CHAPTER 1 What Is Economics?
• Economics: the social science that studies the choices that individuals, businesses,
governments an entire societies make as they cope with scarcity and incentives
that influence and reconcile those choices.
• Microeconomics: the study of the choices that individuals and businesses make,
the way these choices interact in markets, and the influence of governments.
• Macroeconomics: the study of the performance of the national economy and the
All economic questions arise because we want more than we can get.
• Scarcity: our inability to satisfy all our wants.
• Goods and Services: the objects that people value and produce o satisfy wants.
Goods: physical objects.
o Services: tasks performed for people.
• Factors of Production:
o Land: the gifts of ‘nature’ that we use to produce goods and services.
o Labor: the work, time, and effort that people devote to producing goods
Human capital: the knowledge and skill that people obtain from
education, onthejob training and work experience.
o Capital: the tools, instruments, machines, buildings, and other
constructions that businesses use to produce goods and services.
Financial capital: money, stocks, bonds
o Entrepreneurship: the human resource that organizes labor, land, and
• Land earns rent. Labor earns wages. Capital earns interest.
Entrepreneurship earns profit.
• Self interest: a choice that you think is the best one available for you.
• Socialinterest: self interested choices promote the social interest if they lead to an
outcome that is the best for society as a whole
o An outcome that uses resources efficiently and distributes goods and
services equitable/fairly among individuals.
• Globalization: the expansion of international trade, borrowing, and lending, and
o An exchange: giving up one thing to get something else.
o Whatever your choice you make you could have chosen something else
o If we want more of one thing we must give up something else to get it
o Buying power can be redistributed (transferred from one person to
another) in three ways.
Through taxes and benefits organized by the government
• Big Tradeoff: the tradeoff between equality and efficiency. o Taxing the rich and making transfers to the poor bring greater economic
• Opportunity Cost: the highest valued alternative that we must give up to get it.
o Seeing choices as tradeoffs emphasizes the idea that to get something, we
must give up something.
o What we give up is the cost of what we get (Opportunity Cost)
• Margin: when a choice is changed by a small amount or by a little at a time; the
choice is made at the margin
• Marginal Benefit: the benefit that arises from an increase in an activity
• Marginal Cost: the cost of an increase in an activity
EX. To make your decision, you compare the marginal benefit
from an extra night of studying with its marginal cost. If the
marginal benefit exceeds the marginal cost, you study the extra
night. If the marginal cost exceeds the marginal benefit, you do
NOT study the extra night.
CHAPTER 2 The Economic Problem
• The Production Possibilities Frontier (PPF):
o The boundary between those combinations of goods and services that can
be produced and those that cannot.
o Describes the limit to what we can produce and provides neat ways about
thinking and illustrating the idea of a tradeoff.
o Illustrates scarcity because we cannot attain the points outside the frontier.
These points describe wants that can’t be satisfied.
o Points inside the frontier are inefficient because resources are wasted or
• Production efficiency:
o Producing goods and services at the lowest possible cost.
o Occurs at points ON the PPF.
o Unused: idle but could be working.
o Misallocated: assigned to tasks for which they are not the best match
• Opportunity Cost Ratio: the decrease in the quantity produced of one good
divided y the increase in the quantity produced of another good as we move along
• Efficiency: when goods and services are produced in the quantities that provide
the greatest possible benefit.
• Marginal Cost (PPF): the opportunity cost of producing one more unit of it.
• Preferences: a description of a person’s likes or dislike
• Marginal Benefit: from a good or service is the benefit received from consuming
one more unit of it.
• Marginal Benefit Curve: a curve that shows the relationship between the marginal
benefit from a good and the quantity consumed of that good.
o It is a general principle that the more we have of any good or service, the
smaller is its marginal benefit and the less we are willing to pay for an additional unit of it (principal of decreasing marginal benefit).
When marginal benefit = marginal cost, resources are being used efficiently.
• Economic Growth: expansion of production
o It increases our standard of living but doesn’t overcome scarcity and avoid
• Technological Change: the development of new goods and of better ways of
producing goods and services
• Capital Accumulation: the growth of capital resources including human capital.
Economic growth is NOT free.
It is not a magic formula for abolishing scarcity.
• Specialization: producing only one good or a few goods.
• Comparative advantage: a person has this in an activity if that person can perform
the activity at a lower opportunity cost than anyone else.
• Absolute Advantage: a person who is more productive than others has this.
o It involves comparing productivities (production/hour) whereas
comparative advantage involves comparing opportunity cost.
• Dynamic Comparative Advantage: a comparative advantage that a person (or
country) has acquired by specialization in an activity and becoming the lowest
cost producers as a result of learningbydoing.
Four complementary social institutions that have evolved over many centuries are
needed, they are:
Firm: an economic unit that hires factors of production and organizes
those factors to produce and sell goods and services.
Markets: any arrangement that enables buyers and sellers to get
information and to do business with each other.
They facilitate trade
Property rights: the social arrangements that govern the ownership, use,
and disposal of anything that people value.
Money: any commodity or token that is generally acceptable as means of
CHAPTER 3 Demand and Supply
• Competitive market: a market that has many buyers and many sellers, so no single
buyer can influence the price.
• Money price: in every day life, the price of an object is the number of dollars that
must be given up in exchange for it.
• Relative Price: the ratio of one price to another, OC.
o If you demand something then you: 1. Want it
2. Can afford it
3. Plan to buy it
o Demand refers to the entire relationship between the price of a good and
the quantity demanded of that good
Quantity demanded refers to a point on the demand curve.
Wants are the unlimited desires or wishes that people have for goods and
Demand reflects a decision about which wants to satisfy.
