EC 10a NOTES
Chapter 1: The Ten Principles of Economics
• The fundamental lessons about individual decision making are that people face
tradeoffs among alternatives goals, that the cost of any action is measured in
terms of forgone opportunities, that rational people make decisions by comparing
marginal costs and marginal benefits, and that people change their behavior in
response to the incentives they face.
• The fundamental lessons about interactions among people are that trade and
interdependence can be mutually beneficial, that markets are usually a good way
of coordinating economic activity among people, and that the government can
potentially improve market outcomes by remedying a market failure of by
promoting greater economic equality.
• The fundamental lessons about the economy as a whole are that productivity is
the ultimate source of living standards, that growth in the quantity of money is the
ultimate source of inflation, and that society faces a shortrun tradeoff between
inflation and unemployment.
Scarcity means that society has limited resources and therefore cannot
produce all the goods and services people wish to have. Just as each member
of a household cannot get everything he or she wants, each individual in a
society cannot attain the highest standard of living to which he or she might
Economics is the study of how society manages its scarce resources. In most
societies, resources are allocated not by an allpowerful dictator but through
the combined actions of millions of households and firms. Economists
therefore study how people make decisions, interact with one another, and
analyze forces and trends that affect the economy as a whole.
Efficiency means that society is getting the maximum benefits from its scarce
Equality means that those benefits are distributed uniformly among society’s
o Equalizing the distribution of economic wellbeing
o When the government redistributes income from the rich to the poor, it
reduces the reward for working hard; as a result, people work less and
produce fewer goods.
Opportunity Cost is what ever must be given up to obtain some item. When
making any decision, decision makers should be aware of the opportunity
costs that accompany each possible action.
Rational People systematically and purposefully do the best they can to
achieve their objectives, given the available opportunities.
Marginal change is a small incremental adjustment to an existing plan of
action. Rational people often make decisions by comparing marginal benefits
to marginal costs. o A rational decision maker takes an action if and only if the marginal
benefit of action exceeds the marginal cost.
An Incentive is something that induces a person to act, such as the prospect of
punishment or reward. “People respond to incentives. The rest is
commentary.”▯Plays a central role in the study of economics
o Ralph Nader’s book Unsafe at Any Speed generated much public
concern over auto safety. Congress responded with laws requiring seat
belts as standard equipment on new cars.
In a Market Economy the decisions of a central planner are replaced by the
decisions of millions of firms and households. Firms decide who to hire and
what to make. Households decide which firms to work for and what to buy
with their incomes. These firms and households interact in the marketplace,
where prices and selfinterest guide their decisions.
o Adam Smith made the most famous observation in all of economics:
Households and firms interacting in markets act as if they are guided
by an “invisible hand.”
o The invisible hand directs economic activity
Market economies need institutions to enforce Property Rights so individuals
can own and control scarce resources.
o We all rely on governmentprovided police and courts to enforce our
rights over the things we produce—and the invisible hand counts on
our ability to enforce our rights.
Market Failure is a situation in which a market left on its own fails to allocate
Externality is the impact of one person’s actions on the wellbeing of a
bystander. Ex: pollution
A possible cause for market failure is Market Power, which refers to the
ability of a single person (or small group) to unduly influence market prices.
Ex: If everyone in town needs water but there is only one well, the owner of
the well is not subject to the rigorous competition with which the invisible
hand normally keeps selfinterest in check.
Almost all variation in living standards is attributable to differences in
countries’ Productivity—that is, the amount of goods and services produced
from each unit of labor input. The growth rate of a nation’s productivity
determines the growth rate of its average income.
Inflation is an increase in the overall level of prices in the economy.
Business Cycle is the irregular and largely unpredictable fluctuations in
economic activity, measured by the production of goods and services or the
number of people employed. Chapter 2: Thinking Like an Economist
• Economists try to address their subjects with a scientist’s objectivity. Like all
scientists, they make appropriate assumptions and build simplified models to
understand the world around them. Two simple economic models are the circular
flow diagram and the production possibilities frontier.
CIRCULARFLOW DIAGRAM PRODUCTION POSSIBILITIES
• The field of economics is divided into two subfields: microeconomics and
macroeconomics. Microeconomists study decision making by households and
firms and the interaction among households and firms in the marketplace.
Macroeconomists study the forces and trends that affect the economy as a whole.
• A positive statement is an assertion about how the world is. A normative statement
is an assertion about how the world ought to be. When economists make
normative statements, they are acting more as policy advisers than scientists.
• Economists who advise policymakers offer conflicting advice either because of
differences in scientific judgments or because of differences in values. At other
times, economists are united in the advice they offer, but policy makers may
choose to ignore it.
