1. Definition of Economics
Scarcity
All economic questions arise because we are unable to satisfy all our wants.
Our inability to satisfy all our wants is called scarcity.
Economics is the social science that studies the choices that we make as we cope with scarcity and the institutions that have evolved to influence and reconcile our choices.
No definition of economics can adequately capture the subject. For that reason, some teachers don’t like definitions and skip right over them. If you are one of these teachers, go ahead. Not much is lost.
Other teachers regard a basic definition as essential, and the textbook takes this view. The definition in the text…“the social science that studies the choices that we make as we cope with scarcity and the institutions that have evolved to influence and reconcile our choices,” is a modern language version of Lionel Robbins famous definition, “Economics is the science which studies human behaviour as a relationship between ends and scarce means that have alternative uses.”
Some teachers like to play with definitions a bit more elaborately. If you are one of these, here are four more, all of which add some useful insight, and the last one, a bit of fun:
John Maynard Keynes: “The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps it possessors to draw correct conclusions.”
Alfred Marshall: “Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.”
Jacob Viner: “Economics is what economists do.”
Jim Duesenberry: “Economics is all about how people make choices. Sociology is about why there isn’t any choice to be made.”
1-1

2. Definition: Economics
Economics is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided.
Economics is the study of how scarce resources are allocated among conflicting demands.

3. The Scope of Economics Microeconomics Macroeconomics
Microeconomics is the study of choices made by individuals and businesses, the way these choices interact, and the influence that governments exert on them.
Macroeconomics
Macroeconomics is the study of the effects on the national and global economy of the choices that individuals, businesses, and governments make.
This note is based on Hal Varian in the New Palgrave Dictionary of Economics, Volume 3, pp Items enclosed in quotation marks are direct quotes from Varian.
“The origins of the terms microeconomics and macroeconomics are surprisingly obscure.”
Fritz Machlup, writing in 1963, says that Ragnar Frisch introduced the terms in But the work cited by Machlup does not contain the words. Instead, it talks about micro-dynamics and macro-dynamics.
The micro-macro distinction became popular after Keynes published the General Theory, but Keynes didn’t use the terms. Nonetheless, Keynes thought the distinction, properly stated, to be a relevant one. Keynes said that the right dichotomy is between:
1. The Theory of the Individual Industry or Firm and the rewards and the distribution of a given quantity of resources, (micro?) and
2. The Theory of Output and Employment as a whole. (macro?) [Keynes italics in both parts.]
P. De Wolff, Economic Journal 1941 seems to be the first person to use the terms in print, but with hyphens—micro-economics and macro-economics.
Modern usage has micro dealing with individual—disaggregated—situations and macro dealing with aggregates. The Keynesian distinction between the economics of full employment and the economics of under-employment, while an interesting distinction, does not capture the flavour of the distinction in practice today.
The definitions of micro and macro that we give here are based on this modern usage (and are in agreement with Varian’s dictionary entry).
1-3

4. The Scope of Economics

5. Opportunity Costs
The opportunity cost of something is that which we give up when we make that choice or decision.
The implication is that all decisions involve trade-offs.
“There’s no such thing as a free lunch!!”

6. Margins and Incentives
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.
1-6

7. The Theory of Comparative Advantage
Ricardo’s theory that specialization and free trade will benefit all trading parties, even those that may be absolutely more efficient producers.
A person or country is said to have a comparative advantage in producing a good if it is relatively more efficient than a trading partner at doing so. In other words they have a lower opportunity cost.

8. 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.
The production possibility frontier (PPF) is the first economic model the students see.
Your first challenge is to ensure that the students understand the mechanics of the model. You can provide some help in the classroom, but you main goal must be to get the students working—to develop good work habits. Encourage them to do the end-of-chapter problems, study guide questions, and Economics in Action tutorial and quiz so that they are comfortable with the mechanics of this chapter. Also encourage them to use the diagnostic quizzes on the Web site and follow the “8 steps to success in economics” in reviewing their understanding.
2-8

9. Production Possibilities and Opportunity Cost
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.
2-9

10. Production Possibilities and Opportunity Cost
A move from C to D increases butter production by 1 tonne.
Guns production decreases from 12 units to 9 units, a decrease of 3 units.
The opportunity cost of 1 tonne of butter is 3 units of guns.
One tonne of butter costs 3 units of guns.
2-10

11. 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.
2-11

12. Using Resources Efficiently
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 or service, the smaller 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.
2-12

13. 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, and we are producing at the point on the PPF that we prefer above all other points.
The point of allocative efficiency is the point on the PPF at which marginal benefit equals marginal cost.