• Demand Curve:
o Shows the relationship between the quantities demanded of a good and its
price when all other influences on a consumers planned purchase remain
o Another way of looking at the demand curve is as a willingnessand
abilitytopay curve (measure of marginal benefit).
o Slopes downward as the price decreases, the quantity demanded increases.
o Can be read two ways:
1. For a given price, the demand curve tells us the quantity that
people plan to buy.
2. For a given quantity, the demand curve tells us the max price that
consumers are willing/able to pay for the last bar available.
• Quantity Demanded: the amount that consumer plan to buy during a given time
period at a particular price.
• The Law of Demand: Other things remaining the same, the higher the price of a
good, the smaller is the quantity demanded, and the lower the price of a good, the
greater is the quantity demanded.
• Six main factors bring changes in demand:
1. Prices of Related Goods
• Substitute: a good that can be used in place of another good
• Complement: a good that is used in conjunction with another good
2. Expected Future Prices:
• If the price of a good is expected to rise in the future and if the good
can be stored, the OC of obtaining the good for future use is lower
today than it will be when the price has increased.
• Consumers income influences demand
• When income increases consumers buy more of most goods, and when
income decreases, consumers buy less of most goods.
4. Expected Future Income and Credit
• Change in the quantity demanded:
o A change in the buyers’ plans that occurs when the price of a good
changes but all other influences on buyers plans remains unchanged. (Illustrated by a movement along the demand curve)
• Substitution Effect:
o When the price of a good rises, other things remaining the same, its
relative price, OC, rises.
o As the OC rises, the incentive to economize on its use and switch to a
substitute becomes stronger.
• Income Effect:
o When a price rises, other things remaining the same, the price rises
relative to the income.
o The good whose price has increased will be one of the goods that people
buy less of.
o If a firm supplies a good or service, the firm:
1. Has the resources and technology to produce it
2. Can profit from producing it
3. Plans to produce and sell it.
o Supply: the entire relationship between the price of a good and the
quantity supplied of it.
• Quantity Supplied: the amount that producers plan to sell during a given time
period at a particular price.
• The Law of Supply: Other tings 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.
• Supply Curve:
o Shows the relationship between the quantities supplied of a good and its
price when all other influences on producers planned scales remain the
o Slopes upwards: as the price of a good increases, the quantity supplied
o Can be read two ways:
1. The quantity that producers plan to sell at that price.
2. Tells us the minimum price at which producers are willing to sell
one more bar.
• Change in Supply: When any factor that influences’ selling plans other than the
price of a good changes. Six factors affect it:
1. Prices of Factors of Production
2. Prices of Related Goods Produced
3. Expected Future Prices
4. The Number of Suppliers
6. The State of Nature
• Equilibrium: a situation in which opposing forces balance each other.
• Equilibrium Price: the price at which the quantity demanded equals the quantity
supplied. • Equilibrium Quantity: the quantity bought and sold at the equilibrium price.
A market moves towards it equilibrium price because:
o Price regulates buying and selling plans.
o Price adjusts when plans don’t match.
1. When demand increases, both the price and the quantity increase.
2. When demand decreases, both the price and the quantity decrease.
1. When supply increases, the quantity increases and the price falls.
2. When supply decreases the quantity decreases and the price rises.
CHAPTER 4 Elasticity
• Price Elasticity of Demand: a units free measure of the responsiveness of the
quantity demanded of a good to change in its price when all other influences on
buying plans remain the same.
o 𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃=,%∆𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃% ∆𝑃𝑃𝑃𝑃𝑃.
o Therefore: =(,∆𝑃𝑃𝑃𝑃𝑃.)/(,∆𝑃𝑃𝑃𝑃𝑃.)
• Perfectly Inelastic Demand: demand with a price elasticity of zero; the quantity
demand remains constant when the price changes.
• Unit Elastic Demand: demand with a price elasticity of one; the percent change in
the quantity demanded equals the percent change in price
• Inelastic Demand: a demand with a price elasticity between zero and one; the
percentage change in the quantity demanded is less than the percent change in
• Perfectly Elastic demand: Demand with an infinite price elasticity; the quantity
demanded changes by an infinitely large percent in response to a tiny price
• Elastic Demand: Demand with a price elasticity greater than one; other things
remaining the same, the percent change in the quantity demanded exceeds the
percent change in price.
• Total Revenue: The value of a firms sales, calculated as the price of the good
multiplied by the quantity sold.
• Total Revenue Test: a method of estimating the price elasticity of demand by
observing the change in total revenue that results from a change in the price when
all of the influences on the quantity sold remain the same
o If a price cut increases total revenue, demand is elastic
o If a price cut decreases total revenue, demand is inelastic
o If a price cut leaves total revenue unchanged, demand if unit elastic
• Factors that influence the Elasticity of Demand:
o The closeness of substitutes: the closer the substitute for a good or service,
the more elastic is the demand for it.
o Proportion of Income spent on the good: other things remaining the same,
the greater the proportion of income spent on the good, the more elastic is the demand for it.
o Time elapsed since price change: the longer the time that has elapsed since
a price change, the more elastic is the demand.
• Cross Elasticity of Demand: a measure of the responsiveness of demand for a
good to change in the price of a substitute or compliment, other things remaining
o =%∆𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃/(%𝑃𝑃𝑃𝑃 𝑃𝑃 𝑃𝑃𝑃)
o + Substitute, complement
• Income Elasticity of Demand: a measure of the responsiveness of the demand for
a good or service to a change in income, other things remaining the same.