Albert Einstein once put, “The whole of science is nothing more than the
refinement of everyday thinking.”
Economists make assumptions for the same reason physicists do: Assumptions
can simplify the complex world and make it easier to understand.
In the CircularFlow Diagram the economy is simplified to include only two
types of decision makers—firms and households. Firms produce goods and
services using inputs, such as labor, land, and capital (buildings and
machines). These inputs are called the factors of production. Households own
the factors of production and consume all the goods and services that the firm
o In the markets for goods and services, households are buyers, and
firms are sellers. o In the markets for the factors of production, households are sellers, and
firms are buyers.
o The circularflow diagram is a visual model of the economy that shows
how dollars flow through markets among households and firms.
The Production Possibilities Frontier is a graph that shows the various
combinations of output that the economy can possibly produce given the
available factors of production and the available production technology that
firms use to turn these factors into output.
Microeconomics is the study of how households and firms make decisions and
how they interact in specific markets.
Macroeconomics is the study of economywide phenomena, including
inflation, unemployment, and economic growth.
Positive Statements are descriptive. They make a claim on how the world is.
Normative Statements are prescriptive. They make a claim about how the
world ought to be.
A key difference between positive and normative statements is how we judge
their validity. We can, in principle, confirm or refute positive statements by
examining evidence. Positive and normative statements are fundamentally
different, but they are often intertwined in a person’s set of beliefs. In
particular, positive views about how the world works affect normative views
about what policies are desirable.
Chapter 3: Interdependence and the Gains from Trade
• Each person consumes goods and services produced by many other people both in
the United States and around the world. Interdependence and trade are desirable
because they allow everyone to enjoy a greater quantity and variety of goods and
services. • There are two ways to compare the ability of two people in producing a good. The
person who can produce the good with the smaller quantity of inputs is said to
have an absolute advantage in producing the good. The person who has the
smaller opportunity cost of producing the good is said to have a comparative
advantage. The gains from trade are based on comparative advantage, not
• Trade makes everyone better off because it allows people to specialize in those
activities in which they have a comparative advantage.
• The principle of comparative advantage applies to countries as well as people.
Economists use the principle of comparative advantage to advocate free trade
Economists use the term Absolute Advantage when comparing the
productivity of one person, firm, or nation to that of another. The producer
that requires a smaller quantity of inputs to produce a good is said to have an
absolute advantage in producing that good.
o The ability to produce a good using fewer inputs than another producer
The Opportunity Cost of some item is what we give up to get that item.
Economists use the term Comparative Advantage when describing the
opportunity cost of two producers. The producer who gives up less of other
goods to produce Good X has the smaller opportunity cost of producing Good
X and is said to have a comparative advantage in producing it.
o It is impossible for one person to have a comparative advantage in
both goods. Because the opportunity cost of one good is the inverse of
the opportunity cost of the other, if a person’s opportunity cost of one
good is relatively high, the opportunity cost of the other good must be
o Comparative advantage reflects the relative opportunity cost. Unless
two people have exactly the same opportunity cost, one person will
have a comparative advantage in one good, and the other person will
have a comparative advantage in the other good.
o The ability to produce a good at a lower opportunity cost than another
o The principle of comparative advantage states that each good should
be produced by the country that has the smaller opportunity cost of
producing that good.
Trade can benefit everyone in society because it allows people to specialize in
activities in which they have a comparative advantage.
For both parties to gain from trade, the price at which they trade must lie
between the two opportunity costs
Imports are goods produced abroad and sold domestically
Exports are goods produced domestically and sold abroad
Chapter 4: The Market Forces of Supply and Demand • Economists use the model of supply and demand to analyze competitive markets.
In a competitive market, there are many buyers and sellers, each of whom has
little or no influence on the market price.
• The demand curve shows how the quantity of a good demanded depends on the
price. According to the law of demand, as the price of a good falls, the quantity
demanded rises. Therefore, the demand curve slopes downwards.
• In addition to price, other determinants of how much consumers want to buy
include income, the prices of substitutes and complements, tastes, expectations,
and the number of buyers. If one of these factors changes the demand curve shifts.
• The supply curve shows how the quantity of a good supplied depends on the
price. According to the law of supply, as the price of a good rises, the quantity
supplied rises. Therefore, the supply curve slopes upward.
• In addition to price, other determinants of how much producers want to sell
include input prices, technology, expectations, and the number of sellers. If one of
these factors changes, the supply curve shifts.
