Chapter 1: What is Economics?
September-11-12 1:00 PM
Definition of Economics
- Scarcity: the inability to get everything we want (universal problem)
- What society can get is limited by the productive resourcesavailable. We are forced to make choices.
- Your choices must somehowbe made consistent with the choices of others. If you choose to buy a
laptop, someoneelse must choose to sell it.
- Incentives reconcile choices. An incentiveis a reward that encourages an action or a penalty that
discourages one. Prices act as incentives. If the price of a laptop is too high, more will be offered for
sale than people want to buy. There is a price at which choices to buy and sell are consistent.
- Economics:the social science that studies the choices that individuals, businesses, governments,and
entire societiesmake as they cope with scarcity and the incentives that influence and reconcile those
choices (2 parts: microeconomics& macroeconomics)
- 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 economyand the global economy
Two Big Economic Questions
- How do choices end up determining what, how, and for whom goods and services are produced?
- Can the choices that people make in the pursuit of their own self-interest also promotethe broader
What, How, and For Whom?
- Goodsand services are the objects that people value and produce to satisfy human wants. Goods
are physical objects. Services are tasks performedfor people.
- Factors of production: goods and services that are produced by using productive resources
(grouped into 4 categories: land, labour,capital,entrepreneurship)
- Land = natural resources
- Our land surface and water resources are renewable and some of our mineral resources can be
recycled. But the resourcesthat we use to create energy are nonrenewable (can only be used
- The work time and work effort that people devote to producing goods and services
- Includes the physical and mental efforts of all the people who work
- The quality of labour depends on human capital,which is the knowledge and skill that people obtain
from education, on-the-job training, and work experience.
- The tools, instruments, machines, buildings, and other constructions that businesses use to produce
goods and services
- Money, stocks,bonds = financial capital -> used to buy physical capital, is not used to produce goods
and services -> not a productive resource
- The human resource that organizes labour, land, and capital
- Entrepreneurs come up with new ideas about what and how to produce, make business decisions,
and bear the risks that arise from these decisions.
- Who consumesthe goods and services that are produced depends on the incomes that people earn.
- People earn their incomes by selling the services of the factors of production they own:
• Land earns rent.
• Labour earns wages. -> earns the most income (around 70%)
• Capital earns interest.
• Entrepreneurship earns profit.
- Distribution of income is unequal. Can the Pursuit of Self-Interest Promotethe Social Interest?
- A choice is in your self-interest if you think that choice is the best one available for you. You order a
home delivery pizza because you're hungry and want to eat.
- A choice is in the socialinterest if it leads to an outcomethat is the best for societyas a whole.
- 2 dimensions: efficiency and equity (or fairness) -> What is best for society is an efficient and fair
use of resources.
- Efficiency: when the available resources are used to produce goods and servicesat the lowest
possible cost and in the quantities that give the greatest possible value or benefit
- Expansion of international trade, borrowing and lending, and investment
- In the self-interest of those consumerswho buy low-cost goods and services produced in other
countries; is in the self-interestof the multinational firms that produce in low-costregions and sell in
The Information-Age Economy
- Technological change of the past 40 years: the Information Revolution
- The information revolutionhas served your self-interest:it has provided your cell phone and laptop.
- make self-interested choices to use electricity and gasoline -> contribute to carbon emissions
- All the banks' choices to borrow and lend and the choices of people and businesses to lend to and
borrow from banks are made in self-interest.
The Economic Way of Thinking
- 6 key ideas that define the economic way of thinking:
• A choice is a tradeoff.
• People make rational choices by comparing benefits and costs.
• Benefit is what you gain from something.
• Cost is what you must give up to get something.
• Most choices are "how much" choices made at the margin.
• Choices respond to incentives.
A Choice Is a Tradeoff
- When we make a choice, we select from the available alternatives.
- Choices are tradeoffs. A tradeoff is an exchange, giving up one thing to get something else.
Making a Rational Choice
- Rationalchoice:choice that comparescosts and benefits and achieves the greatest benefit over cost
for the person making the choice
- Only the wants of the person making a choice are relevant to determine its rationality. For example,
you might like your coffee black and strong but your friend prefers his milky and sweet. It is rational
for you to choose espresso and for your friend to choose cappuccino.
- What goods and services will be produced and in what quantities? Those that people rationally
choose to buy.
Benefit: What You Gain
- The benefit of something is the gain or pleasure that it brings and is determined by preferences: by
what a person likes and dislikes and the intensity of those feelings.
- Economistsmeasure benefit as the most that a person is willing to give up to get something.
Cost: What You Must Give Up
- Opportunitycost: the highest-valued alternative that must be given up to get it
- Most situations involve choosing how much of an activityto do.
How Much? Choosing at the Margin
- When you compare the benefit with its cost, you're making your choice at the margin. - When you compare the benefit with its cost, you're making your choice at the margin.
- Marginalbenefit: the benefit that arises from an increase in an activity
• e.g. Your marginal benefit from one more night of study before a test is the boost it gives to your
grade. Your marginal benefit doesn't include the grade you're already achieving without that extra
- The opportunity cost of an increase in an activity is called marginalcost. The marginal cost of
studying one more night is the cost of not spending that night on your favourite leisure activity.
Choices Respond to Incentives
- Self-interested actions are not necessarily selfish actions. A self-interested act gets the most benefit
for you based on your view about benefit.
- The central idea of economicsis that we can predict the self-interested choices that people make by
looking at the incentives they face. People undertake those activitiesfor which marginal benefit
exceeds marginal cost; and they reject options for which marginal cost exceed marginal benefit.
- Incentives is the key to reconciling self-interest and social interest. When our choices are not in the
social interest, it is because of the incentives we face.
Economics as Social Science and Policy Tool
Economistas Social Scientist
- A positive statementis about what is. It says what is currently believed about the way the world
operates. A positive statementmight be right or wrong, but we can test it by checking it against
- Economics-> emerged in late 1700s
- A normative statementis about what ought to be. It depends on values. Policy goals are normative
statements.You may agree or disagree with it. It doesn't assert a fact that can be checked.
Unscrambling Cause and Effect
- Economicmodel: a description of some aspect of the economicworld that includes only those
features that are needed for the purpose at hand
• e.g. An economicmodel of a cellphone network might include features such as the prices of calls,
the number of cellphone users, and the volume of calls. But the model would ignore cellphone
- A model is tested by comparing its predictions with the facts -> difficult, we observe the outcomesof
the simultaneous change of many factors
- To cope with this problem, economistslook for natural experiments (situations in the ordinary
course of economiclife in which the one factor of interest is different and other things are equal or
similar); conduct statistical investigations to find correlations;and perform economicexperiments by
putting people in decision-making situations and varying the influence of one factor at a time.
Economistas Policy Adviser
- Economicsis a toolkit used to provide advice on government,business, & personal economic
- All the policy questions on which economistsprovide advice involve a blend of the positive and
normative.Economicscan't help with the normativepart, the policy goal. But for a given goal,
economicsprovide a method of evaluating alternativesolutions, comparing marginal benefits and
marginal costs and finding the solution that makes the best use of available resources. Chapter 2: The Economic Problem
September-13-12 1:00 PM
Production Possibilitiesand Opportunity Cost
- The quantities of goods and services that we can produce are limited both by our available resources
and by technology. If we want to increase our production of one good, we must decrease our
production of somethingelse - we face a tradeoff.
- The productionpossibilitiesfrontier (PPF) is the boundary between those combinationsof goods
and services that can be produced and those that cannot. We focus on 2 goods at a time and hold
the quantities produced of all the other goods and services constant.
- Figure 2.1 (p.30)
• Illustrates scarcity -> cannot attain the points outside the frontier (wants that can't be satisfied)
• We can produce any point inside the PPF or on the PPF -> points are attainable
- Productionefficiency is achieved if we produce goods and services at the lowestpossible cost. This
outcomeoccurs at all the points on the PPF. At points inside the PPF, production is inefficient
because we are giving up more than necessary of one good to produce a given quantity of the other
- Production is inefficient inside the PPF because resources are either unused or misallocated or both.
- Resources are unused when they are idle but could be working.
- Resources are misallocated when they are assigned to tasks for which they are not the best match.
Tradeoff Along the PPF
- Every choice along the PPF involves a tradeoff.