• 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
o Depends on:
1. Resource Substitution Possibilities: some goods and services can be
produced only by using unique or rare production resources
2. Time Frame for Supply Decision:
a. Three frames of supply:
i. Momentary Supply
ii. Longrun Supply
iii. Shortrun Supply
CHAPTER 5 Efficiency and Equity
• Resources might be allocated by:
o Market Price: when a market price allocates a scarce resource, the people
who are willing and able to pay that price get the resource
o Command: a command system allocates resources by the order of
command of someone in authority
o Majority Rule: (voting) This allocates resources in the way that a majority
of voters choose. Societies use majority rule to elect representative
governments that make some of the biggest decisions.
o Contest: this allocates resources to a winner (group)
o First come, First served: this method allocates resources to those who are
first in line
o Lottery: allocates resources to those who pick the winning number, draw
the lucky cards or come up lucky in some other gaming system
o Personal Characteristics: when resources are allocated on the basis of
personal characteristics, people with the ‘right’ characteristics get the
o Force: force plays a crucial role, for both good and ill, in allocating scarce
War, theft • Demand:
Value is what we get, Price is what we pay.
• Individual Demand: the relationship between the price of a good and the quantity
demanded by one person
• Market Demand: the relationship between the price of a good and the quantity
demanded by all buyers.
• The Market Demand Curve: the horizontal sum of the individual demand curves
and is formed by adding the quantities demanded by al the individuals at each
• Consumer Surplus: the value (or marginal benefit) of a good minus the price paid
for it, summed over the quantity bought
Cost is what a producer gives up; Price is what a producer receives.
The cost of producing one more unit of a good or service is its marginal cost.
• Individual Supply: the relationship between the price of a good and the quantity
supplied by all producers
• Market Supply: the relationship between the price od a good and the quantity
supplied by all producers
• The Market Supply Curve: the horizontal sum of the individual supply curves and
is formed by adding the quantities supplied by all the producers at each price
• Producer Surplus: the price received for a good minus its minimum supply price
• Marginal Social Benefit (MSB): marginal benefit of the entire society
o When the efficient quantity is produced, the total surplus (the sum of
consumer surplus and producer surplus) is maximized
• Under production:
o Deadweight loss: the decrease in total surplus that results from an
inefficient level of production
• Over production:
o Social loss: deadweight loss is borne by the entire society
• The obstacles to efficiency that bring under production or over production are:
o Price and Quantity Regulations:
Price regulations that put a cap on the rent a landlord is permitted
to charge and laws that require employers to pay a minimum wage
sometimes block the price adjustments that balance the quantity
demanded and the quantity supplied and lead to under production
Quantity Regulations that limit the amount that a farm is permitted
to produce also lead to underproduction
o Taxes and Subsides:
Taxes increase the prices paid by buyers and lower the prices
received by sellers.
Subsides which are payments by the government to producers,
decrease the prices paid by buyers and increase the prices received
by sellers. o Externalities: A cost or benefit that affects someone other than the seller or
An External loss arises when an electric utility burns coal and
An External benefit arises when an apartment owner installs a
smoke detector and decreases her neighbor’s fire risk.
o Public Goods and Common Resources:
Public good: a good or service that is consumed simultaneously by
everyone even if they don’t pay for it
Common resource: owned by no one but available to be used by
A monopoly is a firm that is the sole provider of a good or service
Leads to underproduction
o High Transaction Costs:
Transaction costs: the OC’s of making trades in a market
When they are high, the market might under produce
o The 19 century idea tat only equality brings efficiency
o A principle that states that we should strive to achieve ‘the greatest
happiness for the greatest number’
• The Big Tradeoff: a tradeoff between efficiency and fairness
CHAPTER 6 Government Actions in Markets
• Price ceiling/ Price cap: a government regulation that makes it illegal to charge a
price higher than a specified level.
o A price ceiling set above the equilibrium has no effect
o A price ceiling set below the equilibrium has powerful effects on a market.
• Rent ceiling: when a price ceiling is applied to a housing market.
o When a rent ceiling is set below equilibrium rent creates:
Increased search activity: time spent looking for someone with
whom to do business.
Black market: an illegal market in which the equilibrium price
exceeds the price ceiling.
• Minimum wage: when a price floor is applied to a labor market
• Price Floor: a government imposed regulation that makes it illegal to change a
price lower than a specified level
Everything you ear and almost everything you buy is taxed.
• Tax incidence: the division of the burden of a tax between buyers and sellers
o It does not depend on the tax law. The law might impose a tax on sellers or on buyers but the outcome is the same in either case.
• Tax on sellers:
o Like an increase in cost so it decreases supply
o To determine the position of the new supply curve, we add the tax to the
minimum price that sellers are willing to accept for each quantity sold
• Tax on buyers:
o A tax on buyers lowers the amount they are willing to pay sellers, so it
decreases demand and shifts the demand curve leftward
o To determine the position of this new demand curve, we subtract the tax
from the max price that buyers are willing to pay for each quantity bought
• Equivalence of Tax on Buyers and Sellers:
o When a transaction is taxed, there are two prices:
The price paid by buyers (which includes the tax)
The price received by seller (which excludes the tax)
Buyers respond to the price that includes the tax and sellers
respond to the price that excludes the tax.
A tax is like a wedge between the price buyers’ pay and the price
sellers receive. The size of the wedge determines the effects of the
tax, not the side of the market on which the government imposes
• The Employment Insurance Tax: an example of a tax that the federal government
imposes on both buyers of labor (employers) and sellers of labor (employees).
