Definition of Economics
All economic questions arise because we want more than we can get.
Our inability to satisfy all our wants is called scarcity.
Because we face scarcity, we must make choices.
The choices we make depend on the incentives we face.
An incentive is a reward that encourages an action or a penalty that discourages
an action.
Economics is the social science that studies the choices that individuals,
businesses, governments, and entire societies make as they cope with scarcity
and the incentives that influence and reconcile those choices.
Economics divides in to main parts:
 Microeconomics
 Macroeconomics
We need to distinguish between them.
Microeconomics is the study of choices that individuals and businesses make,
the way those choices interact in markets, and the influence of governments.
Macroeconomics is the study of the performance of the national and global
economies.
Two Big Economic Questions
Two big questions summarize the scope of economics:
 How do choices end up determining what, how, and for whom
goods and services get produced?
 When do choices made in the pursuit of self-interest also promote
the social interest?
What, How, and For Whom?
Goods and services are the objects that people value and produce to satisfy
human wants.
How?
Goods and services are produced by using productive resources that economists
call factors of production.
Factors of production are grouped into four categories:
 Land
 Labor
 Capital
 Entrepreneurship
- The “gifts of nature” that we use to produce goods and services are land.
- The work time and work effort that people devote to producing goods and
services is labor.
1
- The quality of labor 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 are capital.
- The human resource that organizes land, labor, and capital is
entrepreneurship
For Whom?
Who gets the goods and services depends on the incomes that people earn.
 Land earns rent.
 Labor earns wages.
 Capital earns interest.
 Entrepreneurship earns profit.
You make choices that are in your self-interest—choices that you think are best
for you.
Choices that are best for society as a whole are said to be in the social interest.
An outcome is in the social interest if it uses resources efficiently and distributes
goods and services fairly.
The Big Question
Is it possible that when each one of us makes choices that are in our selfinterest, it also turns out that these choices are also in the social interest?
Self-Interest in the Social Interest
Five topics that generate discussion and that illustrate tension between selfinterest and social interest are
 Globalization
 The information-age economy
 Global warming
 Natural resource depletion
 Economic instability
Opportunity Cost
Thinking about a choice as a tradeoff emphasizes cost as an opportunity forgone.
The highest-valued alternative that we give up to get something is the
opportunity cost of the activity chosen.
The Economic Way of Thinking
Choosing at the Margin
People make choices at the margin, which means that they evaluate the
consequences of making incremental changes in the use of their resources.
The benefit from pursuing an incremental increase in an activity is its marginal
benefit.
The opportunity cost of pursuing an incremental increase in an activity is its
marginal cost.
2
CHAPTER-2
THE ECONOMIC PROBLEM
Why does food cost much more today than it did a few years ago?
We use an economic model—the production possibilities frontier—to explain
the economic problem. (Scarcity-problem)
We also use this model to study how we can expand our production possibilities;
how we gain by trading with others; and why the social institutions have
evolved.
Production Possibilities and Opportunity Cost
The production possibilities frontier (PPF) is the boundary between those
combinations of goods and services that can be produced and those that cannot.
To illustrate the PPF, we focus on two goods at a time and hold the quantities of
all other goods and services constant.
That is, we look at a model economy in which everything remains the same
(ceteris paribus) except the two goods we’re considering.
Production Possibilities and Opportunity Cost
Production Possibilities Frontier
Figure 2.1 shows the PPF
for two goods: cola and
pizza.
Any point on the frontier
such as E and any point
inside the PPF such as Z
are attainable.
Points outside the PPF are
unattainable.
3
Production Efficiency
We achieve production efficiency if we cannot produce more of one good
without producing less of some other good.
Points on the frontier are efficient.
Any point inside the frontier, such as Z, is inefficient.
At such a point, it is possible to produce more of one good without producing
less of the other good.
At Z, resources are either unemployed or misallocated.
Tradeoff Along the PPF
Every choice along the PPF involves a tradeoff.
On this PPF, we must give up some cola to get more pizzas or give up some pizzas
to get more cola.
Opportunity Cost
As we move down along the PPF, we produce more pizzas, but the quantity of
cola we can produce decreases.
The opportunity cost of a pizza is the cola decline.
In moving from E to F,
the quantity of pizzas increases by 1 million.
The quantity of cola decreases by 5 million cans.
The opportunity cost of the pizzas is 5 million cans of cola.
In moving from F to E, the quantity of cola produced increases by 5 million.
The quantity of pizzas decreases by 1 million.
Because resources are not equally productive in all activities, the PPF bows
outward—is concave.
The outward bow of the PPF means that as the quantity produced of each good
increases, so does its opportunity cost.
Using Resources Efficiently
All the points along the PPF are efficient.
To determine which of the alternative efficient quantities to produce, we
compare costs and benefits.
The PPF and Marginal Cost
The PPF determines opportunity cost.
The marginal cost of a good or service is the opportunity cost of producing one
more unit of it.
4
Figure 2.2 illustrates the
marginal cost of pizza.
As we move along the
PPF in part (a), the
opportunity cost of a
pizza increases.
The opportunity cost of
producing one more
pizza is the marginal cost
of a pizza.
In part (b) of Fig. 2.2,
the bars illustrate the
increasing opportunity
cost of pizza.
The black dots and the
line MC show the
marginal cost of pizza.
The MC curve passes
through the center of
each bar.
5
Preferences and Marginal Benefit
Preferences are a description of a person’s likes and dislikes.
To describe preferences, economists use the concepts of marginal benefit and the
marginal benefit curve.
The marginal benefit of a good or service is the benefit received from
consuming one more unit of it.
We measure marginal benefit by the amount that a person is willing to pay for an
additional unit of a good or service.
- It is a general principle that the more we have of any good, the smaller is its
marginal benefit and the less we are willing to pay for an additional unit of it.
- We call this general principle the principle of decreasing marginal benefit.
- The marginal benefit curve shows the relationship between the marginal
benefit of a good and the quantity of that good consumed.
Figure 2.3 shows a marginal
benefit curve.
The curve slopes downward to reflect the principle of decreasing marginal
benefit.
- At point A, with pizza production at 0.5 million, people are willing to pay 5 cans
of cola for a pizza.
