep food
resources under control
People behave the way Homo Economicus predicts
Homo Economicus presumes pure selfishness
Eg. Experience with socialism
An economic situation is said to be in equilibrium when it is not possible for anyone to improve their
outcome by changing their current behaviour
A system should always be moving towards this but should never reach it
Occurs only in a stable market situation
6. Money circulation
Main functions of money
allows trade in small quantities with little transaction costs – allows specialisation
a store of value: allows for pensions over weeks, years or decades
a unit of calculation – gives a price or a value
Bottom line: allows/is needed for cheap trade of the result of time investments with others and oneself
Jessica King BSB113 - Economics Semester 1, 2009 3
critical for trade
needed in a functioning market
Keeps control of money in the market – if not it leads to money problems eg. inflation
people use money to store value
more money for the same amount of goods, increases the number of notes (value) per good
ie. money loses its value
hyper-inflation – wipes out the value of savings and leads to fluctuations in relative prices,
undermining specialisation (eg. Germany 1930‟s)
loss of confidence in money leads to alternative means of exchange eg. barter or people trading
goods and reduced specialisation
7. Creative Destruction
How do we progress?
A continuous stream of shocks and discoveries constantly creates new opportunities and closes down
ways of doing things
Always new ideas/opportunities coming up.
Links are need to work in an economy but new opportunities often break existing links
A firm faced with new technological possibilities must attain expertise of incorporating the new
technology and has to ditch the old technology ie. Job loss as technology increases the issue of human
vs capital labor will become more significant especially in certain manufacturing industries
Policy implications of the bones of economics
Individuals must have an incentive to invest and innovate. Therefore, good rules are need to ensure one
receives rewards for their efforts
Equilibrium requests everybody can do what he/she wants and everyone has a much information as
Market systems allow everybody to participate and as such, barriers to entering the market should be
Allow as much trade as possible
TEXTBOOK NOTES – Chapter 1: The Bare Bones of Economic Thought
Home economicus: someone who rationally maximises his or her own material welfare
Economics: how and why a society produces things and how governments should manage things for the best in
a calm and rational way
Utilitarianism: what a government should care about is the combined welfare of all inhabitants.
Inflation: More money without extra production in an economy is going to put upward pressure on prices
because there would be more bank notes buying the same amount of goods
Equilibrium: An economic system is said to be in equilibrium when it is not possible for anyone to improve on
their outcome by changing their current behaviour.
Economics by moral philosophy
Economists‟ view f the rest of humanity is that they are almost solely interested in having as many
possessions as possible ie. materialism
Functioning markets: the advantage of specialisation
Not everyone has equal abilities in terms of production and it is therefore efficient to specialise.
Jessica King BSB113 - Economics Semester 1, 2009 4
Through specialisation everyone will gain from trade as, all will benefit from the fact that they do not
have to make all products individually but can specialise in what they do best
Trade allows specialisation into fields of relative excellence (also known as comparative advantage)
The immutability of Homo economicus
Two related big ideas in economics: A large part of the behaviour of individuals is dictated by their
material interest and that it is not possible to have a continuously growing economy without appealing
to material motivations
Equilibrium and rationality
An economic system is said to be in equilibrium when it is not possible for anyone to improve on their
outcome by changing their current behaviour
When individuals have all available information as to all possible opportunities for improvements and
can freely contract with others, that the whole system will move towards a situation where all
opportunities from improvement gradually disappear
The relation between the notion of equilibrium and rationality is clear: if expectations are roughly right
then the economy should always be moving towards equilibrium
Economies of Scale
Increasing economies of scale occur when the average cost of producing something goes down if the
scale of production goes up.
Decreasing economies of scale also know as diseconomies of scale, occur when the average cost of
production goes up if the sale of production goes up.
Eg. The cheapest way to produce billions of cares and computer chips is believed to involve very large
plants with lots of automated processes rather than many small backyard production facilities.
However, when companies become too big they may begin to suffer from disadvantage eg. Law firms
made up from merely a couple of lawyers are for instance believed to operate at lower average costs
than huge law firms.
Money and Money Circulation
The main role of money was as a means of exchange and a storage of value
Money allows people to trade the equivalent goods for the value of the notes/coins
Money allows individuals with different talents to trade the result of their time without even meeting
each other and to allow any individual to trade with himself over time.
More money without extra production in an economy is going to put upward pressure on prices because
there would be more bank notes buying the same amount of goods, which is known as inflation.
Creative destruction and growth
Creative destruction believes that the world around us is constantly changing in a million different ways,
opening new business opportunities and closing old ones.
Continuous search for new opportunities via experimentation with organisations, technology and trading
Within the market place, flexibility in terms of who does what and well-established property right such
that individuals have incentives to take opportunities that present themselves (ie. enterprise) is needed.
In order for individuals to take opportunities there must be something in it for them, hence patent laws
and business ownership
The fact that changes are so massive and multiply all the time means a large slice of the population
needs to be on the lookout for these new opportunities
Recognition of opportunities needs as much useful information as possible
More barriers to changes = the less new opportunities that can be taken up quickly.