- Tradeoffs arise in every real-world situation in which a choice must be made. At any given point in
time, we have a fixed amount of labour, land, capital, and entrepreneurship. By using our available
technologies,we can employthese resources to produce goods and services, but we are limited in
what we can produce. This limit defines a boundary between what we can attain and what we
cannot attain. On our real-world PPF, we can produce more of any one good or service only if we
produce less of some other goods or services.
- All tradeoffs involve a cost: an opportunity cost.
- The highest-valued alternative forgone
- The opportunity cost of producing an additional pizza is the cola we must forgo.
- The opportunity cost of producing an additional can of cola is equal to the inverse of the opportunity
cost of producing an additional pizza.
Opportunity Cost Is a Ratio
- decrease in the quantity produced of 1 good ÷ the increase in the quantity produced of another
good as we movealong the PPF (Give Up ÷ Get)
Increasing Opportunity Cost
- The PPF is bowed outward because resources are not all equally productive in all activities.People
with many years of experience working at PepsiCo are good at producing cola but not very good at
making pizzas. So if we movesome of these people from PepsiCo to Domino's,we get a small
increase in the quantity of pizzas but a large decrease in the quantity of cola.
- As we produce more of 1 good, we must use resources that are less suited to that activity and more
suited to producing the other good, so we face increasing opportunity cost.
- Increasing opportunity cost is a universal phenomenon. When the rate of production increases, so
does the opportunity cost of production.
Using Resources Efficiently
- We achieve production efficiency at every point on the PPF, but which point is best? The point on the
PPF at which goods and services are produced in the quantities that provide the greatest possible
benefit. When goods and services are produced at the lowest possible cost and in the quantities that benefit. When goods and services are produced at the lowest possible cost and in the quantities that
provide the greatest possible benefit, we have achieved allocativeefficiency.
The PPF and Marginal Cost
- Marginalcost: the opportunity cost of producing one moreunit of it, calculated from the slope of
- As the quantity of pizzas produced increases, the PPF gets steeper and the marginal cost of a pizza
increases (Figure 2.2 (p.33)).
- Marginal cost curve slopes upwards because of increasing opportunity cost
Preferencesand Marginal Benefit
- The marginalbenefit from a good or service is the benefit received from consuming 1 more unit of
it. This benefit is subjective; it depends on people's preferences: people's likes and dislikes and the
intensity of those feelings.
- Marginal benefit and preferences stand in sharp contrast to marginal cost and production
possibilities. Preferencesdescribe what people like and want and the production possibilities
describe the limits or constraints on what is feasible.
- We use the marginalbenefitcurve (a curve that shows the relationship between the marginal
benefit from a good and the quantity consumed of that good) to show the preferences. The
marginal benefit curve is unrelated to the PPF and cannot be derived from it. The marginalbenefit
curve slopes downwards because of decreasing marginal benefit.
- We measure the marginal benefit from a good or service by the most that people are willing to pay
for an additional unit of it. You are willing to pay less for a good than it is worth to you but you are
not willing to pay more: the most you are willing to pay for something is its marginal benefit.
- principleof decreasing marginalbenefit: the more we have of any good/service,the smaller is its
marginal benefit and the less we are willing to pay for an additional unit of it
- Marginal benefit decreases because we like variety (get tired and switch to somethingelse).
- The marginal benefit, measured by what you are willing to pay for something, is the quantity of
other goods and services that you are willing to forgo.
- Figure 2.3 (p.34)
- Figure 2.4 (p.35)
• MB > MC (produce more pizzas)
• MB < MC (produce fewer pizzas)
• MB = MC (efficient quantity of pizzas)
- The expansion of production possibilities
- Increases our standard of living, but it doesn't overcomescarcity and avoid opportunity cost
- To make our economygrow, we face a tradeoff: the faster we make production grow, the greater is
the opportunity cost of economicgrowth.
The Cost of EconomicGrowth
- Economicgrowth comesfrom technological change and capital accumulation (expanded production
possibilities). Technologicalchange is the developmentof new goods and of better ways of
producing goods and services. Capitalaccumulation is the growth of capital resources,including
- If we use our resources to develop new technologiesand produce capital, we must decrease our
production of consumptiongoods and services. There is an opportunity cost.
- Figure 2.5 (p.36)
• The amount by which our production possibilities expand depends on the resourceswe devote to
technological change and capital accumulation. If we devote no resources to this activity (point A),
our PPF remains the blue curve. If we cut the current pizza production and produce 6 ovens (point
B), then in the future, we'll have more capital and our PPF will rotate outward to the position shown
in red. The fewer resources we use for producing pizza and the more resources we use for producing
ovens, the greater is the expansion of our future production possibilities.
- Economicgrowth brings enormousbenefits in the form of increased consumption in the future, but - Economicgrowth brings enormousbenefits in the form of increased consumption in the future, but
it is not free and it doesn't abolish scarcity.
- The opportunity cost of more pizzas in the future is fewer pizzas today.
A Nation's EconomicGrowth
- If a nation devotes all its factors of production to producing consumption goods and services and
none to advancing technology and accumulating capital, its production possibilities in the future will
be the same as they are today.
- To expand production possibilities in the future, a nation must devotefewer resources to producing
current consumption goods and services and some resources to accumulating capital and developing
new technologies. As production possibilities expand, consumptionin the future can increase. The
decrease in today's consumption is the opportunity cost of tomorrow'sincrease in consumption.
Gains from Trade
- Specialization: producing only one good or a few goods
ComparativeAdvantage and Absolute Advantage
- A person has a comparativeadvantage in an activityif that person can perform the activity at a
lower opportunity cost than anyone else. Differencesin opportunity costs arise from differences in
individual abilities and from differences in the characteristicsof other resources.
- Although no one excels at everything, some people excel and can outperform others in a large
number of activities (even in all activities).A person who is more productive than others has an
- Absolute advantage involves comparing productivities, production per hour, whereas comparative
advantage involvescomparing opportunity costs.
- A person who has an absolute advantage does not have a comparative advantage in every activity.
John Grisham is a better lawyer and a better author of fast-paced thrillers than most people. He has
an absolute advantage in these 2 activities. But compared to others, he is a better writer than
lawyer, so his comparative advantage is in writing.
- Table 2.1 & 2.2 (p.38-39)
Liz's Comparative Advantage
- Liz has a comparativeadvantage in producing smoothies.Her opportunity cost of a smoothieis
Joe's Comparative Advantage
- If Liz has a comparativeadvantage in producing smoothies,Joe must have a comparativeadvantage
in producing salads. His opportunity cost of a salad is lower.
Achieving the Gains from Trade
- Table 2.3 (p.39)
- Despite Liz being more productive than Joe, both of them gain from specializing, producing the good
in which they have a comparativeadvantage, and trading.
- People gain by specializing in the production of those goods and services in which they have a
comparativeadvantage and then trading with each other. For billions of individuals to specialize and
produce millions of different goods and services,their choices must somehowbe coordinated.
- Two competing economiccoordination systemshave been used: central economicplanning and
- Central economicplanning was tried in Russia and China and is still used in Cuba and North Korea.
This system works badly because governmenteconomicplanners don't know people's production
possibilities and preferences. Resourcesget wasted, production ends up inside the PPF, and the
wrong things get produced.
- Decentralized coordination works best but to do so it needs 4 complementarysocial institutions:
firms, markets, property rights, and money.
- An economicunit that hires factors of production and organizes those factors to produce and sell
goods and services (e.g. Tim Hortons) goods and services (e.g. Tim Hortons)
- Coordinate a huge amount of economicactivity, but there is a limit to the efficient size of a firm
• e.g. Canadian Tire buys or rents buildings.
- Canadian Tire doesn't produce the goods that it sells. It could own and coordinateproduction of all
the goods it sells. But John W. and Alfred J. Billes succeeded by specializing in providing good service
and retailing supplies from other firms that specialize. This trade between firms takes place in
- Any arrangement that enables buyers and sellers to get information and to do business with each
- Have evolvedbecause they facilitate trade. Without organized markets,we would miss out on a
substantial part of the potential gains from trade. Enterprising individuals and firms, each pursuing
their own self-interest, have profited from making markets, standing ready to buy or sell the items in
which they specialize. But marketscan work only when property rights exist.
- Social arrangements that govern the ownership, use, and disposal of anything that people value
- Real property includes land, buildings and durable goods, such as plant and equipment.