14. Determinants of Household Demand:
The price of the product in question
The income available to the household
The households amount of accumulated wealth
The prices of other products available
Tastes and preferences
Expectations about future income, wealth, and prices
Population

15. Changes in Quantity Demanded vs. Changes in Demand
Changes in the price of a product affect the quantity demanded per period. Changes in any other factor, such as income or preferences, affect demand. An increase in income, for instance, tends to increase demand. While a drop in prices will increase the quantity demanded.

16. The Law of Demand
The negative relationship between price and quantity demanded. As price rises, quantity demanded decreases. As price falls, quantity demanded increases
This is why we observe a negative slope in demand curves.

17. Substitution Effect When the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded decreases. When the price of a product falls, that product becomes more attractive relative to potential substitutes. Income Effect When the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded decreases. When the price of a product falls, a consumer has more purchasing power with the same amount of income and is better off.

18. Income as a Determinant of Demand
Income: The total of all earnings received by a household in a given period of time
Normal Goods: Goods for which demand goes up when income is higher and for which demand goes down when income is lower.
Inferior Goods: Goods for which demand falls when income rises.

19. Prices of Other Goods and Services as Determinants of Demand
Substitutes: Goods that can serve as replacements for one another; when the price of one increases, demand for the other goes up.
Perfect substitutes are identical products.
Complements: Goods that “go together”; when the price of one increases, demand for the other goes down, and vice versa.

20. Other Determinants of Household Demand:
Tastes and Preferences - These are quite subjective and tend to change over time.
Expectations - With respect to future income, wealth, prices, and availability.

21. Shift of Demand vs. Movement Along Demand Curve
Shift of a demand curve is the change that takes place in a demand curve when a new relationship between the quantity demanded of a good and the price of that good is brought about by a change in the original conditions.
Movement along the demand curve is what happens when a change in price causes quantity demanded to change.

22. Anna’s Demand for Telephone Calls -A Change in Quantity Demanded
$15.00 30
$10.00
$7.50
$3.50
$ .50 25 7 3 1
Quantity demanded
Price
The graph shows a shift in quantity demanded from 3 to 7 caused by a change in price from $7.50 to $3.50.

23. Anna’s Demand for Telephone Calls - A Change in Demand
$15.00
When any factor except price changes the relationship between price and quantity is different; there is a shift of the demand curve, in this case from D1 to D2.
$10.00
$7.50
$3.50 30 25 D1 D2
$ .50 1 3 7

24. Changes in Demand: Prices of Related Goods
Price of hamburger rises P P Q
Quantity of hamburger demanded falls D1 D2 D2 D1
Demand for complement good (ketchup) shifts left Q
Demand for substitute
good (chicken) shifts right Q

25. From Household to Market Demand
Demand for a good or service can be defined for an individual household, or for a group of households that make up a market.
Market demand may be defined as the sum of all the quantities of a good or service demanded per period by all the households buying in the market for that good or service.

26. Deriving market demand from the individual demand curves:P P P
$3.50 DA
$3.50 DC DB
$3.50
$1.50
$1.50
$1.50 4 8 Qd 3 Qd 4 9 Qd
Price
Market Demand
$3.50
$1.50 8 20 Qd

27. Supply
A firm’s decision about what quantity of product to supply depends on:
The price of the good or service
The cost of producing the product which depends on:
The price of required inputs (land, labour, capital)
The technologies to be used to produce the product
The prices of related products
Expected future prices
The number of suppliers

28. Quantity Supplied and The Law of Supply
Quantity Supplied : The amount of a particular product that a firm would be willing and able to offer for sale at a particular price during a given time period.
The Law of Supply : The positive relationship between price and quantity of a good supplied. An increase in market price will lead to an increase in quantity supplied, and a decrease in market price will lead to a decrease in quantity supplied.