• Tax Incidence and Elasticity of Demand: The division of the tax between buyers
and sellers depends in part on the elasticity of demand. There are two extreme
o Perfectly Inelastic Demand (buyers pay)
o Perfectly Elastic Demand (sellers pay)
o We’ve seen that when demand is perfectly inelastic, buyers pay the entire
tax and when demand is perfectly elastic, sellers pay the entire tax. In the
usual case, demand is neither perfectly inelastic no perfectly elastic and
the tax is split between buyers and seller. But the division depends on the
elasticity of demand: the more inelastic the demand, the larger is the
amount of tax aid by buyers.
• Tax Incidence and Elasticity of Supply: The division of the tax between buyers
and sellers also depends, in part, on the elasticity of supply. There are two
o Perfectly inelastic supply (sellers pay)
o Perfectly elastic Supply (buyers pay)
We’ve seen that when supply is perfectly inelastic, sellers pay the
entire tax; and when supply is perfectly elastic, buyers pay the
entire tax. In the usual case, supply is neither perfectly inelastic
now perfectly elastic and the tax is split between buyers and
sellers. But how the tax is split depends on the elasticity of supply:
The more elastic the supply, the larger is the amount of tax paid by
buyers. • Taxes and efficiency: The price buyers’ pay is also the buyers’ willingness to pay,
which measures marginal social benefit. The price sellers receive is also the
seller’ minimum supplyprice, which equals marginal social cost.
• Taxes and Fairness: Economics have proposed two conflicting principles of
fairness to apply to a tax system:
o The benefits principle: it is the proposition that people should pay taxes
equal to the benefits they receive from the services provided by the
government, This arrangement is fair because it means that those who
benefit most pay the most taxes.
o The abilitytopay principle: 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 abilityto
pay principle can reinforce the benefits principle to justify high rates of
income tax on high incomes.
• Production Quotas and Subsidies: Price floors that work a bit like the minimum
wage might be used. But this type of government action creates a surplus and is
inefficient. These same conclusions apply to the effects of a price floor for farm
products. Governments often use two other methods of intervention in the markets
for farm products:
o Production Quotas: an upper limit to the quantity of a good that may be
produced in a specified period. The effect of a production quota depends
on whether it is set below or above the equilibrium quantity. If the
government introduced a production quota above the equilibrium quantity,
nothing would change. But a production quota set below the equilibrium
has big effects, which are:
A decrease in supply
A rise in price
A decrease in marginal cost
And incentive to cheat and overproduce
o Subsidies: a payment made by the government to a producer. The effects
of a subsidy are similar to the effects of a tax but they go in the opposite
direction. These effects are:
An increase in supply
A fall in price and increase in quantity produced
An increase in marginal coat
Payments by government to farmers
o Governments intervene in some markets by making it illegal to trade in a
• Markets for Illegal Goods: The markets for many goods and services are
regulated, and buying and selling some goods is illegal. Despite the fact that these
drugs are illegal, trade in them is a multimilliondollar business.
o A free market for a drug: The demand curve shows that other things
remaining the same, the lower the price of the drug, the larger is the quantity of the drug demanded. The supply curve shows that, other things
remaining the same, the lower the price of the drug, the smaller is the
quantity supplied. If the drug were not illegal, the quantity bought and sold
would be Qc, and the price would be Pc.
o A Market for an illegal drug: When a good is illegal, the cost of trading in
the good increases. By how much the cost increases and who bears the
cost depend on the penalties for violating the law and the degree to which
the law is enforced. The larger the penalties and the better the policing, the
higher are the costs.
Penalties on Sellers:
• Drug dealers in Canada face large penalties if their
activities are detected. These penalties are part of the cost
of supplying illegal drugs, and they bring a decrease in
supply. To determine the new supply curve, we add the cost
of breaking the law to the minimum price that drug dealers
are willing to accept.
Penalties on Buyers:
• In Canada, it is illegal to possess drugs such as marijuana,
cocaine, ecstasy, and heroine. Penalties fall on buyers, and
the cost of breaking the law must be subtracted form the
value of the good to determine the maximum price buyers
are willing to pay for drugs. Demand decreases, and the
demand curve shifts leftward.
Penalties on both sellers and buyers:
• If penalties are imposed on bother sellers and buyers, both
supply and demand decrease and both the supply curve and
the demand curve shift.
• The larger the penalties and the greater the degree of law
enforcement, the larger is the decrease in demand and/or
• With high enough penalties and effective law enforcement,
it is possible to decrease demand and/or supply to the point
at which the quantity bought is zero. But in reality such an
outcome is unusual.
o Legalizing and taxing drugs:
Imposing a sufficiently high tax could decrease the supply, raise
the price, and achieve the same decrease in the quantity bought, as
does a prohibition on drugs. The government would collect large
CHAPTER 8 Utility and Demand
You know that diamonds are expensive and water is cheap. Doesn’t that seem
odd? Why do we place a higher value on useless diamonds than on essentialto
life water? • Utility: the benefit or satisfaction that a person gets from the consumption of
goods and services. To understand how people’s choices maximize utility, we
distinguish between two concepts:
o Total Utility: the total benefit that a person gets from the consumption of
all the different goods and services. Total utility depends on the level of
consumption more consumption generally gives more total utility.
o Marginal Utility: the change in the total utility that results from a oneunit
increase in the quantity of a good consumed.
Positive Marginal Utility: All the things that people enjoy and want
more of have a positive marginal utility.
Diminishing Marginal Utility: The tendency for marginal utility to
decrease as the consumption of a good increase is so general and
universal we give it the status of a principle.
o The utility maximizing choice:
Consumer equilibrium: a situation in which a consumer has
allocated all of his or her available income in the way that
maximizes his or her total utility.
o Choosing at the margin: A consumer’s total utility is maximized by
following the rule:
Spend all the available income: Because more consumption brings
more utility, only those choices that exhaust income can maximize
Equalize the marginal utility per dollar for all goods: Marginal
utility per dollar is the marginal utility from a good obtained by
spending one more dollar on that good.