Jessica King BSB113 - Economics Semester 1, 2009 5
Summary Table of Basic Ideas and their Relevance
Basic Concept Intuitive Content of Basic Concept Policy Relevance of Basic Concept
Scarcity Everyone wants more than is possible There is always a trade-off implicit in any
Competition The fear of losing business to another will Social production costs can be lowered by
make me demand no more than my costs competition
for a service
Functioning Markets Competition arises when the fear of losing Close down all options of avoiding
cannot be taken away except by efficient competition or making money by defrauding
specialisation consumers in other ways
Benevolent rue setters The state can count on a loyalty to overall The state can somewhat impartially set the
good from some of its employees rules for overall good.
Homo economicus All individuals and their organisations are Do not design policies that go heavily against
to a large degree consciously looking for material motives for long periods of time
Economic rationality Homo econmicus is a fairly good Take account of the fact that people
calculator anticipate and adapt to policies
Equilibrium The situation where all opportunities for Thinking of all the opportunities that open up
gain are exhausted towards which we after a policy change
Money circulation All exchange is paid for in money, linking Increasing the money supply without
the prices of the supply of money producing more goods means more money
per good ie. inflation
Creative Destruction A continuous stream of shocks and 1. Allow incentives to search and take the
discoveries constantly creates new new opportunities
opportunities and closes down old ones 2. Aid the exchange of information
3. Allow old ways to die in order to make
room for the new.
Jessica King BSB113 - Economics Semester 1, 2009 6
LECTURE 2: BASIC MICROECONOMICS – SCARCITY AND CHOICE
2. Free goods
6. Opportunity cost
8. Tax rates
9. Poverty trap
Everyone has many different types of wants and needs
4 key reasons why wants and needs are virtually unlimited:
- goods eventually wear out and need to be replaced
- new or improved products become available
- people got fed up with what they already own
- the more you have, the more you want
What is actually scarce?
Commodities are produced by using resources
Resources/factors of production:
Type Description Reward
Land* All natural resources RENT
Labour* All physical and mental work of people WAGES
Capital All human-made tools/machines INTEREST
Enterprise All managers and organisers PROFIT
*limited and are the only ones which are actually scarce
All resources are eventually reducible to labour (time) and natural resources (restricted in the amount).
Physical and other capital can be seen as the conserved result of previous production. Entrepreneurship
effort is actually another form of labour and therefore, time.
Types of (scarce) goods
Free good: available without the use of resources eg. air
Economic good: limited in supply eg. water or oil
Expenditure on capital goods is called a cost or an investment
Capital (good) is a productive asset eg. a machine, building
Terminology of economics
Production: transforming the combination of production factors into something consumable – it
contributes to GDP
Home production: untaxed production in households
Transfer: a change/swap in ownership of a resource or good eg. trade for trade or a good for money
Economists often look at things from different perspectives. The difference between cost, a transfer, a return on
an asset and production depends on the judge/their perspective.
Jessica King BSB113 - Economics Semester 1, 2009 7
The economic problem
Refers to the scarcity of commodities – only a limited amount of resources available to produce the
unlimited amount of goods and services desired by society
Choice implies to choose one thing and forego another
Opportunity cost principle – the cost (or value) of one good in terms of the next best alternative
Implicitly or explicitly a choice for X limits the other options – there are tradeoffs inherent in any choice
The set of possible choices is called the opportunity set, the feasibility set or the budget constraint ie.
something‟s are just not possible.
There is not necessarily always a „best‟ decision – but some decisions are worse than others
Quality Adjusted Life Year (QuALY)
The estimated costs for various medical procedures, environmental regulation and safety measures
Policies implicitly set the value of a year of decent life and not all get an equal amount
Try to cease the more ineffective measures (less QuALY/dollar spent) in favour of more effective ones
Managing People: Policies and the work place
Taxation is the policy which most affects people’s behaviour
Suppose pre-tax revenue = Y and tax bill = T
Average tax is total bill divided by pre-tax revenue ie. T/Y
Marginal tax is the percentage of the last dollar of revenue that gets paid in tax ie. dT/dY
Progressive tax – average tax increases with pre-tax revenue
Regressive tax – average tax decreases with pre-tax revenue ie. a lump sum tax is set for the whole
population of eg. $1000. For a person on a high salary this amount would be small, but for a person on a
low salary, this amount could be significant
Effective marginal tax rate – percentage of the last dollar in Y that is paid in tax or reduces the slide
payments. Where transfers from the government which depend on income = W, (d(T-W)/dY).
Taxation and Choice
The effect of taxes on people‟s choices particular their decision to work, is significant
In example 1 (slide 28), tax system has high EMTR, in area where marginal taxes kick in and welfare
payments are reduced.
High EMTR makes it less attractive to seek work
This situation can be changed by decreasing welfare payments or avoiding areas where the reduction of
welfare payments coincide with marginal tax
Poverty trap: situation whereby a person with generally few marketable skills earns less in work than
out of work. Occurs when EMTR goes over 100%.
Defined contributions compared to defined benefits and the effect on taxes
When does one stop working?
- EMTR is the percentage of a year‟s income somebody close to retirement loses due to taxes and
changes in pension payments
Two possible systems:
1. Defined contributions – save 12% of income. Sum of savings defines your pension
2. Defined benefits – pay 12% into a pension fund and get a fixed percentage of average income for
the last 3 years you work.