- At point B, with pizza production at 1.5 million, people are willing to pay 4 cans
of cola for a pizza.
- At point E, with pizza production at 4.5 million, people are willing to pay 1 can
of cola for a pizza.
6
Allocative Efficiency
When we cannot produce more of any one good without giving up some other
good, we have achieved production efficiency. We are producing at a point on
the PPF.
When we cannot produce more of any one good without giving up some other
good that we value more highly, we have achieved allocative efficiency, We are
producing at the point on the PPF that we prefer above all other points.
Figure 2.4 illustrates allocative
efficiency.
The point of allocative efficiency
is the point on the PPF at which
marginal benefit equals marginal
cost.
If we produce exactly 2.5 million
pizzas, i.e. at the equilibrium, the
marginal cost equals marginal
benefit.
If we produce less than 2.5
million pizzas, i.e. an
equilibrium, the marginal
benefit exceeds the marginal
cost.
7
If we produce more
than 2.5 million
pizzas, i.e. the
equilibrium, the
marginal cost
exceeds marginal
benefit.
Economic Growth
The expansion of production possibilities—and increase in the standard of
living—is called economic growth.
Two key factors influence economic growth:
 Technological change
 Capital accumulation
Technological change is the development of new goods and of better ways of
producing goods and services.
Capital accumulation is the growth of capital resources, which includes human
capital.
The Cost of Economic Growth
To use resources in research and development and to produce new capital, we
must decrease our production of consumption goods and services.
So economic growth is not free.
The opportunity cost of economic growth is less current consumption.
Figure 2.5 illustrates the
tradeoff we face.
We can produce pizzas or
pizza ovens along PPF0.
By using some resources
to produce pizza ovens
today, the PPF shifts
outward in the future.
8
chapter 3 : How Markets Work
Demand
Introduction
• Economics is about choices that people make to face scarcity and how
those choices are affected by incentives.
• Prices act as incentives.
• The demand & supply model is the main tool of Economics . It tells us
how people respond to prices and how prices are determined by demand
& supply.
• This model helps us to answer the economic
questions : What How , and for whom are goods and services are produced?
Prices And Markets
• Prices of goods and services are determined by demand and supply of
these goods and services in the markets.
• A market has two sides : buyers & sellers.
• Examples of goods and services:
• Some markets are physical places where buyers & sellers meet.
• Some markets are groups of people around the world who never meet ,
but connected through
Internet. Examples: E-commerce markets and currency markets.
Money Prices & Relative Prices
• A Money Price of a good is the amount of money must be paid in exchange
of it.
• A Relative Price is the ratio of the price of one good to another and it is
an opportunity cost.
• Example : If the money price of coffee is 1 SR and the money price of
gum is 0.5 SR , then the relative price of coffee to gum= 1 /0.5 = 2 : 1 and
it is the opportunity cost of a cup of coffee : To get one cup of coffee ,you
must give up two packs of gum.
Demand
• If you demand something that means:
• You want it.
• You can afford it ,and
• Plan to buy it.
• Demand reflect a choice : What wants to be satisfied and by what goods
and services.
The Quantity Demanded
• The quantity demanded of goods & services is the amount that consumer
plan to buy during a period of time at a particular price.
• Many factors influence buying plans and price is one of them.
9
The Law of Demand
• Other things remain the same , the higher the price of a good , the smaller
the quantity demanded and the lower the price of a good , the greater the
quantity demanded.
Substitution Effect and Income Effect
• To explain why a higher price reduce the quantity demanded ?
• For two reasons:
1. Substitution Effect: When the price of a good rises . Other things
remaining the same, its relative price ( the opportunity cost) rises.
As the opportunity cost of a good rises , the incentive to reduce its use
and switch to a substitute becomes stronger.
2. Income Effect
When the price of a good rises , Other things remaining the same , people
face a higher price and an unchanged income. They cannot pay for all
goods and services that they used to buy. So when the price of a good
rises , Other things remaining the same , they must decrease the
quantities of some goods and services specially the good whose price has
increased.
The Demand Curve
• shows the inverse relationship between the quantity demanded of a good
and its price , other things that affect demand being the same.
A Demand Schedule
Quantity
demanded
22
15
10
7
5
Price
Point
0.5
1
1.5
2
2.5
A
B
C
D
E
It lists the quantity demanded
at each price other things that
influence demand being the
same. Example:
The Demand Curve
Draw it
A change in the quantity demanded
• A change in the quantity demanded = movement along the demand
curve
• If the price of the good changes, but no other influence on buying plans
changes, that means we have movement along the demand curve ; there
is a change in the quantity demanded as price changes.
• The change in the quantity demanded due to the changes in the price of
the good.
10
A Change in Demand
•
•
•
When a factor that affects the buying plan other than the price of the good
changes , there is a change in demand.
Increase in demand means movement of the demand curve to the right
and quantity demanded increases at each price. (draw it)
Decrease in demand means movement of the demand curve to the left and
quantity demanded decreases at each price. (draw it)
Factors bring Changes in Demand
1. The Prices of Related Goods:
The related goods are:
Substitutes &Complement.
A substitute is a good that can be used in place of another one. There is
positive relationship between the price of a substitute and the demand for the
good. If the price of tea rises the demand for coffee increases and vise versa.
A complement is a good is used with another one to satisfy the same needs.
There is negative relationship between the price of a complement and the
demand for the good. If the price of sugar rises the demand for tea decreases
and vise versa.
2. Expected Future Prices:
If the price of a good is expected to rise in the future , and if the good can be
stored , the demand for the good increases today and vise versa. Examples.
3. Income: Consumers’ income influences demand.
• When income increases , consumers buy more of most goods and when
income decreases , consumers buy less of most goods.
• The positive relationship between income and demand for the good is
true for most goods, they are the normal goods. But the relationship
between income and demand for the good is negative for few goods; the
inferior goods.
• Example: air travel and long – distance bus trips.
4. Expected Future Income & Credit:
When income is expected to increase in the future . Or when credit is easy to
obtain , the demand might increase now. Example.
5. Population :
Demand depends on the size and the age structure of the population .