29. An increase in the quantity supplied
Changes in Quantity Supplied vs. Changes in Supply: Changes in quantity supplied imply movement along a supply curve. Changes in supply imply a shift in the entire supply curve. P P S S1 S2 Q Q
An increase in supply
An increase in the quantity supplied

30. From Individual Firm to Market Supply: Market Supply
The supply of a good or service can be defined for an individual firm, or for a group of firms that make up a market or an industry.
Market Supply : The sum of all the quantities of a good or service supplied per period by all the firms selling in the market for that good or service.
As with market demand, market supply is the horizontal summation of the individual firms’ supply curves.

31. From Individual Firm to Market Supply

32. Market Equilibrium
The operation of the market depends on the interaction between suppliers and demanders.
An equilibrium is the condition that exists when quantity supplied and quantity demanded are equal.
At equilibrium, there is no tendency for the price to change.

33. Market Equilibrium P S E PE D Q QE

34. Excess Demand: is the condition that exists when quantity demanded exceeds quantity supplied at the current price.
At $85 per tonne quantity demanded exceeds quantity supplied by 2500 tonnes.
Excess demand tends to lead to an increase in prices.

35. Excess Supply: Excess supply is the condition that exists when quantity supplied exceeds quantity demanded at the current price.
At $150, quantity supplied exceeds the quantity demanded by 2000 tonnes.
This causes prices to fall

36. Price Elasticity of Demand
The price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in price.
Price Elasticity of Demand = % change in quantity demanded % change in price

37. Inelastic Demand
Perfectly inelastic demand is demand in which quantity demanded does not respond at all to a change in price.
An example could be the demand for insulin.
Inelastic demand is demand that responds somewhat, but not a great deal, to changes in price. Inelastic demand always has a numerical value between zero minus one.
An example would be the demand for housing or telephone service.

38. Unitary Elasticity
Unitary elasticity is a demand relationship in which the percentage change in quantity of a product demanded is the same as the percentage change in price.
The elasticity is always equal to minus one.

39. Elastic Demand
Elastic demand is a demand relationship in which the percentage change in quantity demanded is larger in absolute value than the percentage change in price.
The demand elasticity has an absolute value greater than one.
An example could be the demand for bananas or any other product for which there are close substitutes.
Perfectly elastic demand is demand in which quantity demanded drops to zero at the slightest increase in price.
An example could be the demand for wheat on the world market, or any other good that can only be sold at a predetermined price.

40. Demand Curves and ElasticityP P D D Q Q
Perfectly elastic
Relatively elastic D P P D Q Q
Perfectly inelastic
Relatively inelastic

41. Elasticity and Total Revenue
Effect of a price increase on a product with inelastic demand: P x Qd = TR
Effect of a price increase on a product with elastic demand: P x Qd = TR
Effect of a price cut on a product with elastic demand: P x Qd = TR
Effect of price cut on a product with inelastic demand: P x Qd = TR

42. Relationship Between Elasticity and Total Revenue

43. Determinants of Demand Elasticity
Availability of substitutes
When substitutes are not readily available, demand is likely to be less elastic.
The importance of being unimportant
When an item represents a small proportion of our total budget, demand is likely to be less elastic.
The time dimension
In the longer run, demand is likely to become more elastic, or responsive, because households make adjustments over time.

44. Other Important Elasticities
Income elasticity of demand
Measures the responsiveness of demand with respect to changes in income
If the income elasticity of demand is greater than 1, demand is income elastic and the good is a normal good.
If the income elasticity of demand is greater than zero but less than 1, demand is income inelastic and the good is a normal good.
If the income elasticity of demand is less than zero (negative) the good is an inferior good.
Cross-price elasticity of demand
A measure of the response of the quantity of one good demanded to a change in the price of another good
The cross elasticity of demand for a substitute is positive.
The cross elasticity of demand for a complement is negative.
Elasticity of supply
A measure of the response of the quantity of a good supplied to a change in the price of that good. Likely to be positive in output markets