- Financial property includes stocks, bonds, and money in the bank.
- Intellectual property is the intangible product of creative effort (e.g. books, music computer
programs, and inventions of all kinds and is protected by copyrights and patents).
- Where property rights are enforced, people have the incentive to specialize and produce the goods
in which they have a comparativeadvantage. Where people can steal the production of others,
resources are devoted not to production, but to protecting possessions.
- Any commodityor token that is generally acceptable as a means of payment
- Trade in markets can exchange any item for any other item.
- Makes trading in marketsmuch moreefficient
Circular Flows Through Markets
- Figure 2.7 (p.43)
• Households specialize and choose the quantities of labour, land, capital, and entrepreneurial
services to sell or rent to firms. Firms choosethe quantities of factors of production to hire. These
(red) flows go through the factor markets. Households choose the quantities of goods and services
to buy, and firms choose the quantities to produce. These (red) flows go through the goods markets.
Households receive incomes and make expenses on goods and services (the green flows).
- Markets coordinatedecisions through price adjustments.
- Suppose that too few hamburgers are available and some people who want to buy hamburgers are
not able to do so. To make buying and selling plans the same, either more hamburgers must be
offered for sale or buyers must scale down their appetites (or both). A rise in the price of a
hamburger produces this outcome.A higher price encourages producers to offer more hamburgers
for sale. Chapter 3: Demand and Supply
September-18-12 1:00 PM
Markets and Prices
- Market: any arrangement that enables buyers and sellers to get informationand to do business with
• 2 sides: buyers & sellers
• for goods, services, factors of production, other manufactured inputs, money & financial securities
• May have physical places where buyers and sellers meet and where an auctioneer/brokerhelps
determine the prices (e.g. produce markets)
• May be groups of people spread around the world who never meet but connected through the
Internet or by telephone and fax (e.g. e-commerce,currency markets, etc.)
• Most are unorganized collectionsof buyers & sellers (do most of your trading in this type of market)
- Competitivemarket: a market that has many buyers and many sellers, so no single buyer or seller
can influence the price
- Producers offer items for sale only if the price is high enough to covertheir opportunity cost.
Consumers respond to changing opportunity cost by seeking cheaper alternatives to expensive
- Price: the # of dollars that must be given up in exchange for a good/service
- Relative price: the ratio of one price to another (Relative price is an opportunity cost.)
- Normal to express a relative price in terms of a "basket" of all goods & services
• Relative price = Money price of a good ÷ Money price of a "basket" of all goods (price index)
- When we predict that a price will fall, we mean that its relative price will fall. Its price will fall relative
to the average price of other goods and services.
- Demand exists only if: you want it, can afford it, and plan to buy it.
- Wants are the unlimited desires/wishesthat people have for goods & services.
- Quantitydemanded: amount that consumers plan to buy during a given time period at a particular
price (measured as an amount per unit of time). Sometimesthe quantity demanded exceeds the
amount of goods available, so the quantity bought is less than the quantity demanded.
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.
- Why does a higher price reduce the quantity demanded? Substitution effect & income effect
- When the price of a good rises, other things remaining the same, its relative price rises.
- Substitutes(other goods that can be used in its place) are available.
- As the opportunity cost of a good rises, the incentive to economizeon its use and switch to a
- When a price rises, other things remaining the same, the price rises relative to income. With higher
prices and unchanged income, people cannot afford to buy all the things they previously bought.
They must decrease the quantities demanded of at least somegoods & services. Normally, the good
whose price has increased will be one of the goods that people buy less of.
Demand Curve and Demand Schedule
- Demand: the entire relationship between the price of a good and the quantity demanded of that
• Shown with a demand curve & demand schedule
- Quantity demanded: a point on a demand curve, the quantity demanded at a particular price
- Demand curve: shows the relationship between the quantity demanded of a good and its price
when all other influences on consumers' planned purchases remain the same
- Demand schedule: lists the quantities demanded at each price when all the other influences on
consumers' planned purchases remain the same
Willingness and Ability to Pay Willingness and Ability to Pay
- Demand curve = willingness-and-ability-to-pay curve
- Willingness and ability to pay is a measure of marginal benefit
- If a small quantity is available, the highest price that someoneis willing and able to pay for one more
unit is high. But as the quantity available increases, the marginal benefit of each additional unit falls
and the highest price that someoneis willing and able to pay also falls along the demand curve.
A Change in Demand
- Changein demand: when any factor that influences buying plans change (other than the price)
- When demand ↑, the demand curve shifts rightward & the quantity demanded at each price is
- 6 main factors: the prices of related goods, expected future prices, income, expected future income
and credit, population, preferences
Prices of Related Goods
- The quantity of a good that consumersplan to buy depends in part on the prices of its substitutes. If
the price of a substitute for a good rises, people buy less of the substitute (demand for good
- The quantity of a good that people plan to buy also depends on the prices of its complements.A
complementis a good that is used in conjunction with another good (e.g. hamburgers & fries).
Expected Future Prices
- If the expected future price of a good rises and if the good can be stored, the opportunity cost of
obtaining the good for future use is lower today than it will be in the future when people expect the
price to be higher. They buy moreof the good now (demand ↑) before its price is expected to rise.
- If the price is expected to keep falling, the current demand for the good is less than otherwisewould
- When income increases, consumers buy moreof most (not all) goods.
- A normalgood is one for which demand increases as income increases. An inferior good is one for
which demand decreases as income increases. As incomes increase, the demand for air travel (a
normal good) increases, and the demand for long-distance bus trips (an inferior good) decreases.
Expected Future Income and Credit
- When expected future income increases or credit becomeseasier to get, demand for the good might
increase now. (e.g. A salesperson gets the news that she will receive a big bonus at the end of the
year, so she goes into debt and buys a car now, rather than wait until she receivesthe bonus.)
- Demand also depends on the size and age structure of the population. The larger the population, the
greater is the demand for all goods and services.
- The larger the proportion of the population in a given age group, the greater is the demand for the
goods & services used by that age group.
- Determinethe value that people place on each good & service
- Depend on things like weather, information,& fashion
- Table 3.1 (p.60)
A Change in the Quantity Demanded Versus a Change in Demand
- Changes in the influences on buying brings either a movementalong or a shift of the demand curve.
Movement Along the Demand Curve
- Price changes -> changein the quantitydemanded
- Fall in price -> quantity demanded increases; rise in price -> quantity demanded decreases
A Shift of the Demand Curve
- Caused by a change in demand (shift to left = decreased demand; shift to right = increased demand)
- If a firm supplies a good/service,the firm has the resources & technologyto produce it, can profit
from producing it, and plans to produce & sell it.
- Resources & technology are the constraints that limit what is possible.
- Quantitysupplied: amount that producers plan to sell during a given time period at a particular
price (measured as an amount per unit of time). Sometimesthe quantity supplied is greater than the price (measured as an amount per unit of time). Sometimesthe quantity supplied is greater than the
quantity demanded, so the quantity sold is less than the quantity supplied. Without the time
dimension, we cannot tell whether a particular quantity is large or small.
Law of Supply
- Other things remaining the same, the higher the price of a good, the greater is the quantity supplied;
and the lower the price of a good, the smaller is quantity supplied.
- Why does a higher price increase the quantity supplied? The marginal cost of producing increases.
- It is never worth producing a good if the price received for the good does not at least cover the
marginal cost of producing it. When the price of a good rises, other things remaining the same,
producers are willing to incur a higher marginal cost, so they increase production. (Higher price = ↑
Supply Curve and Supply Schedule
- Supply:the entire relationship between the price of a good and the quantity supplied of it
• Illustrated by the supply curve & supply schedule
- Quantity supplied: a point on a supply curve, the quantity supplied at a particular price
- Supplycurve: shows the relationship between the quantity supplied of a good and its price when all
other influences on producers' planned sales remain the same
- Supply schedule: lists the quantities supplied at each price when all the other influences on
producers' planned sales remain the same
Minimum Supply Price
- Supply curve = minimum-supply-pricecurve (a curve that shows the lowestprice (marginal cost) at
which someoneis willing to sell)
- If a small quantity is produced, the lowest price at which someoneis willing to sell one more unit is
low. But as the quantity produced increases, the marginal cost of each additional unit rises, so the
lowest price at which someoneis willing to sell an additional unit rises along the supply curve.