The larger the population ,the greater the demand for all goods and services
and vise versa.
• Also ,the larger the proportion of the population in a given age group , the
greater is the demand for the goods and services used by that group.
Example.
6. Preferences:
Demand depends on preferences .
11
Preferences determine the value that people place on each good and service.
Preferences are affected by things such as weather , information and fashion.
The demand for the good Decreases if :
1.
2.
3.
4.
5.
6.
The price of a substitute falls.
The price of a complement rises.
The price of the good is expected to fall.
Income falls.
Expected Income falls or credit becomes harder to get.
The population decreases.
Increases if : …….
Supply
If firm supplies a good or a service , the firm:
Has the resources and technology to produce it , Can make profit from
producing it , and Plan to produce & sell it.
The Quantity Supplied
The quantity supplied of a good or a service is the amount that producers
plan to sell during a given time period at a particular price.
The law of supply states:
Other things remaining the same, the higher the price , the greater is the
quantity supplied; and the lower the price , the smaller is the quantity
supplied.
The reason for the positive relationship: When price rises , other things
remaining the same , producers can bear higher costs by increasing the
quantity supplied.
Remember : Opportunity cost ( the cost of the last unit produced of the
good measured by the decrease in the quantity of the other good )
increases as the production of the good increases.
Supply Schedule
The Supply Schedule of Energy Bar
Price
The
Quantity
Supplied
A
0.5
0
B
1
6
C
1.5
10
D
2
13
E
2.5
15
12
The supply schedule lists the
quantity supplied at each
price when all other things
that affect producers’ planned
sales remain the same.
The Supply Curve of Energy Bar: The supply curve shows the
relationship between the quantity supplied of a good and its price when
all other things that affect producers’ planned sales remain the same.
(Draw it)
A Change in Supply
•
When any other factor affecting supply of a good other than its price
changes , there is a change in supply curve it would shift to the right or to
the left. ( draw it )
We are going to study these factors and their effects on the supply curve
1. The Prices of Factors of Production ( - ) :
The prices of factors of production are costs of production , if they
increase this means higher costs and lower profits so producers decrease
production at each price and supply curve shifts to the left.
•
•
2.Prices of Related Goods Produced :
If price of a substitute ( - ) rises , firms switch production from the good
to the substitute and supply decreases ,and vice versa. ( example ).
If a price of a complement ( + ) rises , the supply of the good increases
and vice versa.
Example : chicken and eggs are complements in production ; they must
be produced together.
3.Expected Future Price ( -) :
If the price of the good is expected to rise , supply decreases today and
increases in the future.
4.The Number of Suppliers ( + ) :
The larger the number of suppliers , the greater is the supply of the good.
As firms enter an industry , the supply increases.
5.Technology ( + ) :
It means the way that factors of production are used to produce a good.
If technology improves and we use new method that lowers costs of
production , production of the good increases and supply shifts to the
right.
•
•
6.The State of Nature :
This includes all natural forces that influence production.
Good weather can increase the supply of agricultural goods and vice
versa.
Extreme natural event such as earthquakes , tornados, and hurricanes can
influence supply.
13
A Change in Quantity Supplied VS. a Change in Supply
• A change in quantity supplied means movement along the curve and it
happens when the price of the good changes.
• a change in supply means that the entire supply curve shifts, it happens
when any of the other factors that influence supply other than the price
of the good changes ( draw it )
Changes in Supply
Decreases if :
1. The price o a factor of production used to produce it rises.
2. The price of a substitute in production rises.
The price of a complement in production falls.
3. The price of the good is expected to rise.
4. The number of suppliers decreases.
5. A technology change decreases production of the good.
6. A natural event decreases production of the good .
Increases if : ……..
•
•
•
•
•
•
Market Equilibrium
Equilibrium in a market occurs when the price balances the plans of
buyers and plans of sellers.
The equilibrium price is the price at which the quantity demanded equals
the quantity supplied.
The equilibrium quantity is the quantity bought & sold at the equilibrium
price .
Price as a Regulator
The price of a good regulates the quantity demands and supplied.
If price is too low , the quantity demanded > the quantity supplied , and
we have a shortage . The shortage bids up price till we reach equilibrium.
If price is too high , the quantity supplied > the quantity demanded , and
we have a surplus . The surplus e bids down the price till we reach
equilibrium. ( draw it )
Price
per
unit
Qd
Qs
Shortage
(−)
Or
Surplus
(+)
0.5
1
1.5
2
2.5
22
15
10
7
5
0
6
10
13
15
-22
-9
0
6
10
14
Table p. 68 shows :
-The equilibrium price at
which Qd = Qs
Above the equilibrium price :
Qs > Qd
A surplus
-Below the equilibrium price :
Qd > Qs
A shortage
Price Adjustment
A shortage forces the price up:
When there is a shortage ,producers raise the price. When price rises Qd
decreases and Qs increases until we reach equilibrium.
A surplus forces the price down:
• When there is a surplus ,producers cut the price. When price falls Qs
decreases and Qd increases until we reach equilibrium. ( draw it )
•
The Effects of changes in Demand and Supply on Market Equilibrium
PP. 70-71
An Increase in Demand
• When number of consumers or income of consumers increases ,or other
things that cause demand increases , the demand curve shifts to the right .
. Both the equilibrium price and quantity increase. ( draw it )
A Decrease in Demand
• When number of consumers or income of consumers decreases ,or other
things that cause demand decreases , the demand curve shifts to the left .
Both the equilibrium price and quantity decrease. (draw it )
An Increase in Supply
• If costs of production fall or producers use a new technology that cause
increase in supply , or other things happen that increase supply , supply
curve shifts to the right.
The equilibrium price decreases and the equilibrium quantity increases.
(draw it)
A Decrease in Supply
• If costs of production rise or producers switch to a substitute, or other
things happen that decrease supply , supply curve shifts to the left.
The equilibrium price rises and the equilibrium quantity decreases.
