Test 1 Review
What is Economics?
•Economics is the study of how society allocates its scarce resources to satisfy
peoples’ unlimited wants.
•Scarcity means that society has limited resources and therefore cannot produce all
the goods and services people wish to have.
•Microeconomics focuses on the individual parts of the economy.
•How households and firms make decisions and how they interact in specific
•Macroeconomics looks at the economy as a whole.
•Economy-wide phenomena, including inflation, unemployment, and economic
•A market economy is one that allocates resources through the decentralized
decisions of firms and households.
•Households decide what to buy and who to work for.
•Firms decide who to hire and how much to produce.
•A command or centrally planned economy is one where all production and
distribution decisions are made by a central authority, like a government.
•Most economies are mixed economies – a combination of both. Canada is a mixed
Basic Principles of Economics
• resource is anything that can be used to produce something else.= ARE SCARCE
•EXAMPLES: land, labour, physical capital (buildings, machinery, etc.)
•The opportunity cost of something is everything you have to give up to get it.
•It is the cost of the best forgone alternative.
•You decide to attend Mac. Your tuition costs $8000, books cost $1000 and your
apartment costs $6000. Your total explicit costs are $15000.
•You could have spent that money on something else – say, a car.
•That car is a foregone alternative – it is an implicit cost of coming to Mac.
•But there are other things you give up when you come to Mac.
•Instead of coming to Mac, you could have lived at home for free and held a full-time
job that earned you $28000. You gave up the $28000 income – this is a larger
foregone alternative and implicit cost.
•So what is the opportunity cost of coming to Mac?
•It’s the value of the best foregone alternative – the lost wages (value of $28000
versus the $15000 car) plus the $15000 spent on tuition, books and
accommodation. Marginal Thinking
•Marginal changes are small, incremental adjustments to an existing plan of action.
•For example, a firm will wonder “What will happen to my profit if I decide to
produce one more good?”
•People make decisions by comparing marginal benefits to marginal costs.
•Marginal changes in costs or benefits motivate people to respond.
•The decision tso choose one alternative over another occurs when that
alternative’s marginal benefits exceed its marginal costs.
•For example, if producing one more good adds more to a firm’s revenue than to its
costs, the firm will produce that good.
•Adam Smith observed that households and firms act as if guided by an “invisible
•If each consumer is allowed to choose freely what to buy and each producer is
allowed to choose freely what to sell and how to produce it, the market will settle on
a product distribution and prices that are beneficial to all the individual members of
a community, and hence to the community as a whole.
Market Moves toward Equilibrium
•An economic situation is in equilibrium when there is no incentive for any
economic actors – households, firms, governments, etc. – to change their behaviour.
•No individual would be better off doing something different.
•Markets usually reach an equilibrium through changes in prices.
Prices guide decision makers to reach outcomes that maximize the welfare of
society as a whole
Gains From Trade
•In a market economy, people engage in trade with each other.
•Not every family or nation can produce everything it needs efficiently.
•We specialize in tasks we do best and trade with others for the things we need that
they can provide.
•In this way, we have gains from trade.
•An economy’s resources are used efficiently when they are used as best as possible
to meet society’s goals.
•The welfare of society is maximized.
•Markets that are left to operate freely usually lead to efficiency.
•Market failure occurs when the market fails to allocate resources efficiently.
•When the market fails (breaks down) government can intervene to promote
efficiency and equity.
•Efficiency means society makes the best use of its resources (economic decisions).
•Equity involves the fair distribution of resources (political decisions).
Market failure may be caused by
•an externality, which is the impact of one person or firm’s actions on the well-being
of a bystander.
•market power, which is the ability of a single person or firm to unduly influence
market prices. •some goods just aren’t suited to the market – for example, donor organs.
•Positive statements are statements that attempt to describe the world as it is.
•Called descriptive analysis
•Normative statements are statements about how the world should be.
•Called prescriptive analysis
Positive or Normative Statements?
•An increase in the minimum wage will cause a decrease in employment among the
•The income gains from a higher minimum wage are worth more than any slight
reductions in employment.
The Circular-Flow Diagram
Markets for Goods and Services
Markets for Factors of Production
Factors of Production
•Inputs used to produce goods and services
•Land, labour, and capital
•The production possibilities frontier, PPF, is a graph that shows the combinations
of output that the economy can possibly produce given the available factors of
production and the available production technology.