With the potential income situation, it can be seen that the average drops compared to the last year and
never reaches that high again
Defined contributions – save less in last years of working life but overall, you will have more money
Jessica King BSB113 - Economics Semester 1, 2009 8
Therefore, pensions systems which are based on last=earned incomes can give rise to very high EMTR
TEXTBOOK NOTES – Chapter 2: Scarcity
Goods and services: physical items and non-physical items that satisfy wants and needs
Factors of production: the items of value used in the production of goods and services
Transfer: a change in ownership of a resource of a consumption good
Scarcity: there is only a limited amount of resources available to produce the unlimited amount of goods
and services that we desire. Scarcity requires making choices
Opportunity cost of a choice x: best available alternative for the resources involved in choosing X (value
of the next best use)
Tradeoffs: exchange of one thing is return for another due to alternative key objectives that cannot be
Budget constraint: the set of possible choices (eg. set of bundles that a consumer can afford)
Quality Adjusted Life Year (QuALY): equals a year of normal living of a person in good health and
Cost-effective policy: policy that minimises the cost of obtaining a given desirable outcome
Cost-benefit analysis: an analysis of all the benefits of a choice as well as the (opportunity) costs
involved in making that choice.
Effective marginal tax rate (EMRT): the increase in taxes and the decrease in side-payments due to the
last additional dollar of pre-tax revenue
Progressive tax: when the average tax increases with pre-tax revenue, the tax is progressive
Regressive tax: when average tax decreases with pre-tax revenue
Poverty trap: when earning more income in the formal economy reduces the material welfare of a
relatively low skilled person
Defined contribution system: a superannuation system whereby the sum you get at the end is determined
by how much you contributed
Benefit system: a superannuation system whereby the sum you get at the end is determined by an
administrative rule not determined by your total contribution
Everyone has many different types of wants and needs
There are four reasons why wants and needs are virtually unlimited:
1. goods eventually wear out and need to be replaced
2. new or improved products become available
3. people get fed up with what they already own
4. the more you have, the more you want
Factors of Production
Physical capital and natural resources are relatively easy to measure
Capital is something that eventually comes from time investments and natural resources spent in the
Hence, from a long-term perspective, the only two ultimate production factors are natural resources and
human time investments
Types of Commodities
A free good is available without the use of priced resources
An economic good is a commodity in limited supply
Expenditure on producer or capital goods is called a cost or an investment
Jessica King BSB113 - Economics Semester 1, 2009 9
The set of possible choices we can make is called the opportunity set, the feasibility set or the budget
Principle states the cost (or value) of one good in terms of the next best alternative
Scarcity and the value of life
The essential task is to make problems comparable by expressing the value of different activities in the
Scarcity of resources forces you to think hard about what you fund and what you don‟t fund
It forces you to think of who loses when someone else wins
Completely reverses what it means to be kind: eg. You are not being kind if you refuse to value life and
simply willy-nilly choose medicine and policies to find
How the government affects choice by changing opportunity costs
Government policy affects the choices of individuals by changing the trade-offs between alternatives –
seen in the taxation and retirement examples
Taxation promotes the thing untaxed and discourages the thing taxed ie. taxation changes the
opportunity costs and therefore will change individual choices.
Jessica King BSB113 - Economics Semester 1, 2009 10
LECTURE 3: DEMAND AND SUPPLY
What determines the demand, supply and prices in a market?
Price taking behaviour
Price taking: you can only decide whether to buy or not. You cannot determine the price.
Is this the same for a seller? No, he/she can set the price … BUT if many shops sell the same (similar)
goods, then a higher price in one shop implies that all customers would buy from another shop. We
assume that (at least in the long run) sellers are also price takers, i.e. can only decide whether to sell at a
price or not.
What do we think that buyers know when they make their decision?
• All prices that are offered by some sellers
• All the sellers (and where their shops are)
• The exact quality/design of products offered
• Buyers know how much a good is worth to them
• Sellers know their costs to produce/supply a good
If buyers and sellers are price takers and all of the five assumptions are holding we speak of Perfect
Willingness to pay
One way to express the opportunity cost is to give the foregone opportunities a monetary value. This is
called the willingness to pay.
The amount of money willing to give up (opportunity cost)/spend on one item
Is influenced by other opportunities
A demand curve depicts the quantity of a good that an individual demands (wants to buy) at a given
Demand curves are (almost always) downwards sloping because for most goods the additional benefit
we get out of consuming more of the same is decreasing. This is called diminishing marginal* utility or
diminishing marginal propensity to consume. This fact is so pervasive that we speak of it as the LAW
Higher price = less likely to consume
The more you have consumed the less willing you are to pay
What affects demand for a (normal) good?
Besides the price (as shown by the demand curve – low price = high demand), the budget, prices of
other goods (opportunity costs) and the taste for something affect the demand and the demand curve
Jessica King BSB113 - Economics Semester 1, 2009 11
Shifts in the Demand Curve
Can the effect of prices on demand be measured?
What is the effect of a price increase from A$ 7 to A$8 or from A$2 to A$3?