A Change in Supply
- When any factor that influences selling plans other than the price of the good changes
6 main factors: prices of factors of production, prices of related goods produced, expected future
prices, # of suppliers, technology,state of nature
Prices of Factors of Production
- If the price of a factor of production rises, the lowest price that a producer is willing to accept for
that good rises, so supply decreases (e.g. rise in min. wage = decreases supply of hamburgers).
Prices of Related Goods Purchased
- e.g. If the price of energy gel rises, firms switch production from bars to gel. The supply of energy
bars decreases. Energy bars and energy gel are substitutes in production (goods that can be
produced by using the same resources).
- e.g. If the price of beef rises, the supply of cowhide increases. Beef and cowhide are complements in
production (goods that must be produced together).
Expected Future Prices
- If the expected future price of a good rises, the return from selling the good in the future increases
and is higher than it is today. Supply decreases today and increases in the future.
The Number of Suppliers
- The larger the number of firms that produce a good, the greater is the supply of the good.
- The way that factors of production are used to produce a good
- A technologychange occurs when a new method is discoveredthat lowers the cost of producing a
good (supply ↑).
The State of Nature
- All the natural forces that influence production (state of weather and natural environment)
- Good weather can increase the supply of many agricultural products. Bad weather decreases supply.
- Table 3.2 (p.65)
A Change in the Quantity Supplied Versus a Change in Supply
- Changein quantitysupplied: movementalong the supply curve (Price falls = QS↓; price rises =
- Change in supply: shift of the supply curve (shift left = decreased supply; shift right = increased
- Price of good rises -> QD decreases and QS increases
- Equilibrium: a situation in which opposing forces balance each other, occurs when the price balances
buying plans and selling plans
- Equilibriumprice: price at which the QD = QS (no surplus, no shortage)
- Equilibriumquantity:quantity bought and sold at the equilibrium price
- A market movestowards its equilibrium because: prices regulates buying and selling plans & price
adjusts when plans don't match.
Price as a Regulator
- The price of a good regulates the quantities demanded and supplied.
- If the price is too high QS > QD. If the price is too low, QD > QS.
- Price is below equilibrium = shortage (QD > QS)
- Price is above equilibrium = surplus (QS > QD)
A Shortage Forces the Price Up
- Powerful forces operate to increase the price and moveit towards the equilibrium price. Some
producers, noticing lines of unsatisfied customers,raise the price. Some producers increase their
output. As producers push the price up, the price rises towards its equilibrium. The rising price
reduces the shortage because it decreases the QD and increases the QS. When the price has
increased to the point at which there is no longer a shortage, the forces moving the price stop
operating. The price comes to rest at its equilibrium.
A Surplus Forces the Price Down
- Powerful forces operate to lower the price and move it towards the equilibrium price. Some
producers, unable to sell the quantities they planned to sell, cut their prices. Some producers scale
back production. As producers cut the price, the price falls towards its equilibrium. The falling price
decreases the surplus because it increases the QD and decreases the QS. When the price has fallen
to the point at which there is no longer a surplus, the forces moving the price stop operating.
The Best Deal Available for Buyers and Sellers
- When the price is below equilibrium, it is forced upward. Why don't buyers resist the increase and
refuse to buy at the higher price? Because they value the good more highly than its current price,
and they can't satisfy their demand at the current price. In some markets(e.g. eBay), the buyers
might even be the ones who force the price up by offering to pay a higher price.
- When the price is above equilibrium, it is bid downward. Why don't sellers resist this decrease and
refuse to sell at the lower price? Because their minimum supply price is below the current price, and
they cannot sell all they would like to at the current price. Sellers willingly lower the price to gain
- At the price at which QD = QS, neither buyers nor sellers can do business at a better price. Buyers
pay the highest price they are willing to pay for the last unit bought, and sellers receive the lowest
price at which they are willing to supply the last unit sold.
- When people freely make offers to buy and sell and when demanders try to buy at the lowest
possible price and suppliers try to sell at the highest possible price, the price at which trade takes
place is the equilibrium price.
PredictingChanges in Price and Quantity
- For a single change either in demand or supply, ceteris paribus (all things equal), when
• Demand increases, P rises and Q increases.
• Demand decreases, P falls and Q decreases.
• Supply increases, P falls and Q increases.
• Supply decreases, P rises and Q decreases.
- When there is a simultaneous change both in demand and supply, we can determine the effect on
either price or quantity. But without information about the relative size of the shifts of the demand
and supply curves, the effect on the other variable is ambiguous. Ceteris paribus, when and supply curves, the effect on the other variable is ambiguous. Ceteris paribus, when
• Both demand and supply increase, P may rise/fall/remainconstant and Q increases.
• Both demand and supply decrease, P may rise/fall/remainconstant and Q decreases.
• Demand increases and supply decreases, P rises and Q may fall/rise/remainconstant.
• Demand decreases and supply increases, P falls and Q may rise/fall/remainconstant. Chapter 4: Elasticity
September-25-12 1:00 PM
Price Elasticityof Demand
- Price elasticityof demand: a units-free measure of the responsivenessof the QD of a good to a change in
its price when all other influences on buying plans remain the same
- Figure 4.1 (p.84)
Calculating Price Elasticity of Demand
- Price elasticity of demand = % change in QD ÷ % change in price
= ΔQ/Q ave÷ ΔP/P ave
• Change in price = % of average price
• Change in QD = % of the average quantity
Average Price and Quantity
- Average price and quantity gives the most precise measurementof elasticity (midpoint between the
original price and new price)
Percentages and Proportions
- % change = proportionate change multiplied by 100
A Units-Free Measure
- Elasticity is a units-free measure because the % change in each variable is independent of the units in
which the variable is measured. The ratio of the two % is a # without units.
Minus Sign and Elasticity
- When the price of a good rises, the QD decreases. Because a positive change in price brings a negative
change in the QD, the price elasticity of demand is a negative number. But it is the magnitude (absolute
value) of the price elasticity of demand that tells us how responsive the QD is.
Inelastic and Elastic Demand
- If the QD remains constant when the price changes, then the price elasticity of demand is 0 -> perfectly
inelasticdemand.(e.g. Insulin is so important to somediabetics that if the price changes, they do not
change the quantity they buy.)
- If the % change in the QD equals the % change in the price, then the price elasticity is 1 -> unit elastic
- 2 cases above: the % change in QD < % change in price
- In this case, the price elasticity of demand is between 0 and 1 -> inelasticdemand (e.g. food & shelter)
- If the QD changes by an infinitely large % in response to a tiny price change, the price elasticity of
demand is infinity -> perfectly elastic demand (e.g. a soft drink from 2 campus machines side to side: If
one machine's price is higher than the other's, by even a small amount, no one buys from the machine
with the higher price. Drinks from the 2 machines are perfect substitutes.). The demand for a good that
has a perfect substitute is perfectly elastic.
- % change in QD > % change in price -> The price elasticityof demand is > 1 -> elastic demand (e.g.
Elasticity Along a Linear Demand Curve
- Elasticity =/= slope
- Prices above the midpoint -> demand is elastic; prices below the midpoint -> demand is inelastic
Total Revenue and Elasticity
- Total Revenue = Price of good × Quantity sold
- The change in total revenue depends on the elasticity of demand in the following ways:
• If demand is elastic, a 1% price cut increases the quantity sold by more than 1 percent and total revenue
• If the demand is inelastic, a 1% price cut increases the quantity sold by less than 1% and total revenue
• If demand is unit elastic, a 1% price cut increases the quantity sold by 1% and total revenue does not
- Totalrevenue 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 other influences on the quantity sold total revenue that results from a change in the price, when all other influences on the quantity sold
remain the same.
• If the price cut increases total revenue, demand is elastic.
• If the price cut decreases total revenue, demand is inelastic.
• If a price cut leaves total revenue unchanged, demand is unit elastic.
Your Expenditure and Your Elasticity
- When a price changes, the change in your expenditure on the good depends on your elasticity of
• If your demand is elastic, a 1% price cut increases the quantity you buy more than 1% of your expenditure
on the item increases.
• If your demand is inelastic, a 1% price cut increases the quantity you buy by less than 1% and your
expenditure on the item decreases.
• If your demand is unit elastic, a 1% price cut increases the quantity you buy by 1% and your expenditure
on the item does not change.