•It shows the best an economy can do if it uses all its resources efficiently, given the
•NOTE: the PPF is often called a production possibilities boundary, PPB.
VIEW chapter 2 slide 7
•Points A, B, C and D on the diagram are productively efficient – to produce these
combos all resources are used, given the technology. •Point H lies outside the PPF – it is unattainable. There are not enough resources to
produce that combo of goods, or the technology is not good enough or possibly both.
•Point K is feasible, but not efficient.
•Every point on the PPF is productively efficient.
•However, you could be on the PPF but producing a combination of goods that
society doesn’t want – i.e., the wrong combination.
•You would be producing at a point that is socially inefficient.
•Efficiency, then, includes productive efficiency (on the PPF) and social efficiency
(producing the combo of goods that society wants).
•Every choice along the PPF involves a trade-off.
•We have to give up some computers to get more cars and vice versa.
•The PPF illustrates opportunity costs – how much we have to give up of one good
to get more of the other.
•Notice that as we move down the PPF, the opportunity cost of a car increases.
•This explains why the PPF is bowed out – increasing opportunity costs.
•In fact, the |slope of the PPF| is the opportunity cost of a car at any point along the
•In general, for any 2 goods X and Y (X is on the horizontal axis), the |slope of PPF| =
opportunity cost of X.
Shifts in PPF
•Any changes to the amount of available resources, their productivity or changes to
the available technology will shift the PPF.
•Economic growth shifts the PPF to the right.
For examples view presentation
•When there exists comparative advantage, each individual should specialize in the
production of the good in which they have comparative advantage.
•They should trade with each other.
•There will be gains from trade for both. •Note that if no economy has a comparative advantage (that is, they have the same
opportunity costs), there won’t be any trade.
•That’s because there would be nothing to gain from trade.
•Describes the productivity of one person, firm, or nation compared to that of
•The producer that requires a smaller quantity of inputs to produce a good (is more
productive) is said to have an absolute advantage in producing that good.
•Productivity can be calculated as
Productivity = quantity produced
number of inputs used
view examples from slides
•A market is a group of buyers and sellers of a particular good or service.
•The terms supply and demand refer to the behavior of people as they interact with
one another in markets.
•Buyers (consumers) determine demand.
•Sellers (firms, producers, suppliers) determine supply.
•Market demand refers to the sum of all individual demands for a particular good or
•Market supply refers to the sum of all individual supplies of a particular good or
•There are different types of market structures.
•A competitive market is one in which there are so many buyers and so many
sellers that each has a negligible impact on the market price.
•A perfectly competitive market:
• all goods are exactly the same
• buyers & sellers so numerous that no one can affect the market price – each is a
•In this chapter, we assume markets are perfectly competitive.
•Quantity demanded, Qd is the amount of a good or service that consumers are
willing and able to buy at a given price, P.
•When the price of a good increases, you buy less of that good.
• We say price and Qd are negatively related.
• As P (up) , Qd (down) The Law of Demand
Other things being equal (ceteris paribus), when the price of a good rises, the
quantity demanded of that good falls.
Other Determinants of Demand
1. When income increases and you buy more of a good, this good is a normal good
(or if income falls and you buy less).
2. When income increases and you buy less of a good, this good is an inferior good
(or if income falls and you buy more).
•Most goods are normal goods. Examples of inferior goods include Kraft Dinner (as
your income increases, you don’t have to eat KD anymore- you can afford steak) and
bus rides (as income increases, you can take a cab or buy a car).
Prices of related goods
1. If an increase in the price of one good leads to an increase in demand for another
good (or vice versa), these goods are substitutes.
•Examples: Coke and Pepsi, satellite dishes and cable TV, new cars and used cars.
2. If an increase in the price of a good leads to a decrease in demand for another
good (or vice versa), these goods are complements.
•Examples: TVs and DVD players, automobiles and gasoline, shoes and shoelaces.
•If peoples’ preferences change towards a good, demand for that good will increase.
•Things like advertising, government policy etc. can change preferences.
•What you expect in the future may affect your demand for a good today.
•Example: If you expect gas prices to go up tomorrow morning, you’ll fill up your
tank tonight – your demand for gas today has increased.
•An increase in population (and therefore an increase in the number of consumers)
will increase demand.