But is this the same? Take the seller‟s perspective, if the price is increased from A$7 to A$8 the number
of drinks demanded drops by 50%. If the price is increased from A$2 to A$3 the number of drinks drops
by only 20%. At the same time, an increase from $7 to $8 is a price increase of 14.3% while an increase
from A$2 to A$3 is a price increase of 50%.
The absolute change in the number of drinks demanded if the price increases by $A 1 is not a good
measure for the effect the price has on demand
Price elasticity of demand
We need to make sure that our measurement is not affected by the size or scale of the price and quantity
involved. Economists use the price elasticity of demand. This answer is always negative and this
calculation allows you to maximise profit
Price elasticity of Demand =
This can also be represented as:
Q/Q P Q
P/ P Q P
Cross price elasticity and substitutes
The price of other goods can also affect the demand for a good. To solve the problem economists use
the cross price elasticity of demand.
Cross price elasticity of demand =percentagechangeinquantitydemandedofgoodstudied
Jessica King BSB113 - Economics Semester 1, 2009 12
Income elasticity of demand
Reaction of the demand to a change in the income a consumer has available for spending. Economists
use the same trick and call it income elasticity of demand. If Y<0 economists speak of inferior goods,
if Y>0 they are normal goods, if Y>1 they are luxury goods, if Y<1 they are necessary goods.
(inferior good = basic food item)
Income Elasticity of demand =
Illustrates that consumers consume more relevant to how much the income is ie. more income=more
What doe elasticises less us?
If price increases, demand decrease
Given that elasticises are small, the price increase has to be quite large.
The effect of tax is that price increases ie. new price is greater than only price hence less is demanded
Alternative policies include: making a substitute more attractive, reduce income, make a complement
more expensive, change owner preferences
The supply side of the market
The supply to a market is determined by producer of goods and services, we need to understand the
production process to understand supply
Matters for the price/how much it costs to produce a good
• Labour (workers, bar men)
• Land (resources, use of space, the place where the bar is)
• Capital (incl. intermediate goods, furniture of the bar, glasses etc.)
Y = f(G,L,K)
• Final consumption goods (Drinks in the bar)
• Intermediate goods (eg. the glasses that are used in the bar)
• Services (the taxi ride to get you home after the bar)
Production just combines inputs to get an output. As economists we can describe this process by stating
the inputs needed to produce a certain quantity of an output. This can be done by formula:
y = f (G, L, K)
where y = Quantity of the output ... Is equal to
f = a function (a certain combination of inputs) of
G = the size of the bar (the ground it covers),
L = labour (hours) used
K = the amount of capital (glasses) used
The letters represent numbers (they are variables).
(Dis)Economies of Scale
Sometimes it needs less additional input the more we produce. In this case we speak of economies of
Jessica King BSB113 - Economics Semester 1, 2009 13
In other cases producing more can imply that a lot more of (additional) inputs is needed. In the latter
case we speak of diseconomies of scale.
If we need constant additional quantities of inputs to increase the output we speak of constant
economies of scale.
Complements and Substitutes in Production
Complements: some inputs are always needed together to produce something
Substitutes: inputs can replace one another
Cost of Production
Calculate the cost if we know the prices for the inputs.
The sum of the expenditures for each input (quantity*price) is equal to the total cost.
TC = pG*G + w*L + pK*K
Components of the Cost Function
Some costs arise independent of whether something is produced or not. These are called fixed cost.
Total cost – fixed cost are the variable cost. This is the part of the cost that varies with the quantity
Average cost = Total cost / quantity
Average cost can tell us about (dis)economies of scale. If the average costs are decreasing with quantity
we observe economies of scale. If the average costs are increasing we observe diseconomies of scale.
Economies of scale are usually only present for some range of quantities produced.
If a firm sells goods at a certain price, comparing the price to the average cost gives an indication
whether the firm makes a profit.
Firms maximize their profit: Revenue – Total cost.
The cost of producing the additional unit (and really just the cost for this one additional unit) are called
The marginal cost curve is the supply curve of an individual firm.
When more than one firm supplies to the market, we need to add up the quantities supplied by each
Supply curves are summed up horizontally
Demand Meets Supply
A market equilibrium is a combination of a quantity and a price where neither agent – neither seller
(producer) nor buyer (consumer) – wants to sell or buy more than s/he currently does.
In equilibrium exists neither excess demand nor excess supply.
If the price is too low, we observe excess demand
If the price is too high we observe excess supply
If the price is right (we say the price is equal to the market clearing price) neither excess demand nor
excess supply exists. The market is in equilibrium.