- So if you spend more on an item when its price falls, your demand for that item is elastic; if you spend the
same amount, your demand is unit elastic; and if you spend less, your demand is inelastic.
The Factors That Influence the Elasticity of Demand
- Closeness of substitutes
- Proportionof income spent on the good
- Time elapsed since the price change
Closeness of Substitutes
- The closer the substitutes for a good/service,the more elastic is the demand for it. Oil from which we
make gasoline has no close substitutes, so the demand for oil is inelastic. Plastics are close substitutes for
metals, so the demand for metals is elastic.
- The degree of substitutability depends on how narrowly (or broadly) we define a good. A PC has no close
substitutes, but a Dell PC is a close substitute for a HP PC. The elasticity of demand for PCs is lower than
the elasticity of demand for a Dell or a HP.
- A necessity has poor substitutes and is crucial for our well being, so it generally has an inelastic demand.
A luxury usually has many substitutes, one of which is not buying it, so it has an elastic demand.
Proportion of Income Spent on the Good
- Other things remaining the same, the greater the proportion of income spent on a good, the more elastic
is the demand for it. If the price of gum doubles, you consumealmost as much as before (inelastic
demand). If apartment rents double, you look for morestudents to share accommodation(elastic).
Time Elapsed Since Price Change
- The longer the time that has elapsed since a price change, the more elastic is demand. When the price of
oil increased by 400% during the 1970s, people barely changed the quantity of oil and gasoline they
bought. But gradually, as more efficient auto and airplane engines were developed, the quantity bought
decreased. The demand for oil became more elastic as more time elapsed following the huge price hike.
More Elasticitiesof Demand
Cross Elasticity of Demand
- A measure of the responsivenessof the demand for a good to a change in the price of a substitute or
complement,other things remaining the same
- Cross elasticityof demand = % change in QD ÷ % change in price of a substitute or complement
- The cross elasticity of demand is positive for a substitute and negative for a complement.
- Pizzas and burgers are substitutes. Because a rise in the price of a burger brings an increase in the
demand for pizza, the cross elasticity of demand for pizza w.r.t. the price of the burger is positive. Both
the price and the quantity change in the same direction.
- Soft drinks and pizzas are complements.Because a rise in the price of a soft drink brings a decrease in the
demand for pizza, the cross elasticity of demand for pizza w.r.t. the price of a soft drink is negative. The
price and quantity change in opposite directions.
- The magnitude of the cross elasticity of demand determineshow far the demand curve shifts. The larger
the cross elasticity (absolute value), the greater is the change in demand and the larger is the shift in the the cross elasticity (absolute value), the greater is the change in demand and the larger is the shift in the
- If 2 items are close substitutes, such as 2 brands of spring water, the cross elasticity is large. If 2 items are
close complements,such as moviesand popcorn, the cross elasticity is large.
- If 2 items are somewhatunrelated to each other, such as newspapers and orange juice, the cross
elasticity is smallperhaps even 0.
Income Elasticity of Demand
- A measure of the responsivenessof the demand for a good/serviceto a change in income, other things
remaining the same
- Income elasticityof demand = % change in QD ÷ % change in income
- Income elasticities of demand can be + or - and they fall into 3 interesting ranges:
• Greater than 1 (normal good, incomeelastic)
• Positiveand less than 1 (normal good, income inelastic)
• Negative (inferior good)
Income Elastic Demand
- When the demand for a good is income elastic, the percentage of income spent on that good increases as
Income Inelastic Demand
- The % increase in QD is +, but less than the % increase in income.
- When the demand for a good is income inelastic, the percentage of income spent on that good decreases
as income increases.
- The QD of an inferior good and the amount spent on it decrease when income increases (e.g. small
motorcycles,potatoes,rice -> Low-incomeconsumersbuy most of these goods.).
- When demand increases, the equilibrium price rises, and the equilibrium quantity increases.
- Figure 4.7 (p.94)
Calculating the Elasticity of Supply
- Elasticityof supply: measures the responsivenessof QS to a change in price of a good when all other
influences on selling plans remain the same
- Elasticityof supply = % change in QS ÷ % change in price
- If the QS is fixed regardless of the price, the supply curve is vertical and the elasticity of supply is 0 ->
- Special case when the % change in price = % change in quantity -> unit elastic -> No matter how steep the
supply curve is and if it is linear and passes through the origin
- If there is a price at which sellers are willing to offer any quantity for sale, the supply curve is horizontal
and the elasticity of supply is infinite -> perfectly elastic
The Factors That Influence the Elasticity of Supply
- Resource substitution possibilities
- Time frame for the supply decision
Resource Substitution Possibilities
- Some goods & services can be produced only by using unique or rare productive resources. These items
have a low, perhaps even 0, elasticity of supply (e.g. a Van Gogh painting). Other goods & services can be
produced by using commonlyavailable resourcesthat could be allocated to a wide variety of tasks (high
- Wheat can be grown on land that is almostequally good for growing corn, so it is just as easy to grow
wheat as corn. The opportunity cost of wheat in terms of forgone corn is almost constant. Thus, the
supply curve of wheat is almost horizontal and its elasticity of supply is very large. Similarly, when a good
is produced in many different countries (e.g. sugar & beef), the supply of the good is highly elastic.
- The supply of most goods & services lies between these 2 extremes. The quantity produced can be
increased but only by incurring a higher cost. If a higher price is offered, the quantity supplied increases.
Such goods & serviceshave an elasticity of supply between 0 and infinity.
Time Frame of the Supply Decision
- 3 time frames of supply: momentarysupply, short-run supply, long-run supply - 3 time frames of supply: momentarysupply, short-run supply, long-run supply
- When the price of a good changes, the immediate response of the QS is determined by the momentary
supply of that good.
- Some goods, (e.g. fruits & vegetables)have a perfectly inelastic momentarysupply. For example, oranges'
planting decisions have to be made many years in advance of the crop being available. Momentarysupply
is perfectly inelastic because, on a given day, no matter what the price of oranges, producers cannot
change their output. They have been picked, packed, and shipped their crop to market, and the quantity
available for that day is fixed.
- Perfectlyelastic momentarysupply -> long-distance phone calls -> When many people simultaneously
make a call, there is a big surge in the demand for telephone cables, computerswitching, and satellite
time. The QS increases, but the price remains constant.
- The response of the QS to a price change when only some technologicallypossible adjustments to
production can be made is determined by short-run supply. Most goods have an inelastic short-run
- For the orange grower, if the price of oranges falls, somepickers can be laid off and oranges left on the
trees to rot. Or if the price of oranges rises, the grower can use more fertilizer and improved irrigation to
increase the yields of their existing trees. But an orange grower can't change the # of trees producing
oranges in the short run.
- The response of the QS to a price change after all the technologically possible ways of adjusting supply
have been exploited is determined by long-run supply. For most goods & services,long-run supply is
elastic and perhaps perfectly elastic.
- For the orange grower, the long run is the time it takes new tree plantings to grow to full maturity (about
15 years). In some cases, the long-run adjustment occurs only after a completelynew production plant
has been built and workershave been trained to operate it (typically a process that takes several years).
- Table 4.1 (p. 97) Chapter 6: Government Actions in Markets
September-25-12 1:00 PM
A Housing Market with a Rent Ceiling
- Price ceiling/pricecap: a governmentregulation that makes it illegal to charge a price higher than a
- A price ceiling set above the equilibrium price has no effect. The price ceiling does not constrain the
market forces. The force of the law and the market forces are not in conflict. A price ceiling below
the equilibrium price has powerful effects on a market. The price ceiling attemptsto prevent the
price from regulating the QD and QS. The force of the law and the market forces are in conflict.
- Rent ceiling: when a price ceiling is applied to a housing market. If it is set below the equilibrium
rent, it creates: a housing shortage, increased search activity, and a black market.
A Housing Shortage
- In a housing market, when the rent is at the equilibrium level, the quantity of housing supplied
equals the quantity of housing demanded and there is neither a shortage nor a surplus of housing.
- Rent set below the equilibrium rent: QD > QS (shortage)
• Shortage occurs: quantity available = QS (must be allocated), 1 way to allocate through↑ search
Increased Search Activity
- Search activity: time spent looking for someonewith whom to do business
- When a price is regulated and there is a shortage, search activity increases.