• The Power if Marginal Analysis: If the marginal gain from an action exceeds the
marginal loss, take action.
o Units of Utility: In maximizing total utility by making the marginal utility
per dollar equal for all goods, the units in which utility is measured do not
matter. Any arbitrary units will work.
o EX. Pop and Movies.
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃=𝑃𝑃𝑃/𝑃𝑃
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃 𝑃𝑃𝑃=𝑃𝑃p/Pp
• Prediction of Marginal Utility Theory: Marginal utility theory predicts the law of
demand. The theory also predicts that a fall in the price of a substitute of a good
decreases the demand for the good and that for a normal good, a rise in income
• The Paradox of Value: The price of water is low and the price of diamonds is
high, but water is essential to life while diamonds are used mostly jus for
decoration. How can valuable water be so cheap while a relatively useless
diamond is so expensive? This is called the Paradox of Value.
o The Paradox Resolved: The paradox is resolved between total utility and
marginal utility. The total utility that we get from water is enormous. But remember the more we consume of something; the small is its marginal
We use so much water that its marginal utility the benefit we get
from one more glass of water or another 30 seconds in the shower
diminishes to a small value.
Diamonds, on the other hand, have a small total utility relative to
water, but because we buy few diamonds, they have a high
The equality of marginal utilities per dollar holds true for
diamonds and water:
• Diamonds have a high price and a high marginal utility.
• Water has a low price and low marginal utility.
• When the high marginal utility of diamonds is divided by
the high price of diamonds, the result is a number that
equals the low marginal utility of water divided by the low
price of water. The marginal utility per dollar is the same
for diamonds and water.
o Value and Consumer Surplus: Another way to think about the paradox of
value and illustrate how it is resolved uses consumer surplus.
CHAPTER 9 Possibilities, Preferences, and Choices
• Budget Line: describes the limits to a household’s consumption choices.
• Real Income: a household’s real income is its income expressed as a quantity of
gods that the household can afford to buy.
• Relative Price: the price of one good divided by the price of another good.
• A change in Prices: When prices change, so does the budget line. The lower the
price of a good measured on the xaxis, other things remaining the same, the
flatter is the budget line.
• A Change in Income: A change in money income changes real income but does
not change the relative price. The budget line shifts, but its slope does not change.
CHAPTER 10 Organizing Production
• Firm: institution that hires factors of production and organizes those factors to
produce and sell goods and services.
• The Firm’s Goal: A firm’s goal is to maximize profit. A firm that does not seek to
maximize profit is either eliminated or taken over by a firm that does seek that
• Economic Accounting:
o Accountants measure a firm’s profit to ensure that the firm pays the
correct amount of income tax and to show its investors how their funds are
o Economists measure a firm’s profit to enable them to predicts the firm’s
decision, and the goal of these decisions is to maximize economic profit. Economic profit is equal to total revenue minus total cost, with
total cost measured as opportunity cost of production
• 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃=𝑃𝑃−𝑃𝑃
• A Firms Opportunity Cost of Production:
o The opportunity cost of any action is the highest valued alternative
forgone. The opportunity cost of production is the value of the best
alternative use of the resources that a firm uses in production.
o A firm’s opportunity cost of production is the value of real alternatives
forgone. A firm’s opportunity cost of production is the sum of the cost of
Bought In the Market: A firm incurs a OC when it buys resources
in the market. The amount spent on these resources is an
opportunity cost of production because the firm could have bought
different resources to produce some other good or service.
Owned by the Firm: When a firm uses its own capital, it implicitly
rents the capital from itself. In this case, the firm’s opportunity cost
of using the capital it owns is called the implicit rental rate f
capital. The implicit rental rate of capital has two components:
economic depreciation and forgone interest.
• Economic Depreciation: Accountants measure
depreciation, the fall in the value of a firm’s capital, using
formulas that are related to the change in the market value
of capital. Economic Depreciation is the fall in the market
value of a firm’s capital over a given period. It equals the
market price of the capital at the beginning of the period
minus the market price of the capital at the end of the
• Forgone Interest: The funds used to buy capital could have
been used for some other purpose, and in their next best
use, they would have earned interest.
Supplied by the Firm’s Owner: A firm’s owner might supply both
entrepreneurship and labor.
• Entrepreneurship: The return to entrepreneurship is profit,
and the profit an entrepreneur earns is on average is called
normal profit. Normal profit is the cost of entrepreneurship
and is a cost of production. (=r/k)
• Owner’s Labor Services: In addition to supplying
entrepreneurship, the owner of a firm might supply labor
but not take a wage.
• Decisions: To achieve the objective of maximum economic profit, a firm must
make five decisions:
1. What to produce and in what quantities.
2. How to produce.
3. How to organize and compensate its managers and workers.
4. How to market and price its products. 5. What to produce itself and buy from others.
• The Firm’s Constraints: Three features of a firm’s environment limit the
maximum economic profit it can make. They are:
o Technology Constraints: A technology is any method of producing a good
or service. Technology advances over time. But at each point in time, to
produce more output and gain more revenue, a firm must hire more
resources and incur greater costs. The increase in profit that a firm can
achieve is limited by the technology available.
o Information Constraints: WE never possess all the information we would
like to have to make decisions. We lack information about both the future
and the present. A firm constrained by limited information about quality
and efforts of its workforce, the current and future buying plans of its
customers, and the plans of its competitors. Workers might make to little
efforts, customers might switch to competing suppliers, and a competitor
might enter the market and take some of the firm’s business.
o Market Constraints: The quantity each firm can sell and the price it can
obtain are constrained by its customer’s willingness to par and by the
prices and marketing efforts of other firms. Market constraints and the
expenditures firms make to overcome the limit the profit a firm can make.
