Economics Notes

Definition of Economics Economics studies the human behavior involved in satisfying

many wants with scarce resources that have alternate uses.

The economic problem = SCARCITY

Economic resources (or factors of production)
= Anything that can be used to make goods and services available.

1) Land
free gifts of nature all natural resources
2) Labor
All human input (physical or mental)
3) Capital
Man-made aids to production (e.g. tools and machines) and finance
4) Enterprise
An entrepreneur combines the other economic resources and takes risks (have to
decide what to make/do with the resources businessman). They organize the
other factors of production.

Economic goods and free goods
Economic goods goods that require scarce economic resources to be used up
Free goods goods that do not require scarce economic resources to be used up (e.g. sea
water, sand)

Opportunity Cost
The value of the next best alternative given up by a course of action.
Example 1 bought a coke opportunity cost = fanta
What else could you have done/bought as a result instead
Example 2 - Could have been at home instead of economics class
Due to scarcity we have to make these decisions all the time. If a good or service has an
opportunity cost then it must be relatively scarce, so it will have a price and be classified as
an economic good.

A production possibility Frontier (PPF)

-A PPF shows all the combinations of two sets of goods which could be produced if all
economic resources are fully used (must be on the line if using all economic resources)
-The slope/gradient of the PPF represents opportunity cost (all different point on the
graph)
-In our case, the opportunity cost of agricultural goods increases as we increase Agricultural
production
-The principal of increasing costs states that as the production of a good expands, the
opportunity cost of producing another unit generally increases.
This is due to the fact that most economic resources are specialized




Graph 1
















Graph 2 Graph 3

















Graph 4 Graph 5














Value Judgments
(or a normative statement)
Economics is better than business = Value judgment
-Based on opinion/belief
-Cannot be proved or disproved as a result of empirical investigation (of the facts)
Economists try to stay away from value judgments

Positive Statement
-Can be proven to be correct or not by empirical investigation
Example: Melissa is 1m72 - can measure her height to prove/disprove this.

Rationality
Economists assume producers, consumers and workers (economic actors) are all rational
expected to work in a way that maximizes our satisfaction.
Consumers max value and lowest prices
Producers get high prices and workers to work as long as possible for lowest possible
wages.
Acting irrationally = opposite

Utility
The satisfaction or benefit gained from the consumption of a good or service. Consumers
expected to spend their money in a way that maximizes their utility (choose something that
gives them the greatest satisfaction.

The Margin
Consumers often take spending decisions one by one (if they have extra money they may
consider the extra utility producers are alike. They may thing what will happen to their
profits if they produce one or more good operating on the margin.)

Economic Growth
Economic Growth is an increase in the capacity of an economy to produce goods and
services, compared from one period of time to another. It refers to an economy that is
getting bigger, not necessarily better. Measure of the increase in economic activity or
national income per capita.

Economic Development
Economic development is a measure of welfare or well-being. Measured by Gross Domestic
Product (GDP) as well as education, health, and social indicators.

Demand and Supply

Market
In economic theory a market is where buyers and sellers come together to carry out an
economic transaction. Markets can be physical places where goods and services are
exchanged for money, but there are also other ways that economic transactions can be
made such as online where products are sold with the use of credit cards or money
transfers.
Product markets where goods and services are bought and sold
Factor markets labor markets, financial markets, stock markets etc

Demand
Demand is the quantity of a good or service that consumers are willing and able to purchase
at a given price in a given time period.
Willingness and ability although consumers may be willing, they must be able (have the
financial means to buy the product)
This is known as effective demand (demand backed up by money - economists not focused
on needs or wants) and is shown on the demand curve.

A demand curve shows how the quantity demanded of a good or service per unit of time
will change as the price of that good changes, holding all other things constant.
Cetaris Paribus holding all other things equal/constant.

According to the law of demand, more is demanded at a lower price rather than a higher
price - why the demand curve (normally) slopes downwards.