(draw it)
15
Chapter 4 Elasticity
Price Elasticity of Demand
In Figure 4.1(a inelastic
demand), an increase in
supply brings
-A large fall in price
- A large fall in price
In Figure 4.1(b
elastic demand), an
increase in supply
brings
- A small fall in
price
- A large increase in
the quantity
demanded
The contrast between the two outcomes in Figure 4.1 depend on The price
elasticity of demand which means the measure of the responsiveness of the
quantity demanded of a good to a change in its price when all other influences on
buyers’ plans remain the same.
16
Calculating Elasticity
Price Elasticity of Demand = % age change in Quantity Demanded
% age change in Price
= = DQ/Qave /DP/Pave
To calculate the price elasticity of demand:
We express the change in price as a percentage of the average price—the average
of the initial and new price,
and we express the change in the quantity demanded as a percentage of the
average quantity demanded—the average of the initial and new quantity.
calculates the price elasticity of demand for pizza from the following table :
The
Original
Point
P = 20.5
The New
Point
The
Average
P = 19.5
P
Q= 9
Q = 11
Q
1
1
2
2
The price initially is $20.50
and the quantity demanded is
9 pizzas an hour.
= 20
aver
= 10
aver
The price falls to
$19.50 and the
quantity demanded
increases to 11
pizzas an hour.
The price falls by
$1 and the quantity
demanded
increases by 2
pizzas an hour.
The average price is
$20 and the
average quantity
demanded is 10
pizzas an hour.
17
The percentage change in
quantity demanded, %DQ,
is calculated as DQ/Qave,
which is 2/10 = 1/5.
The percentage change in
price, %DP, is calculated as
DP/Pave, which is $1/$20 =
1/20.
The price elasticity of
demand is
%DQ/ %DP =
(1/5)/(1/20)
= 20/5 = 4
The formula yields a negative value, because price and quantity move in opposite
directions.
But it is the magnitude, or absolute value, of the measure that reveals how
responsive the quantity change has been to a price change.
The ratio of two proportionate changes is the same as the ratio of two
percentage changes.
The measure is units free because it is a ratio of two percentage changes and the
percentages cancel out.
Changing the units of measurement of price or quantity leave the elasticity value
the same.
Inelastic and Elastic Demand
Demand can be inelastic, unit elastic, or elastic, and can range from zero to
infinity.
18
- If the quantity demanded
doesn’t change when the
price changes, the price
elasticity of demand is zero
and the good as a perfectly
inelastic demand and the
demand curve is vertical.
- If the percentage change in
the quantity demanded equals
the percentage change in
price, the price elasticity of
demand equals 1 and the good
has unit elastic demand and
the demand curve with ever
declining slope.
- If the percentage change in the quantity demanded is smaller than the
percentage change in price, the price elasticity of demand is less than 1 and the
good has inelastic demand.
For example Insulin; patients that require insulin will continue to pay almost any
price for it.
- If the percentage change in the quantity demanded is greater than the
percentage change in price, the price elasticity of demand is greater than 1 and
the good has elastic demand.
For example: The airline industry is very elastic because all airlines offer a very
similar service.
19
- If the percentage change in
the quantity demanded is
infinitely large when the
price barely changes, the
price elasticity of demand is
infinite and the good has a
perfectly elastic demand,
and the demand curve is
horizontal .
Factors Affecting Elasticity :
The elasticity of demand for a good depends on:
1. Substitutes: When there are more substitutes for a good, elasticity is
higher, as consumers can easily switch to other goods in response to price
changes.
2. Proportion of Income Spent on the Good : The greater the proportion of
income consumers spent on a good, the larger is its elasticity of demand.
3. Time Elapsed Since Price Changes : In the short run, demand for goods
tends to be inelastic. But In the long run, demand for goods tends to be
elastic, as consumers have the opportunity to change their spending
habits.
4. Necessity and luxury: Necessities, such as food or housing, generally have
inelastic demand.
Luxuries, such as exotic vacations, generally have elastic demand.
20
Elasticity Along a straight- Line Demand Curve
Elasticity decreases as the price
falls and quantity demanded
increases.
At midpoint of a demand curve , the
demand is unit elastic.
At prices above the midpoint of a
demand curve , the demand is
elastic.
At prices below the midpoint of a
demand curve , the demand is
inelastic.
-For example, if the price falls
from $25 to $15, the quantity
demanded increases from 0 to
20 pizzas an hour.
The average price is $20 and the
average quantity is 10 pizzas.
The price elasticity of demand is
(20/10)/(10/20), which equals
4.
-If the price falls from $10 to
$0, the quantity demanded
increases from 30 to 50 pizzas
an hour.
The average price is $5 and the
average quantity is 40 pizzas.
The price elasticity is
(20/40)/(10/5), which equals
1/4.
-If the price falls from $15 to
$10, the quantity demanded
increases from 20 to 30 pizzas
an hour.
The average price is $12.50 and
the average quantity is 25
pizzas.
The price elasticity is
(10/25)/(5/12.5), which equals
1.
21
Note: we use average price & average quantity in each case to calculate elasticity.
Elasticity decreases as the price falls and quantity demanded increases.
Total Revenue and Elasticity
The total revenue from the sale of good or service equals the price of the good
multiplied by the quantity sold. TR = P x Qd
When the price changes, total revenue also changes. But a rise in price doesn’t
always increase total revenue.
The change in total revenue due to a change in price depends on the
elasticity of demand:
 If demand is elastic, a 1 percent price cut increases the quantity
sold by more than 1 percent, and total revenue increases.
-at the same time your expenditure ( as a consumer ) on the item
increases .
 If demand is inelastic, a 1 percent price cut increases the quantity
sold by less than 1 percent, and total revenues decreases.
-at the same time your expenditure ( as a consumer ) on the item
decreases .
 If demand is unit elastic, a 1 percent price cut increases the
quantity sold by 1 percent, and total revenue remains unchanged.
- at the same time your expenditure ( as a consumer ) on the item does not
change.
The total revenue test is a method of estimating the price elasticity of demand by
observing the change in total revenue that results from a price change (when all
other influences on the quantity sold remain the same).
For example if the price
falls from $25 to $12.50,
the quantity demanded
increases from 0 to 25
pizzas, the demand will be
elastic, and total revenue
increases.
22
-At $12.50, demand is unit
elastic and total revenue
stops increasing. ( At 25,
demand is unit elastic, and
total revenue is at its
maximum ) .