TEXTBOOK NOTES – Chapter 3: Demand and Supply
Price taking: Buyers and sellers cannot influence the price, they can only decide whether to buy or sell a good
at a given market price
Jessica King BSB113 - Economics Semester 1, 2009 14
Perfect competition: a situation where everybody (buyers and sellers) are price takers, because there are many
buyers and many sellers and everybody has perfect competition
Willingness to pay: the maximum price at which a buyer would purchase a unit of a good
Demand curve: combination of the quantity demanded at a certain price and the respective price. Given by the
willingness to pay for a certain unit of the good
Law of demand: the higher the price, the fewer units‟ consumers‟ demand of a good
Complements: goods that go well together, a price decrease for one good increase the demand for another good
Substitutes: goods that compete with each other, a price decrease for one good decrease the demand for the
Elastic demand: the percentage change in the quantity demanded is larger than the percentage change in the
Market demand: the sum of individual demands of many customers
Inputs: all factors used for production – classified as either land, labour or capital
Final consumption goods: goods produced for immediate consumption by consumers
Intermediate goods: products/goods that are inputs in another production process
Services: intangible outputs that can be directly consumed or used as inputs in other production processes
Production function: representation of the production technology using a mathematical function
Substitutes in production: factors that can replace each other to produce a certain quantity of output
Complements in production: factors that both have to increase production of an output
Diminishing marginal return or diseconomies of scale: these are present if the marginal productivity of
production factors decrease the larger the produced quantity
Total cost: sum of costs to produce a certain quantity
Average cost: total cost divided by quantity produced
Cost function: (minimum) cost to produce a certain quantity using the production technology in the best way
Fixed cost: cost that is independent of the quantity produced
Variable cost: cost that changes with the quantity produced
Marginal cost: cost to produce one additional unit equals the change in the total cost when output is increased
by one unit.
Profit maximisation: the quantity is chosen such that the price is equal to the marginal cost. At a lower quantity
the price is larger than the marginal cost hence profits increase with an increase in the quantity produced.
Supply curve: quantity that a firm supplies to the market at a given price
Market supply: sum of the supplies of all firms active on the market
Market clearing price: price at which market demand equals market supply
Market equilibrium: situation where neither buyers nor sellers want to change their behaviour ie. they cannot
profit from a change
Excess demand: demand is larger than supply usually because the price is too low
Excess supply: supply in a market is larger than demand usually because the price is too high
Customers are price takers
But so too are sellers as a seller charging higher prices may sell some items but in the long run nobody
will buy from this sell if the competition are selling it cheaper
Willingness to pay and demand curves
Willingness to pay provides all the information needed to derive the quantity demanded at a given price
This information is represented on a demand curve. A demand curve depicts the quantity of a good that
an individual demands at a given price. It is simply the picture of the willingness to pay for a good
Demand curve captures the important observation that as the quantity demanded decreases, price
The law of demand
Jessica King BSB113 - Economics Semester 1, 2009 15
Demand curves are downward slopping which comes from the observation that the willingness to pay
for each unit of a good decreases with each additional unit consumed
Consumers tend to demand less of a good as its price becomes higher is so pervasive that economists
refer to it as the law of demand
The reason for this is diminishing marginal propensity to consume or diminishing marginal utility
meaning willingness to pay becomes less for each additional item consumed.
What affects demand?
Preferences change and this changes willingness to consume/pay for a commodities
Goods that have a characteristic that demand increases when income or budget of a consumer increases
are referred to as normal goods
Goods for which there is lower demand as income increases are called inferior goods
Whenever demand for a good increases with a lower price of another good, we call these goods
High price usually results in a lower quantity demanded as shown in the downward slope of the demand
Rightward shift in the demand curve is illustrated by a change in the demand for complements
Demand curve only shows the quantity demanded of a certain good at each price, therefore showing the
relationship between price and quantity keeping everything else equal. Shifts in the demand curve result
from changes in one of the factors included in “everything else”
Price elasticity of demand
By what percentage does the quantity demanded decrease if the price increases by 1%?
By representing changes in relative or percentage terms, the problem of scale is avoided ie. comparing a
change from $2 to $3 and a change from $10 to $11
This is the idea of the economist‟s description of the reactivity of demand towards price changes defined
as the price elasticity of demand.
Price elasticity of demand =
This can also be represented as:
Q/Q P Q
P/ P Q P
Where = the change in the variable when considering a change in quantity (Q) and a change in price
(P). The minus sign in front of the faction simply demonstrated that an increase in the price of a good is
always associated with a decrease in the demand for that good.
Economists refer to an elastic demand if the elasticity is greater than one and to an inelastic demand if it
is less than one.
The elasticity of demand changes along the demand curve.
One must also study the income elasticity of demand which is defined as:
Income Elasticity of demand = percentagechangeinquantitydemanded
This is used to observe whether the demand for a good increases or decreases if income increases. If
demand for a good increase with income, income elasticity of demand is positive and economists call
such goods normal goods. If demand for a good decrease with income, the income elasticity of demand
is negative and such goods are called inferior goods.
Cross price elasticity of demand, defined as:
Cross price elasticity of demand =
Classification of Outputs
Jessica King BSB113 - Economics Semester 1, 2009 16
Final consumption goods Goods produced for final Drinks, car, TV sets, clothes
consumption by consumers
Intermediate goods Goods that are produced by one Drinks in casks, electronic circuits,
firm to serve as inputs for other oil, grains, fabrics
firms producing final consumption
Services Goods that are intangible but of Cleaning services, car repairs,
immediate value to the consumer or health services
producer consuming them
Complements and substitutes in production
Substitutes in the production process: one input factor can, to some extent, be replaced by another
factor, but with other inputs this may not be possible
If two inputs must be combined to supply a certain quantity of output, we say the inputs are
Alternatively, to produce more output you need more of both inputs if they are complements but if the
inputs are substitutes you can use more of one or more of another.