Demand is influenced by 2 sets of factors
1.The price of the good in question
When the price changes, the curve doesnt change, instead there is movement along the
demand curve.
Extension in demand caused by a FALL in price of the good
Contraction in demand caused by a RISE in price of the good
Graph












2. Non-price determinants of demand (conditions of demand)
a) Prices of related goods
Substitutes if the price of butter rises, the QD for margarine increases.
The demand for a good varies directly with the price of its substitute.
Complements (products that are often purchased together) If the price of petrol rises, the
price for petrol-thirsty cars will decrease
The demand for a good varies indirectly (inversely) with the price of any complement.
Unrelated Goods If products unrelated, the change in price will have no effect on the other.

b) Consumer Incomes
Normal Goods defined as goods for which demand rises as income rises (demand curve
will increase/shift to the right)
Inferior Goods if a good is considered inferior, the demand for a product will fall as income
rises and the consumer starts to buy higher priced substitutes in place of the inferior good.
(e.g. Zeeman is an inferior good. If income rises consumers will shop at H&M instead)
c) Fashion, Advertising, etc.

d) Demographic Factors
Demography study of population (e.g. as the life expectancy in Holland rises, the demand
for certain goods will increase.

Diminishing Marginal Utility
How much satisfaction/benefit will you get from one more?
Why does the demand curve slope downward marginal utility decreases (if you have one
sofa, you would not need another as much.)
It is the amount by which the consumption of one more good or service increases total
utility.
- For most goods MU gets smaller as we consume more but there are exceptions such as
heroin and stamps.
According to the principle of DMU, additional units of a good make successively smaller
contributions to the total satisfaction of the consumer.

Since the general MU declines, people will only buy more of a good if the price falls. People
will buy more of a good as long as its MU is greater than its price.

Optimal Purchase Condition (P=MU)
We would imagine someone would continue to buy gold as long as MU is greater than P
the optimal purchase condition.
DMU helps explain 1. Why the demand curve slopes downward and 2. Diamonds-water
paradox
- Not everything that is scarce has lots of value. Measured by marginal utility (different
things have different marginal utility.)
When we buy goods we are comparing price with marginal utility, NOT total utility. In
Holland the MU of water is relatively low which helps explain the low price for water
relative to diamonds (Diamonds-water paradox)

Consumer Surplus
The consumer surplus is the difference between how much buyers are prepared to pay for
a good and what they actually pay. Producers will think of ways to reduce consumer
surplus if possible.
Everyone has different marginal utility; therefore in practice everybody is willing to pay a
different amount.
Graph












Market demand curve
Add up all the individual demands (sum of all individual demand curves)

Supply
Supply is the willingness and ability of producers to produce a quantity of a good or service
at a given price in a given time period.
Willingness and ability although producers may be willing, they must be able (have the
financial means to produce the product)
This is known as effective supply (supply backed up by money) and is shown on the supply
curve.
According to the Law of supply, as the price of a product rises, the quantity supplied of the
product will usually increase, ceteris paribus. Why the supply curve slopes upwards.

Supply is influenced by 2 sets of factors
1.The price of the good in question
When the price changes, the curve will remain the same
Extension Caused by a RISE in price of the good
Contraction Caused by a FALL in price of the good
(Opposite to demand)
Graph












2. Non-price determinants of Supply (conditions of supply)
a) Changes in the price of necessary economic resources
e.g. a rise in price of labor will mean at any given price less will be supplied (resources
needed to make that good) decrease or increase in supply

b) State of technology
Improvements in the state of technology will generally cause for an increase in supply. In
the event of severe natural disasters there may be a backwards step in state of technology
causing a decrease in supply (although unlikely)

c) Weather (for some goods)
e.g. good harvest conditions will cause the supply of wheat to increase.

d) Government Intervention
-Government production taxes (VAT/BTW)
e.g. an increase in VAT will raise the production cost in effect and supply for any given price.
Supply decreases
-Government subsidies (payments made by the government to firms that will, in effect,
reduce their costs). Supply increases - shifts to the right

e) Price of related goods
- Joint supply when two or more goods are produced together so that a change in the
supply affects the supply of another (e.g. beef and leather)
-Competitive Supply goods in competitive supply are alternate products that a business
could make with its economic resources (e.g. land used for wheat or corn)

f) Expectations
e.g. producers may be optimistic (or not) about future sales

Graphs













Producer Surplus
The difference between the price producers are willing to receive (market price) and the
price at which (some) producers are willing to supply.
Graph












Producer Surplus + Consumer surplus = Community Surplus

Market Equilibrium
Equilibrium is where the supply and demand curves intersect (where QD=QS)

Shortage and Surplus
Surplus when supply is greater than demand decrease in price of good
Shortage when demand is greater than supply increase in price
If there is a surplus, we would expect (in a free market) that the price would fall until it
reaches equilibrium.
If there is a shortage, the price would rise.
In the market economy, the price will adjust in order to equalize QD and QS.

