Modern Principles: Microeconomics
Incentives: rewards and penalties that motivate behavior
Ex: the owners of the ship would get money for each prisoner placed on the ship, but economists
changed it to paying the captains money for each prisoner getting off the ship (different incentive
that shot the survival rate up); before incentive was to treat the prisoner badly, now to treat them
well (instead of giving them food, they stole it to sell for money in Australia)
Not always self-centered but sometimes; fame, power, reputation, sex, and love are all important
Benevolence too responds; Anonymous Hall (when people give money to charities)
Good Institutions Align Self-Interest with the Social Interest
When self-interest aligns with the broader public interest, we get good outcomes, but when self-
interest and the social interest are at odds, we get bad outcomes, sometimes even cruel and
inhumane outcomes (ship captains did the right thing for themselves, prisoners, and for
government paying for them)
“Greed is good”
Bad when a firm has a great incentive to emit pollution; when fisherman have a great incentive
to drive the stock of fish into collapse
When you get a flu shot, are you thinking about your well being or keeping others from getting
sick as well?
Trade-offs are everywhere
Testing takes time so more testing means that good drugs are delayed, just like bad drugs. So the
longer it takes to bring new drugs to market the more people are harmed who could have
benefited. You can die because an unsafe drug is approved but you can also die if a drug has not
yet been approved. This is drug lag. And the greater the costs of testing, the fewer new drugs
there will be. Drug loss if a safe drug is never developed.
So more testing means drugs are safer but also means drug lag and loss.
Also relates to…
Opportunity cost: (of a choice) is the value of the opportunities lost
Important. First, if you don’t understand the opportunities you are losing when you make a
choice, you wont recognize the real trade-offs that you face. Recognizing trade offs is the first
step to making wise choices. Second, most of the time people do respond to changes in
opportunity costs (even when money costs have not changed) so if you want to understand
behavior, understand ^
*When economy is booming and unemployment rate is low, the college enrollment rate tends to
be low as well (same for the other way around)
Thinking on the Margin
Thinking on the margin is just making choices by thinking in terms of marginal benefits and
marginal costs, the benefits and costs of a little bit more (or a little bit less). Ex: the speed limit,
going a little over? Should the consumer buy a few more apples or a few less? Should the oil well produce a few
more barrels of oil or a few less?
Marginal cost (the addition cost from producing a little bit more)
Marginal Revenue (the additional revenue from producing a little bit more)
Marginal Tax Rates (the tax rate on an additional dollar of income)
The Power of Trade
The power goes beyond those of exchange. The real power is the power to increase production
through specialization. Self-sufficiency is death. Through the division of knowledge, the sum of
knowledge increases and in this way so does productivity. Trade also allows us to take advantage
of economies of scale, the reduction in costs created when goods are mass-produced. Everyone
needs trade. Someone’s opportunity cost for running their certain business is going to be higher
than something else in their life.
The Importance of Wealth and Economic Growth
Wealth-the ability to pay for the prevention of malaria – ended malaria in the US and wealth
comes from economic growth, so the incidence of malaria is not just about geography, its also
about economics. Overall, it’s the wealthiest countries that have the highest rates of infant
survival. Wealth brings women’s rights, antibiotics, education, fun vacations etc. In all – wealth
Among the most powerful institutions for supporting good incentives are property rights,
political stability, honest gov, a dependable legal system, and competitive and open markets.
North and South Korea are so different – what differs is their economic system and incentives at
Macroeconomists are interested in the incentives to produce new ideas. New ideas require new
incentives and that means an active community and the freedom to put out new ideas. Ideas can
feed the whole world. Never used up. Good implications for understanding benefits or trade,
future of economic growth, etc.
Economic Booms and Busts cannot be avoided but can be moderated
No economy grows at a constant pace. We cannot avoid all recessions. Not all booms and busts
are normal, however. Great Depression was not normal, catastrophic event (some think it could
have been avoided but the tools at disposal (monetary and fiscal policy) weren’t that good)
Prices Rise when the Government Prints Too much Money
Inflation: an increase in the general level of prices
Inflation makes people feel poorer, but perhaps more important, rising and especially volatile
prices make it harder for people to figure out the real value of goods, services, and investments.
Where does it come from? When people have more money, they spend it, and without an
increase in the supply of goods, prices must rise.
The Federal Reserve has the power and responsibility to regulate the supply of money in the
Central Banking is a Hard Job The Fed faces a really hard job – you can never fully predict the future. They have to shoot at a
moving target because there is time between the decision and the effects it makes in the
Economics is Fun
Teaches us how make the world a better place. It’s about the difference between wealth and
poverty, work and unemployment, happiness and squalor.
Demand curve: a function that shows the quantity demanded at different prices
The quantity demanded is the quantity that buyers are willing and able to buy at a particular
The demand curves tell us the quantity demanded at any price or the mx willingness to pay (per
unit) for any quantity. (Pages 28-29)
*The fact that oil is not equally valuable in all of its uses explains why the demand curve for oil
has a negative slope; when the price of oil is high, oil will only be used in its higher-valued uses.