• The intersection of the supply and demand curves determines the market
equilibrium. At the equilibrium price, the quantity demanded equals the quantity
• The behavior of buyers and sellers naturally drives markets toward their
equilibrium. When the market price is above the equilibrium price, there is a
surplus of the good, which causes the market price to fall. When the market price
is below the equilibrium price, there is a shortage, which causes the market price
• To analyze how any event influences a market, we use the supplyanddemand
diagram to examine how the even affects the equilibrium price and quantity. To do
this, we follow three steps. First, we decide whether the event shifts the supply
curve or the demand curve (or both). Second, we decide in which direction the
curve shifts. Third, we compare the new equilibrium with the initial equilibrium.
• In market economies, prices are the signals that guide economics decisions and
thereby allocate scarce resources. For every good in the economy, the price
ensures that supply and demand are in balance. The equilibrium price then
determines how much of the good buyers choose to consume and how much
sellers choose to produce.
A Market is a group of buyers and sellers of a particular good or service. The
buyers as a group determine the demand for the product, and the sellers as a
group determine the supply of the product.
Economists use the term Competitive Market to describe a market in which
there are so many buyers and so many sellers that each has a negligible impact
on the market price.
For markets to be perfectly competitive the goods offered for sale must all be
exactly the same and the buyers and sellers are so numerous that no single
buyer or seller has any influence over the market price. Because buyers and sellers in perfectly competitive markets must accept the
price the market determines, they are said to be price takers. At the market
price buyers can buy all they want, and sellers can sell all they want.
Not all goods and services, however, are sold in perfectly competitive
markets. Some markets have only one seller, and this seller sets the price.
Such a seller is called a monopoly.
The Quantity of Demand of any good is the amount of the good that buys are
willing and able to purchase.
The Law of Demand says that other things equal, when the price of a good
rises, the quantity demanded of the good falls, and when the price falls, the
quantity demanded rises.
A Demand Schedule is a table that shows the relationship between price of a
good and the quantity demanded, holding constant everything else that
influences how much of the good consumers want to buy.
Demand Curve is a graph of the relationship between the price of a good and
the quantity demanded.
Market demand is the sum of all the individual demands for a particular good
Any change that increases the quantity demanded at every price shifts the
demand curve to the right and is called an increase in demand. Any change
that reduces the quantity demanded at every price shifts the demand curve to
the left and is called a decrease in demand.
Normal Good is a good for which, other things equal, an increase in income
leads to an increase in demand.
Inferior Good is a good for which, other things equal, an increase in income
leads to a decrease in demand.
Substitutes are two goods for which an increase in the price of one leads to an
increase in the demand for the other.
Complements are two goods for which an increase in the price of one leads to
a decrease in the demand for the other.
Quantity Supplied is the amount of a good that sellers are willing and able to
Law of Supply is the claim that, other things equal, when the price of a good
rises, the quantity of the good also rises, and when the price falls, the quantity
supplied also falls.
Supply Schedule is a table that shows the relationship between the price of a
good and the quantity supplied, holding constant everything else that
influences how much producers of the good want to sell.
Supply Curve is a graph of the relationship between the price of a good and
the quantity supplied.
Any change that raises quantity supplied at every price shifts the supply curve
to the right and is called an increase in supply. Similarly, any change that
reduces the quantity supplied at every price shifts the supply curve to the left
and is called a decrease in supply. Equilibrium is a situation in which the market price has reached the level at
which quantity supplied equals quantity demanded.
Equilibrium Price is the price that balances quantity supplied and quantity
o At the equilibrium price, the quantity of the good that buyers are
willing and able to buy exactly balances the quantity that sellers are
willing and able to sell.
o The equilibrium price is often called the marketclearing price
because, at this price, everyone in the market has been satisfied:
buyers have bought all they want to buy, and sellers have sold all they
want to sell.
Equilibrium Quantity is the quantity supplied and demanded at the
Surplus is a situation in which quantity supplied is greater than quantity
o Suppliers are unable to sell all they want at the going price.
o A surplus is sometimes called a situation of excess supply.
Shortage is a situation in which quantity demanded is greater than quantity
o A shortage is sometimes called a situation of excess demand.
Law of Supply and Demand is the claim that the price of any good adjusts to
bring the quantity supplied and the quantity demanded for that good into
Supply refers to the position of the supply curve, where as the quantity
supplied refers to the amount suppliers wish to sell.
A shift in the supply curve is called a change in supply, and a shift in the
demand curve is called a change in demand. A movement along a fixed supply
curve is called a change in the quantity supplied, and a movement along a
fixed demand curve is called a change in the quantity demanded.