Rules of thumb
1. highly skilled labour and capital are usually complements. This implies that highly skilled labour profits
from a lower price of capital
2. low skilled labour and capital are usually substitutes. This implies low skilled labour suffers a loss from
a lower price of capital
3. the more specialised a produce process the more complementary the different types of labour.
Economies of scale and diseconomies of scale in production
Diseconomies of scale are important for equilibrium in an economy and are more common in many
Where the marginal contribution of an increase in input factors increases, we speak of economies of
scale. If the marginal contribution decreases we are speaking of diseconomies of scale and if it stays
constant we speak of constant economies of scale
The cost of production
Inputs in the production process need to be paid for, they are the cost of production
The average cost of production is the cost per unit of output – calculated by divided the total cost (TC)
by the quantity of output (Q)
Total cost and average cost are closely related – both can be used to determine a firm‟s profitability.
The profit of a firm is calculated as total revenue minus total cost (TR – TC)
Revenue is the quantity of sold output multiplied by the price received (TR = Q x P)
One can use average costs (AC = TC/Q) to determine the profitability of a firm – firm is profitable when
price per unit sold is greater than average cost of production
The cost function
Gives the lowest possible costs of producing a certain quantity of the output
Components of the total cost
Costs that have been paid independent of the quantity produced are called fixed costs
Some costs are variable that is costs that vary with the quantity of output eg. the hours of labour.
Variable cost is the total cost minus fixed cost (VC = TC – FC)
Jessica King BSB113 - Economics Semester 1, 2009 17
Firms care about their marginal cost when determining their output. Marginal cost is the change in the
total cost when producing one more unit.
Total cost and economies of scale
If total cost increase faster than the quantity of output then we can say that a production technology
exhibits diseconomies of scale. If total cost increases less rapidly than the quantity of output then we can
say a technology exhibits economies of scale.
Economies of scale are usually not present for the whole range of quantities produced
Supply of a firm and profit maximisation
To maximise profits, the owner compares for each additional unit sold whether the price earned is larger
than the cost incurred to produce the additional unit of output, the marginal cost of this unit.
Quantity supplied depends only on the marginal cost
Supply curve indicates the quantity that firms will supply at each price
Demand curve indicates the quantity consumer‟s demand at each price.
The intersection of the supply and demand curve indicates the price at which no seller wants to sell
more and no buyer would like to buy more – equilibrium or market clearing price
Thus, the market is in equilibrium, nobody active in this market would like to change their behaviour,
consumers do not demand more (or less) units at this price and sellers do want to supply more (or less)
units at this price
Excess demand and excess supply
If demand is higher than supply at a certain price, there is excess demand. Whenever demand is in
excess, we expect the price to rise because buyers will be willing to pay more for the good and thus
sellers will be able to increase prices
If demand is lower than supply at a certain price there is excess supply. In this case, sellers will be
required and willing to lower their price to sell more.
Only at the market clearing price is the quantity demanded equal to the quantity supplied, there is no
excess supply and no excess demand.
Concepts in this chapter
1. Price taking
2. Willingness to pay
3. Complements and Substitutes in Demand
4. Aggregation of demand
5. Demand curve
6. Factors of production
7. Complements and substitutes in production
8. Economies of scale and diseconomies of scale
9. The production function
10. Total costs = FC plus VC
11. The cost function
12. Marginal Cost
13. Price = Marginal cost determines the supply curve
14. Aggregate supply
15. Market clearing price
16. Excess demand and excess supply
Jessica King BSB113 - Economics Semester 1, 2009 18
LECTURE 4: THE BARE BONES OF ECONOMICS
What is good for an economist?
Allocation: the division of resources among people. Allocations can change across time through the
exchange of goods
- seller: allocation of money increases and allocation of goods decreases
- buyer: allocation of money decreases and allocation of goods increases
Pareto Efficient: an allocation is efficient (good) if we cannot improve anyone‟s allocation without
making someone worse off. It does not consider the fairness (equity) of allocations.
If an allocation if Pareto inefficient (bad) then we should change it.
Normative analysis: When asking what is „good‟ for a society, we need to make a judgement.
Positive analysis: (alternative to above) tries to understand what is happening and avoids value
judgements eg. cause and effect questions such as how interest rates affect inflation
Advantage of exchanging goods
Self-sufficiency: the situation where a person, household or village consumes one what it produces
themselves – no goods are exchanged
As a result of exchange, the total number of goods increased – therefore resulting in more overall goods
Consumption possibilities: combinations of goods a person can choose from
Whenever an individual can choose among more options, he or she will never be worse of (they can still
choose the original option!). Therefore, exchanging goods is good!
Are Markets Efficient?
Determined by determining the benefits consumers and producers receive through exchange
Consumer surplus: benefits consumers derive from using the market ie. whether the consumer benefited
from buying something
Willingness to pay was the maximum price a buyer was willing to bay for a good. The difference
between the willingness to pay and the actual price is a „surplus‟ to the buyer
Consumer surplus = Willingness to pay – Price
Aggregate consumer surplus is the sum of individual consumer surplus.
Consumer surplus can never been negative.
Consumer surplus can be calculated as the area between the demand curve and the horizontal price line
(know how to calculate this and the value!)