-As the price falls from
$12.50 to zero, the quantity
demanded increases from
25 to 50 pizzas. Demand is
inelastic, and total revenue
decreases.
More Elasticities of Demand
Cross Elasticity of Demand
The cross elasticity of demand measures how the quantity demanded of a good
responds to a change in the price of a substitute or a complement, other things
remaining the same.
Cross Elasticity =
% age change in Quantity Demanded
% age change in Price of substitute or complement
The cross elasticity of demand is :
 Positive for substitute goods : the increase in the quantity of
pizza demanded when the price of burger (a substitute for
pizza) rises.
 Negative for complement goods : the decrease in the quantity of
pizza demanded when the price of a soft drink (a complement of
pizza) rises.
23
If there is an increase in the price
of pizza (a substitute of burger),
people will switch to burger,
therefore the cross elasticity of
this substitute good moves rightside (positive).
If there is an increase in the price
of Pepsi (a compliment with
pizza), then people will reduce
their demand for pizza and Pepsi,
both, therefore the cross elasticity
of this compliment goods moves
left-side (negative).
Income Elasticity of Demand
The income elasticity of demand measures how the quantity demanded of a good
responds to a change in income, other things remaining the same.
Income Elasticity =
% age change in Quantity Demanded
% age change in Income
- If the income elasticity of demand is greater than zero, the good is a normal
good.
- If the income elasticity of demand is less than zero (negative) the good is an
inferior good.
- If the income elasticity of demand is greater than 1, demand is elastic and the
good is luxury goods.
- If the income elasticity of demand is less than 1, demand is inelastic and the
good is essential goods.
24
In Figure 4.7(a), an
increase in demand
while the supply is
inelastic, brings
A large rise in price
And A small increase
in the quantity
supplied
In Figure 4.7(b),
an increase in
demand while
the supply is
elastic, brings
A small rise in
price and A
large increase in
the quantity
supplied
25
Chapter 8 : utility of demand
Preferences
A household’s preferences determine the benefits or satisfaction a person
receives consuming a good or service.
The benefit or satisfaction from consuming a good or service is called utility.
Total utility (TU) is the total benefit a person gets from the consumption of
goods. Generally, more consumption gives more utility.
Total utility from a good increases as the quantity of the good increases. For
example, as the number of movies seen in a month increases, total utility from
movies increases.
Marginal utility (MU) is the change in total utility that results from a one-unit
increase in the quantity of a good consumed.
As the quantity consumed of a good increases, the marginal utility from
consuming it decreases. We call this the principle of diminishing marginal utility.
Table 8.1 provides an example of total and marginal utility schedule.
26
Figure 8.1(a) shows a
total utility curve for
soda.
Total utility increases
with the consumption
of a soda increases.
Figure 8.1(b) illustrates
diminishing marginal utility.
As the quantity of soda
increases, the marginal
utility from soda diminishes.
The key assumption of marginal utility theory is that the household chooses the
consumption possibility that maximizes total utility.
27
The Utility-Maximizing Choice
We can find the utility-maximizing choice by looking at the total utility that
arises from each affordable combination.
The utility-maximizing combination is called a consumer equilibrium.
Table 8.2 shows Lisa’s utility-maximizing choice.
-Lisa has $40 a month to spend on movies and soda.
The price of a movie (PM) is $8 and the price of soda (PS) is $4 a case.
Each row of the table shows a combination of movies and soda that exhausts
Lisa’s $40.
-Lisa chooses the combination that gives her the highest total utility.
Lisa maximizes her total utility when she sees two movies and drinks 6 cases of
soda a month.
-Lisa gets 90 units of utility from the 2 movies and 225 units of utility from the 6
cases of soda.
Choosing at the Margin
A consumer’s total utility is maximized by following these rules:
Spend all available income.
Equalize the marginal utility per dollar for all goods (the marginal utility from a
good divided by its price ).
28
Total utility is maximized when:
MUM/PM = MUS/PS = 5
Table 8.3 shows why the utility-maximizing rule works.
The combination is each row is affordable (costs $40).
In row C
If MUM/PM > MUS/PS, ( in point B ), then spend less on soda and more on movies.
MUM decreases and MUS increases.
If MUS/PS > MUM/PM, ( in point D ), then spend more on soda and less on movies.
MUS decreases and MUM increases.
So Only when MUM/PM = MUS/PS, is it not possible to reallocate the budget and
increase total utility.
Predictions of Marginal Utility Theory
A Fall in the Price of a Movie
When the price of a good falls the quantity demanded of that good increases—
the demand curve slopes downward.
For example, if the price of a movie falls, we know that MUM/PM rises, so before
the consumer changes the quantities bought, MUM/PM > MUS/PS.
To restore consumer equilibrium (maximum total utility) the consumer
increases the movies seen to drive down the MUM and restore MUM/PM = MUS/PS.
29
A change in the price of one good changes the demand for another good.
You’ve seen that if the price of a movie falls, MUM/PM rises, so before the
consumer changes the quantities consumed, MUM/PM > MUS/PS.
To restore consumer equilibrium (maximum total utility) the consumer
decreases the quantity of soda consumed to drive up the MUS and restore
MUM/PM = MUS/PS.
Table 8.4 shows Lisa’s affordable combinations when the price of a movie is $4.
Before Lisa changes what she buys MUM/PM > MUS/PS To maximize her total
utility, Lisa sees more movies and drinks less soda.
30
Predictions
:
Figure
8.2
illustrates these predictions: A
fall in the price of a movie
increases the quantity of movies
demanded a movement along the
demand curve for movies, and
decreases the demand for soda—
a shift of the demand curve for
soda.
A Rise in the Price of Soda
Now suppose the price of soda
rises.
We know that MUS/PS falls, so
before the consumer changes the
quantities bought, MUS/PS <
MUM/PM.
To restore consumer equilibrium
(maximum total utility) the
consumer decreases the quantity
of soda consumed to drive up the
MUS and increases the quantity of
movies seen to drive down MUM.
These changes restore MUM/PM =
MUS/PS.