45. Efficiency: A Refresher
An efficient allocation of resources occurs when we produce the goods and services that people value most highly.
Resources are allocated efficiently when it is not possible to produce more of a good or service without giving up some other good or service that is valued more highly.
The substance of this section is identical to Chapter 2, pp. 35–37. Send the students back to Chapter 2 to emphasize the fact that they are building on what they’ve learned before. Emphasize that learning economics isn’t memorizing facts, but understanding principles and ideas, and that one idea builds on another. Explain that this section provides an alternative example of the same ideas as those in Chapter 2 and serves as a springboard for going forward. It also illustrates the connection between what they’ve learned about demand, supply, market price, and quantity in Chapter 3 and what they learned about efficiency in Chapter 2.
5-45

46. Value, Willingness to Pay, and Demand
The value of one more unit of a good or service is its marginal benefit, which we can measure as maximum price that a person is willing to pay.
A demand curve for a good or service shows the quantity demanded at each price.
A demand curve also shows the maximum price that consumers are willing to pay at each quantity.
The only thing that students sometimes get hung up on is the exact shape of the consumer surplus area—steps versus the complete triangle. The point isn’t worth labouring, but if students raise the matter and are curious, you might explain that we’re assuming that the good (pizza in the example) is finely divisible so that the whole triangle is (approximately) the consumer surplus.
[You will look at consumer surplus again if you cover marginal utility theory.]
5-46

47. Cost, Minimum Supply-Price, and Supply
The cost of one more unit of a good or service is its marginal cost, which we can measure as minimum price that a firm is willing to accept.
A supply curve of a good or service shows the quantity supplied at each price. A supply curve also shows the minimum price that producers are willing to accept at each quantity.
A similar issue about the shapes of the areas arises here too. You might want to emphasize that the total revenue of the producer is the rectangle whose corners are (0, 0) and (P, Q). This total revenue divides into cost and producer surplus, and the supply = marginal cost curve marks the boundary for the division.
The issue is not likely to arise at this point in the course, but you might like to keep the relationship between producer surplus and economic profit up your sleeve for later. The textbook doesn’t spend any time on this relationship because for most students, it is too esoteric. But, a few thoughtful students may want to know. You can explain that producer surplus = total revenue minus total variable cost; economic profit = total revenue minus total cost; so producer surplus = economic profit plus total fixed cost. Don’t try to explain this now. Wait until you get a question when you’re in Chapter 9, 10, 11, or 12.
5-47

48. Producer Surplus, Consumer surplus
Producer surplus is the price of a good minus the marginal cost of producing it, summed over the quantity sold.
Producer surplus is measured by the area below the price and above the supply curve, up to the quantity sold.
Consumer surplus is the value of a good minus the price paid for it, summed over the quantity bought.
It is measured by the area under the demand curve and above the price paid, up to the quantity bought.
5-48

49. Is the Competitive Market Efficient?
At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the efficient quantity.
The sum of consumer and producer surplus is maximized at this efficient level of output.
The A-D-M proof is deeper and more restricted that the arm waving words and diagrams of a principles text. But we do not mislead our students by being enthusiastic and amazed at the astonishing proposition. Selfish people all pursuing their own ends and making themselves as well off as possible end up allocating resources in such a way that no one can be made better off (qualified by the exceptions that we quickly note in the chapter).
Don’t get hung up on the mechanics of how the obstacles to efficiency work. Just note at this stage that they bring either underproduction or overproduction and emphasize the deadweight loss that they generate. You will go into the details in later chapters. The list is a guide to what is coming.
In the overproduction case, you might like to bring the PPF back into the story and point out that the overproduction of one good means the underproduction of some other good. If you’re brave, you might want to explain that in the two-goods world of the PPF, you get the complete efficiency analysis by looking at only one of the markets. If you use guns and butter again, the overproduction of guns implies the underproduction of butter. You can measure the deadweight loss in either the market for guns (overproduction like Figure 5.7b) or in the market for butter (underproduction like Figure 5.7a). Make this extension only with bright students in an honours section.
5-49

50. Is the Competitive Market Efficient?
Obstacles to Efficiency
Markets are not always efficient. Obstacles to efficiency are:
Price ceilings and floors
Taxes, subsidies, and quotas
Monopoly
Public goods
External costs and external benefits
5-50

51. Is the Competitive Market Efficient?
Figure shows the effects of underproduction.
The efficient quantity is 10,000 pizzas a day.
If production is restricted to 5,000 pizzas a day, a deadweight loss arises from underproduction.
5-51