A fall in price increases consumer surplus through two channels:
1. again to consumers would have bought at the original price
2. again to consumers who are persuaded to buy at the lower price
Decline in price = increase in consumer surplus and therefore increase in consumer benefits
Shaded area = benefits to consumers from buying at this cost
Sellers to need to benefit as well, without it there would be no sellers
Producer Surplus: benefits producers derive from using the market
Producers compare marginal cost of production to the price received – marginal cost curve is the supply
Difference between the price received and the marginal cost is a measure to the benefit to a producer
Producer surplus = Price – Marginal Cost
Where price = what they get for the good and marginal cost = what they sell the good for
Where marginal cost is higher than the selling price, producers will not sell as the cost of production is
higher than cost. Therefore, if they did sell, they would selling at a loss!
Jessica King BSB113 - Economics Semester 1, 2009 19
Producer surplus can be calculated as the area between the price line and the supply curve
Supply curve represents the marginal cost
When the price of goods rises, producer surplus increases through two channels:
1. A gain to producers who would have sold at the original price
2. A gain to producers who are induced to supply the good by the higher price.
Sometimes governments force producers to sell more or less or to sell at a certain level less than they
would if profit maximising eg. taxi fare charges
Maximising total surplus
Maximising the welfare of individuals in society is equivalent to maximising the surpluses, because it is
always better to have more to share
If total surplus was not maximised, we could:
- change the allocation to one that maximises total surplus
- the benefit to winners will be larger than the loses to losers
- winners compensate those that lose
Consumers are irrational
If the price is 30, the supply is 40 units and consumers demand 60 units, therefore there is excess demand
Marginal costs are lower than marginal willingness to pay, so the social benefit can be increased by
Extra producer surplus greater than lower consumer surplus
Equilibrium – supply = demand
Producer supply+ increases producers gain and they are now selling more
If price of 40 is greater than the quantity of 60, the market is therefore efficient – maximising total surplus
Markets are efficient
Equilibrium market price (demand = supply) and the resulting quantity demanded maximises total
There will always be winners and losers however, the main point is that the total surplus is larger
Benefits to winners will be larger than the loses to losers and winners could make payments to losers t
compensate them for the loss
Given this, the allocation is Pareto efficient and therefore so too are markets
Maximises total surpluses:
1. people who want the goods the most are the ones who want it most – i.e. they are willing the pay the
most for a good
2. those who producer goods most efficiently at the lowest costs – these producers supply the goods
3. every exchange benefits both consumers and producers
4. no extra benefits to be had – every beneficial exchange has taken place.
At market equilibrium, there is no way to make some people better off without making others worse of
– THIS IS THE DEFINITION OF EFFICIENCY.
Cost of government intervention
We do not always have free markets
Demand is restricted eg. alcohol
Supply is restricted eg. blue cards
Governments charge taxes – good reasons exist for these interventions but under such interference
markets cannot work properly
Jessica King BSB113 - Economics Semester 1, 2009 20
Cost of restricting demand
This rotates the demand curve inwards
Leads to lower prices and quantities and reduces the total surplus
Losers are the restricted consumers and the producers who would sell to them
Cost of taxation
Cost of taxation arises from the efficiency losses
What you pay the state is income for the state, hence nothing is lost as a benefit to one is a loss to
Efficiency costs arise because you change your behaviour ie. Consume less than you would.
Two views on consumption taxes (eg. GST)
- tax is an additional cost to the seller – shifts supply curve upwards
- tax reduces the buyers willingness to pay – shifts the demand curve downwards
- both views yield the same results
- both have the same effect- the price to consumers rises
Tax revenue forms an extra part of the demand/supply curve, therefore meaning that three people gain
Deadweight loss increases as the tax rate increases
Decreases depend on people‟s behaviour
The size of deadweight loss depends on other factors
Whenever tax significantly alters people‟s behaviour, the deadweight loss will be large – the price
elasticity of demand (how much people demand as a result of changes in price)
High elasticity of demand results from price increases from tax (flat demand curve) leads to large
deadweight cost. This is largely significant in the sale of luxury goods and results in a less inefficient
tax system. However, high elasticity of demand increases market inefficiency
Steep demand curve results in lower elasticity of demand which is relevant to basic food/necessities
Quantity of change in demand is significant
TEXTBOOK NOTES – Chapter 4: Markets and Exchange
Allocation: describes the distribution of scarce goods among the members of a society
Pareto efficiency: an allocation is Pareto efficient if no member of a society can be made better off without
making at least one member of the society worse off
Self sufficiency: is the situation where an economic unit (a person, household, village) consumes only what it
produces itself. No goods are exchanged. The consumption possibilities are equal to the production possibilities
Production possibilities: the combinations of goods that can be produced given the resources an economies unit
Consumption possibilities: the set of possible combinations of goods an economic unit can choose the goods it
wants to consume from
Consumer surplus: the benefit that consumers derive from market interaction
Producer surplus: the benefit that all producers derive from market interaction
Market equilibrium is an efficient allocation: perfect markets are efficient because they maximise the sum of
producer and consumer surplus
Tax revenue: the money collected by government from tax
Deadweight loss of taxation: the reduction in the sum of consumer and producer surplus that is not
compensated by the tax revenue
Allocations can change over time
A sale is thus a particular change in the allocation of goods
Buyer‟s allocation of the good in question increases while his or her money allocation decreases. At the
same time, the seller‟s allocation of the good decreases while his or her allocation of money increases
Jessica King BSB113 - Economics Semester 1, 2009 21
Notion of equilibrium includes the idea that self=interested people use all beneficial opportunities
Can we improve on a situation such that nobody is worse off and at least one person is better off?