31
Table 8.5 shows Lisa’s affordable combinations when the price of soda is $8 a
case and a movie is is $4.
Before Lisa changes what she buys MUs/Ps < MUm/Pm , To maximize her total
utility, Lisa drinks less soda.
Figure 8.3 illustrates these
predictions.
A rise in the price of soda
decreases the quantity of
soda demanded—a
movement along the
demand curve for soda.
32
Chapter 11 : output and costs :
Decision Time Frames
The firm makes many decisions to achieve its main objective: profit
maximization.
Some decisions are critical to the survival of the firm, Some decisions are
irreversible (or very costly to reverse), and Other decisions are easily reversed
and are less critical to the survival of the firm, but still influence profit.
All decisions can be placed in two time frames: The short run and The long run.
The short run is a time frame in which the quantity of one or more resources
used in production is fixed.
For most firms, the capital, called the firm’s plant, is fixed in the short run. Other
resources used by the firm (such as labor, raw materials, and energy) can be
changed in the short run.
Short-run decisions are easily reversed.
The long run is a time frame in which the quantities of all resources—including
the plant size—can be varied.
Long-run decisions are not easily reversed.
Short-Run Technology Constraint
In the Short Run We assume that:
1. Labor units are homogenous.
2. Capital & Technology are fixed.
3. We can increase or decrease production by increasing or
decreasing the variable resources such as labor.
Three concepts describe the relationship between output and the quantity of
labor employed: Total product, Marginal product, and Average product.
-Total product is the total output produced in a given period.
-The marginal product of labor is the change in total product that results from a
one-unit increase in the quantity of labor employed, with all other inputs
remaining the same.
- The average product of labor is equal to total product divided by the quantity
of labor employed.
Table 11.1 shows a firm’s product schedules. As the quantity of labor employed
increases:
33
 Total product increases.
 Marginal product increases initially but eventually decreases.
 Average product increases initially but eventually decreases.
Product Curves
Product curves are graphs of the three product concepts that show how total
product, marginal product, and average product change as the quantity of labor
employed changes.
Figure 11.1 shows a total
product curve :
The total product curve
shows how total product
changes with the quantity
of labor employed.
34
The total product curve is
similar to the PPF.
It separates attainable
output levels from
unattainable output levels
in the short run.
The figure shows the
marginal product of labor
curve and how the marginal
product curve relates to the
total product curve.
If the first worker hired
produces 4 units of output.
And the second worker
hired produces 6 units of
output and total product
becomes 10 units. The third
worker hired produces 3
units of output and total
product becomes 13 units.
And so on.
The height of each bar measures the marginal product of labor. For example,
when labor increases from 2 to 3, total product increases from 10 to 13, so the
marginal product of the third worker is 3 units of output.
To make a graph of
the marginal product
of labor, we can stack
the bars in the
previous graph side
by side.
The marginal product
of labor curve passes
through the midpoints of these bars.
35
Almost all production processes are like the one shown here and have:
 Increasing marginal returns initially
 Diminishing marginal returns eventually
- When the marginal
product of a worker
exceeds the marginal
product of the previous
worker, the marginal
product of labor
increases and the firm
experiences increasing
marginal returns.
- When the marginal
product of a worker is
less than the marginal
product of the previous
worker, the marginal
product of labor
decreases and the firm
experiences
diminishing marginal
returns.
Increasing marginal returns arise from increased specialization and division of
labor.
Diminishing marginal returns arises from the fact that employing additional
units of labor means each worker has less access to capital and less space in
which to work.
Diminishing marginal returns are so pervasive ( general ) that they are elevated
to the status of a “law.
The law of diminishing returns states that:
As a firm uses more of a variable input with a given quantity of fixed inputs, the
marginal product of the variable input eventually diminishes.
36
Average Product
Curve: Figure 11.3
shows the average
product curve and its
relationship with the
marginal product
curve.
-When marginal
product exceeds
average product,
average product
increases.
-When marginal
product is below
average product,
average product
decreases.
-When marginal
product equals
average product,
average product is at
its maximum.
Short-Run Cost
To produce more output in the short run, the firm must employ more labor,
which means that it must increase its costs.
We describe the way a firm’s costs change as total product changes by using
three cost concepts and three types of cost curve:
 Total cost
 Marginal cost
 Average cost
Total Cost
A firm’s total cost (TC) is the cost of all resources used.
Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not
change with output.
Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs
do change with output.
Total cost equals total fixed cost plus total variable cost. That is: TC = TFC + TVC
37
Figure 11.4 shows a
firm’s total cost curves.
Total fixed cost is the
same at each output
level.
Total variable cost
increases as output
increases.
Total cost, which is the
sum of TFC and TVC also
increases as output
increases.
Notice that the TP curve becomes steeper at low output levels and then less
steep at high output levels.
In contrast, the TVC curve becomes less steep at low output levels and steeper at
high output levels.
To see the relationship
between the TVC curve
and the TP curve, lets
look again at the TP
curve.
But let us add a second
x-axis to measure total
variable cost.
If wage rate is $25 per
worker, then:
1 worker costs $25; 2
workers cost $50: and
so on, so the two x-axes
line up.
38
We can replace the
quantity of labor on the
x-axis with total
variable cost.
When we do that, we
must change the name
of the curve. It is now
the TVC curve.
But it is graphed with
cost on the x-axis and
output on the y-axis.
Redraw the graph
with cost on the yaxis and output on
the x-axis, and you’ve
got the TVC curve
drawn the usual way.
Put the TFC curve
back in the figure,
and add TFC to TVC,
and you’ve got the TC
curve.
39
Marginal Cost
Marginal cost (MC) is the increase in total cost that results from a one-unit
increase in total product.
MP
MC
Max. point
Min. point
Labor
Output
-Over the output range with increasing marginal returns, marginal cost falls as
output increases.
-Over the output range with diminishing marginal returns, marginal cost rises as
output increases.
-When marginal output at its maximum point, marginal cost at its minimum
point.
Average Cost
Average cost measures can be derived from each of the total cost measures:
Average fixed cost (AFC) is total fixed cost per unit of output.
Average variable cost (AVC) is total variable cost per unit of output.