• Technological Efficiency: occurs when the firm produces a given output by using
the least amount of inputs
• Economic Efficiency: occurs when the firm produces a given output at the least
• Information and Organization: Each firm organizes the production of goods and
services by combining and coordination the factors of production it hires. But the
way firms organize production varies and they use a mixture of two systems:
o Command Systems: A command system is a method of organizing
production that uses a managerial hierarchy. Commands pass downward
through the hierarchy, and the information passes upward.
o Incentive Systems: An incentive System is a method of organizing
production that uses a marketlike mechanism inside the firm. Instead of
issuing commands, senior managers create compensation schemes to
induce workers to perform in ways that maximize the firm’s profit.
o Mixing the Systems: Firms use the mixture of commands and incentives,
and they choose the mixture that maximizes profit. Firm’s use commands
when it is easy to monitor performance or when a small deviation from an
ideal performance is very costly. They use incentives when monitoring
performance is either not possible or too costly to be worth doing.
• The principleagent problem: It is the problem of devising compensation rules
that induce an agent to act in the best interest of a principle. The stockholders’
(the principles) must induce the managers (agents) to act in stockholders’ best
• Coping with the principleagent problem: Issuing commands does not address the
principleagent problem. In most firms, the shareholders can’t monitor the
managers and often the managers can’t monitor the workers. Each principle must create incentives that induce each agent to work in the interests of the principle.
Three ways of attempting to cope with the principalagent problem are:
o Ownership: By assigning ownership (or partownership) of a business to
managers or workers, it is sometimes possible to induce a job performance
that increases a firm’s profits. Part ownership is quite common for senior
managers but less common for workers.
o Incentive Pay: Incentive paypay related to performanceis very common.
o Longterm contracts
• Types of Business Organizations: The three main types of business organizations
o Sole proprietorship: A sole proprietorship is a firm with a single ownera
proprietor who has unlimited liability. Unlimited liability for all debts of
a firm up to an amount equal to the entire wealth of the owner.
o Partnership: A partnership is a firm with two or more owners who have
unlimited liability. Liability for full debts of the partnership is called joint
unlimited liability. Most law firms are partnerships.
o Corporation: A corporation is a firm owned by one or more limited
liability stockholders. Limited liability means that the owners have legal
liability only for the value of their initial investment.
• Pros and Cons of different types of firms:
o Rule 1: Diversification pays (limited liability makes it possible) (don’t put
all your eggs in one basket)
o Rule 2: Nothing else matters.
• Markets and the Competitive Environment: Economists identify four market
o Perfect Competition: This arises when there are many firms, each selling
an identical product, many buyers, and no restrictions on the entry of the
entry of new firms into the industry. The many firms and buyers are all
well informed about the prices of the products of each firm in the industry.
o Monopolistic Competition: This is a market structure in which large
numbers of firms compete by making similar but slightly different
products. Making a product slightly different form the product of a
competing firm is called product differentiation.
o Oligopoly: This is a market structure in which a small number of firms
compete. Oligopolies might produce almost identical products (such as the
colas produced by Coke and Pepsi).
o Monopoly: This is a market structure in which there is only one firm and it
produces a good or service that has no close substitutes and the firm is
protected by a barrier preventing the entry of new firms.
• Measures of Competition:
o The four firm concentration ratio: It is the percentage of the value of sales
accounted for by the four largest firms in an industry.
o The HerfindahlHirschman Index: This index also called HHI is the square
of the percentage market share of each firm summed over the largest 50
firms in a market. • Markets and Firms: A firm is an institution that hires factors of production and
organizes them to produce and sell goods and services. To organize production,
firms coordinate the economic decisions and activities of many individuals.
Firms are often more efficient then markets as coordinators of economic activity
because they can achieve:
o Lower transaction costs: Transaction costs are the costs that arise from
finding someone with whom to do business, or reaching the agreement
about the price and other aspects of the exchange and of ensuring that the
terms of agreement are fulfilled. Market transactions require buyers and
sellers to get together and to negotiate the terms and conditions of their
o Economies of Scale: When the cost of producing a unit of a good falls as
its output rate increases, economies of scale exist. Economies of scale
arise from specialization and the division of labor that can be reaped more
effectively by firm coordination rather than market coordination.
o Economies of Scope: A firm experiences economies of scope when it uses
specialized (and often expensive) resources to produce a range of goods
o Economies of Team Production: production process in which the
individuals in a group specialize in mutually supportive tasks.
CHAPTER 11 Output and Costs
• Decision Time Frames: People who operate firms make many decisions, and all
of their decision are aimed at achieving one overriding goal: maximum attainable
profit. To study the relationship between a firm’s output decision and its costs, we
distinguish between two decision time frames:
o The Short Run: The short run is a time frame in which the quantity of at
least one factor of production is fixed. For most firms’ capital, land, and
entrepreneurship are fixed factors of production and labor is the variable
factor of production. We call the fixed factors of production the firm’s
plant: In the short run, a firm’s plant is fixed. Short run decisions are
o The Long Run: The long run is a time frame in which the quantities of all
factors of production can be varied. That is, the long run is a period in
which the firm can change its plant. To increase output in the long run, a
firm can change its plant as well as the quantity of labor it hires. Long run
decisions are not easily reversed. To emphasize this fact, we call past
expenditure on a plant that has no resale value a sunk cost. A sunk cost is
irrelevant to the firm’s current decisions. The only costs that influence its
current decision are the shortrun cost of changing its labor inputs and the
long run cost of changing its labor inputs and the longrun cost of
changing its plant.