As the price of oil falls, oil will also be used in lower-valued uses.
The lower the price, the greater the quantity demanded – this is often called the “law of
Consumer surplus: the consumer’s gain from exchange. Or the difference between the max
price a consumer is willing to pay for a certain quantity and the market price
Total consumer price: measured by the area beneath the demand curve and above the price
(Base times height divided all by 2) the top section (figure 3.4 page 30)
(For ex: when president is willing to pay $80 per barrel when its only $20)
*An increase in demand shifts the demand curve outward, up and to the right (greater willingness
to pay for the same quantity)
*A decrease in demand shifts the demand curve inward, down and to the left (smaller quantity
demanded at the same price)
Important Demand Shifters
-Price of substitutes
-Price of complements
Keep in mind: what would make people willing to pay more for the same quantity?
Normal good: is a good for which demand increases when income increases
When an increase in income increases the demand for a good, we say the good is a normal good.
Inferior good: is a good for which demand decreases when income increases
(When get more money, don’t want easy mac or ramen anymore, you want restaurants) Population:
More people, more demand. Demographers are also studying which age group makes up the
most of the population because then we can see which goods and services might increase.
Prices of Substitutes:
If two goods are substitutes, a decrease in the price of one good leads to a decrease in demand for
the other good.
Price of Compliments:
If two goods are complements, a decrease in the price of one good leads to an increase in the
demand for the other good.
Ex: ground beef and hamburger buns; if price of beef goes down, people buy more beef and this
also increases the demand for buns (so market will want to stock up on both)
*The expectation of a reduction in the future oil supply increased the demand for oil today
For a hurricane, we all stock up on storm supplies
Changes in tastes caused by fads, fashions, and advertising can all increase or decrease demand.
Diets, Michael Jordan tennis shoes; can tastes change something like the demand for oil? Yes,
the environmental movement has made people more aware of global climate change –hybrid cars
demand increase, recycling
Supply curve: is a function that shows the quantity supplied at different prices
The quantity supplied is the amount of a good that sellers are willing and able to sell at a
PAGE 35 – make sure I can read a supply and demand graph
*At a price of $20, suppliers are willing to sell 30 million barrel of oil per day.
*To produce 30 million barrels of oil a day, suppliers must be paid at least $20 per barrel.
*As the price of oil rises, it becomes profitable to produce oil using methods and from regions of
the world with higher costs of production. The higher the price of oil, the deeper the wells.
Law of supply: the higher the price, the greater the quantity supplied
Producer surplus: the producer’s gain from exchange, or the difference between the market
price and the minimum price at which a producer would be willing to sell a particular quantity.
Total producer surplus: measured by the area above the supply curve and below the price
What happens to the supply curve when the cost of producing falls? (New technology)
Decrease in costs increases supply. In the diagram, a decrease in costs mean that the supply
curve shifts down and to the right. Higher costs mean that the supply curve shifts up and to the
Important Supply Shifters (5) LOOK AT page 38-39 Technological innovations and changes in the price of inputs
Improvements in tech can reduce costs, thus increasing supply; a reduction in input prices also
reduces costs and thus has a similar effect (fall/increase in wages)
Taxes and subsidies
As far as firms are concerned, a tax on output is the same as an increase in costs. Firms will
make sure they still get the same profit. The $10 tax shifts the supply curve up by $10 at every
point along the curve. A subsidy is the same as a negative or “reserve” tax.
The shifting of supply in response to price expectations is the essence of speculation, the attempt
to profit from future price changes. (People who expect prices to increase will have incentive to
sell less today so they can store goods for future sale)
Entry or exit of producers
The entry of more firms meant that at any price a greater quantity of lumber was available, that is
the supply curve shifted to the right.
Changes in opportunity costs
Suppose a farmer could grow soybeans or wheat. If the price of wheat increases, the farmer’s
opportunity cost of growing soybeans increases and the farmer will want to shift into a more
profitable alternative of wheat production.
Pg 41 - Summary
MAKE SURE YOU KNOW THE GRAPHS
Equilibrium: How Supply and Demand Determine Prices
The price at the meeting point is called the equilibrium price and the quantity at the meeting
point is called the equilibrium quantity (these are the only prices in a free market that are stable)
*Occurs when the quantity demanded equals the quantity supplied
A surplus is a situation in which the quantity supplied is greater than the quantity demanded
-Competition will push prices down whenever there is a surplus (seller will have to lower prices
to sell their surplus of goods)
-As competition pushes prices down, the quantity demanded would increase and quantity
supplied will decrease
A shortage is a situation in which the quantity demanded is greater than the quantity supplied
-Competition will push prices up whenever there is a shortage
What will sellers do if they discover that a price of $15 they can easily sell all of their output and
still have buyers asking for more? Raise prices!