Average total cost (ATC) is total cost per unit of output : ATC = AFC + AVC
40
-The figure shows the MC,
AFC, AVC, and ATC curves.
The AFC curve shows that
average fixed cost falls as
output increases.
-The AVC curve is Ushaped. As output
increases, average variable
cost falls to a minimum
and then increases.
-The ATC curve is also
U-shaped.
-The MC curve is very
special.
-The outputs over which
AVC is falling, MC is below
AVC.
-The outputs over which
AVC is rising, MC is above
AVC.
The output at which AVC is
at the minimum, MC
equals AVC.
-Similarly, the
outputs over
which ATC is
falling, MC is
below ATC.
-The outputs
over which ATC
is rising, MC is
above ATC.
-At the
minimum ATC,
MC equals ATC.
41
Why the Average Total Cost
Curve Is U-Shaped?
-The AVC curve is U-shaped
because:
-Initially, marginal product
exceeds average product, which
brings rising average product
and falling AVC.
-Eventually, marginal product
falls below average product,
which brings falling average
product and rising AVC.
- The ATC curve is U-shaped for
the same reasons. In addition,
ATC falls at low output levels
because AFC is falling steeply.
Cost Curves and Product
Curves
The shapes of a firm’s cost
curves are determined by the
technology it uses:
-MC is at its minimum at the
same output level at which
marginal product is at its
maximum.
-When marginal product is
rising, marginal cost is falling.
-AVC is at its minimum at the
same output level at which
average product is at its
maximum.
When average product is rising,
average variable cost is falling.
42
Shifts in Cost Curves
The position of a firm’s cost curves depend on two factors:
 Technology
 Prices of factors of production
Technology
Technological change influences both the productivity curves and the cost
curves.
An increase in productivity shifts the average and marginal product curves
upward and the average and marginal cost curves downward.
If a technological advance brings more capital and less labor into use, fixed costs
increase and variable costs decrease.
In this case, average total cost increases at low output levels and decreases at
high output levels.
Prices of Factors of Production
An increase in the price of a factor of production increases costs and shifts the
cost curves.
An increase in a fixed cost shifts the total cost (TC ) and average total cost (ATC )
curves upward but does not shift the marginal cost (MC ) curve.
An increase in a variable cost shifts the total cost (TC ), average total cost (ATC ),
and marginal cost (MC ) curves upward.
Long-Run Cost
In the long run, all inputs are variable and all costs are variable.
The Production Function
The behavior of long-run cost depends upon the firm’s production function.
The firm’s production function is the relationship between the maximum output
attainable and the quantities of both capital and labor.
Chapter 13 : Commodities markets
Economists identify four market types: Perfect competition, Monopoly,
Monopolistic competition, and Oligopoly.
1.Perfect competition is a market structure with
 Many firms sell identical products to many buyers.
 No restrictions on entry of new firms to the industry
 Both firms and buyers are all well informed about the prices and products of
all firms in the industry.
 Established firms have no advantages over new ones.
2.Monopoly is a market structure in which
. One firm produces the entire output of the industry.
. There are no close substitutes for the product.
43
.There are barriers to entry that protect the firm from competition by entering
firms.
How Monopoly Arises
A monopoly has two key features: No close substitutes, and Barriers to entry.
-No Close Substitute:
 If a good has a close substitute, even if it is produced by only one firm,
that firm effectively faces competition from the producers of the
substitute.
 A monopoly sells a good that has no close substitutes.
-Barriers to Entry:
A constraint that protects a firm from potential competitors are called barriers to
entry. Three types of barriers to entry are:
a.Natural Barriers to Entry: A natural monopoly is an industry in which
economies of scale enable one firm to supply the entire market at the lowest
possible cost.
b.Ownership Barriers to Entry: An ownership barrier to entry occurs if one firm
owns a significant portion of a key resource.
c.Legal Barriers to Entry: A legal monopoly is a market in which competition and
entry are restricted by the granting of a Public franchise, Government license,
and Patent or copyright.
A monopoly is a price setter, not a price taker like a firm in perfect competition.
To sell a larger output, a monopoly must set a lower price.
Monopoly Price-Setting Strategies
 A single-price monopoly
 Price discrimination. Many firms price discriminate, but not all of them
are monopoly firms.
3.Monopolistic competition is a market structure with
 A large number of firms compete: which implies:
-Each firm has limited market power to influence the price of its product
-no one firm’s actions directly affect the actions of others.
 Each firm produces a differentiated product.
 Firms compete on product quality, price, and marketing.
 Firms are free to enter and exit the industry.
4.Oligopoly is a market structure in which
 A small number of firms compete.
 The firms might produce almost identical products or differentiated
products.
44

Barriers to entry limit entry into the market.
*Interdependence: With a small number of firms, each firm’s profit
depends on every firm’s actions.
*A Cartel: is an illegal group of firms acting together to limit output, raise
price, and increase profit.
Chapter 12: perfect competition
How Perfect Competition Arises
 When firm’s minimum efficient scale is small relative to market
demand so there is room for many firms in the industry.
 And when each firm is perceived to produce a good or service that
has no unique characteristics, so consumers don’t care which firm
they buy from.
Price Takers
 In perfect competition, each firm is a price taker.
 No single firm can influence the price, it must “take” the equilibrium
market price.
 Each firm’s output is a perfect substitute for the output of the other firms,
so the demand for each firm’s output is perfectly elastic.
Economic Profit and Revenue
The goal of each firm is to maximize economic profit, which equals total revenue
minus total cost.
-Total cost is the opportunity cost of production, which includes normal profit.
-A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P × Q.
-A firm’s marginal revenue is the change in total revenue that results from a
one-unit increase in the quantity sold.
Calculation of Total Revenue & Marginal Revenue
45
Quantity Sold
Q
Price
P
Total Revenue
TR= P×Q
Marginal
Revenue
=ΔTR / ΔQ
8
25
200
9
25
225
225 – 200 / 9 –
8 = 25
10
25
250
250 – 225 / 10
-9 = 25
Figure 12.1 illustrates
a firm’s revenue
concepts.
Part (a) shows that
market demand and
market supply
determine the market
price that the firm
must take.