- Opportunity cost of housing = the rent (regulated price) + time/resourcesspent searching for the
restricted quantity available
- Search activity is costly. It uses time & resources that could have been used in other productive
- A rent ceiling controls only the rent portion of the cost of housing. The cost of increased search
activity might end up making the full cost of housing higher than it would be without a rent ceiling.
A Black Market
- An illegal market in which the equilibrium price > the price ceiling
- Occur in rent-controlledhousing and many other markets (e.g. Scalpers run black markets in tickets
for rock concerts.)
- When rent ceiling is in force, frustrated renters and landlords constantly seek ways of increasing
rents. One commonway is for a new tenant to pay a high price for worthless fittings. Another is for
the tenant to pay an exorbitant price for new locks and keys ("key money").
- The level of a black market rent depends on how tightly the rent ceiling is enforced. With loose
enforcement,the black market rent is close to the unregulated rent. But with strict enforcement,the
black market rent is equal to the maximum price that a renter is willing to pay.
- Figure 6.1 (p.129): To rent the 60 000th unit, someoneis willing to pay $1 200 a month. They might
pay this amount by incurring search costs that bring the total cost of housing to $1 200 a month, or
they might pay a black market price of $1 200 a month. They end up incurring a cost that exceeds
what the equilibrium rent would be in an unregulated market.
Inefficiency of a Rent Ceiling
- A rent ceiling set below the equilibrium rent results in an inefficient underproduction of housing
services. The marginal social benefit of housing exceeds its marginal social cost and a deadweight
loss shrinks the producer surplus and consumer surplus.
- Figure 6.2 (p.129)
• QS < EQ = deadweight loss
• Potential loss from housing search is carried by consumers and the full loss from the rent ceiling is
the sum of the deadweight loss and the increased cost of search.
Are Rent Ceilings Fair?
- According to the fair rules view, anything that blocks voluntaryexchange is unfair, so rent ceilings
are unfair. But according to the fair result view, a fair outcomeis one that benefits the less well off. are unfair. But according to the fair result view, a fair outcomeis one that benefits the less well off.
Thus, the fairest outcomeis the one that allocates scarce housing to the poorest.
- Blocking rent adjustments doesn't eliminate scarcity. Because it decreases the quantity of housing
available, it creates an even bigger challenge for the housing market. The market must ration a
smaller quantity of housing and allocate that housing among the people who demand it.
- When the rent is not permitted to allocate scarce housing, some possible mechanisms are: a lottery,
first-come,first served, & discrimination.
- A lotteryallocates housing to those who are lucky, not to those who are poor. First-come, first-
served allocates housing to those who have the greatest foresight and who get their names on a list
first, not to the poorest. Discriminationallocates scarce housing based on the views and self-interest
of the owner of the housing. In the case of public housing, what counts is the self-interest of the
bureaucracy that administers the allocation.
- In principle, self-interested owners and bureaucracy could allocate housing to satisfy some criterion
of fairness, but they are not likely to do so.
A Labour Market with a Minimum Wage
- The labour market is the market the influences the jobs we get and the wages we earn. Firms decide
how much labour to demand, and the lower the wage rate, the greater is the QD. Households decide
how much labour to supply, and the higher the wage rate, the greater is the QS. The wage rate
adjusts to make QD = QS.
- When wage rates are low, or when they fail to keep up with rising prices, labour unions might turn
to governmentsand lobby for a higher wage rate.
- Price floor: a governmentregulation that makes it illegal to charge a price lower than a specified
- A price floor set below the equilibrium price has no effect. The price floor does not constrain the
market forces. The force of the law and the market forces are not in conflict. But a price above the
equilibrium price has powerful effects on a market.The reason is that the price floor attemptsto
prevent the price from regulating the QD and QS. The force of the law and the market forces are in
- Minimumwage: when a price floor is applied to a labour market
• Imposed at a level that is above the equilibrium wage creates unemployment
Minimum Wage Brings Unemployment
- At a wage rate above the equilibrium wage (e.g. minimum wage), the QS > QD (surplus ->
- Figure 6.3 (p.131)
Inefficiency of a Minimum Wage
- In the labour market, the supply curve measuresthe marginal social cost of labour to workers. This
cost is leisure forgone. The demand curve measures the marginal social benefit from labour. This
benefit is the value of the goods and services produced. An unregulated labour market allocates the
economy'sscarce labour resourcesto the jobs in which they are valued mosthighly. The market is
- The minimum wage frustrates the market mechanism and results in unemploymentand increased
job search. At the quantity of labour employed, the marginal social benefit of labour exceeds its
marginal cost and a deadweight loss shrinks the firms' surplus and the workers' surplus.
- Figure 6.4 (p.132)
• QS < EQ = deadweight loss
• Potential loss from job search is carried by workers. The full loss from the minimum wage is the sum
of the deadweight loss and the increased cost of job search.
Is the Minimum Wage Fair?
- The result is unfair because only those people who have jobs and keep them benefit from the
minimum wage. The unemployed end up worse off than they would be with no minimumwage.
Some of those who search for jobs and find them end up worse off because of the increased cost of
job search they incur. Those who find jobs aren't always the least well off. When the wage rate
doesn't allocate labour, other mechanisms determine who finds a job. One mechanismis
discrimination (unfairness). discrimination (unfairness).
- The minimum wage imposes an unfair rule because it blocks voluntary exchange. Firms are willing to
hire more labour and people are willing to work more, but they are not permitted by the minimum
wage law to do so.
- The division of the burden of a tax between buyers and sellers
- When the governmentimposes a tax on the sale of a good, the price paid by buyers might rise by
the full amount of the tax, by a lesser amount, or not at all. If the price paid by buyers rises by the
full amount of the tax, then the burden of the tax falls entirely on buyers (the buyers pay the tax). If
the price paid by buyers rises by a lesser amount than the tax, then the burden of the tax falls partly
on buyers and partly on sellers. If the price paid by buyers doesn't change at all, then the burden of
the tax falls entirely on sellers.
- Does not depend on the tax law
A Tax on Sellers
- A tax on sellers is like an increase in cost, so it decreases supply.
- Figure 6.5 (p.134)
A Tax on Buyers
- Lowers the amount buyers are willing to pay sellers: decreases demand
- Figure 6.6 (p.135)
Equivalence of Tax on Buyers and Sellers
Can We Share the Burden Equally?
- When a transaction is taxed, there are 2 prices: the price paid by buyers, which includes the tax; and
the price received by sellers, which excludes the tax. Buyers respond to the price that includes the
tax and sellers respond to the price that excludes the tax.
The Employment Insurance Tax
A tax that the federal governmentimposes equally on both buyers (employers)and sellers (workers)
of labour. The marketfor labour decides how the burden of the EI tax is divided between firms &
Tax Incidence and Elasticity of Demand
- The division of the tax between buyers and sellers depend in part on the elasticity of demand. There
are 2 extremecases:
• Perfectlyinelastic demand -> buyers pay.
• Perfectlyelastic demand -> sellers pay.
Perfectly Inelastic Demand
- Figure 6.7 (p.135)
Perfectly Elastic Demand
- Figure 6.8 (p.136)
- Usual case: demand is neither perfectly inelastic nor perfectly elastic & the tax is split (buyers &
- The division depends on the elasticity of demand, the more inelastic the demand, the larger is the
amount of the tax paid by buyers.
Tax Incidence and Elasticity of Supply
- The division of the tax between buyers and sellers also depends on the elasticityof supply There are
• Perfectlyinelastic supply -> sellers pay.
• Perfectlyelastic supply -> buyers pay.
Perfectly Inelastic Supply
- Figure 6.9 (p.137)
Perfectly Elastic Supply
- Figure 6.9 (p.137)
- Usual case: supply is neither perfectly inelastic nor perfectly elastic & the tax is split (buyers & - Usual case: supply is neither perfectly inelastic nor perfectly elastic & the tax is split (buyers &
- The division 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 the buyers' willingness to pay, which measures marginal social benefit. The
price sellers receive is also the sellers' minimum supply-price, which equals marginal social cost.
- A tax makes marginal social benefit exceed marginal social cost, shrinks the producer surplus and
consumer surplus, and creates a deadweight loss.
- Figure 6.10 (p.137) -> The new supply curve does not show marginal social cost. The tax component
isn't a social cost of production. It is a transfer of resources to the government.