Pareto efficient: Given current resource allocations, we cannot improve the situation of society without
making another member worse off. Describes in a normative way what type of situation allocation we
would like to see (referred to as normative analysis)
Normative analysis: economists try to describe an ideal world
The alternative is positive analysis: when economists describe and try to explain how people actually
behave without making any judgement on whether the behaviour is good or bad.
Without exchange, every household or consumer needs to be self-sufficient
Exchange allows consumers to choose from a larger consumption possibilities et.
Whenever an individual can choose more instead of few options, they will never be worse off and they
may be better off
May also result in specialisation
Under self-sufficiency, without exchange, consumption is equal to production: With exchange one can
see that the consumption possibilities have improved for both
Exchange can greatly improve the options for both trading partners at the same time
A person specialising in one activity becomes more proficient at that activity. When specialisation
comes improved production which increase the potential gains from exchange even more.
Efficiency means that no party active in a market can benefit without another party being harmed
A buyer has a certain willingness it pay for a good he or she wishes to buy
Willingness to pay is greater than the price of the good, the consumer will buy the good. However, the
price is lower than that which he or she is willing to pay, then the buyer makes in one sense a „profit‟ –
when you buy something that is cheaper than what you are prepared to pay for it.
Profit is referred to as consumer surplus
To calculate consumer surplus, we have to find the difference between the willingness to pay and the
price at which consumers can buy the good.
In a market economy, nobody is forced to buy a good and thus consumer surplus is never negative.
When referring to consumer surplus, we do not refer to each individual buyer‟s surplus to the surplus of
all consumers. Aggregate consumer surplus is simply the sum of the individual consumer surplus
generated by market exchanges.
Consumer surplus can be calculated as the area between the demand curve and the horizontal price line
Consumer surplus = area between the demand curve and the price line
The shaded area represents consumer surplus
Consumer aggregate demand depends on the relationship between willingness to pay and price
Consumer surplus measures the benefits buyers derive from trade, producer surplus measures the
benefits of sellers or producers of the good
Profit, or the producer surplus, when selling this unit is therefore given as the price minus the marginal
cost. Usually producers sell more than one unit of output, nonetheless, the same logical applies.
Producer surplus = area between the price line and the supply curve
Sometimes governments force producers to sell more or less than they would decide to sell if they based
their decision on their profit maximising producer surplus – this type of government intervention is
Jessica King BSB113 - Economics Semester 1, 2009 22
Firms can be regulated to sell at a certain price all the goods that are demanded usually firms cannot be
forced to enter the market
Surplus is positive show‟s producer‟s gain from selling but surplus would be higher if government could
choose to sell fewer units.
Maximising the sum of consumer and producer surplus
A society can share among its constituents the benefits consumers derive – the consumer surplus – plus
the benefits producers derive – the producer surplus
The sum of consumer surplus and producer surplus is not maximised then changing the allocation to one
that maximises the sum of surpluses would generate a benefit to the „winners‟ that is larger than the loss
to „losers‟ of such a change
It is always better to have more to share among the members of society than to have less to share
Consumers are rationed – this is the case of people queuing the buy goods because there is not enough
Still, these consumers that get the goods receive a higher consumer surplus, in the best case – if
consumers with the highest willingness to pay get the goods – the consumer surplus is equal the area
shaded in pink
The social benefit – the sum of producer and consumer surplus – can be increased by selling more
Lowering the price producer surplus would be recorded, but at the same time there would be a greater
increase in consumer surplus
Markets are efficient
A decrease in price reduces producer surplus – producers are harmed – and thus a reduction in prices I
not Pareto efficient, because the benefit to consumers causes harm to the producer.
Given the benefit to consumers is larger than the loss to producers, consumers could give
„presents‟/make payments to producers to compensate for their loss
This not feasible if the sum of consumer and producer surplus is already maximised
An efficient allocation is one where the sum of consumer and producer surplus is maximised.
Equilibrium market price maximises the sum of surpluses we can state that the market equilibrium is an
The market mechanism ensures that the willingness to pay for products is always at least a high as the
cost for society to produce the goods.
The costs of government intervention
If such restrictions are imposed, markets cannot work properly and hence the outcome is usually an
The loss of efficiency in one market may help to avoid efficiency costs in another market
The cost of restricting supply and demand
With restricted supply, prices are usually higher compared to a market without intervention, thus
increasing producer surplus, but reducing consumer surplus without intervention, thus increasing
producer surplus but reducing consumer surplus
The sum of surpluses is reduced as indicated by the grey triangle which represents the costs of such
Higher profits accruing to sellers may be used to force suppliers to invest in activities they would not
Similar effect can be observed if the government restricts demand
Access restriction is independent of willingness to pay for the goods, demand at a particular price will
simply be reduced by a certain percentage
The price is lower with a consequential lower producer surplus
Jessica King BSB113 - Economics Semester 1, 2009 23