* Also known as excess Supply and Demand

Graphs












Resource Allocation
How we use our resources (they are SCARCE)
In a market economy, price has a signaling and incentive function. If the demand for I-pads
increases, the price will rise and that will be a sign to Apple to use more resources to make
I-pads. If the demand for BlackBerrys decreases, that will be a signal for fewer resources to
be used in their production. If the cost of producing oil increases, the rise in price will be a
signal for consumers to economize on their use of petrol.

Linear Demand and Supply Functions
In economics QD/QS is dependent on P (ceteris paribus). This means that P is the
independent Variable and QD/QS is the dependent variable. But in economics it is the
convention to put P on the Y-axis and Q on the X-axis.
In math slope= Rise/Run
In economics slope = Run/Rise (QD/P)

Linear demand Function
Demand Function = an equation showing the relationship between the market demand for a
product and the price of the product.

QD = a bP

QD= Quantity demanded
P= Price
a= The quantity that would be demanded if price were zero
b= sets the slope of the curve

A change in the a term causes a shift (increase or decrease) in the demand curve.
A change in the b term causes a change in the steepness/tilt of the line. As the absolute
value of the slope rises, the demand curve gets flatter and as the absolute value of the slope
falls, the demand curve will be steeper (demand curve with slope -20 will be flatter than
demand curve with slope -10).


Linear Supply Function
Supply Function = an equation showing the relationship between the market supply for a
product and the price of the product.

QS = c dP

QS= Quantity Supplied
P= Price
c= Quantity that would be supplied if the price were zero
d= sets the slope of the curve

A change in the c term causes a shift (increase or decrease) in the supply curve.
A change in the b term causes a change in the steepness/tilt of the line.
As the value of the slope rises, the supply curve gets flatter and as the absolute value of the
slope falls, the supply curve will be steeper (supply curve with slope 500 will be flatter than
demand curve with slope 400).

Remembering SLOPE
- Demand curve= flatter line when smaller slope
- Supply curve = flatter line when bigger slope

Calculating Equilibrium Price and Quantity
Example










Calculating Surplus at a given Price
Example










Consumer and Producer Surplus
Consumer Surplus The difference between how much buyers are prepared to pay for a
good and what they actually pay
Producer Surplus The difference between the market price producers receive and the
price at which they are prepared to supply
Producer Surplus + Consumer surplus = Community Surplus
Equation A= bh (area of a triangle)
Graph















Allocative Efficiency
The sum of consumer and producer surplus equals community surplus
-In theory, a free market should lead to the community surplus being maximized so it is the
optimum allocation of resources from societys point of view.

Community Surplus
If consumers decide they want more of a good, demand increases which raises price signal
for producers to use more resources.
If resources become in short supply, the price will rise sign for consumers to reduce
demand for the good.
Community Surplus1 Community Surplus2 = Net Welfare Loss

Market Failure (Welfare Loss)
If market does not function properly, the price mechanism gives out the wrong signs and
resources are not allocated properly in societys point of view.
Monopoly = one company that dominates the market
Community Surplus1 Community Surplus2 = Net Welfare Loss
Graph









Government Intervention in the Price Mechanism
1) Minimum Wage
The least amount you are legally allowed to be paid.
The lower the wage, the more people/workers (more workers as wages fall). As the
minimum wage goes up, more people want to work.
Graph













For min. wage to have an impact, it must be above the EQ
For social reasons, many governments have min. wages to prevent worker exploitation but
this simply creates a surplus of unemployed workers and the number of workers in
employment falls from EQ to Q1 as a result of the min. wage.