• Short Run Technology Constraint: To increase output in the short run, a firm must
increase the quantity of labor employed. We describe the relationship between
output and the quantity of labor employed by using three related concepts: o Total Product: the maximum output that a given quantity of labor can
o Marginal Labor: the increase in total product that results form a oneunit
increase in the quantity of labor employed, other inputs remaining the
o Average Product: the average product of labor is equal to the total product
divided by the quantity of labor employed.
• Product Curve: Product curves are graphs of the relationship between
employment and the three product concepts. They show how total product,
marginal product, and average product change as employment changes.
• Total Product Curve: The total product curve is similar to the productions
possibilities frontier. It separates the attainable output levels from those that are
unattainable. All the points that lie above the curve are unattainable. Points that
lie below the curve are attainable but inefficient. They use more labor than is
necessary to produce a given output. Only the points on the total product curve
are technologically efficient.
• Marginal Product Curve: The total product and marginal product curves differ
across firms and types of goods. But the shapes of the product curves are similar
because almost every production process has two features:
o Increasing marginal returns initially: This occurs when the marginal
product of an additional worker exceeds the marginal product of the
previous worker. Increasing marginal returns arise from increased
specialization and division of labor in the production process.
o Diminishing Marginal Returns: Most production processes experience
increasing marginal return initially, but all production processes
eventually reach a point of diminishing marginal returns. Diminishing
marginal returns occur when the marginal product of an additional worker
is less than the marginal product of the pervious worker. Diminishing
marginal returns arise from the fact that more and more workers are using
the same capital and working in the same space. As more workers are
added there is less and less for the additional workers to do that is
productive. The law of diminishing returns states that: As a firm uses more
of a variable factor of production, with a given quantity of the fixed factor
of production, the marginal product of the variable factor eventually
• Average Product Curve: It shows the relationship between average product and
marginal product. The marginal product curve cuts the average product curve at
the point of maximum average product. For the number of workers at which
marginal product exceeds average product, average product is increasing. For the
number of workers at which marginal product is less than average product,
average product is decreasing.
• Short Run Cost: To produce more output in the short run, a firm must employ
more labor, which means that it must increase its costs. We describe the
relationship between output and cost by using three cost concepts:
o Total Cost: A firms total cost (TC) is the cost of all factors of production it uses. We separate the total cost into total fixed cost, and total variable
Total fixed cost (TFC): It is the cost of the firm’s fixes factors. The
quantities of fixed factors don’t change as the output changes, so
total fixed cost is the same at all outputs.
Total Variable Cost (TVC)” It is the cost of the firms variable
factors. Total variable cost changes as output changes.
Total cost is the sun of the total fixed cost and the total variable
cost: = TFC+TVC.
Total fixed cost equals the vertical distance between the TVC and
o Marginal Cost: Total variable cost and total cost increase at a decreasing
rate at small outputs, but eventually, as output increases total variable cost
and total cost increase at an increasing rate. A firm’s marginal cost is the
increase in total cost that results from a oneunit increase in output. We
calculate marginal cost as the increase in total cost divided by the increase
in output. At small outputs, marginal cost decreases as output increases
because of greater specialization and the division of labor, but as output
increases further, marginal cost eventually increases because of the law of
o Average Cost: Three average costs of production are:
1. Average Fixed Cost (AFC): it is total fixed cost per unit of output.
2. Average Variable Cost (AVC): it is the total variable cost per unit
3. Average Total Cost (ATC): the total cost per unit of output.
The average cost concepts are calculated from the total cost
concepts as follows:
o Divide each total cost term by the quantity produced. Q, to
get: ,𝑃𝑃𝑃.=,𝑃𝑃𝑃𝑃.+,𝑃𝑃𝑃𝑃. or 𝑃𝑃𝑃=𝑃𝑃𝑃+𝑃𝑃𝑃.
• Marginal Cost and Average Cost: The marginal cost curve (MC) intersects the
average variable cost curve and the average total cost curve at their minimum
points. When marginal cost is less than average cost, average cost is decreasing,
and when marginal cost exceeds average cost, average cost is increasing.
• Shifts in the Cost Curves: The position of a firms’ short run cost curves depend on
o Technology: A technological change that increases productivity increases
the marginal product and average product of labor. With better
technology, the same factors of production can produce more output, so
the technological advance lowers the costs of production and shifts the
cost curve downward,
o Prices of Factors of Production: AN increase in the price of a factor of
production increases the firm’s costs and shifts its curves. But how the
curves shift depends on which factor price changes. • Long Run Cost: In the long run, a firm can vary both the quantity of labor and the
quantity of capital, so in the long run, all the firms’ costs are variable. The
behavior of longrun cost depends on the firm’s production function, which is the
relationship between the maximum output attainable and the quantities of both
labor and capital.
• The Production Function:
o Diminishing Returns: Diminishing returns occur with each of the four
plant sizes as the quantity of labor increases. With each plant size, as the
firm increases the quantity of labor employed, the marginal product of
labor (eventually) diminishes.
o Diminishing Marginal Product of Capital: Diminishing returns also occur
with each quantity of labor as the quantity of capital increases. You can
check that fact by calculating the marginal product of capital at a given
quantity of labor. The marginal product of capital is the change in total
product divided by the change in capital when the quantity of labor is
constant equivalently, the change in output resulting from a oneunit
increase in the quantity of capital.