- Only in the extremecases of perfectly inelastic demand and perfectly inelastic supply does a tax not
change the quantity bought and sold so that no deadweight loss arises.
Taxes and Fairness
- Economistshave proposed 2 conflicting principles of fairness to apply to a tax system:the benefits
principle and the ability-to-pay principle.
The Benefits Principle
- The proposition that people should pay taxes equal to the benefits they receive from the services
provided by government(those who benefit the most pay the most taxes)
- Can justify high fuel taxes to pay for highways, high taxes on alcoholic beverages and tobacco
products to pay for public healthcare services, and high rates of income tax on high incomes to pay
for the benefits from law and order and from living in a secure environment
The Ability-To-Pay Principle
- The proposition that people should pay taxes according to how easily they can bear the burden of
the tax (e.g. a rich person can more easily bear the burden than a poor person)
- Reinforces the benefits principle to justify high rates of income tax on high incomes
Production Quotas and Subsidies
Fluctuations in the weather bring fluctuations in farm output and prices and sometimesleave
farmers with low incomes. To help farmers avoid low prices and low incomes, governments
intervene in the markets for farm products.
- Governmentsoften use 2 methodsof intervention in the markets for farm products: production
quotas & subsidies.
- An upper limit to the quantity of a good that may be produced in a specified period
- If the governmentintroduced a production quota above the equilibrium quantity, nothing would
change because milk farmers would already be producing less than the quota. But a production
quota set below the equilibrium quantity has big effects: a decrease in supply, a rise in price, a
decrease in marginal cost, inefficient underproduction, and an incentive to cheat and overproduce
(Figure 6.11 (p.139)).
A Decrease in Supply
- The QS becomesthe amount permitted by the production quota, and this quantity is fixed. The
supply becomesperfectly inelastic at the quantity permitted under the quota.
A Rise in Price
- The production quota raises the price of milk. When the governmentsets a production quota, it
leaves market forces free to determine the price. Because the quota decreases the supply, it raises
A Decrease in Marginal Cost
- Occurs because farmers produce less and stop using the resources with the highest marginal cost
- Marginal social benefit at the quantity produced is equal to the market price, which as risen.
Marginal social cost at the quantity produced has decreased and is less than the market price. So
marginal social benefit exceeds marginal social cost and a deadweight loss arises.
An Incentive to Cheat and Overproduce
- With the quota, the price exceeds marginal cost, so the farmer can get a larger profit by producing - With the quota, the price exceeds marginal cost, so the farmer can get a larger profit by producing
one more unit. If all farmers produce more than their assigned limit, the production quota becomes
ineffective,and the price falls to the equilibrium (no quota) price.
- To make the production quota effective,farmers must set up a monitoring system to ensure that no
one cheats and overproduces.
- Because of the difficulty of operating a quota, producers often lobby governmentsto establish a
quota and provide the monitoring and punishment systems that make it work.
- Paymentmade by the governmentto a producer
- Effects of a subsidy: an increase in supply, a fall in price and increase in quantity produced, an
increase in marginal cost, payments by governmentto farmers, inefficient overproduction(Figure
An Increase in Supply
- A subsidy is like a negative tax. A tax is equivalent to an increase in cost, so a subsidy is equivalent to
a decrease in cost. The subsidy brings an increase in supply.
- To determine the position of the new supply curve, we subtract the subsidy from the farmers'
A Fall in Price and Increase in Quantity Produced
- The subsidy lowers the price and increases the quantity produced.
An Increase in Marginal Cost
- Occurs because farmers grow more -> begin to use some resourcesthat are less ideal for growing
Payments by Government to Farmers
- The governmentpays a subsidy to farmers on, for example, each tonne of grain produced.
- At the quantity produced with the subsidy, marginal social benefit is equal to the market price,
which has fallen. Marginal social cost has increased and it exceeds the market price. Because
marginal social cost exceeds marginal social benefit, the increased production brings inefficiency.
- Because a subsidy lowers the domesticmarket price, subsidized farmers will offer some of their
output for sale on the world market. The increase in supply on the world marketlowers the price in
the rest of the world. Faced with lower prices, farmers in other countries ↓ production & receive
Markets for IllegalGoods
A Free Market for a Drug
- Figure 6.13 (p.142): If the drug was not illegal, price and quantity would be at equilibrium.
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
- 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.
- When sellers' penalties > buyers' penalties, Q decreases & P rises.
Penalties on Buyers
- The cost of breaking the law must be subtracted from the value of the good to determine the
maximum price buyers are willing to pay for the illegal goods. Demand decreases.
- When sellers' penalties < buyers' penalties, Q decreases & P falls.
Penalties on Both Sellers and Buyers
- Both supply and demand will decrease.
- The larger the penalties and the greater the degree of law enforcement,the larger is the decrease in
demand and/or supply. If the penalties are heavier on sellers, the supply curve shifts farther than
the demand curve and the market price rises above EP. If the penalties are heavier on buyers, the
demand curve shifts farther than the supply curve and the market price falls below EP.
- 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 0. In reality, such an outcomeis unusual. supply to the point at which the quantity bought is 0. In reality, such an outcomeis unusual.
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 governmentwould collect a
large tax revenue.
Illegal Trading to Evade the Tax
- It is likely that an extremelyhigh tax rate would be needed to cut the quantity of drugs bought to the
level prevailing with a prohibition. It is also likely that many drug dealers and consumerswould try to
cover up their activities to evade the tax. However, they would face the cost of breaking the tax law.
Taxes Versus Prohibition: Some Pros and Cons
- Prohibition or taxes? In favour of taxes is the fact that the tax revenue can be used to make law
enforcementmore effective.In favour of prohibition is the fact that prohibition sends a signal that
might influence preferences, decreasing the demand for illegal drugs. Some people intensely dislike
the idea of the governmentprofiting from trade in harmful substances. Chapter 8: Utility and Demand
October-16-12 1:00 PM
- Influenced by consumptionpossibilities & preferences
- All things that you can afford to buy (limited by income & prices)
A Consumer's Budget Line
- Budgetline: limit to consumption possibilities/boundarybetween what is affordable & unaffordable
- Figure 8.1 (p.180)
• Can afford all points on budget line & inside it; points outside the line = unaffordable
Changes in Consumption Possibilities
- Changes occur when income or prices change
- ↑ income shifts the budget line outward, slope is unchanged
- Change in price changes the slope of the line
- Budget line shows what is possible; preferences (likes & dislikes) determine which possibility is
- Utility: the benefit/satisfactionthat a person gets from the consumption of goods & services
- Total benefit that a person gets from the consumption of all the different goods & services
- Depends on the level of consumption -> moreconsumption = more total utility
- Change in total utility that results from a one-unit increase in the quantity of a good consumed
- Is positive, but it diminishes as the quantity of a good consumed ↑
Positive Marginal Utility
- All things that people enjoy and want more of have positive marginal utility. Hard labour & polluted
air can generate negative marginal utility & lower total utility.
- Total utility ↑ as quantity consumed ↑
Diminishing Marginal Utility
- Tendency for marginal utility to↓ as the consumptionof a good increases
Graphing Lisa's Utility Schedules
- Figure 8.2 (p.182)
• Total utility curve slopes upwards
• Marginal utility curve slopes downward
Find the Total Utility for Each Just-Affordable Combination
- consumer's objective:maximize total utility (best choice)
- A situation in which a consumer has allocated all of his/her available income in the way that
maximizes his/her total utility, given the prices of goods & services
Choosing at the Margin
Marginal Utility per Dollar
- the marginal utility from a good that results from spending one more dollar on it
- Marginal utility: the increase in total utility that results from consuming one more unit of a good
- Equi-marginal Principle:
- MU a/P a= MU b/P b-> maximizing utility/movingfrom this allocation of budget = being worse off
• MU a/MU b = Pa/P b
- A consumer's total utility is maximizedby the following rule:
• Spend all the available income
○ Because more consumption brings more utility, only those choices that exhaust income can
maximize utility. maximize utility.
○ Equalize the marginal utility per dollar for all goods (MU a/Pa = MU b/P b)
○ Move$ from good A from good B if doing so ↑ utility from good A by more than it ↓ the utility from
good B (possible if MU a/Pa > MU b/P b)
○ Buying moreof good A ↓ its marginal utility; buying less of good B ↑ its marginal utility
○ By moving $ from good A to good B, total utility ↑, but the gap between the marginal utilities per
dollar gets smaller.