Chapter 5: Elasticity and Its Application
• The price elasticity of demand measures how much the quantity demanded
responds to changes in the price. Demand tends to be more elastic if close
substitutes are available, if the good is a luxury rather than a necessity, if the market is narrowly defined, or if buyers have substantial time to react to a price
• The price elasticity of demand is calculated as the percentage change in quantity
demanded divided by the percentage change in price. If quantity demanded moves
proportionately less than the price, then the elasticity is less than 1, and demand is
said to be inelastic. If quantity demanded more proportionately more than the
price, then the elasticity is greater than 1, and demand is said to be elastic.
• Total revenue, the total amount paid for a good, equals the price of the good times
the quantity sold. For inelastic demand curves, total revenue moves in the same
direction as the price. For elastic demand curves, total revenue moves in the
opposite direction as the price.
• The income elasticity of demand measures how much the quantity demanded
responds to changes in consumers’ income. The crossprice elasticity of demand
measures how much the quantity demanded of one good responds to changes in
the price of another good.
• The price elasticity of supply measures how much the quantity supplied responds
to changes in the price. This elasticity often depend on the time horizon under
consideration. In most markets, supply is more elastic in the long run than in the
• The price elasticity of supply is calculated as the percentage change in quantity
supplied divided by the percentage change in price. If quantity supplied moves
proportionately less than the price, then the elasticity is less than 1, and supply is
said to be inelastic. If quantity supplied moves proportionately more than the
price, then the elasticity is greater than 1, and supply is said to be elastic.
• The tools of supply and demand can be applied in many different kinds of
markets. This chapter uses them to analyze the market for wheat, the market for
oil, and the market for illegal drugs.
Elasticity is the measure of the responsiveness of quantity demanded or
quantity supplied to a change in one of its determinants.
o To measure how much consumers respond to changes in these
variables, economists use the concept of elasticity.
Price Elasticity of Demand is the measure of how much the quantity
demanded of a good responds to a change in the price of that good, computed
as the percentage change in quantity demanded divided by the percentage
change in price.
o Demand for a good is said to be elastic if the quantity demanded
responds substantially to changes in the price.
o Demand is said to be inelastic if the quantity demanded responds only
slightly to changes in the price.
Economists compute the price elasticity of demand as the percentage change
in the quantity demanded divided by the percentage change in the price.
The standard procedure for computing a percentage change is to divide the
change by the initial level. By contrast, the midpoint method computes initial
and final levels. If elasticity is exactly 1, the quantity moves the same amount proportionately
as the price, and demand is said to have unit elasticity.
Total Revenue is the amount paid by buyers and received by sellers of a good,
computed as the price of the good times the quantity sold.
o When demand is inelastic (a price elasticity less than 1), price and total
revenue move in the same direction
o When demand is elastic (a price elasticity greater than 1), price and
total revenue move in opposite directions
o If demand is unit elastic (a price elasticity exactly equal to 1), total
revenue remains constant when the price changes
Income Elasticity of Demand is the measure of how much the quantity
demanded of a good responds to a change in consumers’ income, computed as
the percentage change in quantity demanded divided by the percentage change
CrossPrice Elasticity of Demand is the measure of how much the quantity
demanded of one good responds to a change in the price of another good,
computed as the percentage change in quantity demanded of the first good
divided by the percentage change in the price of the second good.
Price Elasticity of Supply is the measure of how much the quantity supplied of
a good responds to a change in the price of that good, computed as the
percentage change in quantity supplied divided by the percentage change in
o A key determinant of the price elasticity of supply is the time period
o The price elasticity of supply measures the responsiveness of quantity
supplied to the price
When the demand curve is inelastic a decrease in price causes total revenue to
In an extreme case of zero elasticity supply is perfectly inelastic, and the
supply curve is vertical. In this case quantity supplied is the same regardless
of the price. As elasticity rises, the supply curve gets flatter, which shows that
the quantity supplied responds more to changes in the price.
At the opposite extreme supply is perfectly elastic. This occurs at the price
elasticity of supply approaches infinity and the supply curve becomes
horizontal, meaning that very small changes in the price lead to very large
changes in the quantity supplied.
Chapter 6: Supply, Demand, and Government Policies
• A price ceiling is a legal maximum on the price of a good or service. An example
is rent control. If the price ceiling is below the equilibrium price, then the price
ceiling is binding, and the quantity demanded exceeds the quantity supplied.
Because of the resulting shortage, sellers must in some way ration the good or
service among buyers. • A price floor is the legal minimum on the price of a good or service. An example
is the minimum wage. If the price floor is above the equilibrium price, then the
price floor is bindi