• Short Run Cost and Long Run Cost:
1. Each short run ATC curve is U shaped.
2. For each short run ATC curve, the larger the plant, the greater is the output
at which average total cost is at a minimum.
o Each short run ATC curve is U shaped because as the quantity of labor
increases and then diminishes. The minimum average total cost for larger
plant occurs at a greater output than it does for a smaller plant because the
larger the plant has a higher total fixed cost and therefor, for any given
output, a higher average fixed cost. The economically efficient plant for
producing a given output is the one that has the lowest average total cost.
When a firm is producing a given output at the least possible cost, it is
operating on its long run average cost curve. The long run average cost
curve is the relationship between the lowest attainable average total cost
and output when the firm can change both the plant it uses and the
quantity of labor it employs.
• Long Run average cost curve: The long run average cost curve LRAC consists of
pieces of the four short run ATC curves.
• Economies an Diseconomies of Scale:
o Economies of Scale are features of a firm’s technology that make average
total cost fall as output increases. When economies of scale are present,
the LRAC curve slopes downward. Greater specialization of both labor
and capital is the main source of economies of scale.
o Diseconomies of Scale are features of a firm’s technology that make
average total cost rise as output increases. The challenge of managing a
large enterprise if the main source of diseconomies of scale.
o Constant returns to scale are features of a firm’s technology that keep
average total cost constant as output increases. When constant returns to
scale are present, the LRAC curve is horizontal. • Minimum Efficient Scale: A firms minimum efficient scale is the smallest output
at which long run average cost reaches its lowest level. The minimum efficient
scale plays a role in determining market structure. In a market in which the
minimum efficient scale is small relative to market demand, the market has room
for many firms, and the market is competitive. In a market in which the minimum
efficient scale is large relative to market demand, only a small number of firms,
and possibly only one firm, can make a profit and the market is either oligopoly or
CHAPTER 12 Perfect Competition
• What is Perfect Competition? The firms face the force of raw competition. We
call this extreme form of competition perfect competition. Perfect competition is a
market in which:
o Many firms sell identical products to many buyers.
o There are no restrictions on entry to the market.
o Established firms have no advantage over new ones.
o Sellers and buyers are well informed about prices.
• How perfect competition arises: Perfect competition arises id the minimum
efficient scale of a single producer is small relative to the market demand for the
good or service. In this situation, there is room in the market for many firms. A
firm’s minimum efficient scale is the smallest output at which longrun average
cost reaches its lowest level. In perfect competition, each firm produces a good
that has no unique characteristics, so consumers don’t care which firm’s good
• Price Takers: Firms in perfect competition are price takers. A price taker is a firm
that cannot influence the market price because its production is an insignificant
part of the total market.
• Economic Profit and Revenue:
o A firms’ goal is to maximize economic profit, which is equal to total
revenue minus total cost. Total cost is the opportunity cost of production,
which includes normal profit.
o The Total Revenue of a firm equals the price of its output multiplied by
the number of units of output sold (price x quantity).
o The Marginal Revenue is the change in the total revenue that results from
a oneunit increase in the quantity sold. Marginal revenue is calculated by
dividing the change in total revenue but the change in quantity sold.
Because the firm in perfect competition is a price taker, the change
in total revenue that results from a oneunit increase in the quantity
sold equals the market price.
o A horizontal demand curve illustrates a perfectly elastic demand, so the
demand for the firms’ product is perfectly elastic.
• The firms’ decisions:
o The goal of the competitive firm is to maximize economic profit, given the
constraints it faces. To achieve this goal, a firm must decide: 1. How to produce at minimum cost
2. What quantity to produce
3. Whether to enter or exit a market
o A firm makes the first decision by operating with the plant that minimizes
longrun average costby being on its longrun average curve.
• The Firms’ s Output Decision:
o A firm’s cost curves (total cost, average cost, and marginal cost) describe
the relationship between its output and costs. A firms revenue curves (total
revenue and marginal revenue) describe the relationship between its
output and revenue. From the firm’s cost curves and revenue curves, we
can find the output that maximizes the firms’ economic profit.
o Marginal analysis and the Supply decision:
Another way to find the profitmaximizes output is to use marginal
analysis, which compares marginal revenue, MR, with marginal
cost, MC. As output increases, marginal revenue is constant but
marginal cost eventually decreases.
o Temporary Shutdown Decision:
Suppose that when marginal revenue (price) equals marginal cost,
price is less than average total cost. In this case the firm incurs an
economic loss. Maximum profit is a loss (minimum loss)
If the firm expects the loss to be permanent, it goes out of business.
But if it expects the los to be temporary, the firm must decide
whether to shut down temporarily and produce no output or to
Loss Comparisons: A firm’s economic loss equals total fixed cost,
TFC, plus total variable cost minus total revenue. Total variable
cost equal average variable cost, AVC, multiplied by the quantity
produced, Q, and total revenue equals price, P, multiplied by the
quantity Q. So:
• 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃=𝑃𝑃𝑃+,𝑃𝑃𝑃−𝑃.∗𝑃
• If the firm shuts down, it produces no output (Q=0). The
firm has no variable costs and no revenue but it must pay
its fixed costs, so its economic loss equals total fixed cost.
The Shutdown Point
• A firm’s shutdown point is the price and quantity at which
it is indifferent between producing and shutting down. The
shutdown point occurs at the price an quantity at which
average variable cost is at a minimum. At the shutdown
point, the firm is minimizing its loss and its loss equals
total fixed cost.
• Output, Price, and Profit in the Short Run
o Market Supply in the Short run:
The shortrun market supply curve shows the quantity supplied by
all the firms in the market at each price when each firm’s plant and
the number of firms remain the same. The market supply curve is derived from the individual supply curves. The quantity supplied
by the market at a given price is the sum of all the firms in th