The Power of Marginal Analysis
- If the marginal gain from an action exceeds the marginal loss, take the action.
• e.g. If the marginal utility per dollar from moviesexceeds the marginal utility per dollar from pop,
see more movies& buy less pop.
Predictions of Marginal UtilityTheory
• Marginal utility theory predicts the law of demand. It also predicts that a ↓ in the price of a
substitute of a good ↓ the demand for the good and that for a normal good, a ↑ in income ↑
A Fall in the Price of a Movie
Finding the New Quantities of Movies and Pop
1. Determinethe just affordable combinations of movies& pop at the new prices.
2. Calculate the new marginal utilities per dollar from the good whose price has changed.
• A person's preferences don't change just because a price has changed (marginal utilities don't
3. Determinethe quantities of movies & pop that make their marginal utilities per dollar equal.
- Lisa's purchases of moviesresults from a substitution effect (she substitutes the now lower-priced
moviesfor pop) & an income effect (she can afford more movies).
A Change in the Quantity Demanded
- The demand curve traces the quantities that maximizeutility at each price, with all other influences
remaining the same. Utility-maximizingchoices generate a downward-sloping demand curve. Utility
maximizationwith diminishing marginal utility implies the law of demand.
A Rise in the Price of Pop
- With different marginal utilities, Lisa might have ↓ or ↑ the quantity of moviesthat she sees when
the price of pop changes.
A Rise in Income
- Demand curves for both moviesand pop shift rightward (↑ in demand for both items)
- Larger income = consumer buys more of a normal good
The Paradox of Value
- How can valuable water be so cheap while a relatively useless diamond is so expensive?
The Paradox Resolved
- The total utility that we get from water is enormous,but the more we consume of something, the
smaller is its marginal utility.
- Diamonds have a small total utility relative to water, but because we buy few diamonds, they have a
high marginal utility.
- The equality of marginal utilities per dollar holds true for diamonds & water: diamonds have a high
price and a high marginal utility. Water has a low price and a low marginal utility -> MU d/Pd =
Value and Consumer Surplus
- Consumersurplus: the excess of the benefit received from a good over the amount paid for it.
- Figure 8.7 (p.191)
• Water -> cheap, large consumer surplus; diamonds -> expensive,small consumer surplus
New Ways of Explaining Consumer Choices
- Studies the way in which limits on the human brain's ability to compute& implementrational - Studies the way in which limits on the human brain's ability to compute& implementrational
decisions influence economicbehaviourboththe decisions that people make & the consequences
of those decisions for the way marketswork
- Starts with observed behaviour -> looks for anomalies (choices that do not seem to be rational)
- 3 impediments that prevent rational choice: bounded rationality, bounded willpower, & bounded
- Rationality that is limited by the computing power of the human brain
- Faced with uncertainty, people might use rules of thumb, listen to the views of others, and make
decisions based on gut instinct rather than on rational calculation.
- The less-than-perfect willpower that prevents us from making a decision that we know, at the time
of implementing the decision, we will later regret
- e.g. Lisa's rational choice is to ignore the temporarythirst and stick to her plan of seeing a movie
later this month. But she might not possess the willpower to do so.
- The limited self-interest that results in sometimessuppressing our own interests to help others
- e.g. Lisa feels sorry for the victims in Florida after a hurricane hits the coast, and decides to donate
The Endowment Effect
- The tendency for people to value something more highly simply because they own it
- If you have allocated your income to maximizeutility, then the price you would be willing to accept
to give up something that you own should be the same as the price you are willing to pay for an
identical one. This behaviour contradicts marginal utility theory.
- uses the ideas & tools of neuroscience to study the effects of economicevents & choices inside the
human brain Chapter 9: Possibilities, Preferences, and Choices
October-16-12 1:00 PM
- Consumption choices are limited by income & by prices.
- budgetline -> describes the limits to its consumption choices
- Figure 9.1 (p.204)
Divisible and Indivisible Goods
- Divisible goods: can be bought in any quantity desired (e.g. gasoline & electricity)
• Consumption possibilities refer to specific points on & intermediate points that form the budget line.
Affordable & Unaffordable Quantities
- Budget line = constraint on choices (boundary between affordable & unaffordable)
- The constraint on consumptiondepends on the prices and one's income, and the constraint changes
when the price of a good or one's income changes.
- Expenditure = Income
- Expenditure = (Priceof A Quantity of A) + (Price of B Quantity of B)
- A household's income expressed as a quantity of goods that the household can afford to buy
- e.g. Expressed in terms of pop, Lisa's real income is Income/P p ($40/$4= 10 cases).
- Point at which the budget line intersects the y-axis in terms of the good measured on that axis
- The price of one good divided by the price of another good
- Is the magnitude of the slope of the budget line
• Slope of budget line = Δy/Δx = - Income/P y÷ Income/P x = -Px/P y
A Change in Prices
- Figure 9.2 (a) (p.206)
• The lower the price of the good measured on the x-axis, the flatter is the budget line (rotates
• The higher the price of the good measured on the x-axis, the steeper is the budget line (rotates
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 (due to same relative prices).
- Figure 9.2 (b) (p.206)
• ↑ money income, ↑ real income, shifts budget line rightward
• ↓ money income, ↓ real income, shifts budget line leftward
Preferences and Indifference Curves
- A preference map helps people sort all the possible combinations of goods into 3 groups: preferred,
not preferred, & indifferent. It is a series of indifference curves that resemble the contour lines on a
- Figure 9.3 (p.207)
- Indifferencecurve: a line that shows combinations of goods among which a consumeris indifferent
- The assumption of a regular indifference curve:
1. Two goods world, good x &good y
2. More is preferred to less
3. Diminishing MU
4. Transitivity (being logical)
- Indifference curves farther from the origin represent higher levels of satisfaction.
- Indifference curves never intersect.
- Slope of the indifference curve (rise/run) = -Δy/Δx = MU x/Mu y= MRS
Marginal Rate of Substitution (MRS)
- The rate at which a person will give up good y (measured on y-axis) to get an additional unit of good
x measured on x-axis) while remaining indifferent (remaining on the same indifference curve) x measured on x-axis) while remaining indifferent (remaining on the same indifference curve)
- The magnitude of the slope of an indifference curve measures the MRS.
• If the indifference curve is steep, the MRS is high. The person is willing to give up a large quantity of
good y to get an additional unit of good x while remaining indifferent.
• If the indifference curve is flat, the MRS is low. The person is willing to give up a small amount of
good y to get an additional unit of good x while remaining indifferent.
- Figure 9.4 (p.208) -> straight line/tangent on curve -> MRS = Quantity of Good Y ÷ Quantity of Good
- DiminishingMRS: a general tendency for a person to be willing to give up less of good y to get one
more unit of good x, while at the same time remaining indifferent as the quantity of x ↑
• key assumption about preferences
Your Diminishing Marginal Rate of Substitution
- The shape of a person's indifference curves incorporates the principle of the diminishing MRS
because the curves are bowed towards the origin. The tightness of the bend of an indifference curve
tells us how willing a person is to substitute one good for another while remaining indifferent.
Degree of Substitutability
- Figure 9.5 (p.209)
• Indifference curves of perfect complementsare L-shaped.
• The closer the 2 goods are to perfect substitutes, the closer the MRS is to being constant (straight
line, sloping downward), rather than diminishing (curved line). Indifference curves for poor
substitutes are tightly curved and lie between the shapes of those shown in Figure 9.5 (a) & (c).
Best Affordable Choice
- Intersection of budget line & highest attainable indifference curve (Figure 9.6 (p.210))
- For every point inside the budget line, there are points on the budget line that one prefers.
- Every point on the budget line lies on an indifference curve.
- MRS = relative price (e.g. willingness to pay for a movie= opportunity cost of a movie)
A Change in Price
- Price effect: the effect of a change in the price of a good on the quantity of the good consumed
• Price Effect = Substitution Effect + Income Effect
- Figure 9.7 (p.211) -> lower price, movementto the right along demand curve
A Change in Income
- Incomeeffect: the effect of a change in income on buying plans.
- Figure 9.8 (p.213) -> income ↓ -> consumersbuy less of both normal goods, ↓ demand
Substitution Effect and Income Effect
- Normal good -> price ↓