2)Price Ceiling
This is a situation where the government sets a maximum price, below the equilibrium
price, which prevents producers from raising the price above it. Price ceilings usually set to
protect consumers and they are usually imposed in markets where the product in question
is a necessity and/or merit good (a good that would be underprovided if the market were
allowed to operate freely.
e.g. During WW2 there were food shortages which lead the government to implement a
price ceiling. This, however, lead to excess demand. The excess demand caused for there to
be informal markets (black markets) where the products would then be sold for even more
than the EP and long queues in shops.
Graph











Ways government may try to reduce the shortage:
-Shift supply curve to the left (until equilibrium is reached at price ceiling): but this would
limit the consumption of the product, which goes against the point of imposing the max
price.
-Shift the supply curve to the right (until equilibrium is reached at price ceiling with more
being supplied and demanded): 1) government could offer subsidies to the firms to
encourage them to produce more, 2) the government could start to produce the product
themselves thus increasing supply or 3) if the government had previously stored some of
the product, then they could release some of the stock (although not possible with all goods
e.g. bread perishable good).

3)Price Floor
This is a situation where the government sets a minimum price, above the equilibrium
price, which then prevents the producers from reducing the price below it.
Mostly set for one of two reasons: 1) To attempt to raise incomes for producers of goods
and services that the government thinks are important, such as agricultural products or 2)
to protect workers by setting a minimum wage, to ensure that workers earn enough to lead
a reasonable existence.
Graph



































Elasticity
A measure of responsiveness. It measures how much something changes when there is a
change in one of the factors that determines it.

Price Elasticity of Supply (PES)
Definition The responsiveness of quantity supplied to a change in price.
Formula
% change in QS
% change in P
If PES>1 supply is elastic
If PES<1 supply is inelastic
If PES=1 unit elasticity
Diagrams








Elasticity of Demand
A measure of how much the demand for a product changes when there is a change in one of
the factors that determine demand.
Three elasticities of demand to consider:
1. Price elasticity of Demand (PED)
2. Cross elasticity of Demand (XED)
3. Income elasticity of Demand (YED)

Price Elasticity of Demand (PED)
Definition Price Elasticity of demand is a measure of how much the quantity demanded of
a product changes when there is a change in the price of the product. It is usually calculated
by using the following equation:

PED= % change QD
% change P

(percentage change = dif/start x100)

When PED < 1, demand is inelastic (not very elastic)
When PED > 1, demand is elastic (very responsive)
When PED = 1, there is unit elasticity (% change QD = % change P)
Diagrams







Determinants of PED
-Availability of substitutes (the more substitutes, the more elastic demand)
-Time (the longer the time period considered, the more elastic demanded)
-% of income (If a good represents a small % of income, e.g. matches, demand is inelastic)
-Degree of necessity (the more it is necessary, the less elastic)

PED slope
Even when the demand curve is a straight line, with a constant slope, PED differs at all
points along the demand curve. This is because if we consider the top half of the demand
curve, where we have high prices and low quantities a change of say 10 units will
represents a small proportion of price and a large proportion of QD therefore demand is
elastic.

PED and Revenue Boxes
1) rise in price where demand is
inelastic





2) fall in price where demand is
inelastic
3) rise in price where demand is
elastic





4) fall in price where demand is
elastic






Cross Elasticity of Demand (XED)
Definition Responiveness of the demand for good X to a change in price of good Y
Formula
% change QD good X
% change P good Y

signs are important here!

Examples
-If the price of mars bars rises 10% and the QD for twix rises 9%
XED = 9/10 = 0.9
These two products are substitutes. They always get a positive number.

-If the price of petrol falls 10% and the QD for Porsche cars rises 8%
XED = 8/-10 = -0.8
These two products are complements. They will get a negative number.

-For unrelated goods
XED = 0
Unrelated goods will not affect each other.

Most businesses, especially in competitive markets, will have a good idea about relative
XEDs.

Income Elasticity of Demand (YED)
Definition The responsiveness of QD to a change in income.
Formula

% change QD
% change Y

For normal goods demand rises as income rises So YED is Positive (+)
For inferior goods, as income rises, demand falls So YED is negative (-)
For necessities such as salt, sugar, etc. income demand is relatively inelastic So we will
typically get a number less than 1 but greater than 0 (0<x<1) you would likely buy a bit
more, but not a lot more.
For luxury goods, YED will be a bigger positive number (larger than 1)