Figure 12.1(b)
shows the firm’s
total revenue curve
(TR)—the
relationship
between total
revenue and
quantity sold.
46
Figure 12.1(c) shows
the marginal revenue
curve (MR).
The firm can sell any
quantity it chooses at
the market price, so
marginal revenue
equals price and the
demand curve for the
firm’s product is
horizontal at the
market price.
*The demand for a firm’s product is perfectly elastic because one firm’s sweater
is a perfect substitute for the sweater of another firm. But the market demand is
not perfectly elastic because a sweater is a substitute for some other good.
*A perfectly competitive firm’s goal is to make maximum economic profit, given
the constraints it faces.
So the firm must decide:
1. How to produce at minimum cost
2. What quantity to produce
3. Whether to enter or exit a market
We start by looking at the firm’s output decision.
The Firm’s Output Decision “Profit-Maximizing Output”
A perfectly competitive firm chooses the output that maximizes its economic
profit, by looking at the total revenue and the total cost curves (Economic Profit
= TR – TC ).
47
-Part (a) In Figure 12.2
shows the total revenue, TR,
curve.
-Part (a) also shows the total
cost curve, TC, which is like
the one in Chapter 11.
-Total revenue minus total
cost is economic profit (or
loss), shown by the curve EP
in part (b).
-At low output levels, the
firm incurs an economic
loss—it can’t cover its fixed
costs.
-At intermediate output
levels, the firm makes an
economic profit.
-At high output levels, the
firm again incurs an
economic loss—now the
firm faces steeply rising
costs because of diminishing
returns.
48
Marginal Analysis and Supply Decision
The firm can use marginal analysis to determine the profit-maximizing output.
Because marginal revenue is constant and marginal cost eventually increases as
output increases, profit is maximized by producing the output at which marginal
revenue, MR, equals marginal cost, MC.
Table 12-3 shows how we can use marginal analysis to determine the profitmaximizing output.
Quantity
Q
6
7
8
9
10
11
Total
Revenue
TR
150
175
200
225
250
275
Marginal
Revenue
MR
25
25
25
25
25
25
Total Cost
TC
126
141
160
185
212
245
Marginal
Cost
MC
12
15
19
25
26
33
Economic
Profit
( TR – TC)
24
34
40
40
38
30
The firm
maximizes
its
economic
profit
when it
produces 9
sweaters a
day.
49
-Figure 12.3 shows the
marginal analysis that
determines the profitmaximizing output.
-If MR > MC, economic
profit increases if output
increases.
-If MR < MC, economic
profit decreases if output
increases.
-If MR = MC, economic
profit decreases if output
changes in either
direction, so economic
profit is maximized.
Profits and Losses in the Short Run
Maximum profit is not always a positive economic profit.
To determine whether a firm is making an economic profit or incurring an
economic loss, we compare the firm’s average total cost at the profit-maximizing
output with the market price.
Output, Price, and Profit in the Short Run
The next figures show the three possible profit outcomes.
In part (a) price equals
average total cost and
the firm makes zero
economic profit (breaks
even).
50
In part (b), price
exceeds average
total cost and the
firm makes a
positive economic
profit.
In part ( c ),
price is less
than the
average total
cost and the
firm incurs an
economic loss –
economic profit
is negative.
51
The Firm’s Output Decision
Temporary Shutdown Decision
If the firm makes an economic loss it must decide to exit the market or to stay in
the market.
If the firm decides to stay in the market, it must decide whether to produce
something or to shut down temporarily.
The decision will be the one that minimizes the firm’s loss.
Loss Comparison
The firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus
total revenue (TR).
Economic loss = TFC + TVC  TR
= TFC + (AVC  P) × Q
If the firm shuts down, Q is 0 and the firm still has to pay its TFC. So the firm
incurs an economic loss equal to TFC. This economic loss is the largest that the
firm must bear.
-A firm’s shutdown point is
the price and quantity at
which it is indifferent
between producing and
shutting down.
-This point is where AVC is
at its minimum (where MC
crosses the AVC).
-The firm incurs a loss equal
to TFC from either action.
-Minimum AVC is $17 a
sweater.
-If the price is $17, the
profit-maximizing output is
7 sweaters a day.
-The firm incurs a loss equal
to the red rectangle.
-If the price of a sweater is
between $17 and $20.14, the
firm produces the quantity
at which marginal cost
equals price.
The firm covers all its
variable cost and at least
part of its fixed cost.
It incurs a loss that is less
than TFC.
52
The Firm’s Supply Curve
A perfectly competitive firm’s supply curve shows how the firm’s profitmaximizing output varies as the market price varies, other things remaining the
same.
Because the firm produces the output at which marginal cost equals marginal
revenue, and because marginal revenue equals price, the firm’s supply curve is
linked to its marginal cost curve.
But at a price below the shutdown point, the firm produces nothing.
-Figure 12.5 shows how
the firm’s supply curve is
constructed.
-If price equals minimum
AVC, $17 in this example,
the firm is uninterested
between producing
nothing and producing at
the shutdown point, T.
-If the price is $25, the
firm produces 9 sweaters
a day, the quantity at
which P = MC.
-If the price is $31, the
firm produces 10 sweaters
a day, the quantity at
which P = MC.
-The blue curve in part (b)
traces the firm’s short-run
supply curve.
53
Market Supply in the Short Run
The short-run market supply curve shows the quantity supplied by all firms in
the market at each price when each firm’s plant and the number of firms remain
the same.
-The figure shows the
supply curve for a
market that has 1,000
firms like Campus
Sweaters.
-The quantity supplied by
the market at any given
price is the sum of the
quantities supplied by all
the firms in the market at
that price.
-At a price equal to
minimum AVC, the
shutdown price, some
firms will produce the
shutdown quantity and
others will produces zero.
-The market supply curve
is perfectly elastic.
Short-Run
Equilibrium
Short-run market
supply and market
demand determine
the market price and
output.
54
A Change in Demand
-An increase in
demand bring a
rightward shift of the
market demand curve:
The price rises and the
quantity increases.
-A decrease in demand
bring a leftward shift of
the market demand
curve: The price falls
and the quantity
decreases.
55