The equilibrium price is the price at which the quantity demanded is equal to the quantity
The equilibrium price is stable because at the equilibrium price the quantity demanded is exactly
equal to the quantity supplied Sellers want higher prices and buyers want lower prices so the person in the street often thinks
that sellers compete against buyers
BUT sellers compete with other sellers more and buyers compete with other buyers (you should
“blame” other buyers for outbidding you)
Gains from Trade are maximized at the equilibrium price and quantity
The equilibrium quantity is the quantity at which the quantity demanded is equal to the
Pg 50 – buyers are willing to pay 57 for an additional barrel of oil, and sellers are willing to sell
and additional barrel for as little as $15
Notice that there are unexploited gains from trade at any quantity less than the equilibrium
If quantity supplied exceeds the equilibrium quantity, it costs the sellers more to produce a barrel
of oil than that barrel of oil is worth to buyers
So we expect in a free market, the quantity bought and sold will decrease until equilibrium
-Limiting number of resources – markets help us achieve this goal
A free market maximizes the gains from trade
A free market maximizes producer plus consumer surplus
When we say that a free market maximizes the gains from trade, we mean…
1. Supply of goods is bought by the buyers with the higher willingness to pay
2. Supply of goods is sold by the sellers with the lower costs
3. Between buyers and sellers, that are no unexploited gains from trade and no wasteful
*Under the right conditions, the pursuit of self-interest leads not to chaos but to a beneficial
An increase in supply reduces the equilibrium price and increase the equilibrium quantity.
Does the model work? Evidence from the Lab
Vernon Smith – established lab experiments as an important tool for economic science
Shifting Demand and Supply Curves
Fall in costs for making the good results curve and to the right (increase in quantity)
A decrease in supply will raise the market price and reduce the market quantity the opposite
effects to an increase in supply
Can you explain why the price and quantity demanded increased with an increase in demand?
A decrease in demand will tend to decrease the price and quantity
Demand Compared with Quantity Demanded and Supply Compared with Quantity
An increase in the quantity demanded is a movement along a fixed demand curve. An increase in
demand is a shift of the entire demand curve (up and to the right) The increase in supply pushes the price down, thereby causing an increase in the quantity
demanded from 70 units to 90 units.
The changes in the quantity demanded are always caused by changes in supply
Shifts in the supply curve cause movements along the demand curve.
Shifts in the demand curve create changes in the quantity supplied.
Chapter 5: Elasticity and its applications
The elasticity of demand measures how responsive the quantity demanded is to a change in
price; more responsive equals more elastic (the more responsive quantity demanded is to a
change in the price, the more elastic is the demand curve
*Elasticity Rule: If two linear demand (or supply) curves run through a common point, then at
any given quantity the curve that is flatter is more elastic
The demand for oil is not very elastic because there are few substitutes for oil in its major use,
If price of cigs go up and people decide to satisfy oral cravings with carrots, carrots are a
substitute for cigs
*The fundamental determinant of the elasticity of demand is how easy it is to substitute one good
for another. The fewer substitutes for a good, the less elastic the demand
(Moving closer to work as a substitute for oil) but people adjust to price increases in many ways
and economists think of all these adjustments as involving substitutes
In short, the more time people have to adjust to change in price, the more elastic the demand
curve will be.
*The demand for a specific brand of a product (Orange Crush) is more elastic than the demand
for a product category (orange soda)
*The demand is less elastic for goods that people consider to be “necessities” and is more elastic
for goods that are considered “luxuries”
*Higher income makes demand less elastic (less concerned with price of item)
*The larger the share of a persons budget is devoted to good, the more elastic
If we care about price – elastic
If we don’t – less elastic
Elasticity of demand = (percentage change in quantity demanded)/(percentage change in price)
^Is a measure of how responsive the quantity demanded is to a change in price
Always negative because when the price goes up, the quantity demanded always goes down (vise
*When the absolute value of the elasticity is…
Less than 1 (<1) the demand is not very elastic inelastic (revenue and price move together)
If greater than 1 (>1) elastic (revenue and price move in opposite directions)
If =1, then unit elastic (revenue stays the same when price changes)
USE THE MIDPOINT FORMULA
(Demanded) Qafter – Qbefore/ (Qafter + Qbefore/2) ALL OVER (divided by)
(price) Qafter – Qbefore/ (Qafter + Qbefore/2) Revenue = price X quantity
If the demand curve is inelastic, then revenues go up when the price goes up. If the demand
curve is elastic, then revenues go down when the price goes up.
*when P goes up by a lot, Q goes down by a little revenues go up
*when demand curve is inelastic, revenues go up when the price goes up, and revenues will go
down when the price goes down
-when the demand curve is inelastic, an increase in price increase revenues
^decrease causes decrease in revenues
-when the demand curve is elastic, an increase in price decreases revenues
^decrease causes an increase in revenues
what happens to revenues when price increases or decreases when the demand curve is UNIT
Ex: the more effective prohibition is at raising costs, the greater are drug industry revenues.
The elasticity of supply measures how responsive the quantity supplied is to a change in price
When the price of a good like oil increases, suppliers will increase the quantity supplied, but by
how much? Will the quan