•Demand schedules are tables that show the relationship between price and
quantity demanded for a good.
Demand curves are graphs of demand schedules
A Change in quantity demanded
•A change in quantity demanded is a movement along the demand curve due to a
change in price of that good.
•The demand curve itself does not move. •A change in demand is a shift of the demand curve due to a change in a determinant
of demand other than price.
•An increase in demand will shift the demand curve to the right: demand is higher at
•A decrease in demand will shift the demand curve to the left: demand is lower at
Shift Factors for Demand
•As income increases, the demand for a normal good will increase – curve shifts to
•As income increases, the demand for an inferior good will decrease – curve shifts to
Prices of Related Goods
•When a fall in the price of one good reduces the demand for its substitute, the
demand for the substitute shifts to the left.
•When a fall in the price of one good increases the demand for its complement, the
demand for the complement shifts to the right.
•Changes in expectations and tastes will shift demand accordingly.
•Increases in population will shift demand to the right.
•Quantity supplied, Qs, is the amount of a good that sellers are willing and able to
•When the price of a good increases, ceteris paribus, selling that good becomes
more profitable and firms will want to offer more for sale.
•Price and Qs are positively related.
•As P (up), Qs (up)
The Law of Supply
Other things being equal (ceteris paribus), the quantity supplied of a good rises
when the price of the good rises.
Other Determinants of Supply
•When the price of an input into production (also called a factor of production) like
labour costs, raw materials, machinery, energy, etc. increases, producing the good
becomes less profitable and firms will offer fewer goods for sale at any price (and
•Advances in technology which reduce production costs will increase supply. Expectations
•If a firm expects selling P to increase in the future, it will hold off selling now and
current supply will decrease.
Number of Firms
•More firms in the market means more supply.
The supply schedule is a table that shows the relationship between the price
of the good and the quantity supplied.
The supply curve is a graph of the supply schedule.
A change in Quantity Supplied
•A change in quantity supplied is a movement along the supply curve due to a
change in the selling price of the good.
•The supply curve does not move.
A change in supply
•A change in supply is a shift of the supply curve due to a change in any of its
determinants except price.
•An (up) in supply means a shift to the right.
•A (down) in supply means a shift to the left.
• If input prices increase, the supply curve shifts to the left (and vice versa).
•Advances in technology and an increase in the number of firms will shift the supply
curve to the right.
•Expectations will shift supply according to the expectation.
•Equilibrium refers to a situation in which the price has reached the level where
quantity supplied equals quantity demanded.
•Buyers have bought all they want to buy and firms have sold all they want.
•There’s no incentive for buyers or sellers to change what they’re doing.
•No one is left without and no one has any extra at the prevailing market price – the
•The price at which Qd = Qs is the equilibrium price, also called the market clearing
•The quantity at which Qd = Qs is the equilibrium quantity.
•It is the quantity traded in the market (the quantity that is actually sold).
Law of Supply and Demand
The price of any good adjusts to bring the quantity supplied and the quantity
demanded for that good into balance.
The market returns to equilibrium if it is left to operate freely.
Analyzing Changes in Equilibrium
•Often, events can happen which will shift demand or supply or both.
•This will lead to a change in eqm. P and Q. •We can use our diagrams to see what happens (this is called comparative statics).
•Decide whether the event shifts the supply or demand curve (or both).
•Decide whether the curve(s) shift(s) to the left or to the right.
•Use the supply-and-demand diagram to see how the shift affects equilibrium price
Changes in both Supply and Demand
•When an event or events shift both D and S at the same time, what happens to eqm.
P and Q depends on the size of the relative shifts.
•For example, we have a simultaneous (up) in D and (up) in S
•Q will increase, but we don’t know what will happen to P – the change in P is
ambiguous and depends on the relative magnitudes of the shifts in D and S.
For examples view slideshow
•is a measure of how much buyers and sellers respond to changes in market
•measures how responsive Qd or Qs is to changes in price, income or prices of
•allows us to analyze supply and demand with greater precision.
Elasticity of Demand
•Price elasticity of demand is a measure of how much the quantity demanded of a
good responds to a change in the price of that good.
•Price elasticity of demand is the percentage change in quantity demanded given a
percent change in the price.
•The price elasticity of demand is computed as the percentage change in the
quantity demanded divided by the percentage change in price.
•We’ll denote price elasticity by Ep.
• Ep = percentage change in Qd
percentage change in P
= % r in Qd
%r in P
•The number we get from our calculations is called the coefficient of elasticity.
•The size of the coefficient, Ep, will tell us how elastic the good is – how responsive
demand is to a change in price.
•Since elasticity will vary, we can define different types of elasticity.
Types of Price Elasticity
•People respond to changes in price differently depending on various factors.
•Are there a large number of substitutes?
•Is the good a luxury or a necessity? •How narrowly defined is the market?
•What about the time period?
•Quantity demanded does not respond strongly to price changes.
•The % change in Qd < % change in P
•Ep < 1
•The demand curve would be fairly steep.
•Example: required textbooks. Your only options to buying a new book is to find a
used copy, which may be difficult.
•Quantity demanded responds strongly to changes in price.
•The % change in Qd > % change in P
•Ep > 1
•The demand curve would be fairly flat.
•Example: most manufactures.
Perfectly Inelastic Demand
•Quantity demanded does not respond to price changes at all.
•Ep = 0
•The demand curve is vertical.
•Example: prescription heart medication. If you need it to stay alive, price is not
even an issue.
Perfectly Elastic Demand
•Quantity demanded changes infinitely with any change in price.
•Ep => infinity
•The demand curve is horizontal.
•Example: wheat. If a supplier raises her price, you’ll find a cheaper supplier
because wheat is wheat – she won’t sell any wheat, so she faces a perfectly elastic
demand for her wheat .
•Quantity demanded changes by the same percentage as the price
•Ep = 1
•The demand curve is non-linear.
•Example: none really exist, so think of unit elasticity as simply a dividing point
between elastic and inelastic.
•If we are given percentage changes in price and the corresponding changes in Qd,
we use the formula
Ep = %r in Qd
%r in P •For example,
The price of milk increases by 2% and Qd decreases by .5%
Ep = -.5/2 = -.25
•Another formula we use is the midpoint formula.
•The midpoint formula is preferable when calculating the price elasticity of demand
because it gives the same answer regardless of the direction of the change.
•We use it when we are given two prices and their corresponding Qd values.
•The midpoint formula is:
Ep = (Q 2 Q )1/ ([Q 2 Q ]1/ 2)
(P 2 P 1 / ([P 2 P ]1/ 2)
•Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the
amount you buy falls from 10 to 8 cones, then your elasticity of demand would be
•P 1 2.00
•P 2 2.20
•Q 1 10
•Q 2 8
Ep = (8 – 10) / (8 + 10) /2
(2.20 - 2.00) / (2.20 + 2.00) /2
= -2 /9
.20 / 2.10
= - .22 / .095
•In both examples, we have an elasticity coefficient that has a negative sign.
•But, remember the law of demand: as P(up), Qd (down). The coefficient will
always be a negative number.
•Since we’re smart economists and know this, when we calculate price elasticity, we
drop the negative sign (we know it will always be negative).
Generalities About Elasticities and Their Determinants
1. Goods that are necessities tend to have inelastic demand.
•Example: the demand for insulin would be perfectly inelastic (no matter how much
price changes, if you have to have insulin, you’ll buy it).
•Example: the demand for dentist visits would be inelastic (if price went up, you
may try to wait or shop around, but you’ll still go to get rid of the pain).
2. Goods that are luxuries tend to have elastic demand.
•Example: the demand for plasma TVs (if the price is right, you may buy one, but
you likely won’t buy one if the price is too high for your budget).
•Example: vacations abroad (same reason as above).
3. Goods that have close substitutes tend to have elastic demand.
•Example: Coke and Pepsi (if the price of Coke goes up, many consumers will switch
•Example: Eggs don’t really have a close substitute (their demand is pretty
inelastic). 4. Goods tend to have more elastic demand over longer time horizons.
•You can find substitutes in the long run where you can’t in the short run.
5. How you define the market makes a difference.
•Example: food – inelastic
vegetables – more elastic
broccoli – even more elastic
•The more narrowly defined the market, the more elastic the demand for that good.
6. How much of your budget you spend on a good determines elasticity.
•If you spend a large proportion of your budget on a good, demand for that good will
tend to be elastic.
•If you only spend a small proportion of your budget on a good, deman